Europe: Needs stronger growth to offset US slowdown, says UN body

by Chakravarthi Raghavan

Geneva, 9 May 2001 - The US slowdown, and Japan’s continued weaknesses, makes it imperative that the EU adopt policies to stimulate growth, the UN regional economic body asserted Wednesday.

In its report, ‘Economic Survey of Europe, 2001 No.1,’ the UN’s Economic Commission for Europe (ECE) said that the short-term outlook for the western market economies is not very favourable now, because of the sharp slowdown in the US, the stalled recovery in Japan and the weakening of growth in Western Europe.

This will have some serious negative effects on the still fragile east European and the economies of the former Soviet Union, the ECE warned.

For the first time since the start of their economic and political transformation, the former centrally planned economies of eastern Europe and the Soviet Union, now grouped in the Commonwealth of Independent States (CIS) have just started growing, but on average these economies are still some 40% below their 1989 GDP levels, and in a number of them, the GDP was still less than half of what it was a decade ago, ECE said.

The prospects for growth of these economies in transition depend very much on the performance of the North American and European economies, given their very high dependence on external demand and world markets, pointing to the potential risks for these economies from adverse external shocks.

The ECE’s chief economist Paul Rayment did not agree with the view that the US would have a short ‘V’ shaped recession and recovery and that there was no need for any stimulative actions in Europe to stimulate the economy and promote higher growth levels.

Despite the bold actions of the US Federal Reserve in cutting interest rates and easing the monetary stance, the slowdown and adjustment in the United States is likely to be longer than envisaged, Rayment said. The lag effects of various elements of the slowdown are beginning to be felt and would take time to work themselves through, and or the adjustments to be made.

Among the huge imbalances which had accumulated in the US over the last five years, as a result of an unsustainable investment and consumption boom, the ECE report said, were “the decline in personal savings (which turned negative in 2000), increases in corporate and personal debt to very high levels, a huge current account deficit and, last but not least, a stock market bubble, notably, but not only, in the market for high technology shares.”

The current expected annual upturn in US economic activity of 1-3/4 percent (compared to the 5% in 2000) implies a moderate upturn in economic activity in the course of 2001, and the current consensus forecast is of a further strengthening of US growth in 2002.

But this scenario could well turn out to be too optimistic and the cyclical downturn could well turn out to be more protracted, the ECE said, pointing to the many imbalances in the US economy needing corrections:

·        adjustment in private household expenditures (and savings) in response to deterioration in economic conditions (including uncertainties over the job market now beginning to show in layoffs and unemployment), loss in wealth effects due to fall in equity prices;

·        the responses of business investment to the downturn, the effectiveness of monetary expansion in an environment dominated by excess capacity and need for private sector balance sheet adjustments;

·        the US current account deficit now amounting to $435 billion or some 4.4% of GDP, and whose sustainability depends on willingness of foreigners to hold dollar-denominated assets; and

·        the adjustments by the rest of the world to a reduction in the US current account deficit, with a correspondingly smaller external surplus for the rest of the world.

Given the current cyclical weakness of US and the chronic weakness in Japan, this adjustment will largely depend on the strengthening of economic growth in western Europe, the ECE report says.

The ECE questioned the sanguine view from the European Central Bank and others about the limited effects of the US slowdown on the EU exports, and pointed to the other links of Europe with the US - including the investment income of its corporations whose subsidiaries produce and supply the US market with goods and services, the reliance of EU countries on exports to third markets like Asia and Latin America and elsewhere - all economies much more sensitive to the US economy.

Rayment said there seemed to be a view in Europe that the US would have a slowdown and a quick recovery, and the European growth (which is now slowing down) would resume again.

But even if there be a ‘V’ shape recovery - a sharp slowdown and quick recovery - the various imbalances in the US economy - the imbalances in the US economy (that would not be corrected in a V shaped recovery) would resume and would be unsustainable, bringing on a new US slowdown and decline, Rayment suggested.

The EU, the ECE report notes, is the main trading partner for all the east European and Baltic economies - accounting for about two-thirds of their exports and imports. Their exposure to the EU in terms of relative importance of these trade flows was much greater than EU exposure to eastern Europe and Baltic States.

Eastern Europe and the Baltic States were thus more susceptible to changes in west European demand.

Two chapters in the report relate to savings and investment and Foreign Direct Investment in the transition economies, and these have a bearing on the same issues that influence investments and economic growth and development in the developing world. The report makes a pointed reference to the similar situations in this regard of the transition economies and the developing world. Some of the ECE analysis relating to FDI, show some direct positive effects in some sectors in upgrading productivity and boosting exports, and the limited, and even negative spill-over effects on domestic enterprises, and possible balance-of-payments problems that may arise when the FDI results in imported inputs linked to exports and there is a slowdown in external demand.

Mobilization of domestic resources, the ECE report says in its analysis of the issue in transition economies, is crucial for raising economic growth and promoting development. Despite many ambiguities, empirical research supports the common sense view that capital investment is a powerful engine of economic growth, and higher levels of domestic savings are associated with higher levels of investment.

“Although foreign investment can be important, its role is essentially complementary, and usually subsequent to domestic efforts: historically, domestic private savings have played the major role in supporting investment in industrialized countries.”

As for FDI, and the role it has played in the transition economies since the 1990s, the ECE says that “the basic conclusion is that the record is a very mixed one and that the wider benefits of FDI are contingent on the domestic economies and institutional environment - there is nothing automatic about them.”

“FDI in the transition economies since 1990 has largely flowed to just a few central European countries, which are also the leading candidates for EU membership. These have indeed benefited from significant FDI financing of the balance-of-payments, and enterprises with foreign investments, not surprisingly, have had high rates of growth of output, productivity and exports.

“However,” says the ECE, “the expected spillover benefits to purely domestic enterprises - which represent the broader advantages of FDI for economic development - are found to be few and far between, and indeed often appear to have been negative rather than positive.

“In the absence of positive spillovers - and a fortiori in the presence of negative ones - the restructuring and development of the domestic enterprise sector may be inhibited, thereby reinforcing fears that an “enclave” economy might be emerging where a technologically advanced FDI sector pulls ahead but has little if any positive impact on the rest of the economy.”

FDI is not a panacea for development, and unless a country is able to raise its domestic savings rate, foreigners are unlikely to come in and invest, Rayment said of the ECE report’s survey, which has looked at the experiences of some of the developing countries, as well as of some developed economies, including the UK, the largest recipient of FDI in Europe.

These studies suggest that when a domestic enterprise has a R&D capacity and skilled labour force, it could benefit form the demonstration or competitive effects of a foreign enterprise in the sector. But those domestic enterprises that do not have the R&D and the skilled labour force, as is the case in the transition and developing economies, would in fact find it difficult to compete with the foreign enterprise and this will have negative effects on the economy.

The report says that despite the case made by proponents, about the positive spillovers of FDI, the statistical evidence for their existence is mixed.

There have been few or no positive productivity spillovers from FDI in the transition economies. In the manufacturing sector, the presence of FDI tends to be associated with relatively poor productivity growth in domestic enterprises which on average perform poorly in relation to the foreign enterprises - as seen in Hungary, the country with the greatest penetration of FDI. In contrast, in Slovenia, where there is comparatively little FDI, domestic enterprises have performed better.

A large foreign investment enterprise (FIE) in an economy may hinder adaptation of domestic enterprises to the market system by a premature intensification of domestic competition, the ECE says.

Determining an optimal degree of FDI penetration - large enough to create positive spillovers, but not so great as to inhibit adaptation by domestic enterprises - deserves greater attention, the ECE adds.

Though written in the context of the ‘transition’ economies (the official designation for the former centrally planned economies of Europe), most developing countries are in fact themselves ‘transition’ economies, transiting from the old colonial structures and economies, to industrialized market economies.

The ECE survey says its data indicate some limited potential for sector-specific spillovers, but spillovers from foreign enterprises to upstream and/or downstream domestic enterprises are potentially more important for technology transfer. But it is not possible to test for inter-industry spillovers using only sectoral data.

The ECE also suggests that in addition to efforts to attract FDI, policy-makers might consider more active measures to help maximise long-term benefits of FDI, particularly those facilitating development of backward and forward linkages.  However, ECE recognizes that international commitments undertaken by many transition economies (national treatment for foreign capital) makes the scope for policies to support development of domestic firms increasingly difficult.

The report underscores in this regard need to have effective competition policies to protect domestic firms from unfair foreign enterprise competition (predatory policies). The report also refers to several studies that show that trade, rather than FDI, may be a better source of technology transfer.

And while the short-term impact of FDI is often positive, “it is possible to overlook the fact that it can eventually have a negative effect on the balance of payments if export revenues fail to offset FDI-related imports and profit repatriation,” says the ECE.

An issue for policy makers is whether it is possible and desirable to discriminate in favour of FDI which is likely to have positive rather than negative BOP consequences, says the ECE A related question is how to channel foreign capital into productive investment and exports as opposed to, for example, real estate speculation.

An issue that the ECE has not looked at in this regard, is what is the effect of  even existing WTO rules and commitments in these matters, and how far the investment and competition policies and rules that the EU and Japan want to promote at the WTO (and which currently received EU-acquis support from transition economies looking to joining the EU) would be permissive or restrictive of such policies. – SUNS4892

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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