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ESG: The metrics jigsaw

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Integration: A work in progress

The European Union has made substantial progress towards economic integration but there is some way to go before it can achieve its full potential, writes Carlo Svaluto Moreolo 

At a glance 

• The Maastricht treaty of 1992 created the European Union with an explicit goal of economic and monetary union.
• Trade remains the most successful area of integration.
• Although banking union is an important achievement it lacks a vital EU deposit insurance scheme.
• Fiscal integration at the EU level is still insufficient.

If treated as an individual entity the economy of the European Union would be the world’s largest by GDP, according to recent World Bank data. In 2014, the EU’s GDP stood at $18.5trn (€15.2trn) at current market prices compared with $17.4trn (€14.2trn) for the US. 

To many economists, however, such comparisons are illegitimate because the EU’s economy is far from fully integrated. But assessing the level of integration of the EU economy is difficult. This is because the EU is far more than a trading bloc. It aspires to use its institutions to create a regional economy that is integrated according to several different dimensions.

This aspiration was explicit in the Maastricht treaty of 1992 which officially created the EU out of what had previously been the European Economic Community. One of the EU’s key goals was stated as the creation of economic and monetary union. This included liberalising capital movements, providing for the convergence of economic policies. 

It also included provision for the creation of the euro and the European Central Bank (ECB). Denmark and the UK obtained a special opt-out from monetary union while some other countries are yet to meet the necessary convergence criteria.

Nevertheless, within these constraints, the EU institutions are attempting to move the region to closer integration. “The EU has been the biggest motor for integration of the economy,” says Jan Randolph, director of sovereign risk at IHS, a firm providing data and analysis services to the business community. “It has significantly reduced political risk from countries joining the union, creating a level-playing field for import-export of goods and services as well as cross-border financial flows.”

In a sense, therefore, to assess the extent of economic integration in the EU it is possible to consider the goals it has set itself. This, in turn, raises the question of the main barriers to achieving integration. 

The European Single Market, essentially a prelude to the creation of the EU, is often identified as the most successful initiative towards integration. Its focus in the economic sphere was on enhancing trade links.

The initiative was embodied in the Single European Act of 1986 with the goal of creating a single market by the end of 1992. It involved all 28 EU countries and guaranteed free movement of goods and services. Thanks to the initiative, trade within the region has increased dramatically over the past two decades.

However, the Single Market is by no means complete. A 2013 report by the Open Europe think tank, argued that “trade liberalisation within the EU is far more developed for goods than for services”. This is despite services accounting for over 70% of Europe’s output, but only about a fifth of the EU’s internal trade. 

The authors of the report argue that the lack of cross-border trade in services is essentially the result of political resistance to liberalisation. 

For various political reasons, the implementation of existing rules and an EU-wide agreement to further services liberalisation has proved difficult to achieve. If services were further liberalised, eliminating barriers such as regulated professions, the EU’s single market could add about €300bn of output per year, according to the report. 

Europe’s financial sector has also achieved integration on many levels over the years, only to encounter significant barriers to fuller integration. 

At the level of distribution of financial products, the economy scores well, according to Andrew Bates, head of financial services at law firm Dillon Eustace. He says the EU market for financial products – particularly life insurance and mutual funds – is significantly integrated, thanks to recent EU regulatory initiatives.

The Undertakings for Collective Investment in Transferable Securities (UCITS) framework, which creates the basis for a pan-European fund market, goes back to the 1980s. However, it has gone through several incarnations since then. The packaged retail and insurance-based investment products (PRIPS) initiative has boosted the life insurance market, creating a level-playing field, according to Bates. 

Meanwhile, the Alternative Investment Fund Managers Directive (AIFMD), which came into force in 2011, is “beginning to be a revolution in the alternative space”, he says.

“Despite there being many misgivings about AIFMD, and all its new regulatory obligations for the industry, the one thing that is clear it has created a 28-member state market for alternative products. And if you have your product and your manager within the EU, you have a wide open space to sell to.”

In other words, through multiple initiatives the EU has created these level-playing fields through harmonised processes for selling and managing products and for authorising their managers. At the same time it has put in place regimes that foster investor comfort and protection. The focus has been on the market, where product providers are trying to find clients or channels that can deliver significant volumes of assets to justify the cost of running their businesses.

However, barriers to selling financial products remain. A 2015 report from Open Europe found serious national hurdles to the distribution of funds domiciled in other EU countries, which add significant costs to asset management business. The hurdles should be removed, argued the report: “They contravene the spirit of the single market and the idea itself of a passport. EU-based asset managers would be more willing to bear some regulatory costs if they were guaranteed full and speedy market access to all 28 EU member states.”

With regard to the banking sector, Randolph notes how the progressive enlargement of the EU stimulated cross-border lending between Western and Eastern Europe. 

However, that process reversed during the financial crisis, as banks reduced balance sheets and cross-border exposure. The euro-zone crisis further contributed to a reduction in cross-border lending. “But as policymakers reacted, we started to see positive lending in parts of Europe. In particular, lending to Eastern Europe has recovered,” adds Randolph.

Despite the uncertain health of the European banking sector, there are policies in place that guarantee a high level of integration within the sector. The main driver of this is the EU’s Banking Union, initiated in 2012 as a response to the euro-zone financial crisis. The framework entails EU-level supervision and resolution of the banking sector. 

Zsolt Darvas, a senior fellow at the Brussels-based think tank Bruegel, says that Banking Union is “the biggest development since the creation of the euro in 1999”. He says: “On the banking side, concerning both oversight and integration, the euro-zone is significantly integrated. I would say non-euro-zone countries are also quite involved, thanks to the existence of the European Banking Authority.”

Darvas’ views are confirmed by an April 2015 report by the European Central Bank (ECB) on financial integration in Europe. The report stated: “The process of improvement in the degree of financial integration in the euro area, which has started with the announcement of the Banking Union and the outright monetary transaction (OMT) framework in 2012, has continued in 2014, reaching a level comparable to the one before the sovereign debt crisis. [….] Apart from equity markets, where the most recent developments have shown some volatility, financial integration in money, bond and banking markets consistently shows a sustained increase.”

“On the banking side, concerning both oversight and integration, the euro-zone is significantly integrated”
Zsolt Darvas

However, Darvas observes several shortcomings within the Banking Union framework. He explains how policymakers, including the European Central Bank (ECB) have identified several instances where European-level supervision and national banking regulation are not consistent within countries. 

The ECB is addressing this issue, having recently published a ‘Guide on options and discretions available in Union law’, which details how the exercise of options and discretions in banking legislation is to be harmonised in the euro area. The central bank called this document “a major step towards creating a level playing field in the euro area banking sector”, while a further ongoing consultation “should complete the European banking supervision process of harmonising options and discretions for the foreseeable future.” 

The other main missing piece from the Banking Union, however, is the European Deposit Insurance Scheme (EDIS). The euro-zone wide insurance scheme for bank deposits, proposed last year by the European Commission, is likely to remain a sticking point because of  its political sensitivity. 

Marion Amiot, euro-zone economist at Oxford Economics, says: “The EU-level deposit insurance scheme would be the next big step in terms of economic integration. The main goal is to break the link between sovereign crises and banking crises. But it is a big step because it entails a degree of fiscal integration. The scheme would have to be ultimately financed through taxes.”

In terms of fiscal integration the region remains a long way off. This would not be a problem had the EU not set itself economic stability goals that are closely linked to fiscal imbalances between member states. 

Darvas notes how the EU budget itself, standing at about 1.2% of GDP is relatively small. But the fiscal rules governing the EU – embodied by the Fiscal Stability Treaty, also referred to as the Fiscal Compact – are particularly messy, according to him. “The rules led to an extremely complicated system. They are based on unsuitable indicators, which are difficult to estimate.” 

A paper he co-authored on the subject argues that the implementation of the fiscal rules is hindered by the “badly-measured structural balance indicator and incorrect forecasts”. This leads to erroneous policy recommendations, which include pro-cyclical fiscal tightening. “The large number of flexibility causes makes the system opaque,” adds Darvas in his paper. 

There is also a problem with surveillance, argues Darvas: “There is a perception by stakeholders in many countries that the current system is not unbiased, but rather politically nominated. Darvas proposes simpler, enforceable rules and an independent European Fiscal Board, akin to the ECB’s governing council.

In conclusion, economic integration in Europe is advanced in many areas but large gaps remain. Darvas cites a 2015 study by the European Central Bank (ECB), which presented a European Index of Regional Institutional Integration (EURII). The index maps the developments in European integration from 1958 to 2014 on the basis of a monthly dataset. The period from 1958 to 1993 is referred to as the “Common Market Era”, whereas the first 20 years of the “Union Era” started in 1994. 

The study highlighted several gaps, including the lack of a developed alternative to bank funding, which the proposed Capital Markets Union (CMU) is trying to address. “The Single Market, in particular, has yet to be completed, while the banking union does not imply, in our understanding, the end of the necessary steps in the financial sphere. Moreover, the third pillar of the banking union (that is, beyond supervision and resolution) is a common deposit insurance system, which still has to be implemented. Finally, capital markets are arguably not integrated enough to provide deep and evenly distributed funding across the European economy as a stable complement, if not an alternative, to bank funding.” 

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