26 May 2016

VoxEU: The European Single Market - A game changer for economic integration

This column argues that the Single Market has delivered substantial benefits to member countries. New empirical evidence is presented of the trade and FDI gains that Central and Eastern European countries have enjoyed since joining the Single Market.

The Single Market has delivered a lot

[...] Both inspecting trends and econometric estimates suggest that the ESM is a game changer. In the six OECD countries that joined the EU in 2004 (Czech Republic, Estonia, Hungary, Poland, Slovak Republic, and Slovenia), total exports and inward foreign direct investment have increased much faster than in the rest of the OECD. The share of OECD exports from these six countries and the share of foreign direct investment towards them have doubled between 2000 and 2008 (Figure 1, Panel A). This rise started before the accession year, as countries began to align policies with EU standards and as firms anticipated the completion of the process. This sharp boost to integration is stronger than the rise observed in other OECD countries that are also catching up to the productivity frontier, such as Chile and Mexico, for instance (Figure 1, Panel B). The specific pattern observed for the countries joining the EU strongly suggests that the integration in the ESM has had a major effect on trade and foreign investment.

Beyond this evidence, econometric analyses also show a strong effect. Estimates with gravity models of bilateral trade and foreign direct investment measure the effect of the ESM, controlling for many other factors that affect integration. This provides a large and significant effect on trade (Fournier et al. 2015) and on foreign direct investment (Fournier 2015). Estimates suggest that in a country where half of foreign direct investment and trade are from or towards countries belonging to the EU, joining the ESM can increase trade by about 30% and the foreign direct investment stock by about 60% in the long run compared with the countries that are outside the ESM.

Regulatory convergence can boost trade and foreign investment

Beyond the explicit barriers to international trade and investment, firms also face national regulatory hurdles. Firms have to deal with numerous specific rules in other countries that can be complex. This complexity has a cost. Harmonisation of regulations reduces such costs and thereby boosts trade and foreign direct investment.

The empirical analysis provides evidence on the positive effect of regulatory convergence on trade and foreign investment. Regulatory convergence plays a role on top of ESM membership, suggesting that a lot more can be done to remove implicit barriers. The analysis thus also helps explain why Head and Mayer (2000) found large negative trade effects of national borders.

The OECD collects detailed data on product market regulations that hamper competition, including, for instance, the involvement of the state in business operations, licencing systems, or sector-specific regulations (e.g. regulations of telecommunication firms). Regulations that do not discourage competition (e.g. safety requirements applied to all firms) are excluded. These data allow one to look at differences of regulatory settings between country pairs. This reveals that there is a sizeable heterogeneity in regulatory settings across countries. [...]

Reducing regulatory differences and regulatory stringency also boosts trade, as my co-authors and I show in Fournier et al. (2015). For instance, a broad reform package that would align product market regulation to the average of the 50% best performers and cut regulatory heterogeneity by one fifth can increase trade intensity within the EU by more than 10%.

In sum, the ESM has already delivered large economic integration gains, but it is also right that more can and should be done to deepen it further. The long list of policy actions that are warranted is well-known (e.g. Monti 2010, Fournier 2014, OECD 2016). Better communicating the successes so far achieved can help to build the necessary momentum to complete the ESM.

Full column on VoxEU

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