EU Enlargement, now scheduled to take place in May 2004, will involve the addition of ten states: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. I will highlight the potential benefits of enlargement as well as the possible areas of contention between the EU and US stemming from the enlargement process.

Enlargement and US Trade
By and large, enlargement will benefit US exporters because tariffs against US products in a number of accession countries will fall sharply after they join the EU. After enlargement, average tariff rates in all the applicant countries will immediately drop to EU levels, an average rate of 4 percent, which will be, on balance, less than the average tariffs currently imposed on US products by the applicant countries. For example, Hungary, the US's third most important export market among the ten, currently imposes average tariff rates of 13 percent on goods imported from countries, like the United States, that have most-favored nation status, but are not party to preferential trade agreements with Hungary. Poland, the United States' largest trading partner in the region, also imposes relatively high tariffs. However, in some instances, average tariffs will remain the same or even rise. The Czech Ministry of Industry and Trade claims that average tariffs on manufactured products are lower in the Czech Republic than in the EU. Estonia eliminated tariffs for a period after independence, but under pressure from the European Commission, imposed tariffs similar to those levied by the EU. Thus, the adoption of EU tariffs by these two countries will provide no benefit to US exporters.

The reduction in tariff rates in the other accession countries will make it possible for US products to be sold more cheaply on accession country markets. It will also make US products more competitive vis-à-vis competing products from countries benefiting from free trade and other favorable trade agreements with these countries. Under the various pre-accession agreements, such as the Europe Agreements with the Central and East European states that had been signed by the EU and the applicant countries, manufactured products from the EU currently enter all the applicant countries duty-free. The accession countries also provide duty-free access to their markets to a number of non-EU states under a variety of other free trade agreements. For example, the Central and East European states have signed the Central European Free Trade Agreement (CEFTA), which provides for duty-free trade among the member states in the same products included under the Europe agreements and the Baltic states have created a Baltic free trade area.

Differential tariff treatment stemming from these free trade agreements has put US exporters at a competitive disadvantage. For example, until granted a temporary exclusion, John Deere, the US farm equipment manufacturer, was locked out of the Polish market because of very high Polish tariffs on tractors and farm equipment—tariffs that EU and Central European competitors did not have to pay. Unfortunately, this exclusion was temporary and had to be renegotiated. Differential tariff rates on automobiles, especially on vehicles with higher capacity engines characteristic of US-manufactured vehicles such as sports utility vehicles and minivans, have effectively precluded significant sales of these vehicles in most Central European markets.

In the case of the Central and East European accession countries, the advantage gained by US competitors from countries with preferential market access has increased over the last ten years. Initially, the EU provided the Central and East European states with asymmetric tariff reductions: tariffs on most products exported from Central and Eastern Europe to the EU were eliminated immediately upon signing the agreements while tariffs on a number of products imported by the Central and East Europeans from the EU were reduced only gradually over the course of the past decade. For example, at the beginning of the 1990s, Poland's tariffs on trucks and cars ran 30 percent. These tariffs were levied on all imported cars and trucks, including those from the EU. They were gradually reduced for EU and Central European manufacturers until they were finally eliminated in 2002. As tariffs imposed by accession countries on imports from EU and CEFTA countries fell, the disadvantage to US exporters from the differential tariffs widened. For example, while US truck exporters continued to face 30 percent tariffs in Poland, their EU competitors enjoyed tariff reductions year after year. The disadvantages faced by US exporters in these instances will fall, once Central and East European tariffs against US goods drop to EU levels after enlargement.

After enlargement, US exporters to the accession countries will benefit from forthcoming tariff reductions agreed upon by the EU in the Uruguay Round. Although in percentage terms these are less than those negotiated with the applicant countries, actual average future tariff rates facing US exports to the accession countries will be substantially lower than they would be, if enlargement were not to happen.

Accession will also reduce other non-tariff barriers. Although all the accession countries accept EU standards and goods manufactured in the EU and certified by EU agencies are accepted in the applicant countries without recertification, US exporters sometimes must recertify goods in the accession countries that have already been certified in the EU or contend with local standards that differ from EU standards. Adapting products to meet local standards in small markets such as those of the accession countries is often prohibitively expensive for US exporters because potential export volumes to these markets are generally quite small. Consequently, the requirement to recertify a product may effectively bar sales of that product in an accession country. This problem will disappear after enlargement.

Enlargement should also serve to improve market access for US exports of pharmaceuticals. Enforcement of intellectual property rights, including patents on pharmaceuticals, has not been as strict in some of the accession countries as in the EU. The health authorities in some accession countries have favored domestically-produced pharmaceuticals over imports, including US imports. Enforcement of competition policy in this area is likely to be more rigorous after these countries join the EU.

Lower tariffs and lower non-tariff barriers to trade will serve to reduce the overall cost of doing business in the accession countries. US companies will find it easier to consolidate their sales organizations. In some instances, they will be able to liquidate subsidiaries set up to serve individual country markets, thereby simplifying their corporate structures. Also, US businesses will no longer have to engage staff in resolving individual country tariff and certification issues.

The downside to these changes will probably be a lower profile in Central and Eastern Europe for US businesses. The gravitation of trade and investment issues to Brussels is likely to lead to the closure of representative offices. US business associations located in these countries may also close due to falling membership. EU membership will also reduce or eliminate incentives for US companies to invest in manufacturing operations targeted at the domestic markets of the applicant countries. Central and Eastern Europe will become part of European or global supply chains. Consequently, some marginal operations, for example, the production of household products in smaller or older plants, are likely to be closed and consolidated into plants servicing an entire region, not just a single country. On the other hand, investment designed to take advantage of the lower labor costs and other competitive advantages of the Central and East European applicants compared to current EU members is likely to rise.

Enlargement will introduce some irritants to US-EU trade and economic relations. Historically, the United States has asked for compensation in the form of lower EU tariffs or enlarged quotas for US exports after new entrants have been accepted into the EU. This is meant to compensate for losses in cases when acceding countries had provided better market access for US products than the EU. For example, when Portugal and Spain joined the EU, the EU enlarged its import quotas for corn and soybeans because Spain had provided better access to US exports of these products than the EU. US exporters generally face higher tariffs in the largest accession country markets than in the EU, but in certain cases the opposite is true. Although the US government has not yet formulated a list of demands for compensation stemming from enlargement, once accession negotiations are concluded, it is clear that it will request some form of compensation, probably in the area of US agricultural exports. The EU, in turn, is likely to argue that the reduction in average tariff rates to accession country markets should be adequate compensation and that no additional measures are needed.

In addition to issues of compensation, enlargement is likely to exacerbate trade frictions in steel and agricultural products – the last a major issue in the Doha trade round. Over the last three decades, the steel industries in the current EU member states have undergone a long period of contraction, consolidation and privatization. During this period, steel capacity has been sharply reduced, employment cut and the major producers have moved into higher value-added products. Although the US steel industry faces competition on all fronts, the EU has become a less important supplier in the lower value-added segments of slabs, bars, etc.

After enlargement, the EU will be saddled with substantial additions to its steel-making capacity, much of which is uneconomic. The Czech Republic, Poland, Slovakia, and to a lesser extent Hungary all have relatively large steel industries in relation to their economies. The Czech Republic and Poland, in particular, still have several million tons of steel-making capacity. Although both countries have been attempting to downsize their industries so as to reduce losses, their industries continue to produce large amounts of lower quality steel and will add substantial capacity to the EU industry in this segment. Hungary and Slovakia also will add capacity to the EU industry, but do not pose as difficult problems for US-EU trade. Slovakia has a more modern steel complex, in which a US producer, US Steel, has acquired a controlling stake. Hungary has permitted two of its three steel complexes to go bankrupt, leaving just one significant producer. The additional capacity for the production of lower cost steel in the Central European countries could potentially lead to more EU exports of lower quality steels to the US market. It is likely that Central European producers will pressure the EU to keep out steel imports from producers in developing countries, Russia, and Ukraine, potentially diverting some of this steel to US markets.

In the long-term, agriculture will be the most contentious issue between the EU and the United States following enlargement. Farmers in the accession countries will not receive massive subsidies to increase production immediately after enlargement. In fact, the initial EU offer on agriculture was greeted coldly by the applicant countries and was the last issue to be concluded in the enlargement negotiations. Because payments must fit into the current overall EU budget plans that extend through 2006, payments to the accession countries under the Common Agricultural Policy (CAP) have to be limited. To keep within the budget, the EU initially offered applicant countries' farmers only 25 percent of what farmers in the current member states receive. Under this proposal, payments within the EU will not achieve parity until 2014. Accession country farmers argued that they would be at an unfair competitive advantage vis-à-vis farmers in current EU member states during this period since West European farmers will receive much higher subsidies while receiving unrestricted access to accession country markets. Ultimately, the EU agreed to permit accession country governments to "top up" payments using their own or other EU support funds. Under the final agreement, accession country farmers may receive 55 percent of EU levels in 2004, rising to 100 percent towards the end of the decade.

Although the EU has shifted away from production and export subsidies and towards income supports over the past decade, export subsidies continue to play an important – if reduced – role in the sale of surplus EU products abroad. Export subsidies have been a very contentious issue in US-EU trade relations. At the Doha meetings that launched a new round of world trade negotiations, the EU made a commitment to negotiate the end of, or at least additional reductions in, export subsidies.

Despite less favorable treatment in terms of subsidies, the extension of CAP to the accession countries will exacerbate problems of overproduction, making the elimination of export subsidies less attractive to EU policymakers. Even the limited package of subsidies currently offered by the EU to the accession countries will boost farm incomes and provide incentives for more people to stay on the farm and for higher agricultural output. Declines in output of some agricultural products during the transition have hidden some of the incipient problems. In Hungary, meat output fell from 2.4 million metric tons (mmt) in 1984 to 1.4 mmt in 1997. At one time, Hungary produced more meat than Denmark and almost as much as Holland. In Poland, beef production has halved over the course of the transition. Given the ‘right' subsidy structure, all of the Central and East European accession countries could easily increase production of beef, pork and grain. As a number of these agricultural products are also important US agricultural products and exports, the additional supply stresses generated by enlargement are going to make agricultural trade negotiations very contentious, especially after the passage of the 2002 farm bill in the United States, which included large increases in subsidies for US farmers with all the attendant implications for US production.

US agricultural exporters are already beginning to complain about these potential problems. Former Senate Minority Leader Trent Lott and former Senate Finance Committee Chairman Max Baucus recently asked the Bush Administration to ensure that enlargement does not damage US agricultural interests. Senators have suggested that the Administration increase tariffs or expand tariff coverage on EU goods in retaliation for the loss of markets stemming from the EU's embargo on US exports of beef raised with growth hormones. Once the applicant countries join the EU, the United States will lose these markets as well. US agriculture trade groups have also complained to the US Trade Representative about the impending loss of Central European markets for US fruits and vegetables, the extension of de facto EU bans on genetically modified products to the accession countries and increased production of sensitive key agricultural products that compete with US products. US chicken and turkey exports to Central Europe are also likely to be lost upon accession because of disputes with the EU.

Enlargement is likely to introduce some irritants into US commercial relations with the accession countries. All of the applicant countries have qualified for participation in the General System of Preferences (GSP) for at least some products. Accession countries are almost certain to lose GSP status upon entry, since current EU member states do not qualify for this program. The sudden loss of these facilities will result in some reductions in accession country exports to the United States and probably some hard feelings on the part of accession country exporters.

The accession countries will also become involved in EU-US trade disputes. WTO dispute mechanisms permit the aggrieved party to impose temporary discretionary tariffs on imports from the offending party. In the case of disputes between the United States and the EU, the United States imposes temporary duties on all imports from the EU and the EU imposes tariffs on US exports that importers in all EU member countries have to pay. These stipulations virtually ensure that the accession countries will be dragged into EU-US trade disputes despite the wishes of their respective governments.

Enlargement will also have repercussions for US businesses that have benefited from financial incentives for foreign investment and free trade zones in the accession countries. The European Commission has informed applicant countries that they will have to phase out programs that provide preferential treatment for foreign investment; many of these programs have been used by US corporations. Hungary and Slovakia will both have to change legislation. Incentives provided by the Slovak government to US Steel connected with its acquisition of a stake in the East Slovakian Steelworks may be at risk. Hungary will have to reduce the number of free trade zones in the country, of which there are currently 95. In most cases, investors, including US corporations, are likely to ask for some sort of compensation. The negotiation of appropriate transition measures may be quite contentious. The process of resolving these issues will not be helped by the abrogation of the bilateral investment treaties that the United States negotiated and signed with each of the accession countries. US businesses have found these treaties very useful for dispute settlement and as a legal assurance for their investments. The European Commission had insisted that the applicant countries abrogate these treaties by the end of 2002.

Enlargement, the Euro, International Financial Flows and Implications for the United States
The dollar has been depreciating against the euro over the last two years; a number of bank economists project the dollar will continue to fall. The large US current account deficit and expectations that US financial assets will become less attractive to foreign investors are the primary motivations for these forecasts. If the forecasters are right, the fall in the dollar against the euro may be quite abrupt and quite large, i.e., the euro may ‘overshoot.' The question in the context of EU enlargement is whether the adoption of the euro by the accession countries could trigger or contribute to a sharp shift in the euro/dollar exchange rate.

The expansion of the Eurozone to the accession countries may affect the dollar/euro exchange rate through:

· Shifts in transaction demand for the two currencies;
· Through shifts in demand for assets denominated in the two currencies;
· Through changes in perceptions of likely future exchange rate trends by market participants.

The additional demand for euros generated by adding the accession countries to the Eurozone will be relatively small. Monetary aggregates in the accession countries are tiny in relation to those in the Eurozone, in part because the accession countries have small economies and in part because financial intermediation in these economies is relatively underdeveloped. Moreover, the accession countries already hold substantial euro reserves, which will be used to convert local currencies to euros, and households and businesses already hold substantial portions of their financial assets in euros. Consequently, the addition of these countries to the Eurozone will have very modest effects on Eurozone monetary aggregates.

Externally, the enlargement of the Eurozone is unlikely to have much effect on transaction demand for dollars. None of the accession countries conducts international trade in domestic currencies: exports and imports are almost exclusively invoiced in dollars or euros. Invoicing is usually dictated by the foreign buyer and seller. As the two invoice streams, dollars and euros, are already fairly well established, domestic adoption of the euro is unlikely to have much effect on the use of one or the other currency in foreign trade.

The addition of these countries to the Eurozone is likely to have a greater effect on asset demand for dollars. Many of the countries hold reserves and issue debt in dollars. After joining the Eurozone, the European Central Bank is likely to increase its foreign exchange reserves (dollars) slightly to reflect the increase in the size of the monetary base, but by less than the total dollar reserves of the accession countries. Cashing in accession country dollar reserves will have a very slight one-off-effect on demand for dollars. Accession countries' public foreign debt is already shifting from dollars to euros; private debt is likely to be increasingly dominated in euros as well. These shifts will be permanent.

Although it is difficult to predict financial market perceptions of adoption of the euro by the accession countries, their inclusion in the Eurozone does not necessarily mean that the euro will be perceived as a weaker currency. Over the past two years, the Czech koruna, Hungarian forint, and Polish zloty, among others, appreciated in nominal terms against both the dollar and the euro. If anything, the addition of the more rapidly growing accession country economies to the Eurozone and the higher volumes of transaction and asset demand for euros they will generate may serve to strengthen the euro.

In short, the adoption of the euro by the accession countries is likely to result in a modest increase in transaction demand for the euro, a larger increase in asset demand because of a shift away from the dollar toward the issuance of euro-denominated debt, and potentially a positive shift in financial market perceptions of the euro as the Eurozone becomes more dynamic economically. However, these shifts in demand will be modest and are unlikely to be so great that the adoption of the euro by the accession countries will trigger a sharp rise in the value of the euro against the dollar.