CHAPTER 8
Europe’s convergence machine ground to a halt in the south at the same time that they turned smoothly in the east. The failure of Greek, Italian, Portuguese, and Spanish firms to benefit from the latest phase of European integration makes their economies uncompetitive, while the possibility of correcting this deficit through devaluation is closed off within the eurozone. Making their companies fit for an enlarged Europe is a priority in the south—not just for their own economies but for the eurozone’s economic health. What is holding southern firms back? Chapter 4 offers two explanations. First, Southern Europe lacks firms of a sufficient size to effectively compete and benefit from European integration. Second, burdensome business regulations keep southern firms small by discouraging investment and growing the shadow economy. Competition from the shadow economy can drag potential valueadded leaders down, perpetuating the low productivity equilibrium. This has not prevented job creation in the south. But too many workers in the EU15’s south are employed in small enterprises with low average productivity. An average gross output per worker of around $40,000, including gross profit and depreciation, is not sufficient to attract a college graduate, so many young skilled workers stay away. The recipe to address the south’s productivity gap is straightforward: better regulation and more internationalization. Rigid employment legislation, cumbersome tax systems, and burdensome product market regulations all make Southern Europe uncompetitive. The last decade has seen a large number of countries make significant strides in improving their business climate. Among the European countries that have made the most impressive progress is the Slovak Republic (box 8.5). Countries looking to create value-added leaders might also look to Singapore’s experience for designing efficient and effective business regulation.
Box 8.4: Crisis-proofing finance: the Czech Republic and Canada Czech Republic Most believe that financial integration with the west made banking systems in emerging Europe more vulnerable to external shocks. Yet, banks in some countries such as the Czech Republic did better than others during the recent global economic crisis. In 2009, Czech banks recorded sound profits: return on equity amounted to 26 percent, and the return of assets stood at 1.5 percent. This resilience reflected timely policy actions, a sound regulatory system, and prudent banking practices. First, the financial sector benefited from a consolidation program that the central bank initiated in the mid-1990s, closing many small banks. Second, the process of financial sector prudential oversight was also consolidated. Since 2005, the Czech central bank has had the authority to oversee all segments of insurance markets and
commercial and investment banking. Third, the banking sector has a strong retail deposit base and benefited from prudent lending practices— nonperforming loans were lower in the Czech Republic than in other Central and Eastern European economies. No country is crisisproof, but Czech financial sector practices and policies have been a source of stability during the financial crisis. Canada Canada’s banking sector survived the 2008–09 crisis without a taxpayer-financed bailout, and its banks remained stable and well capitalized. What did Canada do right? First, heading into the crisis, the structure of bank funding was favorable, as banks relied much more on depository funding than wholesale funding. Second, the country has one of the most restrictive capital adequacy standards in the world in risk-weighting, allowable capital
deductions, and definitions of permissible regulatory capital. Third, the structure of the banking system has traditionally made the sector more stable. Heavy regulation and tight restrictions on entry led to a highly concentrated banking system dominated by five large competitors. While this system made the sector less competitive, it also made the sector easier to regulate, limiting the size of the shadow banking sector. Supervisors always face a tradeoff between competitiveness and stability—the “regulator’s dilemma.” The performance of the economy before the crisis—annual GDP growth rates ranged between 2 and 4 percent during 1999–2008—and of the banking sector during the crisis suggests that Canada has struck the right balance. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth
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