Trade Liberalization with the East
Which EU Industries are Sensitive?

It is generally agreed that EU trade liberalization towards the CEECs will benefit both parties. But at the same time, unrestricted liberalization could cause substantial disruptions in some sectors and regions of the EU. At a lunchtime discussion meeting held at the London offices of the European Commission on 6 March, Damien Neven explored which EU industries are both sensitive and politically effective, where the CEECs might have comparative advantages, and the impacts these might have on the North and South of the Union. Neven is Professor of Economics at the Université de Lausanne and Co-Director of CEPR's Industrial Organization programme. His talk was based on his CEPR Discussion Paper No. 1000, Trade Liberalization with Eastern Nations: How Sensitive? also published as a chapter in European Union Trade with Eastern Europe: Adjustment and Opportunities.

Since 1989, there has been much resistance in the EU to the prospect of trade liberalization with the CEECs. The Europe Agreements, for example, provide special treatment for the `sensitive sectors', which account for as much as 40% of imports from Eastern nations. This resistance arises from fears that rapid trade liberalization would leave some sectors much worse off, leading to restructuring, job losses and downward pressure on wages. Is this concern justified? If so, can we identify those who are likely to lose (or gain) from a rapid liberalization? Neven first looks at the recent changes in imports from the CEECs in order to identify those sectors that may be hurt by trade liberalization. His analysis leads him to question the widely held belief that trade liberalization necessarily leads to job losses and downward pressure on wages.

Neven's research has five key results. First, aggregate trade flows between the EU 12 and Eastern countries are still relatively small despite a sharp acceleration since 1985. Most of the increase is yet to come, however. Aggregate trade flows with the East have increased much faster than overall EU trade since 1985; whereas overall imports by the EU increased by about 30% between 1985–92 and intra-EU trade increased by close to 40%, &nbspimports of manufactures from the Eastern countries nearly doubled. Yet, if the trade flows observed between developed western countries are extrapolated to EU-CEEC trade, imports could increase by five times as much in the short to medium term. As the income of Eastern nations increases, imports can be expected to rise further still.

Second, the sensitive sectors do not seem to be all that vulnerable. Between 1985–92, the imports of sensitive products (agricultural goods, textiles, footwear, iron and steel, metal products, motor vehicles and furniture) have doubled, in line with the average for manufactures. Most sub-sectors in the food processing and textile industries have actually experienced increases that are below the average. The largest increases in import penetration are observed in industries such as building materials, wood and metal products and mechanical engineering, with some increasing more than six-fold.

Third, the comparative advantage of Eastern nations (in the manufacturing sector) may be relatively close to that of Southern Europe. This is indicated by the relative importance of intra-industry trade for the latter region. When different countries have a similar comparative advantage, they will be competitive in similar sectors and most of their trade will take place within industries. Indeed, we observe that more than half of the trade between Spain and Eastern nations takes place within industrial sectors. In the case of trade between the CEECs and France or the Benelux countries, such trade accounts for less than 30% of aggregate flows, suggesting that North European countries may enjoy rather different areas of comparative advantage.

Fourth, even though the comparative advantages of East and South European countries may not be too different, some specialization can be observed. For example, South European countries have a large and positive trade imbalance in industries that use relatively little capital while the CEECs may be better positioned in industries that use both capital and unskilled labour, like motor cars, glassware, steel, transformation of metals, plastics, rubber, textile, wood transformation and printing. Relative to Northern Europe, Eastern nations seem to have a clear comparative advantage in industries which use relatively unskilled labour, while Northern countries have a clear edge in high-tech and human capital intensive industries.

Finally and overall, this analysis suggests that the Eastern countries may profitably specialize further in industries intensive in labour and capital, where they have a comparative advantage with respect to both Southern and Northern Europe. In addition, they may profitably export to Northern Europe commodities that are intensive in labour and use less capital. In this area, however, they are likely to face strong competition from the South of Europe.

Of course, the pattern of comparative advantage revealed by recent trade flows may reflect short-term advantages associated with the process of transition, restructuring being easier in some sectors than others. Significant modifications in the pattern of comparative advantage since 1985 can indeed be observed, especially for the Visegrád countries. In these cases, the comparative advantage in capital intensive industries has reduced over time with these countries specializing more in labour intensive industries. Accordingly, in their areas of comparative advantage, these countries may become increasingly close to those of the South. In the case of Hungary, however, net imports in human capital intensive industries have significantly reduced over time, suggesting that its comparative advantage may be rather different from that of other Eastern nations and possibly closer to that of Northern Europe.

Given this pattern of comparative advantage, can we identify those who are likely to lose from rapid trade liberalization? A traditional neo-classical analysis would suggest that there is a clear divide between the North and South of Europe. In the North, both heavy and light industries using unskilled labour are likely to shrink further, whereas high-tech and human capital intensive industries should expand. If anything, this should put further pressure on labour markets and exacerbate the inequality of labour income across different types of skills in Northern Europe. The wage of unskilled labour could fall by 5–7%. To the extent that the interest of unskilled labour is well represented in the political process, one can expect that protectionist pressures in the North of Europe should continue. Such a bleak prediction is also reinforced by the observation that the vulnerable sectors tend to be concentrated in particular regions. In the case of the UK and Italy, potential pressures may be even stronger as the vulnerable regions are also the poorest ones and those where unemployment is highest. Regions like &nbspLorraine, &nbspNord Pas de Calais and Franche Comté in France, Saarland, Tubingen and Oberfranken in Germany, and the Midlands in the UK are particularly vulnerable.

Pressures for protection should be more limited in the South of Europe and will also come from different quarters. To the extent that the comparative advantages of Eastern countries may be similar, all industries will tend to expand further, possibly with a small bias in favour of labour intensive industries and against heavy industries. Pressures on the labour market and the distribution of labour income across types of skills should be very limited. The regional factor could also be rather unimportant. For instance, vulnerable regions in Spain, where heavy industries are concentrated, are also the regions where unemployment tends to be low and income per head high. As all industries are likely to face competition from the East, however, industrialists are likely to seek protection of the specific factors and rents earned in their sector. Pressure for protection will thus take the form of a collection of industry-specific requests. To the extent that the protection of particular narrow interests will appear innocuous to the general public, governments in the South may find it politically expedient to grant such protection.

Overall, given the disparity of starting positions, and the potential for specialization across and within industries, trade liberalization with Eastern nations should bring large economic benefits to the EU. These benefits should accrue to most factors and regions in the South, but not in the North, where existing pressures on labour markets, on the distribution of labour income and on regional disparities could be further exacerbated.

How far should we believe this analysis? Recent work on the effect of trade on employment and wages suggests that import competition does not necessarily lead to job losses and downward pressure on wages. Not all sectors are affected in the same way. Some, like clothing and metal constructions, are clearly affected on a large scale: there, relative prices and wages fall, production and employment shrinks and the input mix remains stable. However, in other sectors, such as ceramics, textiles, shipbuilding or the large-scale production of shoes, we observe that in parallel with the fall in relative (import) prices, wages and employment may rise, production may increase and the input mix shift towards a more intensive use of physical and human capital. One possible interpretation of this evolution is that trade pressure induces some changes of product strategy by domestic firms and possibly some shifts in technology. Along this line of reasoning, domestic firms react by developing products that developing countries cannot reproduce and technologies that do not diffuse abroad.

This evidence does not suggest that interest groups affected by trade liberalization will not attempt to obtain protection: they may want to avoid adjustment altogether, even if after adjustment, the industry would be better off. But the evidence does provide another reason why governments should not listen to these groups. By granting protection, governments may forego significant technical progress and the long-term creation of better, more secure, jobs.