Dr Sinikka Salo's presentation at the seminar "Business and Management – Splendid opportunities for Women in Europe", Kuopio 11.6.2007
Economic challenges of Europe - innovations and entrepreneurship
The last hundred years have witnessed an unparalleled period of economic growth almost all over the world, with global per capita GDP increasing almost five-fold. Viewed from this long time perspective, the performance of European and other industrialised countries has been remarkable. The richest quarter of the world’s population have increased its per capita GDP in hundred years nearly six-fold, thus even more rapidly than the rest of the world. Rapid economic growth has enabled progress also in non-economic aspects of life, such as heath care, social and other welfare services or women's rights in the society, allowing us to enjoy the benefits of the so called European social model we rightly are proud of.
Rapid economic and social progress should not be taken for granted. European countries learnt this in the hard way during the first half of the last century, when they turned their back on trade and cooperation and retreated into closed economies, protectionism and pervasive capital controls – and ultimately war. Policies were reversed after the Second Word War and economic growth revived. For most of the post-war period, economic development has been fostered by deepening and widening European integration, as manifested among other things in the emergence of functioning internal markets and the adoption of the euro, as well as strengthened trade and investment links to the global economy.
Traditionally, Europe has been weak in employment creation but has compensated this by good productivity performance. Taking the USA as a point of comparison, Europe's relative per capita GDP increased from less than 50 per cent in the 1950s to over 70 per cent in the early 1980s. However, the convergence of the per capita GDP levels stalled in the 1980s and in the mid-1990s the gap between EU and US started to widen again, dwarfing any expectations of its closure in a near future. Since 1995, Europe's growth performance has been disappointing, the average GDP growth in the EU25 being about 2.3% compared to about 2.7% in non-EU industrial countries and 3.3% in the USA.
Weakening productivity growth is a key explanatory factor for the EU's economic stagnation. The annual trend growth of labour productivity in the EU declined from the level of 5–6 per cent in the 1960s to some 2 per cent or even lower in the beginning of this decennium. This unfavourable trend can be traced back to structural constraints including a comparatively outdated and inflexible industrial structure that has been slow to adapt to the intensifying pressures of globalisation and rapid technological changes. In the USA, productivity growth accelerated in the 1990s, reflecting the country's ability to produce and absorb new technologies. The USA has been strong in the information and communication technology (ICT), where its industry has been supported by focused R&D activities, world-class research/teaching establishments, substantial funding via defence procurement as well as a unique combination of financing mechanisms and competitive markets. Productivity developments in Europe have lagged behind those in the USA also in information intensive service industries such as retail trade and financial services.
Recently, there have been some indications of improvements in Europe's economic performance. Growth rebounded in 2006 in the euro area, where it had been particularly weak earlier, and fundamentals appear to be in place for continued solid growth appear also in next few years. These fundamentals include favourable profitability, financing conditions, and external demand as well as improved fiscal positions. Growth is underpinned in particular by buoyant employment growth fuelled by labour market and welfare system reforms.
The declining trend of labour productivity growth came to an end by 2003 and there has been some acceleration in productivity growth thereafter. For the first time in years, in 2007 productivity growth in the euro area is expected to exceed that in the USA. This is a remarkable achievement, especially in light of the simultaneous increase in employment and a fall in unemployment. To some extent, acceleration in productivity growth, especially in network industries, is due to reforms undertaken in the 1990s. However, it is too early to say whether recent pick up represents a structural change in the trend or simply a cyclical rebound from an earlier cyclical weakness. Moreover, recent improvements in productivity growth have been rather modest, especially if calculated per hour worked rather than per employee. In the foreseeable future weak productivity growth is likely to remain one of the main economic challenges in Europe.
Long-run productivity growth in industrialized economies is largely driven by innovations – that is the commercial and economic exploitation of scientific and technical inventions – entailing new and improved products and services, or new and more efficient ways of producing existing products. Research and development outlays are essential inputs to the innovation process, even though the end results of the process – namely successful innovations – do not depend only on them.
One explanation for the diverging productivity trends in the EU and the USA since the 1990s is differences in inputs to research and development. The overall expenditure on R&D in relation to GDP in the USA is about one and half times that in Europe. Moreover, relatively little R&D is financed in Europe by the private sector. 80% of the gap between US and EU in R&D expenditure is due to a difference in business expenditure, which may help to explain why Europe has been slow in translating scientific research into commercial products and services.
The link between insufficient innovation and weak long-term growth performance has been widely recognized by European policy makers. During its meeting in Lisbon in 2000, the European Council launched a "Lisbon Strategy", which aims at making the European Union the most competitive and dynamic knowledge-based economy in the world by 2010. This strategy, developed at subsequent meetings of the European Council, rests on three pillars:
First, there is an economic pillar preparing the ground for the transition to a competitive, dynamic, knowledge-based economy. Emphasis is placed on the need to adapt constantly to changes in the information society and to boost research and development.
Second, a social pillar is designed to modernise the European social model by investing in human resources and combating social exclusion. The Member States are expected to invest in education and training, and to conduct an active policy for employment, making it easier to move to a knowledge economy.
Third, an environmental pillar was added at the Göteborg European Council meeting in 2001, drawing attention to the fact that economic growth must be decoupled from the use of natural resources.
Strengthening of innovation activity was identified as a major means to boost productivity and achieve higher rates of sustainable economic growth. A target was set to increase R&D spending to the level of 3% of GDP by 2010, with 2/3 of the total R&D spending to be funded by the private sector.
Since the launch of the strategy, the Member States had made some progress towards the goals agreed in Lisbon. However, the mid-term review of the strategy in 2005 revealed that overall the results achieved had been rather modest and the objectives of the strategy had become muddled. Without further effort, the goals set for 2010 threatened to remain unattainable. The review did not identify any fundamental deficiencies in the strategy itself; rather, the weakness was mainly in the implementation of reforms at the national level.
To revamp the Lisbon strategy, a new partnership was approved in 2005, focusing efforts on the achievement of stronger, lasting growth and the creation of more and better jobs. The key areas of the revamped strategy include boosting productivity growth by investing in Research & Development, improving European infrastructure, enhancing human capital and promoting competition. Productivity gains stemming from reorganization and reallocation of production, from improved labour skills, from the introduction of new products and processes, in particular through ICT, would contribute to increased investment demand and further progress in labour productivity in terms of capital deepening and total factor productivity growth.
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Financial markets play a crucial role in the growth process by channelling savings to investment and allocating capital efficiently among economic agents and the promotion of deep and efficient European-wide financial markets has been one of the key objectives of European policy makers for years. During most of the 1990s, much of the development efforts in Europe's financial markets were focused on achieving a smooth transition to the single European currency, with the broader issue of the functioning of the EU financial markets taking a back seat. Once the introduction of euro was secured, however, attention turned to making improvements to the single financial market.
In recent years, there have been important initiatives to improve the performance of European financial markets. In this context, I would like to mention in particular the EU's Financial Services Action Plan, which was geared in 1999 towards the core objective of creating a single deep and liquid financial market to serve as a motor for growth, job creation and improved competitiveness in the European economy. The Financial Services Action Plan tied in very closely with the Lisbon strategy. Most of the Plan's legislative measures were completed before the scheduled completion time by 2005. The Financial Services Action Plan led to also an improved co-operation between the EU's legislative institutions, i.e. the Commission, the Council and the Parliament, with streamlined procedures to introduce legislative measures for the regulation of financial markets and the revival of certain initiatives which seemed to have reached a dead-end.
Due to the Financial Services Action Plan and other steps to improve the functioning of Europe's financial markets, we have now larger and more liquid securities markets, which offer enterprises access to a wider range of more competitive financing opportunities. At the same time, securitization is developing, alongside with other more innovative forms of financing such as derivatives markets etc. However, progress have been uneven in the different market segments and some market segments still appear relatively undeveloped and fragmented, if we compare them to those in other leading countries, in particular the USA.
One relatively undeveloped market segment in Europe is risk financing.
Risk financing has been made in different forms for centuries if not for millenniums. Specialized risk financing, commonly referred to as private equity investment, is however a feature of mature financial markets. Private equity investment is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradeable on a public stock market. It refers to the manner in which the funds have been raised, namely on the private markets, as opposed to the public markets. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.
Private equity investment is typically made in stages. In the model case, the first investors for early stage financing are providers of seed capital (often the entrepreneur himself, or his/her family, friends, business angels – even some seed funds), who provide the capital needed to explore the ‘marketability’ of the innovation and establish the commercial structure.
Early stage financing of innovative enterprises is almost always very risky. This is largely due to the fact that innovation projects have a very skew risk distribution. There are many failures, and few successes, but returns from successful innovation projects can be very large. It is not easy to distinguish ex ante between successful and unsuccessful projects. Furthermore, funding decisions are complicated by the fact that start-up costs may be large, and that it may take years before the profitability of the project can be assessed. Typically, during the start-up period there emerges little if any tangible capital which may be used as collateral for financing, and often the true prospects of the project remain vague for a long period. In these circumstances, risk financing requires considerable skill and competence. Banks, in general, are rarely interested in this risky business.
Once the innovative product or service is designed, the markets and operations established, venture capital funds start to become interested. This is the expansion stage where larger amounts of capital are needed. These investments help the company to grow and reach the critical size to generate profits. Venture capital is typically provided by professional, institutionally-backed outside investors to new, growth businesses. Generally made as cash in exchange for shares in the company, venture capital investments are usually high risk, but offer the potential for high returns. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships.
At the final stage comes the exiting of the investment. Here financial markets play a role, most visibly when the exit is through a public flotation of the company to attract a wide base of investors, both private and institutional. In a majority of cases, however, exit involves a trade sale to an established company.
In its modern form, private equity investment was conceived in the USA after the war, and the aim of the first private equity firms was to exploit commercially technologies developed during the Second World War. Private equity market in the USA continue to be more developed than in the EU and the stock of venture capital in the USA is estimated to be a multiple of that in Europe. In particular, start-up financing is still relatively poorly developed in Europe, even though the situations in different EU countries differ and there are some European start-up funds which have been highly successful.
Undeveloped private equity markets are a handicap for innovation and entrepreneurship in Europe. In particular, innovative small and start-up enterprises in Europe have a narrower spectrum of financial instruments available and face a higher cost of capital than their competitors in the USA. Fragmented markets also tend to channel too much funds to small projects and complicate the financing of large-scale projects. Deep and well-functioning single European markets for risk-capital would be useful especially for dynamic high-tech start-ups, especially for those whose survival strategies are based on the exploitation of scale economies offered by the larger European and global markets, instead of national markets.
One of main reasons for the relative weakness of European private equity investment is the segmentation of markets along national borders. Even though cross-border investment has increased, European private equity investment is still predominantly national. In recent years, some 60% of the investment of European private equity and buy-out funds has been invested in the fund's home country, whereas the share of other European countries has been only about 35%.
The segmentation of European risk capital market is often explained by the various tax and administrative obstacles, which still may impede risk investment over national borders. The existence of different national legal systems may also hamper European-wide risk investment.
Europe's productivity performance could get a major boost from the integration of financial markets. To that end, financial services need to become more contestable and Europe's capital markets developed further. The Financial Services Action Plan needs to be implemented consistently across the Member States and there is a need to proceed firmly in the integration of fragmented market structures.
The venture capital industry has consistently highlighted the need for a real pan-European growth stock market. To preserve liquidity and market for support services, it is important to avoid the mistakes of the late 1990s, when a proliferation of small, nationally-oriented growth markets led then to a situation where none of them could sustain liquidity in a market downturn. The lack of liquidity is a key factor limiting investor interest in growth stocks and thereby preventing the financing chain from functioning and constraining the exit strategies of risk financers.
One of the main remaining obstacles to the truly European-wide financial markets is fragmented market infrastructures. Financial systems have emerged historically as national systems, and in each country, market infrastructure has been developed without considering its compatibility with other national systems. Fragmented market infrastructures tend to make cross-border transactions more expensive and cumbersome than national transactions. Data processing systems and other parts of market infrastructure tend to be heavy, and significant changes in them are costly and can only take place over time.
The introduction of the euro has given a strong new impulse to the integration of financial market infrastructures. The large-value payment system TARGET of the ECB and the national central banks was instrumental in linking the euro area's national money markets, and in coupling them into an almost completely integrated euro area money market. TARGET is planned to be replaced in a near future by TARGET2, where payment services are offered on a common platform. The ECB and national central banks are also considering the possibility of offering settlement services in central bank money, using the TARGET2 platform.
In this context I would also like to mention the Single Euro Payment Area (SEPA) initiative of the European banking community. This initiative involves the creation of a zone for the euro in which all electronic payments are considered domestic, and where a difference between national and international payments does not exist. Once implemented, the project improves the efficiency of international payments and also help develop common financial instruments, standards, procedures, and infrastructure to enable economies of scale. This should in turn reduce the overall cost to the European economy of moving capital around the region, estimated today as 2%-3% of total GDP.
There are two major milestones for the establishment of SEPA. Pan-European payment instruments for credit transfers, direct debits and debit cards, will be available from 1 January 2008, in addition to national ones. At the end of 2010, all present national payment infrastructures and payment processors should be in full competition to increase efficiency through consolidation and economies of scale.
SEPA will increase the intensity of competition amongst banks across borders within Europe. It also provides business opportunities for banks to reduce costs and develop new payment services. Multinational businesses and banks can consolidate their payments processing onto common platforms across the Eurozone. They also benefit from substantial efficiencies by choosing among competing suppliers offering a range of solutions and operating across borders. For consumers, the benefits of SEPA could mean cheaper, more efficient and faster payments transfer when moving euro from one Eurozone country to another.
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Ladies and gentlemen!
After the war, Europe experienced a long period of favourable economic growth and was able catch up much of the US lead in per capita GDP and standard of living. However, the trend changed and in the mid-1990s the gap between EU and US started to widen again. The key explanation for the EU's relative stagnation is weakening productivity growth. This unfavourable trend can be traced mainly to structural constraints including an industrial structure that has been slow to adapt to the intensifying pressures of globalisation and rapid technological changes. More fundamentally, the lack of dynamism of the EU economy reflects a weakness of innovation ability and entrepreneurship.
In order to reinvigorate the dynamism of their economies the EU Member State governments must adopt policies enhancing innovation and entrepreneurship. The policies most often referred to in this context are increasing research funding by the Member States and putting in place measures to encourage private R&D investment. I have stressed in this presentation the importance of well-functioning financial markets.
There has been much effort recently towards the goal of well-functioning European financial markets, even though it has largely remained invisible for the public at large. Consequently, there has been significant progress in the integration of financial markets in Europe and in fact many market segments can be regarded now as fully integrated, the prime example being the interbank money market.
However, the integration of European financial markets is yet far from complete and some market segments have remained more or less national. One such market segment is risk financing. The example of the USA shows that wide and deep risk market for private equity investment can significantly enhance the growth potential of dynamic high-tech firms and the whole economy. I see no reason to doubt that integrated risk finance markets would help improve also the dynamism of the EU economy, facilitating the funding of innovative start-ups, especially those aiming directly at European or global markets. They would offer benefits also for the investors, as these could diversify their risks further and utilize their scarce expert resources more efficiently. Important for the longer term development of the private equity industry would be the existence of a well-functioning pan-European growth stock market, which would help exit from private equity investments through IPOs.
Even though financial markets in Europe still remain to some extent fragmented, I feel confident about their future developments. The basic reason for this is that benefits from fully integration financial markets are simply too large to be neglected. This however does not mean that integration could proceed without the strong commitment of all relevant parties, and we need to keep market integration high on the political agenda in both the EU and the Member States. One concrete development object currently actual is the integration of national financial infrastructures, as exemplified by the SEPA initiative.
In this presentation I have focused mainly on financial markets and the supply of finance. This is not meant to indicate that Europe's main problem is lack of corporate or even risk finance. At least equally important is to have a sufficient supply of potential entrepreneurs and a group selected entrepreneurs with the rare combination of both visionary ability – the ability to identify projects with significant commercial potential – and managerial ability – the ability to turn grand-scale visions into business reality.
Many women already have demonstrated their capacity as entrepreneurs, having succeeded in making successful brands even in industries not usually regarded as promising. However, in today's Europe, only about one third of all entrepreneurs are women. I see no reason why women should be less suited to become entrepreneurs than men. Rather, their under-representation among entrepreneurs suggests that in our society female entrepreneurial resources are today underutilized. This under-utilization is a loss for those women who have the capacity to become successful entrepreneurs, but have not become entrepreneurs. However, it is important to note that it is also a loss for the whole society. In today's rapidly changing world, entrepreneurial capacity is a scarce resource and we can leave women's half of it to be underutilized only at an economic loss.
I see great potential for the increase of female entrepreneurship; it may even have a major role in the efforts to re-invigorate Europe's economic growth. For that reason I expect that the position of women in business and management will strengthen in future and that this development will indeed offer splendid opportunities for women – but not only for them. There are many aspect of this issue which require closer thought. I would like to conclude by thanking the organizers of this seminar for a marvellous opportunity to discuss some of them here in Kuopio.