Who is competitive and rich?
For Central and Eastern Europe, the crisis has not only meant austerity and slowing growth, but also some doubts about the sustainability of its growth model. Was it all simply an economic boom driven by capital inflows and over-consumption, where, behind the high headline growth figures, economies did not invest and become more productive? Looking at actual growth figures, it looks like economic convergence is taking a break.
First, we dig deep into the characteristics of the CEE growth model, which is essentially an industrial one. CEE countries have used the re-integration of Europe to their own economic benefit and foreign investors have discovered the region as a place in which to invest. And they did so in more and more sophisticated branches of the economy, which brought enormous productivity gains. Productivity levels are still lower than in Western European countries, but this is compensated for by low labor costs. The countries of the region have thus used their relative cost advantage to modernize their industry with foreign technologies. High stocks of FDI and a high share of exports to GDP are testimony to this success and have survived the financial crisis well.
So the recipe for success is intact, but pure cost competitiveness is not enough when countries are approaching the technological frontier. The key to further catching up will be to replace the importing of knowledge by innovative and new products generated in the countries. And this is only possible with highly educated people and a significant increase in expenditure on R&D. The aim is to become a knowledge economy which relies on knowledge as the key engine of economic growth. Investing in education and innovation can help CEE countries to restart the convergence machine in difficult times and at the same time prepare the way for joining the high-tech league of countries.
Among our sample of CEE countries, the Czech Republic, Slovakia and Poland are the frontrunners in terms of competitiveness and knowledge, with Hungary falling behind this group of countries. Romania and Serbia are on their way, but can still exploit more efficiency reserves before becoming innovating economies. Croatia must become more competitive to preserve its relatively high income level, whereas Turkey still has to move towards a knowledge economy.
Finally, we ask how CEE will fare in terms of growth of potential output, i.e. whether the catching-up story will continue. Major forecasts say that CEE will maintain its growth advantage over Western peers in the short- and long-run.
Economic Convergence Takes a Break
Financial crisis slows down catching up process
Over the last twenty years, the countries of Central and Eastern Europe have come a long way in economic terms. Slovakia, for instance, started at 36% of the EU-15 average GDP per capita in purchasing power terms in 1992 and was estimated to have reached 69% of the EU-15 GDP per capita in 2012. Of course, the higher the initial level, the more moderate the catching up – the Czech Republic is a point in case. But what is true for the countries shown in the graph below is that the year 2008 put a brake on the convergence process. Only Poland and Turkey – able to distance themselves more from the Eurozone recession – buck the trend.
Europe: convergence machine
The history behind economic convergence is the re-integration of Europe after the fall of the Iron Curtain. The early prospect of entry into the European Union propelled CEE countries to undertake structural reforms which not only led to political progress, but also invited foreign investors into the countries. FDI inflows brought new technology, which raised productivity and promoted exports. CEE countries were thus able to excel in the industrial sector. After the 2008 downturn, the industrial sector quickly gained momentum again in CEE, whereas the peripheral countries of the Eurozone were faced with prolonged de-industrialization.
How sustainable is convergence?
However, it would be premature for CEE to rest on its laurels, as the success of CEE economies is still dependent on imported productivity gains. But, as the region approaches the technological standards of advanced economies, they need institutions that promote innovation. Home-grown technologies will have to replace an economic model based on external inputs which are widely available. Competition, high-quality tertiary education and the availability of venture capital finance will gain in importance. In the remainder of the report we outline the classical and future drivers of growth in Central and Eastern Europe.
Sound Industrial Growth Model
CEE: industrial region
CEE economies are dominated by the secondary sector. The share of industry in the overall economic activity oscillates around 30%, whereas the industrial sector in the Eurozone lies at only 19% of GDP.
Middle-income trap avoided
The strong industrial basis of CEE countries helped them to move from the status of middle-income to high-income economies. Romania, Serbia and Turkey are still classified as upper-middle-income countries by the World Bank, but their peers have already managed to surpass the so-called middle-income trap. This trap characterizes a situation where a country gets stuck at a certain level of income due to weak rule of law, a lack of open competition and a lack of individual freedom to create and innovate.2 In such a stalemate, productivity stagnates and the road to convergence gets blocked. Of course, the investment case for such a country is impaired, as investment opportunities ultimately depend on growth prospects.
Productivity gains drove catching up
So, the good news is that CEE escaped the middle-income trap, but further growth will depend on increasing productivity of capital and labor by their own means. The concept which shows this kind of improvement is called total factor productivity (TFP), which measures increases in output not explained by traditional inputs such as additional labor and capital. This proxy for technological dynamism has shown remarkable development in CEE in the last fifteen years. However, since the financial crisis the paths diverge, with Romania reversing some of its high-flying productivity growth. The comparison of CEE countries with the rather moderate increase of TFP in Germany demonstrates that increases in productivity are more difficult to achieve if already operating at the highest technological levels and thus relying on innovation from internal sources.
When TFP is put in relation to the importance of other drivers of growth, it shows again that productivity gains are the dominant force in CEE.
Productivity gains not eaten up by high labour costs
These productivity gains are part of the convergence pattern, as the level of productivity in CEE still lags behind the productivity standards of Western European countries. But the relative competitiveness is intact, as labor costs are even further from Western European standards.
Unit Labour Costs diverge during crisis in the manufacturing sector
Looking at how unit labor costs (ULC) have developed in the manufacturing sector, which is representative of the tradable sector, since 2005, we see that some European countries could follow a cost-saving/productivity raising strategy and others not. The manufacturing industry of Germany, Greece, Spain, Hungary, Poland and Romania has become more efficient in the last six years, whereas the Czech Republic, Slovakia, France and Italy have been faced with rising ULC. The room for maneuver for the Czech Republic and Slovakia is still there, but here again the point could be made that the more advanced a country is, the harder the productivity gains are to achieve.
FDI stabilized at high level
Another specificity of the CEE growth model held up quite well during the financial crisis. There is a high stock of total FDI in CEE economies, having attributed strongly to the above-mentioned productivity gains. The crisis year 2008 constituted a break in the accumulation of the FDI stock, but until 2011, the FDI stock stabilized in all countries. Hungary’s FDI stock has seen the most negative development: From a peak of 75% of GDP in 2009, it came down by more than 10 percentage points in only two years.
Export performance still strengthening
Last but not least, another specialty of growth in CEE is excellence in exports. Exports are important on a macro level, as they contribute to growth, but also on a firm level, as there are reciprocal linkages between productivity and export performance. Looking at export’s share of GDP, differences within the CEE region become obvious: starting at already high levels, the CEE-3 were able to raise their share of exports in the crisis years. Poland, Croatia and Romania can be found in the middle range, which is partly due to the size of the markets (larger countries tend to export less), but also to non-competitive structures. However, their performance is still superior to the Southern European countries.
Shift of labour from agriculture to industry supports economic catching-up
To conclude the characterization of the growth model in CEE countries, it is worth looking at the sectoral composition of employment. Corresponding to the stage of economic development (as shown by GDP per capita in the below graph), CEE countries have more people working in industry and agriculture than their Western peers who run an economic model with a stronger service sector. A study of the Austrian Research Institute4 has shown that, for those regions/countries catching up, a success factor is to reduce the share of employment in agriculture and raise the share in industry. In this sense, Poland and especially Romania seem to have too high a share of people working in agriculture, whereas Slovakia and the Czech Republic have been highly successful in shifting labor from agriculture to industry. Additionally, the process of catching up is helped by a high share of employment in high-tech sectors5, where the Czech Republic, Slovakia and Hungary are frontrunners. The former two countries can especially be regarded as success stories in terms of economic development.
The World Bank has explained in a case study how Slovakia grew value added: Slovak manufacturing expanded its base as well into a variety of products. A rise in labour force participation helped to mobilize the production factor labour. The Slovak Republic has enjoyed a growing inflow of FDI and become an integral part of global value chains, while, finally, policy improvements allowed for higher productivity growth in the country.
For the investor, it is important, whether the labour costs, the productivity levels and the structure of the economy actually translate into higher return on capital. Looking at the below graph, we can see that Slovakia, Czech Republic and Poland offer higher ROC than the Eurozone average.
How competitive are CEE economies?
Moving from efficiency to innovation as drivers of competitiveness
Having argued that the growth drivers are intact, the question for the future is how sustainable the growth model is. In our view, the key question is how Central and Eastern Europe can move beyond pure cost competitiveness as reflected in the unit labor costs shown above. We would thus like to look at a more comprehensive measure of competitiveness. We use the concept of competitiveness as developed by the World Economic Forum, as it links pillars of competitiveness to the stage of development6 of a country:
• Serbia and Romania are in the efficiency-driven stage of development, when they must begin to develop more efficient production processes and increase product quality, because wages have risen and they cannot increase prices. At this stage, competitiveness is increasingly driven by efficiency enhancers such as higher education & training, efficiency of goods and labor markets, financial market development, technological readiness and a large domestic or foreign market.
• Turkey, Croatia, Hungary and Poland are in transition from the efficiency to the innovation-driven stage.
• Slovakia and the Czech Republic have already made it to the highest innovation-driven stage. At this point, wages have risen by so much that those higher wages can only be sustained if their business can compete with new and unique products. Thus innovation and sophistications factors such as using the most sophisticated production processes and innovating new ones are the drivers of competitiveness.
Need for more sophistication
The main message is that countries at different stages of development need different drivers of competitiveness: For Romania and Serbia, the red efficiency enhancers are key. Out of the countries in transition, Poland stands out as very competitive, but still mainly due to efficiency and not yet innovation. And the innovative economies like Slovakia and the Czech Republic face the challenge of increasing the green-colored innovative and sophisticated parts of their economy, with the Czech Republic looking better off than Slovakia.
Looking at the 12 pillars of competitiveness shown above confirms the bigger picture that CEE countries are good on basic requirements such as health and primary education. The weak point among the basic requirements is in institutions, where CEE countries show rather low scores on issues related to the judicial system and corruption.
Schumpeter for CEE
On efficiency enhancers, such as higher education and market development, the performance of CEE countries is good (shown by scores above 4). Labor market flexibility and product market competition are the basis for innovation-based growth which goes along with a higher degree of firm and job turnover. This results directly from creative destruction which is the most important principle of the Schumpeterian growth paradigm7. New innovations must be allowed to make old innovations, old technologies, and old skills obsolete.
As for the key factors for innovation-driven economies, i.e. innovation and business sophistication, CEE countries still have to catch up. More investment like R&D and firms’ investment in skills are paramount.
As for overall competitiveness, our sample of CEE countries hovers around a value of 4 on a scale from 1 to 7. This amounts to a rank of 39 for the Czech Republic and a rank of 95 for Serbia, out of 144 countries. Some Western European countries display clearly better ranks, which leaves us to conclude that, in terms of a wider concept of competitiveness, CEE still has some way to go. The cost advantage of CEE countries shown in the right-hand graph gives them time to do so.
Moving Towards a Knowledge Economy
Time to invest in education and research
As it is all about encouraging innovation, countries on the brink of becoming knowledge-based societies need more education and research. The European Commission has identified respective indicators in its Europe 2020 Strategy which aim at enhancing jobs and smart, sustainable and inclusive growth. The overall EU target for R&D as a percentage of GDP is 3% and the EU target of people aged 30 to 34 having enjoyed tertiary education is 40%. (National targets for new member states have been set lower.) Looking at the graph below, it is evident that R&D expenditure in CEE should be scaled up. The level of tertiary education is quite diverse, but for most CEE countries it oscillates around 20% of people from 30 to 34 years and is thus far from the level needed for a labor force engaged in highly innovative sectors.
The World Bank has taken the issues of the future further and has developed a Knowledge Economy framework which rests on four pillars:
• An economic and institutional regime to provide incentives for the efficient use of existing and new knowledge and the flourishing of entrepreneurship;
• An educated and skilled population to create, share, and use knowledge well;
• An efficient innovation system of firms, research centers, universities, consultants and other organizations to tap into the growing stock of global knowledge, assimilate and adapt it to local needs, and create new technology;
• Information and communication technology to facilitate the effective creation, dissemination, and processing of information.
Based on those four pillars, the Knowledge Economy Index has been calculated which shows whether the environment in a country is conducive for knowledge to be used effectively for economic development. As in the competitiveness ranking of the WEF, our sample of CEE countries occupies middle ranks among 146 countries assessed. However, in this ranking Hungary scores significantly better, whereas Turkey lags the other CEE countries. Although CEE countries still can rely on wage competitiveness, it is important to work on an early paradigm shift towards a knowledge-based society. Otherwise, the mature economies would extend their lead by innovating and the catching-up process of transitional economies would be impaired.
Restarting the Convergence Machine
Focus on innovative reforms in times of sluggish growth
The financial crisis has impacted Western and Eastern European economies alike and actual and potential output growth rates have diminished. A recovery from the crisis will not be possible for CEE in the absence of a resolution to the Eurozone debt crisis. However, making production more efficient and the economy more innovative are measures which can be taken independently of the economic cycle. Those measures build up the potential output of an economy which is defined as the highest level of GDP which can be sustained over the longer term. Thus through structural reforms, the convergence machine can be restarted and the European Commission actually sees this happening in CEE in 2013 and 2014: The graph below shows that the growth rates of potential output are forecast to recover to higher levels in CEE countries, with the exception of Hungary. This implies that in the short to medium term, CEE countries will again embark on their path of catching up with the technological frontier.
CEE-4 maintains growth advantage over Western Europe until 2050
In the longer run gaps in technology and human capital will be closing and productivity growth may slow down if the above-mentioned deficits in home-grown innovation are not tackled. Endogenous sources of productivity will become more important, as the stimulus via FDI and exports may be moderate in the coming years if the crisis drags on. The challenge for Central and Eastern Europe in general is to manage the transition from imported productivity gains to endogenous sources of innovation as drivers of growth. From the graphs below, it can be seen that, even in the very long run, potential output growth will mainly be driven by productivity gains, as very European few countries can rely on positive demographic dynamics like Turkey. According to the forecasts of the OECD, CEE countries will not be able to beat non-OECD countries (e.g. China and India) in terms of growth of potential output. This is due to their already higher level of economic development. However, the Czech Republic, Hungary, Slovakia, Poland and Turkey will continue to outgrow their Western peers in the very long run.
You will find the full report in pdf document attached.
