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A new model for new Europe

Jan 26,2014 - Last updated at Jan 26,2014

Five years ago, Central and Eastern Europe was home to one of the world’s most impressive growth stories.

Annual GDP growth was close to 5 per cent, just behind China and India. Foreign direct investment poured into Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, Slovakia and Slovenia at a rate of more than $40 billion per year.

One in six cars sold in greater Europe was being exported from factories in the region. Productivity and per capita GDP were rising briskly, narrowing the gap with Western Europe.

But the region has struggled to regain momentum since the global financial crisis and subsequent recession.

Economic growth rates have fallen to less than a third of their pre-crisis levels. Foreign direct investment, which plunged 75 per cent from 2008 to 2009, has only partly recovered.

Indeed, the region appears to have dropped off the radar of global businesses and investors. Yet our new research finds that the attributes that had made the region so attractive remain intact.

Growth and FDI inflows are still depressed, but, overall, the region has weathered the crisis in relatively good shape.

In most countries, public debt as a share of GDP has not exceeded 60 per cent since 2004 — in stark contrast to many of the 15 countries that were members of the European Union prior to that year.

And it remains the case that these countries collectively boast a highly educated labour force and wage levels that are 75 per cent lower, on average, than in the EU-15 economies.

At the same time, the region shared in some of the same excesses — notably in the property market — that helped to bring about the crisis.

In Romania, real estate prices rose 23 per cent annually from 2004 to 2007.

And, despite substantial improvement in the business environment throughout the region, these economies rank behind their EU-15 neighbours on corruption (though they are doing better than other emerging economies, including China, India, Brazil and Russia).

More important, the crisis exposed significant weaknesses in the region’s economic model: over-reliance on exports to Western Europe and a high level of consumption relative to other developing regions, fuelled by borrowing and heavy reliance on FDI to fund capital investment.

But Central and Eastern Europe can fashion a new model that we believe would enable a return to GDP growth rates of 4-5 per cent.

This model has three major components: expanding and upgrading exports; raising productivity in sectors where it is weak; and reviving FDI while developing ways for the region’s economies to fund more of their own growth through higher domestic saving.

The region has a major opportunity to raise the value of its exports of goods and services.

For example, it is well positioned to become a regional food-processing hub for greater Europe and beyond.

The region’s wage rates are still sufficiently low that sausages made in Poland and sold in Berlin cost about 40 per cent less than those made in Hamburg.

The region is already a net exporter of “knowledge-intensive” goods such as automobiles and aerospace products.

It could move into even more sophisticated areas with additional investment in education and further development of industry clusters such as Dolina Lotnicza (Aviation Valley) in southeastern Poland.

One promising opportunity lies in knowledge-intensive services. Led by Poland, the region is an increasingly important location for outsourcing and offshoring work. Its outsourcing industry is growing twice as fast as India’s.

But there could be even greater scope for growth, given two trends in Asia: rising wage costs and increasing concern among Western outsourcing customers about persistent cultural and language issues.

Central and Eastern Europe is well placed to benefit from these trends, given its strong language skills and cultural familiarity with European and North American clients.

The region is also many time zones closer to European and US clients than firms in Asia.

Several sectors are also ripe for productivity improvement.

In construction, which is a highly informal sector, productivity is 31 per cent below EU-15 levels.

Productivity is also low in agriculture, owing to the predominance of small farms that are not highly mechanised. Opening up the agricultural sector to foreign investment would help to scale up average farm sizes and introduce more modern methods.

“Network” industries, such as electric utilities and rail systems, have been partly privatised in most of the region. Opening them more fully to competition and market incentives would help to raise productivity in these industries.

To reduce reliance on borrowing for consumption and the vagaries of FDI inflows, the region’s domestic saving rates must be raised once demand picks up.

Pension reform and further development of financial markets would help.

Implementing the components of this growth model for Central and Eastern Europe will require further reforms aimed at making it easier to do business and strengthening protections for investors.

The region’s economies should also invest significantly more in infrastructure and address the effects of ageing, which could clip 0.7 per cent from annual growth rates in the coming decade.

Getting more women into the workforce would be one way to raise labour-force participation to EU-15 levels and avoid soaring dependency ratios.

Central and Eastern Europe will inevitably be in the global spotlight this year.

The 25th anniversary of the fall of the Iron Curtain and the 10th anniversary of the accession to the EU of the Czech Republic, Hungary, Poland, Slovakia and Slovenia provide an opportunity for the region to showcase how far it has come in the last quarter-century.

But realising the region’s considerable potential for further success will require a fresh approach to growth.

Martin N. Baily, chairman of the President’s Council of Economic Advisers under Bill Clinton, is chair in Economic Policy Development at the Brookings Institution. Pål Erik Sjåtil is McKinsey’s managing partner for Eastern Europe, CIS, the Middle East and Africa. ©Project Syndicate, 2014. www.project-syndicate.org

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