Friday, November 28, 2014

A New Model for New Europe

WARSAW – 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%, 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% 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% 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 labor force and wage levels that are 75% 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% annually from 2004 to 2007. And, despite substantial improvement in the business environment throughout the region, these economies rank behind their EU-15 neighbors 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, fueled 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%. 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% 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% below EU-15 levels. Productivity is also low in agriculture, owing to the predominance of small farms that are not highly mechanized. 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 privatized 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 aging, which could clip 0.7% from annual growth rates in the coming decade. Getting more women into the work force would be one way to raise labor-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 realizing the region’s considerable potential for further success will require a fresh approach to growth.

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    1. CommentedJoseph Jaroszek

      to start with, did they (we) ask for that growth, or it should be accepted as a default position just because some dull cabal of growth fetishists said so? There's a new book out, 'I spend therefore I am', so thanks but no thanks, some of us got more to our lives than just conforming to fantasies of deluded number fiends.

    2. CommentedPaul Lunt

      What a load of rubbish, what is being put forward here is essentially the same model that the UK has used. That means that all profits go to the rich and the rest of the country work like serfs to prop it up. The article proposes that everything is sold off and run by foreign conglomerates. The article states that "Real Estate prices rose by 23% annually", who cares, this is not growth but a bubble. Please could we have some original thought.

    3. CommentedZsolt Hermann

      I think there are two important issues here:
      1. Constant quantitative growth is unsustainable, it has always been an illusion and today we are waking up to reality. Big news yesterday were China's dramatic slow down to levels 14 years before, more and more people are talking about chronic stagnation.
      Not only Europe but the whole global world has to build a completely new economic model that is based on available means and natural necessities, fitting into the closed and finite natural system we exist in. The American Dream of excessive demand, artificial over-consumption is over.
      2. We live in an interconnected and interdependent world, so within the European Union and beyond a much deeper integration, a supra-national paradigm is necessary to analyse and solve global problems, especially as today there are no local or regional problems any longer.
      As the example of China and other regions show, there simply cannot exist a scenario when nations, regions "pull away", or 'drive" others, one succeeds while others lose, we entered the phase of "all or nothing", we are al sitting on the same boat, which is sinking because we still do not understand or don't want to accept the above principles.

    4. CommentedJoshua Ioji Konov

      Most of the CEE countries followed the trickle-down economics strait to the point: St Therese of Lisieux: Bigger than the Pope attitude. They came out of a Communist Ideology to just jump into a Neo-liberal ideology, whereas both are ideologies that do not perform in the present Globalization and rising Productivity's World..., the European Union problems well reflect their attitude of a mishandled very complicated economics whereas the needed "as it comes, as it goes" market economics that could have worked as we can see in China, Japan and the US