Studies Eastern European Markets
Eastern European Markets
November 2004

Tauno Tiusanen, Jatta Kinnunen, Sami Kallela:
EU’s Enlargement Process: Investment Climate in 10 Transitional Economies
NORDI publication 7, 2004
Lappeenranta University of Technology

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In the early period of post-communism, all formerly planned economies experienced a deep slump. This period of economic decline was in hindsight natural: many communist-time activities were so badly organized that they had no chance to survive under market conditions of competitive pressure. In the era of the Cold War, communist countries were mainly trading with each others. Global market was regarded by communist states as an alien element dominated by hostile powers. International competition was hardly affecting enterprise activities in the centrally planned economies. Basically national planning units in communist states centrally fixed all prices. Prices did not reflect local scarcities. Relatively stable prices did, however, not guarantee equilibrium: there were permanent supply bottlenecks with harmful effects on customers.

The systemic change has evidently revolutionary nature. In the transitional period, the market became the master in all post-communist societies. Resources are supposed to be allocated on the basis of free demand and supply with liberal price formation. Under these circumstances, it was no surprise that all TEs experienced inflationary shock waves in the 1990s.

Capital market is an essential part of capitalism. Assets can be bought and sold only in economies based on private ownership. The big bulk of productive assets have been privatised in TEs. Western companies have extensively participated in this process. In very general terms, it can be maintained that institutional environment has changed very rapidly in TEs. This complicated process has been rather successful.

It is important to note that there has been one extremely important external factor in this revolutionary process: ten TEs declared their willingness to join the EU, which demanded Western-like political and economic reforms. Eight TEs (out of ten) under review where able to sign EU-membership documents in 2003. Economic development in these ten TEs has not been even. Romania and Bulgaria were not able to get EU-membership in the 2004 enlargement wave. These two TEs are obvious laggards in the sphere of economic reform.

In very general terms, economic growth performance in TEs has been positive – after the slump of the early 1990s. Therefore, the development gap between East and West is now somewhat narrower than a decade ago. An extremely important component in the Eastern dynamism has been the Western FDI flow. Foreign investors have had a quantitative, and even more importantly, a qualitative impact in the TE-transitional process. This impact is very concrete in the Eastern productivity scene, in which overall results are pretty encouraging. Foreign companies have also helped TEs to enhance their export performance. Essential improvement in productivity means that the demand for blue-collar work is not necessarily increasing. This fact is visible in the labour market figures: amid economic boom, unemployment has been on a rather high level. In this respect, Poland is an extreme case: the number of people out of work, as well as the unemployment rate, are on a very high level. In the transitional process, wages have had the tendency to increase more rapidly than the overall economic growth. This is not necessarily advantageous from the point of view of job creation.

The development of unit labour costs has certain interesting features. In Western comparison, ULC figures in TEs were very advantageous in the mid 1990s obviously attracting many labour-intensive activities to the TE-region. This advantage has eroded lately. ULC-level is, however, still lower in TE-region than in the “old” EU (of 15 countries). TEs have a comparative, but no absolute advantage in ULC sphere (for example, China can offer better ULC-conditions in many branches). It is assumed in this study that the big post-communist FDI boom is over. Certain branches (banking, telecom operators, etc) show clear saturation levels, and thus, high FDI inflows are unlikely. Therefore, FDI inflows have started to decelerate, but not stop altogether. First cases of FDI withdrawals in the TE-region can be observed. Electronics supplier Flextronics left Hungary in 2003 announcing the relocation to China. IBM did the same, however, there is no strong trend visible in FDIs leaving the TE-region.

Economic stability shows some very positive trends. Price inflation has been abating in the TE-region, where supply advanced enormously in the first decade of post-communism. This fact brings inflation rates to “international” level. Balance of payments on current account (CA) is a delicate indicator in TEs under review, because none of them is really rich on natural resources, and thus, import plenty of inputs. In 1997, the Czech Republic suffered a CA crisis, during which it gave up her fixed exchange rate regime. Currently, Estonia has an excessive CA deficit, but a big part of it is financed by FDI inflow. CA deficits in the range of 14-15% of GDP are not sustainable. Overall, CA deficits are not on a critical level in TEs under review. However, alongside of Estonia, Bulgaria and Latvia must pay attention to CA deficit.

Budget deficits in TEs are presently relatively well under control. However, there is plenty of pressure in this respect in all TEs. Overall tax burdens are clearly more moderate in TEs in Scandinavian comparison. At the same time, there is high pressure to improve public services. Thus, it can be assumed that the share of the public sector in transitional economies will increase in the long run. This can only happen by increasing the overall tax burden. EMU rules set certain limits for budget deficits and public sector debts. Monetary union rules are supposed to be taken seriously by TEs under review. Annual budget deficits are not supposed to exceed the 3% limit (of GDP).

All TE-currencies are undervalued. However, there are considerable differences in the undervaluation levels, which can be measured by using exchange rate deviation indeces (ERDI). Slovenian exchange rate is relatively close to the equilibrium. ERDI values have a tendency to decrease via economic development and improvement of the export performance. ERDI values seem to remain on a rather high level in Romania and Bulgaria indicating that these two TEs are laggards in economic reform.

Relative FDI-figures (per capita) correlate positively with living standard: the better the economy, the more the country attracts FDI. This correlation is not perfect: Estonia, for example, has received FDIs “overproportionally” (living standard is not on the top level). Bulgaria and Romania offer the best wage advantages (in nominal and in ULC terms), but have received a rather low relative stock of FDIs. It can be concluded from the above correlation that a large share of FDIs in TEs are market-seeking, rather than sourcing-oriented. Furthermore, it can be assumed that in the FDI-scene, there is the so-called cumulative effect: an investment in “a core industry” attracts supplementary FDI (car-part makers in the Skoda environment in the Czech Republic).

All TEs under scrutiny here are individual cases. In many sense, differences between TEs are striking. Obviously, the Baltic States are definitely success stories. Bulgaria and Romania are on the other side of the scale. No complete failures can be found among ten TEs under review.

In this context it is important to note that FDI is not the only factor of co-operation between TEs and “old” capitalist countries. Many international companies with strong brands get products or components done in TEs on the basis of contract manufacturing or sub-contracting. This “outsourcing” cannot be reliably measured by statistical means. However, it is a well-known fact that many labour-intensive products in the West are manufactured in “cheap labour” locations. A multitude of enterprises in the TE-region produce Western products on contractual arrangement basis without investment commitment by brand-owners. For many contractors, TE-region is an attractive playing-ground when low-cost environment is looked for.

It is often pointed out that human capital is in short supply in Europe. Engineers earn in average more in the USA and Japan than in Europe. Empirical evidence is here brought up showing a clear difference in pay level of engineers in the “old” EU-countries in comparison to transitional economies: engineers in countries under review receive rather modest compensation in nominal terms. Thus, using reserves in this sphere is presently very advantageous from the point of view of Western employers. It can be assumed that this important cost factor will enhance co-operation between various parts of Europe in the near future.

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