Central Europe’s new economy

The textbook example of Central Europe becoming an industrial hub for the wider EU used to be the automobile sector. According to ZAPSR, the local industry association, the automobile sector accounts for 30% of total industrial output in Slovakia and around 20% of both manufacturing and exports in the Czech Republic. The textbooks of tomorrow may no longer use this example.

From electronics to pharmaceuticals and power equipment, the region now houses clusters of production capacity served by a wide domestic supplier base. Much of this activity can be traced back to the 1990s, when multinationals like Volkswagen and GE started to build up their networks and manufacturing base in the region. More recently, with the move of the region towards higher-value production, they have started to employ local Central European manufacturers as suppliers. Rather than viewing the region as a cheap production base, multinationals increasingly consider it to be a source of expertise.

Central Europe no longer enjoys emphatic cost advantages over richer countries to the West. A Boston Consulting Group study released this August, for example, found that both the Czech Republic and Poland are now slightly more expensive manufacturing bases than the US—although they retain a cost advantage over other European countries like Germany, France or Italy. Rapid economic growth and rising wages before the 2008-09 financial crisis means, however, that advantages in labour costs can no longer compensate for low levels of labour productivity, which, in the region, are often below the European average. The Czech Republic and Hungary, for example, produce $32 and $29.3 per hour worked versus an EU average of $47.6/h.

In reality, the highly efficient plants set up in Central Europe do still enjoy cost advantages over often older and more heavily unionised plants in Western Europe; in addition, the national figures are skewed by what the European Commission calls Central Europe’s “two-tier economy”—split between modern foreign plants and small, inefficient and lightly funded local companies. Now, however, “the boundaries are blurring”, says Erik Berglof, chief economist at the European Bank for Reconstruction and Development. Rather than being islands of excellence, removed from the local economy and supplied by foreign companies, multinational plants now use parts from companies like the Brano Group and Brisk Tábor, two Czech component makers that now sell internationally.

That trend can be expected to continue, creating a deep supplier base in the region as local companies become integrated into global supply chains. Mr Berglof also points out that Central Europe’s production gains have come squarely from better management (increases in total factor productivity in the jargon), rather than from growing populations and capital investment, which is the case in Asia.

With Central Europe’s role as an efficient production hub for Europe, multinationals’ presence in these countries has grown increasingly deep. Take GE, for example. The company, which will be celebrating its 25th year of activity as an investor in the region on November 14, started operations in the region with the acquisition of Hungary’s Tungsram light-bulb maker, a famous deal signed in 1989, the year that communism fell. GE has since built up its presence in the country dramatically, buying Budapest Bank in 1995 and making multi-billion-dollar investments in Hungarian production as well as technology development for global markets. Today, the company employs 27,000 people–half of whom are located in Hungary—and uses local engineers to develop some of its global software solutions and power equipment for Europe and the Middle East. This increasing reliance on local talent also means that GE can now source more products locally—up to two-thirds in Hungary.

A growing talent base also offers opportunities for economic diversification. Central Europe’s rise as a nexus for offshore service centres, in particular, can be expected to follow the same development pattern as the manufacturing sector, with limited acquisition becoming a high-value presence over time. One bank that set up an offshore centre in Poland in the 1990s to do low-value back-office administration, for example, now uses Polish mathematicians to develop complex trading algorithms. On current trends, every third person employed in the banking sector in Poland may soon work for banks that have no onshore client offering at all, according to Piotr Romanowski, a partner at PwC.

Equally, some deals now involve the purchase of high-tech companies  squarely for their knowledge. Skype, the Internet phone service developed by two Estonians and then sold first to eBay and then to Microsoft for multi-billion-dollar sums, is a well-known success. Although exits of this kind remain rare, technology companies are starting to scour the region as it becomes known for its software developers: Last year, 16 of the 24 finalists of Google’s annual Code Jam programming competition were from Central and Eastern Europe.

Central Europe’s cost advantages explain why it has become an integral part of European and global manufacturing. Going up the value chain will require it to leverage the full potential of its strong talent pool.

Published in collaboration with GE Look Ahead

Author: Michael-Kapoor is a writer for GE Look Ahead.

Image: The Skoda Fabia car is seen in a test room exposed to high temperatures simulating the sun shining. REUTERS/Petr Josek