Download Resilience Central and Eastern Europe: Moving up the value chain

Resilience
Reprinted from Resilience: A journal of strategy and risk
Central and Eastern
Europe: Moving up
the value chain
By Otilia Simkova
www.pwc.com/resilience
Central and Eastern Europe:
Moving up the value chain By Otilia Simkova
With investment from and export markets in the Eurozone stalling,
Central and Eastern Europe (CEE) is looking to shift its focus of growth
toward higher-value production and services. This is a bold step for a
region that has, up until now, relied heavily on low labour costs to fuel
foreign investment. In this fourth article, we look at the challenges and
opportunities ahead for countries in the region and foreign investors as
CEE prepares to carve out an ambitious new economic path.
Over the past two decades, EU
investors and consumers have helped
drive growth in CEE, leaving this
region especially vulnerable to the
protracted Eurozone crisis. In
response to the crisis, governments
in the region have been forced to
reorient their growth strategies to
focus on developing more resilient
sectors and attracting investors
outside of the EU. In recent months, a
new trend has emerged: a move away
from reliance on foreign direct
investment (FDI) in low-cost labour
production toward strategic FDI,
emphasising high-quality labour
forces, excellent infrastructure and
technological support. On the
surface, the shift may seem like a
minor adjustment of policies that
support export-orientated FDI, but it
is in fact a strategic turn of the entire
FDI framework toward high valueadded production.
Opportunities are emerging in the
region for investors seeking strategic
assets crucial for high value-added
sectors. As companies weigh various
investment opportunities,
fundamentals such as political
stability and a sound regulatory
framework will be crucial, as will the
capacity of individual governments
to implement the institutional and
policy changes necessary to build a
knowledge economy.
Low labour costs drive investment
When CEE economies opened to FDI
after the fall of communism, foreign
investors enjoyed a plethora of
opportunities. The core countries of
the EU comprised the region’s
primary investors, and they also
became the main consumers of the
CEE countries’ products and services.
German manufacturing companies,
most notably car manufacturers and
food producers, moved first into CEE
markets.
FDI proved to be vital in facilitating
the modernisation, restructuring and
privatisation of the previously
centrally planned economies of CEE
countries. With this infusion of FDI
came new technology and skills,
increased productivity and jobs. The
winners in this round of FDI
competition were the countries with
solid manufacturing track records
that are located closest to the western
EU markets: the Czech Republic,
Hungary, Slovakia and Poland. As
Figure 1 illustrates, the correlation
between real GDP and inward FDI
was very strong in the CEE region
between 1990 and 2005,1 suggesting
that FDI was crucial to economic
growth in these countries. These
developments encouraged
governments to align their regulatory
and incentives frameworks toward
foreign investors, resulting in
regional competition for investment.
As a result, CEE countries developed
an almost uniform model of exportoriented investment in low-skilled
production, including policies
focused on infrastructure
investment, build-up of industrial
parks and incentives for investors in
the form of cash subsidies or tax
breaks.
1- K
ornecki, L. (2008) ‘Foreign Direct Investment and macroeconomic changes in CEE integrating into the global market’, Investment Management and
Financial Innovations, FM-4-05058, Issue 4.
18 I Resilience: Winning with risk The Eurozone crisis spurs
a rethink
The 2008–2009 global financial
crisis and the ensuing Eurozone
sovereign debt crisis have proved that
FDI in CEE countries is highly
vulnerable to economic downturns.
The share of FDI as a percentage of
GDP peaked between 2005 and 2007,
but has dropped significantly over
the past few years. The European
economic downturn and the
Eurozone crisis have created
difficulties for many European
companies. Banks have reduced their
lending and consumers lessened their
demand for goods and services.
Figure 1: GDP growth and Inward FDI flows
Annual % change
15
10
5
0
-5
-10
-15
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Bulgaria
Czech Republic
Estonia
Hungary
Poland
Source: IMF World Economic Outlook
Figure 2: Inward FDI flows
25
Billions of US dollars
Western European investors
benefited from the convenient
geographical location, comparatively
low labour costs, lower overall
production costs and high-quality
products in CEE economies.
Investors’ business strategies
typically focused on producing
manufactured goods for export.
Notable exceptions to this pattern
were investments into
underdeveloped financial sectors and
infrastructure, which, by their very
nature, service the domestic market.
The CEE countries competed fiercely
among themselves for each and every
investor, thereby putting businesses
in a strong position, with leverage to
negotiate the best possible
conditions, investment incentives or
subsidies from their host
governments.
20
15
10
5
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Bulgaria
Czech Republic
Estonia
Hungary
Poland
Source: UN Conference on Trade and Development, UNCTADstat
Resilience: Winning with risk I 19 These circumstances have prompted
rapid capital flight from the CEE
region and decreased demand for the
exports on which these countries’
economic growth models depended.
Exports remain subdued at present
amid the ongoing turmoil of the
Eurozone crisis and FDI has failed to
recover substantially as European
companies continue to pursue
cautious business strategies in an
uncertain economic environment. In
a sharp contrast to the pre-crisis
period, almost all CEE countries
currently trend below the EU average
in terms of FDI. For companies
seeking new investments, this
situation creates an opportunity to
take advantage of a strong
negotiating position as countries once
again compete with each other for a
limited pool of FDI (see Figure 2).
Moving up
However, governments across the
CEE region are not competing with
one another in the same way as
before. The Eurozone crisis has
spurred them to rethink their FDI
strategies. Empirical observation, as
well as economic data, suggests that
high value-added sectors have been
considerably more resilient to the
crisis than those relying on low-cost
manufacturing. In Bulgaria, for
example, the economy contracted
from 6.4% growth in 2007 to -5.5%
in 2009 and only last year recovered
to 1.7% growth.2 However, Bulgaria’s
information and communications
technology (ICT) sector expanded
throughout the crisis, achieving 5%
growth in 2011, and its contribution
to Bulgaria’s economy rose to almost
10% of total GDP.3 Countries across
Figure 2: FDI as % of GDP
16
14
12
10
8
6
4
2
0
-2
-4
2002
2003
Bulgaria
Estonia
Latvia
2004
2005
2006
Poland
Romania
CEE average
2007
2008
2009
2010
2011
EU (27 countries)
Source: Eurostat
2- Eurostat, Real GDP growth rate.
3- Bulgarian Association of Software Companies (BASSCOM), 1 December 2011, press conference, quoted.
20 I Resilience: Winning with risk Promoting the Czech
Republic’s new FDI strategy
The framework of the Czech
Republic’s FDI strategy has shifted
from low-cost, labour-reliant
manufacturing toward high valueadded sectors. An incentive scheme
introduced in July explicitly
promotes technological and strategic
service centres. It offers the same
advantages in terms of cash
subsidies on investment and tax
breaks as was previously extended
only to manufacturing companies.
The Czech Invest Agency’s priority
sectors now comprise software and
information and communications
technology services, business
support services, advanced
renewable energy and clean
technologies, nanotechnology,
aerospace, advanced automotive,
life sciences, electronics and
industrial machinery sectors. The
agency’s latest project, Czech Link,
is a merger and acquisitions support
programme centred on these
industries. Publicity material
highlights the opening of R&D
centres and energy research
clusters, as well as the successes of
the Silicon Valley–based Czech
Accelerator project for innovative
Czech start-ups.
And it is not only the Czech
Republic making such advances. Its
regional peers are undergoing
change, too: Slovakia promotes its
university-linked centres of
excellence, Latvia provides
recruitment support for
sophisticated business process
outsourcing and Estonia is calling
for the next EU budget (2014–
2020) to focus on the support of
smart economic growth.
the region recorded similar
experiences in other high valueadded sectors such as custom
software development, sophisticated
manufacturing, nanotechnology and
clean energy technology. Shared
experience motivated governments
across the region to redirect their FDI
strategies and launch new campaigns
to attract investors.
This opens up a new round of
investment opportunities in the
region, as CEE governments aiming
to attract capital and generate
growth are once again racing to offer
the best conditions for foreign firms.
Given that governments tend to rely
on supply-side measures to motivate
export-oriented FDI, investors in high
value-added sectors will be able to
take advantage of these schemes and
measures, and in many cases
negotiate additional advantages.
Investment incentive frameworks,
which have typically been the most
widely used supply-side measure in
the CEE region, are now being
tailored to accommodate high
value-added projects—for instance,
by reducing the size of eligible
projects (since high value-added
investments tend to be smaller) and
introducing new schemes for small
businesses and for cross-border
mergers and acquisitions (since high
value-added firms are often new and
innovative and have steep costs).
New industrial parks focusing
explicitly on sophisticated business
process outsourcing, software
development or biotechnology are
being constructed throughout the
region. And authorities are seeking to
highlight these policy changes. For
example, investment agencies have
switched from stressing low labour
costs to promoting the high quality of
the workforce (volume of science
graduates, high numbers of PhD
researchers and advanced language
skills of the population). Meanwhile,
nanotechnology colloquiums have
replaced manufacturing fairs.
Attracting fresh investment
These new FDI frameworks face a
sizable challenge. Virtually all
investment in CEE countries over the
past two decades originated in the
EU. While CEE governments tend to
be the most comfortable with EU
investors, the lingering Eurozone
crisis is forcing CEE officials to look
significantly further afield to
capitalise on their newly developed
strategies. So firms based outside of
the EU may now find investing in
CEE economies easier and more
appealing, as they will enjoy the
same benefits (political stability,
quality infrastructure and favourable
regulations) as do companies from
the EU.
CEE governments are forging
relationships with investors in
countries such as China, Qatar and
Israel. With regards to China,
governments are attempting to
develop investment relationships
with various companies, building on
strong (albeit unbalanced) trade
relations with Beijing. One of the
latest examples is the declared
interest of a Chinese investment fund
in Burgas, Bulgaria’s fourth-largest
city (see box below). CEE countries
are also vying to attract Qatari
attention. This includes competing to
sign cooperation agreements,
opening embassies and sending
business delegations to the Gulf
kingdom. CEE countries are targeting
Israel specifically for its expertise in
R&D and technology as growth
sectors. Thus far, success has been
relatively limited, so the impact of
new investors in the region is likely to
remain modest in the near future.
Bulgaria’s experience highlights challenges
Bulgaria has been setting the pace in seeking alternative sources of
investment, as demonstrated by the recent announcement of Chinese
investors’ interest in the Burgas industrial zone. Qatari investors,
meanwhile, are reportedly considering launching ventures in Bulgaria in
areas ranging from agriculture to infrastructure development.
But difficulties remain. Despite the country’s best efforts, Bulgaria’s once
stellar ability to attract FDI started to yield strong results again only this
year. In the first six months of 2012, the country attracted €810.1 million
($1.05 billion) in investment—still relatively low, but vastly higher than
the €273.9 million ($353.34 million) it attracted a year ago. Approaching
new investors has proven to be more difficult than building up
relationships with existing ones and challenges remain in governance and
the rule of law. Bulgaria’s efforts to build new relationships are likely to
be rewarded only in the medium term, and require progress on regulatory
reforms.
Resilience: Winning with risk I 21 Investment considerations
Businesses considering entering or
strengthening their presence in CEE
markets should take account of the
differences in the foreign investment
environments across the region. In
general, CEE countries compare very
well with other emerging markets
when it comes to setting the
preconditions for the development of
high value-added sectors. A highly
educated workforce is perhaps one of
the most important qualities of the
CEE labour market, which boasts
some of the highest tertiary
enrollment rates and researcher
headcounts in the world.4 In addition,
the growth of labour productivity in
the region has outperformed that of
most of the rest of the world in the
past two decades. And general
political stability and reliable
infrastructure provide basic
preconditions for successful business
operations. Yet firms operating in the
region will find that CEE countries
share a common weakness—
underdeveloped financial markets—
and that modern technologies have
only a limited impact on the
development of business and
organisational models in these states.
Figure 3: Global Innovation Index
2012 rankings
Estonia
19
Slovenia
26
Czech Republic
27
Latvia
30
Hungary
31
Lithuania
38
Slovakia
40
Bulgaria
43
Poland
44
Romania
52
Note: The Global Innovation Index ranks 141
countries worldwide, based on innovation as a
driver of economic growth.
Sources: INSEAD and the World Intellectual
Property Organisation (WIPO).
4- Source: World Bank, ‘School enrollment—tertiary’, UNESCO Institute for Statistics.
22 I Resilience: Winning with risk Despite these commonalities, CEE
countries differ in many ways that
potential investors should be aware
of when assessing investment
decisions. Regulatory quality and
governance will remain key factors in
investment decision-making for all
businesses interested in the region.
The regulatory environment and rule
of law are most problematic in
Romania and Bulgaria. The existing
FDI base is also a major factor, as
investors are more likely to roll out
high value-added manufacturing in
markets where this type of work has
already been established.
Investors should also be aware of the
strengths and weaknesses of various
CEE countries with regard to
different high value-added
industries. As the innovation index in
Figure 3 highlights, Estonia is, for
instance, typically credited for
fostering successful high value-added
development in the region. The
country deserves its high rankings
for ICT services and software
development. And Estonia’s internet
connectivity and creativity in
developing online content remain
unrivalled in the CEE region. Estonia,
nonetheless, has the lowest number
of science-related graduates in the
region and lags behind some of its
neighbours in healthcare-related
sectors such as pharmaceutical
development and laser optics
equipment manufacturing. Slovenia
lags behind Estonia’s emerging
strength in software, but it leads on
R&D in terms of numbers of
researchers and expenditure as a
share of GDP. At the same time, the
Czech Republic has been building on
its traditional strength in engineering
and applied science, placing
emphasis on the development of new
capacities in sectors such as
nanotechnology and aeronautics.
Latvia excels in environmental and
sustainability projects, and Slovakia
at advanced automotive
manufacturing; Lithuania positions
itself as a regional leader in life
sciences and laser optics, and
Romania is a leader in the area of
environmentally friendly production.
In the competition for FDI
opportunities in the CEE region,
investors in high value-added sectors
can benefit from governments’ policy
redirection, as well as individual
countries’ existing strategic assets.
But to make the best of these
emerging opportunities, strategic
planning and decision-making
should be supported by a detailed
analysis of the specific political risks
and regulatory environments of
individual countries, as their
characteristics differ across sectors.
Even though the Czech Republic and
Estonia are currently the frontrunners for investor attention, other
countries in the region can provide
better operating environments in
particular sectors (for example, it
would be difficult to place a
metallurgical research facility in
Estonia). Moreover, companies
looking to invest in the CEE region
may find that the countries lagging
just behind the front-runners can
offer similar assets at a lower price or
with added incentives for investors.
In this regional competitive
environment, the search for the best
opportunities is likely to lead
businesses beyond the obvious
choices.
In conclusion, the strong
fundamentals of political stability, a
well-educated workforce and
governments’ keenness to support
incoming investment have opened up
a valuable window of opportunity for
technology and other high valueadded businesses. Targeting is going
to be crucial, with particular
countries offering specific expertise.
And in this fast-moving and highly
competitive investment environment,
the most attractive opportunities
may be found among the up-andcomers rather than just the frontrunners.
Figure 4: High value-added sector development in CEE
Turkey
Poland
Czech
Republic
Romania
Hungary
Slovakia
Bulgaria
Estonia
Manufacturing
Advanced automotive
Aerospace
Renewable energy
Electrical engineering
Mechanical engineering
Biotechnologies
R&D
Life sciences
Nanotechnologies
Services
Pharmacy
Software development
Software services
Sophisticated business process
outsourcing
High Well-developed industry
Medium -Developing industry
Low
Potential to develop industry
Source: Eurasia Group research
Resilience: Winning with risk I 23 Figure 5: CEE countries have increasingly educated labor forces
40%
30%
20%
10%
0%
2000
2001
2002
Bulgaria
Czech Republic
Estonia
2003
2004
Poland
Romania
Slovakia
2005
2006
2007
Hungary
Note: Graph shows the percentage of the total labor force with a tertiary education.
24 I Resilience: Winning with risk 2008
2009
2010
Figure 6: Services and industry increasingly dominate CEE economies
20%
Percent growth
15%
10%
5%
0%
Agriculture
Industry
Slovenia
Slovakia
Romania
Lithuania
Latvia
Hungary
Estonia
Czech Republic
Bulgaria
-5%
Services
Source: World Bank World Development Indicators
Otilia Simkova is an analyst in Eurasia Group’s Europe practice, focusing
on Central and Eastern Europe. She previously worked at the Economist
Intelligence Unit, specialising in global indexes research. Earlier in her
career, Simkova advised corporate clients and investors at the Slovak
British-Business Council and Premier Consulting’s UK firm. Simkova holds
a master’s degree in Russian and East European studies from the University
of Oxford, St. Antony’s College. She also earned a bachelor’s degree in
international relations and diplomacy at Matej Bel University in Slovakia.
Simkova is currently completing a PhD in the geopolitics of Central Europe
at King’s College London.
Resilience: Winning with risk I 25 Resilience
Reprinted from Resilience: A journal of strategy and risk
Publishers
Dennis Chesley
Global Risk Consulting Leader
PwC US
Miles Everson
US Advisory Financial Services Leader
PwC US
Executive Editors
Robert G. Eccles
Professor of Management Practice
Harvard Business School
Christopher Michaelson
Director, Strategy and Risk Institute, PwC Global Advisory
Associate Professor, University of St. Thomas Opus College of Business
Managing Editor
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+1 (646) 471 5116
[email protected]
PwC US
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+1 (646) 471 1102
[email protected]
PwC US
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Vice Chairman, Global Advisory Services
PricewaterhouseCoopers International Ltd.
[email protected]
+1 646 471 4000
Special thanks to the following parties for their production and editorial assistance:
John Ashworth, Chris Barbee, Lisa Cockette, Ashley Hislop, Angela Lang, Sarah McQuaid, Roxana Opris,
Malcolm Preston, Alastair Rimmer, Suzanne Snowden, Tracy Fullham and Guatam Verma
Author
Otilia Simkova
Eurasia Group
[email protected]
+44 (0) 207 553 9839
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