By Jacob L. Shapiro
Summary Two weeks ago, we published an in-depth study of the troubles on the horizon for the German economy. But because it has Europe’s largest economy in terms of GDP, problems in Germany will not stay confined to Germany. Today, we take a closer look at what the repercussions will be for four countries whose economies are deeply intertwined with Germany: Poland, the Czech Republic, Slovakia and Hungary. In the short term, struggles in Germany will pose a challenge because of how integrated these countries are into Germany’s export regime. In the longer term, however, Germany’s struggles will be an opportunity for these Central European nations.
While Germany has relied on exports to fuel its economic growth for the past 15 years, the Visegrad Four (V4) countries – Poland, the Czech Republic, Slovakia and Hungary – have done the same. They now make up a large industrial supply chain, and significant percentages of V4 exports to Germany are parts or semi-finished goods that Germany packages into finished products, which are then exported. As a result, lower demand for German exports will be felt in each of these countries, narrowing profits and decreasing foreign direct investment from Berlin. From our perspective, Poland and Slovakia face particularly acute problems, but the Czech Republic and Hungary are also both exposed, to varying degrees, to weakness in the German economy.
But these challenges also come with opportunities. Now that demand for German exports is decreasing, Germany’s competitiveness in the marketplace is declining as well. The V4 countries are all much smaller than Germany, which gives them more room to maneuver, and they also have slightly younger populations than Germany, which means they stand a better chance of remaining competitive in the future. It will not be a smooth transition, but as German exports decline, countries like these four will have a chance to retain some of their exports to Germany and will become more competitive in the global marketplace as well.
Measuring Impact of the Export Market
The simplest place to begin determining Germany’s economic impact on these countries is with the percentage of GDP each of these countries gets from exports. Germany, as we have noted in the past, gets almost half of its GDP from exports. Poland is in a similar situation, with 47.4 percent of its GDP derived from exports, according to the World Bank. But for the other V4 countries, the figure is almost double. Exports account for 89.3 percent of GDP for Hungary, 91.9 percent for Slovakia and 83.8 percent for the Czech Republic. Each of these countries is highly dependent on exports.
However, these figures do not tell us whether the V4 countries will suffer if German exports decline. To find out, we must examine the way in which the German-Central European supply chain has expanded since the 1990s. German manufacturers were trying to make their exports more competitive in the global market and found on their doorstep Central European states with low labor costs, favorable tax environments and a productive and educated workforce. And the V4 countries were happy to be on the receiving end of new jobs and wealth. The result was increased demand for German exports, fueling economic growth in Germany; in turn, German demand for Central European exports increased, fueling growth in the region.
Exposure to Global Demand Through the Supply Chain
At the same time that these economies were booming, their exposure to fluctuations in demand outside Europe was also increasing. A study produced by the International Monetary Fund in July 2013 discovered that, despite the fact that the majority of V4 exports were going to European countries, exposure of both Germany and the V4 to demand outside Europe was increasing. This was true across the board, but let’s use Hungary as an example. In 2009, though only 1.5 percent of Hungary’s exports went to China, according to U.N. Comtrade data, the study estimated that Hungary’s exposure to China was actually 4.2 percent. Almost three-quarters of Hungarian exports went to Europe, and yet Hungary’s exposure to the EU was actually closer to 68 percent. Exports were booming, but dependence on non-European demand for exports was also creeping upwards.
The reason Germany became more dependent on demand outside Europe is fairly simple: it was German strategy to use the EU to make its exports more profitable on the global stage. But understanding the link between German exports and V4 exports requires a little more explanation. The Czech Republic is an excellent example of the double-edged sword Central European countries are holding in their hands. A study published in the Prague Economic Papers journal in 2015 found statistical correlations between Czech exports and both German GDP and German exports. But the study also revealed a striking observation about the types of product the Czech Republic exports to Germany. In 2011, roughly 32 percent of Czech exports went to Germany. But 9 percent of those exports were semi-finished parts for motor vehicles. Therefore, a significant percentage of Czech exports to Germany are used to manufacture goods that are then exported.
The numbers are striking for Poland and Slovakia as well. In 2014, 26 percent of Polish exports were bound for Germany. According to a Morgan Stanley report, between 30 percent and 40 percent of those exports did not find their final destination in Germany, but rather as parts of German products exported throughout the rest of the world. That means almost 10 percent of total Polish exports are tied not to German consumer markets, but to markets throughout the world. And Germany has become increasingly dependent on exports to China, although it has been insulated from decreased Chinese demand by a surge in demand for its cars in the U.S. and the U.K. However, we do not believe demand from China and other countries affected by the exporters’ crisis is about to resurrect to the previous levels.
Slovakia’s story is similar. Twenty-two percent of Slovakian exports were bound for Germany in 2014. Roughly 11 percent of those exports were cars, but almost 20 percent were either bodies for motor vehicles or automotive parts. In addition, Slovakia has by far the highest unemployment rate of the V4 countries at 12.1 percent, according to Eurostat. The next closest is Poland, with 7.9 percent, and Poland is in a much better overall economic position than Slovakia. German companies will have to react to declining demand for their exports by cutting prices, which will mean lower profits and trimming wages or even eliminating jobs at manufacturing plants, some of which are located in Slovakia.
Short- and Long-Term Implications
In the short term, the V4 countries will feel Germany’s pain. Germany is hoping to stave it off by relying on domestic consumption: Germany projects growth of 1.7 percent in 2016 and expects domestic consumption, rather than net foreign trade, to be the engine for that growth. It is unclear whether German domestic consumption can generate enough demand for German and V4 exports. But even if it can, V4 countries will still be hit by declining demand for German products outside of Europe.
In the long term, however, this is a significant opportunity for the V4 countries. The same IMF study mentioned earlier also noted that, with the exception of Poland, Germany no longer holds a significant advantage in knowledge-intensive manufacturing sectors compared to V4 countries. This is in part due to the technology transfers that enabled the export growth of V4 countries in the first place. And for its part, Poland could invest more in research and development and rely on an excellent education system and highly literate public to fill the gap. The trick for all these countries is to climb up the value-added export ladder while keeping wages down in order to remain competitive and take the place of Germany (or China) in the global market.
Clearly, declining demand for German exports will have economic implications for the V4 countries. But there will also be political ramifications of a declining German economy. For the last two decades, Germany and the V4 countries have had economic interests in common. But what happens when these interests diverge? Each of the V4 countries has long memories of how Germany reacts when it feels it must assert its national interests. If, as we expect, problems in the Italian banking sector and German export economy continue to worsen, they will lead to political challenges far more significant than the economic problems we have outlined here.