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Eastern Europe’s Competitive Edge

Sept. 28, 2017 The region is taking advantage of its geographic location, which was once its downfall.

Deep Dive

|September 29, 2017

Summary

Eastern Europe is the most dynamic part of the European continent. So great is its potential that it is among the subjects at our annual conference in October. But before we can explain why this is, we must first define what we mean by Eastern Europe. For the purposes of this Deep Dive, Eastern Europe includes nine countries: Bulgaria, the Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland, Romania and Slovakia.

We are, however, leaving out some countries that are widely considered Eastern European. We’ve excluded the Balkans, for example, because the geopolitics of that region is fundamentally different from the geopolitics of the countries we are including in our analysis. Belarus, Ukraine, Moldova and Russia are similarly often lumped into Eastern Europe, but they have different economic and political structures, so they should be dealt with separately. We are, however, including the Baltic states. They see themselves as part of Northern Europe rather than Eastern Europe but mostly out of a desire not to be called “eastern.”

Classifications such as these are inherently imperfect. But our definition of this region has no political valence; it is an analytical tool. Analysis literally means breaking apart an abstract entity into its constituent elements. Europe is an abstract entity, and these countries share enough politically, economically and historically that they can be thought of as a constituent element of Europe. They are small countries that emerged after the fall of the Soviet Union as relatively poor and closed off compared to Western Europe. They are also all caught between Germany and Russia, and that unfortunate geography has defined their history.

But now a rare thing is happening: Germany and Russia are weakening at the same time. That presents tremendous opportunity – and tremendous risk – for this part of the world.

The Opportunities

Despite making up roughly 20 percent of the total population of the EU, Eastern Europe accounts for only about 7.4 percent of the EU’s gross domestic product. The two biggest countries in Eastern Europe, both geographically and economically, are Poland and Romania. Poland alone accounts for almost 30 percent of Eastern Europe’s GDP, and together, they account for over half of the region’s population.


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Eastern Europe still lags behind much of the rest of Europe in development and economic heft, even though it has exhibited some impressive growth rates over the past decade. There are many factors that explain why, but among the most important is that these countries spent decades behind the Soviet Union’s Iron Curtain. That Eastern Europe makes up only 7.4 percent of the EU’s GDP is not an indictment of its recent economic performance; it is an indicator of just how much of a head start the West had over the East.


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This lack of development has been in some ways a blessing for Eastern European countries. These countries have an abundance of skilled and cheap labor, which has fueled much of the economic activity in the region. For example, in the 1990s and 2000s, as German manufacturers were trying to make their exports more competitive, they found countries on their doorstep – particularly the Visegrad Four countries (Hungary, Slovakia, Poland and the Czech Republic) – with low labor costs, favorable tax environments, and a productive and educated workforce. Companies from around the world continue to target Eastern Europe for investment because of the human capital the region brings to bear. According to the latest European Investment Monitor, which tracks investment across Europe, foreign direct investment in Eastern Europe has increased markedly, rising by as much as 57 percent in the Czech Republic and 35 percent in Romania in 2016 compared to 2015. Looking at jobs created by FDI, Poland is second only to the United Kingdom, while Romania holds fourth place, narrowly outpaced by Germany. Eastern Europe may still lag behind in terms of total FDI – Poland received about 20 percent as much FDI as Germany in 2016 – but its recent gains are nonetheless impressive.


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Once again, Eastern Europe’s labor force is one of the main factors behind these high investment levels, and we can see why by comparing Poland’s labor force to Germany’s. A greater proportion of Poland’s population has a post-secondary education than Germany’s, yet the cost of labor in Poland is lower than in Germany. The minimum wage in Germany during the second quarter of 2017 was 1,498 euros ($1,767) a month, but it was just 473 euros a month in Poland – and that is a relatively high minimum wage compared with other countries in Eastern Europe. In 2016, the average salary in Germany was more than three times the average salary in Poland, and the total cost of labor (defined by Eurostat as employers’ core expenditure related to employing staff) in Germany was more than four times the cost of labor in Poland. (Polish salaries, however, have been rising – average monthly wages rose 4.1 percent in April year over year.)


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But the Poland-Germany comparison is just one example; in fact, Eastern European countries beat their Western European counterparts in terms of supply of cheap labor across the board. The point, however, is not just that Eastern European labor is cheap; it is also becoming more productive. Labor productivity in Romania, for example, almost doubled between 2005 and 2016. Over the same period, labor productivity in France declined by over 4 percent. With the exception of Hungary, labor productivity in Eastern Europe has increased markedly over the past 11 years, especially compared to other European countries.


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For a region looking to attract investment capital, labor has been a significant advantage. But one of the main factors that gives Eastern Europe this advantage – relatively cheap wages – is also driving workers out of the region. According to a 2016 International Monetary Fund study, over the past 25 years, almost 20 million people – over 5 percent of Eastern Europe’s population – have left Eastern Europe to find better-paying jobs. The same report also concluded that, despite a lack of consistent data on return migration in the region, bilateral inflows of foreign citizens suggest that only a fraction of people have returned to their countries of origin. They might return to their home countries as they get older, the report suggests, but their contribution to the labor pool by that point will be limited.

The media has fixated on this point, obsessing over the challenges Eastern European countries will face because of the high emigration rates combined with low fertility rates. It should be noted that fertility rates in Europe are low across the board – the average fertility rate in the EU in 2015 was 1.58 live births per woman. (The replacement rate is about 2.1 children per woman.) Seven of the nine Eastern European countries have fertility rates even lower than the EU average; Poland’s is just 1.32 live births per woman. The concern is that a rapidly aging population will result in dramatic contractions in GDP because of a lack of domestic consumption.

To be sure, Eastern European countries are worried about demographics. Poland and Hungary are among the top four countries in Europe when it comes to government payouts to encourage women to have children. But demographics may not be as large a problem as it is made out to be. Despite the high emigration numbers, GDP growth in Eastern Europe has remained appreciably higher than in the rest of Europe. The potential decrease in domestic demand from declining population levels has been tempered by increasing wages and employment, which help boost demand. As long as GDP does not decline faster than the population, Eastern European countries will see increasing per capita GDPs, especially in the service and medical industries as the population ages.

In addition, Eurostat projections for net migration are not nearly as dire as they are made out to be. Hungary, the Czech Republic, Estonia and Slovakia are projected to have net positive migration flows in 2020. The figures for migration flows in Eastern Europe shown in the chart below are somewhat misleading. Some of the 2015 numbers are of course emigrants from Eastern Europe looking for new jobs. But these numbers also include refugees and migrants from the Middle East in search of new homes and opportunities. Western European countries are already struggling to integrate these immigrants into their economic and political systems, and they will likely continue to struggle as even more immigrants cross their borders.


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Demographics, moreover, are not Eastern Europe’s greatest concern. A potentially bigger problem is that wages could rise too high and too fast, cutting into the region’s competitive edge. Eastern European countries boast significant human capital, but they still need outside investment and technology so that they can climb up the value-added export ladder while keeping wages down to remain competitive in the global market. Rising wages are not all bad, however; they are only bad if they rise so high that Eastern Europe loses its competitive advantage. But if wage growth can be controlled, higher wages for Eastern European workers could actually help stimulate the domestic economy and help wean Eastern Europe off of its major vulnerability: exports.

The Risks

Reliance on external demand for their goods gives Eastern European countries less control over their own economic well-being, particularly in times of crisis. From this perspective, Slovakia stands out the most, with 93.8 percent of its GDP derived from exports. Romania has the lowest figure but still garners 40 percent of its GDP from exports. Any economy that depends so greatly on one component of GDP is at risk of economic contraction if that component experiences a downturn. Shocks in the global trading system could cause major disruptions in the economies of Eastern Europe. Anything from a cyclical U.S. recession to a seizure in the Chinese economy could lead to a fall in export demand.


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The problem, however, is not just the dependence on exports. For most of these Eastern European countries, the Baltic states being a notable exception, the dependence on exports is also a dependence on Germany, and Germany’s own export industry. Germany is a major exporter, and German companies have outsourced the production of various components to Eastern European countries. Their reliance on one partner makes these economies even more vulnerable because if demand for German goods falls, so too will demand for Eastern European goods. Even more worrying, the region’s dependence on Germany has not abated in recent years. In fact, for many Eastern European countries, Germany is not just their largest trading partner but also their fastest growing partner.


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Vital Allies

Thus far, our focus has been on economic factors. There is, however, a significant political factor that bodes well for Eastern Europe’s future: the region’s strategic importance to the United States. Poland and Romania are already firm U.S. allies, as are the Baltic states, and the U.S. is eager to secure strategic partnerships with all Eastern European countries. It does not want Russia to extend its influence westward, but as Moscow weakens, it will look to push outward to secure buffer zones along its western edge. That makes Eastern Europe a potential battleground.

One of the main reasons Eastern Europe has lagged behind the rest of the Continent is because the Soviet Union continued to project its influence in the region following World War II. The U.S. felt it needed to rebuild Western Europe to contain the Soviet Union, and it needed to do so quickly. So it established the Marshall Plan, which provided over $13 billion (roughly $150 billion in 2017 dollars) in aid to 16 European countries. According to the Congressional Research Service, by the end of 1951, industrial production for participating countries had increased by 64 percent, and gross national product had risen by 25 percent. European countries set up entities like the Organization for European Economic Cooperation (which later became the Organization for Economic Cooperation and Development) and the European Coal and Steel Community (the forerunner of the European Union).

Eastern Europe didn’t have the benefit of such a massive U.S. investment at the time. But now, the Continent’s circumstances have changed: Western Europe, a wealthy and self-sustaining region, is of less strategic importance to the U.S., while Eastern Europe, the frontline in the competition between Russia and the U.S., is a key partner for Washington. The U.S. has been pursuing allies in the region at the bilateral level for years now, in part because it sees that NATO’s unified sense of purpose and mission has decreased in recent years, and it needs to ensure that if it must act in Eastern Europe, it has allies upon which it can depend.

This does not mean the U.S. is about to write Eastern Europe a $150 billion check. The American public would balk at such a move in a way that it didn’t when the enemy it was facing was the Soviet Union and much more was at stake for the United States. But the U.S. will be focused on building relationships with Eastern European countries, and with that will likely come U.S. investment and other economic benefits. The U.S., unlike Germany, is not a massive exporter, but it is a significant importer, taking in over $2 trillion in imports in 2016. Trade between Eastern European countries and the U.S. is still relatively small, but exports to the U.S. have been steadily rising. Between 2012 and 2016, Polish exports to the U.S. increased by over 33 percent; Hungarian exports increased by over 45 percent; and Lithuanian exports tripled.

In Eastern Europe, the common wisdom that demographics and migration issues will destroy the economic potential of the region is faulty. The makeup of its workforce as well as its increasing productivity rates make the region a particularly attractive destination for foreign investment. The Achilles’ heel of these countries is their dependence on exports, and in particular their dependence on Germany. They need to find alternative consumers for their exports and to continue to attract investment and technology to help them modernize their economies. Eastern Europe’s geography, so long its curse, now attracts the attention of the global superpower, and as long as Russia remains a significant geopolitical challenge for the U.S., this region will succeed at trading cooperation with Washington for economic benefits.