Promise in emerging Europe despite slow revival

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The countries of central and eastern Europe have had their fair share of crises. The brutal slump following the collapse of communism gave way in the past decade to a spurt of growth – one that has ended once again in a steep regional slowdown.

Even now, as “emerging” Europe starts to bounce back from last year’s recession, the pace of its recovery has been thrown into doubt by the Greek debt crisis and the problems in the eurozone. Its revival may lag behind that of some other emerging economies, notably in Asia, but the region is once again a place of great promise for business.

Per capita incomes are already well ahead of those in the biggest emerging markets, such as China and India, giving consumers considerable spending power – even while closing the gap with the EU still provides much scope for growth.

In addition to the investments already made by western European companies in finance, retail and consumer goods, and manufacturing, there may be new opportunities. Upgrading much of emerging Europe’s still dilapidated infrastructure is taking on a new priority, as is developing more innovative, high-technology businesses to broaden and diversify the regional economy.

“For us, central and eastern Europe is a fantastic opportunity,” says Peter Löscher, chief executive of Siemens, the German engineering giant. “There are short-term challenges such as consolidating fiscal policy and public debt, but in the medium term it is a very important growth opportunity.

“Even this year, [economic] growth is forecast, and in the coming years you see a very solid growth pattern of maybe 3-4 per cent a year.”

The post-communist adjustment of the 1990s caused huge disruption as the region embraced market reforms and privatised industries that had long been controlled by the state. The dislocations led to economic slumps, in some cases rivalling the US Great Depression of the 1930s.

In many countries, not just Russia, they also gave birth to oligarchs. These were local business people who often accumulated capital through trade, or by offering the first commercial banking services and then using that to buy former state industries in privatisation programmes at knockdown prices. Many remain among the region’s several dozen billionaires today.

The reforms led to a major reorientation of trade and investment flows. Countries that had previously traded mostly with other members of the Soviet bloc turned westwards and became increasingly integrated with western Europe.

By 2008, for example, Germany accounted for between a fifth and a third of the exports of Poland, the Czech Republic, Slovakia and Hungary. In Poland’s case, more than 40 per cent of its exports go to Germany, France, Italy and the UK. Russia remains a significant supplier to many of the central and eastern European countries, although much of this is energy and raw materials.

EU membership for eight central and eastern European countries in 2004 and two more in 2007 gave a decisive boost to the region’s connections in terms of trade and business with western Europe. Two of those countries, Slovakia and Slovenia, have taken the additional step of joining the single currency, the euro, in a move that saw a big jump in capital flows and foreign investment into the eastern portion of Europe from the west.

A study by PwC this year found that foreign direct investment into 14 central and eastern European countries, including Russia, jumped fivefold from $30bn (£20.5bn, €24.6bn) in 2003 to $155bn in 2008. The attractions were a growing consumer market as well as lower relative wage costs for manufacturing.

Western banks, in particular, now dominate banking further east. Often that has been achieved through acquisition of regional businesses and by building on historical and cultural ties.

Among the biggest players are Austria’s Raiffeisen and Erste Bank and Italy’s UniCredit. Swedish banks such as Swedbank and SEB have been particularly active in their near neighbours, the Baltic states of Estonia, Latvia and Lithuania, and in Ukraine.

Meanwhile, Greece’s big four banks – National Bank of Greece, EFG Eurobank, Piraeus Bank and Alpha Bank – spent the past decade expanding into Romania, the Balkans (particularly Bulgaria) and Turkey.

The region has been a strong draw for consumer goods companies, and for retailers such as the UK’s Tesco, France’s Auchan and Carrefour, and Germany’s Metro and Rewe. Wal-Mart of the US, the world’s biggest retailer, is thought to have its eye on entering the Russian market.

Yet the movement of goods has not been all one way. Removal of trade barriers through EU membership strengthened central European countries’ ability to act as low-cost manufacturing centres.

That was especially true in the automotive industry, with many of western Europe’s biggest carmakers opening plants in the region. Industry figures show central and eastern Europe (excluding Russia and Ukraine) continued to increase its share of production of European vehicles, reaching 24 per cent last year, despite the downturn. The Czech Republic and Poland overtook Italy in terms of vehicle output, now ranking fifth and sixth, respectively, in the EU.

A report by UniCredit found auto production was continuing to move eastwards, with Fiat modernising a plant in Serbia and Daimler building an €800m (£668m, $976m) factory in Hungary. The auto industry has become a mainstay of central European economies – vehicles account for a fifth of Slovakia’s manufactured exports.

But the huge inflow of capital from the west proved to be double-edged. It left emerging Europe’s businesses heavily reliant upon foreign funding, much of it in euros, while the region was slow to develop its own capital markets and local-currency lending. The flood of cheap credit, moreover, encouraged overborrowing and helped inflate asset price bubbles, notably in markets such as property.

When flows of capital and credit froze in late 2008, businesses and households were left with high levels of foreign-currency debt. It also delivered a shock that resulted in much of the region being harder hit by the international financial crisis than any other world market.

“While financial integration has done more good than harm, we cannot close our eyes to the harm it has done,” Thomas Mirow, president of the European Bank for Reconstruction and Development, told the bank’s annual meeting in Zagreb last month.

But, as Mr Mirow noted, the fact foreign banks did not turn their back on central and eastern Europe during the crisis helped avert the regional meltdown that financial markets feared early last year. Their readiness to remain invested was helped, in part, by the so-called Vienna Initiative support programme led by the EBRD and the International Monetary Fund.

Average growth across emerging Europe is expected to be relatively robust this year – certainly compared with the 1 per cent increase in GDP forecast for the EU. The EBRD last month upgraded its economic forecasts for the 28 countries where it has operations (including central and eastern Europe, Turkey and the former Soviet Union) to 3.7 per cent, from a 3.3 per cent forecast in January. But the overall average is boosted by strong recoveries in certain countries such as Russia, and masks sizeable variations.

Perhaps ironically, how resilient the countries of emerging Europe were during the crisis – and their recovery prospects now – depended in part on the size of their own domestic markets and the extent to which they relied upon exports to the EU.

Poland, for example, which has a sizeable internal market and did not gorge on foreign-currency lending like some of its neighbours, was the only EU country last year to avoid recession. Its economy grew by 1.7 per cent. Along with Turkey, another country with a large domestic sector, it is now among the countries poised to fare best in the next year or two.

The Czech Republic and Slovakia, despite being more reliant upon recovery in the EU market, are also in the front rank, thanks to their manufacturing strength and attractiveness to foreign investment.

Ukraine and Russia are both experiencing a bounce after deep slumps last year. Russia is being helped by the recovery in oil and commodity prices, and Ukraine by a reviving steel market and greater political stability since the election in February of Viktor Yanukovich as president.

But the economic revival will take longer in the three Baltic republics, as well as in Romania and Bulgaria. Since the Baltic states were determined to keep their exchange rates pegged to the euro, they were unable to devalue their currencies.

That forced them to undertake painful “internal” devaluations, reducing wages and prices to improve their competitiveness, which led to double-digit economic contractions last year.

Over the next decade, the growth of emerging Europe is still expected to outstrip that of western Europe. But there are important questions over the pace of economic convergence and the further integration of the two halves of Europe.

The eurozone crisis, sparked by the rising deficit and debts of eurozone “periphery” countries such as Greece, is likely to make core EU members such as France and Germany wary of admitting smaller, poorer countries into the single currency. Although Estonia’s bid to join in January has been backed by the European Commission, other aspiring members may face tougher scrutiny in coming years to ensure they meet the Maastricht criteria on debt and deficits in a durable way.

Emerging European countries themselves generally remain committed to eventual euro membership. But they say the eurozone must carry out its own internal reforms first.

“Maybe it’s better that we are in our own little house and, in a few years, when the eurozone has been renovated, we’ll move in,” says Jacek Rostowski, Poland’s finance minister.

Scarcer capital may also mean growth is slower than in the boom years just before the financial crisis. PwC suggests foreign direct investment flows may not surpass their 2008 peak until 2014.

But, says Marco Annunziata, chief economist at UniCredit, even if central and eastern Europe’s growth rate may be a little lower than before the crisis, the region retains much of its long-term appeal. “Many countries still have lower labour costs, and have made big strides in terms of the ease of doing business and the strength of their institutions,” he says. “It remains a place that is very attractive compared to the eurozone.”

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