Emerging Europe's competitiveness is deteriorating and, with it, its attraction as a foreign direct investment destination. Wage growth has outpaced productivity improvements, and Germany, the main source of FDI, has lost enthusiasm for investing in its eastern neighbours.

Despite the fact that German workers earn much more per hour than workers in emerging Europe, ABN Amro research suggests that Germany has become more competitive on a unit cost basis than the Czech Republic, Lithuania and Estonia, and only slightly less competitive than Slovenia, Slovakia, Latvia and Hungary.

The reasons vary. In Hungary and Slovakia, tight labour markets have led to sharp wage increases 10 per cent a year compared with 2 per cent in Germany. In the Czech Republic, the koruna's rise against the euro has eroded competitiveness.

Although such factors as tax rates and transport infrastructure are significant, labour costs are the most important driver of outsourcing decisions. The decline in the region's comparative advantage is one reason why FDI flows to emerging Europe from Germany 7bn in 1999 have fallen dramatically. More and more German companies are looking further east. In 2003, German FDI to Asia exceeded that to emerging Europe for the first time since 1991.

Eastern Europe may be able to recapture the initiative - but its attractions will increasingly depend on its advantages in terms of language, skills and proximity rather than cheapness.

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