The Euro Economy

There’s a dark side to otherwise welcome news that growth in central and Eastern Europe picked up significantly in the third quarter, helping to drive robust growth of 2.5% year-on-year in the EU’s economy. As growing wages and lower taxes spurred consumer spending, third-quarter expansion in the EU’s eastern member states beat both EU averages and market predictions, with Latvia’s economy growing by 6.2%, Poland’s and the Czech Republic’s by 5%, and Romania’s by a whopping 8.8% — even stronger than China’s.

But as the European Bank for Reconstruction and Development (EBRD) pointed out in its latest report, eastern and central European countries have become mired in a “middle-income trap”: the phenomenon in which growth stagnates as technological progress slows and rising wages neutralize former competitive advantages of low labour costs, complicating efforts to make the leap from a middle- to high-income nation. The trap is a common one in developing countries and has already sucked in a number of economies in Latin America and Asia, from Brazil to the Philippines. To avoid stagnating on a plateau for years, or even decades, governments in the region will thus need to enact significant reforms.

To be fair, some economist have countered that the middle-income trap is overemphasized, if not a myth. But the fact remains that it is just as difficult, if not more, for middle-income countries to progress towards high-income status as quickly. For instance, policymakers in these developing countries often try to hold onto out-dated, manufacturing-based growth models too long or try hurdling towards joining the ‘knowledge economy’ too quickly, with the result that they are squeezed by countries with cheap labour on one side and by wealthy innovators on the other.

The question for central and Eastern European countries is thus, how can they avoid falling into this trap and continue their impressive growth rates – and eventually catch up with their high-income EU neighbours?

First, the regional economy will have to boost innovation and productivity levels. As the EBRD report showed, lack of dynamism at the firm level is one of the main challenges facing Eastern and Central European economies. The region is still dominated by small, relatively inefficient firms, which have a history of lagging behind larger firms found in wealthier economies in terms of innovation, access to capital, and productivity. For instance, 80% of firms in central and Eastern Europe employ less than 10 people, and large firms have a productivity advantage of roughly 70% over micro-sized firms in the region, compared with 40% in Western Europe.

This means governments need to prioritize policies that raise access to external funding and technology for these businesses; build a business environment that fosters competition; and prioritize global trade integration, which provides an additional catalyst for spurring innovation.

In Bulgaria, for example, the EU state that scored last in the region in the World Bank’s most recent Ease of Doing Business rankings, efforts to boost its competitiveness and attract more FDI have stalled. Most concerning is the fact that investment as a share of GDP has tumbled, from 28.3% in 2007 to 18.6% in 2016, with FDI falling from 18.8% to 1.4%. Some issues turning away foreign investors from the Bulgarian market have included slow issuing of permits and licenses for investors in certain sectors like manufacturing, a poorly regulated property market, and lack of judicial independence. Many experts are also worried that the country discriminates against foreign investors at the behest of local vested interests, as a series of recent high-profile cases has shown. Such disputes often act as a deterrent to other aspiring foreign investors in a country that should be trying to nurture them.

The European Commission’s latest corruption report agrees on the need to protect the rule of law, criticizing the government for its weak progress and pointing out that the country actually backslid on judicial reform. Streamlining the market entry process, eliminating red tape, and combatting lingering issues of corruption would go far towards boosting Bulgaria’s prospects for attracting more investors, and expand its economy.

Second, infrastructure investment must also become a central component of government policy in the region. To be fair, central and Eastern Europe on the whole has decent access to basic infrastructure, and governments in the region have acknowledged the need to upgrade their transportation and energy infrastructure to boost competitiveness and reduce dependence on Russian oil and gas.

But in many countries, the quality of the infrastructure still has far to go. Romania, for instance, ranked 128th out of 138 for its road infrastructure in the World Economic Forum Global Competitiveness Report, while its out-dated railway system was only moderately better ranked at 79. Across the region as a whole, an average of nearly 10% of firms cite poor transport infrastructure as a major challenge that has a daily impact on the way they do business.

But evidence from Turkey’s recent upgrades to its road networks suggests that improving transport infrastructure can go far towards raising domestic trade, employment, and overall economic prospects. As the EBRD highlighted, since the government started road upgrades in 2005, travel times between pairs of Turkish cities have dropped by 1.5 hours, translating to more than $4 million in trade flow increases over 10 years –a considerable return on investment.

To wrap up, channelling more funds into infrastructure, governments need to spur more foreign investment, streamline regulations, and encourage privatization. Of course, a main reason for the considerable economic growth that central and Eastern Europe has seen over the past 25 years is in part a reflection of the hard political decisions that were taken to liberalize markets, encourage FDI, privatize state-owned firms, and cut subsidies. But there is still far to go.

If governments in the region don’t take concerted steps to stop such backsliding – and instead prioritize ways to boost innovation and productivity – then this week’s good news might turn out to be little more than a short-lived blip before impending stagnation comes home to roost.

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