Central Europe Has Fallen out of Love

Poland and Hungary are moving fast towards a new state-led model of development that could heighten tensions with foreign investors and the European Commission.

Central Europe has fallen out of love with foreign investment, on which the region has based its transformation for the past two decades. Foreign investors are now routinely blamed for everything from deceitful food branding to the region’s failure to catch up with Western European living standards.

And this is not just whingeing. Poland and Hungary are moving fast towards a new state-led model of development that could heighten tensions with foreign investors and the European Commission.

Of course, the privatization of Central Europe’s “crown jewels” and granting investment incentives to foreign investors have rarely been popular, either with voters or local business elites.

Suspicious Foreign Investments

Paradoxically, rightwing parties in Central Europe were most suspicious of the wave of foreign investment into the region that followed the collapse of communism. They argued that local entrepreneurs should be given the first chance to buy state-owned assets, and that granting incentives to foreign investors was unnecessary and could stifle nascent domestic entrepreneurship.

The most vocal proponent on this view was former Czech Premier and President Václav Klaus, who used coupon privatization and soft loans by state banks to try to build up a home-grown business elite that would support his Civic Democrat Party.

However, this model crashed and burned in the 1997 Czech currency crisis and 1998 banking crash, which revealed the acute need for restructuring in the industrial and financial sectors. Even Klaus was forced to agree to a pilot foreign investment incentives scheme before his government collapsed. Miloš Zeman’s Social Democrat government then used privatization (particularly of the banks) and incentives to harness foreign investors to transform the Czech economic model.

“We had to attract final manufacturing plants, including assembly lines, because they were pioneers to modernize Czech industry,” says Jan Havelka, who built CzechInvest into the best investment promotion agency in the region in the late 1990s. “They were creating innovation for the whole cluster.”

The privatization of Central Europe’s “crown jewels” and granting investment incentives to foreign investors have rarely been popular, either with voters or local business elites.

Hungary, under the socialists, had already embraced this model in the mid-1990s and took an early lead in attracting foreign investment. Slovakia, too, became an eager convert under Mikuláš Dzurinda’s broad reform coalition after the 1998 election. Poland remained the laggard, though eventually in the noughties its sheer potential triggered a foreign investment wave, although big companies remained largely state-owned.

The Crisis’ Impact in the Region

Foreign investment provided capital and technology and managerial and marketing know-how, revolutionizing old sectors and building new ones, quickly dominating exports. Locally-owned companies then learnt by example, by becoming part of the foreign investors’ global supply chains.

However, the 2008 global financial crisis exposed the drawbacks of this model. Countries such as Slovakia, which were tightly embedded into global supply chains, were highly vulnerable to the economic downturn that followed the crisis as exports plunged and foreign investors retrenched. Afterwards, the foreign-owned banks were accused of starving local companies of nance while they mended their capital bu ers back home.

The crisis also had a long-lasting impact on interest in the region. Apart from Hungary, inflows of foreign direct investment (FDI) to the V4 countries have so far never recovered to the pre-2008 levels.

Furthermore, the sluggish recovery since 2008 has raised fears that the region is now stuck in a “middle income trap,” one where the low-hanging fruit have already been plucked, and something different than the FDI-led model will be needed to converge with West European income levels.

Meanwhile, the huge profits that are once again being made by foreign-owned companies have stoked resentment, with trade unions criticizing them for paying wages that are still well below Western Europe while extracting huge dividends that ow abroad. “Our future cannot be built on the cheap labor model that started in the mid-1990s,” Josef Středula, head of the Czech trade union confederation, told the Aspen Annual Conference in Prague in November.

The 2008 global financial crisis exposed the drawbacks of this model. Countries such as Slovakia, which were tightly embedded into global supply chains, were highly vulnerable to the economic downturn that followed the crisis as exports plunged and foreign investors retrenched. Afterwards, the foreign-owned banks were accused of starving local companies of nance while they mended their capital buffers back home.

Multinationals are criticized both for concealing pro ts by dubious transfer pricing and other tax avoidance techniques and for not reinvesting those profits they do declare into their domestic operations.

The Bashing of Foreign Investors

The continuing income gap with Western Europe has created fertile ground for the populist political uprising that has convulsed the region. “If you sit next to Germany and Austria it is di cult to be happy that you exceeded Greece or Portugal,” says Miroslav Singer, chief economist of Generali CEE and a former governor of the Czech Central Bank.

Attacking foreign investors enhances nationalist and populist credentials, helps win support from local business elites, and can provide tax revenue. This time around, bashing foreign investors is a game that the left can play too, though the right are more naturally gifted at it.

Hungary’s rightwing strongman Viktor Orbán has targeted foreign investors since returning to power in a landslide in 2010, after the ruling socialists were discredited by the economic crisis.

Orbán has focused on the banking, retail, energy, and media sectors, industries that he wants to be dominated by the state or by friendly local entrepreneurs. These sectors were pro table and therefore offered rich pickings, they also often raised emotions, and his lack of influence there became a constant frustration. By expanding domestic control of the banks he could direct lending, influence over the energy sector would minimize price rises unpopular with the public, while domination of the media would silence the opposition voices.

Levies were imposed on banks, large (essentially foreign-owned) retailers were hamstrung by restrictions aimed at helping smaller local rivals, and energy price rises were blocked. Foreign-owned media were harassed and denied state advertising until they either sold up to friendly tycoons or shut up.

His blueprint has been copied by the region’s other dominant political figures: Robert Fico, Slovakia’s Social Democrat Premier since 2012, and Jarosław Kaczyński, leader of Poland’s rightwing populist Law and Justice Party, which won back power in 2015.

A New Industrial Model in Central Europe

After harassing foreign investors, forcing some to sell out and exit, Central Europe’s populists are now moving on to a second stage of using state and domestic-owned champions to build a new industrial model.

This drive also reflects a new phenomenon: fear that Central Europe could be left on the scrapheap by the new global industrial revolution. Policy-makers are worried that Central Europe’s manufacturing base faces a losing battle against digitalization (for example 3D printers) and improvements in robot technology. According to the OECD, almost half the jobs in the Czech Republic and Slovakia could be at risk from automation.¹ A report prepared by the last Czech government said the country could lose 140,00 jobs by 2025.

Hungary’s rightwing strongman Viktor Orbán has targeted foreign investors since returning to power in a landslide in 2010, after the ruling socialists were discredited by the economic crisis.

For the automotive industry in particular, the region’s dominant segment, the increasing automation could destroy jobs while the shift towards electric or self-driving cars could leave Central Europe’s car plants in the slow lane, focused on soon-to-be redundant models.

Many of these fears are overdone. Central Europe’s assembly plants are state of the art, wage costs are still low, and they now have a supplier ecosystem, therefore they are unlikely to be the first to be closed or left to become obsolescent. “If you have a cluster that is a big advantage,” says Ján Tóth, former deputy governor at the Slovak Central Bank. “This should be the last place to shut down a car plant.”

After harassing foreign investors, forcing some to sell out and exit, Central Europe’s populists are now moving on to a second stage of using state and domestic-owned champions to build a new industrial model.

Nevertheless, it is true that the region needs to look beyond manufacturing—particularly if it refuses to countenance increased migration to increase the labor supply. And yet, it remains woefully backward in services and the new knowledge-based industries that could replace these lost jobs.

Reversing the Privatizations of the 1990s

The solution, according to a growing consensus in the region, is a greater state intervention on the Asian model: as an owner of companies and banks, as a supporter of domestic-owned champions, or as a facilitator of the industries of the future. Successful local companies will invest, create jobs, and pay taxes at home, and could also then expand abroad. They will make end products, not just low value-added components for Western European giants.

As before, it is Orbán’s Hungary that has led the drive towards a new industrial model. His government has built up new state champions in the banking and electricity sectors by buying up exiting foreign investors, in effect reversing the privatizations of the 1990s that it argues went too far. The government is also trying to create a new domestic-owned telecom group to rival the privatized Magyar Telekom, owned by Deutsche Telekom. Orbán has also encouraged strong domestic-owned groups to grow up and expand abroad, such as banking group OTP and oil and gas giant MOL.

Fico has followed a similar trajectory in the Slovak energy sector. His government has harassed Italy’s Enel into agreeing a phased sale of its 66% stake in Slovenske Elektrarne to local group EPH, leaving itself an option of buying half that stake later, which would enable it to regain majority control of the utility.

Poland now has plans to be even more ambitious. As well as building up state-owned banking and electricity groups like Hungary has done, it has drawn up a far-reaching plan for a new hyperactive industrial policy under economy minister and now Prime Minister Mateusz Morawiecki.

The Risks of Central Europe’s New Turn

The odd man out in this rethink on foreign investors has been the Czech Republic, perhaps because of its formative experience in the 1990s. This attitude may now be about to change under new Premier Andrej Babiš, who is likely to restrict the use of investment incentives. “The thinking is already changing in the Czech Republic, because too much foreign ownership became a problem,” says Radek Špicar, vice president of the Czech federation of industry.

There are three serious risks to Central Europe’s new turn.

The first is that FDI is still crucial to the region’s development—both in terms of adopting new technology and joining global supply chains—and harassing foreign investors and curbing incentives would be self-harming. Foreign investors are often criticized for not doing enough research and development locally, but they still are responsible for the bulk of the private R&D that takes place.

Yet, even as they antagonize foreign investors, all four countries have continued to pursue green eld manufacturing FDI, often competing, as with the Jaguar Land Rover investment won by Slovakia, to offer very generous incentives.

It is true that the region needs to look beyond manufacturing—particularly if it refuses to countenance increased migration to increase the labor supply. And yet, it remains woefully backward in services.

The growing consensus now is to target incentives on higher value-added investments. Under the Morawiecki plan, for example, Poland wants to direct FDI into sectors that it regards as priorities, rather than just accepting whatever is offered.

Moreover, even if several companies in the sectors targeted by the populist governments have exited, foreign investors in general do not appear to be put o by the attacks. Political risk is a factor, but it is often trumped by others. Ironically, Hungary, the most aggressive of the V4 countries, has been the overall regional leader in FDI as a percentage of GDP since 2011.

A Triumph of Hope over Experience?

The second main risk is of running into conflicts with the European Commission over competition, something that Hungary and Poland have already incurred with their discriminatory measures, particularly against large retailers. However, given that both governments are already in trouble with the EU over a range of more serious issues, this is probably a risk they are pre- pared to keep taking.

Foreign investors are often criticized for not doing enough research and development locally, but they still are responsible for the bulk of the private R&D that takes place.

Perhaps the biggest risk is that a state-centered industrial strategy will run into the same problems as in the early 1990s: the wasting of money, corruption, and incompetence. Given the quality of governance, giving the state more power to direct industry may turn out to be a triumph of hope over experience.

It could also be a diversion from the real challenges of improving infrastructure, the business environment, R&D, and skills—the key obstacles for developing new industries. “We don’t have another growth model right now,” says David Marek, head of O&G Research in Prague. “New enterprises are our only chance to change it,” he adds.

Even economists sympathetic to a more active industrial policy remain worried about nationalization or the risk of encouraging oligopolies and oligarchization.

“It all depends on the role of the state,” says Petr Zahradník, an EU adviser for Česká spořitelna bank (owned by Austria’s Erste). “The state role should be an intermediary, not a new owner, a conductor managing the ownership change from a foreign to a domestic owner.”

Robert Anderson

was the Financial Times correspondent for the Czech and Slovak Republics between 1997-2007. He is currently the managing editor of intellinews.com, a business news website covering the CEE region. He tweets at rjanderson8.

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