Central and Eastern Europe: failure of FDI-fuelled growth

In 1989, more than three decades ago the Iron Curtain fell, ending the Communist rule in Central and Eastern Europe, followed by the collapse and the dissolution of the Soviet Union. At that time, peoples of the region looked at the future with optimism: it was a widely accepted idea that freedom from oppression would also bring prosperity along with it, a way of life that is similar to people living on the western side of the continent. Then, the accession to the European Union following the year 2004 propelled these dreams forward, as becoming part of one of the most developed blocs in the world was expected to bring economic convergence with the west.

The results are somewhat bittersweet. All of these countries in the region did manage to partially close the wealth gap with the West, however, this convergence was not at all homogenous. In addition, it was also slower than people had hoped for: even after 30 years, none of the post-Communist countries have achieved the average level of development of the EU.

Due to the relative lack of capital and advanced technology, which characterized post-Communist countries at the time of transition, they chose to rely heavily on foreign direct investment (FDI) i.e. long-term investments, factories, and subsidiaries of foreign companies, mainly from the West to achieve convergence. These FDI projects were supposed to be a cure for all of these issues: they promised substantial capital inflows as well as advanced production and management processes to the region that would propel long-term economic growth. The FDI model was also encouraged by the process of accession to the European Union—privatization and facilitation of FDI inflows were important aspects of what the EU looked at for evaluating accession to the Bloc. Thus, all of the countries in the region brought attracting as much FDI as possible into their focus.

By the 2010s, however, it became increasingly clear that the post-transition growth model was not delivering the results everyone had hoped for. Foreign companies that set foot in the region, mainly operate as enclaves, only slightly or not at all integrating themselves into the local supply chain ecosystem but rather using their own well-established supplier relationships. They generally import their raw materials and export their end products abroad as well. Thus the trickle-down effects – be it know-how, capital, or even business relationships – from these western companies are very limited that can positively affect local enterprises. Consequently, a dual economic system developed in which the efficient foreign companies coexist with much less efficient local ones. Put it differently, the economic development of these countries currently does not depend on how innovative and efficient their businesses are but rather how many relatively low value-add and jobs they can attract from abroad.

A huge amount of studies have been devoted to the possible solutions to the above situation. There seems to be a lot of agreement around the statement that a competitiveness strategy that prioritizes the development of the quality of institutions could be the solution to the so-called ‘middle-income trap’ problem. Estonia is a positive example that managed to create high-quality institutions that in turn propel growth generated by local businesses instead of FDI. For example, the country put a lot of focus on modernising its governmental administration services, a broad project called e-Estonia: since 2002, every citizen has a digital ID that allows them to do almost everything online from paying taxes to voting. This is just one of the pillars but a good tangible example of institutional reforms.

The above overarching processes are very useful to understand when considering investment into the region’s companies. The base case situation of the region is positive: it is part of the European Union, some countries have the Euro, and it has an educated and relatively cheap workforce. Monitoring how the governance situation develops in different countries of the region could present long-term investors with an edge. In case a series of positive reforms are formulated in a country, the local enterprises could deserve a closer look.

Disclaimer: This article was issued by Tamas Jozsa, research analyst at Calamatta Cuschieri. For more information visit?www.cc.com.mt. The information, view, and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.