BUCHAREST BLOG: Southeast Europe steps up its FDI challenge

BUCHAREST BLOG: Southeast Europe steps up its FDI challenge
By Clare Nuttall in Bucharest September 28, 2017

Comparatively low labour costs and proximity to Germany, and other major West European markets, have for the last couple of decades made a compelling case for international firms to locate manufacturing, and to a lesser extent IT, operations in Central Europe. Now, however, rising wages and low unemployment in the region are raising questions about for how long the EU member states of CEE can remain popular among manufacturers and whether lower-cost countries to the south-east will usurp their place.

Recent data from the Visegrad Four countries confirms the changing situation. Both Czechia and Slovakia reported record low unemployment this summer, while Poland’s unemployment rate fell to a 26-year low. At just 4.0% in August, Czechia’s unemployment rate is now the lowest in the EU28.

Falling unemployment and a growing number of unfilled vacancies across the region, where GDP is uniformly showing robust growth, are pushing up wages. Czech wage growth reached the fastest pace in the last decade in Q2, and wages are set to rise further after Prime Minister Bohuslav Sobotka announced pay hikes for public sector workers as the country heads for a general election in October. Wage growth is also accelerating in Poland, reaching 6.6% in August.

“We see labour markets tightening across CEE, mostly because of cyclical developments; as the economies grow more workers are needed. There are also some structural phenomena behind this, specifically the lack of skilled workers which has been more or less a problem in CEE for the last 10 to 20 years but has come to the surface given the current fast economic growth,” Zoltán Árokszállási, chief analyst, CEE macro/FI research at Erste bank told bne IntelliNews, attributing this at least partly to the departure of hundreds of thousands of CEE citizens for Western Europe.

“Labour markets have tightened — the unemployment levels have been falling in most cases and tend to be pretty low," agrees Leon Podkaminer, senior economist at the Vienna Institute for International Economic Studies (wiiw). “Shortages of (skilled) labour are felt throughout the region. This has much to do with large numbers of the region’s nationals working in the West.”

There are some other factors at work — for example the unemployment rate in Hungary has been pushed down by the government’s massive state-sponsored employment scheme — but overall this represents a radical change of the picture that first attracted international investors to the region.

FDI has been pouring into the region for a couple of decades now, since before the first wave of accession of post-Communist countries to the EU. The auto assembly and components sector was one of the first to relocate production to CEE on a large scale, a phenomenon that turned Slovakia into the world’s top carmaker in terms of car output per capita. But automakers are not the only industry to find CEE attractive; a wide range of manufacturing operations are now located in the region, along with outsourced IT and shared service activities.

Now, however, recent media reports from the region reveal automakers are struggling to find workers, and often looking south to Serbia or east to Ukraine to fill the gaps. Earlier this year, Volkswagen’s Slovak unit reportedly had to bring in around 500 workers from Audi’s factory in neighbouring Hungary, while Kia imported workers from Bulgaria. Similar stories are coming out of Czechia, most recently that vehicle backseat producer Adient was unable to meet unexpectedly high demand from Skoda Auto due to a shortage of workers, daily Hospodarske noviny reported.

The situation has not yet reached crisis point. Iwona Janas, regional managing director Manpower Group Poland and Russia, points out that while “the market is shortening and we are seeing an increasing talent shortage… still compared to more developed countries of Western Europe we are not seeing the same level of talent shortage”. Janas also believes the ongoing tightening of labour markets in the region is a natural evolution that is closely linked to economic growth.

Shifting south

However, the combination of rising costs and a shortage of workers has raised the question of whether investors will shift south-eastwards to the even newer EU member states of Romania and Bulgaria, or the prospective member states of the Western Balkans.

In the last few years, there has already been an increasing flow of export-oriented FDI into countries such as Romania, Bulgaria, Serbia, Macedonia and Moldova. On the other hand, this has not been the result of companies relocating their operations from CEE to Southeast Europe, and the relative labour productivity of the two regions undermines the rationale for moving from CEE to SEE in search of lower labour costs.

“Although Romanian workers earn less than CEE counterparts, the country is not really cheaper than other CEE countries. The nominal labour costs per hour are lower, but if you account for productivity, this difference vanishes,” says Árokszállási.

Other issues such as the sharp difference in the quality of infrastructure are also relevant. Daimler’s selection of Poland over Romania and other destinations in the region for a new plant was attributed by Romania’s then economy minister Costin Borc to the poor infrastructure in the Southeast European country. The relatively small populations of most Southeast European countries (with the exception of Romania) is another limiting factor for employers looking for hundreds or thousands of workers.

“From the [unit labour cost] ULC viewpoint it makes sense to move the activities (especially the labour and wage intensive) from the West into the [new EU member states],” says Podkaminer. “Moving the activities from Poland or the Czech Republic into Romania and Bulgaria may also make sense. But one would have to consider also the fact that the latter two countries are located much further away (at least from Germany and the Nordic countries) … Besides, their resources of properly skilled labour may be insufficient, the business services underdeveloped, etc.”   

Nonetheless, despite having lower productivity than the Visegrad countries, Romania has managed to attract numerous manufacturers, among them major auto parts suppliers Dräxlmaier and Continental, but most are concentrated in the west of the country where exporters can take advantage of the proximity to Hungary’s much better road network.

And even in Romania, an available pool of low-cost workers is by no means a given these days. One economy ministry official told bne IntelliNews that manufacturers were increasingly having to look to smaller industrial towns to find workers. In the IT sector, the labour market is overheating dramatically, and firms are now looking beyond the capital Bucharest and second city Cluj Napoca (recently rated the preferred destination for Romanians to relocate) to other university towns.

Elsewhere in Southeast Europe, the government of Serbia — a prospective EU member and the largest economy in the Western Balkans — has been seeking to take on the mantle of Europe’s low-cost factory by offering tax breaks and subsidies to export-oriented investors, but this policy has become increasingly controversial.

Back in 2008, Serbia scored a coup when Fiat agreed to take over the old Kragujevac car factory. However, production at the plant was recently shut down by a strike over pay and working conditions, which only ended when Prime Minister Ana Brnabic stepped in amid fears the Italian giant could quit Serbia altogether. While this was averted, the three-week strike at Serbia’s top exporter is likely to hit the country’s export figures for this quarter.

The Fiat Chrysler Automobiles strike coincided with a separate strike by workers at another Serbian factory, owned by Slovenian domestic appliance maker Gorenje, which has located some of its production in Serbia as costs are considerably cheaper.

The two strikes threw the spotlight onto growing opposition to efforts by the government to take advantage of Serbia’s low costs to bring in foreign investors. While the government hopes to tackle chronic unemployment, which is set to worsen when IMF-required public sector reforms are launched, opponents say foreign investors are benefitting by exploiting Serbian workers.

This was one of the mixed bag of grievances voiced during the protests that followed Aleksandar Vucic’s election as president in April, where some protesters carried banners stating “We won't be a cheap labour force”. Outrage has also been sparked recently by allegations about working conditions at a plant operated by Korean Yura Corporation, a long-term investor in Serbia that produces electrical components for the auto industry, where workers reportedly were made to wear adult diapers during their shifts to avoid wasting time with toilet breaks.

Efforts to attract FDI in neighbouring Macedonia have also come under scrutiny as the new Social Democrat-led government declassified information on ad hoc subsidies paid by its predecessor to foreign investors. Subsidies and tax breaks extended in the 10 years the conservative VMRO-DPMNE was in power amounted to €225mn — or €11,000 per job created.

Converging economies

The current tightening of the CEE region’s labour markets may not continue to accelerate indefinitely. There are already signs that the wave of migration that started when they joined the EU is slowing, and could even be reversed in future.

This is backed up by a study from real estate firm Colliers International which lists new “pull” factors for CEE migrants as tighter labour markets push wages up and negatives such as corruption and political instability lessen, while at the same time governments try to entice migrants back.

“We believe that the emigration wave has peaked and that workers will start to return eastwards to CEE-6,” says the Colliers study, which looks at the Visegrad Four countries plus Bulgaria and Romania. This will contribute to “filling the skills gaps that these workers created by seeking work in the West,” it adds. “This market dynamic, termed the ‘labour force boomerang', is likely to translate into increased investment interest, provided that worker productivity can keep pace with Europe,” forecasts Colliers’ EMEA director of client services, Peter Leyburn.

And as citizens of the CEE countries have moved westwards, workers from Ukraine in particular and other countries to the south and east have arrived to take up jobs in the countries they left behind. All the Visegrad countries have seen strong inflows of Ukrainians, with Czechia, Hungary and Slovakia all experiencing net immigration in 2015, the OECD’s latest International Migration Outlook showed. As of the end of 2015, 20% of the foreigners in Czechia were Ukrainian nationals, with many more arriving from Russia and Slovakia. The Czech government is now under pressure to open the way to allow more Ukrainians to work in the country, something that unions have vowed to oppose.

“If the talent shortage intensifies, it will force companies to be more creative and innovative in finding and keeping talent,” argues Janas. She has already seen companies increasing their efforts to recruit across national borders, with a particular focus on countries such as Ukraine.

All this could lead to a moderating of the labour market squeeze, at least temporarily. Yet in the longer term, as the CEE economies converge with those of their EU peers to the west, rising labour costs are inevitable. Keeping CEE as a low-cost destination will not only be difficult, it will also lead to the region’s development and convergence with Western Europe being held back.

“The countries in CEE are starting to realise that convergence is not possible if they stay low-cost destinations forever,” says Árokszállási. “There has to be an increase in wage levels, and what makes this possible is better healthcare, better education — not just university education but technical training as well, and more spending on R&D. In the Czech Republic and Slovenia, for example, R&D spending has already increased to very close to the OECD average, and the number of people with tertiary education in several of the CEE countries is rising faster than the OECD average.”

There are already strong signs the CEE economies are moving up the value chain in terms of the type of investment they attract, which is a positive sign for future convergence.

“Labour shortages do not seem to have impaired investment so far,” says Podkaminer. However, he adds that, “They may be restricting some labour-intensive types of investment in future — this supporting the use of more labour-saving technologies.”

Janas also believes that as long as the labour market squeeze continues, as well as being more creative in their recruiting, employers will also have to put more effort into boosting the skills of their workforce and investing into automation and process optimisation.

These are all positive signs for the future, indicating that while CEE employers may be feeling the squeeze at the moment, the tighter labour market is likely to bring longer-term benefits in terms of pushing investors and governments alike to make the investments needed to turn the region into a higher value destination.