The six Western Balkans countries are attracting investments in sectors from automotive parts production to IT thanks to their proximity to Central Europe and relatively low costs. Yet there is the potential to draw in more investment if it manages to raise productivity. Currently, wages in the Western Balkans are increasing faster than productivity, holding back the region from attracting investment and catching up with Central Europe. 

In 2023, real wages in the Western Balkans – comprising Albania, Bosnia & Herzegovina, Kosovo, Montenegro, North Macedonia and Serbia – grew sharply, reversing development in the previous year when inflation consistently outstripped wage increases. A spring 2024 World Bank report revealed an average real wage increase of 8.4% across the region, juxtaposed with a meagre productivity growth rate of just 0.2%.

Despite the positive indicators of wage growth, this uptick largely reflects policy adjustments rather than underlying economic strength. “[I]n all countries except Kosovo, average wage growth was faster than productivity growth, suggesting that the primary drivers of higher pay were more due to minimum wage reforms and labour shortages rather than improved firm-level dynamics,” the report said. 

The hike in real wages came after in 2022, the region's real wages experienced a significant downturn amid soaring inflation sparked by the war in Ukraine and associated energy crises, with Bosnia suffering the steepest decline at 8.7%. However, the surge in real wages in 2023 was not accompanied by corresponding productivity enhancements, raising concerns about the sustainability of this trend.

The faster advance of real wages than productivity is not limited to 2023. The World Bank’s report shows that since 2015, real wage growth in most Western Balkan countries has consistently outpaced productivity growth.

Source: World Bank. 

This trend is particularly pronounced in Albania and Bosnia, where real wages have surged by double digits, even as productivity stagnated or declined. Similar patterns have emerged in Serbia, Montenegro and North Macedonia, especially within key sectors like manufacturing, construction and public services. These wage increases, although beneficial in the short term, stem from factors unrelated to productivity improvements, such as minimum wage hikes and labour shortages.

The World Bank report attributes this discrepancy to several factors, including low public sector productivity and inefficiencies in how firms operate and allocate resources across sectors. “Low productivity improvements through sectoral reallocation, between and within firms, and weak public sector productivity” are cited as major contributors to this growing wage-productivity gap, which, if left unchecked, could exacerbate economic challenges in the region.

The report highlights that low productivity improvements, both between and within firms, alongside weak public sector performance, are critical contributors to this growing gap. If these issues are not addressed, the Western Balkans risk exacerbating their economic challenges, as their capacity to compete for investment diminishes in an increasingly competitive global market.

Competitiveness at risk 

The World Bank warns that the current state of real wages, which do not align with productivity growth, poses significant risks for the region's economic future. Policymakers must focus on enhancing firm-level productivity, particularly by bolstering public sector efficiency and fostering investments that drive innovation and sectoral reallocation, the report says. Without these critical reforms, the Western Balkans may find themselves increasingly uncompetitive, especially as neighbouring Central European countries continue to enhance their productivity levels.

Central Europe has historically benefited from higher productivity rates and more significant foreign direct investment (FDI), which in turn has facilitated sustained wage growth.

A special report from the European Bank for Reconstruction and Development (EBRD) published earlier in 2024 reinforces the urgency of addressing the productivity issue in the Western Balkans. It points out that region remains significantly behind the European Union in terms of both living standards and economic productivity. According to the EBRD, the GDP per capita (adjusted for purchasing power parity) of all six Western Balkan countries is less than half the EU average. While there has been some progress in narrowing the gap over the past few decades, the pace of convergence has stagnated since the global financial crisis of 2008-09. Projections indicate that under current trends, it could take the Western Balkan countries up to 70 years or more to catch up with their EU counterparts.

“The fundamental problem is low productivity in the economy, a result of many years of under-investment, weak institutions, unfavourable demographics and a difficult business environment,” said the EBRD report. 

“The gap in labour productivity between the EU-27 and the WB-6 has barely changed since 2001, and not at all since 2009, implying that the (limited) economic convergence that has taken place since then was driven by rising employment levels in the WB-6,” the report adds. 

Source: EBRD. 

The EBRD stressed the need for a fundamental shift from consumption-driven growth toward increased private investment, particularly in export-oriented industries capable of driving productivity growth.

Labour productivity stagnates

The stagnation of labour productivity is among the most formidable obstacles to economic growth in the Western Balkans. As noted by the EBRD, state-owned enterprises (SOEs) exhibit markedly lower productivity levels compared to private companies, further dragging down the overall productivity metrics for the region. Moreover, the complexity and value added of the region's exports remain concerns.

A significant area of concern lies in the region's human capital, particularly concerning labour participation rates and skills development. The Western Balkan countries report lower labour participation rates than the average for the EU members from Central and Southeast Europe, with a substantial percentage of young people classified as not in education, employment or training (NEETs). This presents a challenge to the future productivity of the region. The relatively low scores on the World Bank’s Human Capital Index underscore how current health and education outcomes hinder the productivity potential of the next generation of workers.

Additionally, the region faces critical gaps in digital skills, with inefficiencies in education and training sectors preventing workers from acquiring the necessary skills to succeed in a modern economy. Access to essential services also poses a problem, especially in areas such as sanitation, financial institution savings, and broadband costs, all of which hamper economic development efforts.

At the same time, the Western Balkan region continues to grapple with the repercussions of decades of under-investment in infrastructure and energy, severely hampering productivity gains. While investment levels in the region align with EU averages as a percentage of GDP, they fall short of the specific regional needs. The EBRD report stressed the importance of prioritising private investment and cautions against relying excessively on fiscal incentives for foreign investors. Enhancing the business environment, particularly for small and medium-sized enterprises (SMEs), and addressing issues within the informal sector are critical steps toward improving competitiveness and fostering economic growth.

Attracting investment 

Despite the issues with productivity, Southeast Europe continues to attract investment from both local and foreign investors. This influx of capital can be attributed to several factors, including a growing appetite for export-oriented investment, particularly in manufacturing sectors such as automotive parts and textiles. The post-pandemic recovery has spurred retail and consumer-oriented businesses to expand operations in the region. 

Investments in Emerging Europe have evolved over decades. Initially, Western firms sought skilled labour at competitive costs in Central Europe during the early transition period. As labour markets tightened, investment interests expanded southward and eastward, with Romania emerging as a popular destination for manufacturing and outsourcing. Today, Romania has transitioned from merely providing basic customer support services to hosting sophisticated tech development centres and high-value manufacturing sectors.

Historically, the Western Balkans lagged behind their more prosperous Central European counterparts. However, rising wages and tightening labour markets in Central Europe, coupled with geopolitical shifts stemming from the war in Ukraine and subsequent sanctions, have prompted investors to consider Southeast Europe as a viable alternative.

The Western Balkan countries are positioned to capitalize on this trend, particularly in lower-tech industries such as textiles and automotive parts manufacturing. Geographically and culturally close to Central and Western Europe, the WB6 countries benefit from proximity to established EU markets. Five of the six countries are already EU candidate states, with Kosovo actively seeking to join the ranks. 

However, taking full advantage would require countries in the region to tackle the wage-productivity gap. 

Central Europe maintains its lead

When comparing productivity and wage growth between Central Europe and the Western Balkans, Central European countries such as Poland, Czechia, Hungary, and Slovakia generally exhibit higher productivity levels, benefiting from advanced industrial sectors, strong integration into the EU’s single market, and a greater propensity for innovation.

A significant element of this comparative advantage is the robust institutional framework present in Central Europe. These nations have invested in the rule of law, regulatory reforms, and measures to foster entrepreneurship. In contrast, the Western Balkan countries often grapple with issues related to corruption, inadequate regulatory environments, and inefficiencies within public sector institutions.

Moreover, Central Europe’s labour markets have demonstrated a higher level of adaptability and responsiveness to changing economic conditions. In contrast, the labour markets in the Western Balkans face constraints related to rigid employment regulations and difficulties in transitioning from informal to formal employment.

The demographic challenge

The Western Balkans is in the midst of an ongoing demographic crisis, characterised by high emigration rates and an aging population. The World Bank highlights that emigration and population aging exacerbate labour market distortions, posing challenges for firms attempting to recruit skilled workers. This labour shortage, coupled with stagnant productivity levels, creates an unsustainable environment for wage growth.

Young professionals and skilled workers continue to migrate to Western Europe and other regions in search of better opportunities, further draining the Western Balkans of its brightest talent. High youth unemployment rates are coupled with long-term unemployment affecting nearly 20% of the workforce. 

In response to the labour shortage, some countries have begun reforming immigration policies to attract foreign workers in critical sectors such as information technology and construction. While these measures have shown promise, they only partially address the broader labour market challenges.

Despite the labour shortages, the total number of hours worked in the Western Balkans has risen since 2014, according to the World Bank, driven by increased female labour force participation. Women’s labour participation has notably increased across various sectors, helping mitigate some of the adverse effects of population decline.

To address the wage-productivity gap and ensure long-term economic sustainability, economists say the Western Balkans must prioritise comprehensive reforms. Boosting private investment in infrastructure, improving the business environment for SMEs, and enhancing the quality of education and vocational training programs are essential. Policymakers must focus on creating favourable conditions for investment that drive productivity improvements while managing wage growth effectively.

Investments in education and training programmes tailored to industry needs can play a pivotal role in bridging the skills gap, according to a comment by the head of the Regional Cooperation Council (RCC), Majlinda Bregu. Enhancing access to essential services, including broadband connectivity and financial resources, will be crucial to stimulating economic growth and improving living standards across the region, according to Bragu.

The Western Balkans must also foster a more inclusive labour market that engages marginalised groups, according to experts. This would need to include women and youth, who remain disproportionately affected by unemployment and underemployment. Targeted policies aimed at supporting these demographics can enhance labour force participation and contribute to productivity gains.

In addressing the myriad challenges it faces, the Western Balkans can work toward building a more resilient and competitive economy. By implementing the necessary reforms and fostering a culture of innovation and investment, the region can navigate the complexities of the modern economic landscape and move closer to achieving sustainable economic growth.