No more low cost: East Europe goes up in the world

Central and Eastern Europe faces the end of an economic era.

With employment rates at record highs, and workers demanding wages closer to western levels, the cheap-labour model that has driven growth since the fall of communism is on the way out.

The challenge that faces governments and companies in the region over the coming years is to find new avenues to growth.

A walkout at the Volkswagen factory in Bratislava in June, the first strike at a major Slovak car plant, led to a staggered 14 percent pay hike in what has become the latest and starkest sign of the shifting economic landscape.

VW was one of dozens of big Western manufacturers beating a path to Slovakia, the Czech Republic, Poland and Hungary after the fall of communism in search of cheap labour.

The rush eastwards marked the birth of an economic model that transformed the region. But a quarter of a century down the line, the regional labour market is running dry, with record low unemployment rates of around 3-7 percent across the region.

As a result wages are rising faster than in the West – led by Hungary with a 12.8 percent year-on-year leap in March.

Zoroslav Smolinsky, the VW Slovakia union leader who engineered the strike, had joined the production line in 1992, when the plant had just been taken over by Germany’s VW .

He was paid the equivalent of 75 euros a month at the time. “We could live on it,” he said. “We had to.”

Today Volkswagen’s 12,300 workers in Bratislava earn an average of 1,804 euros a month.

Such rates, however, remain less than half the average Volkswagen pay packet in Germany, and Smolinsky says such huge disparity can no longer be justified.

“Times have changed,” the 48-year-old said. “We’re in the EU and have to keep up with trends and gradually narrow the gap.”

The strike was resolved with the wage increase phased over more than two years, as well as a 500 euro one-off bonus for each employee and an extra day of holiday. VW is not alone in facing rising labour costs and strife.

French carmaker Peugeot and South Korea’s Kia have both raised pay this year in Slovakia, while Audi and Mercedes have faced strike threats in Hungary.

The moves by the car makers are particularly significant because the auto industry represents the lion’s share of foreign investment in Central and Eastern Europe. Volkswagen units, for example, are the biggest companies in Slovakia and the Czech Republic, while Slovakia has become the world’s top carmaker per capita, producing more than 1 million a year.

Moscow-based investment banking group Renaissance Capital said foreign investors would not abandon existing projects in the region, but new investments were likely to go elsewhere.

“Never again is Central Europe likely to offer what it did in the 1990s,” it said in a note to investors.

Turkey, North Africa

Companies are taking steps to improve productivity via methods like increased automation in order to offset rising costs, say executives, policymakers and analysts. In the longer-term some could go to other countries instead in search of cheaper labour.

Volkswagen signalled it could steer clear of Slovakia for future investments if faced with another costly showdown with workers.

Another sharp rise in wages would “threaten the stability of jobs”, Lucia Kovarovic Makayova, a spokeswoman for Volkswagen Slovakia, told Reuters. “It could happen that the group gives preference to a factory with lower personnel costs when deciding on sourcing production of the next product.”

Renaissance Capital said investors in search of cheap labour would ultimately look further south and east.

“When European business confidence is high again, we think the next wave of investment expansion will lap the shores of Turkey and the southern Mediterranean,” it added, also singling out Morocco, Tunisia, Egypt and possibly Ukraine and Iran.

Filip Eisenreich, CEO of Czech ventilation and cooling system producer Janka Engineering, a unit of India-based Lloyd Group, said his company was raising wages by 7-8 percent this year and was “pretty much on the edge” in terms of labour costs.

“Further growth (in wages) without concurrent growth in productivity would not be sustainable for us,” he told Reuters.

While labour productivity has long been lower than in Western Europe, “this difference has so far been compensated for by lower wage costs, but those rise faster every year than in western European countries”, he added.

Radek Spicar, vice-president of the Czech Confederation of Industry, said intensifying wage pressures were forcing firms to automate more, something his organisation trains. Seminars “have been packed to the roof”, he said.

SECOND-CLASS EUROPEANS

The issue of wage disparity is a highly charged one that is pervading society and politics across the region.

It is at the heart of a perception among Poles, Slovaks, Czechs and Hungarians that they are seen by Western Europe as second-class Europeans. Politicians have seized on such grievances and have taken up the call for better pay.

Slovak Prime Minister Robert Fico backed the Volkswagen strikers, while in the Czech Republic the ruling Social Democrats have erected billboards ahead of an October election declaring “The End of Cheap Labour”.

However political and labour leaders aiming to bring wages in line with the West must find alternative paths to economic success. Crucial to this, most agree, is to move industries up the value chain into higher-margin areas.

Big manufacturers share less of their income with employees in Central and Eastern Europe than they do in Western Europe. In the EU, wages on average accounts for 47.5 percent of economic output, according to Eurostat – but while that figure reaches 50.9 in Germany it drops to just 40.4 in the Czech Republic.

But workers in Central and Eastern Europe are less financially productive. According to OECD data, an hour of work in Germany produces 52.7 euros of German economic output, but just 19.4 euros in the Czech Republic.

Part of the reason is that many Czech firms produce lower-margin components for global chains rather than the finished products that deliver higher margins and profits.

“We are not just cheaper-labour economy but also a low-cost economy,” said Spicar. “We are also a supplier economy, part of global production chains, with low share of final products.”

Policymakers are looking to invest in higher-margin sectors.

“We have to get ourselves away from the economic model based on being a low-cost economy and switch to production with higher added-value,” said Michal Picl, head of analysis in the Czech prime minister’s office.

There are already examples, such as Czech government support for a plan by U.S. aircraft engine supplier GE Aviation, part of General Electric, to build a 350-million-euro development and production plant for turboprop engines in Prague.

Peter Stracar, General Electric’s CEO for Central and Eastern Europe, said the region’s future industrial success hinged on moving into higher-margin businesses.

“We must find ways to create more value-added technology in CEE and GE is at the forefront in doing so,” he told Reuters.

He said his company had hired over 2,500 highly qualified employees in Hungary in engineering, finance and software development over the past three years. The region had much to offer beyond low wages, he added, citing factors including the stability of its legal systems and its geographical proximity to the markets of Western Europe.

“It is not just a question of low cost,” he said.