Beyond the middle-income trap

Taking the next economic step requires innovation and greater productivity

Benjamin Cunningham
30 September 2014

The good news is that the Visegrad Four countries all appear to have escaped the dreaded middle-income trap – that theoretical scenario in which specialization helps a country grow its economy to a certain level only to see complacency and over-dependence lead to stagnation. The bad news is that much of the region remains highly dependent on manufacturing that was drawn in by low labor costs during the 1990s, and that further growth – or better said, growth rates that might allow the region to match the earnings of its Western European counterparts – requires a shift in emphasis.

While most economists now consider all of Central Europe in the high-income bracket of global economic players statistically, that may come as news to many in the region. Per capita GDP in Poland, for example, is still less than 30% of neighboring Germany. If nothing else, this proves that there is indeed a clear distinction between merely avoiding a trap and reaching maximum potential.

If history is any indication, taking the next economic step requires a country to alter its course toward innovation and greater productivity, in the best-case scenario, morphing from an economy of makers to an economy of creators. Today, serious economic creativity almost always boils down to information technology of some sort. At 1.88%, the Czech Republic far and away leads the region in percentage of GDP dedicated to research and development, but still trails EU-leader Finland’s 3.55% by a significant margin. There is room for improvement (especially in Slovakia, which spends just 0.82% of GDP on R&D), but also reasons for optimism. The Czech economy actually places greater emphasis on R&D than the UK.

 

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There have been notable examples of inventive, new-economy businesses in the region, some of which are now serious global players in their respective fields. AVG and Avast, for example, are Czech anti-virus software companies of international scope; however, the fact that nearly every businessperson in the V4 would probably name the same handful of firms on a shortlist of regional homegrown success stories is also a sign that there are far too few.

There remain explanations for this, some well known and others less so, but this is a subject we shall return to later. First, it is worth noting some of the innovative firms from the region that may be helping pull V4 economies a rung or two further up the global economic ladder today. As Roland Manger, a partner at the Berlin-based venture capital firm Earlybird, notes, there remains promise in the region. Earlybird launched a 130-million-dollar “Digital East” investment fund earlier this year, and demand was such that they had to turn some investors away. Manger finds the region’s strong heritage in technical education a draw, as well as what he firmly believes is a knack for ingenuity that still manages to fly below the global radar. “This means that we get to pick the prettiest flowers,” he says of his firm.

 

Regional success stories

Perhaps Earlybird’s most fruitful V4-based blossom is Socialbakers, a Prague-based company that uses analytics to monitor commercial marketing campaigns on social media. From a handful of founders starting out in Pilsen in 2008, they have grown to some 400 employees. In addition to Prague and Plzeň, they now have offices in Istanbul, London, Mexico City, Munich, Paris, San Francisco, Sao Paulo, and elsewhere. “We started out of college without any capital,” says Lukáš Maixner, one of the founders. “We are growing in two dimensions – vertically with more data and insight, and horizontally, integrating more and more platforms.”

Also based in Prague and targeting the commercial use of social networks is Brand Embassy, which created software that allows companies to manage customer service via Facebook, Twitter, and other social media. The company launched in 2011, and essentially channels customer comments, complaints, and requests on such platforms directly to the person at the company most likely to be able to solve the problem. “Social media was not built for customer service,” says Vít Horký, the company’s CEO. “We help.” Brand Embassy has about twenty-five employees, twenty based in Prague. They count about fifty large companies as clients, including AVG, Diageo, GE Money, ING, Johnson & Johnson, KIA, Prezi, Telefonica O2, T-Mobile, and Vodafone.

The aforementioned Prezi is another of the V4’s big success stories. They make cloud-based presentation software that allows presenters to create 3-D effects and zoom in and out between slides. The firm has about 250 employees and 45 million users worldwide. It got its start in 2009 out of Kitchen Budapest, an ideas lab based in the Hungarian capital that was launched in 2007. “The world has changed a lot since then,” says Zsolt Winkler, Kitchen Budapest’s managing director. “These days, three university students can create something, put it on Kickstarter and turn out a product. What we offer is a mixture of an innovation and an incubation lab.”

Slovakia has also been home to a number of innovative tech-oriented startups. One of the most successful of these is Piano Media, which started in April 2001 as a media pay wall system that bundled much of Slovakia’s news web sites into a single subscription. The company then launched similar operations in Slovenia and Poland, before starting to offer a variety of more individually tailored pay wall products for individual media outlets. Earlier this year Piano Media signed a deal to set up and run the pay wall of the re-launched version of the American magazine Newsweek.

 

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A new Slovak up-and-comer is Diagnose Me, still with just ten employees. It is something of a social networking platform for doctors and patients. The website allows medical patients to get a second opinion on a diagnosis from anywhere in the world in a number of languages. Patients upload images from scans, x-rays, or MRIs and connect with any number of a team of doctors who review the files and either confirm or contradict the original diagnosis. The doctors set their own fees and Diagnose Me collects a 30% share. “The original idea was that we would have many people from India and China,” said Martin Kolesar, the company’s director of product development. “Actually, we found we have many the UK.”

In Poland, among the more intriguing tech firms is Uxpin. Their product is used to design web and mobile applications. The goal is to fill a significant market gap between overly specialized design software that requires special training and tools that are too simple to make interesting applications. While it has a kind of middle-market appeal, professional designers are increasingly taking it up as well. Revenue rose 950% year-on-year in 2013 and the Gdynia-launched startup now has an office in Silicon Valley.

“We believe that designing a website or a mobile app should be as easy as building things from Lego, said Marcin Kowalski, one of the founders. “You can’t achieve that by using such tools as Adobe Photoshop, which is definitely a powerful tool, but far too complex for web and mobile design.”

Companies like these are hardly alone in the region. Poland has Reaktor Warsaw, Mybaze, and Nozbe. In Slovakia, LiveDispatcher, TheSpot, and Kickresume won awards at the Central European Startup Awards. The Hungarian firms Crypttalk, iCatapult, and Zinbox are generating buzz. Rising Czech firms include Liftago, TechSquare, and Kaicore. Such startups are proof that it can be done, but what is to be done so that investors like Earlybird’s Roland Manger, and the region itself, will one day have an even more appealing garden to harvest? While the conditions among V4 countries vary, there are also overlaps and trends.

 

V4 Startup 2.0

There is some sense that V4 tech companies initially benefit from the same dynamics that led heavy manufacturing to migrate to the region in the 1990s: specifically, a skilled labor force working for lower wages than elsewhere. Such arrangements, however, do little to gain ground in Western European economies, with lower wages meaning lower domestic consumption and slower growth for other industries too.

Programmers and web developers indeed still do work for lower pay on average than their counterparts in Western Europe, the United States, and elsewhere. “There is talent and it is our advantage that we were able to build at relatively low cost compared to San Francisco or Western Europe. It is just the way it is,” Maixner of Socialbakers says. But when it comes to tech and the twenty-first century, this dynamic only partially holds true. While startups may exploit lower wages at very early stages of development, that competitive advantage quickly evaporates as the company grows.

“At the end of the day, your competition is based in Silicon Valley,” Kolesar of Diagnose Me notes. Innovative tech companies can operate from anywhere, so incomes for skilled specialists quickly enter the realm of global competition. Put another way, Manger says: “Once companies become internationally active they are on the global labor market.”

A dynamic like this is a prime example of how tech startups can help spur wage and economic growth in the region more generally – assuming they stay based in the V4, that is. Piano Media recently moved its headquarters from Bratislava across the Danube to Vienna. The change came as the company sought additional capital and prioritized the German-language market. Brand Embassy’s creation story provides an interesting example of possible gaps in the system that slow V4 innovation. Should these persist, we may see more companies created in the region move to financially greener pastures.

While the vast majority of Brand Embassy’s operations are in Prague, the company was technically founded in the UK. “Setting up a company in the Czech Republic is still pretty difficult,” Horký says, citing unpredictable changes in commercial law and poorly thought-out thresholds in asset valuation required to register as one type of firm or another. The company was also able gain some early funding from UK Trade and Invest, a public entity comparable to Czech Invest, which helps firms target export markets. Czech Invest, Horký notes, has historically worked with larger more established firms, rather than startups of the type his was at the time.

As any retail customer or mortgage holder in the Czech Republic might know, the practicalities of banking in the country are occasionally frustrating. This carries over into the commercial sphere. “The situation is not good,” Horký says. “There are a lot of constraints on opening accounts, getting overdraft protection, getting support to set up a multi-currency account.”

Such logistical issues are a significant weakness in a global marketplace, but the region quite obviously has advantages as well. Sometimes these strengths and weaknesses can even, somewhat contradictorily, be one and the same – as is it when it comes to V4 education systems. Top-notch technical education is always noted as one of the V4 strengths by businesses in tech or elsewhere. At the same time, nearly all creativity-driven industries also cite the education system as a weakness. “The region is extremely strong in technical education, but in business it is still mostly about your own education,” Kolesar says. “To create added value, you need more than that. Slovakia needs to improve college education in the liberal arts. This may sound contrary, but what is missing is that schools don’t teach students to think for themselves.”

 

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Kowalski recently helped mentor youngsters in entrepreneurship as part of a workshop program at Gdansk Business Week. “I realized that this is something that we should have in Poland on a regular basis,” he said. “Not as a one-week initiative, but something that we teach at schools: entrepreneurship, leadership, creativity, teamwork, and a basic understanding of what it is like to run a company – pitching ideas and public speaking.”

Beyond this, there are larger culturally engrained hurdles that still must be cleared for the V4 to tap its full tech potential. “In Poland we’re far behind the U.S., where most Americans are natural-born salespeople and marketers,” Kowalski says. “Secondly, there is a big difference in knowledge-sharing in general. There is a culture of knowledge-sharing in Silicon Valley.”

In Budapest, Winkler is perhaps best positioned to see how the whole tech startup ecosystem works, sitting at the intersection of experimentation, ideas, and capital, and companies big and small. Kitchen Budapest provides a space for freelance experimentation, but also provide small startup funding (up to 35,000 dollars) and mentoring for some of the most promising ideas. KIBU, as they call themselves, are backed by Deutsche Telekom via their local Hungarian arm. “The big investments are coming from outside the country,” he says. “It is the risk part of capitalism that is missing from capitalists here.”

This is perhaps the biggest cloud hanging over the full bloom of tech entrepreneurship in the region. While Earlybird’s Manger notes that there are small startup funds and incubators that can help V4 tech companies get started, taking the next step – and thus generating jobs, increased salaries, and economic growth – almost always requires money from outside the region. He counts his own firm and 3TS Capital Partners as perhaps the only serious, consistent players on the market and remarks that many V4-native investors impose “unwise conditions that are more politically driven than commercially.” Such flaws no doubt slow innovation and perhaps, even worse, risk pushing domestic innovators outside the V4 once they do find success.

“We are committed to the region and find it particularly interesting because for some reason nobody else has found it interesting for investment,” Manger says. “We are always looking for exceptional people and unless you are a chauvinist, you realize that gifted people are equally distributed throughout the world.”

This article is taken from Visegrad Insight 2 (6) 2014.

 

Benjamin Cunningham writes about Central and Eastern Europe for The Economist, The Christian Science Monitor, Time magazine, Body, and others. He is a fellow at the Institut für die Wissenschaften vom Menschen (IWM) in Vienna.

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