The great leap forward?

Central Europeans need to move away from the model of a cheap labour force and become leaders in innovation if they want economic prosperity to continue

Tim Gosling
29 May 2017

The Czechs are by far the happiest in the Visegrad region, according to the World Happiness Report 2016 anyway. They sit 27th in the world, which is topped by the usual Scandinavian and Antipodean suspects. Around 20 places lower mope the Slovakians and Poles. Hungarians are found sulking in the 91st position.

It may be true that money can’t buy happiness, but it’s unlikely mere coincidence that the (relatively) happy-go-lucky Czechs have led the region in terms of economic prosperity since communism was cast off. The country’s GDP is close to 90% of the EU average.

Some look far into the past for the basis of the Czech lead. Developed during the Habsburg Monarchy, industrial concentration made the western reaches of Czechoslovakia one of Europe’s leading manufacturing economies by the time of the First Republic in the early 20th century. 

There are many other potential factors that may well play a role: geography, infrastructure or culture for instance. However, the most convincing is stability, whether in terms of institutions, policy, fiscal management or banking.

“It would be hard to find a more stable economy in the entire world,” suggests David Marek, chief economist at Deloitte Czech Republic.

It’s no coincidence that investors simply ignore the common corruption and crises that have earmarked the Czech political scene over the past 25 years. The president may have all but orchestrated a 6-month coup in 2013, for instance, but Czech bond remained at record low yields. Compare that to the reactions of investors to controversial political events in Hungary and Poland in recent years.

Stability is the key factor that has separated the Czech Republic from its Visegrad peers, and by extension is the main driving force behind the country’s lead in economic prosperity over the past 25 years. Given the current populist climate across the globe, that should be a huge competitive advantage going forwards, if policymakers can harness it to help maintain that lead and accelerate convergence with the EU.

Space

Visegrad has spent the last 25 years seeking to catch up with western Europe based on one simple economic model: selling cheap labour to foreign investors to assemble goods for export. It’s time for an update, and not only because protectionist policy is rising across the globe.

Looking longer term, the shift in global economic power that was flagged by the crisis sparked in 2007 has not gone away. The traditional leading nations in North America, Western Europe and Japan will continue to lose their advantage over emerging markets. Meanwhile, technology and automation is undermining traditional industry and labour markets.

The Czech Republic has the strongest base in Visegrad to ride that wave of change. It also has the most political space, which is a pre-requisite to roll out the necessary long-term strategy. Systemic reform is the antithesis of the populism taking hold across Europe and the US.

Poland’s PiS government is busy building a nationalist project centred on handouts to the population and increased state control of the economy. Hungary’s Prime Minister Viktor Orban is concentrating on regaining his constitutional majority at next year’s elections using his usual toolbox – a mix of conservative nationalism, cronyism and short term economic strategy that has just seen corporate tax slashed and wages hiked.

Slovakia is still catching up with its peers on the basis of the old model, and therefore has less motivation to rip up the strategy for the meantime. However, Bratislava has adjusted its tax policy to encourage higher-added value investment in recent years, and is now working on schemes to help channel state funding to entrepreneurial start-ups, mentioned Michal Polak from the country’s finance ministry.

“The tendency of these governments [is] to run looser (more “populist”) fiscal policy,” notes Neil Shearing at Capital Economics. “Depending on the particular circumstances, this can lead to a burst of growth; albeit one that is short-lived. In the long run, however, economic growth will inevitably suffer, for two main reasons. The first is the perception that increased centralisation of power tends to undermine judicial independence and can erode property rights; the second is that overseas investment is deterred by the more hostile stance towards foreign capital. Both of these factors will tend to depress investment.”

Andrej Babis is the best illustration of the political space the Czechs enjoy. The likely next prime minister is perhaps the only populist leader in the world selling a form of austerity rather than handouts – no matter that he vehemently denies it. While rival Bohuslav Sobotka is starting to aim at easy targets such as foreign investors and wages and pensions, Babis has been making hay from fiscal consolidation.

Yet at the same time, an election year is no time for systemic reform. The stability of Czech institutions, finances and banks is well established and does not look at risk, but whether the Czech government can take advantage of the uncertainty stalking its regional rivals to take a real leap ahead by modernising the economy looks far less certain.

Golden hands

 Steps towards modernisation are becoming more urgent. The evident disappointment amongst Visegrad populations with the benefits of EU membership is just one of the mounting signs that the old economic strategy is progressively unable to deliver.

“The increasingly apparent labour shortages demonstrate that the growth model based on cheap skilled labour and FDI is largely coming to an end in Eastern Europe,” states Evghenia Sleptsova at Oxford economics.

Ironically, given the hostility to immigration across Visegrad, the response thus far has been to import labour from Ukraine. It’s a solution that’s clearly short term, but how to leap into the modern age when you’re still catching up with most of Europe?

Some issues are obvious and headline click bait: develop the e-economy and digital infrastructure. But ask Estonia, which suffers from perhaps CEE’s most acute labour shortage despite having crafted a reputation as a global tech hotspot, how that’s worked out.

The details are more prosaic, longer term, and harder to pin down, especially for electorates yearning for a higher quality of life.

Further than that, the necessary revolution means countries need to adapt traditional ways of thinking about themselves. The Czech Republic’s success over recent decades could hold it back.

“The country has a strong industrial pedigree, and is rightly proud of it,” suggests Gunter Deuber, head of CEE research at Raiffeisen Bank International. “That tends to mean the country is too focused on classical industry. It’s an intellectual challenge they need to overcome to move forwards. Does the Czech Republic need to concentrate resources on twentieth century physical infrastructure or e-connectivity?”

That’s a debate going on right now in Germany; a country whose supply chain provides a huge chunk of the export demand that keeps Czech factories – and the economy – running.

“Central Europe’s great dependence on German trade and investment poses risks for economic development,” writes Konrad Popławski at the Centre for Eastern Studies (OSW). “First, Germany specialises in exporting capital goods based on traditional industrial companies. German companies have still not shown any significant successes in the IT sector, which may determine the strength of the economy in the future. Secondly, the role of Central Europe as an assembly plant for German companies is linked in the medium term with the risk of losing that position to countries with lower production costs.”

That’s a key point. Not only does the Czech Republic need to shift its strategy if it wants to catch up with countries to the west, but it risks losing ground as its competitive advantage is usurped by the east.

“We need to add more working heads than hands,” states Marek. In other words, “golden Czech hands” must give way to “clever (golden) Czech heads”.

In spite of the state

Indeed, Prague can’t change the structure of the economy overnight, but it needs to add continually to what it’s already good at by evolving the model of the 20th century. But again, that’s a tough political move. Despite the relatively strong economy, the political climate couldn’t be more hostile to questioning tradition.

Prime Minister Bohuslav Sobotka has hinted he could introduce special taxes for certain large, foreign-owned companies, similar to those in Hungary, Poland and Slovakia. It seems likely that such talk is little more than pre-election rhetoric, but it still dents the country’s image for investors seeking a home for higher added value operations.

However, the PM also announced in December that a long term economic strategy is finally on the way. The Czech Republic will have to leave the growth model based on foreign investment and low wages, and enhance domestic businesses, in particular SME’s, he stated.

But Prague is also wary. A recent report warned that Industry 4.0 – essentially automation and digitalization – could cut 140,000 jobs by 2025, and the country has some way to go towards any modern industrial revolution.

The Czech Republic stood 17th in Europe in the 2017 Global Innovation Index, and even those segments that are making progress claim to be doing so in spite of the state.

The Association for Internet Development (SPIR) said in January that although Czech companies are amongst the biggest users of the internet in Europe and online sales are the second highest on the continent, total retail turnover, infrastructure and other vital building blocks are lagging.

Prague has now appointed a coordinator for the digital economy, but Tomáš Prouza must split that role with his job as Secretary of State for European affairs. SPIR complains that the development of the high-speed internet is stunted, with just 7% of companies connected to a network that rarely ventures far from the major cities, while access to mobile data is pricey and e-government remains in its infancy.

Taxation without innovation

Policy at national level is the key, and there are several obvious but mundane obstacles to pushing the economy up glamorous global innovation rankings.

Tax, labour and pension policy is perhaps the most common issue mentioned by analysts. “It’s not just the stronger base that is making Czech convergence with the EU slower than its peers,” claims Marek. Prague should take note of tax and pensions reform in other countries of the region, he suggests.

In particular, the Czechs could consider shifting the tax burden away from labour to indirect taxes such as VAT and excise. “Indirect taxes are less evil for the economy,” Marek notes. “High taxes on labour or capital can create negative motivation for work or entrepreneurship.”

Czech income tax sits in the middle of the European scale at 15-22%, while the average salary of $21,689 in 2015 stood around half that in the OECD. Corporate tax sits at 19% – not the lowest, but still 2 percentage points below the European average.

Yet companies don’t worry so much what employees take home, but what they cost. The Czech Republic tacks 28% in social insurance onto that average wage, and the overall tax wedge on labour is the third highest in the EU. The likes of Slovakia have already made moves to shift some of that burden to indirect taxation.

While the Czech labour tax wedge still sits lower than France and Belgium, the country can’t compete with Western Europe in terms of modern infrastructure and technical advancement. That leaves the Czech Republic lagging in terms of the competitive advantage it can offer to attract higher added value investment.

The high relative cost of labour makes it harder for companies to justify basing higher paying, more skilled jobs in the country. That’s especially the case if they have to pour money into training ill-prepared employees. Several analysts suggest tax breaks or subsidies should be on the table for companies ready to do just that.

Tax incentives could also be offered to companies ready to invest in R&D rather than the simpler assembly operations that dominate FDI in CEE. At the same time, local innovative SMEs and entrepreneurs could do with more encouragement.

Prague might do well to look to the Nordic countries, which crowd into the top ten of the 2017 Bloomberg Innovation Index. “The incentives are there and the tax system favours [innovators],” claims Magnus Henrekson, director of Sweden’s Research Institute of Industrial Economics.

Hunting angels

Czech innovators also need better access to funding. While the country improved in several other categories in the World Economic Forum’s European Innovation Scoreboard 2016 – such as patent revenues – venture capital investment dropped 30%.

The banks are not a great source of finance for innovative companies. The stability of the Czech banking sector has been a major boon for the economy over the past 25 years, and the country is regularly described as the perfect banking market: “boring”. But such sobriety only makes it even more difficult for small and innovative companies to borrow.

That leaves the EU to step into the breach. The European Investment Bank announced on January 17th that it will make €100m in financing available to Czech SMEs to promote innovation, with another €160m to be spread across CEE.

“The operation will allow for a significant increase in financing to innovative companies to fund their working capital and long-term investment needs, particularly in the areas of research, development and introduction of innovation in production,” the development bank notes.

“Innovation is a driver of economic growth,” EIB Vice President Vazil Hudak points out. “Yet access to finance is scarce in this particular segment.”

Slovakia – ironically the one Visegrad economy to see incoming investment maintain a healthy level in 2016 – seems to be grasping the point. Speaking at an event hosted by Erste Bank to boast of a new ‘social banking’ unit that will seek out entrepreneurs to fund, the finance ministry’s Polak joined the scepticism displayed by business incubators that commercial banks can take on the necessary risk. Contrary to the calls of the bankers present, he insists the state must take the lead for now on channelling funding to smaller projects.

Bratislava is on the same page. The government says it sees the problem, and wants to put EU and state funds to work. The economy ministry is “thinking about introducing new, previously unused forms of help, such as support via angel investors or non-financial aid” for innovative start-ups,” reads a report discussed by the cabinet in January.

Still, governments need to stimulate private funding. Financial markets in CEE remain under-developed, meaning venture capital and angel investors are scarce. Reform is needed to improve legislation on setting up venture capital funds says Marek, and again, incentives should be offered.

Old school

Financing matters little, however, if investors can’t find skilled staff for innovative operations.

A worrying 76% of CEOs in CEE cited availability of key skills as the top threat to growth prospects in a recent survey by PwC. “As technological change drives changes in the way companies work, automating old processes and creating demand for new skills, the war for talent is intensifying,” the report reads.

A growing labour shortage is already viewed as a major threat to investment and economic growth in Visegrad. Unemployment in the Czech Republic dropped to an EU-low of 3.6% in 2016.

However, governments are wary of embracing the challenge. Sobotka has admitted education needs to react to changes on the labour market, but he also warned that if new jobs are not created, “the processes of robotisation and digitation may threaten employment”.

While the country has avoided the teachers protests across the rest of Visegrad against the dumbing down of the curriculum by nationalist governments, education in the Czech Republic is also going backwards.

Surveys reveal declining results at schools, and no government since the fall of communism has taken education reform seriously. The Czech Republic advanced three places overall in the 2017 Bloomberg Innovation Index to 28th out of the world’s top 50 innovative economies, but still trailed both Poland and Hungary, and placed a lowly 38th for education.

“Today, in the ICT sector, there are around 140,000 people working,” Prouza says. “That number is rising very fast as Czech companies digitalize and modernize and as start-ups begin to develop and grow. All that means that we are going to need a much bigger workforce and a different type of qualifications and capabilities than what we have been used to in the past. Everyone knows that we are lacking tens of thousands of IT experts.”

The American Chamber of Commerce in the Czech Republic called for several measures in education reform as well as training incentives in a recent paper. “Innovation in manufacturing could be assisted by providing training subsidies or tax breaks for retraining the existing workforce when improving or expanding production lines,” the document reads. Meanwhile, the government should put its still considerable role in the economy to work, the paper continues. Public research money should be allocated to basic and applied research related to the development of the next generation of company products. This research will likely require the import of leading researchers who will both conduct research and educate graduate students.

The issues stem not only from the government side, however. The PwC survey notes that old school management approaches dominate in CEE. “[B]usiness leaders also face a challenge that’s human, not technical:” the report states, “the need to address the different motivations and ways of working embraced by employees from the Millennial generation.”

Managers in CEE need to become more comfortable with employees that have the skill sets needed, but may be outside the office or even the company, the survey says. A full 86% of regional CEOs report that it is “somewhat … or very difficult” to recruit people with leadership qualities.

Reflecting that old-school approach, the Deputy Chairman of the Czech Association of Exporters, Otto Danek, recently called for prejudicial state policy. Students of engineering disciplines should continue to enjoy free university, he said, but those working in “unnecessary fields” should pay.

The suggestion illustrates the difficulties of systemic reform. It’s a short-term reaction to a tricky, long term challenge.

The Czech economy needs technical graduates right now, and companies persistently complain about a lack of qualified candidates. But there are two potential problems in elevating one strata over another, rather than improving the quality and the relevance of education to a modern economy across the board.

On the one hand, who can pinpoint the specific requirements the economy will have in the coming decades? On the other, state education should aim to turn out skilled critical thinkers in all disciplines; anything less could produce a far bigger problem than a labour shortage; a vicious circle in which economic stagnation and increased inequality puts the fundamentals of liberal democracy at even greater risk.

Tim Gosling based in Prague, Central Europe Bureau Chief of bne Ltd.

The article was first published in Visegrad Insight 1 (10) 2017.

Cover photo: Maurycy Gomulicki, Golden Shower, Warsaw, 2016. Photo by Marek Krzyżanek, courtesy of Zachęta National Gallery of Art