House of Commons - Trade and Industry

Select Committee on Trade and Industry Eleventh Report

3 The Business Environment in the A8/A2 Countries

44. The A8/A2 countries have shown consistently strong economic growth since the Russian financial crisis of the late 1990s. Although growth varies significantly between individual countries, their combined average GDP growth rate has consistently been more than double that of the EU15 since 2001. Indeed, their average growth rates have been comparable with those of the so-called BRIC countries (Brazil, Russia, India and China) for much of the same period.

Average Annual GDP Growth Rates 1997-2006 (%)

Source: Ev57 'DTI'; International Monetary Fund, World Economic Outlook Database, April 2007

45. Growth varies significantly between the individual A8/A2 member states. The strongest performers are Estonia (11.4% growth in 2006), Latvia (11.9%) and Slovakia—whose growth rate of 8.3% in 2006 significantly exceeded the expectations outlined in the DTI's evidence to us. The majority of countries had growth rates of between six and eight percent, led by Lithuania (7.6%) and Romania (7.7%). Slovenia (5.8%) and Poland (5.2%) both fell short of the six percent mark, but only Hungary (3.9%) had a growth rate comparable with the EU15 average of 2.7%.[74]

46. A key question for investors is whether this growth can be maintained. The pattern of growth outlined above suggests that the A8/A2 countries are becoming increasingly resilient to global downturns. The Russian crisis of 1999 affected these countries to a much greater extent than more established market economies or the more distant BRIC countries. An encouraging sign is that the A8/A2 as a whole seemed relatively unaffected by the post-2001 economic downturn compared to the EU15—indeed, average GDP growth marginally increased during the period 2001-2002.

EU Funding

47. The A8/A2 countries are set to benefit considerably from the 2007-2013 round of European Union spending on cohesion policy. In total around €176 billion will be spent on the A8/A2 countries over the five year period, with the A8/A2 countries receiving net transfers of, on average, around 3% of their GDP over the next funding period.[75] We heard that much of this money will be designated for infrastructure projects—such as investment in the ten transport 'corridors' intended to link Western, Central and Eastern Europe agreed at the 1997 Helsinki Pan-European Transport Conference—and some A8/A2 governments have expressed interest in public/private partnerships, which the UK is well placed to support.[76] The significant influx of EU money into the A8/A2 during the 2007-2013 funding period will provide excellent opportunities for UK companies—particularly in the fields of construction and financing. The ministers and officials we met during our visits indicated that they were determined to achieve the best value possible and would welcome British involvement in the resulting investment. We hope that the British government and business look seriously at the new opportunities that will arise from these developments.

Labour Market

48. Wage rates in the A8/A2 countries remain around a fifth of those in the rest of the European Union. The average hourly wage for the A8/A2 as a whole in 2005 was €4.88 compared to €24.41 in the Eurozone and €24.47 in the UK.[77] Average wage growth across the A8/A2 between 2004 and 2005 was 9.5%. As the diagram below shows, although wage growth in the A8/A2 outstrips the EU15 in percentage terms, average wages will still remain significantly lower than the EU15 for the foreseeable future if current trends are maintained.[78]

Average Hourly Wage Rates (Euros)

Source: Ev58 'DTI'

49. Our witnesses told us that the major attraction of the A8 countries was not that they had the lowest wages. EEF told us that labour costs in China are "a mere fraction" of those in the A8/A2 and the Chief Economist of the Centre for European Reform observed that genuinely low-cost production was already being moved further east into the A2 and outside the EU.[79] Instead they stressed the combination of low labour costs relative to Western Europe with a high level of skills and competency. For example, Intellect told us that working with technology—for example in electronics or software—has a much more positive image in the A8/A2 countries than in the UK, leading higher quality people to take up a career in those sectors. Moreover, those graduates who do pursue such a career tend to be "highly competent" and often possess 'legacy' skills, which are no longer taught in UK educational institutions that consider the relevant technology obsolete.[80]

50. EEF told us that the relatively high skill levels of employees in the A8/A2 countries were a key factor in ensuring higher productivity than in lower-cost locations.[81] We were told by manufacturing companies in Lithuania, Hungary and especially Slovakia that the Soviet focus on heavy industry has left many A8/A2 countries with education systems and skills profiles especially suited to manufacturing and engineering work. For example, Slovakia was a major manufacturer of armoured vehicles during the Cold War and the skills legacy from this era is seen as a major reason behind Slovakia's success as a location for car manufacturers.

51. Although the wages: productivity: education ratio is very favourable to business in the A8/A2 we also heard that there are limitations. The education systems left over from the Soviet era are rigid systems which are often narrowly focused on specific disciplines. We were told this has advantages in terms of producing a disciplined workforce with a strong focus on manufacturing and technology; indeed the results of these systems on paper are more impressive than in many Western European countries. On the other hand, we heard that the skills given by the existing system were limited in scope—problem solving, managerial and creative skills in particular were identified both by witnesses and by people in the three countries we visited as considerably weaker than Western Europe.[82] A good example comes from a DTI report on the computer games industry in the Czech Republic; whilst noting that Czech technical graduates have programming and development skills comparable with, if not better than, those in the UK, it notes problems recruiting people skilled in the arts side of the industry—animators, artists and so forth.[83]

52. We also heard widespread concerns about a growing shortage of skilled labour and resulting upward pressures on wages. In Slovakia and Lithuania we were told repeatedly that widespread migration westwards was beginning to cause a labour shortage in and around large urban centres such as Vilnius and Bratislava. Evidence from the British Romanian Chamber of Commerce and in Hungary also suggested a labour shortage despite lower migration rates.[84] The DTI told us that inward migration from outside the European Union—for example Moldova and Ukraine—was beginning to occur to fill these gaps. This was supported by evidence received during our visits.[85]

53. The concept of a labour shortage in countries with unemployment rates running as high as 13.8% (Poland), 13.4% (Slovakia) and 7.5% (Hungary) seems paradoxical.[86] We were told that this reflects the geographical concentration of investment, with labour in short supply around the major cities but high levels of unemployment—as high as 15% or more in parts of southern and eastern Hungary and Slovakia—in more disadvantaged areas.

54. Such geographical factors should also be considered when discussing average wage rates. We were told that wages in the highly developed areas around major cities were rising much faster than the statistics for the entire country would suggest. Some businessmen and officials we spoke to told us that the wages for the top employees and executives were comparable with those in Western Europe, and we heard that wages for construction workers in Vilnius were—in some cases—approaching those being paid in London. In Hungary we were told that wage growth was about 10% a year and that Bulgaria and Romania were both much more competitive in terms of labour costs—despite the very low labour mobility of the Hungarian workforce.

55. Our witnesses cited the labour market as one of the major attractions of the A8 as investment locations due to the strong work ethic and technical skills of the workforce combined with relatively low labour costs. The evidence we received suggest that it is no longer accurate to describe the A8 as 'low-cost economies'. Although average labour costs remain just over a quarter of those in the EU15, genuinely low-cost, low-skill production is already heading further east, to the A2, Ukraine and China where wage rates are much lower. Employers in the A8/A2 countries repeatedly stressed to us that skills, not wages, were the major reason for their presence in the A8/A2 countries. This was further reinforced by government officials and ministers from the countries we visited, who accepted that their countries could not compete on cost with China, India or other emerging economies.

56. One of the major economic challenges facing the A8/A2 at present is a growing labour shortage in the areas most attractive to overseas investment. Foreign investment is often concentrated around the major cities, increasing demand for labour on areas with relatively small populations. Rather than move to the cities to meet this demand many A8/A2 nationals—and especially the most skilled—are choosing to move to Western Europe, in effect putting employers based in Bratislava, Vilnius or Warsaw in direct competition for labour with employers in London or Dublin as well as local rivals. In some areas and sectors—for example the Lithuanian construction industry or the highest levels of company management—we were told that this is pushing wage costs up towards Western European levels. The people we spoke to during our visits emphasised that these shortages were a real problem for new companies seeking to move into well established sectors.

Transparency and Corruption

57. According to Transparency International, corruption is still perceived to be more of a problem in the A8/A2 than Western Europe. According to their rankings, Estonia is the best performing of the A8/A2, with a global ranking of 24^th. The majority of the A8/A2 are ranked between 61^st (Poland) and joint 46^th (Czech Republic and Lithuania), with Romania the worst performer at 84^th.[87] These rankings do not entirely tally with our experiences of the three countries we visited. In Lithuania (ranked 46^th) the overwhelming majority of people we spoke to told us that corruption was not a problem, whilst in Hungary (ranked 41^st) we were given a wide range of examples, including the erratic application of regulations by local officials and unofficial payments to health professionals in return for appointments; similar concerns were also raised in Slovakia (ranked 49^th). In all three countries it was agreed that the situation had improved significantly over the past ten years. We commend the work being done by UK embassies in A8/A2 countries, for example in Hungary, to combat corruption. We recommend that the UK continues to be active through its embassies to assist national governments in building upon the improvements of the last ten years and further reducing corruption.

Ease of Doing Business

58. The A8/A2 countries range widely on the World Bank's Doing Business 2006 rankings. The Baltic States rank highly, with Lithuania in 16^th place, Estonia in 17^th and Latvia in 24^th. The poorest performer of the A8/A2 on these rankings is Poland (75^th) with Hungary (66^th) and Slovenia (61^st) also fairing poorly. The remaining countries fall between Slovakia (34^th) and Bulgaria (54^th). Nonetheless, even Poland fares considerably better than China—the best of the four BRIC emerging economies—at 93^rd.[88]

59. As members of the European Union, the A8/A2 have committed to the acquis—the body of European law. In principle this provides a degree of commonality in terms of market regulation between these countries and the UK market which is lacking in non-European Union markets. We were told on several occasions that whilst European law is often associated with increasing regulation in the UK, in Central and Eastern Europe (with the exception of the Baltic States) it has actually served to reduce regulation.[89] The A8/A2 have rapidly adopted the acquis into their national law, with transposition rates (the percentage of European Internal Market law which has made it into national law) among the best in the European Union. The new member states also have some of the lowest rates of infringement of internal market legislation in the European Union.[90] We were given a number of explanations for this by our witnesses, including a greater respect for the Commission than among longer-standing members, a desire to impress in the lead-up to and immediate aftermath of accession, the relatively small size of these countries and the lack of time since accession in which infringement action could be brought against them.[91]

60. In terms of barriers to entry into these markets, the evidence we received was mixed. Complex, unfamiliar and slow administrative and legal procedures were a complaint which we heard in the three countries we visited—in particular relating to local administration in Hungary where there appeared to be a fine line between erratic application of regulations and corruption.[92] The Hungarian legal system also came in for criticism from some companies which had suffered from malicious or unfounded cases being brought against them, resulting in lengthy and time-consuming legal action. This ties in with a perception that although the legal, political and economic systems have changed since Soviet times, it will take longer to change many people's mentalities—particularly in some government ministries. This was particularly noticeable in relation to public procurement in Slovakia. The other major barriers to entry we heard about were the pressure on the labour market referred to earlier and the highly competitive nature of many of these markets.

61. Despite these concerns there are many areas in which the barriers to entry and risk in the A8/A2 are significantly less than in many other fast-growing overseas markets. A few examples we heard about were the lack of a major time difference between the UK and Central and Eastern Europe, a good level of English spoken in the business communities of many (though not all) A8/A2 countries, relatively minor cultural differences compared with Asia or the Middle East, a welcoming attitude towards UK investors (particularly in the Baltic States) and access to the Internal Market.[93]

62. As with any overseas market, the A8/A2 countries present a range of challenges to UK investors and exporters. Our witnesses raised concerns about complex, unfamiliar and slow administrative and legal procedures in many of the A8/A2 countries—although we note that similar concerns are also raised about some well-established EU15 countries. Nonetheless, we believe that in terms of high-growth economies worldwide the A8/A2 countries present relatively few barriers to entry and relatively few risks. Their comparative nearness to the UK, membership of the European Union and open economies are key competitive advantages for the A8/A2 countries in dealing with UK business.

Taxation

63. The introduction of 'flat' rates of taxation in many of the A8/A2 countries, initially by Estonia in 1994 and subsequently by other countries in the region ranging from Slovakia to Russia, has been cited as a key competitive advantage held by those countries. Some companies suggested to us that the relative simplicity of these tax regimes is an attraction to investors and therefore a competitive advantage. It was not regarded as a decisive advantage; and the majority opinion among the people we met in these countries was that issues such as skills base, labour costs, the granting of 'tax holidays' and economic growth were more weighty considerations in the minds of potential investors. The point was also made to us that a low, flat rate of tax does not always mean lower tax in practice when compared to the more complex systems used in Western Europe. For example, Estonia has a headline tax of 0% on reinvested profits, but collects a higher percentage of its GDP through corporation taxes than Germany where the headline rate is 38%.[94]

Size of Market

64. The majority of the A8/A2 countries are relatively small markets. As the figure below shows, in 2006 Poland was by far the largest economy in the region—the 21^st largest in the world—with Romania the next largest and the 42^nd largest worldwide.[95] In total, the A8/A2 countries have a combined GDP about a third that of the UK.[96] We were told on our visits that the relatively small size of many of the A8/A2 economies was a significant disincentive towards investment or exports by British firms. We heard that the A8/A2 countries do not comprise a homogenous market and that this is particularly true of service and communications sectors where different regulatory regimes and competitive environments ensure that each country has to be examined on its own merits. In such circumstances larger companies often do not feel that the market of, say, Lithuania, is large enough to warrant investment. This is less true of sectors like manufacturing, where we saw plants based in—for example—Slovakia or Hungary acting as a regional presence for a company within the EU and also exporting further east into Belarus or Ukraine.

Total GDP of A8/A2

Source: World Bank Data http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP_PPP.pdf

65. Although the A8/A2 countries are relatively small when compared to the major emerging economies—both in terms of population and GDP—we were reminded that when these countries joined the European Union their combined economy was the size of the Netherlands; now Poland alone has a larger economy than that of the Netherlands and it buys £2.8 billion a year worth of UK exports—around the same as China.[97] Moreover, the World Bank places the A8 as 'upper middle income' countries (with the exception of Slovenia which is classified as 'high income'), making them more prosperous markets than countries like India or China.[98] Businesses we spoke to in Lithuania and Slovakia also told us that the small size of the country bought advantages in terms of access to senior people and also in terms of the availability of market niches where smaller companies could find opportunities. We were also told that while, for example, the large City of London law firms had decided not to invest in Lithuania, regional players (in particular from Scotland and the North of England) have an effective presence.

The Future

66. A key question for investors is the potential for the A8/A2 economies in the future. It has been suggested that the A8/A2 economies are reaching the peak of their economic performance, that a combination of pressures on the labour market, an increasing reluctance to pay the political price for economic reform now EU membership has been obtained, ever-increasing competition from Asia and the end of privatisation programmes will slow both economic growth and foreign direct investment flows into these countries.[99]

67. The opinion of our witnesses was that, in the short to medium-term, such views are excessively pessimistic. There is a great deal of confidence in the countries we visited that labour shortages can be met by a combination of returnees—attracted back by rising wages and standards of living—and migration from further east. It was pointed out that overall employment levels in the larger A8/A2 countries remain much lower than in Western Europe, partly due to geography and infrastructure, partly due to skills mismatches and partly due to longstanding social problems—for example among the Roma community in Slovakia. Significant investment of European Union funds in these poorer regions could create newly attractive regions for investment and British companies should be aware of this possibility.[100]

68. In the longer term we were told that future growth depends on these countries being able to move their economies up the value chain, to attract more innovative and creative industries and to increase the size and sophistication of their service sectors. The challenge in this area should not be underestimated. We were told that the A8/A2 perform poorly on international comparisons of R&D intensity and other indicators. Although the workforces of these countries were praised for their discipline, production and engineering skills we also heard that the education systems which produced them were in need of reform—especially in higher education.[101] Nonetheless, we were left with the impression during our visits that government and business were both very aware of this challenge and of their inability to compete with Asia on price alone. The ambition to attract high-value-added investments has been supported by government incentives—such as tax holidays and exemptions to labour laws—and we saw evidence that a number of companies were willing to make high-tech or innovative investments in the A8/A2 on that basis.[102] To judge from the sophistication of some of the facilities we visited, the A8/A2 countries can already compete with the UK in terms of cutting-edge technology.

69. British government and business should be aware that the more forward-thinking A8/A2 countries are actively targeting high-value-added sectors such as biotechnology, ICT and pharmaceuticals and are seeking to attract research and development and other innovative investments—for example Samsung's and Kia's investments in Slovakia or GlaxoSmithKlein's vaccine research facilities in Hungary. This is both a significant opportunity for partnership—making use of the skills bases, newly built facilities and dynamism of these countries and the new opportunities that come with a developing market—and a potential competitive challenge for UK business in the longer term. UK policy makers need to recognise that in attempting to build an innovation-driven economy, our potential partners and competitors are not limited to the USA, France and Germany; the A8/A2 countries are increasingly becoming home to facilities of a very high level of sophistication and technical knowhow.

74 Ev57 (DTI); World Bank, http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP_PPP.pdf Back

75 European Commission Enlargement Two Years After, p. 34; Eurostat, http://ec.europa.eu/regional_policy/policy/fonds/pdf/annexe-recto.pdf - these figures are indicative. Back

76 Ev88-94 (Corporation of London) Back

77 Eurostat, http://epp.eurostat.ec.europa.eu/portal/page?_pageid=1073,46870091&_dad=portal&_schema=PORTAL&p_product_code=DBB10000 Back

78 Ev58 (DTI) Back

79 Q28 'EEF'; Q257 (Katinka Barysch) Back

80 Ev113 (Intellect); Q144 (Intellect) Back

81 Ev101 (EEF) Back

82 Q256 (Katinka Barysch) Back

83 DTI (2006) The Games Industry in Eastern Europe, p. 15 Back

84 Ev83 (British Romanian Chamber of Commerce) Back

85 Q54 (DTI) Back