Central and Eastern Europe has the opportunity to enter the high-tech league

Central and Eastern Europe will need to move away from classic catch-up through imitation in the coming decade and shift towards a knowledge-based system with greater added value and more diverse exports.

Since the fall of communism, Central and Eastern Europe has become a typical example of economic convergence through European integration. However, the financial crisis caused a halt to this process. The conclusion of a special report by Erste Group, published today under the title ‘Convergence 2.0’, is that the growth drivers are still in place, but Central and Eastern Europe will need to move away from classic catch-up through imitation in the coming decade and shift towards a knowledge-based system with greater added value and more diverse exports.

-Cost competitiveness alone is not enough at a time when countries are approaching the technological frontier. Countries in Central and Southeast Europe will need to increase capital and labor productivity through their own means, making investments in education and research and development crucial,” explains Birgit Niessner, chief analyst in the macro research sector for Central and Southeast Europe at Erste Group.

The Czech Republic, Slovakia, and Poland are leaders in terms of competitiveness and knowledge in our sample of Central and Southeast European countries, while Hungary lags behind this group of countries. Romania and Serbia are on this path, but still have room for more efficient utilization of reserves before they become innovative economies. Croatia must become more competitive to maintain its relatively high income level, while Turkey has yet to take a step towards a knowledge economy.

The high level of foreign direct investment is stable, exports remain strong, but CEE must move away from low costs as the main advantage. Countries in Central and Southeast Europe have leveraged the reintegration of Europe to achieve their own economic benefits, and foreign investors have discovered the region as an investment destination. The countries in the region have so far utilized their relative cost advantage to modernize their industries with the help of foreign technologies. The state of total foreign investments and the high share of exports in GDP testify to this and have successfully survived the financial crisis. The crisis year of 2008 marked a turning point in the accumulation of foreign direct investments, but they stabilized by 2011 in all countries. Hungary has the most negative trend regarding foreign direct investments, which have fallen in that country over the last two years from a peak of 75% of GDP in 2009 by more than 10 percentage points. Last but not least, export excellence is another feature of growth in Central and Eastern Europe. Analyzing the share of exports in GDP reveals differences within the Central and Eastern European region. The CEE-3 countries, which started with high levels, managed to increase their export shares during the crisis years. Poland, Croatia, and Romania are in the middle, partly due to market size (larger countries usually export less), but also due to uncompetitive structures. However, their results are still better than those of Southern European countries.

Thus, European integration has been successful and has played a very important role in catching up the economic pace of the Central and Eastern European region. Now the question arises of how to reform the integration growth model.

-To use the terminology of the World Economic Forum (WEF), the challenge is to move from efficiency as a driver of competitiveness to innovation. The key to further catching up will be in replacing the import of knowledge with innovative and new products created in Central and Eastern European countries. Competitiveness, high-quality higher education, and access to financing from venture capital funds will gain importance,” explains Niessner.

The level of higher and tertiary education in Central and Eastern European countries is quite diverse, but in most countries, it revolves around 20 percent of the population aged between 30 and 34 years, which means it is far from the EU target level of 40 percent and the level needed for the workforce in highly innovative sectors.

CEE is significantly more industrialized than the Eurozone (30% compared to 19%), but still needs to catch up in competitiveness. The secondary sector dominates the economies of Central and Eastern Europe. The share of industry in total economic activity is around approximately 30%, while the share of the industrial sector in the Eurozone GDP is only 19%. When it comes to overall competitiveness, the Central and Eastern European countries analyzed in this report are generally around a value of 4 on a scale from 1 to 7. The Czech Republic ranks 39th, while Serbia ranks 95th in a competition of 144 countries. Some Western European countries are obviously better ranked, which leads Erste analysts to conclude that Central and Eastern Europe still has a long way to go regarding the broader concept of competitiveness.

The question is how much time is left for the economies of Central and Eastern Europe to catch up in productivity, which, along with the long-term development of the workforce, determines the potential output of the economy. The latter value is determined by the highest level of GDP that can be sustained over a longer period, offering a view of the economy that is not dependent on the economic cycle. Actual and potential rates of production growth fell in most European countries during the financial crisis, while Portugal, Greece, Italy, and Ireland even had negative rates of potential production growth (on average from 2009 to 2012). “It is expected that the rates of potential production growth in Central and Eastern European countries, with the exception of Hungary, will recover during 2013 and 2014, reaching higher levels. This means that in the short and medium term, Central and Eastern European countries will again embark on the path of catching up with the technological frontier. However, as soon as they bridge the gap in technologies and human capital, growth will slow down, and the mentioned deficits in domestic innovation will become relevant,” concludes the report’s author. Endogenous sources of productivity may also gain importance as incentives from foreign direct investments and exports in the coming years could be limited if the crisis continues.

In general, Central and Eastern Europe faces the challenge of transitioning from imported productivity growth to endogenous sources of innovation as growth drivers. Analysts estimate that even in the very long term, potential production growth will mainly be driven by productivity gains, as only a few European countries can rely on positive demographic dynamics, as is the case with Turkey. According to OECD forecasts, Central and Eastern European countries will not be able to outpace non-OECD countries (such as India and China) in terms of potential production growth, due to already higher levels of economic development. However, the Czech Republic, Hungary, Slovakia, Poland, and Turkey will continue to outperform their Western counterparts until 2050.