The convergence process that began for central and eastern Europe following the fall of the Iron Curtain has achieved much for their economies and peoples. But the journey is far from over.
The 10 new EU members in the region have been successful in transforming from ex-communist states to more-developed market economies. Although the transition led to high economic growth, GDP per capita is still well below the western European average. Their population (about 100 million) is about 20% of the entire EU, but their GDP last year contributed less than 8%. There’s still a long way to go.
The integration into the EU has been an important milestone which triggered reforms and attracted western European companies to the region thanks to its well- educated labor force, low unit-labor costs and lower taxes. Asian companies also took the chance to enter the EU via the region.
This foreign direct investment (FDI), plus EU structural and cohesion funds, provided the capital to create new jobs and to develop infrastructure. These economies are catching up, and as GDP per capita increases, income can be spent on durable goods and discretionary items.
In combination with an improved infrastructure, this sets the stage for a new wave of investment.
However, the process is not complete and it is not without challenges. It is very important for countries on the development journey to become production hubs and improve transportation. Although Poland has doubled its highways since 2004, it still has just 20% of the highway density of Germany. Therefore, much more has to be done.
Near-term factors are slowing the process. These economies show 3-4% potential growth per annum, but in the short term, growth is likely to remain below trend.
Discover eastern Europe’s impressive edifices
After the fall of the Iron Curtain, ex-communist countries display initial successes of the convergence process. At 111m in height, Russia's modern Chelyabinsk City skyscraper towers over old city neighborhoods.
A depressed eurozone is one factor, as the region is affected by slower growth and fiscal austerity in the eurozone via trade links, capital flows and the deleveraging process of European banks. Furthermore, as large FDI flows have already happened, growth from here on will depend more on further productivity gains and domestic demand. Poland, the largest economy by far with 38 million people, shows relatively attractive growth potential due to its more balanced character, while open economies such as the Czech Republic and Hungary risk suffering slower growth due to strong trade links with the EU.
There are also political risks. New taxes in Hungary, which also suffers from high public and private debt, have hit investor and consumer confidence, while political tensions have weighed on Romania. Despite these concerns, the region should still outpace western Europe’s growth rates as their fiscal balances and consumer leverage are in much better shape than in the EU.
Resource-rich Russia has a different set of priorities, strengths and frailties. It has benefited from higher commodity prices, but it is increasingly important for Russia to rebalance the economy and finally introduce structural reforms. With a large population of 140 million people, domestic demand is evolving with the middle class, but economic reforms need to be delivered to improve the investment climate if capital inflows are to drive GDP growth. If reform happens, Russia has huge growth potential, with recent World Trade Organization accession acting as an important catalyst.
While demographics are not generally favorable in central Europe or Russia, the progress of development should be supported by a trend towards further urbanization. Consistent with rising per capita GDP due to urbanization and productivity gains, higher disposable household income will result in stronger domestic demand, driving economic growth.
Turkey, by contrast, is in a sweet spot with a young population and annual growth in the working-age population of 1.4% over the next 20 years. Improvements after the 2001 crisis mean it has a sound banking system, the ratio of government debt to GDP is down tremendously and it occupies a prime position between Europe, the Middle East and Asia. Turkey’s priorities for action include its current structural account deficit. It needs to become more of an R&D and production location to promote exports. The country has already started to diversify its exports toward the Middle East and North Africa, making it less dependent on the EU.
The whole region has strong growth potential, but the convergence process will happen at different paces. Countries with better macro fundamentals – such as lower debt levels, a healthy banking sector and no structural problems – will converge faster. Over the long term, Poland, Russia and Turkey have the highest growth potential and are already supported by stronger domestic demand. Does this consumer-sector growth mean these nations will soon reach parity with the West? As it is a gradual process, moving up the value chain is a long journey.