Central Europe is, perhaps, catching up with the West too rapidly

By bne IntelliNews August 16, 2007

Nicholas Watson in Prague -

There's no doubting that the integration of the Central European countries into the EU is proving one of the bloc's more successful projects. But perhaps it's succeeding a little too quickly for comfort.

Anecdotal and statistical evidence is mounting that the convergence process, whereby the national incomes of the new, poorer members of the EU catch up with those of the older EU states, is picking up. And this process is being exacerbated by another side-effect of joining the EU, which is that droves of workers are heading west, resulting in skilled-labour shortages and wage levels rising too rapidly.

The result, say analysts, is that over the next few years Central Europe is at risk of losing not only its cost competitiveness but also its macroeconomic control, which could put the entire convergence process at risk and cause an almighty headache that might take years to wear off.

Speed limits

Nominally speaking, the difference in wages between Central and Western Europe is still large. Eurostat figures show that in 2005, the average hourly way in Eurozone countries was near €25 compared with just €5-6 in Czech Republic, Poland, Hungary and Slovakia. Even so, few doubt that wages in the EU's newest members will one day catch up with their Western counterparts. And according to a report from Dr Ralf Wiegert, senior economist at the consultancy Global Insight, "that point in time could be closer to the present than many would expect today."

Poland's wage growth in June was 9.3% in annual terms, up from 8.9% in May and more than many analysts had predicted. As Wiegert notes, on an aggregate level rising wages are not such a big problem for a country's cost competitiveness as long as labour productivity grows in step. However, recent evidence shows that while salaries are rising in Poland, productivity is not keeping pace. An analysis by BPH bank estimates that unit labour costs - the preferred measure for economists since it takes into account productivity - rose at an annual rate of 6% in June.

The rising wages come as unemployment falls across the region. The most startling change has come in Poland. In 2004 when the country joined the EU, a fifth of its population was unemployed; now the unemployment rate is down to 12.4%, making it no longer the highest in the EU. This pattern has been repeated in the Baltics and Slovakia, where the vast investment by the world's automobile firms has made the country a centre for car making in Europe.

Wage costs matter, but so too does the supply of labour, and here the countries of Central Europe are also struggling. There has been a massive move westwards by young and skilled people form Central Europe, seeking well paid jobs in the UK and elsewhere. The rate of migration has taken everyone by surprise. The UK government announced in July that national insurance numbers issued to migrants, mostly from CEE countries that have joined the EU since 2004, rose from 18,000 in 2003-04 to 321,000 last year. The latest annual increase from the accession countries, although lower than in recent years, was still 16%. And these figures don't include an estimated 500,000 illegal immigrants thought to be living and working in the UK. While this migration has helped to bring down unemployment, it also deprives these Central European countries of many promising and talented people.

The crucial point of all this, notes Wiegert, is that the key competitive advantage of these new EU members - the comparatively low level of labour costs and the abundance of skilled labour - is now rapidly eroding. And this is starting to exasperate foreign investors already in Central Europe and, many suspect, dissuade others from coming. "For us, the biggest problem is human resources," says Hak Bong Sung, the manager of an enormous factory producing flat screen LCD television sets for South Korea's LGE in the western Polish city of Wroclaw.

"FDI patterns between the Baltic rim and the Black Sea are about to change," says Wiegert, "The challenge is to keep the convergence process going, even with a depleted labour force, until the income differential with Western Europe is low enough to discourage would-be migrants from leaving, while luring expatriates home again."

That challenge is not necessarily one that many people believe the notoriously short-lived governments in the region are up to. The problem is that there is little that governments can do to halt this process of migration; however, what governments can do is to start making the structural reforms necessary to their economies. But true to form, instead of using these good times to push through reforms that will be much more painful later, the politicians of these countries are spending like drunks.

"The danger is that these countries will repeat the Portuguese experience as it headed into the Eurozone," says Wiegert.

After enjoying large floods of FDI and rapid growth during the 1990s, by the time Portugal joined the euro in 1999, the economy was characterised by mounting imbalances and structural weaknesses. This set the stage for the economy to be hit hard by the next cyclical downturn, which arrived in 2001.

What lessons, then, can EMU candidates derive from Portugal's experience?

"The most obvious and important lesson is clearly that fiscal policy must be focused on counteracting the imbalances that inevitably arise during the process of interest rate convergence," says Martin Gahbauer of Global Insight. "By fuelling the frenzy of the late-1990s credit boom and allowing its fiscal position to deteriorate, the Portuguese government created long-term structural problems and limited the scope for policy intervention in cyclical downturns. EMU candidate countries would be wise to avoid the same mistakes."

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