Tomas Holinka & Anna Zabrodzka of Moody’s Analytics -

• The pre-crisis build-up of rigidities has not been fixed.

• Low wages will continue to attract foreign investment.

• The number of temporary jobs differs markedly across the region.

• Labour reforms are needed to support long-term economic growth.

The countries of Central and Eastern Europe continue to outperform their peers in Western Europe. Except for Slovenia, where a troubled banking sector has been dragging on the recovery, all CEE economies expanded in the second quarter and the pace of recovery is expected to accelerate in the second half of 2013. Accommodative monetary policy, easing fiscal restrictions and favourable external sentiment for the region, particularly for bond markets, will likely support the economic rebound.

While net exports will be the main growth driver, domestic demand will continue to wane in coming quarters. Increased reliance on exports makes the region's economies more susceptible to external shocks, while the retreat of fixed investment due to a slowdown in foreign direct investment and a reversal of cross-border lending is worrying for the countries' long-term growth. Countries within the region benefited from a decade of steady growth before the 2008-2009 financial crisis, bank restructuring, and accession into the European Union, all of which lowered the incentives for deep structural changes. The boom during the pre-crisis years resulted in a build-up of rigidities, especially in the labour market, which can affect growth.

Wage growth well above productivity, together with exchange rate appreciation, eroded competitiveness and led to a widening of the current account deficits. While in the Baltics and in Bulgaria unit labour costs outpaced the euro zone average, in the Czech Republic, Poland and Slovakia they stayed close to the euro zone average. Unit labour costs jumped by 85% in Latvia, 55% in Estonia and 35% in both Lithuania and Bulgaria from 2005 to 2008, but rose only around 10% in the Czech Republic, Poland and Slovakia.

Bulgaria stands out even among the new EU members. Despite the rapid pace of wage growth, Bulgaria still has one of the lowest wages in the EU. In 2011 the monthly wage was €328, just 15% of the EU average of €2,165. More broadly, the average monthly wage in most CEE countries is only one-third of the German wage–with the exception of Slovenia, where wages are two-thirds of the average German wage. Lower wages and a skilled labour force will continue to attract foreign investment into the region.

When the financial crisis hit, the region's rapid wage growth slowed. Many countries introduced austerity measures. Bulgaria, for example, froze the minimum wage for 2 years starting in 2009. The three Baltic countries, which were not members of the euro zone at the time, did not devalue their currencies, which had been pegged to the euro to prepare for their eventual accession. The Baltic governments instead adopted a strategy called "internal devaluation," which among other measures included a sharp drop in wages. Public sector salaries fell by 10% in Estonia and by as much as 40% in Latvia.

Recently, however, wage growth has reaccelerated. From September 2011 to April 2012, Bulgaria hiked its minimum wage by around 20%. But the pace is still slower than it was before the crisis and even stalled in Slovenia and Slovakia, which joined the euro zone in 2009 and 2011, respectively. For euro zone countries, where monetary policy is set by the European Central Bank and where rising debt levels limit the ability to use fiscal policy, flexible labour markets are key to stabilizing economies and regaining competitiveness. Because these countries cannot use fiscal and monetary policies to stabilize their economies, their ability to increase wages is limited.

Labour markets reacted differently

Although unemployment has risen across the region, there is substantial variation within segments. The increase in the jobless rate has been driven mainly by the low-educated workforce, with the exception of Slovakia, where the jobless rate was already high, at 45%, before the crisis.

The largest increase in the unemployment rate of the low educated occurs in countries that had fast growth rates before the crisis, such as the Baltic countries. In these new EU members growth was driven by massive expansion in construction, which created an abundance of low-skilled jobs. However, when the crisis hit and construction halted, these workers were quickly laid off. Despite the recent recovery, the pace of expansion is still far below pre-crisis levels, and unemployment in this segment has remained elevated over the last two years. The situation should improve after the new EU budget for 2014-2020 becomes effective, as it will likely boost construction in Central and Eastern Europe through the so-called Cohesion Fund.

Rise of temporary jobs

Theoretically, surging unemployment during a downturn should increase the share of temporary jobs in a labour market. Although workers would prefer permanent positions, employers tend to offer short-term contracts, which make it easier to lay off staff if necessary.

The share of temporary employment differs markedly across CEE countries. The proportion of temporary contracts increased from 2007 to 2011 in Poland and Slovenia, where unemployment recently ran above 10%, but remained low in the Czech Republic, Hungary, and Estonia, where jobless rates hover between 5% and 10%. To reduce unemployment, Slovakia could increase the share of temporary jobs; institutional barriers, however, constrain short-term employment and jobs for students. Furthermore, Slovakia suffers from a rigid labour market, with high youth and long-term unemployment and a lack of support from the Labour Office.

On the downside, although temporary jobs make the labour market more flexible, they also pose risks. In Poland, the rise in joblessness and lack of regulation regarding temporary workers has allowed employers to create so-called junk contracts, where the contract is renewed every month and workers are not eligible for any benefits, lowering employers' costs significantly.

The productivity puzzle

By definition, productivity rises if GDP stays constant but fewer people are working. This is not the case for most CEE countries, where output has shrunk faster than employment. Despite rising joblessness, productivity has fallen in the Czech Republic, Hungary, Slovakia, Slovenia, and Romania. While unemployment jumped by 6 percentage points in Slovakia and Slovenia, labour productivity fell by 2 percentage points from 2007 to 2012. In Poland, however, a 4-percentage point jump in unemployment was accompanied by a 1.7-percentage point gain in productivity. In Baltic countries, the situation is also encouraging.

Still, in order not to lose international competitiveness, governments across the region should focus on increasing productivity as the wage difference between the West and the East narrows. A skilled and highly educated workforce is essential to attracting more knowledge-intensive industries placed higher in the value-added chain, while active labour market policies that provide job training would help offset the long-term negative impact of unemployment.