Nicholas Watson in Prague -

Croatia is too developed to tempt foreign low-cost producers, but is more attractive as a "bridge" into the economies of the former Yugoslavia and beyond.

With its quaint capital and touristy coast, Croatia doesn't look much like its Balkan neighbours. And once it joins the EU, probably in 2010, the economy is also expected to take a different path from the other new members.

The eight Central and Eastern European countries that have already joined the EU and the two that are set to join next year, Bulgaria and Romania, have benefited from the flow of manufacturing and services to these low-cost centres of production.

However, due to the conflicts that blighted the former Yugoslavia during the 1990s, Croatia lost out on this first wave of Western European firms hunting for cheap labour in the east. Today, with its open and well-developed market economy and high standard of living boosted by the upmarket tourist industry, Croatia is seeing the second wave of such jobs bypass it and flow south to its poorer neighbours.

"Investors will go to Croatia not for cheap labour like they do for Bulgaria and Romania, but for the new opportunities in the local market," reckons Matteo Ferrazzi, economist of the UniCredit New Europe Research Network.

Ferrazzi says these so-called "market-seeking" direct investments – ie. those aimed at finding new opportunities in local market as opposed to "efficiency seeking" investments, which are aimed at taking advantage of lower costs – are found mostly in the services sector, such as in finance, IT, retail and wholesale trade. This is unsurprising given that the population, despite being small with less than 4.5m inhabitants, is relatively well-off and sophisticated in its demand. Croatia's gross domestic product (GDP) per capita is €6,965, just shy of the average €7,412 for the eight CEE countries that joined the EU in May 2004.

"The stable economy and affluence of the population is why labour costs are so high," says Ferrazzi.

In its latest research report on the competitiveness of Croatia, UniCredit's New Europe Research department found that the majority of foreign direct investment (FDI) from 1993 to 2005 flowed into sectors that are predominantly involved with the local market, namely the financial sector, telecommunications, trade, and hotels and restaurants.

FDI in the manufacturing industry, however, accounted for only 32.7% of all FDI inflows during the period and was highly concentrated in only three sectors that are also notably oriented toward the domestic market: the chemical industry (pharmaceuticals), production of petroleum products and production of non-metal mineral products.

While not attracting firms in search of cheap labour, Croatia does, nevertheless, offer manufacturers two other important reasons to invest.

Balkan bridge

The first is that Croatia offers foreign firms a highly skilled labour force – in sectors such as chemical, petroleum and IT – which is still internationally competitive. Siemens used this to good effect when it established a presence in Croatia in 1995 through several acquisitions. Since then it has grown to 2,000 employees and its R&D department there is now a leader in certain parts of the German firm's business.

Siemens is also using Croatia for what is perhaps the country's most important attribute right now – as a gateway, or bridge, into not only the rest of the rapidly growing Balkans, but also perhaps to the exceptionally promising market of Russia.

Raiffeisen Research, the research unit of the RZB Group, said in its latest analysis about the Southeast Europe region that trade between the various member states is thriving once again thanks to the establishment of bilateral and multilateral free trade agreements, such as the Central European Free Trade Agreement (CEFTA), which is about to welcome Serbia into its fold at the end of the year.

According to Raiffeisen, trade within the region grew from €2.6bn in 2002 to more than €3.5bn in 2004, with Croatia increasing its trade with its regional neighbours by 27% and Bosnia & Herzegovina boosting its regional trade by 63%

Croatia's juxtaposition to the other markets of the former Yugoslavia and Austria and the northeast of Italy means it is seeing a lot of investment from Western companies like the Austrian retailer Billa owned by the German group Rewe, and the Italian retail chain Coop Hipermarketi, sister company of the Italian Coop Consumatori Nord-Est, which operates 90 supermarkets and shopping malls in the northeast of Italy.

Coop's presence in Croatia dates back to 1999 when management decided to invest there rather than in the countries of Central Europe where it felt the markets were already saturated. By establishing a presence and a brand in Croatia, Coop is perhaps preparing the ground for a move into Bosnia, where many people are already familiar with the brand after visiting Croatia on shopping sprees.

The ultimate target in the region is, of course, the potentially huge market of Serbia. Still struggling with legacies of the war, Serbia is nonetheless growing strongly and the government predicts this year’s GDP growth will be 7-8%.

At the same time, trade is booming between these two erstwhile enemies. At a Croatian-Serbian business forum in Zagreb in October, the head of the Croatian Chamber of Commerce, Nadan Vidosevic, said trade between Croatia and Serbia had increased ten-fold since the restoration of economic relations in 2000, though it is still 10 times smaller than it was in 1989 when it amounted to $5bn.

As well as being a potentially large market in itself, Serbia is the only country in the region to have signed a free trade agreement with the Russian Federation and thus a route into the highly lucrative market there. "Serbia is very important for its huge links to Russia, which is a very big country, with highly educated people and high economic potential give the high oil prices," says Ferrazzi.

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