Sherelle Jacobs in Cologne -

With its proximity to Western Europe, cheap labour and EU credentials, much of Central and Eastern Europe's (CEE) potential remains largely untapped by Western Europe's small and medium-sized enterprises (SMEs), though the Mittelstand (Germany's legion of SME family firms) are certainly leading the way. But has their daring paid off and what does the future hold?

Germany's vaunted Mittelstand are famous for their knack for identifying and exploiting unglamorous but highly lucrative market niches. And their appetite for external expansion is laureate. The attitude of Mittelstand towards the CEE region is no exception. An expanding anthology of pioneering Mittelstand are rolling out operations in the region, from Hako Holdings, which manufactures cleaning machines in Poland, to Sortimo International, which makes innovative equipment and accessories for vans.

The movement of German companies into the region is traceable back to the immediate post-Cold War period; when the Iron Curtain fell, German firms flocked to their eastern neighbours and established tens of thousands of subsidiaries. Today, Germany is by far the region's largest investor, with total investment reaching €77bn in 2008. German SMEs contribute a healthy proportion of this activity, with Slovakia a case in point. "We estimate the number of German companies operating in Slovakia at around 450. These companies include both global players such as Volkswagen or Siemens and numerous smaller and medium-sized enterprises," explains Markus Halt, a spokesperson for the German Chamber of Commerce in Slovakia.

Land and labour

For many Mittelstand, for whom profitability depends on the leanness of their operations, the cheaper cost of manufacturing products in Emerging Europe has been the main force pulling them towards the region; labour and land, two of their biggest input costs, are much cheaper in the region in comparison with Germany. Like countless other German firms, such a reality spurred Leoni, which makes wires and cables, to make the move eastwards. "We could no longer afford to produce wiring systems for the automotive industry in Western Europe due to competition reasons," says Sven Schmidt, a representative at Leoni.

Cheaper labour has also been a particularly strong draw for Germany's numerous medium-sized clothing and apparel firms, like Hammer Fashion and Gerry Weber, which have established factories in countries like Romania, Hungary and Bulgaria.

That many CEE countries are part of the EU is also seen as a big plus for the naturally cautious Mittelstand, which often do not have large amounts of capital to fall back on if business decisions backfire. Romania, which had a chequered legal reputation before joining the EU, is a good example of a country where EU accession has made a real difference. "Since Romania became a EU member, much of its legislation has been adapted to European legislation, which is a relief for investors," says Carmen Kleininger, a spokesperson for the German Chamber of Commerce in Romania.

The fact that the region still has a lot unharnessed potential and space for niche industries is also a big draw for many SMEs. "The Slovak automotive industry and its supplier branches continue to draw the attention of export-oriented companies in Germany," says Halt of the country's German chamber. "Its potential still is not fully tapped in particular for smaller and medium-sized businesses."

Deeper reasons for the attraction of Mittelstand towards the region could lie in fact that the German business culture amongst SMEs is generally more enterprising and outward-looking than that in other countries. German SMEs, along with those from China, Bulgaria and Latvia, supply the largest quantities of foreign direct investment in the world within their business classification. German SMES also have higher levels of technical cooperation with foreign enterprises than those of any other country. There are other, often overlooked but revealing, indications of the outward perspectives of German SMEs. For example, 82% of firms have their own website, a tool which effectively operates as a global window into a company's business activities, way above the EU average.

Another factor cited is the similarity between CEE business culture and that in Germany. "The cultural relationship (contrary to Asian markets) facilitates quick orientation within the respective market and also cultivates a working relationship based on trust," explains Ute Lochner of Brose, a medium-sized car parts supplying firm with operations in the region.

Local challenges

Yet operating in CEE is not without its challenges, a fact which the Mittelstand are acutely aware of. Wages, one of the biggest headaches for SMEs, which must compete with larger companies in the final pricing of their products, are proving troublesome for smaller companies. The yearly rise in hourly labour costs in some countries in the region, such as Slovakia, Romania and Poland, was more than double the EU average in the third quarter of 2011.

Reports of the labour force in CEE lacking requisite skills are also increasing. Given the intense, artisan specialism that the Mittelstand are renowned for, this is a serious stumbling block. Some also cite bureaucracy and corruption as prominent problems for firms (see box stories).

A study published by the German Chamber of Commerce in the summer of 2011 reveals these quandaries may be taking their toll on investor confidence; it found that German business optimism in the region has declined in recent years, with the proportion of companies that see the economic climate in CEE positively plummeting from 33% in 2008 to 14% in 2011. While that's possibly partly a reflection of the impact of the global downturn on CEE, worryingly the proportion of companies that view their company's progress in CEE as good has also decreased, from a high of 58% in 2007 to 42% in 2011.

Such a mediocre outlook has prompted some experts to question whether German SMEs will, in the long term, seek to relocate to emerging markets further afield, such as the BRIC countries. But others point to the savings on transport and other costs that will prompt firms to stay the course.

There is both quantitative and anecdotal evidence to suggest the latter assertion is likelier: German SMEs across the region are continuing to expand their operations and move into new locations. And anecdotal evidence suggests that German companies are ready to embrace the challenges. The outlook of the company Brose is typical. "International business always brings challenges due to intercultural differences, different laws or different educational standards. Running business in 23 different countries worldwide for us means to face these challenges and adapt business accordingly to the different needs of the different countries," says Lochner.

There are strong indications that, for now at least, Germany's Mittelstand have sufficient mettle and nerve to commit to the region and reap the long-term benefits. SMEs across Western Europe should take note.