Benjamin Cunningham in Prague -

As the emissions scandal surrounding German carmaker Volkswagen grows, significant knock-on effects in Slovakia and the Czech Republic - first and second in per capita car production globally - as well as Hungary look inevitable, and threaten prosperity in two of the European Union's fastest growing economies.

Central European governments have long sought to harness their traditional manufacturing knowhow to foreign cutting edge car technology, and have offered big financial incentives to attract direct investment into assembly plants and car suppliers. Some now worry they may have gone too far, leaving the region vulnerable to fickle sales cycles.

"Cars are a luxury good with a high demand sensitivity" as compared to the service or food production sectors, notes David Marek, chief economist with consultants Deloitte in Prague, to bne IntelliNews.

According to Bank of America Merrill Lynch, "the importance of the auto industry and the strong linkages to German producers put central and eastern Europe in an exceptionally vulnerable position to the Volkswagen fallout". The bank says that the Czech Republic and Hungary are likely to be affected the most and "in a worst case scenario, we estimate 1-1.5 percentage points would be cut from GDP growth and the current account in these two countries".

In recent years, booming auto sales - in Europe new car sales grew through 24 consecutive months to August, according to the European Automobile Manufacturers Association - have fuelled wider economic growth in Central Europe. Now, after VW admitted to systematically cheating in US emissions tests for diesel cars, there are fears the crisis could spread to German and European carmaking generally, with the potential to choke regional industry.

Beyond hosting assembly plants for a host of marques, the Czechs and Slovaks are also significant contributors to German supply chains. Global parts suppliers including TRW, Bosch, Tesla and Continental have a hefty presence, while local firms are numerous.

Both countries also have ties to VW directly.   The German company owns top Czech exporter Skoda Auto, and some older Skoda models appear to feature the same EA 189 engines that are at the centre of the emissions scandal. Switzerland recently banned sales of several VW marques - including Skoda, Audi and Seat - that are powered by 1.2-, 1.6- and 2.0 litre diesel engines.  

"Skoda will not be hit as hard as VW itself, but some damage is inevitable," Marek warns.

Industry and Trade Minister Jan Mladek also insists Skoda should weather the storm reasonably well. However, he has warned that supply chain issues could be much bigger. "Our experience from the 2008-2009 crisis suggests that Czech sub-contractors doing business with German car manufacturers will be much harder hit than our own car plants," he told Czech Television.

Auto addicts

In the Czech Republic, the auto sector accounts for 21% of industrial output and 20% of exports. The industry employs close to 150,000, two thirds of them working for parts suppliers. Wages, hirings, sales and exports all grew in 2014. In addition to Skoda, the country hosts plants for Korea's Hyundai and Toyota Peugeot Citroen Automobile, a joint venture between the Japanese and French groups.   

Slovakia is even more auto dependent. Cars account for a full 41% of industrial production and 12% of GDP. Radovan Durana, an economist at the Institute of Economic and Social Studies in Bratislava, estimates that including logistics and third level suppliers some 200,000 workers - or 1 in 10 - are connected to the car industry.

VW's plant in Bratislava employs some 10,000, is the country's largest exporter, and accounts for 40% of overall car production. An estimated 11% of the cars made at the VW plant go to the United States, where the emissions scandal kicked off.

"Production of some models that are heavily exported to the US, such as the Audi Q7, are likely to be curbed," according to a forecast by Erste Bank. Meanwhile, the slowdown in China has already led to sales being trimmed in recent months.

In addition to the VW plant, which produced 394,000 cars last year, Slovakia is home to a Peugeot-Citroen plant, as well as a factory for South Korea's Kia. The country looks set to have a fourth major assembly plant, with Jaguar Land Rover, now a division of India's Tata Motors, set to launch in 2018.

Durana is critical of the massive package of state incentives that helped draw the iconic British marque. "Show me one study that says Slovakia needs another car producer," he asks. "More and more the concentration of this kind of industry is government driven."

Nonsense

While not quite as exposed, other Central European economies also rely heavily on auto making. Some governments are already suggesting that the current troubles illustrate a need to diversify.

Poland hosts three VW factories, with a fourth expected to launch production in 2016, and the Wielkopolska region looks particularly vulnerable to any longer term VW downturn.

In Hungary, Audi's engine plant produced 2mn of the 11mn flawed engines at the heart of the scandal. Economy Minister Mihaly Varga has warned that the scandal could cost the country as much as 0.6% of overall GDP. By September 29, he was openly stating that the country must diversify its manufacturing base.

Such emphasis on car manufacturing has long prompted charges that the region, with the Czechs and Slovaks leading the way, remains too dependent on car making. However, in a recent interview with Czech daily Hospodarske Noviny, Skoda Auto CEO Winfried Vahland called that allegation "incomprehensible".

"The automotive industry is, as in many other countries, the driving force of economic development and growth," Vahland insisted. "We pay taxes, we never go into losses, we massively invest in our plants, we educate young people and offer job security."

Marek also finds the dependency argument problematic. "What should we have done, told Hyundai we don't want their investment?" he asks. "Instead you need a government policy that accounts for this higher volatility, more space to react to GDP swings within the budget and in monetary policy."

Durana has little problem with the industry itself, but condemns Slovak state incentives as wasteful "economic nonsense".

At the same time, there are some in Slovakia seeking a bright side to the scandal. Analysts at Erste bank suggest the wider industry shakeup could "lead to greater investment in green technologies, thus contributing positively to the sustainable development path of the country”.