The CESEE growth model needs polishing

Matteo Ferrazzi (EIB), Julia Wörz (OeNB)

While the CESEE economies have done a good job catching up with the EU, they seem to have lost some momentum more recently. However, there is plenty of economic growth potential, a joint research project of the OeNB, the Vienna Institute for International Economic Studies (wiiw) and the European Investment Bank (EIB) shows. We have identified both, products and sectors where CESEE countries could succeed and existing gaps and challenges that need to be addressed in order to thereby spur economic activity in the region and avoid the middle-income trap.

During the last decade, the Central, Eastern and South-Eastern (CESEE) EU member countries continued their convergence toward the EU average. CESEE incomes moved from 40% of the German average in 1997 to 70% in 2023. With a purchasing power of 80% of Germany's income, people in Slovenia and Czechia are now richer than people in Spain and at a comparable level with Italy. Yet, the catching-up process has slowed notably in recent years. Two-thirds of the catching-up occurred in the decade before the Global Financial Crisis of 2008–09, and only one-third in the 15 years since. What happened? Why has productivity growth slowed down? And what could be the region’s new growth drivers?

The CESEE growth model needs modernization
Clearly, the CESEE development model took shape in the past: it was based on large inflows of foreign direct investments and the idea of serving as the manufacturing arm of Western Europe. Integration into global supply chains and joining the EU facilitated a swift transfer of modern technologies, allowing the CESEE countries to tap larger export markets, and supported institution building. The manufacturing sector emerged as the backbone of economic activity, and CESEE economies became highly competitive, with market shares and export quality improving notably. In countries like Czechia, Hungary and Slovakia, the quality of export products is at par with German exports.

On the flip side, this growth model has brought about a high dependence on global value chains, with all its related risks, which became visible in the pandemic. Also, CESEE economies are currently suffering from weak external demand weighing on their growth performance. Finally, they are still “factory economies,” overspecialized in production with low value added.

Some service sectors have emerged as highly successful
However, the CESEE growth model is evolving: Besides manufacturing, computer programming, consultancy, and information service activities have been performing strongly, both in generating income and as competitive exports. These sectors are already star performers in five countries (Bulgaria, Croatia, Estonia, Latvia and Romania), and they hold future growth potential in the remaining six countries of the region too.

The “product space” identifies promising products for development
So how do we identify future potential? For the manufacturing sector, we use the concept of the “product space,” looking at the knowledge, inputs and skills that are needed for producing a product together with the ability of an economy to produce this or similar products. Putting together product-specific characteristics and country-specific competitiveness points to future export opportunities. For the majority of the CESEE economies, we identify relatively complex products that could be easily targeted to spur the upgrading of the economy.

Our analysis identifies a total of 102 products for ten countries.¹ Of these, 42 are unique to one of the economies. For example, “radars” only emerge as an opportunity for Estonia, while “batteries” only emerges for Romania. The other products emerge as opportunities for two or more countries. The most commonly identified products are listed in the table, together with the countries for which these products are identified as growth potential.

^{1 Czechia is excluded here as the country has explored much of the product space and is successfully exporting a wide variety of complex products. Hence, its key challenge at this juncture is not necessarily to explore more complex products in the product space, but rather to upgrade to more complex activities in the value chain.}

We identify many products as opportunities for all eleven CESEE EU countries. Intuitively, we can explain this by these countries’ similar specializations. From a policy perspective, this finding implies that each country has to deploy a battery of indicators to identify profitable and realistic niches within these broadly defined product categories. This is what smart specialization strategies aim for.

Innovative capacity has increased, but some significant gaps remain
We also find that the CESEE region has substantially increased its innovative capacity over the past decade. Businesses are employing twice the number of R&D personnel than a decade earlier. The share of investments dedicated to intellectual property has seen a gradual uptick, moving from 10% to 12%. Labor productivity growth has slowed but remains higher than in the EU’s northern and western member states. Moreover, businesses are gravitating toward higher value-added segments of production. In the manufacturing sector, numerous foreign companies are relocating product development to CESEE.

A more mixed picture emerges for human capital: The human capital index and PISA scores are at the level of the EU average. However, according to the EIB Investment Survey, firms in the CESEE region spend about a third less on training than firms in the rest of the EU – a reflection of the region’s specialization in lower-value added production. Emigration is draining the pool of skilled people: the overall number of graduates has declined by over 20% over the past decade. The immigration of skilled people could partially offset this decline.

Spurring innovation and attracting venture capital are key challenges
As regards the still existing gaps, CESEE firms invest less in R&D and digitalization than their European peers. Foreign-owned firms in the region tend to be more innovative and productive than domestically owned ones, but much of this advantage appears to be due to size, age, and sectoral differences.

Another challenge is developing the ability to transform new ideas into products and services. Here, a shortage of risk capital is one of the main obstacles. In fact, even though venture capital investments have grown significantly during the last decade, they still represented only 5% of the EU total in 2023. The key issues that need to be addressed together are: small scale, poor liquidity, and few diversification opportunities. As regards funding, development banks can play an important role in substituting for absent private markets and in supporting their development.

Our research project identifies industries and product categories as well as existing development gaps that could help the region to move up the technological ladder and avoid middle-income traps. It is up to firms and policymakers in the CESEE region to adopt a “smart specialization” approach and build on current areas of strength as well as areas with potential for future competitiveness and technological upgrading.

Die zum Ausdruck gebrachten Ansichten müssen nicht zwingend mit den Ansichten der OeNB bzw. des Eurosystems übereinstimmen.