From a modest starting base in the early 1990s, central and eastern Europe (CEE) has become a major destination for FDI. With a collective population of just over 100 million, the CEE-10 (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic and Slovenia) attracted $174.1bn of FDI between 2001 and 2006. During the same period, Brazil (with a population of 186 million) received $99.8bn of FDI, Russia (142 million people) $65.7bn, and India (1.1 billion people) $37.1bn.
CEE’s ability to compete against larger emerging markets in the global bidding for FDI illustrates the region’s distinctive assets: dramatic improvements in the regional business environment stemming from the accession of the CEE-10 to the EU; the region’s geographic centrality in the pan-European theatre; and its impressive endowment of human capital.
The EU’s eastward enlargement project has significantly increased the CEE region’s attractiveness to foreign investors. Adoption of the EU’s acquis communautaire aligns the CEE-10 with EU legal/regulatory norms, lowering the risks of FDI and conferring an important advantage over other emerging markets (particularly China), where intellectual property rights remain poorly enforced.
Eastward enlargement also provides new member states and accession candidates with access to EU structural funds, accelerating modernisation of regional infrastructure and easing transportation and logistics for foreign multinationals that often chafe at the deficient infrastructures of the BRIC countries (Brazil, Russia, India and China).
EU monetary integration further differentiates CEE from other emerging markets, lowering the region’s risk profile for a foreign investor community that is skittish over financial gyrations in countries such as Brazil, Indonesia, Mexico, Russia, and Turkey. Eastward expansion of the eurozone has been delayed but the transitional mechanism of ERM II (in which the Baltic republics and Slovak Republic are already members) provides an institutional vehicle for non-inflationary growth, while competitive pressure from the fast-track euro candidates heightens monetary discipline on regional laggards.
To exploit the locational advantages resulting from the EU’s eastward enlargement project, foreign investors should pay special attention to:
- possibilities for establishing east European manufacturing platforms to leverage the CEE-10’s duty-free access to the gigantic EU market;
- opportunities for launching IP-intensive investments in east-central Europe to reap the benefits of EU-mandated legal and regulatory reforms;
- prospects for penetrating the domestic markets of the new EU member states, where household income levels and consumer expectations are steadily rising;
- mechanisms for managing foreign exchange risk amid the multi-speed monetary integration under way in the CEE-10 countries.
The geographic position of the CEE-10 – bounded on the west by the rich EU market and on the east and south by the rapidly growing markets of the Balkans and former Soviet Union – provides the region with another important advantage over rival emerging markets. With the exceptions of Poland and Romania, CEE domestic markets are not large enough to warrant significant amounts of market-seeking FDI.
But the CEE-10 are highly attractive as export platforms to service the newly enlarged EU market, which constitutes the world’s largest regional market with 500 million people. Equally significant, the CEE-10 are uniquely well positioned to service the large emerging markets on the European periphery. The combined populations of Russia, Turkey and Ukraine constitute 360 million people, rising numbers of whom are migrating to middle-class status, creating major commercial opportunities for foreign investors.
The CEE-10’s geographic centrality in the pan-European space confers special advantages to foreign investors based in the following industries:
- proximity-sensitive industries, in which physical distance to target markets is critical (for example, oil and gas, and chemicals);
- industries that place a premium on rapid responses to shifts in consumer market (for example, cosmetics and fashion garments);
- export industries that emphasise heavy, bulky or fragile products (for example, automobiles, furniture, steel and household appliances).
The migration of labour-intensive manufacturing from east-central Europe to lower-cost locales on the Balkan peninsula recalls the ‘flying geese’ phenomenon of east Asia, where foreign investment flowed from Japan to north-east Asia, then to south-east Asia, then to China, and more recently to Vietnam.
The rising per capita income levels of the advanced transition states signal increasing living standards and growing purchasing power, heightening the region’s appeal to market-seeking foreign investors. But high real wage growth (approaching 10% a year in some CEE-10 states) also threatens to erode east-central Europe’s labour cost advantages for efficiency-seeking multinationals. Manufacturing labour costs in the Czech Republic, Hungary and Slovenia are now comparable to Taiwan’s, and well surpass those of Brazil, China, India, and Mexico.
The highly publicised decision of Flextronics to relocate production of the Microsoft Xbox from Hungary to China dramatised the competitive challenges facing CEE countries.
Here the strong human capital assets of the CEE-10 provide cause for optimism about the region’s ability to compete against lower cost emerging economies. High labour productivity growth rates (ranging between 4% and 5% a year in the Czech Republic, Hungary, Poland and the Slovak Republic, and even higher in the Baltic states) serve to offset inter-regional disparities in nominal labour costs. Indeed, a study by the Boston Consulting Group (The Central and East European Opportunity, January 2005) determined that inclusion of productivity differences neutralises China’s cost advantages over eastern Europe in key manufacturing industries.
In addition to the region’s high productivity levels, the CEE region enjoys important attributes in the cultural dimensions of human capital. For example, a survey by the McKinsey Global Institute found that international human resource managers regard university-graduate young professionals in Hungary, the Czech Republic and Poland more “suitable” (that is, possessing practical business skills) for employment at western multinationals than graduates with comparable degrees in the BRIC countries, Mexico, Philippines and Malaysia.
For multinational corporations surveying growth opportunities in emerging markets, the human capital resources of east-central Europe hold considerable allure. Among such resources, world-class engineers and scientists facilitate infusions of FDI in pharmaceuticals, medical instruments, industrial controls, and other high-technology industries; skilled production workers support the rise of the CEE region as a hub for advanced manufacturing; and an ample supply of software engineers and IT specialists (many of whom possess foreign language skills aligned with the needs of west European multinationals) position CEE as an offshoring alternative to India.
CEE’s locational assets have attracted major investments by leading multinational corporations in motor vehicles, information technology, branded consumer, energy and other sectors. These companies have employed a variety of strategies in the region.
For multinationals already present in CEE, reinvestment of foreign affiliate earnings represents the main form of investment in the region. This strategy offers several advantages:
- It generates goodwill among managers and workers of CEE affiliates.
- It signals the parent company’s long-term commitment to the host economy.
- It aligns expansion of CEE production capacity with foreign affiliate performance.
It averts the inter-corporate turf battles that often ensue from alternative modes of foreign affiliate financing (for example, parent company loans).
Incumbent multinationals supplementing their foreign subsidiary earnings and new foreign investors entering CEE enjoy three other options: joint ventures, greenfield investments, and mergers and acquisitions.
Joint ventures constitute an attractive mode of entry for foreign companies lacking experience in the region and seeking CEE partners that possess an idiosyncratic knowledge of local/regional supply chains and distribution channels. The business-friendly environment of CEE permits easier due diligence of partner candidates than in other less transparent emerging markets. Moreover, the maturation of the CEE economies in the past 15 years has enlarged the regional stock of qualified joint venture partners.
Joint venture advice
But, similar to the pattern in China and India, joint ventures undertaken as entrée mechanisms in east-central Europe often do not endure as one or both of the partners exit from what typically begin as asymmetrical arrangements. In light of this trend, foreign investors entering CEE joint ventures should pay careful attention to the following:
- locating partners whose operational capabilities, organisational structure and corporate values are properly aligned with the regional objectives of the investor;
- achieving a clear understanding of the strategic goals, spheres of co-operation and mutual expectations of the partnership;
- identifying potential exit options in the event that the partnership turns sour and/or exhausts its business value.
Following a lull in the mid and late 1990s (when privatisation-led FDI dominated the attention of multinationals), greenfield investments are enjoying a resurgence in east-central Europe. Between 2002 and 2005, 810 greenfield projects were started in regional leader Hungary, approaching the total of Brazil and surpassing those of several EU-15 countries (Spain, Austria, Finland, Denmark, Ireland and Portugal). Poland (709 project starts), Romania (635) and the Czech Republic (499) have also become important greenfield destinations.
Greenfield investments are a favoured strategy for multinationals that are unable to locate suitable joint venture partners or acquisition targets in CEE, intent on maximising parent company control of CEE subsidiaries, and determined to establish state-of-the-art facilities to support regional growth campaigns. Foreign investors contemplating east European greenfields should carefully evaluate the trade-offs between (1) the strategic/ operational/proprietary benefits of this mode of entry and (2) the comparatively high start-up costs of greenfield projects.
The most noteworthy development in the CEE foreign investment sphere is the regional surge in mergers and acquisitions (M&A). Between 2003 and 2005, M&A in the CEE-10 countries grew by 389%. During that period, M&A represented 74% of FDI in Bulgaria and the Czech Republic and 51% of inbound FDI reaching Estonia. By contrast, M&A represented just 10% of China’s 2003/05 foreign investment portfolio. M&A activity is accelerating in a number of eastern European industries, ranging from telecommunications (Telefonica and Vodafone in the Czech Republic) to financial services (Foerenings Sparbanken in Estonia) to airports (BAA International Holdings in Hungary).
Foreign investors pursuing M&A in the CEE region should heed the experiences of the US and western Europe, where two-thirds of M&As have failed to achieve the parties’ declared objectives. The poor track record of M&A in the West underscores the importance in CEE M&As of the demonstration of a compelling strategic logic before undertaking the transaction; clear, frank and continuous communications between managers, employers and stakeholders; and due attention to the cultural dimensions of M&As, which often prove more troublesome than the financial and operational aspects.
The region’s small and medium-sized enterprise sector is also attracting growing attention from the foreign investor community, particularly American and western European-based private equity firms that are seeking to expand their emerging market portfolios. Until now, CEE has not played a prominent role in private equity investments, whose recent expansion has spearheaded the global surge in M&A.
But private equity activity in the region is quickening. One reason for this is a growing supply of acquisition targets in the CEE-10 countries, many of which are SMEs founded by east European entrepreneurs in the 1990s that have since reached maturity and that are unencumbered by the succession issues that often thwart buyouts of family-owned businesses in the US and western Europe. Another reason is the increasing average transaction sizes, which broaden the universe of east European acquisition targets within the threshold of west European and American funds. A third reason is the deepening of regional stock markets, which enlarges initial public offering exit opportunities for private investors.
The rise of private equity markets in east-central Europe augurs favourably for the region’s competitive position in the global economy and creates an important venue for foreign investors expanding their emerging market portfolios.
David Bartlett is economic adviser to RSM International, a global network of tax, accounting, and business consulting firms headquartered in London.