The anatomy of mediocrity: FDI and Eastern Europe’s mid-level manufacturing trap

Cornel Ban

The 1990s and the 2000s were decades replete with economic myths. Remember the hubristic stories about the end of manufacturing or the endless opportunities afforded by the “new economy”? Remember the paeans to the virtues of radical financial deregulation? Correspondingly, it was a time when many apparently sensible people would scoff at warnings about the export of manufactured goods loaded with predominantly domestic innovations, cautious optimism about the added value of technological somersaults, and skepticism about the benefits of light touch regulation. The new EU member states from Eastern Europe were no exception. In the initially euphoric transitions experienced by those inhabiting the former space of really existing socialism, the new myths had an even greater appeal. Indeed, they provided starry-eyed reformers with the contours of the very market economy of the future.

How times have changed! The financial crisis and the success that the old-fashioned German economy has had in overcoming its worst aftereffects, have had a sobering effect on the frenzied talk and economic “newspeak” of the previous two decades. Vocational training, patient finance, economic coordination and such elements of stigma in, say, 2006, were being reconsidered by 2012 as far as British conservative circles.

Perhaps the most powerful economic myth in the EU’s Eastern rim has been that massive Foreign Direct Investment (FDI) inflows will not only arrest deindustrialization and consolidate strong export economies integrated into Germany’s transnational industrial cluster, but also have a trickle down effect on research and development and keep at home more value over time. Like all economic myths, when looked at from a certain angle, this expectation had some believable features. Chief amongst these was the region’s low cost and vast army of engineers, the wide availability of strong mathematical skills in the skilled labor force, and the extensive network of research institutes left behind by the technoscientific legacy of state socialism. To wit, Hungary and the Czech Republic have a strong industrial tradition dating back to the early 20^th century.

As long as the music kept playing and massive FDI kept flowing in the region, turning East-Central Europe into export powerhouses, there were few incentives for policy elites in those countries to take a second look at the details of the evidence about costs of exclusive reliance on FDI for their development.  It took the unprecedented collapse of these inflows after 2008, the collapse of Western European demand after the crisis of the euro, and the resulting fiscal problems experienced by these countries to change the reformers’ gazes from starry-eyed to angst-ridden. What stood out in these expressions of concern has been the realization that this FDI-dependent model had in-built structural weaknesses embedded in it that made it perform considerably below the potential of, say, many of the up and coming Asian economies.

Most importantly, it became obvious that FDI had only marginal effects on local research and development capacity, the hallmark of sustainable growth. In fact, it became clear that the entire region was stuck in a bad, medium-level manufacturing trap. For all of them the FDI story started with investments in basic manufacturing and then it went up the scale of technological sophistication, with different speeds, to the mid-level and then remained there. At first it would be textiles, footwear and basic engineering. Then, emboldened by the fact that cold war propaganda about Eastern Europe’s feet-dragging and kleptomaniac labor force was…just propaganda, foreign investors ventured far afield and started investing in car assembly, car parts, electric and electronic equipment. “We found in Romania an incredibly well-trained corps of engineers and industrial workers, whose skills were not unlike anything you would find in West European countries with strong industrial traditions.” This was  how it was put to me in 2008 by a Renault executive involved in the manufacturing miracle called Dacia, the Romanian-made car of the Renault group that turned out to be the cash cow of this venerable French industrial firm.

Similar stories came from the Slovakian and Polish car industry or the excellent performance of Hungary-based electronics companies. Indeed, for a while, it seemed like the region would be the next big “tiger,” with FDI also triggering the development of R&D capacities in these industrial fields at the domestic level. Yet this has not occurred on a systemic level. In fact, by itself, the FDI did not create more than a gigantic assembly platform of predominantly mid-level manufactured products. This was true whether one refers to the Czech Republic, a country with one of Europe’s oldest industrial traditions and one of the most sophisticated export economies of the region, or to Bulgaria, where industrialization did not start until much later. The IT sector aside, almost all of innovation was the result of R&D processes taking place in the home base of the foreign investors in question, with generally minimal local content incorporated in them.

What is more, foreign investments in the East European export boom have been carried out using finance provided by the financial institutions of the foreign firms, rather than by the financial sectors of the ex-communist countries. As it turned out, despite the fact that the region was rather special in the world, in that it had converted the bulk of its banks into mere subsidiaries of foreign (mostly West and Northern European) banks. But rather than fund domestic industry or some local innovation boom, these banks proved themselves to much better at funding a consumption bubble that in many cases (Latvia, Hungary, Romania) helped lead the local economies down on the bleak road of EU and IMF orchestrated bailouts by 2010. When credit rating agencies began to fidget about the high level of foreign ownership in the region’s financial sectors, even the most ardent believers in foreign capital as the panacea to the economic challenges of postcommunism began to have doubts.

In short, the FDI-driven export miracles of the EU’s East European member states have not landed these economies on the high-octane development path of postwar Finland, Austria and France, or closer to home, the recent experiences of Singapore, South Korea and to a more limited extent of Brazil. In these countries, the integration into global supply chains involved making an ideal range of domestically designed products compete in world markets against Western household names. But for that to happen it is not enough to create the macroeconomic, regulatory and infrastructure enticement for foreign investors. One also needs intelligent industrial policies, patient public finance and bold and well-funded public-private partnerships in R&D that will integrate FDI into medium and long-term development targets defined by the government.

Unfortunately, with the possible exception of Slovenia, East European reformers either rejected such policies with anti-government fervor or, following the policy fashions of the day, saw them as items of mothballed policy paradigms. The result is that the industrial future of the region looks more like that of Mexico’s maquiladoras than that of the Finnish or Korean industrial powerhouses. This makes one wonder whether in fact it’s not high time for East European policy elites to develop better critical and independent thinking skills when encountering policy fads. Or, who knows, even read a bit of heterodox development economics, just for fun. For if they don’t, their competitors in Asia certainly are.

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