McKinsey Global Institute – A new dawn: Reigniting growth in Central and Eastern Europe

A recent report from the McKinsey Global Institute finds that the Central and Eastern Europe economies can resume rapid expansion if they adopt a new growth model to raise investment, unleash productivity, and expand high-value exports.

• Download Executive Summary (PDF–882KB)
• Download Full Report (PDF–4MB)

From the early 1990s until the onset of the global financial crisis, in 2008, the economies of Central and Eastern Europe established a record of growth and economic progress that few regions have matched. Emerging from decades of socialism, Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, Slovakia, and Slovenia became standout performers in the global economy. Their inherent strengths were unleashed as state-owned industries were privatized and labor reforms implemented, attracting a flood of capital and foreign direct investment that drove productivity improvements and per capita GDP growth.

Yet these economies—like the United States and Western Europe—have struggled to regain momentum since the end of the recession. Despite their underlying intact strengths, such as highly educated yet inexpensive labor forces, they need to modify their economic models to restore the 4 to 5 percent annual growth rates of the precrisis years. The region must emphasize investment-led growth, expand high-value-added exports, and increase both foreign direct investment and domestic savings. For this strategy to succeed, the nations of Central and Eastern Europe will also need to build the foundation for growth, including infrastructure improvements, accelerated urbanization, regulatory reforms, institution building, investments in labor-force skills, and efforts to encourage R&D and innovation. In addition, these economies must address the aging of the workforce by raising the labor-participation rate of women and younger workers.

The new growth model

The global recession exposed certain weaknesses in the growth strategy that had propelled Central and Eastern European economies before the crisis. These weaknesses included very high consumption (on average, about 80 percent of GDP from 2005 to 2008) enabled by unsustainable levels of borrowing. Easy lending standards helped create real-estate bubbles in Bulgaria, Romania, and Slovakia; prices in Bucharest rose by three and a half times from 2000 to 2007. Moreover, since at least 1995, overall savings in these economies failed to cover investment: national savings rates averaged 19 percent of GDP, while investment generally hovered at around 24 percent. The region depended on foreign direct investment, which collapsed during the crisis and has only partly recovered. In addition, trade was overly concentrated on Western Europe and a handful of categories, such as autos. And despite strong flows of foreign direct investment, outlays on machinery and technology were modest in many sectors. A new growth model would expand exports of higher-value-added goods and services, increase productivity in lagging domestic sectors, and finance growth with renewed foreign direct investment and higher savings:

• Expand high-value-added exports. The region has recently become a net exporter of knowledge-intensive manufactured goods (including finished automobiles and parts, aerospace products, and electronics), with a surplus equivalent to 2 percent of GDP. It can evolve, for example, from being the source of inexpensive labor for Western European carmakers to providing broader, higher-value functions. The region has also built a highly competitive outsourcing and offshoring capability and is now in a position to move into more high-value-added activities, becoming regional hubs serving all of Europe and beyond.
• Unleash growth, productivity, and investment in domestic sectors. The region’s construction, transportation, retail, and network industries (such as railroads and electric utilities) continue to show significant productivity gaps compared with their counterparts in Western Europe. These economies should therefore seek to reduce their reliance on informal labor and encourage companies to invest in equipment and to adopt modern methods and materials. Truckers could consider moving up to higher-value-added services, such as logistics. The retail sector is relatively modern, but companies can raise their productivity by adopting technology and lean processes. The region should also continue on the path of liberalization and competition in network industries.
• Renew foreign direct investment and generate higher domestic savings. The economies of Central and Eastern Europe have among the world’s lowest savings rates—a problem reflected in long-standing current-account deficits. The region should promote the further development of stable financial markets and more liquid corporate bond and equity markets, as well as create demand for financial products by reforming pension and insurance systems.

Building a strong foundation for growth

Implementing such strategies can help the region achieve an “aspirational” GDP growth rate of 4.6 percent a year—about its average from 2000 to 2008 (exhibit). To support this growth, these economies need:

• Infrastructure. The region should invest more than 5 percent of GDP in infrastructure, up from a recent average of 4.1 percent. More than 20 percent of this investment must go into roads, which would help to bring trucking productivity closer to EU-15¹ levels, among other benefits.

• Urbanization. The countries of Central and Eastern Europe are less urbanized than those of Western Europe: 62 percent of their residents live in cities, compared with 77 percent in the EU-15. Cities often offer greater employment opportunities and higher levels of wealth. They can also deliver public services more efficiently. In the private sector, population density is important for the success of services such as modern-format retailing.
• Regulation and institution building. While these economies have advanced in the global rankings for providing a good environment for business, additional regulatory reforms can help attract investment and encourage entrepreneurship. In surveys, foreign investors raise questions about legal protections in many countries of Central and Eastern Europe, and opening a business can still take far longer there than it does in other parts of the world. These countries can also make the institutions that implement and enforce regulations more responsive and efficient by improving their capabilities.
• Education and skills. Despite the region’s success in providing highly skilled labor, it must make additional investments in education and training in fields such as advanced manufacturing and outsourcing. Overall, its students score below the OECD² average on the PISA test,³ it lacks outstanding research universities, and its postsecondary education is not well aligned with the labor market’s needs. Another immediate priority should be to revamp vocational training to create a workforce with job-ready skills and reduce youth unemployment. These economies also suffer from a lack of management skills, in part because qualified candidates have emigrated. Policies to encourage the repatriation of émigré workers have worked well elsewhere.
• R&D and innovation. R&D spending in the region averaged 0.9 percent of GDP in 2010, compared with 2.9 percent in the United States, 2.1 percent in the EU-15, and 1.4 percent in the BRIC economies (Brazil, Russia, India, and China).⁴ Central and Eastern European economies should increase their investment in R&D from both private and public sources. They should also further develop industry clusters in knowledge-intensive industries and increase industry–university collaborations and support for start-ups.

The region’s eight economies have demonstrated their commitment to improve the lives of their citizens through growth. They undertook sweeping reforms in the 1990s to open their economies to investment and trade and took difficult decisions to raise productivity, which led to rising wealth. The crisis and the slow global recovery have interrupted this progress, but a new growth model and renewed efforts to address the issues that hold back growth can make the region one of the global economy’s most dynamic areas of economic development.