Adolescence is over. Time for updates to the Central European growth model

Panorama of Warsaw. Photo: Lukasz Pawel Szczepanski / Shutterstock

This positive image, however, has been undermined in recent years since the convergence process has significantly slowed down in many countries in the region. In contrast, the EU itself as a whole is losing its development dynamics. It is worth noting that in the last decade, the dynamics of convergence with the EU average varied significantly in Central Europe. Its high pace was maintained in Romania (+8 percentage points), Poland (+11), Croatia (+9), Slovenia (+8) and Lithuania (+9) or Hungary (+9). In comparison, it was much lower in Estonia (+6), Latvia (+6), Bulgaria (+5), the Czech Republic (+4) and Slovakia (+3). In the last three years, these two last countries have been coping with the challenge to bring their economies back to pre-pandemic growth levels.

Lost decade

The last decade should have been a lesson that, unfortunately, the EU is not a club ensuring everlasting GDP growth. Errors in economic policy exposed by the global financial crisis (2008) and turbulence in the eurozone (2010-14) resulted in many years of stagnation in the development of many countries. The economic positions of France (-12 percentage points), Spain (-12), Greece (-20) and Italy (-23) have significantly weakened compared to the EU average. Reliance on debt and the absence of reforms in the context of growing competition in the world and the EU itself resulted in deep economic and social problems. An uncontrolled increase in production costs, such as the level of wages in the case of the southern countries of the eurozone, all with dependence on the inflow of capital from abroad, may lead to a sharp deterioration of competitiveness and a jump in unemployment to very high levels. As a result, there may be many years of stagnation. This is especially true for members of the monetary union, who are unable to devalue one’s currency.

Another problem is that the EU faces problems with economic competitiveness and is losing its position as a technological leader in many sectors. While Central Europe is trying to catch up with the EU average in terms of GDP per capita, the EU is increasingly not a point of reference as it has ceased to be the locomotive of global growth in the last decade. The series of crises concerning the eurozone, Brexit, the pandemic and energy essentially cost the EU a decade in terms of GDP growth.

Before the global financial crisis, the EU and the United States were almost equal competitors regarding the size of the economy in dollar terms. Today, the US economy is one-third larger. A strong appreciation of the dollar explains part of this, though it cannot be ignored that the US scores better regarding digital technologies, the inflow of capital or demography. Whereas China and the US are crafting new concepts of industrial policy, the EU is still behind in this respect.

Challenging geopolitical environment

The question about the economic model of Central Europe becomes even more important when we look at the foreign policy challenges on the horizon. Looking at the trends in the international environment, it is not likely that the next two decades will be easier for Central Europe. The threats arising from Russia’s increasingly aggressive policy will likely generate certain risks and significant fiscal expenditures for a prolonged period.

There is already a visible trend of a significant increase in military spending in the region’s countries, constituting a substantial burden on national budgets. In 2023, of the ten NATO countries with the highest defence spending in relation to GDP, six were in Central Europe. Only four countries in the region, Bulgaria, Croatia, the Czech Republic and Slovenia, did not meet the NATO criterion of allocating two per cent of GDP for defence purposes. In contrast, only Finland and Greece met this obligation among the remaining EU countries. The region needs to keep on track with its economic growth to meet such challenges.

However, the increased uncertainty might provide some opportunities. The lower appetite for risk on the part of global business in the face of the growing labour shortages in Western Europe may encourage it to locate higher added-value activities in Central Europe. One condition for this would be a stronger tendency towards “friendshoring” in EU regulations. In other words, this involves imposing obligations on enterprises to diversify risk and limit dependence on supplies from countries that threaten interests related to European security. The EU should also start redeveloping its industrial policy. Bringing back some production to Europe could result in higher production costs for some goods. Still, the benefit-cost balance could be profitable due to the return of a significant part of added value to the EU. Central Europe could benefit from these trends and develop competencies in areas where Asian producers have so far dominated. The lesson here should be to ensure that the EU does not make similar mistakes, leading to industrial production in the region moving outside Europe.

Western countries are increasingly noticing the problems of losing added value in industrial production. Considering the location of supply chains only based on business criteria, without taking into account geographical or security requirements, leads to the EU or the US losing competencies (especially the necessary human capital) in the production of various components which, in many cases, leads to the domination of specific markets by manufacturers from Asia. An excellent example of this can be seen in the production of weapons. Since western countries have shut down their factories, they now have huge problems with resuming large-scale production. Russia has a significant advantage in this respect despite its generally much lower economic potential.

Drawbacks of the growth model of Central Europe

Accession to the EU enabled Central European countries to integrate into the EU single market. In practical terms, this offered local companies the possibility of more robust expansion into the supply chains of many foreign global corporations. It facilitated the inflow of capital, technology and better methods of organizing production. As a result, Central Europe is most dependent on exports to the EU market. Four out of five EU countries with the highest export dependence on the EU market are in Central Europe. These are the Czech Republic (82 per cent of exports go to the EU), Slovakia (80 per cent), Hungary (78 per cent) and Poland (76 per cent).

However, the price for this cooperation has been a subordination to the hierarchy in existing supply chains and the need to keep labour costs as low as possible. This was amplified by the fact that the countries of the region were exposed to intense mutual competition for incoming investments. This model will be hard to maintain in the coming years. Firstly, the weakening technological competitiveness of the European companies may limit the demand for the production of Central European suppliers. The beginnings of this process can be seen in electric vehicles, where many Central European countries, so far with a powerful position in the production of combustion cars, are having difficulties attracting electro-mobility investments. Secondly, the gradual increase in wages in the region to the level of Western Europe might reduce its attractiveness as a supplier of components.

If Central European countries mainly play a role as suppliers of cheaper components for the final products of global corporations, then profits from the sale of final products, as well as their marketing and distribution, go to the countries which own the overall products. They obtain much higher margins and retain control over the entire production process, particularly when it comes to product data and further development. Therefore, a question should be asked: does the path of being a supplier lead towards progress in innovation and technology? So far, intense competition conditions have limited the region’s possibilities for combining local companies’ competencies to develop more advanced components, products and services.Foreign investors in Central Europe are not related to the local market, so most often, they do not build research and development centres on-site, leaving such activities in the country of origin.

An additional burden may be the all-too-rapid pace of implementing the energy transformation and climate obligations, which may increase production costs. How important this factor is for competitiveness is perfectly reflected in the situation of the German economy, which, because of errors in the implementation of the energy transformation and excessive dependence on imports of energy resources from Russia, was forced to accelerate diversification. The costs have had a heavy impact on the economic situation in recent years.

All the Central European economies demonstrate significantly higher CO2 emissions intensity per percentage point of GDP. Thus, the green transition process will be costlier for this region. In addition, Central Europe is starting to experience problems with labour shortages. When entering the EU, the countries of Central Europe had one great advantage at that time – there seemed to be an inexhaustible reservoir of inexpensive and well-skilled workers. In 2003 in many countries of the region the unemployment rate exceeded ten per cent and in countries such as Poland, Slovakia and Croatia, it reached close to 20 per cent. After 20 years of EU membership, the countries of Central Europe are in a completely different place. Poland (2.8 per cent), Czech Republic (2.8), Hungary (3.9) and Bulgaria (4.6) are among the countries with the lowest unemployment rates in the EU.

Although the region experienced a substantial population decline already right after accession, it occurred in favourable demographic conditions and with a relatively young population structure. In 2004 the average median age, according to Eurostat, was 38 years, while this indicator for the entire EU was 39 years. Nowadays, the situation is much worse. In Central Europe in 2023 the median age was 44 years; in the EU, the result was similar and amounted to 44.5 years. According to Eurostat data, population ageing is the fastest in Central Europe compared to the already rapid process in other EU countries. Between 2012 and 2022 the percentage of people aged 65 and over increased by 3.6 percentage points in the region, while in the EU on average this grew by three points. The top ten fastest ageing countries include five Central European countries, with Poland being an inglorious leader.

Economic agenda. Rule-takers or stakeholders?

An in-depth analysis of the economic situation of Central Europe shows one thing. Adolescence is over. In the next decade, many countries in the region could become net contributors to the EU budget. Therefore, it is time to have more influence on EU decision-making to start building a new, more innovative growth model.

To fulfil this, several conditions must be met. First, Central Europe should keep improving its infrastructure with a particular emphasis on railways, which is crucial for matching ecological obligations. An important goal should be to increase the role of rail in freight transport and to construct critical cross-border investments (including sections of highways, railway lines, and opening new road and rail border crossings) between the countries of Central Europe, which could increase trade turnover between the countries of the region. It is also necessary for the region’s countries to develop infrastructure for intermodal transport, especially networks of transhipment terminals.

Second, Central Europe should cooperate on common positions in EU sectoral issues, such as the negotiations for the Multiannual Financial Framework for 2028-34, creating a new EU industrial policy and modifying the Green Deal to adjust it better to the needs of manufacturing economies. Rebuilding the economic model of Central Europe is a task that goes beyond the capabilities of individual countries, as decisions made at the EU level are an essential determinant. Due to the similarity of development challenges, regional cooperation seems to be crucial for the Central Europe in order to be a responsible stakeholder of the EU and ensure that de-carbonization plans do not lead to de-industrialization.

Third, Central Europe should be active in negotiations for Ukraine’s accession to the EU. It will benefit the region if it co-shapes the entrance criteria to make the Ukrainian economy fit into the single market. This will help Kyiv to complement the Central European economies, all the while strengthening synergies with the manufacturing sectors in the region. Otherwise, there is a risk that the enlargement negotiation process will become a victim of various economic disputes, weakening societal support in the region for the accession of Ukraine.

Konrad Popławski is the project coordinator for the connectivity and regional integration programme at the Centre of Eastern Studies (OSW) in Warsaw.

Central Europe, economics, economy, Poland