Boosting regional integration in the EU-10

Boosting regional integration in the EU-10

By Alex Lehmann, Marcin Tomaszewski and Cagatay Bircan

Domestic investment in the central Europe region remains subdued and foreign direct investment (FDI) inflows coming from their traditional sources in western Europe are much below their pre-crisis peaks. At the same time it is often suggested that the EU-10 (the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, Slovenia, Romania and Bulgaria, all countries that joined the EU in 2004 and 2007) could, over time, attract FDI from their peers within the region.

This would allow them to build a more resilient investor base, one less prone to fluctuations in the investment cycle in the Eurozone core, while the investing firms would likely reap benefits in terms of greater productivity growth.

The distribution of investment can be assessed based on the stocks of outward FDI by partner country that are published annually by Eurostat, the EU’s statistical agency. This is no more than a rough approximation of actual investment stocks since these data typically omit value corrections and depreciation, and, more importantly, exclude funds attracted from other sources (for example, in local financial markets) to the affiliate company.

In addition, about 17 per cent of EU-10 outward FDI has been directed to financial centres, such as Cyprus or Luxemburg, from where it is typically re-routed, thereby overstating the importance of Western Europe as the final investment destination.

A first point to observe from the left-hand chart below is that, overall, the outward FDI from the EU-10 countries remains very small. The weighted average of total outward FDI stocks to GDP of the ten new EU countries is only about 8.7 per cent, far less than of such established investor countries such as Germany or the UK, where it is 36 per cent and 74 per cent respectively.

Among the group of EU-10 countries investors from Hungary (such as MOL, an international oil and gas group) and Estonia are the most prominent. Polish multinationals, such as petrochemicals group PKN Orlen, are well known though clearly represent as yet an insignificant capital engagement relative to the size of the Polish economy.

The second point is that the EU-10’s outward FDI is more concentrated in the EU-15 countries, amounting to roughly twice the stock that goes into other EU-10 countries (3.3 vs 1.7 per cent of the regional GDP respectively). The right hand chart underlines the fact that, within the EU-10 region itself, the three Baltic countries, and the Czech and Slovak Republics show the greatest intensity of intra-regional engagement, largely due to strong historical linkages to their immediate neighbours.

The total outward FDI directed to Russia and other countries of the Commonwealth of Independent States (CIS) represents only about 0.5 per cent of GDP, and relative to the total FDI engagement this is significant only for the Baltic countries and Romania.

EU-10 economies are generally very export oriented (with export shares of above 80 per cent of GDP in Hungary or Slovakia). 22 per cent of total exports (or 11 per cent of the regional GDP) is directed to other countries within the EU-10 region, and this share has been steadily increasing since EU accession led to a full dismantling of barriers to trade within the internal market.

In other emerging markets the integration through trade flows has been typically followed by closer intra-regional investment, also known as ‘south-south’ FDI. According to UNCTAD figures, the share of the thirty largest emerging markets in global outward FDI has roughly tripled in the last two decades to slightly over 20 per cent, and these flows accounted for roughly 30 per cent of FDI inflows into emerging markets.

As emerging markets gain global weight in terms of supply of capital and domestic demand, and more intense competition provides greater incentives for efficiency-seeking investment abroad, this trend is generally expected to continue. The Association of Southeast Asian Nations (ASEAN) may be an example of member countries managing to specialise in different parts of global value chains.

Such regional integration constitutes a springboard for export growth. The so called “flying geese paradigm” stipulates that relatively more advanced countries successively shed their labour-intensive production in favour of more capital-intensive activities. These countries developed a high degree of specialisation.

Trade of intermediate components represents about 40 per cent of the total intra-ASEAN trade, allowing the region to raise its global competitiveness and, thus, elevating its exports of final products to the rest of the world.

In contrast, the outward FDI of the EU-10 countries is nowhere near as developed as the export linkages of these economies. There may be two reasons for this. Firstly, the traditional market-seeking motive for FDI is unlikely to be very strong, as there is little incentive to gain access to the relatively small regional markets by establishing a local presence in the absence of explicit barriers to trade within the EU’s single market.

Secondly, the regulatory environment for doing business is not just still cumbersome but the nature of these obstacles also varies significantly from one market to another. Mid-sized firms considering locating another stage of production elsewhere in the region may thus be hard placed to navigate investment obstacles that will be very different from those they have encountered in their home base. For instance, the number of days needed to lease public land designated for industrial use amounts to 162 days in Poland compared to roughly 62 day in the UK.

Outward foreign direct investment by the EU-10 countries is a relatively recent phenomenon. In Poland, for instance, 93 per cent of outward FDI was accumulated since 2005. The experience of other emerging markets suggests that a significant potential for growth of outward FDI still remains.

To date, the economic weight of the EU-15 has dominated not just trade but also FDI patterns. To the extent that market regulations are being liberalised and converge across the ten new member states and with the rest of the EU the region will also become more attractive for intra-regional investment. As in other emerging markets, such regional integration among the EU-10 countries could provide an important boost to productivity growth within firms. However, integration through FDI will be a more drawn out process than that through trade.