Too much of a good thing

Date: 22/11/03

The Visegrad countries should aim for smaller government

FOR investors in central Europe, May 1st will come and go almost like any other day. True, the countries into which they have sunk their money will be joining the European Union, but they discounted that outcome some years ago, even if they could not say exactly when it would happen. The key issue for business was access to EU markets, and that has already come, thanks to a progressive freeing of trade over the past decade. The abolition of customs formalities at national borders next May will merely streamline things a bit.

EU enlargement might even be something that investors in central Europe would rather see delayed another couple of years. When it happens, EU laws on competition and state aid will mean an end to most tax breaks. Expensive new EU environmental and health standards will have to be respected and paid for. Governments may lose interest in reform once they feel the big political goal of EU entry has been achieved. Workers may demand bigger pay rises as they identify more readily and more enviously with workers in rich EU countries.

The Visegrad countries have plenty to worry about on those last counts, and most of all Hungary, which a few years ago was leading the region in both quantity and quality of foreign direct investment. Last year the inflow fell sharply, as did foreign direct investment globally, though not in central and eastern Europe. The first half of this year may well have seen a net outflow of investment from Hungary - partly because Hungarian companies are rich and confident enough to make big investments overseas, but also because foreign investors are shying away.

They complain about a tightening labour market, soaring wages and a tax-take which is high by regional standards. Public-sector wages rose 28% last year and almost 25% in the first half of this year, the fruit of extravagant promises made during last year's election campaign. Private-sector wages rose by 13% last year and almost 9% in the first half of this year. Three years ago the average wage in Hungary was a third less than that in Poland: now the wages are about the same.

The public-sector wage rises are all the more dismaying because there has been little attempt so far to link them with productivity rises. Hungary's ministries and government agencies are among the most over-staffed in Europe, while skilled labour for the private sector is running short. The government has acknowledged the problem by promising to cut staff in ministries by 10%, and in regional agencies by 6%. But its record on austerity is not good. Worries about public finances, and about the currency, have pushed interest rates up and investors' spirits down. “The government is saying that the corporate sector should do this and that, when the weak link in competitiveness is the government,” says a businessman.

If neighbouring countries seem to be doing better than Hungary, they have cyclical factors to thank as much as policy. Poland is emerging from two years of very weak growth which kept unemployment high and wages down. As growth recovers this year and next, investment should do so too. But neither the investment, nor the growth, will be as strong as it might be, because the government is shying away from getting public finances under control. It wastes far too much money on social-security schemes that are rife with cheating. Next year's budget deficit will probably exceed 5% of GDP, a dismaying figure for any country without a very good excuse, though not nearly as bad as Hungary's 9.9% deficit last year.

The Czech Republic can point to strong foreign investment, and wage growth that is only mildly worrying. But it, too, has problems with public spending. The problem, as in Poland, is a weak centre-left government which could hardly get tough fiscal adjustments through parliament even if it truly wanted them. It has to settle for modest ones, and struggle for those.

The Czechs still lead the region in terms of foreign investment per person, and Prague is still the favourite city for a regional business headquarters. But they find themselves losing ground to Slovakia, from which they cut loose a decade ago when they thought it too backward.

Now Slovakia is punching above its weight thanks to a centre-right coalition government which is fragile politically but is launching bold reforms all the same. It promises a flat-rate tax of 19% on corporate profits and personal income next year, plus reforms in public pensions, healthcare and education. Those policies, coupled with some of the lowest wages in the region, have made Slovakia a new favourite among foreign investors, with inflows far outstripping the regional average. This year a French carmaker, Peugeot-Citron, chose the country as the site for a big new car factory costing €700m ($804m).

Peugeot-Citron's investment confirms the strength of central Europe as a centre for car making. The concentration of assemblers and component suppliers in the Prague-Bratislava-Gyor triangle will attract further investment for a generation to come. The region's other leading industry, electronics, is moving up-market. Factories which made computer monitors last year will make television sets this year. But rising wages are forcing out industries such as textiles, clothing, furniture and food processing, which can move to the cheaper countries of south-eastern Europe.

It is only healthy for rising wages to price out jobs that add little value. But they need to be replaced with more skilled jobs, in science and the service industries, and those are jobs that can leave even more quickly than production-line ones if workers elsewhere start doing them better or more cheaply. It is a measure of how competitive central Europe has been until now, that foreign-owned firms provide half the manufacturing jobs there, twice the share they have in the EU. The world has wanted to invest. The trick now is to keep investors excited about the prospects for growth in the years ahead - not just foreign investors, but domestic ones too, who will matter far more in the long run.

The experience of other countries suggests that high growth rates in Hungary and its Visegrad neighbours will be possible only if governments there get smaller and more efficient, as those in the Baltic countries have done. Rich countries may feel, however misguidedly, that they can afford big public sectors and high taxes which redistribute wealth, but poor countries certainly cannot. Government spending accounted for 53% of GDP in Hungary last year (including net lending), 47% in the Czech Republic, 44% in Poland and 41% in Slovakia. It needs to come down, even in Slovakia. The inspiration here should be Ireland, everybody's favourite example of a poor country that got rich within the EU. It did so while keeping government spending below 35% of GDP from 1998.

Nor does it take for ever to cut spending, however eternal the attachment to big government might appear. Sweden cut social security and welfare payments by six percentage points of GDP between 1993 and 1998. To learn how, finance ministers can study the IMF's report on Hungary this year, which devotes 22 pages to comparative studies of fiscal adjustments in different European countries and the means by which they have been achieved. That must count as one of the heaviest hints ever dropped by an international financial institution, and one of the most helpful.

The Visegrad countries should aim for smaller government. Article is part of a survey 'When east meets west: a survey of EU enlargement'.

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