EASTERN EUROPE: THE ROCKY ROAD EAST.

EASTERN EUROPE: THE ROCKY ROAD EAST. - UK firms are still lagging far behind others on the road to eastern Europe. Investing there remains largely an act of faith, but moderate rewards can now be had in return for moderate risk.

by Tom Pullar-Strecker.
Last Updated: 31 Aug 2010

UK firms are still lagging far behind others on the road to eastern Europe. Investing there remains largely an act of faith, but moderate rewards can now be had in return for moderate risk.

You don't have to look far to find a pundit who's come a cropper in eastern Europe. A report by the Adam Smith Institute in 1991, hailed at the time by the Independent as 'the most comprehensive study of privatisation plans in eastern Europe to date', concluded, 'The economic industrial structure in general in ex-Comecon Europe is heading for nothing less than catastrophe and is in a far worse condition than even the most pessimistic observers believe. The size of the impending catastrophe and the political implications of such a catastrophe are not fully understood.' Four years on, Paul Reynolds, one of the co-authors of the report, maintains, 'I wouldn't say we'd got it wrong, that is far from the truth.' He reels off the usual list of woes that still dog the emerging economies of the region: the uncertainties created by the burden of inter-company debts, the skeleton in the cupboard represented by banks' non-performing loans, the lack of clear legislative frameworks, foreign debt (especially in Hungary), and so on.

But all the same, even Reynolds admits that the kind of economic-political meltdown of which the Adam Smith Institute seemed to warn is not going to happen. He observes, 'Meltdowns don't occur do they? Where has there ever been a meltdown?' Not in eastern Europe it seems. Last year, for the first time, all the east European economies - with the exception of those in the former Soviet Union and those that made up Yugoslavia - reported single-digit GDP growth. From Tallinn in Estonia (GDP up 5%) to Tirana in Albania (GDP up 7%), the fog is slowly lifting to reveal an eastern Europe of seemingly manageable economic risks.

Alarmingly perhaps, it is growth in which Great Britain plc has only a limited stake. At $575 million, British direct investment in the more developed (Visegrad) countries of Hungary, Poland, the Czech Republic and Slovakia is not only negligible in comparison with that from Germany and the US, it is also lower than that from Austrian, French, Dutch, Belgian and Italian industry.

Reynolds himself is the first to criticise British firms for being slow on the uptake. He argues, 'If you go anywhere (British companies) are really slothful generally speaking. The Germans are there, the Italians are there, the French are there, the Americans are there and there is usually some British trade mission with a bunch of bow-tied idiots getting drunk.' Jeremy Elgin of the East European Trade Council (EETC), among whose tasks it falls to arrange such trade missions, counters, 'The level of UK investment is probably greater than the figures suggest because big investments by multinationals such as Unilever and Shell are usually registered as being Dutch, for example. That being said,' he concedes, 'we are not as active in these markets as we should be.' Elgin explains, 'The big multinationals perceive central and eastern Europe as a "European" marketplace and feel they have to have a presence, especially if they have global aspirations. For them, 263 million people is too big a market to miss. Where the UK is missing out is with respect to medium-sized companies. There is a lack of awareness and ignorance and a tendency to over-estimate political risks.' This is a criticism made more forcibly by Andrew Warren, an executive partner of Coopers & Lybrand who has charge of the consultants' 11 subsidiaries in eastern Europe. He observes, 'We are talking to everyone but British companies. Medium-sized companies are very ignorant compared to their European counterparts. I am amazed how little they know and how forbidding they find it.' To suggest that it is feasible simply to pick up a factory in western Europe and ship it off lock, stock and barrel to the Czech Republic, for example, may seem naive. But one company that has done exactly that is the British firm AVX Electronic Components, a part of the Japanese Kyocera conglomerate and the largest UK investor in the Czech Republic.

When it received a letter from a Czech capacitor manufacturer, Tesla Lanskroun, suggesting the two firms co-operate, it despatched a search party and gave the Czech firm some subcontracting work. Six months later AVX decided to close its own plant in Bishole in Bavaria, trucked all its plant to Lanskroun, and leased a building from Tesla Lanskroun, founding its own subsidiary. One year later, AVX Czech Republic was formed. It now employs over 1,000 blue-collar workers and meets nearly a third of the world demand for tantalum capacitors.

Its general manager/director is the former head of Tesla Lanskroun, Jiri Skala.

Production leapt by 50% as a result of the move. The Czech workers earn about £1 an hour and it became feasible to keep the plant open 24 hours a day, seven days a week - something that simply wasn't possible in Germany's tightly regulated labour market. Indeed the success of the Czech operation is such that AVX in the UK is reluctant to risk rocking its own boat by discussing it.

Marketing director Glenn Louch explains, 'We still have large ongoing manufacturing commitments in both Germany and the rest of Europe (including a plant employing 600 in Devon) which we are committed to.' Such export-oriented investments constitute an opportunity for the individual UK firms who make them but comprise more of a threat for UK business as a whole than competition from locally-owned east European exporters, relatively few of whom have the marketing skills, contacts and quality certificates needed to trouble British producers in the domestic market.

For the most part, however, investments in eastern Europe have been geared to fulfilling local demand and don't raise such dilemmas. Another of the few British companies to take the plunge is Pilkington, which lit the furnaces on1June at the £115-million float glass plant in Poland in which it has a 40% stake. George Murray, a former vice president of Pilkington (since retired), explains, 'The positive reasons for investing were very powerful. It's a country of almost 40 million people, so it's a big market, and they didn't have any modern float glass capacity. 'My view is that if you go in early it is bound to be more difficult, but if you don't, you miss opportunities and things are likely to cost more.' But if the hazards of investing can be over-emphasised, so too can the potential rewards. There are no simple answers to the rejoinder, 'Why eastern Europe?' because there are no straightforward questions. Labour costs may be low, but they are not as low as in China. Access to west European markets may be better than in Malaysia, but it is not like being in the EU itself. Political risks may be dissipating but they are higher than in Portugal. Education levels may be good, but there are more available skills in the US. Prospects for market growth may be promising, but not as promising as on the Pacific Rim. The case for investing may seem enticing when sold by a persuasive management consultant, but in the cold light of day, the complex trade-offs may seem to add up to something less than compelling.

Bottlenecks exist for all sorts of critical staff and services. Office rents can outstrip those in London, getting sufficient telephone lines installed can be a major headache and finding locals with a knowledge of both UK and east European accounting systems has been described as like finding strawberries in winter.

The rates of corporation tax will also come as a shock. Across eastern Europe, home-grown firms have successfully pressed their case for 'a level playing-field' with foreign competition. Only Hungary still offers sizeable tax breaks. Even there, the government has acted to claw back some of the five-year tax holidays that it used to grant virtually unconditionally by cutting corporation tax from 36% to 18% and introducing a 23% tax at source on the distribution of profits - from which there is no relief. In Poland there are tax breaks for investment by both Polish and foreign firms, but they can only be claimed against the following year's profits and if a company is building up an operation from scratch that's often not much use.

Even the most obvious competitive advantage of the region - low labour costs - can prove a mirage for those companies which don't envisage manufacturing locally. Data on average wage costs speaks for itself and it is true that differentials for skilled manual workers are low, reflecting the socialist rationale that a worker was a worker and all the more honourable for it. But when it comes to recruiting staff who are perceived to have skills useful to a western firm's local head office, the situation is highly fluid. An experienced English-speaking secretary in Prague, Budapest or Warsaw, for example, is unlikely to demand much less than $10,000 a year from a foreign employer.

Jan Kluk, managing director of ICL Poland and president of the British Chamber of Commerce in Poland, comments, 'I have recently been going through an interviewing process for middle managers and I am getting people who are opening up the conversation at levels of 100 million (old) zlotys (£2,700) a month. We would have to pay an accommodation allowance for an ex-pat, but it is getting to the stage that if an out-of-work ex-pat was prepared to do without an accommodation allowance it would actually be cheaper to hire a foreigner than a Pole.

'In the UK, the average middle manager will be earning £30-35,000, less tax, plus car. That's a man with some experience. Here, you are talking about people who haven't got experience, because there isn't a tradition of marketing and sales in Poland and there isn't a tradition of more than six years of business management.' The flip side of this is that concerns regarding infrastructure in the Visegrad countries can be over-estimated. It may take a month to get business cards printed and the logo may not exactly match the corporate colours, as one firm complained, but AVX had no trouble finding local contractors to bus its workers to Lanskroun or provide 24-hour security, for example; and the quality of local services in general is improving as markets mature and the weaker of the region's local start-ups are weeded out.

Ironically, one of the key remaining missing links identified by the EETC's Elgin has its roots closer to home. 'One of the big drawbacks is the lack of representation of British banks,' he complains. 'It is something we are very concerned about. There is a reluctance to look at innovative ways of financing exports, like leasing, which frequently mean going to a non-UK bank.' There is also what can only be described as the 'hassle factor'. The honorary consul of a Commonwealth country recalls bribing an official to get a telephone connection: 'I didn't know how to bribe someone; you can't just hand the money over. In the end I put a high-denomination note into a box of chocolates and left it in their top drawer when they were out of the office.' But for most people the attractions of working in the region outweigh the drawbacks. The stereotype of obstructive and corrupt bureaucrats clinging to totalitarian traditions, in particular, is largely a myth - in the Visegrad countries at least. Kluk comments, 'I have a lot of contact with the bureaucrats. They are keen to do things and understand the necessity for inward investment. The things that are happening are very positive, very constructive. If there wasn't so much work to be done it would be smoother but the civil service has been under phenomenal pressure with new legislation and, frankly, given that they don't get paid very much I am full of admiration for the way people are dedicated to their jobs.' If the new, growing eastern Europe is one of only moderate risks and rewards, it makes identifying quality busi-ness opportunities all the more important. Boardroom ruminations over the question 'Why eastern Europe?' lose significance and low-level research at the EETC's library or the City Business Library comes into its own.

There are stereotypes regarding national specialities which have some basis in truth; Andrew Warren comments, 'Czechs are good engineers, Poles are good entrepreneurs.' And many pundits have their own favourite would-be goldmines. Warren says, 'In Romania we came across excellent furniture companies. If you are a British furniture manufacturer it might be a good strategic move to use them to break into markets in Germany.' For companies seeking to sell into east-European markets, it is local weaknesses rather than strengths which need to be exploited. Most east-European companies have difficulty getting finance, suffer from poor, ingrained attitudes towards customer service, and are new to operating in a market economy. The best opportunities are therefore for foreign companies working in mature vertical markets with well-honed customer service practices and some capital requirements, and a successful operational structure that can simply be transplanted.

Supermarkets are a good case in point. In the Czech Republic, going to a supermarket means visiting a branch of the Belgian chain Delhaize. Tesco has dipped its toes into the water in Hungary, acquiring a 57% stake in the 43 stores operated by Hungarian chain Global in June 1994 for £15 million. According to Tesco, the profitability of the Hungarian stores has leapt 40% since the takeover and that's before introducing checkout scanning and computer-controlled distribution. Tesco is now considering changing the name of all the stores to its own banner, and plans to build new 20,000 sq.ft supermarkets in Hungary and research opportunities elsewhere in eastern Europe.

But such 'safe bets' are few and far between and even Elgin concedes that the bottom line is that investing in eastern Europe is still 'an act of faith'. Rightly or wrongly, it seems that on the whole British firms have found that less satisfactory than have their foreign competitors. Kluk argues, 'The financial control of British companies in terms of understanding costs and understanding ratios is a big plus. But when it comes to long-term strategy the accountants who tend to rule British companies at the moment tend to be a bit of a brake.

'There isn't an immediate answer in any management situation today that says "This is the way that you look at short-term income as well as long-term strategy." When you are looking at a short-term investment and then a secondary decision on whether to continue with that investment, you are probably aiming at a return of 30% in the first year, which is difficult to achieve. But if you have the guts for a long-term commitment and you are prepared in a sensible way to manage your short-term and long-term objectives and don't take away all the profits, then you have an excellent opportunity to establish yourself in this region.'

How eastern Europe shapes up

Foreign Investment in Visegrad States

US $2,795m

Germany $2,630m

Austria $1,521m

France $1,425m

Holland $863m

Supranationals $863m

Belgium $754m

Italy $589m

UK $576m

Switzerland $233m

Others $1,247

Source: National Banks

Figures to end-1994

Figures originally compiled by Business Central Europe (Economist

Group), reprinted with permission

1994 Standard of Living Index

European Union Average = 100

Czech Republic 54

Hungary 46

Poland 37

Russia 27

Source: Vienna Institute for Comparative EC Studies Index adjusts per

capita nominal GDP to take into account local price levels

1994 Average Wages (gross per month)

Hungary $396

Czech Republic $279

Poland $243

Russia $105

Source: Stockholm Institute of East European Economics

1994 Office Rents: sq.m./month (range)

Moscow $55-70

Warsaw $30-50

Central London $28-67

Budapest $20-31

Prague $18-38

Source: East 8 Petrol Costs: 4 star, price per litre at the pumps

Hungary 67.15p

UK 61.70p

Czech Republic 56.11p

Poland 28.99p

Source: Automobile Association

As at 15 July 1995

1994 Telephone Costs (ex-VAT)

to Germany per min to US per min

Czech Republic (1)$0.88 $2.19

Poland (1)$0.73 $1.63

Hungary (1)$0.62 $1.52

UK (2)$0.38 $0.53

Source: National PTTs (1) April 1994 charges, converted at 1994

average exchange rates (2) July 1995 charges, converted at £1=$1.59

Corporation Tax

Poland 40%

Czech Republic 41%

Hungary *33.3%

UK 33%

*Effective rate (18% corporation tax plus 23% tax on distributed

profits charged on 65% of the tax base of subsidiaries)

Cadbury Schweppes

Sweet dreams are made of this

Matthew Cadbury (left), regional development director of Cadbury Schweppes, first went to eastern Europe in 1993 when Cadbury decided to invest £20 million in setting up a greenfield chocolate factory in Wroclaw in Poland. 'I expected it would be the most complete dump,' he recalls. 'But in fact it is a perfectly respectable country.' Last year the company committed a further £75 million to establish a plant near St Petersburg.

Cadbury sold 280 million chocolate bars in Russia last year, necessitating what the company's annual report describes as 'a major international sourcing drive.' Even for a company the size of Cadbury Schweppes, the investments amount to a significant financial commitment. Cadbury explains, 'Our business has relatively low labour costs so that's not really a significant factor (Cadbury's Polish workers earn between $400 and $500 a month on average). But you do have quite significant transport costs from the UK. Also some ingredients are far cheaper in eastern Europe than they are in the EU. The price of sugar here in the UK is about £400 per ton; when I was in the Ukraine it was $170 per ton. If you take that into account it is cheaper to produce in Poland.' Cadbury experienced some difficulties it couldn't foresee when actually setting up the plant. Cadbury notes, 'One of the things we did was we shipped in all the steelwork from the UK. They don't make I-section girders in Poland. All they do is have a chap weld pieces of metal together to make it into an 'I' and the result is that it uses 50% more steel.' He also warns that 'there is an unbelievable amount of bureaucratic confusion'. He adds, 'I can safely say that we haven't paid any bribes to anybody in Poland and in spite of that we have built the factory from scratch in a year when people in Poland told us we were insane and it would take at least three. I guess we are finding it more difficult in Russia but we're still hopeful we'll make it.' Cadbury won't say what return on investment Cadbury Schweppes was aiming at, but describes short-term returns of 30% as unrealistic. He comments, 'Some people make the mistake of thinking there's nothing in eastern Europe and it is somehow "empty" and you can just walk in and take what you want.

Everyone's in Poland. It's nice and competitive.'.

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