Enlargement futures project : expert panel on economic transformation : final report.
Date: 2011-07-28
Institutions: Institute for Prospective Technological Studies
Subjects: economic development, economic disparity, economic integration, economics, enlargement of the Union, pre-accession strategy

ENLARGEMENT FUTURES PROJECT

Expert Panel on Economic Transformation

Andries Brandsma, Nikolaus Thumm, Alexander Tübke

Final Report

IPTS, November 2001

European Commission

Joint Research Centre (DG JRC)

Institute for Prospective Technological
Studies

http://www.jrc.es

Legal notice

Neither the European Commission nor any
person acting on behalf of the Commission
is responsible for the use which might be
made of the following information.

Report EUR 20116 EN

© European Communities, 2001

Reproduction is authorised provided the
source is acknowledged.

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Table of Contents

TABLE OF CONTENTS ............................................................................................................................................................ 3

EXECUTIVE SUMMARY......................................................................................................................................................... 5

1. INTRODUCTION.................................................................................................................................................................... 9

2. THE MAIN FEATURES OF THE ECONOMIC CATCHING-UP PROCESS......................................................... 11

2.1. THE CROSSING OF EMPLOYMENT TRENDS......................................................................................................................... 14
2.2. THE PATCHWORK OF REGIONAL GROWTH AND CONVERGENCE ....................................................................................... 17
2.3. FOREIGN DIRECT INVESTMENT: A MIXED BLESSING?........................................................................................................ 21
2.4. FINDING THE RIGHT MIX OF ECONOMIC ACTIVITIES.......................................................................................................... 26
2.4.1. The declining role of agriculture............................................................................................................................... 26
2.4.2. The increasing role of services.................................................................................................................................. 27
2.4.3. Privatisation: a bridge too far?................................................................................................................................. 28
2.4.4. The trend towards smaller businesses....................................................................................................................... 31
2.5. TECHNOLOGY TRANSFER AND INNOVATION..................................................................................................................... 33
2.5.1. The technology gap model......................................................................................................................................... 34
2.5.2. The legal framework .................................................................................................................................................. 35
2.5.3. The financial framework............................................................................................................................................ 35
2.5.4. Own market development .......................................................................................................................................... 36
2.5.5. Sectoral trends............................................................................................................................................................ 38
2.6. BUSINESS ACTIVITY AND ENTREPRENEURSHIP ................................................................................................................. 48
2.6.1. The role of trans-national corporations.................................................................................................................... 49
2.6.2. Business start-ups....................................................................................................................................................... 53
2.6.3. Venture capital........................................................................................................................................................... 55
2.7. Intellectual property rights ........................................................................................................................................... 56
2.8. THE PATTERNS OF SPECIALISATION AND TRADE............................................................................................................... 68
2.8.1. Comparative advantages........................................................................................................................................... 69
2.8.2. Competitive advantages............................................................................................................................................. 72

3. THE SIX MAIN CHALLENGES IDENTIFIED BY THE PANEL.............................................................................. 77

3.1. THE AGEING OF THE POPULATION...................................................................................................................................... 77
3.2. ICT DIFFUSION/PRODUCTION/USE..................................................................................................................................... 79
3.3. THE RETOOLING OF THE AGRI-FOOD CHAIN ...................................................................................................................... 81
3.4. THE GEOGRAPHY OF ECONOMIC ACTIVITIES ..................................................................................................................... 85
3.5. THE DYNAMICS OF HUMAN CAPITAL FORMATION............................................................................................................. 87
3.6. THE ECONOMICS OF SUSTAINABILITY................................................................................................................................ 88

4. CONCLUSION....................................................................................................................................................................... 91

PANEL MEMBERS .................................................................................................................................................................. 93

REFERENCES ........................................................................................................................................................................... 95

ANNEX A1 BULGARIA: SIRMA CASE STUDY.............................................................................................................100

ANNEX A2 BULGARIA: EPIQ CASE STUDY.................................................................................................................112

ANNEX B - SLOVENIA: FOREIGN DIRECT INVESTMENT TRENDS, FACTORS AND PROSPECTS ........126

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4

Executive Summary

Inspired by the prospect of EU membership, the economies of the candidate countries are climbing
out  of  the  trough  in  which  they  inevitably  fell  at  the  start  of  transition.  If  the  experience  of  the
relatively poor countries that joined the Union earlier is anything to go by, the catching up of the
new  member  states  will  be  characterised  by  considerable  periods  of  gestation,  followed  and
sparked by more spectacular increases in GDP growth.

On  the  whole,  the  blueprint  provided  by  the  single  market  programme  and  the  acquis
communautaire can be expected to serve the new member states well. The main complication is that,
as candidate countries, they are making choices for the transformation of their economies that will
have  consequences  for  their  future  place  in  the  Union.  They  are  making  these  choices  without
knowing exactly in which direction the EU’s legal and institutional framework will be developing.
Nevertheless, for the enlarged Union, the greater diversity of economic and social models could
be turned into a major advantage.

Stable  macroeconomic  conditions,  including  moves  towards  predictable  exchange  rates  and  hard
budget constraints, have already allowed the governments of many candidate countries to focus on
the choices to be made. They have recognised the importance of legal certainty for the making of
economic decisions, both in the public and in the private sector. However, the catching-up process
will  be  vulnerable,  especially  if  the  benefits  of  economic  progress  are  not  evenly  spread.  Twelve
years into transition, sizeable parts of the population of  central and eastern  Europe are still
living in conditions of great poverty.

At its Lisbon summit in March 2000 the EU formulated the objective of increasing the employment
rate (the rate of employed persons between 15 and 65 years, as a percentage of the total population in
the same age bracket) from an average of about 63% today (72% for men, 54% for women) to 70%
by 2010 (60% for women alone) across all EU member states. In this light, the downward trend in
employment rates in the candidate countries, if it continued, would be a worrying development
for the Union, especially since a year later, in Stockholm, the Council set itself the interim targets of
67% (and 57% for women) to be reached by 2005.

That employment rates in many of the candidate countries have been falling in the past few years,
whereas  they  have  been  rising  in  a  number  of  EU  member  states,  is  even  more  salient  since  the
economies of the candidate countries have been growing faster than the EU-15. Although 2000 was
the  first  year  in  which  all  candidate  countries  had  positive  GDP  growth  rates  at  the  same  time,
Poland, Hungary and Slovenia have consistently had higher growth than the EU average in the last 5
years.  The  fall  in  employment  is  subsiding  in  most  of  the  candidate  countries,  and  employment
growth  is  picking  up  in  some,  but  what  remains  is  a  substantial  gap  between  real  GDP  and
employment  growth.  In  macroeconomic  terms  this  amounts  to  high  overall  labour  productivity
growth in the candidate countries, which in itself is a sign of catching up. Provided that the external
demand for the goods and services of the candidate countries is developing, and that they will not be
faced  with  a  shortage  of  capital,  there  will  be  jumps  in  GDP  growth  when  the  part  of  the
population  that  at  present  is  involved  in  subsistence  and  learning  activities  enters  the
registered labour force.

High economic growth and catching up usually go together with a disruption of existing sectoral and
regional patterns of production, to be followed by a period in which the gains become more equally
distributed over the country and its population. To force a personal redistribution of income early on
would take away some of the incentives for undertaking entrepreneurial activities. To put in place a

5

too  generous  mechanism  for  regional  redistribution  and  support  reduces  the  incentives  for
moving to the more prosperous areas with a higher growth potential.

In the high growth regions of the EU, job creation is driven mainly by a dynamic service sector. In
regions  with  lower  employment  rates  the  contribution  of  industry  becomes  more  sizeable  but
remains less than that of services. In the low growth regions, on the other hand, the contribution of
industry to employment growth is negative. Most striking is the profile of the jobs being created in
regions with already high employment rates, where firms aim  to  recruit  people with a medium to
high educational attainment level. At the same time, there are job losses for workers with only lower
education. This suggests that to achieve a high employment rate requires the  region to have  a
sufficiently educated workforce, more or less independent of the main sector of employment
within the region. Perhaps not surprisingly, voluntary part-time work also takes a higher flight in the
high profile regions than in regions with low employment rates and below average growth.

With  the  next  enlargement  the  regional  disparities  in  the  Union  will  widen  very  substantially.
Roughly,  in  the  words  of  the  Second  Report  on  Economic  and  Social  Cohesion:  were  the
enlargement to 27 members to happen tomorrow, the average income per head of the 10% of the
population living in the least prosperous regions of the enlarged Union would be only 31% of the EU
average, where it is 61% in today’s Union. One third of the population in the enlarged EU would live
in so-called cohesion countries – that have an income per head of more than 10 % below the EU-
average  –  as  compared  to  one-sixth  in  the  present  EU-15.  On  a  country  by  country  basis  of
comparison, it could take the present candidate countries between 8 and 70 years to close the
gap.

European  thinking  and  policymaking  has  meandered  between  the  idea  that  free  trade  and  the
removal of barriers to the free movement of capital and labour would reduce the regional disparities
of  income  across  the  Community  and  the  notion  that  EU  transfers  are  needed  to  achieve  a  more
equitable distribution. The active policy option is based on the belief that there are parts of the Union
that are losing out, in the sense of ending up to be worse off than without the moves towards further
economic integration in an enlarged Union; a belief that can be substantiated nor refuted on the basis
of  past  regional  performances.  The  lessons  learned  in  the  past  suggest  strongly  that  structural
support to the least prosperous parts of the Union should continue to be focused on a small
number  of  regions,  that  it  should  be  for  a  limited  period  and  clearly  be  perceived  to  be
temporary by the recipient countries and regions.

In  terms  of  future  economic  efficiency,  the  Union  might  want  to  consider  the  alternative  of
promoting  and  facilitating  migration  and  the  interregional  mobility  of  labour.  The  outflow  of
labour, followed by the remittances to the home region and the likely return of migrants might
have more lasting effects than the generous provision of financial support.

Foreign direct investment (FDI) flows into the candidate countries have grown rapidly, especially in
the second half of the 1990s. FDI was initially concentrated in manufacturing, but the emphasis has
moved towards services, some of which may formerly have been in state hands. Much FDI has been
attracted  by  the  privatisation  and  liberalisation  of  public  infrastructure  and  utility  industries,  and
more recently by the banking sector. However, the first and second wave of FDI have resulted in
poles  of  activity  that  appear  to  stand  on  their  own  and  have  no  direct  spin-offs  to  existing
industries. They typically have not made use of the  existing  domestic  science  base  and  have  not
helped to preserve and expand the local R&D capacity.

While all emerging economies are in urgent need of FDI, they may lose out in the competition for
such investments. In many of the candidate countries the financial and banking institutions do not yet

6

function well and do not act as an intermediary to attract FDI. The lack of financial security is a
particular problem for the small and medium-sized enterprises that up to now have been the
main  drivers  of  the  growth  performance  of  the  candidate  countries.  In  contrast,  large-scale
foreign investments can be fairly independent of the actual economic situation in the host country.
Multinationals usually come with their own finance and are more concerned with the prospects of
long-term political stability and the development of new markets in the region than with the existing
financial and social infrastructure.

Which sectors will develop first and fastest has more to do with enhanced market efficiencies and
prospects  for  the  future  than  with  short-term  opportunities  for  investors.  If  the  singular  cases  in
which local R&D capacities have been recreated by foreign investors would develop into a trend,
there  is  some  hope  that  the  candidate  countries  will  become  economically  integrated  into  the  EU
rather quickly. If there remains a big divide between local firms and foreign-owned companies
the knowledge base of the candidate countries will have to be reconstructed from scratch. This
would  have  the  likely  effect  of  slowing  down  the  catching  up  of  the  candidate  countries,  with
negative implications for their degree of economic integration in the EU and for the economic and
social cohesion of the Community.

The  technology  gap  model  predicts  that  technologically  advanced  countries  will  specialise  in
technology  intensive  production  and  that  technologically  backward  countries  produce  more
traditional  goods.  However,  technology  is  not  a  production  factor  in  its  own  right;  technological
progress can be represented by structural shifts in the combination of capital and labour. It can also
be  embedded  in  capital  and  labour  inflows  from  abroad.  In  either  case  it  is  important  for  the
candidate  countries  to  have  local  innovative  capacity  in  order  to  enjoy  the  externalities  of
technological change in the long run.

Patent application data, which are available for relatively long periods of time and allow for a split
between resident and non-resident applicants, show that applications in the candidate countries are
typically  made  by  the  research  departments  of  an  international  company,  and  not  by  a  single
inventor.  Patents  have  the  double  function  of  providing  incentives  to  innovate  and  making
knowledge  available  to  outsiders.  Foreign  companies  exporting  to  a  country  have  an  interest  to
register intellectual property rights in order to secure and if possible protect a piece of the market. In
view of the amazingly different approval rates of national patent offices, within the EU as well
as in the candidate countries, there is a case to be made for the harmonisation of standards
and  procedures  for  the  establishment  of  intellectual  property  rights.  As  in  similar  moves  on
other  single  market  issues  in  the  past,  the  Community  has  the  choice  between  centralisation  and
enhanced mutual recognition. This is clearly an example of an area that would benefit from finding a
common and agreed approach even before the Union is enlarged.

On a sectoral level, clear winners in the candidate countries are the producers of electrical and optical
equipment,  with  transport  equipment  next.  The  exceptions  are  Bulgaria  and  Estonia,  where  the
second highest productivity gains are in the sector of wood and wood products.

The higher the productivity gains the lower the rise in unit labour cost, which suggests that wage
earners are not fully compensated for the labour productivity gains in their sector. This is confirmed
by a comparison of the distribution of productivity gains and wage rises across the sectors. Although
the wages in high performing sectors are higher than in sectors with low  productivity growth, the
wage dispersion is less than the productivity dispersion. It also turns out that a higher proportion of
FDI in the total investment in a branch has a clear positive impact on labour productivity.

7

Finally,  the  report  looks  at  other  factors  that  could  play  a  role  in  the  future  development  of
productivity and competitiveness in the catching-up countries, such as the quality of the workforce
and the gradual disappearance of the under-valuation of the exchange rate. It concludes that there is a
lot to be desired in terms of the training of human resources and that the candidate countries’ own
financial means to improve the situation are scarce in view of the constraints on public finance. It
also emphasises that real exchange rate  appreciation  –  either  by  the  country’s  currency  becoming
more expensive in terms of foreign currency or by upward adjustments of the prices of traded goods
followed  by  upward  pressure  on  the  prices  of  not-so-much-traded  goods  –  cannot  be  avoided  or
postponed. In fact, the better is the reputation of a country in terms of solid fiscal policy and
moderate wage setting, the faster and more predictable is the appreciation of its exchange rate.
There is some evidence that the greater certainty and predictability of exchange rate movements can
act as an important incentive for the best performers under the exporting firms to continue to make
productivity improvements.

The need for environmental protection is met with much less consensus in the candidate countries.
The  notion  that  they  could  make  a  head-start  on  the  EU  member  states  by  adopting  the  cleanest
technologies available when making new investments is not generally accepted, mainly because of
short-term economic considerations. In this respect it might be useful to invoke the concept of path
dependency  from  the  recent  literature  on  economic  dynamics:  different  short-term  strategies  may
have  consequences  for  the  longer  term,  even  when  the  structural  economic  differences  have
disappeared in the meantime. For example, attracting foreign business by offering exemptions from
environmental standards might seem to pay off in the short run but would imply a cost in the long
run when the acquis communautaire in this area can be expected to be enforced and extended. In the
same  vein,  applying  environmental  regulations  before  accession  may  be  considered  to  incur
high costs but might also attract companies that need to take a long-term view on where EU-
wide legislation is going. The uncertainties about future developments in many branches of industry
are such that, once they has made a decision on where to locate themselves, firms would be hesitant
to move again.

Agriculture is another area in which the candidate countries would have much to lose in economic
terms when they would expect to go down the road travelled by the EU member states in the past.
Since  both  the  position  of  agriculture  within  the  national  economies  and  the  global
environment have changed compared to when the Common Agricultural Policy was originally
formulated, and will continue to change, the future of European agriculture is an area  in  which
foresight exercises would have much to add in sketching the implications of different scenarios for
the economy, the society and the environment.

The overall message of the panel report on Economic Transformation is that the EU should not stand
still at its achievements in the fields of market integration and the co-ordination of national economic
policies. It  should  move  on to  find  and  exchange  the  best  practices  in  the  fields  of  education, the
environment,  the  use  of  energy  and  transport,  information  and  communication  technologies  and
social  systems.  The  experience  in  the  field  of  economics  shows  that  a  multitude  of  institutions,
interest groups and less formal bodies can fruitfully work towards a successful outcome. In order to
be able to do so in other fields, standards of comparison need to be developed within the EU and
innovative approaches should be welcomed. On an operational level, the first thing is to make better
use of the huge amount of data, statistics and studies that are being produced.

8

1. Introduction

In the next ten years the EU enlargement process will move beyond its present focus on negotiations
for accession with the candidate countries and broaden its scope to the challenges and opportunities
of an enlarged European Union.

The  Futures  project  of  the  Institute  for  Prospective  Technological  Studies  (IPTS)  included  a  first
drawing  of  the  possible  consequences  of  enlargement  in  the  fields  of  science,  technology,
employment and competitiveness. Its presentation and report in 2000 were favourably received by
foresight experts as well as policymakers. They asked for a further deepening of the understanding of
the uncertainties and challenges surrounding the enlargement process.

In parallel to the Futures project the IPTS launched an informal  network of  experts  from the pre-
accession countries, with the aim of extending the prospective dialogue on science and technology
developments  and  their  interrelations  with  socio-economic  issues  to  the  candidate  countries.  At  a
high-level  meeting  in  Tallinn  in  September  2000  it  was  agreed  that  the  IPTS  together  with  the
network participants should start a ”foresight activity on the techno-economic and social impact of
enlargement”, matching both the format of the Futures project and its policy relevance.

The  aim  of  the  Futures  Enlargement  project  is  to  examine  the  main  contemporary  technological,
economic,  political  and  social  drivers  in  the  candidate  countries  and  their  possible  impact  on
technology/science, competitiveness and employment in the enlarged Union with a time horizon of
ten  years.  It  is  also  expected  to  look  into  the  consequences  for  policymakers  –  in  the  candidate
countries,  in  the  member  states  and  in  the  European  Union  –  of  responding  to  the  challenges,
problems and opportunities posed by enlargement.

The  project  engages  experts  and  policymakers,  both  from  the  candidate  countries  and  the  EU
member  states  in  an  interactive  process  structured  into  thematic  expert  panels  and  supported  by
background research. Ten to fifteen experts were invited for each of the panels. They also benefited
from the participation of Commission staff. Their agenda was set in a steering group meeting at the
end of January 2001. Preliminary results were discussed at a seminar in Prague in September.

The four final panel reports on

•  Economic transformation
•  Technology, knowledge and learning
•  Employment and societal change
•  Sustainability, environment and natural resources

are building upon the body of research on these topics that already exists in the candidate countries
and the EU member states. They pay special attention to those issues that are on the crossroads of
technological  and  economic  development,  taking  into  account  environmental  sustainability
constraints  and  social  boundary  conditions.  The  accession  of  countries  with  a  potential  for
development  equal  to  that  of  the  present  catching-up  countries  among  the  member  states  raises
questions on the degree of competitiveness and the required cohesion of the enlarged EU.

9

The present document, prepared by IPTS staff, gives the state of play on the topics covered under
“Economic transformation”, following the mid-term seminar of all four panels and the steering group
in Prague, 17-19 September 2001. It is not meant to be exhaustive in its analysis, does not pretend to
give all the answers and raises questions deliberately in a slightly provocative manner.

The report gives a description of the technological, economic and social trends that were emphasised
and discussed by the panel members: the effects of the ageing of the society and other demographic
changes  on  the  economy;  the  production/costs/diffusion/use  of  information  and  communication
technologies;  the  retooling  of  the  agri-food  chain;  the  geography  of  economic  activities;  the
dynamics of human capital formation; and the economics of sustainability. Under these six headings
the consequences for economic policymaking in an enlarged Union and the specific challenges for
the candidate countries are analysed.

The panel made an attempt to formulate the most appropriate macroeconomic framework in which
this  analysis  should  take  place.  The  trade-offs  between  achieving  high  growth  and  maintaining
macroeconomic  stability  were  considered  to  be  highly  relevant  for  the  setting  of  intermediate
economic objectives  in  catching-up  countries.  In  the  initial  period  of  macroeconomic  stabilisation
growth will be subdued by the need to keep inflation low, the government budget balanced and the
current  account  balance  in  long-term  equilibrium.  Even  when  macroeconomic  stability  has  been
firmly established the performance with respect to these intermediate economic objectives, together
with the need to  attract external finance  and  foreign  capital, will  continue to  act as constraints on
policies to stimulate economic growth.

Innovation and R&D capacities are crucial elements for future growth. The panel discussed to what
extent the current economic performance of the candidate countries is determined by innovation and
R&D and what impact their economic priorities and present fiscal stance will have on their future
capacity to innovate.

In addition to public finance considerations, policy choices are constrained by political feasibility and
social acceptability. In this respect there are big differences between the candidate countries. One of
the  issues  on  which  the  population  and  the  governments  of  the  candidate  countries  might  have
perceptions that need to be cleared up is the need for environmental protection and to what extent it
should be allowed to shape present and future production processes.

The  panel  report  does  not  come  up  with  any  concrete  policy  recommendations.  It  recognises  the
need  for  flexibility  in  the  policy  options  open  to  catching-up  countries,  but  takes  as  a  point  of
departure  that  the  adoption  of  the  acquis  communautaire  and  the  overriding  objective  of  EU
accession appear to be convenient shortcuts for economic policymaking in most candidate countries.

10

2. The main features of the economic catching-up process

With the next enlargement the EU will be expanded with a number of countries that have established
themselves  as  functioning  market  economies,  able  to  cope  with  competition  and  market  forces
within  the  Union,  more  recently  than  the  present  Member  States.  These  countries  will  seek  to
emulate  the  successes  in  catching  up  of  countries  that  joined  the  European  Community:  Ireland
(1973),  Greece  (1981),  Spain  (1986)  and  Portugal  (1986).  There  will  be  differences  between  the
economic performances of the new member states, as there have been between the four “cohesion
countries”.  They  will  be  the  combined  result  of  the  different  starting  positions  of  the  candidate
countries,  their  policies  of  the  last  twelve  years  and  external  influences.  There  will  inevitably  be
disappointments  and  setbacks  in  the  further  development  of  the  new  member  states,  possibly
reflecting  exaggerated  expectations,  and  resulting  from  events  beyond  the  control  of  the
policymakers  rather  than  from  specific  policy  mistakes.  However,  on  the  whole  the  blueprint  for
obtaining EU membership can be expected to serve the candidate countries well and to continue to
set  them  apart  from  other  economies  emerging  from  the  former  Soviet  bloc  (EBRD  Transition
Report 2000).

Figure 1  Real convergence between the EU and the candidate countries

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derived from observed average growth in all previous periods (t-1, t-2, …, 1993).  The boom in
Malta and Cyprus in 1996-2000 reflects the openness and trade dependence of their economies
(Eurostat; 2001).
Source: Compiled from World Bank (2000), CIA (2001), EBRD (2000), European Central Bank,
IMF (2000) and Eurostat

Stable macroeconomic conditions, including exchange rates, have allowed the governments of many
candidate countries to focus on the choices to be made within hardening budget constraints. Their
governments are increasingly convinced of the need to improve tax collection and enforcement in
order to create more room for manoeuvre on the expenditure front. They have also recognised the
importance of legal certainty for the making of economic decisions and for the proper functioning of
their  economies.  Nevertheless,  the  catching-up  process  is  vulnerable,  especially  if  the  benefits  of

11

 
 
economic  progress  will  not  be  evenly  spread.  Twelve  years  into  transition,  sizeable  parts  of  the
population of central and eastern Europe are still living in conditions of great poverty.

The case of Ireland – the most successful of the cohesion countries – has inspired many of the newly
emerging market economies. Its gross domestic product (GDP) per head rose from 60-65% of the
European average in the 1960s and 70s to nearly 80% in 1992, and then to well above the average
from 1997 onwards. Ireland’s final jump is spectacular – it is likely to lift Ireland soon to the second
richest position in the EU after Luxembourg – while it has to be noted that the Irish economy was at
two thirds of European GDP per head or below in its first fifteen years of EC membership. On the
same score, Spain has lingered long in the 70-80% range, whereas Portugal raised its GDP per head
from  nearly  55%  of  the  EU  average  in  1986  to  almost  75%  at  present.  The  Greek  economy  has
declined after accession and has remained below 70% of the European average ever since its entry
into the Union in 1981.

On the basis of the figures above, it can be stated that the EU’s single market programme and the
move towards the introduction of the Euro have not made the cohesion countries worse off in terms
of income per capita. However, it remains an open issue whether the EU should continue to offset
the perceived adverse effects of its future policy moves on population groups and regions, or whether
it  should  try  to  find  strategies  to  take  greater  advantage  of  the  enhanced  diversity  in  an  enlarged
Union.

The main features of the European Union to be negotiated between the existing Member States and
the candidate countries turned out to be not the establishment of a capitalist economy and a “free for
all” society but rather the ability to reach an internal consensus about the framework of economic
and social relations  and the  capacity and willingness to  co-ordinate  the  national  interests  with  the
international  players  on  that  basis.  Easier  access  to  information  as  a  result  of  increased  trade  and
travel and advances in information and communication technology had undoubtedly helped to clear
the view from the East on the economic successes of the West. Nevertheless, by its very purpose of
contrasting  Eastern  and  Western  experiences,  and  by  the  channels  of  communication  that  were
chosen, the image of the West remained distorted. This has had consequences for the approach of the
candidate countries towards the EU. Implicit in the application for EU membership was the choice
for the blueprint that had proved to be successful in the first set-up of the Community with its six
founding member states and also after the enlargements, which included some of the most backward
and  previously  oppressed  countries  in  Europe.  A  major  complication  in  the  negotiations  with  the
present wave of candidate countries, however, is that a discussion is going on within the Union on
the institutional set-up and policy co-ordination procedures, which touches upon the role and position
of national governments and Community institutions and is heavier than before.

The  transformation  of  the  central  and  eastern  European  candidate  countries  into  open  market
economies  so  far  has  concentrated  on  the  establishment  of  a  new  legal  framework,  with  the
corresponding institutions, as well as on structural changes. The structural reform of the economy
has included the privatisation of state-owned companies (including farms) and public property, the
modernisation  of  enterprises,  the  introduction  of  new  technologies,  the  development  of  different
forms  of  management  and  the  adoption  of  financial  and  accounting  principles  appropriate  to  the
establishment of a functioning market economy. Many countries have also embarked upon research
and entrepreneurial support activities that follow EU examples.

Although  most  candidate  countries  have  profoundly  reorganised  their  industries  and  enterprises,
leading  to  revised  production  structures,  mergers  with  EU-based  companies  and  changes  in
ownership, the process of industrial restructuring is far from complete. Rapid growth has generally
been  achieved  in  sectors  that  have  successfully  gone  through  the  first  phase  of  restructuring  and

12

modernisation  or  have  received  foreign  direct  investment  (car  industry,  food  processing,
telecommunications,  personal  computer  manufacturing  and  software  development).    Domestic
investment  in  other  industries  (steel,  textiles,  metal  and  wood  processing,  leather)  has  so  far  not
achieved similar effects.  The gaps are especially wide for the less developed regions of the candidate
countries.  Moreover, in many countries the development of financial institutions and services has
been slow and has lagged behind the growth of small and medium-sized business activities.

Significant differences can be observed between the pre-accession countries. Some countries with a
strong engineering tradition are moving towards a more R&D intensive structure of production and
trade.  Other  candidate  countries  are  following  a  strategy  based  on  low  tech,  labour  intensive
production  and  moderate  wages.  This  raises  critical  questions  about  the  economic  and  social
cohesion of an enlarged EU.

The main difficulty for the candidate countries is that they are making choices for the transformation
of their economies right now that will have consequences for their future place in the Union. They
demand to know where the EU is going: on various occasions the move towards EU membership
has  been  described  as  "shooting  at  a  moving  target”.  However,  the  complication  of  a  changing
acquis communautaire should not necessarily be taken for an impenetrable fog obstructing a long-
term  view. On the  contrary,  the diversity of  economic and social models  in the  Union,  combined
with the exchange of information on best practices, could be turned into a major advantage of the
Community approach in an enlarged Union.

The Enlargement Futures project is an attempt to reduce the uncertainties by mapping some of the
strategic choices and policy options open to the present and future member states and by drawing
from a wider circle of experts than government and science alone.

13

Table 1: GDP per head in purchasing power standards and real economic
growth in the EU and the candidate countries

GDP per head in
PPS
(EU-15=100)

Real GDP growth per
year (%)

Belgium
Bulgaria
Cyprus
Czech Republic
Denmark
Germany
Greece
Spain
Estonia
France
Hungary
Ireland
Italy
Latvia
Lithuania
Luxembourg
Malta
Netherlands
Austria
Poland
Portugal
Romania
Finland
Slovakia
Slovenia
Sweden
Turkey
United Kingdom

Candidate countries

1996
111
25
80
65
119
110
67
80
33
102
47
94
103
25
29
171
51
107
112
36
71
33
96
46
66
102
30
98

36 a

EU-15
a Average, weighted by population
b Average, weighted by GDP
Source: Eurostat

100

2000
110
24
82
60
120
105
69
81
38
98
52
123
102
29
29
192
53
117
110
39
74
27
103
48
71
102
29
104

35 a

100

1996-2000
2.7
-1.3
3.7
0.9
2.7
1.8
3.3
3.7
5.1
2.5
4.0
9.5
1.9
4.7
3.2
6.2
4.3
3.7
2.5
5.1
3.6
-1.6
5.1
4.1
4.3
2.9
3.9
2.8

3.5 b

2.6

2000
4.0
5.8
4.8
2.9
2.9
3.0
4.1
4.1
6.9
3.1
5.2
10.7
2.9
6.6
3.3
8.5
5.0
3.9
3.2
4.0
3.3
1.6
5.7
2.2
4.6
3.6
7.2
3.1

5.2 b

3.3

2.1. The crossing of employment trends

Two  consecutive  trends  that  have  characterised  the  economic  transformation  of  the  present  EU
member states since the 1950s are the increase of the share of industrial production in GDP at the

14

expense of agricultural production and the increase in the share of services. This does not necessarily
imply that the production of any of the three sectors has declined in absolute terms. It just means that
the  services  of  delivering,  selling,  marketing  and  repairing  the  goods  have  grown,  and  that  other
services have appeared that, for instance, allow consumers to buy the goods before they have earned
the  money  and  that  entertain  the  workers  and  their  families  in  the  slack  time  they  have  created
through productivity increases. However, in international trade, there would be very few countries
that would be able to specialise in services only.

Figure 2: Employment rates in Spain, Hungary, Poland, Turkey compared with the EU-15 average

%

65

60

55

50

45

40

ES

HU

PL

TR

EU-15

1996

1997

1998

1999

2000

Source: Eurostat

Note: For the sake of comparison, data points are given for the years for which Labour Force survey
data  are  available.  More  LFS  data  can  be  found  in  "Employment  in  Europe  2001",  European
Commission July 2001.

Looking  at  the  places  of  employment,  there  have  been  absolute  decreases  in  the  number  of
agricultural workers as well as in the number of industrial workers in the EU member states in the
past decades. At the same time, the number of public sector employees has increased. Except for the
increase in public  sector employment, and in a  more global economic environment, the  candidate
countries are broadly following the same trends: agricultural employment is declining, whereas new
service jobs are being created, mainly in connection with domestic demand growth. In the first phase
of  transition,  as  a  result  of  the  restructuring  of  state  enterprises  and  the  opening  up  to  foreign
competition,  industrial  production  decreased  and  jobs  disappeared.  The  responses  of  the
entrepreneurs  in  the  candidate  countries  to  the  potentially  sharp  drop  in  employment  have  been
twofold,  in  most  countries  involving  a  mix  of  labour  hoarding  in  state-owned  firms  –  keeping
employees on the wage roll in the hope of better times – and the springing up of many new small
enterprises.

Whether  delayed,  as  for  instance  in  the  Czech  Republic,  or  not,  the  sharp  drop  in  official
employment opportunities triggered two types of individual responses: a retreat from the labour force
or an effort to become self-employed. The strategy of retreating from the labour force, which could
involve seeking early retirement or relying on family support, in particular in rural societies, in many
cases resulted in a subsistence standard of living and over-reporting of agricultural employment. In
addition, many potential young entrants to the labour market decided to stay in the education system

15

longer than previous  generations  used  to do. They did this  both  in  order  to  improve  their  general
knowledge and to increase their chances of employment when economic growth would pick up. The
upshot is that, whereas the countries in central and eastern Europe generally had higher employment
rates than the EU average in 1990, their employment rates in 2000 are lower, with the exception of
the Czech Republic and Romania. Of the Mediterranean candidate countries, Cyprus is at the higher
end of the scale, whereas Malta and Turkey are at the bottom, together with Poland and Bulgaria.

Figure 3: Employment rates in Ireland, the Netherlands and Sweden

90

80

70

60

50

40

30

20

10

0

IE

NL

SE

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Source: Eurostat

The  downward  trend  in  employment  rates  in  the  candidate  countries,  if  it  continued,  would  be  a
worrying development for the Union, which at its Lisbon summit in March 2000 set the target of
increasing  the  employment  rate  from  an  average  of  about  63%  today  (72%  for  men,  54%  for
women)  to  70%  by  2010  (60%  for  women  alone)  across  all  EU  member  states.  A  year  later,  in
Stockholm, the Council gave itself the interim targets of 67% (and 57% for women) to be reached by
2005. The EU-15 are therefore expected to be on an upward trend. This is to be the combined result
of  a  general  surge  in  labour  demand,  resulting  from  economic  growth,  and  an  increase  in  female
participation rates, mainly encouraged by the creation of part-time jobs.

That employment rates in many of the candidate countries have been falling in the past few years,
whereas  they  have  been  rising  in  a  number  of  EU  member  states,  is  even  more  salient  since  the
economies of the candidate countries have been growing faster than the EU-15. Although 2000 was
the  first  year  in  which  all  candidate  countries  had  positive  GDP  growth  rates  at  the  same  time,
Poland, Hungary and Slovenia have consistently had higher growth than the EU average in the last 5
years.  The  fall  in  employment  is  subsiding  in  most  of  the  candidate  countries,  and  employment
growth  is  picking  up  in  some,  but  what  remains  is  a  substantial  gap  between  real  GDP  and
employment  growth.  In  macroeconomic  terms  this  amounts  to  high  overall  labour  productivity
growth in the candidate countries, which in itself is a sign of catching up. Provided there is a demand
for the country’s goods and services, and that there is no shortage of capital, economic growth could
jump up even more when the newly educated part of the population decides to enter the labour force.

16

Table 2: Employment rates in the EU-15 and the candidate countries

Country

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

2000

Belgium (BE)

54.5 55.9 56.3 55.8 55.7 56.1

56.3

56.9

57.5

59.3

Bulgaria (BG)

Cyprus (CY)

Czech
Republic (CZ)

Denmark (DK)

74.7 74.2 73.7

72

72.3 73.4

Germany (DE)

67.7 66.4 65.1 64.7 64.6

73.8

64.1

Greece (GR)

54.6 53.4 53.7 53.7 54.2 54.7

55

Spain (ES)

49.7 49.6 48.3 45.9 45.4 46.2

47.1

Estonia (EE)

France (FR)

60.7 60.4 59.9 59.3 59.1 59.6

59.6

Hungary (HU)

Ireland (IE)

51.9 51.4 51.2 51.7 53.1 54.4

52

55.4

50.9

50.6

68.6

67.5

74.9

63.7

55.1

48.5

64.9

59.6

52

57.5

51

75.1

63.9

55.5

50.2

65.3

60.1

53.2

60.5

51.7

58.7

62.9

60.5

64.2

65.6

76

64.8

55.3

52.7

62

60.9

55.4

63.2

52.5

59.5

65

61.7

60.5

51.5

65.5

64.9

76.3

65.4

55.6

55

60.6

62.2

55.9

65.1

53.5

58.2

60.1

62.9

Italy (IT)

Latvia (LV)

Lithuania (LT)

Luxembourg
(LU)

Malta (MT)

Netherlands
(NL)

Austria (AT)

Poland (PL)

59.5 60.8 61.4 60.8 59.9 58.7

59.2

59.9

61.3 62.5 63.6 63.6 63.9 64.5

65.9

68

69.8

71.3

73.2

Portugal (PT)

65.5

67

65.2 63.4 62.1 61.3

61.2

Romania (RO)

Slovakia (SK)

Slovenia (SI)

Finland (FI)

74.7 70.7 65.5 61.4 60.7

62

Sweden (SE)

81.4 79.5 75.9 71.3 70.2 70.9

Turkey (TR)

United
Kingdom (UK)

71

69.5 68.2 68.5 68.1 68.7

69.3

68.6

67.7

67.7

58.8

62.2

67.2

62.8

63.6

69.4

48.7

70.2

67.8

59.2

66.6

65.9

63.5

64.8

70.3

48.7

70.8

68.4

57.5

67.5

65

58

62.5

66.6

71.6

47

68.3

55.1

68.3

64.2

56.3

62.7

67.5

73

46

70.9

71.2

61.7

62.8

70.3

50

EU-15

62.2 61.1 59.9 59.7

60

60.1

60.5

61.3

62.3

63.3

Source: Eurostat

2.2. The patchwork of regional growth and convergence

Unemployment in the central  and  eastern  European  candidate  countries  (CECC)  has  mirrored  the
trend  in  employment  rates  and  has  crossed  that  of  the  EU  member.  The  average  number  of
unemployed in the EU-15 fell from 10.4% of the labour force in 1998 to 8.5% in 2000. In the same
years the CECC-10 unemployment rate moved up from 9.1% to 12.5%. In 2000 only Hungary had a
falling unemployment rate. Interestingly, although the range of regional unemployment figures for

17

the  regions  at  NUTS  2  level  in  the  CECC  widened  with  the  increase  in  national  unemployment
figures,  the  overall  differences  between  the  CECC  regions  are  still  smaller  than  between  the  EU
regions. At 3.4% of the region’s labour force the Czech capital region of Prague, which in terms of
GDP  per  capita  has  already  surpassed  the  EU-15  average,  has  the  lowest  unemployment  of  the
CECC-10  regions;  at  31%  the  Bulgarian  region  of  Severozapaden  has  the  highest.  This  range  is
similar to the one for the EU, where regional unemployment varies from 1.8% of the labour force in
Centro  Portugal  (apart  from  1.7%  on  Åland,  Finland)  to  27.7%  in  Calabria,  Italy  (and  33.1%  on
Réunion).  Encouragingly,  and  again  in  a  reversal  of  what  is  the  case  in  the  EU-15,  female
unemployment in the CECC regions is within a slightly tighter range than male unemployment.

As in the EU, youth unemployment in the CECC-10 shows a wider variation than male and female
unemployment rates. The number of unemployed in the 16-24 age bracket ranges from 7.9% in the
Hungarian region of Közép-Dunántúl to 73.1% in Severozapaden, Bulgaria.

The  experience  of  the  cohesion  countries  suggests  that  the  regional  distributions  of  income  and
unemployment  in  the  CECC  might  stretch  even  more  in  the  remaining  part  of  the  catching-up
process. To gain some more insight into the prospects of the high unemployment regions, it might be
useful  to  have  a  closer  look  at  the  present  EU  regions,  classified  according  to  the  level  of
employment rates and recent employment growth (Eurostat, Statistics in focus, Theme 3, 12/2001).
Eurostat  finds,  for  instance,  that  in  the  regions  with  low  employment  rates  and  high  employment
growth  employment  grew  by  4%  per  year  between  1996  and  2000,  whereas  in  the  low  growth
regions it practically stagnated. One category concerns the quartile with the lowest employment rates
and  of  that  quarter  of  the  regions  the  half  with  below  average  employment  growth.  Youth
unemployment in those EU regions in 2000 was nearly 40%, as compared to 8% in the quarter of the
regions with the highest employment rates and growth. The situation on female unemployment was
equally bad: over 20% in the least favoured regions, against just under 4% in the best-off category.

Especially in the high growth regions of the EU, job creation is driven mainly by a dynamic service
sector. In regions with lower employment rates the contribution of industry becomes more sizeable
but remains less than that of services. In the low growth regions, on the other hand, the contribution
of industry to employment growth is negative. Most striking is the profile of the jobs being created in
regions with already high employment rates, where firms aim  to  recruit  people with a medium to
high educational attainment level. At the same time, there are job losses for workers with only lower
education.  This  suggests  that  a  high  employment  rate  requires  the  region  to  have  a  sufficiently
educated  workforce,  more  or  less  independent  of  the  sector  of  employment  within  the  region.
Perhaps  not  surprisingly,  voluntary  part-time  work  also  takes  a  higher  flight  in  the  high  profile
regions than in regions with low employment rates and below average growth.

With  the  next  enlargement  the  regional  disparities  in  the  Union  will  widen  very  substantially.
Roughly,  in  the  words  of  the  Second  Report  on  Economic  and  Social  Cohesion:  were  the
enlargement to 27 members to happen tomorrow, the average income per head of the 10 % of the
population living in the least prosperous regions of the enlarged Union would be only 31% of the EU
average, where it is 61% in today’s Union. One third of the population in the enlarged EU would live
in so-called cohesion countries – that have an income per head of more than 10 % below the EU-
average – as compared to one-sixth in the present EU-15.

Given  the  cohesion  objective  as  it  is  enshrined  in  the  Treaty  –  "In  order  to  promote  its  overall
harmonious  development,  the  Community  shall  develop  and  pursue  its  actions  leading  to  the
strengthening  of  its  economic  and  social  cohesion.  In  particular,  the  Community  shall  aim  at
reducing disparities between the levels of development of the various regions and the backwardness
of  the  least  favoured  regions  or  islands,  including  rural  areas."  –  it  would  seem  that  a  greater

18

Community effort would be  needed  after  enlargement.  The Structural and  Cohesion  Funds would
need  to  be  increased  in  size  and  their  area  of  distribution  would  need  to  be  further  extended.  Of
course, in doing so, it would be useful to take into account the lessons of the past.  Agenda 2000 has
shown that there is room for structural  support  to the  poorest  member  states,  but it also  has  set  a
ceiling to the Structural and Cohesion Funds that could be quickly eroded when the new member
states grow faster than expected in terms of their nominal GDP.  It would also be useful to have a
closer look at the relevance of individual income differentials for migration, both within the Member
States  and  in  comparisons  between.    There  are  many  indications  that  pecuniary  motives  do  not
prevail in decisions to move, when the standard of living is above subsistence level.  Table 3 contains
a simple but popularly appealing illustration.  (MacDonald ‘s hamburger prices across the World are
based on thorough field research of household expenditure.)

Table 3: Price of a Big Mac, 1997-2001

in US $ at market exchange rates

US price=100

Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01

2.42
2.95
1.81
3.95
 -
3.04
2.86
1.52
2.73
1.39
2.60
3.37

2.56
3.05
1.57
3.39
 -
2.84
2.69
1.22
2.47
1.53
2.40
3.00

2.43
3.07
 -
3.58
2.71
2.87
2.72
1.26
2.50
1.38
2.43
2.88

2.50
3.00
1.39
3.08
2.37
2.62
2.37
1.21
2.16
1.28
2.09
2.71

2.54
2.85
1.43
2.93
2.27
2.49
2.30
1.32
1.96
1.46
2.09
2.33

100
122
75
163
 -
126
118
63
113
57
107
139

100
119
61
132
 -
111
105
48
96
60
94
117

100
126
 -
147
112
118
112
52
103
57
100
119

100
120
56
123
95
105
95
48
86
51
84
108

100
112
56
115
89
98
91
52
77
57
82
92

USA
Britain
Czech Republic
Denmark
Euro area
France
Germany
Hungary
Italy
Poland
Spain
Sweden

Source: The Economist, various editions; see Hallet (2001).

In Agenda 2000 the EU member states decided to keep Community support in the form of Structural
and  Cohesion  Funds  below  a  ceiling  of  0.45%  of  the  EU’s  aggregated  Gross  National  Product
(GNP) and to concentrate the spending on a shrinking part of the enlarging Union. The Commission
argued that it would be possible to combine generous support to the new member states, at a ceiling
of  4%  of  their  Gross  Domestic  Product  (GDP),  with  the  gradual  phasing  out  of  structural  funds
flowing to the richer member states. The Commission's simulations were based on the assumption
that,  in  nominal  terms,  the  combined  GDP  of  the  candidate  countries  –  which  at  the  time  of  the
calculations was only about 5% of the EU-15 GDP – would still be a relatively minor proportion of
EU-GDP when they would join.

In presenting their calculations, which in essence constituted an economic growth scenario for the
next ten years and a proposal for the EU’s 2000-2006 financial framework, the Commission touched
upon two issues that are crucial for the future of an enlarging Union:

–  Should  new  member  states  expect  the  same  treatment  as  the  founding  member  states  and  the

countries that joined at earlier points of time?

–  Should old members, after having successfully used the Structural and Cohesion Funds that were
made available, expect to have their funding slashed and to become eventually net contributors to
the Community budget?

The Union's answer to those questions were somewhat hidden behind the numbers: the relative share
of  structural  support  to  the  poorer  member  states  and  least  favoured  regions  in  Community

19

expenditure is to remain at 0.45% of EU-GNP; and the new member states can expect  to receive
funding  up  to  a  ceiling  that  relative  to  their  GDP  is  at  the  same  level  as  the  amounts  flowing  to
Greece and Portugal in the mid 1990s’. This corresponds with the maximum amount received by any
member state in any year of the Community's existence. This approach would leave intact the EU’s
instrument of regional redistribution and, in the reasoning of the Commission and the Council, there
would be equal treatment of members that joined the Union at different points of time.

There are two, essentially favourable developments which could make this reasoning go wrong. The
first  is  highlighted  in  the  Second  Cohesion  Report  when  it  indicates  that  with  enlargement  the
income  distribution  over  the  regions  would  stretch  to  twice  its  present  width,  on  various
measurements. A rapid catching up of the candidate countries would help to reduce the disparities,
although  it  is  unlikely  that  major  parts  would  be  lifted  above  the  level  at  which  they  would  be
entitled to receive support from the structural funds. However, while rapid growth and convergence
would probably not be sufficient to reduce the number of regions eligible for Community support, it
would imply that larger amounts flow into the new member states if the benchmark figure of 4% of
their GDP is applied. It would also imply that average GDP per capita in the EU ends up to be higher
than what was assumed in Agenda 2000, so that a larger number of poor regions in the old member
states would still qualify for EC support. In other words, the more successful the Union would be in
fulfilling its cohesion objective, the greater would be the number of countries that would lay a claim
on the limited funds that are available. Moreover, without adjustment of the ceilings (at most 4% of
GDP) and thresholds (for member states with a GDP per capita that lies more than 25% below the
EU  average)  the  level  of  the  claims  would  rise  faster  than  the  total  of  the  contributions  of  the
member states to the Community budget.

A  second  ground  on  which  the  Agenda  2000  engagement  could  be  challenged  is  that  the  single
market  is  much  closer  to  completion  now  than  it  was  when  Spain  and  Portugal  joined  the
Community. The doubling of the structural funds between 1989 and 1999 was motivated in part by
the fear that peripheral regions would lose out in the moves  towards  establishing  a  single  market.
Removing  the  barriers  to  trade,  combined  with  a  reduction  of  the  possibilities  for  state  aid  to  be
granted, was expected to lead to a greater concentration of economic activities to the detriment of
regions with the greatest distance to the centre. With the moves towards the introduction of the single
currency this argument was widened to be applied to the whole area of some of the poorer member
states, the so-called cohesion countries.

Ten years later the convergence effects of structural support cannot be disentangled from the impacts
that the unification of Germany, the accession of Austria, Finland and Sweden, the completion of the
single market and the opening up to the East have had on the EU economy but, on a macroeconomic
level, it can be established that convergence between the member states has taken place. The GDP
per capita in purchasing power parities of Greece, Portugal and Spain – the three least prosperous
member states – has risen from 68% of the EU-average in 1988 to roughly 80%. Ireland, the fourth
cohesion country that received generous support, has even raised its income per head far above the
EU average. On a regional level, however, the convergence performance within the Union has been
much less favourable in the sense of the cohesion objective, mainly because of the inclusion of the
East German Länder but also because the gaps have widened within EU member states other than
Germany.

Since questions about the effectiveness of EU structural support cannot confidently be answered on
empirical grounds, it is difficult to make fundamental changes to the framework as it stands before
the accession of the present candidate countries. This would inevitably and justifiably be construed
as  unfair  towards  future  member  states.  Moreover,  not  only  does  empirical  research  not  provide

20

conclusive answers to questions concerning the redistribution of regional income, economic theory
and thinking is equally muddled.

A recent review begins by noting that regional disparities in the EU are twice as large as those in the
US, when measured by the ratio of the income of the top and bottom decile of the regions or states.
The  inequalities  in  the  Union  will  be  stretched  further  with  the  accession  of  central  and  eastern
European countries, whose average GDP per capita is at the level of the poorest EU region, Ipeiros in
Greece. The richer city regions of Europe have an average income per head that is 5 times as large.

The crucial issue addressed by the most prominent economists of the last century, and paralleled by
European  concepts  and  thoughts  on  economic  policy,  is  whether,  if  countries  and  regions  within
those countries would be left on their own without any redistribution of income, market forces would
be strong enough to induce convergence.

European  thinking  and  policymaking  has  meandered  between  the  idea  that  free  trade  and  the
removal of barriers to the free movement of capital and labour would reduce the regional disparities
of  income  across  the  Community  and  the  notion  that  EU  transfers  are  needed  to  achieve  a  more
equitable distribution. The latter would be based on the belief that there are parts of the Union that
would be losing out, in the sense of ending up to be worse off than they would be without the moves
towards  further  economic  integration  in  an  enlarged  Union;  a  belief  that  can  be  substantiated  nor
refuted  on  the  basis  of  past  regional  performances.  However,  the  lessons  learned  in  providing
structural and financial support to the EU’s least prosperous regions in the past strongly suggest that
it should be focused on a smaller number of regions, and that it should be for a limited period and
clearly  be  perceived  as  such  by  the  regions  concerned.  Moreover,  in  terms  of  future  economic
efficiency,  the  Union  might  need  to  spend  some  thought  on  the  alternative  of  promoting  and
facilitating migration and the interregional mobility of labour. If the provision of EU resources to the
least favoured regions does not have positive effects, even after stretching the period in which they
are  granted,  the  outflow  of  labour,  the  remittances  to  the  home  region  and  the  likely  return  of
migrants,  either  after  retirement  or  because  the  region  has  developed  a  critical  mass  to  pass  to  a
higher  level  of  prosperity  in  the  meantime,  might  have  more  lasting  effects  than  the  generous
provision of financial support.

2.3. Foreign direct investment: a mixed blessing?

Foreign  direct  investment  (FDI)  flows  into  the  pre-accession  countries  have  grown  rapidly,
especially in the second half of the 1990s (see Futures Report Series 15, Figure 5, p. 17). Total FDI
inflows  into  Central  and  Eastern  Europe,  including  Russia  and  former  Yugoslavia,  increased  to  a
new record level of $27 billion in 2000 (UNCTAD, World Investment Report 2001). Between 1994
and 1998 the FDI flows from the EU member states to the candidate countries amounted to over € 30
billion (Eurostat, Statistics in focus, Theme 2, 26/2000). Hungary, the Czech Republic and Poland
were the main recipients, with about 25% each, followed by Turkey, with 10%. German investors
account for more than one third of the EU assets in the candidate countries, before Dutch, Austrian,
French and British investors. There are some strong bilateral links, for instance between Austria and
Slovenia and between Finland and Estonia. The rates of return on EU investments in the candidate
countries  are  gradually  converging,  from  below,  towards  the  rates  of  return  in  other  parts  of  the
world, despite minor hiccups in this trend in Hungary in 1997 and major ones in Slovakia and the
Czech Republic. The technology that comes with FDI is as crucial for the economic development of
catching-up countries as the net inflow of FDI itself is for financing the current account deficits.

21

Foreign Direct Investment (FDI1) is an important element for the economic development of the Pre-
accession  Countries  (PACs).  The  accession  process  and  the  reforms  in  the  PACs  have  attracted
considerable FDI, which has played a key role in the privatisation and transformation of the former
centrally planned economies2. The following figure shows the FDI flows as a percentage of gross
fixed capital formation.

Figure 4: FDI flows as percentage of gross fixed capital formation in selected PACs and the EU in
1996-1998

European Union

Latvia

Bulgaria

Estonia

Lithuania

Hungary

Poland

Romania

Czech Republic

Slovenia

Slovak Republic

FDI Outflows

FDI Inflows

of gross fixed
capital formation

0%

10%

20%

30%

40%

50%

Source: Compiled from UNCTAD (2000), p.34 and 68

The figure reveals that a considerable part of fixed capital formation is due to FDI in most PACs.
Apart from a capital flow, FDI produces a shift from domestic to foreign ownership. In transition
economies, the foreign owners can usually make a more efficient use of the acquired assets, provide
access to international markets, and invest into new technologies and human resource formation. In a
study among 5 PACs3 in 1998, labour productivity in foreign investment enterprises was between
1,5 times (Estonia) and three times (Hungary) that of domestic enterprises4. The share of services in
FDI  has  increased  from  50%  in  1998  to  56%  in  19995.  This  reveals  that  the  efficiency  gains  in
manufacturing are increasingly complemented by performance improvements of the service sector.

The  bigger  PACs  have  received  the  highest  shares  of  FDI.  This  not  only  reflects  the  investors'
aspiration to develop a significant position in the local market of the country of investment, but also

1 Foreign Direct Investment (FDI) is defined as the investment involving a long-term relationship
and reflecting a lasting interest and control of a resident entity in one economy (FDI investor or
parent enterprise) in an enterprise resident in another economy (FDI enterprise or affiliate
enterprise or foreign affiliate) (UNCTAD (2000), p.267).
2 See UNECE (2000)
3 The Czech Republic, Estonia, Hungary, Poland and Slovenia
4 See ADE (2001), p.61
5 See UNCTAD (2000), p.67

22

                                                     
depends on factors such as the legal framework, privatisation policies6, and development potentials.
The following figure shows the FDI figures for 1998 and 1999.

Figure 5: Inflows of FDI in the PACs in 1998-1999 in billion US$

Poland

Czech Republic

Hungary

Turkey

Romania

Bulgaria

Estonia

Lithuania

Latvia

Slovak Republic

Slovenia

1998

1999

0

1

2

3

4

5

6

7

8

Source: Compiled from UNCTAD (2000), p.50 and 65

These  flows  reflect  the  concentration  of  the  FDI  stock  in  the  PACs,  of  which  Poland,  the  Czech
Republic and Hungary account for almost three fourths7. Two thirds of the FDI come from the EU,
and  half  of  the  remaining  third  from  the  US.  However,  FDI  coming  from  the  EU  into  the  PACs
made-up for only 7,2 % of total EU FDI outflows in 1998 and 6,2 % in 1999.

Some of the PACs have already developed such economic strength that they have become foreign
direct investors themselves. Where reported, FDI outflows from the PACs are still modest, totaling
around U$ 1 billion in 1998 and U$ 0,72 billion in 1999. As shown in the figure below, the PACs are
receiving many times the FDI they invest.

6 In the Czech Republic, privatisation policies during the first half of the 1990ies excluded foreign
participation, which hampered FDI inflows. The recent reform of privatisation policies, involving also
foreign firms, lead to new records of FDI inflows in 1999.
7 See UNCTAD (2000), p.64

23

                                                     
Figure 6: Ratio of FDI received to FDI invested in 1998 and 1999 in selected PACs and the EU

140

120

f

o
o

i
t

a
R

100

I

D
F

80

60

40

20

0

1998

1999

a
i
n
a
m
o
R

a
i
n
a
u
h
t
i
L

a
i
n
o
t
s
E

a
i
n
e
v
o
S

l

h
c
e
z
C

c
i
l

b
u
p
e
R

y
r
a
g
n
u
H

d
n
a
l
o
P

n
a
e
p
o
r
u
E

i

n
o
n
U

Source: Compilation from UNCTAD (2000), p. 30, 32, 50 and 64

In  most  cases,  the  FDI  outflow  from  the  PACs  concerns  inter-regional  investments  between
neighbouring  countries.  This  explains  why  the  countries  with  a  more  central  location  among  the
PACs  report  lower  ratios  of  FDI  received  to  FDI  invested  in  the  figure  above.  Apart  from  the
location,  the  PACs  ability  to  create  FDI  outflow  also  seems  to  be  bigger  in  the  larger  and  more
advanced countries.

FDI was initially concentrated in manufacturing, but the emphasis has now moved towards services,
some of which may previously have been provided by the state. Much FDI has been attracted by the
privatisation and liberalisation of public infrastructure and utility industries, and more recently by the
banking sector (WIIW, Structural Report 1999). However, the first and second wave of FDI have
resulted in poles of activity that appear to stand on their own and have no direct spin-offs to existing
industries.  They  typically  have  not  made  use  of  the  existing  domestic  science  base  and  have  not
helped to preserve and expand the local R&D capacity. A recent collection of case studies by the
Institute  for  Advanced  Studies  (Biegelbauer,  Grießler,  Leuthold,  The  Impact  of  Foreign  Direct
Investment on the Knowledge Base of Central and Eastern European Countries, IAS, Vienna, June
2001) ended up with mixed results. It found some evidence of positive spill-overs of FDI on locally
owned firms, but also some indications  of a negative impact  on  indigenous  firms. Foreign-owned
firms are often technologically advanced and set out to eliminate their domestic competitors. With
the possible exception of Hungary, where greenfield investment has become important, FDI tends to
flow  to  those  domestic  enterprises  that  have  the  highest  productivity  and  profitability,  thereby
crowding  out  the  relatively  less  competitive  firms  and  eroding  the  domestic  R&D  capacity.
Although, after the early 1990s, when foreign investors wilfully destroyed the domestic R&D base,
there have been some efforts by foreign-dominated enterprises to recreate this capacity, the spill-over
to  local  companies  has  remained  a  trickle.  There  is  also  a  beginning  of  a  cooperation  between
foreign-owned  companies  with  local  universities  and  other  knowledge-producing  institutions,  but
again it is unclear whether this will develop into a solid trend.

24

 
While all emerging economies are in urgent need of FDI, they may lose out in the competition for
such investments. In many of the CECC-10 the financial and banking institutions do not yet function
well and do not act as an intermediary to attract FDI. This is a problem in particular for small and
medium-sized  enterprises.  On  the  other  hand,  large-scale  foreign  investments  can  be  fairly
independent of the actual economic situation in the host country. Multinationals usually come with
their own finance and are more concerned with the prospects of long-term political stability and the
development of new markets in the region than with the existing financial and social infrastructure.

At present the big attraction of the CECC is a combination of fast productivity growth, at around 10
per cent per annum, and low unit labour costs, at around 40 to 60 per cent of the EU level. A major
uncertainty, however, is whether their industrial specialisation pattern will continue to reflect their
current comparative advantages in low-tech, labour-intensive, low-wage industries. If that would be
the case, it would also mean that the contribution of FDI to technological progress in the candidate
countries  remains  low.  It  would  be  interesting  to  know  why  foreign  investors  have  picked  a
particular country and how the acquired firm fits in the investor’s supply and production chains.

The  EBRD  2000  Transition  Report  focuses  on  employment  and  skills  in  transition  countries.  A
survey of the Office of its Chief Economist among foreign investors in Eastern Europe confirms that
the CECC, followed by the South-East European transition countries, have been more successful in
attracting foreign investment than other parts of the former Soviet bloc. The foreign investors list the
local availability of relatively cheap skilled labour as the second most important factor, after the size
and attractiveness of the host market. Cheap labour in general and a favourable regulatory regime are
much  less  important.  This  suggests  that,  in  making  location  decisions,  geographic  and  cultural
proximity outweigh tax and cost advantages, which are likely to be temporary. It is encouraging that
the investors do not seem to have great difficulties in recruiting skilled staff. However, 37% of the
respondents have trouble in finding local managers and employ expatriates instead. Because of high
wage costs, some of them report to have difficulties in the hiring of IT and financial staff.

The technological  performance  of  socialist  countries  was  always  considered  to  be  relatively  good
due to their education system for technicians and  engineers.  However,  trade  flows in  recent years
show a clear technological dependency on the West and in particular on the EU, suggesting that the
level  of  acquired  knowledge  and  skills  was  inadequate  for  Western  style  production.  The  EBRD
survey shows that the main deficiency listed by foreign investors concerns the general flexibility and
the  ability  to  learn  and  adapt.  An  encouraging  sign  for  the  CECC  is  that  this  becomes  less  of  a
problem for the higher educated, but 46% of the respondents still list it as a deficiency of university
graduates in the candidate countries. For employees from the CECC with vocational education, the
lack of ICT skills is the second major deficiency. For employees with secondary education or less it
is technical skills that are missing. One way to improve the situation would be to do something about
the poor conditions for the teaching profession – low wages; ageing; unbalanced gender situation;
bad infrastructure, healthcare and meals.

In particular in relation to the acquisition of information and communication skills, it is a paradox
that a greater focus on technology in the education system is in danger of increasing the digital divide
in the next decades. A careful balance needs to be struck between giving general access to modern
education to everyone, not restricted to schooling age, and not excluding those that have not taken up
the opportunity from the labour force. In this respect, the candidate countries may need to be advised
not too put all eggs in the same basket.

However, exercises such as the EBRD survey do not seem to carry the present analysis much further
and  their  results  do  probably  not  have  much  predictive  power  for  future  developments.  Which
sectors will develop first and fastest has more to do with enhanced market efficiencies and prospects

25

for the future than with short-term opportunities for investors. In other words, in an exercise with a
horizon of ten years the investment decisions for a shorter time-span are of no great relevance, unless
they would generate spin-offs with longer-lasting effects. The collection of case  studies of FDI in
Hungary, Slovenia, Slovakia and the Czech Republic, quoted above, concludes that, if the singular
cases in which local R&D capacities have been recreated by foreign investors would develop into a
trend, there is some hope that the candidate countries will become economically integrated into the
EU  rather  quickly.  The  alternative  in  which  there  remains  a  big  divide  between  local  firms  and
foreign-owned companies would mean that the CECC’s will squander their existing knowledge base
and will have to rebuild one from scratch. This would have the likely effect of slowing down the
catching  up  of  the  candidate  countries,  with  negative  implications  for  their  degree  of  economic
integration in the EU and for the economic and social cohesion of the Community.

2.4. Finding the right mix of economic activities

A common feature of the central and eastern European candidate countries is that the services sector
has grown  rapidly  in  recent  years.  Services  now  constitute  approximately  60%  of  GDP,  which  is
only slightly below the EU average.

The shift from industry to services could mean that knowledge and human capital become relatively
more  important  than  physical  and  financial  capital  as  input  in  the  production  process  (Dunning,
OECD, 1997).

Although the panel did not discuss this item separately, they made a number of interesting remarks
under more general headings:

- 

- 

- 

The  common  finding  that  traditional  statistics  do  not  capture  changes  in  the  economic
structure very well applies in particular to services. Whereas minute distinctions are made in
the  classification  of  industrial  production,  trade,  banking  and  personal  services  (healthcare,
hairdressing, hotels, recreation, …), all ICT-related activities, for instance, need to be  fitted
into a single category.

The question whether the pre-accession countries lack only finance and management capacity
or  also  the  ability  to  design  new  products  fitted  to  the  needs  of  the  (local  and  foreign)
customers needs to be addressed.

The  redirection  of  investment  flows  to  services  and  small  and  medium-sized  enterprises
(SMEs) may be partly inspired by the feature that the typical payback period of investment in
retail, trade and services is 2-3 years, whereas it is closer to 7 years in industry.

2.4.1. The declining role of agriculture

The  Futures  project  identified  agriculture  and  what  it  will  look  like  in  an  enlarged  EU,  once  the
modernisation  process  in  the  candidate  countries  and  the  Agenda  2000  reforms  of  the  common
agricultural policy have taken hold, as an interesting issue to explore. (See Futures Report Series 12,
p. 53).

The accession of the  central and eastern  European candidate countries has the potential  of  almost
doubling the arable area of the EU, whereas its population will increase by one third. This implies a
permanent structural shock to the agricultural productive capacity of the EU, which needs to be taken

26

into account very seriously when the future of the CAP is considered; as are trends that would occur
more  or  less  independently,  such  as  the  changing  pattern  of  specialisation  in  agriculture  and  the
vertical integration of the agro-food industry, showing a tendency  for  farms  to  be  included  in the
production chain in order to control the quality and the origin of food products.

The pre-accession countries have large agricultural sectors (see Futures Report Series 15, Table 4, p.
30). The share of agriculture in their GDP and employment is between three and ten times higher
than  in  the  EU.  Agricultural  employment  in  these  countries  represents  about  one  fifth  of  total
employment, with peaks of 25% in Bulgaria and Lithuania and almost 40% in Romania. About one
fifth  of  the  labour  force  in  Poland  recorded  as  being  employed  in  agriculture.  Reinforcing  the
establishment of new complementary patterns of specialisation in agriculture in both the entrant and
incumbent  EU  member  states  is  a  challenge  for  the  longer  term.  With  the  inevitable  decline  of
agricultural employment in the central and eastern European candidate countries, millions of people
in low productivity agriculture will need to find other work locally  or  move  elsewhere.  These  are
typically not among the first migrants to move onto the labour markets of other countries, nor would
their  migration  offer  a  solution  to  possible  labour  shortages  in  the  present  EU  member  states.
Nevertheless, adjusting the common agricultural policy to meet the new challenges, while getting the
timing of the changes right, is crucial to avoid the risk of severe shocks to agricultural production and
employment in the enlarged EU.

2.4.2. The increasing role of services

In a medium perspective, focussing on the services sector in the candidate countries, the panel made
the following observations:

•  Many knowledge-intensive services are directly or indirectly linked to industrial activities. They

can only emerge in the candidate countries if and when the industrial sector recovers.

• 

If  firms  in  pre-accession  countries  do  in  fact  concentrate  on  supply  functions  for  EU
multinationals,  at  the  beginning  of  the  production  chain  rather  than  at  the  end,  the  scope  for
knowledge-intensive  business  services  in  the  candidate  countries  will  be  rather  limited.  Such
services flourish in an environment where there production facilities consist of more than simple
assembly lines and where there is a need for sophisticated customer support. At present there is a
lack of the human resources needed to manage such services. Perhaps, given the reasonably high
level  of  education  and  vocational  training  in  the  candidate  countries,  this  shortage  could  be
overcome, but the  shift  of  qualified  people  from  industry  and R&D  into  this  sector  would  still
need to be supported by re-training and learning by doing. (See Section 3.5 for an assessment of
the  level  of  education  in  the  candidate  countries  and  the  possible  usefulness  of  re-training
programmes).

•  Electronic commerce requires a trustworthy, robust and technologically advanced banking system
and  an  appropriate  ICT  infrastructure,  accompanied  by  a  legal  framework  which  will  ensure
liability and privacy. This needs time to be built up.

•  Banking,  insurance  and  financial  services  are  still  underdeveloped  in  the  central  and  eastern
European candidate countries, even if they have started to attract FDI recently. Their expansion is
crucial because of their support function for the operation of the market economy, including the
mobilisation  of  domestic  savings.  When  a  powerful  and  reliable  supervision  framework  is  in
place, financial services can be expected to grow rapidly in the coming years.

27

•  The  future  growth  in  utility  services  will  depend  on  the  progress  towards  liberalisation  and
privatisation. Telecommunications and transport in particular are key services with cross-cutting
functions within the economy. Their performance can be expected to improve significantly when
continued  privatisation  and  greater  competition  are  introduced  in  anticipation  of  the  EU  single
market provisions.

An increasing part of our household budget is spent on housing costs and services and at least a fixed
sum on healthcare, no matter whether it is provided by the public or private sector. There are trends
in  the  customisation  and  packaging  of  products  and  services  that  should  have  consequences  for
competition policy. In the eyes of the regulators it is increasingly difficult to separate markets and
pinpoint a firm for having a dominant position. New EU-wide accountancy standards will help to
make the complex market structure more transparent, but either strong co-operation and unrestricted
exchange of information between competition authorities, nationally as well as internationally, or the
establishment  of  a  single  competition  authority  are  needed  to  counterbalance  the  diffuse  market
powers that are emerging. New competition rules must ensure that the public interest is safeguarded
and at the same time encourage innovation. They should also take into account  the digitisation  of
many  products,  which  could  have  serious  and  as  yet  not  well  understood  repercussions  on  the
efficiency of traditional market mechanisms.

Can competition authorities ever be fast enough to ensure that the most appropriate standards are set
without impeding too heavily on innovation and investment? The panel did not discuss this question
at  great  length,  but  even  if  authorities  are  always  (and  almost  by  definition)  too  late  to  recognise
innovative  developments  they  do  need  to  be  prepared  to  step  in  when  the  economic  and  social
consequences tend to get out of hand. The difficulty may be to identify the point at which normal
market mechanisms and corrections have lost their effect.

2.4.3. Privatisation: a bridge too far?

One area in which candidate countries could enter into a void when they would try to leapfrog the
experiences of the EU member states is that of the privatisation of public services.

For different reasons, the privatisation of state-run enterprises and public utilities has been taken up
almost everywhere in Europe. The motives of the EU member states for the selling of state assets
were: the greater efficiency of the private sector in the provision of marketable services; the needs to
slim  down  the  public  sector  and  to  reduce  the  tax  burden;  the  breaking  of  state  monopolies;  the
citizen's freedom of choice between providers. The underlying reasons may have been different: the
need to finance a growing government deficit; the breaking of trade union power; the closure of state
enterprises that had turned out to be bottomless pits.

Against the legacy of the communist system, in which a wider selection of enterprises and services
were  typically  left  in  state  hands,  a  number  of  candidate  countries  have  taken  their  cue  from  the
privatisation efforts of the EU member states. They have presented progress on the selling of state
assets  as  a  proxy  for  the  establishment  of  a  functioning  market  economy.  As  in  the  EU,  the
underlying motives may have been different. There have been some cases of rather self-serving sales
of state enterprises to the old management, while the interrelations between the political and business
communities has not always been very transparent.

While  privatisation  can  be  expected  to  support  economic  liberalisation  and  the  establishment  of
functioning market economies in the candidate countries, their policies varied considerably. For large
and  medium-sized  companies,  attempts  at  privatisation  were  often  a  way  to  circumvent  political

28

constraints and to exploit existing power imbalances. In the same vein, the lack of political influence
of the management of small firms has made their privatisation much simpler and is well advanced in
most candidate countries. The privatisation of small enterprises has therefore been much faster and
generally  more  successful  than  that  of  large  enterprises.  (See  the  Commission’s  2001  Regular
Reports on the Candidate Countries’ Progress towards Accession).

For the central and eastern European candidate countries, the present stage of privatisation focuses
on the utilities, transport and energy sectors. Except for Romania and, to a lesser extent, Bulgaria,
privatisation  of  the  manufacturing  sector  is  regarded  as  relatively  complete8.  Box  1  presents  the
current state and specific obstacles of the privatisation process in the ten countries.

Box 1: The state of affairs on privatisation in the central and eastern European candidate countries

“Privatisation  of  manufacturing  enterprises  is  almost  completed  in  many  CEEC-10,  with  the
exception of Romania, where the privatisation agenda is still large, and to a lesser extent Bulgaria.
Poland  still  needs  to  devise  viable  privatisation  and  restructuring  strategies  for  some  important
traditional sectors. Privatisation strategies have moved into sectors such as the  utilities, transport
and energy and are accompanied by efforts to restructure these sectors. In the financial sector, the
bank privatisation agenda is completed in a number of candidates such as Estonia,  Hungary, Latvia
and the Czech Republic. It has advanced in Lithuania, Romania, Poland and Slovakia and is lagging
considerably behind in Slovenia. Concerning the state-owned banks not intended for privatisation, it
is important that governments do not interfere with their operating practices and credit policies. For
other parts of the financial sector, progress in privatisation is hesitant and uneven across candidates.
The completion of land reform with the creation of a functioning land market lingers in many CEEC-
10.  This  is  hindering  the  development  of  land  and  housing  markets  and  of  construction,  with
unfavourable implications for the labour markets and financial intermediation.”

From  “Making  a  success  of  enlargement:  Strategy  Paper  and  Report  of  the  European
Commission  on  the  progress  towards  accession  of  each  of  the  candidate  countries”,  European
Commission, 2001, http://europa.eu.int/comm/enlargement/report2001/index.htm#Strategy Paper
2001

Bulgaria  has  privatised  half  of  state-owned  assets  by  the  end  of  20009.  Privatisation  of  SMEs
through public tenders is well underway10. However, privatisation of the manufacturing sector has
not yet been achieved. For the privatisation of large companies, amendments to the privatisation act
and the management of the privatisation agency are expected to make the process more transparent.
After the failure of the first effort to privatise the country's telecom company, a second effort should
lead to telecom privatisation by the end of  2001. Privatisation  of  the state-owned  tobacco and car
companies is expected to advance during this year. In the future, Bulgaria's privatisation strategy will
focus  on  infrastructure  and  utilities  in  general  and  the  energy  sector  in  particular.  The  long
discussions over amendments to the Energy Act, the slow pace of the withdrawal of subsidies and
the lack of discipline in fee collection significantly hampered privatisation in the district heat and gas
sector.  The  restructuring  of  the  Bulgarian  national  railway  company  is  facing  serious  problems11.

8 See European Commission (2001).
9 For this paragraph see the Bulgarian Letter of Intent and Memorandum of Economic Policies to
the IMF, 7 March 2001.
10 54 % of the 547 companies put up for sale had been successfully privatised by March 2001 (see
"Bulgaria: Selected Issues and Statistical Appendix", IMF, Washington, 2001).
11 For this paragraph see the Bulgarian Letter of Intent and Memorandum of Economic Policies to
the IMF, 7 March 2001.

29

                                                     
The restructuring of the national electric company has been pushed forward, but electricity prices are
still too low to cover the company's costs.

Privatisation in the Czech Republic started with a radical and comprehensive approach. In parallel
to the adoption of a modernised legal framework, the recapitalisation of banks, and the liberalisation
of the economy, a huge number of firms were privatised through the voucher method. From today's
point of view, this initially praised method has apparently not worked as well as the more gradual
approaches. It seems that the rapid delineation of private ownership rights in combination with weak
capital market and banking legislation has lead to a rather short-term gain oriented than longer-term
investment  oriented  behaviour  of  the  new  owners12.  The  consequence  has  been  mismanagement,
especially  in  banks  and  financial  holdings  with  important  negative  effects  on  the  structure  of  the
banking  system.  Although the  bank  privatisation  agenda  is  completed,  the  banking  system  is  still
regarded as a constraint for the country's economic growth13. In this respect, further restructuring will
be  necessary.  Energy  prices  are  still  heavily  subsidised  in  the  country  and  the  reformation  of  the
energy sector advances slowly. Market-like prices will be gradually introduced by 2002.

A rigorous focus on privatisation and the early involvement of foreign companies has been a factor
for growth in Hungary. During the last ten years, more than 90% of the close to 2000 state-owned
enterprises have changed hands14. Bank privatisation in Hungary is completed.

Also Estonia has been able to feed its high growth rates through an intensive programme of large-
scale privatisation. Bank privatisation in the country is regarded as complete.

Privatisation and restructuring of large companies have been delayed in Latvia. Bank privatisation in
Latvia has been achieved.

Despite  of  Lithuania's  commitment  to  further  privatisation  and  encouraging  experience  from
privatising the telecom and savings banks sector, utilities privatisation faced a set-back in the course
of  the  disputes  over  the  privatisation  of  the  main  oil  refinery15.  The  national  energy  and  gas
companies are expected to be privatised in the course of this year.

After rapid mass privatisation was blocked by the veto power of worker councils at the beginning of
the  1990ies,  Poland  has  privatised  its  economy  at  a  growing  pace.  The  Enterprise  and  Bank
Restructuring Program linked the privatisation of banks and large firms and has enhanced the role of
central  and  regional  governments.  This  gradual  approach  has  lead  to  new  forms  of  public-private
partnerships, which apparently have benefited growth among the privatised units16.

Restructuring and privatisation in Romania have largely stalled since 1996. It is lagging far behind
the other countries.

The  reformed  legislation  on  energy,  telecommunication  and  maritime  transport  are  expected  to
facilitate  and  speed  up  the  privatisation  process  in  Slovenia.  However,  the  country  is  lagging
considerably behind in bank privatisation17.

12 See McDermott (2000), p.11.
13 Source: Deutsche Bank research.
14 Source: Deutsche Bank research.
15 Source: Deutsche Bank research.
16 See McDermott (2000), p.36.
17 See European Commission (2001).

30

                                                     
In  Slovakia,  the  split  of  the  nationally  owned  rail  transport  company  into  an  operating  and  an
infrastructure  holding  company  prepares  the  sector  for  liberalisation18.  The  energy  sector  will
undergo a similar procedure in 2001. Until the end of that year, large minority stakes of the Slovak
gas  company  and  the  national  petrol  company  are  expected  to  be  sold.  Slovakia  is  undertaking
efforts to reform its energy sector through the establishment of a regulatory authority by 200219. The
national electricity company is separated into two in 2001 in order to prepare its privatisation.

In  total,  privatisation  and  restructuring  of  the  economy  can  be  regarded  as  relatively  complete  in
Estonia and Hungary. In Lithuania, Poland and Slovakia, promising measures are underway or being
implemented.  Further  efforts  will  be  necessary  in  Bulgaria,  the  Czech  Republic,  Latvia,  Romania
and Slovakia.

Privatisation revenues can be used to finance reform, for instance when the tax system is not yet fully
geared up. Alternatively they can be used to pay off public debt and reduce the country's foreign debt
if sold to a foreign investor. Some candidate countries have earmarked the revenues for setting up a
funded pension scheme (this makes sense only if the fund is independently managed). The sale of
state  enterprises  implies  a  drain  on  future  state  income  if  the  company  could  have  been  made
profitable  in  selling  its  services.  Many  services  are  commercially  exploitable,  and  almost  by
definition  more  so  in  the  candidate  countries  than  in  the  member  states.  In  those  cases  there  is  a
sound economic argument for privatisation. If  the company provided non-essential  services  at  the
expense of the tax payer, it should be allowed to fail in a market situation, and it probably would
when the services were unnecessary. This would imply a loss of employment but not necessarily a
reduction of aggregate national income. In other cases the services are exploitable but also socially
indispensable. Here the state could find itself in a position where it would have to re-establish public
services such as water supply, energy supply, railway transport. Publicly supervised contracts with
former  state  enterprises  can  never  contain  watertight  guarantees  against  the  risk  that  the  new
company fails to become profitable in a market situation, as the Californian energy supply crisis has
abundantly shown, certainly not if output prices are regulated while input prices are determined by
market forces. Other considerations that need to be taken into account in public service provision are
the citizen’s right to be informed and to be connected. Why should the access to telecommunications
be guaranteed everywhere and the access to public transport not?

2.4.4. The trend towards smaller businesses

A  new  fabric  of  the  enterprise  system  has  developed  in  many  candidate  countries.  The  share  of
industrial companies in the total is 30% larger than the EU-15 average and they employ 50% more
people20. Business and personal services, on the other hand, are much less widespread than in the
EU-15: the number of enterprises in the central and eastern European candidate countries is half as
large as in the EU, while the number of employees is roughly one third of what it is in the present
member  states21.  Many  companies  will  shift  from  the  “low  budget”  sector  to  the  part  providing
higher  value  added  services.  In  doing  so,  they  may  change  their  legal  status  and  SME  support  is
likely play a key role in the transition.

18 See the Slovakian Letter of Intent and Statement of Economic Policies to the IMF, 9 May 2001
19 See the Slovakian Letter of Intent and Statement of Economic Policies to the IMF, 9 May 2001
20 16.9 % of enterprises in the PACs vs. 12 % in the EU-15 operate in the industrial sector. 45 % of
total employment in the PACs vs. 30.2 % in the EU-15 work in the industrial sector (see Eurostat
(1998), p.51).
21 18.4 % of enterprises in the EU-15 vs. 9 % in the PACs and 15.4 % of total employment vs. 5 %
in the PACs work in the sectoral and personal services (see Eurostat (1998), p.51).

31

                                                     
One particularity of companies in the candidate countries is that a much smaller proportion of their
workforce is registered to be filled by wage earners than in the present EU22. People working for a
company often have multiple jobs and  shared ownership of small companies is very  common for
start-up enterprises, which complicates a direct comparison of the distribution of company sizes in
the  present  EU  member  states  and  the  candidate  countries.  Nevertheless,  it  is  clear  that  small
enterprises with only a couple of employees play a driving role in the transformation of the enterprise
system in the candidate countries23.

The following figure details the  composition of the firm  base  in the  central  and eastern European
candidate countries by main size classes24.

Figure 7: Company sizes in the ten central and eastern European candidate countries in 1995

Manufacture of Agri-Foods

Hotels, Restaurants and Catering

Manufacture of Capital Goods

Real Estate

Trade

Manufacture of Consum er Goods

Manufacture of Interm ediary Goods

Financial Intermediation

Social and Personal Services

Business Services

Construction

Education, Health and Social Work

Transports

All

< 2 employees

2 employees

3 to 4 employees

5 to 9 employees

10 to 19 employees 

20 to 49 employees

> 49 employees

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

 Source: Eurostat (1998), p. 57

Small  and  very  small  firms  (less  than  9  employees)  prevail  in  the  service  sectors,  especially  in
transport, trade, social and personal services, business services, hotels, restaurants and catering. The
largest shares of medium-sized firms (from 10 to 49 employees) are in the manufacturing of agri-
food products and capital goods and in the sector of real estate. Large firms (50 employees or more)
are mainly concentrated in the more capital intensive sectors. This illustrates the important role of
small businesses in the economic transformation of the candidate countries – from being primarily
industry-based  to  becoming  increasingly  service-oriented.  In  the  Czech  Republic,  Hungary  and

22 See Eurostat (1998), p.53
23 op.cit.
24 Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak
Republic, and Slovenia.

32

                                                     
Poland, for instance, SMEs account for more than 95% of the number of companies25. In each of
these countries, small to medium-sized enterprises employ almost two thirds of the total workforce,
with significantly higher employment shares in services than the manufacturing sector. In order to
foster  the  creation  and  growth  of  SMEs,  the  Czech  Republic,  Hungary  and  Poland  have  targeted
programmes. Similar programmes also exist in other candidate countries that are well advanced in
the process of reform. It is still too early to speculate on the success of such policies, but it seems that
the earlier market-conform SME support policies are put in place, the better they are for the fabric of
the enterprise system in the candidate countries and the functioning of their economies.

Figure 8: Shares of SMEs in employment around 1997

100%

80%

60%

40%

20%

0%

Manufacturing

Service

Total

l

e
b
a

l
i

a
v
a
t
o
N

Czech Republic*

Hungary**

Poland*

* SME has less than 250 employees, ** SME has less than 100 employees

Source: Compiled from OECD (2000)

2.5. Technology transfer and innovation

This section of the report focuses on the main drivers for change in the candidate countries and in
particular on the factors that generate economic growth and innovation in these countries.

During  the  last  decade  numerous  reforms  have  been  undertaken  in  the  candidate  countries.  They
have  been  able  to  put  in  place  an  institutional  framework  supporting  their  economic  growth26.
Although the pace of the reform process has slowed in some countries, the ratification of important
chapters of the acquis communautaire and the approach of EU accession will foster the enforcement
of market rules and lead to an advanced institutional and legal framework in the future.

Unlike  in  the  past,  future  growth  in  the  candidate  countries  will  depend  less  on  institutional  and
regulatory reform and more on their capacity to create the local growth they need to ensure longer-
term economic development and stability27. Literature on this subject is sparse and heterogeneous.

25 See OECD (2000). In the Czech Republic and Poland, companies with less than 250 employees
were considered as SMEs. In Hungary, SMEs were companies with less than 100 employees.
26 See EBRD (2000), p.13.
27 Radosevic (2001).

33

                                                     
This  report  takes  a  five-step  approach  in  order  to  construct  a  qualitative  picture  of  the  sources  of
growth and innovation in these countries.

First, a short overview of the framework conditions for economic activity in the candidate countries
is given, including the role of commercial law and the situation in the banking sector. This gives an
indication of the market development gap and the potential for further reforms. Trends in seven key
sectors  are  then  considered,  where  past  changes  have  had  an  effect  and  where  they  have  been
transformed into sources of growth. The trends are more typical for sector developments than for the
country  in  which  the  activities  take  place.  As  a  result  of  the  exposure  of  the  formerly  protected
economies to international competition, sectoral trends are increasingly important as determinants of
the overall economic performance of the candidate countries.  In addition, this chapter analysis the
possible  effects  of  different  forms  of  policy  support  for  sectoral  development.    This  enables  a
qualitative view on the sources of growth and innovation in the candidate countries.

2.5.1. The technology gap model

Central  planners  saw  technology  as  an  information-type  commodity  which  emerged,  neatly  and
cleanly,  from  R&D  (see  Pavitt,  1997,  p.44).  Given  the  remarkable  rapidity  with  which  transition
countries assimilated Western product and technology standards and industrial property rights, the
origins of innovation are now to be found abroad. On the other hand, the level of human capital, the
size of the R&D system, and the availability of design and engineering capacities suggest that the
candidate  countries  have  the  potential  to  develop  strengths  of  their  own  in  the  areas  of
manufacturing, R&D and product design.

In  the  first  phase  of  transition  R&D  investment  and  innovative  activity  have  fallen  (see  Futures
Report Series 15, Figure 13, p. 39). Before 1989, relatively high amounts of GDP were devoted to
R&D  in  centrally  planned  economies.  Gross  expenditures  for  R&D  per  capita  in  the  central  and
eastern European candidate countries were two times higher than the expenditures of countries such
as Spain and Ireland and four times higher than those of Greece and Portugal (see Radosevic, 1996,
p. 188). This resulted in “innovation” that was mainly based on huge physical investments, which
did not prevent a deterioration in general economic performance.  After  1989,  investment in R&D
began  to  decrease  but  after  a  number  of  years  the  economic  situation  of  the  central  and  eastern
European countries that opted for EU membership began to improve. So, whereas large investments
in technical and human capital did not result in much economic growth in central and eastern Europe
before  1989,  the  economies  of  most  of  the  candidate  countries  grew  afterwards  on  the  back  of
economic restructuring. However, the future growth needed for catching up will increasingly depend
on domestic investment and innovation rather than on the further restructuring of the economy.

There are at least four ways by which technology can be transferred to developing countries:

•  Via foreign direct investment. The main impediment seems to be the uncertainty about the legal

framework and the improper functioning of the market economy.

•  Via licensing. License trading by the central and eastern European candidate countries, however,

has decreased. In Hungary the figures have halved since 1989.

•  Via learning by exporting. Despite complaints about the high costs of complying with the acquis
communautaire,  the  desire  to  export  forces  the  candidate  countries  to  raise  the  quality  of  their
products and to adopt EU-conform standards of certification and regulation.

•  Via imitation. As yet there is not much evidence that the candidate countries are taking Western

products apart in order to copy their design.

34

The  technology  gap  model  predicts  that  technologically  advanced  countries  will  specialise  in
technology-intensive  production  and  that  technologically  backward  countries  produce  more
traditional  goods.  However,  technology  is  not  a  production  factor  in  its  own  right;  technological
progress can be represented by structural shifts in the combination of capital and labour. It can also
be embedded in capital and labour inflows from abroad. In either case it is important for a country to
have some local innovative capacity in order to enjoy the externalities of technological change in the
long run.

2.5.2. The legal framework

The creation and enforcement of a stable and predictable legislative environment is the most basic
prerequisite  for  the  creation  of  growth28.  The  adoption  of  the  acquis  communautaire  and  further
experience  with  commercial  law  will  lead  to  advances  in  the  future.  From  the  international
perspective, the conditions of the legal framework will lead to a further differentiation between the
candidate countries.

Considerable  progress  has  been  made  in  improving  the  legal  framework  and  the  effectiveness  of
jurisdiction during the recent past. Except for the Czech Republic, Romania and Slovakia, company
law  and  pledge  law  are  relatively  extensive  and  approach  minimum  international  standards29.
Bankruptcy  law,  however,  is  not  as  well  developed  as  company  and  pledge  law.  The  Czech
Republic, Romania and Slovakia have revised the bankruptcy laws in 2000 but extensiveness is still
lower  than  in  the  other  countries.  In  many  central  and  eastern  European  candidate  countries  the
underdevelopment  of  bankruptcy  law  has  negative  consequences  for  financing  practices  and  the
position of creditors.

However,  the  effectiveness  of  implementation  leaves  significant  room  for  improvement.  For
company law, observed effectiveness is much higher than for pledge and bankruptcy law. This has
been attributed to the fact that company law in most of the candidate countries was enacted earlier
than  the  other  two.  Courts  and  lawyers  had  therefore  more  time  to  become  familiar  with  its
enforcement. Implementation problems remain in the effectiveness of shareholder rights. In terms of
commercial  law  enforcement,  the  Czech  Republic,  Estonia,  Lithuania  and  Slovakia  are  lagging
behind the other candidate countries.

The Czech Republic, Romania and Slovakia show a slower pace of legal reform and enforcement
than the other candidate countries. This might have important long term effects, as these countries
lose  out  in  terms  of  timing  and  competitiveness.  Potential  investors,  entrepreneurs  and  business
partners want to be  able  to  rely  on  well-designed  and  effective  legal  procedures  that  protect  their
legitimate interests in case of conflicts. A high degree of enforcement of pledge and bankruptcy law
is a prerequisite for providing credit to entrepreneurs or companies. Countries that do not offer these
instruments at a minimum international level, the Czech Republic, Lithuania and Slovakia, and for
that matter Croatia, leave significant obstacles in the way of entrepreneurial undertakings.

2.5.3. The financial framework

Financial regulation concerns the state and enforcement of banking and securities legislation. In the
light of globalisation and the high speed of capital mobility today, the efficiency of financial systems

28 See IMD (2001), p.53.
29 This section is largely based on EBRD (2000), pp.34, and IMD (2001).

35

                                                     
and markets determines whether and how easily a country can attract capital. The more efficient the
financial system, the greater is its leverage on growth and innovation .

The adoption of the acquis communautaire will abolish restrictions on the free movement of capital
and the financial and banking systems will be increasingly exposed to international competition.

The Czech Republic, Estonia, Hungary, Lithuania, Poland, Romania and Slovenia have adopted a
comprehensive capital market legislation that generally approaches international standards, mainly as
a result of their harmonisation with the respective EU directives30. In addition, the Czech Republic
and Lithuania improved aspects of their capital market regulation the last year.

The  effectiveness  of  capital  market  regulators  in  all  candidate  countries  leaves  much  room  for
improvement.  At  present,  the  leading  countries  with  respect  to  capital  market  effectiveness  are
Hungary and Poland. Regulation and enforcement in the banking sector are lower than in the capital
market. Only in Hungary, Poland and Slovenia the banking sector has reached a maturity to support
economic growth in the future.  The Polish financial system has a high share of foreign banks and for
this reason receives high marks  from  some  large  international  private  banks31. Romania,  with  the
failure  of  the  country's  largest  investment  fund,  faced  a  serious  banking  crisis  in  2000,  but  bank
supervision has been strengthened since then. The Czech Republic has also been criticised in the past
for its banking regulation and the insufficient governance of banks. All this illustrates that financial
sector reforms need to be in step with the development of the economy and that the central banks and
the  governments  of  the  candidate  countries  need  to  increase  their  efforts  of  supervision  and
regulation when the restructuring of the banking system is lagging behind.

2.5.4. Own market development

Apart from the specific obstacles within the framework conditions, most of the candidate countries
will have to have long periods of high economic growth in order to come close to EU wealth levels.
Due to the low level of purchasing power in many candidate countries, multinational firms do not
find access to these markets especially attractive in itself32. As shown in the following table, low per
capita income levels can be expected to remain so for the foreseeable future.

30 EBRD (2001), pp.37.
31 See: Deutsche Bank research.
32 See Ambler et al (2000), p.16.

36

                                                     
Table 4: The market development gap

GDP per capita
(at PPP in US$)

Average GDP
growth p.a. from
1998 until
2001 (expected)*

Years of growth
before
convergence with
EU-15 average**

Years of growth
before
convergence with
EU-15
minimum***

Bulgaria

Czech Republic

Estonia

Hungary

Latvia

Lithuania

Poland

Romania

Slovak Republic

Slovenia

5.149

10.184

13.389

8.223

6.074

6.833

11.256

5.807

10.230

15.669

3,55 %

2,9 %

6,2 %

5,13 %

3,3 %

1,73 %

4,7 %

-4,4 %

2,8 %

4,5 %

43

29

9

20

41

70

15

-

29

8

31

14

3

13

28

47

7

-

15

0

* This does not consider the years of transitional recession in the early nineties ** EU-15 average in PPP weight in
Note: 
1999: 22.672 US$ *** EU-15 minimum in PPP weight in 1999: 15.207 US$**** Weighted per GDP size ***** Weighted per
GDP size and without Romania

Source: Compiled from EBRD (2000), p.65 and p.76; IMF (2000), p.140

This has got important implications for the functioning and the future perspectives of the economies
of the candidate countries. In general, it cannot be expected that many of them will reach European
standards of living in the short to medium term. However, much less time will be needed to reach
and  surpass  the  EU  threshold  above  which  the  eligibility  for  EU  structural  funds  starts  to  be
perceived as a temporary phenomenon.  Furthermore, although there are large differences between
the GDP per capita levels of the candidate countries, they are not set in stone. The figures are known
to be somewhat obscured by measurement errors and their have been real cases of overtaking as well
as cases where rather spectacular shifts in position have been due to a revision of the data.

Seen from a longer-term perspective, the market development gap indicates an upward adjustment
potential33. A statistically significant inverse relation has been found between enterprise density and
the upward adjustment potential in the candidate countries.  Such an inverse relation is not found
across  the  EU-15,  which  is  an  indication  that  the  system  of  entrepreneurship  in  the  candidate
countries is in a developing  stage.  The  following  figure  presents the  relation  between  the  upward
adjustment  potential  with  respect  to  the  US  and  firm  density  in  the  central  and  eastern  European
candidate countries in 1995.

33 The upward adjustment potential measures the development gap between a particularly
advanced country as a reference point (in this case the US). It is calculated by dividing a country’s
GDP per capita in purchasing power standards by the GDP per capita of the reference country,
also in PPS (see Eurostat, 1998, p.48).

37

                                                     
Figure 9: Upward adjustment potential with respect to the US and firm density in the PACs in 1995

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

80

70

60

50

40

30

20

10

0

Upward
adjustment
potential to
the US (left
scale)

Firms per
1000
inhabitants
(right scale)

d
n
a
l
o
P

h
c
e
z
C

c
i
l

b
u
p
e
R

a
i
n
e
v
o
S

l

a
i
k
a
v
o
S

l

y
r
a
g
n
u
H

a
i
v
t
a
L

a
i
r
a
g
u
B

l

a
i
n
o
t
s
E

a
i
n
a
u
h
t
i
L

a
i
n
a
m
o
R

Source: Eurostat (1998), p.49

This figure also gives an idea  about  the remaining need for renewal of the enterprise  system  as a
whole. Seen from 1995, countries such as Latvia, Estonia, Lithuania or Romania, with a very low
enterprise  density,  needed  bigger  efforts  than  their  peers  to  establish  an  SME  base  for  creating
growth and innovation on the longer-run.

2.5.5. Sectoral trends

The shape and speed of the catching-up process is highly influenced by sectoral developments. A
comparative  study  in  selected  sectors  was  undertaken  by  Landesmann34  based  on  a  standard
convergence model. Considering two low-tech sectors35 and two medium to high-tech sectors36, the
predicted  productivity  gains  in  transition  economies  were  much  higher  than  the  wage  gains  and
varied considerably. Productivity gains in the high-tech sectors were much higher for the high-tech
sectors than for the low-tech ones.

With  respect  to  the  upgrading  of  the  product  quality  to  EU  standards,  measured  by  export-price
convergence,  there  were  clear  differences  between  the  categories  of  "textiles  and  clothing"  and
"engineering", which were reflected in the performance of the different country groups. The average
estimated time for closing the gap to six EU core countries37 was 20 years for central and eastern
Europe, including Russia.  Convergence for seven  countries38  since  1991  was  higher  in  the  textile
sector  (22  years)  than  in  engineering  (25  years).  The  same  indicator  for  six  candidate  countries39
since 1993 showed much faster convergence in engineering (1 year) than in textiles (8 years). This
highlights that convergence is not a linear process. Convergence can be rather fast in the beginning,

34 See UNECE (1999), pp.109
35 Textiles and wearing apparel
36 Non-electrical machinery and electrical machinery
37 Belgium, France, Germany, Italy, the Netherlands, and the UK
38 Bulgaria, Czech Republic, Hungary, Poland, Romania, Russian Federation, and Slovenia
39 Czech Republic, Hungary, Poland, Slovakia, Slovenia, and the Baltic States

38

                                                     
when it is most related to productivity improvements through the acquisition of new technologies,
but  then  slows  down,  mainly  because  productivity  can  subsequently  only  be  improved  through
incremental steps based on the new technology.

Convergence in the textiles sector seems to have started earlier than in engineering. That productivity
improvements resulting from the application of new technologies  show their  effect earlier in low-
tech than in high-tech sectors might be due to the higher degree of complexity and novelty of the
technologies in the high-tech sector, where they need to be complemented by knowledge and skills
to be acquired by the workforce in order to lead to productivity improvements. The time lag in the
convergence  of  the  engineering  sector  in  terms  of  product  quality  might  thus  be  explained  as
resulting from a "learning gap". This is confirmed when examining the patterns of the  changes in
wages, productivity and unit labour cost in seven candidate countries between 1991 and 1998. The
following  figure  shows  that  unit  labour  costs  in  the  low-tech  sectors40  have  grown  considerably
faster than in the medium and high-tech sectors41.

40 Textiles and leather
41 Machinery, electrical equipment and transport

39

                                                     
Figure 10: Unit labour costs in 1998 compared to 1991 in seven candidate countries in sectors with
different levels of required technology

1
9
9
1

o
t

n
o
i
t
a
e
r

l

n

i

8
9
9
1

n

i

s
t
s
o
c

r
u
o
b
a

l

t
i
n
U

700%

600%

500%

400%

300%

200%

100%

0%

Low Tech

Medium/High
Tech

y
r
a
g
n
u
H

d
n
a
l
o
P

a
i
n
a
m
o
R

a
i
n
e
v
o
S

l

a
i
r
a
g
u
B

l

a
i
k
a
v
o
S

l

h
c
e
z
C

c
i
l

b
u
p
e
R

Source: Compiled from UNECE (1999), pp.103

In three countries (Hungary, Poland and Romania), unit labour costs in the medium and high-tech
sectors  have  fallen,  compared  to  1991.  The  medium  and  high-tech  sectors  in  the  seven  countries
have  developed  or  improved  their  comparative  cost  advantages,  whereas  the  low-tech  sectors  in
these candidate countries have been losing out.

Studies directed at specific sectors are sparse and heterogeneous, and not many studies have been
conducted  enabling  a  comparison  of  sectoral  trends  between  countries42.    Based  on  the  stage  of
advancement of the sectoral reforms, the presence of competitive markets, their importance for the
national economies and their possible impact on future developments, seven key sectors have been
identified  and  are  analysed  in  greater  detail  below:  manufacturing  (with  consumer-goods
manufacturing  as  a  sub-sector),  retailing,  utilities,  media  and  entertainment,  telecommunications,
financial  services  and  electronic  business.    (e-Commerce  is  or  is  going  to  be  relevant  in  all  these
sectors.)   Developments in the manufacturing industry are investigated in more detail because of the
special significance of this sector for the economies of most candidate countries.

Manufacturing  in  the  PACs  has  been  forced  to  undergo  a  painful  restructuring  over  the  last  ten
years, in which more than five million jobs have been lost43. However, manufacturing still plays a
very  important  role  in  terms  of  value  creation  in  these  countries,  accounting  for  between  13%
(Estonia) and 27% (Czech Republic) of employment. FDI patterns vary considerably between sub-
sectors  and  depend  on  the  relative  cost  position  of  the  PAC  together  with  its  expected  national
market potential44. In the Czech Republic, Poland, Slovakia and Slovenia, industrial structures have

42 ERT (2001), Havlik (2001), Ambler et al. (2000) and ERT (1999).
43 In absolute terms, job losses were the biggest in Romania with 1.76 million layoffs. Relative
losses ranged from 25% (Poland) over 50% (Romania) to 60% (Bulgaria) of the whole
manufacturing sector (see Havlik (2001), p.5).
44 FDI ranges from the acquisition of local manufacturers (e.g. Renault's major stake in Revoz Ltd.,
which produces the Renault Clio) through Joint Ventures (e.g. Krupp-Bilstein's Joint Venture with
the Romanian automotive parts manufacturere Compa S.A. in order to produce shock absorbers

40

                                                     
 
 
 
 
 
 
 
 
come fairly close to EU-15 average. Bulgaria, Romania and the three Baltic candidate countries have
a  rather  different  industrial  structure  with  a  stronger  focus  on labour-intensive  sectors.  The  figure
below shows  the  composition  of  value-added  in  manufacturing  in  most  PACs  compared  with the
EU-15 average.  The trade dependency of the smaller PACs and especially that of Cyprus and Malta
has to be taken into account.

Figure 11: Composition of value added in manufacturing in the PACs (except Estonia and Lithuania)
and the EU-15 (by GDP level)

EU-15 (99)

Cyprus (99)

Slovenia (96)

Malta (96)

Poland (97)

Slovak Republic (94)

Czech Republic (98)*

Hungary (96-98)

Turkey (98)

Latvia (96)

Romania (93)

Bulgaria (93-96)

Chemicals

Food, beverage and
tobacco

Machinery and
transport equipment

Textiles and clothes

Other manufacturing

reference year
of the data

0%

20%

40%

60%

80%

100%

percentage of
value-added in
manufacturing

Note: For the Czech Republic data for tobacco, petroleum, pottery, china
         and earthware are not available and therefore not included

Source: Compiled from Eurostat (2001) (b), p.350, UNIDO (2001), and World Bank (2000)

In Cyprus, Poland, Latvia, Romania and Bulgaria, the food, beverage and tobacco sector plays an
important role in the PAC economies. Compared to the EU-15, Bulgaria, Cyprus, and Romania have
little activity in the machinery and transport equipment sector. A closer look at this sector reveals that
the Czech Republic, Hungary, Slovakia and Slovenia have benefited from the investment of foreign
car-makers  that  produce  for  export  to  the  EU45.  In  Hungary,  Slovakia  and  Slovenia,  cars  are

for the Romanian and European market) to greenfield investments (e.g. Saint-Gobain's 90 million
Euro investment into a state-of-the-art flat glass plant in Poland) (see ERT (1999), pp.37).
45 See Eurostat (2001) (c), p.2

41

                                                                                                                                                      
assembled from imported parts and exported to the EU. In Latvia and Bulgaria the chemical industry
is under-developed as a source of value-added.

Because  of  their  relatively  low  wage  levels,  most  of  the  PACs  have  advantages  in  the  labour-
intensive textiles and clothes sector, especially with  regard to clothing  and accessories. Malta  and
Romania are specialised in footwear.

Within  the  other  manufacturing  sectors,  Malta  has  a  strong  focus  on  electronic  products  and
produces professional, scientific and controlling instruments46. Estonia and Hungary are specialised
in  telecommunications  equipment47.  In  Hungary  there  is  also  considerable  activity  in  office
machinery and power generating machinery and equipment. Estonia, Poland, Romania and Slovenia
have  developed  strong  furniture  sectors,  and  Latvia  cork  and  wood  manufacturers.  Slovakia  and
Bulgaria have considerable industry for metal products, especially for iron and steel manufactured
goods. Bulgaria is also strong in non-ferrous metal goods.

The  composition  of  the  manufacturing  value  added  is  the  result  of  the  inherited  structures  and
traditional  strengths  blended  with  upcoming  strengths  in  new  sectors.  However,  for  the  industrial
structures  to  approach  those  of  the  EU-15  countries,  most  PACs  will  have  to  move  further  away
from  the  labour-intensive  production  to  higher  value-added  sectors48.  In  fact,  a  polarisation  of
industry  structures  between  different  groups  of  PACs  is  emerging.  Cyprus,  the  Czech  Republic,
Hungary,  Malta,  Slovenia  and,  to  a  lesser  degree,  Poland  and  Slovakia  have  become  much  more
oriented towards technology and skill-intensive branches and been able to reduce their dependency
on energy and labour-intensive sectors49.  In the other  PACs,  especially  in  Bulgaria  and  Romania,
deficiencies in technology and skills have become further pronounced, resulting in a concentration
on low-skill labour-intensive sectors.

The  strongest  productivity  improvements  generally  accrue  to  the  technologically  intensive
machinery  and  equipment  sectors.  This  has  lead  to  a  characteristic  pattern  of  labour  productivity
gains in the more advanced countries.  Figure 12 shows manufacturing labour productivity compared
to  the  EU-15  in  1992  or  1993  (horizontal  bar)  and  the  labour  productivity  advances  in  different
manufacturing sectors of these countries since then (vertical bars). The horizontal bars thus show the
base level the country started from in the manufacturing sector as a whole, while the vertical bars
reveal the relative productivity improvements in the sub sectors.

46 See CIA (2001)
47 See Eurostat (2001) (c), p.2
48 See ERT (2001), p.27
49 See WIIW (2001), p.2-12

42

                                                     
Figure 12: Labour productivity changes in manufacturing in some PACs from 1992(3) to 1999

160

140

120

100

80

60

40

20

0

Total

Food

Textiles

Non metallic
products

Base &
fabricated
metal products
Machinery &
equipment
n.e.c.
relative to EU-
15 since 1992
or 1993

*
a
i
r
a
g
u
B

l

h
c
e
z
C

*
c
i
l

b
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e
R

*
a
i
n
o
t
s
E

*
a
i
v
t
a
L

*
*
y
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a
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*
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a
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t
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*
*
d
n
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*
*
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*
a
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o
S

l

*
a
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n
e
v
o
S

l

* since 1993
** since 1992

Source: Compiled from IMF (2001), p.16 and OECD (2001)

In  Latvia  and  Lithuania  labour  productivity  improvements  in  the  technically  more  advanced
manufacturing  sectors  were  not  sufficient  to  lead  to  overall  productivity  growth.  In  these  two
countries, restructuring in the food, textile and non-metallic products sectors also does not seem to
have gone far enough. These are indications that Latvia’s and Lithuania’s manufacturing sectors are
not yet sufficiently developed to become a basis for future growth.

A  second  group  of  countries  presents  modest  overall  productivity  gains.  Romania,  Slovakia  and
Slovenia  were  able  to  translate  industrial  reform  into  productivity  growth.  Unlike  these  countries,
Bulgaria, coming from  the lowest  manufacturing  productivity  level,  has  not  been  able  to  produce
significant  productivity  gains  in  the  machinery  and  equipment  sector.  This  might  explain  why
Bulgaria  is  considerably  behind  in  technological  development  and  is  thus  losing  out  in  terms  of
competitive advantage.

The  Czech  Republic  and  Estonia  show  medium  overall  productivity  growth.  Estonia  relies  on  its
gains in the textiles, plastics and metal products sectors. The Czech Republic benefits from strong
productivity advances in the machinery and equipment sector, a traditional strength of this country.

The  only  country  without  productivity  losses  in  any  manufacturing  sector  is  Hungary,  which
managed  a  very  high  overall  productivity  growth.  This  reflects  the  country's  good  competitive
situation not only in comparison to other PACs, but also at the international level.

43

Manufacturing  of  electric,  optical  and  transport  equipment  has  been  the  clearest  source  of
productivity growth in almost all the PACs during the last 8 years50. In countries such as the Czech
Republic, Hungary, Poland and Slovenia the engagement of Western car manufacturers has played
an important role51. Their investments were motivated by low relative labour costs and the growth
potential the local markets. In the Baltic States and the Czech Republic the rubber and plastics, non-
metallic mineral products and the basic and fabricated metals sectors also showed high productivity
growth. It is a characteristic of these sectors that productivity growth has been quicker than labour
cost growth, indicating that companies were able to increase cost advantages over time and gain a
favourable competitive position on the longer-run52.

In international comparison, manufacturing labour productivity in the PACs  is considerably lower
than  in  Germany.  A  branch-specific  unit  value  ratio  comparison  showed  that  Hungarian
manufacturing industry labour productivity was about 41 % of the German level in 199653. For the
Czech  Republic,  it  was  37  %,  and  for  Poland  34  %.  However,  there  were  considerable  sectoral
differences. In Hungary, manufacturing  industry labour productivity reached 62 % of the German
level in the electrical equipment sector and 91 % in the transport equipment sector. In Poland, the
rubber  and  plastics  sector  reached  82  %  of  the  German  labour  productivity.  In  textiles,  leather
manufacturing  and  coke  and  refined  petroleum  products,  the  productivity  gaps  to  Germany  were
very pronounced for these three PACs.

Where competitive advantages have been achieved, the sectors concerned have shifted from being
low value-added labour-intensive producers to high value-added knowledge or technology-intensive
producers. This generates exports that  produce an inflow of foreign  exchange,  creating  a  virtuous
cycle of further technology investment and rejuvenating industrial structures, which in turn further
enhance  companies’  competitive  advantage.  As  shown  in  the  following  figure,  high  value-added
goods already form an important share of exports in some countries.

Figure 13: High value-added goods as a proportion of exports (in %)

70%

60%

50%

40%

30%

20%

10%

0%

y
r
a
g
n
u
H

k
a
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o
S

l

c

i
l

b
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p
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R

h
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e
z
C

c

i
l

b
u
p
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R

a
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o
S

l

i

a
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o
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E

d
n
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P

a
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a
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r
a
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B

l

a
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n
a
m
o
R

a

i
v
t
a
L

50 See Havlik (2001), p.12
51 See ERT (1999), pp. 38
52 See Havlik (2001), p.26
53 See Monnikhof and van Ark (2000)

44

                                                     
Source: ERT (2001), p.28 (based on Smith (2000))

Hungary,  Slovakia,  the  Czech  Republic,  Slovenia,  Estonia  and,  to  a  lesser  extent  Poland,  have
already  entered  in  such  virtuous  cycles.  However,  the  high  degree  of  specialisation  in  certain
products makes the economies of the PACs vulnerable to economic shocks. The specialisation of the
manufacturing industry is significantly more pronounced in the PACs than in the EU-15, resulting in
a  much  higher  vulnerability  of  the  PACs  towards  shocks54.  In  the  PACs,  the  top  five  sectors
accounted for more than 60 % of the total manufacturing output in 1999 and only for little less of
total employment. The shares of the top five sectors (CR-555) in total output and in total employment
are presented in the figure below.

Figure 14: CR-5 in output and employment in 1999 and CR-5 changes between 1990 and 1999 for
ten PACs

120%

100%

80%

60%

40%

20%

0%

-20%

Change in CR-5
output from 90-99

Change in CR-5
employment from
90-99

CR-5 output share
in 1999

CR-5 employment
share in 1999

y
r
a
g
n
u
H

a
i
v
t
a
L

a
i
r
a
g
u
B

l

a
i
n
a
u
h
t
i
L

d
n
a
l
o
P

k
a
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o
S

l

c
i
l

b
u
p
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R

a
i
n
o
t
s
E

a
i
n
a
m
o
R

h
c
e
z
C

c
i
l

b
u
p
e
R

a
i
n
e
v
o
S

l

Source: Own compilation from WIIW (2001), p.3-6

The concentration ratios both in output and employment terms were very high in 1999. Except for
the Baltics, the changes in output concentration during the last ten years were significantly higher
than  the  changes  in  employment  concentration.  This  is  an  indication  of  significant  shifts  in  the
industrial structures and required skill patterns. Only in the Baltics, output gains went together with
employment gains in the top-five sectors. In other countries, sectoral output gains were not translated
into  employment  gains  or  even  accompanied  by  employment  reductions  (especially  in  Hungary,
Poland and the Czech Republic).

In  Hungary,  Latvia  and  Bulgaria,  the  output  share  of  the  top  five  sectors  was  higher  than  its
employment  share  in  1999.  This  indicates  that  the  top  five  sectors  in  these  countries  were  more
productive than the top five sectors in countries with a lower output share than employment share,
for example Estonia, Romania, the Czech Republic or Slovenia.

54 See WIIW (2001), p.3-5
55 CR-5 (concentration ratio 5) indicates the country's share of the five largest two-digit NACE
industries in total manufacturing or employment.

45

                                                     
In total, the changes in output concentration reveal the enormous efforts undertaken during the last
ten  years  of  transition,  which  have  lead  to  new  industrial  structures.  The  high  level  of  the
concentration ratios in absolute terms reveals that these changes will need further time for extending
themselves on the whole economy and build a broader base of industrial structures. In the meantime,
due to their output concentration, the PACs remain relatively vulnerable towards external shocks.

In total, manufacturing has become a source of growth in those countries that combine a high relative
labour productivity (as compared with the EU-15) with significant productivity gains in high value-
added  sectors.  This  has  created  competitive  advantages  and  virtuous  cycles  of  value  creation
primarily in the Czech Republic, Hungary, Slovakia and Slovenia, but also in Estonia and Poland.
Despite significant productivity improvements in Lithuania and Romania, further efforts need to be
made  to  improve  overall  labour  productivity  in  relation  to  the  EU-15.  Latvia  and  Romania  are
particularly  dependent  on  labour-intensive  manufacturing,  and  a  source  of  concern  in  Latvia,
Lithuania, Romania and Bulgaria is the dependency on labour-intensive production. In Bulgaria, the
productivity gains reached in manufacturing over the last seven years, and the weakness of the sector
compared to the EU-15, suggest that the manufacturing sector still faces serious obstacles.

Developments in the consumer goods manufacturing sector are characterized by mature demand
for many products, slim margins and strong competition. The low wages and the outlook for growth
in future local demand have attracted a considerable amount of FDI, especially in tobacco, detergents
and consumer electronics56. Foreign companies have been able to establish leading market positions
in  these  areas.  In  many  other  product  categories,  local  companies  could  enhance  their  production
capacity and market positions significantly given the fact that their products are well suited to low
local incomes and local consumer patterns. For both the bigger local and the international companies
rising  wages  in  the  more  developed  PACs  are  starting  to  pose  a  problem.  Some  companies  have
started  to  examine  relocating  to  areas  with  even  lower  manufacturing  costs.  However,  access  to
national markets and  expected income growth are factors  militating  against  relocation.  The  future
structure of the consumer goods sector will be determined by location decisions.

The  last  ten  years  have  seen  a  complete  transformation  of  the  retail  sector  and  rapid  growth.
However, the regulatory environment has not kept up with the development of the sector, especially
with regard to food safety or against counterfeiting of branded products57. The relative maturity of
the sector now means that further potential is limited. Retail margins are expected to shrink as the
market  players  have  to  take  a  stronger  consumer  perspective.  This  is  likely  to  lead  to  further
consolidation. Local businesses might have to seek alliances with other partners or go for regional
expansion to cope with the increasing capital intensity of the sector.

In the utility sector rising energy prices and technological progress have forced governments to seek
cooperation with western companies and attract foreign investment58. Indirect subsidies and prices
set below cost by regulatory control still remain the biggest obstacles to the reform of the sector in

56 Some examples include the acquisition of the Hungarian cigarette firm Pecs by BAT, Philips'
engagement in Hungary, where it now employs over 8000 people, the Profilo group share in the
Lithuanian colour picture tube company Ekranas, or Unilever's acquisition of the Romanian
detergent manufacturer DERO (see ERT (1999), pp.32).
57 See Ambler et al. (2000)
58 For large Western companies, the opening up of the PACs has started to provide opportunities
for international growth away from the mature home markets. Their entry creates a rapid transfer of
environmental know-how and technologies and the possibility of large-scale infrastructure
investments. The Suez Lyonnaise des Eaux group's has established Joint Ventures and long-term
co-operation agreements with municipalities and companies in the Czech Republic and Hungary.
Veba's cooperation with Latvia's Latvenergo has lead to the construction of wind energy converters
(see ERT(1999), pp.44).

46

                                                     
most PACs.  Artificially  low energy  costs lead to  wasteful use  of energy,  which affects the  whole
economy. The EU enlargement process will have significant impacts on the utilities sector, fostering
further  reforms,  encouraging  greater  emphasis  on  environmental  considerations  and  forcing  more
efficient energy use through energy prices that reflect more closely costs. However, due to the high
government  stakes  in  the  sector  and  the  strategic  importance  some  governments  assign  to  it,  the
reform process might meet obstacles.

The media and entertainment sector in the Czech Republic, Hungary and Poland has experienced
high growth rates from a  small base,  partly  enabled by  a  regulation  that  has  not  restricted  certain
contents. Significant local businesses have emerged but have not become international players due to
low local incomes. Poland has attracted foreign investment due to its large population, and the Czech
Republic and Hungary due to the expectation of rapid economic growth59. However, the PACs are
not seen as critical markets on the international media scene, where North American and European
giants fight for dominance in key media. For the local businesses, development is linked to income
growth within their cultural and linguistic area of coverage.

By  making  large  investments  into  high  technology  infrastructure,  international  companies  took
important  stakes  in  the  national  telecommunication  operators.  Mobile  phone  penetration  has
increased significantly in recent years, but is still lower than in the EU-15 because of the high tariff-
income  ratio.  Despite  the  marked  rate  of  improvements,  the  shortcomings  in  both  the  ‘soft’  and
‘hard’  telecommunications  infrastructure  still  limits  growth  opportunities.  By  how  far  the
telecommunication operators will be able to exploit productivity and competitiveness improvements
will  be  determined  by  the  development  of  the  "new  economy",  which  is  based  on  the  use  of
telecommunications. On their way they will struggle for control of the mobile phone and the Internet
access  markets.  In  addition,  companies  will  have  to  prepare  for  competition  in  the  enlarged  EU
market, which will lead to further consolidation.

Foreign banks entered the financial services sector early and made Central and Eastern Europe one
of the most intensively banked markets in the world. Bank privatisation is regarded as completed in
the  Czech  Republic,  Estonia,  Hungary  and  Latvia60.  It  has  made  progress  in  Lithuania,  Poland,
Romania  and Slovakia, but lags considerably  behind  in Slovenia. The  more  dynamic  the  banking
reform policies have been and the more a country had opened towards the participation of foreign
banks the more the financial sector has since contributed to the development of other sectors of the
economy61.  However,  this  has  led  to  a  predominance  of  foreign  banks  in  the  Czech  Republic,
Hungary  and  Poland.  Further  consolidation  in  the  financial  services  sector  due  to  service-related
competition  and the need for cost-reduction is  expected. However, financial  intermediation is still
weak, with negative effects on  financing investment  and  the  private  sector  especially  in  Bulgaria,
Lithuania and Romania. The European Commission's progress report points out that the supervision
of  the  financial  intermediaries  should  be  improved62.  Reform  of  the  pensions  system  and  the
broadening  of  the  customer  base  will  open  up  new  opportunities  in  retail  banking.  In  corporate
banking, banks will have to focus increasingly on the SME segment, given the fact that  the large
corporate segment is already well developed. A decision on when some of the PACs will be able to
join European  Monetary  Union  (EMU) would speed-up the development of the financial  services

59 One example is Bertelsmann's investment in these three countries, where it started book club
businesses in 1991 (the Czech Republic and Hungary) and in 1993 (Poland). These investments
were on a relatively small scale, but have become profitable quickly. They are seen as an
experience that builds a potential for expanding into other group activities in the future (see ERT
(1999), p.35).
60 See European Commission (2001), p.9
61 See Ambler et al. (2000)
62 See European Commission (2001), p.10

47

                                                     
sector. Banks are expected to further restructure through greater use of information technologies, to
prepare for further consolidation and to find new ways to address local customers and companies.

The electronic business sector has not been able to develop very far as yet. The limited use of PCs,
in particular in firms, the low telephone and internet penetration, the high internet access costs at the
local level, the absence of local language Internet content, the lack of a supportive soft infrastructure,
and the limited use of electronic payment methods hamper the expansion of the sector. Obstacles like
a more developed and better-valued customer service, comprehensive legal customer protection for
electronic business transactions, and the development of the distribution infrastructure will have to
be  overcome63.  For  local  companies  it  will  be  important  not  to  miss  the  opportunities  created  by
electronic  commerce.  Even  the  more  advanced  companies  will  be  forced  to  revamp  their  internal
structures and develop the technological and organisational expertise that enables them to compete
over the Internet.

2.6. Business activity and entrepreneurship

As  a  result  of  economic  liberalisation  and  privatisation  since  1989  the  PACs  have  seen  a  very
dynamic development in their private sectors. The private share in output today ranges from nearly
60% in Slovenia to over 80% in Hungary and the Czech Republic. These figures might overestimate
the real shares because the whole output of companies that are only partly privatised or that have just
been set up for privatisation is included in the private sector.

Whereas most PACs proceeded rather rapidly with the privatisation of the multitude of small firms
in the trade and services sectors – where the reputation of the managers and the interest of potential
stakeholders  were  so  diminished  after  the  breakdown  of  the  communist  system  that  they  had  no
power  to  stop  the  privatisation  –  the  sale  of  large  state-owned  enterprises  has  been  more
troublesome.  This  concerns  for  instance  the  privatisation  in  the  areas  of  steel,  agriculture,  energy
supply  and  telecommunications.  The  mistakes  that  were  made  are  now  generally  recognised  and
debated in the pre-accession countries. Serious attempts are made to clear the situation and make the
whole process more transparent. Although a consensus is developing on the importance of choosing
the  right  corporate  governance  model  for  the  privatised  company,  there  is  less  agreement  on  the
extent and the pace of privatisation in the candidate countries.

The issue of privatisation needs to be put in perspective here. Green-field investments and business
start-ups generally have a much greater positive impact in terms of employment than privatisation as
such.  Many of the better trained and highly skilled choose not to be employed by formerly state-
owned  companies,  not  even  when  they  have  been  privatised  completely.    Self-employment  and
employment in foreign-owned companies has been more appealing and has generated high earnings
for those that have been fast to adapt to the new circumstances.

Up to the mid-1990s a huge number of new enterprises were created in the candidate countries, but
primarily  as  one-man  businesses.  With  regard  to  employment  the  restructuring  of  existing
enterprises, including spin-offs and changes in their legal position, still has had a much more sizeable
impact. Genuinely new firms are generally much smaller than those emerging from restructuring and
privatisation.  The  study  also  highlights  important  differences  between  the  central  European
candidate countries in attracting and hosting companies that have affiliates in several other countries.
Slovenia has the highest ratio of parent companies to affiliates of international companies located in
the country. The Czech Republic has attracted a considerable share of parent companies located in

63 This includes the postal code system and lower postal fees.

48

                                                     
central and eastern Europe as well, as a consequence of its rigorous privatisation policy early on, but
has not been able to maintain a high ratio of domestically owned companies of that type. As in the
other candidate countries, which with the exception of Turkey have even lower ratios, this might be
an indication of future problems to generate indigenous growth.

2.6.1. The role of trans-national corporations

Trans-national corporations (TNCs) play a vital role in the structure of an economy. They channel
investments, attract customers and suppliers, stabilise and open the national economy. They are thus
one factor of growth and innovation. Being able to create, attract and retain trans-national companies
produces national competitive advantage towards other countries.

While FDI flows vary from year to year, the presence of TNCs points at longer-term structures of
economic activity and company networks. They can also give a hint about the relative attractiveness
of their country of origin towards engagements in other countries. TNCs account for a large share in
world trade. Especially in technology and skill-intensive industries, they set-up integrated production
systems across countries in order to benefit from specialisation by technology level and labour cost,
source national resources and resource-based manufacturers, and relocate labour-intensive activities
to  low-wage  countries64.  For  their  country  of  origin,  the  presence  of  TNCs  raises  export
opportunities,  provides  access  to  missing  skills  and  resources,  produces  positive  effects  on
competitiveness,  and  creates  value,  because  the  high-value  added  activities  are  generally
concentrated in  the  country of  origin. The presence of  TNC  headquarters  within  an  economy  can
therefore be interpreted as an indicator of the level of development of the economy and its ability to
create value.

The  presence  of  TNC  affiliates  strengthens  a  country's  access  to  international  markets,  induces
technology  and  skill  transfer,  and  improves  the  access  to  foreign  capital.  The  presence  of  TNC
affiliates is therefore generally perceived as positive, although the impacts are highly dependant on
the skills and structures present and the openness and flexibility of the local economy. The presence
of TNC affiliates can therefore be interpreted as an indicator of the attractiveness of an economy in
the  eyes  of  foreign  investors  and  a  mirror  of  their  longer  term  expectations  and  willingness  to
contribute.

64 See UNCTAD (2000), p.190

49

                                                     
Figure 15: Number of TNCs and TNC affiliates in selected PACs and Germany

1

Germany

Slovenia

Czech Republic

Turkey

Poland

Bulgaria

Romania

Lithuania

Estonia

Hungary

Slovak Republic

Note: Logarithmic Scale (times ten from one category to the
other)
10

100000

10000

1000

100

TNCs based
in economy

Affiliates of
foreign TNCs
located in
economy

Number of TNCs based in the

Number of TNCs based in the

Number of TNCs based in the

         Source: Compiled from UNCTAD (2000), p.11

In Slovenia, as in Germany, the number of TNCs based in the economy is comparable to the number
of affiliates of foreign TNCs, which reveals the attractiveness of Slovenia for foreign investors. The
Czech  Republic  and  Turkey  show  a  considerable  number  of  TNCs  based  in  their  economies,
whereas Poland, Bulgaria and Romania host a very small number of TNC headquarters with respect
to the size of their country. However, the extremely high number of affiliates of foreign TNCs in the
Czech Republic, Poland, Romania and Hungary is an indication that these countries have reached a
certain level of attractiveness for foreign investors. To a somewhat lesser extent this is also the case
for Lithuania, Estonia and the Slovak Republic when considering the size of the country in relation
to the number of affiliates of foreign TNCs. The low number of foreign affiliates in Turkey might be
due to the different pace of its transition and accession process.

While FDI measures the yearly investment flows and the activities of TNCs constitute a longer-term
engagement, they are both indicators of the state of and the expectations concerning the economic
advancement of a country.   The following observations can be made on the activities of TNCs65:

(cid:1)  The latest and most modern technologies are generally not transferred through licensing and joint
ventures,  but  rather  through  company  internal  technology  transfer.  However,  the  conditions
within  the  host  economy  (skills,  wages,  infrastructure,  complementarities,  etc.)  determine  the
nature of the technology transferred. This transfer is often accompanied by a transfer of advanced
management and organisational techniques.

(cid:1)  Technology  diffusion  occurs  through  spillovers  and  spin-offs.  Local  competition  and
collaboration, mobility and proximity foster the adoption of technologies introduced by TNCs or
their affiliates.

65 See UNCTAD (2000), pp.173

50

                                                     
(cid:1)  Technology generation is mainly concentrated on the country of origin of the TNC. However,
together  with  the  rising  skill  level  of  human  resources,  some  TNCs  have  allocated  technology
development capacities in developing countries.

(cid:1)  The effect on the number of employees varies. Setting-up new affiliates or expanding acquired
businesses raises employment. Sometimes, firms that would otherwise go bankrupt are acquired
and restructured by foreign investors. In other cases, the closure of inefficient activities might lead
to a reduction of employment.

(cid:1)  The  qualitative  effects  on  employment  are  generally  positive.  TNCs  and  TNC  affiliates
generally pay higher wages, offer more job security, better working conditions, and better care for
the skills of their employees.

(cid:1)  In terms of export competitiveness and trade, TNCs account for a large share of world imports
and exports. They exploit local competitive advantage through FDI, create dynamic comparative
advantages in countries with adequate education and capabilities, provide access to international
markets, and raise local linkages through local sourcing.

These effects may lead to the establishment of a "virtuous cycle" for those countries that can attract
and maintain a critical mass of TNCs and TNC affiliates. It is therefore of high importance for each
single PAC not to fall behind with respect to the other PACs and to reach this critical mass as soon as
possible. Especially those countries that have not been able to attract a number of TNCs and TNC
affiliates otherwise run the risk of falling further behind those that did develop this ability.

There are considerable differences in firm performance and competitiveness of the TNCs originating
from the PACs and their counterparts in the EU. Among the 25 largest trans-national corporations in
the Central and Eastern European countries there were 19 from six enlargement countries66. Their
assets  and  sales  per  employee  as  well  as  their  overall  average  sales  are  compared  with  the
performance of the Siemens corporation in the following figure67.

66 In 1998 by country, size and main activity: Czech Republic: Motokov a.s. (trade), Skoda Group
Plzen (diversified), Pilsner Urquell a.s. (food & beverages); Hungary: MOL Hungarian Oil and Gas
plc (petroleum and natural gas), Zalakerámia Rt. (clay products and refractory), Malev Hungarian
Airlines (air transport), TVK ltd (chemicals), Graphisoft (software); Latvia: Latvian Shipping Co.
(sea transportation); Poland: KGHM Polska Miedz S.A. (mining & quarrying), Elektrim S.A. (trade
and diversified), Budimex Capital Group (construction); Slovakia: VSZ a.s. Kosice (iron & steel),
Slovnaft a.s. (petroleum and natural gas), Matador j.s.c. (rubber and plastics); Slovenia: Gorenje
Group (domestic appliances), Adria Airways d.d. (air transport), Krka d.d. (pharmaceuticals), Petrol
d.d. (petroleum and natural gas) (compiled from UNCTAD (2000))
67 Siemens is a very large and very diversified company with world-wide activities. It seems
therefore a suitable benchmark in the framework of this cross-sector comparison.

51

                                                     
Figure 16: Key-figures of TNCs in selected PACs compared to Siemens

250

200

150

100

50

0

66000

1000

800

600

400

200

0

$
S
U
d
n
a
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s
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a
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o

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i

m
n

i
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a
p
m
o
c

r
e
p
s
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a
s

total
assets per
employee

total sales
per
employee

average
sales per
company 

h
c
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C

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i
l

b
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p
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o
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a
i
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S

l

)
s
n
e
m
e
i
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(

Source: Compiled from UNCTAD (2000)

In terms of sales per company, the TNCs based in these PACs are relatively small at international
standards. The 19 companies together have a turn-over in US$ that is one-fifth of that of Siemens
and their total workforce is 40% of that of Siemens.

The Slovenian companies show asset and sales per employee ratios that are comparable to those of
Siemens. Although they are the second smallest behind their peers in terms of total sales, it suggests
that the Slovenian companies have a competitive asset intensity and profitability.

The one company representing Latvia in this figure is characterised by a high asset intensity due to
its sector of operation. Sales are much below the asset level and are relatively small.

Asset and sales ratios per employee are falling from Hungary over Slovakia to the Czech Republic
and Poland as does the competitive position of these companies at international level. Even when the
different sectors of activity are taken into account, these companies will need further efforts in order
not  to  fall  further  behind.  They  do therefore  play  a  modest,  but  still  positive  role  for  growth  and
innovation in their countries.

The combination of figures 15 and 16 suggests that, both in terms of number and competitiveness,
Slovenia's  trans-national  companies  can  be  considered  as  a  factor  that  stabilises  and  supports  its
economy. Especially due to the adequate share of TNCs based in the economy, positive effects on
the  national  economy  can  be  expected.  The  number  of  TNCs  in  the  Czech  Republic  is  relatively
small  in  relation  to  the  size  of  the  country,  and  they  have  weaker  asset  and  sales  ratios  than  in
Slovenia.  Both  in  absolute  terms  as  in  relation  to  the  size  of  the  country,  Polish  trans-national
companies do not seem to constitute a significant factor for growth and innovation in the economy.
Reasons for this is their small number on the one hand and their backlog in asset and sales volumes
on the other.

52

 
 
 
 
 
 
 
 
 
 
 
 
2.6.2. Business start-ups

Firm creation in general has been extremely high during the last ten years in the PACs. Up to the
middle  of  the  nineties  a  huge  number  of  new  enterprises  has  been  formed,  mainly  as  one-man
businesses. Restructuring of existing companies has had its role in new firm creation, but in 1995
only  one  of  eight  start-ups  in  the  Central  and  Eastern  European  had  its  origins  in  a  previously
existing  production  unit.  Although  depending  on  the  state  of  the  privatisation  process  in  each
individual  country,  it  can  be  presumed  that  this  share  is  now  lower.  However,  genuine  new  firm
creation has only been part of changes in the enterprise system. Restructuring of existing firms, spin-
offs, take-overs, privatisation or changes in the legal form still have a larger impact on the enterprise
system as a whole than true start-ups, especially with regard to employment.  Genuinely new firms
are generally much smaller than those emerging from restructuring or privatisation.

Figure 17: Number of enterprises by size according to their method of creation in 1995

Change of legal form

Privatisation

Corporate Spin-Off

Takeover

Spin-Off of a cooperative

Genuine new  creation

All

0%

10%

20%

30%

40%

50%

60%

70%

80%

90% 100%

< 2 employees

2 to 9 employees

10 to 49 employees

> 50 employees

Source: Eurostat (1998), p.54

Starting an own business is increasingly becoming a pro-active choice of individuals that are highly
skilled and better trained and more experienced than the average population. Hungary for example
has  seen  a  large  wave  of  newly  created  firms  during  the  last  years.    Other  countries,  for  instance
Poland, have a long tradition of self-employment. The share of self-employment in total employment
is ten percent in Poland, with an additional five percent of “non-paid family workers”. This reveals
the  huge  importance  of  self-employment  for  total  employment,  which  is  even  bigger  when  the
indirect effects of job creation are taken into account. However, the jobs created are not always paid.
Especially smaller firms employ a considerable share of non-salaried staff.

53

Figure 18: Age of enterprises by country in 1995

Poland

Czech Republic

Slovakia

Slovenia

Bulgaria

Hungary

Estonia

Rom ania

Latvia

Lithuania

All

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

< 2 years

2 to 3 years 

4 to 5 years

6 to 10 years

> 10 years

Source: Eurostat (1998), p.54

Two groups of countries can be distinguished on the basis of this statistics reflecting the situation in
1995. All PACs show a very high share of young firms with the biggest firm creation wave around
1993. In Poland, Slovenia and Hungary, more than one fifth of the enterprises were already existing
before  the  reform  process  started.  This  indicates  that  these  countries  were  able  to  preserve  a
considerable  part  of  their  existing  enterprise  structures.  As  shown  in  the  following  figure  the
conservation  of  the  industrial  base  has  gone  along  with  a  considerable  increase  in  productivity,
especially in the case of Hungary  and Poland. It should be  noted  that  a  well  developed  industrial
sector is a main support for the economy as a whole and the service sector in particular.

Figure 19: Industrial production (except construction) in the PACs (without Bulgaria)

Hungary

Poland

Estonia

Slovakia

Czech
Republic

Slovenia

Lithuania

Latvia

Rom ania

180

160

140

120

100

80

60

1997

1998

1999

2000

Source: OECD (2001)

54

The other countries experienced a more radical rejuvenation of their enterprise system. In Romania
the rejuvenation of the enterprise system has not yet led to significant improvements compared to the
situation in 1995.

The  reasons  for  creating  one’s  own  firm  in  the  PACs  differ  from  those  in  the  EU-15,  which  can
count on a stable economic and legal environment. Difficult economic conditions, the reduction of
state subsidies and relatively low income levels have motivated individuals to create new firms.

Table 5: Motives for starting an own company

Push factors

Pull factors

Small firm in general

Academic Spin-Off

(cid:1)  Unemployment
(cid:1)  Labour market uncertainty
(cid:1)  Low and inadequate salaries

(cid:1) 

Imbalances of demand and
supply

(cid:1)  Market opportunities
(cid:1)  Opportunities from

privatisation

(cid:1)  Falling public expenditure
(cid:1)  Loss of former partners
(cid:1)  Restructuring
(cid:1)  No demand for research
(cid:1)  Opportunity to defend human

capacity

(cid:1)  New foreign and domestic

partners

(cid:1)  Exploitation of expertise
(cid:1)  Demand for advice and

consultancy

The  results  of  firm  creation  show  a  similar  pattern  to  the  reasons  they  were  created  for,  and
especially lack the element of inducing technological change or developing own technologies. While
small firms in many cases create considerable earnings for their owners, they stay concentrated on
income generation and do not produce a technology-push. Academic spin-offs, which are the most
important  technology  push  factor  in  many  advanced  countries,  are  lacking  an  orientation  on
technology and growth in the candidate countries and are focusing on consultancy and knowledge
dissemination.

There  are  technology  gaps  and  a  very  low  degree  of  generating  “indigenous”  technologies  in  the
candidate  countries.    The  current  forms  of  entrepreneurial  activity  do  not  seem  to  remedy  these
deficiencies in the medium term. In addition, barriers for the entry of new firms are still high and an
encouraging  “passive” environment as well as the pursuit of “active” policies for firm creation are
missing.

2.6.3. Venture capital

Venture capital is a funding source for companies at high-risk stages of development, like seed, start-
up, expansion or buy-out phases. In the US and increasingly in the EU-15 it is an important source of
capital for new firm creation and expansion especially for innovative firms. The presence and use of
venture capital is an important indicator of a country's attitude towards innovation.

Venture capital investment in the PACs  has been very  little at international measures.  Data is not
available for all countries, but in the four major countries Poland, the Czech Republic, Hungary and
Slovakia, 227 million U$ have been invested in 1999. This corresponds to two thirds of the venture
capital investment in Norway or 1.8% of the investment in the UK in 1999. 424 million U$ have
been raised in these four countries in 1999, almost twice the amount of venture capital being invested
there. This points to a lack of investment opportunities in the venture capital sector in the four PACs

55

investigated.  Almost  half  of  the  amount  invested  in  these  countries  went  into  high-technology
investments with IT, telecommunications and media being the most important sectors.

The following figure presents the stage of venture capital investment in Poland, the Czech Republic,
Hungary and Slovakia in 1999 compared to 1998. It has to be taken into account that the data are
highly volatile. Between 1998 and 1999, venture capital raised by half in Poland to 180 million U$,
by the same percentage in the Czech Republic to 31 million U$ and plummeted by 80% to 8 million
U$ in Hungary. Venture capital is highly sensitive towards the framework conditions in general and
the availability of ventures that stand a risk-benefit assessment at international level in particular.

Figure  20:  Stage  of  venture  capital  investments  in  Poland,  the  Czech  Republic,  Hungary  and
Slovakia

186 million U$

224 million U$

29840 million U$

100%

80%

60%

40%

20%

0%

Buy-out

Replacem ent
Capital

Expansion

Start-up

Seed

1998

1999

Europe

Source: Compiled from Ritchie and Arundale (2000), p.10 and evca (2000), p.1

Compared  to  the  European  average,  a  smaller  amount  was  dedicated  to  the  generation  of  new
ventures (seed and start-up investments) and to the change of ownership of existing businesses (buy-
out). A much higher percentage went into expansion financing, which concerns existing businesses.
Although  these  differences  should  not  be  over-interpreted  and  considerable  annual  changes  are
possible  due  to  the  relatively  little  total  volume,  this  suggests  that  venture  capital  in  Poland,  the
Czech Republic, Hungary and Slovakia was directed mainly to existing businesses. It did not seem to
have a large impact on firm generation or ownership changes.

2.7. Intellectual property rights

The panel looked at patent application data as a proxy for the output of local innovation activities.
They  are  available  for  relatively  long  periods  of  time  and  they  usually  allow  for  a  split  between
domestic  and  foreign  applicants.  Some  of  the  results  for  the  candidate  countries  will  be  sketched
below.  To  dispel  one  of  the  popular  images  of  innovative  activity  immediately:  most  patent
applications are typically made by the research departments of an international company, and not by
a single inventor. To show that innovation is not a minor activity: the European Patent Office (a self-
financing  co-operative  body  of  several  European  countries,  including  all  EU  member  states  and

56

Turkey,  with offices  in  Munich,  The Hague, Berlin and  Vienna and about 4,700  staff)  received  a
total of 113,400  applications  in 1998.  In addition there  are  national  patent offices with amazingly
different approval rates: France grants some 90% of all applications, against only 35% in Germany.

Patents  have  the  double  function  of  providing  incentives  to  innovate  and  making  knowledge
available  to  outsiders.  Foreign  companies  exporting  to  a  country  have  an  interest  to  register
intellectual property rights in order to secure and if possible protect a piece of the market. Gaining
monopolistic power is usually not the main motive, although some kind of temporary monopoly or
first-mover rents may be regarded as a pay off for the efforts to go for patent applications in smaller
countries.

2.7.1. The economics of patenting

In the technology gap model68 the production of new  commodities is not  so much  determined by
absolute or relative cost advantages but by technological advancement.  Technology-rich countries
will  specialise  in  technology-intensive  products  and  technologically  less-developed  countries  in
traditional products.  The central and eastern European candidate countries traditionally had a strong
basis in research and development within the Soviet bloc, but with the fall of the iron curtain this
situation changed.  There is a technological gap between the candidate countries and the EU member
states69  and  it  needs  to  be  investigated  to  what  extent  this  affects  their  economic  development,
looking at the role and importance of local innovation, at the technology content of trade and at the
technological dependency of the candidate countries on the West.

Empirical  studies  are  usually  based  on  patent  application  and  grant  data  as  an  output  measure  of
innovation.  The  analysis  below  uses  patent  applications  (respectively  grants)  in  the  candidate
countries (filed at national offices), international ones with denominations in candidate countries and
grants with the US Patent and Trademark Office.  Patent data are available for relatively long periods
of time and they provide very detailed information such as company data and industrial sector data
which  can  be  attributed  to  national  innovative  activity  of  certain  countries.    However,  there  are
pitfalls in the use of patent applications or grants as an indicator of economic activity.

First of all, not all inventions that are economically exploitable are patented, or even suited to be filed
for  patenting.70    Some  companies  frequently  consider  secrecy  as  a  more  appropriate  tool  for
protection,  especially  where  product  life  cycles  are  relatively  short,  as  they  are  in  computer
industries.71  Patents are used to protect inventions, but also in strategic ways e.g. in order to hinder
competitors  from  accessing  markets  or  to  mislead  them.72    It  also  needs  to  be  recognised  that
inventions protected by patents differ in their economic value.  There are very few real breakthrough
inventions.73  Finally, not only technological  but also  organisational  aspects need to be taken into
account.

Granting quotes differ a lot between national offices. National grants bear the risk of distortion, when
national authorities discriminate between foreign and local applications, whereas foreign applications
usually  indicate  a  higher  market  value  from  the  point  of  view  of  the  applicant  who  is  willing  to
tolerate higher costs and more extensive administrative procedures.

68 Posner, 1961.
69 For instance, see Thumm, 1999.
70 For example, European software products fall under copyright law.
71 Secrecy allows firms to make full use of first mover advantage, whereas it takes 3 to 4 years
before full protection by patent is awarded.
72 Thumm, 2001
73 Griliches, 1990.

57

                                                     
For  patent  information,  three  different  data  sources  are  relevant,  national  data  (applications  and
grants  through  national  patent  offices,  including  the  United  States  Patent  and  Trademark  Office,
representing  the  largest  national  market)  world  wide  data  of  Paris  Convention  Treaty  (PCT)
applications  (granted  through  the  World  Intellectual  Property  Organisation  (WIPO)),  and  finally
regional  cross  country  data  such  as  the  European  patent  granted  at  the  European  Patent  Office
(EPO).  The US foreign patents measure primarily commercially relevant technological effort at the
world frontier.  US patents measure only a minor part of the technological efforts of countries such
as the PACs.

On a microeconomic level, intellectual property rights promise to fulfil a double growth promoting
function by providing the right incentive  structure  to  innovate  on  the  one  hand  and  by  distributing
technological knowledge across countries and industries on the other.  Exporting companies tend to
base their decision to export on the existence of a system of intellectual property protection abroad,
and on the adequate strength of these rights and their enforcement.

In analysing the trade-relation of intellectual property rights two counteracting microeconomic effects
are relevant, the “market-power”  effect and the “market-expansion” effect.74 Stronger protection of
intellectual  property  in  PACs’  domestic  markets  can  reduce  the  elasticity  of  demand  faced  by  the
importer, by providing the company with a type of monopolistic  market  power,75 and  thus induces
companies’ imports into the relevant market (“market-power” effect). The “market-expansion” effect
however,  increases  demand  for  the  foreign  importer  when  he  is  conquering  new  markets,  thus,  it
raises his sales as a consequence. Both effects can be related to the size of the country. The market-
power effect is expected to be stronger for smaller countries whereas the market-expansion effect is,
by definition, stronger for larger countries.

Another important aspect for PACs is the relationship between intellectual property rights within these
countries and the local demand for certain technologies. What are the technological needs, where are
the technology gaps within the PACs and does the provision of intellectual property right protection
correspond  adequately  to  technological  needs?  Companies  from  countries  with  less  effective
protection may have a tendency themselves to search for more protection abroad. This is one reason
why it is important to analyse also the patterns of patenting outside of PACs.

2.7.2. The diffusion of knowledge through FDI and trade

The differences in productivity and the size of the technological gap between countries determine the
„catching-up“  process  of  less  developed  economies  to  market  leaders.  This  gap  determines  the
velocity of the process of convergence. The larger the gap, the higher the speed of convergence. Thus,
less developed economies have a higher potential for rapid growth to catch-up and their potential for
growth decreases, as they converge on the leaders. Abramovitz (1986) argues in a historical review
that it is not only a gap of technological performance between different countries which explains the
differences  in  economic  growth  but  also  an  element  which  he  calls  “social  capability“.76    This

74 Maskus and Penubarti, 1995.
75 It is a great misconception of economic theory to perceive that intellectual property rights provide
pure monopolistic market power. According to Rapp and Rozek the idea of monopoly power fails in
practice. At least for pharmaceutical industries intellectual property rights may not mean more than
„foothold access to well-populated, competitive markets which permit sellers to do no more than
charge competitive prices and earn competitive returns, including the returns to innovation“.Rapp,
R.; Rozek, R. (1990): Benefits and Costs of Intellectual Property Protection in Developing
Countries. in: Journal of World Trade Law 24:2, p. 101.
76 Examples are the shift of technological leadership from the UK to the US in the early 20th century
and the rapid post-war growth of western European economies.

58

                                                     
includes  the  countries’  educational  level  as  well  as  its  existing  institutional  arrangements  and  its
degree  of  openness  to  competition.  Convergence  in  growth  between  economies  takes  place  only
where less developed economies are technologically backward but socially advanced.  Therefore it is
both,  the  breadth  of  the  technological  gap  and  social  capabilities  which  determine  „a  country’s
potentiality for productivity advance by the way of catch-up“.  Nevertheless, the real level of catching-
up  also  strongly  depends  on  international  channels  of  diffusion  of  knowledge,  such  as  technical
communication,  multinational  corporations,  the  state  of  international  trade  and  direct  foreign
investment. Intellectual property rights have to be considered in this respect both as part of the social
capacity, because they, in turn, are part of domestic national innovation systems and as such constitute
the  local  attractiveness  for  investment  in  innovation.  But  they  are  also  an  important  means  of
technological knowledge diffusion at an international level.

Following the theoretical findings of Taylor (1994), Currie, Levine et al (1996) and Maskus (2000),
international intellectual property rights appear to be deeply related to foreign direct investment and
trade.  However,  these  macroeconomic  relationships  are  hard  to  distinguish  from  the  question  of
adequate  incentive  structures  at  a  microeconomic  level.    Firms  are  still  the  economic  actors,  who
decide whether investment conditions are favourable or not somewhere abroad.  Various factors, such
as different levels of labour skills and different technological capabilities, can override the influence of
intellectual property rights on foreign direct investment.77  Due to this difficulty and due to the strong
relationship between intellectual property rights and the microeconomic incentive structure it is hard
to identify any clear macroeconomic impact on trade and foreign direct investment. Less innovative
countries  depend  on  foreign  direct  investment  and  foreign  technology  from  innovative  countries.
Thus, if they do not want to be bypassed by international technological and economic developments
and if they want to hold out against competing countries in the race for foreign direct investment they
have  to  make  their  markets  attractive,  which  among  other  things  means  a  standardised  intellectual
property right protection.

Trade requires a certain guarantee for the proprietary of traded goods. Thus the performance of trade
depends, at least partly, on property rights, which also include systems of national intellectual property
rights. Here intellectual property rights fulfil a double function, they stimulate domestic innovation on
the one hand and attract multinational companies on the other.  There is some empirical evidence,78
but the actual interactions of intellectual property rights, foreign direct investment and trade deserve
further investigation.

Patents do matter for the exports and imports of PACs.79  It could be argued that adequate in-house
protection and IPR systems are lacking, and that this is at the disadvantage of potential foreign trade
partners.  In how far this might be used as an argument for the establishment and the harmonisation of
IPR systems in central and eastern European candidate countries – there seems to be no doubt about
the need of such – is an open question.  It still remains very difficult to evaluate in how far intellectual
property right protection is an essential condition for the transfer of technology with traded goods.

2.7.3. IPR in the candidate countries

After  the  opening  of  the  “iron  curtain”  Central  and  Eastern  European  countries  became  more
important as product markets for western multinationals than they used to be formerly.  This was also
reflected in the need for the  protection of intellectual property, which is incorporated in the traded

77 Correa, 1995.
78 Mansfield, 1994.
79 Thumm, 2000.

59

                                                     
goods. The building  up of  intellectual  property  right systems  and their  harmonisation  with  western
European standards is one of the consequences of this process.

Central and eastern European countries now face a double process of alignment of their intellectual
property right systems. First, they have to establish conditions for international agreements like TRIPs
and the Paris Convention. Secondly, they are trying to standardise their countries to the EU system
and standards in order to open the doors to membership of the Union in the near future. Eight central
and eastern European candidate countries applied to join the European Patent Organisation and were
granted  an  observer  status  on  the  Administrative  Council.  On  29  January  1999  the  Administrative
Council  of  the  European  patent  office  invited  Bulgaria,  the  Czech  Republic,  Estonia,  Hungary,
Poland, Romania, Slovakia and Slovenia to accede to the European Patent Convention as from 1 July
2002.

One  aim  of  the  accession  agreements  is  to  secure  the  protection  of  intellectual,  industrial  and
commercial property at a similar level to the one of the European Union and to harmonise national
legislation with the regulations and the standards of the law binding on the members of the European
Union.  Another  option  of  patent  protection  is  the  so  called  “extension  system”  with  the  European
Patent Office, applied by Albania, Latvia, Lithuania, Romania and Slovenia which results in a patent
application with a direct effect in the country of extension so that the patent holder has no need to go
through a separate local application procedure.

With  respect  to  international  agreements,  it  is  important  to  recognise  that  all  countries  are  already
members  of  the  Patent  Co-operation  Treaty  (PCT)  and  that  the  relative  rapidity  with  which
assimilation into the international agreements has taken place since the fall of the „iron  curtain“, is
remarkable.    The  Europe  Agreements  commit  all  countries  to  respect  the  Paris  Convention,  the
Madrid Convention and the PCT.

Czech Republic

With  the  political  changes  of  the  year  1989  a  return  to  the  classical  system  of  exclusive
industrial legal protection was possible. Until the end of 1990 legal protection of inventions
could still be provided in the form of an author`s certificate or alternatively by a patent. With
the Act No 527/1990 industrial property protection in Czechoslovakia was reconstructed from
its foundation and a new Czechoslovakian patent law was established.  The law was geared
towards the European patent system and marks the beginning of a gradual harmonisation of
the legal regulations with the law of the European Community.

In  1992  the  protection  of  utility  models  was  introduced  (Law  478/1992).  The  new  Europe
Agreement on Association of the Czech Republic to the European Communities from 1993
particularly  commits  the  Czech  Republic  to  become  a  member  of  the  European  Patent
Convention (EPC).  In 1996 the Czech Republic filed a request to be allowed to accede to the
EPC.  In October 1995 a new trademark law came into force which was a further step towards
harmonisation with the European Union.

Hungary

In  the  past  Hungary  had  a  system  of  certificates  of  authorship.    It  eliminated  this  system
already in 1957 and returned to the patent system in 1969.   In 1996 Hungary applied for full
membership  of  the  European  Patent  Convention.    On  January  1  of  the  same  year  the  new
Hungarian Patent Law 9 (Law XXXIII of 1996) entered into force.

60

Poland

Also Poland applied for membership of the European Patent Organisation and in the Annexes
XIII Art 66 of the Europe Agreement commits itself to continue to develop the protection of
intellectual, industrial and commercial property rights in such a way as to achieve a similar
level of protection to that in the European Community, including comparable measures for the
assertion of such rights.

Figure 21: Number of patent applications for Hungary and the Czech Republic

5000

4500

4000

3500

3000

2500

2000

1500

1000

500

0

Hungary

Czech Republic

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

Source: Derwent World Patents Index

The  overall  trends  in  the  candidate  countries  can  be  illustrated  by  the  figures  for  the  Czech
Republic and Hungary, who with Slovenia are the frontrunners in terms of the number of patent
applications. One of the findings is that the ratio of non-resident applications to resident ones
has risen remarkably. The top 20 firms in patenting activity in Hungary and the Czech Republic
are exclusively foreign and they file mostly for patents on consumer goods, pharmaceuticals and
inventions in the area of organic chemistry.

A general picture of the structure of patent applications in a country can be obtained by looking
at  national  applications  filed  at  the  national  office  and  dividing  them  into  resident  and  non-
resident  applications.  Such  a  division  provides  two  different  kinds  of  information.  First,
assuming  that patent  applications somehow give information on  where  and  when  marketable
inventions  (innovations)  show  up,  these  data  can  demonstrate  whether  a  country  is
technologically  dependent  (technology  transfer  from  abroad  for  a  high  proportion  of  non-
resident applications) or whether it tends to be self-sufficient (for a high proportion of resident
applications  in  respect  to  foreign  ones).  The  second  kind  of  information,  which  could  be
provided by such a differentiation, is in how far the national or the international patent system is
used by foreigners and nationals, meaning the attractiveness of a national means of protection.

61

Figure 22: Dependency rates of the Czech Republic, Hungary and Poland

90

80

70

60

50

40

30

20

10

0

Hungary

Poland

1990 1991 1992 1993 1994 1995 1996 1997 1988 1999 2000

Source: Calculations based on data from national offices

This becomes in particular clear, while looking at the rate of technological dependency (figure
22).  The OECD defines the rate of technological dependency (dependency rate) as the ratio of
the  number  of  non-resident  patent  applications  divided  by  the  number  of  resident  patent
applications.

Figure 22 shows the development of the dependency rate for Hungary and Poland, for which
the  most  complete  series  of  data  are  available.  Technological  dependency  rises  for  both
countries from 1990 on.  In Poland this trend is relatively moderate in comparison to Hungary,
but the Polish dependency rate still reaches a level of 6 in 2000.  In Hungary it rises to a level of
76 at a strongly increasing trend.80

For Hungary and the Czech Republic the overall patent applications have been rising over the
last  years.  This  is  mainly  due  to  an  increase  of  the  applications  by  non-residents,  whereas
resident applications decline. The dominance of non-residents among the patent applicants can
also  be  observed  in  table  6.    There  the  top  20  firms  are  listed  according  to  their  patenting
activity in the Czech Republic and in Hungary.  All firms are foreign firms. In both countries
the first local firm stands at position 27.

80 For comparison, the dependency rates (OECD definition) of some EU member states in 1994
were: Germany, 1.58; the Netherlands, 14.17; Greece, 1463;  Portugal, 437; Spain, 26.  The
divergence already demonstrates that it is difficult to compare dependency rates between
countries.  Peculiarities of the legal system would have to be taken into consideration.

62

                                                     
Table 6: Most actively patenting firms in the Czech Republic and Hungary, ranked by number
of patent applications in 1995

Czech Republic

Hungary

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

PROCTER &
HOECHST AG
BAYER AG
LILLY & CO ELI
BASF AG
CIBA GEIGY AG
NOVARTIS AG
PFIZER INC
SIEMENS AG
MERCK
UNILEVER NV
UNILEVER PLC
AMERICAN
ASTRA AB
MERCK & CO
RHONE
CIBA GEIGY
ZENECA LTD
SANDOZ LTD
BOSCH GMBH

LILLY & CO
BAYER AG
PROCTER & GAMBLE
NOVARTIS AG
JOHNSON & JOHNSON
PFIZER INC
AMERICAN CYANAMID
CIBA GEIGY AG
HOECHST AG
BASF AG
MERCK & CO INC
MERCK PATENT GMBH
JOHNSON & JOHNSON
VISION PROD PIONEER
MERRELL DOW PHARM
MERRELL PHARM INC
BRISTOL-MYERS
AMERICAN HOME PROD
HOFFMANN LA ROCHE &
L'OREAL SA

Source: Derwent World Patents Index

Figure 23 shows the origin of the patent priority applications in the field of pharmaceuticals for
Hungary  and  the  Czech  Republic.  Most  files  originate  from  the  United  States,  in  Hungary
(56%)  more  than  in  the  Czech  Republic.  The  most  innovative  European  countries  in
pharmaceuticals  follow,  Germany,  France  and  Great  Britain.  Remarkable  is  that  Germany,
taking  its  strong  pharmaceutical  industry  into  consideration  is  underrepresented  in  Hungary
with only 3% of the applications. Hungary shows up with some local patenting activity in the
field  of  pharmaceuticals  (47  applications  out  of  780),  whereas  the  Czech  Republic's  patent
applications in the field vanish against the large domination by foreign applications (24 out of
1284).

63

Figure  23:  Patent  priority  applications  1998  in  pharmaceuticals,  in  Hungary  and  the  Czech
Republic

Hungary, 780 patent priority applications 1998 in pharmaceuticals

others
6%

DE
3%

WO
3%

AU
3%

ZA
3%

JP
3%

EP
4%

GB
5%

HU
6%

FR
8%

US
56%

Czech Republic, 1284 patent priority applications 1998 in pharmaceuticals

others
9%

AU
2%

WO
2%

SE
2%

ZA
2%

JP
4%

EP
5%

FR
6%

GB
9%

DE
10%

US
49%

Source: IC=A61K, Derwent World Patents Index

64

Figure  24:  Numbers  of  patent  grants  of  candidate  countries  at  the  United  States  Patent  and
Trademark Office

100

90

80

70

60

50

40

30

20

10

0

PL
HU
CZ
CS
RO
BG
TR
SI

90

91

92

93

94

95

96

97

98

Source: USPTO; search on Inventor Country AND application date

Note: Many inventions originate from research teams in international companies.

US patents capture only part of the technology effort in lagging economies.  Irrespective of their
size they indicate the existence of the technology effort at the world innovation frontier.  They
indicate the existence of underlying, much greater imitative technology effort or R&D.  Figures
24, 25 and 26 look at patent grants at the USPTO.  Taking into consideration that the granting
procedure  can  take  up  to  three  years,  numbers  are  only  complete  until  1998.    Numbers  for
smaller countries such as Cyprus and Malta are not considered.  Data for Czechoslovakia (CS)
are  inserted  for  the  Czech  Republic  for  the  years  before  1993.    In  Hungary  the  numbers  of
patent  grants  decreased  significantly  in  the  course  of  the  1990s,  slightly  recovering  in  1998.
Slovenia  with  only  2  million  inhabitants  shows  a  remarkable  number  of  patent  grants  at  the
USPTO.   Poland and the Czech Republic also increased their number of very important patent
grants, so that by 1998 they show a level of 40 to 50 patents, which is comparable to that of
Greece  (27).  In  comparison  with  the  1998  data  for  other  EU  countries,  such  as  Germany
(10020), Italy (1711), Belgium (812), Spain (310) and Ireland (169), these numbers are low.

65

Figure 25: Inventiveness of the candidate countries as registered at the United States Patent and
Trade Mark Office (number of patent grants per million inhabitants).

12

10

8

6

4

2

0

PL
HU
CZ
RO
BG
TR
SI

90

91

92

93

94

95

96

97

98

Source: USPTO; search on Inventor Country AND application date

The results from figure 25 confirm those from figure 24, but in proportion to the population of
the  candidate  country  concerned.  Figure  25  shows  the  inventiveness  of  PACs  defined  as  the
number of USPTO patent grants within one year per million inhabitants. Slovenia with a high
number of patent grants per inhabitants performs best, followed by Hungary and by the Czech
Republic.  With 38 million inhabitants, Poland’s “US-oriented  inventiveness” turns out to  be
comparable to that of Romania, Turkey and Bulgaria.

Figure 26: Patent grants of Hungary, Poland, Czech Republic and Slovenia in 1997 and 1998 at
the United States Patent and Trademark office

Others
22%

Consumer goods
15%

Transport
3%

Medical technology
4%

Materials processing
5%

Chemical and petrol 
industry
6%

Telecom.
6%

Analysis measurement
7%

Pharmaceuticals
14%

Organic chemistry
11%

Electrical machinery
7%

Source: USPTO; search according to OST/INPI/ISI industrial categories, defined by IPC classes

66

In Figure  24 the industrial structure of patent grants in  1997  and  1998  where  the  inventor is
from Hungary, Poland, the Czech Republic or Slovenia is demonstrated. Remarkable is the high
percentage of consumer goods in great detail (e.g. a cut stone, drinking glass stem, cup cover
etc.).  The  high percentages  of  pharmaceuticals, organic chemistry  and  the  petrol  industry  are
characteristic for the sample. These industries are the classical one of high patenting activity.
Table 7 is completing figure 26. The Czech Republic and Slovenia file most of their patents
with consumer goods. Hungary shows a clear focus on pharmaceuticals and organic chemistry.
The good performance of the Czech Republic and Slovenia in terms of inventiveness in figure
25 turns out to be based on traditional inventive activity in the field of consumer goods. From
all  countries  there  are  very  few  patent  grants  in  the  biotechnology  sector  and  in  information
technologies.

Table 7: Patent grants of Hungary, Poland, the Czech Republic and Slovenia in 1997 and 1998
at the United States Patent and Trademark Office.

Consumer goods
Pharmaceuticals
Organic chemistry
Electrical machinery
Analysis
measurement
Telecom.
Chemical and petrol
industry
Materials processing
Medical technology
Transport
Chemical engineering
Biotechnology
Info. Tech.
Agricultural
processing
Engines
Handling, printing
Thermal processes
Machine tools
Civil engineering
Audio-visual tech.
total

PL
6
10
13
2
4

2
4

1
3
2
2
2
4
4

2
3
1
1
1
67

HU
7
14
10
13
10

6
4

6
3
4
2
2
1

2
2
2

1
89

CZ
16
11
3
4
3

4
4

7
3
2

3
1

4

1
3
2
71

SI
11
2
4
0
2

3
3

3
1
4

2

1

3
1

40

total
40
37
30
19
19

15
15

14
12
9
8
7
6
6

6
5
5
5
5
4
267

The general analysis of patenting performance in the analysed countries shows that patenting
activity is more and more getting into the hands of foreigners. This is true both, evidently for the
international  ways  of  application,  but  also  for  national  patents.  The  activity  of  intellectual
property  right  performance  is  related  to  the  establishment  of  a  legal  framework.  However,
according to the pure numbers the interest in such seems to be stronger for foreigners. Thus, if
patenting  numbers  represent  somehow  technological  performance,  we  observe  an  increasing
technological  dependency  of  the  Czech  Republic,  Hungary  and  Poland  from  main  western
world industrial countries. Therefore, one major conclusion from the analysis is that means of

67

protection  from  the  new  legal  framework  are  predominantly  used  by  foreigners.  Intellectual
property rights do matter for foreigners for investments and the orientation of trade.

In how far this development is an expression of the period of transition and the right approach
for technological catching up has to be seen. In the long run foreign technology will probably
help to close technological gaps wherever they exist and thus transferred technology also should
help to build up local innovation.

There are already some inventions from PACs at the world frontier (filed at the USPTO) but
these  numbers  are  still  low  in  comparison  with  other  western  countries.  Inventive  activity  is
based on traditional industrial sectors with a focus on consumer goods. Innovative activities in
prospective fields like biotechnology and information technologies are still relatively low.

For stable long run economic growth it would be best to take care of the establishment of local
innovation processes. It is difficult to evaluate whether the establishment of patent systems in
PACs is so far a direct benefit for locals, evidently it is for multinational companies. In the long
run  the patent system  could spur the local  innovation  process. It is  in  the political  interest  to
search harmonisation with western standards of the European Union.

From  the  analysis  follows  also,  that  the  new  institutional  settings,  like  new  legislation,
regulations  and  harmonisation  efforts  do  not  spur  on  the  national  innovative  process  in  the
candidate countries themselves so far, but they facilitate the transfer of western technology there
In how far the  institution  of local innovative systems or the transfer of foreign technology is
more important for the process of transition and for long term economic growth of economies in
transition  cannot  be  answered  here  and  has  to  be  left  to  theoretical  considerations  and  future
empirical studies.

It would be very valuable for future research to investigate the role of intellectual property rights
as part of the social capacity to innovate in central and eastern European candidate countries and
to  discover  their  specific  contribution  to  the  process  of  transition.  It  would  be  interesting  to
assess  in  which  countries  and  for  what  industries  technological  gaps  exist.  The  relationship
between intellectual property protection and trade has to be analysed carefully.

Much work has to be left for future research, such as the evaluation of the market-power effect
and the market-expansion effect from stronger IPRs, the relationship of IPR and foreign direct
investment as well as the analysis of the relationship between IPR and technological needs in
the candidate countries.

On the basis of scant evidence, and awaiting further research, it is difficult to sketch in which
direction  the  developments  could  go  in  the  candidate  countries.  At  one  end  is  a  scenario  in
which foreign investors capture the new markets completely, stifling any incentives to domestic
innovation activities. At the other end is technology transfer by imitation mainly, combined with
some further revival of local efforts based on a tradition of inventive skills and activities in some
of the candidate countries.

2.8. The patterns of specialisation and trade

In an attempt to grasp the future development this section describes the pattern of production in the
candidate countries and their comparative advantages in trade. A more detailed analysis can be found

68

in a recent report to the European Commission, DG Enterprise, on the competitiveness of industry in
the central and eastern European candidate countries (WIIW, 2001).

The strengths and weaknesses of production in the present EU member states have been set out in
the Competitiveness Map that was part of the IPTS Futures project. European producers and service
providers were found to be relatively good at responding to the specific and diversified needs of their
customers;  the  most  recent  examples  being  the  application  of  new  technologies  in  mobile
communications and for medical treatment. On the demand side, however, European customers are
considered to be more reluctant to buy new technology products than their American and Japanese
counterparts. Products incorporating or associated with genetically modified organisms (GMOs) are
the most topical example, but there are other cases in which EU consumers have genuine concerns.
As  the  recent  experience  with  ICTs  has  shown,  the  best  marketing  strategies  cannot  prevent  a
technology push from reaching a saturation point at which consumers decide not to but into the latest
generation of products. The irony is that, whereas the productivity boost of ICT may have come to a
standstill, it has allowed dissatisfied customers and worried consumers to be mobilised much more
quickly  than  in the  past  and  to  taint  companies  with  a  bad  reputation.  In  general,  the  image  of  a
product, including a record of where it has been made and how, has tended to become as important
to consumers as the quality/price ratio.

Raising  the  social  and  environmental  concerns  of  consumers  in  multilateral  trade  negotiations  is
easily understood as making a case for protection. The argument is that, within generally agreed and
enforced intellectual property rights and environmental standards, what to produce and how is better
left  to  the  decisions  of  the  market  participants,  including  the  revealed  needs  and  preferences  of
consumers world-wide.  To place this in the context of EU enlargement: what is not clear is to what
extent the profile of consumer demand in the candidate countries will be different from that in the
EU member states. What is clear, however, is that the accession of new member states will add to the
existing diversity and differences of view in the Union.

2.8.1. Comparative advantages

The analysis in the recent WIIW report covers the whole manufacturing sector, disaggregated into 14
NACE  branches  at  the  two-digit  level.  In  the  most  advanced  of  the  CEEC-10  the  manufacturing
industry  has  been  able  to  recapture  its  pre-1990  position  thanks  to  active  restructuring  and
privatisation  efforts,  fostered  by  FDI  inflows.  Nevertheless,  by  2000  only  Hungary  and  Poland
produced more industrial goods than at the start of the transition period. At the bottom of the list, the
production of Bulgaria’s and Romania’s industry was still only half of what it had been in 1990.  The
decline in employment during the last decade was even more dramatic and involved a loss of ever 5
million manufacturing jobs in the 10 CECC together. During the second half of the 1990s there was
a modest increase in manufacturing employment in Hungary, but elsewhere it continued to fall, with
the possible exception of Poland in one or two years.

At the same time, the CEEC-10 increased their degree of specialisation: the top 5 branches account
for 60-70% of total manufacturing industry output.  Among the top 3 branches are food, beverages
and tobacco; transport equipment; and basic metals and fabricated metal products. Next to food and
drinks, the categories of textiles and wood products figure  high  on the  list  in  the  Baltic  candidate
countries. In terms of both production and employment, the structure of the manufacturing industry
in  the  Czech  Republic,  Hungary,  Poland,  Slovakia  and  Slovenia  is  fairly  close  to  that  in  the  EU
member states, and in particular to that in Spain, Portugal and Greece.

69

The above findings confirm that central and eastern European candidate countries  still have  some
comparative  advantages  in  labour  intensive  and  natural  resource  intensive  sectors,  as  well  as
disadvantages in capital intensive sectors.  To get an idea of possible future developments the WIIW
report  takes  a  look  at  the  productivity  improvements  per  branch  in  the  second  half  of  the  1990s.
Clear  winners  everywhere  are  electrical  and  optical  equipment,  with  transport  equipment  next,
except in Bulgaria and Estonia where the second highest productivity gains are in wood processing.

The  higher  the  productivity  gains  the  lower  the  rise  in  unit  labour  cost,  which  suggest  that  wage
earners are not fully compensated for the labour productivity gains in their sector. This is confirmed
by a comparison of the distribution of productivity gains and wage rises across the sectors. Although
the wages in high performing sectors are higher than in sectors with low  productivity growth, the
wage dispersion is less than the productivity dispersion.  It also turns out that a higher proportion of
FDI in the total investment in a branch has a clear positive impact on labour productivity, while the
rises in wages and unit labour costs are kept better under control.

Finally, the WIIW report looks at other factors that could play a role in the future development of
productivity and competitiveness in the catching-up countries, such as the quality of the workforce
and the gradual disappearance of the under-valuation of the exchange rate.  It concludes that there is
a lot to be desired in terms of the training of human resources and that the candidate countries’ own
financial means to improve the situation are scarce in view of the constraints on public finance. It
also emphasises that real exchange rate  appreciation  –  either  by  the  country’s  currency  becoming
more expensive in terms of foreign currency, or by upward adjustments of the prices of traded goods,
followed  by  upward  pressure  on  the  prices  of  not-so-much-traded  goods  –  cannot  be  avoided  or
postponed.  In  fact,  the  better  is  the  reputation  of  a  country  in  terms  of  solid  fiscal  policy  and
moderate wage setting, the faster and more predictable is the appreciation of its exchange rate. There
is some evidence that the greater certainty and predictability of exchange rate movements can act as
an  important  incentive  for  the  best  performers  under  the  exporting  firms  to  continue  to  make
productivity improvements.

The  following  table  combines  sectors  of  comparative  advantages  between  the  PACs  and  the  EU
together with areas of political priority.

70

Table 8: Comparative advantages between the PACs and the EU and political priority areas

.

p
e
R
h
c
e
z
C

+

+

+

+

-

-

-

--

y
r
a
g
n
u
H

++

+

+

--

++

-

--

Clothing

Metalworks

Wood

Coke, petrol
and energy

Furniture &
manufactd.
products

Radio, TV,
telecom and
electronics

Food and
drinks

Chemical
products

Motor vehicles
& transport

Textiles

Machinery and
Equipment

d
n
a
l
o
P

a
i
n
a
m
o
R

a
i
n
e
v
o
l
S

a
i
k
a
v
o
l
S

a
i
r
a
g
l
u
B

++

+++

++

++++

+++

++++

+++

+

+

+

-

-

-

--

++

+

--

--

+

+

+

-

--

-

-

-

---

a
i
n
a
u
h
t
i

L

++

+

++

+

a
i
v
t
a
L

a
i
n
o
t
s
E

+

+++

+++

++++

++++

--

--

-

-

-

-

-

--

trade 

the 
each
indicates  a  policy  priority

balance, 

--

-

--

to 
field 

+ 

contribution 
Note:  each 
positive 
a 
- indicates a 10-point negative contribution to the trade balance
shadowed 
Source: Compiled from CCIP (2000), p.20 and Gourova et al. (2000), Annex 1

indicates 

10-point 

a 

Although it has to be taken into account that the level of detail of official documents, from which the
policy priorities were derived is not homogeneous, the following trends can be observed:

•  A  diminishing  importance  of  the  existing  capital-intensive  industries,  especially  in  the  more

advanced economies of Poland, Slovenia and, to a lesser extent, Hungary.

•  A  continuing  specialisation  in  labour-intensive  industries  (e.g.  clothing  and  footwear),  with  the

exception of Hungary and Slovenia.

•  A  narrowing  of  the  gap  in  some  R&D-intensive  sectors  (transport  machinery,  electronic  and

electrical products) in Hungary, the Czech and Slovak Republics and Bulgaria.

•  A persistence of the large gap in skills-intensive industries, although the situation is improving in

Hungary, Bulgaria, and the Czech and Slovak Republics.

71

 
Dispersion

Low and
decreasing

Increasing

Low and
decreasing

Decreasing &
bifurcation

2.8.2. Competitive advantages

A study of the transformation of technology trade patterns in Bulgaria, the Czech Republic, Hungary,
Poland, the Slovak Republic and Slovenia has revealed trends of technological development between
1988 and 1995. The following table presents the relative competitive advantage towards the EU.

Table 9: Relative comparative advantage towards the EU in technology areas from 1988 to 1995

Embodiment

Relative comparative advantage to EU

Human
capital

Physical
capital

Base
level

Change

Technology Area

Science-based

++

Negative

Stable

Specialised
suppliers

Supplier dominated

Technology-based,
scale intensive

Resource-based,
scale intensive

+

-

-

+

-

-

+

+

Negative

Positive

(Selective)
improvement

Stable
improvement

Mixed to negative

Variation

Mixed

Declining

Decreasing

Source: Compiled from Kubielas (1998), pp.4. and pp.25

Although the data concern a relatively early period of the transition process, technological gaps, once
established, tend to persist on the longer run. Shifts in technological competitiveness at the country
level  usually  take  at  least  a  decade,  so  that  it  will  take  some  time  until  the  technological  gaps
established at the beginning  of the transition process can be at least partly leaped.  The  above table
confirms the observations of the sectoral table, whereby  the PACs  have  comparative advantages  in
labour and natural resource intensive sectors. These correspond to the supplier-dominated row in the
above table. In this technological area, the PACs have instantly adjusted upwards at the beginning of
the  transition,  but  now  show  a  kind  of  stagnation.  However,  a  trend  of  bifurcation  between  those
countries that keep with the pace of change and those that do not, especially Bulgaria and Romania,
can be observed.

The relative trade balances and export levels confirm the observations made in the previous table.

72

Table 10: Relative trade balances and export levels towards the EU technology areas from 1988 to
1995

Embodiment

Trade balances and export levels

Human
capital

Physical
capital

Trade
level

Change

Trade
volume

Technology Area

Science-based

Specialised suppliers

Supplier dominated

Technology-based,
scale intensive

Resource-based,
scale intensive

++

+

-

-

+

Large deficit

Stable

Small

Large deficit

Stable, with slight
variety

Medium

Large surplus

Variation

Large

Mixed (surpluses
and deficits)

Variation

Medium
to large

Balanced

Slightly declining

Medium

-

-

+

+

Source: Compiled from Kubielas (1998), pp.4. and pp.25

Despite of the high level of education in the PACs and the important role of basic science in the S&T
system, the science-based technology sectors show high trade deficits and low levels of trade volume.

From  this,  a  two-sided  pattern  of  the  S&T  systems  within  the  PACs  emerges.  On  the  one  hand,
technical change is quickly adopted through training, acquisition of equipment and competition. On
the other, technological learning takes place in a very limited way. Virtually all the stimuli and internal
and external feedback mechanisms for technology learning in the PACs are missing.

Table 11: Mechanisms of the Knowledge Acquisition System

Technical Change

Technological Learning

Stimuli

Short-term changes in demand,

Government policy encouraging

Competitive threats and opportunities,

innovation,

Demonstration effects

Culture and norms of social

environment,

Strategic awareness of economic trends

Knowledge
feedback

Skills and knowledge gained from

Skills and knowledge gained from

experience of production,

investment projects,

External
inputs

Interaction between producers and users

Insights gained from effecting

improvements and modifications

Training in operating skills,

Training in strategic planning, design,

Hiring skilled labour,

Technical advice services

and management of technology,

Collaboration between research and

industry,

Consultancy services

Source: After Albu (1997), p.13

73

Except  for  niche  areas,  the  PACs  therefore  face  the  problem  of  staying  technical  applicators
dependent from external technological progress for a longer period of time.

Although empirical evidence indicates that trade volumes of EU countries with other Member States
are between 20 and 60 percent higher than those with non-EU countries, it is worth noting that the
conditions of trade with the PACs already resemble those of trade with other EU Members. Thus, the
further  impact  of  accession  on  the  trade  potential  is  likely  to  be  fairly  moderate  .  The  EU  exports
goods produced with a high intensity of physical capital and high-skilled labour to the CEE countries,
and imports goods with high labour intensity from there.

Geographical proximity plays a key role in trade between the EU and the PACs. Three-quarters of all
EU  trade  with  the  PACs  is  carried  out  by  countries  immediately  bordering  them,  i.e.  by  Austria,
Germany, Greece, Italy and Finland. In these countries, the share of trade with PACs in total trade and
GDP is markedly higher than in other EU countries. Moreover, some regional trade data from Austria
and Germany indicate that, within these countries, exporters to and importers from CEE countries are
concentrated in the border regions. If the impact of trade on wages and employment can be felt at all
in the present EU, then it is in those regions.

The following figure shows the "contribution to trade balance" indicators for six sectors between the
PACs and the EU in 199981. A positive indicator reveals a comparative advantage of the respective
country in relation to the EU, while a negative indicator shows a comparative disadvantage.

81 This indicator expresses the difference between a sector's observed trade balance with a third
country and its share of the total trade of the home country. A positive indicator reveals a
comparative advantage as the country exports a mayor part of its production. A negative indicator
shows a comparative disadvantage, as the country imports a mayor proportion of a product in
order to satisfy local demand (see Eurostat (2001) (c), p.3).

74

                                                     
Figure 27: "Contribution to trade balance" indicators between the EU and the PACs for six sectors in
1999

Crude materials except
fuels

Energy

Chemical products

Manufactured goods 

Machinery and
transport equipment

Miscellaneous
manufactured articles

Poland

Czech Republic

Slovakia

Hungary

Romania

Bulgaria

Turkey

Slovenia

Estonia

Latvia

Lithuania

Malta

Cyprus

-100

-75

-50

-25

0

25

50

75

100

in 1/1000s of GDP

Source:  Compiled  from  Eurostat:  "Specialisation  of  candidate  countries  in  relation  to  EU",  Statistics  in  Focus,  6,
Luxembourg, 2001

The  analysis  of  the  sectors  in  the  above  figure  and  the  sub-sectors  (not  shown)  reveals  that  most
PACs  show  comparative  advantage  in  miscellaneous  manufactured  articles,  mainly  consisting  of
furniture,  clothing  and  footwear.  These  activities  are  generally  labour-intensive.  All  the  PACs  are
strong in clothing and accessories. Malta and Romania are specialised in footwear. Mainly Estonia,

75

Poland, Romania and Slovenia have comparative advantage in furniture. Malta is the only country
with a comparative advantage in professional, scientific and controlling instruments and apparatus.

Especially  the  Baltics  have  comparative  advantage  in  crude  materials,  except  fuels.  Estonia  and
Latvia are specialised in cork and wood. Because of their location and the presence of the necessary
infrastructure, the Baltics are traditionally intermediaries for materials coming from Russia, Belarus
and the Ukraine. They have also developed significant capacities in oil refinery.

Most  PACs,  except  for  the  Czech  Republic,  Cyprus,  Hungary  and  Slovakia,  have  comparative
disadvantages in the machinery and transport equipment sector. A closer look at this sector reveals
that the Czech Republic, Slovakia and Slovenia have comparative advantages for road vehicles due
to the investments of EU car manufacturers, who take advantage of the relatively lower labour costs
in  order  to  produce  cars  that  are  sold  in  the  EU.  Hungary  has  the  most  significant  comparative
disadvantage for road vehicles because, like in Slovakia and Slovenia, cars are assembled in these
countries  using  imported  parts82.  Slovenia  and  Malta  have  comparative  advantage  in  electrical
machinery,  and  Malta  especially  for  electronic  products,  which  accounted  for  about  half  of  its
exports in 1999. Estonia is manufacturing and assembling telecommunications equipment for high-
tech Scandinavian and Western firms. Hungary stands out with its comparative advantage in office
machinery and power generating machinery and equipment.

In  heavy  industry,  some  PACs  could  benefit  from  the  heritage  of  the  necessary  infrastructure.
Slovakia  and  Bulgaria  are  strong  in  metal  products  and  in  iron  and  steel  manufactured  goods.
Bulgaria is specialised in non-ferrous metal goods.

At the sectoral level, rather high trade shares of the PACs in sectors such as clothing and footwear
indicate  that  wages  and  employment  of  the  unskilled  might  be  negatively  affected  there,  while  the
more  capital-intensive  textile  sector  experiences  a  large  trade-surplus  vis-à-vis  the  PACs.
Furthermore, construction workers in some German regions might be negatively affected by imports
of the respective services, especially from the central and eastern European candidate countries.

Conversely, large export-surpluses can be observed on side of the EU in physical and human capital
intensive industries such as communication equipment, measuring instruments, computers and motor
vehicles.  It  is  worth  noting  that  these  surpluses  are  accompanied  by  rising  shares  of  intra-industry
trade. Large differences in unit-values indicate that this intra-industry trade is of the vertical type, i.e.
that  physical  and  human  capital  intensive  activities  are  located  in  the  EU  and  labour-intensive
activities in the PACs. An increasing segmentation of production processes between the EU and the
PACs may affect wages and employment of the unskilled. But, trade volumes are too small to expect
significant effects beyond some specific regions.

It is often feared that labour intensive production is relocated from the EU to PACs through foreign
direct  investment  (FDI).  However,  a  detailed  analysis  of  the  structure  of  foreign  direct  investment
does not confirm these concerns. Nearly half of the foreign direct investment from the EU to PACs is
directed  at  non-tradables  (i.e.  public  utilities  and  communication,  financial  intermediation,  other
services). The branch structure of investment, as well as enterprise polls, indicate that market access is
the primary investment motive. Around one-fifth of foreign investment is allocated to the production
of tradables in sectors where low labour costs play a significant role and the share of unskilled labour
is relatively high. This holds true for clothing and footwear, electrical machinery, rubber and plastic
products.  In  these  branches  a  distinct  gap  in  the  capital  intensity  of  production  between  the  parent

82 See Eurostat: "Specialisation of candidate countries in relation to EU", Statistics in Focus, 6,
Luxembourg, 2001, p.2

76

                                                     
companies  and  their  foreign  affiliates  can  be  observed.  Furthermore,  the  respective  FDI  is  highly
correlated to increasing shares of intra-industry trade, which is an indication that production processes
are  increasingly  segmented  in  human  capital  intensive  activities  on  the  side  of  the  EU  and  labour-
intensive activities in the PACs .

3. The six main challenges identified by the panel

3.1. The ageing of the population

All over Europe, the ageing of the population has been identified as a potential problem, mainly in
relation  to  the  financial  affordability  of  pension  arrangements.  Within  the  EU,  the  differences
between the pension systems are striking. Some member states rely on pay-as-you-go arrangements,
in which the pensions of the over 65 are collected from taxes on the present labour force. In other
member  states,  the  employers  and  employees  make  obligatory  contributions  to  a  pension  fund,
which pays the present pensions on the basis of the capital built up in the past, and from which the
present workers can expect to benefit when they will be over 65. Over the years, the national and
sectoral pension funds have become less and less restricted in where they invest their capital. At the
same  time,  more  people  have  added  to  their  future  pension  through  investing  in  real  estate  and
buying private insurance. This has blurred the demarcation lines between public and private pension
provision  –  between  the  collective  responsibility  for  rewarding  retired  workers  and  the  individual
responsibility  for  earning  one's  living.  Pension  reform  has  so  become  the  focus  point  of  public
finance  decisions  and  considerations  concerning  the  distribution  of  income.  In  essence  these  are
about claims on current and  future production,  in times  of  ever  increasing  labour productivity, by
today's wage earners and the workers of the past.

C h a r t   1

M e d i a n   A g e   o f   t h e   p o p u l a t i o n ,   2 0 0 0 - 2 0 3 0

S o u r c e   o f   d a t a   :   U N O   2 0 0 0   R e v i s i o n

L i f e _ e x p _ P A C

5   O l d

S I

A T + D E + E S + G R + I T

C Z

B G

L V

L T

E E

S K

H U

P L

R O

M T

C Y

I E + L U

T R

2 0

2 5

3 0

3 5

4 0

4 5

5 0

5 5

2 0 3 0

2 0 0 0

77

In the  past decade the trend of  an increasing  population in  the  older  age  brackets  together  with  a
decrease in fertility rates (the number of live births per women) has become even more pronounced
in the candidate countries than in the EU member states. In addition they have had to cope with the
consequences of early retirement, granted on a large scale in the final years of the communist regime,
and with the lack of  pension  funds  and  private insurance  in  general.  Mainly  on  the  advice  of  the
World Bank, the CEECs have introduced three-pillar pension systems that are a mix of pay-as-you-
go financing, monetary contributions for the build up of capital funding and complementary private
insurance. An interesting feature of the setting up of the systems in some of the candidate countries is
that employees in the different age brackets are given a choice about the balancing of the three pillars
in their particular case. The difficulty of this set up is that, depending on the whole of the individual
choices  that  are  made,  the  parameters  of  the  system  -  retirement  age,  minimum  level  of  benefits,
mandatory  contribution  rate  -  may  need  to  be  adjusted.  In  this  respect,  however,  the  candidate
countries are not in a situation that is fundamentally different from the member states, which all will
have to do something to rebalance their pension systems and keep them financially affordable in the
future.

The former socialist system left the CEECs with a legacy of low statutory retirement ages; typically
60 years for men, 55 years for women. On average, there was more than one pensioner for every two
workers.  This  is  the  range  of  old  age  dependency  rates  into  which  the  EU-15  are  likely  to  move
within the next 20 years. If the retirement age in the CEECs had been the same as in the EU member
states, their dependency rates would actually have been lower, given that female participation rates in
the  labour  force  were  higher.  However,  with  time,  they  are  projected  to  grow  above  the  EU-15
dependency rates as a result of the more dramatic decline in fertility rates and the increases in life
expectancy in the CEECs.

It is obvious that for a long time to come pensioners in the candidate countries will be worse off, in
absolute as well as relative terms, compared to their counterparts in the present EU member states. It
is also obvious  that the  pensions  of  old-age  people  in  the  few  member  states  with  a  fully  funded
system  are  more  secure  than  those  in  countries  that  have  maintained  a  pay-as-you-go  system.
Perhaps  a  more  interesting  question  with  regard  to  the  future  is  whether  in  the  long  run  the
pensioners in the candidate countries would be better off with a pension system that is started to be
funded now from scratch than with a pay-as-you-go system.

Many of the economic arguments for an against the introduction of a fully funded pension scheme
do not stand up to closer scrutiny from the point of view of maximising a society's welfare. They are
related to the administrative cost of managing the funds separate from the government's budget, the
positive  effect  of  mandatory  contributions  on  the  savings  rate,  the  impetus  that  the  creation  of  a
pension fund has on the functioning and sophistication of the financial markets and the greater ease
with which the intergenerational redistribution of income can be  brought  about. These may all  be
valid arguments when concerned with government efficiency and the functioning of the economy,
but it should be kept in mind that in principle any funded scheme can be closely approximated by a
combination of taxation and pension contribution that runs through the public finance system. It can
also be argued that the introduction of the euro, and the EU constraints on public finance and debt
accumulation that went with it, have tilted the scales in favour of funded systems over pay-as-you-go
arrangements.  But  again  this  is  an  argument  that  befits  second-best  approaches  to  social  welfare
maximisation. This is not to say that there  is  anything wrong with  policy  discussions and choices
made on the basis of these arguments, except that they sometimes obscure the fundamental social
choices that need to be made.

What really matters is the choice between the degree of fairness and solidarity that is implied by the
redistribution of income via the government's budget and the more individualistic evaluation of the

78

capital  accumulation  in  a  pension  fund.  This  choice  is  among  the  most  important  decisions  for
CEECs to make in the area of public policy. It is estimated that for a typical candidate country the
capital to be built up for a fair distribution of pensions over the generations will need to peak at 300
% of the wage bill by 2040. Neither of the two options is without consequences for public finance,
nor can any  of the  options  be  implemented  without  market  distortions.  The  creation  of  a  pension
fund perhaps appears to be closest to market principles, certainly when it is to be managed within the
private  sector,  but  it  usually  involves  minimum  benefits  and  other  parameters  that  are  set  in  the
process of democratic decision making. That they constrain the fund managers in their operation as
full market participants is not unusual in private companies either. However, in addition, social fund
managers need to be aware that their capital is built up with contributions from the tax payers and
that they cannot risk the entitlements of future pensioners. It needs to be recognised as well that, if
not corrected, the present generation of workers (and policy makers) in the candidate countries will
benefit from setting up a pension fund, at the expense of future generations, because they will not
need  to  have  paid  in  the  full  amount.  Similar  arguments  apply  to  the  privatisation  of  healthcare,
where private insurance companies would need to be compensated for taking on the "bad risks".

There  is  perhaps  less  to  say  on  the  other  extreme  of  running  a  pay-as-you-go  pension  scheme
completely through the government's budget. The usual illusions of tax payers about the meaning of
public debt and who benefits from public expenditure play a role. That is, in fact, the main reason
why policy makers in the candidate countries have found it useful to earmark the revenues from the
sale of state asserts for the building up of a pension fund. From a management point of view, the
difference between a pay-as-you-go system and a pension fund can be characterised in the same way
as that between any collective non-profit organisation and a company  with shareholders. Whereas
the decisions of the executive directors in the company are sanctioned by the shareholders or their
representatives, mainly on the basis of market principles, the decisions on who to let in and what to
pay  out  in  collective  organisations  are  assumed  to  be  guided  to  a  greater  extent  by  democratic
procedures.

(See also Chapters C and D of ESTO/IPTS project.)

3.2. ICT diffusion/production/use

The number of PCs and the number of internet hosts in the candidate countries is still relatively low
compared  to  what  they  are  in  the  EU  member  states.    In  2000  about  6  in  every  100  inhabitants
owned a computer, which is four times less than the EU average.  However, there has been a strong
growth of PCs (+24% in 1999) and internet hosts (+60% in 2001) in recent years.  The number of
mobile  phone  subscriptions  is  also  growing  strongly  (+87%  in  2000).    There  are  considerable
differences between the candidate countries: while the density of PCs in Slovenia is close to the EU
average, it stands at only about 10% of the EU level in Romania.  Furthermore, while the number of
internet  users  per  100  inhabitants  is  slightly  higher  than  the  EU  average  in  Estonia,  it  is  at  only
roughly 12% of the EU average in Turkey.

79

 Table 12  Information Society 2000/2001 (in millions)

Number of PCs
(December 2000)
- per 100 inhabitants

Internet hosts (July
2001)
- per 100 inhabitants

Internet users
(December 2000)
- per 100 inhabitants

Mobile phone
subscriptions (December
2000)
-per 100 inhabitants

Candidate
Countries

11

6

1

10

10

6

38

22

EU-15

108

25

12

91

91

24

236

63

USA

161

59

79

154

154

56

100

36

World

442

8

107

352

352

6

720

12

 Source: See Eurostat, Statistics in focus, Theme 4 – 37/2001

 The rapid development of information and communication technology presents both producers and
consumers with big  opportunities.  However,  as  with  the  introduction  of  steam  engines,  electricity
and, for instance, gramophones in the past, the eventual usefulness of the new technology and  its
social implications may be substantially different from what the inventors and pioneering users had
in  mind.  The  panel  discussed  some  of  the  possible  consequences  of  ICT  development  in  an
economic context.

In analysing the contributions of ICT to future changes in production and consumption patterns the
production of physical information carriers and the services directly  associated  with this  sector  of
industry must be distinguished from the role of information and communication in the production of
other goods and services. In a basic sense, the division of labour over the ages, leading to the modern
trends  of  mass  production  and  a  continuous  increase  in  the  weight  of  the  services  sector  in
industrialised economies, would not have been possible without communication between workers,
information  on  how  to  use  new  technologies  and  the  exchange  of  information  necessary  for  the
selling and marketing of products. What more recent ICT developments have added to this age-old
process is to make the coding and transmission of information so efficient (digital) and independent
of  physical  connections  (cordless)  that  it  allows  the  producers  of  manufactured  goods  to  almost
completely  break  the  link  between  where  the  resources  are  and  where  the  consumers.  This  has
consequences for the weight and location of economic activities, which will be discussed in the next
two  sections.    It  also  has  social  implications  in  terms  of  the  availability  and  accessibility  of  ICT
products.

The  spectacular  reduction  in  the  size  and  cost  of  chips  and  other  information  carriers  has  made
personal computers, mobile phones and electronically controlled cars and toys an everyday existence
in  the  life  of  the  European  citizen.  There  is  a  tendency  among  EU  consumers  to  spend  a  fixed
proportion of their income on such items, so if the price of the standard product goes down they just
go for more or for higher quality. Interestingly, after providing for food and other basic necessities,
ICT products are among the first items on which consumers in the candidate countries tend to spend

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a rise in their income, more so than on improved housing and travel. This illustrates how important it
is for European societies to make such goods affordable and widely available to everybody, and also
has  implications  for  the  education  system  and  the  building  up  of  knowledge  in  the  candidate
countries.

The  role  of  the  EU  in  these  developments  is  again  to  set  standards  where  possible,  without
hampering  innovative  and  useful  activities  in individual  member  states  and  without  distorting  the
mechanisms  of  competition.  It  needs  to  be  recognised  that,  apart  from  becoming  embedded  in
machinery and production processes, technology  is  a  weightless  and  non-rival  good.  This  implies
that  it  will  be  fostered  and  diffused  within  the  private  sector  only  under  conditions  of  imperfect
competition, and that at some point the government may need to step in to ensure that innovative
research and development are continued.

In the case of mobile telecommunications the European authorities, in co-operation with business,
acted early on in the 1980s in setting the GSM standard. By doing so they prevented the carving up
of the European market for national champions that had been characteristic for the building up of
railway networks and the production of electrical equipment.  The GSM standard has been adopted
by many non-European countries and there has been healthy competition in the market for mobile
phones within the EU as well, without hardly any financial support from national governments. This
is  an  example  that  may  be  worth  repeating  in  other  fields.  It  is  important,  however,  to  note  the
elements of success: the governments’ initiative was timely; it was undertaken at the EU level; there
was  little  or  no  interference  with  the  industry  and  its  markets  once  the  standard  was  set;  and  no
vested  interests  developed  in  the  form  of  state-owned  monopolies.    In  attempts  to  replicate  the
approach  in  other  fields,  such  as  the  medical  applications  of  gene  technology,  it  may  also  be
necessary to take a closer look at the role of publicly funded research and the system of intellectual
property rights.

3.3. The retooling of the agri-food chain

The special position of the agricultural sector in the European production system is reflected by the
high proportion of the EU budget that is spent on support to the sector, which although destined to
decline is still close to 40%. Financial funding under the Common Agricultural Policy (CAP) also
stands apart from other EU expenditures for structural support, because, strictly speaking, it does not
require co-finance from national  sources. The  roughly 0.5%  or  less  of the EU-15’s  gross national
product spent on price and income support to farmers via the Community budget is not supposed to
be  topped  up  by  national  subsidies.  One  of  the  options  discussed  within  the  context  of  future
financial frameworks for the EU is the “re-nationalisation” of part of the agricultural support. Other
directions of reform, that were indicated in Agenda 2000 and are being followed up to some extent,
are to let market principles play a bigger role and to give social and environmental considerations a
more prominent place in the common agricultural policy.

During  the  past  forty  years  the  CAP  has  guided  the  intensification  and  industrialisation  of
agricultural  production  processes,  which  has  succeeded  in  making  the  EU  self-sufficient  in  the
provision of food. In fact, the EU has become a net exporter of agricultural products, and in a global
setting is  being  heavily criticised  for continuing  with  production  subsidies  and  price  support  even
after it had reached its favourable trade position in the late 1980s.  At the same time, the agricultural
stakeholders  in  the  candidate  countries  –  which,  for  the  time  being,  and  with  the  exception  of
Hungary, have developed into net importers of food products from the EU-15 – are in two minds
about either expecting similar levels of support in the future as their EC counterparts have received in
the past or anticipating upon the opportunities that a reformed and extended European agricultural

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policy would provide. In order to be able to respond to the challenge they need to be aware of the
proposed adjustments to the CAP and have greater certainty about the direction that it will take.

Future CAP reforms – the ones proposed in Agenda 2000 and others that are likely to follow – aim
to move the EU’s agricultural policy away from production subsidies and price support, with direct
payments  to  farmers  to  offset  the  effect  of  price  reductions,  towards  a  more  comprehensive
framework, which includes environmental, social and rural development objectives. In addition, the
series  of  food  scares  of  the  past  decade  have  emphasised  the  need  to  provide  consumers  with
guarantees of the safety and quality of agricultural products.

With  its  proposal  to  mix  the  original  production  oriented  objectives  with  elements  related  to  the
environment, the quality of food and the standard of living of rural communities, Agenda 2000 has
opted  for  a  revisionist  approach  to  the  common  agricultural  policy.  More  radical  changes  of
direction, which still are likely to be needed in the future, could involve the rigorous adoption of free
market principles, at one extreme, or the incorporation of rural development and other objectives, in
addition  to  the  environmental  and  social  ones  that  are  already  present,  at  the  opposite  end  of  the
scale.

Following a rigorous free market approach would negate the  need  to  have  a  common agricultural
policy in the first place, if not retrospectively for the existing Community then at least as far as the
candidate  countries  are  concerned.  In  doing  so,  it  would  call  into  question  the  argument  that
continued price stabilisation and direct income support would create greater certainty for the long-
term decisions to be made by the farmers in the candidate countries. Free market advocates would
also  need  to  counter  the  economic  argument  that  public  finance  support  could  be  justified  on  the
basis of externalities in such areas as the provision of infrastructure, the education and training  of
farmers  and  the  pooling  of  agricultural  research.  Moreover,  as  the  difficult  negotiations  on  CAP
reform have shown in the past, any move in a market-oriented direction would require compensation
payments to be made to farmers that expect to lose out from the change in policy.

The  holistic  approach,  on  the  other  hand,  is  in  danger  of  obscuring  the  determination  of  the
Community’s  preferences,  and  the  preferences  of  different  interest  groups  within  the  EC,  by  the
financial incentives included in the integral agricultural and rural development policy. To charge this
matter by exaggeration, there is a danger that the end result of the holistic approach would remind
the  population  of  the  central  and  eastern  European  candidate  countries  of  their  experiences  with
central planning in the past – perhaps with all the good intentions to start with, but very bureaucratic
and economically inefficient in the way the new policy would be worked out.

The middle way between the free market and holistic extremes is to let market mechanisms play a
role where they can but provide incentives for farmers in the enlarged Union to change course when
that is felt to be socially desirable. This is much easier said than done. Both the regulation of market
forces within the Union and the correction of the economic incentives for externalities that are not
properly  reflected  in  the  costs  of  inputs  and  outputs  require  a  deep  knowledge  of  production  and
marketing  processes,  including  the  possible  contribution  of  new  technologies.  Government
interventions in market mechanisms also require strong political backing in the EU member states,
moving up to the Community level.

82

Agricultural production as a percentage of total gross value added in the economy of
Figure 28
the candidate countries and agricultural employment as a percentage of total employment, estimated
data for 2000

45

40

35

30

25

20

15

10

5

0

% Gross Value Added

% Employment

Source: European Commission, 2001 Regular Reports

BG

CY

CZ

EE

HU

LV

LT

MT

PL

RO

SK

SI

TR

In many candidate countries, at present, the commitment to agricultural reform seems to be lagging
behind the  political  drive  to  become an EU member state. Farmers expect  to receive sizeable EU
funding,  without  anticipating  the  rationalisations  and  innovations  that  will  be  needed  in  the
agricultural  sector.  Other  stakeholders  argue  that  the  candidate  countries  are  net  importers  of  EU
agricultural  products  and  that  farmers  in  the  candidate  countries  have  the  right  to  be  treated  as
generously as their EC counterparts were in the past.  They prefer to ignore the adjustments that are
already included in Agenda 2000 and the recent EU moves to reduce the distortion of trade. This will
make it difficult to find a one-size-fits-all type of solution. A more differentiated approach, both with
respect to the trade position and the phase of adjustment of the candidate country, may eventually be
called for.  However, what is needed in the first place is in-depth research and clear information on
how the EU’s agricultural policy can be made more targeted and market-oriented.

Any  redesign  of  the  Community’s  agricultural  policy  should  give  careful  consideration  to  the
accompanying measures included in rural development and consumer protection programmes.  One
concrete example of an innovative but knowledge demanding approach in the EU is the introduction
of a labelling method that would allow consumers to trace the composition as well as the origins of a
product. Such product information systems need to be accompanied by continuous monitoring and
updating  to  be  useful  to  the  customer.  Although  their  functioning  would  obviously  benefit  from
independent  research  and  open  information  to  the  public,  there  remains  a  question  mark  in  the
economics literature on who should bear the cost for the provision of reliable labelling and quality
control  in  the  first  instance:  the  producer,  the  consumer  or  the  government.  To  the  extent  that
consumers in the candidate countries have a preference for food products produced in the West, as
their consumption patterns revealed in the 1990s, they could expect to benefit from European-wide
labelling  schemes  that  include  the  future  EU  member  states  if  they  show  that  the  quality  of  their
home-grown and domestically produced goods is in line with that of EU member states.

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A companion ESTO study on the prospects of the candidate countries in an enlarged EU looked into
organic farming and the production of noon-food crops for energy and fibre production as areas in
which  the  candidate  countries  could  potentially  benefit  from  preference  shifts  in  the  EU  and  its
member states.

The  market  share  of  certified  organic  food  products  in  the  candidate  countries  is  still  very  small,
although a Polish survey in 1998 indicated that 40% of the  consumers  would  be  prepared  to  buy
organic products if available in their local shop. At present, only about 200 shops in Poland have a
reasonable  assortment  of  such  food,  both  domestically  produced  and  imported.  In  spite  of  some
interest of foreign supermarket chains in a direct link with Polish producers, the export of organic
products is still very much in its infancy. The number of farms that are certified to grow organic food
is  only  0.03%  of  the  total  number  of  farms;  at  15  hectares  their  average  size  is  twice  that  of  the
average farm in Poland. Similar tendencies are reported for Bulgaria, where it is noted that the cost
of conversion to organic forms of agriculture is relatively low thanks to the limited use of fertilisers,
pesticides and herbicides in the past.

The  relative  abundance  of  land  in  the  candidate  countries,  compared  to  the  present  EU,  could
perhaps be used to grow non-food crops that can be transformed into fuel on a larger scale. There
appears to be a market for rape-based bio-diesel, whereas crops such as sweet sorghum can be a rich
source of bio-ethanol. It is technically feasible to produce energy sources and fuel additives in this
way,  and  there  are  indications  of  advanced  knowledge  of  applications  in  the  candidate  countries.
This is also the case for the production of cellulose from non-food crops. However, artificially low
fossil fuel prices, in the sense that they do not fully reflect environmental and other externalities, in
combination  with  forceful  lobbies  from  the  existing  coal,  petrol  and  paper  industries  could  block
environmentally  friendly  moves  in  these  directions  that  could  otherwise  have  been  economically
profitable.

Foreign  direct  investment  in  the  agri-food  chain  has  most  notably  been  attracted  to  the  food-
processing and retail sectors, with a focus on tobacco, beverages, ice-cream and sweets. Investing in
farms  has  not  been  taken  up  widely,  mainly  because  they  are  not  seen  as  very  creditworthy  or
because  there  are  problems  with  land  ownership.  However,  the  heavy  emphasis  on  strategic
investment in the food-processing and retail sectors does mean that a greater proportion of farms is
indirectly  controlled  by  large  foreign  companies,  including  Western  supermarket  chains,  than  by
local investors. It is also interesting to note that a dichotomy is observed in some of the candidate
countries,  in  which  an  intensification  is  taking  place  on  the  larger  plots,  sometimes  with  foreign
assistance, whereas alternative forms of land use are being experimented with on the smaller plots.
Some of this may have to do with the buffer function of agriculture for the employment shake-out
resulting from industrial restructuring.

The  present  CAP  reforms  are  increasingly  freeing  up  land  for  environmental  and  recreational
purposes, while providing direct income support to farmers in difficult areas and compensation for
land  that  is  set  aside.  In  the  livestock  sector  the  recent  food  scares  and  the  concern  about  animal
welfare have highlighted the urgency of a shift towards more responsible methods of farming.  This
may be achieved by greater control and regulation of food suppliers, lifted to the EU level, but at the
same time there could be a tendency for consumers to turn increasingly towards local suppliers in
which they have greater trust. As in other areas, the  EU has the  choice  between setting European
standards and allowing Member States to forge ahead of others in the pursuit of commonly agreed
objectives  if  these  standards  are  too  close  to  the  lowest  common  denominator.  It  is  especially
important for the candidate countries, which are not full partners in the decision process, that the EU
is  as  clear  as  possible  about  where  the  balance  is  struck.  In  this  respect,  increasing  the  weight  of
social  and  environmental  considerations  in  agricultural  policy  making  complicates  things,  and

84

possibly makes the decisions less transparent, since it moves attention away from economic interests
that  are  easier  to  measure  and  negotiate  in  concrete  terms.  A  targeted  and  more  market-oriented
reform  of  the  common  agricultural  policy,  allowing  the  Member  States  to  follow  their  own
preferences on social and environmental issues, might therefore turn out to serve the consumers in
both the EU member states and the candidate countries better than a more encompassing approach.

3.4. The geography of economic activities

Uncertainty about future developments is the main reason for not investing in a foreign economy and
for  staying  where  you  are,  even  when  the  economic  opportunities  appear  to  be  obvious.  This
includes the uncertainty about the establishment and implementation of a legal framework and the
possibility of disruptive political  events.  The CEECs  are attractive to foreign  investors because of
their low wages and relatively highly skilled labour force – although the measurement of the latter is
open to some doubt – and because they provide non-EU investors with an opportunity to become
part of the European  single  market  in  due  time,  without  immediately  having  to  conform  with  the
social and environmental acquis. At the same time this suggests that the investors of today could as
easily move to other locations as soon as the CEEC has become part of the EU.

The developments in the area of ICT continue to enhance the cost-cutting effects of the single market
programme.  Lower  transport  costs  and  greater  economies  of  scale  have  induced  a  dispersion  of
economic activity across the EU, including in some cases the candidate countries. Car manufacturers
and firms in electronics have been among the prime investors.

The  continued  reduction  of  the  cost  of  transportation,  after  the  full  removal  of  the  cost  of  border
crossing,  has two  consequences  that  can  pull  firms in  different  sectors  in  different  directions.  For
some  industries it has  become  easier to reap the benefits of  vertical  integration  and  economies  of
scale. They tend to move to places where there is already an agglomeration of economic activities. In
contrast, the location of other industries becomes less dependent on where the markets are, and they
have an incentive to move to more peripheral regions. The interesting result is that the patchwork of
productive  activities  becomes  both  more  volatile  and  more  diverse,  with  regional  success  stories
popping  up  in  unexpected  places,  and  industrial  belts  and  metropolitan  areas,  where  most  of  the
services still are located, becoming increasingly congested.

The seemingly random  pattern of regional  economic  development,  combined  with the  impression
that  firms  tend  to  be  sticking  where  they  are  once  they  have  made  a  move,  has  been  invoked  to
rationalise the behaviour of national and local authorities in offering incentives to firms willing to
invest  in  one  of  the  CEECs.  Companies  have  been  tempted  in  turn  to  play  off  the  offer  of  one
candidate country against that of another. Some of the practices that were adopted would actually not
be allowed under the EU acquis and certainly went against the spirit of the single market. Although
nobody  is  going  to  turn  back  the  clock,  there  will  be  serious  and  greater  challenges  to  EU
competition authorities after enlargement, if only because of the increase in the number of regions
and the number of governments with which they will have to deal.

The idea of countries competing on  a  global level as  if they  were companies is of  course a gross
misconception.  Nevertheless  it  enters  popular  discourse,  for  instance  when  politicians  refer  to  the
need to maintain the competitiveness of the economy. The economic criteria for EU accession are
often  quoted  to  say  bluntly  that  the  country  "should  be  able  to  compete",  whereas  the  wording
chosen by the European Council in Copenhagen was  that  the  candidate  country  should  have  “the
capacity to cope with competitive pressure and market forces within the Union”. Recent empirical
economic research suggests that national endowments and country characteristics do play a role in

85

location decisions but that changes in location and trends in relocation follow different patterns and
country preferences for different industries.

The main findings of a recent study done for the Directorate General for Economic and Financial
Affairs of the European Commission are that:

•  Most EU countries saw a significant convergence of their industrial structure during the 1970s but

a reversal of this trend from the early 1980s onwards.

•  From the early 1980s onwards the countries showed increasing specialisation, with the emergence
of  high  technology  and  high  skill  industries  in  Ireland  and  Finland  as  the  most  remarkable
examples.

•  A number of mainly unskilled labour intensive industries that were initially spatially distributed

have become more concentrated.

•  Significant dispersion has taken place in a number of medium to high technology industries, with

activity spreading from the high tech centre towards the more peripheral locations.

•  R&D intensive industries have moved to locations where highly skilled researchers are available.

•  Central locations are increasingly attracting industries higher up the value added chain, which are

highly dependent on intermediate inputs.

•  The reaping of increasing returns to scale as a motive for locations in central regions has lost some

of its attraction.

•  Services have become more spatially dispersed.

To  the  extent  that  it  is  possible  to  make  comparisons  between  the  EU  and  the  US,  there  are
indications  that  European  industries  are  still  less  concentrated  in  space  than  their  American
counterparts. However, while the industrial structures of EU member states show some divergence,
the US of America are in a phase of convergence.

The  concentration  of  the  car  industry  on  both  continents  as  always  provides  some  appealing
illustrations. Between 1970 and 1996, the top two EU countries in terms of car production increased
their share from 58 % to 62 %. In 1970 the situation in the US was similar to Europe: two states
produced 58 % of the cars. By 1996 that number had increased to 6: the production of cars in at least
six states in the US needed to be added up to cover 62% of the total US car production. In the same
period the states producing cars in the US have become less specialised, although still more so than
in  Europe.  The  main  car  producing  countries  in  the  EU  still  have  a  much  higher  share  in  total
manufacturing than their US counterparts.

If the convergence in the industrial structure of the states of the US, with their longer history of a
single market, is anything to go by, the EU could expect to arrive at some stage in a new phase in
which the member states become less specialised and dependent on a small number of industries.
Since labour mobility has traditionally been much higher in the US, the convergence in the EU will
probably always remain at a lower level. In any case, the accession of the candidate countries will
give a boost to diversity to start with. Capital movements, which in theory could make up for the lack
of labour mobility in the EU, are so volatile today that a stable and equitable regional distribution of
income is unlikely to be established. What is interesting to observe, however,  is  that, whereas the

86

single market programme and the introduction of the euro appear to have broken the trend in which
all member states were developing a base in the same industries, the lowering of the cost of transport
and communication so far has not led to a new phase of convergence in the industrial structures of
the old member states to the same extent as it has done in the US.

3.5. The dynamics of human capital formation

Although  the  education statistics on  the candidate countries  show  relatively  high  scores,  there  are
indications  that  their  education  systems  are  not  really  geared  up  to  teaching  the  technical  and
managerial skills needed in modern market economies. In some cases the availability of particular
skills has generated foreign direct investment, in other cases the lack of skilled workers has held back
FDI.  A special case is Slovenia, where a foreign investor actually had to hire skilled labour from
abroad.

Without  the  possibility  of  labour  migration  the  future  development  of  human  capital  is  rather
deterministic. Allowing for education and training abroad provides greater flexibility but only when
there  are  economic  incentives  for  the  migrants  to  return  after  a  sufficient  level  of  skills  has  been
acquired.

Figure 29

Bulgaria

Cyprus

Czech Republic

Estonia

Hungary

Latvia

Lithuania

Malta

Poland

Romania

Slovak Republic

Slovenia

Turkey

40

60

80

100

120

140

160

180

200

percent

  Class size
  Expenditures/GNP

If measured by conventional indicators of educational input and output, most candidate countries do
not  show  substantial  differences  from  the  EU  average  (see  Chapter  B  of  the  ESTO/IPTS  Study).
However, these measures may not capture the economically relevant stock of human capital.  East

87

Germany’s  experience  with  being  included  in  the  EU  provides  some  evidence  that  the  stock  of
human  capital  in  central  and  eastern  Europe  could  be  grossly  overstated  by  statistical  indicators
relying only on formal education and training.

To foster human capital formation in the long run, an efficient and cost-effective schooling system
would  be  required,  that  would  provide  incentives  to  improve  on  student  performance  and  set
standards for comparison with other countries (see Gundlach, Wößmann and Gmelin, 2001).

An even more compelling argument for public investment in human capital – and one which goes
much beyond narrow economic interests – is that well-educated citizens are less likely to follow non-
democratic  ideologies.    In  this  sense,  public  expenditure  on  education  can  be  seen  as  a  means  to
foster democratic stability, which may be the linchpin condition for sustained economic growth.

3.6. The economics of sustainability

Figure 30

Output

Economic Growth

Sustainability

Natural 
Resources

Social
Choices

Production
Process

Capital

Democracy

Social Security

Physical
Infrastucture

Individual Values 
and Objectives

Public
Expenditure

Education

Labour

Technology

Knowledge 
Base

Science

The word “sustainable” appears in at least six different places in the Treaty establishing the European
Community, only once (Article 6) with a direct reference to environmental protection. This reflects
the wider meaning of sustainability as a criterion for policy choices. Policies which are beneficial in
the short run may cause (or run into) serious difficulties in the long run. These difficulties can vary
from public finance problems to banking crises in the case of economic policies; from social tensions
to explosive situations in the context of society; and from energy crises to ecological disasters in the
area of environmental protection. Only some of these uncertainties can be quantified in probability

88

terms and so become operational for making policy decisions. In other cases policy makers need to
rely on common sense, as exemplified by the precautionary principle of not taking any risk, even if
estimated to be small, when the possible negative consequences are enormous. Since the generally
accepted  concept  of  sustainability  refers  to  the  needs  of  the  present  without  compromising  the
abilities of future generations to satisfy their own needs, it belongs to the field of ecology rather than
to that of social sciences.

Research  into  the  depletion  of  the  world’s  natural  resources  and  the  identification  of  alternative
sources of energy which are renewable within one generation can be very relevant for the making of
economic decisions. Ideally the incentives and price signals received by the decision makers, both as
producers  and  as  consumers,  should  discount  and  internalise  externalities  and  the  cost  to  future
generations. They should be able to base their decisions on calculated risks. If that is not possible, the
market mechanism will have its imperfections and occasional failures and there is a  case for self-
regulation  or  government  intervention.  In  such  cases,  it  is  important  to  recognise  that  policy  co-
ordination  between  countries  requires  that  they  are  aware  of  each  other’s  socially  revealed
preferences and that their governments base their decisions on verifiable information. Proposals to
correct the national accounting system for externalities (“green accounting”) are not very helpful in
this  respect,  because  they  can  confuse  the  process  democratic  decision  making  if  there  is  no
consensus on preferences and measurement.

In the field of energy use there are plans for the introduction for carbon taxes and for permit trading,
which could actually benefit catching-up countries since they have the chance to switch to alternative
sources of energy without the cost of writing off the capital build up with investment based on the
wrong incentives. The EU also allows its member states to go ahead with tax exemptions for the use
of  cleaner  technology  if  that  is  recognised  to  be  interest  of  a  commonly  agreed  objective.    Some
Member States are experimenting with schemes that allow consumers to make their choice of energy
not only on the basis of cost but also on the basis of verifiable information on the source of energy.
This  confirms  the  general  trend  that  the  consumer  wishes  to  know  more  than  only  the  price  of  a
product.

89

Figure 31

Social Values

EU Treaties

National Objectives

National Policies

Acquis
national

s
u
s
n
e
s
n
o
C

n
o

i
t
a
n

i

d
r
o
o
C

s
t
n

i

a
r
t
s
n
o
C

Community Objectives

Prosperity

Equity

Culture

Nature

Agriculture

Trade

Competition

Environment

Education

Research

Justice and
Home Affairs

EU Policies

Acquis
communautaire

90

4. Conclusion

This  paper  presents  the  main  economic  challenges  of  Enlargement  and  rearranges  them  into  six
topics  for  further  analysis.    The  responses  to  these  challenges  will  differ  between  the  candidate
countries:  they  need  to  take  into  account  the  limitations  of  government  actions  in  influencing  the
economic decisions of private agents (producers, entrepreneurs, consumers, tax payers, citizens) and
the  conditions  of  public  finance  that  are  specific  to  each  country.    The  policy  choices  should  be
compatible with the macroeconomic constraints faced by the country concerned.

There is a great deal of consensus on the most appropriate macroeconomic policy framework for the
candidate countries.  The main trade-off is that between high growth and macroeconomic stability
(characterised  by  low  and  predictable  inflation  rates,  an  equitable  income  distribution,  a  balanced
government  budget  and  equilibrium  on  the  balance  of  payments).    The  main  differences  are  the
greater need for institutional changes and the lack of macroeconomic stability in some countries.

There is a time dimension to the trade-off between high growth and macroeconomic stability that is
especially important for transition countries: in the period of macroeconomic stabilisation the price
adjustment  of  non-traded  goods  and  services  will  exert  upward  pressure  on  overall  inflation,  the
income distribution will be stretched, the government’s budget will be out of balance because of the
necessary investment and social support, and the current account will run into deficits because of the
imports of capital goods. It is generally recognised that an influx of FDI is needed both because it
generates the  necessary  transfer  of  technology  and  know-how  and  because  it  helps  to  finance  the
current account deficits.

Social acceptability (reflected by the income distribution in economic terms) and political feasibility
are major concerns of the policymakers. If the implementation of the policies is not credible this will
be reflected in the interest rates that are charged for external financing. Since the means of taxation
are  limited  –  and  enforcement  usually  is  not  very  strong  –  this  leads  to  immediate  financing
problems for the government.

Although  the  proper  sequencing  of  institutional  and  policy  changes  is  important,  in  practice  the
changes will need to be made in parallel. It is crucial that the institutional set-up and the policies that
are chosen are seen to reinforce each other. Macroeconomic stability, once established, can only be
maintained if the institutions are in place.  The proper functioning of the markets and stable relations
between  the  social  partners  are  among  the  prerequisites.  A  tripartite  set-up  for  wage  bargaining,
including trade unions, employer representatives and the government, has been successful in some
countries.  There might also be a need for trial  and  error  to find  the right  balance  in terms of the
burden of taxation.

To sum up the macroeconomic issues, credibility is the factor that binds business-cycle management
and  structural  policies:  a  solid  fiscal  stance  reinforces  the  government’s  ability  to  carry  through
structural  reform,  and  coherent  policy  responses  to  the  challenges  of  Enlargement  enhance  the
government’s reputation on maintaining macroeconomic stability.

The overall message of the panel report on Economic Transformation is that the EU should not stand
still at its achievements in the fields of market integration and the co-ordination of national economic
policies.   It should move on to find and exchange the best practices in the fields of education, the
environment,  the  use  of  energy  and  transport,  information  and  communication  technologies  and
social systems.  Practical examples are the eEurope+ initiative and the idea of having transferable
credit point systems for education across the EU.  The experience in the field of economics shows

91

that a multitude of institutions, interest groups and less formal bodies can fruitfully work towards a
successful outcome.  In order to be able to do so in other fields, standards of comparison need to be
developed within the EU and innovative approaches should be welcomed. For instance, innovative
activities  are  hampered  in  countries  with  rigid  competition  policies,  where  new  entrants  are
confronted with the power of large subsidised conglomerates, and in countries where the financial
sector  is  too  underdeveloped  to  provide  venture  capital  to  smaller  entrepreneurs.  The  adoption  of
new laws compatible with the EU acquis is only the first step.  As the recent experiences with a lack
of supervision on agri-food production have shown, they can only be effectively implemented when
the enforcement mechanisms are in place and when sanctions are credible.  On an operational level,
the first thing to do is to make better use of the huge amount of data, statistics and studies that are
being  produced,  and  to  make  research  more  independent  of  economic  interests.    The  types  of
services that are needed and developed in countries with different standards of living require special
attention.  In the end, what is most important, is to establish a degree of trust and mutual recognition
between the Member States of the enlarged EU that allows for increased trade and other exchanges
between the people of the different countries

Just-in-time production and a shortening of delivery times have been welcome consequences of ICT
in the industrialised world. In this respect the impact of ICT is comparable with that of the EU single
market:  the  costs  of  communication  and  transportation  are  lowered,  which  leads  to  a  different
geographical dispersion of economic activities. Interestingly, the new concentration/decentralisation
of  production  units  is  almost  unpredictable  and  therefore  appears  to  be  random.  This  leaves  local
authorities  with  the  impression  that  they  can  influence  the  location  choice  of  firms  by  offering
incentives and firms with the temptation to play off one country or region against another.

The behaviour of firms in making their location decisions also offers an opportunity for the PACs
that are attractive to investors because they have relatively low wages and high skills. Although some
companies  such  as  car  manufacturers  have  become  increasingly  footloose,  there  is  a  chance  that
firms with the continuation of relatively favourable business conditions decide to stay where they are
once the EU is enlarged.

The panel emphasised the relevance of the concept of path dependency in the recent  literature on
economic dynamics: different short-term developments may have consequences for the longer term,
even  when  the  structural  economic  differences  are  expected  to  disappear  in  the  meantime.  Even
when  the  costs  of  relocation  are  small,  the  differences  are  easily  usurped  by  the  uncertainties
surrounding future developments.

92

Panel Members

Mrs. Christina CIONGA
Agricultural Advisor
Romanian-American Capital and Trade
Development Group
Romania
E-mail: cristina.cionga@ractdg.raef.ro

Prof. Dr. Constantin CIUPAGEA
Director
Institute of World Economy
Romania
E-mail: ciupagea@rnc.ro

Dr. László HALPERN
Deputy Director
Institute of Economics, Academy of
Sciences
Hungary
E-mail: Halpern@econ.core.hu

Prof. Jeremy HOWELLS
Director
PREST-University of Manchester
United Kingdom
E-mail: jeremy.howells@man.ac.uk

Prof. Jerzy KLEER
Warsaw University, Department of
Economics
Poland
E-mail: kondratowicz@wne.uw.edu.pl

Dr. Konrad LAMMERS
Head of Department of European
Integration
Hamburg Institute of International
Economics
Germany
E-Mail: lammers@hwwa.de

Dr. Edward MAJEWSKI
Head of International MBA in Agribusiness
Management
Faculty of Agricultural Economics,
Warsaw Agricultural University
Poland
E-Mail: majewski@alpha.sggw.waw.pl

Prof. Garabed MINASSIAN
Institute of Economics, Academy of
Sciences
Bulgaria
E-mail: g.minassian@iki.bas.bg

Dr. Slavo RADOSEVIC
University College London, School of
Slavonic and East European Studies
Senate House, Malet Street
United Kingdom
E-mail: s.radosevic@ssees.ac.uk

Prof. Dr. Jan SIEBRAND
Research Director Globalisation,
Regionalism and National Adjustment
Programme
Department of Economics
Erasmus University Rotterdam
The Netherlands
E-mail: siebrand@few.eur.nl

Dr. Malinka Dimitrova SLAVOVA
University of National and World
Economics, Department of International
Economics and Business
Bulgaria
E-mail: sslavov@ced.bg

Dr. Peter STANOVNIK
Director
Institute for Economic Research
Slovenia
E-mail: stanovnikp@ier.si

Prof. Dr. Ergun TURKCAN
Acting Head of Science and Technology
Policy Dept.
TUBITAK
Turkey
E-mail: eturkcan@tubitak.gov.tr

Prof. Uldis VIESTURS
Director of Institute of Microbiology and
Biotechnology
University of Latvia
E-mail: chem@lza.lv, koks@edi.lv

93

European Commission

Mr. Andries BRANDSMA
Enlargement Project Manager
IPTS TECS-Unit
E-Mail: Andries.Brandsma@jrc.es

Gustavo FAHRENKROG
Head of TECS-Unit
IPTS
E-Mail: Gustavo.Fahrenkrog@jrc.es

Mr. Blaz GOLOB
IPTS TECS-Unit
E-Mail: Blaz.Golob@jrc.es

Mrs. Elissaveta GOUROVA
IPTS TECS-Unit
E-Mail: Elissaveta.Gurova@jrc.es

Mr. Peder JENSEN
IPTS TSD-Unit
E-Mail: Peder.Jensen@jrc.es

Mr. Nikolaus THUMM
IPTS TECS-Unit
E-Mail: Nikolaus.Thumm@jrc.es

Mr. Alexander TÜBKE
IPTS TECS-Unit
E-Mail: Alexander.Tubke@jrc.es

94

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99

Annex A1 Bulgaria: SIRMA Case Study

(Contributed by Dr. Malinka Slavova)83

SIRMA Ltd.: Globally Competitive From Day One

Company Background

SIRMA  Group  Ltd.  produces  software  in  Bulgaria  and  sells  in  Canada  and  North  America.  The
company  was  registered  in  1992,  and  from  Day  One  has  been  a  Bulgaria-Canadian  partnership.
Partners  based  in  Canada  hold  30%  of  the  shares,  while  Bulgarian  associates  in  Sofia  hold  70%.
Currently, there are 54 SIRMA employees in Bulgaria and 11 in the two Canadian branches. Of the
Canadian shares, the SIRMA Group member in Ottawa holds 51%, and (until recently) 90% in the
Montreal branch. The rest of the shares belong to the company’s personnel and investors.84 The full
name  of  the  group  is  SIRMA  AI  where  “AI”  stands  for  “artificial  intelligence”.  It  is  involved  in
research  and  software  development  and,  as  the  company  self-estimation  says,  it  is  a  “technology
backbone for a number of marketing-oriented companies in US, Canada and Europe.” 

It was by chance that one of SIRMA’s current partners traveled to Canada and started working at
creating  concepts  for  IT  solutions.  She  began  to seek  help  from  colleagues  designing  software  in
Bulgaria, and then redesigned it and sold it in Canada. This strategy appeared to be a formula for
success. SIRMA Group’s field of activity since its incorporation has been software production. The
core personnel are drawn from a laboratory that, even during the Socialist period, operated on market
principles.  The  company’s  strategy  is  to  apply  for  projects  demanding  specific  software.  The
Company  produces  only  within  Bulgaria,  and  sells  almost  100%  abroad  (with  the  negligible
exceptions of retail sales to clients in Sofia before 1996, but with signs of return to domestic market
in 2001).

83 Dr. Krassen Stanchev, of the Institute for Market Economy (IME), prepared this Case Study. This
case study is  built  on  the  information  received  from in-debt  interviews  (August  2000 –  February  2001)  with
SIRMA Executive Director, Mr. Nikolai Dimitrov, and subsequent consultation with George Zahariev, currently
president  of  Bit’s  Ltd.  and  Board  chairman  of  IME.  Irina  Alexieva,  part  time  researcher  at  IME,  drafted
questions, and organized and recoded interviews. Zora Blagoeva, IME competitiveness coordinator, translated
them  into  English.  George  Zachariev  was  involved  in  training  the  founders  of  SIRMA,  and  was  informally
advising them when they established the company. (In 1992, he was a president of ICL-Bulgaria, and had the
biggest share of the computer market of Bulgaria.) Currently, he is a Board Member of WorkLogicDotCom Inc.
(one of SIRMA Canadian companies), and is a member of the Advisory Council of SIRMA Group. Subsequent
interviews were held with Michal Ryan of WorkLogic who demonstrated SIRMA products to the author, and
with  Asparuh  Kolev  of  WizCom  to  better  reflect  the  rivalry  situation  of  SIRMA.  Additional  information  was
collected through sessions of First Tuesday Club in Sofia and via two focus groups and 20 other interviews led
in  early  February  2001  by  George  Sadowsky  (a  vice chairman  of  the  Global  Internet  Society)  in  which  the
author assisted Mr. Sadowsky. The name of the company became known to IME in 1998. Then the Institute
was asked by the World Bank to select  one or  two  Bulgarian  entrepreneurs to be invited  to  the IMF/World
Bank 1999 Annual meeting and to take part in World Bank Institute Round Table on Competitiveness in South
East Europe. SIRMA was one of the likeliest candidates pre-selected by IME Board members Frank Bauer,
Andrei  Evtimov,  Levon  Hampartzumian,  George  Zachariev  and  Martin  Zaimov.  A  principal  source  of
information  about  SIRMA  is  also  the  company’s  website:  www.SIRMA.bg.  IME  would  like  to  express  its
appreciation  and  acknowledgements.  Additional  information  on  Bulgarian  IT  industry  might  be  found  in  the
upcoming George Sadowsky’s Report of a Mission to Bulgaria, and in: Ivaylo Georgiev, Krassen Stanchev,
Bulgarian IT Market Background, indented to be published at: www.competitiveness.bg.
84 In February 2000, there was a new shareholders’ agreement to allow the Montreal based
WorkLogic DotCom Inc. to sell equity to venture capital investors; the information on new
ownership structure is not yet available.

100

                                                     
The company website explains  that: “SIRMA AI Ltd. was  founded  in  1992 by  a  group  of highly
qualified young software engineers with strong interests in OO programming, Artificial Intelligence
and Knowledge Management.” They are still the core of the company that now employs more than
people. The company has established a long-term relation with several customers in Canada and US.
The website continues: “Apart from working on custom projects, SIRMA AI Ltd. has developed two
software  product  suites  -  EngView  Systems  and  InterpriseSite  (web-based  business  automation
applications). Two spin-off companies were founded in Canada to allow access to the world's largest
market for software, and to attract venture capital.”

The Diamond

Demand Conditions and International Clientele

Domestic Demand

The  domestic  market  is  weak  –  potential  domestic  consumers  lack  financial  resources  and  are
considered to be too small to afford SIRMA products, despite the preferential terms often offered to
domestic  purchasers.  SIRMA’s  major  markets  are  the  U.S.  and  Canada.  The  company  develops
software in two primary areas: management and working-place logistic systems, and CAD/CAM85
software systems.

The original clients in Bulgaria were mostly banks and one government department: the Ministry of
Environment,  International  Orthodox  Bank  "St.  Nikola",  First  East  International  Bank,  TSBank,
ElitBank, First Private Bank, and Bromak Financial House. In 1996-1998 four of the bank clients
were closed under Central Bank receivership86, and one was  restructured and sold to new owners
who did not renew contracts with SIRMA. By mid-2000, the other two contracts expired as well.

The clientele before 1997  logically consisted of banks and financial house: it  was  the  sector  with
most  rapid  development,  which  required  software  to  manage  capital  flow  and  link  management
systems  of  bank  branches  into  the  system  of  the  mother-bank.  Ministry  of  environment  was  the
prime user of management software due to the fact that it was one of the few government agencies to
benefit  from  EU  (particularly  the  PHARE  Program)  technical  assistance.87  Other  government
departments were slow to restructure and modernize, and respective programs were launched only in
1999-2000.

The private sector was an unlikely customer, due “to the size and old-fashioned technology base”,
explained  Mr.  Nikolay  Dimitrov.  His  assessment  is  confirmed  by  the  official  statistics,  available
from the National Statistics Institute (NSI).

85“CAD” stands for Computer Added Design, and “CAM” for Computer Added Manufacturing.
86 On the situation within Bulgaria’s banking industry in 1990-1997, see: Assenka Yonkova,
Krassen Stanchev (editors), In Search for Growth: Policies and Lessons from Bulgarian Transition,
IME Newsletter, Vol. 5, № 11-12, 1999. See also on the same issue: 1999 OECD Economic Surveys:
Bulgaria, p. 59, 102-103. On the current situation of the Bulgarian finance see: Assenka Yonkova,
Bulgaria Finance 2001, www.competitivenes.bg.
87 See for details: Krassen Stanchev, Foreign Environment Aid: The Case of Bulgaria, in Duncan
Fisher  (editor),  An  Independent  Assessment  of  Foreign  Environment  Assistance  to  Central  and  Eastern
Europe,  London,  East West  Environment,  1993.  The  structure  of  the  ministry  of  environment,  which,
besides  the  central  agency  in  the  capital  city  of  Sofia,  includes  16  regional  inspectorates  run
separately  from  the  main  territorial  structure  of  the  government  (based  on  28  district  centers),
required fast on-line link to transfer data and to run multiple projects simultaneously.

101

                                                     
Share of R&D, Software and Patents in Non-financial Enterprise Balance sheets (1996-1998*)

Research and
Development
products
Software products
Patents, licenses,
consignments,
know-how, firm and
trade marks
Total

1996
%
0.01

0.1
0.2

1997
%
0.02

0.1
0.3

1998
%
0.05

0.1
0.5

0.31

0.41

0.65

Source: NSI; *Data for 1999 and 2000 is not available.

For  example,  in  1998,  private  (non-banking)  sector  investment  in  electronics,  digital  systems,
computers, R & D, software, patents, know how, trade marks, etc. is reported to have been less than
0.65% of the total assets of the non-financial enterprises. The table above is evidence of the relative
low  share  of  software  and  other  knowledge-based  products  in  the  development  of  the  Bulgarian
industries.

The  picture  is  similar  if  we  try  to  use  the  investment  statistics.  In  the  table  below  electronic  and
software  products  might  be  listed  only  under  the  categories  of  “machines  and  equipment”  and
“other” products.

Gross Domestic Investment (1996-1999 Dynamics)*

Relative
share 1996-
1999
43%

50%

0.1%

1.2%

5.7%
100%

1996

1997

1998

1999

100%

100%

100%

100%

100%
100%

+0.9%

+23.8%

+61.5%

-14%

+25.64%

+34.5%

-79%

-93.7%

 -91%

-8%

-4.3%

+6.3%

+1.3%
-7.6%

+73.6%
+26.2%

+61.4
+45.9%

Construction and Real
Estate
Machines and
Equipment
Exploration and
melioration
Research &
Development
Other
Total

Source: NSI, own calculations

* Before estimating the trend, the investments are transformed in USD to ignore the influence of
the corresponding annual inflation;

The  relative  share  of  these  investments  for  the  period  of  1996-1999  is  56%  of  the  total  gross
domestic investment. The dynamic is greater in the category of “other” because of the relative low
starting point. Under both categories, however, there are signs of upward trend in investment.

102

Following the upper trends of restructuring of the Bulgarian economy after 1998, in early 2001, the
local  market  reemerged  for  SIRMA  and  it  has  three  new  domestic  contracts  currently  under
preparation: one CAD/CAM for packaging pharmaceutical products and two management systems.88

International Clientele
In  1996  –  2000,  clients  in  Canada,  USA  and  Turkey  replaced  the  loss  of  the  domestic  clients  in
Bulgaria.  In  Canada  SIRMA  is  a  key  contractor  for  management  systems  of  the  Canadian
government, a relatively big consumer as such.

The list of Canadian clients includes: the Department of Environment, the Department of Transport,
the  Department  of  Human  Resources  Development,  the  Revenue  Canada  Taxation,  GS  General
Strategies, Inc., AXTECH North Ontario Mould, Ltd., Rockwood Informatics Corp., IST Corp., the
Library of Parliament.89 In early 2001 a new big client was added to the list, the Royal  Canadian
Mounted Police. Canada-based Group Members are also clients for the branch in Bulgaria.

In  USA,  the  website  list  three  corporate  clients:  Optical  Gagging  Products  (OGP),  Nextera
Interactive Corp. in San Francisco and Instill Corp. in Palo Alto, California. The contract with OGP
is for a strategic cooperation in supplying software for computerized video quality control systems.

The importance of Turkish clientele (DEMA 3000 Corp. and Ozkardesler) is that (since mid-1990’s)
they brought SIRMA into CAD/CAM software production, and profoundly influenced the company
strategy.

“Besides these original and still important clients”, the website continues, “SIRMA supplies software
systems to the world leader in video control systems, and has clients in the packaging industries of
Malaysia, Turkey, Brazil, Singapore, etc.”

Firm Strategy, Structure, and Rivalry

SIRMA  participates  in  the  competition  of  the  North  America’s  software  markets.  Its  areas  of
specialization,  as  explained  by  the  company  website,  are  in:  OOP,  AI,  Theory  of  Recursive
Functions,  Declarative  Languages  for  KR,  Logic  Programming,  Functional  Programming,
Programming Languages, Data Structures, Lexical KB and Ontology. Perhaps because it started to
compete early,  SIRMA  is  one  of  the  few  Bulgarian software companies,  if  not  the  only  one,  that
markets  entirely  own  products.  All  interviews  we  had  during  the  preparation  of  this  case  study
appreciated this feature of the company.

88 However, the statistics on IT investment must be taken with a pinch of salt. For the period since
reforms  started  the  Generally  Accepted  Accounting  Principles  (GAAP)  were  introduced  only  the
banks while enterprise reports reflect National Accounting Standards where investment categories
in the  left column of  the  above  table  are  rather  abstract.  E.g.  IT  investment  is  spread  into  three
categories  and  it  is  hard  to  obtain  firm  data  without  concrete  research.  In  addition,  there  is  little
sense to report expenses if computers, software and other similar products purchased by  a firm
are either not considered an investment (until 1998 the depreciation period of computer equipment
under  the  Bulgarian  tax  legislation  was  five  years;  currently,  under  the  accelerated  depreciation
technique, the term is still five  years - but for the first three the rate might be, roughly,  70%),  or
have been purchased under loose copyright laws. This situation increases marketing and strategy
related costs of a firm. Mr. Dimitrov may well be misled in his judgments on domestic demand (see
his  estimates  on  the  size  of  the  companies),  while  SIRMA  reestablishes  its  presence  on  the
domestic market in 2001.
89 Source: www.sirma.bg.

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SIRMA and the rest of the software industry of Bulgaria

This  makes  SIRMA  different  from  the  rest  of  the  Bulgarian  software  industry.  It  is,  perhaps,  the
second largest software company in the country, with a turnover of average USD 1 million in mid-
1990,  and  almost  4 million  in  2000.  The  biggest  software  house  in  the  country,  RILA  Solutions,
established with US investment in 1998, works entirely on orders. The same is the case with another
relatively big company, SkalaSoft (originally a German investment, acquired recently by a Spanish
VC). A recent focus group on the Current Development Stage of Bulgarian IT Industry listed five
Bulgarian companies that successfully market their own products: SIRMA, Apis, Daxi, GreatBear
and WizCom. Of them (besides SIRMA), only WizCom markets its product internationally.90

SIRMA in Canada

SIRMA’s branch in Ottawa, WorkLogicDotCom Inc., is specialized in the automation of working
process management, e.g. governmental structures, internet-based products, etc. It  leads  SIRMA’s
management systems sales. Software produced by this branch has been sold already to 10 Canadian
ministries  and  government  institutions.  SIRMA’s  most  significant  recent  sale  was  for  “Canadian
Election  Support,”  and  is  used  for  political  elections.  The  system  is  designed  in  such  a  way  that
anybody  interested  in  election-related  issues  can  place  a  question  online  and  be  answered  shortly
through the Internet. One of SIRMA’s buyers of this product is the Canadian Ministry of Defense. In
a current competition, SIRMA expects Bell Canada, the biggest Canadian telecom operator, to select
between SIRMA and Xerox to design an internal system for consolidating over 30,000 customers.

Products

Some of the major products and product lines developed by SIRMA Group include: IPL Interprise
Product Line, Engineering View Systems, Forex Assistant, Vulcan - Artillery Fire C3 System (AFCS), ETES
- Extrusion Tools Expert Selector, IWA - Intelligent Workstation Architecture, EcoRisk and OmniSys.

Strategy

SIRMA  is  one  of  the  few  software  companies  in  Bulgaria  that  seeks  distinct  company  identity.
Managers believe that this approach helps to build and follow good competitive strategy and to keep
the innovative ardor of the personnel.

As presented in company documents, the mission of SIRMA is two-fold, depending on the areas  of  prime
company involvement:

•  For  business  solutions:  To  be  a  leading  provider  of  strategic  business  solutions  that  enable
continuous  organizational  improvement,  by  applying  advanced  knowledge  and  information
processing technologies.

•  For  R&D  services:  To  develop  innovative  products  and  technologies  through  long-term
research  combined  with  strong  software  development  capabilities.  To  create  and  grow
knowledge-based products by partnering with domain expert organizations

90  To  the  extent  that  we  managed  to  obtain  information,  the  WizCom  product  is  a  specialized
software  for  Multi-Nature  Post-Merger  Layout  that  facilitates  cohesion  of  companies’  accounting
and projects after mergers and acquisitions; despite the limited number of sales thus far, WizCom
Marketing Director (Mr. Kolev) believes in the bright future of the product.

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The Company’s organizational philosophy presumes to be realized through the following tasks:

•  To  provide  unparalleled  value  and  satisfaction  to  clients  through  competence,  professional

integrity and managerial ability;

•  To achieve an invigorating working environment that fosters professional and personal growth;

•  To achieve steady business development and maximize shareholders' value;

•  To encourage the proliferation of knowledge processing concepts.

SIRMA’s objective, says Mr. Dimitrov, is to become a world leader in CAD systems, a realistic goal
given the company’s background in computer-quality-control and packaging software. At the same
time,  it  is  a  market  that  the  company  entered  rather  by  chance;  accumulated  experience  is  a
prerequisite of success in this area.

Entry  into  the  CAD/CAM  business  helped  to  establish  an  internal  model  to  meet  competitive
challenges applicable to all (not only CAD/CAM) products. Mr. Dimitrov explained the model in the
following manner: “We plan to develop a new product, then to perfect it, and, eventually, to launch a
new  application  or  innovation.”  SIRMA’s  CAD  system  itself  had  originally  been  extremely
innovative, and company representatives believe their success is due the constant perfection of the
product. Currently about 15 software engineers work daily on the product, which SIRMA originally
developed, to some extent serendipitously.

It  was  the  packaging  industry  that  first  provided  the  market  for  the  SIRMA’s  development  of
CAD/CAM  software  systems.  Bulgarians  working  as  managers  in  a  packaging  factory  in  Turkey
contacted  SIRMA  in  1995  with  a  request  to  develop  a  product  for  the  needs  of  their  production.
Currently the product is the global best seller of its kind.

Based on CAD/CAM systems, SIRMA is developing a new product combining video control with
precise  computerized  management.  For  instance,  with  the  product,  a  camera  would  shoot  certain
details,  and  the  picture  would  later  be  compared  with  the  standard  model  by  a  computer.  The
company’s  primary  client  for  this  product  is  world-leading  supplier  of  video  recording  devices,
OGP. Nearly every item sold by OGP is equipped with SIRMA software.

Recognition for excellence and its background

In  1999,  the  SIRMA  CAD/CAM  packaging  system  received  the  European  Union’s  Award  in
Information Technology, for its “market potential and social direction”.91 The product has already
been marketed in 10 countries, some of them already mentioned above.

EngView Package Die-maker (EVPD) is a computer integrated packaging structural design and die-
making. EVPD is the flagship product of the SIRMA’s EngView Systems family. The product is a
CAD/CAM environment with a number of specialized functions for the vertical market of packaging
design and die-making. The novel core of the product is a geometric construction problems solver,
which  makes  it  one  of  the  few  CAD  systems  that  allow  Variational  and  Parametric  design.
According  to  the  company’s  website  the  trends  in  packaging  industry  show  rapid  shift  towards
complete  automation  and  extensive  use  of  non-computer  machines.  Therefore,  in  1995,  SIRMA

91  The  European  IST  Prize  is  organised  by  the  European  Council  of  Applied  Sciences  and  Engineering  (Euro-CASE),  with  the
sponsorship and support of the Information Society Technologies Programme of the European Commission.

105

                                                     
began to develop our product in cooperation with various industry experts. Gradually it created and
tested on the market the entire EngView Systems family of products.

EVPD consists of a number of modules. A powerful CAD system allows the user to easily draft a
box and set geometric relations. The program automatically keeps them afterwards, no matter how
the dimensions of the draft are changed. The parametric feature allows creation of easily resizable
standards.  Various  other  modules  enable  the  designer  to  fulfil  a  number  of  sequential  functions,
specific to the industry, like placing and editing of cutting or creasing knives, bridges etc. When the
design is completed, the CAM module generates the optimal toolpath, and operates any type of NC
machines  like  lasers,  cutting  plotters,  rule  processors  etc.  All  products  of  the  EngView  Systems
family are integrated and cover completely the production and business process of a large dieshop.

Vision and experience

SIRMA envisages its development in the area, which it calls Artificial Intelligence (AI). The main
directions are: Constraint Propagation Expert Systems, Natural Language Processing, Fuzzy Logic
Systems,  Knowledge  Engineering,  Machine  Learning  &  Neural  Networks,  Pattern  Matching  &
Pattern Recognition, Data-mining, and Speech encoding.

The prospects of implementing this vision depend of several factors, already applied by SIRMA. It
has  already  accumulated  experience  in  applying  AI  techniques  to  complex  and  hard  product
development challenges, and the personnel have academic and practical experience in many areas of
AI listed above. The company already has developed design methods, technologies and ready-to-use
libraries,  and  can  implement  them  in  real-life  systems.  SIRMA-designed  tools  are  proven  in  the
systems for processing expert knowledge, controlling complex software systems, image processing
and complex graphical objects recognition, etc. The experience in AI and the knowledge acquisition
techniques  has  been  already  extensively  used  to  analyse  and  better  understand  customer  needs,
expectations and goals.

One of the company’s  slogans  is:  “We  compete  on  the  basis  of  quality.”  Successful  and  globally
competitive companies fully  and  efficiently  utilize  the  accumulated  knowledge  and  the  individual
creativity of their personnel. SIRMA is no exception. Its ability to provide quality is based on a team
of  highly  motivated  professionals  with  solid  academic  background  and  significant  working
experience. The commitment to quality is obvious at all levels, from customer service and support,
and  project  management,  to  innovative  research  and  development.  When  attempting  to  order  a
software program produced by WorkLogic, the author had the opportunity to be assured that SIRMA
works together with clients to improve the quality of both its services and to launch operations that
would ensure long-term development of the customer projects and ideas.

Factor Conditions

Financing

The  branch  registered  in  Ottawa  is  financially  self-sustainable  at  North  America  standards.  The
Montreal company (WorkLogic) anticipates more investment from a VC company. For this reason,
as mentioned above, the company has been restructured. The details have not been disclosed but the
idea  is  to  reduce  the  control  on  behalf  of  the  mother  company  in  Sofia  and  allow  for  financial
independence  of  WorkLogic,  retaining  a  minority  share  in  combination  with  a  set  of  supply  and

106

service  contracts  from  other  Group  members.  In  addition,  WorkLogic  receives  some  (internal)
specialized marketing support.

For  the  time  being,  SIRMA’s  financing  strategy  has  depended  exclusively  on  its  own  revenues.
However, such a strategy is already inefficient at this stage of the company’s development. There is a
need for larger-scale investment in the improvement of the product base and the marketing of the
company products. The company’s managers are beginning to look for sources of external financing.
As this study goes to print, SIRMA is finalizing negotiations with the IFC for a three-year loan of
USD 5 million. SIRMA’s reserve strategy is to pursue other types of financing - for instance, venture
capital funds in Canada, Bulgaria and other countries. Additional finance is particularly necessary for
SIRMA at this time because, while the company meets and perhaps exceeds the standard rhythm of
renovations and innovations in its industry, its marketing causes delays in realizing profits. Investing
in marketing is therefore a vital part of the company’s strategy.

Marketing (assessment of the website)

As  mentioned  above,  the  marketing  activities  were  to  some  extend  assigned  to  WorkLogic.  The
impression  from  the  author’s  7-  month  communication  with  SIRMA  is  that  the  key  product
promotion  tool  is  individual  discussions  with  provisional  clientele,  and  that  the  branch  in  Sofia,
which is responsible for the presentation of the entire Group, is lacking marketing skills.

The website, the only readily available company presentation, contains description of family events
(e.g. children born) of the company staff, and it resembles “snap-shot” advertisement rather than an
explanation of SIRMA services and products. Perhaps the: involvement of family peculiarities in the
company presentations may create a suspicion that the entire group is managed like a family; at the
same time, the  close  relation  between company members was  a factor  that  has kept the  company
together between 1992 and 2000.92

Human capital at SIRMA

“SIRMA’s  most  important investment  is  in  its  human  capital”,  repeated  Mr.  Dimitrov  on  several
occasions. Equipment is a minor part of the company’s necessary capital investment; the bulk of the
company’s  investment  is  channeled  to  research  and  human  resource  development.  A  sign  of  this
commitment  to  human  capital  is  that  the  company’s  personnel  turnover  is  very  limited.  Since
SIRMA was incorporated, only seven people have left the company, and two of these are studying
abroad and expected back.

The  roots  of  SIRMA’s  human  resource  policy  go  back  to  the  mid-1980s,  when  the  company’s
current managers were either in their first years at the faculty of mathematics of the University of
Sofia or were about to finish Sofia Mathematics Gymnasium. In 1984-1985 they were selected to
work  for  the  PROGRAMA  Applied  Science  Laboratory,  a  market  oriented  institution  of  the
Bulgarian  Academy  of  Sciences  operating  independently  of  government  subsidies.  Apart  from
scores, the selection  criteria to work  at  this  elite  institution  included  team  work  and  the  ability  to
solve  cutting-edge  methodological  tasks.  The  firm  began  with  four  computers,  books  and
documentation, and a competition-oriented management. In 1986, it received its first award from the

92 The ownership restructuring is taking place in late 2000 – early  2001. The assessment of the
company website was shared on March 14, 2001 during a meeting  between SIRMA managers,
Mr. George Sadowsky and the author; We learnt, then, that a new set of promotion materials and
new website are under preparation.

107

                                                     
International Plovdiv Fair. In fact, the core SIRMA people came from PROGRAMA Lab after it was
closed, and essentially continued to do what they were doing before the reforms.

SIRMA was experienced in addressing development challenges under difficult circumstances, and
expects to build upon that experience. Mr. Dimitrov says: “The only way to gain experience is to
keep  and  develop  your  staff.  We  are  almost  60  people  now  and  for  the  last  8  years,  since  the
foundation of the company in 1992, only 5 people have left us.”

SIRMA  takes  it  for  granted  that  given  the  contemporary  communication  canal  a  company  may
operate  in  a  virtual  manner:  locating  the  coordination  at  one  spot  and  placing  research  and
development  at  different  locations,  where  direct  access  to  knowledge  is  available.  This
understanding is reflected by the human capital conditions of the company.

SIRMA’s labor contracts do not contain loyalty and restriction clauses. Instead, employee loyalty is
maintained by the challenging work offered by the company, and by the respected corporate identity,
say managers. The core research personnel consists of six doctors and two masters of from respected
universities93, who cover a large variety of areas related to software development.

Since  SIRMA’s  development  strategy  is  based  on  new  applications  and  innovation,  the  company
needs to attract more industries to implement the software, incorporating it into their products. The
company management believes that it is (for the time being) almost impossible to offer its software
as a separate, free-standing product. So, SIRMA’s development and competitive vision is to identify
niches in the numerous crossroads of the software industry.

“The partnership approach is a main principle of our business strategy”, declares the website. But it
means rather a partnership with the client than cooperation with domestic members of the IT cluster.
this cooperation is still in status nascendi.94

The  synergy  with  the  customer  is  achieved  by  combining  the  client's  know-how  with  SIRMA's
expertise and development capabilities.

The key element here is to use the “out-sourcing” system of software designing. It works as follows:

•  A company (or a customer) that needs software designed to particular specifications, but does
not  have  the  necessary  capacity  to  develop  it  independently,  contracts  out  the  software  to  a
design company;

•  The latter, in turn, divides the process  into two parts: designing the code of the software, and

subsequently designing the entire software or the application, if there is a need.

SIRMA is involved in designing the code itself. Two Canadian companies cooperate with SIRMA
for the second stage of the process. During the development of a given system, SIRMA handles the
areas that require expertise in knowledge processing technologies and software engineering and the
client supplies the know-how of its business. This approach creates a long-term business partnership
that results in high-quality systems, best suited to the client's own corporate culture and strategy. It is

93 Most of the research and engineering staff graduated Sofia and mathematic schools in Bulgaria,
then started their education in Bulgarian universities, and later received a chance to defend their
doctor  thesis  at  the  following  universities:  University  of  Alberta,  Canada,  University  of  Sheffield,
U.K.,  University  of  Reading,  U.K.,  Columbia  University,  U.S.A.,  University  of  Exeter,  U.K.,  and
University of Victoria, B.C., Canada. Sofia University, Faculty of mathematics.
94 See below for details on emerging cluster cooperation.

108

                                                     
a  general  policy  of  SIRMA  to  affect  technology  transfer  and  to  help  our  clients  manage  their
constantly changing business and technological environment. Some systems, developed under such a
partnership, are then marketed through joint-venture companies or other channels.

As already mentioned, SIRMA has chosen to design the software in Bulgaria and export it to North
America.  For  the  past  five  years,  SIRMA  has  specialized  in  business-to-business  relations  and  e-
commerce. It has been part of a joint group to create a virtual gateway through which a customer can
order anything from the food industry, or contact any distributor or supplier. This activity is currently
the most profitable activity of SIRMA but it does not have a critical mass of customers in Bulgaria in
order to rely on better domestic cooperation.

SIRMA and the cooperation with the rest of the sector

Before October 2000,  there  were  insufficient in Sofia where SIRMA and  other  Bulgarian  leading
software and IT companies could discuss their common development issues, and deliberate on the
macro and micro conditions of the industry. There are business associations attempting to represent
the industry but their major preoccupation is with conditions for companies supplying the domestic
market.95  SIRMA,  Rila  Solutions,  SkalaSofr  and  other  companies  that  market  their  products  and
services internationally found themselves excluded from local advocacy agendas. But since October
2000, the First Tuesday Club has operated in Sofia. Its mission is to bring together representatives of
IT and financial industry. Deliberation on development prospects with the participation  of leaders
like  SIRMA  has  already  passed  started,  and  companies  seek  opportunities  for  cooperation  in  the
following major areas of mutual interest:

•  The quality of the education system and knowledge development programs;

•  Telecommunications  monopoly  and  its  role  for  the  development  of  the  Internet  service

providers;

•  Ways to secure proper technology based for the Bulgarian IT sector.

SIRMA is a key participant in these deliberations.

SIRMA and the government

SIRMA  clearly  benefits  from  the  decent  level  of  high  school  education  in  Bulgaria.  But  its
innovative  and competitive position is based  on  the  opportunity  to  utilize  knowledge  produced  in
leading international universities. Cooperation with domestic academia is sporadic and based on ad
hoc  relations.  SIRMA  compensates  for  the  limited  research  interface  between  Bulgarian  software
industry and the research community via tapping global knowledge market. It also secures desired
quality of the personnel via providing scholarship and working perspectives for students from Sofia
University and the Technical University of Sofia.

There  is  no  special  government  policy  that  has  influenced  or  impacted  SIRMA  directly.  The
management benefited from the high level of education at schools and universities in Bulgaria on the
eve of reforms. The old regime was already allowing some freedoms, and SIRMA’s founders were
trained  in  a  “free”  environment.  When  SIRMA  was  incorporated,  its  management  already

95 One of those associations is the Bulgarian Association for Information Technologies, see for
details: Ivaylo Georgiev, Krassen Stanchev, Op. cit.

109

                                                     
understood that their destiny lay in their own hands, and they were already accustomed to meeting
challenges within their highly competitive industry.

A policy that hampers prospects for companies like SIRMA is the application of VAT regulations.
Currently, it is virtually impossible for a software company in Bulgaria to be refunded for VAT paid
on domestically supplied inputs when exporting their products. Software is not considered to be an
export. SIRMA is leading the dialogue with the government to resolve the issue. The prospects to
succeed are supported by the adoption of the Electronic Signature Act, which set the legal grounds to
prove product-like characteristics of exported software. Copyright identification in software and for
IT industry in general would also be a positive step.

110

111

Annex A2 Bulgaria: EPIQ Case Study

(Contributed by Dr. Malinka Slavova)96

EPIQ Electronic Assembly: Integrated Circuit Producer

Background

EPIQ Electronic  Assembly  (EA)  Bulgaria  is  an  integrated  circuits  and  parts  producer  for  western
home appliance and toy manufactures and carmakers. Its 2000 turnover so far has been Bulgarian
Lev (BGN) 25 million.

The beginnings of the EPIQ Bulgaria can be traced to the years of early reform, 1989-1992. Sigma
Delta (Belgium) was looking at half-ready privatization lists of Central and East European countries
to  buy  a  “clean  room”  for  the  purposes  of  integrated  circuit  production.  In  1991,  a  consultant  of
Bulgarian  origin  introduced  Sigma  Delta  to  the  then  state-owned  Microelectronica,  based  in
Botevgrad, at that time a center of the Bulgarian computer industry. Microelectronica was already in
critical condition, losing markets and accumulating debts,  but  there was  no  will  on the  part  of  its
government  owners  to  allow  a  joint  venture  or  to  sell  the  company’s  attractive  clean  room.  In
addition,  while  privatization  regulations  had  already  been  adopted,  the  implementing  institutions
were not yet prepared to act.

Eventually, Sigma Delta abandoned its plan to have a production clean room in Bulgaria, and bought
for DM 1 (plus 15 million debt coverage, and an employment and investment commitment) a clean
room  near  Erfurt,  ex-GDR,  which  gradually  proved  to  be  a  success.  A  benefit  for  the  future
Bulgarian  partners,  however,  was  that  Belgium  entrepreneurs  had  become  aware  of  Bulgaria’s
potential  in  integrated  schemes  manufacturing,  and  had  acquainted  themselves  with  the  country’s
many qualified engineers. As a result, Sigma Delta established the daughter company Sigma Delta
Bulgaria. It was launched in 1993, in Sofia, as a green-field investment employing five people.

96 Dr. Krassen Stanchev, of the Institute for Market Economy (IME), prepared this Case Study. This
case study is  built  on  the  information  received  from in-debt  interviews  (August  2000 –  February  2001)  with
SIRMA Executive Director, Mr. Nikolai Dimitrov, and subsequent consultation with George Zahariev, currently
president  of  Bit’s  Ltd.  and  Board  chairman  of  IME.  Irina  Alexieva,  part  time  researcher  at  IME,  drafted
questions, and organized and recoded interviews. Zora Blagoeva, IME competitiveness coordinator, translated
them  into  English.  George  Zachariev  was  involved  in  training  the  founders  of  SIRMA,  and  was  informally
advising them when they established the company. (In 1992, he was a president of ICL-Bulgaria, and had the
biggest share of the computer market of Bulgaria.) Currently, he is a Board Member of WorkLogicDotCom Inc.
(one of SIRMA Canadian companies), and is a member of the Advisory Council of SIRMA Group. Subsequent
interviews were held with Michal Ryan of WorkLogic who demonstrated SIRMA products to the author, and
with  Asparuh  Kolev  of  WizCom  to  better  reflect  the  rivalry  situation  of  SIRMA.  Additional  information  was
collected through sessions of First Tuesday Club in Sofia and via two focus groups and 20 other interviews led
in  early  February  2001  by  George  Sadowsky  (a  vice chairman  of  the  Global  Internet  Society)  in  which  the
author assisted Mr. Sadowsky. The name of the company became known to IME in 1998. Then the Institute
was asked by the World  Bank to select  one or  two  Bulgarian  entrepreneurs to be invited  to  the IMF/World
Bank 1999 Annual meeting and to take part in World Bank Institute Round Table on Competitiveness in South
East Europe. SIRMA was one of the likeliest candidates pre-selected by IME Board members Frank Bauer,
Andrei  Evtimov,  Levon  Hampartzumian,  George  Zachariev  and  Martin  Zaimov.  A  principal  source  of
information  about  SIRMA  is  also  the  company’s  website:  www.SIRMA.bg.  IME  would  like  to  express  its
appreciation  and  acknowledgements.  Additional  information  on  Bulgarian  IT  industry  might  be  found  in  the
upcoming George Sadowsky’s Report of a Mission to Bulgaria, and in: Ivaylo Georgiev, Krassen Stanchev,
Bulgarian IT Market Background, indented to be published at: www.competitiveness.bg.

112

                                                     
The “Internal” Cluster

EPIQ  Bulgaria  was  originally  (1993)  a  daughter  company  of  the  Belgium  based  EPIQ  Group  /
Sigma Delta SA (incorporated in 1989). Currently it is a part of EPIQ Group, a holding company,
established by Sigma Delta, with an annual turnover in 1999 of EURO 55 million. It has been listed
on  EASDAQ  since  July  1998.  The  Electronic  Assembly  in  Bulgaria,  with  its  BGN  25  million
turnover in 2000, accounts for more than 1/4 of the total Group turnover. The initial public offering
of DM 4 million was sold promptly to big investors, like PARIBAS, and EPIQ Group is currently
30% publicly owned.

Since it went public, the Group company structure developed into a worldwide one, currently, the
international locations of EPIQ companies are as follows:

•  Belgium, Fremach Plastics nv;

•  Bulgaria: EPIQ EA;

•  Czech Republic: EKER spol. s.r.o.;

•  France: EPIQ Besançon, EPIQ Paris Sales Office, EPIQ Dieppe;

•  Germany: FRANKONIA GmbH, EKER GmbH;

•  Hong Kong: MANIPA (Far East Purchasing Office);

•  Mexico: EKER de Saltillo.

For  2001  the  plans  are  to  open  a  plant  in  China  (EPIQ  Shenzhen)  and  in  2002  in  Brazil  (EPIQ
Brazil).

Vertical coordination with the Group “cluster” is well organized, though subject to changes, which
re-shape functions of the Bulgarian and Czech company.97 Manipa purchases chips and other basic
inputs in the Far East. The EPIQ Group is an electronic subcontractor with around 1,900 workers in
6 countries, with global sales. In ex-COMECON countries, in addition to its Bulgarian operation, the
EPIQ Group has a factory the Czech Republic, in Tremosna.

The Group’s focus is “on development and high volume (100,000 plus) production efficiency of the
electronic  subsystem”.  According  to  its  management,  the  EPIQ  Group  “typically  makes  systems
which are more integrated (using fewer components for a given functionality) than the competition”,
and, thus, “EPIQ-built products show a better reliability at lower cost”.98 Managers of the Group are
confident that it has one of the most competitive European assembly infrastructures in terms of costs.
The  company  appears  to  seek  comparative  advantage  via  investment  in  European  emerging
economies since it has developed some key production facilities in low-labor cost countries and/or
regions (Bulgaria, ex-GDR, as well as the location in the Czech Republic). The Bulgarian manager
believes that Bulgarian designers and engineers are at least five times cheaper than their counterparts
in  France  and  Belgium.  The  specialization  of  the  Group’s  companies  in  micro-electronic  sub-
contracting  is  as  follows:  EPIQ,  France  (two  factories)  –  automotive  and  telecommunications;
EKER, Germany – household appliances; and SIGMA-DELTA, Belgium & Bulgaria – appliances

97 See below the paragraph on strategies.
98 Source: EPIQ Group website: www.epiq.com, before it last update of end of January 2001.

113

                                                     
and  toys.  In  late  1999,  the  Bulgarian  branch  qualified  for  QS  9000.  It  is  currently  moving  into
automotive flex circuits as well.

Belgian branches of the holding company are responsible for design, marketing and financing. But
member-companies enjoy a great degree of independence in these areas as well. In this manner, the
Group services a good spectrum of customers: Alkatel, Bosch, Lucas, Philips, Rowenta, Siemens,
Sony, Tefal, Texas Instruments and Valco.99

The  Group  is  deliberately  aiming  at  establishing  a  sort  of  internal  (within  the  Group)  cluster
supported  by  the  division  of  functions,  mentioned  above,  and  internal  (mutual)  supply.  The
impression from the website presentation is that Belgium and France branches have a comparatively
heavier  weight  in  financial  maters  and  marketing  (although  every  one  applies  for  credits
independently).

The chapter in Bulgaria has followed the same internal-integrated strategy, gradually establishing a
three-company group (see below).

EPIQ EA Bulgaria has rarely relied on credit form Bulgarian banks. It holds its accounts with the
Sofia Municipal Bank, but even this bank provides more expensive credit than PARIBAS and other
EU-based banks, Mr. Berov said. The Group qualified for an equity financing from IFC of the World
Bank, and negotiation is to be finalized by end of March 2001. Obviously, for EPIQ EA cooperation
with foreign credit institutions is easier than with domestic banks.

Other  industry  members  are  briefly  described  below  in  the  paragraph  on  strategy  and  rivalry.
Because the active ones work on materials and orders supplied by customers and/or partners in joint
venture,  the  cooperation  within  the  sector  is  rather  limited.  The  supply  from  domestic  markets  is
fairly limited, mostly plastics and plastic forms, and orders filled by semiconductor producers.

Demand

Mr.  Berov  estimates  the  total  European  turnover  in  electronics  for  the  1999  –  2004  period  to  be
EURO 13-14 billion, or 2.4 billion annually, of which about one third is produced by companies in
Hungary,  Czech  Republic  and  Romania.  We  estimate  that,  in  2000,  EPIQ  as  a  group  (with  all  it
branches) has 0.57% of European annual volume and 1.73% of the volume produced in Hungary,
Czech Republic and Romania. However minimal these market shares seem, the EPIQ EA is, to the
best  of  our  knowledge,  the  most  competitive  Bulgarian-based  electronic  assembly  enterprise.  It
produces 100% for the export market – it has had no customers in Bulgaria since 1992.

99  Actually,  the  list  clients  of  EPIQ  Group  looks  like  enumeration  of  biggest  global  suppliers  of
customers for household products (Agfa, Barco,Black & Decker, Bosch-Siemens, Braun, Calor, De
Longhi,  Eksen,  Electrolux  /  AEG,  Emide,  Fluke,  Hamilton  Beach,  Jeux  Nathan,  Maico,  Miele,
Moulinex,  Niko,  Petra,  Philips,  Pioneer,  Rowenta,  Saunier,  Duval,  SEB,  Severin,  Shin-Etsu,
Stenlay,  Tefal,  UFESA,  and  Wolf  Klimatechnik),  and  of  customers  for  automotive  and  telecom
products  (Alcatel,  Ascom,  Banksys,  Brose,  Clarion,  Delphi,  Eaton,  ECE,  Electricfil,  Ericsson,
Esselte,  FCI,  Info  Realite,  Investix,  Lucas  Electronics,  Magneti  Marelli,  Philips,  Rank  Xerox,
Sagem,  Schmid  Telecom,  Somfy,  Sony,  Sylea,  Texas  Instruments,  TRW,  Valeo,  VDO,  and
Wehrle.)

114

                                                     
In 1999-2000 the market destinations of the company’s products are:

•  70% - European Union,

•  10% - Hong Kong,

•  10% - Mexico,

•  10% - United States.

EPIQ  EA  is  not  even  listed  in  the  most  recent  catalogue,  The  Catalogue  of  Electronic,  Data
Processing  and  Electric  Equipment  Companies.100  This  complete  orientation  to  leading  global
markets  is  to  some  extent  explained  by  background  reasons.  Between  1984  and  1989,  Bulgaria’s
monopoly  in  electronic,  information  and  computing  technology  in  the  COMECON  market  was
secured by the internal Eastern Block’s internal division of labor. The government of Bulgaria, or
companies  themselves,  borrowed  under  government  guarantee  from  the  London  Club  members
against  re-exporting  subsidized  raw  materials  and  energy  resources  from  ex-USSR,  and,  in  turn,
were  operated  technology  transfers  with  former  Communist  countries.  The  only  opportunity  to
sustain  production  was  to  redirect  markets  operations  and/or  to  become  a  part  of  international
production and distribution network. Sigma Delta was the first Bulgarian company to embark on this
path.

Factor Conditions

Given  the  above-mentioned  background,  the  Bulgaria  IT  and  software  industry  had  received
substantial investment before the start of the reforms in early 1990, but suffered market losses and
unsatisfactory domestic demand during the last decade. By the start of the economic reforms, aside
from Microelectronica, the infrastructure of the sector consisted of Electronica Co. and Computing
Technology Plant in Sofia, two clean rooms for circuit production.

Basic Factors

The official enterprise statistics of Bulgarian economy do not allow for a comprehensive comparison
of the Bulgarian IT and software industry with that of other economies.

Share of R&D, Software and Patents in Non-financial Enterprise Balance sheets (1996-1998*)
Source: NSI; *Data for 1999 and 2000 is not available.

Research and Development
products
Software products
Patents, licenses, consignments,
know-how, firm and trade marks
Total

1996
%
0.01

0.1
0.2

0.31

1997
%
0.02

0.1
0.3

0.41

1998
%
0.05

0.1
0.5

0.65

100 This Catalogue is available on Internet: www.elmedia.net; interestingly enough very few of the Bulgaria
based joint ventures in electronic are listed in the catalogue and none of the competitive software companies
(e.g. SIRMA AI Ltd. and RILA Solutions Ltd.) provided its name and profile to the catalogue, although there is no
other source of company information.

115

                                                     
As  an  example,  however,  in  1998,  private  (non-banking)  sector  investment  in  electronics,  digital
systems, computers, R & D, software, patents, know how, trade marks, etc. is reported to be less than
0.65% of the total assets of the non-financial enterprises. The table above is evidence of the relative
low share of knowledge-based products in the development of the Bulgarian industries.

The picture is similar if we try to use the investment statistics. In the table below electronic products
would be listed only under the categories of “machines and equipment” and “other” products.

Gross Domestic Investment (1996-1999 Dynamics)*

Relative
share 1996-
1999
43%

50%

0.1%

1.2%

5.7%
100%

1996

1997

1998

1999

100%

100%

100%

100%

100%
100%

+0.9%

+23.8%

+61.5%

-14%

-79%

-8%

+1.3%
-7.6%

+25.64
%
-93.7%

+34.5%

 -91%

-4.3%

+6.3%

+73.6%
+26.2%

+61.4
+45.9%

Construction and Real
Estate
Machines and
Equipment
Exploration and
melioration
Research &
Development
Other
Total

Source: NSI, own calculations

* Before estimating the trend, the investments are transformed in USD to ignore the influence of the
corresponding annual inflation;

The  relative  share  of  these  investments  for  the  period  of  1996-1999  is  56%  of  the  total  gross
domestic investment. The growth appears greater in the category of “other” because of the relative
low starting point. Under both categories, however, there are signs of upward trend in investment.

Access to Capital

EPIQ EA is believed  to have  relatively  easy access  to  capital,  borrowing  from  foreign  banks  and
tapping  international  stock  markets  as  a  member  of  EPIQ  Group.  In  the  past,  when  enterprises,
entrepreneurs,  and  politicians  were  asked  to  identify  the  single  greatest  impediment  to
competitiveness  for  Bulgarian  industries,  they  would  often  point  to  the  limited  availability  of
credit.101 EPIQ EA background is an evidence of the opposite: after securing its place as a part of an
international company it has received an opportunity to finance its operations. As Mr. Berov pointed
out  several  times:  “whenever  there  is  a  prospect  of  competitive  development,  companies  will  do
what is necessary to overcome the problem with financing”, i.e. they will secure it. It is interesting,
however,  that  on  average,  general  terms  of  access  to  credit  must  not  be  as  difficult  as  many
politicians and businessmen think. The table below manifests the dynamic of interest rate conditions
over the last six years.

101 See: Report on SME 1996-1999, Sofia Agency for Small and Medium Size Enterprise, 2000.

116

                                                     
Interest Rates (annual, %)

Dec-
1995

38.5

Dec-
1996
435.03

44.01

442.14

Dec-
1997

6.95

1.58

Dec-
1998

5.17

2.86

Dec-99

4.49

2.53

Dec-
2000*
4.73

2.03

51.43

481.11

13.85

13.52

13.33

14.17

25.29
11.31

211.87
-66.69

3.04
-4.74

3.30
23.51

3.27
23.30

  3.12**
0.9

-7.89

-82.12

-13.82

12.39

12.35

-0.91

Basic interest
rate
Interbank rate
(average)
Short-term
credits
Time deposits
Real lending
rate
Real deposit
rate

Source: BNB, World Bank, IME calculations

* Third week of December 2000; ** October 2000

Perhaps, the way people think about access to credit reflects either past (1998-1999) difficulties of
borrowing under lower interest terms, or banks’ perception of risk and related to it credit crunch, or
both102. In earlier periods the company did not rely on any domestic credit, but the situation may
change in the future. EPIQ has qualified for an IFC/World Bank loan of USD 3 million, and Sofia
Municipal Bank, the bank that services EPIQ accounts and international transfers, is considering a
revolving credit line for the company.103

Human Capital: Conditions

In a recent publication on  factor  conditions,  Rossen  Rozenov104  managed  to  collect  evidence  that
evidence  that  despite  relative  stable  shares  of  R&D  in  GDP,  scientists  in  engineering  (technical
science) and the number of personnel engaged in research and development is declining.

Investments (R&D to Gross Domestic Investment)

1996

1,4%

1997

1,4%

1998

1%

1999

1%

2000

1.2%

Investment
in
R&D/Gross
investment
 Source: NSI

Scientists in engineering

1996

28%

1997

28%

1998

27%

1999

25%

2000

25%

Engineering
and
Technology
/ Total
 Source: NSI

102 For details, see the upcoming analysis: Assenka Yonkova-Hristova, Banking Sector: Bulgaria 2000.
103 Currently the terms suggested by the bank are at 15% lower rates than the average, but it is still 20% more expensive
than the credit the company can get from foreign banks.
104 See: Rossen Rozenov, Factor Conditions, prepared by IME for J.E. Austin Associates and MSI on
www.competitiveness.bg. See also the above tables on enterprise balance sheets and investment.

117

                                                     
Private sector personnel engaged in research as share to all workers

1998

1999

Total

In the private
sector

Total

In the private
sector

Researchers

21 945

687

20 860

853

Researchers/
All workers

3%

0,5%

3%

0,7%

 Source: NSI
Data on the private sector that is more recent than 1999 is not available. It is not clear whether the
increase  of  private  sector’s  R&D  personnel  marks  a  beginning  of  a  trend.  How  does  EPIQ  EA
behave in these general conditions?

The company began with only five employees, but currently employs 530, Mr. Berov said. 5 of them
are development engineers, dealing with designs and instrument development, the rest are qualified
workers.

The major problem with human capital is its turnover: 1.5-2 employees leave each month, seeking
better careers and opportunities, often abroad.105

What steps is EPIQ taking to improve its access to the needed personnel? There is no easy strategy
but the company is doing the following:

• 

• 

• 

• 

It is bringing student engineers to the company during their second or third university year when
they start to specialize;

It initiated an Electronic Center at the Technical University of Sofia;

It participates in curriculum development; and

It organizes and finances courses, project development seminars and internships.

Strategy, Structure, and Rivalry

Expansion and quality
The company has passed through three different stages of development:

•  As Sigma Delta Bulgaria owned by Sigma Delta Belgium (1993-1997),

•  As  EPIQ  Electronic  Assembly  Bulgaria,  member  of  the  EPIQ  GROUP  (listed  on  EASDAQ)

(1997-1999),

105The Executive Directors told the following story from the EPIQ group experience. It illustrates the degree of rivalry in global
electronic assembling: EPIQ Group daughter company Milexis announced a job competition in India, looking for engineers for
an applied electronic unit in Eastern Europe; 1000 candidates sent their CV’s; 20 were short-listed and interviewed; 3 were
selected; eventually, 2 of them quit for better jobs in US and 1 arrived at the assignment but left “for personal reasons”.

118

                                                     
•  And as EPIQ EA Bulgaria (2000 -).

In  1993,  the  strategy  of  Sigma  Delta  Belgium,  itself  a  relatively  young  company  operating  in
circumstances of highly sophisticated demand and fierce rivalry, was to produce high quality articles
at  a  competitive  price.  Its  Bulgarian  partner  was  expected  to  produce  at  the  company  quality
standard.  The  company’s  first  stage  was  used  to  secure  patents,  to  set  up  production  (Bulgaria
subcontractors  often  failed  to  supply  according  to  the  agreed  terms),  and  to  establish  internal
facilities to accommodate the production. Sales revenues allowed for growth and fulfillment of the
strategy. The original decision for Sigma Delta to invest in Bulgaria was most likely motivated by
the costs of highly qualified labor. This strategy has been sustained: in late 2000, being one of the
quality leaders within the Group (see below), Epiq EA employs 28% of the EPIQ labor force.106

As already noted, the Group’s direct access to capital from listing on the electronic exchange (1997-
1999) coincided with the period when EPIQ EA Bulgaria secured quality certification (ISO 9002,
VALEO 1000, and QS 9000). During this period, the Group’s  financing was allocated  to product
development and innovation. The costs of borrowing for the Bulgarian member were the average for
the  Group  –  a  10%  interest  rate.  This  rate  gave  EPIQ  Bulgaria  considerable  advantage  vis-à-vis
fellow  Bulgarian  borrowers.  The  table  below  shows  the  saving/borrowing  conditions  for  average
Bulgarian  credit  seekers  in  selected  time  frames.  It  suggests  also,  that,  if  secured,  access  to  non-
Bulgarian lending institutions could secure an advantage for individual companies.

Strategizing: EPIQ EA and the sector

There is a difference between the general vision and strategy of Bulgaria’s IT industry and that of
EPIQ.

In 1997-1999, the author was a volunteer program director of the Bulgaria Economic Forum (BEF),
an  annual  Bulgarian  “Davos”,  at  which  investors,  industry  leaders,  IFI’s,  academia  and  senior
government representatives meet  and  deliberate  on  economic  development  prospects.  Since  1997,
the  industry’s  most  representative  association,  Bulgarian  Association  for  Intellectual  Technology
(BAIT) has organized an annual fair in Sofia where the industry members present their products.

In early 1998, the association decided to organize a spring forum on Bulgaria’s High Tech Industry,
inviting  global  leaders  to  meet  their  Bulgarian  partners  and  the  government.  The  original  policy
agenda of the domestic IT business associations was based on protectionism and direct and quasi-
fiscal subsidies. Although the Forum focused on the dimensions and strategies of the New Economy,
these  initial  agenda  surfaced.  The  government  picked  up  the  mood  and  drafted  a  High  Tech  bill,
which  provided  for  tax  breaks  and  government  financing  for  companies  and  activities  at  the
government’s  discretion.  The  bill  was  sent  to  the  parliament  and  passed  on  first  hearings  in  July
2000, but there is a little chance to have it adopted before the elections of  June 2001. Meanwhile
BAIT  and  other  associations  changed  their  vision,  advocating  a  focus  on  general  conditions  and
education. Currently the parliament is struggling to redraft the bill in accordance with the new vision,
which seems to have been taking deeper roots in stakeholders’ thinking.

From late 1999 to the present, EPIQ EA Bulgaria established a degree of vertical integration through
the establishment of two companies, a structure that is expected to better serve the clients. EPIQ EA
Bulgaria currently unites Sigma Delta (SD) Bulgaria with recently registered XPECT and MILEXIS
Bulgaria. All of them are members of the EPIQ EA Group.

106 Mr. Berov says that the investors information (third quarter of 2000, see the website: www.epiq.com ) is
outdated, he believes Bulgarian share in the EPIQ Group labor must currently be as high as 40%.

119

                                                     
Secured access to capital and markets: restructuring in the EPIQ Group

After  its  greenfield  startup  in  1993,  Sigma  Delta  (SD)  was  initially  based  in  Sofia.  It  began  its
expansion based on a patent of an integrated circuit used for “smart”-toys. The company’s Executive
Director  and  its  engineers  had  experience  from  working  in  Botevgrad  Microelectronica.  Initially,
Sigma  Delta  subcontracted  idle  state-owned  enterprises,  which  “often  failed  to  meet  contracted
deadlines and were difficult to bring to terms”. These difficulties motivated the company to pursue
opportunities to build production on its own. This goal was relatively easy for the plastic assembly
workshops (for toys), but not for the main parts and circuits.

•  EPIQ  Group’s  listing  on  the  stock  exchange  (July,  1998)  coincided  with  SD  Bulgaria’s
purchasing  of  parts  of  the  then-bankrupted  Microelectronica.  As  a  result,  EPIQ  Group  was
working to raise resources at the same time SD was attempting to build its own production and
facilities. EASDAQ  information shows that  EPIQ  stock  has  sustained  good  performance  over
three  years,  with  little  volatility,  and  share-price  stability  during  the  spring  of  2000  slump  in
electronic stocks. Its membership in the Group secured access to capital for EPIQ EA Bulgaria.
But,  more  importantly,  it  facilitated  access  to  highly  competitive  markets  driven  by  a  rather
sophisticated demand. At the same time EPIQ EA membership in the Group does not prevent it
from raising capital on its own. (as seen from the above-mentioned negotiations with IFC and
Sofia Municipal Bank.

•  However, marketing and sales functions of the Bulgarian Group-members are influenced by the
overall expansion of the Group and the division of functions within the Group. After the IPO in
1998, EPIQ acquired Frankonia GmbH in 1999, a German contract electronic manufacturer for
larger household appliances. The main products are components for large household appliances.
In  January  2000,  EPIQ  Group  acquired  FMC-Systemtechnik,  a  German  manufacturer  of
electronics in smaller series. The merger with the Fremach group107 in July 2000, was the most
recent  step  towards  the  creation  of  an  emerging  European  Force  in  system  building.  These
changes necessitated a deeper specialization of the EPIQ EA in Bulgaria: in 2001 its prime focus
is  already  production  of  components  for  small  household  appliances.  At  the  same  time  the
quality standards acquired in 1998-2000 (including those for automotive parts and circuits) allow
for smooth supply from EPIQ EA to other Group-members.

•  The development of the product structure of the Group as such is as follows:

107 At the time it was acquired, Fremach was an expanding company active in injection molding and finishing of
plastics for telecom, automotive and household appliances. The major source for the information in this
paragraph is the EPIQ website (www.epiq.com).

120

                                                     
EPIQ Group Product Structure (Legacy and Development)

2000 (%)
49

25
15

11

Type

Household

Automotive
Telecommunicatio
ns
Other (including
medical)108

2002 (%)
30

30
20

20

The Group’s development plan shows better distribution of products across lead knowledge-based global
industrial sectors. With the household specialization EPIQ EA bears greater responsibility for the products of
this type in the Group, though this is the product segment with most the intense concentration of Group
members. At the same time, it is likely that EPIQ EA development and marketing functions are diminishing,
since other group members play a more important role in performing them.

Division of Functions Between EPIQ Group Members

Type of product/
function

Headquarter and
Marketing

Household

Automotive

Telecommunication
s

Other

EKER GmbH

EPIQ Dieppe

EPIQ Fremach

EKER GmbH

Development

EKER GmbH

EPIQ SM2
Besancon

EPIQ Fremach

EKER Gmbh

EPIQ Dieppe,

EPIQ Fremach,

EPIQ SM2
Besancon,

EPIQ Fremach

EPIQ Dieppe,

EPIQ SM2
Besancon,

EPIQ SM2
Besancon,

EKER GmbH,

EPIQ Fremach

Production

EKER spol.
s.r.o.,

EKER de
Saltino,

EKER GmbH,

EPIQ Electronic
Assembly,

Frankonia-
Elektronik
GmbH

Ensuring quality

A  strategy  to  ensure  quality  is  important  to  EPIQ  EA  Bulgaria,  and  the  company  has  established
internal quality control systems. An inability to meet quality standards could easily cause EPIQ EA
Bulgaria  to  perform  poorly  in  comparison  to  other  Group  members.  Relatively  prompt
accomplishment  of  ISO  9002  and  VALEO  1000  (Valeo  is  a  standard  setter  in  auto-electronics
instruments)  in  1998  established  the  conditions  for  EPIQ  EA  Bulgaria  to  grow  and  compete
internationally as a full-right member of the Group, securing for itself access to the Group’s pool of
capital and improving profitability for the network.

A break-through in quality management was achieved at EPIQ Bulgaria in November 1999. It took
the managers almost a year to qualify for QS 9000, a standard for car electronics reliability set by
Daimler-Chrysler, Ford and General Motors. This standard certifies that the products it is associated

108 This category also involves engineering services, but their share in the total product structure is not yet
reflected in the available information sources.

121

                                                     
with  are free of deficiencies and  of high  quality.  Since  there  are  no  standard-licensing  companies
(TUV, CGS nor Veritas) operating in Bulgaria which could certify for QS 9000, EPIQ EA Bulgaria
received  it  certification  from  CGS  –  Belgium.  Internal  systems  for  quality  control  include  the
following:

•  40 procedures to control quality;

•  An additional list of working rules; and

•  Patterns of action, which allow for more rapid improvement after the roots of the problem, are

identified.

EPIQ EA, along with  EPIQ  Dieppe  and  EPIQ  SM2  Besancon,  lead  within  the  group  in  terms  of
meeting quality standards. The difference between them is that the French branches, specializing in
automotive products, have already qualified for VALEO 1000 Plus. Some group members (one of
the Germany based companies, and those in the Czech Republic and Mexico) still need to establish
more basic ISO standards. Achieving a wide spectrum of quality standards allows for flexibility; e.g.
the  Bulgarian  company  would  easily  back  up  a  provisionally  enlarged  market  for  the  Group’s
automotive products.

Sales and Financial performance

The recent performance of the Group is promising. By the end of the first quarter of 2000, the Group
had doubled its revenues on an annual basis by increasing sales across the range of products. For the
same period, sales to households doubled, sales to automotive industries increased by 2.5 times, and
sales to telecommunication companies tripled. Net profit per share double as well.

These trends continued in the second quarter of the year 2000. Products for the automotive industry
lead  in  sales,  and  modules  for  medical  equipment  performed  well  compared  to  previous  periods.
Turnover is up by 61% compared to the same period of 1999, and has grown by another 13% since
the  first  quarter  of  2000.  The  EBIT  quadrupled  on  an  annual  basis.  EPIQ’s  Bulgarian  branch  has
taken part in these positive trends, if anything exceeding average returns for the Group.

Diversity and customer based rivalry

In order to understand better the strategy of EPIQ EA Bulgaria, it is important to take into account
the  specific  nature  of  electronic  assembly  as  an  industry  and  its  market.  Thanks  to  forward
integration,  carmakers,  telecommunication  companies  and  home-appliance  producers  often
outsource assembly, and there is a tendency to subcontract modules rather than parts. The so-called
“original  electronic  manufacturing”  (OEM)  is  placed  between  the  industry  designing  the  final
product  and  the  assembling  subcontractor.  However,  the  subcontracting,  or  the  “contractual
electronic assembly” (CEM) still constitutes the bulk of the industry. Its share is thought to be more
than 60% of the global assembly market.

EPIQ  EA  Bulgaria  began  with  an  original  product.  Currently,  the  company’s  product  diversity  is
30% OEM and 70% CEM. Most of the OEM’s are in home/kitchen appliances.

EPIQ  EA  Bulgaria  supplies  its  patented  timer  (used  in  irons)  to  Texas  Instruments.  It  is  more
environmentally friendly (for not using mercury) and provides for better protection against product
liability charges. With Tefal, for example, the company’s strategy is different:

122

•  EPIQ works together with the client developing the product, and

•  Seeks teaming and investment in design and production.

Client orientation was, in fact, the major reason to change the structure of the company. The original
company Sigma Delta Bulgaria has been split into two: Melexis Bulgaria, dealing with design and
integral  circuits,  and  XPECT,  which  is  responsible  for  specific  equipment  and  the  company’s
instruments workshop.

Rivalry

As mentioned, 30% of the European Union’s supply of electronic products is based in three Eastern
European countries. While the Bulgarian branch of EPIQ Group is the only company of its status in
Bulgaria,  elsewhere  the  situation  is  different.  In  Romania,  for  instance,  in  the  Temisuara  district
alone there are 26 firms trying to improve their competitive position on the same market. According
to the company registry (BULSTAT), there are 30 other companies that declare that they operate in
the field of electronics.109 There is no evidence that more that four actually operate. Two previously
state-owned enterprises, Optico Electron and OMZ, have been privatized by companies established
by managers and employees, and there are two joint ventures. All of them work on orders. One of
them, a part of the already-mentioned Microelectronica, is still in a critical condition; the other two
exist on paper, living from renting their premises.

The structure of joint ventures and foreign investment is developing. Curtis Electronics is producing
magnetic disks in Razlog, in southwest Bulgaria. There are three major joint ventures with Siemens:
INKOMTELEKOMS  AD,  specializing  in  digital  systems,  technology  transfers  and  telecom
electronic  for  the  government-owned  Bulgarian  Telecom  Co.  and  which  also  supplies  to  other
Siemens Group members; and MIG 2000 and SIMAX AD, specializing in industrial electronics for
the domestic and international markets. All these companies in fact do not compete with one another
but within their respective groups and networks, thus participating in the global competition.

The Electronics Cluster in Bulgaria

There is a vacuum in the industry in terms of collaboration.

Aside from  the  fact that  above-mentioned companies  rarely cooperate,  the numbers  of  companies
“pretending”  to  operate  in  electronics  suggest  that  there  is  a  relatively  widespread  self-esteem  of
being involved in the electronics cluster. To some extend this is due to the fact that in the 1980’s
Bulgaria was educating electronic engineers in large quantities to serve the needs of the COMECON
market; currently many operate in private business and would like to be involved in the electronic
industry.

There are currently four universities educating students in the field of electronics, computer science
and informatics: Technical Universities in Sofia, Varna and Gabrovo, and Angel Kanchev University
in Russe. Sofia Technical University (STU) has a daughter college established in 1987, the Institute

109 Other sources name more companies. e.g. Bulgaria’s Firms Encyclopedia: Who’s Who In Bulgarian
Business, Sofia, InterIdea, 2001, lists 99 companies using the definition of the areas of activity by firms
themselves. Roughly one-third of them are trading pc hardware and spare parts, 10% assemble digital
instrument for the local market, and another one-third are listed as providers of hardware and software, network
and communication equipment. Some of the companies mentioned below, especially joint ventures and recently
privatized companies, are not described available sources.

123

                                                     
of  Electronics,  in  Botevgrad  (the  town  where  EPIQ  EA  plant  is  located);  there  is  cooperation
between EPIQ and the Institute in setting the curriculum and organizing internships).

In addition to the Institute of Electronics (or the college) in Botevgrad, there are six other institutes in
the field of electronics: one of them was registered in 1987 as a government-sponsored non-profit
organization  (The  Center  of  Plasma  Technology  and  Research).  One  is  the  government-owned
Business Innovation  Center  (IZOT), and  the rest are government-owned institutes: the  Institute of
Electronics  of  the  Bulgarian  Academy  of  Science  (BAS),  the  Institute  for  Instrumentation  and
Computer Technique Inc. in Sofia (BAS owned company), the Central Mechatronics Lab of BAS,
and  the  Central  Institute  of  Computing  Technique  and  Technology.  There  are  three  business
associations that advocate development for Bulgaria’s computer and electronics: one universal, the
Bulgarian Chamber of Commerce and Industry (BCCI), and two guilds – BAIT and a Chamber of
Electronics  and  Computer  Industry  (itself  a  member  of  another  universal  association,  Bulgarian
Industrial Association, BIA). There are two guilds in the industry: the already mentioned BAIT, and
the Electronics Industry and Informatics Chamber, a member of the Bulgarian Industrial Association.
is  a  scientists  and  engineers’  Electronics,  Electric  Technology  and
In  addition, 
Telecommunications  Union.  EPIQ  EA  “is  a  member  of  everything”,  says  Mr.  Berov,  but  sees
membership  as  an  attempt  to  help  others,  not  finding  it  particularly  useful  for  the  company.  We
think, this is an assessment shared by most leaders electronics and IT industries: they do not exclude
themselves from the available dialogue channels, but solve issues related to diverse quality standards
and copyright protection through internal diversification of production.

there 

The  cooperation  between  EPIQ  EA  and  academia  seems  to  be  of  a  special  importance  for  the
company. Through this, it makes sure that it recruits best available young engineers.

The  general  pattern  of  cooperation  is  that  individual  companies  commission  services  to  some  of
those  organizations  or  support  courses  in  the  college  or  the  universities.  There  is  no  regular
scientific- or business-oriented publication, magazine or journal. The only exception is the monthly
magazine Engineering Review published, by Luibomira Mancheva and edited by Luiben Georgiev;
it devotes about 15% of its volume to electronics.

Government Policy: Epiq EA Benefits

During  its  short  history,  there  have  been  two  occasions  when  the  interests  of  EPIQ  Electronic
Assembly  Bulgaria  were  directly  and  substantially  impacted  by  government  policies.  These  two
occasions were:

•  The  attempt  to  privatize  a  clean  room  in  Botevgrad  for  the  purposes  of  integral  circuit

production;

•  The purchasing of a facility from the already bankrupted Microelectronica.

The first case deals with the privatization of state owned industries. The second, again rather self-
evidently, centers on the government’s policy to secure the enforcement of bankruptcy and creditors
rights. The first was a failure, but the second proved to be a success for the company.

During  the  interviews,  EPIQ  Group  and  the  leaders  of  the  Bulgarian  branch  had  no  interest  in
discussing  the  past,  making  it  difficult  to  collect  information  on  what  exactly  happened  in  1992.
However, it is useful to summarize the experience in order to derive some explanations and lessons.

124

During those negotiations, Sigma Delta Belgium came to the country at very peculiar time. To the
extent it is possible to judge now, the failure resulted from the following causes:

•  Privatization laws had been adopted (April  1992),  but had not  yet  been  implemented  by  May

1993, when the first privatization deal was signed;

•  The leading concept in the privatization regulations was to sell enterprises as a whole, but not to

detach and sell units which raised investors’ interests;

•  There were mixed objectives of privatization per se, often including “social” goals (employment
targets, etc.) which the government pursued at the expense of economic and fiscal efficiency;

•  Due to all of the above circumstances, the government demonstrated no flexibility and did not

employ any transitional strategy (e.g. signing a joint venture, etc.).

Concerning the second occasion, EPIQ Bulgaria’s Executive Director was more willing to provide
information.  In  August  2000  he  told  the  Business  Ethics  Round  Table  of  the  Rozhen  2000  Pan-
Bulgarian Summit (hosted by the President of the country): “The experience of our company proves
that the only government policy we benefited from was enforcement of bankruptcy laws; in our case
it happened later than expected, and at the cost of many lost opportunities, not just for us, but for
everybody in Botevgrad and the industry. If the government merely secures financial discipline and
equality before the law, it is more than enough to launch a competitive strategy.”

How, in fact, did EPIQ benefit? It managed to establish its production facility in a constituency that
was not foreign to the industry. But the clean room has not been used for 10 years. Neither EPIQ not
any other company had the chance to use it for the production of cutting edge products, for which it
was originally designed. In fact, as the company sells timers to Texas Instruments, EPIQ Bulgaria
benefits  more  from  the  policies  of  the  US  government,  especially  those  enforcing  strict  product
liability and high environmental standards.

125

Annex B - SLOVENIA: FOREIGN DIRECT INVESTMENT TRENDS, FACTORS
AND PROSPECTS

(Contributed by Dr. Matija Rojec, Faculty of Social Sciences, University of
Ljubljana, through Dr. Peter Stanovnik)

1.

FDI trends and basic features

1.1. Flows and stocks of FDI

FDI stock - foreign equity and reinvested profits plus net liabilities of foreign investment enterprises
(FIEs),  i.e.  companies  with  10%  or  higher  foreign  equity  share,  to  foreign  parent  companies  -  in
Slovenia  at  the  end  of  2000  amounted  to  USD  2,808.5  million.  Taking  into  account  USD  187.7
million of FDI inflows in January-May 2001 the present stock of inward FDI in Slovenia stands at
about USD 3 billion.

TABLE 1: Flows, stock and changes of stock of inward FDI1 in Slovenia in 1993-20002

1993

1994

1995

1996

1997

1998

1999

2000

954.3
709.7

1,325.9
966.5

1,763.4
1,203.5

1,998.1
1,274,9

2,207.3
1,559.4

2,765.8
2,011.6

2,656.5
1,893.9

2,808.5
1,883.2

244.4
n.a.
112.6
112.6
n.a.

359.4
371.6
128.1
128.1
n.a.

559.8
437.5
177.4
176.0
1.4

723.1
234.7
194.0
185.5
8.5

647.9
209.2
375.2
320.8
54.4

754.2
558.5
247.9
165.4
82.5

762.6
-109.3
181.2
83.4
97.8

925.3
152.0
181.0
83.4
97.6

VALUES, in millions of USD
Year-end stock – total

Equity&reinvested earnings
Net liabilities to foreign
investors

Changes of stock – total3
Annual inflow – total3
  Inflows from abroad
  Reinvested earnings
GROWTH RATES, in %
Year-end stock – total
Annual inflow – total

n.a.
1.4

38.9
13.7

33.0
38.5
Source: Bank of Slovenia; Notes: 1/ FDI whereby a foreign investor holds a 10% or higher share in a company;
2/ From 1996 onwards direct investments with indirectly affiliated enterprises are also included; 3/ Inflows are in
principle  smaller  than  changes  in  stocks  since  international  payments  transactions  comprise  only  part  of  the
changes  in  stock;  most  notably,  inflows  data  do  not  include  changes  in  net  liabilities  to  foreign  investors.
Furthermore,  inflows  do  not  include  data  on  directly  affiliated  companies.  From  1995  onwards  data  on
reinvested earnings are also included in inflows and, thus, in the balance of payments; n.a. = not available.

-4.0
-26.9

25.3
-33.9

10.5
93.4

13.3
9.4

5.7
0.0

Stock of inward FDI in Slovenia in the period 1993-2000 increased from USD 954.3 million to USD
2,808.5 million110, that is by 2.9 times. FDI inflows and stock were increasing rather fast all until the
end of 1997. Afterwards, Slovenia experienced a slowdown in FDI inflows which recovered only in
2001. First half of 2001 brought about an important positive change in FDI inflows in Slovenia; in
January-May  2001  FDI  inflows  amounted  to  USD  187.7  million,  compared  to  only  USD  34.4
million in the same period of 2000. Higher inflows are predominantly the consequence of a limited
number of foreign acquisitions, most notably two of them – French bank Societe Generale acquired
majority  share  in  SKB  bank  and  Austrian  Mobilkom  acquired  majority  share  in  mobile  phone

110 The decrease of stock by USD 109.3 million in 1999 is predominantly due to high appreciation of USD

against SIT in that year; in fact, the stock measured in EUR increased by EUR 317.8 million.

126

                                                     
operater  Simobil.  Until  the  end  of  2001  one  can  expect  continuation  of  higher  inflows  of  FDI  in
Slovenia.  FDI  projects  already  realized  or  announced  for  2001  indicate  FDI  inflows  in  the
approximate  amount  of  USD  500  million  what  would  be  far  the  highest  annual  FDI  inflow  in
Slovenia recorded so far. In the years to come, one can expect the same or even higher inflows of
FDI.  The  major  reason  for  that  is  the  forthcoming  privatization  of  the  state  property,  mostly  in
financial sector and public utilities. Motivation of the government to involve foreign investors in the
forthcoming privatization is strong and is related to strategic development as well as fiscal reasons.
Expected  participation  of  foreign  investors  in  the  privatization,  accompanied  by  the  support  of
investment  incentives  policy,  embodied  in  the  government  Program  for  the  Promotion  of  FDI  in
2001-2004 (TIPO 2001), would eventually have a positive influence on the perception of Slovenia as
investment location and, consequently, also on the increase of FDI inflows in general.

If FDI stock is divided into equity and reinvested earnings, on one hand, and net liabilities to foreign
investors, on the other, one can notice an increasing share of net liabilities in total stock. The share
increased from 25.6% to 36.2% in 1993-1996 period, then it decreased to 28.7% in 1999 and again
increased to 32.9% in 2000. Basically the increasing share of net liabilities in FDI stock indicates the
increasing importance of consolidation of existing FDI versus new FDI projects. This pattern is also
confirmed if one divides FDI inflows to new inflows from abroad and reinvested earnings. The share
of the latter  is  increasingly  relevant  and  in  1999  and  2000  represents  approximately  54%  of  total
inflows. Existing foreign investors in Slovenia seem to appreciate the investment environment in the
country more than potential new investors.

As far as the mode of entry of foreign investors in Slovenia is concerned, the Bank of Slovenia’s data
distinguish between greenfield FDI, acquisitions and other investments (in institutions, subsidiaries
and foundations). By number, greenfield FDI is the most frequent type accounting for 55.8% of all
foreign  investments  at  the  end  of  1999.  41.9%  of  foreign  investments  have  been  acquisitions.  In
terms of equity the situation is the opposite. Acquisitions account for 68.7% of  all  foreign equity,
while greenfield FDI 31.0%. Other investments are negligible. The average value of foreign equity in
acquisitions is USD 1.8 million and in greenfield USD 0.6 million.

TABLE 2: Flows, stock and changes of stock of outward FDI1 from Slovenia in 1993-2000; in USD
million

Year-end stock – total

Equity and reinvested
earnings
Net claims to companies
abroad

1993
280.6
241.7

1994
354.0
342.4

1995
489.9
366.2

1996
459.5
342.9

1997
459.4
324.7

1998
608.3
367.8

1999
605.0
359.6

2000
794.0
466.2

38.9

11.7

123.7

116.5

134.7

240.5

245.4

327.8

Changes of stock – total
Annual outflow2
Source:  Bank  of  Slovenia;  Notes:  1/  FDI  whereby  a  foreign  investor  holds  a  10%  or  higher  share  in  a
company; 2/ “-“ means outflow; n.a. = not available.

135.9
5.1

189.0
-47.6

148.9
1.7

-30.4
-6.3

-3.3
-37.5

-0.1
-35.6

73.4
2.9

n.a.
-1.3

In 2000, Slovenia registered a record USD 47.6 million outflow of FDI. At the end of 2000 the stock
of Slovenian outward FDI was USD 794 million. In the period January-May 2001, the outflows were
USD 24.7 million, twice as much as USD 12.5 million in the same period of 2000. In 2000, stock of
Slovenian outward investment increased by USD 189 million, what was more than the increase of
inward  FDI  stock  in  the  same  year  (USD  152  million).  The  increase  was  more  due  to  increased
equity  and  reinvested  earnings  (increase  of  USD  106.6  million)  than  to  increased  net  claims  to
companies abroad (increase of USD 82.4 million). In fact, 2000 was the first year after 1994 which
saw a considerable increase of equity and reinvested earnings. In 1994-1999, equity and reinvested

127

earnings  increased  only  by  USD  17.2  million,  while  net  claims  to  companies  abroad  in  the  same
period increased by USD 233.7 million. These trends seem to indicate that Slovenian investors in the
1994-1999 period were mostly consolidating their existing investments abroad, while in 2000 and
especially in 2001 a more vivid activity of establishing new FDI projects abroad, mostly related to
the successor countries of the former Yugoslavia, is present.

1.2. Countries of origin and destination

Investors from EU countries dominate FDI in Slovenia. At year end 2000 no less than 84.0% of total
inward FDI stock was accounted by EU countries, the major investors among them being Austria
(45.6%  of  total  foreign  equity  stock  at  year-end  2000),  Germany  and  France,  followed  by  Italy,
United Kingdom and Netherlands. FDI from other EU countries lags behind. Of non-EU countries,
only USA, Czech Republic, Switzerland and Croatia are relevant investors. Share of EU countries in
inward FDI stock in Slovenia in 1994-2000 increased heavily, i.e. from 62.0% to 84.0%111. By far
the  highest  increase,  i.e.  23.2  percentage  points,  was  made  by  Austrian  investors.  Proximity  of
Slovenia  to  the  EU  and  traditionally  strong  economic  co-operation  of  Slovenia  with  Austria,
Germany,  Italy  and  France  are  the  major  reasons  for  the  domination  of  investors  from  these
countries.

TABLE 3: Distribution of end-year stocks (total value) of FDI in Slovenia by investing countries1 in
1994 and 2000; USD million and %

1994

2000

Austria
Germany
France
Italy
United Kingdom
Netherlands
Denmark
Luxembourg
Sweden
Belgium
Ireland
Finland
EU – Total
USA
Czech Republic
Switzerland
Croatia
Liechtenstein
Cyprus
Other countries
TOTAL

Value
1,279.4
350.5
299.2
152.0
101.5
82.9
42.4
29.6
13.5
7.1
1.2
0.5
2,359.8
109.3
104.9
102.0
48.0
14.4
14.4
55.7
2,808.5
Source: Bank of Slovenia; Notes: All countries with higher than USD 10 million end-2000 stock are included plus
other EU countries.

Change of share
1994-2000
+23.2
-2.3
-0.9
-4.9
+3.2
+2.2
+0.2
+1.1
+0.5
-0.1
0.0
0.0
+22.0
+3.0
+3.7
-1.1
-29.2
+0.4
+0.5
-0.7
0.0

Value
296.9
196.3
154.2
136.0
5.5
11.0
16.9
0.2
0.2
4.9
-0.1
0.0
821.7
12.2
0.1
62.9
409.8
1.7
0.3
17.2
1,325.9

Share
22.4
14.8
11.6
10.3
0.4
0.8
1.3
0.0
0.0
0.4
0.0
0.0
62.0
0.9
0.0
4.7
30.9
0.1
0.0
1.3
100.0

Share
45.6
12.5
10.7
5.4
3.6
3.0
1.5
1.1
0.5
0.3
0.0
0.0
84.0
3.9
3.7
3.6
1.7
0.5
0.5
2.0
100.0

111 Shifts of the shares are importantly influenced by heavy reduction of the share of Croatia. This is mostly due
to the fact that since 1998 the Croatian share in the Nuclear Power Plant Krško is no more included in the
FDI stock; Slovenia and Croatia still negotiates the future status of the plant.

128

                                                     
Although a typical foreign investor in Slovenia is a small to medium sized company from one of the
nearby  EU  countries,  especially  Austria,  FDI  in  Slovenia  is  heavily  concentrated  on  a  relatively
small number of the largest FDI projects mostly with European multinational enterprises (MNEs).
These projects determine the investing country as well as the industrial breakdown of FDI stock in
Slovenia. The largest 5 FDI projects (out of 1,726) account for 23.1% of total 1998 end year stock of
FDI  in  Slovenia,  the  largest  10  for  35.4%,  the  largest  15  for  45.6%,  while  46  FDI  projects  with
foreign equity above USD 10 million account for 68.6% (Rojec 2000a). Of the later only 5 are of
non-EU  (mostly  US)  origin.  These  investors  are  Goodyear  and  Kirkwood  Industries  from  USA,
Renault,  Leclerc  and  Societe  Generale  from  France,  Meyr  Melnhof,  Henkel,  OMV,  Brigl  and
Bergmeister,  Interspar  and  Bank  Austria  from  Austria,  E.G.O.  from  Switzerland,  Siemens,
Reemtsma, Pfleiderer and Porsche from Germany etc.

TABLE 4: Distribution of end-year stocks (total value) of Slovenian FDI abroad by host countries1
in 1994 and 2000; USD million and %

Austria
Germany
France
Italy
United Kingdom
Denmark
Other EU countries
EU – Total
Croatia
Macedonia
Bosnia and Hercegovina
Yugoslavia
Successor countries of former
Yugoslavia – Total
Czech Republic
Poland
Russia
Ukraine
Romania
Slovakia
Other transition countries
Transition countries – Total
USA
Switzerland
Liberia
Iraq
Other countries
TOTAL

1994

2000

Value
9.6
30.6
-0.8
6.2
0.4
0.0
-4.8
41.2
193.0
15.9
14.8
27.9

251.6
2.4
13.3
4.8
5.0
0.3
0.3
4.7
30.8
13.9
11.8
16.6
0.0
-11.9
354.0

Share
2.7
8.6
-0.2
1.8
0.1
0.0
-1.4
11.6
54.5
4.5
4.2
7.9

71.1
0.7
3.8
1.4
1.4
0.1
0.1
1.3
8.7
3.9
3.3
4.7
0.0
-3.4
100.0

Value
27.7
70.5
8.0
8.2
10.4
8.3
-7.6
125.5
357.7
66.1
61.9
26.6

512.3
10.4
55.7
15.8
7.4
5.5
5.2
6.6
106.6
22.1
8.4
23.7
9.9
-14.5
794.0

Share
3.5
8.9
1.0
1.0
1.3
1.0
-1.0
15.8
45.1
8.3
7.8
3.4

64.5
1.3
7.0
2.0
0.9
0.7
0.7
0.8
13.4
2.8
1.1
3.0
1.2
-1.8
100.0

Change of share
1994-2000
+0.8
+0.3
+1.2
-0.8
+1.2
+1.0
+0.4
+4.2
-9.4
+3.8
+3.6
-4.5

-6.6
+0.6
+3.2
+0.6
-0.5
+0.6
+0.6
-0.5
+4.7
-1.1
-2.2
-1.7
+1.2
+1.6
0.0

Source:  Bank  of  Slovenia;  Notes:  1/  All  countries  with  higher  than  USD  5  million  end-2000  stock  are  included.
Data concerning real estate owned by Slovenian households abroad (mainly real estate in Croatia) are not included.
Also claims on other successor countries of the former Yugoslavia, subject of negotiations on succession, expatriate
assets in these countries, and other assets transferred to the Slovenian government during the process of privatization
are not included.

While inward FDI in Slovenia is getting particulary strong from Austria (45.6% of end-2000 inward
FDI stock), Slovenia's outward FDI is as much concentrated on Croatia having 45.1% of Slovenia's
end-2000  outward  FDI  stock.  In  addition  to  Croatia,  countries  that  are  increasingly  attractive  for

129

Slovenian  investors  are  Macedonia,  Bosnia  and  Hercegovina,  Poland  and  Germany.  Obviously
gradual  increasing  of  outward  investment  of  Slovenian  firms  is  related  mostly  to  the  activity  of
Slovenian firms in the successor countries of the former Yugoslavia (64.5% of end-2000 outward
FDI stock). Transition countries of Central and Eastern Europe and EU are much less represented as
host  countries.  Slovenian  firms  are  more  and  more  aware  of  the  necessity  of  intensified
internationalization in which outward FDI is increasingly important method. Successor countries of
the former Yugoslavia (proximity and familiarity with the environment, previous intensive business
connections, knowing of languages) and, to a certain extent, transition countries represent a kind of
logical first step in this direction (Svetličič, Rojec and Trtnik 2000). Announcement of establishment
of  regional  investment  fund  for  South-East  Europe,  to  be  initiated  by  the  Slovenian  government,
seems to indicate that the government is aware of the strategic importance of Slovenian investment
in the region, as well as of the problems the investing firms are faced with.

1.3. Distribution by economic activity

Manufacturing with 43.1% of total 2000 end year FDI stock is by far the most important recipient of
FDI  in  Slovenia.  Inside  manufacturing,  FDI  is  heavily  concentrated  in  paper  and  paper  products,
chemicals and chemical products, machinery and equipment, rubber and plastic products, and motor
vehicles and trailers. Outside manufacturing, FDI is concentrated in trade, financial intermediation
and  other  business  services.  Industrial  distribution  of  FDI  is  to  a  major  extent  determined  by  a
handful of large (for Slovenian circumstances) FDI projects, which as a rule emerged out of previous
co-operation  between  foreign  investor  and  invested-in  Slovenian  company.  Foreign  investors  in
Slovenia  have  been  far  more  attracted  by  “attractiveness”  of  individual  Slovenian  companies  (as
target companies or joint venture partners), that is by their specific individual characteristics, than by
“attractiveness” of individual industries as such (Rojec 1998).

In the manufacturing industry the major investments are the investment of Renault from France in
car manufacturing  (Revoz),  Meyr Melnhof (Količevo karton) and  Brigl  &  Bergmeister  (Papirnica
Vevče) both from Austria in paper, IPB from Czech Republic also in paper (VIPAP Videm Krško),
E.G.O.  from  Switzerland  in  electro-thermic  apparatus  (ETA  Cerkno),  Siemens  from  Germany  in
telecommunications  equipment  (Iskratel),  Kirkwood  Industries  from  USA  in  commutators
(Kolektor), Danfoss from Denmark in compressors for refrigerators (Danfoss Compressors) and in
heating  and  ventilation  control  systems  (Danfoss  Trata),  Bosch-Siemens  from  Germany  in  small
household  appliances  (BSH  Hišni  aparati),  Reemtsma  from  Germany  and  Seita  from  France  in
cigarette  (Tobačna  Ljubljana),  Pfleiderer  from  Germany  in  insulation  materials  (Pfleiderer
Novoterm),  Henkel  from  Austria  in  detergents  and  cosmetics  (Henkel-Zlatorog)  and  in  chemical
industry  (Henkel  Ecolab),  Goodyear  from  USA  in  car  tires  (Sava  Tires,  Goodyear  Engineered
Products),  Gruppo  Bonazzi  from  Italy  in  synthetic  fibers  (Yulon)  and  textiles  (Aquasava),  Hella
from Germany in car lightning equipment (Saturnus Avtooprema), Messer Griesheim from Germany
in industrial gases (Messer Slovenija), Safilo Group from Italy in spectacles frames (Carrera Optyl),
Bayer  from  Germany  in  pharmaceuticals  (Bayer  Pharma),  Inexa  from  Sweden  in  steel,  Johnson
Controls from Germany in automotive components manufacturing (NTU Johnson Controls) etc. In
trade,  major  FDI  projects  are  Interspar  from  Austria,  Porsche  from  Germany  and  Leclerc  from
France,  in  banking  there  are  Bank  Austria  Creditanstalt  and  Volksbank  from  Austria  and  Societe
Generale from France, while in telecommunications there are Mobilkom from Austria and Western
Wireless from USA.

130

TABLE 5: Distribution of end-year stocks (total value) of FDI in Slovenia by industries1 in 1994
and 2000; USD million and %

1994

2000

NACE industries
15 Food products and beverages
17 Textiles
19 Leather and leather products
21 Pulp, paper and paper products
22 Publishing and printing
24 Chemicals and chemical products
25 Rubber and plastic products
26 Other non-metal mineral products
27 Basic metals
28 Fabricated metal products
29 Machinery and equipment n.e.c.
31 Electrical machinery and apparatus
32 Radio, television and equipment
33 Medical and precision instruments
34 Motor vehicles and trailers
Other manufacturing industries2
D Manufacturing – Total
40 Electricity, gas, steam & water supply
50 Sale & repair of motor vehicles/fuel
51 Wholesale and commission trade
52 Retail trade and other repairs
55 Hotels and restaurants
63 Supporting & aux. transport activities
64 Post and telecommunications
65 Financial intermediation
66 Insurance, pension funds
70 Real estate business
74 Other business services
92 Recreational, cultural & sport activ.
Other activities
TOTAL

Share
1.2
0.6
0.0
9.1
0.5
6.1
1.1
2.0
0.5
0.3
6.2
1.7
1.1
0.6
10.7
3.5
45.3
22.4
5.0
6.9
2.9
0.6
0.7
0.0
6.4
0.8
0.2
6.9
0.0
1.9
100.0
Source: Bank of Slovenia; Note: 1/ Only industries  with  more than USD  10  million  2000  end  year  FDI  stock;  2/
Industries with less than 3 FDI entities are all included here. The major part relates to tobacco products.

Change of share
1994-2000
+0.2
-0.1
+0.4
-2.7
0.0
+0.1
+3.9
+0.6
+1.4
+1.0
-1.0
+0.3
0.0
+0.6
-6.0
-0.6
-2.2
-21.8
-3.4
+2.4
+0.2
0.0
+0.3
+0.4
+19.0
-0.4
+0.7
+5.1
+0.7
-0.9
0.0

Value
15.8
8.4
0.1
120.0
6.8
80.5
14.9
26.7
6.8
4.6
82.8
21.9
14.0
8.6
142.4
46.3
600.6
296.6
66.7
90.9
37.9
8.6
9.5
0.0
84.7
10.7
2.0
91.8
0.2
25.7
1,325.9

Value
38.5
12.7
12.4
178.7
12.8
173.2
141.4
73.3
53.2
35.3
144.7
57.3
31.5
32.4
131.8
80.3
1,209.5
17.2
44.8
261.6
87.9
17.4
28.4
10.3
712.6
10.7
24.0
337.8
18.8
27.5
2,808.5

Share
1.4
0.5
0.4
6.4
0.5
6.2
5.0
2.6
1.9
1.3
5.2
2.0
1.1
1.2
4.7
2.9
43.1
0.6
1.6
9.3
3.1
0.6
1.0
0.4
25.4
0.4
0.9
12.0
0.7
1.0
100.0

In 1994-2000, there have been some interesting shifts in relative importance of individual industries
as  FDI  recipients  (see  Table  5).  Most  manufacturing  industries  retain  or  somehow  increase  their
shares in FDI stock. The highest increase was in rubber and plastic products due to the entrance of
Goodyear in car tires manufacturing. On the other hand, a decrease of share is noticeable in motor
vehicles and trailers, and in paper and paper products. Outside manufacturing, shifts have been more
intensive. Due to erasure of nuclear power plant Krško (Croatian-Slovene joint venture) from the list
of  FIEs,  FDI  in  electricity  supply  almost  disappeared.  On  the  other  hand,  there  was  really
considerable  increase  of  the  share  of  financial  intermediation  and  other  business  activities  in  FDI
stock.

131

TABLE 6: Distribution of end-year stocks (total value) of Slovenia’s FDI abroad by industries1 in
1994 and 2000; USD million and %

1994

2000

NACE industries
15 Food products and beverages
17 Textiles
18 Wearing apparel, dressing fur
19 Leather and leather products
20 Wood&wood products, exc. furniture
21 Pulp, paper and paper products
22 Publishing and printing
24 Chemicals and chemical products
26 Other non-metal mineral products
28 Fabricated metal products
29 Machinery and equipment n.e.c.
31 Electrical machinery and apparatus
32 Radio, television and equipment
33 Medical and precision instruments
34 Motor vehicles and trailers
Other manufacturing industries
D Manufacturing – Total
40 Electricity, gas, steam & water supply
45 Construction
51 Wholesale and commission trade
52 Retail trade and other repairs
63 Supporting & aux. transport activities
65 Financial intermediation
66 Insurance, pension funds
74 Other business activities
Other activities2
TOTAL

Share
8.6
-0.8
0.9
7.0
3.2
2.2
1.1
12.2
-0.6
2.3
4.0
0.2
0.4
1.7
-3.8
3.1
41.7
14.0
2.5
16.4
2.9
1.6
11.6
1.2
5.6
2.5
100.0
Source:  Bank  of  Slovenia;  Note:  1/  Only  industries  with  more  than  USD  5  million  2000  end  year  FDI  stock;  2/
Industries with less than 3 FDI entities are all included here.

Change of share
1994-2000
-0.6
+1.6
+0.3
-5.7
-2.1
-1.3
-0.3
+3.2
+3.0
+3.6
+6.2
+2.1
+0.3
-0.3
+5.9
-3.1
+12.7
-8.7
-0.5
-13.1
+4.9
+0.8
+0.3
+1.9
+0.3
+1.3
0.0

Share
8.0
0.8
1.2
1.3
1.1
0.9
0.8
15.4
2.4
5.9
10.2
2.3
0,7
1.4
2.1
0,0
54.4
5.3
2.0
3.3
7.8
2.4
11.9
3.1
5.9
3.8
100.0

Value
63.4
6.0
9.7
10.6
9.0
7.5
6.0
121.9
19.0
47.2
81.2
17.9
5.6
10.8
16.4
0.1
431.9
42.3
16.2
26.1
62.2
19.3
94.7
24.3
47.0
30.0
794.0

Value
30.4
-3.0
3.2
24.8
11.2
7.9
4.1
43.2
-2.0
8.1
14.3
0.7
1.3
6.1
-13.4
10.8
147.7
49.7
8.7
58.2
10.1
5.6
41.1
4.3
19.7
8.9
354.0

As much as 54.4% of Slovenia’s end-2000 outward FDI stock is accounted by manufacturing, 12.7
percentage points more than in 1994. This indicates the increasing necessity and ability of Slovenian
manufacturing enterprises to internationalize (Svetličič and Jaklič 2001). Industries that account for
the main part of Slovenia’s manufacturing outward FDI are chemicals and chemical products (more
notably  pharmaceuticals),  machinery  and  equipment,  food  products  and  beverages,  and  fabricated
metal products. Outside manufacturing Slovenian investors are the most active in financial services,
retail trade and other business activities.

2.

Major explanatory factors behind FDI and future prospects

2.1. Motivation for investing in Slovenia and strategic pattern of FDI in Slovenia: factor
cost advantages versus market seeking FDI

From the point of view of motivation and strategic pattern of foreign investors' behavior in Slovenia
it  is  reasonable  to  distinguish  between  market-seeking  (horizontal)  and  factor  cost  advantages-
seeking (vertical FDI, such as resource-seeking, efficiency-seeking and strategic asset-seeking) FDI.

132

The latter are motivated by differentials in factor endowments, or by different kind of capabilities,
expertise  and  skills,  advantage  of  economies  of  scale  and  scope,  and  by  differences  in  consumer
tastes  and  supply  capabilities.  Factor  cost  advantages-seeking  FDI  consists  of  geographical
separation of different stages of the value-added chain with forward and backward integration. On
the other hand, market-seeking or horizontal FDI is motivated by market access. Orientation of sales
to local market in the case of market-seeking and to exports in the case of factor cost advantages-
seeking FDI is one of the major distinguishing characteristics between both types of FDI (Dunning
1993, Caves 1971,1982).

In  existing  analysis  of  foreign  investors’  motivation  in  Slovenia,  gaining  access  to  or  enlarging
market  share  has  traditionally  been  the  most  important  motive  of  foreign  investors  for  coming  to
Slovenia.  But  foreign  investors  generally  have  quoted  to  have  multiple  objectives  (growth,
profitability, expansion of exports, etc.) in their ventures in Slovenia. Foreign investors also ranked
as  important  motives  such  as  reduction  of  production  costs  and  having  an  export  base  for  third
countries (see, for instance,  Rojec  1998). In  the  latest  available  analysis  on the  subject  (Dedek  &
Novak 1998, see Table 7), access to the local and other (adjacent, neighboring) markets remain the
two most important single motives, however, altogether relevance of other motives - like technology
and know-how, quality of labor, recognized trade marks and financial support of the Slovenian target
company/joint  venture  partner  and  securing  material  and  parts  -  denoting  factor  cost  advantages-
seeking  FDI  seem  to  prevail.  The  interviews  of  foreign  investors,  therefore,  seem  to  indicate  that
most of FDI in Slovenia is of the factor cost advantages-seeking type. As far as the role of labor in
that is concerned, it is obvious that it is not the low price (only 1.8% of interviewees quote it as a
motive)  but  rather  the  quality  (26.9%)  of  labor  which  motivates  foreign  investors  in  the  case  of
Slovenia.

TABLE 7: Motives of foreign investors in Slovenia

Motive
Access to Slovenian market
Access to other markets
Technology and know-how
Quality of labor
Financial support
Recognized trade mark
Purchasing of material and parts
Low cost of labor
Acquisition of company in bankruptcy procedure
Other

% of FIEs quoting individual motive1
41.5
36.3
29.8
26.9
25.1
17.0
10.5
1.8
1.8
7.0

Source: Dedek & Novak, 1998. Notes: 1/ 183 FIEs answered the question. Each respondent was
allowed to quote more motives.

Case studies of FIEs give another set of information on the motivation and strategic pattern of FDI in
Slovenia.  Eight  cases  of  FDI  offer  a  variety  of  motivation  and  strategies  of  foreign  firms  when
investing in Slovenia:

Motor  vehicle  lightning  equipment  manufacturer  Saturnus  Avtooprema  was  acquired  by
a/
German Hella in the context of Hella’s recognition of the need to grow faster and to globalize, i.e.
establish direct presence in all major countries in which its major customers (final car assemblers)
establish  production.  In  this  context  Hella  especially  needed  somebody  who  would  be  able  to
adequately handle the Italian market. By acquiring Saturnus, the idea has been to combine Hella’s
R&D capabilities and Saturnus’es lower (labor) costs to penetrate the Italian market. Saturnus has in
fact succeeded to penetrate among FIAT’s suppliers.

133

Polyamid filaments and chips manufacturer Yulon was acquired by Italian Gruppo Bonazzi in
b/
the context of the increasing concentration and globalization of the industry which urged Bonazzi to
sped up growth as much as possible. The major motivation of Bonazzi to buy Yulon was basically
strategic, i.e. to quickly increase its capacities by acquisition, and in such a way improve its position
in a highly oligopolized industry. Strategic motivation was combined by other reasons of a market,
costs etc. nature; in spite of not low labor costs in Slovenia, the relations between the labor costs and
labor quality/productivity was considered as favorable (Rojec & Stanojević 2001).

c/
Danfoss  from  Denmark  acquired  a  compressors’  manufacturing  company  Danfoss
Compressors with a motive to get access to relatively inexpensive skilled labor. The investment was
aimed  at  a  relatively  low  cost  location  from  which  to  serve  a  very  competitive  market.  The
investment was a relocation of part of Danfoss manufacturing capacity in Germany. Almost all the
output  is  exported,  EU  being  the  major  market.  Danfoss  is  grooming  its  subsidiary  to  gain  sole
responsibility for the European compressor market.

Bosch-Siemens from Germany took over MGA, which produces small household appliance
d/
which are sold under the various Bosch-Siemens brand names, because it was interested in the lower
cost of skilled labor in Slovenia and in order to consolidate existing unprofitable sites. MGA exports
its entire output. MGA’s competitive advantage is work force which is more highly trained than in
Southeast Asia (Lorentzen, Moellgaard & Rojec 1998).

e/
Acquisition of Papirnica Količevo (papermill) by Saffa from Italy was made in a context of
Saffa’s program of strengthening its position in the international cartonboard industry. By acquiring
Količevo, Saffa hoped to gain control over the South European markets, to create a strategic position
for future penetration on CEE markets and to get production capacities which were in a position to
be expanded substantially at reasonable costs (Rojec & Svetličič 1998a).

f/
Motivation of Siemens to enter as a minority shareholder in Iskratel which produces switching
devices for telecommunication systems was to get a foothold in the regional market, to get access to
skilled labor and manufactured inputs as well as the attempt to exercise control over third markets (in
the then CMEA), access to indigenous technology, and first mover advantages. The investment is not
a  relocation  of  an  existing  facility.  Siemens  extensively  uses  services  of  Iskratel’s  engineers  who
produce customized software solutions for Siemens systems (Lorentzen, Moellgaard & Rojec 1998).

g/
Two  major  factors  which  influenced  the  decision  of  Reemtsma  from  Germany  to  acquire
cigarette  manufacturer  Tobačna  Ljubljana  were  to  strengthen  Reemtsma’s  position  in  the  CEE
region  and  to  increase  its  market  share  in  the  former  Yugoslavia.  The  whole  project  was  in  the
context  of  efforts  to  strengthen  the  position  of  European  cigarette  manufacturers  faced  with
increasingly  agressive  penetration  of  the  leading  U.S.  cigarette  MNEs  to  the  European  cigarette
market.  Collapse  of  the  former  Yugoslav  market  has  made  Tobačna  mostly  exporter  of  cigarettes
(Rojec & Svetličič, 1998b).

h/
Renault’s  major  motive  for  investment  in  Revoz  in  1991  was  the  then  Yugoslav  market.
Lower  labor  costs  and  availability  of  skilled  labor  were  additional  relevant  motives.  After  the
collapse of the Yugoslav market, Renault had to reorient to export markets. This basically changed
market-seeking  into  factor  cost  advantages-seeking  FDI,  what  made  factor  costs  determinants  of
investment dominant. In spite of loss of the Yugoslav market, Renault obviously assessed Revoz as
being competitive enough to be fully integrated into Renault’s industrial system (Rojec & Stanojević
2001).

134

The  cases  offer  three  basic  conclusions.  The  first  conclusion  relates  to  the  pattern  of  foreign
investors’ motivation  and  strategic  behavior in the case of  Slovenia  which  is  characterized  by  the
following (i) investing in Slovenia is not some solitary operation but is going on in the context of
foreign  investors’  strategy  of  internationalization  which  they  feel  as  increasingly  urgent;
relocation/restructuring via FDI in the context of globalization becomes a necessity and not a matter
of  choice;  (ii)  foreign  investors  do  not  follow  a  single  motive  but,  in  principle,  a  multiple  set  of
market-seeking,  factor  cost  advantges-seeking  and  strategic  motives;  (iii)  cheaper  labor  is  an
important  motive  but  the  accent  is  always  on  the  favorable  price  of  skilled  labor;  (iv)  a  good
opportunity, especially possibility to buy a company in the privatization process, and good previous
cooperation  between  the  prospective  foreign  investor  and  a  target  company/local  joint  venture
partner are important stimulators for a foreign company to decide to invest. The second conclusion is
that,  in  spite  of  the  relevance  of  local  (ex-Yugoslav)  market  as  a  motive,  factor  cost  advantages-
seeking FDI is predominant in Slovenia. The third conclusion is that in the framework of factor cost
advantages-seeking FDI, one could distinguish among four kinds of FDI, notably among FDI like (i)
Danfoss  Compressors  and  MGA  which  means  relocation  of  existing  facilities  or  consolidation  of
existing  unprofitable  sites;  (ii)  Saturnus  and  Yulon  with  no  actual  relocation  but  one  might
hypothesise that, theoretically, there was an alternative option of domestic investment112; (iii) Sarrio
and Iskratel which really are a combination of market-seeking, factor cost advantages-seeking and
strategic considerations; and (iv) Tobačna and Revoz where initial market-seeking motivation was,
due  to  collapse  of  ex-Yugoslav  market,  switched  for  factor  cost  advantages-seeking  motivation
(Rojec & Stanojević 2001).

One set of factors which co-determine the extent of export oriented factor cost advantages-seeking
FDI versus (local) market-seeking FDI relates to host country characteristics. The issue here is, to
what extent specific characteristics of Slovenia as a host country stimulate factor cost advantages-
seeking  FDI  as  compared  to  market-seeking  FDI.  Four  host  country  characteristics  seem  to  be
especially relevant for export propensity of FIEs: (i) most of the evidence suggests that the smaller
the host country market the more export oriented are FIEs, (ii) higher host country development level
is generally correlated with factor cost advantages-seeking rather than market-seeking FDI, (iii) FDI
projects  in  Central  and  Eastern  European  countries  that  are  in  more  advanced  stage  of  transition
reforms  are  more  likely  to  be  export  oriented  and  integrated  into  foreign  parents’  multinational
production process what is characteristic of factor cost advantages-seeking FDI, (iv) liberalization of
FDI and trade regime, and economic integration (free access to foreign markets) have proved to be
crucial  stimulators  of  export  oriented  FDI  (more  on  that  in  Rojec,  2000b).  These  host  country
characteristics clearly qualify Slovenia for export oriented factor cost advantages-seeking rather than
market-seeking  FDI.  Slovenia  is  a  very  small  market  (less  than  2  million  inhabitants  with  USD
18,122 million GDP in 2000; IMAD 2001), it is a relatively developed country (GDP per capita of
USD  9,105  in  2000;  IMAD  2001)  at  a  more  advanced  stage  of  transition  reforms  (first  round
candidate country for EU membership), with export-oriented outward-looking development concept
(59.0% share of exports and 62.6% share of imports of goods and services in GDP in 2000; IMAD
2001) and liberal economic policy, liberalized foreign trade regime (the estimated rate of protection
for  manufacturing  was  reduced  from  36.7%  in  1986,  to  4.18%  in  1993  and  2.72%  in  1997;
Stanovnik,  Majcen  &  Lavrač,  2000)  and  increasing  economic  integration  with  other  countries
(Europe Agreement with EU, membership in WTO and CEFTA, free trade agreements with EFTA
and a number of other countries).

112 In practice, there  was no alternative, because  objectives realized  by  the  FDI  could  never  be  achieved  by
investment  at  home,  because  acquisition  opportunity  made  the  investment  more  rationale  and  simply
because both projects were made in the context of internationalization processes of parent companies.

135

                                                     
Actual exports data of FIEs in Table 8 strongly confirm the above conclusions, i.e. the increasing
importance  and  prevalence  of  export  oriented  factor  cost  advantages-seeking  FDI  in  Slovenian
manufacturing sector and prevalence of market-seeking FDI in service and public utilities sector. In
1999 FIEs in Slovenia exported 42.6% of their sales. This was to a major extent due to situation in
the manufacturing sector which was responsible for no less than 88.0% of all FIEs exports. In 1999,
manufacturing FIEs exported as much as 68.2% of their overall sales (in 1994 62.9%). Situation in
non-manufacturing activities is pretty much different since they on average exported only 11.4% of
their sales, mostly in the field of transport and communications, trade and business services. Of 20
manufacturing industries in Table 8, FIEs in 5 has exports to sales ratio higher than 80% (medical
and precision instruments, electrical  machinery  and apparatus, machinery  and equipment, wearing
apparel and basic metals), in 2 higher than 75% (textiles, fabricated metal products) and in 3 higher
than  70%  (leather,  footwear  and  leather  products,  rubber  and  plastic  products,  motor  vehicles).
Therefore, there are at least 10 manufacturing industries in Slovenia which distinctively attract factor
cost advantages-seeking  FDI.  The  major two are motor vehicles  and  trailers  with  exports  to  sales
ratio of 74.5%  and  32.8%  share  in  total  FIEs  exports,  and  machinery  and  equipment  with  82.8%
exports  to  sales  ratio  and  11.9%  share  in  total  FIEs  exports.  Also,  in  no  less  than  15  out  of  20
manufacturing industries in Table 8, FIEs has higher exports to sales ratio than domestic enterprises
(DEs). On average, export orientation of FIEs in the Slovenian manufacturing sector is 43% higher
than  that  of  DEs.  This  additionally  confirms  distinctively  high  export  orientation  of  FIEs  in
Slovenian manufacturing sector113.

TABLE 8: Export to sales ratio in FIEs and DEs by industries in %; 1999 income statements/balance
sheets data

NACE industries

15 Food products and beverages
17 Textiles
18 Wearing apparel, dressing fur
19 Leather, footwear & leather products
20 Wood & wood prod., exc. furniture
21 Pulp, paper and paper products
22 Publishing and printing
24 Chemicals and chemical products
25 Rubber and plastic products
26 Other non-metal mineral products
27 Basic metals
28 Fabricated metal products
29 Machinery and equipment n.e.c.
31 Electrical machinery and apparatus
32 Radio, television and equipment
33 Medical and precision instruments
34 Motor vehicles and trailers
35 Other transport equipment
36 Furniture, manufacture n.e.c.
Other manufacturing industries1

Exports to sales ratio (%)
DEs

FIEs

FIEs/DEs
(Index)
129
109
180
117
73
130
706
99
137
112
127
162
132
136
82
137
116
82
49
395

FIEs - Distribution
of exports by
industries (%)
1.0
2.2
0.0
0.4
0.3
6.6
0.7
7.6
4.5
2.6
3.5
2.1
11.9
4.8
3.3
1.8
32.8
0.0
0.0
2.0

17.3
76.5
98.9
72.3
37.7
68.0
48.1
65.5
73.2
44.0
80.8
78.4
82.8
84.8
48.9
84.4
74.5
40.7
24.5
47.8

13.4
70.1
54.8
61.8
51.8
52.2
6.8
65.9
53.5
39.1
63.6
48.4
62.7
62.3
59.3
61.4
64.5
49.8
50.3
12.1

113 FIEs  in  Slovenian  manufacturing  sector  are,  however,  not  only  much  more  export  but  also  much  more
import oriented than DEs. Share of FIEs in total manufacturing sector exports in 1997 was 28.2%, in imports
34.4%  and  in  trade  balance  surplus  16.6%.  In  FIEs  imports  to  sales  ratio  was  54.4%  while  in  DEs  only
27.7%. Both groups of companies, FIEs and DEs realized high surpluses in their foreign trade flows, but the
relative effect on foreign trade account (measured by the surplus to exports ratio) was much higher in the
case of DEs (40.5%) than FIEs (20.5%).

136

                                                     
D Manufacturing – Total
Non-manufacturing activities
A Agriculture, hunting, forestry
C Mining and quarrying
E Electricity, gas and water supply
F Construction
G  Wholesale  and  retail  trade,  certain
repair
H Hotels and restaurants
I Transport, storage, communications
J Financial intermediation services
K Real estate, renting, business services
M Education
N Health services and social work
O  Other  community  and  personal
services
TOTAL

68.2
11.4
11.3
2.0
6.6
7.0
10.4

0.0
28.5
0.8
24.9
0.0
10.7
2.9

42.6

47.6
9.1
5.9
3.3
1.4
2.6
7.5

14.8
28.8
0.3
7.4
3.2
7.5
36.3

21.4

143
126
192
59
475
272
139

0
99
258
336
0
142
8

199

88.0
12.0
0.0
0.0
0.0
0.1
8.8

0.0
1.3
0.0
1.7
0.0
0.0
0.0

100.0

Source:  Institute  for  Macroeconomic  Analysis  and  Development;  based  on  Bank  of  Slovenia  and  Agency  for
Payments data. Notes: 1/ Sum of industries with less than 3 FIEs (16 - tobacco manufactures, 30 - office machinery,
37 - recycling).

To conclude, although local and adjacent (neighboring) markets are important motives for investing
in Slovenia, consideration of specific characteristics of Slovenia as  a  host  country, case studies of
foreign investors’ strategy in Slovenia and especially the actual very high export orientation of FIEs
in the manufacturing sector support the view that factor cost advantages-seeking FDI dominates in
the  manufacturing  sector  of  Slovenia.  Quite  the  opposite  is  in  service  and  public  utilities  sector,
where market-seeking motivation clearly prevails.

2.2. Wages as a determinant of FDI in Slovenia

Motivation of foreign investors in Slovenia show, as far as labor is concerned, that it is rather quality
and not low costs of labor that motivate foreign investors. This is not surprising, knowing that labor
costs in Slovenia are far the highest among Central and Eastern European countries in transition. In
1997, monthly labor costs in Slovenia were USD 980, compared to USD 536 in Hungary, USD 461
in Czech Republic, USD 458 in Poland, USD 400 in Slovak Republic, USD 158 in Romania and
USD 126 in Bulgaria (WIIW 1999, pp. 180-186).

137

TABLE 9: Growth of real gross wages per employee and of labor productivity in the manufacturing
sector of Slovenia in 1992-1999

Year

1992
1993
1994
1995
1996
1997
1998
1999

Monthly gross
wages per
employee (in
USD)
532.7
551.8
616.0
783.6
784.1
744.9
795.0
792.8

Growth of real gross
wages per employee1
(chain index in %)

Growth of labor
producticity2
(chain index in %)

95.6
108.6
104.9
103.2
104.0
103.4
102.9
102.8

96.4
107.2
111.9
108.4
106.7
104.5
105.3
101.8

Ratio between growth
of productivity and
growth of wages (in
%)
100.8
98.7
106.7
105.0
102.6
101.1
102.3
99.0

Source: Institute for Macroeconomic Analysis and Development; based on  Bank  of  Slovenia  and  Agency  for
Payments data. Notes: 1/ Deflated with consumer price index; 2/ Volume of industrial production per employee.

The  finding  that  it  is  rather  quality  than  the  price  of  labor  which  motivates  foreign  investors  in
Slovenia is further confirmed by sectoral distribution of FDI in Slovenia characterized by tendency
of FIEs to locate rather in capital than in labor intensive manufacturing industries. Even more, not
only that they tend to locate in capital intensive industries, FIEs also tend to use much more capital
intensive techniques than DEs inside the same manufacturing industries. Out of 20 manufacturing
industries in Table 10, in no less than 17 FIEs have higher machinery and equipment per employee
than  DEs.  On  average,  manufacturing  FIEs  use  2.33  times  more  machinery  and  equipment  per
employee than DEs.

One would expect that more capital intensive techniques in FIEs also request the use of more skilled
labor  than  in  DEs.  The  data,  however,  do  not  seem  to  support  this.  If  FIEs  in  the  manufacturing
sector use as much as 2.33 times more machinery and equipment per employee than DEs, they pay
on average only 17% higher labor costs per employee. The existing evidence suggests that a relevant
part if not most of the difference in wages is due to the fact that for the same skills FIEs tend to pay
somewhat higher, approximately 10%, wages than DEs. For instance, in Tobačna Ljubljana after the
acquisition,  the  policy  has  been  to  keep  wages  approximately  10%  above  the  Slovenian  average
(Rojec & Svetličič 1998b), in Biterm (thermostats producing company with minority share of Danish
Danfoss)  wages  are  claimed  to  be  slightly  higher  as  compared  to  other  companies  in  the  local
community (Rojec & Svetličič 1998c), in Saturnus Avtooprema foreign parent company’s policy is
that wages should be approximately 10% above the Slovenian average, in Yulon the level of wages
is also quoted to be higher than average in Slovenia (Rojec & Stanojević 2001). The conclusion is
obvious.  In  Slovenian  manufacturing  sector,  FIEs  do  tend  to  use  much  more  capital  intensive
production techniques than DEs, but these techniques are rather standardized and, in principle, do not
request more skilled labor. What FIEs do is that they use more or less equally skilled labor as DEs,
pay somewhat higher wages, but with these higher wages FIEs are able to achieve much higher labor
productivity, in terms of value added per employee, than DEs. Workers in a typical FIE would agree
that  work  load  have  increased  (considerably)  since  foreign  investor  took  over  a  company114.
Indicator of value added per labor costs is very persuasive in this regard. With 1 SIT of labor costs,
manufacturing FIEs are able to produce 1.84 SIT of value added, what is 33% more than DEs115.

114 See, for instance, the cases of Tobačna Ljubljana (Rojec and Svetličič 1998b), Sarrio Slovenija (Rojec and

Svetličič 1998a), Yulon and Saturnus Avtooprema (Rojec & Stanojević 2001).

115 On average, in all activities with 1 SIT of labor costs FIEs are able to produce SIT 1.78 of value added, what

is 25% more than DEs (see Table 10 for detail).

138

                                                     
TABLE 10: Machinery and equipment per employee and labor costs per employee in manufacturing
FIEs; 1999 income statements/balance sheets data

NACE industries

and 

leather

chemical

non-metal  mineral

15 Food products and beverages
17 Textiles
18 Wearing apparel, dressing fur
19  Leather,  footwear  & 
products
20  Wood  &  wood  prod.,  exc.
furniture
21 Pulp, paper and paper products
22 Publishing and printing
24  Chemicals 
products
25 Rubber and plastic products
26  Other 
products
27 Basic metals
28 Fabricated metal products
29 Machinery and equipment n.e.c.
31  Electrical  machinery 
and
apparatus
32 Radio, television and equipment
33  Medical 
precision
instruments
34 Motor vehicles and trailers
35 Other transport equipment
36 Furniture, manufacture n.e.c.
16,  30,  37  Other  manufact.
industries3
D MANUFACTURING - Total
TOTAL - All activities

and 

Machinery&equip.
per employee

Labor costs
per employee

Value added1
per employee

Value added1
per labor costs

FIEs,
mill. SIT
4.8
3.6
0.1
1.2

FIE/DE
Index,%2
126
277
20
171

FIEs,
mill. SIT
3.6
1.9
1.4
2.4

FIE/DE
Index,%2
129
100
82
126

FIEs,
mill. SIT
4.3
3.8
1.3
3.8

FIE/DE
Index,%2
105
162
7.2
185

FIEs
(Ratio)
1.17
1.98
0.93
1.58

FIE/DE
Index,%2
80
162
86
150

6.1

17.6
5.4
7.4

2.1
6.9

5.0
2.4
2.6
2.6

1.1
1.7

6.6
2.8
1.9
7.8

4.9
4.4

469

677
225
224

42
256

143
104
163
153

85
155

388
311
158
433

233
148

2.4

3.1
2.7
3.2

2.5
3.0

3.0
2.4
2.4
2.8

3.6
2.1

2.9
1.9
1.8
4.0

2.8
3.0

120

1.41
71
84

96
130

120
104
100
112

164
81

138
79
90
138

117
115

4.7

6.3
4.1
7.9

3.5
7.1

4.9
3.7
4.2
4.7

5.5
3.3

6.0
2.3
2.5
13.5

5.1
5.3

189

205
82
113

85
201

148
116
132
135

198
99

250
96
95
304

153
146

2.00

2.04
1.54
2.47

1.44
2.35

1.66
1.51
1.76
1.68

1.53
1.58

2.06
1.20
1.40
3.35

1.84
1.78

161

149
117
134

91
157

123
110
132
120

120
122

184
125
106
220

133
125

Source:  Institute  for  Macroeconomic  Analysis  and  Development; based  on  Bank  of  Slovenia  and  Agency  for  Payments  data.  Notes:  1/  Value
added is gross vale added, calculated as difference between sales and costs of merchandise, material and services; 2/ Index between indicator for
FIEs and indicator for DEs; 3/ Sum of industries with less than 3 FIEs (tobacco manufactures, office machinery, recycling).

What  is  the  rationale  of  foreign  investors  in  the  above  context?  If  increasing  labor  costs  at  home
make  certain  production  non-viable  one  of  the  possible  solutions  of  the  problem  is  relocation  of
production abroad. By moving production facilities abroad, enterprise continue to utilize its existing
industry specific assets, including its given production technique, but swap the home country labor
force with the cheaper one in a host country (more on that see in Meyer 1995). In a situation of a
given  production  technique,  an  enterprise  would  make  a  relocation/restructuring  decision  on  the
basis of value added to labor costs ratio criteria. The maximum amount of value added per employee
which could be produced by a certain production technique is more or less fixed and, therefore, with
increasing  labor  costs  per  employee  at  home,  value  added  to  labor  costs  ratio  is  decreasing.  To
prevent the decreasing of value added to labor costs ratio, or better to say, to increase it, an enterprise
would establish production capacities abroad, in a country with labor force being able to produce the
expected amount of value added per employee with given production technique, but at lower labor
costs per employee. Therefore, there are two basic conditions to relocate/restructure via FDI abroad;
the first is adequate quality of labor force  in  a  host  country,  meaning  that it  is  able  to  realize  the
expected amount of value added per employee with a given production technique and the second is
lower wages than at the existing location.

139

TABLE 11: Value added per employee, labor costs per employee and value added per labor costs in
the manufacturing sector of Slovenia and major EU investing countries in Slovenia in 1998; national
accounts data

EU – 15
Austria
Germany
Italy
France
Slovenia
FIEs2 in Slovenia

Value added
per employee
(Eur)
48,800
58,072
56,120
38,552
62,952
16,680
22,565

Labor costs1
per employee
(Eur)
33,400
34,736
39,078
27,722
38,744
10,624
11,784

Value added
per labor costs
(Ratio)
1.46
1.67
1.44
1.39
1.63
1.57
1.92

Source: Eurostat 2000; Statistical Office of the Republic of Slovenia 1999. Notes: 1/ Remuneration in the case of
EU countries and compensation of employees in the case of Slovenia; 2/ Calculated by applying FIEs/All enterprises
indexes from company financial statements data (Institute for Macroeconomic Analysis and Development; based on
Bank of Slovenia and Agency for Payments data) to national accounts data for Slovenian manufacturing as a whole.

Table  11  clearly  demonstrates  that  one  can  not  make  a  relocation/restructuring,  i.e.  investment
decision  only  on  the  basis  of  labor  costs  per  employee.  Slovenia  does  have  much  lower  price  of
labor, i.e. labor costs per employee, than any of the major EU investing countries, but it lags behind
very much also in terms of productivity, i.e. quality of labor measured by value added per employee.
The  only  possible  basis  for  decision  is  comparison  of  productivity  and  price  of  labor  in  terms  of
value added per labor costs. Ex ante, and from the point of view of prospective foreign investor, this
means that, when foreign investor makes a decision to  relocate/restructure  abroad, he is confident
that with the given production technique he will achieve approximately the same productivity as at
home but at lower labor costs. It is not that prospective foreign investor is looking at the value added
per  employee  data  in  a  host  country;  instead  he  checks  whether  the  conditions  which  enable
achieving requested level of productivity are in place. Ex post, successful foreign investors decisions
about relocating/restructuring abroad should in fact be demonstrated in higher value added per labor
costs  in  foreign  subsidiaries  than  at  home.  The  case  of  Slovenia  seems  to  confirm  this  rationale.
Value added per labor costs ratio in manufacturing foreign FIEs in Slovenia is much higher than in
the manufacturing sector of any of the major EU investing countries in Slovenia (Rojec & Stanojević
2001).

Investment opportunities and competitive advantages of Slovenia as investment

2.3.
location

Existing analysis of foreign investors’ motivation (see for instance Dedek & Novak 1998,
Rojec  1998)  and  of  competitive  advantages  of  Slovenia  as  investment  location  (see  for
instance FIAS 1998, TIPO 1999) suggest that it is reasonable to distinguish between (i)
investment opportunities opened to foreign investors which represent a direct motive, that
is  a  factor  because  of  which  foreign  investor  would  begin  to  consider  investment  in
Slovenia,  and  (ii)  natural  and  created  factors/environment  and  investment  climate  in
Slovenia  in  the  framework  of  which  the  potential  investment  is  realized.  The  latter
represents  a  framework  which  determines  to  a  considerable  degree  whether  an  investor
will decide to attempt to realize an investment opportunity.

Investment  opportunities  for  foreign  investors  in  Slovenia  could  be  classified  into  five
groups:

140

a/ Acquisitions of and joint ventures with Slovenian enterprises where investment opportunities arise

from:
- High domestic purcahsing power (GDP per capita higher than in any other Central and Eastern
European country in transition; approximately at the level of Greece and Portugal) and growth
potential of small domestic market (4%-5% GDP growth rates in the last mid-term period).
- High export propensity of Slovenian companies with relevant market shares in EU countries.
- Strong  trade  and  business  links  of  Slovenian  companies  with  other  parts  of  the  former

Yugoslavia and with Central and Eastern European countries in transition.

- High level of managerial and technical skills in companies.
- Local industrial environment assures technological capabilities which enable speedy mastering

of the technology transferred by foreign investor.

- Transport costs are low; main investing countries are near, transport connections are good.
- Good acquisition opportunities (of not yet privatized) Slovenian companies being in process of
rehabilitation (companies in the portfolio of Slovenian Development Corporation, companies of
Slovenian Ironworks etc.).

b/ Subsidiaries in Slovenia as part of integrated international production of multinational enterprises.

Investment opportunities arise from:

- Quality of workforce: well educated and trained, dedication to work, industrial tradition,

language skills, high level of computer literacy.

- Low labor costs if compared to productivity level (high value added to labor costs ratio).

- Relatively high level of managerial and technical skills in companies.
- Central geographical position (proximity) making transport costs low (good international

transport and communication linkages).

- Trade links with other countries; liberal foreign trade regime and integration in the EU and

CEFTA.

-

Industrial tradition and especially experiences in manufacturing of middle technology level

products.

Opportunities for location of parts of integrated international production in Slovenia are especially

in production asking for higher level of workforce quality, industrial experiences, middle

technology level and low transport costs.

c/

Investment in infrastructural sectors – public utilities. Investment opportunities arise from:

-

Slovenia is just about to start privatization of public utilities.

- Gap between Slovenian investment needs in infrastructural facilities and available financial

sources requests more intensive engagement of private capital in infrastructural investment.

d/ Slovenia as a location for regional headquarters, as regional and not as a local market. Investment

opportunities arise from:

141

-  Location  between  EU  countries  (Slovenia  is  among  the  most  qualified  candidates  for  EU
membership), CEFTA countries (Slovenia is member of CEFTA) and successor countries of
former Yugoslavia (Slovenia has free trade agreements with Croatia and Macedonia, is about
to  sign  one  with  Bosnia  and  Hercegovina  and  is  eager  to  improve  framework  for  doing
business with Federal Republic of Yugoslavia, excellent knowledge of the markets and long
established  business  links)  with  well  developed  business  links  with  all  three  groups  of
countries.

- High level of managerial and technical skills in companies.
- High quality of life for representatives and executives of foreign investors, including high level

of security.

- Good international transport and communication links.
- Political stability.

e/

FDI in services, especially in business infrastructure. Investment opportunities arise from:

- Fast growing economy and market with very high demand for business services.
- Forthcoming privatization of financial sector.
- Full liberalization of capital flows, introduction of funded pension schemes, changing of savings
habits of population and modes of investment financing in enterprises strongly increase the need
for financial intermediation, especially via capital market116.

Factors which create attractive and friendly environment for investing in Slovenia are:

a/ Market factors consisting of:

- Growing  and open  economy.  In  2000  GDP  growth  rate  was  4.2%  and  exports  to  GDP  ratio

59.0% (IMAD 2001).

- Economic  and  political  stability  with  the  highest  international  ratings  among  Central  and
Eastern European countries in transition. In 2000 inflation rate was 8.9%, general government
deficit 1.4% of GDP, current account deficit 3.3%, unemployment rate 7.0% (IMAD 2001).
- Good  access  to  markets  on  the  West,  East  and  South-East  Europe.  Slovenia  has  Europe
Agreement  with  the  EU  and  is  among  the  most  qualified  candidates  for  EU  membership,  is
member of CEFTA and has free trade agreements with numerous countries.

b/ Production factors consisting of:

- Location in the heart of Europe with a maritime cargo port.
- Excellent infrastructure with extensive transport grid and telecommunications network.
- Long industrial tradition coupled with ability to implement new technologies.
- Well educated, flexible and motivated work force with good command of foreign languages –

model industrial relations.

- Experienced managers.
- High quality of life.

c/ Regulatory framework consisting of:

-

Intensive adoption of EU legal  and  system  framework.  By  the  end  of  2002  Slovenia  will  be
ready for EU membership.

116 More on the investment opportunities for foreign investors in Slovenia see especially in FIAS 1998, and

TIPO 1999.

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- Liberal  regime  of  international  economic  relations,  characterized  by  WTO  membership  and

European Agreement with the EU.

- Liberal  FDI  regime,  based  on  national  treatment  principle  and  unlimited  profit  and  equity

repatriation.

- Low, 25% corporate profit tax and other incentives for FDI.

2.4. Barriers to FDI

In  spite  of  the  above  mentioned  investment  opportunities  and  positive  aspects  of
investment climate in Slovenia which resulted in fast increase of FDI in the last decade, it
seems that other transition countries of Central and Eastern Europe, being members of the
OECD have succeeded to attract relatively higher amounts of FDI. This is not so in terms
of FDI stock per capita where Slovenia with USD 1,411 (2000 data) is before Poland with
USD 828 and Slovakia with USD 686, and does not lag much behind Hungary with USD
1,900 and Czech Republic with USD 1,752, but in terms of FDI stock as a share of GDP
where  Slovenia  with  15.5%  (2000  data)  lags  behind  the  other  four  countries.  The
respective figure for Hungary is 43.2%, for Czech Republic 40.4%, for Poland 20.1% and
for Slovakia 19.3% (Hunya & Stankovsky 2001)117. If in FDI inflows one distinguishes
between inflows from abroad and reinvested earnings, it is obvious that low inflows in the
recent  years  were  mainly  due  to  a  low  number  and  value  of  new  FDI  projects.  The
increasing amount of reinvested earnings by existing foreign investors in Slovenia, on the
other  hand,  tend  to  show  that  existing  foreign  investors  strengthen  and  increase  their
operations  in  Slovenia,  indicating  their  positive  appreciation  of  Slovenia  as  investment
location.  What  are  the  reasons  for  FDI  inflows  not  being  as  high  as  in  countries  like
Hungary and Czech Republic? Overview of analysis on the subject (Rojec 1998, Dedek &
Novak 1998, IMAD 1999, FIAS 1998, FIAS 2000) suggests the following factors:

a/ Small local market. The small size of Slovenian domestic market is the major constraint preventing

more FDI inflows.

b/ Monetary  considerations  have  for  a  long  time  been  one  of  the  major  scruples  of  the  Bank  of
Slovenia  about  foreign  capital  inflow.  In  the  regime  of  managed  floating  foreign  exchange  rate
where  money  comes  into  circulation  almost  exclusively  by  foreign  exchange  transactions,  in  a
situation where Slovenia is faced with a problem of a small monetary area and in a situation of a
positive current account balance all until the end of 1997, capital inflows represented a constant
pressure on domestic currency appreciation. In these circumstances the central bank embarked on
various measures to counteract exchange rate pressures, among them also on various measures to
cope with the risks associated with capital inflows118. Although these measures have served their
monetary purpose, i.e. preventing a negative impact of excessive speculative capital inflows, and
although they were not directed directly to FDI, they have also tended to discourage FDI (Mrak,
Rojec & Potočnik 2001).

c/ Privatization and enterprise restructuring. There are several aspects because of which privatization
have  not  contributed  enough  to  FDI  inflows.  (i)  The  first  is  the  (mass)privatization  concept  in

117 In Slovenia in 1993-2000 period, stock of FDI per capita increased from USD 479 to USD 1,411, while the

share of FDI stock in GDP increased from 7.5% to 15.5%.

118 They  included  measures  to  control  the  credit  activity  of  banks,  such  as  limited  transformation  of  foreign
savings into domestic liquidity and limited transformation of bank short-term liabilities into long-term assets.
Other measures raised the costs of foreign funds. Among them, the most important ones were a 40% non-
interest bearing tolar deposit for each foreign loan with maturity of up to five (and later on seven) years that is
intended for conversion, which was introduced in February 1995, and the introduction of custodian accounts
to regulate the inflow of portfolio investments.

143

                                                     
industry  and  trade  which  implicitly  favored  internal  (employee  and  management)  buy-outs.
Foreign acquisitions were only exceptional in the privatization dominated by distribution through
the use  of ownership  certificates  and  internal  buy-out  at  considerable  discounts.  (ii)  The  second
aspect is not fast enough (transition) restructuring process in the privatized enterprises, which do
not  encourage  them  to  search  for  strategic  foreign  partners.  (iii)  The  third  aspect  is  hesitant
privatization  of  state  ownership  in  the  financial  and  public  utilities  sector,  where  only  recently
more decisive moves have been initiated.

d/ Political  instability  due  to  collapse  of  the  former  Yugoslavia  was  for  a  long  time  an  important
constraint for more FDI in Slovenia. According to various country risk assessments, political risk is
no more an inhibiting factor in the case of  Slovenia. For  instance,  in  Euromoney's  political  risk
assessments, Slovenia has better rating than Poland, Hungary, Czech Republic or Slovakia119.
e/ Unfinished  transition  process.  Incomplete  transition  increases  the  costs  of  establishing  and
operating a company. This is especially reflected in the so called implementation gap, i.e. the gap
between  formally  adopted  regulation  and  inability  to  (fully)  implement  it.  Economic  and  legal
systems  are  now  approaching  fast  to  the  one  consistent  with  EU  and  one  can  expect
accomplishment of this process along with the integration in the EU.

f/ Administrative barriers to investment and operating of companies are a relevant constraint to more
active  engagement  of  domestic  and  foreign  investors  since  they  increase  the  costs  of  company
establishing  and  operating.  Although  in  a  number  of  areas  (like  tax  administration,  customs
procedures, industrial property rights and standardization procedures, and to a certain extent also
procedures  for  establishing  businesses  and  foreign  exchange  transaction  reporting  requirement)
definite  or  important  breakthroughs  have  already  been  made,  in  certain  areas  administrative
procedures remain to long and complicated. FIAS (2000) gives specific recommendations to the
Slovenian  government  on  how  to  ease  and  improve  administrative  procedures  in  the  field  of
company registration, business activity permit, acquiring land, site development, expatriate work
permit and employment regulation.

g/ Problems in acquiring industrial locations. Access to business premises and land to do business,
especially  for  industry,  getting  clear  title  to  it,  and  getting  the  necessary  permits  to  build  and
operate  a  factory,  are  often  complex  and  time  consuming.  Problem  is  also  high  price  and  low
availability of land and industrial and business premises in general (FIAS 2000).

h/ Relatively  rigid  and  protective  labor  legislation  which  does  not  take  into  account  enough  the
interests  of  employers,  i.e.  in  general,  the  rules  governing  the  relationship  of  employers  and
employees is biased towards employees (FIAS 2000).

i/ Relatively rigid labor market. Slovenia has relatively well educated and productive labor force, but
labor costs are relatively high compared to competitive investment locations, and mobility of labor
force in Slovenia is relatively low (in certain regions there is a lack of certain professions which are
in surplus in other regions) (FIAS 2000).

j/ Policy of promoting FDI was long rather passive (insufficient funds and people for a serious FDI
promotion  activity).  Since  2000  the  government  has  put  more  efforts  and  has  devoted  more
resources in attracting foreign investors. In the future these activities are to be further strengthened
(TIPO 2001):

2.5. Determinants of future inward FDI trends in Slovenia

Apart  from  the  elimination  of  the  above  mentioned  barriers  to  inward  FDI,  two  major
determinants of future FDI inflows in Slovenia will be: (i) process of integration in the EU
and (ii) process of privatization of financial sector and public utilities. In this framework,
of  course,  a  number  of  other  factors  will  be  relevant;  above  all  the  finalization  of  the

119 According to September 2000 issue of Euromoney Slovenia's political risk rating was 17.43 (of maximum 25

points), that of Czech Republic 17.11, Hungary 17.06, Poland 16.56 and Slovakia 12.86.

144

                                                     
transition  process.  Namely,  adequate  framework  of  macroeconomic  and  macro-
organizational policies (more on that see in Dunning 1992) is extremely important for the
attraction of export-oriented FDI projects which dominate in Slovenia.

Slovenia’s  integration in  the EU. EU integration processes  are  strong  incentive  for  FDI
among  member  countries,  but  also  for  FDI  from  non-member  to  member  countries.
Accession of a new country in the EU is even stronger incentive for increasing FDI flows
in  the  accessing  country.  With  accession  in  the  EU,  the  accessing  country  becomes  an
integral part of the internal market and adopts internal market’s common rules of the game
(acquis communautaire) what stimulates FDI inflows from EU member countries as well
as from other countries. With accession in the EU, the problem of small local market as
the most important constraint for more FDI inflows in Slovenia, will also cease to exist
(Rosati 1998).

(banks  and 

financial  sector 

Privatization of financial sector and public utilities. Dynamics and mode of privatization in
the 
insurance  companies)  and  public  utilities
(telecommunications, airline company, energy sector etc.) will be the second crucial factor
of future FDI inflows in Slovenia. There is no doubt that foreign investors will be included
in these processes. The definite modalities of privatization are, however, not yet definitely
defined, except in the banking sector. In any case it is safe to conclude that privatization
will lead to considerable FDI inflows in the near future.

Completion of transition process. Another important factor of  future FDI  inflows in the
country will be the dynamics of transition reforms and reforms related to the integration in
the  EU.  The  fact  that  Slovenia  is  among  the  forefront  candidate  countries  for  EU
membership considerably reduces the perception of risk of doing business with Slovenia
by potential foreign investors. This is mostly because potential foreign investors are sure
of what the future economic and legal system will look like (acquis communautaire) and
the  timing  of  the  adoption  of  this  system  is  also  known  (National  Program  for  the
Adoption of the Acquis). Adoption of appropriate normative framework is, however, not
enough;  the  catch  word  is  implementation  of  this  framework.  The  completion  of
transition, thus, much depends on the enforcing and implementing of changes, establishing
of enterprise sector which will be able to viably compete on the internal market of the EU,
establishing  of  efficient  corporate  governance,  of  competition  and  competitiveness  of
public utilities, of competitive banking sector. In short, the completion of transition means
establishment  of  (fully)  functioning  market  economy  institutions.  For  Slovenia,  the
process  of  EU  accession  is  nothing  else  but  an  acceleration  of  the  transition  process,  a
guarantee that transition process will be faster and more thorough.

Slovenia  as  a  springboard  for  South-East  Europe.  Stability  Pact  for  South-East  Europe
and,  after  changes  that  happened  in  Federal  Republic  of  Yugoslavia,  gradual  long-term
integration of the area in European integration processes have definitely demonstrated the
possibilities  which  Slovenia  has  in  the  region.  Therefore,  affirmation  of  Slovenia  as  a
springboard  for  doing  business  in  the  successor  countries  of  the  former  Yugoslavia  is
definitely one of the possibilities for increasing future FDI inflows in Slovenia. Slovenia
should  try  to  persuade  foreign  investors  to  handle  the  markets  of  other  parts  of  former
Yugoslavia from Slovenia (establishing of regional headquarters for successor countries of
former  Yugoslavia  in  Slovenia).  Slovenia  has  undeniable  advantages  in  this  regard,  i.e.
much  lower  country  risk,  knowledge  of  circumstances,  language,  culture,  people,  high
reputation of Slovenian products in these countries, geographical location.

145

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