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Is bigger better for European Union?

Central and East European countries will continue to have a comparative advantage as destinations of foreign direct investment, although the changing environment will oblige them to diversify further into more service and knowledge-intensive sectors, said a researcher from the Japan External Trade Organization.

A recent JETRO survey shows that a majority of Japanese firms planning to build new manufacturing operations in Europe consider central and eastern parts of the region as candidate sites, Masakazu Tachikawa, director of the Europe Division of JETRO’s Overseas Research Department, told the July 19 symposium.

The accession of eight former Soviet bloc nations into the European Union in 2004 has contributed to improved business infrastructure in those countries, where low-cost and highly educated labor remains an advantage over the so-called old EU members, Tachikawa said.

According to Tachikawa, the annual volume of foreign direct investment in Central and Eastern Europe, which stood at around 10 billion euros in the mid-1990s, began to pick up in 1997 as the process for the countries’ entry into the EU accelerated, and topped 30 billion euros in 2004 and 2005.

Investment by Japanese firms in the region has also increased since the late 1990s and, despite ups and downs over the years, topped 50 billion yen in 2003, he said.

As of late 2005, the Czech Republic was the fourth-largest destination of Japanese manufacturing firms in Europe — after Britain, Germany and France — and two other Central and East European nations — Hungary and Poland — were among the top 10 countries, Tachikawa told the audience.

The number of local subsidiaries of Japanese manufacturers in the region has more than doubled during the past five years, he added.

In the 15 years since the end of communist rule, the region has become a major manufacturing base for European, Japanese and other Asian automakers, including Volkswagen, Renault, Fiat, Toyota, Suzuki, Hyundai and Daewoo.

Poland hosts production facilities of European, American and Asian manufacturers of household electrical goods such as refrigerators, washing machines and air conditioners. The Czech Republic has become a key production base for the world’s computer industry while Hungary has attracted large amounts of investment from information technology firms, Tachikawa said.

In the run-up to their EU accession in 2004, the Central and East European countries offered incentives to foreign manufacturers to make them more attractive than their counterparts in the west, including establishment of special economic zones, reduction/exemption of corporate tax, and lower tariffs on imports of production facilities, he said.

The foreign manufacturers in turn were attracted by the low-cost, highly educated labor in the region, where wage levels were one-fifth to one-sixth of Western Europe, Tachikawa said.

Under the association agreements signed with the prospective members, the EU basically eliminated tariffs to imports from those countries in 1997, giving investors in the region tariff-free access to the EU market, he added.

How has the investment environment changed since their accession to the EU? As one of the positive changes, Tachikawa pointed to improved logistics efficiency due to simplified customs procedures, including border checks on cargo, between the new members and the rest of the union.

He also cited greater transparency of legal systems due to harmonization to EU standards, as well as infrastructure improvement with the use of EU funds for less developed members.

On the other hand, the accession has obliged the Central and East European countries to either scale down or abolish the investment incentives to conform to the framework of EU competition policy, Tachikawa said. For example, they have had to discontinue the exemption of customs tariffs on imports of production equipment.

Conformity to EU standards resulted in tightened regulations, including those on the environment, he said.

Tachikawa also pointed to the sharp rise in personnel costs in the Central and East European countries, with some estimates showing that wage levels in the region have doubled in the 10 years since 1995.

A JETRO survey shows that labor costs in Budapest, which were one-seventh of those in Dusseldorf, Germany, three years ago, have increased to one-fourth the level, he said. But the figures also show that the new EU members still retain a steep labor cost advantage over the old members, he added.

The rising costs put the new EU members at a comparative disadvantage against non-EU members in the area such as Romania and Ukraine, which has prompted them to shift the target of investment promotion from labor-intensive sectors to knowledge-intensive sectors such as service industries and research and development, Tachikawa said.

Foreign investment in the service sector is in fact on the rise, including the establishment of a shared service center of Philips in Poland, a British Telecom call center in Hungary and regional headquarters of Hewlett-Packard in the Czech Republic, he said.

Investment in automobile sectors has continued after the accession, including the recent new projects by Kia and PSA Peugeot Citroen in Slovakia and Hyundai in the Czech Republic.

Tachikawa also pointed to a series of investments by liquid crystal display TV makers and component manufacturers, many of them in the Czech Republic and Poland.

While labor costs in the Central and East European countries are higher than in China, they still retain an advantage in terms of their access to the European market because many of the products manufactured in the region are for consumption in Europe, Tachikawa said.

Overall, Tachikawa said Central and Eastern Europe will remain a promising region. The lingering huge economic gap with the old EU members to the west means that they have the potential for continued high growth, he said. Average growth rate in the region between 2005 and 2007 is estimated to be in the 4 percent range, compared to 2 percent in Western Europe, he added.

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