Colloquium 1995 Panel IV : External Economic Relations and Integration into the World Economy

The External Relations of the Eastern European Countries: a Comparative Assessment Andreas Gummich The ability of the economies in transition to succeed in their external economic relations can be judged according to some very practical guidelines, according to Dr. Andreas Gummich. Most countries know what they have to do to interact with outside markets. The question is, are they taking action? Those countries that put their policies where their mouth is will be able to create export-led growth, and be able to attract foreign investment - and in the long run increase their nation's wealth, he says. Dr. Gummich is Vice President, Deutsche Bank Research, Frankfurt am Main.

Introduction In this paper I will outline eight points, starting with a ranking of the Eastern European reforming economies. Chart 1 is dated one year ago, and today it has become almost obsolete. It shows three groups of countries in the shape of concentric circles. For the most progressive, most advanced among these countries down from the Baltics via Belarus, Ukraine, Moldavia, Romania, Bulgaria, down to Albania, the structure is no longer valid because Estonia among the Baltics e.g. has possibly in the meantime joined the first group. Belarus does not know itself whether it is on the road to reform. Ukraine has started to reform its economy. Romania has emerged as a country with high economic growth in the southeast of Europe, and also Albania has made good progress. So today, therefore, there are a lot of differentiations among these countries. Let us finally look at the third group of countries, i.e. Russia. This is now 89 different regions and, maybe, has 89 different journeys on the road to reform. Some regions are moving quickly, some of them very slowly; and some of them are not moving at all because they have run out of fuel. But even on the fastest journeys in Russia and its reforming regions, we sometimes do not know who is actually in the driver's seat. Ranking of Europe's Economies in Transition My second point is the external comparative assessment for Eastern European reforming countries. Let me give you the following criteria for this external comparative assessment: Foreign direct investment. Foreign debt. The rating by international agencies and, therefore, the refinancing opportunities for the country. Volumes, structure, potential and bottlenecks of trade. Convertibility. Membership in international organisations. Foreign Direct Investment Chart 2 shows you the per capita foreign direct investment in several Eastern European countries. Hungary attracted most investment, followed by the other countries that you see here in the chart. How is it that Hungary has been so successful? You know that Hungary is famous for salami, for its paprika, for Rubik's cube and for the New York-based billionaire, George Soros, who lived in Hungary until 1956. But these are not all reasons for the attractiveness of Hungary for foreign investment. The reason was the long-term success as a reforming economy since 1968 when they established goulash communism, which was followed by goulash capitalism in 1990. Today they are accused sometimes of implementing goulash gradualism. But this has been sorted out now by the new austerity programme under the new finance minister, Mr. Lajos Bokros, since March of this year. So Hungary has had an easy investment process and, furthermore, it is a country that marketed its reforms properly. It did not make the same mistake as a German pharmaceutical company once made when they wanted to market a headache drug in an Arab country. The company thought that they would launch an advertising campaign and they tried to do it in a major Cairo newspaper. They used three cartoons. The first picture showed an Arab man. Well, you could really see that he suffered. He had headache. He looked not good and he really was in a lot of pain. The second picture showed the same man opening the box with the German headache drug, taking the drug and eating it. In the third picture you could finally see him completely relieved. He smiled, he was relaxed, everything was all right, he had no headache any longer. This advertising campaign was a complete failure. Why was it a failure?

Foreign Direct Investment It was a failure because the strategists in the headquarters of the pharmaceutical company in Germany had not taken into consideration that in Arab countries you do not read a newspaper from the left to the right. Hungary has not made this kind of mistake in marketing its abilities and its potential. It has attracted $7-8 billion up to the end of 1994 in foreign direct investment. The exact number depends on your method of calculation. It is followed by Poland with approximately $3.5 billion and the Czech Republic with $3.1 billion. These three countries altogether make up for more than 50 percent of total foreign direct investment in the 26 reforming economies. The whole region attracted $22 billion for investment. That might sound like a lot, but the actual annual inflow of foreign direct investment into the region of $7 billion is about the same inflow as into Argentina alone. And the total accumulated stock of foreign direct investment in the entire Eastern European and former Soviet region, with more than 400 million inhabitants, is less than the accumulated stock of strategic investments in Thailand. Nevertheless, this foreign direct investment in the East is certainly a success because the countries started only a few years ago and they started from scratch. Chart 3 shows wage levels in the Eastern European region, indicating why these countries are so attractive to foreign direct investors. Wage costs even in the most expensive country amount to less than 10 percent of West German wage levels, including social benefits. It is important to say, however, that these low wage levels make these countries very attractive for strategic, greenfield investors who like to produce and manufacture in the economies. On the other hand, there is a big productivity gap, compared to the West, in all of these countries. So the very low wage level in Russia actually does not mean that the unit-costs are much more attractive than, let us say, in West Germany. No, if you calculate the productivity, the over-manning, the lack of quality and the image gap of products, and the lack of marketing skills, then you end up with the same unit-cost per unit in the West as in some of these countries, as especially here in this example, in Russia. Foreign Debt My fourth point is foreign debt. In absolute terms, Russia is the most indebted country, with $89 billion worth of Soviet debt. They have also taken responsibility for 100 percent of this debt from other republics. If we add new debt that has emerged since 1992 for Russia, we end up at a number higher than $130 billion. Poland ranks second with $42 billion, Hungary with $28 billion, Bulgaria with $14 billion, Czech Republic with $9 billion, Romania with $4.6 billion and Slovakia with $4.1 billion. One may use another statistic and measure foreign debt on a per capita base. Here Hungary is in the lead with $2,800 per capita in foreign debt, followed by Bulgaria with $1,800 and Poland with $1,100. Russia comes afterwards with about $1,000 dollars per capita, followed by Czech Republic and Slovakia with $900 dollars per capita and Romania with only $200 dollars per capita. Bankers tend to use another method of calculating debt burden: the debt ratio. The debt ratio is the ratio of net foreign debt to total annual export earnings. It expresses how many years of exports are needed to repay the foreign debt of a country in full. To give you an example: if a country is indebted to the other countries, to the international markets, with $20 billion and has annual exports worth $10 billion, the debt ratio would be 2.0 because two years of exports would be needed to repay the entire debt. Here, Hungary and Bulgaria are in the (negative) lead with 2.0, followed by Russia with 1.9 and Poland with 1.6; the numbers for Romania, Slovakia and Czech Republic are 0.9, 0.7 and 0.3 respectively. It also makes a big difference whether the countries asked for a rescheduling in the past or not. Poland had a major rescheduling with the Paris Club already in 1991 and had a rescheduling concerning its commercial debt to Western banks only a year ago in 1994. Hungary, the highest per capita debtor, never asked for a rescheduling. In the early 1990s, a lot of Western critics advised them to do so - but they chose to service their debt punctually, which brought them an early seal of approval from the IMF. They were a good debtor country - in contrast to Poland which stopped servicing its debt in 1989, asked for a rescheduling and received a worse international credit rating. And that made it possible for Hungary to attract such a lot of foreign direct investment. For Russia, the rescheduling question is still open. We hope in the London Club and in the Paris Club to achieve a long-term solution. In both Clubs there are negotiations under way and we are optimistic that we will arrive at a solution for this $89 billion debt which is divided into about $28 billion commercial debt with about 600 banks (London Club) and about $56 billion with the 19 member governments of the Paris Club. The rest of the debt is supplier credits. The non-existence of a long-term international rescheduling agreement puts a big shadow on the creditworthiness of Russia and also on other CIS-States, although Russia accounts for the entire debt today.

Rating and Refinancing Only three countries in the region have received a rating by Moody's, for example. Hungary has the longest history of refinancing its economy with Eurobonds, but Hungary has fallen a little bit behind now. Poland, just a few weeks ago, as a surprise, received a rating by Moody's of BAA 3, which is the lowest level of investment grade rating for quality-conscious Western portfolio investors. The Hungarian rating (BBB) today is worse than the Polish one whereas the rating of the Czech National Bank is higher. The Czech National Bank is a bond issuer; Poland is going to be one soon and there are rumours that Russia in the third quarter of the year is going to issue Eurobonds again. Refinancing of these countries is possible when portfolio investors go into the country and invest there on the basis of this rating. You know how portfolio investors can behave in these markets. You know the definition of an emerging market? This definition holds true: an emerging market is a market where you have to be ready to emerge in case of emergency. And this is what portfolio investors tend to do sometimes. In contrast to the positive implications brought into a country's economy by foreign capital this practice endangers the stability of these economies, in extreme situations, by immediate withdrawal of invested capital. Trade We have done analyses in the CEFTA countries (Central European Free Trade Association - Poland, Czech Republic, Hungary and Slovakia) and compared the trade structures from 1990 to 1994. The major findings are as follows: the level of openness of these economies is today almost the same as the level of openness of the EU member-countries. The level of openness expressed in the export quota, for example in the Czech Republic compared to Austria - both similar countries with similar sizes of population - is 55 percent today (in Austria) as against 38 percent. If we exclude Czech trade with Slovakia, we still end at an export quota of 37 percent. Another comparison: Poland and Spain. Those countries have similar size populations, Spain's export quota was 20 percent, and the export quota of Poland was 24 percent at the end of 1994. All of the countries in Central and Eastern Europe show a higher share in trade with the EU than four or eight years ago. In 1986 their share of trade with the EU was only 27 percent. Today it is 50 to 60 percent and, again, this is almost as much as Spain's or Austria's trade with the EU. There is, interestingly enough, a reduction in exports of sensitive goods from Central and Eastern Europe to the EU. Producers in sectors like textiles, agricultural products, iron and steel maintain that they have to protect their markets against exports from Central and Eastern Europe and the fact is, if you go into a Belgian restaurant today and order raspberries, they are very likely not from Poland. And this is because the Scottish raspberry farmers have lobbied much more successfully than the Polish ones. Exports from the eastern region in sensitive goods into the EU area have even decreased and, what surprised me most in doing this analysis, there is only a slight surplus in sensitive goods in bilateral trade from Central and Eastern Europe with the EU. There is just a surplus of one billion ECU into the EU regarding iron, steel, textiles, agricultural products; this is just 0.1 percent of total imports of the EU from outside. So there is really not much real danger in imports from Central and Eastern Europe, at least for the domestic industries in the EU. Russia's trade is a problem. There are poor statistics. Russia is a phenomenon in itself. Winston Churchill, 50 years ago, helped us in saying: We can't analyse Russia. Russia is a puzzle, surrounded by an enigma, wrapped into a mystery". So are the trade statistics. In the far East of Russia a year ago, I saw airplanes packed with Russian tourists. They flew to Hong Kong, Seoul and Tokyo and each of them brought back not just the normal economy class baggage allowance, but a lot of boxes. They (the Russians) are allowed by law to bring back goods worth up to 2,000 dollars tax free. Look at these non-statistical imports. Just imagine that every 15th Russian, namely 10 million Russians, only once a year travels abroad and brings back goods worth up to 2,000 dollars, and you have non-statistical imports of $20 billion. This is more than 50 percent of the imports officially reported from Russia. Russia - in contrast to other reforming economies - is rich in easily-marketable natural resources. This means Russia can earn hard currency (namely more than $50 billion in annual exports) by exporting oil, gas, gold, diamonds, coal, timber and metals. While gradually restructuring its manufacturing industries Russia, therefore, can bridge the gap, earn money abroad and feed its people. Other countries, not as largely endowed with resources, do not have this opportunity to generate hard cash. Nevertheless, there are bottlenecks in trade, such as the low technology standards that dominate the Eastern exports, shortages in quality and marketing abilities, and the limited access to Western markets. There is - last but not least - a task for the West, too.

Convertibility There is a race now between the Czech Republic, Poland, and Hungary as to who gets a completely convertible currency first. All the three countries have already a so-called current-account convertibility, i.e. for commercial transactions. They have fared well with this if we leave aside the deterioration of international competitiveness because of real revaluations. Today they seem to be unable to wait for full convertibility. Maybe they should go a little bit slower It took Germany 11 years after the introduction of the Deutschmark in 1948 before the currency became completely convertible and the Austrian shilling and the Swedish krona became completely convertible in 1989 and 1991 respectively . So one could argue about this whether a race is right. Membership of International Economic Organisations The way towards the European Union is illustrated in Chart 4. We have seen the European agreements. The Czech Republic, Hungary and Poland received these European agreements in December 1991, coming to force in early 1992; Slovakia, Bulgaria and Romania in the meantime. The last countries we have seen receiving that status are the three Baltics. Nevertheless, a good topic for discussion might be when these countries will be able to become full members of the Club. The external situation differs very much from country to country. There are some countries - like Poland and Hungary - that can afford to run a negative current account balance. They can balance this debt through refinancing or by an influx of foreign direct investment. Ukraine, in contrast, has a big problem in bridging the gaps created by a negative current account. It is vital to solve old external debt problems of the Eastern countries, because refinancing opportunities improve and strategic investors will be more willing to invest their capital in the country. Also, badly needed imports to restructure the economy can better be financed. The overall success on the external front, finally, is both determined and reflected by the total commitments of the respective country to reforms. In other words: those who show clear commitment by putting the right policies in place - including on the external front - will gain from export-led growth, attract foreign investment and will be able to increase the wealth of their nation and will fare better.