Nomura

From the factory to the lab: Central and Eastern Europe’s innovation push

  • Central and Eastern Europe is home to some of Europe's quickest-growing economies
  • Manufacturing has been central to this growth, but the industry faces challenges

Central and Eastern Europe has been a manufacturing hub for the rest of the continent, but the model is creaking as labour costs rise; will innovation in software and digital write the next chapter in its growth story?

Today, Central and Eastern Europe (CEE) is home to some of Europe’s quickest-growing economies; Romania was the EU's fastest-growing last year, hitting 6.4%, and of the 12 EU members forecast to grow by more than 3% this year, nine are former communist countries in the east—led by Romania (4.5%), Poland (4.2%) and Slovenia (4.2%), with record-low unemployment rates of 3-7 percent.

Manufacturing has been a central growth engine, with CEE serving EU markets in a similar manner to the way that Asia served the US: a lower-cost production base of factories and assembly plants, geared to export. Ties with Germany have been especially strong, and many manufacturers—from European names like Volkswagen and Fiat to US brands like GM and Asia’s LG Electronics, Samsung and Hyundai—have invested in CEE, notably in Slovakia, the Czech Republic, Poland and Hungary, while small and medium-sized enterprises (SMEs) are often found making parts for final machine production in Germany.

But the model faces challenges. A heavy movement of labour from CEE to Western Europe, where salaries and living standards are higher, combined with ageing populations at home, is leading to a demographic pinch. Wages are rising, eroding cost-competitiveness, although the differential with Western Europe is still large.

The region’s second challenge is political, with the likes of Hungary and Poland recently evincing anti-immigration tendencies, including towards refugees, which could prompt tensions with other EU members—and even with the core democratic principles of the EU.

Comparing to emerging markets elsewhere

Bilal Hafeez, head of EMEA research at Nomura, says investing in CEE is “a play on Europe. This wouldn’t be a global play like Asia, where China is moving so quickly into the technology space and challenging South Korea, or where Vietnam is in textiles and electronics. Then you have other interesting countries like Nigeria and Kenya, with English-speaking populations that have been under-utilised. Eastern Europe cannot compete with those.” However, what the region does have is strong links to Europe. “If you have a positive view on Europe,” he continues, “there is no better place than Eastern Europe because of the convergence factor.”

CEE firms will need to move beyond manufacturing if they want to find new sources of growth rather than relying solely on low wages. Plenty of firms are challenging global brands in the digital space. Estonia has been the standout, having birthed disruptors like Skype in internet telephony and Transferwise in cross-border payments. Märt Kroodo, co-founder and CEO of 1oT, an Estonian-based cellular connectivity provider for Internet of Things (IoT) device makers, puts his country’s success down to a “start-up mentality”, fostered by “an open attitude to changing business environments, and the small size of the home market, which pushes start-ups to think globally”.

The government’s “e-everything” approach has helped, explains Mr Hafeez, even stretching to an innovative “e-residency” scheme that allows start-ups and entrepreneurs to base themselves in Estonia without any physical presence there. Mr Kroodo believes the government’s efforts to provide seamless and efficient digital services at minimal cost “helps citizens reduce administrative hassle and enables them to focus more on bringing value elsewhere”.

Accessing a 500m-strong market—and EU funding

EU innovation funding has been an important stimulus to firms like Mr Kroodo’s. The two flagship initiatives are Horizon 2020, whose near-€80bn budget makes it the largest such programme in EU history, and European Structural and Investment Funds, which are devoting €110bn across four pillars: innovation, digital, the SME sector and the low-carbon economy.

“EU Regional Development Funds helped us to launch our product, covered part of our R&D costs and helped us to build up technical competencies to be able to truly offer our services throughout the EU and internationally,” says Mr Kroodo. “Because of this, we have been able to rapidly roll out new features to our service and build much faster than we would have done with 100% self-financing.”

Estonia is not the only country producing innovative firms in the digital and technology sectors. Aeromobil, a Slovakian company, is competing with the likes of Uber to build flying cars, while Iryo, a Slovenian-born network, is exploring the use of blockchain for health records.

Furthermore, the Global Innovation Index ranks the Czech Republic, Hungary, Latvia and Estonia in the top innovation tier, comprising the top 34 economies in the world for innovation, with Lithuania, Poland, Slovakia, Romania, Croatia and Bulgaria in the second tier. Top spenders include Slovakia, whose R&D investment has grown at four times the EU average rate and, in 2015, was just shy of reaching its national target of spending 1.2% of gross domestic spending on R&D (most East European countries fall below 1%), while the Czech Republic and Slovenia are spending the same proportionally on R&D as Western European countries.

EU funds will help CEE firms go further in digital and technology. One of 1oT’s fellow grant winners in the recent European Innovation Council funding round was Croatian satellite software company Amphinicy Technologies. Mirta Medanic, the firm's programme manager, says the SME grant allows Europe’s brightest entrepreneurs to “request funding for breakthrough ideas with the potential to create entirely new markets or revolutionise existing ones”.

While most of those securing funding in the recent round were West European and Scandinavian, the presence of a Croatian firm among the recipients should send a message to other CEE businesses. “Companies from the UK, France, Poland, Croatia and other countries all compete on a level playing field,” says Ms Medanic. “Success comes down to the team behind the project, the situation in the market and having a clear vision. If those align, a completely new level of project development opportunities opens up.”

Produced by (E) BrandConnect, a commercial division of The Economist Group, which operates separately from the editorial staffs of The Economist and The Economist Intelligence Unit. Neither (E) BrandConnect nor its affiliates accept any responsibility or liability for reliance by any party on this content.

Contributor

  • Bilal Hafeez

    Head of Fixed Income Research, EMEA

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