Gathering storm

For the past 20 years, foreign businesspeople working in central and eastern Europe have seen unremitting progress in local business conditions, particularly in the 10 states that joined the European Union in 2004.

The modernisation of laws, regulations and commercial practices, integration with western Europe, huge investments in infrastructure, and, above all, rapid economic growth have transformed the business environment.

But now the global economic crisis has added a new dimension of difficulties. The crisis is hitting the region principally through the financial sector. The west European banks that dominate the market are suffering unprecedented difficulties refinancing themselves, both for their day-to-day operations and for capital to boost their balance sheets to cope with increases in bad debts.

Credit growth has slowed dramatically, leaving companies, particularly smaller enterprises, desperately short of cash. As in western Europe, businesses are increasingly cautious about choosing clients and suppliers, and setting contract terms. Companies prefer to trust the counterparties they know best, making it even harder for newcomers to break into the market.

While all of these challenges have also emerged in western Europe, they are much more acute in some east European states, particularly those most dependent on foreign financing.

Katinka Barysch, deputy director of the Centre for European Reform, a think-tank, writes in a recent report: “The traditional central and east European growth model appears to be broken, at least for now.”

But it is important to keep in mind that the region is composed of states with increasingly different business environments. As the common communist starting point fades into history, economic conditions come under the influence of more recent policymaking. In Hungary, for example, successive years of high government borrowing helped drive the country into economic crisis and forced it to seek an emergency loan from the International Monetary Fund.

By contrast, its central European peers – Poland, the Czech Republic and Slovakia – ran tighter budgets and have weathered the storm better. Slovakia, like Slovenia, has the added advantage of being in the eurozone.

As Manfred Wimmer, chief financial officer of Erste Group, the Austrian bank which has extensive east European operations, says: “What’s been lost in this crisis, very often, has been the ability of people to differentiate.”

For foreign businesspeople new to the region, the challenges are particularly relevant. Government agencies and chambers of commerce are aware of the problems and are offering to help with information and contacts. Nevertheless, as in western Europe, the authorities are finding it difficult to counteract the caution in the market place, especially in the crucial banking sector.

Foreign investment is shrinking dramatically. The Institute of International Finance, a bankers’ umbrella group, estimates that private capital flows to emerging Europe (including Russia and Turkey) shrank from £283bn in 2007 to £183bn in 2008, and just £21bn so far this year. The turnround in banking finance makes a dramatic contribution to these totals: dropping from an inflow of £156bn in 2007 to one of £88bn last year to a forecast net outflow of £19bn this year.

And yet, there is business to be done in these conditions. The credit crunch is driving down asset prices, with debt-laden owners forced to do deals or sell out altogether at valuations they would have found laughable a year ago.

Those owners who can afford to wait for better times will do so, but others cannot. For cash-rich investors this creates a rare chance to invest in the region, at prices not seen for years. Industrial companies, private equity funds and rich individuals are all sniffing around in the hope of snapping up a bargain.

Among them is, for example, Zdenek Bakala, a Czech entrepreneur. His coal company, New World Resources, is buying a 25 per cent stake in Ferrexpo, the Ukrainian iron ore group, from Kostyantin Zhevago, Ferrexpo’s controlling shareholder, after Mr Zhevago came under financial pressure and had to sell the stock.

The same arguments apply in trade. Companies were raising prices for their products a year ago but are now under pressure to cut prices. In comparison with western European companies, they may find this easier to do because they are more flexible, having lived through a series of mini-crises in the past two decades.

Lower wage costs, for example, were one reason Dell, the US computer maker, decided to cut operations in Ireland and move them to an existing site in Poland. The sharp decline in eastern European currencies has also increased the competitiveness of the region’s exporters.

Meanwhile, the crisis has had little impact on the ease of doing business in the region – in terms of dealing with officialdom and red tape. But this may not last, if governments increase their role in the economy. As the European Bank for Reconstruction and Development noted in its annual review last autumn: “While there has been no serious backtracking on reform in any transition country during the past year, there have been worrying instances of the state taking a more intrusive role in key sectors of the economy, notably in Russia.”

After years of reform, conditions in the most advanced east European states are now approaching west European levels. The World Bank reported last summer that Slovakia, the top-rated east European state, came 36th on a global list of countries ranked by the ease of setting up companies and similar functions, only nine places behind Austria. Hungary was not far behind in 41st place. Admittedly the east European “tail” is rather long, with the Czech Republic ranked 75th, Poland 76th and Ukraine 145th. And the World Bank does not capture the whole picture. Bulgaria and Romania do well on its criteria, ranking 45th and 47th, but they have a poor reputation for fighting corruption.

Some observers fear that if the state’s economic role increases, it could make life more difficult for businesses, particularly newcomers with little knowledge of domestic bureaucratic practices. Pavol Demes, a former Slovak foreign minister and head of the central and east European office of the German Marshall Fund, a US think-tank, says that people are beginning “to question” liberal democracy, market economics and the loose regulatory frameworks of recent years.

Ivan Krastev, head of the Centre for Liberal Studies, a Bulgarian think-tank, warns that the crisis is undermining the people who were the strongest supporters of the globalisation drive and creating opportunities for inward-looking politically oriented rivals. “The worst hit are the best integrated, best managed and most westernised companies,” he says.

But, for the moment, these risks should not be exaggerated. Countries inside the EU will be obliged to continue operating within the single market’s rules. Candidate countries will have to stick to these regulations too, or jeopardise their accession hopes. While populist leaders may demand, for example, protectionist policies, east European governments will have to bear in mind that they are currently significant beneficiaries of EU aid programmes, financed by west European states.

For multinational businesses, the principal attraction of the region remains: low-cost, high-skilled labour inside the huge EU market. Even in the depths of the crisis, companies are intensely aware of this.

Sergio Marchionne, chief executive of Fiat, the Italian carmaker, recently pointed out that the group’s one Polish factory makes 400,000 cars a year, while the six Italian plants together produce 600,000. “This is offensive,” he told an Italian newspaper.

It may also become unsustainable.

Stefan Wagstyl is eastern Europe editor