EASTERN EUROPE, DOING BUSINESS
IN

Since the fall of the Berlin Wall in 1989 and the subsequent retreat of Soviet dominance back to the Russian border, profound economic changes have come about in Eastern Europe. Fledgling market economies, while facing many problems, are striving to fill the vacuum left by the now-defunct communist regimes. Although these various communist regimes have been thoroughly discredited, remnants of their policies of central planning continue to haunt the new transitional economies, presenting great challenges for the region's budding entrepreneurs as well as foreign investors and other representatives of the Western business community.

The new economies of Eastern Europe are best described as transitional in that they are moving away from a centrally planned economy and towards a marketplace economic system. The new economies, however, are to one degree or another still based on social institutions that have been in existence at least since the end of World War II and in some cases for centuries. The development and functioning of the new economies is still to one degree or another influenced by the same banks, schools, public sector industries, major manufacturing companies, social milieu, and cultural habits that existed prior to 1989. What has changed, however, is the why and the way of doing things, especially economic things. Unlike developing countries which undergo profound institutional changes—an industrial revolution displacing an agrarian-based economy—Eastern Europe is undergoing a transition from state-dominated economies to economies driven by the demands of the marketplace.

The term "Eastern Europe" as used to describe a region that has no specific geographic delineation. Often, countries on the eastern edge of continental Europe, such as Poland, are described as being part of Central Europe while countries more to the center of the continent, such as Hungary, are often described as being in East Central Europe. The western part of what once was the Soviet Union was often classified as part of Europe but the more contemporary term "Eurasian" is gaining popularity. On the other hand part of Turkey, albeit a small part, falls clearly in Eastern Europe but Turkey has nonetheless always been regarded as an Asian country. Other geographic terms to be considered are "the Balkans" and "the Baltic States," both sub-regions of Eastern Europe, one delineated by topography and the other more by politics and location. For the purpose of this essay, however, "Eastern Europe" will embrace Poland, Hungary, the former Czechoslovakia, and the Balkan states, which consist of the former Yugoslavia, as well as Romania, Bulgaria, and Albania. Greece and the European part of Turkey, although clearly part of the Balkan Peninsula, will not be discussed as they are not transitional economies. The Baltic States (Estonia, Latvia, and Lithuania) likewise fall outside of the purview of this essay as does Russia and the Eurasian republics of the former Soviet Union which now gather in a loose coalition known as the Commonwealth of Independent States.

There has also been a bewildering number of changes in the political map of Eastern Europe since the Soviet withdrawal. In 1991 Croatia, Slovenia, and Macedonia, all constituent republics of Yugoslavia, declared their independence. Thereupon Serbia, another Yugoslav constituent republic and Montenegro, a region of Yugoslavia, jointly proclaimed the formation of the "Federal Republic of Yugoslavia." Kosovo is an area in southern Serbia that has a population of 2 million, with 90 percent being ethnic Albanian. With the breakup of Yugoslavia, Albanian secessionists quickly proclaimed an independent Republic of Kosovo, but Serbia and its military contested this breakaway movement and as of early 1999 retained control of much of Kosovo. Bosnia and Herzegovina were both regions in the Balkans that were eventually joined together as the Yugoslav constituent republic of Bosnia and Herzegovina. In 1991 it likewise became an independent state although its independence was greatly compromised by Serbian military action. Unlike Yugoslavia, the political changes in Czechoslovakia came about by ballot rather than bullet. In 1993 the country voted to divide itself into two sovereign and separate states—the Czech Republic and Slovakia.

Because of great unrest, violence, and military uncertainty, Yugoslavia and Kosovo are dangerous places for foreigners and the region's general instability is certainly not conducive to business development and foreign investment. The U.S. Department of State issues traveler's advisories for dangerous parts of the world and it is strongly recommended that travelers to these Yugoslav areas avail themselves of this service. For these reasons this area will not be considered in this essay. These conditions do not apply to the former Yugoslav republics of Croatia and Slovenia, both of which have thriving economic sectors.

Although all of these Eastern European countries had centrally planned economies the application of communist economic principles and ideology varied greatly from country to country. Some of these countries (especially Yugoslavia and Hungary), for a variety of reasons had freer economic systems and thus were "one up" on the rest of Eastern Europe when communism collapsed. Nonetheless it is still possible to generalize about the problems facing these transitional economies.

According to a lengthy survey of the economic problems of Eastern Europe by the Economist, the one single challenge facing all of these countries is the need to completely integrate their economies with the rest of the world. This can only come about when the region is able to produce high-quality goods and services from well-managed companies employing well-trained workers with high morale. Concurrent is the need to develop easily accessible local capital markets and financial institutions supported by national governments sympathetic to the goals of their respective business communities.

To enhance this transition the fiscal policies of the various governments must address three issues: liberalization, stabilization, and privatization. Liberalization and stabilization refer to "taming hyperinflation," freeing prices, and liberalizing or deregulating foreign exchange activities while still maintaining enough regulation over capital markets so as to prevent "financial anarchy." Privatization refers to the government divesting itself of state-owned industries.

The same survey also found the transitional economies of Eastern Europe to have certain short-term economic advantages over Western Europe. The greatest single advantage is the low cost of labor and the resultant lower price for goods and services. Auto workers in Poland, for instance, earn about 20 percent of what their Western European counterparts make. Analysts predict, however, that by the early years of the 21st century Eastern European wages will have risen to approximately two-thirds of the European Union average. Although wages are expected to rise, their annual rate of growth is nonetheless declining. Growth in real wages stood at 6 percent in 1997, but the same figure was expected to be 4 percent for 1999.

Concurrent with rising wages will be rising costs for other things such as energy. Under communism the energy used to run manufacturing facilities was greatly subsidized by the state. In postcommunist Eastern Europe the price of energy used by the private sector reflects the world price of energy. To offset this invariable rise in wages and other costs, the economies of eastern Europe can only remain competitive by reforming capital markets, attracting foreign investment, and improving productivity.

A major drawback of most Eastern European economies are their banking systems and financial markets. According to one Western executive, "There is not a bank in Warsaw which can satisfactorily cope with 200 bank transfers a day." While major multinational companies can cope with situations like this, smaller start-up companies often cannot. Eastern Europe also suffers from a deficiency of local institutional investors, such as major pension funds, which according to the Economist are needed to add depth and firmer corporate governance to the market. Poland, however, is taking measures to correct its antiquated pension system. Warsaw-based Alicja Malecka—an executive for the Pioneer Group, a Boston-based asset manager with operations in many Eastern European countries, including Poland—believes that newly enacted Polish legislation is a first step in reforming Poland's "pay-as-you-go" pension system. The new law will require 3.5 million Poles under the age of 30 to start paying part of their wages into private pension funds. Malecka's company manages $400 million worth of funds in Poland and hopes to expand its operations when 400 companies—in order to comply with the new law—begin instituting corporate pension plans to supplement government social security payments. Malecka is optimistic. "Five years down the road, most of our assets will come from pension funds," she told the New York Times in 1999. The development of pools of capital available for business loans is also hampered by the relatively low rate of savings in Eastern Europe. By

1996, the average savings rate had fallen to about 18 percent of gross domestic product (GDP), or about half that of the so-called Tiger economies of Asia. Properly run mutual funds, life insurance companies, and private pension funds would greatly boost the rate of savings while reducing the cost of capital in Eastern Europe.

Even with these pending reforms, foreign investment in Eastern Europe has lagged. Eastern Europe has an aggregate GDP of $358 billion but attracted only $46 billion in foreign money between 1992 and 1997. Foreign direct investment in Eastern Europe even declined from $14 billion in 1995 to $12 billion in 1996. The flow of foreign direct investment in 1996 was nonetheless more than double the average of the period from 1992 to 1994, according to the United Nations. Two-thirds of foreign investment in Eastern Europe is concentrated in the Czech Republic, Hungary, and Poland. Transnational companies from Western Europe account for most of these investments followed by companies from the United States and then Asia. Surprisingly, intraregion foreign investment is increasing as more Eastern European companies are beginning to invest in neighboring countries. The United Nations expects foreign direct investment to begin climbing, especially in Bulgaria and Romania, as these countries begin instituting large-scale privatization schemes similar to those instituted by Hungary, Poland, and the Czech Republic.

Productivity in some sectors of these transitional economies is approaching that of the West. It is not uncommon for a new factory in Eastern Europe under Western management and with a well-trained and highly motivated workforce to reach productivity close to 90 percent of Western levels. This has been the experience of Volkswagen, which in 1991 bought a controlling share of Skoda, a Czech Republic auto company that was previously run by the national government. According to the Economist, Erik Fougner—a Prague-based executive for ABB, an engineering conglomerate with many Eastern European interests—has found that his company's Czech operations perform at a level comparable to, if not sometimes better than, its operations in the West. Fougner and other analysts believe that employee training coupled with rising productivity will offset rising costs in Eastern Europe. "The big productivity gains are still to come, in the interface between sales and engineering," Fougner told the Economist. Foreign executives are also surprised to find that bureaucracy can sometimes be less of a problem in Eastern Europe. Eastern European trade unions for example are less strident than their Western counterparts and factories operating seven days a week are not uncommon. A recent book, Poland to 2005: The Challenge of Europe, estimates that the industrial output of private firms has tripled from 16 percent of gross sales in 1989 to 45 percent in 1995. This represents an annual growth rate of more than 20 percent. This increasing productivity also indicates that Eastern European workers are excising malingering habits learned under communism. It also reflects the high quality of the Eastern European educational system, especially in the areas of mathematics and technical subjects.

The slackening in Western investment is not due entirely to a lack of interest by Western countries; a major factor has been the unwillingness of many Eastern European nations to sell off their assets or surrender meaningful control to Western companies. There are a number of reasons for this attitude including the fear of selling assets either too cheaply or too hurriedly, consternation over cross-cultural issues and foreign sensitivity to social concerns, and concern that foreign companies will use Eastern Europe as a source for cheap labor and quick profits but not as a site for long-term investment especially in the area of research and development. Such a policy, Eastern Europeans fear, would result in overall job losses. Although this feeling lingers among Eastern Europeans, it is slowly being allayed. For instance, in 1998 General Motors opened a new $535 million plant in southern Poland. Headed by Scott Mackie, the factory represents GM's long-term commitment to doing business in Poland. Mackie told the New York Times, ' Our ambition is not just get a toe in the door, but a significant stake in the market. We don't build plants with a five year horizon, but with a 30 to 40 year horizon." Various studies also support this commitment. For example, a 1997 survey by Czechinvest, a Czech Republic government agency, found that between 1993 and 1996 two-thirds of those companies taken over by Western concerns created more jobs than they cut.

Foreign direct investment, although currently lagging, is expected to improve as many countries of Eastern Europe move toward membership in the European Union (EU). In 1998 the EU finalized "accession partnerships" for ten Eastern European countries, including Bulgaria, the Czech Republic, Hungary, Poland, Romania, Slovakia, and Slovenia. The accession partnerships are meant to assist applicant states by providing a framework for preaccession strategy. Criteria for eventual inclusion in the EU include: stability of institutions, democratic governments, respect for human rights, a functioning market economy, the capacity to cope with market forces and competition within the EU, and commitment to the aims of the European economic and monetary union. These requirements thus encompass political, social, as well as economic activities in the applicant countries. For example, the Czech Republic has been asked to institute tighter regulations on its banking, securities, and insurance industries; Poland is required to reduce its foreign debt while restructuring its steel industry; and Slovakia has been asked to hold "free and fair" elections and legislate safeguards concerning the use of minority languages within its borders. The "big economies" of Eastern Europe—Poland, Hungary, and the Czech Republic—are expected to be the first eastern entrants into the EU, quickly followed by Slovenia. Such a move into the EU can only strengthen and stabilize the economies of Eastern Europe. According to a spokesman for the European Bank for Reconstruction and Development, "As long as there are clear signals that accession to the European Union is on track, then Central European countries are going to be decoupled from emerging market risks."

While all of the economies of Eastern Europe languished under communism, some, for a variety of reasons, suffered less than others. The economies of Poland, Hungary, Slovenia, and the Czech Republic found reintegration into the West easier than other countries in the region, and are thus more attractive to Western investment. Slovenia was once part of Yugoslavia, which under the rule of its enigmatic leader, Marshal Tito (1892-1980), had many Western cultural and business contacts and managed to escape Soviet economic domination. Hungary also had a comparatively liberalized economy which tolerated foreign banks and allowed its citizens to travel, run small businesses, and even involve themselves with equity trading. Poland also saw itself enter the postcommunist era with a well-traveled commercial class of citizens that the Economist characterized as a "raggle-taggle army of suitcase traders," somewhat akin to street hustlers who may lack sophistication but know how to haggle a good deal. The Czech Republic has suffered in the postcommunist period because of the breakup of Czechoslovakia and the rigidly planned economy that it inherited. The Czech Republic nevertheless had a per capita GDP of $8,000 in 1996. Although high for Eastern Europe this per capita GDP is one-half the average for the EU and one-third that of America.

What all these transitional economies need are business managers well versed in Western business techniques—managers who know how to manage money, people, and time. Eastern European managers generally try to solve problems with their company's checkbook—that is, they try to use technology rather than good management to solve problems. They also try to solve problems in-house rather than looking elsewhere for solutions. "Big companies still try to develop their own applications, whereas in the U.S. or western Europe they would outsource," according to Barry Caine, a computer company executive working out of Prague. The inability to properly delegate authority is another shortcoming of Eastern European managers. A management consultant told the Economist, "A Czech executive typically wastes 90 percent of his time solving problems which are five management levels beneath him." Another executive likewise commented on the poor time management habits of many Eastern European managers. "I am constantly amazed," the Warsaw senior banking executive said, "by how bad the top manager's time management is. You try to have a meeting with them and two phones on their desk are ringing constantly, plus their mobile. And on top of that every few minutes somebody comes barging in with an urgent paper that needs signing." According to a Dutch economist based in Budapest Eastern European managers are strong in technical skills and formal education but lacking in managerial skills, organization, the ability to handle complex technology, and training. In an article in Entrepreneur, Nicole R. Achs used an analogy comparing Eastern European managers and the transitional economies of Eastern Europe to a cook concerned with a cake rising properly. According to Achs, "In the ripening markets of the former Eastern bloc, many new business owners have the products, demand, and commitment to see their business rise. What they don't have is the recipe." Western entrepreneurship and business acumen can supply the recipe.