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Thursday
Apr102008

Next Stop Kamchatka?

As the economic train of the Baltics and Eastern Europe (and soon I would imagine Russia) steadily slows down while at the same time producing a tremendous amount of steam in the form of rampant inflation industrial organizations and businesses seem to be waking up to the fact that something is afoot in Eastern Europe. And what are we talking about then? Well, regular readers of this space will know the story just about as well as the chorus of their favorite rock ballad but allow me to repeat it anyway. As such and in a historical context the success of Eastern Europe after the fall of the Berlin Wall can hardly be disputed. Throughout the 1990s structural reforms were slowly but surely put in place and immediately up to as well as after the grand meeting in Copenhagen in 2004 where eight Eastern European countries were adopted into the EU (followed by Romania and Bulgaria in 2007) growth rates were very impressive. These notable growth rates were accompanied by strong capital and investment inflows as well as expectations of future growth both from the perspective of regional policy makers and foreign investors. However, you cannot escape history and even though I wholeheartedly agree with Stefan Karlsson's assertion that Eastern Europe is not a homogenous region the current region wide slowdown and lingering risk of stagflation/deflation do seem to mark a structural break. Contrary to what you might expect it is not these countries' Communist and Soviet history that haunts them but rather a demographic ghost which emerged in the midst of the region at the beginning of the 1990s. Thus almost two decades worth of lowest low fertility (i.e. at TFR below 1.5) as well as a steady outward trickle of labour of the prime vintage to Western Europe are now showing its effect in the form of adding to an increasingly tighter labour market and ensuing inflation and rising wage costs. Slowly but surely, the mainstream media and business managers are thus beginning to wake up the inescapable fact that the biggest risk they now face in the context of Eastern Europe and beyond is not dodgy institutions but missing labour.

A while ago in my continuous coverage of Lithuania I noted that Bloomberg, in one of their small news snippets, were relating the dropping unemployment rate and subsequent inflation and wage cost issues to net outward migration. From this point it is not a big leap to the inclusion of core demographic variables such as most notably fertility. This worrying fact of missing labour to feed the cranes, factories and offices of western companies marching East is beginning to show up all across the board not least in the former cheap sweatshop of the world China where we recently learned how those hitherto labour abundant rural areas are running dangerously dry.

A couple of recent pieces by Reuters and Bloomberg respectively further intensifies this change in discourse. Reuters' Simun Shuster takes us to Russia which is fast becoming anything but the promised land foreign investors marked it out to be. The main problem as you might have expected is a latent shortage of labour which is fuelling wage costs and inflation with the important and much cited point that the former by far out paces the growth in productivity. As could have been expected this tendency is rolling in much to the chagrin of foreign executives and HR managers. As Nestlé's head of corporate affairs Andrei Bader notes; 

"There needs to be a balance between the quality of the labour and its cost ... Once that balance is broken, the future of this economy loses its promise," Bader said.   

This is a discussion about quality then rather than quantity and this also leads to a positive spin of the current situation by Russian authorities and interest groups.

"Will this scare away foreign investors? Yes, absolutely. This is what we need, to scare away the speculators and slave traders. The responsible employers will stay," Shmakov [head of Russian trade union] said. "Russian workers are not Chinese workers. We will fight."

However, if we consult the underlying state of Russian demographics it is very easy to plug holes in this positive narrative. As such, both in terms of quantity and quality Russia's labour market is in a very poor condition. As in all other countries in the Eastern European edifice fertility has been at rock-bottom for nearly two decades. Even though Russia remains a magnet for intra-regional migration flows her overall population is still declining. And when it comes to quality the news is not much better. A lingering and rising problem with AIDS and a persistently too comfortable relationship with alcohol are showing up in aggregate statistics in the form of an appalling track record in terms of male life expectancy. With this as a backdrop and keeping in mind that the current inflation and wage issues are set to continue the human capital foundation is by far the biggest challenge for Russia's economy even though some would also argue that the ongoing poor state of societal and political institutions are equally important.

I am of course painting too much of an ominous picture here. But the message from Shuster's piece is not to be taken lightly. Business comes to Russia to invest, in expectations of conditions which are not present. At all points in time economic growth on a microeconomic as well as a macroeconomic level is primarily driven by people, especially in the context of Russia and Eastern Europe where re-locations have been made in expectations of relatively cheap and abundant labour not to mention the access to a growing middle class with purchasing power to buy more than the bare necessities. It thus my argument that at the heart of the predicament is a mismatch between the process of economic and institutional development which is fairly well known and documented and then a less known but crucial process known as the demographic transition. This is also why I have always felt that Goldman's old 'BRIC economy' narrative should not include the R for Russia since Russia is completely different from the rest. Moreover, one of the big challenges globally will be to make sure China does not go down the same road in terms of a mismatch between expectations of and actual growth potential. Sadly, it seems as if this may precisely what is about to occur in China now in the sense that inflation now seems to have taken an effective hold.

Turning to the piece by Bloomberg authored by James M. Gomez and Andrea Dudikova it echoes the themes from Simon Shuster's piece. However, in stead of focusing on one country Bloomberg presents a veritable tableau d'horreur of stories by companies and business managers and how they cope with the reality of labour scarcity. The main theme, as I have been chanting endlessly here, is that the Eastern European growth story itself is now threatened by the erosion of the human capital foundation. As for concrete examples? Well, why don't we have a look at the travails of one my fellow country men. 

Such costs [i.e. labour costs and inflation] helped drive Niels Larsen, a Dane who founded Amber Furniture in Riga, Latvia, out of business. His company was the Baltic nation's largest furniture maker until it went bust late last year. (...) ``Latvia went from being one of the cheapest places in east Europe to do business to one of the most expensive,'' he said. ``We just couldn't cope. What we had in the last three years was what we call the perfect storm.''  

Indeed as you can see, the honeymoon stage enjoyed by foreign business in Eastern Europe is now clearly over. But what are the solutions then? Well, one obvious solution is to substitute man for machine as we learn Volkswagen is contemplating on a number of their factories. Of course this begs the question of who is actually going to buy all those Passats and Golfs but that will be for another day. Another reply by foreign investors which I find more interesting is the common call to peer further to the East. Thus and contrary to what the Pet Shop Boys sang in 1992 business managers across Europe are readying themselves for an expedition to the East in order to satisfy their hunger for human capital. Gomez' and Dudikova's article even commences with a quote by Jiri Cerny employed by the PSA group in the Czech Republic noting that the company was now eyeing Mongolia as a potential labour repository. And before you dismiss this completely I would recommend that you had a look at Edward's recent potboiler on the Czech Republic over at Global Economy Matters which indeed shows that Mongolians are steadily but surely making their presence felt in the Czech Republic; and so, by the way, are the Vietnamese.

In the end and as companies across Eastern and Western Europe saddle up for a trip across the Ural and then on to the barren lands of Siberia the main question remains as to what exactly is going on. I mean, where are all the people? Above I have tried to present my answer. And as all those business and HR managers work their way across the Asian mainland they will perhaps even venture a trip to the Kamchatka Peninsula. There, I will be sitting in my hut offering a nice pot of cod, scallop and squid and over my premises will be a sign, bent in neon, reading; "Yes Virginia, fertility does matter."

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Reader Comments (2)

Nicely said, Claus. The quote from the furniture maker sums the situation nicely: from cheapest to most expensive in just a few years. I think this transformation of Eastern Europe will be a prominent feature in history texts in a few years.

On the other hand, the quote from Shmakov is comical. Foreign capital holders don't have any responsibility to invest in Russia. Making bombastic comments about "slave traders" isn't going to encourage folks to invest in Russia either. I don't think wages in Russia since the fall of the USSR have approached the levels that Chinese workers started out at at the beginning of China's growth cycle anyway.

Mongolia, with a population of about 2.9 million, isn't likely to be able to absorb a lot of investment with out wage inflation. Mongolia seems to have been fairly progressive in adopting Western economic systems, and I don't know that there are a lot of grossly underemployed folks there. It seems to me that two waves of wage inflation, one from the west and another from the east will converge somewhere in central Asia to form a colossal "rogue" wave of wage inflation.
April 10, 2008 | Unregistered CommenterScott
Hi Scott,

Thanks for the comment. We obviously agree on that Shmakov guy since as you say there does not seem to be the kind of labour dynamics as we have seen in China, Vietnam, India etc. I.e. Russia simply moved through the demographic transition too fast for this. Actually, the expectation that Russia is like China once was is, to a large extent, what is creating the problems.

"It seems to me that two waves of wage inflation, one from the west and another from the east will converge somewhere in central Asia to form a colossal "rogue" wave of wage inflation."

Exactly! And what happens once the fire burns out? Well that is what worries me the most since while some countries will manage to carry on some won't and this will create tensions, vicious circles not to speak of wholly un-managable economic conditions.

Claus
April 11, 2008 | Unregistered CommenterCV

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