The economies of the Central Europe region have struggled to restart growth since the financial crisis of 2008, but as the global economy has found a stronger footing – and the region’s trading and investment partners in Western Europe have moved past the Euro crisis – 2014 has brought promising signs: in the first quarter of 2014 major CE economies grew by 2–3% or more. Yet growth across the eight CE countries we analyzed in our recent research (Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, Slovakia, and Slovenia) remains far below pre-crisis levels. From 2000 to 2008, GDP growth averaged 4.6 annually, making CE economies among the fastest growing in the world and raising per capita GDP from 38% of the EU15 average in 1995 to 52% in 2011.

According to a recent report by the McKinsey Global Institute entitled “A new dawn: Reigniting growth in Central and Eastern Europe” it is still possible for CE economies to generate 4%-plus GDP growth, but only if they can modify their growth model to reflect the new realities of the global economy. The model that served the region so well prior to the crisis depended on Western Europe as a source of both demand for exports and the foreign direct investment (FDI) that allowed the region to raise productivity from 37% of the EU level in 1995 to 60% in 2011, and made it an important manufacturing hub, particularly for automobiles. In retrospect, it is also clear that growth was dependent on debt-fuelled consumption that could not be sustained.

A new growth model would include expanding exports in knowledge-intensive goods and services, raising productivity in lagging sectors such as transportation, and building sources of domestic financing to fund growth while attracting renewed FDI. Underpinning these strategies would be enablers such as improved infrastructure, urbanization, and better education and training.

If the CE economies can make these strategic shifts and investments, we estimate that regional growth can return to the 4.6% average through 2025; without these changes, the region could expect to see average growth of 2.8% (Exhibit 1). This model calls for shifts in strategic focus and long-term investments.

We find that the underlying strengths that made rapid growth possible in the pre-crisis period remain intact. The core strengths of the CE region, an area with 100 million people and 1.3 trillion dollars (0.9 trillion euros) in GDP in nominal terms, are:

Highly educated yet affordable workforce. About 22% of the entire labor force has tertiary education and 29% of workers aged 25 to 34 have college degrees, matching the Western European rate for all workers. Yet wages average 75% less than in the EU-15 and are as much as 90% lower in Bulgaria and Romania.

Stable macroeconomic environment. The CE economies have relatively strong balance sheets (public debt in most nations has not exceeded 60% of GDP since 2004), and exchange rates have been relatively stable at plus or minus 15% versus the euro.

Favorable business environment. While there is room for improvement, the region now ranks just behind the high-income economies of the Organisation for Economic Cooperation and Development (OECD) for ease of doing business.[1] Statutory corporate tax rates average 18%, compared with an average of 26% in the EU-15, 22% in Asia, 28% in Latin America, and 29% in Africa. On metrics of corruption, the CE economies lag behind the EU-15 nations but are far ahead of China, India, Brazil, and Russia.[2]

Strategic location. CE nations are, at most, 1,500 kilometers from Germany and the other Western European economies. Russia and other Commonwealth of Independent States (CIS) nations lie to the East, as well as Turkey and the Middle East. As global economic growth moves east and south, Central and Eastern Europe could be well positioned to participate.

The crisis, however, exposed significant weaknesses in the CE growth formula. High GDP growth across the CE region was heavily dependent on consumption, which averaged 80% of GDP between 2005 and 2008 – far above levels in other fast-growing economies. When the crisis hit, foreign direct investment flows – 80% of which had originated in Western Europe – virtually collapsed. Demand in Western Europe, which takes nearly 60% of CE exports, also fell sharply and remains weak.

A new growth model

Restoring the 4.6% annual GDP growth that the CE economies averaged from 2000 to 2008 would require a new growth model. In our research we identify three thrusts and a series of enablers. The thrusts would expand exports in specific sectors to balance trade (as has been achieved recently), raise productivity in lagging sectors, and ensure domestic financing to fund growth while attracting renewed FDI. Underpinning these strategies would be enablers such as improved infrastructure, urbanization, regulatory and institutional reforms, and better education and training.

Expanding exports of higher value-added goods and services

CE nations have an opportunity to raise both the volume and value of exports from the region. With its well-educated labor force, it has the talent to become a stronger global center for advanced manufacturing, which includes automotive, aerospace, electronics, semiconductors, and medical products. The region also is well-positioned to become a food-processing hub for greater Europe, moving up from cereals and meats (where it has a strong position but where value-added per worker is limited) to packaged foods such as pasta and beverages.

There is a particular opportunity in knowledge-intensive manufacturing and service exports, where CE nations already have a strong position in fields such as automobiles and aerospace. To seize the opportunity, CE companies and governments will need to invest more in R&D and continue to cultivate a high-skill labor force. They will be competing with fast-growing Asian economies that are attempting to move up the manufacturing value chain and are already making such investments. Governments can help fund R&D and innovation, through grants and tax incentives and by acting as the initial purchasers of new innovations.

Governments also can support further growth of industry clusters (the region has strong automotive, aerospace, and electronics clusters) and invest in technical education. Finally, to continue attracting FDI in knowledge-intensive industries, CE policy makers should continue liberalizing their markets and reducing regulatory complexity. CE economies also have an opportunity to move up the value chain in outsourcing and offshoring to take on more sophisticated work such as design services, which will depend on continuing investments in education.

Unleash productivity and growth in lagging sectors

Despite the productivity gains of the pre-crisis era, CE economies still have large productivity gaps to Western Europe in many sectors. The most obvious targets are construction, transportation, and retail industries. Today, road freight productivity in the region is 35% below EU-15 levels, reflecting both the condition of CE roads and a highly fragmented industry, which has made limited investment in technologies to optimize routes and scheduling. In construction, productivity is severely limited both by fragmentation (there are few large players) and a high degree of informality; an estimated 39% of CE construction output in 2011 was carried out with informal labor, compared with 24% in the EU-15.

CE economies can redouble efforts to improve the performance of network industries such as railways, postal services, and electric and telecom systems. CE nations are at different stages of reforming state-owned rail systems and can benefit from strategies such as unbundling infrastructure from operations and opening the systems to more competition. Electric utilities have been only partly privatized. CE postal services have still not diversified into other services such as overnight package delivery, and have not streamlined operations. The CE telecom sector has successfully introduced competition, but now has a fragmented market that could benefit from consolidation. The sector needs to prepare for the EU push for a single digital market, which would permit companies to compete across all EU markets.

Diversify sources of investment capital

The CE region attracted large flows of FDI from the early 1990s onward as nations opened markets to competition and sold state assets. Investors from Western Europe accounted for most of the flow, concentrating on the automobile manufacturing sector and on finance (foreign interests own 85% of the capital in the region’s top 10 banks). Between 2004 and 2008, total FDI flows were 1.5 trillion euros, but the flow fell sharply after the crisis and the region stills suffers from the global slowdown in cross-border investment.

While CE nations can take steps to attract more FDI, such as investing in infrastructure and removing regulatory barriers, the more urgent priority now is to build up domestic sources of capital. The crisis exposed a critical weakness that now needs to be addressed: for nearly twenty years, overall savings have failed to cover investment. Household saving habits, as well as government fiscal problems, are the root causes of anemic saving rates in the CE economies. Low household saving rates stem from many factors, including modest income levels, a wariness of investing in financial assets, and the effect of government-financed education, health care, and pensions – three needs that usually drive savings. When families have the income to invest, they put their money into real estate rather than financial assets. Changing these habits will take time.

Governments can help by providing incentives, such as requiring workers to contribute to pension plans and by continuing to create efficient and transparent securities markets to build investor confidence in these institutions. Finally, governments can create incentives for banks to address financial inclusion (an estimated 30% of the population is “unbanked”) and increase lending to the small and medium-sized enterprises that could be an important source of job growth.

Putting the CE region back on the fast-growth track is not a simple affair. The three strategic thrusts would need to be backed up by additional reforms to make doing business easier and strengthen protections for investors. However, if the CE economies recognize their advantages and learn how to leverage them in new ways, we believe this region can once again be a bright spot in the global economy.

This interview was first published in Visegrad Insight 2 (6) 2014.

Wojciech Bogdan is a partner in McKinsey’s Warsaw office and a co-author of the report “A new dawn: Reigniting growth in Central and Eastern Europe.”

[1] Doing Business 2014, World Bank and International Finance Corporation, 2013. This analysis groups Eastern Europe and Central Asia, which include the eight economies we consider here, as well as the CIS countries, the Western Balkans and the Baltic states.

[2] The World Bank ranks nations for corruption on a 0 to 100 scale, with 100 being least corrupt. The average for CE countries was 51. This compares with EU-15: 68; Brazil: 43; China: 39; India: 36; and Russia: 28. See Corruption perceptions index 2012, Transparency International, 2012.