AI in CEE: Time to ponder

The advent of Artificial Intelligence (AI) applied to many sectors of national economies and thus driving Industrial Revolution 4.0. will likely bring a large increase in output and labor productivity in economies of Central and Eastern Europe. This is because the nature of work will change due to robotization and the application of AI to new technologies will likely bring revolutionary breakthroughs. Also, our lives, professional and otherwise, will be transformed in fundamental ways. According to the estimate of McKinsey Global Institute, a yearly contribution of AI to global produced value could be as high as 7 % of the world’s GDP, unfolding gradually in the coming years. This is an enormous boost to the world economic product and if harnessed properly can enhance prosperity in many places, including in CEE.

However, the application of AI to many sectors will bring also many challenges and risk of disruption to which national economies and their leaders will have to react. Transformation of the nature of work in many sectors and robotization will mean that many workers will be displaced from their current jobs. While predictions vary as to how precisely the AI will transform the economies and to what extent the labor market will be affected, it is presumed that the impact will be nothing short of fundamental. It might be worth pondering the potential adverse effects of the AI to the labor market now since the unfolding of AI revolution with both enormously positive gains but also concomitant negative economic side effects can come relatively quickly.

There are at least three areas where one could think a progress made would help prepare for the coming challenges :

First, it is clear that supporting the sector of lifelong learning should bring dividends on many fronts. Many displaced workers will likely not be able to find a new job in the same sector where they worked previously. Here the retraining – possibly subsidized one way or another by the governments – could help. Furthermore, a more complex response to boosting the whole sector of lifelong learning – such as through various tax-related schemes that would encourage private sector provision of retraining and encourage the flow of resources to the sector – could also help.

Second, large infrastructure projects which are still needed in many CEE countries would help absorb released workers – however, financing of such projects will be circumscribed by the usual fiscal constraint. Hence even more cautious than usual fiscal policy stance in the coming years would help prepare the fiscal position of individual countries for extraordinary expenditures should AI-related labor displacements prove significant and a launch of infrastructure projects be chosen as one of the solutions.

Third, but perhaps most importantly, promoting entrepreneurship and supporting various schemes to help start-ups would go a long way towards creating ground from which many new enterprises can spring ready to absorb displaced workers. Since the industry is particularly vulnerable to labor displacements due to likely future robotization and while start-ups in that sector are particularly demanding undertaking, innovative ways to help such start-ups would be called for. An increased flow of resources to the R&D sector could help CEE countries further reduce the gap from the technological frontier; the effective collaboration between business and universities would mean that advances in research would translate into commercialized products. Additionally, small business and self-employed workers should be particularly encouraged through various schemes. Also, more philosophically, support of Small business could be an effective recipe for many ills which the current integrated economic system brings, along with prosperity.

AI-related revolution is right at the corner. In order to fully realize its potential, which is enormous both for economic prosperity as well as quality of life, it is time to ponder the best medium-term solutions to some of the downsides that it is likely to bring along with the great benefits.

Vladimir Zlacky
26.october 2019

AI and Slovakia: Will FDI diminish ?

Artificial intelligence (AI) fueling 4.0 Industrial Revolution has put on center stage several questions in the context of a converging economy, such as the one of Slovakia. Will the introduction of AI help the main pillars of the Slovak economy such as FDI-owned manufacturing industries ? Which policy challenges will it bring to the fore ?

Economic convergence leads to rising wages

Convergence of a national economy to the level of Western economies in the European Union means that via labor productivity increases the overall economic growth surpasses that in the EU – over time the gap between the level of economic performance of Western and Eastern countries decreases. With an overall national wage growth at a certain level – as some key sectors over-perform – some sectors may run out of potential for productivity gains and its labor productivity tempo might be lagging behind the national average of wage growth.

Which are the two scenarios for the development of such sector i.e. sector where labor productivity growth no longer goes hand in hand with wage growth at the national level ?

A) Scenario without much introduction of new machinery

Assume labor compensation/output remains at significant levels (say 40-50%) as is oftentimes the case in manufacturing sectors. Given that wages are rising at the national level, company X must somehow upgrade the production so that supposedly positive gap between return and cost of capital is not eaten up. This can happen either through new processes or introduction of new higher-value products (such as higher value-added car models in car industry). This continuous upgrade of production must go on until the labor productivity growth reaches its limits. At that point, the factory could continue producing but the economic rate of return (ROIC- cost of capital) would start shrinking. Or it can re-allocate production to some other place such as further East. Given that labor constitutes a significant share of output, much lower labor costs in the East in excess of the re-allocation costs may drive decision to move eastward, to a cheaper location.

B) Scenario with a heavy introduction of new machines, incl AI

With the introduction of labor-saving new machinery such as AI machines, labor compensation to output ratio (labor share) would likely plummet (let’s say from 40-50% levels to, say, 10% level) – hence cost advantage of labor diminishes since now labor accounts of much smaller share in cost structure. Whether it is Slovakia or low wage Kazakhstan, there is not much difference in labor cost to produce. However, the costs of re-allocation to the East remain still significant.

On the basis of this simplified analysis, it is clearly in the interest of Slovakia that foreign-owned car plants introduce labor-saving machines since this reduces the incentives that headquarters re-allocate production to cheaper locations, such as in the East.
This is because after AI machines are employed, a labor share on a company level declines dramatically to the point where it nearly does not matter where the factory is located geographically. If now labor accounts for let’s say 10% of produced economic value this means that whether the factory is in France or Slovakia or Kazakhstan matters much less than before from the viewpoint of labor costs. However, given that it is costly to set up a new factory in the East, it is not very likely the car factory would migrate eastward (Kazakhstan). If anything, given the advantages of being in home country it may rather go back to home country (France) despite higher hourly labor costs.

In order to summarize, on the basis of this simplified analysis it seems that sectors where introduction of AI factories is feasible and makes economic sense, their installation would reduce incentives to migrate eastward. On the other hand, a significant gap between domestic wage level and a wage level in the East may create very sharp incentives to re-allocate whenever the labor costs constitute major share of costs, as is the case in sectors without AI machines introduction.

The good news and the bad news for Slovakia

At a nutshell, for Slovakia AI introduction will be good and bad news at the same time. It will be good news because AI will lead to reduction of importance of labor costs in certain sectors as the competitive factor and will blunt incentives for the existing manufacturing plants to leave Slovakia and move eastward where wages are lower than in Slovakia. In such case, geographical location is much less important and given the existence of re-allocation costs incentives will likely be to remain intact geographically.

However, it also means that for a country such as Slovakia future FDI will be much harder to acquire since the advantage of low labor cost as a competitive factor will be significantly reduced in AI intensive sectors. Things like quality of the business environment, tax regime or reduction of country risk ( which will reduce the cost of capital) through better institutional environment will matter relatively more. More generally, it means we might thus move into the world where soft factors such business/institutional environment factors matter more for investment decisions than the labor cost.
Sector-level wise, at the national policy level in Slovakia one should focus efforts to attract FDI on areas where AI will not make much difference and a ratio of wage bill to output remains significant (such as tourism, hospitality, some other services). This is because attempts to lure FDI – in absence of strong advantages in the institutional arena – where wages do not constitute a high share of output anymore would likely prove futile.

AI likely to suppress incentives for FDI

More generally, the application of AI to manufacturing will likely lead to reduction of downhill FDIs globally in the future and probably mean a less integrated world going forward. Pending AI machines installation projects may even already explain some of the recent fall in cross-border FDI in 2018. The world with much less FDI puts a premium on domestic economic policies to nurture home companies and fuel domestic economic growth.

The quality of human capital will continue to matter and its relatively low cost may be a driver for certain inward investments (such as shared services) in sectors where there is still a high share of labor compensation on output. Investment in country’s human capital should thus remain important – after-all, AI machines dominated factories will require presence of super-sophisticated managers/engineers. Given that future incoming FDI will likely slow down – at least in those sectors where robots can replace humans – much higher effort should be focused on building a domestic enterprise sector via start-ups support and different schemes of nurturing domestic entrepreneurship.

A divergence back again ?

If the simplified analysis above is correct, implications of it seem quite dim for developing countries and challenges they are facing. Given that their business and institutional environments are relatively weak and labor cost is a primary competitive advantage factor, FDI where robots can replace humans will likely be not lured to such areas to the same extent as before. Some FDI factories might even migrate uphill to areas with better business, tax and institutional environment since importance of labor cost will be so drastically reduced. In developing countries, bottlenecks on markets with super-sophisticated managers/engineers to run such AI-intensive factories may contribute to that as well. Weak business and institutional environment, underdeveloped human capital all leading to now much lower intake of FDI and low sophistication of domestic economies to begin with, mean that such developing countries might face challenges to develop modern export sectors and thus to follow development model based on export-led growth focusing on sophisticated sectors. It could also lead to the race to the bottom regarding environmental standards as developing countries try to compete on non-labor cost factors. Whether AI heavily applied to manufacturing sector also means a higher probability of middle-income trap incidence for countries such as Slovakia is worth pondering too.

Vladimir Zlacky,
Bratislava, 26 JUne 2019

It is brands, Economist !

It is brands, Economist !

Typically, many economists have not always fully appreciated business disciplines of softer nature – marketing as a field quickly comes to one’s mind. Yet, it is enormous how significant is the value astute marketing people can create for the national economy. They not only help salespeople of companies penetrate markets home and far abroad but through strategic brand-building enormously enhance the economic value of production.

It is not rare that a branded product – a product which carries a recognized and reputed brand – can sell for a multiple of price of a generic product. This is typically a result of concerted brand-building efforts by and within a given organization. Consistent and attractive visuals and designs of products, thought-out media advertising, marketing events of many kinds, aligned organizational behavior – these all can come under a rubric of brand-building. Yes, brand-building also entails a cost but typically astute marketing people can create the brand where a brand price premium can exceed the incurred cost substantially.

When the national economy has many high-quality brands this might also have macroeconomic implications. It can mean that countries with the most astute marketing people can see their GDP enhanced by these strategic marketing efforts more than others. This is something not completely obvious when one thinks about the role and the effect of marketing in the economy (one would think perhaps, in a first cut, of mostly zero-sum game when analyzing marketing effects within a sector). Furthermore, branded products command a much higher degree of customer loyalty – this has implications for competitiveness of the national economies. Just think what a 20% appreciation of domestic currency does with the competitiveness/profit margins of commodities exporting countries vs. highly branded products exporting countries. The latter economy is clearly much more robust to currency value shocks.

When looking at this issue via the glasses of somebody born and living in a Central-Eastern European (CEE) country one has to appreciate the road traveled since the inception of transformation of these economies to a market model also in case of local marketing activities. The marketing area was extremely neglected during the socialism regime as very little advertising and brand-building took place. During the last 30 years enormous progress was achieved as demonstrated by springing up of many attractive brands in these economies, although most of them are only of local significance. Obviously, not all progress was domestically driven but rather the effect of inflow of FDI, which brought some marketing practices, and of other foreign influences cannot be underestimated.

Yet, while the marketing expertise in the CEE economies has advanced, further improvement could be achieved by bringing business education closer to business people in these countries. Offshoots of Western business schools could perhaps find this high growth terrain of converging economies of CEE a very lucrative base for spreading their influence. If establishing their branches in CEE, they could further nurture Western management practices and culture in these countries. Besides so important marketing field as noted above, other creative areas such as general/strategic management, leadership and people management or entrepreneurship could thus be supported in CEE too. By means of not only degree programs but of various executive and evening/weekend programs such schools could help local business people grow in expertise. Spearheading entrepreneurial and start-ups culture in countries where FDIs have been a typical engine of development to date should also be commended if such school(s) appeared in the region.

Given that human capital – also that entailing best business practices – seems one of the bottlenecks of further economic development in CEE, the government could also contribute by introducing tax incentives for the whole sector of lifelong learning, including business school education.

Vladimir Zlacky
May 4, 2019

Euro and real exchange rates

This year it has been twenty years since the introduction of the euro on the financial markets following the fixing the cross-exchange rates of the currencies of founding eurozone countries. For some, this step as of 1 January 1999 meant a reason for celebration as the formation of eurozone was the milestone towards the accomplishment of the so-called European project. To others, it presents the opportunity to ponder the economic viability and sustainability of the euro-zone area going forward. This is because the sheer construction of this currency area implies many risks and the sustainability of this monetary construct is not beyond doubt.

The Mundell’s theory of optimal currency area was supposed to justify the euro-zone project. However, whether the eurozone as now constructed, which includes the peripheral South as well as some countries of the converging East , is such area is not without a question. This blog argues that with such degree of heterogeneity, as it is now present in the Eurozone, and – by definition of the monetary area – a lack of adjustment via cross nominal exchange rates in the euro area, we would be lucky if that by now significant dis-equilibria would not appear in the countries of this currency area.

First, to be fair if little speculatively, a brief comment on (im)possibility of installing equilibria in many-countries-world, the case of the flexible exchange rate regime notwithstanding. In a hypothetical world with two countries and two currencies at least in principle it should be possible to achieve equilibria in these two countries – flexible nominal exchange rate should arrive at the level such that both countries have achieved internal and external equilibria. This, in theory, could be achieved very fast or even instantaneously by the movement of the nominal exchange rate between two currencies. However, what happens if there are three, four, five or many more countries as it is the case in the real world ? Does a set of cross-exchange rates equilibrate these economies in the world in which we live ? It seems to the author that, given this complexity, even in the world of flexible exchange rates it might be difficult to achieve equilibria in all countries. This is because there are too many variables – and relations among them – at play. Furthermore, some are fixed or slow-moving in the short-term. However, adjustment towards the equilibrium in an individual country can be fast in the world of flexible exchange rates.

In order to see the issue of dis/equilibria more clearly, let’s remind ourselves of the concept of real effective exchange rate (REER). It is constructed as the nominal effective exchange rate i.e. trade-weighted exchange rates against currencies of trading partners adjusted for a trade-weighted differential of price inflation. Empirically, the inflation index to be used can be CPI (consumer price index), PPI (producer price index) or ULC (unit labor costs). Such REER can then be a useful indicator of competitiveness or existing imbalances, especially if compared with some equilibrium yardstick.

Of course, cross nominal exchange rates in eurozone countries were eliminated as their currencies ceased to exist when the countries formed the currency block. However, does this mean that we should cease to track the respective real effective exchange rates of the eurozone countries ? Of course not – they continue to be a useful concept. There still is a substantial room for variation of REERs of eurozone countries because a) there exists an inflation differential between individual eurozone countries and trading partners whether eurozone members or other countries; b) eurozone countries trade with non-eurozone countries ( portfolio of trading partners differs in each country) and the nominal exchange rates of euro vis-a-vis those countries can adjust; c) trade weights change over time too.

Hence – given that the eurozone is far from homogeneous and fully synchronized entity (think about the South or East) and because of the effect of non-eurozone countries on REERs – real effective exchange rates of individual eurozone countries could follow various paths and possibly diverge widely from where they were at the onset of the euro (and their equilibrium trajectories). Therefore, after twenty years of its inception and a lack of cross nominal exchange rates among eurozone countries, we might be in the world where REERs are far from equilibrium in many a eurozone country. These REERs trajectories and their divergence from equilibrium paths may represent the fault lines of this monetary area. The only question now is how far from equilibrium we are in the individual countries. Of course, the most significant challenge is that under the euro regime i.e. with no possibility of nominal exchange rate adjustment on an individual basis – redress towards the equilibrium might be protracted and in some cases very painful.

Here, some additional economic research could help further shed light on issues. By using a suitable equilibrium framework – be that some form of FEER ( fundamental equilibrium exchange rate) or BEER (behavioral equilibrium exchange rate) which are known in the literature – one could quantitatively gauge the extent of the current imbalances in individual eurozone member economies. Given that fast redress via own currency movement is foreclosed – since individual currencies of eurozone countries no longer exist – certain countries could be stuck far from equilibrium. The additional research on REERs in the eurozone could further ignite thinking how to eliminate or at least reduce imbalances under constraints present within the current euro-zone construct and engineer the paths closer to the equilibria in the most efficient and socially least costly ways.

Vladimir Zlacky

Beyond FDI model

Nearly three decades ago, at the onset of transition, ex-socialist countries’ enterprise sector was lagging severely behind that in the developed West – machines, and technology more broadly, were largely obsolete, labor productivity low and managerial techniques inadequate for a modern economy. Restructuring of enterprises i.e. installation of new technologies, improvement in quality of products, introduction of new processes, upgrade of the labor and management and exploration of new markets was crucial for the success of transition.

While early macroeconomic policies were designed to address macroeconomic disequilibria, they in combination with policies for micro-level adjustments were to conduce to enterprise restructuring. In many transition countries, foreign direct investment (FDI) was the key solution towards the task of enterprise restructuring. This was because – at the inception of transition and ensuing first years of reforms – there was a severe lack of capital, inadequate domestic technology and underdeveloped managerial talent.

This demand for FDI capital led to a huge inflow of foreign direct investment to the transition countries when literally hundreds of billions euro worth capital led to acquisition of a substantial share of domestic productive capacity in these countries. Relatedly, some numbers will demonstrate that – in a small economy of Estonia by 2017 cumulative inward FDI reached nearly 90% of its GDP (net position being 61% of GDP). Other countries became significant hosts of FDI as well – inward investment in Czechia were 72% of GDP while that in Hungary was 65% of GDP by 2017.

Source: OECD

It seems fair to say that up to now the FDI has been the main driver of growth in most post-socialist countries. However, these countries have matured by now – a pool of managerial talent has grown both by quantity and quality, countries have been integrated into international sales chains, capital for sound projects is available from private equity groups or banking sectors. Domestic R&D and science have moved closer to the world’s frontier in some countries and the quality of managers and other experts is such that the technological know how can be imported easily. In other words, investment landscape in at least most advanced countries of the region has changed and is conducive to formation and growth of world competitive but domestically owned companies.

Hence, it seems that at the end of 2010’s the big “growth” question is which model of growth to promote ? To further a model based on FDI or attempt to nurture domestic enterprises ? As often-times is the case, the middle road will likely deliver the best results. FDI still brings most modern managerial know-how and corporate culture, tested processes, high quality products and connection to existing markets – all valuable attributes of a modern enterprise. It would be a mistake to discourage their inflow.

However, should generous FDI incentives be kept in many countries or these resources be rather targeted to creation of domestic startups and existing companies ? To be sure, domestic companies have certain advantages too. First, large domestic investment groups/enterprises are probably more keen to invest in public goods than foreign-owned enterprises. Things like very local infrastructure, education, culture or sports – investments that have spillovers – are much more likely to be supported by local big entrepreneurs than by branches of large multinational companies. Second, at times, domestic policymakers may want – through a moral suasion or otherwise – coordinate with a private sector and in such cases domestic entrepreneurs will more likely be brought on board to cooperate.

Last but not least, as Prof. Dani Rodrik1 reminds us, FDI ownership shifts the bargaining power from labor to capital leading to lower wages on a company level (and may lead to lower labor/output ratios in the whole economy). In extreme case, detachment of labor from the companies in combination with perceived unfair wage treatment may lead to backlash against foreign ownership as such. A legitimacy of the current highly integrated economic system might be called into question as well. From this point of view, a more balanced economic structure – one in which both foreign and domestic enterprises co-thrive – seems to lead to more sustainable economic model.

Hence, given limited resources available, it might make sense to earmark some share of resources yet devoted for FDI incentives for the support domestic start-ups instead. Given that typical start-ups do not require much funding, a relatively large number of small starting entrepreneurs could be thus supported. One way to accomplish this is through a independently run fund with multi-source funding – perhaps partly private charity sponsored – from which the entrepreneurs could petition a support or via which various other schemes of support could be administered. Only a small share of funds hitherto available to huge FDI projects and redirected to small business could make a big difference to many individuals. The support of start-ups or small entrepreneurship would have an added advantage of pulling employees into entrepreneurship thus converting them into “capital-owners” with positive implications for social mobility, distribution of income and nurturing of entrepreneurial culture in these countries. Furthermore, this all could work as a potential recipe against the backlash against the current economic system which in its nascent form seems ubiquitous at many corners of the world.

Vladimir Zlacky

1. Dani Rodrik, “Populism and the economics of Globalization”, Journal of International Business Policy, 2018

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