AI and Slovakia: Labor cost to become less important

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 and risks will it bring to the fore?

In a nutshell, for Slovakia AI introduction will likely be good and bad news at the same time. Coming introduction of AI technologies will drive down labor to output ratios on a company level and will thus mean that the labor cost will become much less important for investment decisions. On one hand, it will be good news because AI introduction will lead to a reduction of the 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 driven by convergence– as it might be happening otherwise.

However, it also means that for a country such as Slovakia it will likely be much harder to acquire future FDI 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 through a better institutional environment will matter relatively more. More generally, it means we might thus move into the world where soft factors such as business/institutional environment 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 in 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 – bar strong improvements 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 a reduction of downhill FDIs globally in the future. A little speculatively, 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 the country’s human capital should thus remain important – after-all, AI machines dominated factories will require the presence of super-sophisticated managers/engineers. Tax incentives, among other reform measures, for support of the sector of lifelong learning, would go a long way towards further beefing up the domestic educational sector which should educate such experts.

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.

Less developed world: Convergence endangered?

If the simplified discourse above is correct, implications of it do not seem necessarily only positive for less developed countries and challenges they are facing. Given that their business and institutional environments are relatively weak and the labor cost is a primary competitive advantage factor, FDI in sectors 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 the importance of labor cost will be so drastically reduced. Bottlenecks on markets with super-sophisticated managers/engineers to run such AI-intensive factories may contribute to that as well. It could also lead to the race to the bottom regarding environmental standards as less developed countries try to compete on non-labor cost factors. Whether AI heavily applied to the manufacturing sector also means a higher probability of middle-income trap incidence for countries such as Slovakia is worth pondering too. Focusing on substantially upgrading the business and institutional environment and supporting domestic start-up scene in middle-income countries like Slovakia could certainly help avert such scenarios.

Vladimir Zlacky, LookingEast.eu
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
LookingEast.eu
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
LookingEast.eu

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
LookingEast.eu


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

Is the advanced East as rich as the Southern Europe?

As a regular visitor and keen admirer of Andalusia of southern Spain or Crete of Greece I not only get enchanted by the marvels of the two vacation heavens. Being an economist from an ex-socialist country, I also like to keep my eyes open to gauge the contrasts and differences between my home country and the European South, cultural as well as those related to the respective economies.

A perusal of various statistics of the real economic performance of the Central Eastern European countries and the European South – here defined as Italy, Spain, Portugal, and Greece – suggests a substantial level of convergence of the former to the level of the latter. While in the early 1990’s – at the onset of transition – the CEE countries lagged substantially behind all Western European countries, now the picture is very different.

In terms of the economic output adjusted for prices (PPP) the most advanced countries of CEE such as Czechia with 89% of GDP of the whole of EU and Slovenia (85%) have overtaken Portugal (77%) and Greece (67%) while are nearing the level of Spain (92%) and Italy (96%). Does it mean that the most advanced countries of CEE are about 10-20 % points richer than Greece/Portugal and about 5-10% points poorer than Spain/Italy ? Does it mean that – with a bit of simplification – we can claim that the level of prosperity in the frontier CEE countries have reached those of the European South?

GDP per capita in PPP, EU=100

Italy

96%

Spain

92%

Czechia

89%

Slovenia

85%

Portugal

77%

Greece

67%

Source: Eurostat 2017

While it is useful to count on the official statistics to paint the picture of overall prosperity in these countries, any visitor to southern Europe vs CEE will make his own assessment on the basis of local incomes, prices, and visual surroundings and probably conclude that something does not quite dovetail. Why ? This article will put in a sharp contrast comparison on the basis of measures of real economic activity vs comparisons which includes the effects of price levels as well as of accumulated wealth.

The fact that CEE countries are normal, in the parlance of Prof. Shleifer1, in the sense that they are coping with issues of typical market-based middle-income economies is well established. From this view angle, the TRANSITION is over – but is the CONVERGENCE process really nearing its completion (when numerically compared to the European South) ? From the point of view of overall prosperity, are really advanced CEE countries approaching the riches of the southern EU countries?

As with many statistics in economics, here also it is instructive to note a difference between flow and stock indicators. The Gross Domestic Product – a value of all goods and services produced on the territory of a given country within a year – is clearly a flow variable. When a comparison is made on the basis of GDP adjusted for prices we compare the level of economic activity in real terms. Since what gets produced, gets distributed, this also says something about a standard of living in countries. In this sense, Czechia/Slovenia are not far from the best performing southern countries (Italy/Spain) while their GDP ( on PPP basis) is higher than that of Portugal and Greece.

While the GDP (PPP based) is a construct of economists who in cross-country comparisons adjust for differing prices, the actual GDP that is produced in economic life is nominal. On an individual level, prices one sees in shops are nominal, wage an individual receives is nominal. On a company level, sales are nominal and so are the investments, for instance. On a country level, current account balances, debt levels or investment flows – all of these indicators are also of nominal variety. In other words, the world in which individual participates, the one he can touch is nominal.

This fact that the actual economic life is “nominal” is oftentimes neglected by economists who overly work with their analytical constructs which adjust for prices, they talk “real” variables. However, for instance, when one thinks about the national economic power, the nominal GDP is much more useful concept than the real GDP ( or the one based on PPP). Investment flows that help some countries grow or outflow of which can devastate others are kept on records in nominal figures. Price signals that transmit crucial information throughout the economy, which are important for decisions of consumers, firms and other entities are also nominal. In other words, the actual world in which we live seems to be nominal.

Hence, in cross-country comparison, there is a clear need to look at GDP figures also before the adjustment is made for price differences i.e. GDP in nominal figures. Because of much less competitive production structures and ensuing foreign imbalances, many of the CEE countries had to put up with severely undervalued currencies at the inception of transition. Hence their price levels at the beginning of transition were much lower than those prevailing in the West (for instance the price level of the Czech economy in 1995 was 38% of the EU level). Even now, nearly three decades after the transition started, prices in CEE countries are much lower than in the Western or Southern parts of the EU. According to Eurostat, in 2017 the Czech price level was only 67% of the average price level in the EU while that in Slovenia was 82%. Prices in Portugal (82%) / Greece (89%) and those in Spain (91%) and Italy (99%) are above the level in CEE countries. On the basis of these statistics, it seems that convergence in real output has outpaced the convergence in prices in CEE. The result is that “the nominal world “ – which is the world a visitor from the East sees when visiting South – is “scaled up” nominally in the South compared to the CEE region.

In order to further explain this analytical point, make the following thought experiment. Let’s say in Eurozone, both a hypothetical country East and country South have the same GDP per capita on a PPP basis (and, say, same labor/output ratios and similar conditions on the labor market – this should more less imply same real wages). However, the country South price level is 30% level higher (nominal wage of worker from South is 30% higher). Would workers of both countries “feel” the same rich ? The argument could be made that visitor from East to the South is worse off than it is in the opposite case, for obvious reasons. Everything being scaled up by 1.3 factor, the South is more expensive for the visitor from the East than is his home country. Obvious implications follow.

As mentioned above, price levels everywhere in Southern Europe are higher than those at most advanced CEE countries. This contributes to one’s skepticism about the claim that “the East has nearly reached the level of wealth abundance of the South”. A comparison of GDP in nominal figures for the six countries, as in the table below, further brings this point home. For instance, Italy and Czechia are much further apart in this comparison; the latter country is behind Portugal.

Country GDP per capita 2017, USD

Index

Italy

31996

100

Spain

28358

88,6

Slovenia

23654

73,9

Portugal

21258

66,4

Czechia

20401

63,8

Greece

18637

58,2

Source: IMF

Source: IMF

Even more important than the “nominal or price effect” is the issue of differences in the accumulated wealth. In flow/stock parlance, accumulated wealth is clearly a stock indicator. According to Credit Suisse, in 2018 the average wealth per adult in Italy was 217,787 USD, Spain 191,177 USD, Portugal 109,362 USD and in Greece 108,127 USD. This is substantially more than 79,097 USD in Slovenia and 61,489 in Czechia. It seems that the advanced countries of CEE are nowhere near the wealth levels compared to the South, be that poorer countries like Portugal or Greece or richer ones like Italy and Spain. This is the second explanation for a much skepticism that the top CEE countries are near the Southern countries in the level of their prosperity.

Source: Credit Suisse: Global Wealth Report, 2018

A more thorough inspection and analysis of economic statistics suggests that the level of convergence of the most advanced CEE countries in prices has not progressed as far as the convergence in real economic activity. Furthermore, differences in wealth likely due to the fact that southern countries have had market-based economic systems for longer than the CEE countries leads to a further explanation for lower perceived wealth abundance of the CEE vis-a-vis the European South.

This answers the question posed at the beginning of this narrative whether the advanced CEE countries reached the level of riches of the South to the negative. Nevertheless, the expected continued convergence in the future is likely to further reduce over time the differences between the CEE and the South, both in income and wealth.

Vladimir Zlacky
LookingEast.eu


1.) Prof. Shleifer, Andrei, and Daniel Treisman. 2014: Normal Countries: The East 25 Years After Communism, Foreign Affairs

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