Boosting human capital is quintessential

Elsewhere recently, I argued that advanced, sophisticated services with an international focus might significantly help the future growth of the Slovak economy. (1) With the manufacturing sector’s dynamism petering out, a more multi-prong policy focus would likely bring strong growth benefits.

Activity in fields like IT services, advanced consulting services, and higher-end tourism are examples of such advanced services. Other examples would include international trade companies, commercial fairs organizers, high-end medical services, top marketing or interior design studios, or even as specialized services as tennis academies or local showbiz (also popular in Czechia). All these services can have a significant international orientation ( perhaps also focusing on China and other eastern markets) and thus tap vast global markets bringing massive export or quasi-export earnings for the Slovak economy in the future.

Which are the policies that would conduce to the development of such an advanced sophisticated services base? These services derive their value mostly from the human talent augmented by education – hence an urgent need to bolster the human-capital capacity of the country. Utilizing the announced massive EU sponsored aid within the Recovery Fund framework would be one way of supporting the proliferation and growth of such services in a foreseeable time horizon.

In a nutshell, aiding the formal education and lifelong learning sectors, engineering reverse brain drain to Slovakia, and helping diffusion of knowledge in the economy would all combined go a long way towards boosting human capital in Slovakia.

Which specific policies would likely be helpful in human capital formation? Helping a formal education sector at all levels would be one way of supporting the growth and prosperity of such firms in the medium to long-term horizon. First, some resources should be channeled to increasing wages in the whole education sector so that the sector attracts better talent than previously. Other specific policies – such as free laptop computers for all children in elementary and high schools or technological upgrades of labs in many fields would go some way towards aiding the formation of technical capabilities of pupils and students. Gratis vouchers of a specific value per year issued for book purchases would prompt children in elementary schools to read more. Importantly, the availability of scientific articles at low or no direct cost to the researcher would help readier adaptation of frontier knowledge in basic and applied research. Hence, some resources from the Recovery Fund could go towards a country-wide subscription to the primary databases of scientific journals. So could the resources be earmarked for more R&D activity via grants subsidized from the Recovery Fund. Efforts to continually redesign and update school curricula at all levels to keep abreast of the best practices internationally should be sine-qua-non.

There are many reasons why lifelong learning can have positive spillover effects on the economy. First, the AI revolution will bring a tremendous amount of innovations and ensuing disruption to the marketplace. The Slovak economy- like most others – will have to undergo a structural change. Some workers will be released from their previous occupations, and many of them will be seeking retraining programs to start economic activity in a new sector. Second, other workers during their careers will need to specialize further and deepen their skills to keep abreast of the knowledge progress – lifelong learning provides an opportunity for such additional expert-skilling. Third, yet some others might have “missed the right career train” when young or at some point. Nevertheless, a well-functioning society aspiring to be creating prosperity for all should not overly penalize weakness or failure and give individuals multiple chances to succeed in the workplace during their lifetime.

Which are the examples of policies that could help trigger massive lifelong learning in the economy? Tax incentives such as no VAT on textbooks and learning instruments could be one way of supporting learning in general. Individual tax credits for undertaken high-quality but oftentimes expensive executive training is another way of incentivizing more training by individuals. Additionally, a lot of education is happening within the corporate sector. Super-tax deductibility of training costs with a higher than 1.0x coefficient – thus increasing tax shield, reducing the effective cost of the corporate-level trainings – would incentivize more training activity in the corporate world.

Importantly, Slovakia has suffered for decades from a massive brain drain. Some of the most talented people of the nation have left the country for better career opportunities outside of Slovakia. The Slovak economy would tremendously benefit from the return of at least some of these workers – they could be the future entrepreneurs, high-level managers, or experts in sophisticated services firms or elsewhere. Given that the pool of the local talent is limited and probably represents a bottleneck to further development, even pecuniary ways of incentivizing the return of Slovak professionals from abroad (such as via tax breaks) could be considered for implementation.

The diffusion of international frontier knowledge in many fields of the economy – so that the knowledge pool can be tapped into by private firms in Slovakia – is quintessential for having internationally competitive domestic firms. Expert scientific and other advanced conferences with foreign experts participating organized in Slovakia could help such diffusion. Subsidizing the costs of hosting such expert conferences could be one direct way of promoting the spread of frontier knowledge in the Slovak economy. The exchange of academics at all levels internationally, perhaps subsidized also from the funds made available by the EU, could be another way of bringing academics closer to the knowledge frontier. Slovak firms could thus tap into such a further augmented talent pool and strengthen their competitiveness.

Aiding the formal education as well as the lifelong learning sectors, engineering reverse brain drain to Slovakia, and helping diffusion of knowledge in the economy would all combined go a long way towards boosting human capital in Slovakia. While valuable in its own right, this could also help the country develop an internationally competitive services sector and return the Slovak economy onto the path of fast growth and convergence in the medium term from which it was derailed.

Vladimir Zlacky
LookingEast.eu

(1) Vladimir Zlacky, Slovak Economy: What next, Slovak Spectator, July 2020

Advanced services: the next big thing?

The result of the three decades of the transformation of Slovakia’s economy has been substantial catching-up with the developed West. In 2019, the income per capita in Slovakia in comparable prices reached 72% of EU-28 even surpassing Greece and nearing the level of Portugal. One particular calculation suggests that Slovakia’s nominal GDP in EUR terms increased about tenfold since the birth of the country in 1993.(1) Sectorally, the structure of the economic activity has reached the Western model and technologically we saw enormous progress (2). While the first decade post 1989 Revolution was characterized by basic economic reforms and thorny path to democracy, the second one was by the admission to the EU and, structurally, the enormous expansion of the automotive and electronics sectors. Unfortunately, the last decade saw a decline of FDI inflow, policy dormancy on certain fronts, and stagnation of the overall economic convergence.

At the start of another decade, the natural question arises: Which is the next big thing for the Slovak economy in the 2020s? Since a future vibrancy of the automotive and electronics sectors is at the question, what will be a future source of Slovak economy dynamism? In this blog, it is argued that domestically owned advanced exportable and quasi exportable services merit substantial policy focus as they could significantly help the growth of the Slovak economy. Things like IT services, advanced professional and consulting services, and high-end tourism are examples of such services. Other examples could include international trade companies, commercial fairs organizers, top-end marketing or interior design studios, or even as specializes services as tennis academies or local showbiz (popular in Czechia) – all with significant international activities. Since start-ups are an important source of the economy’s vibrancy, let us ponder – what are the advantages of advanced services start-ups vis-a-vis the ones in manufacturing?

First, the advanced services firms are easier to establish logistically – compare what it takes to construct and start running a production factory vis-a-vis to, say, establishing a consulting firm. No doubt, for most manufacturing projects the startup process is a very complex and demanding undertaking with substantial operational risks relative to advanced service sector startups.

Second, advanced sophisticated services usually feature very high added value produced per capita – higher than the value added created in most sectors of manufacturing. Hence, from the point of view of the nation-wide allocation of resources and the resulting recording of created value added in national accounting, it should be advantageous if resources flow to the sector of advanced services. This is also an environmentally friendly allocation of human resources.

Third, it can be argued that, in most cases, it is easier to reach the knowledge/technology frontier in case of advanced services than it is in the case of advanced manufacturing production. R&D in manufacturing is a complex, difficult, and costly undertaking and it is a question of how advanced Slovakia’s R&D base compares to the developed West. For illustration, just compare what is easier – to be on the knowledge frontier for creating, for instance, a corporate identity package by a Slovak marketing studio for a foreign client or to be on the technology frontier for producing a branded Swiss-like watch to export?

Fourth, clearly, most manufacturing start-ups require a lot more capital than start-ups in services do. Furthermore, a start-upper/entrepreneur in some manufacturing sector has much more to lose financially if his project fails. Hence many relatively risky projects might never be implemented in manufacturing while comparable start-up projects in the advanced services sector may still be undertaken. Ceteris paribus, this can lead to more entrepreneurial activity in a country where policy focus pushes resources to flow to a less capital intensive advanced services sector.

Last but not least, advanced services firms typically feature a much higher labor share on a produced value than does a typical manufacturing firm. With the AI revolution expected to dramatically drive the labor share down in the economy and thus magnifying distributional issues, the proliferation of advanced services firms can counter such trends.

Manufacturing and the automotive/engineering cluster within it have an enormous tradition in Slovakia. The sector has been a driver of economic growth to date in Slovakia and, no doubt, efforts should be made to develop the cluster further. However, the AI revolution and ensuing robotization will reduce the importance of labor costs advantage across sectors including in the automotive. For at least that reason, attempts to attract additional FDI in the sector might be an uphill battle in the future. Given that the manufacturing start-ups are not an easy undertaking in their own right, we should not forget that the development of a vibrant sector of advanced services represents probably an easier route to higher income per capita levels. A policy focus should not overlook that.

Vladimir Zlacky
LookingEast.eu

(1) Vladimir Zlacky, Slovak Economy: What next, Slovak Spectator, July 2020

(2) Vladimir Zlacky, Lubos Korsnak: A brief note on sector productivity in CEE 1995-2009,2012, UniCredit research note, published on LookingEast.eu

Slovak economy: What next?

After the Velvet revolution in 1989, Slovakia – as a part of former Czechoslovakia – embarked upon the road to building a new socio-economic system based on market principles and liberal democracy. A thorough transformation of its economy was needed as the country significantly lagged behind the developed West in its income level. The growth of the centrally planned economy ran out of the steam as various inefficiencies and a lack of innovative vibrancy were brought to the fore leading to relatively low labor productivity achieved by the end 1980’s (compared to the West). Initial reforms orchestrated and pushed from Prague in the area of liberalization, privatization, and stabilization led to a quick transformation of the centrally planned economy into the one run by market principles (if a bit imperfectly). Later reforms focused on institutions building – to a large extent driven by institutional harmonization in the run-up to the EU membership – further strengthened the economic capacity of the country, led to a reduction of Slovakia’s country risk, the inflow of FDI and other foreign capital, and later an economic takeoff in the second half of the 2000’s.

Over the last three decades, the country has traveled a long and thorny path but the result is one of substantial economic convergence. In order to illustrate: in 2019, the income per capita in Slovakia recalculated to take account of differing prices across borders (PPS) reached 72 % of the EU28 level while in 1993’s the figure was below 40%. Even more staggering picture is provided by a look at created GDP in current prices expressed in foreign currency. While in 1993, the GDP of Slovakia – i.e. the market value of all goods and services produced on the territory of the country -reached about 337 billion of SKK ( less than 10 bn EUR). (1)  Since 1993, the yearly created GDP has thus increased nearly tenfold to 94 billion EUR in 2019! This is a remarkable scale of the economic expansion in Slovakia (even if expressed in nominal figures) and was driven by three factors a) relatively high real GDP growth; b) extra inflation driven by price convergence; c) a substantial nominal currency appreciation of SKK vis-a-vis EUR. Obviously, this does not mean that the level of well being of an average person has increased to the same extent as this is a figure expressed in nominal terms but it says something about the size of the economy and how Slovakia progressed economicly over the last nearly three decades.

Structurally, the high GDP growth was driven mostly by the industrial sector – for instance during the high growth decade of 2001-2010 nearly half of the addition to the growth of value-added created by the economy was due to the manufacturing sector (2). Car and electronics sectors were leading sectors with double-digit yearly growth rates recorded in that decade in both cases. Technologically, the decade of 2000’a also saw a substantial upgrade of production when by the end of that decade nearly 40% of the manufacturing sector’s production was of high- medium-high tech variety- this means that the share nearly doubled over the 10 years.

In the past decade (2010-2019) the convergence tempo has subsided and the end of it has brought substantial challenges. Industrial Revolution 4.0, to borrow the name from the WEF parlance, brings an enormous amount of innovations to the market and means that structural changes are inevitable for the Slovak economy to remain competitive. The upcoming robotization and automatization will bring disruption to the marketplace and several leading manufacturing sectors will likely need to streamline their operations in terms of the employed labor. Value-ladder augmentation of the car/engineering cluster towards higher value-added activities will probably be necessary for the cluster to keep its relative importance. Manufacturing start-ups tapping into an expected pool of labor made available by the upcoming AI revolution (and resulting labor redundancies) would be highly needed but their proliferation of any significance will represent a substantial challenge.

Services sectors will not remain immune to the AI revolution and shared and other services will have to adjust. However, in the author’s view, it is the sector of sophisticated high value-added exportable services – be that IT sector, sophisticated professional, consulting, and high-end tourism services – perhaps focusing on the eastern markets (such as China) that could be the source of future dynamism of the Slovak economy (3). These services derive their value mostly from human talent – hence an urgent need to bolster the human-capital formation sector perhaps also tapping into the announced massive EU sponsored aid so that these services spring up even more widely in a foreseeable time horizon.

In a nutshell, Slovakia in the next decade will probably need to focus more on domestic sources of growth to complement the FDIs as those will be harder to get. Improvements in the area of the business environment, strong support of the domestic start-up scene and of human capital formation together with further institutional improvements leading to lower country risk will be the key to improve the competitiveness of the Slovak economy. Seen in this light, the recent batch of reforms in the area of business environment adopted by the government is a welcome step in a positive direction. Same importantly, data-driven and sophisticated country growth strategy adopted by the local policymakers would be a highly needed yardstick to project pro-growth policies in a multiyear horizon.

Vladimir Zlacky
LookingEast.eu

1) Slovenska ekonomika 1990-1993; Akademicky project FM UK, Vladimir Zlacky, Lubos Pastor, Jan Toth
2) Slovak Growth Story: All about Manufacturing, UniCredit report, 2012, published on LookingEast.eu – DOWNLOAD
3)  On an anecdotal note, even as specialized service as tennis academies ( that bring foreign kids in for practice), commercial fairs companies, or high-end marketing or interior design studios which undertake projects outside of the country could be examples of such high-value added services.

Nominal vs Real: An Inquiry

In my blog from December 2018 – Is the advanced East as rich as Southern Europe? – I tried to flash out why it is worth looking at nominal variables alongside the real ones when gauging the state of convergence of the Eastern European countries to the developed West. This blog argues that nominal figures are overlooked in many cases also in some other contexts.

Let’s take a simple question: Which is the biggest economy in the world? Is it still the US or has China overtaken? The answer depends on which figures one looks at. According to the official IMF statistics of the gross domestic product (GDP) in 2019 in nominal figures, the US still is the biggest economy, its GDP was 21 439 bn USD while that of China was only 14 140 bn USD (even the economy of the EU was bigger than the Chinese one, its GDP in nominal prices was 18 705 bn USD in 2019). However, given that prices of goods and services in China are typically much lower than those prevailing in the US when adjustment is made for differences in prices ( re-calculation based on so-called Purchasing Power Parity metric), the Chinese economy is the world’s most productive with the GDP based on PPP 27 309 bn USD while that of the US is 21 439 bn USD ( the US is a base country for PPP calculations). In a nutshell, the US has the world’s biggest economy in nominal USD terms while China prides the world’s most productive economy based on the PPP recalculation.

Which set of numbers is more relevant for policy analysis? Figures adjusted by PPP suggest how productive the real economy is in terms of produced goods and services – hence the given figures for the Chinese economy suggest that China has the most productive economy in the world in terms of real output. However, when we would intend to calculate the size of the economy in terms of “the sheer economic mass” – perhaps to suggest how economicly powerful the individual countries are – then nominal figures might be more useful. In other words, the actual world in which we live is nominal: wages, prices of goods, sales or capex of firms, macro- capital flows or debt all are nominal variables. Economic figures adjusted for price differences are an artificial construct of economists. While they might be useful for economic modeling and analysis, an individual does not observe them in the real world.

Since we are using the figures of IMF, an additional small comment might be useful here. According to the World Economic Outlook, the world’s GDP growth projection for 2020 is 3.3 %. This is just illustration – this figure is now probably obsolete and given the current unfolding crisis it will be much lower. However, the real question is as follows: Is this the projected growth of the world economy by the IMF in PPP, constant prices or is it a growth of the world’s nominal GDP (in USD)? While the Fund in its headline communique does not say so explicitly, from other IMF outputs it can be inferred that it is a figure based on GDP growth in constant prices of individual countries. Many companies in the world and its planners who prepare company-level projections might compare the growth of their relevant world market with this headline figure. However, the relevant figure should be the growth of the world’s nominal GDP, not the real one. This is because corporate-sector planners work with sales figures in nominal terms recorded in the actual world.

How high is then the growth of the world’s nominal GDP in normal times? Probably significantly higher than the current projection of 3.3%, given a high nominal GDP growth in China and other emerging market economies and existence of inflation nearly everywhere(nominal exchange rate fluctuations vis-a-vis the dollar obfuscate otherwise straightforward calculation). A little speculatively, the world’s nominal GDP growth in USD could be 1-2 % higher than the figure based on the constant prices, in normal times.

One last comment of somebody who has prepared company valuations before. When valuing a company, say with global sales, using a discounted cash-flow framework one splits projection into two stages – an explicit projection phase and approximation of terminal value using the so-called Gordon growth formula. However, where do we cap the growth of a company’s cash-flow in the terminal value formula? Clearly, the rate of growth of the company’s cash flow in perpetuity must be below the cost of capital, otherwise, the model is invalid. Additionally, in the Gordon growth formula, the permanent growth of the cash-flow of a firm should be further below the projected long-term growth of the world economy, lest the company would overtake the whole world in an infinite horizon. However, which growth rate of the world economy shall we use as a ballpark of the upper limit? In the author’s opinion – since everything in the cash-flow model is in the nominal figures – the relevant ceiling is the rate of the growth of the world economy in nominal terms (let’s say, in USD), rather the growth rate based on constant prices.

Does this imply that some market participants might systematically undervalue assets?

Vladimir Zlacky
8 April 2020
LookingEast.eu

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

LookingEast.eu
26.october 2019

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

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