A major occupational hazard for emerging-market investors traversing through Central and Eastern Europe is letting the heart rule the head. After all, it's easy to believe that if Prague and Dubrovnik are such great places to visit, they must be great places to invest as well.
Then there is Warsaw. With much of the city's pristine architecture decimated in World War II and replaced by Soviet-style building blocks, it's easier to objectively assess the region's economic prospects. But the takeaway, even from Warsaw, is that the region is in the midst of a growth miracle that parallels East Asia in the 1970s and '80s.
There are some striking similarities. For a long period of time in East Asia, the continent's small- to midsize economies fed off each other's success, growing quickly. It was described as the "wild geese flying" model of development—a reference to the V-shaped pattern those birds fly in, providing a thrust to one another with the flapping of their wings.
That's true of Central Europe today. Many of its economies are racing against each other toward
the common goal of rapidly integrating with the European Union. Over the past few years, the CE4 countries of Poland, the Czech Republic, Hungary and Slovakia have averaged growth rates of 5 percent, the Balkan nations of Romania and Bulgaria have grown at nearly 7 percent, and the Baltic nations of Estonia, Latvia and Lithuania have expanded at 10 percent.
The process of economic catch-up is playing itself out in the classic way: the poorer the country, the faster the growth rate. As a result, the region's living standards are fast converging with those of the European Union. Per capita income in each of the CE4 nations is now above $10,000. The pace of expansion is particularly impressive as it is not fueled by any commodity boom, and unlike other emerging markets, a negative population growth is helping per capita income increase faster than economic growth.
Foreign direct investment (FDI) inflows are one of the most influential forces behind this convergence story. Faced with huge unemployment following the breakdown of their old communist systems, these countries were forced to institute Western European laws to pull in investors—a stabilizing trait that's often missing in emerging markets. The total stock of FDI in the CE4 countries is nearly half the value of the overall economy; that is an unprecedented proportion.
Human capital is another key factor. Much of the labor force is well educated—partly a legacy of the communist era—and this has helped contribute to a labor productivity growth of 10 percent a year in countries such as Poland. Studies show the combination of highly skilled workers and substantial FDI play the most important role in determining the pace of long-term economic development.
The Eastern European economies may therefore have more legs than their East Asian counterparts. Many of the old growth stars of East Asia—such as Thailand and Malaysia—have been struggling to regain their momentum this decade, unable to make the transition to producing higher value-added goods due to lower productivity growth. The CE4 countries are still achieving growth rates in excess of 5 percent despite breaking past the $10,000 per capita income mark because they are operating in high-skill manufacturing areas like autos, electronics and information-technology services.
There is a downside in Eastern Europe, mainly to do with current accounts. The large current-account deficits and heavy foreign indebtedness of the Baltic nations in particular are sure signs of overheating and make them vulnerable to any reversal in foreign flows. Furthermore, the sharp slowdown in Hungary after the government was forced to pare back the large budget deficit serves as an example of how things can go wrong.
However, most other countries—particularly the larger economies of Poland and the Czech Republic—are running current account deficits that are still manageable at less than 5 percent of the economy, and are simply the mirror image of large capital inflows. To keep the money flowing, the developing economies of Europe need to carry out further reforms, principally involving reduced state spending and less bureaucratic intervention.
The latest election results in Poland are very encouraging in that regard. The right-wing and reform-oriented Civic Platform, or PO, pulled off a surprise win. Its victory bucks the trend shown in many other emerging markets, which often become complacent about reform after some success.
Poland has a history of acting as the bellwether in the region, from being the first country to break from communism to more recently heralding the trend toward greater populism and Euro-skepticism.
But the PO's comeback last month may signal a return to the reform path. The flying geese of Eastern Europe are then poised to enjoy an even greater uplift after already traveling much farther than what anyone ever imagined.