Germany’s trade and FDI with CEECs

Authors: Günter Heiduk and Agnieszka McCaleb

Abstract

The article discusses the economic relations between Germany and the main CEECs being Visegrad countries (V4), Czech Republic, Hungary, Poland and Slovakia. It starts with historical background sketching the relations after the WW II and the importance of V4 in the improvement of international competitiveness of German companies. The current high level of interdependency, Germany is the largest trade partner for all V4 countries, is reflected in trade as well as investments. V4 countries became part of German supply chain mainly in automotive and machinery products. The case study of German automotive industry in CEECs is exemplification of movement of part of German/European production eastwards.

The background of Germany-CEEC economic relations

Germany and other Western European countries suffered a large-scale damage of their economies during World War II. The two postwar decades of reconstruction fuelled West Germany’s GDP growth with the result of becoming the most prosperous economy in Europe. In the 1980s a controversial debate arose about the question whether reconstruction was the main driving force of West Germany’s growth (Reichel, 2002).  A number of studies (e.g. Dumke, 1990) argued that the German miracle (“Wirtschaftswunder”) measured in average annual growth rate of 8-10% is explained by reconstruction growth. Others (e.g. Dornbusch, 1993) attributed the high German growth to the economic reforms of the “social market economy” which had been introduced by Ludwig Erhard (Minister of Economy) in 1948. Reichel’s (2002, p. 438) analysis reconciled the counterparties by concluding that “Erhard’s policy change resulted in higher growth rates and that rapid reconstruction did not take place automatically, at least not of the rates observed.” The collapse of East Germany’s as well as Central and Eastern European countries’ centrally planned economies in 1989 and their relatively high economic growth after a period of transition into market economies supports the hypothesis of the importance of the systemic change.

In the decade following the reunification, Germany was often described as “the new sick man of Europe” (Dustman et al, 2014). In addition to the direct economic burden of the reunification (e.g. the West German’s solidarity tax and the transfer of West Germany’s social security system to the East) the allocation of investment in East Germany’s outdated infrastructure and industry weakened the growth dynamics of reunited Germany except the early 1990s. The immediately after 1989 following reunification boom was accompanied by a government deficit as well as a current account deficit whereas the capital account changed into a surplus (figure 1). Furthermore, the uncertainties regarding the future of the European Monetary System (EMS) led to the appreciation of the German currency against currencies of important export markets. The sudden end of the reunification boom was also caused by other external (decreasing global demand, newly emerging competitors) and internal (growing inflexibility of the labor market) reasons. In the late 1990s, Germany’s economic growth rate averaged only around 1.2% and unemployment rates exceeded 10%. Germany’s manufacturing industry which was and still is the backbone of its economy experienced a significant loss in international competitiveness. Main reasons had been the increasing labor costs relative to productivity growth as well as the growing inflexibility of the labor market due to new regulations. According to calculations offered by Dustman et al (2014, p. 172) only real wages in the tradable manufacturing sector rose in all sectors of wage distribution until 2004, whereas real wages decreased in the non-tradable sector. Giersch et al (1992) noted that the loss of Germany’s competitiveness in manufacturing is a rather gradually creeping process than a sudden event like the reunification. Anyhow, Germany’s manufacturing industry faced the pressure to fundamentally reorganize and modernize the production processes. Germany’s firms from MNCs to SMEs accepted the challenge.

Figure 1.   Germany‘s balance of payments, selected years (billion euro)

                           Source: Deutsche Bundesbank  

Germany’s recovery to an “economic superstar” (Dustman et al, 2014) is strongly reflected in the decline of the unemployment rate from 11.1 in 2005 to 4.7 in July 2015 which is half of the average EU-28 unemployment rate (Eurostat). This is particularly surprising as Germany’s GDP sharply declined in 2008 and 2009 due to the global economic and financial crisis. Even the recent crisis of the Euro seems to have had no negative effects on Germany’s economy. Studies on Germany’s re-gained international competitiveness in manufacturing list a number of reasons that range from reforms in the labor market and a positive governance structure of the system of industrial relation to the introduction of innovative production processes. At first view it may seem paradoxical that increasing real wages in manufacturing does not hurt exports in this sector. Dustman et al (2014, p. 174) show that the value of domestic inputs on total inputs in tradable manufacturing decreased and explain this by the increasing use of relatively cheap imported inputs as well as by decreasing domestic real wages in non-tradable and tradable service sectors.

The relatively high trade openness of Germany’s economy suggests that the overall performance is reflected in its export and import path. The stagnation of exports during the reunification boom mirrors that shift from external demand to the increased domestic demand (figure 2). Surprisingly, the “sickness period” can hardly be seen in trade data except an import stagnation around the turn of the millennium. The sharp increase of exports and imports from 2005 on which was interrupted by a two years absolute drop of Germany’s trade went along with the improvement of domestic indicators such as the employment rate. This leads to the question about the causes of Germany’s economic recovery to become the European economic powerhouse.

Figure 2.   Germany’s exports and imports, 1989-2014 (million euro)

                           Source: Eurostat

The role of CEECs for the improvement of German’s global competitiveness

The conclusion of the previous rudimentary analysis of Germany’s economic development path since its reunification is that this sudden change as well as a certain freeze of market mechanisms caused pressure to regain lost international competitiveness.  In the following it is aimed to deliver evidence for the hypothesis that the transformation and opening up of Central and Eastern European countries (CEECs) are major factors which contributes to the currently strong global competitiveness of Germany’s manufacturing industries. The obvious question why other countries did not take comparable advantage from the new Central and Eastern Europe will not be deepened here. A simple argument might be Germany’s geographical and cultural proximity to its Eastern neighbors.

The data mostly refer to the four Visegrad countries Czech Republic, Hungary, Poland and Slovakia (V4) because they dominate CEECs economic relations with Germany. The following sub-sections deal with Germany’s impact on transformation and integration processes in V4 and their benefits for Germany.

Transformation

It goes without saying that the successful exploration of comparative advantages in trade and location advantages in investment between Germany and CEECs needs an institutional basis, broadly defined as a market economic system. Several new political leaders gained theoretical knowledge by studying in Western countries before 1989. As history has often taught, the pendulum swung in some CEECs from the extreme system of a planned economy to an extreme system of free market economy. Václav Klaus, first democratically elected Prime Minister of Czech Republic, used to call the German social market economy model as “soft socialism” (Stegherr, 2010, p. 191). The social component of the German market economy model was not of prime concern, the urgent political decision regarding the transformation concerned the choice between gradualism and shock therapy (e.g. Aslund, 2007; Dehejia, 2003; Popov, 2007). Only in Poland the concept of the social market economy is laid down in Article 20 of its Constitution.  Spohn (2002, p. 1) argues that the new “Ostpolitik” of the German chancellors Willy Brandt and Helmut Kohl as well as the reunification created the basis for a special partnership between Germany and Poland. “United Germany has promoted itself to the first advocate for Poland’s accession to the European Union, whereas Poland has learned to accept Germany as the most important gateway in its ‘return to Europe’.”

CEECs transformation processes had been also shaped by a variety of business and personal contacts where the geographic and cultural proximity of Germany played an important role. Last but not least, the strong German presence in CEECs is documented by a number of advisory and technical assistance programs in fields such as energy and environment.

In the literature on the variety of capitalism (Hall and Soskice, 2001) Germany is usually included into the group of “Coordinated Market Economies” (Sikulova and Frank, 2014, p. 547). While Farkas (2011) noted that CEECs cannot be put into one of the stylized Western types of market economies or welfare systems, Sikulova and Frank (2014, p. 551) conclude that “the way of conducting transition from the centrally planned to the market economy by itself does not predetermine successfulness of the whole transition process in terms of economic performance.   

Integration

From both the political and the economic point of view it is quite understandable that the member states of the European Union (EU) widely shared the goal to integrate the CEECs into their community. Between 1991 and 1995 ten CEECs signed on a bilateral basis “European Association Agreements” (EA) with the EU which offered them preferential access to EU’s markets. At the European Council meeting in Copenhagen in 1993 the criteria had been fixed which CEECs have to fullfil in order to apply for EU membership. Since the establishment of the European Economic Community in 1958 econometric studies aimed to quantify the effects of this regional agreement. Aitken (1973) found that the regional integration agreements have significant impact on intra-regional trade, whereas Bergstrand (1985) reached the opposite result. Rault et al (2007) analyzed the EA agreements by adding non-economic objectives (e.g. political stability, intensification of democracy, increased negotiating power with third parties) to the well-known economic factors (e.g. economic distance, geographic distance, FDI, traditional trade relations). The study (Rault et al, 2007, p. 8) argues that “[t]he gains from the signature of the association agreement are those associated to the advantages the foreign direct investment and to a political stability.” Based on a gravity model the econometric exercise showed that the EA agreements positively influence bilateral exports. Schumacher (1995) aimed to estimate the potential trade between Germany and CEECs by applying a purely economic-based regression model with distance, total GDP and GDP per capita as variables. Not surprisingly, the study found out that Germany’s real trade with its nearest CEECs (Czech Republic, Hungary and Poland) already exceeded in 1992 the estimated trade. It is obvious to assume that in the early 1990s the sectoral structure of Germany’s trade with CEECs is determined firstly by differences in wages, availability of human capital and geographic distance. Imports of consumer goods from CEECs and exports of capital intensive goods to CEECs confirm this assumption. Especially increasing imports of textiles, clothing and leather goods resulted from relocation of production to the CEECs.  Already in the middle of the 1990s capital intensive industries such as the automotive industry started to invest in CEECs which leads to a drastic change in the value, regional and sectoral structure of Germany’s trade with CEECs.  Taking a region-wide perspective, Germany kept from the early 1990s CEEC’S integration process into the EU moving forward. It considerably contributed to their indirect – and in the last decade direct – integration into the global economy

Trade

The development paths of Germany’s trade with the nearest countries in the East are to a large extent determined by the economic size of these V4 countries (figure 3a and 3b). The high imports from Czech Republic are the only exception. Even though its GDP is approximately half of Poland’s GDP, its exports to Germany have been almost the same over more than 20 years. Furthermore, the dynamics of the development paths of these two countries’ trade with Germany is higher than that of Hungary and Slovakia.

Figure 3a.   Germany’s exports to Visegrad countries, 1993-2014 (million euro)

Figure 3b.   Germany’s imports from Visegrad countries, 1993-2014 (million euro)

         Source: Eurostat

The ranking of V4 countries’ trade partners puts Germany on the top (figure 6).

Product structure of Germany-V4 trade

The years of division of Europe where Central and Eastern European countries belonged to the Soviet Block (iron curtain) caused slow down of their technological development. After the collapse of the centrally planned economy system in V4 countries they were in urgent need of technology and capital. In the times before the both World Wars the CEE countries were suppliers of raw materials and food to the Western Europe. This division and interdependency was disrupted by the cold war. After the V4 countries reintegrated with the Europe’s division of labor Germany again became their biggest economic, trade and investment partner.

Czech Republic

Machinery and equipment (SITC 7) dominates Czech Republic’s exports to Germany. Since 2000 this commodity group’s share in total exports to Germany has been steadily rising to reach 57.25% in 2014. The structure of Czech Republic’s imports from Germany is more diversified than the exports to Germany as SITC 7 constituted 45.45% in 2014 (Czech Statistical Office). Czech exports to Germany are highly correlated with German total imports (Singer, 2013) (see figures 4,5).

Figure 4. Czech Republic’s top import products from Germany (%)

Source: Czech Statistical Office.

Figure 5. Czech Republic’s top export products to Germany (%)

Source: Czech Statistical Office.

Hungary

Hungary’s exports to Germany increased from 2294 million euros in 1990 to 10 633 million
euros in 2000 and 17 758 million euros in 2008. During 1990-2008 the structure of Hunagry’s export to Germany changed significantly due to investments of German companies in Hungary. The operations of German companies in Hungary resulted in appearance of new products (70% of the total) in Hunagry’s exports mainly in machines, equipment, and transport vehicles category (Kőrösi, 2009, p 57) (see tables 1,2). According to Kőrösi (2009, p 61), 25% of products exported to Hungary derive from automotive industry where Audi is the biggest exporter. As to Hungarian imports from Germany machinery and transport equipment constituted 60% and processed products 30% of the total in 2008 (Kőrösi, 2009, p 61).

Table 1. Hungary’s export to Germany by product categories (%)

Source: Kőrösi, 2009, p. 88.

Table 2 Hungary’s import from Germany by product categories (%)

Source: Kőrösi, 2009, p. 89.

Poland

As in the case of other V4 countries, Poland’s trade with Germany is dominated by the product group “Machinery and transport equipment” (table 3). The major commodities in the structure of Polish exports are: processed products, parts and accessories for motor vehicles, furniture, combustion engines, automobiles, refined copper, wire, reception apparatus for television, structures for construction of bridges and boats. The following product categories had the biggest share in exports: machinery and mechanical appliances and electrical equipment (22%), base metals (17%) and vehicles (15%). The imports products comprise mostly of machinery and mechanical appliances (25%), metals (16%), vehicles (14%) as well as plastics, in particular parts and accessories for motor vehicles, motor vehicles, petroleum oils, engine parts, medicines, rolled products of iron or steel, fittings, machinery and mechanical appliances (Polish Ministry of Economy, 2015).

Table 3. Poland’s import from and export to Germany in 2014 by SITC product groups.

Slovakia

Slovak Republic’s imports from and exports to Germany as to commodity structure are both made up mostly of motor vehicles and motor vehicle parts, products of the eletro-technical industry and machinery (Liptáková, 2012; Simonazzi et al., 2013, p 661). The study by ING (2013) aimed at forecasting trends in Slovakia’s international trade by 2017 argue that these categories will remain unchanged. The exports to Germany should be dominated by road vehicles and transport equipment; office, telecom and electrical equipment; industrial machinery (in that order). While imports from Germany will mostly comprise of: office, telecom and electrical equipment; road vehicles and transport equipment; industrial machinery (in that order) (see table 4,5).

Table 4. Top 10 largest import flows by product and country of origin

Source: ING 2013.

Table 5. Top 10 largest export flows by product and destination country

Source: ING 2013.

Figure 6.   V4 countries’ bilateral trade with major global players

     Source: IMF, 2013, p. 7.

Investment

Already in the early 1990s German companies started to invest in CEECs, especially in Poland, Hungary and Czech Republic. According to OECD data their share on total German FDI outflows quickly increased after 1989 and reached 7.5% in 1993. However, with the ongoing globalization of German companies this share did not grow significantly. In 2010, the V4 group received 6.4% of Germany’s FDI outflows. It is striking that the outflows to the four countries show an extremely unstable development paths (figure 7). The drop down between 2000 and 2003 corresponds with Germany’s aforementioned “sickness period”. Poland was the main beneficiary from the recovery after 2003 as well as after 2009 having by now the largest stock of German FDI (figure 8). The large differences in German FDI stock suggest differences within the V4 group as well as in relation to East Germany regarding their competitiveness on the national and sub-national (regional) level, their development paths, and their geographic and cultural proximity to West Germany. Angenendt (2011) found out that location decisions depend to a considerable degree on regional factors such as the existence of clusters characterized by high educational level, regional specialization and  agglomeration economies.   

Figure 7.   Germany’s FDI outflows to V4 countries, 1993-2012 (million euro)

Source: OECD

Figure 8.  Stock of Germany’s FDI in CEECs, 2012 (millions euro)

                      Source: Deutsche Bundesbank

The EA agreements with their rules on capital movements, competition and intellectual property rights created a framework which promised to protect foreign investment. “Initially, German investment in these four states went toward the transportation, energy, and communication sectors. But by the late 1990s Germans were increasingly investing in manufacturing. And they were no longer just buying up old enterprises; they were also helping to found brand new ones. By the end of the 1990s, three-quarters of German FDI in Eastern Europe was in manufacturing, and one-third of all German investment in the region went toward “greenfield sights,” or new production centers. All told, between 1990 and 1997, 11 percent of all German FDI went into Eastern Europe, and German firms acquired or established some 2,300 affiliates. By the end of the 1990s, between 20 and 30 percent of the foreign investment flowing into the Visegrad Group was German… By 2000, then, Germany was the single largest foreign investor in Hungary, Poland, the Czech Republic, and Slovakia. And, crucially, German investment was a key factor driving the growth of German trade in the region. Indeed, by 2000 Germany was also the single largest trade partner with the Visegrad Group. In 2004 Germany’s share in the trade of all Central and Eastern European countries had risen to 21 percent.” (Gross, 2013, p. 29)                                                                                

Focusing on the firm level, Buch and Kleinert (2006) aimed to find out whether German firms’ subsidiaries in CEECs differ in terms of size and labor intensity from those in EU-15 countries. The obviously existing differences, namely smaller size and higher labor intensity, are rooted not only in host countries low wages or large markets, but also in parent firms’ characteristics. Contrary to intuitive expectations, large German firms are more active in CEECs than SMEs.  

The trade – FDI link

The above shown dynamics of Germany’s trade with the V4 group is closely related to changes in the industrial structure of exports and imports which – according to Gross (2013) – had been highly correlated with German companies’ FDI from the early 1990s on. The observed trade-FDI link is in line with theoretical contributions in the field of “New Trade Theory” (e.g. Helpman, 2006) as well as with empirical studies (e.g. Egger and Pfaffermayr, 2004). The expectation that Germany’s long border to Poland and Czech Republic should result in intensive trade-FDI links between border regions has not been convincingly confirmed so far. Mitze (2012, p. 132) argues that the short time span after 1989 is not sufficient to build up a normal FDI stock (in the sense of the gravity model estimates) which allows to test the border hypothesis.  Based on a rough calculation of trade and FDI in the early 1990s, Schmidt (1997, p. 56) suggests a positive correlation which is evident for Poland, ex-Czechoslovakia and Hungary because of their common border with Germany and Austria.

Gross (2013b) emphasizes that Germany’s leading position in trade and FDI in V4 countries has important roots in the German “Ostpolitik” of the 1970s. The trade-FDI link – more precise the interpendence between vertical FDI and intra-industry trade – has developed over the past 25 years into cross-border supply chains and production networks.  Dustman et al (2008, p.176) concluded that “to increase the competitiveness of its own final products, the [German] manufacturing sector has made increased use of trade integration with Eastern European countries through inputs imported from abroad, and far more so than other European countries. These inputs made up 14.5 percent of total output in the manufacturing sector in 1995 and 21.5 percent in 2007. Calculating the outsourcing indicator suggested by Egger and Egger (2003, p. 642) for Germany, France, and Italy regarding imported inputs from Poland, Hungary, the Czech and the Slovak Republics … shows that in the year 2000, imported inputs from these four countries amounted to about 8.5 percent of inputs in Germany, compared to 2.5 percent in Italy and 1.9 percent in France (relative to GDP).” The findings of studies on the employment effects in the home country range from destroying to creating jobs. The considerable differences in wages offered an attractive incentive to shift parts and components production to CEECs, especially in the “German sickness period”. Bluhm (2000, p. 16) puts forward the argument that “German firms hesitate to utilize the low cost option in proximity aggressively in their internal labor policy at home. Rather, they tend to avoid confrontations with their employees on production shifts. The necessity of collaboration between both sides of the border, the relative strength of workers in the domestic high-quality production system and the constraints of the industrial relations system provide explanations for this rather moderate behavior. In other words, exploiting the new opportunities in order to impose changes on the basic rules and practices of the ‘German model’, shifting toward the liberal, Anglo-Saxon market model is still pretty risky for manufacturers in mature industries (whatever individual preferences might be). This keeps firms behind the bargaining table in spite of the greater asymmetry in labor relations caused by higher capital mobility. The outcome of the bargained reorganization so far is that firms gain more labor flexibility, performance-related differentiation and labor-cost rationalization without challenging the long-term employment commitments, institutionalized in the German production regime.”  In a more recent study, Braakmann and Volgel (2010, p. 321) basically confirm the moderate employment effect even for border regions. In most industries the accession of V4 countries which further facilitates cross-border trade and FDI flows did not affect employment and wages in German border firms negatively.

Studies which compare the Germany - CEECs trade and FDI pattern with that of other EU-15 countries (e.g. Giovannetti and Lucetti, 2008) find out that Germany’s dominance in FDI is stronger than in trade. Furthermore, Germany’s trade is to a higher degree concentrated on capital-intensive product groups (e.g. automotive industry), whereas for example Italy’s trade is rather concentrated in labor-intensive industries (e.g. textiles). The sectoral trade pattern explains to a certain degree the location pattern. Germany’s trade is relatively high with the industrialized, relative high wage Czech Republic, whereas Italy’s trade is relatively high with low-wage Romania. These patterns match up with the sectoral and regional distribution of FDI.

German – CEE supply chain

The most obvious feature of Germany – CEECs trade is the high share of intra-industry trade in parts and components. Already in the 1990s, Germany’s exports in parts and components accounted for approximately 40% of total CEECs’ exports in parts and components, whereas its imports from CEECs amounted to 50% (Kaminski and Ng, 2001, p. 16). In some industries, intra-industry trade also developed fast in final products. By using the Grubel-Lloyd intra-industry trade index (GLI), Ito and Okubo (2012) found out that this index considerably increased since 1989 (figure 9). In 2010, the V4 group’s GLI reached approximately the same level as the German – Netherland, - Austria, - Italy, - Belgium GLI. The decomposition of intra-industry trade (IIT) into horizontal and vertical IIT (HIIT, VIIT) (Fontagné and Freudenberg, 1997) allows deeper insights into Germany – CEEC trade. The example of Poland shows that the HIIT generally increased with some minor dips at the end of the 1990s and 2006/2007. The dynamics of HIIT (and VIIT as well) depends on the threshold value. The higher this value – Ito and Okubo (2012, p. 1133) tested values between 5% and 50% - , the higher is the dynamics. Regarding the VIIT, the study for the first time introduced a differentiation between upper and lower sides of VIIT index. The empirical exercise exemplified by Germany – CEECs/China VIIT shows a sharp contrast between the trends of upper and lower sides IIT indices (figure 10a, b). Furthermore, in both cases the trend of China’s index differs from those of CEECs. The sharp increase in the trend of Germany’s lower side VIIT index with CEECs and China’s stable trend indicate that CEECs generally move up the quality ladder and particularly compared to China with higher speed.

Figure 9.   Germany’s IIT index with CEECs and China, 1989-2010

Source: Ito and Okubo, 2012, p. 1131.

     Figure 10a.   Germany’s upper side VIIT index with CEECs and China, 1989-2010

Figure 10b.   Germany’s lower side VIIT index with CEECs and China, 1989-2010

                Source: Ito and Okubo, 2012, p. 1135-36.

The literature on intra-industry trade on the one hand, and the literature on FDI on the other hand are merging more and more under the new umbrella of global/regional value chains or production networks. The focus of empirical studies is turning from a flow-oriented view toward a value-added view. Gross exports are decomposed into several categories of value-added exports (Koopman et al, 2011). From a global point of view, Rahman and Zhao (2013, p. 6) found out that since the middle of the 1990s exports in manufacturing and services experienced a) declining share of domestic value-added, b) increasing supply links, c) increasing foreign value-added. In the V4 countries the foreign value-added components in their exports reached over 50%. Based on a gravity model, Rahman and Zhao (2013, p. 26) showed that Germany is the most important hub in the export supply network of Europe in terms of value of trade. They argue that the high intra-industry trade of Germany with the V4 group is an important driver for supply links. This leads to an extension of the gravity equation by adding to the well-known variables (common border, common language, free trade area) the industrial similarity as a new determinant of cross-border supply chains. Rahman and Zhao (2011, p. 17) calculate a high “industry similarity index” for Germany’s export structure compared to V4 countries’ export structure.  

As demonstrated in figure 11, the German-V4 group interdependencies in supply links developed more dynamically than with other Western and Eastern European countries. For the V4 group this means that they not only depend on Germany’s domestic economic performance but also indirectly on global growth because of Germany’s deep embeddedness into the world economy. Depending on the methodology of calculating the indirect exposure, a substantial fraction of V4 exports pass through Germany before being exported outside the EU (IMF, 2013, p. 5).  

Figure 11.   Share of German value-added in total exports, V4 and other European countries, 1995 versus 2009

                                                                                 Source: IMF, 2013, p. 4.

In the 1990s, the main driving force of the German-V4 value chain was the wage differential. With increasing unit labor costs, V4 countries cost advantage will decline. The supply may move eastward where countries like Bulgaria and Romania have the potential to substitute the V4 countries. The emergence of the German-V4 value chain created a permanent knowledge transfer to the V4 countries. However, there is evidence that there are considerable differences between industries and even between companies. If labor skills increase, V4 countries may gradually move up into knowledge-intensive value chains. The IMF study (2013, p. 14) points to a number of other positive effects for the V4 group such as increasing domestic value-added, accelerating income convergence, attracting investors from outside Europe and therefore integrating into global value chains, synchronization of business cycles.

Germany’s automotive industry in CEECs

One of the special features of the automobile industry is the outstanding importance of suppliers and subcontractors which make up around 75% of an automobile’s manufacturing costs (Frigant and Miollan, 2014, p. 2).  From this point of view it is understandable that the analysis of internationalization of the automotive industry pay attention to horizontal FDI (multiplant operations) as well as to vertical FDI and outsourcing/subcontracting (parts and components production).  Despite the fact that Germany remains its position as the center of European vehicle assembly plants, the reality is – as Figran and Miollan (2014, p. 10) noted – that European production has shifted eastwards. This also holds for suppliers as they often seek proximity to their manufacturer customers. Suppliers in CEECs are a special case as they are often connected to Western European manufacturer by ownership or contracts. Their share of exports and imports on total production tends to be larger than suppliers in other regions in the world. Similar to the German dominance in assembling motor vehicles in CEECs, Germany takes the top rank in foreign owned subsidiaries in the parts and component production with almost 60% of the total value in Czech Republic and Hungary (figure 12). 

Figure 12.  Foreign subsidiaries’ share in automotive industry: production value, 2010

                                   Source: Frigant and Miollan, 2014, p. 18.

The automotive industry in CEE before 1989 was concentrated on Czechoslovakia (Skoda), Poland (license with Fiat) and Romania (Dacia, license from Renault). Due to low quality, outdated design, lack of service infrastructure these cars were not competitive in Western Europe despite their low price. In the 1990s, CEECs’ automotive exports and imports in final products, parts and components increased rapidly, especially in Czech Republic, Hungary, Poland, Slovakia and Slovenia. The integration of CEECs’ automotive industry into European production networks was mainly driven by FDI from German (Volkswagen and Opel) and French (Renault) automotive companies as well as Italy’s Fiat (Van Tulder and Ruigrok, 1998). Japanese and Korean automotive companies established assembly plants (e.g. Suzuki in Hungary) or invested in privatized domestic companies (e.g Daewoo in Romania). Contrary to Western European automotive companies which integrated CEECs in their production networks, the Asian car makers invested in CEECs in order to gain “tariff jumping” advantages even before CEECs’ accession to the EU.  

 “The shift of German automotive production towards the CE4 [V4] started in the mid-1990s and was a natural outcome of demand and supply forces. On the demand side, German automobile manufacturers needed to more competitive environment in an increasingly globalized world, while on the supply side, the CE4 countries offered an attractive mix of characteristics whose appeal only strengthened their accession to the EU in 2004. Geographic proximity, relatively low unit labor costs, the favorable tax environment, and a highly qualified workforce with a history of expertise in the automobile industry played an important role” (IMF, 2013, p. 13). The decomposition of V4 countries’ gross exports in the automotive industry into the origins of the value-added highlights the deepening of the German-V4 value chain from the mid-1990s on. In 1995, Poland recorded with 7% the lowest German-related value-added in its exports in the automotive industry, while this share grew to 11% in 2009. Hungary achieved the highest share with 16%, up from 11% in 1995.  

According to Jürgens and Krzywdzinski (2009) the German car makers applied two strategies to integrate CEECs into their production networks, firstly, the specialization of their CEECs plants on the production of sub-compact cars in the low price segment and secondly, the parallel production of the same model. The acquistion of Skoda by  Volkswagen (brownfield investment) is an example for the former strategy, while Opel produced the Opel Astra in Germany as well as Poland. Furthermore, German car makers established subsidiaries or outsourced parts and component production to CEECs. The stock of FDI of German automobile and supplier industry in CEECs increased from 1189 mio euro in 1995 to 5405 moi euro in 2002 (Nunnenkamp, 2005, p. 9). The production of German car producers increased in V4 countries from 240.1 million units in 1996 to 782.4 million units in 2003. The trade balance in this industry switched from surplus in 1995 to deficit in 2003. Data on Volkswagen’s production at home, with production in V4 countries, and German-V4 exports and imports suggest that production in V4 countries results in a substitution effect. From the perspective of the German automobile industry, the majority of studies do not confirm significant substitution – and related negative employment – effects. This also holds for the parts and component production. Jürgens and Krzywdzinski (2009, p. 32) argue "[r]ather than displacing manufacturing in Germany, component imports from CE countries seem to have supplanted imports from Western Europe and the Iberian Peninsula."

Case Study: Volkswagen - Skoda

Immediately after the fall of the Iron Curtain in 1989, numerous problems of leading manufacturer in CEECs became obvious. It was common ground that the existing automotive industry in CEECs was not competitive in an open European market. But Western European automotive companies quickly identified a new business chance by engaging to solve shortcomings of companies in CEECs such as outdated technology, low productivity, lack of market orientation, inefficient organizational structure. The case of Skoda showed an additional special feature: In the 1970s and 1980s, the shortage of labor forced Skoda to employ approximately 1500 convicts and 1500 Vietnamese (Pavlinek, 2008, p. 79).  As a result of the presidential amnesty in January 1990 all convicts left Skoda. The sudden stop of production and the reopening with new inexperienced workers led to high financial losses which influenced negatively the value of the company by the time of its privatization in early 1991. The menacing insolvency threatened the existence of more than 200 domestic suppliers. A Joint Venture with a foreign company seemed to be the only realistic solution to prevent bankruptcy. At first sight it might seem astonishing that more than 20 foreign automotive companies registered to participate in the public tender to privatize Skoda. This can be interpreted as a clear sign of positive expectations regarding CEE as a low cost production location and new market with high potential. The government announced a number of requirements which the foreign partner had to fullfil such as keeping Skoda as a brand, maintaining contracts with domestic components suppliers, extending the production capacity. Finally, Renault and VW had been short-listed. Renault offered in its (second) proposal a model of an indirect holding of 40% by a newly established company, while VW proposed a direct capital relationship in a Joint Venture and guaranteed to include Skoda as an equal partner of VW, Audi and Seat. Furthermore, VW promised to modernize Skoda by investing around 6 billion USD up to 2000. All in all, VW’ offer was higher ranked than Renault’s offer. The agreement between the government and VW was signed in March 1991 and the Joint Venture was formed on month later. VW increased its share from originally 31% up to 70% in 1995 by paying around 900 million USD. The successful bidding made VW the first mover in implementing a full-fledged CEE strategy. It was also the  biggest-ever Western European investment in an Eastern European Company. By 2000, VW's investment in working capital and in repaying Skoda's debt reached 2.05 billion Deutsche Mark (Vojtech, 2011, p. 24). From 2004 on, Skoda was obliged to send annual dividends to VW. Frigant and Miollan (2014, p. 3) consider VW’s takeover of Skoda as the “trailblazer” of CEE strategies of Western and Asian automotive companies. As a first mover, VW benefitted from tax preferences, duty free import of technologies, relative high import tax for foreign competitors.  

In the early 1990s, the new Skoda company was challenged by a drastic decline of sales compared to pre-1989 sales resulting in a loss of 1.1 billion USD until 1993. Furthermore, the originally planned new engine plant was cancelled, but instead of that established in Hungary. At the end of 1994 an addendum to the Joint Venture agreement was signed confirming VW’s general commitment, but reducing investment and production targets. The government promised among others to increase protectionist measures. In 2000, Skoda became a wholly-owned part of the Volkswagen Group. 

The old and new management of Skoda initially believed in the superiority of VW’s production and organizational knowledge and were willing to transfer it without adjustment to Skoda despite the completely different environment. Finally, Pavlinek (2008, p. 93) stated that “the simple and total transfer of VW’s production and management practices that ignored the existing experiences, attitudes and overall ways of making cars at Skoda obviously did not work as smoothly and efficiently as VW’s managers had planned.” The experiment with “tandem team” faced among others language and social status problems, but was finally considered to be an efficient and speedy way of knowledge transfer. In terms of modernizing the production process, VW introduced concept of “strategic insourcing” resulting in lower logistical and warehousing costs. The closer contacts to suppliers were used to motivate them to establish Joint Ventures with Western suppliers. At the end of the 1990s, Skoda was included into VW’s Group to develop a common platform for cars of similar size and implement it into VW, Seat and Skoda cars. Since 1999, all Skoda models have been based on VW corporate platforms. This reduced the dependence on local suppliers.                                  

Not surprisingly, the restructuring process led to job losses, especially foreign workers. After take-off of the car production in the second half of the 1990s, Skoda reacted on short-term fluctuations in its production by hiring or firing Polish (respectively more recently by Ukrainian) workers. Earlier than other European car makers, Skoda introduced a new production system (“Skoda Production System”) in order to maintain its competitive advantage compared to newcomers such as Japanese and Korean companies. Pavlinek (2008, p. 105) noted that “Škoda’s restructuring strategy proved to be very successful. The company was transformed into a low-volume low-cost producer of good quality automobiles without fully reaping the benefits of economies of scale. Škoda could compete with Japanese and South Korean auto makers in terms of production costs (but not yet in terms of the quality and reliability of its vehicles).”

All in all, after a short period of start-up problems, the affiliation with VW results not only in an recovery, but in an impressive growth of sales (figure 13). With the backing of VW’s internationalization know-how, Skoda sells cars on more than 90 countries. More than 80% of Skoda cars are sold within the EU of which 55% account for Western Europe. This raises concerns that Skoda sales grow at the expense of higher priced VW models. According to Pavlinek (2008, p. 111) there is evidence that Skoda’s relative freedom within the VW Group has been curtailed and it has been more subordinated to the VW headquarter.

Figure 13.      Annual production of automobiles by Skoda, 1990-2014

                                                     Source: Skoda, Annual Reports

Skoda has three production plants in Czech Republic (Mladá Boleslav and Kvasiny for cars and Vrchlaby for gears). Currently, Skoda cars are also produced in China at Shanghai Volkswagen production plants (Anting, Yizheng, Ningbo), India (Pune and Aurangabad), Russia (Volkswagen Group assembly plant in Kaluga and the GAZ plant in Nizhny Novgorod) and Slovakia (Volkswagen production plant in Bratislava). In 2014, Skoda produced almost 280000 cars in China which is by far the largest foreign production of the company. The sales in China are also ranked on the top of foreign markets followed by Germany (slightly over 5o% of sales in China). With the removal of tariffs in Poland in 2002, the main reason for assembling Skoda cars in Poland vanished. Consequently, Skoda completely stopped this plant.

To conclude, the takeover of Skoda by Volkswagen can be regarded without doubt as a successful brownfield investment. One of the key factors of this success is the combination of VW’s and Skoda’s strengths. Skoda holds a market share in Czech Republic of around 30% in 2012. Last but not least, it should be noted that Skoda considerably contributes to the positive economic development in Czech Republic. The company is the largest employer in Czech Republic with around 25000 employees in its three production plants. Furthermore, approximately 100000 employees in supplier firms are indirectly depending on Skoda.

Conclusion

Since the CEECs’ transition to the market economy at the beginning of the 1990s their economic ties with Germany started to be rebuilt to achieve the importance of Germany as number one economic partner from before the WW II period. The bilateral trade of V4 countries with Germany became dominated by vehicles, machinery and their parts.  It was caused by the movement of German companies’ parts of production chain to these countries to benefit from lower production costs which allowed them to maintain their competitiveness on the global market. High exports shares of Germany in V4 countries’ total exports are mostly coming from German subsidiaries located in CEECs. Poland is the largest recipient of German FDI in the region followed by Czech Republic, Hungary and Slovak Republic (in that order). German companies when choosing location for their operations in V4 are motivated mainly by agglomeration economies, proximity to universities producing skilled labor, proximity to the German border as well as the quality of infrastructure. The V4 countries remain favored destinations of German investors (Singer, 2013; Polish Embassy in Berlin, 2014).

As a result of very close economic ties between Germany and V4 countries the latter’s industrial production, export and import are highly dependent on the situation of German production. It is especially the case of small economies such as Slovak Republic where this response is almost one-to-one (IMF, 2014).

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