Who Gains From the New Europe? (1989)

By Richard I. Kirkland Jr.

With the fall of the Wall and the lifting of the Curtain, Western managers and investors must rethink their strategies for doing business in Europe in the 1990s. Suddenly the Old World has gained a new frontier. East of the Elbe, Communist parties are on the run. A year from now, or even sooner, most will probably be sharing power — and some may even be out. Freer politics inevitably will create freer markets. The possibilities are huge. Among the 12 members of the European Community, the campaign to forge a true common market by the end of 1992 was already boosting growth rates and capital spending. Now, says Percy Barnevik, the lanky Swede who heads Switzerland-based Asea Brown Boveri (ABB), the world’s largest heavy-engineering company, ”the opening of Eastern Europe could prove even more important than the drive for a single market.” The combined GNP of East Germany, Hungary, and Czechoslovakia is larger than that of China. The three countries also have relatively well-trained and reliable workers who toil for less than a quarter of what their Western brethren are paid. Give them access to their developed neighbors’ markets and hefty injections of Western capital, predicts Robert Hormats, vice chairman of ( Goldman Sachs International, and ”they could become the tigers of Europe.” Morgan Stanley chief equity strategist Barton Biggs believes that over the next five years East Germany could prove ”the fastest-growing economy in the world.” He advises buying West German and possibly Austrian stocks as the best way to play this emerging market. Who wins and who loses if the East’s backward economies finally integrate into the global economy and take off? The right answer is everybody wins and nobody loses — except, of course, the political leaders who are toppling. Sure, a lot of investment that might have flowed to Spain, southern Italy, or other low-labor-cost areas along Europe’s Mediterranean sunbelt could be diverted to Central Europe in the 1990s. West Germany’s high labor costs, for example, are particularly hurtful for a mass-market carmaker like Volkswagen. But John Lawson, an auto industry analyst with Nomura Securities in London, says, ”The opening of the East could prove the salvation of the West German motor car industry.” East Germany’s new Prime Minister, Hans Modrow, recently suggested that his country would reverse course and allow Westerners to form joint ventures and make direct investments. If that happens, why should Volkswagen, whose Wolfsburg headquarters is just five miles from the East German border, continue to export capital to distant Barcelona when it can tap workers in nearby Karl Marx City who speak the same language and cost less than $3 an hour?

Because Europe’s overall growth would accelerate, plenty of other eager foreign investors — from the U.S., Japan, possibly even South America — will almost surely pour into Spain to fill that gap. Expanding global markets is not a zero-sum game. Western Europe has the most to gain from Communism’s march toward freer markets. At $43 billion last year, its exports to the Russians and their satellites were ten times larger than America’s and more than 11 times larger than Japan’s. Within Europe, West German companies will be the biggest winners, followed by the Austrians, Italians, French, and Finns. And the big West German banks, along with Siemens, Mannesmann, and other capital goods makers, will lead the charge. Last year Deutsche Bank alone financed more than 20% of West Germany’s $15 billion in exports to the East. American companies will benefit because they will be able to increase sales to a Western Europe made even more dynamic by its expanding Eastern frontier. $ Deutsche Bank chief economist Norbert Walter estimates that the 600,000 ethnic Germans and East Germans who have emigrated from Eastern Europe this year will add a full percentage point to West German consumer spending in 1990. Their hunger for Western goods was poignantly captured by TV images of East Germans prowling the Kurfurstendamm, West Berlin’s main shopping street. Since West German factories are humming at full capacity, only a surge in imports will satisfy that demand. And in the slightly longer run, if peace really does break out between the superpowers, no Western economy — or stock market — ultimately stands to gain more from falling defense spending than America’s. Farsighted executives had their eyes on these opportunities well before the Berlin Wall blew open on November 9. In September, General Electric of the U.S. began negotiating with Hungary’s reform-minded government to buy Tungsram, a state-owned lighting manufacturer with sizable exports to the West. By mid-November, GE Chairman Jack Welch had a deal. For $150 million GE bought just over 50% of Tungsram — plus an option to purchase 20% more if the company’s exports can double. Says Welch: ”We recognize that we are swimming in uncharted waters. But acquiring Tungsram gives us an entry into a part of the world that has been held primarily by Siemens and Philips. By positioning us for a Europe in which, down the road, East and West will blur, it helps us toward our strategic goal of being No. 1 in our global markets.”

Other companies with long experience in the East are either expanding there or contemplating doing so. Fiat has licensed technology to Polish carmakers since 1921. In 1991, Poland’s state-owned FSM will start exporting more than 50,000 subcompact Fiat Mickros to the West — the first time a completely new Fiat car has been built outside Italy. Fiat is also talking with FSO, another Polish automaker, about building a medium-size car and is on the verge of striking a giant joint venture deal with the Soviet Union. ABB is negotiating with two Polish turbine makers, Domel and Camech, to form joint ventures to sell components in both Eastern and Western Europe. Two years ago Eastman Kodak set up a joint venture in Hungary that sells $5 million of film, cameras, and photo processing a year. David Harari, Kodak’s manager for Eastern Europe, says he is discussing a deal with Poland ”six to seven times larger.” Political leaders on both sides have barely begun to grapple with the challenges of melding Europe’s postwar halves. How much aid should the Western allies offer the East, under what conditions, and in what form? What if demonstrators filling the streets of Leipzig or Prague, having won first an inch and then a yard, suddenly demand unlimited mileage — a complete break with the Warsaw Pact? How would Mikhail Gorbachev respond? Will reunification, or at least economic reintegration, of the two Germanys derail Europe’s Project 1992 or merely slow it? And how and when should the U.S. and the Soviet Union bring troops home from Central Europe? The uncertain outlook for Russia’s perestroika — and thus Mikhail Gorbachev’s survival — guarantees that Western investors in the East will have to live with higher than average political risk for at least the next decade. But political risk isn’t the worry it used to be. The Communist bloc is so desperate for Western technology and capital that even if hard-liners regain control, they’re unlikely to expropriate foreigners’ factories or profits. That certainly did not happen in China after last June’s Tiananmen Square massacre. The bigger risks are economic. If your host government is going to let inflation explode, fail to deliver vital supplies, and waste foreign loans on consumer subsidies, you might be wiser to reject his invitation. Hungary and Poland, which are the most eager to attract Western investment, are also among the East’s biggest debtors. Forecasters at WEFA Group near Philadelphia estimate that the two countries’ ratios of net debt to hard currency exports are 237% and 500%, respectively.

Partly because of their troubles — and because they have made the greatest strides toward democracy — the Poles and Hungarians are furthest ahead in introducing promarket reforms. But will they go far enough? Says Britain’s Philip Hanson, a professor at the University of Birmingham’s Center for Russian and East European studies: ”Serious radical reform — cutting subsidies, freeing prices, and allowing convertible currencies — is acutely painful for large numbers of ordinary people, who at least temporarily lose their economic security. That’s why I’m not convinced that any of these countries will make the breakthrough to a true market economy.” Given the gap between Eastern Europe’s vast potential and its present woes, would-be investors may feel understandably confused about what they should be doing. Here are tips from old hands in the region. — Place affordable bets. Says Dwayne O. Andreas, chairman of Archer Daniels Midland and an ardent advocate of more East-West trade: ”It’s like anything else. You don’t risk the farm. You risk three acres.” GE’s $150 million purchase of Tungsram is the largest Western investment in Hungary since World War II. But that investment is less than 10% of what the company may spend buying back its own stock next year, and even smaller potatoes compared with GE’s total capital spending budget. — Do your homework carefully. Four of the eight Eastern European countries don’t even appear on most Western shopping lists (see table). Under longtime leader Nicolae Ceausescu, Rumania’s once promising economy is on a quick march back to the 15th century — a century tiny Albania never left. Ethnic animosity and hyperinflation could tear Yugoslavia apart well before the next millennium. Bulgaria is at least trying harder, but it’s a long way from Sophia to Vienna.

At the moment Hungary gives Western investors the most options. Some 850 foreign joint ventures with outside capital of roughly $1 billion will operate there by year’s end. Many have begun in just the past 12 months. In addition, Hungary’s ambitious new privatization program may well expand if, as expected, an even more promarket coalition government comes to power in next spring’s elections. Meanwhile, auditors from Price Waterhouse, Ernst & Young, and other major accounting firms are busily checking the books of Hungarian companies that plan to list shares on the Eastern bloc’s first stock market, scheduled to open in Budapest next year. Though Poland shares Hungary’s eagerness to attract Western capital, its economy — and its accounting practices — are both in much worse shape. Says economist Warren Oliver of the London brokerage firm UBS Phillips & Drew: ”It’s simply impossible to know what you’re buying in Poland. I’d challenge GE’s acquisitions department to make sense of the books kept by a Polish state industry.” What Poland’s Solidarity-led government does offer is a breathtakingly radical plan to cut subsidies, free prices, and move quickly to a convertible currency. Says Deutsche Bank’s Walter: ”No Communist country has ever adopted a more conceptually convincing program for moving to a market-oriented economy. We must all look more carefully at what could happen in Poland.” Because their break with the past is so sharp, the Poles can also expect big injections of Western aid. The U.S. Congress just approved an $852 million package, while West German Chancellor Helmut Kohl has promised at least $1.5 billion. East Germany is almost everyone’s favorite turnaround candidate. Though its economy has been hammered by the migration of many of its best young workers, that damage can be repaired quickly — if the Communists move to adopt fundamental reforms, including free elections. Should that happen, Jan Vanous, research director of PlanEcon, a Washington, D.C., consulting firm, believes the annual flow of private and public money from West Germany alone could ”easily” top $10 billion and continue for at least a decade. Says he: ”No other East European country can dream of this type of windfall from making the right political and economic moves. It would take real talent not to pull the East German economy above the average standard of living in the Common Market by the year 2000.” — Don’t leap into Eastern Europe without a hard-currency safety net. You’ll need some way to get your cash out. A system of fully convertible currencies won’t emerge for several more years, possibly longer. If your main interest is serving the domestic market, creative bartering is still the only way to change your zlotys or forints into real money. For example, PepsiCo exports chairs from timber-rich Poland to its Pizza Hut franchisees in the U.S. in order to get profits out of its Polish bottling operations. Manufacturers must make sure they strike the right balance between exports and local sales. France’s Saint Gobain recently joined forces with Yugoslavia’s largest glassmaker. Though a major customer of this new factory will be state carmaker IMV, which itself exports compacts in a joint venture with Renault, Saint Gobain earns no hard currency from those sales. That will come from exports to Greece. — Don’t expect a quick payoff. Says Juergen Aumueller, president of American Express Travel Services in Europe: ”Patience is the key.” Despite the current euphoria, no Eastern European country is moving from Stalinism to Thatcherism overnight. Outmoded plants and unpredictable supply lines will continue to make planning an art, not a science. Richard Norton, PepsiCo’s vice president for Eastern Europe, figures lack of spare parts alone forces plants there to endure 20% more downtime than their U.S. counterparts. Corruption will remain endemic, contacts essential. Unless you’ve got the % in-house expertise to negotiate this morass, William Cornelius, director of trade policy for Dow Chemical, suggests it may be wise not to take a majority stake in an Eastern bloc joint venture. Says he: ”Without at least 50% of the deal, your partner may not direct enough of his energies toward solving your company’s problems.” — Above all, don’t delay. Start exploring the possibilities in Eastern Europe. The number of companies capable of competing successfully on world markets, as do Tungsram or Ikarus, a Hungarian busmaker, is larger than you might think — but it’s still limited. Demand for these islands of efficiency is sure to rise. Smart investors, such as America’s George Soros and Italy’s Carlo de Benedetti, are already sniffing out opportunities. Japanese interest is also growing. Daihatsu, Japan’s No. 8 auto company, is talking with Poland’s FSO about a joint venture that would produce 120,000 small cars a year, some for export to the Soviet Union and the West. Says Stewart White, a partner in the London law firm of Denton Hall Burgin & Warrens: ”In our new Tokyo office the first question potential Japanese clients ask these days is whether we have expertise in East-West trade.” Early birds will also grab the best local managers. Peter Hargitay, owner of a private holding company in Zurich that specializes in communications, finance, and public relations, expanded into Hungary more than a year ago, just as the latest round of reforms were launched. By doing so, he was able to recruit Janos Fekete, the former head of Hungary’s National Bank, as chairman of his subsidiary. Fekete also heads the commission advising Hungary’s Parliament on future economic reforms. As the world enters a new decade, a new Europe is emerging as well. What’s in doubt isn’t the trend but the timing. The day after the Berlin Wall split apart, David Roche, Morgan Stanley’s top European equity strategist, advised his clients to immediately boost their stake in German stocks, despite the likelihood that an overheating economy could temporarily drive up interest rates. Explains Roche: ”I’m trying to tell people where they’re going to make money over the next five to ten years. Just as markets in the 1980s were defined by Reaganomics and Thatcherism, the 1990s will be defined by the shifting of the ideological plates that have separated the world’s geopolitical land masses.” Despite the difficulties that lie ahead, companies that aim to remain globally competitive shouldn’t wait too long to invest ; either time or money in those changes.

Reporter associate: Mark M. Colodny