A few weeks ago, the European Commission published a research report by a group led by former ECB Governor M. Draghi. This report is interesting for several reasons, but its dominant theme is the authors’ attempt to strengthen the EU’s competitiveness. The authors are motivated in part by geopolitical changes, which are leading to competition between the U.S. and China, and primarily by Europe’s loss in this competitive battle. Europe’s weak competitiveness is explained by the static industrial structure of the Eurozone, which Martin Wolf, a well-known commentator for the Financial Times, referred to as an “industrial museum.”
I’m not sure how familiar M. Draghi or M. Wolf are familiar with the Czech economy, but Draghi’s report seems almost tailor-made for Czechia and its economic problems. As is well known, Czechia is a very industrial country (the most industrial in the EU) and served the Austro-Hungarian Monarchy until its dissolution in 1918, then the Comecon during communism, and liberalized Europe after 1990. But even though it may not seem like it yet, as shown by low unemployment figures, rising incomes, and inflation control, the economy is suffering. The economy hasn’t grown for the past five years, which means family income growth will be threatened in the future, as will the current efforts to reduce national debt or finance social needs like healthcare, education, single mothers, not to mention the financing of the police or the army.
Czechia is a classic case of the problems the report discusses. The stagnation of the Czech economy is linked to its competitiveness issues, which, in turn, stem from a too-static industrial structure. This structure is completely dominated by the automotive sector, which represents around 22-24% of the total exports of Czechia. After Germany (31%), this is the second largest dominance of the automotive sector in exports in the entire EU. Automakers are and have been significant employers in both countries. The three largest investors in R&D (research and development) in the EU are automakers. This is certainly related to the restructuring of automakers in connection with the Green Deal, but it does not reflect the ability of other sectors to innovate convincingly and create new value.
The dominance of automobiles in exports strongly affects national income growth. This is due to Czechia’s high dependence on foreign trade and the openness of its economy to foreign investors. The share of employees engaged in foreign trade activities is a staggering 60%. In this respect, Czechia is the second most dependent country in the EU on foreign trade (after Luxembourg). The automotive industry is the main driver of exports in Czechia and, thus, the entire economy. Apart from automobiles, the only other “success” in exports seems to be the arms sector, responding to the explosion in demand for weapons due to conflicts in Ukraine and the Middle East. Otherwise, Czech structural development is rather haphazard, depending on the successful business activities of smaller companies, including startups.
What causes the unsatisfactory response from other industrial sectors? One factor is certainly the system of incentives operating in the Czech market. One such incentive is exchange rate policy, which is dominated by the Czech National Bank’s effort to control inflation, with part of this policy being to ensure a stable exchange rate. This policy is favorable to exporters because it reduces exchange rate risk, but it also leads to the appreciation of the real exchange rate due to different inflation rates in Czechia and the EU. This , in turn, hinders more dynamic export development, while imports crowd out domestic production. Higher inflation in Czechia than in the EU has also caused relatively higher interest rates, which, of course, further hamper the competitiveness of smaller industrial companies and startups.
Exchange rates and interest rates are under the control of the Czech National Bank, but the question is whether the revival of industrial production should be supported in Czechia by a more active industrial policy. However, the room for a more active policy in the areas of tax, subsidies, trade policy, and to some extent regulation is highly limited by our ties to EU industrial policy, which M. Draghi is calling to fundamentally reform. Most Czech industrial policy experts draw from the EU’s Industry 4.0 program (with small exceptions, e.g., MfDnes – Blamáž jménem Průmysl 4.0) and agree that “ To maintain the competitiveness of domestic companies, fundamental changes in the education system and support for investments that bring innovation, research, and added value are crucial)” (Source: https://www.penize.cz/svetova-ekonomika/326519-ocima-expertu-ctvrta-prumyslova-revoluce-co-nam-da-a-co-vezme). These “wise” suggestions sound great, but Czech governments have been attempting them for 30 years with poor results.
However, there is some room for domestic intervention. Better use of bankruptcy tools and the reallocation of inefficiently used resources to more dynamic companies would help, for example. Supporting startups and so-called unicorns—entities that emerge from growing small and medium-sized enterprises, whose growth is hindered by a lack of domestic resources—is also essential. This is a key difference between the rigidity of firms in the EU and the dynamism of development in the U.S., Israel, Taiwan, Vietnam, or China. This again relates to the weakness of the Czech capital market as well as the high fragmentation of European capital markets.
China has been pursuing its industrial policy for 20 years despite being a member of the WTO. The U.S. is also moving toward a more active industrial policy, which will strengthen if D. Trump wins the election, and M. Draghi is also calling for an active industrial policy. Successful examples of industrial policy include South Korea and, to some extent, Thailand and Vietnam. Australia and Canada are also more active and successful in this area. It is clear that Czech exporters cannot compete in the global market by touting the purity of the market environment, but must face fierce competition with their own competitiveness. We have only two choices—we can hope the EU convinces China and the U.S. to abandon their industrial policy interventions, or we must adapt and help our industry with more effective policies. The first option is utopian, and thus Draghi’s report is a welcome first attempt to prevent us from becoming an industrial museum.
Dr. Zdenek Drabek
Charles University, former advisor at the World Trade Organization and the World Bank
Prague, 4 October 2024