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Will There Be a Unified European Economy? International Production Networks, Foreign Direct Investment, and Trade in Eastern Europe

Berkeley Roundtable on the International Economy,

With additional support from the Copenhagen Business School, the UC Center for German and European Studies, and the Economic Development Institute of the World Bank

Vienna, Austria

June 5-6, 1997

Day One: Thursday June 5
Creating the Terms of Unification


Day Two: Friday June 6
The Industry Stories: Patterns of Production,Trade, and Investment In Eastern Europe

    Session I: Electronics, Autos, and Textiles

    Session II: Food Processing/Agriculture And Infrastructure

      Presenters

      1. Food Processing/Agriculture

          Timothy Josling — Professor of Agricultural Economics at Stanford University, Food Research Institute.
          Stefan Tangermann — Professor of Agricultural Economics at the University of Göttingen, and Vice-President, University of Göttingen.

      2. Energy

          Brian Kick – Consultant, Hagler Bailly Consulting, Inc.

      3. Commentators

          Gabriel Eichler — First Vice Chairman and CFO, Czech Power Company.
          Márton Szabó — Professor, Research and Information Institute for Agricultural Economics, Hungary.

      Background papers prepared for conference

      1. "Cross-Border Linkages in the Agricultural Sector", Tim Josling and Stefan Tangermann
      2. "The Electric Power Sector in Eastern Europe during the Transition", Dean White and Brian Kick

    Conclusion: Implications for Europe and Vienna



Introductory Briefing Paper

This project considers the industrial integration of Central/Eastern Europe into the broader European economy in light of the fundamental new phenomena emerging in the international market economy. International production networks (IPNs) consist of both traditional "internally managed" corporate networks and "cross national production networks" (CPNs). (For a full definition see the extended comment on production networks below.) Cross-national production networks have emerged as part of a reconstitution of competition and production best characterized as "Wintelism," visible especially in the cutting-edge electronics sector. The East Asian regional case is used in the background papers to illustrate how International Production Networks operate in practice. A central question is whether such production arrangements will become a significant element in the Eastern transition to a market economy, the reintegration of Europe, and the evolution of Europe's regional position in the "global" economy.

Day One: Thursday, June 5 Creating the Terms of Unification

Session I: Setting the Stage For International Production Networks: the Economic and Political Issues

Proposition I. International Production Networks and the Changing Terms of Global Competition

International Production Networks, part of an increasingly fine international division of labor and a significant shift in the terms of international industrial competition, will be a significant feature of the production integration (goods and services) of Central/Eastern Europe and the Former Soviet Union into a unified European Economy. Their significance has been greatest to date in the electronics production which has been the underpinning sector of Asian rapid growth. Consequently, the optic of Asian production networks provides a distinct perspective on the European transitions, reintegration, and production reorganization. Of course, European networks, reflecting specific European logics and conditions, will take a different character than Asian networks.

Proposition II. Production Networks and the Politics of Integration

International Production Networks have a political, not simply economic, significance. The new regional economic heterogeneity in Europe, created by the end of the cold war, opens new production and market possibilities. The heterogeneity of the Asian region has permitted firms to create a fine division of labor that integrates diverse and variegated national producers. IPNs can weave together a reality of shared economic possibility that may be required for any political strategy of EU extension or enlargement. Eastern Europe need not be a rival or a cost for the West, but rather part of a significant production reorganization that sustains growth and makes firms in the region as a whole more competitive. Cross-national production arrangements have the potential to turn Eastern European producers into complements to rather than rivals of Western producers, muting the conflicts resulting from, or amplified by, their economic disparities. (This issue will be discussed in papers for Session III.)

Proposition III. International Production Networks and Firm Strategies

Firms create and participate in International Production Networks in order to solve strategic and tactical problems they confront in the market. These networks therefore must be understood in terms of market competition. Of course, firms make choices in environments created by political and policy choices. We ask, evidently, which policy choices-West or East-will encourage and facilitate a competitive production reorganization.

To establish a consistent vocabulary to discuss these issues, we talk about firms making choices in a framework of incentives and constraints. Those frameworks are always created by political and policy choices.

  • We refer to the Western decisions about the rules of market access, investment, monetary ties, and the like as the "Western Parameters of Access to Finance, Technology and Markets", or the "Parameters" that will shape and contain the interplay of economic actors in East and West.
  • The Central/East European and Former Soviet Union countries are themselves making a set of fundamental decisions about the creation of market systems of property, money and price-driven dynamics as well as about macro policies, exchange rate policies and investment policies. The politics and policies for the transition/transformation are generating implicit development strategies. The collection of these sometimes intentional, and probably more often unintentional, Eastern decisions should be labeled as "Implicit Development Strategies" of the emerging market economies as they integrate into the Western market system. Those "Implicit Development Strategies" will set distinctive options and constraints on the firm operating in particular countries, and give their particular emerging markets a particular logic.

An Elaboration of Proposition I: A Note on International Production Networks

International production networks consist of both traditional internally managed international corporate production networks and "cross national production networks, which is a label we apply to the dis-integration of the industry's value chain into constituent functions that can be contracted out to independent producers wherever those companies are located in the global economy. IPNs, and CPNs in particular, permit and result from an increasingly fine division of labor. The networks permit firms to weave together the constituent elements of the value-chain into competitively effective new production systems, while facilitating diverse points of innovation. But perhaps most important, CPNs have turned large segments of complex manufacturing into a commodity available in the market. The networks emerged in a series of overlapping steps.

  • Outward processing, Branch Plant Production
  • Contract Factories and OEM (Original Equipment Manufacturing)
  • Cross-National Production Networks (These networks involve the reweaving of the varied individual activities into entire production systems that exploit local specializations throughout the region. Those networks were initially organized by MNCs.)
  • Turnkey Production Network Services: (Production network intermediaries such as Solectron arise who can manage the entire manufacturing network for a customer by providing turnkey production networks.)

Trade data and foreign direct investment data can provide clues about the extent and nature of these networks, but by themselves they cannot reveal their significance.

The expanding importance of IPNs, particularly in the form of CPNs, reflect fundamental changes in the terms of international industrial competition affecting corporate strategy and production organization in all regions and across an increasingly broad range of industrial sectors. As a code word for those changes, we have adopted a blending of Intel and Windows, "Wintelism" to reflect the shift in competition away from final assembly and vertical control of markets by final assemblers. The character or terms of competition in the "Wintelist" era, by contrast, is a struggle over setting and evolving de facto product standards in the market, with market power lodged anywhere in the value-chain, including product architectures, components, and software. Those constituent system elements-from components and subsystems through operating and applications software-become separate and critical competitive markets. Wintelism is not just a story of the ineluctable competitive elaboration of the interior logic of new technology. Rather, this particular thread has been spun out principally by American firms responding to international competition within the confines and logic of the American market and its particularly defined political rules.

"Wintelism" and International Production Networks are altering the terms of competition in many global markets and shifting the structure of many industries. They have emerged most evidently and powerfully in Asia as a result of the character of US-Japanese competition in electronics and the entrenched heterogeneity of the Asian region with its diverse economies and political rivalries. (Post-war development and politics in Europe has by contrast driven toward regional homogeneity.) It may take the jolt of looking through an East Asian lens to see the possibilities implicit in the new production strategies, and the cross national production strategies that both implement and permit them, because European producers have not been major players in Asia and have not extensively implemented such contract manufacturing and key in hand production networks we observe elsewhere. IPNs in Europe will certainly reflect the particulars of the European situation and may not look precisely like their counterparts in Asia. Even within Asia the networks of different firms, from different national home bases, vary (i.e. Japanese and American networks have a different structure). Significant features of the European circumstance include substantial but mis-oriented industrial growth in parts of Eastern Europe that requires structural adjustment not just development; the decomposition of the administrative structures of the formerly Communist States; the "Big Bang" strategies of economic transition rooted in ideologies of free trade as compared to a multiplicity of explicit national development strategies in Asia that range from state-led efforts at autonomous technology development to Third Tier state strategies of insertion into production networks; land-based transport in Europe requiring extensive investment in rail and road compared to water-based, intra-regional transport in Asia requiring port-based investment not dependent for its success on the actions of neighbors.

BRIE Background Papers:

  1. "Tales from the Global Economy" John Zysman, Eileen Doherty, Andrew Schwartz
  2. "Wintelism and the Changing Terms of Global Competition:Prototype of the Future?" Michael Borrus and John Zysman
  3. "Riches and Rivalry: Production Networks and the Industrial Integration of Asia" Michael Borrus
  4. "Flows, Nodes, and Networks" Steve Cohen and Matthew Zook
  5. "Why The Changed Relation Between Security and Economics Will Alter the Character of the European Union" Steve Weber and John Zysman

Session II: What Does the Aggregate Data Tell Us About Patterns of Production Between East and West?

Issue I . The Reorientation of Eastern European Trade and Industry

There have been dramatic changes in the extent and direction of trade by the countries of Central/Eastern Europe and the Former Soviet Union. There is great uncertainty about the longer term characteristics of East-West economic integration. Much of the final form of production will depend upon the extent, speed and nature of catching-up processes for the CEE economies. The shifts amount to creating comparative advantage in the now "global" market economy with resources developed in the era of a Soviet-dominated command economy in which political decision set lines of industrial development. Now firms must find competitive position, and countries their comparative advantage, within Western markets. This, evidently, forces very substantial industrial adjustment and a reorientation of markets. These market adaptations must happen even as existing "production units" transform into "firms", new entrepreneurial enterprises are founded, and the very institutions of a market economy and mechanisms of market regulation are established.

Issue II . Might International Production Networks Emerge to Link Linking East and West in Europe?

Evidence of several kinds (traditional aggregate trade data, highly disaggregated data using a structural-evolutionist approach, and industrial organization data and case analysis) suggests that at least some Eastern production is being woven into Western company supply chains as part of a reorganization of the European division of labor. The conditions for the creation of IPNs are very different in Europe than in Asia. There are substantial economic disparities among countries in the new Europe, but certainly they are narrower in Europe than in Asia. Moreover, many of the Eastern countries are at least partly industrial and developed, whereas the Third Tier Asian countries could not base their strategy on a legacy of previous production, no matter how out-moded.

There is great variety in the patterns of Eastern entanglement with Western producers. There are differences between the more advanced countries most proximate to Western Europe and the others, and there are substantial differences as well as within each set. Similarly, there are diverse patterns of Western involvement in Eastern production with, for now, principally German firms and to a lesser extent Italian firms, strategically involving the East in production reorganization. The real debate is about the extent and significance of that reorganization and the possibilities for continued development that it represents.

Issue III . What Form Might Networks Take?

It is still too soon to estimate the form IPNs will take in Europe. Papers for this session consider the place in the production reorganization of FDI, OPT, contract manufacturing, and CPNs. Firms organize networks in Europe both to reorganize production to more competitively supply Western Europe and by efforts to meet Eastern consumer demand. The supply networks divide into two sets: least cost efforts to utilize cheap labor and complementary production to utilize low cost engineering and technical skills.

The evidence from Asia is clear about two matters. First, the national home base, and hence the strategies, of the firms organizing the networks powerfully influence the character of the networks that do emerge. Consequently we should expect quite a variety of arrangements in Europe. Second, the capacity of firms to establish enduring market advantage and to sustain their growth through product and process innovation rested in substantial measure on public investments in human capital and infrastructure as well as on public strategies for trade and industry. Many of the Asian trade and industry strategies are rejected by Eastern Europe, but the investments in infrastructure and the social capacity for sustained technological development are likely to be crucial.

Background Papers:

  1. "The New Role of Eastern Europe in the Industrial Division of Labor" Volker Wittke and Constance Kurz
  2. "East-West Integration: Vertical Product Differentiation, Wage and Productivity Hierarchies" Michael Landesmann
  3. "Trade Patterns, FDI, and the Industrial Restructuring of Central/Eastern Europe" Paolo Guerrieri
  4. "Integrating Central/Eastern Europe in the European Trade and Production Networks" Françoise Lemoine
  5. "Outward Processing Traffic" Julie Pellegrin

Session III: Creating the Terms of Unification: How Are Western Choices Shaping Eastern Possibilities?

Issue I . The Ambiguous Future of European Relationships

The terms on which firms located to the East will participate in West European markets are ambiguous because the terms of EU expansion toward the East are unclear. Despite commitments in words, and often evident benefits from the involvement of the Eastern Economies with the West, negotiating terms and conditions of participation is difficult. The actual monetary costs for Western Europe of integrating Eastern Europe are argued to be low, but the political costs are another matter. In several countries the domestic political costs of adjustment are high, and in any case European decision-making may be extremely complicated.

Issue II . The Changed Relation Between Economy and Security Create Contradictions in Policy Approaches to the East

Enlargement of the EU is being asked to serve two potentially contradictory purposes: create firm political attachments for many of the Eastern countries to Western Europe and create the economic conditions for sustained growth for Europe as a whole. However, the terms of full membership represent policy conditions that may blunt the costs and the advantages for the Eastern economies-advantages they require during this period of transition and transformation. That contradiction in policy is rooted in the changed relationship of economy and security.

Issue III . How Will European Choices Matter to the Course of Eastern Development?

These ambiguities and contradictions in European policy are of great significance to the East. Helping establish the conditions for stable, politically enduring market rules may prove to be the critical contribution the West can make. Since formal trade barriers are increasingly limited and capital markets are increasingly developed, there is a view that Western government choices about trade and investment will only marginally influence the trajectories of Eastern development.

Issue IV . Is There A Model of Development or Transition That Can Guide Europe in Its Decision-Making?

There are no real analogies to Eastern adaptation and transition from which simple policy lessons can be drawn. Certainly, the experience of First and Second Tier Asian countries (Japan, Korea, and Taiwan) with heavy state intervention and promotion coupled with trade protection has little relevance to the Eastern group. Neither a substantial state domestic role nor a protectionist developmental strategy is possible. A better analogy would be either the Iberian story or the story of Third Tier Asian development, where countries chose to integrate themselves into the world of the advanced economies, rather than isolate themselves. In the case of Iberia, the choice to enter the EU was essentially a decision to adopt the rules and market conditions of the advanced country, to adopt the goal of converging toward a homogeneous European economy. In the conditions of rivalry and tension between political and security issues, Third Tier Asian countries retained national policy autonomy. Companies, however, were encouraged to insert themselves into Western supply networks.

Background Papers:

  1. "Variable Geometry in Europe: Implications for External Relations" Jean Pisani-Ferry
  2. "The Impact of Western Europe on the Transition in Eastern Europe: A Trade and Institutions Perspective" Barry Eichengreen and Richard Kohl
  3. "Coming to Terms with a Larger Europe: Options for Economic Integration" Helen Wallace

Session IV: Implicit Development Strategies in Eastern Europe: How Will the New Market Institutions Affect Business Relations Between East and West?

Issue I . Will Eastern Roads to Development Involve International Production Networks?

Involvement of Eastern firms or subsidiaries in IPNs may take many forms-from subcontracting of particular tasks through contract manufacturing, or FDI to establish major production subsidiaries. First, the participation of local firms in the different Eastern countries will depend not only on the skill-level of the workforce and the capital resources, but on the capacity of firms for flexible entrepreneurial action and on-time, quality production. Third, the capacity to upgrade an initial participation in CPNs to more sophisticated or higher value-added constituent elements can depend on public investment in people (human capital) and infra-structure (telecommunications, energy).

Issue II . Will Different "Implicit" Development Strategies Generate Different Patterns of Involvement In Production Networks?

The Eastern countries share the experience of shifting from a planned state socialist system to forms of market economy in which the economic decisions are made against a struggle to overcome socialism and in order to secure a position in the West. The particular national choices have centered around the sequencing and character of liberalization, stabilization, and privatization-the transition/transformation strategies which generate "implicit" development strategies. Those nationally specific choices have generated different mixes of firms and engagements with Western producers.

Issue III . The Russian Question: Will the Initial Limited Eastern Involvement in International Production Networks Grow and Spread?

In Asia, the significance of IPNs in industrial reorganization has grown steadily. A seemingly continuous stream of new entrants into the regional economy and the efforts of firms, often supported by their governments, to move up to higher value-added positions within the networks has fueled the process. Indeed, not only have American and Japanese firms generated IPNs, but firms from Tier Two countries such as Korea and Taiwan have also generated their own production networks. In exploring the European parallel, one question is whether producers-whether indigenous producers, joint ventures, or foreign subsidiaries-located in the more advanced Eastern countries will eventually create their own networks to facilitate their own position in global markets?

The reform movement in China virtually guarantees an unlimited supply of low wage firms continuously entering the market-thus creating a constant upward pressure on the market position of earlier entrants. The establishment of the Enterprise Zones and later the broader commitment to market reforms has drawn foreign direct investment into China and drawn enterprises in China (joint ventures, state owned operations, town and village enterprises, and operations created by mainland money round-tripping to Hong Kong) into these International Production Networks. (Indeed countries such as Korea find themselves squeezed between wage pressure from Asian Third Tier competitors and the technological position of their advanced country competitors.)

Russia is the clear European analog to China in Asia. The critical question for Europe as a whole is the place of European Russia in the production reorganization. However, the evidence is clear that networks aimed at mutual support in a game of extracting rents, rather than entrepreneurial networks creating wealth, predominate. The capacity to scale-up European wide production networks and make them a pervasive and significant feature of the European economy may turn not just on the most advanced western and proximate countries, but on Russia. But unlike the measured reforms of China, a strategy of "crossing the river by groping for stones", the Russian story of eliminating the old without replacing it with new structures generates a struggle for survival that diminishes the potential and ability for entrepreneurial activity.

Background Papers:

  1. "The Limitations of East European Institutions on East/West Investment Linkages" Ellen Comisso
  2. "Variation in Property Rights and Foreign Direct Investment in Central/Eastern Europe" Andrew Schwartz
  3. "Russia's Development and Europe's Future" Manuel Castells
  4. "Regional and Sectoral Structures in the Transition" Peter Huber and Andreas Wörgötter
  5. "The Baltics: Outlier or Fertile Ground for Production Reorganization?" Niels Mygind

Day Two: Friday June 6 The Industry Stories: Patterns of Production, Trade, and Investment in Eastern Europe?

Aggregate data can provide clues and suggestions. However, industry cases are required to assess the place of International Production Networks and Foreign Direct Investment in the integration of Eastern Europe into a unified European market. If IPNs are part of corporate adaptation and industrial readjustment, the evidence will first appear in corporate strategies and only slowly in more aggregate data. For example, in the American electronics industry the emergence of CPNs began as a series of ad hoc tentative tactical moves that blossomed into a self-conscious strategic approach to production and competition. Europe is certainly in an early tentative phase.

An analysis of IPNs, CPNs, and FDI in European industrial adaptation must ask what role these tactics play in corporate production and strategy. Are there suggestions from the stories of market competition that suggest that the winners are using these tools in distinctive ways to create advantage or alter the character of competition? Or, alternately, as was the case in the early use of off-shore production by American companies who could not understand the growing evidence of Japanese production innovation, does the lure of cheap labor lock-in outmoded production or market approaches and blind firms to significant available innovations?

International production networks in Europe will have distinctive features, and consequently the Asian experience is only a suggestion of their significance, not a model of their final form. For example, while electronics were critical in the Asian story, autos are only now emerging as a significant part of the pattern of trade and investment. In Europe, almost certainly, that pattern will be reversed. In East Asia there were two primary network creators: Japanese and American firms. In Europe there will be a larger and more diverse range of participants. The range will include both a diversity of European firms from quite different national economies, the Americans, the Japanese, and the Koreans. East European investments are often already a means of entry into the West European markets by Korean and weaker Japanese firms.

Issue I . Networks and the Competitive Position of Europe

Cross National Production networks are much more extensively developed in Asia and amongst American firms than in Europe. Is the absence of these networks and an understanding of their possibilities a competitive disadvantage for European companies? Is the absence a reflection of significant weakness by electronics firms of European origin? Does it reflect differences in corporate strategy or constraints of labor market policy?

Issue II . The automobile sector as the driver of networks.

Will automobiles be the sector in which IPNs linking West and East Europe begin to demonstrate their significance? What do we make of the varied corporate strategies and company positions in the auto sector? Fiat is well positioned in the Polish market, while Daewoo would use Poland, and an Asian styled production network in Eastern Europe, as a means of entering West European markets. Suzuki is trying to use Hungarian parts production as a means of entering European markets. The Czechs have begun to be positioned as producers in an MNC network of cars slotted for the lower end of the market.

Issue III . Labor Costs and Textiles.

Some believe that labor cost is the entire story in the case of textile networks, but that transferring elements of production to the East will serve to keep production and design in Europe that might otherwise have migrated to Asia. This would then permit increasing FDI to facilitate an "upgrading" for East European firms in the clothing sector. Others believe that in an Eastern Europe that is bifurcated between a mis-developed but industrial set of countries and a set of essentially developing economies, textiles will reinforce that regional division rather than, as it did in Asia, serving as a first rung on the ladder of development.

Issue IV . Agriculture: Where does Advantage Lie?

Given the traditional political importance of agriculture in the European Union and its constituent nations, the competitive position of East European agriculture is critical both for market and political dynamics. Is agriculture a separate and distinct case bounded by distinct political rules, if not distinct market logics, or is it likely to become another sector linked by investment, equipment trade, and cross-national production networks? Does Eastern agriculture represent a threat to established producers in the West? Certainly, a complex pattern of intra-industry trade is likely to emerge with the West shipping production equipment, such as Danish pig farming systems, to the East. The question is where the Eastern comparative advantage within the agricultural sector will lie. But comparative advantage aside, the market position of the East in agriculture almost certainly cannot be understood without reference to the Common Agricultural Policy and the varied lines of proposed reform.

Issue V . European Policy and the Patterns Of Industrial Development

Will European policy have significant effects on the patterns of development in these sectors? In the textiles case, for example, OPT quotas have affected Western (and by extension, Eastern) firm strategy significantly - in some cases encouraging OPT arrangements, but in other cases discouraging firms from certain countries (like Italy) from being able to take full advantage of OPT strategies. Certainly, OPT as a tariff system for the CEECs is supposed to disappear in 1998, when the last tariffs on non-OPT imports will disappear. One question in this textile case will be whether, when OPT regulations are "liberalized", firm strategies nevertheless continue to be affected by past rules that seemed to reinforce a first-mover advantage for some. Another is, will there be similar policy issues affecting the character of the networks in the other industrial sectors?

Background Papers:

  1. "The Electronics Sector in Eastern Europe" Tim Sturgeon
  2. "European Cross National Production Networks in the Auto Industry: How Eastern Europe is Becoming the Low End of European Car Complexes" Rob Van Tulder and Winfried Ruigrok
  3. "Globalisation of Production in the Textile and Clothing Sector: The Case of Italian FDI and Outward Processing in Eastern Europe" Giovanni Graziani
  4. "Cross-Border Linkages in the Agricultural Sector" Tim Josling and Stefan Tangermann
  5. "The Electric Power Sector in Eastern Europe during the Transition" Brian Kick and Dean White

 

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