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Welcome To The New Frontier

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With its cobblestone streets and arched Renaissance galleries, the medieval city of Kraków has long been Poland’s most popular tourist attraction. But the biggest local crowds these days are flocking to monuments with a much shorter history, such as the very 21st century M1 shopping mall near the decrepit, socialist-era Nowa Huta steel mill on the outskirts of town. The M1’s architectural splendor consists mainly of faux Greek columns, cloud murals and a scattering of disconcertingly lifelike stuffed pigeons. Even so, the mall drew more than 6 million visitors last year. Some of them were lured by free entertainment — a concert by the Polish rock band Perfect; a runway saunter by Miss Poland, Karolina Gorazda, that was broadcast live on mtv Polska. But most come to shop ’til they drop at M1’s 90 stores, which sell everything from Yves Rocher cosmetics to oscypek, a traditional Polish smoked cheese.

For Europe’s retailers, Kraków is the new frontier. M1, built by Germany’s Metro Group, is one of eight massive shopping centers that have sprung up in this ancient capital in recent years, including two Tescos (British), two Carrefours (French) and several other big German stores. In all, Kraków is now home to some 20 hypermarkets, giving it one of the highest per-capita concentrations of megastores anywhere in Europe. And it’s not over yet. Despite a moribund economy, two more hypermarkets are planned in the next two years. “The competition is horrific,” says Kevin Doherty, president of Tesco Polska, which is headquartered in Kraków. “If you don’t win in Poland, you can’t win in Europe.”

Kraków’s retail onslaught is mirrored in towns and cities across Central and Eastern Europe, as Western firms tap into emerging markets in the E.U.’s 10 new member states. German publishers have bought up many of the leading Polish magazines and newspapers; virtually all the world’s auto manufacturers have set up plants across the region; and last week two French companies opened a customer-service center in Prague to help Air France passengers worldwide find lost luggage. There will be no economic “big bang” on May 1 when the new members join. The most significant changes — the lifting of most tariffs, introducing free market competition and harmonizing national legislation with E.U. norms — have been phased in over the past decade. But Kraków’s retail free-for-all is a harbinger of things to come in the rest of the economy.

Most forecasters predict that E.U. accession will give a healthy boost to the region’s economies over the medium term, propelling trade and accelerating productivity and investment. The consulting firm McKinsey & Co. estimates that joining the E.U. could add 1% to 1.8% to the annual growth rates of new members. If that’s sustained, countries like the Czech Republic could match the per-capita gross domestic product (gdp) of countries such as Greece and Portugal within 15 years. But to get there, the region must continue opening up key sectors of its economy to international competition. And unlike the Spaniards, Portuguese and Greeks before them, these new members won’t have the benefit of lavish subsidies from the E.U. to help cushion the blow. Many workers may lose their jobs temporarily as overstaffed or undercapitalized domestic firms go out of business, although in the longer term a more efficient economy should mean more stable employment.

Still, Central and East Europeans and residents of the Baltic states are already much better off on average than they were a decade ago, as the shopping-mall mania shows. Per-capita gdp has risen by more than 50% in most of the countries, and has about doubled in the smallest ones such as Estonia and Lithuania. The bad news is, spending has been rising too fast in some places, especially Poland, Hungary and the Czech Republic. Wage increases have outstripped productivity, household debt and government budget deficits are soaring and, in some places, economic-reform efforts appear to have stalled. “After years of hardship, people feel it’s time for jam today, and that’s understandable. But they’ll be hit by the full blast of E.U. competition,” warns Willem Buiter, chief economist at the European Bank for Reconstruction and Development (ebrd) in London. “I strongly urge them to get their noses back to the grindstone.”

Many small firms will be ground out of business as the foreign-owned giants arrive. Last month a motion to reduce shopping hours at stores of over 300 sq m on Saturdays and ban it altogether on Sundays was narrowly defeated in the Kraków city council, though its sponsors say they will now try to take it to the National Assembly. The effort was spearheaded by the city’s Merchants Guild, an organization of 2,000 members that has existed without interruption since 1410. “There are too many [hypermarkets],” argues Wojciech Wojtowicz, 45, guild president and a small-shop owner. “We agree with a free market, but this is a free market without regulation.” He says the city has lost almost 3,000 shops in the past two years alone, out of a total of about 20,000. “This process is inevitable, but it’s happening too fast.” Dariusz Rudzinski, manager of the M1 mall, takes a different view. “It’s not a fight between small shops and big shops,” he says. “It’s a fight between bad shops and good shops. Plenty of big shops are losing too,” because they are badly run and don’t cater to customer needs.

The debate in Kraków reflects a broader suspicion among many Poles that E.U. membership isn’t all it’s cracked up to be. It doesn’t help that unemployment is high in most of the region. Poverty is also rife, especially among the elderly. But foreign investors are still bullish. Over the past decade, some $75 billion has flowed into Hungary, Poland, the Czech Republic and Slovakia, which together account for as much as 90% of direct foreign investment into Eastern and Central Europe. Some of the companies that invested in the region in the 1990s, including automakers Volkswagen and Daimler-Benz, did so to establish a low-cost manufacturing base to meet West European demand. Others took a bet on local markets that is now starting to pay off. The Swiss food company Nestlé, for example, acquired a cluster of local brands, including the Polish soup and sauce company Winiary. It revamped the factories and now has total annual sales of about $1 billion in Eastern Europe.

The flood of foreign direct investment has slowed, but some of the most recent cash has come from U.S. and West European companies setting up service operations. They include General Electric, which initially came to Hungary to manufacture light bulbs and now has a European back- office and IT support center there; and DHL, which last year announced plans to shift its IT operations from Britain and Switzerland to Prague. Economists say it’s critical for the East Europeans to keep such investments coming, and not price themselves out of the market, which explains concerns about rising wages and reckless spending.

Hungary is one of the worst offenders. Since 2000, Hungarian household consumption has soared by more than 30%, fueled by the greater availability of consumer credit, rising private-sector wages, and, in 2002, a whopping 50% increase in public-sector wages. The number of new cars sold in Hungary almost doubled between 2000 and 2003. Although the Hungarian National Bank expects household consumption growth to slow to 3% this year, it may accelerate again as a result of Hungary’s E.U. membership. “If you think the future is bright, it’s better to become indebted,” says István Hamecz, the Hungarian National Bank’s managing director. To brake the consumption boom, the bank has repeatedly raised interest rates, currently at 12.25%. It has also tried to persuade the government to moderate its fiscal outlays and cut its deficit, which reached about 6% of gdp in 2003, double the level in sickly Germany. The story is similar in the Czech Republic, where household credit has tripled since 1998. Today, Czechs buy not only their TVs and cars but also their vacations on credit.

One exception is Slovakia, which began introducing serious economic reform relatively late, only after the fall of the authoritarian and fiscally reckless Vladimír Meciar government in 1998. Wages have been rising in Slovakia as well, but they remain about 20% lower than in Hungary. The government has cut taxes for corporations and individuals to a flat 19% rate, and has aggressively courted foreign firms. That’s paying off. Among other deals, Slovakia recently won a hotly contested competition for a $1.4 billion European production center for Kia Motors that will produce up to 300,000 small and mid-sized vehicles.

Manufacturing wages in the accession countries are about one-seventh of the E.U. average, but productivity is only about half as much. According to McKinsey, the ratio of labor cost to productivity — the total wages needed to produce one unit of output — ranges from about 30% of the E.U. average in Hungary to about 80% in Slovenia. Still, the increase in wages troubles manufacturers who rely on cheap labor to produce everything from TV sets to automobiles, particularly when coupled with economic stagnation in Western Europe, which takes about 75% of the region’s production.

“It’s not a good message to investors,” says Péter Spányik, ceo of the Hungarian Investment and Trade Development Agency. Still, he adds, “Hungary’s future doesn’t lie in relying on a cheap labor force. Even Slovakia and the Czech Republic can’t compete with Vietnam or China, with their $1.50-per-day salaries. You can’t maintain a cheap labor force for long if you liberalize the economy.” Indeed, many firms in the region are already starting to outsource jobs to even cheaper labor markets further east (see box).

So where does the future lie? Perhaps with companies like Delta Pekárny, a Czech food processor with sales of $140 million and bakeries in the Czech Republic, Hungary, Poland and Slovakia. Starting on May 1, when customs restrictions will be eased, Marko Parík, the general director, sees new prospects for freshly baked products in neighboring Germany and Austria — prospects that have so far been impossible to exploit due to administrative obstacles and long waits at the border. Parík’s managers have been learning English, and his truck drivers have been taking German lessons. He set up a subsidiary in Nuremberg to give Delta Pekárny the cachet of a German manufacturer. “We see this as a huge opportunity,” he says.

It remains to be seen whether Germans will snap up Czech bread as willingly as Czechs, Hungarians and Poles hang out at German-built malls in their own countries. Back at the M1 in Kraków, a stall selling pierogi, lazanki and other Polish specialties does a brisk business across the aisle from a McDonald’s festooned with ads for its McKielbasa burger. Teens hang out sipping beer through a straw to strains of Pink Floyd’s Another Brick in the Wall. Attendants on rollerblades scoop up empty baskets. “If the economy was humming like it was five years ago, it would be brilliant,” says manager Rudzinski. Still, it’s a sign of how good times are that 100% of the space is leased and the company is considering adding another 5,000 sq m to the current 42,500. “In Western Europe, it took two generations to make the leap from small retail shops to the shopping mall,” says Wojciech Sokól, a Kraków native and head of corporate affairs at Tesco Polska. “Here we’ve done it in just over a decade.” There’s no doubt that the E.U.’s newest members have made a great leap forward; now all they have to do is land on their feet.

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