Middle-Income Trap? Looking for New Paths to Economic Growth

The main engine for the Central Eastern European (CEE) economies is foreign investment, attracted by cheap labor. Are rising wages leading to a loss of competitiveness, and, if so, how should the economic development model adapt to this new reality?

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Middle-income trap and rising wages can be a challenge for CEE develompent
Many economists believe CEE countries will have to shift their economic profiles away from cheap labor and instead focus on higher productivity and technological competence. Photo: iStock.com / Skynesher

The countries of Central and Eastern Europe (CEE) have developed the fastest in terms of economic growth in the European Union since the beginning of the broader expansion of the European Community. An evolution that is, in fact, normal because, naturally, the former communist countries had much more room for growth.

For the last 20-30 years, foreign investors have courted these countries, attracted by low labor costs and friendly taxation. However, economists believe that this economic growth model is about to be exhausted. Consequently, Central and Eastern European countries will need to find a new economic growth model.

Middle-income trap

One of the concerns is the so-called “middle-income trap.” This “trap” means that as wages rise in a country, it becomes less attractive for foreign investment. The most vulnerable are the countries of the Three Seas Initiative, most of which have traditionally based their economic growth on foreign investment.

Now that the main attraction – low wages – is disappearing, countries need to find a new way to be competitive based on added value. This can also be an opportunity because as the economy develops and moves to more and more skilled and well-paid jobs, it rises in the hierarchy of global value chains.

A joint study by The Vienna Institute for International Economic Studies (wiiw) and Friedrich Ebert Stiftung Foundation found that “various indicators suggest that the successful catching-up process of the Central Eastern European ‘factory economies’ will come under considerable pressure in the coming decade. Raising environmental requirements, especially concerning climate protection, a profound technological change in the automotive sector, digitalization of production and logistics processes, and changing demographics threaten to undermine the basis of the region’s economic model.”

Thus, economists believe CEE countries will have to change their economic profiles away from cheap labor and instead focus on higher productivity and technological competence. Eurostat data shows that the countries within the Three Seas Initiative still have lower labor costs than the European Union average, with Austria as the exception.

Wages in CEE – the trap of growth?

However, these same countries have recorded the largest cost increases, with Bulgaria, Lithuania, and Romania doubling between 2012 and 2021. By comparison, labor costs in Belgium increased by less than 10% in Germany by 22% over the same period. Average European labor costs increased by 20% in the period from 2012 to 2021, according to the Labor Cost Index (LCI).

Do Three Seas Initiative countries still have room for growth based on low labor costs? Or have costs increased to the point that these countries need to reposition themselves in the value chain and leave production in cheaper countries in terms of labor? For example, Eurostat data for 2021 shows that Bulgaria is still competitive with the lowest labor cost in the EU (24% of the European average). On the other hand, Austria cannot be considered a low-cost labor country, with labor costs 29% higher than the European average.

In conclusion, although it is the fastest in the European Union, economic growth in Central and Eastern Europe has its limits. Market growth is limited, and companies in this region face a shortage of labor. Thus, emphasis on skilled labor specialization needs to increase, requiring significant investments in education and IT&C infrastructure. CEE countries also need to position themselves correctly in front of environmental challenges.

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