Industrial upgrading in Western Balkans and policy implications

1. Industrial upgrading in Western Balkans and policy implications Prof. Slavo Radosevic Keynote remarks The Impact of Economic Crisis in Western Balkans: Implications for Politics, Innovation and Change EBRD, Roundtable discussion, Friday 12th February 2010

2. Outline • Western Balkans: a brief recap of recent and not so recent history • Industrial upgrading: production and innovation capability and foreign levers to growth • Policy lessons

3. Western Balkans: a brief recap of recent and past history • After 1989: the SEE/WB has become a new European periphery • Lesson from history: the growth of periphery is inextricably linked to its international economic integration (Berend and Ranki, 1982). • Catch up with the EU core = f (the relative roles of exogenous and endogenous forces * the nature of their interaction) • The direct economic ‘pull’ of the old EU through finance,FDI and intra-industry trade > < the domestic forces (national system of political economy) which enable the external influences to have spin off effects • My lenses today: industrial upgrading

4. Motivation • A big income gap should enable mixing up of different ‘production functions’ or integration to the EU through increasingly fragmented industrial networks and value chains. Why we do not see it happening? • What hinders exploitation of productive potential which should emerge from the big income differences between EU15/WeBa? • Why WeBa is not location to low cost export oriented FDI to EU15?

5. WeBa countries: basic factors and their efficient use as drivers of growth Source: WEF (2007)

6. Industrial upgrading: how to move up along value chain? • Cost vs. quality vs. technology based competition • Requirements for technology based competition • competition based on product/process innovation • sophisticated demand • user requirements • certificates and standards • marketing barriers (brand) • after sale services and warranty • IPRs • affordable access of NTBFs to technical infrastructure • available finance to upscale production • For the time being, upgrading in WeBa is about production not innovation capability

7. An example of B&H in a comparative perspective • A recap of the recent history: From relatively developed industry R&D oriented RTD system towards decimated and dominantly HES oriented research system (see next two slides) • There is not alternative magic route but back towards enterprise based RTD system

8. Shares in GERD of CEE - 10 (NMS) performed by different sectors (based on averages)….. a huge structural gap of B&H BES R&D B&H ?

9. Decimated research system of B&H Radosevic, S. South Eastern Europe, UNESCO World Science Report 2010, Paris (forthcoming)

10. Collaboration paradox of laggards: science systems which are highly dependent on foreigners Source : data from Thomson Reuters (Scientific) Inc. Web of Science

11. There is not world frontier technology effort coming from WeBa

12. B&H: What is use of R&D at $4,625 pc (IMF 2008) (B&H GDPpc) ? • A limited direct role of R&D to contribute to economic growth at this income level • Absorption and diffusion of new technology is the key driver of growth; RTD as an important precondition to absorb and diffuse • R&D as a proxy for absorptive capacity as ‘R&D not only generates new information, but also enhances the firm's ability to assimilate and exploit existing information’ (Cohen and Levinthal, 1989).

13. Different institutional profiles of R&D systems ….

14. Institutional structure of funding and performing R&D in WeBa: Government and HES SEE dominated systems

15. BES dominated R&D systems are feature of countries above $15Kpc

16. An indirect R&D content dominates in the EU 10 CEE:Percentage share of total R&D content in the manufacturing of ICT equipment Source: Knell M. (2008), Embodied technology diffusion and intersectoral linkages in Europe. Europe Innova Sectoral Innovation Watch deliverable WP4. European Commission, Brussels.

17. Direct and indirect R&D content: policy implications • A majority of the NMS and all WeBa are technology users and have a high indirect technology intensity • Non-EIS pattern of technology upgrading: • -> low overall technology intensity -> high indirect technology intensity -> average direct and indirect technology intensity -> high direct technology intensity • Policy implication: integrate FDI / technology transfer into innovation policy (increase R&D but in interaction with imported and indirect domestic R&D (embodied in capital goods and inputs)

18. Production capability as driver of productivity; the inefficiency of NIS in EE • Production capability and R&D as drivers of productivity (see next two slides) • Given their levels of R&D, innovation and quality related activities (ISO9000), EBRD economies have lower levels of GNI per capita compared to the ROW. • The models that include sub-regional dummies (11 and 12) show improved explanatory power confirming that inefficiency of the NSI characterizes all EBRD sub-regions • EBRD countries sample: ISO certification as a proxy for production capability significantly contributes to explaining the differences in productivity. In a catching up context, R&D denotes absorptive rather than innovative capability

19. The dependent variable in all the regressions is gross national income (GNI) per capita. Method of estimation: panel data model with fixed effects (Model 7-10) and step-wise OLS (Model 11 – a reestimation of Model 8 with dummies, and Model 12 - a reestimation of Model 10 with dummies) with fixed effects for years (year dummies are not reported in the final presentation or results) and groups of EE countries Source: Kravtsova and Radosevic (2010)

20. Note: Dependent variable in all regressions: GNI per capita. Method of estimation: panel data model with fixed effects {Model 7-10} and step-wise OLS in Model 11 {reestimation of Model 8 with dummies} and Model 12 {reestimation of Model 10 with dummies} with fixed effects for years {dummies for years are not reported in the final presentation} and groups of EE countries Source: Kravtsova and Radosevic (2010)

21. A shift from production to innovation capability is not automatic and linear process • S and D factors for RTD are driven by different forces (cf. notsignificant correlation between aggregates) • Not significant correlation between firm level technology absorption and company spending on RD across countries* + not significant link between firm level technology absorption and capacity for innovation > significant difference between innovation capacity and production capability/absorptive capacity. • Innovation variables (capacity for innovation and company spending on RTD ) are strongly and significantly correlated toexternal RTD factors (local specialised research and training, quality of scientific research institutes and to demand) and to demand factors (customer orientation, buyer sophistication). • *For very similar result see EBRD TR 2009, p. 102: there is not link between management practises and either % of innovative sales or R&D spending (cf. not, this is not measurement error) Source: Radosevic, S (2009) ‘Research And Development and Competitiveness, and European Integration of South Eastern Europe’, Euro-Asia Studies, June 2009, Vol. 61, No. 4, June

23. Assessment of demand and supply for local R&D in SEE - Supply of RTD is still above demand for RTD Source: Radosevic, S (2009) ‘Research And Development and Competitiveness, and European Integration of South Eastern Europe’, Euro-Asia Studies, June 2009, Vol. 61, No. 4, June

24. Supply Quality of education Quality of math and science teaching Local availability of spec. research and training Quality of public (free) schools Quality of scientific research institutes Availability of scientists and engineers Demand Extent of staff training Firm level technology absorption Production process sophistication Buyer sophistication Customer orientation Company spending on R&D Government procurement adv. techn products Capacity for innovation Proxies for quality of supply and demand for RTD in SEE Note: These are responses of local business communities which are assessing demand and supply for RTD from the perspective of their economy, Not some objective external benchmark.Source: WEF data 2006

25. Results • The most of the SEE countries have RTD demand gap i.e. they are not able to employ their RTD capacities effectively • Causes: factors like low sophistication of businesses processes which do not use new technologies or inappropriate structure or quality of RTD capacities. • Serbia and Montenegro have the biggest demand – supply gap. • SI and TK show signs of RTD supply gap i.e. limited RTD capacities or possibly types of capacities given state of their demand for RTD. • Greece suffers from weak demand for RTD which probably is caused by its industry structure which is dominated by small firms in traditional industries. • A small RTD demand – supply gap for Albania is mainly sign of very low levels and quality of demand and supply for RTD > a ‘low level equilibrium’ • A bigger but still small RTD gap in case of Bosnia and Herzegovina should be interpreted from similar perspective but which have to take into account its specific post-war situation.

26. SEE: a local demand is much stronger constraint to growth in software sector than in CEB Source: Radosevic (2006)

27. The sources of productivity improvements in CEE: Global value chains and production capability improvements Productivity of FDI subsidiaries is significantly explained by ‘quality control’ (production capability) (Majcen et al, 2009)(se next slide) Production capability: upgrading quality in existing products seem to be a more automatic process. Countries converge in quality (measured by unit prices) with the international leaders at an annual rate of 5-6% unconditionally (Hausman, Hwang and Rodrik, 2007) This ‘automatism ‘ in the case of CEECs it is actually FDI assisted or subcontracting driven mastery of production capability Some CEECs (Hungary, Croatia, Lithuania, Romania, Slovenia) have lesser scope for further quality improvements and must instead move to new products (EBRD, 2008)

28. CEE subsidiaries are mainly production oriented, i.e. competitive advantage is based on production, not technological or marketing capability. Notes: (i) Dependent variable: productivity growth; (ii) Z-statistics in parentheses; (iii) **, * and + indicate significance at 1%, 5% and 10%, respectively. 1/ Control of subsidiary - overall: Average value of foreign parent company's control of all 13 business functions; 2/ Operational control: Average value of foreign parent company's control of 4 operational business functions; 3/ Marketing control: Average value of foreign parent company's control of 5 marketing business functions; 4/ Strategic control: Average value of foreign parent company's control of 4 strategic business functions (see Table 2). The rest of dummies including country dummies are not reported. Based on data on 433 subsidiaries in five CEECs. Source: Majcen, Radosevic and Rojec (2009)

29. Quantity vs. quality of FDI: a further research is needed Econometrics of FDI spillovers in CEE: contradictory results, not very helpful Damijan et al (2008): direct effects from foreign ownership and spillovers from FDI do substantially depend on the absorptive capacity and productivity level of individual firms Ho: Differences explained by differences in levels of local technological capability and differences in market orientation of FDI.

30. The challenge for ‘periphery’: Missing levers to growth? Weak vertical integration & horizontal fragmentation Vertical and horizontal links do not work in WeBa ? Policy focus: - Support to the weakest agent: local business R&D - Transfer function on supply side (R&D) - Transfer function on demand side (FDI/local firms)

31. Broaden approach to RTD: innovation policy focused on country’s innovation capacity and its elements • Education, training and skills • Labour market • RTO – industry linkages) • Small firms’ linkages (clusters) • Large – small firms linkages • Linkages: foreign and local firms • (vertical and horizontal • Enterprise as a source of supply • and demand for innovation • R&D system and its links to economy • Intra-mural vs. extra-mural R&D • Narrow view: capacity of public services (ministry, agency, etc.) to manage cycle of policy development and implementation; • Broader view: capacity to coordinate large number of explicit and implicit policy measures that affect innovation process • Demand for technology_ large and SMEs • Tax incentives • Macroeconomic stability • Financial system • Competition policy Source: Radosevic (2006)

32. Invest in ‘knowledge infrastructure’ but only closely linked to careful assessment of BES demand • S&T Parks and dangers of ‘surrogate modernization’ • Priorities: First: projects and services (functions), and only than buildings (organisations) • Give preference to technology specific (critical mass) vs. generic parks (preferably linked to large enterprises)

33. Support current drivers of technology upgrading • Quality (ISO9000 etc is precondition to export) and vocational training (key to developed production capability) • Support for domestic firms to become quality suppliers for MNEs (cf. Hungarian INTEGRATOR) • Support programs for engineering and software

34. Support integrated and complementary support to NTBFs • Policy support is focused on opposite edges of new technology venturing • Funding gap • mini-grants: to explore commercial feasibility of technical idea • matching grants: to encourage risk sharing with firm + potential to create linkages

35. WeBa 2010: how ‘to extend transition agenda’? • Policy package of the last 15-20 years: focus on business environment (market automatism) + add well functioning state (2009) • Meagre results: slower X than of CE; large trade and CA deficits; appreciating ExRat; quality of life worse in 2009 than in 1989 (except Rom and Alb) • Add dimension of industrial upgrading into analysis and policy coupled with FDI/industrial networks • How to address demand shock? Further opening of regional (EU/SEE) market (cf. ‘jugosfera’ as the remaining lifeblood of local businesses). EBRD and regional projects?