„The Experience of Austria, Hungary and Bulgaria with the Integration into the European Union“, Tagung in Sofia

Andrea Szalavetz, ‚‚The Hungarian manufacturing sector in an enlarged Europe‘ – A paper prepared for the Tri­national Seminar on the Enlargement Process of the European Union:

“Experience of Austria, Hungary and Bulgaria with Integration into the European Union”

7­9 November, 2004, Sofia

‚One of the major challenges ahead of a catching­up country’s manufacturing sector is productivity convergence to the level of advanced economies. Achieving a sustained productivity growth requires both a high rate of capital accumulation, technological upgrading, and the related changes in human resources. This paper addresses the past achievements and the deficiencies of the Hungarian manufacturing sector by analyzing the changes and the challenges of the f​actor side of the well­known production function, according to which output is the function of factors (capital and labor) and efficiency.

Y = f( Factors (K;L), Efficiency)

Most papers relate income and productivity differences to efficiency differences, explaining this latter with technology absorption difficulties, an inadequate human capital stock as well as with institutional deficiencies. There are relatively few analyses of inter­country disparities in physical capital accumulation1 and of disparities in the composition and the technological level of the physical capital stocks.2 This paper intends to contribute to the closing of this gap by examining the manufacturing sector from the point of view of the factors involved in the production activity. The factor to be examined in the first section is physical capital, while the second section reviews how skilled and unskilled labor progressed during the transformation years. It tries to identify whether as a result of its modernization the manufacturing sector has experienced a skill­biased technical change. The third section concludes and suggests some policy implications.

Capital accumulation

The 1990s were a decade of par excellence investment specific technical progress in Hungary. Transformation and modernization have been accompanied by major changes in the composition of the physical capital stock of the Hungarian manufacturing sector.

On the one hand a significant part of fixed assets has become obsolete under the new market economy conditions leading to major unplanned, simultaneous discard of obsolete assets.

On the other hand foreign direct investment (FDI) driven physical capital accumulation began, partly in the form of in­kind investments, but also in the form of purchases of used and new capital equipment.

This has led not only to substantial c​apital widening but also to significant capital deepening. By capital widening I mean the accumulation of physical capital which occurred as a result of the introduction of new, previously non­existing industries. The stock of physical capital increased due to an inflow of a large volume of greenfield investments and to the quick capacity increase with the run­up of production.

The restructuring of the manufacturing sector also involved c​apital deepening i.e. the capital­labor ratio has increased. Capital deepening has been driven ahead by three factors:

• technological upgrading
• inter­industry changes in the production structure, i.e. structural change in favor of

  more capital­-intensive sectors than before, and

• within­-industry changes in the production and product structures.
  While the first two factors are well­known, the third one requires some further clarifications. To understand the factors behind within­industry structural changes, the properties of the Hungarian manufacturing sector’s integration in the global patterns of manufacturing have to be examined. Hungary’s integration coincided with the rapidly evolving fragmentation of the value chain, driven by information technology revolution, that cut coordination and monitoring costs, facilitated the codification of knowledge and reduced the importance of geographical distance at least in the context of specific activities. Following its integration in the globally organized processing activities, many of the representatives of the Hungarian manufacturing sector specialized in intermediate goods: in parts and components instead of complex finished goods. Manufacturing components for global customers requires long production runs, efficient machinery and raw labor – note that most greenfield investors came to Hungary with resource and/or efficiency seeking motivations.3

  The shift to intermediaries necessitated different technology than the manufacturing of complex finished products. It requires increased automation and mechanization of the production technology. The volume of output increased considerably but the ratio of local value added decreased. In sum, the shift in the product structure, together with investments into the necessary production equipment increased the capital­labor ratio.

   

   

  
  Technological upgrading

  Much has been written about the beneficial role FDI played in technological upgrading, and corporate competitiveness increase. The main deficiency of technological upgrading in the Hungarian manufacturing sector was the fact that technical catch­up has not been homogenous across industries.

FDI­- driven modernization has resulted in sizeable differences in the investment rates as well as in the volume and the quality of the physical assets among industries that had been capable to attract substantial FDI and industries that hadn’t. In globally concentrated, new economy related manufacturing industries (in which a couple of production sites account for the world output) the distance of local subsidiaries’ physical asset stock to the world technology frontier is minimal if any – even if the production facilities are located in peripheral countries. D​istance to the technology frontier is much greater in mature and traditional industries where the share of foreign capital in the industry’s total equity is not as high as in emerging industries.​

The representatives of traditional industries have been trying to maintain their eroding competitiveness by increasing labor input and holding factor prices down. They specialized in “handmade” products, i.e. tried to compensate for the low mechanization level and the lack of modern equipment by entering market niches that require much skilled labor input and much shorter than the industry’s global average production runs. This was the only way in which high quality could be achieved also with obsolete production machinery. This strategy is however hardly sustainable for a long time.

Physical capital and human capital

The assumption of capital skill complementarity has been a widely accepted thesis of economic theory since G​riliches. G​riliches argued for the hypothesis that skill or education is more complementary to physical capital than unskilled or raw labor. Complementarity in this case means, that technical progress increases the demand for relatively skilled workers while it s​ubstitutes f​or the labor of unskilled (raw) workers. Economic history has more or less supported this claim. Although there were some exceptional episodes of skill replacing (de­skilling) technical change, like the introduction of the assembly line and the related organizational innovation: the factory system that replaced skilled artisans, hired an “army of unskilled workers”, and thereby contributed to a considerable productivity increase – technical progress was in most of the cases skill­biased. This was especially true in the case of the investment boom in the 1990s, related to information technology revolution. Capital deepening in the 1990s was accompanied by a rapidly increasing demand for skilled labor.

As opposed to this near consensus finding in international academic literature, the experience of the countries that recently underwent a modernization and catching up phase, and became integrated in the world economy with the help of FDI inflows is quite ambiguous in this respect.

My hypothesis is, that as opposed to the prevailing tendencies in advanced, knowledge­based economies, t​echnical progress in the newly integrated countries was skill­replacing, and not skill­biased,​at least in the first transformation years. Although it was not explicitly affirmed as a conclusion, but mentioned rather as a puzzling finding difficult to explain, still the de­skilling character of technical progress is well documented by Hungarian labor economics researchers. Although enrollment rates rose considerably, but we can speak of skill­biased technical change only in case 1) there is a strong positive correlation between the capital­labor ratio and the skill premium, i.e. the wage gap between skilled and unskilled employees; 2) there is strong capital­skill complementarity, i.e. capital accumulation brings about an increased demand in skilled workers (which then leads to increasing skill premium).

Several statistical analyses tried to quantify this relation in Hungary. K​ézdi reports a modest effect of the capital­labor ratio on the skill premium and a very slowly increasing capital­skill complementarity. K​ertesi–Köllő’s calculations even document a small n​egative relation between the capital­labor ratio and the wage level.

In fact, i​n Hungary the improving technological level of production machinery did not coincide with increasing skill requirements of the processing jobs. Although high­tech equipment is used in the production, the required skills to operate the machinery can be acquired in two or three weeks of on­the­job training. No special education related basic skills are necessary. Furthermore, the increase in the technological level of production equipment made some of the former highly skilled workers superfluous. Processing tasks have become much more routinized, simpler, and easier to learn than they used to be. Highly skilled workers capable of both maintenance and production became superfluous since the maintenance of the new machinery was in most cases outsourced to specialized firms or carried out by the employees of the equipment manufacturers in the frame of product related services. Thus the human capital stock that had been accumulated during the command economy era suddenly depreciated.

The relative de­skilling character of the capital accumulation period in the early 1990s can partly be explained also by local manufacturing subsidiaries’ integration features. As it was detailed in the previous section, local subsidiaries’ integration into their new owners’ multinational organization was in many cases characterized by a step backwards along the value added chain (intermediaries instead of finished products). Integration has however involved another step back, the consequence of which was even more unfavorable for the average skill level of manufacturing activities. The variety of corporate functions was reduced many of the previously internally performed production related knowledge­intensive services have been suspended. These services included product and process development, design, logistics, value chain management, legal and financial services, marketing, sales etc. The activity of the local subsidiaries was restricted to physical processing thus local affiliates have become single­functional production facilities within their multinational owners’ organization.

In sum, the Hungarian experience of the 1990s with technical progress of a skill­replacing character contradicts the textbook thesis of skill­biased technical change.

Conclusions and policy implications

The distortions in the factor structure are the result of the almost exclusively exogenous, FDI­ and transfer­driven pattern of the Hungarian modernization. Following the change of the regime, the state has almost completely abandoned its developmental interventions. In the first half of the 1990s the passive policy stance of the state did not allow any competitiveness promotion in general and investment promotion in particular. Investment promotion was restricted to FDI attraction or at least to the creation of new jobs during the whole decade. Linking investment promotion exclusively to job creation does not support technological upgrading. These incentives target only capital widening but not the necessary capital deepening.

On the one hand FDI inflows driven capital accumulation was a real success story. According to H​amar’s calculations, the share of foreign subsidiaries in total manufacturing investment was 48,8 % in 1993. It increased to 85,3 % by 1998 and has remained above 80 % since then.

Besides embodied technology, investors have also transferred the technology related tacit knowledge, management know­how, and invested into organizational change. Investors provided for the necessary technical assistance that facilitated absorption and learning by using. This explains that the issue of absorption difficulties and inter­industry disparities in absorption achievements is lacking from the analyses of transition countries’ technological catching­up. Analyses mainly detail the decline of the local R&D intensity of manufacturing production, the transformation of the science and technology system and the dramatic deterioration of local R&D performance. The spectacular improvement of technology absorption is not acknowledged as an asset, it is considered a free side­effect of FDI­led accumulation.

However, on the other hand it has soon become clear that a passive policy stance restricted to FDI attraction cannot contribute to across­the­board capital accumulation and technical progress. FDI flew in specific industries and neglected others, inducing thereby an excessive concentration in the production and export structures and making the country vulnerable to business cycle fluctuations.

This has important policy implications. A dualistic development can be avoided only in case both policy interventions and micro­level efforts are systematically aimed at increasing the capital­skill complementarity and the skill­biased character of further technological upgrading.

In industries unable to attract the necessary amount of FDI, where the local representatives have been trying to make up for the lacking physical capital by augmenting the (skilled) labor input – a well­designed investment promotion policy could be the solution.

Arguing for more state activism in governing and promoting modernization and capital accumulation may seem obsolete in an era that is characterized by increasing erosion of state capacity. The erosion of state capacity is due to the globalization of markets, firms and technologies as well as to the shift of policy action to new: sub­national and supranational levels. The EU­-compatibility of the proposed incentives may thus seem questionable at first sight.

As opposed to ideological principles, European policy practice abounds in examples of state activism. On the one hand, sizeable governmental intervention to promote capital accumulation and technological upgrading is carried out under the “pretext” of regional development. Another policy area with extensive public support and public investment is technology and innovation policies.

In FDI­recipient industries capital­skill complementarity, and the skill­biased character of technical change can be enhanced by local actors’ systematic moving along the industrial learning curve. This involves new human capital accumulation, and a conscientious diversification of local subsidiaries’ corporate function portfolio, i.e. the assuming of production related services.‘