Europe turns east: the EU's expansion could create opportunities--and pitfalls. (Regional Report: Europe).

Next time you're in Vienna, try renting a car to drive across the Austrian border, just 40 miles away. Start by mentioning that you're aiming for Hungary and watch the rental clerk turn pale. You'll be in for a shock too, when you see the price for a day's rental of a plain old VW Golf suddenly zoom to the level of a BMW luxury sedan. "It's our special price class 'Certified for Eastern Europe,"' murmurs the clerk at EuropCar, a large rental agency. "It means that the chances this car will be stolen over the border are pretty high."

Welcome to the Wild New Europe. As the heads of 10 eastern and southern European nations gathered in Athens on April 16 to sign a treaty that would enlarge the European Union as of May 2004, they brought along a sense of the looming threat of organized crime, an unmistakable fervor of fresh converts to the market economy and a raw quality of power that comes with the potential for strong growth. Western investors with foresight, patience and cash have already tapped into such potential -and have had their first taste of the problems. Businessmen, bankers and economists agree there's still plenty left for other investors. "EU membership will be a huge advantage because it will increase the size of the cessible market," says Petros Mavromichalis, top aide to the head of the Enlargement Directorate at the European Commission.

But Daniel Gros, director of the Center for European Policy Studies in Brussels, cautions that the size issue may be exaggerated unless the investor wants to sell Europe-wide. "Many East European markets are too small to justify setup costs," he says.

What all Western Europeans hope, however, is that as incomes in eastern Europe rise, they might help rev up the sputtering motor of the European economy. Although hardly uniform, the economies of all the 10 EU candidates (eight easterners--the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia--as well as two southerners, Cyprus and Malta) have consistently expanded 15 to 90 percent faster than the current EU has over the past six years. And, despite a current economic slump in Europe, analysts predict that GDP growth in this accession group will keep outstripping the west by 70 percent this year and 90 percent next year.

Small wonder. With economies growing and labor markets improving, around 76 million consumers of the newcomer group have only begun making a dent in their shopping lists of more than basic goods and services. As incomes grow rapidly, so will those consumers ability to improve their quality of life: buy a new car, travel, build a house.

So far, these newcomers have been economic dwarfs: While boosting the EU population by 20 percent, their combined GDP will add less than 5 percent to the EU. So it might take them years to catch up: 10 years for Slovenia, 19 years for Poland and 594 years For Romania, which aims to join the club in 2007.

Ultimately, the Fate of eastern Europe is partly in the hands of American and European companies that must decide how--or whether--to knit these countries into their broader regional and international strategies. German companies have been the biggest investors, followed by the Dutch and the Americans. (General Electric's investment in Hungary is one of the largest.) The CEOs of these companies are discovering that cheap labor by itself is not sufficiently compelling.

They must find the right labor and integrate their new activities into higher-value added operations elsewhere.

Hungarian rhapsody

That's what Audi AG, a unit of the Volkswagen Group, has done. Ten years ago, Audi's planners were looking for a place to build a major new car-engine plant that would escape the suffocating vise of German labor costs--and deliver the craftsman-like quality of German engineering.

Jurgen Lunemann, 51, headed the planning team at Audi's headquarters in Ingolstadt, Bavaria. He says that after having considered 180 locations throughout Europe, the team finally zeroed in on Gyor, Hungary's third largest city, 30 miles from the Austrian border.

What clinched the deal for Gyor--and brought Hungary a total of 1.6 billion euros in investment from Audi--was a unique combination of low labor costs, highly flexible labor rules, a large pool of skilled workers and an unusual logistics advantage: The location Audi picked sat on a railroad track that took trains directly to the company's main car factory in Germany. On top of that came Gyor's status as a duty-free zone and the tax breaks offered by the Hungarian government. "Hungary has created an investor-friendly environment," says Lunemann, who now runs Audi Hungaria Motor and commutes between the two cities. He hastens to add that while the tax breaks will be phased out after Hungary's accession to the EU, "all the important plus points Gyor had then will remain."

The government's largesse has paid off: Hungary has attracted top investment dollars from the West and now has one of the lowest unemployment rates among the accession candidates. Since the early 1990s, Hungary's inflation has fallen into the single digits while personal income levels have grown by more than 40 percent, boosting demand for products that consumers and businesses can now afford.

Since its launch, Audi Hungaria, which assembles high-tech engines and cars from parts sent down from Ingolstadt, has grown from 80 workers to 4,800, expanded its capacity three times, created more than 10,000 additional jobs in the area and became the main supplier of engines to the Audi group as well as other VW plants. It was in the black a year after launch and has reported strong profits since then. Freedom from corporate income taxes or import duties on the assembly components delivered from Germany--which make up 95 percent of entire material input--certainly helped the bottom line, at least initially.

But the biggest boon has been its local labor force: flexible, well-trained and very affordable. At 400 to 450 euros a month, about 10 to 15 percent more than the going industrial wage for a skilled worker in Hungary, the company is still paying out only around one-sixth of the current average wage in Germany, up from the one-seventh it paid when the factory went operational. "We have here an enormous labor cost advantage over other locations,"' says Lunemann.

But if the price of labor is important, other factors are vital: As a capital-intensive operation, the company must be able to remain flexible about how much and when it uses its production capacity. "We have over 20 percent more workdays here than in Germany and, theoretically, we can work 352 days a year," says Lunemann. "This way, we can use our production facilities to a much greater degree than in Germany."

Getting skilled staff is crucial to reach maximum productivity, so Audi invests heavily in training. Gyor has a good technical college, which has just been upgraded to a university. In addition, Audi has instituted the famous German apprenticeship system, which provides intensive on-the-job training combined with a very strong emphasis on quality. University grads and trainees end up with desirable careers as Audi employees. "People value working for us," says Lunemann. "We train well and we pay well."

'Bobcatizing' engineers

Less than 600 miles northeast of Gyor, the mood is similarly upbeat in Dobris, a small Czech Republic town less than an hour's drive from Prague. This is where, in 2001, Ingersoll Rand bought a small local backhoe factory to use as a base to expand the product range of its Bobcat unit of heavy equipment. The factory's sales have been growing, and the company has been adding staff to the 200-plus it took on at the time of purchase. "We get young kids from local engineering colleges and 'Bobcatize' them," says Jean Voorhees, Bobcat's marketing manager for infrastructure equipment. "Their quality [of education] is good, but then, like everywhere, you hire the successes, you don't hire failures."

Companies such as Bobcat are especially likely to benefit from the 22 billion euros that the EU has earmarked for infrastructure improvement in the accession countries over the next three years. "We have a pretty low price-entry threshold," explains Voorhees. "If someone wants to become an independent contractor, it won't cost him that much to purchase the equipment.

Indeed, Bobcat's operations in the Czech Republic can hardly be called a failure. "We started by exporting into this region, but now we're selling from this region into the rest of Europe and North America," says Voorhees. "Business is definitely ramping up."

About 600 miles up north, in Krakow, Poland, Richard Lada, Motorola's vice president and director, central and eastern Europe, waxes enthusiastic about his company's decision to set up software development centers in the late 1990s in central and eastern Europe. "We're very happy with the results," he says. "In fact, if I were setting up our business again, I'd come in even more heavily."

Initially, Motorola hired a couple of programmers in Krakow and a few more in St. Petersburg, Russia, to work on application software for telephone network base stations. Their quality and productivity were so remarkable that the company quickly expanded into Romania, the Czech Republic and the Ukraine. From a handful of programmers, Motorola's east European operations now employ more than 500 software engineers and 300-plus salespeople and support staff. More hiring is in the works. Moreover, product quality has remained so high that the Krakow and St. Petersburg facilities were awarded SEI Level 5, the highest certification in the software industry. "These are the only software companies in the region with such excellent credentials," boasts Lada.

His secret: "Quality of education, motivation and creativity levels must be very high if you want to run a successful software engineering operation. All these are available in central and eastern Europe."

From Poland to Hungary, such success stories prove that with foresight and long-term investment, Western manufacturing and service companies have been able to leverage their expertise, harness the opportunities offered by the burgeoning eastern European markets and create profitable production platforms. And all despite the difficulty of operating in immature economies and an unsettled political environment.

Yet, has it been nothing but success for those who went east? And will the changes that European enlargement brings be all for the better?

No managers like to talk about their failures. But Dirk Muller, managing director of the American Chamber of Commerce in Germany, recalls how a major U.S. consumer goods maker, which successfully reaped the benefits of its low-cost operation in the region, decided to change the labeling on a new product. As its supplier failed to deliver a specific type of dye on time, the product launch had to be cancelled; the firm lost money and is now scaling back its investments in the region. "Companies that focus on low labor costs and forget to look at the entire value chain pay a high price," says Muller.

He points out that problems arise when a would-be investor wrongly matches the complexity of its products with the know-how and the skill level of its labor force. "If you're a manufacturing operation with high-labor content, then low-skill labor is preferable," he says. "So to make light bulbs you would go to Hungary (as General Electric's Tungsram has done), but to make cell phones, it's better to go to Germany or U.K."

Another pitfall companies face are cultural barriers. "If you want to be successful in these markets, you need to develop local know-how in your own organization," points out David C. Everitt, John Deere & Co.'s president of agriculture division for Europe and other regions. "Therefore, we have hired quite a number of well-educated experts directly from these markets who have helped us to build and grow our business."

Investment primer

Matching your investment strategy to the market is key, says Albrecht Graf Matuschka, an investment banker in Frankfurt who has been long involved in advising U.S. businesses, and whose firm runs an "EntryPreneur" program that helps U.S. companies enter the German and European markets.

His advice: Don't invest a lot of money in big production facilities. Instead, try to leverage your existing product line and generate additional sales in the region. Once you're past this stage, build alliances with partners who can help you integrate products and services in this field. "From a specific product operation to a systems-solution business, preferably one with local distribution and coproduction partners, plunking down a lot of money isn't the way to go about it," says Matuschka.

Partnering locally is exactly the route John Deere has taken. The iconic American company got to the region early and was one of the first Western manufacturers to supply tractors -- from Belgium -- and combines -- from Germany-to Hungary and Yugoslavia in the 70's and 80's. It helped that agriculture in these countries is similar to that of the U.S.: large-scale farming with highly productive machines. Says John Deere's Everitt: "We built strong relationships with local partners to develop reliable infrastructures for our businesses.

Even when enlargement becomes reality, and most of Eastern Europe joins the EU, investors will have to customize their approach to the area. How they go about it depends largely on their local contacts and the nature of the market. "If you know somebody who is very good in Slovakia, start there rather than in a very mature market, like Poland, where you have a lot more competition," points out Matuschka.

Competition, however, will be hard to escape, argues Motorola's Lada. "Once these countries are in the EU, the perception of risk will go down amongst those who are still hesitant to invest in the region," he says. "So lots of companies will come in and you'll have greater competition for labor, and prices will go up." But he says that won't happen overnight: "This region will remain a low labor cost area for the next 10 to 15 years--and maybe longer."

[GRAPH OMITTED]

Candidate Countries

                Population       GDP       Unemployment
                 millions   US $ billions       %

Estonia            1.4            8            12.4
Latvia             2.4            8            13.1
Lithuania          3.5           12            16.5
Poland            38.6          176            18.4
Solvakia           5.4           20            19.4
Hungary           10.2           52             5.7
Slovenia           2.0           19             5.7
Czech Republic    10.2           57             8.0