Current Pay Trends

Before 1989, pay in the former USSR and its satellites was largely controlled by the state, either through central dictum or by means of collective agreements concluded with state-controlled trade union organisations. There was a huge income disparity between the small elite of 'party officials' and the rest of the population, wage rates were often little above subsistence level and it was common for wage arrears to extend for periods of several months at a time. Even if an individual gained a little disposable income, the shortage of consumer goods meant that there was little to spend their money on.

To eke out their uncertain incomes, people often needed to keep small plots of land where they could grow vegetables and rear livestock, even in large cities. In some countries, people survived by holding down second jobs, or by operating special working arrangements. In Hungary, for example, there was a practice of factory workers renting out production facilities after normal working hours to produce items they could sell back to their employers.

THE FALL OF COMMUNISM

The fall of communism created the freedom necessary to improve living standards, but at the cost of many of the formal protections that had been provided under the old regime. New constraints were placed on the welfare system, cutbacks occurred to former benefits such as childcare for working parents and many people were forced to find employment in the newly enlarged informal economy. Governments no longer saw it as their duty to maintain full employment, and without state sponsorship, trade unions dwindled away.

Today, real personal income levels in the majority of central and eastern European countries are rising faster than in the more established market economies. This is largely due to increased productivity brought about by new investments in plant and equipment, together with people's desire to work hard for the rewards now on offer.

Problems such as wage arrears have not completely gone away, but the states joining the EU have found a much wider market for their goods. Many western companies have switched production to these states in order to take advantage of lower labour costs and competitive corporate tax levels.

GAP IN PAY COSTS

Although the new EU member states have a combined population of 74 million, their economies initially added less than 5% to the EU's gross domestic product. In February 2004, basic median hourly pay plus social security costs stood at €17.77 across the established EU member states (EU15), compared with a weighted average of just €3.31 per hour in the new member states (N8*). Basic hourly labour costs also represented 61.6% of labour productivity in the EU15 states compared to just 41.6% in the N8.

This pattern is only to be expected in rapidly developing market economies, because a substantial amount of labour productivity is needed as capital for reinvestment by companies in new buildings, plant and equipment. However, as the economies of the N8 states grow, employees will demand an increasing amount of the generated wealth in the form of pay and welfare benefits. The future success of the N8 will depend on how they manage this cost / productivity gap as they move towards the general pattern of practice for the EU15 states.

THE FUTURE OF COST ADVANTAGES?

One problem facing western companies investing in the N8 is the uncertainty about how long the cost advantages over the EU15 states will last. There is already a move within the EU administration to achieve greater harmonisation of corporate taxation rates, which could threaten low tax regimes such as those in the Baltic states. But how quickly will labour costs differentials disappear? Cost elements such as social security are a matter for governments to decide, but remuneration costs (which makes up the bulk of labour costs) can be projected more readily.

If Germany and Poland are taken as points of comparison, and it is assumed that gross (pre-tax) pay levels rise at an average annual rate of 10% in Poland and 1% in Germany, then gross pay levels in Poland would not catch up with those in Germany until the year 2027. This means that a significant cost advantage would exist for at least 15 to 20 years – long enough to justify a financial return on most investments in plant and equipment.

A major area of concern in the N8 states is the fiscal burden being created by high pay increases for state employees. For example, between the first half of 2004 and the same period of 2005, average gross monthly earnings in Hungary rose by 7.3% in the private sector compared with 18% in the public sector. This disparity is largely due to poor budgetary control and the higher level of unionisation in state organisations. But governments will need to control this trend if they wish to attract further inward investment. An increasing number of foreign companies that moved into countries such as Hungary and the Czech Republic during the first wave of market liberalisation are now realising that other N8 and accession countries, such as Romania, offer much greater investment potential.

NARROWING DIFFERENTIALS

One of the major problems facing companies in the N8 states is the narrowing of differentials throughout the pay structure. This makes it difficult for companies seeking to reward individuals for their qualifications, experience, performance and for taking up more senior positions. There is no absolute measure for determining how job size should be related to remuneration, but if the differential between key positions is too narrow, a company will not be able to recruit, motivate and retain the services of the most able professionals and managers in the labour market.

The narrowing of pay differentials for those at the bottom of the earnings ladder is mainly due to the movement of Statutory Minimum Wage Rates (SMWR). In Western Europe, the country with the highest SMWR is Luxembourg, where rates increased by 7.2% between 2003 and 2005. In contrast, the increase in SMWR in Estonia over the same period was 20.3% and in Ukraine 41.6%. It is true that in many countries, the SMWR is below subsistence level and only exists as an official reference point for calculating state allowances. Even so, some changes have been made, even against the advice of international funding agencies.

For example, the Bulgarian government increased its SMWR by 25% in January 2005, in spite of a requirement by the International Monetary Fund to limit the increase to 8%. The Polish government has recently gone as far as committing itself to a fixed formula for setting its SMWR. In 2005, the Polish parliament voted to accept a new law that will require the government to increase the SMWR by the forecast inflation for the coming year, plus two-thirds of the expected GDP growth rate. By this means, it is hoped progressively to increase the rate from 35% to 50% of the national average wage.

GETTING THE BALANCE RIGHT

Of course, economies can also suffer from excessive pay divides. The resulting deep sense of inequality will often create wide scale alienation and social instability, even if open pathways exist for individuals to improve their qualifications and move into higher-paid positions. In the Russian Federation, the existence of a large and persistent pay divide has provoked strong public criticism. Earlier this year, the Russian regional development minister, Vladimir Yakovlev, revealed that the gap between the earnings of the top 10% and the bottom 10% of the working population had reached 700% and warned that a gap of such proportions could lead to a revolutionary situation in any country.

One way to ensure that pay differences do not become either too narrow or too wide is to link pay levels to job-evaluated benchmarks. FedEE has developed a job evaluation and pricing system that relates different elements of job worth to national and sectoral pay markets in order to produce a benchmark rate for a chosen job. Another way to reward performance without distorting the pay market is for employers to ensure that a significant proportion of any pay increase is in the form of a one-off non-contractual bonus. Although it is fairly commonplace to award such bonuses in EU15 countries, they are far less popular in Central and Eastern Europe and seldom account for more than 5% of an individual's total remuneration.

Foreign employers moving into Eastern Europe for the first time often rely on management consultancy salary surveys and the advice of recruitment agencies to establish pay rates. This can be risky, however, because salary surveys will often be based solely on the practices of other inward-investing companies, all of which share a common level of uncertainty about what to pay in a particular market. Many will have been advised by recruiters to pay much more than local rates in order to attract the best staff. Such advice, however, is likely to be conditioned by a wish to make the recruitment process as easy as possible and to maximise recruitment fees (which are usually linked to salary levels).

By relying too heavily on the advice of others, companies are depriving themselves of the opportunity to test the market and determine what the optimum salary levels should be for their chosen location and economic sector. Experimenting with salary levels would also provide feedback on hard-to-fill vacancies, giving a rational basis for any 'red circling' that might be required.

* The states referred to as N8 are the former communist states that joined the EU in May 2004 (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, Slovenia). The other states joining the EU at this time were Cyprus and Malta, neither of which is covered in this article.