'Detroit East' Vulnerable to Auto Plunge

Central Europe has benefited mightily from a surge in car manufacturing. But the industry downturn could take a heavy economic toll

So often the soothsayers of that hopelessly unpredictable invisible hand, economists rarely get the opportunity for a hearty, "I told you so!"

But surely it's ringing out these days in the offices of the biggest banks in the Czech Republic and Slovakia.

For years, as more and more of the world's mightiest car manufacturers set up shop around Prague and Bratislava, local analysts have warned against their economies falling into auto-dependency. The automotive industry is too sensitive to the ups and downs of the market, they said; and, while these often mammoth investments are hastening economic development, over-reliance on car manufacturing will come back to bite us on the bumper.

"Any time the global economy speeds up, the car industry speeds up as well," Vladimir Pikora, then chief economist at Volksbank in Prague, told me back in 2005. "Any time it slows down, the car industry slows down as well. We have to be aware that Czech growth is largely influenced by the car industry, and we need to have more investment in other industries."

It looks as if Pikora and others were right to urge caution.

Worldwide, high fuel prices, weakening economies, and, now, tightening credit have imperiled the auto industry. Sales are plummeting on both sides of the pond, and U.S. behemoth General Motors (GM) is begging the government to save it from a bankruptcy filing that would threaten hundreds of thousands of jobs.

For the Czech Republic and Slovakia, the automotive industry's woes are particularly troubling. That's because more than a decade of investment from companies such as Volkswagen (VOWG.DE), Kia Motors, Hyundai, and Toyota (TM) has made what Daniel Gros, an economist and director of the Center for European Policy Studies in Brussels, calls a "moribund industry" the very foundation of their economies.

Indeed, Slovakia is often called the Detroit of Europe. It's home to South Korean company Kia Motors' Central European plant and operations by Volkswagen and PSA Peugeot Citroen (PEUP.PA). Auto production accounts for around 25 percent of GDP. That figure is only slightly lower in the Czech Republic, also host to several international manufacturing hubs, at just under 20 percent.

Most of this production is sold abroad. As a result, Slovakia and the Czech Republic's export economies have flourished in recent years, becoming the force behind each country's robust growth.

Problem is, that makes their economies highly sensitive to the market fluctuations of their trading partners. If their partners begin struggling—if unemployment increases, it becomes harder to get consumer loans or growth slows—demand falls. Western Europe is the destination of most Slovak and Czech-made cars, and it's expected to be in or hovering around recession for a while to come.

It doesn't take much arithmetic to understand how painful things could get for these two auto-making hubs. Both are already feeling the first twinges.

Skoda Auto, the Czech Republic's largest car manufacturer and a subsidiary of Volkswagen since 1991, has cut production, and the Czech Automotive Industry Association predicts nearly 10 percent of the country's auto workers, or around 10,000 people, could lose their jobs within six months. Because of the industry's troubles, many economists have cut GDP growth forecasts to below 3 percent in 2009 from more than 4.5 percent this year. That figure would be even lower if not for the 10 November launch of production at Hyundai's new plant in the eastern Czech Republic.

Though domestic car sales have been on the rise recently in Slovakia, the country's September trade surplus shorted the monthly forecast by a third, which many analysts attributed to lower demand for Slovak-made cars. Major manufacturers haven't announced production cuts or layoffs, but the Finance Ministry predicts growth will fall significantly next year, and Peugeot Citroen's Slovak operation, at least, is preparing for a bear market, albeit in vague language.

"The automotive market in Europe has been experiencing an actual drop in demand," Peter Svec, the company’s communications director in Slovakia, recently told The Slovak Spectator, the Bratislava-based English-language newspaper. "All the big players in the automotive industry must therefore adjust their production programs to the emerging situation."

In Prague, laypeople and experts alike are speculating on how bad things might get. Some say the Czech economy will be in full limp by mid-2009, especially if the strong crown continues making domestic goods dearer abroad. (Slovakia's euro zone accession next year will insulate its exporters from similar currency liability.) Others, such as Pikora, now of Next Finance, say the pain, while real, won't be extreme because Slovak and Czech-made cars—cheap by Western European and U.S. standards—will gain appeal as wallets lighten.

Much will depend on how thrifty Europeans become. Car sales throughout the continent have fallen for five straight months, the longest stretch in three years. If consumers continue shunning auto showrooms, the Czech Republic and Slovakia face tough times ahead.