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Economic Reform in a Planned Economy: the Case of Poland Efforts to introduce market–oriented mechanisms

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1988
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Karen A. Swiderski

In 1987 the Polish Government put forward proposals to reinvigorate the process of economic reform initiated in the early 1980s. The aim once again was to decentralize economic decision making so that the fulfillment of plan objectives could be achieved primarily through the response of enterprises to market-type instruments rather than through direct central controls. Some first steps in this direction were taken in November 1987. The government apparatus was streamlined with the number of economic ministries being reduced. The Government also held a referendum on its proposals for radical economic reform and political democratization. While the majority of those who voted supported the proposals, the supporters comprised less than half the electorate. The authorities have, however, indicated that the fundamental aims of the reform will not be affected by the referendum results. In early 1988, the Government adopted a program calling for the progressive implementation of a wide range of institutional, legal, and policy changes. At the same time, a number of important policy measures, including a major restructuring of prices, was introduced.

Reform of the economic system has been—albeit intermittently—an important policy objective in Poland for much of the postwar period. This article looks at the record with a view to identifying the problems that have constrained the most recent reform effort, and the conditions that could provide a stronger basis for such efforts in the future. Many of the factors that have impeded economic reform in Poland have also, in varying forms, been encountered in other countries attempting to combine elements of market and planned economies.

The long-established social values of planned economies, including a commitment to full employment and an aversion to price increases and to inequalities in the distribution of income, are frequently at odds with the functioning of market mechanisms. The development of these mechanisms is further inhibited by the authorities’ desire to continue to control certain key activities. Moreover, the structure of planned economies in the postwar period—characterized by state-owned monopolistic industries, a restrictive foreign trade system, and low degrees of capital and labor mobility—has contributed to a perception that the reallocation of resources that could result from too rapid a movement toward a market-oriented economy would entail excessive inflation, short-term labor redundancies, and other disruptions. Finally, systemic changes are unlikely to be successfully implemented unless macro-economic equilibrium is achieved and maintained through sound financial and incomes policies. Some countries have found it difficult to maintain macroeconomic control while in the process of decentralizing their economic systems.

Background

The character of the Polish economy changed fundamentally in the years following World War II. The state took over most industries and, although there was relatively little collectivization, it intervened heavily in the agricultural sector. Central planning came to play an increasingly dominant role in economic management. While output and investment rose rapidly during the first postwar decade, there was thereafter a growing dissatisfaction with the performance of the economy. This led to successive reform attempts—particularly in the late 1950s and early 1970s—to decentralize the economic system in order to increase its overall efficiency and growth prospects. These efforts met with limited success.

In the first half of the 1970s there was a deliberate policy of heavy borrowing to finance rapid expansion of output and invest-ment. In a clear break with the past, foreign trade with the West increased rapidly. However, with imports growing much more rapidly than exports, the current account deficit with the convertible currency area became unsustainable by the middle of the decade. Attempts to redress this situation, by curtailing investment and imports, were unsuccessful and contributed to a declining level of output in the final years of the decade. The economic situation deteriorated further at the beginning of the 1980s. In convertible currencies, the current account deficit reached the equivalent of around six percent of GDP, the external debt rose to $26 billion, compared with negligible levels ten years earlier, and the debt service ratio exceeded 150 percent. This led to a collapse in creditor confidence and in capital inflows, and to the emergence of sizeable payments arrears. Domestically, a growing conflict between the trade union movement and the Government contributed to significant losses in output and exports. The brunt of retrenchment measures once again fell on investment and imports, exacerbating supply shortages and contributing to the downward spiral of output. This declining trend did not stop until 1982, when real output amounted to only three quarters of the pre-crisis peak level attained in 1978.

Reforms of the early 1980s

A further reform effort—more comprehensive than its predecessors—was launched in the wake of the economic crisis of the early 1980s. Its overall objective was a radical decentralization of decision-making authority to enterprises. As a first step, there was to be a reduction in the number of branch ministries and a diminution of their role in directing the activities of enterprises, as well as a dissolution of most of the large economic organizations that were created in the 1970s through the merging of enterprises. With these intermediate levels of authority removed, the main agents were to be the central planning authorities and individual enterprises. Annual and multiyear planning was to continue, based on the broad objectives of economic policy established by the central authorities. However, these plans were to be implemented primarily through reliance on indirect policy instruments—such as tax rates, credit policy, and the exchange rate—rather than through direct central control.

As a corollary to the intended increase in their autonomy, enterprises were to receive less financial support from the central authorities. It was recognized that the phasing out of interventionist planning would involve not only a greater role for financial policies, but also, if financial magnitudes were accurately to reflect relative costs and prices, a reform of the price structure. This in turn would necessitate a reduction of subsidies, a move toward a more standardized tax system, a realignment of the exchange rate, and a more direct relationship between domestic and world prices.

Starting in late 1981 a considerable body of legislation codified the terms of the reform. While important changes were introduced that affected agriculture, the main focus was on the status of industrial enterprises. The legislation provided that they be independent in the sense of determining their own pattern of output and investment and setting their own prices; self-managing, ultimately by their own work force; and self-financing. To promote the latter aim, a banking law established the ground rules for credit policy to operate as an independent constraint on enterprise behavior. Meanwhile, a bankruptcy law stipulated the procedures to be followed, including possible liquidation, in cases where enterprise performance was unsatisfactory. The legislation also gave enterprises greater autonomy in deterniining employee remuneration, simplified and partially standardized the tax regime, and ended the monopoly that foreign trade organizations had previously enjoyed in the conduct of foreign trade. A later monopoly law provided the basis for dismantling other monopolies.

Various other policy changes complemented the new legislative and institutional framework. At the beginning of 1982 a unified, and depreciated, exchange rate was introduced which applied to all transactions with countries outside the Council for Mutual Economic Assistance (CMEA, comprising Bulgaria, Cuba, Czechoslovakia, the German Democratic Republic, Hungary, Mongolia, Poland, Romania, the Soviet Union, and Viet Nam). A major restructuring of prices was also effected in early 1982 which resulted in a sharp decline in real wages and in the real value of the household sector’s monetary assets. There was a corresponding improvement in enterprise profitability and a reduction in the budget deficit. Finally, a progressive levy on enterprise profits was introduced both to contain wage increases and relate them more closely to changes in productivity.

Implementation

Although the Polish authorities recognized from the outset that the realization of reform objectives would take time, implementation of the reform blueprint has generally been slower than originally anticipated. As a result, the current economic system, while changed in many important respects from that which existed in 1981, differs from the one envisaged by the reform.

The external environment—characterized by acute debt-servicing difficulties and thus the need to run a substantial trade surplus with the convertible currency area—has constrained the process of economic liberalization. Difficulties in implementing the reforms have been encountered on several other fronts as well. With financial indicators having only a limited usefulness because of continuing price distortions and shortages, administrative interventions have continued to play an important role in economic management. Moreover, it was always intended that certain enterprises and sectors (including the energy sector) should be excluded, wholly or partly, from the terms of the basic reform legislation. These considerations, together with a commitment to other social policy objectives, such as the desire to limit price increases and to maintain full employment, have tended to slow the pace at which the authorities have felt it appropriate to dismantle central controls.

The decentralization process was hindered by the fact that the first stage of reform coincided with a period of social unrest during which martial law was imposed (martial law was lifted on July 22, 1983). Moreover, the authorities expanded the original list of enterprises over which they retained direct control to ensure that sufficient resources were available for various priority purposes. On similar grounds, the so-called founding bodies of enterprises, notably the relevant government ministries, have continued to exercise their rights to require certain tasks to be carried out by enterprises under their control. Founding bodies have also retained considerable powers over the appointment and dismissal of enterprise managers.

Two other institutional factors have also served to dilute somewhat the effective autonomy of the enterprise sector. First, certain enterprises have been required to join industrial associations (typically including other enterprises in the same sector) to which they are administratively subordinate in some matters. Second, the central atiministration has to date continued to play a strong role in determining trading patterns with CMEA partners. Most trade with these countries is conducted under bilateral agree-ments negotiated annually in the framework of five-year agreements.

The importance attached to social objectives is most evident in the sphere of pricing policy. Following the first steps to liberalize prices in 1982, the authorities considered it necessary for social reasons to restrain the rate of price increase. In 1983, the proportion of transactions taking place at prices under explicit adrninistrative control, after having been considerably reduced the year before, was increased to about one third for producer goods and almost one half for consumer goods. Subsequently, these proportions have not changed significantly. Moreover, since April 1983, virtually all changes in producer prices subject to “contract” pricing (in principle set at the discretion of individual enterprises), have been under some form of control. In 1984, the latter regulations were extended to the retail market with a significant, but subsequently declining, proportion of prices of manufactured goods being controlled. As a result, the relative price structure remains distorted, with prices for many products staying below market-clearing levels, and excess demand and shortages persist.

In the absence of market-clearing prices, a number of nonprice instruments have been employed in the domestic market to ensure sufficient resources for various priority purposes. Although rationing has been significantly reduced in scope, in 1987 some 35 percent of the total supply of basic raw materials and other production inputs still remained formally subject to administrative allocation. At the retail level, geographical rationing of products through the local governments has continued. Moreover, in 1987 ration cards were still used for four product groups, including most meat and petroleum products. Similarly, to ensure adequate production of some essential items, schemes are in operation whereby enterprises are either instructed or invited to submit bids to carry out certain tasks for which they are guaranteed access to the necessary inputs and foreign exchange. These schemes and other priority uses absorb over a third of administratively allocated inputs.

Significant central controls also remain over investment. It was always intended that centrally planned investments, which now account for less than one fifth of total investment outlays, should continue to cover expenditure on large projects as well as those in the nonproductive sphere. In practice, however, the central authorities have a considerably greater influence over all investment, especially since many projects started before the reforms are still being implemented. The structure of investment, thus, continues to be influenced by past policies aimed at self-sufficiency in key products as well as by the long-established trading patterns with CMEA countries.

A key factor that has led the authorities to retain price controls and administrative intervention in the allocation of resources has been the difficulty of maintaining sufficiently tight financial policies, particularly since 1984, when measures were taken to decentralize the wage system. Reflecting this new freedom, wages have consistently exceeded plan targets and real wages have increased considerably since 1982. At the same time, interest rates have remained negative in real terms: in 1987, the average rate on bank deposits was 5 percent compared with an inflation rate of 26 percent. In addition to having a dampening effect on household savings, this has contributed to overruns in fixed investment and to a continued high level of stockbuilding. As a result, at the prevailing —and substantially controlled—price level, aggregate excess demand for the output of the socialized sector has persisted.

This macroeconomic phenomenon, in conjunction with inefficiences at the microecono-mic level has, among other things, led to a spillover of demand into the nonsocialized sector and informal parallel markets. Activity in informal parallel markets, in which prices may be significantly above comparable prices in the socialized sector, has played a particu-elarly important role in absorbing excess demand pressures in Poland. A large part of parallel market transactions is carried out in foreign currency which is traded at a very large premium over the official rate. Household foreign currency deposits with domestic banks, valued at the official exchange rate, account for over 10 percent of the banks’ liquidity and, in addition, there are thought to be appreciable holdings of foreign currency notes. The possibility of a redirection of demand currently absorbed in parallel markets to the official sector in the event of price liberalization has been one of the factors behind the retention of price controls.

The reluctance to allow prices to rise to market-clearing levels has had direct implications for the conduct of external economic policies. The linkage of domestic prices to world prices remains incomplete although the exchange rate has been adjusted more flexibly since 1982, especially in the last two years. A certain proportion of export transactions (currently about one fifth) has remained unprofitable and excess demand for imports persists. Export incentives conferred through the budget—at rapidly increasing cost—in the form of tax reliefs and subsidies, and the granting of foreign exchange retention rights to enterprises have continued to be important policy tools in guiding foreign trade. At the same time, reflecting the authorities’ concerns over domestic resource and foreign exchange shortages, wide-ranging controls on both exports and imports have been maintained: over two thirds of imports from the convertible currency area continue to be centrally financed.

Underlying the difficulties of implementing the reform blueprint has been a reluctance to allow real behavior to be modified by financial constraints. One manifestation of this is the continuation of sizable explicit budgetary subsidies (equivalent to about one sixth of GDP), although reduced considerably since 1981. A further, and perhaps more pervasive, manifestation is the continuing influence of microeconomic considerations on budgetary policy. This is reflected in the very considerable differentiation of tax rates and exemptions among sectors and enterprises and changes in these arrangements, over time, in response to bargaining with enterprises and other pressures. Credit policy also continues to play an active role in the discretionary intermediation of resources within the economy, with priority tasks and key sectors having preferential access to bank credit.

Review and assessment

Reform of economic systems is inevitably a long and complex process. Questions thus arise about the most effective ways of introducing elements of a new system while elements of the old system remain. The Polish experience of the recent period sheds some light on how to formulate an approach aimed at decentralizing economic structures that is sufficiently focused to be capable of implementation but at the same time comprehensive enough to produce lasting results.

As noted earlier, underlying the progressive loss of momentum in previous attempts at economic reform in Poland has been the persistence of price distortions at both the micro and macroeconomic levels. With a high priority attached to limiting the rate of price increases, domestic prices for many items have not been allowed to reach market-clearing levels and the linkages between domestic and world prices have remained weak. As a result, aggregate excess demand for the output of the socialized sector has not been eradicated: shortages have persisted and a parallel economy has continued to play a significant role. These difficulties have been exacerbated by serious distortions in the relative price structure, notably in the under-pricing of foreign exchange, capital, and energy products. Financial performance has thus continued to be a poor guide to economic efficiency. With prices not performing the signalling role assigned to them in the reform blueprint, there has been a concomitant need to allocate resources by other means. This has helped perpetuate the old system of adrruhistrative intervention.

The adjustment of prices to market clearing levels has proved to be a more difficult task than originally envisaged because of inadequate supporting financial policies. If reliance on price controls and administrative intervention in the allocation of resources is to be reduced—and more market-oriented mechanisms introduced—while ensuring that inflation is contained at acceptable levels, firm control of demand pressures is essential. In formulating such policies, account needs to be taken of demand pressures absorbed in parallel markets but which may be redirected to the official sector. The need for tight management of domestic demand is even greater in situations where there is little scope for raising imports. Demand management, as in market economies, would operate through the application of monetary and fiscal policies, perhaps buttressed by other measures to control the growth of incomes, especially in cases where there is relatively little experience of an active use of financial policies. The latter can be strengthened by adjusting interest rates to positive levels in real terms. By inducing people to hold money voluntarily, any excess liquidity in the household sector can be reduced, lessening in turn the degree of restraint required over household incomes. Positive real interest rates are also likely to be essential to overcome enterprises’ deeply rooted preference for real assets—often held in socially unproductive forms such as excessive inventories— over financial assets, as well as to reduce their demand for bank credit. Firm demand management is also essential if adjustments in relative prices are not simply to be transformed into an increase in the general price level.

While equilibrium prices are a necessary condition for a well functioning system of decentralized markets, they are by no means sufficient. To be effective, enterprises must be given the flexibility and incentive to respond to changing price signals. The more successful enterprises and their work forces need to be rewarded while for the least successful there must be sanctions, in other words, financial discipline. Faced with financial difficulties, many enterprises in Poland continue to find that the payoff from seeking some form of relief from the fiscal and monetary authorities is far greater than from modifying their real behavior. This has been an important factor underlying the granting of liberal wage increases at the enterprise level, even though since 1982 increases beyond a certain threshold have, in principle, been taxed at steeply progressive rates. Admittedly, the lack of financial discipline partly stems from the existence of price distortions. But it would also appear to reflect the inertia arising from certain long-established practices and attitudes, often prevalent in planned economies. As a result, few unprofitable operations have been liquidated —despite the bankruptcy law of 1983—and attempts at widening wage differentials have met with resistance.

If an economic system is to be based on price-responsive markets, the threat of bankruptcy must be real. In order to minimize the social costs and economic disruptions of transferring resources to other uses—concern over which has inhibited previous reform attempts—supporting policies need to be in place to increase the mobility of factors of production. Among other things, this might entail a reduction in the barriers to labor mobility, partly through the authorities’ con-tinuing efforts to ease an acute housing shortage, and the development of a capital market. Equally important, however, is the development of competition in a system that is dominated by monopolistic structures. In addition to dismantling some of the existing conglomerates, this could include measures to make it easier to establish new enterprises in response to market opportunities. The latter issue was not directly addressed by the 1981-82 reform legislation and the relevant decisions continued to be left in the hands of the founding bodies; the authorities have subsequently taken steps, however, to facilitate the establishment of new enterprises, including those with participation by foreign investors and the domestic nonsocialized sector. A liberalization of the import regime is also likely to play a key role in reducing the power of domestic monopolists. However, in an economy starting from a position of acute foreign exchange shortage, the achievement of import liberalization is, in turn, likely to depend on active use of the exchange rate as part of a strategy to raise the relative price of tradable goods.

In sum, if the aim is to raise the efficiency and output of the economy by introducing more market-oriented mechanisms, then firm demand management and financial discipline are indispensable. Without these elements other policy initiatives are likely to be ineffective. It is essential that the authorities be prepared to implement these policies in a comprehensive and sustained way. This is particularly important because the process of economic reform entails short-run costs, which can be reduced but, in practice, cannot be eliminated.

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