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When Will Eastern Europe Catch up with the West?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1992
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While the high productivity of capital augurs well for growth over the next five years, substantial structural reform will be needed to unleash investment and mobilize savings

Although there is no doubt that recent revolutionary changes in the formerly socialist governments of Eastern Europe were primarily motivated by political goals, economic aspirations have also been an important driving force. Indeed, it is the expectation of achieving living standards comparable to those of west European nations that has carried these countries through the painful process of transformation into market economies.

What are the prospects for achieving such standards of living, and at what cost? Sustained economic growth requires the accumulation of productive assets (labor, human capital, and physical capital) via investment. The amount of investment required for the economies of the previously centrally planned economies to start “catching up” with Western Europe will depend on the initial economic situation, which is relatively favorable in terms of available human resources. The real challenge thus lies in ensuring that economic agents—both domestic and foreign—have incentives to acquire productive assets. Encouraging such investment demand is, however, only half the challenge; equally important is the promotion of sufficient domestic and foreign- saving to support the necessary investment.

For details of the research reported in this article, see “Savings, Investment, and Growth” by Eduardo Borensztein and Peter Montiel, IMF Working Paper WP/91/61, available from the authors.

This article, based on a more extensive study (see box), evaluates the nature of the policy challenge facing east European countries in the areas of growth, saving, and investment by focusing on the experiences of Czechoslovakia, Hungary, and Poland.

How much capital accumulation?

The amount of capital required to achieve targeted rates of economic growth in developing countries has long been calculated by the “financing needs” approach. Straightforward applications of this approach to east European economies yields estimates of required investment that are much too large to be feasible, even by the previous central planning standards, when investment rates tended to exceed the typical rates observed in market economies.

Consider, for example, the case of an east European economy with an initial level of per capita real GNP equivalent to 40 percent of west European levels, and suppose that the goal is to catch up with Western Europe in 15 years. Assuming that per capita GNP grows at 1 percent per year in Western Europe in the meantime, the country would have to average an annual per capita growth rate of 7½ percent a year during the 15-year long “catch-up” period. With annual population growth of 1 percent and a rate of depreciation of capital of 4 percent a year, and assuming an incremental capital/output ratio (ICOR) of 2.5, this catchup process would require average annual investment rates of over 30 percent of GNP.

Such high investment needs naturally create doubts about the ability of these economies to catch up. These types of calculations may be flawed in several ways, however. First, such calculations do not take into account the contributions of improved resource allocation and greater productive efficiency to economic growth. Second, the ICOR is not an immutable constant. It depends, among other things, on the supply of factors of production, such as human capital, which are complementary to physical capital. When such factors are plentiful, an incremental unit of capital will be very productive, the ICOR will be low, and the amount of investment required to achieve a given growth rate, at least over the short run, will also be low.

Certainly, both these considerations apply to Eastern Europe. The switch to a market system should greatly enhance the efficiency of these economies and sustain a higher growth rate than one based on capital and labor accumulation. In addition, investments—particularly in physical plant and equipment—are largely irreversible in the sense that they cannot be converted to other uses. The stock of “useful” capital that could be productively employed in a market economy, therefore, might be very small. The relative capital scarcity of these economies thus implies high rates of productivity of capital. These countries also have relatively abundant human capital that comprises a highly educated labor force. Investment in new, useful, physical capital is, therefore, likely to prove more productive than the “financing needs” approach might suggest. Even modest investment rates may achieve satisfactory growth rates in the reforming economies of Eastern Europe.

Inefficiency of resource allocation: Czechoslovakia, Hungary, and Poland
Actual GDP

as a percent

of US GDP

(1985)
Predicted

GDP
GDP

shortfall

(In percent)
Actual

average

investment

as share of

GDP

(1965-65)
Required

investment

as share of

GDP
Redundant

investment

(In percent)
Redundant

resources

(In percent)
Sample averages 134.719.4
Czechoslovakia40.064.037.526.312.552.517.0
Hungary29.065.055.428.87.175.429.2
Poland26.056.046.424.06.572.928.0
Source: IMF Working Paper WP/91/61.

This is a sample of 75 (industrial and developing) countries included in the regression. See Mankiw, Romer. and Weil (1990).

Source: IMF Working Paper WP/91/61.

This is a sample of 75 (industrial and developing) countries included in the regression. See Mankiw, Romer. and Weil (1990).

Quantitative results

To provide more rigor to our observations, we estimated the extent to which general inefficiency in resource allocation affected the levels of per capita output achieved under central planning. For this purpose, we used a study by Gregory Mankiw, David Romer, and David Weil (“A Contribution to the Empirics of Economic Growth,” NBER Working Paper No. 3541, December 1990), where econometric techniques were used to explain the levels of real per capita GDP in a large cross-section of countries on the basis of historical rates of investment and of human capital accumulation (using education as a proxy variable). By substituting the corresponding levels of investment and educational attainment for Czechoslovakia, Hungary, and Poland into their estimated equations, we derived “predicted” levels of per capita GDP for these countries. The difference between actual per capita GDP and the predicted values implied by the empirical equation was substantial, ranging from 37 to over 55 percent, as shown in the accompanying table. The estimated “shortfall” or output deficiency tells us that resources were generally used inefficiently in the past, suggesting a substantial misallocation of physical capital.

Conversely, we can compute the proportion of investment that has been “wasted” by a comparison with the performance of other countries in the regression study. That is, we can use the regression results to determine how much “efficient” investment would have been needed to attain the per capita GDP level that currently prevails in these countries. We can then estimate the extent of redundant investment as the difference between actual investment and necessary investment thus measured. These calculations indicate that between 53 and 75 percent of the fixed investment has been in excess of the amounts required to obtain the observed output performance in the three countries.

The above calculations ascribe all the productive inefficiency to fixed investment. More realistically, inefficiencies must also result from other factors of production. In fact, anecdotal evidence suggests widespread redundancy of labor and poor work habits in public enterprises. If one assumes that all productive factors have been underutilized in a similar proportion, the common rate of redundancy for all factors ranges between 17 to nearly 30 percent for these three countries.

On the basis of the above estimates, we calculated prospective growth rates that could be achieved in Czechoslovakia, Hungary, and Poland. We assumed, for the sake of illustration, that physical investment would be constant at 22 percent of GDP, which is a very conservative estimate compared with historical standards. Our simulations show that even under such modest rates of fixed investment, these countries could achieve healthy growth rates of per capita GDP—an average of between 6 and 7 percent for Hungary and Poland and about 3¼ percent for Czechoslovakia—over the next five years. Growth rates would be slower in later years, however, if substantial amounts of capital have already been accumulated. Medium-term growth prospects for these countries are good, therefore, if moderate amounts of efficient domestic investment are forthcoming.

Prospects for investment

But will domestic investment be forthcoming? While the analysis suggests that the rates of return on investment may be high for the reforming east European economies, there are many other factors in the current transitional phase that may dampen or delay future investment projects. These factors, which are mostly related to the structural reform process, are discussed below.

Private investment. There are important legal and institutional conditions that must, to some degree, be in place to stimulate private investment. These include a system of private property rights, the removal of legal barriers to entry by private agents into new fields of economic activity, and the availability of finance. Although a major revamping of the legal system is under way in many of the reforming economies, sorting out existing claims on assets will take longer to resolve because of issues such as restitution of property and the rights of worker councils.

Even with these conditions in place and the promise of high expected returns, investors may be slow to commit because of the uncertainty of the transition process. Most capital investment tends to be irreversible, so that any change in the economic environment that alters the profitability of an investment could pose large potential losses for investors. In this setting, an investor may opt to wait for new information that might affect the desirability and timing of the investment. Thus, private investors—both domestic and foreign—are likely to remain on the sidelines in the reforming countries until major sources of uncertainty are resolved.

Two major sources of uncertainty are worth highlighting. One is linked to the privatization of large firms. Investors would certainly like to know who their competitors are and whether existing productive assets will be available for purchase. The other is the credibility of policy reforms. This relates to the public’s perceptions about both the internal consistency of the adjustment program and the government’s willingness to stay the course even in the face of mounting social costs in the short run. Unless investors view the adjustment program as fully credible in both senses, the possibility of a future policy reversal would decrease the attractiveness of investment. In fact, a similar problem is encountered by any reforming economy, and experience has shown that private investment ensues only after credibility has been established. Credibility could be enhanced by a wide range of measures, from ensuring the viability of the financial system, to a “safety net” for displaced workers, to political liberalization and the acceptance of conditional foreign assistance.

Public investment. Since privatization is likely to be a slow process, large-scale enterprises in most east European countries are likely to remain in public hands for some time and a large share of investment decisions will be made by the public sector. The problem is that during the transition period preceding privatization, the system of incentives for investment by public enterprises may not be favorable. For even though these enterprises will not have a central plan, they will also not be following a clear profit maximization objective because management is not yet answerable to private owners. In such circumstances, managers have more incentives to sell enterprise assets (and increase wages) than to initiate new investments. This perverse system of incentives had the consequence of spurring a number of “spontaneous privatizations” in Hungary and Poland, where managers sold enterprises under favorable conditions for buyers.

A step toward achieving profit maximization on the part of public enterprises (and therefore investment efficiency) is to fully liberalize prices and to impose “hard” budget constraints on enterprises. Price liberalization has basically been implemented in Czechoslovakia and Poland, and is in progress in Hungary. The imposition of hard budget constraints, however, seems more difficult. Such a constraint requires, among other things, that credit be allocated according to profitability criteria. A fundamental problem with both enterprises and banks run by the public sector is that the perception of risk may be distorted. Banks may perceive that the state will ultimately prevent the bankruptcy of a large public enterprise and may, therefore, continue to lend to failing enterprises. This suggests that opening up the financial sector to new private entrants, liberalizing the financial system, and privatizing financial institutions should also be early steps in the reform process.

Prospects for saving

To the extent that the levels of investment required for satisfactory growth performance are indeed forthcoming in the reforming east European countries, domestic saving has a key role to play in permitting investment to be financed without generating macroeconomic imbalances. Yet here, too, the situation is fraught with uncertainty. Several observations are pertinent concerning the saving contribution of the public and private sector.

Private sector saving. This raises a number of issues, some of which are particular to the reforming economies in Eastern Europe. One such issue is the implications for saving of the “monetary overhang,” that is, the accumulation of idle money balances under central planning owing to the limited availability of goods. In the context of market liberalization, such an “overhang” is expected to lead to a spending binge on the part of households, with obvious consequences for domestic saving. While there are both theoretical and empirical reasons to doubt the importance of this phenomenon, at the very least we would expect substantial wealth reallocations upon liberalization and increased demand for consumer durables. This would lead to a reduction in measured household saving.

A second issue is the potential effect on saving of massive privatizations. It is likely that “giveaway” privatizations would reduce household saving, because households would feel wealthier. Although such a giveaway privatization would have the indirect effect of increasing the tax burden on the private sector—as the government has to make up the revenue loss from giving away its assets—it is likely that the net effect would be perceived by capital markets as an increase in private wealth.

Finally, prospects for external inflows are also uncertain, at least in the short run. Private foreign investors are likely to be deterred in the near term by some of the same sources of uncertainty that give pause to domestic investors. In addition, current high levels of indebtedness in Poland and Hungary would place some limits on the amount of resources that could be borrowed from private sources. Furthermore, the dismantling of the Council of Mutual Economic Assistance trading arrangements has meant the loss of a foreign subsidy for the east European economies, which was implicit in the low prices for oil and other industrial inputs. In the immediate run, official assistance seems to offer the best prospects of providing foreign saving on a meaningful scale, including assistance in the form of the debt forgiveness granted to Poland by the Paris Club early in 1991.

Public sector saving. As the contributions of the domestic private and the external sectors are likely to be limited, it is obvious that the public sector will need to make a substantial contribution. In view of the significant demands on public spending, and especially in the areas of “safety nets,” infrastructure, and the environment, developing an efficient revenue base for the public sector must be accorded high priority.

The raising of revenue will imply the design of new revenue systems, which may prove difficult to administer in the short run. Though several of the reforming economies registered an improved fiscal position in 1990, this may have been a transitory phenomenon, primarily resulting from reductions in real wages that accompanied price liberalization, leading to improved profit performance of public enterprises and reduced subsidies. Thus the revenue challenge remains to be met.

Conclusion

Our message, then, is mixed. On the one hand, prospects for economic growth in Eastern Europe are brighter than simple “financing needs” calculations would suggest, primarily because the levels of investment required to achieve healthy per capita growth rates are probably not as large as commonly supposed. This is because investment in physical capital will likely pay large social dividends, essentially because of the presence of complementary factors of production. On the other hand, achieving even moderate levels of domestic investment and saving will pose a substantial policy challenge, namely, to proceed quickly and resolutely with the structural reform process, while protecting the credibility and stability of the new economic system.

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