Ten years after the transition process began in Central and Eastern Europe, policymakers, academics, and IMF and World Bank officials gathered to discuss what could be learned from the experience. Participants in the conference, held February 1-3 at the IMF, were also eager to distill the lessons into better policies and more effective reforms for an increasingly diverse group of transition economies in Central and Eastern Europe, the Baltics, Russia, and other countries of the former Soviet Union.
Summing up themes that ran through much of the conference, Shigemitsu Sugisaki, IMF Deputy Managing Director, stressed that fiscal and monetary stability is a must if the transition process is to take hold and that a sound financial sector is an essential component of macroeconomic stability. Furthermore, privatization remains a key step in forming a viable market-oriented economy, and measures to address rising income inequality are becoming increasingly important. At the heart of the transition process, however, is the complex and time-consuming task of creating a modern, effective state and building institutions supportive of a market-oriented economy.
Progress in Transition
Following IMF Managing Director Michel Camdessus’s overview (IMF Survey, February 8, page 42), IMF Institute Deputy Director Saleh Nsouli opened the proceedings, noting the importance of such a conference “in taking stock of the achievements of the transition economies and in reviewing the policies needed to meet the challenges that lie ahead.” The first session reviewed experience with inflation and growth and examined the East Asian experience as a point of contrast.
Inflation. In analyzing developments in 25 Central and Eastern European countries and countries of the former Soviet Union, Peter Doyle (IMF) said he and his co-author, Carlo Cottarelli (IMF), found a striking reduction in inflation in the early 1990s across the transition area. Once disinflation was undertaken, progress was swift and growth resumed. Four factors, Doyle said, underlay the robust output growth during disinflation.
The context for disinflation was better than it appeared, as inflation exhibited limited inertia and political support for disinflation was often strong.
Inflation stabilization was carried out first and was intended to be rapid, without waiting for comprehensive structural reforms.
Comprehensive fiscal consolidation underwrote disinflation, and funding sources were diversified through developing financial markets.
Where “fiscal fundamentals” were addressed, various monetary frameworks were effective.
Doyle cautioned, however, that in many cases the achievements were not durable. In some countries, there had been a resurgence of inflation, or price controls on basic consumer goods were intensified. At the same time, conditions in the countries in Central and Eastern Europe are now almost ideal for inflation to be lowered further. Indeed, a number of these countries are committed to lowering inflation to industrial country levels in preparation for accession to the European Union.
Growth. With regard to growth, Oleh Havrylyshyn and Thomas Wolf (IMF) found that most transition countries—particularly the Central European and Baltic countries—have made good progress and are now facing issues similar to those of middle-income market countries. For Russia and other countries of the former Soviet Union, and to some extent those of southeastern Europe, a large unfinished agenda of market reforms remains, however.
In all countries, observed Havrylyshyn, who presented the paper, the objective should be to establish good economic governance. In many countries, particularly in Russia and other countries of the former Soviet Union and in southeastern Europe, the government has not pulled back far enough from intervening in economic activity, and, conversely, has been insufficiently proactive in providing law and order and a secure legal framework for citizens to choose the economic activity in which they wish to engage. The vicious cycle in which poor economic governance has delayed economic reform, inhibited economic recovery, and constrained the development of a more dynamic business sector must be broken.
In East Asia. The distinct situation of the transition economies of East Asia was considered in a paper by Sanjay Kalra, Torsten Slok, and David J. Robinson (IMF) that assessed the progress made in China, which is often characterized as having followed a gradual pace of reform; Mongolia, where reform had been relatively rapid; and the Lao People’s Democratic Republic and Vietnam, where the pace of reform had been somewhere in between. Robinson, who presented the paper, said that the experience in these countries—in particular, China—had generally been more favorable than in other transition countries, especially in terms of growth and inflation. While some observers had argued that this experience suggested that a more gradual approach to reform was desirable, Robinson underscored that growth in these countries had been most rapid in areas where reforms had been most far-reaching, notably agriculture. He also noted the importance of more favorable initial conditions—specifically, the relatively large agricultural sector and rural labor surpluses that had facilitated higher growth without requiring state enterprise restructuring—and (with the exception of Mongolia) the relative insulation of these economies from the collapse of the Council for Mutual Economic Assistance.
Crisis in Russia
In the keynote address, Egor Gaidar, the former prime minister of Russia, provided a tour d’horizon of the Russian experience. He saw the crisis in Russia as deriving from the combined continuation of soft budget constraints from the socialist period and a substantial weakening of the previous hard administrative controls. This, together with corrupt individual relationships, culminated in the technical bankruptcy of state enterprises and a major macroeconomic crisis.
The first years of transition in Russia, he said, were marked by weak macroeconomic policy, very slow disinflation, weak budgetary and monetary constraints, and inflation that eroded budgetary revenues. Attempts at market stabilization had failed, and the country was not able to borrow abroad to finance its deficits. In the years immediately preceding 1998, tension mounted between the ingrained tendencies toward weak budget constraints and the effort to tighten budgetary policy. In the end, the state failed to cut the level of its obligations or improve revenue collection, and the huge deficits it ran up proved unsustainable.
The lessons of the crisis, Gaidar observed, were to disinflate as rapidly as possible, but also to reduce budget deficits quickly, address the vulnerability of the exchange rate regime to crisis, and seek to make the economy more efficient and transparent.
Privatization. Privatization has generally improved financial and operating performance, John Nellis of the World Bank observed, but its mixed record (notably in the countries of the former Soviet Union) has fueled questions about its methods and outcomes. Critics of mass privatization, for example, argue that it has done little more than turn poor-quality assets over to large numbers of poor owners, while high-quality assets have been concentrated in the hands of the “agile and well connected.” Others suggest that it is counterproductive to insist on a change in ownership when institutional reforms have yet to create the underpinnings for a viable private sector. It would be better, critics argue, to suspend privatization until the basic infrastructure can be developed or to renationalize—that is, return privatized firms to the public sector.
Pointing to successful efforts in Estonia, Hungary, Poland, Slovakia, and Slovenia, Nellis maintained that privatization does work. Institutions do matter, and some privatizations have been hasty, he acknowledged, but there is no reasonable alternative to continuing privatization. How, he asked, could a state that has trouble privatizing do a better job at managing public enterprises? It would be more advisable for the state to channel its energies into more effective privatizations—seeking ways, among other steps, to enlarge capital and to ensure sales to strategic investors.
Bank Restructuring. From his survey of the experience of the Baltics and Eastern Europe with banking sector reform, Lajos Bokros of the World Bank cited three pillars of effective restructuring: corporate governance, competition, and prudential regulation and supervision. Prudential regulation and supervision was “not really good” in any country in the region, he said, but strong performers shared a number of features. He highlighted, for example, the importance of effective foreign and domestic bank entry and exit regulations in liberalization and the crucial role of new private commercial banking. But perhaps the most important step in the restructuring process was privatization, and here he noted the element of soundness that foreign bank participation can provide. Weak performers also tended to share traits—namely, a lack of competition, poor asset quality, a lack of sector-specific expertise, significant state ownership, low levels of corporate lending, and an unstable macroeconomic environment.
Progress in bank restructuring in transition countries, as elsewhere, would also require an appropriate incentives structure to direct banks to their primary function of financing investment and activities for economic growth, and away from risky investments in pursuit of quick profits.
Institutions Do Matter
What Moves Capital? Virtually all transition countries have sharply reduced inflation, but only some have attracted significant levels of foreign direct investment. In a paper examining the size and composition of capital flows for 25 transition economies between 1991 and 1997, Pietro Garibaldi, Nada Mora, Ratna Sahay, and Jeromin Zettelmeyer of the IMF reported that total capital inflows to transition countries rose to significant levels by developing country standards, and early reliance on exceptional finance gave way to foreign direct investment and other flows. But the distribution of the inflows was markedly uneven, with Central and Eastern European countries and the Baltics accounting for 80 percent of total inflows and Russia remaining a net exporter of capital.
To determine what prompted this differentiation, the IMF study first weighed the impact of growth, inflation, and economic liberalization, but found limited evidence of an important direct effect of these on foreign direct investment. Legal and political climates and market-based assessments of risk, by contrast, correlated very highly with levels of foreign direct investment.
Fundamentals still matter, argued Sahay, who presented the paper, and policymakers can take comfort in the fact that fundamentals tend to be reflected in risk ratings. But a sound macroeconomic environment, though a key to growth, may not be sufficient to encourage investment. The study’s findings, she said, make a strong case for institutional reforms and point to the need to move these reforms to the top of the transition agenda.
Don’t Underestimate the Underground Economy. The underground economy is a mainstream economic issue, Simon Johnson (Massachusetts Institute of Technology) said, presenting a paper co-authored with Daniel Kaufmann (World Bank). Drawing on electricity-based measurements of the unofficial economic activity—as well as independent assessments of taxes, regulations, and corruption—the authors estimated that the underground economy accounts for more than 40 percent of total GDP in Azerbaijan, Georgia, Russia, and Ukraine, and 20 percent or more in many other economies.
What drives firms underground, they suggested, was not high taxes but excessive regulatory discretion, weak rule of law, and corruption. This “underground trap” has become a vicious cycle in which regulatory discretion leads, in turn, to corruption, hidden firm activity, reduced public revenues, weakened legal institutions, greater opportunities for corruption, and so forth. To break this cycle, governments needed to reduce regulatory discretion, reform bureaucracies, simplify and enforce laws, create an independent judiciary, and enhance transparency and public oversight.
Changing Role of Government. The changes wrought by shock therapy, Vito Tanzi of the IMF cautioned, are the easy ones. They have dismantled a command economy, but cannot, in themselves, create a new market economy. The development of a market economy will entail new institutions, changes in incentives, and a complete rethinking of the government’s role. According to Tanzi, these institutional changes, which lie at the heart of the transformation process, are profound steps that require deep, difficult, and lengthy structural reforms.
Government’s revamped role will be embodied in new tax, budgetary, and regulatory systems, Tanzi explained. Permits and authorizations, which characterized the old system and gave rise to widespread corruption, must be replaced by legal and regulatory environments that set the rules of the game and enforce competition. There will also be, he said, a more positive role for government in addressing growing income inequality. He urged special attention be given to fiscal reform and warned that government attempts to deal with large fiscal deficits by delaying wage or pension payments in effect corrupted the whole budgetary process.
Increased Income Inequality. The transition from planned to market economies has been accompanied by a very large shift in income inequality, Branko Milanovic of the World Bank observed. In countries such as Bulgaria, Russia, and Ukraine, where inequality has risen most sharply, the rapidity of the increase in income inequality was three to four times greater than that experienced in the United Kingdom and the United States in the 1980s.
What is propelling this striking gap in incomes? Milanovic found greater income inequality in the new private sector, and noted that income from self-employment and property—traditionally unequal— now figured more prominently in total income. Additionally, a segment of former state employees remained unemployed, and social transfers, though a larger part of total income, were not reaching the poor.
At the end of three days, two things seemed clear: the experience of transition economies with privatization, income inequality, and institutional needs is becoming increasingly diverse (with historical and geographical differences being credited for part of this diversity); and the achievement of macroeconomic stabilization, widely recognized as necessary, is only a first step in the transition process. The vital next stage for these countries will be to strengthen or create the legal, fiscal, and regulatory infrastructures—and incentives—needed for the operation of a market economy.
In a concluding panel discussion, participants Richard Portes (London School of Business), Darius Rosati (Central Bank of Poland), Nicholas Stern (European Bank for Reconstruction and Development (EBRD)), Michael Deppler (IMF), Marcelo Selowsky (World Bank), and John Odling-Smee (IMF) reviewed the conference findings and offered their perspectives on country and international financial institution priorities in the coming years.
Both Portes and Selowsky noted that the future course for the more advanced Central and Eastern European economies will largely be guided by accession requirements for the European Union. Portes cautioned against proceeding too quickly toward monetary union (given the pressures for real appreciation of these currencies), but the lead-up to accession should, he said, drive down the perception of risk and increase the attractiveness of these countries for foreign direct investment.
The diverse performance of transition economies, Rosati said, underscored the role of policy mistakes and initial conditions. He emphasized that it is “absolutely important” that transition countries develop a new state that is a “market maker, and a maker and enforcer of laws”
Stern agreed. Repeating themes first laid out in a luncheon address, he acknowledged that the difficulty of creating basic institutions for a market economy had been greatly underestimated. Enterprise reform is the key next step, he stressed, and finding foreign strategic owners and shifting social responsibilities to the state would be among the crucial requirements in carrying out this reform. More broadly, Stern said, it will be important for the EBRD and other international financial institutions to help transition countries develop a new mind-set—a new willingness and readiness to change.
From the World Bank’s perspective, Selowsky said, there will be greater efforts to address the size of the public sector and banking sector weakness. Breaking the vicious cycle in Russia will, he added, require increased revenues to finance social spending and an improved environment to attract increased investment.
Deppler urged participants not to be misled by the old shock therapy versus gradualism debate. In truth, bold policies had proven the most effective way to stabilize, whereas structural reforms are by their nature gradual. But even here, the attitude of the authorities had much to do with the outcome: those who forced the pace reaped the better results. Deppler added that financial crises should be avoided through prudent macropolicies.
Odling-Smee suggested that progress in the Commonwealth of Independent States (CIS) countries would be determined by the outcome of the struggle between authorities attempting to impose macroeconomic discipline and enterprises eager to avoid hard budget constraints. After 10 years, what did the score card look like? He observed that the CIS countries had reduced inflation; achieved good, but fragile, growth; and strengthened their central banks. But enterprises had failed to move into the market economy, corruption had become a major concern, and external viability had yet to be established. There was clearly still much to be done.
A Decade of Transition
Papers presented at the conference
“Disinflation in Transition Economies,” by Carlo Cottarelli and Peter Doyle
“Growth Experience in Transition Economies,” by Oleh Havrylyshyn and Thomas Wolf
“Inflation and Growth in Transition: Are the Asian Economies Different?” by Sanjay Kalra and Torsten Sløk, with David J. Robinson
“Time to Rethink Privatization,” by John Nellis
“What Moves Capital to Transition Economies?” by Pietro Garibaldi, Nada Mora, Ratna Sahay, and Jeromin Zettelmeyer
“Banking Sector Reforms in Eastern Europe,” by Lajos Bokros
“In the Underground,” by Simon Johnson and Daniel Kaufmann
“The Changing Role of Government During the Transition,” by Vito Tanzi
“Explaining the Increase in Inequity During the Transition,” by Branko Milanovic