Journal Issue

Dubrovnik conference Participants conclude economic transition was more difficult than expected

International Monetary Fund. External Relations Dept.
Published Date:
January 1999
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Dangers of partial reform

The most significant disparity in the transition experience was between the countries of Central Europe and the Baltics, which have broadly returned to positive growth rates, and many countries of the former Soviet Union, which are still in recession, Johannes Linn of the World Bank noted. Differences in overall macroeconomic policy adjustment were less striking than those in the quality of adjustment and structural reforms, and high levels of economic distortion still prevailed in the laggard economies. This reflected weak public institutions, high levels of corruption, and a legacy of deeper central planning. Jan Svejnar of the William Davidson Institute noted that a significant disparity in growth rates across transformation economies had emerged in 1994-95, when countries that had initially undertaken more substantial structural reforms began to perform better. Many countries now found it difficult to catch up, with reforms more difficult to undertake later on.

Arye Hillman of Bar Illan University offered a sobering illustration of how countries could get stuck in an unproductive phase. An increase in rent-seeking activity by insiders in the first stages of transition could result in an equilibrium wherein more resources were switched to unproductive activities. Such a low-productivity equilibrium could be stable, especially in the context of a culture of subservience as had been promoted in the socialist tradition, and would be very difficult to challenge by disorganized outsiders. To escape from this situation, transition economies needed either a strong leader or a substantial shock and, in many cases, neither had been forthcoming, Hillman noted.

In support of this rent-seeking paradigm, three speakers focusing on the former Soviet Union pointed to the emergence of a culture of corruption that was difficult to dislodge. Yegor Gaidar of the Institute for Economy in Transition explained how in countries adopting a more “populist” approach to reform, the administrative constraints of the old system had not been replaced by market-driven hard budgets. Insider firms had retained preferential access to resources, a lack of clear ownership rights had encouraged theft, and newer enterprises faced unfair competition for resources and markets. In Russia, for example, the triumph of nomenklatura capital over the government had made it impossible to introduce meaningful stabilization, and a financial crisis would be required to change this ascendancy. Anders Åslund of the Carnegie Endowment for International Peace showed how piecemeal reforms had led to extraordinary levels of corruption in Ukraine, and he argued that this rent-seeking equilibrium would not be upset without major macroeconomic destabilization. [See also story on page 241.] Mario Nuti of the London Business School said that Belarus, which was still a command economy with a dominant state enterprise sector and controlled prices, had performed better than Russia in some respects because it had not even attempted meaningful reforms and had, therefore, kept corruption in check.

Daniel Daianu of the University of Economics in Bucharest argued that attempts to protect an initial resource misallocation could breed a silent conspiracy against transformation that could eventually overwhelm a fragile institutional structure and undermine stability. The initial misallocation was larger in Romania than in some other transition countries, and the subsequent distribution struggle, far from being resolved through restructuring, led to large interenterprise arrears and bad bank loans that could be resolved only through high inflation. Similarly, Ilian Mihov of INSEAD explained that in Bulgaria, partial reforms had led to an accumulation of enterprise losses that eventually undermined financial stability. The introduction of a currency board regime reimposed financial discipline, but there was a significant cost in terms of the deflationary impact of an appreciating real exchange rate.

Institution building and costs of reform

The development of market-based institutions and incentives was viewed as central to the success of transition, and participants highlighted the danger that institutional failure could lead to a second round of transition costs and undermine stability. Oleh Havrylyshyn (presenting a paper written with Ron van Rooden, both of the IMF’s European II Department) concluded that while macroeconomic policies and structural reforms were the most important factors affecting growth in transition economies, indicators of institutional development were also a significant contributor.

Institution building in the financial sector was particularly important, but John Bonin of Wesleyan University and Paul Wachtel of the Leonard Stern School of Business pointed to how difficult this could be. Governments should limit themselves to providing a clear regulatory framework and could even actively help in developing a sound infrastructure. However, in many instances, these efforts had failed, and governments had instead created moral hazard by absorbing risks. Warren Coats of the IMF’s Monetary and Exchange Affairs Department and Marko Škreb agreed that the development of an efficient banking system, free of losses and crises, had been slower than expected in most transition economies and had led to a continuation of financial distortions. Also, Velimir Šonje and Boris Vujcic of the Croatian National Bank detailed how a fledgling regulatory supervisor had found it difficult to control opportunistic behavior by banks in Croatia, generating a second round of fiscal transformation costs.

Using a novel approach, Velimir Bole of the Economics Institute of Law Faculty found that the first round of fiscal transformation costs in Slovenia reached a maximum of over 3 percent of GDP in the early stages and still exceeded 1 percent of GDP a year. Highlighting the more general difficulties associated with transition, a paper by JüArgen von Hagen of the University of Bonn and Rolf Strauch of the Bundesbank argued that the east German transition presented only a mixed picture of success. Even though it was conducted in the most ideal circumstances, with large initial transfers and a ready-made institutional and political structure, individual consumption and labor choices in eastern Germany now resemble those in west Germany but are still heavily dependent on transfers from there.

Lessons and future paths

Vito Tanzi, Director of the IMF’s Fiscal Affairs Department (in a paper written with George Tsibouris, also of the Fiscal Affairs Department), called for a systematic and realistic reexamination of the role of government in transition economies. Public expenditures had often been cut from desperation rather than consideration, creating an institutional vacuum in which small groups had acquired enormous wealth. Governments needed to undertake a deeper transformation that would entail establishing and enforcing the rules of the game, raising revenues and spending productively, and providing public goods. More generally, David Begg of Birbeck College and Charles Wyplosz of the Graduate Institute of International Studies in Geneva examined the size of government in transition economies. They noted that, while government expenditures had generally fallen in size, they were still larger than would be predicted from a model developed for the Organization for Economic Cooperation and Development countries.

Robert Mundell of Columbia University also advocated a reduction in the size of government and regretted that countries did not universally adopt foreign currencies at the outset of transition to ensure the stability necessary for a new private sector to emerge. This could still be accomplished, in many cases, through the adoption of a stable fix to the euro. However, Begg and Wyplosz (in a second paper) advocated a move to a more flexible exchange rate regime for many countries that had initially adopted pegged exchange rates. The most successful exit strategy was to simultaneously lower the rate of exchange rate crawl, and widen the exchange rate band.

Gur Ofer of the Hebrew University of Jerusalem proposed a stylized development strategy for transition economies that drew on the rich experience of developing economies. This strategy would combine openness, a financial sector based on a small number of banks, and a leading sector composed of large corporations with foreign participation. Constantine Michalopoulos of the World Trade Organization (WTO) also stressed the international dimension in transition, noting that the difficult process of accession to the WTO had provided a useful discipline for many countries in transmitting price signals from the world market to domestic resource allocation.

Those countries facing accession to the European Union faced an additional set of challenges and opportunities. Laszlo Halpern of the Budapest Institute of Economics (in a paper written with Judit Nemenyi of the National Bank of Hungary) called for a flexible interpretation of the convergence criteria such that, in the presence of once-off shocks, fiscal policies would not be overly restricted and exchange rates would not bear the full burden of a real appreciation of the currency. In Poland, Marek Dabrowski of CASE (in Warsaw) regretted that the reform process had slowed in the mid-1990s, but was optimistic that the pace had again picked up, driven by the harmonization requirements of the European Union. Similarly, Vladimir Dlouhy of GSE Prague decried the slowdown of reforms in the Czech Republic in the mid-1990s, which ultimately produced a costly crisis in 1997. He warned that a failure to liberate banks from state control would prove very costly and could yet jeopardize stability.


Putting the discussion in a broader perspective, Jacob Frenkel, Governor of the Bank of Israel, noted that all economies are constantly in a state of transition as they adapt to market forces. The overriding requirement is for a set of rules and a strategy to guide this evolutionary process; policymakers need to be resolute in applying such rules—avoiding both the creation of moral hazard and the temptation to overregulate. International capital markets will be the bridge to new states of equilibrium and have developed to the extent that they will impose severe punishment for policy mistakes, cheating, or political opportunism. In the same vein, Jacques de Larosière of Banque Paribas noted that transition was now well advanced in those countries that have vigorously pursued structural reforms. He argued that the second phase of transition would need to be based on a coherent legal environment and on a strong institutional and financial framework.

Ian S. McDonald


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