1 A Decade of Transition

Saleh Nsouli, and Oleh Havrylyshyn
Published Date:
April 2001
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Oleh Havrylyshyn and Saleh M. Nsouli 

Since the fall of the Berlin Wall nearly a decade ago, the former centrally planned economies of Central and Eastern Europe and the Baltics, Russia, and other former Soviet Union countries have made major strides in moving toward market-based economies. Initially, this historic transformation was accompanied by considerable price and output instability. In many countries, stabilization programs supported by the IMF and the World Bank helped contain this instability and bolstered the momentum for structural reforms. Yet by 1998, only countries in Central Europe had achieved sustained growth and recovery from the recession that followed the transition. And even in that region, Albania, Bulgaria, and Romania suffered setbacks during 1996–97. The crisis that beset Russia in 1998 not only exacerbated the recession in the region, it highlighted the key challenge of transition: achieving sustained economic growth.

To take stock of the accomplishments of the transition economies over the past 10 years and identify the challenges ahead, in February 1999 the IMF organized a conference for senior officials from transition countries, academics, and staff of international organizations. This volume contains the papers presented at the conference. The chapters explore a broad set of issues in the transition process—from the overarching macroeconomic problems of achieving stabilization and sustained growth to the microeconomic building blocks of the transformation. Specifically, the chapters examine private sector development, financial sector evolution, external sector relations, social protection, and most important, the proper role of government, the rule of law, and the effective functioning of market-friendly institutions.

In his opening remarks, former IMF Managing Director Michel Camdessus set the tone of the IMF conference. He pointed to the progress made, but cautioned that important challenges remained, reminding participants that most countries now had to turn to the much more difficult and time-consuming task of implementing second-generation reforms, at the heart of which is: “enforcing the rule of law and fostering a culture that respects and welcomes a framework of law, regulation, and codes of good practice.”

Achievements, Shortfalls, and Lessons

The non-Asian transition economies have generally achieved considerable inflation control, and many have begun to grow. The economic literature on the transition process has grappled with two critical questions on disinflation. First, how rapid has disinflation been during transition? Second, what effect has disinflation had on output? Carlo Cottarelli and Peter Doyle, whose chapter explores the record on disinflation, found that many transition countries achieved rapid disinflation. The median inflation rate in the CEE countries dropped from 84 percent in 1992 to about 9 percent in 1995. Disinflation was achieved even more quickly in the Baltics, Russia, and other former Soviet Union countries, where the median inflation rate fell from 1,210 percent in 1992 to 60 percent in 1995. The two groups of countries converged to a median inflation rate of about 11–12 percent by 1997. But the reduction in inflation has not always been sustained, and inflation has resurged in some countries.

Despite the rapid disinflation, the authors found no evidence that disinflation had a role in depressing output. Four factors played a key role in limiting the impact of disinflation on output: first, there was considerable political support for disinflation and price liberalization; second, stabilization policies were introduced early; third, in several countries comprehensive fiscal consolidation underpinned disinflation; and fourth, the monetary frameworks were appropriately flexible. Rather than depressing output, the resulting moderate- and low-inflation environment had an eventual positive impact on growth. Although few participants disagreed with these views, some emphasized that inflation control, while necessary, was not enough to increase output and had to be made sustainable, primarily by controlling the fiscal situation.

Nonetheless, in the early years of transition virtually every country in the region experienced a substantial decline in recorded output. According to Oleh Havrylyshyn and Thomas Wolf, although long time lags were inevitable in reallocating resources to more efficient uses in a decentralized system, the initial loss in output reflected the collapse of the highly centralized and inefficient production and distribution network of the command economy. Moreover, differences in the conditions and policies of the transition economies had different effects on output. These differences led to a much greater decline at the beginning of transition in the Baltics, Russia, and other former Soviet Union countries than in the Central and Eastern European countries. But after about three years of decline, output began to grow in many countries, although Albania, Bulgaria, and Romania suffered setbacks during 1996–97 because of failure to undertake some important structural reforms. Moreover, Kazakhstan, Moldova, Russia, Tajikistan, Turkmenistan, and Ukraine have registered little or no growth after eight years of transition, primarily because of civil conflict, weak policies, and the decline in world oil prices. And as already mentioned, the spillover effects of the Russian crisis in 1998—which itself reflects political uncertainties and an unfinished structural reform agenda—further exacerbated the recession in these countries.

Havrylyshyn and Wolf, using econometric analysis, demonstrated that after accounting for differences in initial conditions, variations in growth performance by country was attributable primarily to the ability of the more successful economies to quickly control inflation and to progress with such structural reforms as privatization, market liberalization, private sector development, and the establishment of financial and legal frameworks. Although conference participants generally agreed with this finding, some were concerned about the effect of underground activity on measuring growth. Others thought that the econometrics could be strengthened to emphasize the study’s conclusions and to show such missing factors as reverse causality. Some participants wanted to extend the discussion to a key future issue: how to “starve” the rent-seekers who in some countries have captured the policymaking process, slowing reform and hurting growth performance.

In contrast to the experience of the Baltics, Russia, and other former Soviet Union countries, the experience of the East Asian transition countries—notably, China—was considerably different in both growth and inflation. Sanjay Kalra and Torsten Sløk observe that the stronger performance of the East Asian countries reflects not only more favorable initial conditions but also far-reaching reforms in several areas—agriculture, in particular—undertaken early in the process. They warned that the lessons of Asian economies—which are still highly agricultural—are not easily transferable to other transition economies.

Promoting the Private Sector

Nicholas Stern noted that the reform of the public enterprise sector has often been patchy and inconsistent in transition economies. As a result, unprofitable enterprises have continued to operate. Furthermore, as John Nellis pointed out, in Russia and elsewhere, too much was promised of privatization. Several conference participants suggested setting clear, but limited goals for privatization, as opposed to the broad objective of creating a good market environment for all private sector activity, including new start-ups. Nellis underscores that some policymakers had incorrectly viewed privatization as a sufficient condition to bring about a new liberal order. Privatization was often pursued without due attention to whether the necessary supporting systems for private enterprises were in place, to the time it would take to establish such systems, or to the likely consequences of privatization in their absence. The poor record of privatization evoked considerable debate on the proper role of government and the political economy of interest group struggles. On balance, however, there was wide consensus for the view that any mistakes in privatization should not be corrected by going back, but by ensuring the development of a proper hard budget and competitive environment for efficient private sector operation.

According to former Prime Minister Yegor Gaidar, at the heart of Russia’s difficulties and setbacks during transition has been its inability to move effectively from a system of “soft” budget constraints with “hard” administrative constraints to the decentralized market system of hard budget constraints with little administrative and political interference. In Russia today both the budget and the administrative constraints have become soft. Even when privatized, enterprises are subjected to hard budget constraints owing to institutional weaknesses. Consequently, the opportunities for rent-seeking (that is, socially unproductive profit-seeking) are in place, but incentives for enhancing efficiency are not. The key to reducing corruption and enhancing efficiency is market discipline under hard macroeconomic constraints. Gaidar emphasizes, however, that macroeconomic discipline has been absent in Russia, and the resulting lax fiscal and monetary policies have proved unsustainable.

Some of the transition countries have large underground economies. According to Simon Johnson and Daniel Kaufmann, overregulation, corruption, and weak legal systems are what drive businesses underground. Aggregate data and microsurveys show that in Russia and Ukraine, unofficial output constitutes 40 to 50 percent of total GDP, whereas in most of Eastern Europe it is under 20 percent. The difference across countries is due primarily to variations in the degree of institutional weaknesses and government corruption. As a result of the growing underground economy, tax revenues have fallen and the quality of public administration has declined accordingly, further reducing firms’ incentives to be “official.” The authors’ main recommendation is to move on with privatization and regulatory and legal reforms in order to provide opportunities and incentives for firms to operate in the official sector.

Social Impact of Transition and the Role of Government

The transition from a planned to a market economy has been accompanied by one of the biggest and fastest increases in income inequality ever recorded. Branko Milanovic showed that, on average, inequality in Eastern Europe, the Baltics, Russia, and other former Soviet Union countries increased rapidly, as measured by a rise in the Gini coefficient from 25–28 to 35–38 in less than 10 years. (The Gini coefficient is a measure of the inequality of income distribution in a country, with 0 representing absolute equality.) In some countries, such as Bulgaria, Russia, and Ukraine, the increase in inequality was even more dramatic, outpacing by three to four times the yearly rate of increase in the Gini coefficient in the United Kingdom and the United States in the 1980s. What were the factors driving this growing inequality? First, wage inequality is greater in the new private sector than in the old, relatively egalitarian state sector. Second, income from self-employment and property, both of which are fairly unequal sources of income, have grown during the transition. And third, the incomes of former state sector workers who are now unemployed have declined, contributing to a “hollowing out” of the middle class.

Some of the commentators wondered whether the calculations might not have overstated the deterioration, given the distorted prices of the earlier period and the existence of shortages, but in general participants agreed that inequality had increased significantly. The implication drawn by the author and shared by most conference participants was clear: the transition governments must make more effort to offset the falling-out effect and to provide support for the neediest and most adversely affected, or risk losing social support for reforms. Nevertheless, some participants cautioned against going too far and undoing the part of the growing inequality that is an inherent outcome of the transition process.

Tanzi and Tsibouris, in examining the proper role of government, outlined the considerable changes made in the fiscal functions (tax collection and budget expenditures), especially in the tax systems. Nevertheless, they consider these structural improvements a beginning of the major changes needed—a beginning that in many instances had caused a sharp deterioration in revenue collections. They argue that, in the long run, transition economies need to develop governments that support but that do not distort markets, that provide the discipline of rule of law, that establish an efficient bureaucracy, and that meet their fiscal obligations and promises.

This view became virtually the identifying theme of the conference. It had relevance to every session and was forcefully echoed in the closing panel. A number of participants emphasized that, despite reforms, the state remained too large in many countries. They agreed that the transformation of the role of government was at the heart of the transition process. Others noted that although much had been achieved in institution building (especially in key agencies like central banks, finance ministries, and regulatory agencies for countries more likely to be integrated into the European Union) continued strengthening of institutions was an essential part of the integration process.

The Support Roles of Financial Sector and External Capital

Following external and internal liberalization, the transition economies had large and growing current account deficits, which were financed largely by capital inflows. Garibaldi and others (1999),1 in their study of capital flows to 25 transition economies between 1991 and 1997, showed sizable net capital inflows to transition economies during the 1990s. On a per capita basis, the inflows were similar to those to the Latin American countries and to the more advanced Asian economies, and much higher than those to other developing regions. The distribution of inflows across countries, however, was not uniform. The more advanced transition countries—Central Europe and the Baltics—generally received much higher net inflows, whereas Russia was a net capital exporter. The econometric analysis demonstrated the importance of perceptions of country risk and institutional obstacles (such as government red tape) in determining foreign direct investment flows.

Generally, capital inflows at the beginning of the transition period consisted largely of exceptional financing, but later their composition shifted to favor foreign direct investment and other private capital. This suggests that official and private debt relief did indeed help the transition economies to adjust and reform.

Lajos Bokros’s survey of banking sector reforms in the Baltics and Eastern Europe shows that competition, corporate governance, and prudential regulation and supervision play a critical role in the transition to a market economy. Of particular importance to their performance were effective foreign and domestic bank entry and exit regulations, which facilitated the entry of foreign banks, thereby fostering competition, increasing the sophistication of the financial products available, and strengthening the domestic banking system. In contrast, the financial sectors in the weak performers lacked competition and sector-specific expertise; had low-quality assets, significant state ownership, and low levels of corporate lending; and operated in an unstable macroeconomic environment. Those with the least progress in bank restructuring were countries with inappropriate incentive structures that encouraged the accumulation of risky assets in pursuit of quick profits.

The Challenges Ahead

The record of the last decade in the transition of countries to a market economy is one of progress, but also of challenges ahead, as pointed out by IMF Deputy Managing Director Shigemitsu Sugisaki in his concluding remarks. Although these countries have generally managed to reduce inflation and to renew output growth, their situation remains fragile. Resurgence of inflation, a weakening of output performance, and an intensification of external sector pressures are all possible. In this regard, the conference identified the main challenges facing these countries:

  • First, the role of government needs to be radically transformed. As pointed out by Vito Tanzi, to function well, market economies need governments that are efficient and evenhanded in establishing and enforcing essential rules for promoting widely shared social objectives, for raising revenues to finance public sector activities, for spending these revenues productively, for bringing required corrections to and controls over the working of the private sector, and for enforcing contracts and protecting property. Governments will need to establish rules of the game that are appropriate to market economies as well as regulations in such areas as private pensions and competition while eliminating most discretionary regulations, often relics of the command economy. Such actions essentially amount to creating an environment conducive to the efficient functioning of market forces, and therefore are critical to fostering the growth of the private sector and shrinking the underground economy. They also reduce the perception of risk, thereby helping to attract foreign direct investment. The great difficulty of creating basic institutions should not be underestimated, however.
  • Second, the process of privatization has to be improved. A strong institutional framework, and openness and transparency, are key to successful privatization. Numerous actions have to be taken to streamline privatization. Downsizing and restructuring can take place through a reallocation of ownership and control, which could be facilitated by involving foreign investors. But in reallocating ownership, officials must avoid transferring labor and social obligations of the old firms to the new owners. These steps must be reinforced by reorienting the role of the state to promote market discipline and by putting in place effective bankruptcy procedures, while ensuring that financing is made dependent on a well-regulated and supervised financial sector and on good business practices. Such actions will effectively harden the budget constraints on enterprises.
  • Third, financial sector reform is fundamental to promoting growth because it improves the intermediation process and increases efficiency in the allocation of financial resources. The progress made in giving greater autonomy to central banks represents a step in the right direction. However, a competitive system open to foreign financial institutions, and the enactment and effective implementation of strong prudential regulations, are key components that still need to be addressed in many transition economies.
  • Fourth, severe income inequalities must be tackled even if one accepts the fact that some increase in inequality is inevitable, and even desirable, when compared with that which existed in the socialist period. Over time, institutional change and increased competition should help reduce economic rents and income inequalities. The process will take time, however, and governments will need to put in place a well-targeted social safety net for the most vulnerable segments of the population. Ensuring adequate support for the neediest is undoubtedly a role of the government, as is providing assistance to workers displaced by reallocation of production. A reform process that ignores the losers and fails to provide for the neediest may falter in the long run for lack of support.
  • Fifth, macroeconomic stabilization is essential for structural reform and the recovery of economic activity and sustained growth. Empirical evidence shows that lower inflation rates, while not sufficient by themselves to ensure growth, are associated with faster economic growth in the long run. Further, transition countries with persistent moderate inflation, as well as other advanced transition countries, now enjoy favorable circumstances for continued disinflation. In transition countries, the inflation threshold above which output costs rise substantially is now comparable to the threshold in industrial countries; therefore, a commitment to slowing inflation to industrial country levels over the medium term is appropriate, especially in countries aspiring to join the European Union.
1Pietro Garibaldi, Nada Mora, Ratna Sahay, and Jeromin Zettelmeyer, 1999, “What Moves Capital to Transition Economies?” (unpublished; Washington: International Monetary Fund). This paper was presented at the conference but is not included in this volume.

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