XII. 2014 and Beyond

James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
Published Date:
October 2014
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After 25 years, where do the transition countries stand, and where are they headed? Does it still make sense to think about this set of countries as a discrete group, or are the differences between them now greater than the commonalities? And what are the main policy priorities looking forward to the next 25 years?

Country situations in 2014

The transition countries have, for the most part, made remarkable progress in the past quarter century. Most are fully functioning market economies, with stable macroeconomics, strong institutions, and income levels that have converged strongly with the West. Indeed, cluster analysis provides evidence that the relative status of the transition economies within Europe has changed over time. Groupings based on a set of indicators expected to be associated with countries’ state of development suggest that in the late 1990s, the continent remained divided along “traditional” west-east lines, with advanced countries on one side and transition countries on the other—albeit with Slovenia already displaying the characteristics of the advanced group.1 Each of these clusters divided into two principal subgroups, again more or less along predictable lines. These relationships are represented by tree diagrams (“dendrograms”) identified by the analysis.

Clusters in Europe

If we fast-forward to the latest data, we see that the continent continues to divide into roughly the same four clusters as before, with only a couple of countries changing groups. However, the relationships between the clusters—again, as shown by the dendrograms—have changed in an important way. The differential development of the transition economies, with more rapid progress in Central Europe and the Baltics than in Southeast Europe and the CIS, has led to greater disparities between the two subgroups. Meanwhile, the effects of the global and euro zone crises have tended to drive the two subgroups apart in Western Europe as well. According to the latest indicators, these two processes have now progressed to the extent that the “advanced” CEE countries have more in common with the EU15 countries (and within them, the “southern” Europe subgroup) than they do with former Comecon partners to the east.

Macroeconomic ranking

This general picture of a more “commingled” continent is also supported by a different approach based on a simple ranking of macroeconomic performance relative to advanced European country norms.2 Taking three-year average values up to 2000, there was almost no overlap between “advanced” and “emerging” Europe. A decade and a half later, some of the CEE countries have moved deep into the former advanced territory, and the rankings are now highly interwoven between the two groups. This ranking also illustrates the growing disparities among the transition economies, as with the broader cluster analysis above—although here it is notable that in purely macroeconomic terms, the more “advanced” CEE countries are close to the best performers in Western Europe, and generally far ahead of the “southern” Eurozone countries.

Of course, any of these results can only be illustrative, and should not be overinterpreted, especially at the individual country level. But the general messages chime with other evidence of transition progress discussed in the earlier chapters of this report.

So, much as the overall progress of the transition economies is to be lauded, there are clouds around the picture. First, even after 25 years some countries have failed to make a decisive break with the past, or have seen former state command replaced with control by private interests. Such countries continue to struggle with low growth, high unemployment and uncompetitive industries, and risk getting left further and further behind.

Second, even in the well-performing economies, the pace of convergence has slowed dramatically in recent years. From 1995 to 2008 the region as a whole was catching up towards average EU incomes at a rate of about 1 percentage point a year, from around 35 percent to nearly to 50 percent. Since the crisis this rate has dropped sharply. Measured against all advanced economies, most countries of the region have been flat or falling back. Relative incomes in Emerging Asia, in contrast, have continued to rise strongly, albeit from a much lower base. 3

Income levels relative to advanced economies

Percent of advanced economies GDP per head at PPPs

Source: WEO.

Relatedly, as discussed in Chapter X, estimates of growth potential going forward have been revised down drastically since the twin crises hit. If such projections materialize in the medium term, the process of convergence—on which the region still pins strong hopes—will be much slower than in the past, threatening disillusionment and posing risks to fiscal and social policies. The recent increase in geopolitical tensions within the region could also adversely affect prospects, the more so if the tensions are long-lasting. Uncertainty, if left unresolved, could lead to a decline in confidence, reducing investment and consumption across countries—and further depressing long-term prospects.

Policy priorities

What needs to be done to revitalize the convergence mdel and reduce the risk of some transition countries yet again falling back into crisis? The first priority is to ensure that policies are moving forwards, and not in reverse. As noted in Chapter VI, the crises of 1997–98 tended to galvanize countries to pursue sound macro policies and structural reforms more vigorously, contributing to the successes of the subsequent period. In contrast, the recent crises appear to have resulted, in a few countries, in a more fundamental questioning of the direction of market reforms.4 Perhaps this mirrors the effect the crisis has had in rethinking some of the orthodoxies of macro policies in the advanced countries. But it is important to draw the right lessons from experience. There seems little to suggest that the problems some countries ran into during the crisis were due to “too much reform,” or that a return to a more activist role of the state in industry or other sectors will help. Instead, as discussed in Box 4, there is good evidence of a strong relationship between reform and convergence, even if the payoffs from reforms sometimes take time to materialize. A better lesson from the crisis might be the importance of establishing strong legal frameworks and adequate macro-prudential controls: generally it was the countries that tried to rein in market excesses during the boom that did better in the bust.

Reform and convergence, 1990-2013

Source: WEO, EBRD.

Note: Baltics, SEE xEU from 1992. Excludes CZE, MDA.

The second priority is a renewed focus on macroeconomic and financial stability. It has come as something of a shock after the “Great Moderation” period, when macroeconomic conditions seemed favorable across the region, that many countries—notably in the Western Balkans—are again facing persistent deficits and rising debt. These countries, which tend also to have high unemployment and high social needs, face a difficult political and economic challenge in restoring sustainability. In 2014 inflation has unexpectedly posed a challenge to macroeconomic policy from below in many countries—turning negative in as many as nine cases—while in some others (mainly in the CIS) it has risen well above target.5 Finally financial sector stability—an area of strength in most of the region—has come under question in isolated cases, and high and rising NPL levels pose challenges more broadly.

The third priority is to increase the pace and depth of structural reforms going forwards. A key lesson from the past 25 years is that sound macroeconomic policies on their own are not enough to achieve convergence—which instead depends fundamentally on deep-seated structural and institutional change. Reform momentum has slowed since the early 2000s across almost all the CEE countries. For some this may reflect an element of “coasting” after the efforts to meet EU membership requirements for 2004 or 2007. It may also reflect the benign global conditions of the boom period, when countries could receive plentiful financing with our without needing to “prove” anything to foreign investors, and certainly without needing to satisfy conditionality from the IMF or others. Conversely, in the wake of the global and euro zone crisis, conditions were so difficult as to mean that energies were directed fully to crisis management rather than structural reform.

Consistent with the results of the cluster analysis presented above, the slowdown may simply reflect the fact that many of these economies are now more like “regular” countries, where reforms tend to be incremental, and to advance via deliberate political processes balancing the interests of stable segments of society. From this perspective the early window of opportunity for very rapid and radical change—exploited much more effectively by some than others, as discussed in this report—may now have closed. But just because countries are no longer identified solely as “transition economies” does not diminish the need to pursue ambitious policy agendas. After all, the strongest calls for structural reforms nowadays tend to be made in countries like Japan or in southern Europe, with no history of communism, which are struggling to restore growth prospects.

Specific policy recommendations vary from country to country, with IMF advice provided in regular consultation reports for each member country. Reflecting the diverging patterns of development discussed above, the most urgent and far-reaching reform priorities are concentrated in many of the Western Balkans and CIS countries. But consistent with the priorities put forward in the preceding thematic chapters, and as also spelled out in the IMF’s October 2013 and April 2014 Regional Economic Issues reports, some common policy themes across the CEE region emerge as elements of pro-growth strategies:

  • Strengthening the business environment is a critical factor throughout the region. This requires actions across a broad front, including corporate governance, property rights and contract enforcement, administrative reform and cutting “red tape,” insolvency law and competition policy. Attracting FDI, further integration into global supply chains—also looking beyond Europe—and moving within these supply chains to higher value-added activities, will be strong determinants of growth potential. For a number of countries, legal and administrative reforms are needed to improve governance more broadly.

  • More balanced composition of fiscal consolidation between expenditure and revenue, and measures to strengthen revenue administration and tax compliance. In many countries demographic pressures point to a need for further reform of pension systems, as well as for broader long-term fiscal consolidation.

  • High NPLs highlight the need for strong and independent banking sector supervision, improved insolvency frameworks and judicial reforms. Reviving credit growth and broadening SMEs’ access to finance remain critical in many countries.

  • Incentives to raise labor market participation and reduce skill mismatches, with use of active labor market policies where appropriate. In some cases institutional reform is needed to reduce duality between formal and informal or temporary employment, while providing support to vulnerable segments of society

The IMF remains closely engaged across the region to help countries advance their policy agendas, continuing to adapt the mix of surveillance, program support and technical assistance as country needs evolve. From the initial urgent search for policy options as central planning collapsed 25 years ago, through good times and bad since, new challenges have constantly arisen compelling the close collaboration between the IMF and its member countries in the region. No doubt such challenges, and such collaboration, will continue through the next 25 years as well.

Cluster analysis is a statistical technique that groups observations (countries in this case), by seeking to maximize similarities within clusters while maximizing differences between clusters, across a range of indicators. The exercise uses normalized series for GDP per capita at purchasing power parity (PPP), life expectancy, energy use per unit of GDP, the share of agriculture in GDP, and the Transparency International corruption perceptions indicator to proxy for institutional strength. Clusters were identified using three-year averages. In both time periods, per capita GDP had the strongest discriminatory power of the five indicators in identifying the clusters.

The macroeconomic ranking is based on a weighted average of seven macroeconomic indicators (current account balance, inflation, unemployment, government balance and debt, GDP per capita at PPP and real GDP growth). Weights were generated by principal components analysis of EU14 countries (EU15 excl. Luxembourg) using 2000–14 averages, which yielded results fairly close to equal weighting across the seven variables (with all taking the expected signs). The variables were normalized against 2000-14 EU14 benchmarks.

Comparisons across other transition countries—especially those in Asia—are difficult, as they began with very different economic structures and political systems. For a discussion, see Sachs and Woo (1994).

See EBRD (2013) for discussion of reform reversals and political factors associated with success in implementing market-oriented policies.

See IMF (2014a), IMF (2014b) for discussion of inflation developments, as well as the impact of Ukraine/Russia tensions and other conjunctural issues.

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