This session focused on the challenges that the Bretton Woods institutions face in helping member countries make the transition from central planning to a market economy. The first speaker was Liu Zhongli, the Minister of Finance of the People’s Republic of China, who spoke about China’s approach to reform. He was followed by Richard Portes, who, as Director of the Centre for Economic Policy Research, has undertaken an extensive program of research on these issues. He discussed the experience of Eastern Europe in economic liberalization. The session was chaired by Viktor Gerashchenko, the Chairman of the Central Bank of the Russian Federation.

Liu Zhongli

I am very pleased to address this session focusing on economic reform, because China itself has been undertaking broad and deep reforms. Over the past 15 years, China has prominently emerged on the path to reform, demonstrating its special characteristics—the reform path that we have chosen to take in the context of the actual situation of our country. At present, we are moving toward the goal of building a socialist market economy. I would like to take this opportunity to provide you with information about China’s reform, our perception of it, and our practice.

The Chinese people initiated the reform program on their own volition. A strong state and a prosperous nation is what the Chinese people have been striving for generation after generation. Ever since the founding of the People’s Republic of China, the Chinese people have been ambitious about reconstructing and developing their country as fast as possible by relying on their own efforts, thereby lifting themselves out of poverty and backwardness. Confronted with the then international environment and the country’s circumstances, China embarked on the road of development based on a highly centrally planned economy.

In the early stages of development in the new China, the economic system of highly centralized planning played an historic role; however, with time and changing circumstances, this traditional system turned out to be increasingly ill-suited to meet the needs of the Chinese economy and was hindering the further improvement of productivity. A development model of self-imposed isolation from the outside world will not enable China to modernize. Faced with a rapidly changing world, the Chinese Government and the people reached a consensus: only through reform will China be prosperous and only by opening up will it keep pace with the outside world.

Unlike other pioneering countries undertaking market-oriented reforms, China was faced at the outset with a unique situation: first, as a low-income, populous developing country, it was characterized by a rural community accounting for 80 percent of the population, regional disparity in development, a generally low level of productivity, and serious poverty problems; and second, China had a system of a highly centrally planned economy with an egalitarian distribution of income and, as a result, had forged an interest structure that suffered from a lack of incentive and discipline.

The restraints of the traditional economic system and the fragility of the low-income economy constituted dual constraints to reform. Reform is a profound transition, which will inevitably break down the traditional interest structure. However, with low incomes and a large population, economic growth has to be the precondition for readjustment of this structure. Only by making a larger cake will it be possible to adjust the way it is shared with the support of the overwhelming majority of the population. China’s reform program has to be implemented in the context of economic growth, and the phasing in of the new economic system must take place alongside the phasing out of the old one. Therefore, a gradualist approach has been adopted to ensure the success of reform under the conditions of the dual constraints. The reform program has been implemented with a balanced combination of short-term and long-term objectives and with proper emphasis on the linkage between reform, development, and stability to ensure the irreversible trend of reform.

Indeed, the reform program aimed at both short- and long-term objectives reflects a strategy to harmonize desirability and practicality. To avert an earthshaking impact on the national economy, the reform program in China did not completely crush the old system overnight. Instead, it advanced from the periphery to the center and from individual parts to the complete whole in order to achieve a range of realistic short-term objectives in succession—as stepping-stones to attain long-term objectives.

In China, reform, development, and stability are interlaced and interdependent. Reform is the engine of development. As development is the groundwork for social stability and national prosperity, it is both the ultimate goal of reform and a necessary condition for its smooth implementation. Stability is a sine qua non of reform and development. We make a point of maintaining stability in order to keep our balance in moving ahead faster than would otherwise be possible. Therefore, it follows that Chinese reform takes the gradualist approach, which has become its distinct feature. This approach has proved effective in China.

Over the past 15 years, the program of reform and opening up has unleashed productive forces and raised the overall strength of the national economy. In 1978–93, China’s GNP grew at an average annual rate of 9 percent, and per capita income of the rural and urban inhabitants, adjusted for inflation, at 6 percent and 8 percent, respectively. Having reaped visible and tangible benefits, the Chinese people, 1.2 billion strong, have embraced the program with the greatest enthusiasm and with unqualified support. They are deeply convinced that they have a significant stake in the far-reaching reform program.

The goal of China’s reform is to establish a socialist market economy. And the reform has continuously evolved in theory and in practice.

Development in theoretical exploration for the reform has focused on how the issue of planning versus market should be addressed. Ranging from the idea of a “dominant planned economy supplemented by market regulation,” which was proposed in 1979 at the early stage of reforms, to that of building a planned socialist commodity economy, as announced in 1984, and then to the goal of building a socialist market economy set by the Party’s Fourteenth Congress in 1992, this process of conceptualization reflects the progress of our understanding of the issue of planning and market.

In practice, the reform program has advanced chr onologically in three phases, reflecting the gradual process of the intensifying reform.

In the first phase of about six years, reform efforts were concentrated in rural areas, providing incentives to farmers to produce agricultural products for the market by setting up various forms of the household contract responsibility system. In urban areas, enterprise reforms intended to extend autonomy were initiated on a trial basis. Meanwhile, special economic zones were established, and 14 port cities were opened to the outside. By launching the reform program in rural areas, which had remained peripheral to the Chinese system of a planned economy, China managed to set reform in motion at the lowest possible cost. For such a large agrarian country, the instant success of the rural reforms was the first critical step in addressing agriculture as a fundamental problem in the Chinese economy, thereby laying a solid foundation for reforms to be developed in a comprehensive way. A remarkable feature of the rural reforms was the mushrooming of township and village enterprises, which injected the vitality of a new mechanism into the Chinese economic system, serving as an instructive prelude to enterprise reform in urban areas.

The second phase covered seven years. During this period, reform efforts shifted to urban areas, with emphasis on revitalizing enterprises. Efforts were made to increase the autonomy of enterprises by delinking them from the government and to transform their operating mechanisms. Meanwhile, moves were also gradually initiated to develop markets and to implement price reform and reform in macroeconomic management. Broad reforms were evolving in both urban and rural areas, in science and technology, education, and the political system. The coastal areas in southern and eastern China were further opened up. Reforms at this stage began to make inroads into the core of the system of the planned economy. Prominent features were the implementation of individual packages and special regional emphasis in a bid to achieve breakthroughs up front in unraveling the old system in certain areas and regions. Price reform was the area that achieved the most outstanding success, with the market beginning to replace planning step by step in price determination.

The third phase started in 1992 when China’s reform entered the era of building a socialist market economy. The essence of the reform at this stage was to create a modern enterprise mechanism, supplemented by sweeping reforms that encompass planning, fiscal policy and taxation, and pricing, labor, and wage systems, as well as the financial, commercial, and trade sectors. Emphasis began to shift from breaking through the old systems to establishing new ones; from readjusting policy to building up a new institutional and regulatory framework; from individual reform packages to integrated reforms; and from prioritization to advancement on all fronts, reinforced by special focuses. Opening up to the outside intensified and broadened on an unprecedented scale.

The 15 years of reforms have led to a sea change in the Chinese economic system and its operating mechanism. The market is beginning to play a dominant role in resource allocation. Nevertheless, China remains in transition from the old to the new system. The flawed traditional system, deficient in discipline and economic incentives, still exists, while the market mechanism of resource allocation is still being developed. Conflict and friction between the two systems have spawned uncertainties in economic activities. The resolution of certain problems has made structural problems even more acute. For instance, questions remain on how to strengthen the basic agriculture sector and overall rural economic development; how to transform the operating mechanisms of enterprises and improve their efficiency; how to narrow regional development disparities between east and west and reduce poverty; and how to develop social equity and establish a social security system without compromising efficiency.

For these issues to be resolved in a fundamental way, the reform process must be accelerated, and a full-fledged socialist market economy established. At present, our basic policy is to seize the opportunity, in tensify reform, open up further, promote development, and maintain stability. The priorities are to establish modern enterprise systems and speed up the reform of macroeconomic management systems in fiscal, taxation, financial, and investment areas, to be supplemented with reforms in related areas. A legal framework for a modern market economy is to be established to govern the new systems with laws and regulations. Substantive measures must now be taken to strengthen and improve macroeconomic management, control inflation, strike a proper balance between reform, development, and stability, and ensure the smooth implementation of reforms. We envisage that by the end of the 1990s a socialist market economy will largely have been established, which will further develop into a mature and stable system in another 20 years or so.

Opening up to the outside world constitutes an integral component of our reform program, and China is committed to more extensive exchanges with the international community in this process. Chinese history contains a humiliating chapter of being coerced to open her doors. Today, full of national confidence, the Chinese people have taken the initiative to open up to the outside. Like a vast ocean willingly absorbing water from all sources, the nation is now opening its arms to the fruits of civilization of the entire human race, including the physical and nonphysical fruits of civilization created by capitalism over the centuries. Opening up to the outside world has substantially contributed to the reform process in China, integrating its economic development with that of the rest of the world.

While mainly relying on our own efforts to implement reform, we have also benefited from broad international support and drawn on valuable cross-country experience. We shall continue to strengthen such international cooperation. It is our consistent view that national situations—economic, cultural, etc.—vary from country to country and that there is no such thing as a universally applicable reform model. China’s reform program has to fit into the actual situation of the country, and the principle governing its implementation is to follow whatever is sound and feasible.

Permit me to say a few words about our cooperation with the World Bank and the IMF in the field of promoting reform. The direct support of these two institutions for our reform is mainly reflected in two areas: at the macro level—providing advisory services for the formulation of policies and strategies—and at the micro level, so far as the Bank is concerned—supporting the actual implementation of the reform program through investment projects charged with reform objectives. Obviously, our cooperation in this way has been very successful, and we expect to enhance our efforts further in this respect. We feel that advisory services and financial support are mutually reinforcing and that therefore neither should be neglected. We feel that the two institutions can play a positive role in supporting the reforms of member countries, as long as they respect member countries’ decision making and take into account their actual situations and their needs.

On the occasion of the fiftieth anniversary of the Bretton Woods institutions, we welcome the continued efforts of the World Bank and Fund to support the undertaking of reform in developing member countries. We think that the institutions should give increasing attention to the special difficulties of low-income countries under reform while addressing the generic issues in developing countries and the common issues of economies in transition. In our view, support for reform and assistance for development are mutually complementary. Reform is aimed at promoting development, which, in turn, will create the necessary material conditions for its further enhancement. This is particularly true in low-income countries where the growth of social wealth is instrumental in the readjustment of the interest structure affecting different groups of people. Following this rationale in stressing their assistance for reform, the Bank and the Fund should not overlook the strategic implications of development for reform. Furthermore, the two institutions should give consideration to the relationship between efficiency and equity. Reform should not only improve the efficiency of economic activities and promote growth but also bring benefits to the majority of people, to ensure the sustainability of reforms. Indeed, this is the ultimate objective of reform.

We appreciate the principle of client orientation recently proposed by the World Bank. We find that low-income countries have a special need for infrastructure development, poverty alleviation, human resource development, and institution building. The Bank’s support in all these areas will bring about favorable economic and social conditions to facilitate reform in these countries.

It is crucial for such a low-income developing country with one fifth of the world’s population as China to set up a socialist market economy. There are still many twists and turns on the road to accomplishing this complex and daunting task. It is our strong belief, however, that China’s reform is in the fundamental interests of this nation and that it also contributes to world peace, stability, and development. Bracing ourselves for future challenges, we will unswervingly move along the path we ourselves have chosen. We are fully confident that we shall be able to attain our objectives!

Richard Portes

Purpose, Procedure, and Principles

We have not seen a reversion to communism or central planning in Eastern Europe and most of the former Soviet Union, and west of Ukraine, the recovery from the depression of the early 1990s has begun. But the economic transformation of Eastern Europe has proved much slower, more difficult, and more costly than we all expected five years ago.

Where incipient hyperinflation was stopped, inflation still remains stubborn in the 25–60 percent per annum range, and some stabilizations have failed. The initial fall in output was far deeper than projected and in some countries still has not been reversed. Liberalization of prices and elimination of central allocation did create functioning markets rapidly, but the accompanying redistribution of income has strained social cohesion. Often the corruption engendered by bureaucratic allocation has given way to more overt criminal activity in unregulated markets. Even giving away state enterprises to private owners takes time (finishing only now in the Czech Republic), and “large privatization” has in most cases gone very slowly. In both state-owned and privatized firms, there has been significant “defensive” restructuring, but the forward-looking, strategic action that changes industrial structure requires both domestic and foreign investment, which has so far been lacking.

Some participants with major stakes or political ambitions maintain that there was no (better) alternative to the policies followed, and they claim vindication in the first signs of recovery. They finally see the light at the end of the tunnel under the vale of tears—not before time, though many had claimed to see it much earlier. Politics is unforgiving, and doubtless one cannot afford the luxury of admitting error. Nevertheless, there is a striking lack of detachment in some of the ex post rationalizations that appear not just in the press but also in the professional literature.

I shall not examine a particular country’s experience, but there is no space for a comprehensive survey. So I shall take a selective, critical view. I shall take most of the “good news” as known—it is natural for policymakers to dwell on their achievements, and this paper is directed toward the policy community. It will therefore focus primarily on errors in the design of the transformation so far, giving some attention to further dangers on the path ahead. The experience of the vanguard should be instructive for the next wave, despite the specificity of individual countries. Evidently, this exercise benefits enormously from the perspective of hindsight. I shall devote special attention to the role in policymaking of the international financial institutions, especially the IMF.

I shall not be so ambitious as to hand down “commandments” to guide the transition or to expose “fallacies” in the positions of other commentators. Both the professional literature and the events of the past five years suggest humility, as well as skepticism toward political rhetoric: the most ardent proponent of “radical shock therapy” or free market ideologist may choose not to raise rents or energy prices to market levels immediately in a single step, to hold back on enforcement of bankruptcy laws, and in other ways to manage the transformation pragmatically—and successfully.

We should therefore avoid labels: not even “radicals” and “gradualists.” It is no more helpful to divide the field among neo- (or any other kind of) liberals, Keynesians, planners, institutionalists, or evolutionists. Economic analysis can get us beyond these clashing categories and the misleading metaphors often used to support them.

We are frequently reminded that we have no general theory of the transformation, no optimal paths or well-defined end points. That is neither surprising nor cause for concern. We do have a wide range of useful tools. As always, we can get quite far with supply and demand embedded in a suitable general equilibrium framework. For macro, we have revealing models of hyperinflation, different approaches to stabilization, and the roles of nominal and real anchors. The political equilibrium literature helps us with credibility and sequencing. Trade theory, economic geography, and gravity models can illuminate trade and investment policy choices. Recent work on incentives, regulation, corporate governance, and financial repression, as well as tax-benefit models all have extensive applications to the issues that arise in transformation.

There are nevertheless key differences between the economic transformation of Eastern Europe and two common analogies: postwar reconstruction; and stabilization, liberalization, and adjustment in middle-income developing countries. I would stress three features that require intellectual and policy innovation:

  • The unprecedented need to move from comprehensive central planning and state ownership simultaneously to markets and private ownership;

  • The underdevelopment of market economy institutions side by side with overdevelopment of industry; and

  • The exceptional degree and extent of distortions in prices, technology, capital stock, and behavior (of managers, workers, and households).

These distinctive characteristics of the transformation were not always properly addressed by our existing tools, and mistakes were made. Before turning to the lessons to be learned, we should note that although these features did not appear in postwar Europe, nor in Latin America, they were—all three—present in China when it began its economic reforms. That is why there are, in fact, many ways in which the East European experience of economic transformation is relevant to China, and conversely.

The Big Issues

Radical/Shock Versus Gradualism/Sequencing Versus Minimum Bang

This issue does not bear lengthy discussion: it is another example of slogans displacing analysis. There is confused, misleading argument over whether Russia did or did not try shock therapy; over whether socalled Polish radicalism has been more successful than so-called Hungarian gradualism, with no attention paid to the initial conditions in each country. This rhetoric is understandable when it comes from politicians, inexcusable from economists.

Here, I have not abandoned my early view that a “robust sequence” should follow a “credible regime change.” The opening package of measures must be sufficient to make the regime change credible, but it is administratively impossible and economically unwise to try to do everything at once. The legal, institutional, economic, and behavioral infrastructure of the capitalist market economy cannot be installed quickly and by fiat, except possibly by a government as authoritarian as the worst of those overthrown in the revolutions of 1989. Thus, policy-makers must choose a sequence. It is better to design that sequence consciously, insofar as possible, rather than just to follow the political winds.

This position may well be “gradualism,” but that is widely (often intentionally) misinterpreted: a gradualist program for a sequence of policy measures is just the opposite of the uncoordinated improvisation of which gradualism is often accused; if it really is drift, then it is not deliberate policy. On the other hand, avoiding drift in a gradualist program does require some ability to precommit, as well as to retain some credibility when political imperatives or exogenous shocks force reoptimization. That is hard, so trying to do everything at once may actually seem easier. It is not, nor is it feasible.

We should therefore beware of those who take the conventional refuge of the extremist ideologue in claiming that the program has not failed, it has just not been implemented fully and consistently. That is a hypothesis that is in principle not testable, because it will always be possible to find a “key” element of the program that could not be applied.

In any case, the range of sensible strategies is limited, and there may be little margin for choice. Some elements of stabilization and liberalization make sense only when done simultaneously. The range observed across countries is in fact surprisingly limited and is mainly a function of initial conditions. Foresight, sequencing, implementation, and political support are the key differences and potential weaknesses. And no country fits particularly well the stereotype that the ideologues assign to it: “gradualist” Hungary was much more “radical” than Poland in its implementation of bankruptcy legislation, and Czechoslovakia was more “radical” than either with its voucher privatization program.

The choices posed by sequencing are not merely sources of academic dispute. There are serious, major decisions: about the priority to be given to privatization of large state-owned enterprises relative to other institutional changes and demonopolization; the urgency of creating a healthy structure of financial intermediation; and many others. These choices are conditioned by political feasibility, but for an economic policy program, the political considerations fall under tactics rather than strategy—and as our models demonstrate, political feasibility is endogenous.

Country Specificities

The range of countries that can now be classed as “in transformation” is vast: Hungary, the Czech Republic, Poland, and Slovakia (the “Central European” or “Visegrád” four); with Bulgaria and Romania, we have the “core six”; adding Slovenia and the Baltic states, we arrive at the likely full list for European Union association agreements (the “Europe agreements”)—the medium-run candidates for accession to the Union; Albania and the rest of the former Yugoslavia complete “Eastern Europe”; farther east, we have Russia, Ukraine, the rest of the former Soviet Union, Mongolia, China, and Viet Nam. Most of my observations will be drawn from the experience of the “core six,” but we want the conclusions to have more general relevance. Is that possible?

Comparisons are undermined by differences in initial conditions. Time series are still short, and we cannot rerun history, so it is especially tempting to compare the experiences of different countries. But they (their policymakers) all think they are quite specific and cannot learn much from each other, much less from countries not undergoing this particular form of transformation.

There are indeed significant differences in initial conditions (see Islam and Mandelbaum, 1993): foreign debt, the history of workers’ power in enterprise management, industrial history, agricultural institutions, the sectoral structure of output and employment, macroeconomic imbalance, natural resources, trade structure, political culture and institutions, previous duration of communism and central planning, previous “reform” efforts, and doubtless much more. There are equally significant differences in the policies these countries have followed.

Politicians and policymakers understandably stress the specificity of their own countries—their circumstances, needs, and achievements. Every country is of course different. But economics aspires to generality, and noting specific successes and failures here and there is little help unless we can interpret what they imply. It is unhelpful to select only the comparisons and generalizations that suit one’s prejudices: for example, those who do see important lessons from the Chinese case for Eastern Europe often reject any analogies with Latin American countries, whereas those relying on the general features of stabilization in Latin America find such strongly specific characteristics in China as to make it irrelevant for Eastern Europe.

Our models and methods help us to make allowances for the clearly relevant differences, and cross-country comparisons are our only hope of constructing counterfactuals. In any case, it is certainly not my purpose here to evaluate various countries’ policies and their relative success—that is hard enough even when the initial conditions are much more similar than they were in Eastern Europe in 1989—but rather to look for generalizations (a representative sample of comparisons and generalizations in the literature might include European Commission, 1991; Portes, 1993; Blanchard and others, 1994; and European Bank for Reconstruction and Development, 1994).

The Importance of Rents

In a fundamental sense, transformation is all about economic rents and income distribution. That is in good part why it is transformation, rather than a smooth transition. Distortions create rents, which in turn create rigidities, resistance to change. In these conditions, economic agents do not so much seek rents but rather seek to protect those rents they have. That is a major source of inertia. It is hard to identify the rents; but if one could, and then proceed to eliminate them all, the government would fall immediately. And such a wrenching redistribution would doubtless be highly inequitable, too.

More concretely, some claim that the initial capital stock in Eastern Europe, both physical and human, was almost entirely unusable or wrongly allocated but not transferable. Experience has shown that this is false. At the same time, however, clear losers are emerging, such as the many who are forced to retire prematurely or simply to withdraw from the labor force when their jobs disappear, because they cannot be moved or retrained. This, in turn, gives some justification, not merely on political but also on equity grounds, for not trying to reduce pension entitlements too drastically even though they are an immense and growing burden on state budgets. The older generation suffered longer under communism, may have lost their savings in a burst of “corrective” inflation, and will have less time to enjoy the fruits of a protracted transformation.

Good News and Bad News

Initial Successes

Considerable progress has been achieved, even in Russia. Farther west, the relative stability of transformation-oriented economic policies through elections and major political swings testifies to credible regime changes in several countries besides the Central European four. Liberalization has been a considerable success, though some of its distributional consequences have been drastic and unfortunate. Price adjustment has been remarkably rapid, except for the remaining controlled prices; in general, goods prices are more flexible than we might have thought and are more likely to adjust to international relative prices quickly. This may be partly a result of the comprehensiveness of the liberalization and the concomitant substantial increases in the overall price level. Stabilization has also succeeded in most of the cases in which it was necessary and feasible, following fairly similar “heterodox” approaches with multiple anchors.

Opening up to market-oriented trade, with relatively liberal trade policies, has brought a successful reorientation of trade flows to the West, especially the European Union. Current account convertibility has proved sustainable where it has been introduced. And correspondingly, policymakers in these countries have been able to conduct a constructive dialogue with the Bretton Woods institutions. There is more good news, including substantial institutional change—but that is not what this paper is about.

Initial Errors

Why were the transformation programs not more successful, more quickly? Two reasons stand out: some of their architects thought it would be easy; and the specificities of these economies were not fully understood, nor their implications appreciated, even by domestic policymakers. Here, I mean not so much the country-specific differences in initial conditions, but rather the differences between economic transformation and either postwar reconstruction or the experience of developing countries.

What were the consequences? First, all forecasts and projections were way off the mark: they underestimated the size of the initial price level shock (“corrective” inflation), the extent of the fall in output and its persistence, and the initial improvement but subsequent deterioration of the fiscal balance and the current account; and they overestimated the amount of foreign investment and aid and, overall, the speed of the transformation process (especially privatization). From precise estimates to broad assessments, almost all these projections were quite overoptimistic. The major exception to that generalization is perhaps the general political stability and progressive character of political development, which are superior to expectations and remarkably restrained in the light of the economic results. Yet the errors were considerable and had political consequences, as shown by the recent Polish and Hungarian elections. Nor can we associate these mistaken expectations with variables overshooting their long-run equilibrium values, whatever those might have been—these were just bad judgments.

The policy errors were closely related to the forecast errors and their causes. Evidently—and fortunately—not all can be observed in any given country, but several appear frequently. Again, they are not features of policies imposed from the outside, by the IMF or anyone else; in most cases, whatever the sources of the arguments that influenced them, the domestic policymakers themselves did want these policies.

Here, it is most convenient just to list the major policy errors briefly before elaborating on them:

  • Programs of restitution of physical property—both real estate and plant and equipment—to pre-nationalization owners, which created great uncertainty and discouraged investment;

  • Overemphasis on macroeconomic relative to microeconomic policies;

  • Excessively tight monetary policies (overestimating the importance of the “monetary overhang” and having to control the exaggerated price shock caused by excessive devaluation);

  • Excessive devaluation and inadequately specified exchange rate policy;

  • Misunderstanding of the capacities and behavior of the state-owned enterprises (and many who thought these enterprises would collapse quickly also thought the private sector could easily step in to compensate for their absence);

  • Overly complex and ambitious plans to privatize state-owned enterprises, which lacked incentives for stakeholders;

  • Sequencing errors—especially the delay in dealing with undercapitalized and technically backward banks and the overhang of bad debt of state-owned enterprises, as well as the initial overemphasis on the potential role of stock markets;

  • Deliberate early dissolution of the Council for Mutual Economic Assistance (CMEA), which contributed to the dramatic fall in inter-regional trade;

  • Overly ambitious and hasty elimination of tariff protection and rejection of any kind of “industrial policies”; and

  • Inadequate emphasis on debt reduction (except Poland) for those countries that required it, and excessive delay in all cases—an error committed by not only domestic policymakers (as in Hungary) but also the international financial institutions and the banks.

The Fall in Output

Rationalizations of the steep fall in output throughout the region are often contradictory. Some apologists admit that the data do not grossly distort the depth of the depression. But they argue that it was inevitable and necessary, indeed desirable, insofar as it represented the abandoning of unwanted or inferior or uneconomic production. Others, on the contrary, claim it is much overstated by the official statistics and has had little impact on “welfare,” especially in view of the elimination of queues. Some find that as the decline has been roughly the same everywhere, it must be due to factors exogenous to domestic policies. Others maintain that as there is significantly less cumulative loss of output in the countries that have chosen radical stabilization, the depression must be due to gradualist policies.

For the majority who regard the fall in output as real, of surprising duration, and on the whole undesirable (for example, Kornai, 1993; the full range of views is reflected in Blejer and others, 1993), there are many plausible explanations. It is difficult to distinguish in the data between demand and supply shocks. The fall in CMEA trade is big enough to account for a lot, but that was partly endogenous, and exports to the West from most countries rose immediately and by almost as much. The military-industrial complex is not big enough, even in Russia, to account for a substantial share of the lost production. My own preferred story is a combination, the weights differing among countries, of excessive monetary contraction (beyond that needed for stabilization, at least if devaluation had not overshot) and the inadequacy of supply response (itself caused by inadequate microfoundations) in the face of shifts in demand that required reallocation.

This story would explain why we do not observe the short-run boost to output that is normal in exchange-rate-based stabilization programs and would thus suggest that the Latin American model is in this respect inappropriate. It does not explain the similar depth of the depression in all the countries of the region; here, we really must go back to country specificities—for example, in Hungary, the (self-inflicted) wave of bankruptcies and the debt-service burden, with its ramifications throughout domestic policy.

Evaluation of Policies

Macroeconomic Policies

We could say monetary policy was too tight here, fiscal policy too loose there, and go into further detail. The main error, however, was simply the overemphasis on macroeconomic policy itself. This is not merely because some countries did not need to stabilize or would not have done so if they had not devalued excessively (for example, Czechoslovakia). The preoccupation with stabilization may be partly a reflection of the leading role of the IMF and its macroeconomic conditionality. This was reinforced by advisors who believed in the endemic macroeconomic disequilibrium of socialist economies and saw hyperinflation around every corner. It was accepted voluntarily by politicians who needed external support and in any case often found IMF policies wholly convincing.

I believe this was a serious strategic error. It was right for the Fund to focus on short-run macroeconomic policies, internal and external balance—that is its mission, if not its deformation professionnelle—but it was wrong to make all other aid conditional on agreement to a stabilization program with the Fund and thereby to put its priorities at the top of policymakers’ agendas. The Fund could not devote much effort to the microfoundations of the macro policies; and until lately, its performance criteria were put entirely in terms of macroeconomic indicators (while the recently imposed conditions on structural reforms appear not to have been enforced—see Gomulka, forthcoming).

The initial conditions described above should have indicated, however, that mere liberalization would not create the microeconomic, institutional basis for the macroeconomic policies appropriate to a market economy. Policymakers have limited time, administrative resources, and political capital. For too long, they devoted an excessive share to only one dimension of the transformation process, and too little to anticipating and dealing with the many other obstacles that would impede it.

That might nevertheless have been justified if macroeconomic stabilization were a necessary condition for microeconomic, structural reforms and for opening the economy to trade. There is ample evidence, however, that this is not so. Recent work on Latin America suggests that this aspect of the conventional wisdom on sequencing has been ignored by several countries, with considerable success (Edwards, 1994). Similarly, in Eastern Europe itself, it has proved possible to implement substantial structural change in high-inflation environments.

Of course it would be better still if there was stabilization, and there may be no medium-run trade-off between stabilization and either output or the speed of transformation. The issue then is feasibility. If immediate stabilization is not feasible (see the “war of attrition” models), there may still be very useful things that can be done, which, by constructing parts of the microfoundations, may also make stabilization that much easier when it does come onto the political agenda.

Fiscal Policy

The initial fiscal deficits in Eastern Europe were not huge by Western European standards, but they were much more difficult to finance in a noninflationary manner. It was relatively easy to cut expenditure in the short run, mainly because price liberalization automatically eliminates large subsidies. Revenue then drops, partly because of recession, partly because of the difficulty of taxing private firms. In the medium run, the basic problem is expenditure—subsidies fall, but social spending rises, especially pensions (early retirement) and unemployment benefits. Unless fast growth finally arrives, the long-run problem will be servicing domestic debt, with large deficits and growth rates below real interest rates.

External Policy

Here, the mistake was not early convertibility or fixed nominal exchange rates, where these were implemented. The big errors were over-devaluation and insufficient precision and clarity regarding the exchange rate regime. The danger of serious overshooting with the initial devaluation arises because there is no reliable indicator of an equilibrium rate, so policymakers take too seriously the preliberalization “free market” rate, which is always deeply undervalued. And even the “equilibrium” rate suggested by purely monetary considerations is likely to be significantly undervalued. The fall in exports to CMEA partners releases resources for export elsewhere, the fall in output reduces the demand for imports, the rationalization of distortions raises the efficiency of trade, and the required expansion of the nontraded services sector should be led by an increase in the relative price of services—hence, a real exchange rate appreciation.

The macroeconomic costs of serious overshooting are an excessive initial price shock, requiring, in turn, excessive monetary stringency to stop it from setting off rapid inflation at the outset and, hence, a strong negative demand shock, coupled with a negative supply shock to import-dependent firms; and, in due course, because the initial real wage is unsustainably low and domestic firms still have significant market power, a catch-up, cost-push inflationary process with real appreciation is required. In Czechoslovakia, the excessive initial devaluation may have actually fostered a shift to lower value-added production, inimical to competitiveness in the medium run.

The trade-off between a fixed and a crawling peg is well understood: a nominal anchor for monetary stability versus a real exchange rate target to maintain competitiveness. Initially the needs of stabilization are paramount and accentuated by the role of a fixed nominal rate in anchoring the price structure, which is shifting radically. Subsequent real appreciation is inevitable and desirable, however, so it is best to announce at the outset that the crawl will begin when the authorities judge that the real rate is in an appropriate longer-run range, which itself is likely to shift gradually.

Current account convertibility frequently has come early in the sequencing of the transformation process—and rightly, at least for the smaller economies with relatively high trade participation and some initial access to international reserves. It is more important in the formerly planned economies than elsewhere because it can play such a key role in creating markets and helping them to function properly. It eliminates bureaucratic influence on the allocation of foreign exchange. And early convertibility, if it can be sustained, is popular and highly visible, so it greatly enhances the credibility of policymakers. Payments union proposals (and their surrogates, like the “Interstate Bank”) were never an appropriate substitute for convertibility, either for Central Europe or the former Soviet Union.

These countries should not, however, suddenly open up their capital accounts, and in general they have not. There are dangers in uncontrolled capital inflows, as well as outflows. Capital account inconvertibility need not discourage foreign direct investment as long as current account convertibility guarantees the freedom to remit profits. Opening up successfully to capital account transactions requires positive real interest rates, a realistic exchange rate, and some depth in domestic financial markets.

Although the postwar European experience was not fully relevant for the Central and Eastern European countries, the Marshall Plan did demonstrate the importance of external assistance and debt consolidation in economic transformation and recovery. Several Eastern European countries, including Poland, Hungary, Bulgaria, and Russia, had serious external debt problems at the outset of the transformation. Given these debt burdens, it has been regrettable that the major western countries’ severe budgetary constraints have made large-scale grants unrealistic; debt relief, which might have been an adequate substitute, has been quite insufficient.

Poland simply did not pay and eventually—in a deal finalized almost five years after the revolutions of 1989—achieved substantial debt reduction. Bulgaria, too, has finally reached a deal; it has meanwhile suffered considerably from the constraints on its external transactions. Hungary presents the most interesting case: walking into the trap, springing it, and struggling valiantly without (yet) crying out.

The initial Hungarian story was that exports were growing so fast that there was no difficulty in financing debt service. This was true until 1993, but only for external finance. The domestic fiscal burden of debt service is crushing, and investment is severely depressed by the impact on financial markets. Fiscal reforms that would imply austerity (in pensions, etc.) are much more difficult, given the austerity already imposed by debt service: debt relief is complementary to, not substitutable for, the “tough policies” needed to put the Hungarian fiscal house in order.

The denouement was foreseeable, and it is partly the fault of the West. The Fund claims unconvincingly that the high proportion of Hungarian debt in bonds would limit the benefit to Hungary of debt reduction relative to the cost of impaired capital market access. But debt consolidation can take many forms, and history suggests a solution could be found if Hungary wanted it and the international institutions offered help rather than opposition. If Mexico deserved and could benefit greatly from debt reduction—and gained rather than lost capital inflows—so also could Hungary. Perhaps policymakers inside and outside Hungary will learn something from the recent announcement that J.P. Morgan expects to receive the “highly prized” mandate for Poland’s forthcoming $500 million Euromarket issue and to offer significantly finer terms than Hungary could get (Financial Times, December 1, 1994). So much for the “elephantine memory” of capital markets and the rewards for “good behavior”!

The external constraint is likely to bite soon and may prematurely inhibit expansion in those economies where recovery is finally beginning. The initial trade balance successes were temporary, the result of special factors: abnormally depressed domestic demand, temporary undervaluation, excess stocks to liquidate, the opening of European Union markets, and the need of state-owned enterprises to maintain cash flows in the face of monetary tightness. Trade balances already deteriorated in 1993, on both exports and imports (except for the Czech Republic and Russia). The good outcome assumed in the early writing on transformation would involve much larger foreign capital inflows to support the imports of investment goods that these countries need. So far, however, foreign direct investment has been disappointingly low. Portfolio capital inflows may pose (familiar) problems in a few countries, including undesired upward pressure on the exchange rate; and in more normal circumstances, Russia’s natural resources might present it with a Dutch disease. These problems of success would be welcome.

Household Behavior

Here, there were no mistaken perceptions: households in these economies have behaved rationally and adapted quickly. Moreover, some problems that were expected have not been significant. Household saving has in most countries held up well, as precautionary motives appear to have dominated life-cycle considerations (even there, while permanent incomes should have risen, the perceived need to provide privately for retirement might also have risen). Migration was a potential vicious circle, insofar as departure of the best and brightest would reduce the attractiveness of investment and, hence, reduce the growth of output and real incomes and stimulate further outflows. For those trying to get the West to increase aid to the East, this specter was a useful lever; but so far, the flows have not been large.

The serious problem arising from household behavior is widespread and strong consumer preference for imports, with little regard to the price differential. That is due partly to long-standing conditioning and the attractions of the previously unattainable, but it is proving remarkably persistent.

State-Owned Enterprises

The role and prospects of these enterprises were underestimated—often with colorful images of dinosaurs producing obsolete goods for the region’s bloated industrial sectors, in particular their rapidly contracting defense establishment. There was no coherent policy toward them, except to privatize as rapidly as possible or simply to make them fold by cutting off finance, so little thought went into trying consciously to modify their behavior before privatization. The result was “state desertion,” sometimes going further to involve explicit tax and other discrimination against state-owned enterprises vis-à-vis private firms.

Recent research suggests that many of the state-owned enterprises can in fact adapt, at least enough to warrant reconsidering policies that explicitly seek to starve them quickly. For example, after an initial lag, they are in most countries reducing employment in advance of privatization, so productivity is beginning to recover. The key is to stop open-ended subsidies and to create incentives with the prospect of ultimate privatization that will not necessarily involve sacking all the managers. Fiscal pressures can actually be useful here, in convincing managers that there is no money so they cannot expect any. Then they must discover that they cannot get it from the banks (see below).

Very severe financial tightening at the aggregate level can have mixed effects through state-owned enterprises on the development of the private sector. The limited credit available tends to go to these enterprises, but it is not enough, and they respond by releasing both labor and capital stock to the private sector. Nevertheless, an excessively severe demand shock weakens the ability of these enterprises to respond, and the shortage of credit hampers restructuring. The pressure can go too far, as it demonstrably has in many cases.

Continuous pressure must be maintained, however, perhaps for a long time to come, because in most countries comprehensive privatization of state-owned enterprises is still not in prospect, and the examples of rapid privatization in Czechoslovakia and Russia are at best problematic. It is much too early to evaluate the results of the Czech voucher privatization scheme, except to applaud the efficiency and determination with which it was executed. It does appear, however, to have created an extraordinary system of corporate governance. The firms are owned by the investment privatization companies to which most individuals entrusted their vouchers. Most of these are managed by the large banks, of which the state still owns (on average) 40 percent, and to which the former state-owned enterprises are heavily indebted. The banks are naturally reticent to call in their loans, even when they look bad, and the authorities have pursued a conscious anti-bankruptcy policy through the activities of the National Property Fund and the Consolidation Bank. The Russian case is simpler, in that in most firms control seems to have gone to insiders; but, again, it is too soon to judge.

Thus the delay in privatization of large state-owned enterprises may not have been as unfortunate as most of us thought, or at least not disastrous, given the constraints and the alternatives. There is still time to do some of the restructuring necessary to make privatization successful.

Financial Intermediation

It now seems to be commonly accepted that the single most important error in sequencing, at least in the core six countries, was not to have implemented urgently a financial cleanout: recapitalizing the banks, canceling debts of state-owned enterprises at the time of privatization, and instituting cash-limited fiscal subsidies to them meanwhile, so that the banks would not have to extend them new loans or capitalize their arrears. Capitalism cannot function without capital markets; stock markets were and are clearly not going to be a major mechanism for financial intermediation or corporate control for many years to come. The banks had to take on the task, and they were too weak to do so. Investment and the growth of new private firms have thereby suffered. Both monetary tightness and the need to maintain high bank intermediation margins to build up a capital base, in the absence of recapitalization, have contributed to high real interest rates, and thus to low investment.

This extremely serious problem was avoidable, but not widely foreseen or understood. The exercise could have been done quickly and comprehensively, and hence better than the partial and repeated efforts that have followed in several countries and that have created considerable moral hazard. It need not have impaired the credibility of the authorities—suggesting they were “soft” financially—if the debt cancellation had been tied explicitly to the one-off event of privatization. The fiscal impact, looking at the accounts of the consolidated public sector, is zero. As long as both banks and firms are state-owned enterprises, the public sector borrowing requirement remains unchanged. For some time, however, the IMF cautioned against the supposed effect on the deficit, and even now one sees warnings against the “high fiscal cost” in World Bank publications. This is nonsense, as the Fund is now willing to state publicly.

Alone among Eastern European countries, Hungary sprang the bankruptcy trap. Any firm unable to meet payments to any creditor had to file for bankruptcy, and a financial restructuring required unanimous consent by creditors. The system could not cope with the resulting 17,000 cases filed for financial restructuring or liquidation in 1992 and early 1993. Those who have been calling for vigorous enforcement of bankruptcy to force true restructuring should examine the Hungarian case and tell us whether any positive longer-run consequences will outweigh the negative short-run effects. In contrast, the Czech Republic has assiduously sought to avoid bankruptcies and the consequent restructuring, at least as long as voucher privatization was still incomplete. There, one can only conjecture how the complex, financially unsound structure of indebtedness and corporate control will unwind.

Labor Markets

In view of the lag in adjustment, unemployment will not control inflation in the early phase of the transformation, so incomes policies are necessary. In the macroeconomics of central planning, incomes policies played the role of nonexistent monetary policies, and until monetary policy can develop its full role as a macroeconomic policy instrument, it will need that help. Most of the initial stabilization programs satisfied this requirement with some version of the “tax on wage increases” first introduced in Hungary in the late 1960s. The inefficiencies created by such a tax may not be too damaging, since there is a case for maintaining a constraint on relative wages (an effect of most versions of this tax), and a perception that wage-setting decisions in state-owned enterprises may be interpreted simply as allocating rents.

Despite real wage moderation, unemployment began to rise. Contrary to some conjectures, the registered unemployed in Eastern Europe really are unemployed, and there are more, according to labor force surveys. Benefits rules are no longer generous. In most countries, there are small inflows into the pool of unemployed, but very small outflows. Hence the long-run problem: the creation of a pool of long-term unemployed, having no moderating influence on wage pressure but constituting a growing fiscal burden, which, in turn, brings restrictive measures that tend to increase unemployment. Starting from extremely high levels, participation rates have already fallen below the norms for industrial countries; that is a social as well as a fiscal burden.

What can be done to promote job creation? Not much in the state-owned enterprises or newly privatized larger firms, and after the first wave, job creation in small and medium-sized enterprises will require investment and, hence, functioning capital markets. Active labor market policies have succeeded in the Czech Republic, and public works offer a more direct alternative: public investment has been abnormally depressed, while infrastructure and public services (health, education, etc.) have deteriorated drastically, bringing a significant perceived decline in welfare. The fiscal burden of paying wages rather than unemployment or other social benefits may not be so great.

Trade and Industrial Policies

The first trap here opened with the deliberate destruction of the CMEA (Csaba, 1994, p. 15, refers to “their [the Visegrád countries’] thrust to get rid of Comecon from late 1989 onwards”) and the disintegration of the former Soviet Union. Eastern Europe compensated, however, by raising exports to the West, mainly the European Union, and especially Germany before its recession took hold.

The next step was to negotiate agreements with the European Union on a bilateral basis. The resulting hub-and-spoke pattern of trade relations marginalizes the individual Eastern countries, artificially discourages economic relations among them, and favors investment in Germany or Austria to supply the East rather than in the East itself. Meanwhile, accession to membership in the Union is likely to take much longer than hopeful early proposals (including my own) had suggested: these countries are too poor, too agricultural, and too populous for the European Union budget to accommodate under anything like present rules. Yet the economic advantages to the Union of opening up to the East are considerable (Faini and Portes, 1995). And if these countries do not have clear prospects for accession to the Union, there is the danger of another vicious circle of low investment, slow growth, and indefinitely receding prospects of membership.

All this argues for mapping out a clearer path to accession that would multilateralize the Europe agreements to create a comprehensive free trade area, then deepen integration in an approach to something like the planned “European Economic Area” comprising the European Union and the European Free Trade Association (Baldwin, 1994). This would be attractive to foreign investors, would promote institutional transformation, and would help to raise intraregional trade further toward the potential levels that gravity models suggest.

Two other policy orientations in this domain testify to exaggerated rejection of governmental action: the rush not only to discard import quotas and other nontariff barriers but also to lower tariffs to negligible levels; and the explicit avoidance of any policies that might possibly be labeled “industrial policies,” no matter how market-friendly, nonselective, nondiscretionary, and transparent they might be. A moderate tariff can yield useful revenue while temporarily protecting “senile” industries, as the demand-shift explanation of output decline would suggest is desirable. The initial overshooting weakened these countries’ negotiating position vis-à-vis the European Union, and it led in any case to irresistible pressures to re-establish various forms of protection.

Nonselective export promotion services and partial state guarantees for credits to small and medium-sized enterprises are examples of industrial policies that might be helpful and not lend themselves to abuse. Anything that helps to create markets or to deal with market failures systematically is surely to be welcomed. The financial cleanout and active labor market policies recommended above are equally examples of such structural policies. It is economic illiteracy or misplaced ideological purity to equate microeconomic policies with detailed state intervention in economic decision making.


The early analyses of the economic opening up and transformation of the East stressed growth: catch-up and convergence. The depression that came unexpectedly in the first years of transformation now requires a “rubber band” response, an equally swift and strong recovery to the trend convergence path. In many countries, the conditions are there, and now that the initial policy errors have been recognized, it should be easier not to repeat them. There will continue to be argument about how much time and output has been avoidably lost, how much physical and human capital rendered unnecessarily obsolete or prematurely scrapped. There will be reform fatigue in an environment of “normal politics.” We may hope, however, that fatigue will not long delay the time when these economies become “normal economies.”

The IMF is implicated in some of the policy errors, and the World Bank, too, especially where it has deferred to the Fund. But this was often the consequence of the mandate given to the Fund. The IMF has played an important role in encouraging liberalization, stabilization, and opening up these economies to the rest of the world; and it is becoming increasingly interested in microeconomic, structural reforms, even where those are not included in its performance criteria. That role must continue and mature.

Chairman’s Remarks

Viktor Gerashchenko agreed with Portes that the countries in transition had made mistakes. Nevertheless, they were trying to learn from their mistakes and the mistakes of others. Russia was currently working on the policy statement of the Government and the Central Bank in close cooperation with the staff of the Fund, a process that was constantly improving. Russia’s initial mistakes were clearly connected with rather abrupt changes that had taken place in 1991; the Government that had come to power in 1992 had been compelled to deal very quickly with the problems that had emerged throughout that huge country. He also agreed with the point made by Portes that the banking system in many transition countries, especially Russia, was still underdeveloped. While some banks had been developing quite well in Russia, they were involved in providing credit not only for short-term finance but also for the industrial sector. Those banks needed, and indeed were demanding from the Government, clear-cut economic priorities.

The Central Bank of Russia was trying to use the instruments at its disposal. For the time being, those instruments were limited to reserve requirements and interest rates, which were closely connected to the interbank market. At the same time, the Central Bank was very much tied up with the problem of financing the budget deficit, because the attitude of the population, companies, and banks was changing only gradually toward a willingness to buy treasury bills. He hoped that the treasury bill market would be developed more actively in 1995. It was by now generally recognized within Russia that the country’s main problem was the budget deficit.

General Discussion

Peter Bod noted that Portes had suggested that mistakes had led to the sharp fall in output—unprecedented in peacetime—among the Visegrád countries. Indeed, according to the official statistics, the output decline of that group amounted to 20–30 percent of GDP. Looking at the social development of those countries—particularly the absence of civil war and mass poverty—it was tempting to conclude that the region was blessed with brilliant politicians and very bad economists. As a central bank governor, lying somewhere between a politician and an economist, he did not agree with that view—and the voters did not seem to agree either. He was not convinced that the approach that Portes had decried as involving a focus on macroeconomic policies at the expense of attention to microeconomic policies, such as excessively tight monetary policy and overambitious trade liberalization, had, in fact, been a mistake. If it was, however, a certain degree of self-criticism would be in order, inasmuch as decision makers in the Visegrád countries had acted under pressure from their colleagues in the West and from international agencies.

In his view, the problem lay mainly in the supply conditions, such as limited access to foreign markets. In the case of the Visegrád countries, the main problem was access to the market of the European Union, especially in the so-called sensitive sectors—agriculture, steel, and textiles—in which the Visegrád countries were competitive. Another problem was the lack of a clear-cut strategy for integrating the countries of Eastern Europe into the European Union, which, together with a lack of pre-accession funding, was discouraging foreign direct investment in the region. Clearly, those countries would need a lot of fresh money for infrastructure.

The reference by Portes to Hungary in the context of debt relief was misplaced. The underlying problem in Hungary was not debt service: in 1993, the interest burden had amounted to 3–4 percent of GDP, while the inflow of foreign capital in the form of foreign direct investment had amounted to 7 percent of GDP. Moreover, any discussion of the need for debt relief would be very risky indeed, possibly endangering the inflow of foreign direct investment.

In sum, the transition countries needed both improved supply conditions—access to markets and to foreign direct investment—as well as strong demand management, which called for macroeconomic stabilization. Thus, his reading of history differed somewhat from that of Portes, although only future economic historians would be able to judge which approach was correct and how far the transition countries had gone toward becoming fully fledged market economies.

Salvatore Zecchini recalled that Liu had clearly stated that the aim of the third phase of economic reform in China was to create a socialist market economy. That aim contrasted very much with the efforts of the former centrally planned economies to move toward a market economy and with the system that was in place in most industrial economies. He asked Liu whether he could elaborate on the difference between a market system and a socialist market system and, in particular, what the qualifier “socialist” added to a market system: it could not be the gradualism to which the minister had referred, as gradualism was a question of timing, not of objective; and it was not a question of sequencing, as Portes had suggested.

Liu replied that in September 1993 China had announced a detailed plan setting out the steps it would follow to achieve the objective of a socialist market economy. Such an economy differed from a purely market economy in two respects: a socialist market economy was based on the dominance of public ownership, supplemented by a variety of different forms of ownership; and it was grounded in a distribution of income based on labor—incomes would not all rise at the same rate. The ultimate goal, however, was to reach common prosperity.

Burke Dillon remarked that Portes and many other academics envisioned a banking system in Russia in which the necessary actions were taken to save the existing system—by canceling debts, for example—in order to move ahead and take over the functions of the new system. In practice, Russia seemed to be following a policy that was more akin to letting 2,000 flowers bloom and allowing only the fittest to survive, a very market-oriented philosophy. She would be interested in Gerashchenko’s reaction to the model envisioned by Portes, and the comments of Portes on the evolution of the banks in Russia.

Gerashchenko replied that the number of banks in Russia was not excessive. Throughout the former Soviet Union, there had been about 6,500 banking enterprises, most of which had been branches of the State Bank of the U.S.S.R., the main commercial banking institution, and approximately 1,000 branches of the Investment Bank. As of September 1, 1994, however, one third of Russia’s 2,400 licensed banking institutions were concentrated in Moscow, which was developing as a financial center; some regions of the country were still without a bank of any type, which was why clearing centers were compelled to serve a small number of clients.

The quality of banking institutions in Russia was also different. He would not go as far as Dillon, however, in suggesting that Russia was allowing all the flowers to bloom before weeding out those that could not survive on their own. Eventually, there would be a period of stabilization in the banking sector, with the liquidation of a number of banks and the successful takeover of others.

As was well known, the Central Bank of Russia had already increased the minimum capital requirements for banks on two occasions. Initially, the decision to increase those requirements had been widely criticized, but it was now accepted by the banking community. It was hoped that toward the beginning of 1999 Russia’s minimum capital requirements would be similar to those prevailing in Western Europe. The Central Bank was also trying to improve dramatically its banking supervision role; the hope was that revised legislation on banks and banking activity, which was expected to have its second reading in parliament in November 1994, would provide the Central Bank with more clearly defined rights in that respect. He could certainly agree with Portes that some of the banks in Russia were not adequately prepared for the task that they would need to play in a changing economy.

Portes remarked that, while he was not familiar with the banking system of Russia, the Central European experience provided some useful insight. First, it was not possible simply to let the fittest banks survive, because they were almost all unfit ex ante. If such a policy were to be pursued, it would be necessary first to try to rehabilitate the banks. It was unlikely that new, smaller banks would at the outset be able to take over the role of the existing banks with respect to the savings bank network, on the one hand, and their questionable assets, on the other. Therefore, a solution had to be found to the problems of the existing banks.

A second lesson from the Central European experience was that the sorts of operations he had suggested could not be implemented until and unless serious budget constraints were imposed on state-owned enterprises through the budget, in the form of cash-limited fiscal subsidies, rather than trying to impose discipline through the banking system. The Central European countries had been prepared to take that step very early on in the reform process, although it was unfortunate that they had not immediately conducted the kind of financial cleanout that he had suggested. In any event, it was not clear that the ground had been prepared for such an approach in Russia.

Referring to the earlier comments of Peter Bod, Portes agreed that it was reasonable to ask whether the absence of civil war and mass poverty in Central and Eastern Europe implied that the politicians in the region were very good, and the economists bad. In certain cases, of course, politicians had been thrown out of office, which might be part of the answer. More generally, however, the social development of those countries was testimony to the remarkable degree of political maturity and stability, and to the ethos underlying economic transformation itself coming out of the revolutions of 1989. He also sympathized with the problems of the decision makers. Indeed, those who were merely observers should be humble.

In answer to the question posed by Bod, Portes viewed the mistakes that had been made as the shared responsibility of everyone involved. With that in mind, it was useful to ask how a better result could have been achieved. As far as the European Union was concerned, Bod had raised some important and very topical issues. He had great sympathy for the view that the market access offered by the European Union in its association agreements with the countries of Eastern Europe was inadequate; access had been improved somewhat, but it was still inadequate. He agreed that there was a lack of a clear-cut strategy for integrating those countries into the European Union, which was partly the fault of the European Union, and that the absence of such a strategy was holding back foreign direct investment. Nevertheless, Eastern Europe had succeeded—despite the limits on sensitive exports and the impact of the Common Agricultural Policy—in expanding exports to the European Union very rapidly. Moreover, the absence of an integration strategy also stemmed from the inability of the Eastern European countries themselves, and the Visegrád countries in particular, to cooperate with each other to any significant extent. The inability to come to joint positions in negotiating with the European Union, for example, had not helped. Finally, he accepted the point made by Bod with respect to the judgment of economic historians, and he realized that his own attempt to draw some tentative conclusions from the experience of Eastern Europe was somewhat presumptuous. Nevertheless, his remarks about Hungary were themselves informed by his work on sovereign borrowing and debt in the 1920s and 1930s.

Portes could not accept the view expressed by Bod about the burden of servicing debt. As he had stated explicitly in his formal presentation, the external debt burden was financeable. The real issue was the internal consequences of the debt burden: for an economy like Hungary, in which domestic financial markets were still inadequately developed, the issuance of government paper to deal with the fiscal deficit had pushed up domestic real interest rates to an intolerable level. It was true, of course, that the interest burden had been only 3–4 percent of GDP in 1993, somewhat lower than the year before, and that foreign direct investment had been strong. The essential question, however, was how to deal with the fiscal burden of servicing debt, an issue that had been clarified by the Latin American experience. The consequences of servicing debt had been extremely unfortunate in Hungary, and he was somewhat surprised that Bod did not seem to consider the issue to be one of Hungary’s biggest problems.


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