Abstract

That the great majority of transition economies have begun an economic recovery—and over half appear to have achieved sustained growth—is evidence that the process of transition has progressed a long way. But the converse is also true: a few economies have faltered, several have only a fragile recovery, and a handful have scarcely begun, suggesting that there is still a considerable future agenda for the transition.

That the great majority of transition economies have begun an economic recovery—and over half appear to have achieved sustained growth—is evidence that the process of transition has progressed a long way. But the converse is also true: a few economies have faltered, several have only a fragile recovery, and a handful have scarcely begun, suggesting that there is still a considerable future agenda for the transition.

For a number of the central European and the Baltic countries, the transition process is very far advanced, and the big problems and issues are becoming more similar to those facing middle-income market economies. Already one sees the “costs of success” for Poland, the Czech Republic, Hungary, Estonia, Latvia, and perhaps Croatia and Slovenia, all of which have to be concerned about a strong recovery running ahead of itself and generating risks of overheating, and possible reversals of capital inflows by creditors and investors. In the case of the Czech Republic, this scenario has already materialized. In the future, these economies will not be able to rely on the early and substantial efficiency improvements from the elimination of the distortions of central planning, and growth will be much more dependent on the mobilization of saving and its efficient intermediation by the financial sector. Also, much more effort will be needed to rationalize and perhaps still reduce the expensive social programs. Otherwise, and ironically, these transition economies could find themselves with new labor market distortions quite soon after the removal of the fundamental product market distortions of central planning.

The major new development has been the fallout from the financial crisis in Russia of August 1998. As a result, there has been a reversal of stabilization and of the incipient recovery in Russia, and there will be a continued negative impact on growth in neighboring countries that have substantial trade ties to Russia. The Russian crisis therefore reinforces two of the key lessons of this study: first, incomplete structural reforms to strengthen property rights and governance jeopardize the sustainability of financial stabilization; and second, the costs of incomplete reform in terms of lost output and renewed inflation can be severe. Though there are many differences between Russia and the three previous cases of reversals of stabilization programs—Albania, Bulgaria, and Romania—all four countries have been characterized by inadequate implementation of structural reforms, major manifestations of which have been the improper use of bank credit and growing problems of nonpayments, offsets, and barter, reflecting a general breakdown of financial discipline. The lesson for other transition countries is that lasting stabilization and recovery is never assured so long as the process of structural and governance reforms is not finished.

Another aspect of recent developments has been the sharp reduction in new capital inflows that can contribute to sustaining growth. This process had. of course, begun earlier, as financial markets reassessed the prospects for emerging markets after events in Asia. In the case of Russia, markets judged that capital inflows had been used to postpone reforms rather than to finance them. One indicator of how far the turnaround in markets has gone is the increase in spreads, and another is the generalized downgrading by private rating agencies. But some differentiation among countries is occurring, with spreads increasing by as little as 60 basis points for the better-performing central European countries and the Baltics, compared with increases of over 1,000 basis points in some CIS countries. In a few cases in central Europe and the Baltics, rating agencies have reaffirmed ratings, or at most posted notices. This still fragmentary evidence suggests that if countries are to benefit from favorable treatment they will need to reinforce the macroeconomic and structural policies that lie behind successful performance on disinflation and growth.

For most of the CIS countries, and to some extent those in southeast Europe, there remains a very large unfinished agenda of market-oriented reforms. The extent of the task varies from the completion of large-scale privatization and a meaningful imposition of hard budget constraints in Bulgaria and Romania, to making a serious start in reform in Belarus and Turkmenistan, and restarting the process in Uzbekistan. In all but these three countries, the first swallows of a market springtime appeared sometime ago. But the winter of uncertain transition appears to be stubbornly reappearing in other countries, as market signals, institutions, and credible government policies supporting markets are buffeted by a lack of clarity, policy reversals, and lack of follow-through in some reform areas. As a result, the reform (and in a few cases even the stabilization) agenda remains quite large in these countries, and in some cases there are dangers of further backsliding.

Finally, in all countries there remains the important task of securely establishing good economic governance—perhaps more so in the CIS and southeast Europe (see in Section IV), In many countries, the government has not pulled back far enough from interventions in economic activity and various types of signaling with respect to resource allocation, but it has at the same time pulled back too far from its crucial task of providing the discipline of law and order, as well as a secure climate for individuals to engage in the fruitful economic activity of their choice.

Indeed, in many countries a kind of vicious circle has developed. Poor economic governance delays structural reforms, which in turn inhibits the economic recovery and constrains the development—and influence on policies—of a new, more dynamic business sector. This is accompanied by the perpetuation of old economic structures and relationships that tend to inhibit improvements in governance. Clearly, this vicious circle needs to be broken by finding ways to promote more actively good economic governance.

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