4 Growth in Transition Countries, 1990–98: The Main Lessons
Author: Mr. Oleh Havrylyshyn
Language:
English
Keywords:
SEM; country; transition country; enterprise; government; economy; CEE country; CIS country; market economy; price liberalization; transition economy; Structural reforms; Legal support in revenue administration; Inflation; Privatization; Baltics; Central and Eastern Europe
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Abstract

Transition is a complex process involving changes in the political, economic, institutional, legal, and social domains. The focus of this chapter is on the record of economic recovery and growth and its relation to progress in transition. The study covers 25 countries in Central and Eastern Europe (CEE), the Baltics, and the Commonwealth of Independent States (CIS). Although, as of this writing, complete data are available only through 1997, and the bulk of the study was prepared in mid-1998, one cannot ignore the dramatic reality of the financial crisis in Russia in August 1998. That crisis resulted in a reversal of growth and had spillover effects on neighboring countries. Thus the discussion of growth performance includes preliminary estimates for 1998, and the conclusions reflect different interpretations of the Russian crisis and how it informs the lessons drawn by the study on the determinants of recovery in transition.

Transition is a complex process involving changes in the political, economic, institutional, legal, and social domains. The focus of this chapter is on the record of economic recovery and growth and its relation to progress in transition. The study covers 25 countries in Central and Eastern Europe (CEE), the Baltics, and the Commonwealth of Independent States (CIS). Although, as of this writing, complete data are available only through 1997, and the bulk of the study was prepared in mid-1998, one cannot ignore the dramatic reality of the financial crisis in Russia in August 1998. That crisis resulted in a reversal of growth and had spillover effects on neighboring countries. Thus the discussion of growth performance includes preliminary estimates for 1998, and the conclusions reflect different interpretations of the Russian crisis and how it informs the lessons drawn by the study on the determinants of recovery in transition.

This chapter first summarizes the emerging consensus on the conceptual meaning of transition and, in particular, how recovery and growth are expected to come about as the transition proceeds. It then reviews the record of decline and recovery in these 25 non-Asian transition countries. The chapter then goes on to explore the possible explanations for the variations in growth performance among countries. The results of the empirical analysis do not provide any great surprises, but rather give an updated confirmation of findings from earlier as well as contemporaneous studies, namely, that controlling inflation is essential and that substantial structural reform is the key policy factor driving growth. The analysis also contributes several new perspectives on growth in transition. First, it provides more of a theoretical rationale for econometric specification than have other studies on growth in transition countries. Second, it shows the importance of distinguishing among three groups of countries: CEE, the Baltics, and the CIS. Third, it distinguishes the period of decline in output (about 1991–93) from the period of recovery (about 1994–98). Fourth, it demonstrates that privatization, despite the many shortcomings in its implementation, is clearly a positive factor in growth performance. Fifth, it shows that initial conditions may matter, but they matter much less than other factors. Sixth, it demonstrates that government size (perhaps by serving as a proxy for intervention) is very important. Finally, the study confirms that there is something to the view that early reforms cause pain, but it also shows that delaying reforms comes at the cost of delayed and slower recovery.

Theoretical Concepts of Growth and Transition

This section summarizes the emerging consensus on what, conceptually, transition means and, in particular, how recovery and growth are expected to come about as the transition proceeds. A comparison with traditional growth analysis for market economies highlights the common points and those unique to the transition.

New Growth Theory and Empirical Evidence

In the mid-1980s a revival of interest in the long-term determinants of economic growth led to the development of a new wave of models, which established a synthesis now known as endogenous growth theory. This theory has produced a large volume of empirical studies of growth. The first element in this synthesis is the earlier prevailing doctrine on economic growth, namely, the neoclassical model of Solow and Swan and of Cass and Koopmans, developed in the 1950s and 1960s, which attributed growth to the expansion of capital and labor, augmented by exogenous technological progress. Simple factor input and factor productivity calculations of the sources of growth are based on this paradigm and continue to be used widely.

The second element is the set of models developed in the mid-1980s and synthesized first in Romer (1990), then in Barro and Sala-i-Martin (1994). Although they retained the role of factor inputs, these models added an explanation of technical progress based on increasing returns, research and development, imperfect competition, human capital, and—an important addition—government policies. Examination of the role of policies was initially focused on narrow economic measures such as macroeconomic stability, openness of the economy, and the degree of distortion in key price signals.

A third element has been added from what might be called political economy growth models. Olson (1997), in particular, summarizes well the conceptual basis for the role of broader policy variables such as property rights, the rule of law, institutions, and corruption. Olson argued that both of the preceding theories incorrectly assume that countries (and policymakers) make the most efficient use of resource inputs and available technology; instead, he posited that many countries are poor simply because they waste a lot of resources. On the basis of earlier work on the political economy of interest groups, he added that the waste was greatest where the institutional basis of property rights and the rule of law is least well developed or observed; an association with a high degree of corruption readily follows from this.

A synthesis of these three elements characterizes growth theory today. In the long run, initial conditions and the expansion of factor inputs still play a role, but the magnitude of such expansion, the efficiency with which factors are employed, and the long-term technological improvements that also increase efficiency depend very much on policy. Good policy includes effective legal support of property rights. The past decade has seen numerous empirical studies based on this model seeking to explain the observed wide differences in growth patterns across countries. These studies have included as determinants various factor inputs (investment, human capital), government policies (monetary and fiscal policy distortions), and institutional indicators of the security of property rights (tax burden and tax fairness, extent of corruption, transparency, political stability, and others).

Some general conclusions can be drawn from this literature.1 First, initial conditions are important in explaining cross-country differences in growth. In particular, most studies have found that growth per capita is inversely related to the initial level of output and that, once other factors are accounted for, poor countries tend to grow faster than rich ones. Further, greater availability of resources does not necessarily ensure growth, and unfavorable geographic circumstances (tropical climate, a landlocked position) can hinder it.

Second, there is a solid consensus that good economic policy (maintenance of macroeconomic stability and nondistortionary interventions) has a strongly positive effect on growth. Thus, reducing inflation not only to levels of 30 to 40 percent but probably even lower seems to be a necessary condition for achieving sustained growth.2 Removing market distortions through price liberalization, more open trade, lower and more uniform taxes, and privatization also contribute to growth.

Third, the underlying legal, political, and institutional basis also matters a great deal. Most recent empirical studies make some attempt to capture these considerations and usually find that growth is higher in countries with better institutional quality, political stability, government credibility, and similar indicators of a market-friendly environment.

Application to Transition Economies

A decade ago it was popular to say that there is no theory to guide the practical process of transition; all we have are theories of capitalism and socialism. This may still be true in the sense that a new consensus paradigm is at best only beginning to emerge from the vast literature on transition. But it is not at all clear how much a unified, cohesive theory is needed. To the extent it is useful to have a compact rather than a complex analytical framework, it is not that difficult to cobble together from a few of the key writings a workable “model” of transition or transformation.

Kornai (1994), in describing the special circumstances of the “transformational” recession compared with a typical recession in a market economy, highlights two key changes that are needed. The first is to force a move from a sellers’ to a buyers’ market (through price liberalization), and the second is to enforce a hard budget constraint (through privatization and the elimination of various government support mechanisms). These provide the two principal incentives for profit-maximizing market behavior by all economic agents. Blanchard (1997) defines the core process of change as comprising two elements: reallocation of resources from old activities to new ones (through closures and bankruptcies, combined with the establishment of new enterprises), and restructuring within surviving firms (through labor rationalization, changes in product lines, and new investment). These can be thought of as the dynamic movements resulting from the establishment of the new incentives and are reminiscent of the Schumpeterian concept of “creative destruction” by entrepreneurial activity, only with a much greater impact than what Schumpeter’s model envisioned.

The policy actions needed to put Kornai’s new incentives structure in place—which also promote Blanchard’s Schumpeterian changes in economic activity—are outlined in many works (including those by Kornai and Blanchard themselves) and are well exemplified in an early study by Fischer and Gelb (1991). The key measures of reform are macroeconomic stabilization and price and market liberalization; liberalization of the foreign exchange and trade systems; privatization; establishment of a competitive environment with few obstacles to market entry and exit; and redefining the role of the state as the provider of macrostability, a stable legal framework, and enforceable property rights, and occasionally as a corrector of market imperfections, for example, in providing income security for those with low incomes.

From these core concepts there follow some implications for growth, which differentiate the transition economies from market economies. First, output will most likely decline initially in the new, buyers’ market and under hard budget constraints, as unsalable goods accumulate and signal the need for cutbacks in production. Further elimination of wastage under the old scheme (perhaps through “destruction” or closure) necessarily precedes creation of the new, and this adds to the production cuts. A second implication is that growth of the new economy will not occur until the new incentives are in place and made credible. That is, the sooner reforms achieve a hard budget constraint and a liberal price environment, the sooner reallocation and the restructuring of the old and the creation of new production can begin. Third, one can infer from this that the proximate sources of growth in the early recovery period are not likely to be the conventional factor inputs that explain medium-term growth (investment and new technology). Rather it may be expected that the initial output recovery will come primarily from a variety of efficiency improvements.

The emphasis on efficiency improvements, at least in the early years of recovery, is perhaps what differentiates the empirical models of growth in transition from the conventional growth literature. The econometric studies summarized below, and our own regression analysis described in the appendix, typically exclude all factor input variables and focus instead on policy variables (inflation, privatization, liberalization) plus initial conditions. The following stylized schema of how recovery and then sustained growth may occur in the process of transition provides a plausible and consistent ex post theoretical framework for such an approach (Box 1 and Figure 1 elaborate on the framework). Five types of mechanisms conducive to increased output may be postulated, some of which may be simultaneous or overlapping: recovery of underutilized capacity; elimination of egregious waste of labor, capital, and materials (X-efficiency, in theoretical terms); efficiency gains from a more appropriate combination of capital and labor (factor efficiency); efficiency gains from reallocation of resources toward goods in which the country has comparative advantage or for which there is unsatisfied consumer demand; and output expansion through new net investment and employment growth.3

Efficiency Improvements, Reallocation, and Investment as Proximate Sources of Growth in the Transition: A Conceptual Framework

The proximate sources of growth in the recovery phase of transition are illustrated in Figure 1. In panel A, CP* represents the point of potential production of goods A and B on the production possibilities frontier under central planning where full capacity is utilized, factors are not wasted (unlike at XI1 in panel B, at which more capital K and labor L are being used to produce one unit of good B than at the efficiency frontier), and shadow prices of K and L are reflected in the central plan’s factor allocation. In this case, the only error under CP* is to ignore world prices.

CPI in panel A is a point where the factor and technical inefficiencies of central planning exist, but capacity is fully utilized; historically this is roughly equivalent to pre-1990 production in the transition economies. CPU reflects a decline in production levels (like that after 1990 in the transition economies) and lower utilization of existing capacity as well as factor and technical inefficiencies.

XI1 in panel B is inside the efficiency frontier of the unit isoquant for good B; K and L are used wastefully relative to the theoretical best practice point for central planning, XI1*.

M1 in panel A is a point on the production possibilities frontier “inherited” from resource accumulation during the period of central planning. No aggregate net investment is necessary in moving to M1, but there could be gross new investment in the expanding sector, so that allocation among goods can change, reflecting adjustment of production (allocation) to world prices. M2 is an efficient goods allocation point with new net investment.

Using this figure, five types of changes (structural shifts) can be defined that provide growth in the sense of more output for a given level of factor availability, and more factor inputs:

  • 1. Recovery from capacity underutilization (from CPU to CPI)

  • 2. Technical or X-efficiency gains, or movement to the efficiency frontier by eliminating wasteful usage of production factors (from CPI to CP*, and from XI1 to XI1*)

  • 3. Efficiency gains from achieving optimal factor proportions (from XI1* to BCP*, and from CPI to CP*)

  • 4. Resource reallocation gains (from CP* to M1; that is, production of more B and less A, hence also from BCP* to BM1)

  • 5. Net factor expansion gains (from M1 to M2, and from BM1 to BM2, plus an analogous shift to a higher-level isoquant for good A).

These shifts are identified by the numbered arrows in panels A and B of Figure 1.

Figure 1.
Figure 1.

Sources of Growth in the Recovery Phase of Transition

Growth Performance in Transition Economies, 1990–98

This section presents the basic facts on growth in the transition economies with an elaboration of the main patterns to be observed. The 25 CEE, Baltic, and CIS countries (Mongolia is not included in this study) have been undergoing a process of transition from a centrally planned to a market-oriented economy for the better part of a decade. Although this transition has depended in all cases on major changes in the political system, particularly during 1989–91, there have been considerable differences across countries in the speed with which the old system of planning has been dismantled and market-oriented reforms have been introduced. In a few countries, such as Hungary and Poland, a number of market-oriented reforms were well under way long before 1989, and the former Socialist Federal Republic of Yugoslavia had achieved a relatively high degree of market liberalization some time earlier. On the other hand, in some countries, such as Belarus, Turkmenistan, and Uzbekistan, comprehensive market-oriented reforms have barely begun.

The year 1989 was probably the last “normal” year for nearly the entire region under the old system. This was the year in which officially measured output peaked in the Soviet Union as well as in most other countries in the region. By 1990 significant economic reforms were under way in such key countries as Hungary and Poland; by the end of 1990 the German Democratic Republic, one of the linchpins of the former Council for Mutual Economic Assistance (CMEA), had merged with the Federal Republic of Germany.4 In part because of these developments, by 1990 the CMEA trading system had already been subjected to major shocks, even before its formal breakup at the beginning of 1991. Of course, partial economic reforms, formal or informal, were already under way by 1990–91 in the Soviet Union as well, before its formal dissolution in late 1991. Thus it is not a simple matter to pinpoint the exact year in which the transition began. However, for purposes of this discussion it is assumed that, for each country, the last pretransition year is the year in which it experienced the significant social and political changes that made possible the beginning of comprehensive market-oriented reform.

Although official data on output in the region are subject to many problems, available alternative estimates are not necessarily better. Estimates of the size of the unofficial economy exist, but different studies use different methodologies, and coverage is incomplete. Consensus is also lacking on the size of GDP. Therefore, despite the probable measurement error, we rely necessarily on official data, which are believed to underestimate the size of the unofficial economy.5

Given the highly distorted production structures and the sheer wastage of resources that characterized central planning, together with the long time lags involved in reallocating resources to more efficient uses in a new, market context,6 it is not surprising that virtually every transition economy experienced a substantial decline in recorded output with the onset of transition. From Table 1 and Figure 2 (upper left panel), however, it is clear that the depth of the decline associated with the beginning of the transition was, in most cases, much greater in the Baltics, Russia, and other countries of the former Soviet Union (BRO) than in CEE. This difference can be attributed to differences in both initial conditions and policies.

Table 1.

GDP Growth in Transition Economies

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Sources: National authorities; and IMF staff estimates.
Figure 2.
Figure 2.

Growth in 25 Transition Economies by Region and Growth Performance1

Sources: National authorities; and IMF staff estimates.Note: T(0) is the full year immediately preceding the beginning of transition; CEE is Central and Eastern Europe; CIS is Commonwealth of Independant States.1 The country groupings are defined in Table 2, except that there the CEE countries are divided into two groups: central Europe and southeastern Europe. Data for the Baltics and the CIS are available only from 1991.2The CEE group comprises 10 countries for the first seven years, but only 7 countries in T(8) and 6 countries in T(9).3The consistent growth group comprises 16 countries for the first seven years, but only 4 countries in T(8) and T(9).
Table 2.

Country Groupings by Economic Performance and Region

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Sources: National authorities; and IMF staff estimates.

First, the BRO countries shared a generally more highly integrated and specialized production structure prior to independence, and this, combined in most instances with greater insulation from the world market, probably meant a greater degree of initial price distortion. Many of the BRO countries were hit by a severe terms-of-trade shock with the transition, as the relative price of imported energy and raw materials rose sharply when the implicit trade subsidies received from Russia were phased out and only partially and temporarily offset by financial transfers.7 Second, the military-industrial complex was proportionately larger in many of these countries, and this led to a greater collapse in output when the transition to a more market-driven, civilian-oriented production structure got under way. Third, in the BRO countries there was a serious lack, at the outset of transition, of independent national institutions and infrastructures within which a framework for comprehensive reform and stabilization programs could be effectively implemented. Fourth, in the CIS countries at least, the inertia of 70 years of Soviet political and administrative structures may explain the early lack of political will and consensus necessary to push ahead boldly with reform and stabilization.8 Finally, in some cases, output declines associated with the transition were exacerbated by civil conflicts, blockades, or sanctions, notably in Armenia, Azerbaijan, Georgia, and Tajikistan among the BRO countries, and in Croatia and the former Yugoslav republic (FYR) of Macedonia in CEE. This affected output directly and delayed reform. For the CEE countries as a group (in terms of the unweighted average of these countries’ growth rates), positive growth had begun by 1994 (Figure 2, upper left panel). For the Baltic countries as a group, output began to recover in 1995. For the CIS group, recovery was evident only by 1997–98, and even then by no means for all countries.

A more appropriate comparison takes into account the differences among countries with respect to the onset of the transition and considers each country–s performance in “transition time.”9 Keeping in mind the earlier caution that the beginning of the transition is hard to pinpoint, it is assumed here that, for Bulgaria, the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic, the first transition year was 1990. Albania, where political developments moved a bit more slowly, is assumed to have begun the transition in 1991. Three of the successor states of the former Socialist Federal Republic of Yugoslavia—Croatia, FYR Macedonia, and Slovenia—are assumed to have begun their transition in 1992, their first full year of independence, and therefore the first year in which more or less independent economic policies became possible. For the BRO, for which the first full year of independence was 1992, this is also considered (again, somewhat arbitrarily) as their first transition year.

When growth performance is viewed from this perspective, three broad categories of transition economies can be identified (Tables 2 and 3).10 First, 16 countries, after an average of 3.1 years of output decline, have been growing now for several years, although, as will be explained below, growth in two and possibly three of these countries may well not be sustainable on the basis of unchanged policies. The three Baltic states have grown at an (unweighted) average annual growth rate during the recovery of 4.7 percent, and the six countries of Central Europe (Croatia, the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia) have averaged 4.3 percent growth during their recovery periods (Table 4). Poland stands out by virtue of its relatively early output recovery and clear rising trend in output growth, which has exceeded 4.5 percent for each of the last five years. Growth in each of the Baltic countries has exceeded 3 percent a year for each of the past three years. Although growth slowed significantly in the Czech Republic in 1997 and output actually declined in 1998, most observers view this as a temporary phenomenon associated with exchange rate and corporate governance issues, and this country is placed in the “consistent growth” category despite this small, temporary reversal.11

Table 3.

GDP Growth in 25 Transition Economies by Country Group

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Sources: National authorities; and IMF staff estimates.

Countries in each group are listed in Table 2.

Table 4.

Average Growth Rates Since Initial Recovery, by Region

(In percent a year)

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Sources: National authorities; and IMF staff estimates.

Six CIS countries have been consistently growing now for three to four years, and indeed their average annual rate of growth during these recovery years has been quite high, at 5.7 percent (Table 4). This is a fairly heterogeneous group, however, since rapid growth in Armenia, Azerbaijan, and Georgia has proceeded from a very low base, in large part reflecting civil conflict in those countries in the early 1990s. But this growth has also been strongly correlated with macroeconomic stabilization and reform (see below) and is likely to be sustainable. Although growth in the Kyrgyz Republic has also been associated with strong financial and structural policies, it appears to be more narrowly based (with the gold mining sector playing a dominant role), and its sustainability is somewhat more open to question. The recent growth of Belarus and Uzbekistan has taken place despite continued high inflation and a fundamental lack of structural reform, and its sustainability is very much open to question in the absence of significant progress toward both bringing down inflation and liberalizing the economy.

Finally, FYR Macedonia, alone among the countries of southeastern Europe, has been growing now for three years, and at an accelerating rate. This country would now appear to belong in the category of “consistently growing” countries as well.

A second broad grouping consists of three countries, all in southeastern Europe (Albania, Bulgaria, and Romania), which began growing three to five years into the transition period but then encountered major output declines in 1996 and/or 1997. The initial output decline for this “growth reversals” group was not as great as for the average of the other two groups (bottom right panel of Figure 2).12 At the same time, and as will be discussed below, these countries had failed to address some important structural reform issues along the way and were consequently unable to sustain the recovery that eventually took place. Only when important structural reforms were initiated and programs of macroeconomic stabilization were renewed did two of these countries (Albania and Bulgaria) recover again in 1998, whereas output in Romania continued to decline. The average annual rate of growth of these three countries since their initial recovery has been only 1.4 percent (Table 4).

A third broad grouping is composed of six CIS countries, which thus far, after eight years of transition, have shown little or no growth. As a group, since their initial recovery, these countries have grown at an average annual rate of only 0.5 percent (Table 4). Tajikistan, following the second-largest cumulative output decline among the 25 transition economies—due largely to civil conflict—actually grew in both 1997 and 1998, and at an accelerated rate. Kazakhstan, which began to recover in 1996–97, experienced a fall in output in 1998, although this was at least partly due to the decline in the world price for oil and the crisis in neighboring Russia. Both Moldova and Russia showed signs of recovery in 1997, only to see output decline sharply in 1998, also, in large part, because of the crisis in Russia itself. After years of decline, Turkmenistan managed to grow in 1998, but output in Ukraine continued to fall, although at the lowest rate during the transition to date.

As of 1998, only three countries had reattained or surpassed their measured output levels in the first year preceding their transition.13 All three were in Central Europe: real GDP in 1998 in both Poland and Slovenia exceeded that in the year immediately prior to the beginning of transition by 17 and 20 percent, respectively, and output in Croatia surpassed the immediate pretransition level by 6.5 percent. At the other extreme, with measured output still less than half the immediate pretransition level, were five CIS countries. One of these, Georgia (at 47 percent of 1991 output), has actually been growing for four straight years. The other four are all in the third grouping (little or no growth): Tajikistan and Turkmenistan (withoutput around 45 percent of the 1991 level), Moldova (40 percent), and Ukraine (41 percent).

Finally, it should be emphasized that the growth rates in most transition economies in 1998 were adversely affected by factors well beyond their control or by the process of transformation itself. For CEE, the general slowdown in the world economy and the region’s diminished export prospects, together with contagion effects for most emerging economies, undoubtedly had a negative influence on growth. For the BRO countries, not only these factors but, more important—for those countries deeply dependent on Russia (either directly or indirectly through their trade ties with other BRO countries)—the Russian crisis had a profound impact on economic growth in 1998.

Main Factors Associated with Growth in the Transition

This section assesses the key factors that may explain the differences in growth performance among these transition economies. We start with a brief summary of earlier empirical studies. The first and probably least controversial conclusion is that stabilization is a necessary condition for recovery of output (Fischer, Sahay, and Végh, 1996 and 1998).14 Two apparent exceptions, Bulgaria and Romania, fell into line when their growth and stabilization reversed. Two other exceptions exist at present—Belarus and Uzbekistan—and their similarity to the reversal cases is discussed below.

A second and somewhat more controversial conclusion relates to the additional, necessary conditions to promote growth, namely, liberalization and structural reforms. Whether the framework was a simple one relating only to growth and some index of structural reforms (Sachs, 1996; Selowsky and Martin, 1996; Åslund, Boone, and Johnson, 1996) or a more sophisticated one reflecting the effects of stabilization, initial conditions, conflicts, and the like (Fischer, Sahay, and Végh, 1996 and 1998; Hernàndez-Catà, 1997; de Melo and others, 1997; Berg and others, 1999), the conclusion was firm: more comprehensive reform is associated with better growth performance. These results, too, are not without exceptions, Belarus and Uzbekistan today being the key ones, and Bulgaria and Romania earlier. Åslund, Boone, and Johnson (1996) point to a dichotomy here: whereas empirical studies concluded that fast and early reforms result in early and strong recovery, theoretical work on transition has often shown that a gradual pace might lead to a smaller initial decline of output (Aghion and Blanchard, 1993).

A third set of conclusions relates to other factors such as war and initial conditions; these do have an effect that is country-specific. Some studies have tried to determine the relative importance of adverse initial conditions and of policies (de Melo and others, 1997; Berg and others, 1999). However, they have not been specific about the trade-offs, such as how much a high share of industrial output impedes growth or how much compensation is needed from faster reforms.15

A fourth set of conclusions relates to such institutions and conditions as the rule of law, the climate for corruption, and the fairness of the tax burden. These factors are even less easily measured than the degree of liberalization; hence, not surprisingly, the statistic used varies a great deal from study to study. Nevertheless, studies such as Brunetti, Kisunko, and Weder (1997a–c); Johnson, Kaufmann, and Shleifer (1997); and Olson, Sarna, and Swarmy (1997) concur that growth is higher where these elements show higher levels of institutional achievement.

Fifth and finally, the conventional factor input explanations of growth theory (which focus on investment, labor, human capital, and the like) are not considered in any of the empirical studies, reflecting the view, noted earlier, that the initial recovery from transitional recession is of a special nature. Only Wolf (1997) actually tests for the statistical importance of investment-GDP ratios, and he finds a negative correlation.

This chapter provides some new facts that illustrate, confirm, and elaborate on these conclusions; it also reports the results of new econometric analysis using data through 1998.16 The new data make it easier to distinguish the factors influencing the decline from those inducing recovery and permit a considerable updating of previous empirical studies. The very fact that recovery began much earlier in some countries and still has not started in others, and that recent rates of growth vary considerably among countries, speaks to the view that recovery and sustained growth are not automatic, nor do they represent merely a cyclical rebound. Six main issues concerning the transition and growth are elaborated here. The first is the applicability of conventional explanations of growth in market economies. The second is the effect of special initial conditions in the transition. The third is the contribution of government policies, in particular financial stabilization and structural reform. The fourth is the sustainability of growth. The fifth is the time pattern of reform, whether gradual or more rapid, early or delayed. The sixth is the political economy determinants of the nature and speed of reform. We summarize the findings by considering which of these explanatory factors deserve greatest policy priority. The assessment made in this section draws on the following evidence: the conclusions of earlier studies; new statistical evidence summarized in comparative group averages; and new regression analysis covering the period 1991–98 (summarized in the appendix).

Conventional Factor Input Explanations

It appears that the conventional determinants of investment, labor, and human capital expansion played only a limited role in the recovery. Although there does appear to be a correlation between investment and growth once the recovery is under way (see below), movements in labor productivity have been a somewhat better predictor of the onset of recovery or output reversals (Figures 3 and 4). There is little disagreement in the general growth literature that investment is a major engine of growth in the medium to long term.

Figure 3.
Figure 3.

Labor Productivity and Output in 25 Transition Economies

(Index, 1992=100)

Sources: National authorities; and IMF staff estimates.
Figure 4.
Figure 4.

GDP and Investment in 25 Transition Economies

Sources: National authorities; and IMF staff estimates.

As de Broeck and Koen (2000) have shown for Central Europe the most common pattern for the investment-GDP ratio is a decline from levels of the central plan period near 30 percent to levels near 20 percent or even lower, and then a strong recovery simultaneous with a rebound in output (this latter phenomenon is captured in Figure 4). In the short run, however, and especially in transition economies with a history of excessive capital accumulation and its inefficient use, the role of new investment in the initial recovery phase may be relatively less important. Unfortunately, investment data for most transition economies are generally not very reliable, and this hypothesis is difficult to test. Available data present a suggestive but incomplete picture, described in Havrylyshyn and others (1999). Of the 16 countries that have shown consistent growth, 13 have adequate data on investment.

A substantial upturn in the ratio of investment to output preceded recovery in only one case, but coincided with the beginning of recovery in three countries and actually lagged the upturn in output in nine. For nine of these same countries for which real investment growth data were available, there was virtually an even three-way split among the number of countries for which the substantial recovery of real investment led, coincided with, or lagged the recovery of real output.

Econometric analysis of growth determinants does not show the usual positive effect of investment on GDP (Wolf, 1997; see also the appendix). At the same time, however, there does not appear to be a correlation between relatively rapid investment growth and recovery in general (Figure 4).

A plausible way to reconcile all this evidence would be to conclude that although aggregate net new investment may not be that important in the initial recovery phase, it becomes increasingly so as the recovery continues.17 For overindustrialized, distorted, and inefficient transition economies, recovery only comes after some elimination of the wasteful old production (see Hernàndez-Catà, 1997) and usually cannot be based on a large investment effort to build new productive capacity before the proper incentives for efficient resource use are in place.

The impact of export growth is less clear. The group averages for export growth (Table 5) show a broad statistical association with economic growth, although the empirical studies generally do not test for openness to exports. (Exceptions are Wolf, 1997, who finds no correlation, and Christoffersen and Doyle, 1998, who find indirect evidence of a correlation between growth and expansion of market opportunities.) The explanation may be simply that almost all transition economies became relatively open very quickly, and those that achieved restructuring earlier were able to reorient their trade quickly to new markets. That is, exports did not simply become the engine of growth, but rather restructuring—which is necessary for growth—also tended to promote exports.

Table 5.

Average Growth Rate of Exports, by Region, 1994–97

(In percent a year)

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Sources: National authorities; and IMF staff estimates.

A similar conclusion applies to foreign direct investment (FDI). Although there is a clear association between economic growth and cumulative FDI per capita (Table 6), at least for CEE and the Baltics, the relationship between growth and FDI may be mutually reinforcing. In other words, although there is little doubt that FDI promotes growth, those factors that promote greater stabilization and reforms, and therefore growth, also attract FDI. Because of this simultaneity, econometric analysis of growth has been unable to isolate FDI as an explanatory factor, although it has been attempted in several of the studies mentioned.

Table 6.

Cumulative Foreign Direct Investment per Capita, by Region, 1990–96

(In dollars)

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Sources: National authorities; and IMF staff estimates.

Effect of Initial Conditions

This study finds that initial conditions are not without importance, but that their impact becomes smaller over time and can be offset by better policies, in particular by slightly faster progress on structural reform. It is not a straightforward matter to observe statistically the effect of initial conditions, such as historical experience and attitudes, differences in the degree of economic distortion under central planning, or levels of development. One reason is the difficulty in measuring these conditions; thus, although there is a broad consensus that before 1990 the Central European countries had relatively less distorted economies than the Soviet Union, this does not provide a quantifiable measure of how much they differed. Another reason is that the impact of initial conditions may be indirect; that is, they may affect growth through policies: the degree of commitment to reforms and their effective implementation may be partially explained by such differences in initial conditions. Three recent studies address this: de Melo and others (1997), Hérnandez-Catà (1997), and Wolf (1997). They find generally that the Central European countries and the Baltics, because of their history of less economic distortion, shorter history of communism, and closer proximity to market economies, were more likely to implement market-based policies early and quickly.

Although such difficulties will qualify any statistical analysis, it is still useful to undertake such analysis, using measures of initial conditions compiled by de Melo and others (1997). The appendix details the results, which illustrate the relative impact of initial conditions on growth. Initial overindustrialization is found to lower the rate of output growth by about 0.4 percentage point for each additional 5 percentage points of the share of industry in total output. But this effect is offset by improvements in the growth rate arising from even modest progress on structural reform. A move from a low level of reform of 0.2 (as measured by the reform index compiled by the European Bank for Reconstruction and Development, or EBRD; Table 7) to one of 0.3 yields 1 to 2 percentage points of additional growth. Thus, moving from an intermediate stage of reform, as indicated by an index value of 0.4, to a more advanced level of 0.7, would add 3 to 6 percentage points of economic growth.

Table 7.

Structural Reform Indices for 25 Transition Economies

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Sources: de Melo, Denizer, and Gelb (1996); and EBRD, Transition Report, various issues.

Another method frequently used to capture initial conditions is the use of dummy variables to identify groups of countries: countries of the former Soviet Union from other countries, countries beset by civil conflict from countries at peace, and so on. Earlier growth studies, as noted above, found these differences to be significant. The regression reported in the appendix, using data through 1998, shows no statistically significant results, suggesting that the impact of such effects diminishes over time. This reaffirms the conclusion of Berg and others (1999); however, when regression analysis is done separately for the CIS and other countries, an interesting result emerges: the impact on growth of a given amount of reform, as measured by an EBRD-type index, is less for the CIS countries.

Other initial conditions matter as well, such as very low income (including after civil strife) and resource availability. Thus in Albania, Armenia, Georgia, and the Kyrgyz Republic, substantial progress toward reform saw growth rates surge, reflecting a catch-up phenomenon as well as the availability of natural resources to be exploited (such as gold in the case of the Kyrgyz Republic). But resource wealth can also be an impediment to reform, providing only temporary, unsustainable (or at least weak) growth; Uzbekistan, with its exportable cotton production, may be such a case (Zettelmeyer, 1999). Civil strife is found by many analysts to affect growth adversely, but the effects seem to disappear quickly (see especially de Melo and others, 1997); the quick recoveries in Armenia, Georgia, and now Tajikistan are examples. Thus, on balance, the evidence suggests that initial conditions have had an effect, but the effect should not be exaggerated, because it declines over time and can be offset by stronger progress toward reform. Furthermore, the effect is possibly more on the political will and capacity to implement reforms than directly on growth; hence the conclusion remains that where more reforms are implemented, more growth will occur.

Economic Reform and Macroeconomic Policies

This study also finds that macroeconomic stabilization and general progress on market-oriented reform are dominant determinants of recovery in the transition period. Both Table 8 and the appendix show this clearly: inflation control is a sine qua non for growth, and greater progress in reform is associated with more rapid growth. The role of stabilization is well established in the growth literature as perhaps the first, virtually necessary condition for recovery, and the hyperinflations in some transition economies in the early to mid-1990s were without question inimical to growth. A recent paper on disinflation in transition economies (Cottarelli and Doyle, in this volume) confirms this relationship and demonstrates further that although recovery may begin once inflation has declined to double-digit levels, sustained growth requires sustained disinflation. But although stabilization appears, with few exceptions,18 to be a necessary condition for achieving growth, it is not a sufficient condition: several of the “little or no growth” cases—Kazakhstan, Turkmenistan, and Ukraine, and until recently, Russia—also have had relatively low inflation rates in recent years. However one may view the “necessary but not sufficient” issue, it is clear that high inflation has generally been detrimental to growth, and that stabilization, along with structural reform, has helped growth to resume.

Table 8.

Average Inflation During Years of Positive Growth, by Region

(In percent a year)

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Sources: National authorities; and IMF staff estimates.

Indeed, accompanying structural reforms, as reflected in the EBRD index, were equally necessary for growth. It is surely not pure coincidence that Poland, which was among the earliest to begin and sustain recovery, was also among the earliest to put in place structural reforms. This was reflected in an increase in its rescaled EBRD index from 0.68 in 1990 to 0.83 in 1994 (Table 7); growth in the Baltics, beginning in 1994–95, was associated with improvements in their reform indices from around 0.30 in 1991 to between 0.70 and 0.85 in 1994; and six CIS countries that have thus far achieved only little or no growth have had an average index well below most others (Table 9).

Table 9.

Average Index of Liberalization, by Region, 19951

(In percent a year)

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Sources: EBRD, Transition Report 1996.

Average of selected EBRD transition indicators normalized between values of 0 and 1.

Excluding Belarus and Uzbekistan.

It is also noteworthy that, in 1997, the share of the private sector in (officially recorded) GDP tended to be higher in countries with sustained growth than in countries with growth reversals or little or no growth (Table 10). In early discussions of transition, privatization was seen as the key mechanism for achieving efficiency and new growth by enforcing a hard budget discipline and providing profit incentives. This would lead first to restructuring, enabling enterprises to reach commercial viability through a variety of measures: labor shedding, increases in sales, closure or sale of unprofitable units, creation of a retail network and marketing, development of new products, seeking contracts with new partners, renovations to improve productivity, a quality control process, and a reduction in barter transactions. Viable firms would increase their productivity and market share, attract more resources, and increase production—hence new growth would occur. Nonviable firms would shrink or close down, and their assets (both human and physical capital) would be reallocated to alternative production. John Nellis (in this volume) summarizes the initial evidence showing that privatization in general does help growth, but only if done right.

Table 10.

Share of Private Sector in GDP, by Region, Mid-1997

(In percent a year)

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Sources: EBRD, Transition Report 1998.

Excluding Belarus and Uzbekistan.

The structural reform index is, of course, a composite of several dimensions. Although some effort has been made to isolate the subcomponents, it has generally not been possible to isolate one element as more important than others. Such a decomposition is, however, found in Fischer, Sahay, and Végh (1996 and 1998) and de Melo and others (1997), as well as in Havrylyshyn, Izvorski, and van Rooden (1998). From the statistical analysis in the appendix, it can be seen that the subcomponents—price liberalization, privatization and enterprise reform, trade and exchange liberalization, and legal reforms—are all closely correlated with general reform. In a statistical test, none is important separately from the general index, although each of them alone “substitutes” for the general index as an explanatory factor of growth. Only price liberalization stands out as unique in its effects over time, as described in the discussion of the timing and pace of reforms below.19

The role of an effective legal framework in promoting growth in transition economies has taken on increased importance, as many analysts of the process have begun to point to the practical barriers in exercising de jure freedom of economic action (see World Bank, 1996a; EBRD, 1997). The finding by some empirical growth studies that the institutional climate of property rights matters is illustrated by the statistical results described in the appendix: the legal framework index (estimated by the EBRD since 1995) is strongly associated with better growth performance.

Sustainability of Growth

There appear to be two groups of counterexamples to the conclusion that growth requires significant progress toward reform. Belarus and Uzbekistan are two “puzzle cases”: they have shown strong positive growth despite limited reforms (rescaled EBRD index figures in 1997 of 0.37 and 0.54, respectively; Table 7); Albania, Bulgaria, and Romania achieved early recoveries only to see them reversed. The two groups are similar in several respects and provide an object lesson in the sustainability of growth. The three cases of reversal had achieved greater reform progress than the two “puzzle” cases, but financial stabilization was incomplete, and the elimination of soft enterprise budget constraints was generally not achieved. Albania, as a result of social upheaval triggered by its pyramid financial schemes, and Bulgaria and Romania, through continued directed credits and energy price supports to state enterprises, experienced a reversal of stabilization. Annual inflation reached an average of 67 percent during the recovery period, followed by a reversal of growth. Belarus and Uzbekistan, having undertaken limited reform, have seen a return to low-cost directed credits, which have fueled recovery but have also given rise to a return of high inflation, to about 50 to 60 percent in 1997 (and over 150 percent within 1998 in Belarus). This picture raises a concern about the sustainability of growth in these two cases. Indeed, estimates for 1998 (Table 1) show the onset of a sharp slowdown in Belarus and continued slow growth in Uzbekistan.

Timing and Sequencing of Reforms

The timing and pace of reform have perhaps been the most provocative issue in debates about growth in transition economies. Often, the discussion has been reduced to a too-simplistic debate between shock therapy and gradualism. It may be better to think of the issue in more nuanced terms, and ask whether an earlier start or more discrete sharp moves toward reforms that can be done quickly (such as price liberalization) lead to better growth performance. The choice is made more complex by the possibility that it is a package of complementary reforms rather than some “silver bullet” that works best. A separate issue is whether, once the conclusion is accepted that moving faster leads to higher growth, the political will or a political environment exists that enables policymakers to choose to inflict pain up front, knowing improvements will come only later. In a sense, despite eight years of experience, it is still too early to judge which approach has worked better, as some countries may still show late but strong growth surges, while others may yet see a reversal, as indeed has already happened in southeastern Europe. Nevertheless, some illustration of the varied effects of differences in the pace and intensity of reforms can be provided.

A useful way of thinking about the time pattern of reforms and resulting output performance is the “creative destruction” framework developed above. At the outset, rapid reforms including price liberalization have more of a destructive than a creative effect (as Hernández-Catà, 1997, also emphasizes). Indeed, it is notable that for the early period, 1990–93, the regression analysis in the appendix suggests that greater price liberalization results in more decline (see the negative coefficient on the price liberalization variable in equation B2). The top panel of Figure 5, using fitted values from the regression analysis, tells a similar story, depicting a U-shaped relationship between growth performance and the degree of progress in reform in 1990–93. Were the analysis to stop at that point, the conclusion could be drawn—as it often has been—that less reform is better than reform that is intermediate in scope. Moreover, since most of those economies at the right (greater reform) end of the U in 1993 were Central European economies, their performance has often been attributed to geography and history—that is, better initial conditions.

Figure 5.
Figure 5.

Impact of Reform on Growth: Fitted Regression Values1

Sources: IMF staff estimates; and EBRD (1997).1 The fitted values are obtained from the multivariate panel data regressions B1 (top panel) and C1 (bottom panel) in Table 11 in the appendix. A polynomial trend line has been added to the fitted regression values.
Table 11.

Regression Analysis of Growth Determinants

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Sources: National authorities; de Melo, Denizer, and Gelb (1996); de Melo and others (1997); EBRD, Transition Report, various issues; and IMF staff estimates.

Note: Dependent variable in all equations is real GDP growth; independent variables are as follows (t-statistics in parentheses):

LNP

Natural logarithm of inflation (CPI, year-on-year).

RI

Structural reform index.

EXP

Government expenditure as a percentage of GDP.

INCOND

Initital conditions (structural indicators from de Melo and others, 1997).

LIP

Structural reform subindex for liberalization of internal prices.

LEN

Structural reform subindex for private entry in markets.

LEX

Structural reform subindex for liberalization of trade and foreign exchange systems.

LEG

Structural reform index for legal reform.

PRO

IMF-supported program implementation indicator (percentage of performance criteria met).

Data are for 1990–97 except where noted otherwise.

Equations including this variable are estimated using 1992–97 data.

Data are for 1990–98.

Data are for 1990–93.

This variable excludes those subcomponents that are included sepearately in the specification.

Data are for 1994–97.

But with the passage of time, one in fact has seen very much what the analytical framework suggests: in the advanced group of countries, as progress in reform continues, the negative, destructive effects of reform come to be strongly outweighed by the positive, creative, and growth-inducing effects. In the bottom panel of Figure 5, which depicts the recovery period, this is now reflected in a very clear positive relation between the degree of reform and growth performance. In the formal regression analysis, the price liberalization variable becomes strongly positive in the second period (see equation C2 in Table 11 in the appendix); indeed, the size of the coefficients for all policy variables tends to be much higher. Of course, a few exceptions remain—Belarus and Uzbekistan again—where limited reform is associated with recovery. But the overwhelming message of the data is that those countries that started early (or started later but moved rapidly) may have paid an initial price in the form of sharper output declines, but are now reaping the benefits in the form of more rapid growth. In contrast, those that have undertaken limited or very moderate reform continue to suffer decline, or at best experience only nascent and fragile recoveries.

Political Economy Factors

In addition to the proximate causes of growth discussed so far, it is useful to consider some factors related to political economy, which, by affecting the nature and effective implementation of economic reforms, indirectly affect growth. At the start of the transition, political support for the transformation of the economy may have been quite widespread, but it was by no means universal. Opposition of varying degrees was to be found among the managerial elite of the Soviet period, the bureaucracy, and many but not all of the Communist Party elite. For most Central European countries and the Baltics, the prospect of eventual accession to the European Union acted as a strong beacon, showing the way to market reform. In those countries, as well as in a few early reformers farther east—Armenia and the Kyrgyz Republic—strong and continued progress on reform created a demonstration effect, as other countries recognized the potential benefits: growth in the service sector, new opportunities for small entrepreneurs, and eventually general recovery. Of course, an early start on comprehensive reform also created opposition to further reform, particularly because of rising unemployment and the removal of privileges. But in many of these countries, the initial goodwill to reform was enough to sustain the reforms politically until the new beneficiaries added their voices to the support for continued reform.20 It is also notable that even though a wave of elections in Central Europe in the mid-1990s brought many left-oriented governments to power, the main direction of economic policy was little changed.

In countries where reform did not get off to an early start or was very incomplete (for example, where there was considerable privatization, but continued soft budget constraints and inadequate development of rule-of-law institutions) the policy process was captured by new vested interests. These were especially concentrated in the energy, banking, and heavy-industry sectors. These vested interests often began by accumulating wealth through the economic rents resulting from large price distortions in energy and raw materials, and by borrowing from the central bank during years of inflation. Mass privatization was often captured by such vested interests, who understandably favored this form of privatization. Once their private ownership of former state assets was assured, they supported inflation control, because it would help stimulate recovery and thus the growth of their newly acquired firms. But these insiders continued to strongly oppose the full liberalization of market opportunities, which would bring in new domestic or foreign competition. With the transformation to the market thus frozen in midcourse, the aims of the new vested interests, those of the old, surviving state enterprises, and a political establishment concerned about employment broadly coincided in a status quo. One manifestation of such a political economy equilibrium is the so-called virtual economy.21 This describes the situation where noncash operations—barter, arrears, in-kind wages, tax offsets—help maintain the status quo and provide a cover of nontransparency for economic operations of low or even negative productivity that are not market based and allow rent seeking and corruption. The potential virtuous circle of reform and growth is replaced by a vicious circle of suspended reform and stagnation.

Which Factors Matter Most?

One can best summarize the implications of all the above evidence by asking whether certain aspects of structural reform are more important determinants of growth than others, and whether some factors deserve greater attention from policymakers. The answer to the first question is no, but the answer to the second is yes. The evidence described so far suggests, if anything, that what is needed is a package of across-the-board policy measures; there is no magic single key to successful growth. In the words of Harberger (1998) in a recent article on growth, it is the “thousand and one” little things that hard-working and innovative managers do that create new output. Aziz and Wescott (1997) provide a more formal demonstration of the need for a comprehensive package. The early studies of growth in transition found many different policy measures to be important: stabilization, general progress on structural reform (including price liberalization and privatization), reduction of the government budget deficit, a strong legal climate of transparency and fairness (the rule of law), openness to external trade, and a high degree of competitiveness.

Having said this, one can still point to certain areas of structural reform that need more attention from policymakers, since the implementation of policy has not been even and across the board. In some instances (such as Ukraine), structural reforms have not advanced very far beyond financial stabilization and initial (often still partial) price and/or exchange rate liberalization, and even liberalization has been delayed in countries such as Belarus, Turkmenistan, and Uzbekistan.

In many transition countries, in both CEE and elsewhere, privatization is well advanced, but the associated conditions of a hard budget constraint and open competition are by no means fully in place.22 Admittedly the extent to which this is true varies from the advanced transition cases such as Croatia, Hungary, Poland, Slovenia, and to a lesser extent the Baltics, through moderately advanced cases such as Armenia, Kazakhstan, Kyrgyz Republic, and in some ways Russia, to the least-advanced reformers. Finally, for almost all countries, but again to varying degrees, the effective implementation of strong legal institutions supporting property rights is a key item on the agenda. Some of the critically needed policy actions concern items that, by their nature, take rather more time to accomplish. Among these are the strengthening of legal institutions, privatization of natural monopolies, and the strengthening of banking systems and more generally the system of financial intermediation, in part through improving mechanisms of prudential regulation and supervision. Others are items that should have been done earlier but were not: the list includes privatization of enterprises other than natural monopolies, price liberalization, and fiscal reform. Perhaps a few are items whose importance as bottlenecks was not well understood earlier; these include simple business registration and entry regulations, agricultural land collateral systems, competition in supply and marketing networks related to agriculture, and effective and quick contract law settlement.

Conclusion

Lessons on Achieving Recovery

Several lessons emerge from this analysis. The consensus is very clear on the first lesson, namely, that stabilization is a sine qua non. All studies agree that inflation must first be controlled and brought down at least to levels well below 50 percent before sustainable recovery can occur. If inflation is not driven further down and prevented from increasing again, any recovery that occurs is unlikely to be sustained. Cases of early recovery accompanied by still-high or rebounding inflation—such as Bulgaria and Romania—eventually saw a reversal, although lack of continued progress in other reforms also played a role. Similar recoveries accompanied by high inflation and limited reform in Belarus and Uzbekistan may also prove unsustainable.

There is no denying that structural reforms cause a dislocation of resources, including labor, and hence pain to some in the economy. It follows that delaying such reforms can delay the pain. However—and this is the second lesson—such delay imposes a cost: the lost opportunity for a vibrant and sustained recovery that provides economic gains to all. Those cases where recovery has occurred despite delays in reform appear to provide only temporary shelter from the inevitable pain. Of four such cases noted above, two suffered strong reversals, while the other two continued to suffer high inflation and in 1998 already showed much slower (Belarus) or still relatively slow growth (Uzbekistan).

A third lesson is that there is no shortcut to reform. No single reform provides a simple key or panacea—a comprehensive package combining at least minimal progress in all areas is required. This does not mean that all aspects of reform—price liberalization, privatization, establishment of competitive markets, open trade, free entry, and enforced bankruptcy for unviable enterprises—have to be imposed overnight. Nor does it mean that the transformation to a new market environment has to be complete in all these dimensions before recovery will occur. It does, however, mean that the process of reform in each of these areas has to begin and proceed at an appropriate but steady pace, with some reforms perhaps moving faster (price liberalization, open trade), and others more slowly (privatization, establishment of competition, security of property rights).

A fourth lesson is that unfavorable initial conditions should not become an excuse for inaction. Initial conditions such as heavier industrialization or a relative dearth of historical contacts with market economies can hamper recovery, but they are not insurmountable obstacles, for several reasons. First, their negative effects decline over time. Second, the empirical studies clearly suggest that these effects can be compensated by modestly faster progress on reforms. And third, perhaps the main effect is indirect; that is, unfavorable initial conditions result in less political will and capacity for reform, and less reform means less growth. This interpretation leaves untouched the simple conclusion that more reform leads to more growth.

A fifth lesson is that developing institutions that create a market-friendly environment cannot be delayed for too long. Putting in place secure property rights, easy entry into business, enforceable contracts, the rule of law, and the whole network of institutions that support value-creating production activities is essential. When these changes should come about is more difficult to say. They have clearly been coming more slowly than other elements of reform, but that may be their nature. In some of the lagging reformers, these institutions are very much undeveloped; indeed, many recent writings on this topic suggest that, because they were delayed for so long, the environment of criminality and disregard for law that filled this vacuum now hinders efforts to introduce the rule of law.

The major new development during 1998 was the fallout from the financial crisis in Russia in August of that year. As a result, a reversal of stabilization and of the incipient recovery has occurred in Russia itself, with a continued negative impact on growth in neighboring countries with substantial trade ties to Russia. The Russian crisis therefore reinforces two of the key lessons of this study: first, that incomplete structural reforms to strengthen property rights and governance jeopardize the sustainability of financial stabilization; and second, that the costs of incomplete reform in terms of lost output and renewed inflation can be severe. True, there are many differences between Russia and the three previous cases in which stabilization programs were reversed (Albania, Bulgaria, and Romania). Yet 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 nonpayment, offsets, and barter, reflecting a general breakdown of financial discipline. The lesson for other transition countries is that lasting stabilization and recovery are never assured so long as the structural and governance reform process is not finished.

Another recent development has been the sharp reduction in the new capital inflows that can contribute to sustaining growth. This process, of course, began earlier, as financial markets reassessed the prospects for emerging markets after the events in East Asia in 1997 and early 1998. In the case of Russia, the financial 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; another is the generalized downgrading by private credit rating agencies. But some differentiation among countries is occurring: spreads increased 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 their ratings, or at most posted notices expressing some concern. 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.

Future Prospects and Challenges

The very fact that the great majority of transition economies have begun an economic recovery—and that nearly two-thirds have already sustained their recoveries for at least three years—is evidence that the transition has come a long way. But by the same token, a few countries have faltered, several have seen only a fragile recovery, and a handful have scarcely begun. Thus the agenda for the transition in these countries remains considerable.

For a number of the Central European countries and the Baltics, the transition process is well advanced, and their problems and issues are becoming more similar to those facing middle-income market economies. Already one has seen, at least until mid-1998, in the Czech Republic, Estonia, Hungary, Latvia, Poland, and perhaps Croatia and Slovenia, a strong recovery running ahead of itself and generating risks of overheating, and contagion leading to reversals of capital inflows. In fact, in the case of the Czech Republic, this scenario materialized in 1997. Furthermore, in the future these more advanced transition economies will not be able to rely on the early and substantial efficiency improvements from the elimination of the distortions of central planning. Rather, their growth will depend much more on the mobilization of savings and their efficient intermediation by the financial sector into high investment. Also, much more effort will be needed to rationalize and perhaps still reduce these countries’ expensive social programs; otherwise, 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.

For most of the CIS countries, and to some extent those in southeastern Europe, a large unfinished agenda of market-oriented reforms remains. The extent of the task ranges from the completion of large-scale privatization and a meaningful imposition of hard budget constraints in Bulgaria and Romania, to making a serious start on reform in Belarus and Turkmenistan, to restarting the process in Uzbekistan. In all but the last three countries, the first swallows of a market springtime in fact appeared some time ago. But the winter of an 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 agenda (and in a few cases even the stabilization agenda) remains quite extensive in these countries, and in some cases there is danger of further backsliding.

Finally, in all countries there remains the very important task of securely establishing good economic governance—this is perhaps more sorely lacking in the CIS and southeastern Europe, but it is important in the others as well. In many countries (especially in this second group) the government has still not pulled back enough from interventions in economic activity and various types of signaling with respect to resource allocation. But at the same time these governments have perhaps pulled back too far from the crucial task of providing the discipline of law and order, as well as a secure climate for individuals to engage in fruitful economic activity of their choice.

Indeed, in many countries a kind of vicious circle has developed. Poor economic governance delays structural reform, 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 more actively promote good economic governance.

Appendix: Regression Analysis of Key Factors Underlying Growth

As Harberger (1998) observed, growth is, at heart, the sum of “a thousand and one” individual initiatives by entrepreneurs and managers to make improvements in products and processes. Regression analysis cannot explain such growth. Rather, it can at best illustrate its nature by organizing the underlying stylized facts. A background paper for this study (Havrylyshyn, Izvorski, and van Rooden, 1998) attempts such an exercise, in a manner similar to several recent studies on transition, by marshaling the stylized facts of growth in 25 countries over eight years (1990–97), together with values for variables reflecting some of the key factors hypothesized to affect growth. The relationship is formulated as follows:

growth = f (inflation, general structural reform progress, elements of reform, size of government, initial economic conditions, compliance with Fund programs).

With 200 observations for most but not all of these variables, the above relationship can be estimated for both the entire period and the subperiods. Although the distinction is somewhat arbitrary, it is useful to consider separately the period of “decline” (1990–93) and the period of “recovery” (1994–97). During the first period, at most a handful of countries saw the beginnings of recovery; during the second, nearly a dozen countries experienced three or more years of growth, and most others either began to grow or at least saw the decline approaching bottom.

Because data for 1998 were still incomplete at the time of this writing, the sample period comprises the years 1990–97. However, when the sample period is extended to include estimates for 1998, the results remain intact.

By far the dominant statistical association is found for two policy variables: the degree of price stabilization and general progress in structural reforms. The equation’s explanatory power is quite high for this type of data set: the adjusted R2 ranges from about 0.50 for the whole period (equation A1 in Table 11) to about 0.80 for the annual growth observed in the recovery period (equation C1). It is notable that the results are stronger and have higher statistical significance on standard econometric tests in regressions for the recovery period, with 100 observations, than in regressions using the full database of 200 observations for the period 1990—97. This is to be expected, of course, because the factors that explain decline are not exactly the same as those that explain recovery. In particular, one factor—the price liberalization subcomponent of the reform index—has an initial partially negative effect on output (which could be due to the Schumpeterian destruction of the “bad”; equation B2). But as reform and time progress, the price liberalization effect is fully positive (Schumpeterian creation of the new “good”; equation C2), or, put differently, early price reform begins to matter once additional reforms in other areas have taken place.

When separate equations are estimated for the CEE countries and the Baltics on the one hand (equations A2 and A2’), and for the CIS countries on the other (equations A3 and A3’), it is notable that a given amount of reform, as measured by the index, has a stronger impact on growth in the first group of countries. This could reflect the fact that, from the onset of the sample period, the CEE countries and the Baltics were already at a more advanced stage of transition than the CIS countries.

Of the reform subcomponents, price liberalization stands out, as noted, as does its statistical explanatory power when included together with the general reform index, which then excludes the price liberalization subcomponent (equations B2 and C2). The other components (trade and foreign exchange reform, privatization and ease of new entry, legal reform) are each close substitutes for the general index. However, they do not have strong additional separate significance in the statistical analysis, except for trade and foreign exchange liberalization in the recovery period, which has a positive effect (equation C6). The generally very close association of the various subcomponents of reform is similar to the results for other economies in Aziz and Wescott (1997), in that a combination of policies is more critical for growth than any single type of policy.

Two factors that usually play a large role in statistical studies of long-term growth in other economies—the investment-GDP ratio and the degree of economic openness (or a proxy for export growth)—were not found to show a significant statistical association with growth in this study (results not shown). For investment, the reason was noted in the text: the nature of transition is such that efficiency improvements are a particularly important potential source of early growth, and large new investments may not be necessary. They may, of course, be necessary to some degree for the growing portions of the economy, but this may be accompanied by the shrinking of investment in other areas. Openness of an economy is difficult to measure, and export growth is as much an effect or reflection of early, efficiency-based growth as it is a cause; for these reasons, its explanatory power may not be great. Foreign direct investment is generally unlikely to contribute to the early recovery, for it will not be forthcoming until after the conditions that generate growth (stabilization and structural reforms) are well in place.

Initial conditions, including overindustrialization, do matter and show a statistically significant negative effect on growth for the sample as a whole (equations A4 and A7). But the magnitude of this effect is very small compared with that of the main policy variables; it requires relatively little additional improvement in macroeconomic and structural policies to compensate for more adverse initial conditions. For example, an industry share 10 percentage points higher in 1990 (say, 40 rather than 30) would have lowered the growth rate by 0.8 percentage point, but this could have been fully offset by a small increase in the reform index (which is scaled 0.0 to 1.0) from, say, 0.2 to 0.24, or from 0.3 to 0.34. From this, we may conclude that policies are the most important factor explaining differences in growth performance among countries.

Equations A6 and A6’ suggest that initial conditions have had a more pronounced adverse impact on growth in the CIS countries than in CEE and the Baltics. However, this again may reflect the more advanced stage of the transition process in the latter group, as the impact of initial conditions can be expected to diminish over time. Moreover, when the equation controls for the size of the government (equations A7, A8, and A9), the impact of initial conditions is actually less strong in the CIS countries.

Finally, turning to the association with Fund programs, it is found that an index of effective program implementation (based on compliance information in the IMF’s database and described in a background paper by Mercer-Blackman and Unigovskaya, 2000) is positively correlated with growth in the regressions (equation C10). In effect, the program implementation variable is closely correlated with the reform index, and both have very similar effects in the regression equations; when both variables are included in the equation for 1994–97, the program implementation variable displaces the structural reform indicator. This stylized fact might be interpreted as reflecting an underlying (and unmeasurable) factor, namely, commitment of the authorities. Where authorities are committed to reform, they know what needs to be done or how to design a policy program, and they ensure that it is implemented. Therefore, one observes early stabilization, early and strong progress on reforms, and effective implementation of Fund programs (all of the sustained growth transition economies except Slovenia have had—and generally still have—Fund programs), and finally, as a result, good growth performance. Thus the variable that is missing in the econometrics may be the most important variable in practice.

1

All of these results, however plausible, need to be interpreted with caution given the measurement and methodological problems involved, not least because many of the variables used are likely to be highly correlated. The pitfalls are well described in a paper by Sala-i-Mar-tin (1997).

2

Bruno and Easterly (1998) suggest the higher range; others, such as Fischer (1993), Sarel (1996), the ESAF Review (IMF, 1997), and Cottarelli and Doyle (in this volume) find the threshold to be much lower.

3

It is an oversimplification to say that all of the first four efficiency improvements can come about without new net investment; what is meant here is that often the investment required is small. Also, such efficiency improvements can take place at the sector or the firm level, even if aggregate net investment in the economy is zero, as new gross investment is directed not to replacing depreciated stocks in “old” industries but to expanding it in the “new” ones.

4

The CMEA consisted of Bulgaria, Cuba, Czechoslovakia, the German Democratic Republic, Hungary, Mongolia, Poland, Romania, the Soviet Union, and Vietnam.

5

The official data may include breaks in series due to revisions of GDP, and there may be reason to believe that the underestimates are less serious for growth rates than for absolute levels. There is also an offsetting bias: initial GDP was overstated under the old regime by distorted pricing and the unaccounted-for cost of queuing in a shortage economy. The elimination of queues has doubtlessly raised welfare, but this is not reflected in the new official GDP figures.

6

The time lag in factor reallocation was particularly pronounced because labor markets were underdeveloped, labor mobility was severely impeded by housing shortages, and capital markets were similarly underdeveloped.

7

See IMF (1994). See also Tarr (1994), who shows that the BRO countries on average were subjected to greater terms-of-trade shocks than most of the CEE countries. Koen and de Masi (1997) also provide evidence on price distortions.

8

Wolf (1997) attempts a statistical explanation of the political will to reform.

9

The concept of transition time is developed in Berg and others (1999).

10

It is noteworthy that these geographical categories, which are based on a consideration of growth performance, to some degree reflect the initial conditions noted earlier, with Central Europe and the Baltics showing better growth performance than southeastern Europe and most of the CIS.

11

The period of time before the initial level of GDP is regained is in most cases probably exaggerated for two reasons. One is that, as already noted, official statistics probably underestimate the size of the unofficial economy during the transition. The other is the likelihood that, again as already noted, initial GDP was in most cases overstated, since it did not reflect the welfare losses due to disequilibrium pricing and associated shortages and queues.

12

In the case of Bulgaria, this can in part be attributed to a break in the GDP time series, whereas in the case of Romania the output decline had already started during the 1980s.

13

Initial output was likely overstated, however, as discussed above.

14

These papers also analyzed the factors behind countries’ success at disinflation, such as budget deficits and exchange rates. These issues are addressed more fully in IMF (1998b).

15

We report below the results of a background econometric study on the magnitudes of these trade-offs.

16

Detailed results with data through 1997 are given in Havrylyshyn, Izvorski, and van Rooden (1998). Using preliminary estimates for 1998, regressions reported in the appendix give virtually the same results.

17

The econometric analysis summarized in the appendix does not find a systematic contribution of aggregate investment to the output recovery in transition economies. This in no way denies, however, that individual investment projects are key in spurring growth in certain sectors, or that the level of aggregate investment does become more central in sustaining growth as the recovery proceeds.

18

There are several instances of countries beginning recovery with inflation still above 50 percent. These include the three reversal cases as well as Belarus and Uzbekistan, whose recent recovery is questioned by some analysts, and Armenia and Croatia.

19

One factor that might also play a role but has not generally been analyzed in the growth studies, perhaps because of the difficulty of measuring it, is the fragility of banking systems and the low degree of financial intermediation.

20

The possible circularity in the causation of reform (reform leads to growth, which leads to more reforms) is not reflected in the ordinary least-squares specification of regression equations. Thus, formally speaking, the coefficients of reform in the growth equation may be overestimated. (We owe this point to Olivier Blanchard.) However, even without a formal test of the hypothesis that growth can lead to reforms, it is evident that so far none of the cases where growth preceded reform (Belarus and Uzbekistan, and Bulgaria and Romania earlier) do we see growth followed by more reform.

21

See in particular Gaddy and Ickes (1998).

22

See Nellis, this volume, and Havrylyshyn and McGettigan (1999).

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