The scale and speed of economic change in Central and Eastern Europe and the former Soviet Union have been remarkable: markets now operate through much of the region, and most national income is generated by the private sector. The new democratic systems have shown remarkable resilience in the face of economic and other crises. However, in much of the region the functioning of markets and the institutions necessary to support them are deeply flawed, for reasons having to do not only with the legacy of the old systems, but also with events during the transition process itself and choices made early in that process. The commitment of governments to reform is being tested by the severe social costs of adjustment as well as by the resistance of vested interests, both old and new.

The scale and speed of economic change in Central and Eastern Europe and the former Soviet Union have been remarkable: markets now operate through much of the region, and most national income is generated by the private sector. The new democratic systems have shown remarkable resilience in the face of economic and other crises. However, in much of the region the functioning of markets and the institutions necessary to support them are deeply flawed, for reasons having to do not only with the legacy of the old systems, but also with events during the transition process itself and choices made early in that process. The commitment of governments to reform is being tested by the severe social costs of adjustment as well as by the resistance of vested interests, both old and new.

Indeed, the challenges go deeper than the resolve of governments, for many of the problems facing the region and its transition lie in the functioning of the state itself. The fundamental questions are not only that special favorite of economists, what the state should do, but also, and in many ways more troubling, how the state can be changed. This chapter briefly reviews the last decade from the perspective of these basic questions and then turns to some of the specific challenges of the coming years.

The Experience of the First 10 Years

The European Bank for Reconstruction and Development (EBRD) assesses the progress of transition each year in its annual Transition Report. Viewed as a whole, the region has made very rapid progress, but that progress has varied strikingly across the different dimensions of transition and from country to country. Over the 1990s the majority of transition economies advanced strongly in price and trade liberalization, as well as in small- and large-scale privatization. The private sector share of GDP exceeds 50 percent in 19 of the 26 countries in which the EBRD operates. On the other hand, progress has been much slower on the more difficult institutional reforms, such as the creation of sound financial systems and securities markets, enterprise restructuring, corporate governance, and effective and market-oriented legal systems.

Transition has also advanced much more slowly in the countries of the Commonwealth of Independent States (CIS) than in the western part of the region, although there is sharp variation both within the CIS and within Central and Eastern Europe. These differences are due in part to initial conditions—economic structures, history, geography, endowments, culture, and levels of indebtedness—which varied dramatically across countries. However, they are also due to the fact that different countries have followed different reform paths. It is therefore crucial to distinguish carefully among countries; generalizations can be misleading.

The first decade of transition has shown that economic reforms can show their returns fairly quickly. In the more advanced reformers in Central Europe and the Baltics, output growth resumed much earlier than elsewhere, and macroeconomic stability has largely been maintained in the face of recent turmoil in emerging markets generally. In these countries, deep restructuring in the enterprise sector has begun, often driven by strategic foreign investors. As competitiveness has grown, trade has been reoriented toward western markets. Reflecting these achievements, five transition countries have been invited to start accession negotiations with the European Union. Renewed commitment to reform is also beginning to bear fruit in countries such as Bulgaria, where reforms had previously been more hesitant.

The slower and less committed reforms in the CIS have been accompanied by much more volatile economic performance. For geographical reasons, but also reflecting the structural legacies of Soviet industrialization, the countries of the CIS remain more dependent on trade with each other. Several have also been disrupted by internal and external military conflict and face the task of reconstruction as well as structural adjustment. The social strains of the transition have also been much more severe in those countries that pursued reforms less aggressively. These are perhaps reflected most strikingly in age-specific mortality rates and life expectancy, which, for example, fell by six years for males in Russia in the early 1990s. It is now lower than that for males in India.

The lessons of recent years, however, go beyond the returns to strong and committed reforms. It is surely now clear, as it should have been from the outset, that the transition is a long haul, not a quick fix. Decisions made early in the process can have profound and long-lasting effects, since vested interests can be established very quickly but dislodged only with difficulty. It has also become clear that the political transition and the economic transition are intricately intertwined and that political support for reform is vital for their success.

The Russian crisis of 1998 embodies all these lessons. Before the crisis, Russia had developed into an economy of striking contrasts. Banks traded sophisticated financial derivatives but were virtually unable to attract ordinary household deposits. Trading on the stock market reached volumes of over $100 million per day, but shareholders were often unable to exercise their most basic rights. Vast financial-industrial groups were created to promote synergies between banks and large-scale enterprises, while an ever-increasing number of firms resorted to barter to stay afloat. The self-styled oligarchs in command of these groups amassed substantial fortunes, but left their workers and the state with a mushrooming backlog of wage and tax arrears. The crisis shows the dangers of early liberalization of short-term capital flows at a time when fiscal discipline is weak and the financial sector is not regulated effectively. The large inflows of foreign capital partly reflected a misjudgment by investors in search of quick profits, who did not think sufficiently carefully about the depth of the underlying structural problems. At the same time, this misjudgment softened the budget constraint of the state and weakened an already fragile resolve to face fiscal challenges and begin tackling the structural imbalances.

However, perhaps the most important lesson from the Russian crisis and the first decade of transition has been that free trade and private ownership will not by themselves bring well-functioning markets, and that market-supporting institutions are fundamental. Russia had developed markets and private ownership no less rapidly than many of the more advanced transition economies had. But the incentives for private actors were distorted through inadequate regulation, corruption, and weakness in the rule of law. Ultimately, it became more attractive to lobby the government for favors and to manipulate the system than to undertake serious restructuring. The roots of the crisis in Russia are discussed in detail in the EBRD’s 1998 Transition Report. Its lessons apply in varying degrees across all the other transition countries and may be summarized in a single sentence: Markets, if they are to function well, need a state with the strength to regulate responsibly, tax effectively, and provide its people with basic services, including the rule of law. This much should have been obvious to us all. What is much less obvious is how such a state can be constructed when the basic foundations have been corroded.

Challenges for the Next Decade

This brief review of the first decade of transition has highlighted the importance of strong, market-supporting institutions. The depth and difficulty of building the institutional basis of a market economy were perhaps misjudged by many at the outset of transition, and this led to overoptimistic assessments of the stresses that would accompany the process and of the time it would take. Although there are many possible approaches, and each country must find its own way, the broad characteristics that sound market institutions should embody are relatively uncontroversial. Again, the deeper challenge is to find ways to build them.

The task of building these institutions is of such magnitude and complexity that it will inevitably take time. Although some rules, procedures, and organizations can and should be set in place rather quickly, the capacity of institutions to build practices and shape behavior can be developed only over the long term. Moreover, institutional change in transition requires the state to change itself and to take on new roles, as a regulator, as an impartial arbiter, and sometimes as an active partner facilitating economic restructuring. A second major reason why the transition will be long and difficult is the scale of the industrial legacy—physical, organizational, environmental, and behavioral—left by the old regime. The problems of adjustment are such, and on such a scale, that they cannot be shaped only by the Darwinian forces of competition, hard budget constraints, and bankruptcy law.

Reform of the enterprise sector will be at the heart of the next phase of transition. It will involve both the entry and growth of new private firms and the restructuring of privatized and state-owned companies. Public and private institutions need significant reform to provide a sound investment climate and improved corporate governance, to facilitate investment and entry, and to establish an effective mechanism for the exit of unprofitable firms. The Russian crisis, analyzed in the EBRD’s 1998 Transition Report, tells a cautionary tale on how shortcomings in enterprise reform can result in dramatic economic instability. Russia’s financial crisis was rooted in a fiscal crisis, which in turn was rooted in a structural crisis of the enterprise sector.

Evidence from across the region indicates that reform of the enterprise sector has been patchy and inconsistent. A few countries have been successful in stimulating growth of new private enterprises. In Poland, for instance, new private firms have driven most of the country’s substantial economic growth over the last decade. In Hungary, the substantial inflow of foreign direct investment has contributed to a vibrant and dynamic economy that has attracted high-technology and research and development activities for both new and existing enterprises. However, most other countries have seen far less entry of new firms, and the “old” enterprise sector has often been slow to adapt to the new market realities.

The most obvious sign of the slow pace of restructuring is the persistence of unprofitable enterprises. From the Czech Republic to Russia, a significant number of firms, especially large ones, are losing money and falling in arrears to their suppliers, banks, and the tax authorities. Their survival is often sanctioned by weak payments discipline and weak creditor rights, combined with ineffective bankruptcy procedures. In Russia and other CIS countries, weak payments discipline has been reinforced by barter, IOUs, arrears, and myriad other arrangements, which reduce the transparency and credibility of enterprises. The state itself, particularly in Russia and Ukraine, has played a significant role here. Publicly owned utilities are prominent in the whole barter and arrears network, effectively undermining the tight credit policies associated with the tough monetary policies that had such an effect in bringing down inflation between 1994 and 1998. These problems have not only eroded the efficiency of the enterprise sector still further, but have also weakened the banking sector and tax collection.

It would be wrong, however, to blame the persistence of these soft budget constraints on a few poor decisions or bad legislation. The real question is why the relevant laws—often styled after Western models—are not applied effectively in practice. Weak institutional capacity of the courts, or, more broadly speaking, low credibility of public institutions, is certainly part of the story. Yet to understand the root causes behind the persistence of unprofitable firms, one needs to examine the role of the state in the transition process.

The state has often been unwilling to accept the significant employment implications associated with the exit or transformation of large firms. In Russia, in particular, the sheer scale of the necessary closure of firms, with their domination of local employment and social services (especially housing), has made the immediate imposition of hard budget constraints politically infeasible. Furthermore, vested interests and the often incestuous relationships between enterprises and the state, involving oligarchs old and new, have often inhibited taking a tough stand toward money-losing enterprises. The insider relationships and vested interests formed near the beginning of the transition are now very difficult to break up.

The economic and social dislocations associated with the sweeping economic changes of a successful transition process require both a vibrant new private sector, to reemploy displaced workers, and an effective social safety net. In the CIS, neither exists today. New economic opportunities are limited by high barriers to entry and growth, such as bureaucratic interference, corruption, and crime, or by lack of access to bank credit. Fiscal constraints and the weak institutional capacity of the state reduce the scope for managing exit through targeted subsidies or social packages.

Given these economic, political, and institutional constraints, restructuring is a formidable challenge for most transition countries. In this context, the international financial institutions (IFIs) can play an important role in fostering change. Since its establishment in 1991, the EBRD has promoted the transition through projects that are financially sound and aimed at enhancing the market orientation of companies and institutions. The EBRD’s management and board have reviewed the experience of the early years of the transition and the EBRD’s strategic orientation set in 1994. As a result of this exercise, the EBRD is reemphasizing its commitment to three important pillars of transition that are at the heart of the enterprise reform process. They are to promote a sound investment climate, to facilitate the growth of a vigorous small and medium-size enterprise sector, and to support the difficult process of enterprise restructuring.

These three pillars of enterprise reform require close coordination and collaboration among governments, the IFIs, foreign investors, and domestic institutions. Important as it is to accentuate the differences among countries, enterprise reform remains a key challenge in most. As already discussed, the problem is not so much agreeing on what types of institutions would be desirable, but agreeing on how these institutions can be built, given the huge obstacles. As already mentioned, it will be essential in all these areas to develop a state with the strength to regulate responsibly, tax effectively, and provide its people with basic services. In what follows, I lay out some key elements of a strategy for change that would support enterprise reform in particular and the functioning of markets and the state in general.

First, creating new opportunities for workers depends crucially on the growth of the new private sector. For this to happen, new entrepreneurs must be able to develop without hindrance from corruption and crime and with the support of sound bank lending practices. Although there is no simple way to eradicate corruption, the effort must be made, and it must entail a reduction of bureaucratic discretion by simplifying laws and regulations. The state thus has a fundamental role to play. The IFIs can help foster new private sector initiatives by channelling finance to enterprises either directly or through local intermediaries, and by providing technical assistance in building the institutions that can foster a more positive investment climate. Small and medium-size enterprises will be the largest source of alternative employment and will lay the foundation for the development of entrepreneurship and future growth. They also provide a sense of participation, a basis for political stability, and a commitment among the population to the market economy. Providing the proper environment and adequate finance for the growth of these enterprises must be a top priority for the next phase of transition.

Second, the downsizing and restructuring of large enterprises will generally require a reallocation and realignment of ownership and control. Foreign strategic investors are often ideal partners in that they both provide crucial skills and seek out profitable opportunities. Given the macroeconomic and political risks in the region, international institutions like the EBRD can play an important role in providing comfort and cofinancing to potential investors, domestic or foreign. They can at the same time provide some reassurance to governments and to companies in the region about the behavior of investors. Generating a spirit of mutual partnership and trust is crucial, and an IFI, if it conducts itself well and shows long-term commitment, can be a fundamental part of the process.

Third, the ability of enterprises to raise working capital and investment finance depends both on an effectively regulated and supervised financial sector and on the business practices of enterprises themselves. Financial sectors across the region will have to be strengthened in order to promote public confidence in financial institutions, an orientation toward the real sector, and an efficient allocation of credit. However, only firms with sound corporate governance standards can attract debt and equity finance. Those enterprises have to respect creditor and shareholder rights, pay their taxes, and adhere to high standards of transparency. IFIs must therefore work to support the development of sound business practices in the local banking sector as well as in the enterprise sector. In this, the state, markets, and IFIs can work together to promote and support the incentives and corporate governance that will encourage enterprises to make the tough decisions necessary for restructuring.

Fourth, new owners in charge of restructuring old companies or parts of such companies cannot and should not take over all labor and social obligations. Governments and IFIs must work together on a coherent strategy to find ways of cushioning the social impact of transition. The fiscal consequences will be challenging, but surely less costly than attempting, as at present, to avoid restructuring through countless implicit subsidies that allow nonviable enterprises to avoid radical change or exit.

Fifth, it is essential to promote a market orientation, payments discipline, and effective bankruptcy procedures. This requires a fundamental reorientation of the role of the state. The state must redefine itself as an effective regulator and provider of market-supporting institutions. Indeed, as I have emphasized, one of the key lessons from the whole transition process so far is that a market economy requires a sound and effective state. Of special importance in the transition economies is the phasing out of implicit support of unrestructured enterprises through tolerance of nonpayment and through barriers to entry for potential competitors. The primary responsibility for rebuilding the state and shaping the transition lies with the country itself. However, a key challenge for IFIs is to find ways to support this process more deeply and to avoid the ritual proposing of simplistic or formulaic prescriptions.

Sixth and finally, none of these initiatives can succeed without macroeconomic stability internally and the growth of market opportunities externally. Transition economies have been grappling with the ripple effects from crises in other emerging markets. More likely than not, contagion will continue to affect the transition economies and pose recurring threats to their hard-won gains from economic stabilization. Experience has shown that those countries that are able to make deep and lasting progress in the difficult institutional reforms outlined above have a better chance of weathering the effects of turmoil in global markets.

But it is not enough for the international community to draw attention to the benefits of reform. It must also work to provide an international environment that is stable, growing, and open. The transition economies have been encouraged to open their own markets, and many—indeed, most—have done so. It is now the responsibility of the more advanced market economies to open their markets still further and take careful account of the implications of their own economic policies for the growth and stability of the region. They also must realize that the restructuring of “old” industries in the transition economies may have implications for sensitive sectors in the European Union and other advanced market economies.

Progress in fundamental enterprise reform and restructuring will require close attention to all six of these issues. This is not to say that unless one does everything, nothing will happen. But the process will move more quickly, more effectively, and less painfully if there is movement on all fronts simultaneously. Governments in the transition countries themselves must take the lead and provide the overall framework. However, the work of the IFIs can assist them in this task. Different IFIs have comparative advantages in different areas. Cooperation among and long-term commitment from central and local governments and the different IFIs will be vital.

In conclusion, the first decade of transition has been one of both real achievement and profound strain. Political freedoms and economic choices have expanded enormously. Market economies exist, and growth has returned in much of the region. A successful transition is of fundamental importance not only to the prosperity and stability of the region itself, but also to the rest of Europe and the world. But we have all come to understand that the transition will be neither brief nor straightforward, particularly in the CIS. The international community, particularly the IFIs, must therefore show a spirit of constructive partnership and of long-term commitment in the difficult years ahead.

Although this paper draws on the EBRD’s 1998 Transition Report and on a recent review of the EBRD’s strategic orientation by its management and board, the responsibility for the views expressed is the author’s own. The author is very grateful for the help and guidance of Vanessa Glasmacher, Christian Mumssen, and Martin Raiser.