Transition: progress, problems and tasks ahead

Since the start of the transition, impressive advances towards a market economy have been made in the countries of Eastern Europe, the Baltics and the Commonwealth of Independent States (CIS), but some of the more difficult tasks at the heart of transition have yet to be tackled. (1)

Most countries in the region have carried out comprehensive liberalisation of prices, foreign trade and currency arrangements. Most small-scale enterprises in the region have been privatised, but progress with large-scale privatisation, enterprise restructuring, financial sector reform, and other areas of structural change varies considerably between countries. Overall, the pace of structural change is now slower than in the first half of the 1990s. This is mainly because reform efforts that were 'easier' to implement were undertaken in the early years of systemic transformation, leaving a core of difficult tasks for subsequent years.

In the past year the transition has continued to advance in most of the region. However, there have been problems in the financial sectors of a number of countries, some slippage on the inflation front, including a macroeconomic crisis in Bulgaria, and some worries about government interference in the private sector. Key developments over the past year include:

• Albania, Romania and most of the CIS have made substantial advances in the privatisation of large state-owned enterprises. The preferred method of privatisation has been a 'mass' transfer of ownership;
• the financial sector continues to lag behind other reform areas, such as price and trade liberalisation and privatisation. Bulgaria, the Czech Republic, Kyrgyzstan, Latvia , Lithuania and Russia witnessed a new spate of banking troubles during 1996;
• the countries most advanced in market-oriented transition, notably the Czech Republic, Estonia and Hungary, have begun to privatise major utilities and transport. Hungary has achieved the most comprehensive privatisation of utilities and been the most ambitious in introducing private sector finance and risk taking in road construction.

In countries at advanced stages of transition, most price-setting has been freed from administrative interference, and foreign trade is relatively open. These countries have privatised most small enterprises and have made considerable progress in privatising larger companies. Generally, markets tend to function reasonably well. Countries at advanced stages of transition are broadly market economies and their structural reforms have been substantial and swift. However, they are far from a well-functioning market economy in areas such as enterprise restructuring, strengthening of financial institutions, commercialisation of infrastructure and environmental clean-up. In many areas of economic activity, effective and transparent corporate governance and appropriate standards of business conduct have yet to be firmly established.

The construction and consolidation of financial institutions has proved particularly challenging. Even in countries at advanced stages of transition, many of the largest commercial banks remain in state hands, and many banks continue to struggle with large stocks of non-performing assets. The success of financial activities depends greatly on experience, and this is being acquired gradually. It also depends on macroeconomic stability and on the establishment among potential borrowers of a track record, of managerial ability, and of accounting skills.

Macroeconomic shocks, inexperience in lending and inadequacies in banking supervision have already led to a number of banking crises in parts of the region, including in countries at more advanced stages of transition. Economic uncertainty has led to unwillingness among the banks to lend for the long term. In addition, severe strains have been imposed on banks, enterprises and governments by the tightening in monetary and fiscal policy. This has restricted the availability of investment finance required for the establishment of a new market-based industrial structure.

All the problems faced by the countries at more advanced stages of transition are present and more acute in countries that are at the early or intermediate stages of transition.

In terms of market liberalisation, most countries at intermediate stages of transition have freed the bulk of their prices from administrative control and have opened up domestic production to competition from imports. However, over the past year, a few countries at the intermediate stages of transition have taken steps backwards in the reform process by reintroducing selective price controls or by backtracking on the convertibility of their currency.

Most countries at intermediate stages of transition have made considerable progress in small-scale and mass privatisation. Large-scale privatisation is far from complete, and banking reform is in its infancy in many countries in the CIS and South-Eastern Europe. To the extent that large-scale privatisation has taken place, it has often lacked transparency. This has sometimes created deep resentment because it appears in some countries to have involved high financial returns to management insiders and those with political influence. It has also at times resulted in weak corporate governance for newly privatised enterprises. These problems have compounded the difficulties of establishing standards of business conduct in the transition economies.

In countries at the early stages of transition progress has been very slow. In these countries, most major economic activity remains under tight central control, and the development of entrepreneurial activity has been hindered. Nevertheless, even in these countries there are some signs of small-scale private activity, indicating a potential for more comprehensive market development if the most important obstacles were to be removed.

Building a new role for the state

A central challenge in the transition is the redefinition and reconstruction of the activities of the state. In general, tax administration is weak. This corrodes civic responsibility, increases the likelihood of corruption, endangers macroeconomic stability and weakens the crucial functions of the state. There are heavy pressures on the financing of pension systems, and constructing the right kind of safety net is proving very difficult.

Moreover, in some cases the relationships between state and industry are disturbingly close, with 'favoured' deals in privatisation programmes to management insiders. There are often allocations of special privileges to individuals and companies, and laws are weakly enforced in many cases. In addition, some governments appear to be having difficulty in upholding promises on tariffs in infrastructure and on environmental aspects of investments. These challenges are faced by countries at all stages of transition. If the problems become too severe, they can begin to undermine political support for the market-oriented transition. There is an important role for international financial institutions in helping 'the state' to develop its new role.

Establishing democracy

Democracy has taken root in much of the region. Second elections may be regarded as a more impressive test of democracy than the first, and many countries have seen several elections. Incumbent parties have not always been re-elected and there have been orderly changes of government. It is likely that the speed of establishment and the robustness of democratic systems in most countries of the region will be regarded as remarkable in years to come. Although the democratic process has seen the electorate in a number of countries express concern over the disruption and stresses of transition, there have been few reversals of either political or economic reforms. However, the path leading towards a solidly constituted democracy can be both long and uneven. This path will depend crucially on the success of the reforms of the economic transition.

Overcoming the environmental legacy

Environmental degradation was pervasive under the old regime. An emphasis on production targets and a focus on heavy industry implied neglect for the environment, producing an unpleasant and dangerous legacy. The origin and scale of the problem make the environment a major transition issue. Prominent among the sources of environmental damage was a profligate attitude to power and energy - prices for these products were ludicrously low and usage wastefully high.

Overcoming the environmental legacy will require changes across the board in both production and consumption. Many of these changes can be promoted by adjusting prices for power and energy to levels that take account of real resource costs and other expenses. There will also be a need for investment to alleviate earlier damage. Investment on the scale required cannot, however, be carried out at once, and much of the investment must be part of the normal replacement cycle for capital goods and building structures.

Options for productive investment in support of environmental improvements tend to grow as countries advance in transition. The 'right' legislation must be in place and enforced and there must be effective monitoring. Only then will the marketplace provide incentives for firms to carry out investment and controls in support of environmental improvement.

Transforming the infrastructure

Efficient, reliable and user-oriented infrastructure is a basic ingredient of a well-functioning market economy. The infrastructure inherited from the command system is badly distorted by the misplaced priorities of the old regime which showed regard neither for the demands of users nor for the environment. In some sectors (telecommunications, water and waste water and, increasingly, road transportation) capacity is very weak relative to the demands that would be expected in a market economy. Other sectors (electric power and railways), however, must adjust to falling demand. While tariffs have been raised from their very low levels under central planning, especially in the countries of Central Europe and the Baltics, they do not reflect the true costs of service delivery nor the financial constraints on government. Tariff collection remains weak and political and social considerations have led to a slow pace of change.

The reform of infrastructure requires commercialisation. This involves attention to cost control, revenues (for which enforcement of tariff reforms and collection are basic) and strong demand-orientation. Commercialisation also creates opportunities for private financing of investment in infrastructure. Private investment in infrastructure is playing an important role worldwide and is expanding in some countries in Eastern Europe and the Baltics. Commercialisation of infrastructure must be supported by effective government regulation. This is a particular challenge in the transition economies, where there is no recent history of regulatory institutions. Careful consideration must be given to designing independent yet accountable institutions, which can underpin competitive provision in infrastructure services, and to provide a credible framework for setting tariffs where competition is not possible.

Savings behaviour and savings institutions in transition

During the transition, the need for investment, and therefore saving, is large and urgent. Investment and domestic savings have fallen dramatically since 1990 from the very high levels (albeit wastefully used) under central planning. This mainly reflects sharp falls in company surpluses, which were the dominant source of domestic savings under the old regime. In many countries it also reflects an increase in government budget deficits. Meanwhile household savings have increased, but not enough to offset the deterioration in the enterprise and government sectors. This trend should be reversed by reducing government budget deficits to raise public savings, and reforming social security systems and public pensions to boost private savings.

An important part of the transition is to expand the range of financial instruments and institutions through which households can accumulate savings. While they are in the early stages of development in the region, contractual savings such as life insurance and pensions are beginning to expand the range of choice in financial services. Life insurance and private pensions can also help to reinforce the transition by promoting development of local capital markets (and therefore corporate governance) and by facilitating the reform of state pension programmes.

Trends in the macroeconomy

Progress towards macroeconomic stability continues in most of the region. Growth remains strong in much of Eastern Europe, and the rate of output decline has gradually decreased in the CIS. However, overall growth for Eastern Europe and the Baltics has slowed from 1995's impressive level. Declining growth in Eastern Europe is a reflection of short-term developments, including a tightening of fiscal policies in some countries and slow growth in the main export markets in the European Union. Positive growth is emerging in some of the smaller CIS countries, but it has still not been achieved in Russia and the Ukraine.

While inflation has continued to fall in most countries, hard-won gains in macroeconomic stabilisation have slipped away in Bulgaria, Romania and Albania, which have seen significant increases in inflation.

The trade balance in a number of countries has deteriorated over the past year, mainly due to a strong expansion in domestic investment and consumption, alongside sluggish growth in export demand from the EU. A deterioration in export competitiveness appears so far to have played less of a role because increasing productivity has offset the impact of rising real exchange rates on competitiveness. However, major industrial restructuring will be required if productivity is to continue to rise.

Prospects

If reforms continue, macroeconomic control is maintained and EU export markets recover, there will be strong prospects for growth across the region. For Eastern Europe, forecasters typically expect growth of about four to five per cent per annum for the remainder of the decade. The medium-term growth prospects are likely to be determined to a great extent by the more efficient allocation of labour, raw materials and capital, as well as by the level of high-quality investment in human and physical capital. However, it will also be important for governments to control their expenditure and collect taxes, to push ahead with structural reforms, and to allow the private sector to work without interference. Those that pursue the best policies in this regard will be the best performers.

References

The European Bank for Reconstruction and Development (EBRD) was established in 1991 to foster the transition towards open market-oriented economies and to promote private and entrepreneurial initiative in the countries of Central and Eastern Europe and the former Soviet Union.

This article is drawn from the 1996 Transition Report published by the EBRD (ISBN 1 89 880204 1, ISSN 1356-3424). It costs £25 and is available worldwide by mail order from The Stationery Office (Tel: + 44 171 873 9090; Fax: +44 171 873 8200) and through booksellers. Details of local stockists can be obtained from The Stationery Office (Fax: +44 171 873 8203). See also the EBRD's Web site: http://www.ebrd.com