Eastern Europe enters a new phase in building a market economy

Steven Fries
Senior Economist, EBRD

Since the fall of the Berlin Wall and the break-up of the former Soviet Union, the countries of Eastern Europe, the Baltics and the Commonwealth of Independent States (CIS) have taken impressive strides towards a market economy and are entering a new phase in the transition process. This is the conclusion of the 1997 Transition Report, recently published by the European Bank for Reconstruction and Development (EBRD).

In years to come the pace of change will be seen to have been remarkably rapid in much of the region. Early this century, it took nearly two decades of political oppression to establish dominant state control over production in Russia. In contrast, 19 countries have already achieved at least a 50 per cent private sector share in production, taking eight years at the most. Democratic institutions and processes also continue to work well throughout most of the region. However, the legacies of the command economy cannot be fully overcome in a few years and major tasks remain in terms of continuing the reform.

For the region as a whole, the process of transition is entering a new phase. The initial period saw strong progress in liberalising markets, in bringing stability to prices and output, and in privatising state enterprises. In this new phase the key challenges will be to build and strengthen the institutions, policies and practice behaviour which underpin a well-functioning market economy, as well as the investment and innovation that drives support growth. Progress in this new phase will serve to strengthen the performance of businesses and financial institutions in the region, while the first phase largely involved the creation of markets and the stabilisation of prices and output. While some countries still have some way to go in the first phase, others are already making progress in the second.

The creation of markets has been a relatively simple task, in the sense that as it required governments to reduce their activities by abandoning their control of prices, production, trade, and access to foreign exchange. Once unshackled from Government controls, producers began the process of establishing new market-based relationships with their suppliers and consumers. However, this process has been very disruptive to production. While the task has of liberalising markets has been largely completed in most transition economies, Belarus, Tajikstan and Turkmenistan have yet to take many of these basic steps, while Uzbekistan has recently backtracked on earlier reforms by re-imposing controls on access to foreign exchange.

There has also been widespread progress in bringing stability to prices and output. To date, nine countries in the region have brought annual inflation below ten per cent, and a further ten have achieved inflation rates between ten and 20 per cent. However, financial crises have unleashed a surge of inflation in Albania and Bulgaria this year, while lax financial policies have undermined hard won gains in reducing inflation in Armenia, Belarus, Romania, Tajikistan and Uzbekistan.

For the first time since the start of the transition process, output for the region as a whole is likely to increase in 1997. This is largely due to improving performance in Russia and the Ukraine. Nine countries in the region are now growing at rates of five per cent or more. However, the short-term outlook is clouded by the deterioration in the balance of payments of many countries over the past two years. Two-thirds of all transition economies recorded current account deficits in excess of five per cent of Gross Domestic Product (GDP) in 1996, with some further weakening in the first half of 1997.

Encouraging strong, commercially oriented businesses has been a more complex and time-consuming task than creating markets and stabilising the economy. This is true for new private firms as well as for both state enterprises and privatised firms, as they are encouraged to adopt a more commercial approach. Responding to the opportunities created by market liberalisation requires of the old enterprises the ability and the incentive to adapt to the new economic environment. The sharp reduction of Government support for enterprises, privatisation and the development of effective corporate governance are crucial, especially if market forces are to operate and if enterprises are to respond effectively. For profit opportunities to develop, entrepreneurs and new businesses must be able enter new markets, unimpeded by discretionary and arbitrary bureaucratic barriers, as well as by any attempts of existing enterprises to dominate markets. In addition, Government must provide much of the 'institutional infrastructure' of a market economy, which shapes the practices, rules and organisations that guide and govern economic activities (such as the judicial protection of property rights and enforcement of contracts).

While there has been considerable progress in fostering commercially oriented enterprises in the region, major challenges remain. Direct budgetary support for enterprises has been sharply reduced in most countries, but in some of them new forms of 'off-budget' support have emerged, such as Government toleration of tax and energy payment arrears. Privatisation is well-advanced in much of the region, but the ability of the new private owners to establish effective control over enterprise managers is often limited. In some countries, such as Poland, the response of entrepreneurs and new private businesses to market opportunities has been a driving force in the sharp improvement of enterprise performance and economic growth. However, in much of the Commonwealth Institute of States (CIS), arbitrary bureaucratic interference, corruption and unpredictable taxation delay development of the new private sector.

The building of market oriented and stable financial systems and commercially oriented infrastructure has been the most challenging aspect of transition. Financial institutions were essentially non-existent under the old regime. They require time, skills, capital and reputations for prudence to perform well. The infrastructure inherited from the previous regime was oriented towards a distorted and ideologically influenced production system, away from final consumers and cost control. In encouraging the development and adaptation of these sectors, Government must perform important regulatory roles to protect its finances and the interests of consumers. These regulations and their application form an important part of the institutional infrastructure.

The past year has seen significant progress in these difficult areas of transition, particularly in those countries already at more advanced stages of transition. The Czech Republic, Hungary and Poland have pressed ahead with the privatisation of major state banks, while Estonia, Hungary, Kazakhstan, Latvia and Poland have passed key legislation to reform their existing 'pay as you go' public pensions, and to introduce privately managed, fully funded schemes. In relation to infrastructure, Poland passed a new energy law which provides for the establishment of an energy agency to set retail electricity tariffs, the privatisation of electric power generation and the creation of a wholesale market for electricity. Russia has overhauled its regulatory structure for public utilities and energy and privatised a major telecommunications holding company.

With the return to growth in the region as a whole, and the continued progress in market reforms in 1997 - even in the more challenging areas - there are two basic questions for the new phase of transition. What are the prospects for sustained growth and what further steps are required to deliver this?

Several factors can affect growth in a market economy, be it mature or in transition. Rising output requires either more inputs, such as plant and equipment and a skilled workforce, employees or better use of existing resources in production. The transition economies are in a unique position, having emerged from a long period in which central planning placed a strong priority on investment and education. Although much of this past investment was misdirected or wasted, there is considerable potential for making better use of these resources, particularly the talents of its people. This change in economic structures and in enterprise operations requires development of the market forces that were under central planning:

  • competition;
  • rivalry among producers in product markets and a strong customer focus to ensure that what is produced is valued;
  • and efficient production.
These market forces will also encourage the type of investments and their innovation that contribute to growth.

The first phase of reforms has already set these market forces in motion. The results are encouraging. There has been a significant shift away from industrial production (over-emphasised by central planning) toward services which were neglected. There is also a shift toward agriculture in some low income transition economies. Therefore, in general, the composition of production is beginning to resemble that of a comparable market economy. At the individual business level, competition, particularly from imports, privatisation and the new private businesses, are all contributing to productivity gains. Initiatives for rapid change, such as in the composition of output, re-structuring, new investment and innovation, are coming both from market forces and the developing private sector.

How fast can transition economies grow over the medium and long-term? While forecasting precise growth rates is not really feasible, there are reasons for both optimism and pessimism.

On the down side, the poor quality of the institutions, policies and practices behaviour needed to underpin a market economy in transition economies is discouraging. Governments need to take a number of important steps to improve the business climate. These include:

  • cracking down on off-budget giveaways to privileged enterprises;
  • overhauling business regulation so that it is driven by good government rather than by opportunities for corruption;
  • developing effective judicial procedures to protect property rights and to enforce contracts;
  • strengthening competition policy to check abuses of market dominance;
  • and reforming taxation so that it is predictable and transparent and that it does not punish the honest taxpayer with punitive levies while others receive special treatment.
Moreover, the new private owners of businesses in the region, particularly of privatised state enterprises, must develop effective means of controlling business operations and instilling a strong focus on profitability.

On the up side, there is the potential for both large productivity gains from structural change and re-structuring, and for significant contributions to growth from the highly skilled workforces in the region. The experiences of Western Europe and Japan, following the Second World War, illustrates the major contribution that the more efficient use of existing resources and technologies can make to growth. In addition, the skilled population of transition countries can play a valuable role in adapting technologies from advanced market economies. It is the combination of high levels of skill and wide technological deficits in transition economies that creates a strong growth potential.

With resolute progress in transition, it could be that looking back in 20 years time, some of the world's 'tiger' economies will have to be found in the region. This is the challenge facing the countries of Central and Eastern Europe, the Baltics and the CIS, as they enter the new phase in their transition to market economies.

For more information:
European Bank for Reconstruction and Development
One Exchange Square
London EC2A 2EH
United Kingdom
Tel: +44 171 338 7553
Fax: +44 171 338 6102
Web site: http://www.ebrd.com

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