Central Europe and the Former Soviet Union: a survey.

Five years after the collapse of state socialism in Central and Eastern Europe and the consequent dissolution of the Soviet Union, democracy and free enterprise are spreading sporadically throughout the region. More than a third of economic output is now produced by the private sector, shortages have virtually disappeared, and fortunes are being accumulated by a new class of entrepreneurs. The casual outside observer may be forgiven for assuming that it will be only a matter of time before these initially disadvantaged countries achieve sustained rates of economic growth and acquire the political and economic characteristics of the richer European nations.

A closer look reveals disquieting phenomena. Among the population at large in the transition countries, enthusiasm for change has greatly diminished. Most are convinced that the economic situation in their countries is deteriorating. People are angry about rising unemployment, falling living standards, growing poverty and inequality, the erosion of social services, and soaring crime rates. Ominously, once disgraced communist leaders have been recalled to power. The transition process is more complicated than initially presumed. Two distinct processes of transition are under way: one from dictatorship to democracy, another from socialism to capitalism. They do not necessarily proceed in tandem. History has shown that it is possible to have capitalism without democracy; whether one can have democracy without capitalism has yet to be demonstrated (Berger, 1994).

No one expected the social costs of transition to be so high. The massive decline of measured GDP in the transition economies was greater than the output and income loss of the United States and Germany during the Great Depression. The proportion of the poor has increased from about 3 percent to 18 percent, or 50 million people. About 60 percent of them live in Russia, with another 20 percent in the other Slavic states of the FSU, not counting the Transcaucasian countries at war or under blockade where the poverty incidence is probably even higher. Poverty rates are unevenly distributed: almost 30 percent in the Baltic countries, around 17 percent in Poland, and much lower (around 1 percent) in the Czech Republic, Hungary, Slovakia, and Slovenia. Income distribution throughout the region has become increasingly unequal as private entrepreneurs and professionals have gained relative to the rest of the population. The increase in inequality, coupled with the decline in overall income and the reduction of social services, explain the large increase in poverty and go far toward explaining the increasing cynicism and displeasure that pervades the region (Milanovic, 1994).

It is interesting to note that the sharp increases in poverty in the United States and Germany during the Great Depression were met with active government policies to counter the problem. In the transition economies, however, the policy prescription - enforced by the International Monetary Fund and the World Bank - has been free-market shock therapy. In spite of sound economic arguments for this approach, its side effects are harsh. In practice, shock therapy has produced significant inflation, has promoted stagnation, and has had the effect of deindustrializing large segments of the economy. As high rates of inflation have eroded the social safety net, social costs have been reflected in unemployment, poverty, and inequality (Amsden, Kochanowicz, and Taylor, 1994). High interest rates as well as high rates of taxation on profits and wages, made necessary by IMF conditionality requirements, have directed entrepreneurship away from long-term productive investment and into arbitrage and speculation.

It is not only the IMF and World Bank that are responsible for shock therapy. Reacting to the recent history of central planning and tight state controls, the political leaders of the transition economies turned to textbook laissez-faire policies long abandoned in western economies. Much of the impetus to these policies stemmed from the newly elected leaders' conviction that rapid, radical economic reform was necessary in order to make the transition process irreversible. In the euphoria of the period, anyone who suggested even minimalist long-range government planning was subject to being labeled a crypto- Stalinist. It was genuinely felt that the rapid introduction of economic and institutional changes would act as policy constraints on future governments, whatever their ideology and value systems. These assumptions were logical but failed to take into consideration the difficulty of modifying institutions built up over decades of central planning to make them appropriate for a market economy. They were, however, sufficient to forestall the adoption of more gradualist policies in most countries.

Free-market policies have been relied upon to integrate the transition economies into the global economy, in sharp contrast to the planning requirements imposed by the Marshall Plan after World War II. In spite of the fact that the West has been relieved of the defense expenditures associated with the Cold War, only a pittance has been redirected to speed the transition process of its former antagonists. Exacerbating the difficulties, import barriers have been erected by the West to protect their relatively rich economies from low-wage competition, thus depriving the transition economies of full utilization of their comparative advantages. An objective observer would have to conclude the future is still uncertain for many of these countries, and that the chances of "stalling out" are at least as likely as "takeoff."

While all transition economies face common problems, considerable differences exist in their initial starting points and in the policies they have adopted. These differences inevitably affect their performance and how they are perceived by outside observers as suitable targets for investment and trade. Space permits only a brief look at individual countries, and some are treated as groups. Emphasis is placed on those countries that are the fartherest along in the transition process. Implications for the major industrial countries are discussed in the conclusion.

THE CZECH REPUBLIC

The Czech Republic has had the most successful transition experience of the formerly centrally planned economies. Inflation has been reduced sharply and continues to fall in 1995. The budget surplus last year, the second in a row, totaled $390 million. A substantial cushion of reserves has been built up, international debt is low, and the Republic's credit rating in the international capital market, higher than that of any other transition economy, has been progressively upgraded. With the completion of the second wave of privatization, about 80 percent of the economy's assets are in private hands. Spectacular strides have been made in reorienting exports to western markets, where gains have more than offset the steep decline in exports to Slovakia and the former Council for Mutual Economic Assistance (CMEA) customs union countries. Initially, the surge in Czech exports was confined mainly to intermediate manufactured products, but from 1993 machinery and transport equipment and miscellaneous manufactured articles have led the growth in exports. The global competitiveness of the Czech economy is evidenced by the improvement of the terms of trade (Banerjee, 1995).

These achievements are noteworthy because the former Czech and Slovak Federal Republic was much less prepared for reform than its neighboring planned economies in Central and Eastern Europe. The state dominated production, few market mechanisms existed, and trade was heavily oriented toward the former CMEA members. While the Czech Republic did not escape the initial declines in economic activity common to transition economies, they were more limited in scope and duration. In 1994 GDP increased 2.5 percent and this growth is continuing, in 1995. The decline in employment was far less pronounced than that in economic activity and unemployment has remained quite low since 1993, fluctuating between 2.5 and 3.5 percent. This is largely explained by the retirement of older workers and the movement of others to the significantly underrecorded services sector. especially in tourism-related activities. Due to its low initial level of public debt, the Czech Republic, unlike other transition economies, has not had to face the pressure of debt service payments. The Czech transformation process is now focused on the consolidation of the gains of stabilization and the restructuring of large enterprises.

HUNGARY

Hungary, unlike other previously centrally planned countries in Central and Eastern Europe, has consistently taken the "gradualist" path toward economic and institutional reforms. As early as 1968, Hungary became the first centrally planned economy to introduce market-oriented reforms. While economic efficiency gains were limited because of inconsistencies with as-yet unreformed features of the economy, Hungary was able to develop a dynamically growing private sector and to attract almost half of the foreign direct investment ($6 billion) that has gone into the region. Hungary was also the first transition country to institute a system of taxation consistent with a market economy. Prices have been liberalized in stages since 1968; by 1989, 83 percent of consumer prices were freely determined, and now government-determined prices remain only for electric energy, public transport, and pharmaceuticals (Krueger and Lutz, 1994).

Although there were some favorable aspects to the gradualist approach (significant enterprise autonomy, relatively few shortages, less domestic price distortion), soft budget constraints have led to continuing macroeconomic imbalances. Failure to adjust to the first oil price shock led to a buildup of international debt that has left Hungary the most heavily indebted nation (on a per capita basis) in Central Europe. The cumulative fall in official GDP during the first years of adjustment - by about 25 percent over 1990-93 - followed a decade of slow growth (about 1.5 percent annually). Real wages, due to institutional features of the labor market, remained relatively stable in spite of the sharp contraction in output and employment. But social expenditures persist at an unsustainable level. Social insurance contributions are equivalent to 60.8 percent of wage bills, the pension system is actuarially unsound, and family allowances (which are not means-tested) remain among the most generous in Europe. The socialist government is now acting, in spite of heavy resistance, to redress this imbalance. Hungary's heavy international debt burden continues to hamper its modest recovery, but the recent devaluation of the forint should spur exports and contribute to economic growth.

POLAND

Poland saw its transition begin from an acutely deteriorated economic situation. In 1989 inflation had reached 55 percent monthly, the fiscal deficit was equivalent to 7 percent of GDP, and the international debt burden was extremely high. The initial reform program introduced a temporary fixed exchange rate and a tax-based incomes policy to restrain wage behavior. Many prices were liberalized, as were international transactions. International negotiations with the London Club led to a significant reduction in the debt burden. Gross output fell dramatically during 1990 and 1991 in response to this classic application of shock therapy, but stabilized in 1992 and real GDP rose 3.8 percent in 1993. During 1992-93, unit labor costs in manufacturing fell 21.9 percent as productivity increased by about the same percentage.

Poland's pragmatic approach to privatization has been broadly successful, with more progress in trade and construction than in industry. Over 50 percent of output is now generated outside the public sector, and the financial performance of many state enterprises has greatly improved. Inflation has been reduced, the range and quality of goods available have dramatically improved, and the shortages and queues of the 1980s have disappeared. A new zloty was introduced in January of 1995, reducing the nominal value of the old zloty by 10,000. The economic is outward- oriented, and economic activity has been increasing for more than two years (Chopra and Ebrill, 1994).

SLOVAKIA

Slovakia has been labelled by The Wall Street Journal as "the rising star in Eastern Europe." This "other half" of the former Czechoslovakia suffers from an aging capital plant, lagging technology, and shortages of energy and other raw materials. Nevertheless, it is establishing itself as one of the fastest growing economies in the region. After several years of decline (22 percent between 1991 and 1993), it is now growing strongly (admittedly from a very low base) within an environment of low inflation and financial stability. Its exports to the West are thriving, its currency is relatively stable, its hard currency reserves are growing, and its budget deficit is a respectable 4 percent of GDP. As yet, Slovakia has failed to attract as much foreign investment as its neighbors, although Slovak wages (averaging $182 per month) are relatively low. Unemployment and persistent difficulties with its Hungarian minority remain as serious problems (Milbank, 1994).

SLOVENIA

Slovenia, by far the most prosperous of the former Yugoslav republics, appears to be in a good position to follow the pattern of the Polish recovery. Its workforce is well educated, its infrastructure is relatively developed, and attitudes of the population toward business are quite westernized. Privatization is proceeding at a slow rate, but this does not seem to have hampered the inflow of foreign investment into joint ventures; at over $1 billion, this compares favorably to other East European countries on a per capita basis (Transition, Jul-Aug, 1994). Severe short-term dislocations in production, employment, and trade ties are being overcome, and the prospects for further economic recovery are relatively bright.

THE FORMER SOVIET UNION

All fifteen states established in the FSU's economic space have experienced substantial declines in trade and economic growth since regaining independence (Michalopoulos and Tarr, 1994). That their economic indicators are moving together is not surprising, because the centralized planning system of the Soviet Union left them heavily interdependent. In 1993, total intraregional trade fell to a third of its 1990 level, somewhat less than the 46 percent decline in their total trade with the rest of the world. GDP dropped by between 30 and 50 percent over the same period. These discouraging statistics stem from the slower-than-expected emergence of market-based mechanisms, as well as poor institutional infrastructures dominated by state trading organizations and supplemented by ineffective trade policies.

Russia

Progress toward macroeconomic stabilization in Russia has been characterized more by ups and downs than by continuous improvement. This is not surprising, granted the conditions under which the country commenced its transition: the dissolution of the USSR, the collapse of the CMEA, recession in Western Europe, obsolete capital stocks, the lack of a market-oriented infrastructure, and only marginal integration into the world economy. On the positive side, the country possesses a highly educated work force accustomed to working for low real wages.

Rather than shock therapy, Russia's transition has been an experiment in economic gradualism amid massive political alignment (Koen and Marrese, 1995). The output collapse had already begun by 1990. A major recession began in 1991, followed by double-digit drops in real GDP for the next three years. Russia's industrial output halved between 1989 and 1994 (Cowley, 1995). GDP in the first quarter of 1995 is expected to be 6 to 8 percent lower than the same period in 1994, with rates of decline in the processing industries greater than in mining and raw materials industries. The overall volume of industrial production fell 21 percent between 1993 and 1994. Between 1991 and 1994, wages grew only half as fast as prices. Average life expectancy has dropped from 65.1 years in 1993 to 64 years in 1994. About 23 percent of the population had money income below the minimum subsistence level. Since 1990, annual agricultural output has fallen by 45 to 50 percent, compared with the 1986-90 average. The number of livestock is declining rapidly (cattle by 24 percent, pigs by 36 percent, and sheep and goats by 40 percent), while fertilizer usage is 8.5 times less than in 1990 and 20 times less than in EU countries. Farmers are short of equipment and fuel, while food shortages in grain, meat, butter, and vegetable oil exist.

The magnitude of the decline has exceeded the depth of any depression in Russia during the past seventy years, and rivals the approximately one-third contraction of the U.S. economy in 1929-33. In spite of the unrelenting gloom of output statistics, widespread social upheaval has been avoided. Official figures are unreliable: they do not take the unrecorded (black) economy into consideration, nor do they reflect the changed incentives of reporting managers. Under the Communist system, they overreported production to meet plan targets; now they underreport to avoid paying taxes.

Although enterprises have been generally slow in adapting to changing market conditions, a gradual hardening of budget constraints has occured as subsidies from federal and local budgets and directed credit from the banking system have declined. Tax revenues collected by federal and local governments are expected to fall to about 25 percent of GDP in 1994, with expenditures running about 35 percent. About 130, 000 enterprises, about half of those operating at the beginning of 1992, have been privatized or leased with a purchase option through late 1994. Most have been small trade and service enterprises, about 70 percent of which were purchased by members of workers' collectives on concessional terms. Proportionately, Russia's state-owned sector is now smaller than Italy's. Approximately 40 million Russians are now stockholders in joint-stock companies or in investment funds. Almost one-third of all apartments have been privatized, most given to their occupants at no cost. About 285,000 private farms have been created, covering about 5 percent of agricultural land.

While it is too early to describe Russia's transition as a success story, much structural reform has been accomplished and hyperinflation has been avoided. The output collapse was largely inevitable and has not had a commensurate negative effect on welfare. But financial stability has not been achieved, and many firms continue to rely too heavily on rent-seeking and state subsidies. The transition process will probably remain chaotic and unpredictable for some time.

Ukraine

After Russia, Ukraine was far and away the most important component of the FSU, producing more than three times the output of the next ranking republic. But it is difficult to find a bright side in the Ukrainian transition story. During 1993 the inflation rate was the highest of any country not at war. Less than 10 percent of total assets have been privatized, and price liberalization has been only partially initiated. Price controls have become pervasive; by mid-1994 the degree of administrative control over the economy was virtually the same as it had been immediately following independence. The exchange rate is fixed at an artificially low level, mandating the use of controls on the allocation of foreign exchange and imports. Economic decline continues; annual GNP dropped by 15-17 percent in both 1992 and 1993 and plummeted by 26 percent in the first half of 1994 (Kaufmann, 1994). Real wages shrank by half between January of 1992 and the first quarter of 1994; Ukrainians on average earn less than $15 a month. The unofficial economy has become a large and liberalized sector, helping to keep the economy afloat while undermining the state's management of it. The informal economy is a survival economy, with trading, services, and short-term concerns dominating its agenda. Large-scale investment and sophisticated production are virtually absent. In such an environment, it is not surprising that there has been little foreign investment, in spite of the country's favorable location and skilled and educated labor force.

Belarus

Neighboring Belarus is one of the most developed of the FSU republics; this country was and remains an important transport link for Russia' s oil exports to the Baltics as well as Eastern and Western Europe. The collapse of traditional trade ties, coupled with a failure to engage in serious economic reform, have resulted in a sharp economic contraction. None of the 371 enterprises slated for privatization has been privatized as yet, nor have any of the inefficient and insolvent firms been forced into bankruptcy. The agricultural sector remains highly subsidized and the central bank continues to flood inefficient industries with credits, fueling inflation and weakening incentives to improve economic performance. The IMF, disappointed with the lack of progress in economic stabilization, is considering the postponement of its previously negotiated $250 million stand-by loan (OMRI, 3/29/95).

The Baltics

As they embarked on broad economic transformation, the Baltic countries moved quickly to reduce inflation via restrictive monetary, fiscal and incomes policies. Price liberalization came quickly, along with abandonment of membership in the ruble area and establishment of national currencies (IMF Survey, 12/ 12/94). Liberal trading regimes were established, less so in Latvia due to that country's powerful agricultural sector. Latvia has also lagged in privatization and has a higher unemployment rate than in the other Baltic countries. Nonetheless, the nation is poised for recovery, its chances bolstered by its well-educated labor force, its diverse industrial structure, and its strategic location on the Baltic Sea.

Estonia has one of the best overall economic reform and privatization records, with an estimated 50 percent of state-owned enterprises transferred to private ownership or control by mid-1994. The country has adopted a range of divestiture methods aimed at putting assets into the hands of those with the incentives and skills to use them wisely. Successful policies have included termination of soft credits to enterprises, active implementation of the bankruptcy law, a currency board system that links money creation to hard currency reserves and keeps inflation at modest levels, liberalized prices, an open trade regime, and the encouragement of foreign investment. Its GDP growth in 1994 (4 percent) was the highest rate projected for any European country. Foreign direct investment constituted about 9.5 percent of GDP in 1993. With a population of only 1.5 million, Estonia has been attracting a larger private capital inflow than Russia.

Lithuania has made steady progress in developing a market economy, and has privatized about 40 percent of state property The nation has a good agricultural potential, a highly skilled labor force, and a diversified industrial sector. Inflation is falling, and the country enjoyed a modest increase in GDP in 1994. (Transition, Jul-Aug, 1994).

Moldova

Moldova, the USSR's former foothold in the Balkans, has pushed boldly ahead on economic reform in spite of activities by separatist groups in the Dniester region. The economy is based largely on agriculture and lacks energy resources. It has freed interest rates, established a convertible currency, and removed price controls and trade restraints on most products. About one-third of state enterprises have been privatized (CIA, 1994).

Caucasus

In the Caucasus, Armenia has a relatively well-developed industrial sector but is a large food and energy importer. Its decline has been particularly severe due to the ongoing conflict over its enclave of Nagorno-Karabakh in Azerbaijan. Only sporadic deliveries of natural gas come through unstable Georgia, as both Turkey and Azerbaijan have blockaded railroad and pipeline traffic. Many industrial enterprises are shut down, and recovery cannot be expected until the conflict is resolved.

Georgia's economy is also disrupted by conflict in Abkahazia, South Ossetia, and Mengrelia. Much industry is functioning at only 20 percent of capacity, heavy disruptions in agriculture have occurred, and tourism is practically nonexistent. To compound matters, Georgia suffers from acute food and energy shortages. Recovery depends on the end of conflict and the reestablishment of trade ties.

Azerbaijan is the less developed of the Caucasian states, and resembles the Central Asian republics in its majority Muslim population, high structural unemployment, and low standard of living. With foreign assistance, oil might generate the funds needed for industrial development, but this is unlikely as long as civil unrest continues to drain the country's economic resources (CIA, 1994).

CENTRAL ASIA

Central Asia is faced with not one but four transitions. In addition to building national economies and moving from centrally planned to market economies, its states must also evolve from being semicolonies of an empire to sovereign nation-states and from totalitarian to democratic societies (Islam, 1994). The transition to market economies is hampered by the fact that these newly independent states are among the least developed of the FSU and the most isolated from market-based economies. Consequently, their capacity to carry out market reforms is relatively weak. Transition toward a market economy has not even begun in Tajikistan because of the civil war that has raged there since 1992. Even before independence. this country had the lowest per capita GDP in the FSU, the highest rate of population growth. and the lowest standard of living. The economy is highly agricultural (43 percent) and is highly specialized in producing cotton for export. A large share of its food and nearly all petroleum products must be imported. Constant political turmoil and the dominance of former Communist officials have slowed the process of economic reform while limiting foreign assistance.

Virtually no economic data are available for Turkmenistan, because the government there has not cooperated with the IMF in providing the necessary statistics. It is a largely desert country with nomadic cattle raising, intensive agriculture in irrigated oases, and huge gas and oil resources. Its approach to economic reform has been cautious; profits from its gas and cotton exports have been used to sustain a generally inefficient economy. Economic restructuring and privatization have barely begun, while price liberalization has been accompanied by generous wage increases and subsidies. The authoritarian ex-Communist regime is warming to economic reforms but still retains its dominance over the economy.

Kazakhstan, a nuclear power with advanced space and satellite technology, and whose industrial output accounts for more than a third of GDP, is second only to Russia in area. Transition to a market economy has been gradual, but new businesses are forming rapidly, the economy is opening to foreign investment (including joint ventures with western oil companies), and about 12 percent of state-owned enterprises have been privatized.

Uzbekistan is the most populous country in the region. Dry, landlocked, and poor, it is the world's third largest cotton exporter, a major producer of gold and natural gas, and a regionally significant producer of chemicals and machinery. An initial policy of tight controls on prices and production proved to be unsustainable, and the government has increased its cooperation with international agencies, accelerated privatization, and increased efforts to attract foreign investors.

Kyrgyzstan is one of the smallest and poorest of the FSU, heavily agricultural with a small and obsolete industrial sector. Substantial privatization is underway, but economic restructuring will cause high unemployment and concomitant political pressures to backtrack on reform measures (CIA. 1994; Islam, 1994).

CONCLUSION

If one were to generalize about the transition process, one could say that those countries which have been the most successful are those in which new market-based mechanisms for allocating resources emerged rapidly. The overall dislocation resulting from the breakup of central planning and the reorientation of trade toward the West meant that initial declines in trade and output were inevitable. Ineffective trade policies designed to keep goods at home and economies on scarce reserves of hard currencies worsened the problem, which was compounded by the trade barriers (primarily in the form of nontariff and contingent restraints) erected by the OECD countries.

As the policy tools of the planned economy are abandoned, as state trading is replaced by temporary export taxes until higher levels of privatization are reached, as progress is made toward currency convertibility and macroeconomic stability, as property rights and a legal system to specify and protect them are established, recovery and fuller integration within the world economy may be expected. With this fuller integration an increased flow of capital into the most advanced states of the region is likely. High-saving nations such as Japan and Germany, followed closely by Britain, France, and Canada, may be expected to redirect their capital flows in this way. The low-saving United States will be forced to save more or pay higher interest rates (probably both), and get serious about deficit reduction. Protectionist pressures are likely to increase both in America and in Western Europe, leading to the growing division of the industrialized world into trade blocs. That this is a second-best policy to trade liberalization is well accepted by most economists, but is usually ignored by politicians who must be attentive to the special interests of their supporters. The biggest losers will be the countries left out, which in the group above are the laggards in the transition process.