Up from Communism

While the Czech Republic, Hungary, and Poland have displayed strong growth, questions remain over the depth of their reforms.

Since the fall of communism in 1989, the countries of the former Soviet bloc have registered diverse records in pursuing economic development through market liberalization and integration into Western institutions. The three former communist countries widely acknowledged as successes- -the Czech Republic, Hungary, and Poland--have themselves encountered different obstacles and undertaken specific approaches to the difficult and uncertain transition process.

After compiling impressive economic and political-reform records, these three countries--along with Slovenia--now constitute the first group being considered for membership in the European Union (EU) and in NATO. They have already gained entry into the Organization for Economic Cooperation and Development, a strong signal of Western approval. Entry into these pillars of European integration and transatlantic security, and the economic opportunities and security assurances that they offer, remains the major foreign-policy priority in these four countries.

While the Czech Republic, Hungary, and Poland have displayed strong growth, stabilized their economies, and transformed their political institutions, questions still remain over the depth of their reforms. Recent elections in all three countries have signaled domestic concern over reform priorities, as former communists were elected in both Hungary and Poland and left-leaning politicians gained strong support in the Czech Republic.

Will such a political backlash threaten the pace of further reform in an effort to address the economic insecurities of a substantial segment of voters? While these countries' industries continue to modernize, large amounts of critical foreign investment are necessary to bolster their economic growth. Concurrently, in order for democratic reforms to become entrenched, the Czech Republic, Hungary, and Poland must seriously consider the impact of their reform agenda if they are to fully realize the economic and security benefits of Western integration.

Czech velvet reforms

As a result of June 1996 elections, the center-right Civic Democratic Party, led by Czech Prime Minister Václav Klaus, and its two smaller coalition partners were unable to form a majority government. The leftist Social Democratic Party more than quadrupled its support from 6 percent in 1992 to 26 percent in 1996.

This surprise showing greatly reflected the Left's ability to attract the votes of those who have not shared in the benefits of the Czech Republic's economic success, and it forced Klaus to negotiate a coalition deal that may hinder some of the government's future austerity plans. With current polls showing fluctuating support for both the ruling coalition and the Social Democrats, Klaus' leadership is coming under increasing criticism.

For the most part, Klaus' monetarist record has held up well for the past few years. Largely responsible for engineering the Czech transition, he has pursued a policy of gradual reform that has helped keep unemployment under 4 percent. While Klaus is widely acknowledged as a strong free- market advocate, the gradual transition of the Czech economy has softened the blow of reform by maintaining rent controls and health care assistance, keeping energy prices low, and helping displaced workers to find new jobs.

The price of supporting the Czech social safety net is manageable, as it accounts for only 3 percent of economic output. One of the pillars of Klaus' program has been a managed exchange rate regime that allows the koruna only modest fluctuations. Such stability anchors domestic prices and allows exporters greater freedom to plan ahead. In addition, the recent passing of foreign exchange legislation has made the Czech Republic the first transition economy to attain IMF standards of currency convertibility.

Much of the Czech success is due to a liberal privatization program that has reformed roughly two-thirds of the economy and attracted substantial inflows of foreign direct investment (FDI), which account for 13 percent of GDP. With a low rate of national savings, the Czech economy is highly dependent upon such FDI. This huge influx of foreign capital is driven by experienced investors who are reshaping and modernizing state-owned properties while cutting jobs. With economic growth at 5 percent, the economy is fully capable of absorbing such layoffs. This dynamic combination of foreign capital and management skills has spurred growth in industrial production to 9.2 percent in 1995 and is expected to top 10 percent in 1996.

Nevertheless, the successful Czech transition does belie some longer- term problems. First, Klaus' gradual approach to economic reform has reduced entrepreneurial incentive and hindered the development of a strong domestic managerial class. The slow pace of privatization also obviated state-owned firms from restructuring to become competitive. Intended to enhance transparency, much-anticipated stock market reforms may force such firms to modernize.

Second, the collapse of some smaller private banks with liquidity problems caused the government to place the largest private bank under forced administration. Considering the small size of those banks that have failed, the Czech banking industry should recover and may even be strengthened by this dose of financial reality. However, the political fallout of the banking crisis is still pending.

Finally, due to industry's need to modernize and the subsequent flood of imported capital equipment, the Czech trade gap, expected to reach $2.8 billion at the end of 1996, is widening considerably. Now, the center-right ruling coalition faces a decision between continuing with large-scale privatization and potentially losing voter confidence or concentrating on social matters and derailing the government's budgetary discipline. Political debate surrounding the government' s decision will be further complicated by the Social Democrats' opposition to further spending cuts, an opposition that has already delayed health- care reform and industrial restructuring.

Hungarian dilemmas

Hungary faces similar domestic political and economic choices. One major difference, however, is the position of 3.5 million ethnic Hungarians in neighboring countries. The status of this large population has proven to be a major obstacle to stabilizing international relations in the region.

Yet with the signing of a Romanian-Hungarian cooperation treaty in September, a positive step was taken, and Hungary thereby greatly increased its chances of membership in the EU and NATO. However, although the treaty guarantees minority rights, it stopped short of allowing full autonomy for Hungarian minorities, and their position could still become a source of dispute.

Domestically, Hungary is a model of political stability, with the current government maintaining a solid parliamentary majority. In 1994, the former communist Hungarian Socialist Party defeated the reformist Hungarian Democratic Forum, resulting in the election of Gyula Horn as prime minister. The Socialists subsequently formed a governing coalition with the Liberal Alliance of Free Democrats. Horn' s government has not deviated from the reformist agenda, however.

Instead, it has attempted to balance various interests, allowing both labor and business groups to express their opinions. This form of governance has been effective in Hungary, where institutional consensus has been pursued. The 1994 Socialist election victory was less an indictment of the Hungarian reform program than a vote for some adjustments that would benefit the neediest sectors of society. Nevertheless, the government has proven to be resolute in maintaining budgetary discipline and limiting welfare spending.

Hungary's economic transition benefited from almost two decades of cautious market reform started under the pre-1989 communist government. This early training in Western financial markets translated into a significant advantage for Hungary over other transition economies striving to attract FDI.

In addition to a rapid privatization program and export-led growth, Hungary's financial experience has helped it become the FDI magnet of central and eastern Europe. Of the $30.8 billion in FDI invested in the region since 1990, 36 percent has gone to Hungary. In 1995, $3.5 billion in private funds were invested in Hungary, which amounted to roughly 25 percent of GDP.

Determined to modernize its state-owned utilities, Hungary has already seen efficiency and quality gains from the privatization of its telephone system and expects similar dividends when it completes privatizing its gas and electrical utilities. Overall productivity in industry is estimated to have risen 50 percent in the past five years. So rapid has Hungary's privatization and modernization program been that foreign investors have complained about being rushed.

According to some estimates, 80 percent of the economy will be privatized by 1997--even under socialist rule. Hungary's current economic program is based on the March 1995 Bokros stabilization package, which imposed fiscal and monetary restraints. Because of the package's austere requirements, however, certain portions of it have not yet been implemented. These critical portions address the state budget and the social welfare system.

Despite Hungary's liberal privatization record and proven ability to attract FDI, its future economic growth is dependent upon further reform of its state budget, which includes servicing the highest per capita national debt in the region. This massive debt burden is the result of two decades of foreign borrowing and an unwieldy social welfare system.

Accounting for roughly 16 percent of GDP, the Hungarian social security system is run by two semi-independent funds that are not directly responsible to the government. Much-needed reform of this system may be crippled, as the socialist government appears to favor a long-term approach to any modifications and will soon be focused on securing votes for the 1998 elections. With only 2 percent growth in GDP last year, high interest rates, and rising inflation, Hungary may be falling behind its competitors in the region.

The government cannot rely solely on its previous experience or its technological and managerial advantages to secure growth in the future. Instead, it must concentrate on getting its domestic accounts in order, while maintaining a stable ruling coalition with parliamentary support.

Polish problems

Poland appears to be the most determined applicant for integration into Western institutions. Plagued by a history of chronic uncertainty and insecurity, it views membership in NATO and the EU as its best assurance for security, stability, and economic prosperity. With public support for NATO and EU membership at the highest levels among all former communist countries--83 percent and 80 percent, respectively- -denial of membership could be a major setback in the country's transformation.

The election of former communist Aleksander Kwasniewski as president of Poland in December 1995 can be attributed to disarray and infighting on the right as well as the left's organizational capabilities, well- defined program and experienced leadership. Fears that the former communist would derail the country's burgeoning economic reform agenda have abated. The new government has maintained the market reform agenda of its predecessor and initiated an administrative decentralization program.

The aggressive administrative reforms, scheduled for October 1996, will reorganize the central government, creating new ministries of treasury and economy; revamp management structures of smaller but more commercially oriented state enterprises; and devolve power to the regional level. The new government has also initiated important legal reforms that will increase the power of the courts and decrease the prerogatives of prosecutors.

Poland's "shock therapy" approach to economic reform has been an effective mixture of monetary and fiscal restraint, trade and price liberalization, and construction of market institutions. The rapid application of such reforms caused high unemployment but also created a dynamic new class of Polish entrepreneurs.

Fueled by exports and foreign investment in 1995, Poland's economy grew by 7 percent, the highest in Europe, and growth is expected to continue at 5--7 percent in 1996--rates that have helped Poland become the first transition economy to surpass 1989 income levels. In addition, the government is pursuing further liberalization of its capital markets with the goal of a fully convertible zloty by 2000.

While Poland received $1.134 billion in FDI in 1995, estimates are for an increase to $2 billion in both 1996 and 1997. These increases are partially due to the size of the country's economy, which in absolute GDP is three times larger than the Czech Republic's and Hungary's.

The largest political obstacle to further Polish reform is the Social Democrats' uncooperative coalition partner, the Polish Peasant Party (PSL). Opposed to international integration and economic liberalization, the PSL has hindered government initiatives on administrative reorganization and economic decentralization. Although the country's next elections are scheduled for late 1997, certain elements of the PSL have threatened to force early elections. Meanwhile, the center-right forces, including former President Lech Walesa, will endeavor to forge a more united front in time for the balloting.

The most serious economic problem for Poland is its social security system. At 15 percent of GDP and with liabilities increasing, the country's public pensions expenditure rivals that of Hungary as one of the highest in Europe. Also, its capacity restructuring has proven difficult in the coal-mining, agriculture, and banking sectors. Due to reporting methods that are inconsistent with the West's, Poland' s banking industry is highly susceptible to financial market speculation. Because such uncertainties weaken the country's fledgling financial sector, better regulations and improved relations between Poland and international lending institutions are required.

The road to Europe

Even though the Czech Republic, Hungary, and Poland have faced different challenges during their transitions, all three can claim impressive economic records. After a series of elections that gave power to former communists in Hungary and Poland, and strengthened the position of Social Democrats in the Czech Republic, each country has maintained political stability and continued to pursue market-oriented reform. Realizing the security benefits of Western institutions and the profitability of integration into the international economy, the socialist parties of central and eastern Europe have in general become staunch supporters of membership in both NATO and the EU.

According to U.S. Secretary of State Warren Christopher, NATO is set to announce in the first six months of 1997 which applicants will be included in expansion and when enlargement will occur. The Czech Republic, Hungary, and Poland appear to be virtual certainties, as they have now met the most critical prerequisites for entry into NATO: a functioning democratic system, subordination of the armed forces to political control, and the absence of minority and border disputes.

Having signed associate Europe Agreements with the EU, the most important trading partner, they are now assured of eventual membership. Such membership will provide vital access to the EU's Common Market of 360 million consumers as well as increased amounts of FDI; FDI remains essential for further reform, as it provides not only new capital to a region with questionable financial markets, but also technology and entrepreneurial competence.

Access to Western markets combined with sound budgetary management and continued market liberalization will help ensure sustained economic development in the Czech Republic, Hungary, and Poland. In addition, regional initiatives such as the Central European Free Trade Association, which recently agreed to liberalize industrial and agricultural trade, will greatly contribute to the three countries' integration into the international economy.

Janusz Bugajski is director of east European studies at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Chad Damro is research associate of east European studies at CSIS.

JANUSZ BUGAJSKI AND CHAD DAMRO, Up from Communism. Vol. 11, The World & I, 12-01-1996, pp 24.