Last updated: May 2002 Volume 48, Special Issue

The rise and fall of central planning will be one of the great themes of twentieth century economic history. At its peak, almost half the world's population lived in economies that described themselves as being centrally planned, and not even the most hostile critics of the system predicted how quickly it would begin to unravel in the late 1980s. But unravel it did, and over the succeeding decade dozens of countries began the often painful transition to a predominantly market economy.

Many have traveled very far down that road—so much so that it is increasingly inappropriate, at the beginning of the twenty-first century, to still label them "transition" economies. Cuba and North Korea are the only significant economies that still profess allegiance to state ownership and central planning. It is a good time, therefore, even to look back at what we have learned from the transition experience and to look forward to the challenges that now face these economies.

This issue of IMF Staff Papers contains eight papers on different aspects of the first 10 years of transition. As a collection of papers, it cannot provide a complete overview of what happened in the first decade, nor of the key issues that arose, nor of the issues that will need to be addressed in future.¹ But it does provide insights into many of the key issues. The fascinating paper by Mark Allen and Rick Haas, who were IMF resident representatives in transition economies, describes the mindset of people in economies setting out on the path of transition; it would serve well as a standard reference on the market economy for an introductory course in economics. Rather than attempt to summarize the other seven papers, I will refer to them as appropriate in the remainder of this introduction.

I. Performance During Transition

Although important reforms began in the 1960s in Hungary and in the 1980s in China, Poland's economic reform program in 1989 was the first attempt at a comprehensive rapid move to a market economy. No one believed that the process would be painless. It was anticipated that output and employment would fall initially as macroeconomic stabilization took place, and as structural reforms moved resources from unproductive to productive uses.

But the adjustment turned out to be much more painful than expected. In the transition economies of Central and Eastern Europe, the Baltics, Russia, and the other countries of the former Soviet Union, output fell by more than 40 percent on average. There are well-known reasons to believe these data exaggerate the real output loss, but there can be no doubt that transition outside east Asia was accompanied by severe dislocations, large redistributions of income, and severe income losses by many people. Both the depth of the initial recession and the strength of the subsequent recovery—it generally took about two years for growth to follow stabilization—varied widely from country to country. Only a handful have seen output recover to pretransition levels. In contrast, the transition economies of east Asia managed to maintain strong growth throughout the transition period, allowing them to enjoy big cumulative gains in output.

Econometric analyses of the factors determining economic performance in the transition economies of Europe and the former Soviet Union are summarized in the paper by Oleh Havrylyshyn. This paper, which makes use of the measures of structural reform developed by the EBRD, confirms some striking lessons. Growth was affected by the initial conditions affecting the economy, including for instance how long it had been in the Soviet bloc and its dependence on previous trade patterns.

But while initial conditions were important in determining the size of the initial recession, they had less influence on the subsequent recovery path. Here—and this is the key point—the strength of reform efforts was the dominant factor. Indeed, the evidence confirms that the basic strategy advocated by market-oriented proponents of reform a decade ago was correct, namely, that both stabilization and structural reforms—particularly price liberalization and the small-scale privatization of state enterprises—contribute significantly to growth. The faster these reforms are implemented—and the more consistently they are pursued—the quicker the economy pulls out of the initial recession and the stronger the subsequent upturn in growth.

In addition to falls in output, the early phases of transition were marked by big price increases in most countries, the results of price liberalization in the presence of inherited monetary overhangs. Falling output and fiscal restructuring widened budget deficits, which in turn were monetized, fueling inflation. The resulting macroeconomic instability was particularly virulent and persistent in the CIS countries. With the help of IMF-supported programs, in most—but not all—cases using exchange rate nominal anchors, most transition economies had achieved reasonable price stability by the mid-1990s.

However, there were setbacks in several countries later in the decade, most of them associated with the Russian crisis in 1998. The Russian crisis was a result of external shocks, capital flight, a weak financial system, failures to undertake structural reforms, and an extremely weak fiscal situation, which had rapidly produced an unmanageable debt servicing burden—all this in the context of a crawling peg exchange regime that had performed well in stabilizing inflation, but that the authorities were loath to give up in time. The Russian fiscal crisis was associated with the seemingly intractable nonpayments problem that beset both the fiscal accounts and other sectors of the economy, an issue taken up by Brian Aitken in his paper. The fiscal crisis was also associated with the loss of revenues by the center to the regions, a process that forcefully raised the issue of fiscal federalism—which is the subject of the paper by Blanchard and Shleifer, and is of great importance also in China and other large countries.

The Russian crisis in 1998 hit the other CIS countries very hard. But across the transition economies as a whole, the situation—with the help of rapid growth in Russia—is now clearly improving. In the past two years, growth in the Central and East European, Baltic, and CIS transition countries has rebounded to 5.5 percent and inflation has more than halved to less than 20 percent, with most countries enjoying single-digit inflation. So in terms of macroeconomic stabilization, much has been achieved. But experience has differed widely from country to country—depending in large part on policy effort.

The same is true of structural reform. Progress has generally been most impressive in central Europe and the Balkans, and most disappointing in the CIS and east Asia. It has also varied widely from one policy area to another. Reform is most advanced in the privatization of small-scale enterprises, the elimination of price controls, and the liberalization of foreign trade and exchange. But less has been achieved in the regulation and supervision of financial sectors, enterprise restructuring, and the reform of governance in the public and private sectors. The paper by Zinnes, Eilat, and Sachs provides evidence on the importance of building institutions for privatization to succeed.

In countries where certain key structural reforms were delayed—notably the elimination of soft budget constraints and the liberalization of trade and prices—inflation has tended to be higher and more protracted and the recovery in output has been less robust. The most successful strategy seems to have involved rapid privatization of small-scale enterprises, followed by more gradual privatization of large-scale enterprises—once commercial legislation has been put in place to ensure sound corporate governance structures and adequate competition (or regulation in the case of natural monopolies).

As shown by Garibaldi, Mora, Sahay, and Zettelmeyer, the more successful reformers have further strengthened their position by gaining rapid access to foreign capital markets and direct investment, thereby reducing their reliance on financing from governments and international financial institutions. At the other extreme, the problems of the less successful reformers—notably Russia—were exacerbated by capital flight.

Much of the evidence in Havrylyshyn's paper and the discussion so far bears on the choice between gradualism and shock therapy, which received a great deal of attention early in the transition process. It was Poland that most clearly elected to do as much as possible as rapidly as possible—though even in that case, privatization lagged a great deal—and until growth began in Poland in about 1993, critics of shock therapy seemed to have the upper hand. Later it became clear both from case studies and from econometric evidence that the countries that had moved faster started to grow sooner. It also became clear that different aspects of reform had to be carried out at different speeds—for instance, that while stabilization could be effected relatively quickly, the creation of the institutions of a market economy, including important aspects of corporate governance, would take much longer.

As Yegor Gaidar makes clear in his memoirs,² in practice the choice between gradualism and shock therapy was very much one of political economy. Careful sequencing, of the type that leads Gerard Roland in his paper in this issue to recommend the gradualist East Asian approach, assumes a degree of political control of the reform process that was simply not available in many of the transition economies, especially in the CIS countries.

One frequent criticism of the reform strategy in the transition economies—and of Western support for it—is that too little thought was given to institution-building, for example, of sound legal and regulatory systems and well-functioning tax administrations. The problem was not one of attention or thought, but of execution. The importance of these elements was recognized from the beginning, in the joint study of the Soviet economy published by the leading international financial institutions in 1991,³ and a massive technical assistance effort was mounted by both the international institutions and on a government-to-government basis to try to build the necessary institutions.

But such changes were too slow to go into effect. No doubt this was partly because the difficulties involved in implementing institutional reforms were underestimated. There was a lack of experienced personnel and the relevant administrative capacity in many countries was limited—and the resistance of existing bureaucracies was very effective. Much still remains to be done in completing the necessary institutional reforms.

II. Why Is Asia Different?

Before turning to policy challenges for the future, it is worth considering further why the experience of the East Asian transition economies—in particular China—has been so different from that of the countries in the former Soviet bloc. Most indicators suggest that progress on structural reform in East Asia has been relatively modest, yet output performance has been far superior to even the best reformers in Europe and the CIS. Some observers and analysts—including, as previously noted, Gerard Roland—have argued that the Chinese experience shows that a gradualist approach to reform is better than a rapid one. Others have argued that China's success has come about despite gradualism rather than because of it, and that the strong output performance there reflects favorable initial conditions and political stability.

It is certainly true that one of the most conspicuous differences between the transition process in East Asia and elsewhere is that in the former it was undertaken by incumbent governments, rather than coinciding with a period of political upheaval. The reform process in China began in the late 1970s, with very rapid changes in the agricultural sector. The present objective of developing a socialist market economy was not formally adopted until 1993. Reforms have been gradual but far-reaching. They have remained on track in part because they were initiated and implemented in a stable political climate, a luxury not on offer elsewhere.

The East Asian transition economies were also able to increase output by drawing on a large pool of surplus labor in the agricultural sector. By permitting greater private sector activity in agriculture and relaxing entry into industry in rural areas, it was possible to increase output substantially without employment falling sharply. In contrast, in most other transition economies, adjustment required large-scale job shedding from big state-owned enterprises.

But China's success has been secured at a price. Reform of large state enterprises has been relatively slow, contributing to a serious worsening of their financial position. This in turn has resulted in a substantial accumulation of nonperforming loans in the state-owned commercial banks. The authorities have made significant progress in privatizing small enterprises and reducing the level of nonperforming loans in state banks, but much remains to be done to restructure large enterprises and to develop a sound and market-oriented commercial banking system. Accession to the World Trade Organization (WTO) means that these problems will have to be tackled with increasing vigor in the future. This in turn will impose fiscal burdens, underlining the need to strengthen the country's budgetary position.

III. The Challenges Ahead

What about the challenges facing the other transition economies? Consider first the relatively successful reformers on the European Union accession track; then Russia and Ukraine; and finally the other countries of the CIS.

The EU has accepted 10 transition economies as full candidates for accession—Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. Many of them have been relatively successful reformers, which many observers attribute to their underlying historical affinity to Western Europe. With central planning introduced to these countries only in the late 1940s, there was still considerable understanding of how a market economy works. The political upheavals of the late 1980s were seen as an opportunity to return to a Western European model. With a national consensus in favor of rejoining Europe, the incentives provided by the EU accession process created a powerful external anchor that has helped keep reform on track, and should continue to do so.

Economic growth has resumed in most of the accession economies, while inflation is moderate or declining. However, relatively large budget and current account deficits remain a source of concern in some economies. On the structural side, for the most part these countries have successfully liberalized trade and foreign exchange systems and privatized many small- and large-scale public enterprises. There has also been significant progress in liberalizing prices. But there has been less progress on competition policy, governance, enterprise restructuring, and the development of financial institutions. In 1999 the European Commission said that 6 of the 10 accession economies in effect had functioning market economies. Lithuania and the Slovak Republic were "close" and Bulgaria had made good progress from a poor starting point, but the situation in Romania remained "very worrying."

Even the best performing accession economies have policy challenges to confront if they are to make the most of EU membership and minimize its risks. For example, all applicants still need to see significant adjustments in their industrial and occupational structures, trade patterns, and financial sectors. These will occur more smoothly and at lower cost if measures are taken to increase the flexibility of product and labor markets. More also needs to be done to strengthen the institutions that support market activity: in particular, concerns about judicial systems, banking system weaknesses, and corruption need to be addressed.

Outside the EU accession group, the remaining transition economies face an even more difficult set of challenges. Although almost all have achieved a reasonable degree of macroeconomic stability, rudimentary financial systems complicate the task of setting monetary policy, while high government spending and inefficient tax collection put upward pressure on budget deficits. Fiscal problems are exacerbated by the nontransparent nature of some spending, notably implicit subsidies to existing enterprises. And structural reforms lag far behind those in the EU accession countries

Among these countries, attention naturally focuses most intensely on Russia and Ukraine. Political factors, including the capture of important elements of the reform process by opponents of reform, bulk large in determining the future of reform. In these countries, there is not much doubt about what needs to be done, and in each country, policymakers frequently proclaim their intention to reform. With growth having returned to both countries in 2000, reform should have become politically easier to implement. The tax reform passed in Russia in 2000 is a major step forward; so would be the Gref reform program if it were implemented. Similarly, the Ukrainian program supported by the IMF at the end of 2000 provides a clear road ahead. Whether those reforms are pursued remains to be seen.

It is in the interests of the Russian and Ukrainian peoples that those reforms be pursued. And given the importance of those two economies—particularly the Russian economy—in the CIS, reform and the beginning of sustained growth in Russia and Ukraine would also help the other countries in the CIS, in most of which economic performance has been very poor.

The precise mix of reforms required in the CIS countries—as well as in the east Asian transition countries—differs from country to country, but there are common challenges in three areas.

• Enterprise restructuring: Inefficiencies and loss-making activities in large-scale enterprises remain a serious drag on economic performance. In Russia and other CIS economies, the problem lies mainly in newly privatized firms, where there has been little incentive to restructure; the ability to amass arrears and take advantage of subsidized energy has maintained soft budget constraints. In China and Vietnam, the problem lies more with state-owned enterprises, where borrowing from state-owned banks is financing overcapacity and debt accumulation. In both cases, hard budget constraints need to be combined with stronger social safety nets to ease the social costs of adjustment.
  
  
• Financial sector reform: In Russia and other CIS economies, the banking system remains small and underdeveloped. Action needs to be taken to deal with those banks that remain insolvent, as well as to develop the sector by stimulating wider private ownership and greater competition. Better regulation and supervision will be required to guard against abuses, including insider lending. Reforms of the legal and regulatory environment are also necessary, but these will inevitably take some time.
  
  In China, the banking system is much bigger and deals with a large proportion of domestic savings, but channels much of it to state-owned enterprises. Nonperforming loans are being transferred from the four state banks to asset management companies, which will strengthen their financial position. But it will be important to ensure that a fresh bad loan problem does not emerge. This means developing a commercial credit culture in the banks and strengthening regulation and supervision. The prospect of WTO accession underlines the need for action, as it will give foreign banks full national treatment by 2005.

• Transforming the role of the state: More needs to be done to establish and enforce the rules of the game for a market economy, especially in the CIS and East Asia. This means strengthening tax systems and tax administration; improving fiscal transparency and government accounting; reforming relationships between central and local government; and strengthening the legal system and systems of corporate governance. It will also require continuing reform of expenditure policies, phasing out subsidies, and strengthening social spending programs.

In many transition economies, progress in these areas is being held up by the resistance of vested interests—a point emphasized for the cases of Russia and Ukraine by Åslund, Boone, and Johnson. Overcoming this problem is no easy task. Pressure to do so could come from a variety of sources: strong political leadership, democratic pressures, pressure from a growing middle class, or pressure from foreigners seeking to compete in domestic markets. The international financial institutions, representing the international community, also have an important role to play in the advice they give and the reforms they support.

Very few countries remain to set out on the path of transition. Yugoslavia is starting now; North Korea and Cuba are likely to follow eventually. The transition strategy for those countries will draw on the lessons learned from the experience of the 26 countries that started the process between 1989 and 1992. Already now, after a decade, many of these countries can no longer be regarded as transition economies, and within the next decade, most of the remaining transition economy members of the 1989–92 group will also have graduated. Increasingly, the problems they face will be the same as those confronting other developing and industrialized economies. And the history of the transition economies will be studied for what it teaches us about economic reform in general, as well as about the history of a particular, important, group of countries.