Speech

So, in this spirit of glasnost at the IMF, I would like to make some remarks about two such public debates of relevance to transition economies:

• The first debate is about the reform strategy advocated to the transition economies by outside advisors, including those at the World Bank and the IMF. Has this strategy been the right one? Did the institutions make mistakes? And more important, what lessons have been learned to improve the quality of policy advice to transition economies?



• The second is the debate over the benefits and risks of globalization—the process of the economic integration of nations. Do the risks outweigh the benefits? Can developing countries take advantage of globalization?

The Policy Advice to the CIS Economies

There was no single, or simple, blueprint for the transition back from the Soviet system to a market economy. To the extent that there was an plan of action recommended by outside observers, it is well summarized in a 1991 paper by Stan Fischer and Alan Gelb.³ According to them, the transition to a market economy was to be achieved through progress in four areas: (1) liberalization of prices and trade; (2) macroeconomic stabilization; (3) restructuring and privatization; (4) legal and institutional reforms.

Under this strategy, liberalization and macroeconomic stabilization were to be undertaken fairly quickly, as was the privatization of small-scale enterprises. Work on privatization of large-scale enterprises, and work on legal and institutional reforms could also begin right away, but it was not expected that it could be completed quickly.

What was wrong with this strategy? Three things, according to some critics :

• First, the sequencing of reforms was said to be wrong. Legal and institutional reforms should have come first, according to this view. Existing institutions, and existing economic and social norms of production, should have been abandoned only as these new institutions were taking hold.



• Second, privatization, in practice, quite often turned into "asset-stripping". It was pushed through in the absence of legal and institutional safeguards such as coherent laws, impartial courts and an honest civil service. In practice, therefore, privatization was often just a way of further enriching the privileged via corruption.



• Third, there is the well-known criticism of speedy liberalization and stabilization: the "shock therapy" was "too much shock, too little therapy." According to the critics, it led to a massive decline in output and worsening social indicators. It dissipated the organizational and social capital that had existed under communism.

How valid are these criticisms? Let's address each one in turn. The first is that legal and institutional reforms should have come before taking the other steps. If only we could have kept communism going for 20 more years while we trained bank regulators and tax examiners, everything would have been better! — that seems to be the argument of the critics. But it is an improbable one.

Market institutions could not have been developed in a laboratory setting and then transplanted into the economy. One had to actually start the messy transition to the market. Institutions take a long time to perfect. The institutions that are there in transition economies today, however imperfect, would not be there if the effort had not been started ten years ago.

Moreover, the Soviet Union did not have the organizational and social capital to maintain the existing level of output and the structure of industry, while the underpinnings of a capitalist economy were being developed. As some observers of the transition have stated: "... many of the old social norms relating to economic activity ... died before the collapse of communism. Indeed, their death was a major reason for its collapse ... Some new institutions therefore had to be created quickly in the hope that new norms would follow ..."⁴

In short, there was no easy alternate strategy of keeping communism going while capitalist institutions were being nurtured in a test-tube. But that said, the experience of the transition economies has made the IMF more aware of the importance of institutional reforms. It has also made us aware of the difficulties involved in getting these reforms off the ground. So our advice today is more likely, on the one hand, to encourage such reforms but, on the other hand, to be realistic about what can be achieved.

The second criticism, namely that privatization often did live not live up to its promise, has somewhat greater merit than the first one.⁵ While privatization of small-scale enterprises was generally a success everywhere, rapid privatization of other enterprises created many problems. Take the case of Russia's privatization. The country's mass privatization program of 1992-94 transferred ownership of over 15,000 firms into private hands. However, contrary to expectations, this did not induce the restructuring of firms in many cases, particularly in cases where the new owners were `insiders' such as the managers and workers of the enterprises. These new owners were more interested in stripping the assets of the firms rather than restructuring and investing in them. Of course, if the enterprises were not privatized, the assets would quite likely have been stripped anyway. So while privatization did not turn out as well as had been hoped, the alternative is not likely to have been any better.

It was hoped that secondary trading would introduce outside ownership of such firms. It was also hoped that transparent methods would be used in the second wave of privatization of remaining firms still in state hands. Neither hope was fulfilled. Insiders were wary of relinquishing control. Workers feared the cost-cutting that might occur under outside control. Managers found it easier to keep enterprises alive by lobbying the state for subsidies than to foster competitive performance through involvement of outsiders. The second wave of privatization, in particular the so-called "loans-for-shares" scheme in Russia, was transparent only in the systematic way in which it favored participants with ties to government interests. It was a scheme ripe for corruption. (As you know, the scheme was criticized at the time by the IMF.)

The critics are also right that too much emphasis was placed in the initial stages of transition on who owned the assets, that is, whether it was the state or the private sector. What turned out to be much more important was whether the owners, state or private, had incentives to restructure. In particular, imposing so-called "hard budget constraints" on all enterprises was the most important single action, and led to some restructuring even of the enterprises that remained in state hands. In addition, opportunities to create new private enterprises were a key part of the strategy.

Does that experience suggest that privatization should become a "dirty word" and renationalization should be considered?⁶ Not at all. When complementary conditions are met, privatized firms do tend to restructure more quickly and perform better than comparable firms that remain in state ownership. The complementary conditions include the presence of hard budget constraints and competition; effective standards of corporate governance; and an effective legal structure and property rights.

Because developing such standards and institutions takes time, we have learned that the choice of privatization strategies is generally between messy and messier; the danger with trying to do privatization cleanly is that it may never take place. So the decision has to be made on a `case by case basis' whether the likely benefits of privatization in a particular case outweigh the potential costs.

The third criticism is of the use of shock therapy in liberalization and stabilization. There is no denying that the calamitous drop in output and the burst of hyperinflation at the start of the transition process imposed severe economic hardship on the people. Why did output fall initially and what explains the recovery of output? These questions have been the subjects of much econometric investigation.⁷ The results suggest that relatively little of the initial decline in output was due to the tight macroeconomic policies used to tame inflation.

Instead, "disorganization" was an important factor. Disorganization refers to disruption in the production network, particularly in the provision of materials and intermediate inputs, resulting from the collapse of central planning and the dismantling of vertically integrated conglomerates that operated under the old system. Such disruption led to a loss in output. (I should acknowledge that many people find the whole notion of a fall in output misleading: much of what was being produced under central planning was not what people wanted, so—according to this view—what happened was not so much a fall in output as a reorientation.)

What explains the subsequent recovery in measured output? One important factor was progress made in lowering inflation.⁸ Countries that tamed inflation quickly and sustained the gains experienced a speedier and stronger recovery in output.⁹

Chart 1: Countries with better inflation performance in the early years
of transition experienced a stronger rebound in output

Sources: Havrylyshyn and others, IMF Occasional Paper 184, 1999 and Havrylyshyn, Izvorski and van Rooden, IMF Working Paper 98/141.
Notes: Each point on the graph represents a country.

Though progress with lowering inflation proved necessary for the revival of growth, it was not sufficient. Structural reforms were key in bringing about sustained recovery by facilitating the growth of the private sector. Where structural reforms were put in place early and firmly, new production networks developed quickly to counter the disorganization in the early years of transition. Countries that undertook more structural reforms in the early years of transition experienced a stronger rebound in output.¹⁰

Chart 2: Countries that undertook more structural reforms in the early years
of transition experienced a stronger rebound in output

Source: Havrylyshyn and others, IMF Occasional Paper 184, 1999.
Notes: The EBRD index measures price liberalization, trade and exchange regime liberalization private sector entry and legal reform. Each point on the graph represents a country.

As mentioned earlier, the social costs in the initial years of transition were immense: high inflation, the emergence of open unemployment, and falling incomes. Another cost was the emergence of greater inequality in incomes in societies where people had grown accustomed to relative equality. But moving slowly on reforms did not help countries avoid such costs. On the contrary, as noted above, countries that moved faster on structural reforms experienced a faster rebound in incomes. Moreover, one study found that, on average, countries that restored growth—by taming inflation and carrying out structural reforms—experienced a smaller increase in inequality.¹¹

Chart 3: Countries with stronger growth performance experienced
a smaller increase in inequality of incomes

Source: Keane and Prasad, IMF Working Paper 00/117, June 2000.
Notes: The horizontal axis shows the change in inequality (Gini coefficient) between pre-transition years (1990 to 1992, depending on the coutnry) and post-transition years (1995 to 1997). The vertical axis measures real GDP growth in the first eight years of transition for each country.
Each point of the graph represents a country. See Keane and Prasad, Table 8 for a list of countries.

To sum up, no transition economy was able to avoid the shock to the system from the collapse of communism. The question was how to get back on one's feet quickly, and countries that went in for rapid liberalization and macroeconomic stabilization did so faster than those who delayed.

Many critics offer China's development strategy as a shining contrast to the one followed in the CIS countries. However, there are many reasons why China's strategy could not have been adopted in wholesale fashion by the CIS countries:¹²

• In the former Soviet Union, over 85 percent of the workforce was in non-agricultural state enterprises compared to under 20 percent of the workforce in China. This allowed China to postpone reforms of its state sector while it grew by transferring surplus agricultural labor to township and village enterprises. In contrast, in the CIS countries subsidies of the state sector had to be ended to free up resources for the new non-state sectors of the economy. Two-track gradualism could not work in that context.



• Moreover, China started its reforms with "the advantage of backwardness": it was one of the poorest countries in the world in 1978. For instance, even today, after 20 years of solid growth, the average income in China remains significantly below the average in Russia.

The best evidence that the Chinese model of two-track reforms could not have worked is that it was in fact tried in some CIS countries and failed. In the mid-1980s, Gorbachev in the Soviet Union and Kadar in Hungary did try a Chinese-style approach of limited reform. It was the failure of these attempts that led to more aggressive attempts toward a market economy.

So where do things stand now, ten years later? As my colleague John-Odling Smee has noted, the improvement of much of the macroeconomic picture is impressive¹³:

• virtually all the economies are growing (after initial output declines that averaged 40 percent), and several at impressive rates, although unemployment levels remain high in many countries;



• inflation has been reduced to low to moderate levels (generally less than 20 percent, and often in single digits);



• and the share of output generated by the private sector now averages over 50 percent of GDP.

And at the same time as economic reforms were being implemented, many new nations had to be established and democratic institutions had to be developed. History will record these positive results as a testament to the extraordinary efforts made by the people in transition economies within a short period of time.

Of course, there is still a long road ahead. Odling-Smee believes that the key to unlocking the long-run growth potential of the CIS countries is to push forward with structural reforms. These include: further reducing the role of the state; maintaining hard budget constraints on all enterprises; correcting price distortions, and fostering competition and a conducive business environment; improving the social safety net; developing financial markets; and building institutions to promote good governance.

Making the Most of Globalization

In an integrated world economy, countries need not only an active domestic agenda of economic reforms, but also have to be aware of how best to capture the gains of globalization. Let me turn then to the second debate, the debate over the benefits and risks of globalization.¹⁴

Globalization is easy to define, but difficult to measure. As a matter of definition, globalization is the flow across national boundaries of goods and services, capital, people, technology, ideas, and culture. Because globalization is multi-dimensional, it is difficult to say for sure whether the pace of globalization has increased or decreased relative to the past. For instance, trade flows may have increased over a given period, but migration may have declined. Has globalization on net gone up or down?

Despite these difficulties in measurement, the last few decades are generally accepted as ones in which globalization advanced, rather than retreated, as a consequence of (i) a secular increase in global trade volumes; (ii) the increase during the 1990s in the volume of global capital flows (disruptions due to financial crises notwithstanding); and (iii) technological breakthroughs that have been shared across the globe.

The proponents of globalization say that it has boosted immensely the quality of life in many parts of the world. Critics say that the world's poorest do not share in its benefits. They claim that free trade favors rich countries and volatile capital markets hurt developing countries.

What does the evidence suggest? In a study released in 2001, colleagues at the World Bank have compared the experience of a group of countries they refer to as globalizers with that of other developing countries.¹⁵ The globalizers are countries, such as China, India, Mexico and Brazil, which saw a big increase in the ratio of trade to GDP over the last two decades—that is, they became more open to trade, by importing and exporting more. For instance, the globalizers reduced import tariffs, on average, by 34 percentage points since 1980.

Chart 4: Poor countries that integrated with global economy are growing fastest

Source: World Bank, 2001.

The globalizers experienced very fast growth is in the 1990s — average per capita income growth of 5 percent a year. They grew far more rapidly than the rich countries. In contrast, the non-globalizers, countries that did not have an increase in the ratio of trade to GDP, suffered declines in income of 1 percent a year.

Is it trade that led to the superior growth performance of the globalizers? We can't be absolutely sure. Countries that open up to trade often carry out a number of domestic policy changes at the same time. So it is very difficult to establish the precise role than trade played in helping growth. But at the very least, it makes it difficult for the anti-globalizers to claim that more trade leads to lower growth.

Of the 5 billion people living in the developing world, 3 billion or so live in the countries that the World Bank has labeled as globalizers. It appears that these countries have been able to reap some of the benefits of globalization by being able to access the markets of the developed nations with their exports. But that leaves 2 billion people in countries that appear to be shut out of the markets of the rich and hence have not yet been able to tap into the benefits of globalization. In some cases, of course, countries have by their own actions shut themselves out of the market.

This is why it is critical to have the so-called Doha Development Round of trade talks succeed. The Doha agenda places the needs and interests of the developing countries closer to the heart of work of the World Trade Organization (WTO). If successful, the Doha agenda would:

• substantially improve market access for agricultural commodities from developing countries;


• reduce tariffs on industrial goods, particularly on products of export interest to developing countries; and



• improve the participation of developing countries in the WTO's dispute settlement mechanism.

It is in almost everyone's interest to see the Doha round succeed. Developing and industrial countries both pay dearly for protectionism. Rich countries spend $300 billion in agriculture subsidies annually that undermine poor farmers in developing countries and hurt farmland in developed countries. As UNDP Administrator Mark Malloch Brown has noted: "Every cow in Europe today is subsidized two dollars a day. That is twice as much as the per capita income of a half of Africa."¹⁶

Estimates from a variety of sources of annual welfare gains from eliminating barriers to merchandise trade range from $250 billion to $620 billion, of which one-third to one-half would accrue to developing countries. But overcoming the strength of protectionist forces will not be easy. To build support for trade liberalization, countries need to do much more to facilitate structural change and to help their citizens adapt to it—for example, by providing more effective adjustment assistance, including for retraining and relocation, for those who are hurt. Developing countries also need to convince their citizens that the benefits of multilateral liberalization outweigh transient trade preferences and special treatment that shield their economies from competition.

Along with the expansion of trade, international capital flows also increased substantially in the 1990s. Private capital flows to developing countries now exceed development aid many times over. Openness to capital flows, when combined with sound domestic policies, gives countries access to a much larger pool of capital with which to finance development. As our Managing Director emphasized in a recent speech, "without this source of capital, emerging market countries, such as Brazil or China, would not be able to develop as rapidly as they do."¹⁷

But global capital flows have also become associated with financial crises, starting with the so-called tequila crisis in Mexico in 1994. Since that time, efforts have been underway to find ways to ensure that "countries can drink from the waters of international capital markets without being drowned by them".¹⁸ Global capital markets are huge relative to the sizes of many developing economies; hence, small portfolio shifts can exert an overwhelming influence on capital flows and domestic financial conditions.

The emerging consensus view—including that of the IMF—is that developing countries need to have a set of preconditions in place to benefit from financial globalization and to avoid an increased probability of a currency or banking crisis. What are the main elements of this more cautious approach to capital flows?

• First, the long end of the market should be opened up before the short—that is, foreign direct investment should come before portfolio flows. There may be a case for imposing or retaining some capital controls, especially price-based controls on short-term inflows. But it would be folly to push this to extremes. It is often difficult to make controls stick; controls that can be circumvented may produce a culture of evasion; and capital controls may well reduce beneficial inflows over the longer term.



• Second, the institutional and regulatory regime in the financial sector is very important. A strong prudential regime should be in place before the capital account is fully liberalized. Banks' open foreign exchange positions should be strictly limited. Moreover, there may be hidden risks: even if banks seemingly have no direct net foreign exchange exposure, they may be exposed through unhedged corporate and household borrowers. Therefore, countries need to seek policies that force corporations and households to be fully sensitive to currency risk.

What types of capital should be restricted and what should be let in? Certainly, foreign direct investment should be encouraged as it is more stable than other types of external finance and speeds up both capital accumulation and the absorption of foreign technologies. As in the case of trade, FDI has been shown to promote economic growth. Foreign holdings of equities, while they can be unstable, provide benefits in terms of risk sharing. Countries should consider whether reversals of equity flows in recent years was more a consequence of having had rigidly fixed exchange rates than of some inherent property of cross-border holding of equities.

The issue of restrictions, therefore, arises more in the case of debt instruments—both short-term flows and certain types of long-term flows (for example, debt payable in foreign currency or indexed to short-term domestic interest rates). Debt lacks the desirable risk-sharing properties of FDI and equity, and it can make countries susceptible to reversals of sentiment and to insolvency problems.

So despite the sometimes heated debates over globalization, there is an emerging consensus of how developing countries—the CIS economies included—can take advantage of the some of the benefits of globalization while minimizing some of the risks. The noted Harvard economist Dani Rodrik has often been critical of globalization; he wrote a book entitled "Has Globalization Gone Too Far?". However even he concludes that: "No country has developed successfully by turning its back on international trade and long-term capital flows". Let me conclude my remarks by saying that I fully agree with him.

² Our Managing Director, Horst Köhler, has in the last three years met with many parliamentarians—including members of the Chilean Senate, the Dutch parliament, members of the parliament of Tanzania, and the Treasury Select Committee of the UK House of Commons. Earlier this week, Mr. Köhler and I participated in a gathering of 140 parliamentarians from 60 countries, including transition economies, under the auspices of the Parliamentary Network of the World Bank.

³ Stanley Fischer and Alan Gelb, 1991, "Issues in Socialist Economy Reform," Journal of Economic Perspectives, Vol. 5 (Fall), pp. 91-105.

⁴ See Dabrowski, Marek, Gomulka, Stanislaw and Jacek Rostowski, "Whence Reform? A Critique of the Stiglitz Perspective." Journal of Policy Reform Vol. 4 (4), 2000, pp. 291-324, and "The Stiglitz-Ellerman Rejoinder: Our Main Criticisms Remain Unanswered." Journal of Policy Reform, 2000, Vol. 4 (4). pp. 339-348.

⁵ The IMF's view on the privatization process in Russia and other transition economies is set out in a number of documents (see, for instance, World Economic Outlook, October 2000; Finance & Development, September 2000).

⁶ This paragraph draws on Birdsall and Nellis, "Privatization's bad name isn't totally deserved," Christian Science Monitor, September 26, 2002. For a fuller discussion that makes many of the same points, see World Economic Outlook, September 2000, Box 3.4 "Privatization in Transition Economies;" Frydman, Gray, Hessel and Rapaczynski, "When Does Privatization Work? The Impact of Private Ownership on Corporate Performance in the Transition Economies," The Quarterly Journal of Economics, November 1999, 1153-91; John Nellis, "Time to Rethink Privatization in Transition Economies," IFC Discussion Paper No. 38, 1999.

⁷ See Stanley Fischer and Ratna Sahay, "Taking Stock," Finance & Development, September 2000, pp. 2-6; Grzegorz W. Kolodko, From Shock to Therapy: The Political Economy of Postsocialist Transformation, Oxford University Press, 2000; "Ten Years of Transformation: Macroeconomic Lessons," Working Paper, April 1999; Oleh Havrylyshyn, Ivailo Izvorski and Ron van Rooden, "Recovery and Growth in Transition Economies, 1990-97: A Stylized Regression Analysis," IMF Working Paper No. 98/141, September 1998; and Carlo Cottarelli and Peter Doyle, "Disinflation in Transition, 1993-97," IMF Occasional Paper No. 179, 1999.

⁸ See Prakash Loungani and Nathan Sheets, "Central Bank Independence, Inflation and Growth in Transition Economies, Journal of Money, Credit and Banking, August 1997, pp. 381-99, and Tonny Lybek, "Central Bank Autonomy, and Inflation and Output Performance in the Baltic States, Russia, and Other Countries in the Former Soviet Union, 1995-97, IMF Working Paper 99/4, January 1999.

⁹ This is illustrated in the chart, which shows the relationship between the change in output in a country, on the one hand, and the progress it made in reducing inflation, on the other. Each "diamond" on the graph represents a country. Countries appearing in the lower right-hand corner of the graph had low inflation (relative to other transition economies) and experienced a recovery of output; countries appearing in the upper left-hand corner had high inflation and suffered output losses.

¹⁰ This is illustrated in the chart. Output, relative to its pre-transition level, was higher in countries where structural reforms, as measured by an index constructed by the European Bank for Reconstruction and Development (EBRD), were the most far-reaching. As in the earlier figure, each "diamond" on the graph represents a country. Countries appearing in the upper right-hand corner of the graph pursued structural reforms more vigorously (than other transition economies) and experienced a recovery of output; countries appearing in the lower left-hand corner of the graph lagged in the implementation of structural policies and suffered output losses.

¹¹ See Michael Keane and Eswar Prasad, "Inequality, Transfers and Growth: New Evidence from the Economic Transition in Poland," IMF Working Paper 00/117, June 2000.

¹² This discussion is based on "Understanding China's Economic Performance," Jeff Sachs and Wing Thye Woo, Journal of Policy Reform 4(1), 2000, 1-50.

¹³ Press Briefing on Developments in Baltic and CIS Countries, Opening Remarks by John Odling-Smee, September 28, 2002 (http://www.imf.org/external/np/speeches/2002/092802.htm).

¹⁴ For a discussion that is more targeted to transition economies, see Grzegorz W. Kolodko "Globalization and Catching-up: From Recession to Growth in Transition Economies," IMF Working Paper, WP/00/100, International Monetary Fund, Washington, DC, (June).

¹⁵ Globalization, Growth and Poverty: Building an Inclusive World Economy, December 2001 (http://econ.worldbank.org/prr/subpage.php?sp=2477).

¹⁶ http://www.undp.org/dpa/statements/administ/2002/november/22nov02.html

¹⁷ See "Strengthening the framework of the global economy," Horst Köhler, November 15, 2002 (http://www.imf.org/external/np/speeches/2002/111502.htm).

¹⁸ See "Rethinking capital controls — when should we keep an open mind," Kenneth Rogoff, Finance & Development, December 2002, vol. 39, no. 4 (http://www.imf.org/external/pubs/ft/fandd/2002/12/rogoff.htm)