There are increasingly encouraging signs that the process of transition is working. Those countries such as Poland, the Baltic countries, the Czech and Slovak Republics, Hungary, and Slovenia, which have pursued comprehensive stabilization and reform policies, are experiencing relatively solid growth, moderate inflation, and good progress in their reintegration into the world economic and financial system. While growth may slow in the short run in the Czech and Slovak Republics as a result of recent exchange market pressures, the setback is expected to be temporary provided the needed policy adjustments are adopted. There are also indications that activity has bottomed out and may have begun to pick up in Russia, where the official statistics may still not fully capture the many new activities and enterprises that are emerging. Elsewhere in the region, progress is still mixed. In Ukraine, in particular, macroeconomic stability is a relatively recent achievement and lack of structural reforms continues to hamper growth. Other countries in the region that have maintained tight financial policies and proceeded with structural reform, including Armenia, Azerbaijan, Georgia, Kazakstan, and the Kyrgyz Republic, are now benefiting from sustained growth and further declines in inflation. Despite slow progress in some cases, 1997 seems likely to be the first year for the transition countries overall to register positive growth.

It is clear, however, that many challenges remain to be addressed to safeguard and further extend the progress that has been achieved. In many of the less advanced transition countries, there remains a need to establish the institutions of a market economy, which are still rudimentary. Moreover, financial systems are generally underdeveloped and plagued by nonperforming loans, restructuring of former state-owned enterprises has not gone very far, and governments are often unable to honor obligations for lack of tax revenues. Appropriate reforms to deal with these problems remain essential for the transition to succeed.

In addition to fiscal and structural policy requirements, the transition countries generally face substantial challenges in the area of monetary policy. Although progress toward stabilization following the initial period of high inflation has been significant, macroeconomic stability is still fragile and can easily be reversed, as demonstrated by the recent financial crises in Albania, Bulgaria, and Romania. Further progress is also needed to put in place the framework of instruments and institutions through which monetary policy can be operated in a market economy. And monetary authorities will need to contain the potential inflationary risks associated with both actual fiscal deficits and quasi-fiscal imbalances in the form of budget arrears. A key priority is to foster the establishment of sound market-based banking systems. Fragile banking systems pose significant inflation risks to the extent that the government may feel obliged to bail out insolvent financial institutions; however, the banking systems in most transition economies are still so small that the fiscal costs of dealing with potential banking sector problems are likely to be smaller as a share of GDP than they have been in several recent banking crises in developing countries.

Economic policies in the most advanced transition countries are beginning to face additional challenges as part of a process that began with large capital inflows in the wake of the launching of adjustment and reform programs. While longer-term capital inflows are attracted by the strong growth prospects of the recipient countries, relatively high interest rates and perceptions that there might be potential for currency appreciation also seem to have played a role in attracting shorter-term financial investments. As witnessed in many developing countries, however, large-scale capital inflows are costly to sterilize and are typically associated with widening external imbalances, which eventually risk provoking sudden reversals of the short-term inflows. While both fiscal and monetary policies need to take into account the dangers from excessive external imbalances, there may also be a need in some countries to allow for greater flexibility in the exchange rate regime to help reduce the risk of speculative pressures. A key issue in this context is the timing of such a change. Also, such a shift in exchange rate regime needs to be supported by continued macroeconomic discipline. The adoption of a fixed exchange rate in the form of a currency board arrangement in Bulgaria reflected the need for a strong anchor for price expectations to help stabilize the economy and restore confidence under circumstances in which a more flexible exchange rate arrangement would not have been credible.

While macroeconomic stability, trade liberalization, and the creation of the basic institutional framework of a market economy are essential for stronger growth, and often sufficient to enhance economic performance significantly for a time, broader-based reforms are necessary to sustain and enhance countries’ longer-run growth performance and ensure that the benefits of reform are more widely shared. Such "second-generation" reform requirements, which also apply in many instances to the advanced economies, include the need to accelerate social progress and invest in human capital by increasing the quality of public expenditures; strengthen the efficiency and robustness of the financial sector, including through appropriate prudential oversight; reform and eventually privatize state-owned enterprises and generally reduce government intervention in the economy in areas where market forces provide for greater efficiency; address corruption and improve governance; and enhance the transparency of government budgets, and generally strengthen the quality and timeliness of economic data to help reduce the risk of disruptive changes in investor confidence when economic or financial problems eventually appear.