As in other parts of the world, the rewards for comprehensive reform and stabilization efforts are very striking among the transition countries, where the results of economic transformation are increasingly visible. While the declines in output during the initial phase of transition were considerably larger than most observers had expected, the countries that are the most advanced in the transition are now clearly experiencing substantial economic growth. Although strong domestic demand has recently been the main factor behind growth in some cases, rapid expansion of exports has continued to play an important role in the recovery, especially given the powerful signals exports provide for investment and restructuring decisions. In addition, many of the advanced transition economies are receiving substantial inflows of foreign direct investment, which complement domestic resources and often bring invaluable transfers of technology and management know-how. The relative success of many of the countries in central and eastern Europe in expanding their exports and attracting foreign investment would not have been possible without determined stabilization and structural reform efforts. Among the central Asian countries, Mongolia's economic performance has also shown the results of considerable reform efforts.

A turnaround in economic activity is expected to materialize relatively soon in many of the countries that started the reform process later, or have only recently succeeded in reducing the high inflation rates that have plagued all of these countries. In Russia, strengthened budgetary policies have been essential to support an anti-inflationary monetary stance that has brought down inflation to an annual rate of 22 percent in the first eight months of 1996. Although output is reported to have contracted further in the first half of 1996, conditions appear to be in place for activity to begin to pick up next year. Containment of fiscal imbalances, especially through greater efforts to collect tax revenues, and further deepening of the reform process are essential if the expected recovery is to become firmly established. Progress in structural reform is expected to stabilize output in Kazakstan in 1996 and permit moderate growth in coming years. In Ukraine, output is expected to contract further in 1996 but progress in implementing the needed reforms and in stabilizing the economy should begin to reverse the economic decline next year. Bulgaria has experienced a particularly serious setback in its stabilization efforts as a result of large quasi-fiscal deficits that have undermined confidence in the banking system. The situation is being addressed within the framework of a Fund-supported stabilization program that places a strong emphasis on structural reform.

The experience of the transition countries over the past five years suggests a number of important lessons. First, the reduction of inflation from high levels is critical for halting and reversing the sharp contractions in output that have been an inevitable feature of the first phase of the transformation process. Second, growth is unlikely to resume unless there is substantial progress with structural reform in a broad range of areas. And third, restructuring the enterprise sector and increasing productivity in existing enterprises may result in relatively high levels of open unemployment, at least for a period. Rather than allowing enterprises to maintain soft budget constraints, governments need to support the transformation process by fostering greater labor mobility and flexibility of wages, by establishing retraining schemes to satisfy skill requirements in expanding sectors of the economy, and also by establishing affordable, well-targeted social safety nets to lessen the hardship associated with unemployment. Sustained progress in all of these areas should permit those countries that have been lagging behind to begin to catch up with the early reformers in the period ahead.

Despite the generally positive outlook for the transition countries, considerable uncertainty attaches to their long-term growth potential. Based on the experience of other groups of countries that have experienced relatively rapid growth over extended periods, it is clear that some, but not all, of the conditions are in place for a significant convergence toward income levels in the industrial countries. One of the most encouraging characteristics of the transition countries is the high level and quality of education, which suggests an advantage in terms of human capital, notwithstanding a considerable need for retraining. The transition countries are also characterized, however, by relatively unfavorable demographic trends that imply a progressive aging of their populations and stagnant or even declining labor forces. Rising dependency ratios suggest that their saving performance, which is currently quite weak, may not improve sufficiently in coming years as to reach the levels of many rapidly growing countries. Since this will constitute an important constraint on the level of investment, increases in productivity will need to make a significant contribution if high growth rates are to be sustained. On the basis of preliminary staff analysis, the various factors that influence productivity growth seem to imply potential long-term growth rates on the order of 4 to 5 percent a year, although the margin of uncertainty that attaches to such estimates is obviously very large.

Government policies will clearly have a significant influence on the outcome. In particular, long-term fiscal strategies will need to ensure that social objectives are met without recourse to persistent budget deficits. It is also essential to establish economic and financial conditions that are conducive to private saving and investment. Capital imports may help to complement domestic saving and it is particularly important to foster high levels of foreign direct investment, which does not add to external indebtedness. Transparent legal frameworks and property rights, further progress with privatization (including of land), and facilitating entry for new enterprises are critical in this regard. But experience from other countries suggests that large-scale reliance on foreign saving may not be sustainable. Therefore, major efforts are also needed in most transition countries to put the banking system on a sound footing; this is essential for the mobilization and effective allocation of domestic saving.