Ifc Regulatory Transformation in Hungary 1989 98

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REGULATORY TRANSFORMATION

IN HUNGARY, 198998

CASE STUDIES ON REFORMIMPLEMENTATION EXPERIENCE


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Corporations (IFCs) Business Enabling Environment Advisory Services and FIAS, the multi-donor investment climate

advisory service. CIC assists the governments of developing countries and transitional economies in reforming their business

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REGULATORY

TRANSFORMATIONIN HUNGARY, 198998

CASE STUDIES ON REFORM

IMPLEMENTATION EXPERIENCE

December 2008


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Acknowledgements

This case study was written by Cesar Cordova(Director, Jacobs and Associates Inc.) based on atemplate developed by FIAS, the multi-donor

business environment advisory service of theWorld Bank Group. The study benefited fromthe inputs of Laszlo Csaba, Zsofi a Czoma, ImreVerebelyi, and Hungarian refugees who wish toremain anonymous. The publication benefitedfrom the valuable comments and supportof Vincent Palmade, Gokhan Akinci, PeterLadegaard, and Delia Rodrigo Enriquez.Florentina Mulaj, Doriana Basamakova, andPatricia Steele provided key comments andeditorial assistance in finalizing the draft for

publication.


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Contents

Executive Summary .............................................................................1

1. Context of Reforms ......................................................................... 3

2. Content of Reforms ......................................................................... 5

Goals 5

Reforms at a Glance 5

Impact of Reforms 12

3. Reform Process and Institutional Design ........................................ 15

Government Leadership and Strategy 15

Institutional Arrangements 16

Changes in the Civil Service and Public Administration 18Legal Reform 19

Management and Involvement of Stakeholders 21

Resource Issues 22

Monitoring and Evaluation of Reform Impacts 23

4. Lessons of Reforms ....................................................................... 24

Success Factors 24

Shortcomings 26

Lessons for Other Countries 26

References ......................................................................................... 28


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Figures1 Foreign Direct Investment in Four Central European Countries, 199098 ................ 13

2 Regulatory Quality in Four Central European Countries, 19962002 ..................... 14

Boxes1 Privatization in Hungary ..................................................................................... 7

2 The Guillotine: Reforming Hungarys Regulatory Framework .................................... 8

3 The Role of the Hungarian Competition Office ....................................................... 9

4 The Role of the Ministry of Justice ....................................................................... 18

5 EU Acquis Communautaire................................................................................ 20


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Among the most difficult challenges facinggovernments is designing, implementing, andsustaining government-wide, multiyear economicand regulatory reforms. Better outcomes are likelyif governments understand the institutional andpolitical economy mechanisms of successful

reforms elsewhere. This paper analyzes and drawslessons from Hungarys implementation of broadregulatory reforms in 198998 as part of itsunprecedented structural metamorphosis. Theseefforts culminated at the end of 1997 with recog-nition by the European Union (EU) that Hungaryhad become a functioning market economy.

The focus of this case study is not on the contentof the reforms, but on the events, strategies, andstakeholders that shaped structural reform efforts.

The reforms had a broad scope consistent withinternational consensus on how to approachregulatory reformthat is, by improving theinstruments, processes, and institutions of all formsof regulation through integrated strategies ofderegulation, re-regulation, and enhanced capacityfor higher-quality regulation that meet social needsand are consistent with open, competitive markets.

Hungarys transition was one of the most successfulin Central and Eastern Europe. Reforms led to aflood of foreign direct investment. A robust privateexport sector has emerged. And solid economicgrowth and low unemployment are helping thecountry meet EU benchmarks. This performance

is due to the efforts of successive administrationsthat, even before the 1989 change in regime,pursued structural and regulatory reforms as well asprudent macroeconomic policies.

Hungary began its transition with significantadvantages over other Eastern European coun-triesnamely, higher living standards and moremarket-oriented economic policies. Soon after thechange in regime the country undertook a majoradjustment that included bold market opening,

price liberalization, and structural reforms, as wellas stabilization measures. But by the mid-1990smacroeconomic performance had deteriorated,and unsustainable current account and fiscaldeficits had reemerged. The country respondedwith a second round of deep, far-reaching reformsthat included more aggressive regulatory reforms,including the famous guillotine processes.

EXECUTIVE SUMMARY


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Lessons from Hungarian reforms that are relevantto other countries are summarized below.

Success Factors

Democratic change and respect for the ruleof law provided political and social mecha-nisms that prevented a violent backlash,which could have caused a reversal ineconomic policyand a crisis.

The timing and sequencing of reformsstarting with market openness and laterdriven by the far more stringent requirementsof EU accessioncontributed to Hungaryssuccessful transition. Opening markets played

a vital role in anchoring structural and regula-tory reforms. Modernization of the stateapparatus came after structural reform.

Commitment to reform by the highest levelsof government was vital to changing theperceptions of foreign investors and lenders.

Reforms were strengthened by carefuladaptation of inherited and accepted institu-tions. International models were adjusted to

Hungarys situation using existing legal andadministrative frameworks.

Economic reforms were more successfulwhen driven by the center, but institutionalreforms were more successful when supportedby decentralized consensus, with ownership-building efforts led by ministries. One key tosuccess was the flexibility of Hungarianreforms in adapting to different politicaleconomy incentives for reform.

Government commissioners drove reformsbut lacked the institutional and legal backingto implement and sustain them. Hungarysapproach to interministerial reform gavecommissioners direct access to the highestlevel of government and provided them with

consultative bodies and specialized staff.Although this approach was successful indriving two guillotine processes, morepermanent institutions were needed toinstitutionalize good regulation habits in

the public administration. An active competition office was an influen-

tial driver of reform implementation,playing a vital role in advocating regulatoryreforms and blocking distorting measures.

Comprehensive, time-bound reviews ofregulations expedited deregulation andre-regulation. The courageous guillotinesystem eliminated obsolete regulations in just

a couple months. Still, policy aimed atsustainable changes in regulatory habits tendsto take decades, not years, to produce results.

Shortcomings

A focus on correcting old regulations missedan opportunity to reinforce the economicrationale for the emerging regulatoryframework, which required longer-terminstitutional reforms.

It was easier to control the stock than theflow of regulations, as shown by repeatedfailures to introduce regulatory impactanalysis. Efforts to deregulate show thatimproving the stock without checking theflow of new regulations raises long-termcosts and does not sustainably improve thebusiness environment.

Speed was important for some economicreforms, but more time is needed whenreforming and building institutions. Some ofthe most important reforms involved trans-forming the legal and institutional setuprequired for markets to function. Such reformsrequire longer, more consensual approaches.


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1. CONTEXT OF REFORMS

Between 1989 and 1998, Hungary moved tocreate a market-based economy by fundamen-tally reorienting the institutions and legalregimes built for socialist economic policiesafter World War II. During this period,Hungarian society also embraced the develop-

ment of a more open, democratic politicalsystem. These dual goalsmarket economicsand democracyframed Hungarys balanced,pragmatic approach to reforms. From the startthe new roles expected of the state in uphold-ing procedural values, such as respect for therule of law and consultation with stakehold-ers, were pursued simultaneously with aggres-sive reforms aimed at increasing economicgrowth.

These reforms did not happen in a vacuum: thecommand and control economy was on its wayout before 1989. By the 1970s, an economic policyknown as goulash communism (which reliedheavily on money borrowed from foreign coun-tries) had transformed Hungary into the mostadvanced country in the Soviet bloc in terms ofliving standards. But large foreign debt and rising

1 In 1982, the government announced that Hungarians werefree to travel to the West. That same year, Hungary joinedthe International Monetary Fund and the World Bank.

inflation and unemployment led to publicdiscontent with the government. As a result, agroup of reformers took power in the mid-1980s.

These communist reformers made cautious butsignificant changes that laid the foundations for

a market economy.1

In particular, they beganusing financial and monetary instruments inplace of fixed controls on production, wages,and prices. Other important reforms includedmodernizing the commercial code, enacting acompetition law, developing the tax system,formalizing legislative and rulemaking processes,and passing laws on companies, capital markets,and foreign investments.

Nonetheless, by the end of the decade the soft

transition model was encountering problemsand contradictions. Semi-markets did notprovide enough incentives and information toproducers and consumers. Distorted economic


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decisions at lower levelssuch as party decisionson state enterprise investments and humanresource policieswere accumulating intomacroeconomic problems. In addition, thegovernment decided to control unemployment

by taking on debt, which grew alarminglyduring the 1980s. Inflation spiraled to double

digits, and the melding of the party and govern-ment created enormous opportunities for rentseeking and corruption. By 1988 the macroeco-nomic situation had become very serious, andthe government had little room to maneuver. In

1989, as external conditions changed, Hungaryentered a new phase in its reforms.


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As noted, economic transformation had alreadybegun before the political upheaval of 1989. Butduring the following decade, in negotiated andpragmatic wayssometimes measured, some-times boldthe legal and regulatory frameworkwas almost completely transformed, changing

the business environment entirely.

Goals

Although an overall blueprint for reform wasnever made explicit, policymakers pursued aclear goal of converging as quickly as possiblewith the Western European economic and socialmodel, and ultimately joining the EuropeanUnion. Policy and institutional reforms, includ-ing constitutional amendments, consistently

focused on building a market economy andestablishing democracy and the rule of law.Hungary was guided by historical traditions,since its new order was based on the structuresof its pre-socialist civil law system, which wassimilar to those of Austria and Germany.

Economic and institutional reforms involvedmutually reinforcing policies, including market

openness, privatization, liberalization, deregu-lation, re-regulation, and institution buildingacross all organs of the state.2 The search for abetter approach to reforms required a constantand difficult balancing between less interven-tion and better intervention (as well as inter-

vention in new areas). But while reform effortsfluctuated, they never stopped. Administrationsfrom different political parties were consistentin their commitment to achieving the Euro-pean model and joining the European Union.

Reforms at a Glance

Major changes came in two main waves sepa-rated by a calmer period (during which therewas some backtracking). The calmer periodseemed to reflect social consensus on the need toconsolidate and regroup, with almost no oneadvocating radical reforms during that time.

2. CONTENT OF REFORMS

2 Hungary also experienced other transformational reformsnot analyzed in this paper, including a major decentraliza-tion process started in the early 1990s, civil service reform,and a new power sharing mechanism between branches ofthe state.


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The First Wave: The Great

Adjustment, 198990

In 1987 the government began privatizing restau-rants and commercial outlets. These reforms werespearheaded by a group of reformists who took

over the Communist Party Politburo. In 1988 theparty created the Reform Committee, whichdeveloped a reform program calling for Hungaryto adopt a self-regulating market economy basedon private ownership and reorientation toward theWest. The government ensured representationacross the political spectrum within the committee.

In early 1989, confronted by serious economicproblems and major political changes through-out Eastern and Central Europe, the govern-

ment accelerated reforms. As a result of historicmeetings that summer, the National Assemblyunder the guidance of Communist Partymadefundamental changes to the Constitution inOctober 1989. Regime change was complete.Within a few weeks the government launchedthe Great Adjustment with comprehensivepolicy reforms based on two pillars: structuralchange and legal and institutional renewal.

To manage the structural reforms, the government

restored the powerful Reform Committee, sup-ported by two subcommitteesone working onmarket openness and the other on general eco-nomic policies. A dozen advisers were appointed toassist the head of the committee and managed tocircumvent the formal hierarchy. The NationalPrice Office also played a prominent role inanalyzing, designing, and implementing reforms.

The structural reforms were grouped into threecomprehensive packages that amounted to

economic shock therapy:

Market openness, ending four decades ofcommand and control economic regimes.

Price and trade liberalization, includingmajor deregulation of economic interven-tions, a revamped tax system, establishmentof a stock exchange, and creation of amarket-based banking system.

Massive privatization of means of production(Box 1).

The second pillar of the Great Adjustment calledfor the de-communization of the legal frame-

work, introduction of institutions needed to securedemocracy and the rule of law, and launch of thecomplex transformation of the state and adminis-trative apparatus. To achieve these goals, thegovernment assigned two high-level commissionersto manage a comprehensive legal and regulatoryimprovement program based partly on the deregu-lation experiences of the United Kingdom, UnitedStates, and other countries in the 1980s. Theseefforts were split between the newly createdEconomic Deregulation Council and Public

Administration Deregulation Council. The Officeof the Council of Ministers provided administra-tive support to the former, and the Ministry ofInterior to the latter. The Office of the Council ofMinisters paid the costs of consultants for both.

In less than two years (spanning a change inadministration), the two commissioners created anew legal and regulatory order based on therevised Constitution, which clarified and limitedthe use of subordinate regulations (those at the

level of government decrees). In particular, amassive guillotine review eliminated outdatedand unneeded regulations and deregulated theremaining legal framework as much as possible(Box 2). The core idea guiding this approachwas that measures not explicitly justified after asix-month review were automatically abolished.

In managing reforms, the main difficulty involvedbuilding a well-functioning, sustainable legalframework. Deregulating economic regimes waseasier than building the social, civil, and adminis-trative institutions and frameworks needed for arule-based economy. The adoption and adapta-tion of economic rules, procedures, and systemscould be based on international precedents,consensus was easier to achieve, and legal imple-mentation was simpler. By contrast, the establish-ment and functioning of new democraticinstitutions required political consensus for everymajor decision, and so took much longer.


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BOX 1

Privatization in Hungary

In Hungary privatization was a steady process that started in 1987, slowed somewhat before and immediately

after the 1994 elections, and picked up again in 1995. By then the government had liquidated more than half ofthe over 2,000 enterprises it owned previously. Privatization of apartments and small and medium-size enterprisesoccurred quickly, and sales of farms were largely complete by 1994. By contrast, privatization of industry pro-ceeded unevenly, and little was done until 2002 to privatize the largest state enterprises and network companies.

Most privatization involved direct sales of assets through management buyouts and employee stock ownershipplans. In addition, restoration in kind and restitution through transferable securities played a limited role. Negoti-ated mechanisms made the process slower to start than in other countries, where mass privatization and bigbang strategies were in vogue. A particular difficulty involved sales of land to local governments where the cen-tral government negotiated the transfers using complex structures and procedures.

The direct sales method ending up favoring foreign investors. Still, the privatization program managed totransfer assets to genuine private interests rather than institutional owners. Selling to private owners wasimportant for strengthening corporate governance, entrepreneurial incentives, and the middle class.

In 1997 private fi rms accounted for nearly 80 percent of GDP. By the end of the 1990s almost three-quartersof the countrys assets were in private hands, with nearly 40 percent held by domestic investors and the restby foreign investors. The central government held 16 percent of assets, local governments 9 percent, andother nonprivate institutions 2 percent.

Source:Voszka 1999; OECD 2000.

Altogether, more than 150 laws and regulationswere eliminated or modified under the firstguillotine review (using a special omnibus law,the Deregulation Act of 1990). A series of

Ministerial Council decrees did the same forsuperfluous or harmful subordinate regulations.But this first systemic review did not address theeconomic soundness of laws and regulations. As aresult, the deregulation process dismantledregulatory requirements and bureaucracies insteadof modernizing economic regulations.

Still, other structural reforms greatly modified theeconomic and business environments. Liberaliz-ing trade and inviting foreign investment were

probably the most important policy changes instimulating the development of a competitivemarket culture (Kovcs and Szbo 1997).

A Slowdown, 199094

After the 1990 elections, Jzsef Antalls adminis-tration slowed the impetus for reform, andfocused on implementing reforms and buildinginstitutions. The deceleration in economic reforms

and privatization was linked to a social backlash.Structural reforms and privatization were creatinghardships for citizens, workers, and firms. Cuts insubsidies led to higher prices for food, medicine,

transportation, and energy. Reduced exports tothe former Soviet bloc and shrinking industrialoutput contributed to a sharp drop in GDP.Privatization and restructuring also increasedunemployment, which reached about 12 percentin 1993. In addition, a damaging taxi driversblockade destabilized the government. In re-sponse, in 1991 the government launched aprogram to stimulate the economy using anartificial squeeze on interest rates.

Despite the slowdown in reforms, this periodbrought important legal and regulatory changesbecause many existing measures had to beadapted to the new constitutional order andeconomic framework implemented during theprevious phase. The period also provided anunexpected, beneficial chance to increase thebureaucracys support for reforms. A broadersense of ownership developed, underpinning thesustainability of key institutional reforms, because


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BOX 2

The Guillotine: Reforming Hungarys Regulatory Framework

During its two main waves of reforms Hungary experimented with a range of methods for reviewing the

extensive regulations that had accumulated over four decades of socialist economics. These can be dividedinto systematic and special reviews.

Systematic reviews embraced a complete, itemized assessment of the entire stock of regulations. The fi rst suchreview occurred in 198990 and focused on removing elements of the previous regime from laws, subordi-nate regulations (such as government decrees), quasi regulations (such as guidelines), and local measures. Asecond review, in 199495, had more ambitious goalsincluding improving the effi ciency and effectivenessof the public administration.

Both reviews took a guillotine approach, which involves automatic repeal after a prescribed period oftargeted measures that cannot be justifi ed by a line ministry to a challenging body. In Hungary the challeng-ing body was made up of commissioners responsible for deregulation (two for the fi rst review, one for thesecond). The guillotine reviews proceeded as follows:

The Ministry of Justice prepared an inventory of existing laws and regulations.

Based on this inventory, line ministries presented commissioners with detailed schedules covering thepreceding period. (The fi rst review assessed laws and regulations in place before 30 June 1990; thesecond covered laws and regulations enacted after that date.) The ministries indicated which measuresshould be maintained and why, and which could be repealed or amended. If ministries proposedamendments, they had to provide draft legal text. Special justifi cation was required to maintain any regula-tions enacted before October 1989.

Commissioners and their teams evaluated regulations based on set criteria and could recommend rejectingministry proposals or ask for further analysis.

The Ministry of Justice prepared a deregulation instrumentto be issued by the government and pre-sented to the Parliamentlisting regulations to be abrogated.

The results of the two guillotine reviews were significant, particularly in terms of deregulation of subordinate

regulations. But in some cases the deregulation was too sweeping, as it created a legal vacuum and practicalproblems for implementation.

Another type of systematic review, in 1997, involved listing all authorizations and licenses affecting 10 keysectors. The commissioners assessed each authorization in an effort to transform it into a notifi cation, reduceauthorities response time, decentralize it to local governments, replace it with a self-regulation schemeenforced by business organizations, or supplant it with performance standards.

The government also used special sectoral and policy reviews, based on expert opinions and focusing onparticular topics. The most important were:

Reviews proposed by independent experts selected by the commissioners. The experts also proposedregulatory solutions.

A national consultation on deregulation suggestions organized in 1995. A country-wide media campaigncollected opinions of enforcers, entrepreneurs, and citizens, then presented them at a meeting attended bythe prime minister and the press.

Brainstorming sessions with senior lawyers, representatives of chambers of commerce and industry, anddomestic and foreign businesspeople.

A review of several hundred municipal rules and regulations.


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of discussions in Parliament and because thedesign and implementation of reforms wereassumed by line ministers who solicitedcooperation from civil society and market players.

Moreover, the Antall administration succeededin building consensus on key non-economicreforms and supervising active institutionbuilding that anchored democracy and the ruleof law. These efforts were presented as a neces-sary re-regulation of a gangster capitalism thatwas supposedly emerging in the poorly regulatedmarket. Especially important was the enactmentof framework laws like the Bankruptcy Act(1991), Privatization Act (1991), AdministrativeJurisdiction Act (1991), Civil Service Act

(1992), and Parliamentary Ombudsman forCivic Rights Act (1993). The government alsoinitiated an ambitious decentralization initiativethat continued in following administrations(Local Self-Government Act of 1990).

In addition, central framework institutions suchas the Ombudsman and the Audit Office werereestablished or recreated. This period also sawthe development and strengthening of pivotalbodies such as the Hungarian Competition

Office, which replaced the National Price Officein 1991 and played a crucial role in the 1990s(Box 3). This office was a key advocate of reform,explicitly and implicitly. It focused on economicregulationsspecifically, the legal framework formarkets after privatization. Institutionalization ofthe offices advice during rulemaking procedureswas crucial to blocking the most burdensomeproposals from line ministries and agencies. Thecompetition office also participated indirectly inthe two guillotine reviews.

Despite having less reform momentum, thegovernment also continued to advance economicreform. The intellectual engine of such reformemerged as a standing Economic Commission

BOX 3

The Role of the Hungarian Competition Offi ce

Hungarys competition policies and institutions are in line with the practices of OECD countries. Indeed,

competition policyas measured by the status and independence of the competition agencyis strongerin Hungary than in many countries.

The Hungarian Competition Offi ce is active, well-staffed, and widely respected in the government and theprivate sector. The head of this independent offi ce has ministerial rank and direct access to policy discussionsat the highest levels. (In most OECD countries the top offi cial for competition policy does not have ministerialrank.) The offi ce also has the power to challenge in court anticompetitive actions by other public agencies.Although the offi ce has never used that power, the threat probably increases i ts clout in policymaking.

The competition offi ce is in charge of traditional competition policy tasks, ensuring that:

Horizontal agreements do not allow groups of fi rms to achieve attributes of monopoly, such as raisingprices, limiting output, or preventing entry or innovation.

Vertical agreements do not allow exclusive control over distribution or allow fi rms to dominate sectorsor become monopolies.

Mergers are not used, through acquisitions or other structural combinations, to exercise market power.

The offi ce is required to be active in advocating competition through reviews of draft laws and regulations. Itsadvice should be sought on all draft proposals or legislation that could restrict competition, grant exclusiverights, or regulate prices or terms of sales. From an early stage, the offi ce became active in reporting con-straints on competition in existing regulations and participating in the governments policy developmentprocess, despite its independent status. The offi ce was particularly infl uential during privatization.

Source:OECD 2000, ch. 3.


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headed by the minister of finance. Commissionmembers included ministers primarily respon-sible for economic matters and two observers:the heads of the National Bank of Hungary andthe Hungarian Competition Office.

Aside from the social backlash, one reason reformefforts dissipated during this period was for lack ofan institution with a clear mandate to drive them.Despite an array of market-based bodies like thecompetition office, no institution or senior officialwas responsible and accountable for promoting andcoordinating reform efforts. An effort to developsuch an official for regulatory reform was made in1992, when the minister of justice was mandatedto implement a modernization program for the

public administration, including a simplificationplan for administrative procedures. In addition, twoadvisory bodies that supported the governmentthe Blue Ribbon Commission and a consultativebody of national and international experts in-tended to create an action plan for economicpolicyfailed to influence decisionmaking.

Aside from the conclusion in 1991 of market-opening reforms, most significant reforms duringthis period were sectoral rather than systemic. But

even the sectoral reforms were often incomplete,due to weaknesses in national and municipaladministrative capacity, unresolved politicalconflicts about policy goals, and competinginstitutional interests within the government. Theresult was incoherent regulatory policy. Legal andregulatory reforms were often changed or under-cut by ad hoc political interventions. Reformproposals from the minister of finance weresystematically opposed by other members of theCabinet, who feared social unrest. Even when

reforms were adopted, implementation oftendeviated from stated goals. Wide variation in theapplication of new laws and regulations increasedbusiness insecurity. And after the minister offinance was demoted, economic reforms nearlycame to a halt.3

Despite the governments stimulus package, theeconomy did not improve. Indeed, decliningoutput and rising social transfer costs led topolitical and social pressures to further slowreforms. A vicious cycle emerged in which

reforms were blamed for lack of economicprogress, further slowing them and furtherundermining the transition.

The durability of the Antall administrationgradually eroded, and the Cabinet became plaguedby internal divisions and falling popularity. Antallsdeath in December 1993 symbolized the end of hisadministration. (Pter Boross carried out the rest ofAntalls term, through July 1994.) In response tosocial pressures nurtured by corruption scandals,

the political pendulum shifted again to the center-left party. The costs of government overspendingand hesitant privatization had become clearlyvisible. And Hungarys external debt, among thehighest in Europe, reached 250 percent of annualexport earnings, while budget and current accountdeficits approached 10 percent of GDP. Antallsparty lost the spring 1994 election.

The Second Wave, 199498

The new administration of Prime Minister

Gyula Horn did not bring an immediate reversalin reform momentum. For the first few monthsthe government maintained the previousapproach, hewing to conservative lobbies. Butinternational pressures and continuing macro-economic deterioration forced a second wave ofradical reforms (Csaba 1998).

In 1995 the government implemented an austerityprogramknown as the Bokros packagesecretlyprepared by Minister of Finance Lakos Bokros. 4

(The secrecy was mostly due to the need toprepare a surprise devaluation of the forint.) Thepackage had macroeconomic and microeconomiccomponents. Reforms focused on economiceffectiveness and efficiency, which were able toonce again take center stage because the basics of

3 In September 1993 the International Monetary Fundsuspended a standby loan for lack of progress on structuralreforms.

4 The secrecy was mostly due to the need to prepare asurprise devaluation of the forint.


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democracy and the rule of law were in place. Thepolicy emphasized attracting strategic foreigndirect investment in energy, telecommunications,transportation, and banking (OECD 2000).

The package coupled aggressive privatization ofstate enterprises with an export-promotingexchange rate regime to reduce debt, with thegoals of cutting the current account deficit andshrinking public spending. To advance institu-tional and administrative reform, and as part ofthe austerity measures, the government reorga-nized executive bodies and agencies. Institutionswere merged and privatization accelerated.

The government also made the reform process

more coherent by recentralizing policymaking ina strengthened prime ministers office. PrimeMinister Horn managed the austerity packagehimself, and assigned responsibility for regulatoryreform to a single Commissioner for PublicAdministration, Imre Vereblyi, supported by astrong Deregulation Council. The commissionerspower grew as the prime minister charged himwith making a 15 percent cut in the civil service.However, no specific coordination was establishedbetween the commissioner and the Ministry of

Finance taskforce overseeing the Bokros package.Commissioner Vereblyis agenda includedtackling the negative results of earlier reforms.As noted, initial zeal in deregulation createdgaps in market rules that encouraged abuses.The business environment had to be regulatedto distinguish between entrepreneurial andcriminal activities. As part of his efforts to dothis, the commissioner launched a secondguillotine review (see Box 2). He also introduced

an initiative to help local governments reviewand reform their decrees and resolutions, andwith help from several think tanks prepareddirectives and methods for that purpose.

Vereblyi also initiated the first systematic effortto improve regulatory management and qualitycontrolin particular, ex ante assessment of thepotential impacts of regulations. But efforts at

regulatory impact analysis did not prosper. Theywere too complex, a common failing of first-time regulatory impact analysis initiatives bywell-meaning reformers. Too few incentives werebuilt into the scheme, which was based on

top-down mandatory requirements and highlytheoretical guidance materials. The system couldnot overcome resistance and skepticism fromentrenched legal departments in line ministries.

On the other hand, an important success ofCommissioner Vereblyi was a drastic control,simplification, and reduction of licenses,authorizations, and permits. Modifications to theAdministrative Procedure Law tightened rulesrequiring prompt decisions on submissions and

applications. In addition, a useful program ofone-stop shops was initiated.

These regulatory reforms were paralleled by majorstructural reforms in 199697, such as implemen-tation of a fully funded pension system, reform ofhigher education, and creation of a nationaltreasury. In 1997, the government asked Commis-sioner Vereblyito start focusing on adopting EUlegislation to support the path to a 1998 agreementto launch an EU accession process for Hungary.

The overall results of these reforms were positive,though the governing party ending up losing the1998 elections. In particular, the Bokros packagewas an economic success. After Hungarys GDPdropped about 18 percent between 1990 and 1993and grew only 1.01.5 percent a year through1996, strong export performance propelled GDPgrowth to 4.4 percent in 1997. Other macroeco-nomic indicators were similarly improved. By theend of 1997 the consolidated public sector deficithad decreased to 4.6 percent of GDP, with publicsector spending falling to less than 50 percent ofGDP. The current account deficit was reduced to2 percent of GDP, and government debt was paiddown to 94 percent of annual export earnings. Thereturn of macroeconomic stability enabled micro-economic reformsregulatory reforms being themost importantto produce more benefits as theprivate sector began to grow strong again.


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5 According to Berend (2001), the transition will be overwhen the transforming countries achieve the economic levelof the least developed EU members. The InternationalMonetary Fund has projected that, if Hungary sustainsannual growth of 4.56.0 percent (against an assumed3 percent in low-income EU countries), it will take 2025years to reach that level.

The 1998 elections brought back a central-rightparty led by Prime Minister Viktor Orban.Though many reforms continueddriven by theEU accession processthe government slowedtheir pace and launched some unhelpful populist

economic initiatives. In particular, privatizationslowed significantly and some nationalizationswere carried out. A central focus of reform becameaccelerating and completing Hungarys decentral-ization. The government also raised wages andfavored domestic over multinational companies.

Between 2002 and 2004, the administration ofPter Medgyessy pushed again for free marketreforms and relaunched some privatizations ofbanks. Many observers have suggested thatMedgyessy was trying to match the gains of the199498 reforms, for which he was one of thearchitects.

Impact of Reforms

Between 1989 and 1998, Hungary underwent afundamental economic and social transformation.A pillar of this transformation was the definitionof a new role for the state, which evolved from aninterventionist, command and control approach

toward a steering, motivating role consistent witha market-based democracy. The transformationprovided important economic benefits, and sincespring 2004 Hungary has been among the newEU members best prepared to integrate, compete,and flourish in the European Union.5

General Economic Performance

Until the 1989 regime change, 65 percent ofHungarys trade was with other Soviet bloccountries. By the end of 1997, Hungary had

shifted much of its trade to the West, with EUcountries accounting for more than 70 percentand OECD members for 80 percent. Germany

became Hungarys largest trade partner. TheUnited States was its 6th largest export market,while Hungary was the 72nd largest export marketfor the United States. Bilateral trade between thetwo countries increased 46 percent in 1997,

reaching more than $1 billion.A dramatic increase in foreign direct investmentwas key to Hungarys transition economy. Be-tween 1990 and 1998 it was the largest recipientof such investment in Central Europe (relative toGDP; Figure 1). With about $18 billion inforeign direct investment since 1989, Hungaryattracted more than a third of all such investmentin Central and Eastern Europe, including theformer Soviet Union. Foreign capital was at-

tracted by the countrys skilled and relativelycheap labor, tax incentives, location, and decenttransportation and telecommunications.

Reforms also improved the business climate fordomestic firms. As a result of privatization,liberalization, and deregulation, the privatesector generated 85 percent of GDP by the late1990sa larger share than in many OECDcountries. Private investment grew by an annualaverage of 9 percentat the end of that decade,led b

y industrial investment. Domestic capitalaccumulation increased. And services as a shareof GDP increased from 55 percent in 1990 to63 percent in 1994 (Berend 2001).

In addition, reforms revitalized and promotedbusiness-like behavior and entrepreneurialism.Hundreds of thousands of new enterprisesemerged, most family-owned. Businesses becamean important constituency favoring reform.Small and medium-size enterprises became theengine of economic growth and a major factor ineconomic restructuring. By the mid-1990s,growth in employment at such enterprises startedto compensate for the heavy job losses caused bymarket openness, liberalization, and privatiza-tion. Employment levels stabilized in 1997 andincreased slightly in 1998 (Bag 2000). By 2000,employment had risen to 2,718,000, and firmswith fewer than 50 employees accounted for halfof GDP and three-quarters of employment.


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Source: UNCTAD Database.

FIGURE 1

Foreign Direct Investment in Four Central European Countries, 199098

InwardFDIStockas%ofGDP

1990 1991 1992 1993 1994 1995 1996 1997 1998

45%

50%

40%

35%

30%

25%

20%

15%

10%

5%

0%

Czech Republic Hungary Poland Slovak Republic

Specific Impacts

The two systematic (guillotine) reviews of lawsand regulations led Hungary to construct analmost entirely new legal framework. By 1998the countrys regulations had reached a higherstandard than those of neighboring countriesatrend that has continued since (Figure 2).

Regulatory reforms aimed at creating and securingthe rule of law became a major political invest-ment, as they became a precondition for HungarysEU membership. Subsequent administrationsstrived to comply with the so-called Copenhagencriteriainstitutional and rule of law standards setby the European Union that had favorable reper-cussions for economic and structural reforms.

Hungary was also quite successful in its deregula-tion efforts, particularly the use of the twoguillotine processes. The reviews eliminated animpressive amount of legal deadweight andreduced discretion in the application of manyregulations, and so minimized opportunities forabuse and corruption. Three deregulation legalmeasures led to the abrogation of several hun-dred laws. Successive reforms included the

elimination of laws, central government decreesand resolutions, and ministerial regulations in1995, elimination and reform of internationalagreements and directives of state secretaries in1997, and elimination of more than 220 otherlaws in 1998.

The simplification program launched during theHorn administration also eased administrativeburdens. Although no evaluation has been madeof the impact of licensing reforms, part of theimpact was due to a 15 percent downsizing ofthe civil service in 1995. In addition, successiveinitiatives (formal and informal) enhanced theopenness of government procedures. Publicparticipation and consultation on rulemakingbecame common across the administration, and

in 2000 became mandatory.Still, these achievements cannot mask two majorweaknesses that remain partly unresolved:

Although the legal and regulatory reviewsreduced many measures (and eliminatedunderpinning communist rules), they did notchange the economic substance of remainingmeasures that were often far more important.


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Some ministries eliminated trivial measuresthat were not used, but maintained otherregulations that were more costly for busi-nesses and society.

Despite several efforts by the government andthe commissioner in charge of emergingregulatory policy, the establishment of anempirical approach to developing new lawsand rules repeatedly failed. Though in theoryregulatory impact analysis was required, inpractice it was not conducted in 198990 or199094 (for the guillotine reviews).6Similarly, regulators used regulatory impactanalysis only occasionally during 199497. In199798, just seven draft laws were accompa-nied by quantitative justifications. Suchanalysis was conducted mostly on nonurgentmeasures not involving political resistance.Implementation of reform proposals, andspecifically of regulator impact analysis, alsosuffered from a shortfall of analytical tech-niques and capacity in ministries.

6 The 1987 Law on Legislation requires quite a developedjustification reportin many ways close to a regulatoryimpact analysis.

Nevertheless, the constant push for economic andinstitutional improvements changed perceptionsof Hungarian markets among foreign and domes-tic investors. Deregulation and market liberaliza-tion produced a more competitive economy andshaped a more entrepreneur-friendly environ-

ment. For instance, the 1995 Bokros package andits structural and institutional reforms galvanizednational and international markets.

These promising efforts notwithstanding, Hun-gary had not finalized reforms by 1998. Indeed, itstill faced many challenges and fell short ofleading countries on the quality of its businessenvironment. Remaining economic problemsincluded the need to tackle regulatory andstructural reforms in public infrastructure (trans-

port, energy, telecommunications), the tax system,the health care system, employment, and localgovernment financing. Still, by the end of 1998Hungary had achieved its main goal of changingthe economy and public governance in anticipa-tion of the countrys accession to the EuropeanUnion. By then, regulatory reform becameembedded into the massive effort of transposingthe EU legislative corpus.

FIGURE 2

Regulatory Quality in Four Central European Countries, 19962002

Source: Kaufmann, Kraay, and Mastruzze 2003.

Hungary Czech Republic Poland Slovak Republic

1.40

1.00

1.20

0.80

0.60

0.40

0.20

0.00

RegulatoryQualityIndex

1996 200220001998


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Several factors explain Hungarys successandshortcomingsin reform. Government leader-ship and institutional adjustments were crucial,as were changes to the public administration,though the latter have been slower to advance.Legal reform was crucial to the development of a

market economy, and stakeholders at all levelswere consulted and involved in changes. Butlimited resources slowed some reforms, andinadequate monitoring and evaluation under-mined the success of many.

Government Leadership and Strategy

Between 1989 and 1998 successive prime minis-ters generally backed reform. The focus of theirsupport evolved as the reforms and society

changed. At the beginning, the overall objectivewas to secure democracy and the rule of law,anchored to a market-based economy. Later thegoal evolved into joining the European Union,which political leaders believed would first requirejoining the OECD (1995) and North AtlanticTreaty Organization (NATO; 1999). But theintensity, approach, and management of reformsvaried according to the three administrations in

charge during this period, which swung from leftto right and back again.

Three strategic elements of the Hungarianapproach to reforms are worth noting. First, thereforms were pragmatic. Since the regime

change of 1989 the effect of reform on seniorgovernment officials has been measured andincrementalthough accelerated by the move-ment of many officials into politics and busi-ness. Hungarys negotiated revolution allowedfor institutional changes that accompaniedradical economic reforms, but did not toleratewitch hunts. Many leading officials of the oldregime enjoyed renewed tenures and late retire-ments (Csaba 2000). Some key actors remainedat the center of the reforms, while others stayed

in power long enough to support them.

Second, the government pushed for concerted,legally based reforms. Even during the two strongwaves of reform and the launching of an austeritypackage (in March 1995), the rule of law waspreserved. Parliament was always actively en-gaged, and democratic elementssuch as thor-ough consultations with all social partners and

3. REFORM PROCESS AND

INSTITUTIONAL DESIGN


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7 In 1998 Parliament opened the council to new interests,transforming it into the Economic Council. In addition tothe social partners, actors like the Hungarian National Bank,Bank Association, Stock Exchange Council, representativesof multinational investors, and economic chambersparticipate in the Economic Council.

opposition memberswere considered funda-mental. During this period a key institution wasthe Council for the Reconciliation of Interests(created in 1990), which built a social dialoguewith businesses and trade unions.7 A second

council, the Social Council (1991) primarily dealtwith the problems of disadvantaged social groups.It sought to identify opinions and problems, andreconcile them by providing information onvarious endeavors and helping to prepare amelio-rating legislation (Bag 2000).

Third, reform strategies alternated betweentop-down and bottom-up approaches. A spark-ing effort from the top of government wasneeded to launch deep-rooted changes and

overcome resistance and apathy. In 1989 ener-getic early reformers designed and launched theGreat Adjustment program. In less than twoyears Hungary had a reformed constitutional,legal, and regulatory framework. A top-downapproach was also pursued in 199596, whenthe Horn administration designed and drove asecond major round of structural, institutional,and legal reforms. Without strong pushes fromthe highest levels of governmentthe guillotinereviews, the Bokros package, and other strong

medicinereforms would have dissolved amidbureaucratic wrangling and opposition.

Between the two waves of reforms a more consen-sus-building, bottom-up approach was used. Thisshift in tactics was caused by the distaste thatdemocratically elected governments had devel-oped after 40 years of a command and controlapproach under communism. Based mostly onexperience, Hungarian leaders knew that success-ful markets required a democratic, legally based

system. During the 1980s the semi-market regime,run by a soft political dictatorship based onobscure and unaccountable orders from the top,

had distorted and restricted markets. Theresulting abuses and inefficiencies reflected theworst of both systems.

The bottom-up strategy pursued by the 199094

Antall administration was also a response to theunexpected backlash against reformers andunelected technocrats. The resistance thatemerged during the painful taxi drivers strike of1990 scared the Cabinet and reminded policy-makers how social unrest could explode and causepolitical disruption (negative in 1956; positive in1989). The bottom-up approach provided anopportunity to reach consensus and settle institu-tion building arrangements, particularly ondecentralization and civil service reform. Such

arrangements typically required more time anddialogue than purely structural changesat thecost of losing competitiveness relative to neigh-boring countries. Indeed, after a few years thebottom-up approach led to policy paralysis andconstant bickering among ministries that weredesigning and implementing reforms.

Institutional Arrangements

In less than a decade Hungary underwent an

almost complete overhaul of its institutionallandscape. Analysis of the institution buildingexperience can be split between the central andadjunct bodies that implemented the reforms.

Driving Institutions

Just as the reform strategy alternated between atop-down and bottom-up approach, so did theinfluence of central institutions. Management ofHungarys reforms fluctuated between strong

central institutions that pushed the processesand a weaker center that acted as an informationdispatcher and coordinator. Consequently, therole of the prime ministers office also varied.

The prime ministers office played a pivotal roleduring the two main reform waves. MiklsNmeths administration (198890) inherited thestructures and traditions of the command and


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control regime and was able to use them to drivethe Great Adjustment. The Horn administration(199498) recognized the need for coherence andcohesion at the center to manage the response toa looming external crisis. During these two

centralization phases the government was able torecover processes inherited from the Austro-Hun-garian tradition. In contrast, the Antall adminis-tration (199094) tended to use the primeministers office as an information dispatchingbody working primarily as the secretariat of theCabinetdespite the fact that, constitutionally,the office was strengthened considerably in 1989.

In terms of institutional machinery, the main toolsused during the two pushing phases were the

creation of ad hoc and informal taskforces domi-nated by the Ministry of Finance but closelylinked to the prime minister, and the establish-ment of formal government commissionersworking from within the prime ministers officewith a clear mandate. The first tool was used todesign one-off reforms that were later imple-mented by line ministries or specific agencies (suchas the privatization agency or competition office).The second was expected to operate longer andengage in laborious reforms like deregulation and

the modernization of the public administration.The two deregulation commissioners during theNmeth administration and the single commis-sioner during the Horn administration hadaccess to the prime minister through dailyreporting. Their mandates and powers allowedthem to make demands on line ministers. Thecommissioners were able to influence the tradi-tionally decentralized ministries based onministerial accountability to the Cabinet and

Parliament, often reflecting the weight of govern-ment coalition partners. If there was seriousdivergence in opinion, the commissioners couldexpress their views to the prime minister andrequest arbitration. Although the commissionerslegal and administrative positions were ambigu-ous inside the structure of the prime ministersoffice, their status was outside the formal hierar-chy (that is, they were not legally mandated

agencies). This status made them better able toadvocate, design, and implement reforms.

Still, even when the government consolidatedpower in the hands of a super minister orcommissioner, it required some accountabilityand openness. Committees were establishedwhere various ministry officials and outsideexperts discussed the proposals and evaluated theundertakings of the commissioners.

As often happens when mandates are centralizedand personalized, coordination and cohesiontended to suffer during the waves of rapidreforms. Communication problems tended tosurface despite the existence of interministerialforums and improving bureaucracy in the primeministers office. Little communication andcoordination occurred between economic andlegal reformers, or between the commissioners.In contrast, the approach taken by the Antalladministrationbased on a weak prime minis-ters office and more collegial decisionmakingtended to increase ownership and acceptanceduring institution building efforts. Responsibil-ity for pushing deregulation and modernizationwas assigned to the Ministry of Justice, with

unsatisfactory results (Box 4).

Supporting Institutions

Whether top-down or bottom-up, reformscannot be sustained and expanded without aweb of supporting institutions. Reforms drivenby single ministrieseven a powerful ministryof financeare hard to sustain in case ofbacklash or a change in administration. Morethan other transition economies, Hungaryengaged in institution building. From the start,the government focused on developing theinstitutionssuch as the competition office,privatization agency, and various sector-specificregulatorsneeded to implement reforms.

The competition office has played an especiallycrucial role in Hungarys reforms, particularlyduring privatization (see Box 3). Sector-specific


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BOX 4

The Role of the Ministry of Justice

Following Central European tradition, Hungarys Ministry of Justice was considered the master of all laws and

regulations. Thus, the Ministry of Justice was in charge of deregulation and re-regulations except during thetwo major waves of reforms (which were handled by commissioners). In addition to maintaining administrativetradition in a quickly changing institutional landscape, the ministrys active involvement ensured that regulatoryreform policy remained close to the owners of the legal information and supported by adequate legalexpertise and institutional memory.

But delegating regulatory reform to the Ministry of Justice in 199094 (and since 1998) seems to have causedmajor problems in managing the reforms and improving regulation. As has been seen in other countries, it isdifficult to merge the goals of improving the legal quality of drafts and infusing economic principles into the law.The latter was neglected by the Ministry of Justice, which lacks economic competence and is often overburdenedwith reforming its traditional areas of expertise (civil and criminal legislation and courts). As a result, reviews of thelegal environment assigned little importance to substantive deregulation relative to the technical qualities of a draft.

Perhaps more damaging from a structural and hierarchical perspective, the Ministry of Justices efforts and

policies were easily challenged and ignored because it was perceived as small, politically weak, and notsuperior to other line ministries producing laws and regulations.

8 The dominance of lawyers in the policymaking structuremight also hamper the need to instill greater empirical andmarket methodssuch as ex ante and ex post evaluationsinpolicies and regulations (SIGMA 1999).

regulators, created to implement key reforms innetwork industries, include the CommunicationAuthority (1993) and Hungarian Energy Office(1994). But these regulators, though playing animportant role in enforcing regulations, haveremained weak and dependent on politicallysensitive ministers (OECD 2000).

Another important driver for the creation ofinstitutions has been a constant preoccupationwith restraining the executive branchs power ina democratic system of governance. Economicreforms were consistently balanced by majorconstitutional reforms and functional counter-weights like the Constitutional Court, StateAudit Office, Ombudsmen for Civil Rights,Ombudsmen for the Rights of National andEthnic Minorities, and Ombudsman forPersonal Data Protection. Moreover, Hungariancitizens and businesses can rely on a powerfuljudicial review of the legality of the publicadministrations decisionmakinga featureunique in the region (SIGMA 1998, 2003).

A third important feature of Hungarys institution-building endeavors was the effort to add credibil-ity to reforms and policy decisions by formalizingand increasing the transparency of administrative

procedures. An insistence on formal proceduresmade the government and Parliament keep andimprove key laws and institutions from theprevious regime, expunging authoritarian anddiscretionary elements from them. This was thecase for the Administrative Procedure Law, Lawon Legislation, and rules and procedures framingthe preparation of Council of Ministers decisions,

which have provided a solid basis for an account-able administration and regulatory management.

Changes in the Civil Serviceand Public Administration

Hungarys civil service has traditionally beenknown for being well-educated, with technicalcredentials and strong legal expertise, rather thanadministrative or management skills (WorldBank 1999). Consequently, reform leaders wereforced to balance the need to preserve the highquality and formality of the system with the needto expand the narrow skills, legalistic culture, andtradition of control and command approaches toregulation.8


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Early on, the government identified the civilservice and, more broadly, the public adminis-tration as key areas for reform and moderniza-tion. Commissioners with clear mandates forsuch changes were established in 1989, a new

law was passed in 1992, and programs of bothbroad and narrow scope were launched. Aboutevery two years the government adopted aresolution on the public administration mod-ernization strategy and on needed next steps.

But results were modest and slow in coming.Successive reform initiatives were unable or unwill-ing to change and simplify approaches to govern-ment interventions. Though a major overhaul anda 15 percentdownsizing of the civil service in 1995made the bureaucracy more effective, by the early2000s one in five workers were still employed bythe government (World Bank 2004). Changes inthe culture, quality, and efficiency of the publicadministration lagged legal reforms.

Reforms were often perceived as painful and soresisted, partly because of a conformist cultureand corporatist reflexes. But structural aspects ofthe public administration also hindered change.Despite the recent introduction of performance-based measures, downsizing was accompanied bya relative and absolute drop in pay for publicservants. Salaries declined relative to sharpincreases in the private sector, creating a seriousbrain drain in the public sector for the mosthighly skilled and trained professionals. More-over, rapid turnover has reduced institutionalmemory, and it has been difficult to recruit youngprofessionals with the skills needed to meet thegovernments demands. (There are exceptions,including the competition authority and the

ministries in charge of EU accession.)Moreover, legal reforms in this area fell short oftheir goals. The 1992 Civil Service Law is hard toenforce, and the government has struggled todepoliticize the public administration. This wasone of the pillars of the law, but political spoilsremain entrenched in the system, with 60 percentof administrative state secretaries spending lessthan two years in office (World Bank 2004).

The bureaucracy remains a bastion of conserva-tism. Despite precise instructions and require-ments, civil servants have rarely deregulated ontheir own, and have tried to limit the functions ofderegulation commissioners to areas as narrow as

possible. For instance, systematic oppositionemerged from state secretaries and senior officialsto any involvement by commissioners in oversee-ing the quality of draft measures. And often, afterdiscrepancies have been solved at the political leveland changes accepted verbally, line ministries havedelayed implementation or made it difficult.

Although policies, bills, regulations, and propos-als have continued to be of high quality in alegal sense, their economic rationality is limit-

edand impractical mechanisms are occasion-ally proposed for their implementation (WorldBank 2004). During the communist era Hun-gary had too many subordinate regulations andtoo few laws. But since then the public adminis-tration has produced too many laws, resulting inoverregulation in some areas (OECD 2000),albeit often linked to EU accession.

Limited resources and the rigidity of the bloatedcivil service have also impeded the government in

supporting civil servants sympathetic to change butreluctant to introduce it for lack of resourcesneeded to perform new tasks in addition to theirexisting workloads. Lack of resources and assistancehas also complicated the introduction of newtechniques, such as regulatory impact analysis, inministries. In particular, additional resources wereunavailable to protect against the natural fear ofthe difficulties associated with any reform.

Legal Reform

As a steppingstone to start reforms, the govern-ment and Parliament enacted a new Constitu-tion in 1990. It promoted democracy and therule of law and provided the basis for transform-ing the legal and regulatory frameworkshifting the balance between laws and subordinateregulations. As a result the discretionary powersof the public administration were systematicallyreduced.


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Tradition and long-held convictions also madelegal reform a cornerstone for the developmentof a market economy. Despite the need to expe-dite changes and thus draft laws in weeks insteadof months, Parliament systematically discussed

and approved reforms. Hungarys strong traditionof open consultation also helped strengthen therule of law. Formalism of procedures was not onlyrecovered from the past, but also strengthened.For instance, during the first wave of reforms thecommissioner meticulously developed proceduresfor deregulating the entire legal systemadaptingderegulation techniques and frameworks used byother countries to Hungarys legal traditions. Thisbackground did not impede the development oflegal innovations like the omnibus Deregulation

Law of 1990, which allowed for the restoration ofdead laws after the guillotine review. Hungaryalso developed new ways of reforming laws,particularly given the difficulty of obtaining aqualified majority in Parliament for importantreforms. (The new Constitution created a special

BOX 5

EU Acquis Communautaire

Candidates for EU membership must meet political and economic criteria and show their ability to assumerelated obligations. Political criteria focus on constitutional structures and human rights. Economic criteria relateto the existence of a working market economy and the capacity to withstand competition within the EuropeanUnion. The obligations relate to the readiness to adopt, implement, and enforce the 29 chapters of the AcquisCommunautaire.

The Acquis Communautaire is the body of legislation of the European Community that has been accumulatedand revised over the past 40 years, comprising more than 96,000 pages of legal text. It includes the:

Founding Treaty of Rome, as revised by the Maastricht, Amsterdam, and Nice treaties.

Regulations and directives passed by the Council of Ministers, most of which relate to the single market.

Judgments of the European Court of Justice.

Recent additions such as the Common Foreign and Security Policy and justice and home affairs coopera-tion, as well as the goals and realization of political, economic, and monetary union.

Countries wishing to join the European Union must implement the entire Acquis on accession, though there issome fl exibility on timing. The European Council has ruled out partial adoption of the Acquis because it feltthat this would create more problems than it would solve, and would water down the Acquis.

Since the 1993 Copenhagen Summit, and in addition to transposing the body of EU legislation into their nationallaw, candidate countries must ensure that EU law is properly implemented and enforced. This may mean thatadministrative structures need to be created or modernized, legal systems reformed, and civil servants andmembers of the judiciary trained. The European Commission assesses progress on these fronts every year.

type of framework law that required a two-thirdsmajority for enactment and amendment.)

Reformers also worked to resuscitate and consoli-date the solid legal infrastructure in place before

the regime change. For instance, the 1987 Lawon Legislation defined the goals and conditionsfor good regulation. In some cases important legalprocesses existed (such as the 1957 Administra-tive Procedure Law) but were unused.

In the mid-1990s legal reform got a new catalyst:the political goal of implementing the EU AcquisCommunautaire. As a result, EU legislationstrongly affected 4060 percent of nationaleconomic legislation (Box 5). Adopting the Acquis

Communautaire provided many benefits forHungary. It gave coherence to the legal frameworkand drove a strong modernization in terms ofsubstance. In particular, EU directives linked tothe single market supported market principlesand helped the administration modernize its


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procedures. On the downside, in some cases theEU framework restricted experimentation andadoption of local solutions and methods. More-over, critics have said that the Acquis Communau-taire introduced some unneeded interventionist

aspects and complex rules, reducing simplificationefforts and increasing burdens on businesses.

Another important feature of Hungarys evolvinglegal and regulatory system is the growing role ofthe judicial system. The courts began to play amajor role in resolving disputes between citizensand the government, between different levels ofgovernment, and between parliamentary andgovernment authorities. For instance, the Consti-tutional Court became one of the busiest in the

world, and judicial review of laws and regula-tions offered a check and balance mechanism onparliamentary and administrative powers.9 Thisis a vivid indicator of the extent to which therule of law has been restored in Hungary.

But these initiatives and assets for rule-basedreform had to confront some major challeng-eswith mixed results. First, the speed ofchange in legislation created instability anddiminishing predictability. For instance, inad-

equate legal implementation of the first guillo-tine review meant that serious legal gapssuddenly appeared. The imperative to create anew legal order also meant frequent creation of,changes to, and dissolution of the regulatoryframework, to the great alarm of citizens andbusinesses. Parliament used reform as a cover torapidly enact half-cooked measures, either forlack of preparation or in search of cosmeticreforms. This phenomenon, called legislationdumping in Hungary, was compounded by the

alternation of coalition governments and dealingof raucous parliaments.

As a result new laws often had to be quicklyamended or corrected. For instance, 58 percentof laws published in 1997 needed amendmentsand sometimes repeal, as did 288 government

decrees and 122 ministerial decrees. Moreover,Hungary was not immune to the legislativeillusion afflicting other countries, where laws arepromulgated for all possible problems withoutsufficient attention to results and alternative

instruments. These phenomena also reflectedsystemic failures to control the quality ofproposals before they were issued.

In addition, decentralization required thatHungary increasingly be administered at locallevels. Yet that created real and potential prob-lems of regulatory duplication, overlap, andinefficiency. Municipalities were too small toreap economies of scale, and transitional prob-lems of creating and maintaining an effective

municipal civil service undermined the develop-ment of a competitive business environment.

Management and Involvementof Stakeholders

With all major reforms, transitional and short-term impacts are more visible than long-termbenefits (or the unseen but growing costs ofmaintaining the status quo). In Hungary manag-ing opposition to reforms was crucial for alternat-

ing governments in the search for consensus andbottom-up policies between the waves of top-down reforms. The need to delicately manageresistance also explains the gradualism of somereforms and the need for governments to acceptthat most of society prefers a smoother transition.In Hungary the gradual approachintended toreduce the costs of transitionwas easier becausemarkets were relatively advanced from the start.

Most reform policies, including privatization,

restitution, and enterprise restructuring, werebased on the desire to create a strong middle classwithin a market economy as the basis for democ-racy. Reaching this goal required achievingwidespread business ownership and entrepre-neurship. The prime ministers in charge duringthe two reform wavesfollowing the recom-mendations of deregulation commissionersoccasionally had to confront opposition. For

9 Though even in 2004 government and ministerial decreesremained off-limits from judicial review.


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instance, in 1996 a high-ranking minister waspushed to resign because of his opposition to therestructuring of his ministry.

Management of reforms implied a tactical effort

to involve and gain support from the opposition,involving it as much as possible. Members of theopposition were often invited to join advisorycouncils and committees. Social partners wereinvolved as well. Widespread consultation withsociety at large required accepting watered-downregulatory goals and methods. For new regula-tion, social acceptance was more important thanany other consideration.

Another important element of reform involvedreaching out to the public and communicatingthe significance of the undertaking. During thefirst wave of reforms the commissioner of publicadministration organized various consultationand promotional activities, one of which in-volved soliciting proposals for deregulation andother reforms from citizens, civil servants, andbusinesspeople. The winners of this competitionreceived monetary prizes. The commissionerand the Deregulation Council also organizedderegulation conferences and technical work-shops throughout the country.

Hungarian reformers were also open to newideas from other sources. Close relationshipsbetween government officials and the spawningthink tanks participating in debates on reformdramatically increased the inflow of good newideas. The International Monetary Fund, WorldBank, U.S. Agency for International Develop-ment, Organisation for Economic Co-operationand Development, U.K. Department forInternational Development, European Commu-nity, and other partners actively supportedreforms. For instance, the World Bank providedfinancing for decentralization and civil servicereform. In addition, Leal (a nongovernmentalorganization) and the Center for InternationalPrivate Enterprise provided significant intellec-tual leverage for pension reform, drawing onexperiences in Argentina and Chile.

At the same time, the cost of reform was neversystematically addressed, except through aconstant effort to accompany all structuralefforts with the steady development of a com-prehensive social safety netthough this

includes the costs of addressing rigidities andother problems to reduce unemployment.Significant costs were also incurred in terms ofincreased poverty and inequality, reducedemployment, deterioration of public services,and growth in corruption. These costs tended tofall heaviest on specific groups, such as pension-ers, rural populations, the Roma, and middle-aged employees of state enterprises.

Such costs were mostly accepted, thanks to the

emergence of a democratic system that allowed achange in government every four years. Overallsocial acceptance was rooted in the belief thatlong-term benefits (particularly EU accession)are worth sacrifices. In addition, the systemprovided two escape valves: the opportunitiesoffered by a dynamic informal sector and thepossibility of emigration. Finally, acceptance ofthe social and economic costs of reform waslinked to active efforts by bilateral and interna-tional donors and by the tangible benefitssuch

as access to better, cheaper consumer goodsofearly reforms to open markets (Ellman 2000).

Resource Issues

Finding resources for reforms was always a chal-lenge due to the governments fragile financialsituation. Indeed, the two waves of reform coin-cided with a need for increased budget control. Butdrivers of reformsuch as the deregulationcommissionerswere always properly supported.At the peak of his activity (199597), the adminis-tration reform commissioner had 20 professionalstaff at his disposal. Members of deregulationcouncils were paid a monthly fee.

But limited resources were allocated to lineministries, which had to rely on their ownhuman resources and capacities to implement


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reforms and comply with new procedures. Andas noted, insufficient resources were allocated tothe civil service. Even when allocated, they wereoften poorly distributed and could not be usedto encourage effective reforms (rewarding specific

progress, for instance).Similarly, economic regulatorssuch as theNational Communications Authorityweregenerally starved of sufficient resources to beeffective and confront incumbents. On the otherhand, the competition office has had adequateresources to play a key role in reforms, contribut-ing in many ways to their success (OECD 2000).

Monitoring and Evaluation

of Reform ImpactsMonitoring and evaluating reforms was asdifficult for Hungary as for most other transi-tion economies. Reform policies seldom settargets, timetables, or surveillance mechanismsto assess progress and retreat. Reforms were

pushed, implemented, sustained, ignored, orreversed through the strength of political will orresistance of interested groups, or because ofexternal obligations (such as to EU accession orinternational donors).

Assessments of progress were complicated by alack of economic analysis, ex post or ex ante, atthe sectoral and macroeconomic levels. Thisproblem was exacerbated by the scope andbreadth of the reforms undertaken in a rela-tively short period. Studies to justify reformsand new policies tend to focus on their feasibil-ity or budget impacts. A lackof administrative capacity and shortage ofanalytically oriented applied economists alsocontributed to weak evaluation, and was exacer-bated by strong opposition from ministries toconducting evidence-based analysis of proposalsand allowing an oversight body to challengetheir assumptions. In many cases inadequatemonitoring and evaluation resulted in inconsis-tencies and sometimes failures.


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Hungarys reform experience points to clearfactors for success, exposes several shortcomings,and offers lessons for other countries.

Success Factors

The timing and sequencing of reformsstarting with market openness and later drivenby the stringent requirements of EU accessioncontributed to one of the most successfultransitions in the region.

In its first 10 years of reform, Hungary movedfaster and made fewer mistakes than many othertransition economies. Many observers have saidthat this was due to effective timing and se-quencing (sometimes fortuitous) of key reforms.

Early market opening reforms certainly played avital role in anchoring structural reforms. Thiscornerstone of reform also provided a long-termadvantage in terms of attracting foreign directinvestment and lowering social and economiccosts through cheaper imports. In addition, itaided privatization and the transfer of technol-ogy needed to sustain future growth.

Perhaps in a more accidental way, successfulsequencing can also be appreciated in terms ofthe differences in implementation effortsaccorded to some reforms. Reform and mod-ernization of the state apparatus came laterthan structural reform. Changes in institutions

are much harder to implement than changes intariffs or prices because people are bound bytheir culture, traditions, and formal andinformal practices. Institutional changes canonly be addressed over time and are seldomquick wins.

In a more pragmatic way, the Horn administra-tion (199498) used the difficult financialsituation and near debt crisis that it inherited tolaunch comprehensive reforms that paid off

handsomely. Commitment to reforms by thehighest levels of government was also vital tochanging perceptions among foreign investorsand creditors. As support waned andthe government tried to advance politicallycostly reforms in the late 1990s, it began usingEU accession as the central engine and justifica-tion for painful changes.

4. LESSONS OF REFORMS


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10 For a small country like Hungary, an open market is also asource and safeguard for competition.

Reforms were strengthened by careful adapta-tion of inherited and accepted institutions.

Successive administrations drew heavily oninternational expertise, but ensured that foreign

models were adapted to the Hungarian situation,using existing legal and administrative frame-works to implement change. For instance, in itssearch for a way to consolidate the rule of law,the government resuscitated earlier frameworklaws such as the 1956 Administrative ProcedureLaw and maintained the 1987 Law on Legisla-tion. And, recognizing the need for a centralforce that could drive and sustain the coherenceof reforms, Hungary created an effective machin-ery in the prime ministers office that could

support focused commissioners (see below). Economic reforms were more successful when

driven by the center, but institutional reformswere more successful when supported by decen-tralized consensus and ministry ownership.

The speed and scope of reforms slowed between1990 and 1994, with real and perceived costs.This deceleration coincided with the center ofgovernment (that is, the prime ministers office)

delegating reforms to line ministries. As it turnedout, the change in pace and approach helpedbuild more cohesive and collective changesforexample, in terms of decentralization of changesto the judiciary. But the decentralized approachalso caused many reforms to dissipate quickly.When reforms required leverage and incitement,the government often relied on focused taskforcesand individual commissioners. But though astrong prime ministers office was probablyrequired for a coherent approach to reforms, it

was insufficient when key functions were absent(as was the case after 1998).

Government commissioners drove reforms,though they lacked the institutional and legalbacking to implement and sustain them.

The speed and scope of Hungarys reforms wouldhave been much harder to achieve through

decentralized processes. As in many parliamentar-ian systems, the countrys collective governancerelies on strong ministerial (sectoral) responsibil-ity and accountability. But such a system facesproblems when horizontal regulatory reform is

launched. A driver of reform located above lineministries is needed to coordinate, monitor, andenforce changes. The Hungarian solution was tocreate commissioners with direct access to thehighest level of the government, supported byconsultative bodies and specialized staff. Thisframework drove two guillotine reviews. Still, thecommissioners lacked the permanencewhichcould perhaps be provided through a legal andparliamentary mandate and a formal institu-tionto manage the incentives and bottom-up

acceptance needed to effect long-term changes inrulemaking practices and procedures.

An active competition office drove reformimplementation.

An outstanding element of Hungarys successwith structural reforms was early and fair accom-modation of competition principlesachievedthrough a world-class competition law enforcedby an independent competition office.10 In

particular, since the mid-1990s the competitionoffice has played a key role in privatization andrulemaking. The competition authority has alsoadvocated regulatory reforms and blocked manydistortionary proposals.

Systematic, comprehensive, time-bound reviewsof regulations accelerated deregulation andre-regulation.

By the early 1990s Hungary had joined the small

group of countries bold enough to launch massivereviews of their entire legal frameworks. Moreover,it used a guillotine review that in just a couplemonths helped eliminate scores of obsoleteregulations. Five years later, in 1995, a secondreview was launched with less success, though it


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annulled more than 350 subordinate regulations. Italso focused on deregulating and simplifyinglicenses and authorizations. Legal harmonizationwith EU law became a justification for a thirdreview and engine for modernizing the regulatory

framework, and continued until accession in2004. Thanks to these efforts, Hungary renewedits legal regime to the benefit of businesses andcitizensin particular, reducing the potential fordiscretionary abuses by the administration(particularly in the licensing system).

Shortcomings

Much of Hungarys reform success in the 1990swas built on market openness, a progressive but

determined privatization program, and a foreigndirect investment strategy based on low wagesand a flexible labor market. As a result, theHungarian economy was able to eliminate andcreate jobs, putting the country on a convergencepath with the average EU member. But the199094 slowdown shows that slowing the paceand accepting too much complacency can rapidlyundermine the competitiveness of domestic firmsand the perceptions of foreign investors anddonors. Now that wages are increasing rapidly

and Hungarians aspire to European standards forsocial and environmental regulations, the coun-trys appeal to foreign investors may deterioratequicklywhich could prompt a dash for a new,cruder regulatory package.

Systematic reviews of existing regulationsmissed the opportunity to reinforce the eco-nomic rationale for the rapidly developingregulatory framework.

Despite a significant inve

Documents

Ifc Regulatory Transformation in Hungary 1989 98