P O L I C Y A N D R E S E A R C H S E R I E S

17 9896

THE TRANSFORMATION OFECONOMIES IN CENTRAL

AND EASTERN EUROPE

Issues, Progress, and Prospects

ALAN H. GFLBAND CHERYL W. GRAY

POLICY, RESEARCH, AND EXTERNAL AFFAIRSTHE WORLD BANK

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Titles in the Policy and Research Series

PRS1 Adjustment Lending: An Evaluation of Ten Years of Experience Country EconomicsDepartment

PRS2 Tax Policy in Sub-Saharan Africa: A Framework for Analysis Zmarak ShaliziLyn Squire

PRS3 The Effects of Industrial Countries' Policies on Developing J. Michael FingerCountries Patrick Messerlin

PRS4 The Reform of State-Owned Enterprises: Lessons from Mary ShirleyWorld Bank Lending

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PRS6 Seatrade, Logistics, and Transport Hans Juirgen Peters

PRS7 Competition Policies for Industrializing Countries Claudio R. Frischtakwith Bita Hadjimichaeland Ulrich Zachau

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Kenneth A. FrootPaul R. Krugman

P O L I C Y A N D R E S E A R C H S E RI E S

17

THE TRANSFORMATION OF ECONOMIES

IN CENTRAL AND EASTERN EUROPE

ISSUES, PROGRESS, AND PROSPECrS

ALAN H. GELBCHERYL W. GRAY

CouNrRy EcoNoMIcs DEPARTMENT

The World BankWashington, D.C.

Copyright i) 1991The World Bank1818 H Street, NWWashington, DC 20433, USA

All rights reservedManufactured in the United States of AmericaFirst printing June 1991PRS17

Papers in the Policy and Research Series present results of policy analysis and research to encouragediscussion and comment. To disseminate the findings with the least possible delay, the text has notbeen edited as would be appropriate to more formal publications, and the World Bank accepts noresponsibility for errors. Citation and the use of such a paper should take account of its provisionalcharacter. The findings, interpretations, and conclusions expressed in this paper are entirely those ofthe author(s) and should not be attributed in any manner to the World Bank, to its affiliated organiza-tions, or to members of its Board of Executive Directors or the countries they represent.

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Alan Gelb is division chief and Cheryl Gray is a senior economist in the Socialist Economies ReformUnit, Country Economics Department, World Bank.

ISSN 1013-3429

Library of Congress Cataloging-in-Publication Data

Gelb, Alan H.The transformation of economies in Central and Eastern Europe:

issues, progress, and prospects/Alan H. Gelb, Cheryl W. Gray.p. cm. - (Policy and research series. ISSN 1013-3429;17)

Includes bibliographical references.ISBN 0-8213-1870-51. Europe, Eastern-Economic policy. 2. Europe, Eastem-Economic

conditions-1989-. 3. Mixed economy-Europe, Eastern. 4. CentralEurope-Economic policy. 5. Central Europe-Economic conditions.6. Mixed economy-Central Europe. I. Gray, Cheryl Williamson. 1954-.II. Title. III. Series: Policy and research series: 17.HC244.G367 1991338.943-dc2O 91-20189

CIP

Table of contents

Introduction 1

1 The socialist legacy 2

Traditional central planning 2Reform socialism 3

2 The task of economic transformation 6

The elements of transformation 7The current stage of system transformation 8

3 Preliminary lessons of experience 11

The political dimension 11The phasing of reforms 12Macroeconomnic reforms 12

Intemal balance 12External balance 15The costs of stabilization 15The interaction of stabilization and system transformation 17

Price and market reform 17The market for goods 17Intemational trade 18The market for labor 19Financial markets 19

Private sector development, privatization, and enterprise restructuring 20New investment 20Privatization 21Restructuring 23

The role of the state 24Institutional reform 24The legal framework 25Fiscal reform 26The social safety net and social services 26

4 Conclusion The challenge to industrialized countries 29

....

Annexes 33

1 Reform of the trade and payments system 342 Privatization of state enterprises 393 Agriculture 424 Financial system reform 455 Fiscal policy 496 Income distribution, poverty, and sociall safety nets 537 The World Bank Group's support for economic transformation in Central and

Eastern Europe 56

Tables

1 Economic indicators for CEE countries, for selected years, 1970-91 42 Social indicators for selected countries, in the 1980s 53 Economic elements of system transforrnation 9

Figures

1 Growth in per capita output in Central and Eastern Europe, 1990-2000 72 Phasing of reform over a 10-year period 13

Boxes

1 Points of debate on phasing 142 Economic developments in east Germany after economic union 163 Issues in housing reform 184 World Bank support for private sector development: The example of Hungary 205 Enterprise privatization in east Germany 226 China's economic reform 247 Cleaning up the environment in CEE countries 258 The key ro e of pensions in economic reform 279 How tfie World Bank's first Structural Adjustment Loan supports system reform

in Poland 30

Annex tables

1.1 Structural dependence in the CMEA 351.2 Convertible currency trade indicators for CEE countries, 1988-90 371.3 Estimates of Soviet subsidies through ithe CMEA 382.1 State-owned sector as share of value-added in selected countries, in the mid-1980s 393.1 Per capita average food consumption, 1985 436.1 Gini coefficients for selected countries and regions 537.1 Status of Bank Group operations in Hungary 587.2 Status of Bank Group operations in Poland 607.3 Status of Bank Group operations in Yugoslavia 617.4 Selected cofinancing operations 64

Annex figure

5.1 Consolidated government expenditures in Eastern Europe as share of GDP,1982-90 50

Annex box

2.1 A recent privatization plan for Poland 41

Endnotes 65

References 72

iv

Acknowledgments

We would like to thank the following people for their in-depth contributions: Martin Schrenk (annex1), Karen Brooks (annex 2), Branko Milanovic (annexes 3, 5, and 6), and Millard Long and Silvia Sagari(annex 4). Annex 7 was prepared by Country Department IV, Europe, Middle East, and North AfricaRegion, with input from the International Finance Corporation's Department of Investments, Europe.

Produced at the PRE Dissemination Center

v

Introduction

ThecountriesofCentralandEasternEurope(CEE)l issues that have arisen and lessons of experienceare now in the midst of a unique and historic to date in the transformation process. Six annexestransformation. Having replaced authoritarian explore selected topics - trade, privatization,regimes with pluralist democracies, they are in- agriculture, the financial sector, fiscal policy, andtentonmovingrapidlyfrommoreorlesscentrally poverty and social safety nets- in greater depth.planned socialist economies to largely private Annex 7 summarizes World Bank Group activi-market economies. The road is perilous - eco- ties in the CEE countries. While the entire papernomicallyandpolitically-andlargelyuntrodden, draws heavily on the extensive experience of thealthough many individual elements of reform World Bank Group in the CEE countries, the pa-have been confronted before in other countries. per is intended to look "outward" to the chal-Still-fragile political systems must address the lenges facing the countries rather than look "in-challenges of complex economic and institutional ward" to assess the World Bank's role. Althoughreformsinanexternalenvironmentmoredifficult the emphasis is on the countries of Central andthanoriginallyenvisagedand,insomecases,amid Eastern Europe, other experiences are cited whererising ethnic and regional tensions. Widespread appropriate. Any conclusions must be regardedinitial euphoria after political transitions in 1989 as tentative, because post-socialist system trans-has been replaced by a more sober assessment of formations are still at an early stage and manythe task ahead. important issues remain unresolved. Neverthe-

This paper first reviews the legacies of the pre- less, experience to date, especially in the morevious economic systems and analyzes the task of advanced reformers, does provide insights usefultransformation toward aprivatemarket economy. in designing policies and assessing prospects forAgainst this backdrop, it then surveys important the future.

1

__~1,

The socialist legacy

The current configuration of Central and Eastern Traditional central planningEurope emerged in the aftermath of World War I,which saw the collapse of the German, Hapsburg, In theory, central planning was a top-down pro-Czarist,and Ottoman empires. Theinterwar;years cess whereby detailed physical plans for statewere a period of considerable economic turbu- enterprises were formulated at the center, typi-lence for much of the region, which needed exten- cally by the state planning commission, to allocatesive reconstruction and suffered terms-of-trade inputs and outputs to their various uses. In prac-shocks with the onset of the Great Depression. tice, however, the center invariably had less infor-Except for Czechoslovakia, the countries had a mationthantheenterprisesaboutproductionpos-largely agrarian economic structure (particularly sibilities; thus there resulted a hierarchical bar-in the Balkans, where agriculture generated over gainingprocessinvolvingcentralandbranchn-n-half of output on average), and incomes per capita istries and state enterprises. To facilitate control,were well below those in much of Western Eu- production and employment were concentratedrope.2 The region traded mostly with Western in large firms with highly oligopolistic or mo-Europe, in particular Germany. nopolistic market structures.

WorldWarIIimposedenormouslossesofpopu- These systems relied little on markets, which,lation, infrastructure, and equipment on mrost of where present, were highlydistorted. Enterprisesthe countries, and Hungary was the only one to emphasized plan fulfillment rather than profit-return to its prewar territorial status. Communist ability. Product markets were distorted by perva-parties achieved dominance under the influence sive production, price, and trade controls thatof the USSR, and the economies of Central and effectively insulated domestic prices from inter-Eastern Europe were reorganized along the lines national ones. Asset and capital markets wereof the centrally planned Soviet economic system. almost nonexistent, with financial flows respond-By 1950, this process was largely completed, pri- ing passively to the demands of the plan. Laborvate sector activities had been marginalized, and markets were distorted by narrow administeredalmost the entire means of production hadl come wage structures and the prohibition of dismissals,under state ownership. Remaining private activi- so that labor movements only partially respondedties were small-scale, and agriculture was wridely to market scarcities.collectivized everywhere except Poland and Yu- Despite planners' desires to promote efficiencygoslavia. In most countries, housing was the and productivity growth, the incentive frame-major private asset other than financial savings, work of central planning was in fact inimical toalthough private rental of housing was illegal. both. Growth was "extensive," relying on forced

2

savings and high investment levels. Severely dis- and little income from property, real incomnestorted input and output prices divorced resource were relatively equally distributed in the socialistuse from resource costs. Plans overemphasized economies. Education and health levels were lowheavy industry and energy sectors at the expense compared with industrial countriesbut quite highof consumer goods and services, and subsidized compared with middle-income countries (tableprices encouraged the overconsumption of their 2). Extensive mnaternity and child-care benefitsproducts. Distorted price structuresweresustain- facilitated high female participation in the laborable because of the relative autarkyof these econo- force. While housing appeared inadequate by themies within their protected Council for Mutual standards of industrial countries, these countriesEconomic Assistance (CMEA) market.3 Com- avoided theurbanpovertyandhomelessnessseenpressed and arbitrary wage structures, job secu- in many market economies at similar income lev-rity, and extensive in-kind benefits poorly linked els. Nevertheless,socialindicatorsimprovedmoreto productivity inhibited worker motivation. Yet slowly in the CEE countries over the past threewithno "bottomline,"nmanagerstypicallyhoarded decades than in most comparable market econo-labor (as all other inputs) at the firm level, so that mies, and in recent years some may actually haveopen unemployment was negligible. Managers deteriorated. Forexample, from the early 1960s toand workers had few incentives for process or 1990 the (unweighted) average of life expectancyproduct innovation, resulting in slow technologi- at birth rose in the CEE countries from 68 to 71;calprogress. Finally,opendiscriminationagainst, during the same period it rose on average from 71if not prohibition of, private activity inhibited to 76 in five industrial country comparators andentrepreneurship. Small firms were relatively from 59 to 67 in upper-mniddle-income compara-few, and entry and exit of firms rare; the planned tors.economy lacked the "creative destruction" char- Finally, a very important part of the planningacteristic of dynamic market systems. As a result legacy common to all countries was the absence orof these factors, the planned economies experi- weakness of core market-oriented institutions,enced abroad secular decline both in competitive- both inside and outside of government. Legal andness (as evidenced in part by declining exports, accounting institutions were weak, standards didparticularly of manufactured goods, to industrial not conform to those generally accepted in marketcountries) and in the growth of their net material economies, and there was no tradition of indepen-product (NMP), from a reported 9.6 percent in the dent audit. Enterprises were profoundly shapedrecovery period of the 1950s to 6.7 percent in the by planning; for example, they lacked marketing1960s and 5.2 percent in the 1970s. Growth rates and strategic planning capabilities and effectivecontinued to fall in the 1980s, as shown in table 1. inventory controls, and they had little informa-

Economic policies also undervalued natural tion on the relative profitability of the variousresources and placed little value on environmen- products they were ordered to produce. CEEtal safeguards, which contributed to serious envi- governments had little expertise in indirect regu-ronmental degradation. The emphasis on heavy latory instruments, such as monetary policy, taxa-industry and low energy prices resulted in a level tion, competition policies, and the prudential su-of energy use per dollar of national income two to pervision of financial institutions. Without suchthree times that of market economies at compa- instruments, macroeconomic balance essentiallyrable income levels, and over three times that of rested on the sum of many microeconomic deci-Western Europe. Much of the energy was derived sions.from highly polluting and environmentally dan-gerous sources; for example, coal (much of it low- Reform socialismquality) accounted for more than 80 percent ofPoland's primary energy use in the 1980s, com- A major impetus behind reforms within socialistpared with less than 25 percent in industrial coun- systems was the slowdown in growth. Sometries. Water use and water pollution in the CEE "reforms" aimed merely to improve the planningcountries were also high compared with those of process by streamlining the bureaucracy, but oth-market economies. ers recognized the serious deficiencies in the ver-

With full employment, narrow wage and pen- tical information flows required for planning andsion differentials, heavy subsidies on basic goods, attempted to decentralize decisionmaking and

3

Table 1 Economic indicators for CEE countries, for selected years, 1970-91

CDP Growth rates Curmnt accountlGDP(billion of (Percen t) Inflation (convertible currency) Exenl debtIGDPdollars) NMP CDP (prcent) (percent) (convertible currency)

Country 1990 1970-80 1980-88 1989 1990 1989 1990 1989 1990 19 91 b 1990

Bulgaria 22A 7.0 4.4 -1.4 -10.2 6.3 100.0 -6.4 -2.7 -8.9 402Czechoslavakia 465 4.7 2.0 1.3 -3.5 1.3 139 0.9 -1.0 -5.1 165Hungary 32.1 4.5 1.3 -0.9 -6.5 18.0 30.0 -4.9 -0.2 -3.7 62.2Poland 623 5.4 1.0 -0.5 -14.0 640.0 249.0 -2.7 -2.5 -4.0c 74.3cRomania 355 9.3 4.7 -5.8 -10.2 2.5 - 5.4 -3.9 -4.8 5.6Yugoslavia 589 5.7 0.4 -7.2 -7.2 2,823.1 118.6 3.2 -1.9 -1.2 27.6

a. Official statistics in the past are believed to have overesthnated growth rates. Output statistics for 1990 may be biased downward due to thefailure fully to indude the smaU but growing private sector.b. 1991 projected current account as a share of 1990 GDP.c. Does not indude effect of Paris Club debt relief.Souuc World Bank data.

replace some of the command system with mar- discipline was therefore weak. Pervasive short-ket-oriented incentives. Yugoslavia decentral- age persisted and reduced the incentives for firmsized decisionmaking with worker self-manage- to raise product quality and service. Incentives toment and relatively few price controls in the mid- innovate were weak, and technology levels fell1950s. Hungary (after 1968) and Poland (in the farther behind those of the industrial countries. 8

1980s) also substantially decentralized decision- Rather than being clarified, property rights be-making concerning production and investment, came obscured as some of the prerogatives ofalbeit with more extensive price intervention. ownership were decentralized to managers andWhile reforms in Hungary and Poland iinitially workers. An important lesson to emerge from thisdelegated control toenterprise management, some phase of "market socialism" is that increasingdegree of worker control via enterprise councils autonomy without making real reforms to defineeventually evolved in about 70 percent of larger ownership rights, increase competition, and en-industrial firms. Bulgaria, the CSFR, and Roma- force financial discipline will have only limitednia maintained stronger central controls, as did success.the GDR. At the same time, these reforms exacerbated

The major lessons of reform socialism in Cen- macroeconomic imbalances. Imbalances are moretral and Eastern Europe were negative.' Efforts to likely to occur in a decentralized socialist systemincrease efficiency and productivity through de- inwhichenterpriseshavemoreautonomytospendcentralization and heavier reliance on mnarket without market-based accountability, and gov-forces met with onlylimited success in the absence ernments tend to accommodate with monetaryof ownership reform or capital markets. Failure to expansion to avoid unemployment. Internal im-dismantle the traditional bureaucracy reinforced balance can result in either open or repressedthe reluctance of the authorities to abdicalte their inflation (the latter associated with the emergenceinfluence on microeconomicdecisionmaking. "In- of a "monetary overhang" depending on the ex-direct" regulation of firm behavior continued, tent and firmness of price controls).9 Poland andthrough the selection of managers, price controls, Yugoslavia embarked on their post-socialist re-and highly selective fiscal and credit policies that forms with the most severe open internal imbal-resulted from continued hierarchical bargaining. ances, as evidenced by inflation rates of 640 andProfits were redistributed between firms to pre- 2,800 percent, respectively, in 1989. An underly-serve existing jobs7 and protect firms from exit. ing cause of inflation in both cases was the subsi-Pre-and post-redistribution profits were essen- dization of loss-making enterprises, in Polandtially unrelated, and the incentive for fin ancial through the banking system and the budget (lead-

4

Table 2 Social indicators for selected countries, in the 1980s(most recent estimates)

AUupper-

Cacho- Yugo- middle- Fed. Rep. of UnitedIndiator Bulga sova Hungary Poland Romtnia slavis inwmea Austria France Spain Germany Kingdom

Populationb 9.0 15.7 10.6 37.8 23.1 23.7 4243 7.6 56.1 38.8 62.0 572

Labor forceparticipationratecTotal na. 789 72.4 78D 79.6 55.8 n.a. 659 65.8 54.7 67.2 72.0

Female na. 73.6 61.7 70.6 na 429 na. 515 50.0 26.7 503 54.1

Health careInfantmortalityrated 15.0 13.1 17.0 175 25.0 25A 469 9.9 7.6 10.0 83 9.1

Early 1960s 30.8 255 38.8 41.7 44.1 71.8 101.1 283 219 37.8 23.8 19.6Lifeexpectancy(years) 72.1 712 702 71.4 70.2 713 67.2 74.1 772 76.6 74.8 752

Early 1960s 69.4 68.7 695 693 67.8 65.8 58. 69.6 713 709 70.2 71.1

EducationPrimaryeducatione 103.0 100.9 98.0 101.0 97.0 87.0 1035 100.0 112.0 101.0 97.0 106.0

Secondaryeducation' 100.0 815 70.0 80D 76.0 82.0 57.8 79.0 95.0 98.0 72.0 85D

a. Indudes upper-ridddle-income countries in Europe, the Middle East~ and North Africa region with per capita income levels comparable tothose in Eastern Europe.b. 1989 estimates, millions.c. Ratio of the economically active population (employed plus unemployed) to the worldng-age population (between 15 and 65 years). Theestimates represent early to mid-1980s.d. Per thousand live births.e. Percentage of school-age group.Sowcf World Bank (1990) and World Bank data; IMF (1991).

ingtoabudgetdeficitof8percentof GNPin 1989) evidenced by high foreign debt, were most pro-and in Yugoslavia through the banking system. nounced in Poland, Hungary, and Bulgaria (an-Polishinflationwasexacerbatedbysharpincreases nex 1, table 1.2).in controlled prices in late 1989. Hungary avoided The limited success of experiments with "mar-high inflation through somewhat tighter ket socialism" and the growing macroeconomicmacroeconomic management, heavier reliance on imbalances they created helped to push CEE gov-price controls, and continued access to external ernments in the new direction of post-socialistfinance;itsinflationratewasaround 10-20percent reform.'0 The experience with "market socialism"in the late 1980s. The CSFR, Bulgaria, and Roma- complicates current reform efforts because of thenia adopted fewer reforms toward "market social- pressures of vested interests, particularly those ofism" and maintained even more extensive price worker-managers. However, it also provides thecontrols. Major macroeconomic imbalances did advantage of greater familiarity with market pro-not arisein the CSFR; Bulgaria and Romania expe- cesses, including more extensive internationalrienced some degree of repressed inflation. On trade with market economies.the external front, macroeconomic imbalances, as

5

2

The task of economic transformation

Levels of income and physical and human capital racy, however, most observers believe that the falldiffered considerably among CEE countries at the in output in 1990 was precipitous. Price levelsbeginning of the process of transformation to free increased in those countries where inflation hadmarket economies in 1989 (table 1). Relative levels formerly been low, partly because of price liberal-were not much different from those in 1937 (see ization and cuts in subsidies; for example, in Hun-endnote 2) except forYugoslavia, which irmproved gary prices rose by 30 percent in 1990, up from 10its position. Income estimates confront rriethod- percent in 1987. While the current account posi-ological difficulties, but GNP per capita in Central tion improved in some countries, the externaland Eastern Europe is above that of Latin America environment for trade and capital flows has wors-and farbelow that of Western Europe. Purchasing ened recently, as discussed in the section on pricepower per capita in the CSFR is estimated at two and market reform and in annex 1. The initialto three times that in Romania, with other coun- years of the post-socialist transition are thereforetries falling in between." Physical infrastbructure ones of economic crisis for the CEE region.is better in the richer countries, particularly the The growth prospects for the CEE countriesCSFR and Hungary, but much capital is either depend on several factors - the consistency withdeteriorated or obsolete. Human capital endow- which they pursue their reform programs, thements, when measured in education and skill impact of exogenous developments (includinglevels, are also higher in the richer couintries. the end of the CMEA trading system, discussedRomania appears to be the most lacking in both furtherin the section onprice andmarketreform),physical and human infrastructure. and the response of the industrialized countries in

As shown in table 1, the persistent slow,dlown in providing technical assistance, finance (includinggrowth that has marked the last two decades debt relief for some countries) and an open trad-sharpened in 1989, with GDP falling in all of the ing environment (see chapter 4). Recovery andCEE countries except the CSFR and inflation ris- growth are expected to be quite slow in the nearing to high levels in Poland and Yugoslavia. Offi- term because of the fundamental systemic andcial measures of outputcontracted furtherin 1990, institutional changes needed. In figure 1, thewith GDP falling in all CEE countries and Poland, middle line shows the projected evolution of perBulgaria, and Romania suffering declines of over capita output averaged for the six CEE countries10 percent. It is important to note that these over the decade 1990-2000.12 Following the sharpofficial measures may overstate the drop in out- drop in 1990, it is projected to decline further input somewhat because they do not fully account 1991 and stay level in 1992 before the recoveryfor the vibrant growth in private sector activity, begins in 1993. Growth in per capita output isalbeit from a small base. Despite the data inaccu- expected to improve to 3-4 percent in the second

6

Figure 1 Growth in per capita output This partly reflects the time needed to reestablishin Central and Eastem Europe, 1990-2000 market-based institutions and build the associ-

ated skill base. But it also reflects inherent limits3.2 on investment capacity. Enormous investments3.1 are needed to rehabilitate, modernize, restruc-3.0 North ture, and augment physical capital stocks in the2.8 CEE countries, especially considering the pros-| 2.8 7 pz pect of major changes in trading patterns with the267 All demise of the CMEA. Most analysis done to date

o 2.6 **, suggests thataspeedier transition(say, over 10-152.4 .01 solo years) would require annual investmentsfarabove2.3 . SoutX_X_ feasiblelevels in terms of either resource availabil-2.2 .j x-X X-X ity (discussed in chapter 4) or absorptive capacity2.1 . IX-XX of these economies.42.0 oSecond, system reforms are unlikely to proceed

1990 1992 1994 1996 1998 2000 smoothly, especially considering their complex-

Sourcr Official country data and World Bank projections. Note the ity and highly political nature. Setbacks can bedata limitations indicated in the text. expected and should not be prematurely inter-

preted as failure of the entire reform process. Ithalf of the decade, as the countries recover from will be important in the years ahead to maintainthe disruptions of their current reform processes political will, patience, and a long-term perspec-and as their economic efficiency and absorptive tive.capacity rise with restructuring. Output per capitais not projected to attain its 1989 level until late in The elements of transformationthe decade; however, that market-determinedoutput should be achieved with greater efficiency All of the CEE countries have crossed a criticaland associated with a higher level of social welfare hurdle-defining the ultimate goal of reform. Allthan the output of 1989. Despite unavoidable are now committed to changing their economnicshort-term costs, reforms set the stage for sustain- systems to predominantly private market econo-able growth in the medium and long run; without mies similar to those of Western Europe. Thereform, the CEE economies would continue to elements of such system transformation can bestagnate into the foreseeable future. grouped into four broad analytical categories, all

The northern tier of countries - Hungary, of which interact strongly in the process (table 3)Poland, and theCSFR-is somewhatbetterplaced and all of which are being supported by Bankto take advantage of future opportunities for Group programs in the CEE countries. The firstgrowth because of the extensive reform measures concerns internal and external macroeconomicalready undertaken (particularly in Hungary and stabilization. This involves tightening fiscal andPoland) and generally better economic infrastruc- credit policies for governments and enterprises,ture. Figure 1 shows separate projections for this andaddressingimbalancescreatedbyamonetarygroup and for the southern tier-Bulgaria, Roma- overhang or large bank losses.nia, and Yugoslavia. These projections suggest The second is the introduction of competitivethat the income gap between the north and south markets and attendant price reform. In the firstis likely to widen considerably over the next de- instance, price reform typically involves decon-cade. While the north regains its 1989 level of per trolling and broadening markets for goods andcapita output by 1996, the south does not regain its services, which in tum requires a restructuringbase level by the year 2000.23 and demonopolization of the trade and transport

Two important general points emerge from sectors. The creation of factor markets, for boththese projections. First, even under fairly favor- labor and financial resources, is also essential.able assumptions on external factors and domes- Reform of international trade and payments sys-tic reforms, the period of catch up toward market tems is considered an integral part of price reformeconomies with levels of income comparable to and competition policy."5

those of the industrial countries will almost cer- The third category of reform is enterprise re-tainly be measured in decades rather than years. form and restructuring. A first important step in

7

enterprise reform involves clarifying publicown- reformed its tax system extensively in 1988 andership rights (and separating them from the regu- 1989, and Poland and Yugoslavia are planning tolatory functions of government) and implement- do so soon.ing more effective control over the management In the other areas, reforms in these three coun-of existing firms, in part through widespread pri- tries are at an earlier stage. They have liftedvatization. Establishing secure private prolperty explicit restrictions on private activities, and thisrights and facilitating the growth of new private has resulted in an impressive growth of smallfirms is also critical. Enterprise restructuring may private business. They have also progressed withinvolve breaking up large monopolies, removing small-scale privatizations; for example, in Polandor reassigning redundant labor, closingloss-mak- at least 50,000 small shops have been privatized.ing operations and disposing of their assets, re- They have only begun to privatize larger enter-structuring balance sheets, or other actions aimed prises (see annex 2) and to undertake reforms inat improving the efficiency of existingenterprises. the agricultural sector (see annex 3). The Polish

Finally, the fourth category of reform (closely government has privatized only five large enter-related to the others) involves reorienting the role prises through public offerings and several moreof the state in the economy, away from direct through private placements, and the Hungariansownership and control over production and to- are also proceeding on a relatively slow, case-by-ward an indirect regulatory role that promotes casebasis. Whilenumbersareuncertain, somel1-adjustment and private economic activity. This 15 percent of nonagricultural production mightchallenge has many dimensions. Privatization now be in private hands.will help reduce the role of govemment in direct Although progress has been made in revisingproduction. Concurrent reforms are needed in the legal framework for enterprise activity, gov-the central institutions of government, including emments have not yet progressed far with enter-the central bank, tax administration, the expendi- prise restructuring. Some firms have taken suchturebudget and control system, and policyma'king initiatives themselves, often through joint ven-bodies. Another important role for the state is to tures with foreign partners. The increasing num-redesign the social safety net to reduce the need ber of firms facing liquidation proceedings in allfor enterprises to perform wider social functions, three countries suggests that financial disciplineto make benefits "portable" to facilitate labor real- is beginning to take hold. However, restructuringlocation, and to cope with rising unemployment activities are not yet at the levels needed for struc-as firms become subject to greater financial disci- tural reforms in any of the three countries. Aspline. The state also needs to provide a suitable discussed later and in annex 4, the pace of restruc-legal framework for collective bargaining and pri- turing affects the pace for resolving the portfoliovate sector activity and to develop legal institu- problems of banks; the latter is thus still in thetions to implement and enforce it. early stages, although some aspects of banking

and financial sector reform are well advanced,The current stage of system transformation particularlyinHungary. Unemploymenthasrisen

to only moderate levels, and wage controls are stillPoland, Hungary, and Yugoslavia were the first to needed pending enterprise reform. Effective fac-begin the transformation process and have gone tor markets are clearly some way off.quite far in the first two categories. In 1990, Activities to transform the role of the state havePoland and Yugoslavia embarked on drastic sta- intensified in these three countries over the pastbilization programs that were particularly signifi- two years. They have made substantial progresscant because their methods also involved impor- in many areas of legislation and economic regula-tant elements of structural reforms. Hungary also tion and in reshaping public institutions. Forimplemented a determined stabilization connpat- example, all have set up privatization agencies,ible with a shift toward a private market economy. abolished or downgraded planning ministries,All three countries have liberalized most prcduct and instituted programs to address unemploy-prices. Trade reforms have complemented price ment. However, there are still many gaps, andliberalization,replacingquantitativecontrols with institutional capacity to implement the new legis-low to moderate tariffs and instituting current lation is severely constrained by the shortage ofaccount convertibilityata unified exchange rate.16 experience and relevant skills. Programs to aug-To complement the shift to the market, Hungary ment the skill base (for example, by training bank

8

Table 3 Economic elements of system transformation

1. Macroeconomic stabilization 4nd controt

Implementation of stabilization programs:Gvernment and enterprises: Fiscal tightening

Tight credit policiesAddressing existing problems (money overhang, bank losses)Expenditure-switching measures for external balance

2. Price and market reform

Goods and services: Domestic price reformInternational trade liberalizationDistribution systems (transport and marketing services)Housing services

Labor: Liberalizing wages and labor marketFinance: Banking system reform

Other financial marketsInterest rate reform

3. Private sector development, privatization, and enterprise restructuring

Facilitating entry and exit of firmsEnterprise governanceEstablishing private property rightsClarifying and allocating property rights: Agricultural land

Industrial capitalHousing stock and commercial real estate

Sectoral and enterprise restructuring, including breakup of monopolies

4. Redefining the role of the state

Legal reforms: Constitutional, property, contract, banking, competition,and so onReform of legal institutionsRegulatory framework for natural monopolies

Information systems (accounting, auditing)Tools and institutions for indirect economic management: Tax system and administration

Budgeting and expenditure controlInstitutions of indirect monetary control

Social areas: Unemployment insurancePension, disabilitySocial services: health, education, and so on

supervisors and potential members of enterprise count transactions, and most international tradeboardsin Poland) are under way but will take time wasliberalized. Legislation passed in 1990 put theto have full effect. private sector on an equal legal footing with state

The CSFR has recently taken several important enterprises, and the government has begun tosteps toward system transformation and is now auction small shops to private owners. Like theabout on par with the more advanced reformers in other three more advanced reformers, the CSFRtheareas of macroeconomic stabilization and price has not moved as far in the latter two areas ofand trade reform. It raised some food, transport, reform, but the government is actively reviewingand petroleumprices in 1990 (withdirect compen- many options and is likely to take major steps insation to consumers for the food price increases) 1991.and removed most price controls on January 1, Bulgaria and Romania began their transforma-1991. Its currency was devalued for a second time tion processes more recently. Bulgaria took majorin January and made convertible for current ac- steps in February 1991 to curb inflation (which

9

had risen from 6 percent in 1989 to about 60 outlinesofaprivatizationplanarebeingfinalized,percent in 1990) and promote structural change in and a privatization law is expected soon to be sentthe economy. It unified exchange rates and moved to Parliament. Significant privatization of agricul-to a floating currency, liberalized most retail and tural land previously owned by cooperatives hasproducer prices, adopted tight control on wages already taken place. The governments of bothin the public sector,'7 and liberalized most foreign Romania and Bulgaria are strongly committed totrade (replacing quantitative restrictions with the reform process but still need to concentrate,moderate tariffs). The government is also taldng more than in the other CEE countries, on consoli-important steps to redefine itsrole,in part through dating political reforms and gaining public sup-reforms in the budget and tax systems. Like the port for difficult economic measures.other CEE countries, it has made less progress in The former GDR is undertaking many of theenterprise restructuring and privatization. same reforms as the others but with several sig-

Romania has also undertaken significant re- nificant differences. Price reform was almost im-forms in the past few months. It freed many retail mediate upon creation of the economic and mon-and producer prices in November 1990 and ad- etary union and subsequent unification with thejusted many administered prices upward in April Federal Republic of Germany (FRG), as was the1991. It has ended foreign trade monopolies and change in the role of government. The countryremoved most quantitative restrictions on trade, imported the FRG's legal and regulatory frame-and it is expected to adopt a transition dual ex- work, along with massive technical assistance tochange rate mechanism as an intermediate step implement it. The inflow of skills and financialtoward a unified exchange rate. Like all ICEE assistance (estimated to amount to some $3,000countries, it has removed restrictions on private per person per year) relaxes severe constraints onactivities and is working hard to define an appro- the speed of reform. Nevertheless, enterprise pri-priate legal framework for private sector activity. vatization and restructuring, though proceedingAlthough little progress has been made with en- relatively rapidly, promise to be a lengthy pro-terprise restructuring or privatization, the broad cess.

10

-~~Preliminary lessons of experience

The political dimension run. The difficulty of carrying out political andeconomic liberalization simultaneously has been

The events in Central and Eastem Europe are first noted in analyses of reform in other countries. Inand foremost a historic political revolution, and the case of the CEE countries, proximity to West-the new political environment is still unsettled. It em Europe and the desire to integrate with it willis clear that the entire process of economic trans- help to set standards for both political and eco-formation depends crucially on political develop- nomic reform.ments. On the one hand, political legitimacy and Regional disputes over power sharing can fur-cohesion are clearly necessary for sustainable eco- ther threaten cohesion, compromise legitimacy,nomic transformation; for example, the major re- and impede the economic reform process. In theforms undertaken by the first elected Solidarity CSFR, the division of authority between the fed-government in Poland (with its relatively cohe- eration and the two republics over policymakingsive public support and strong legitimacy) con- and budgetary control is still unclear. The prob-trast sharply with the paucity of reforms in the lem is magnified in Yugoslavia and the USSR,USSR. But the complex and tumultuous process where reaching consensus on the political rela-of political change often constrains economic re- tions and distribution of power among the centerform. Rather than setting out an optimal reform and republics is likely to be a prerequisite forpath, economic analysts continually need to de- large-scale reforms and macroeconomic stability.velop feasible reforms that avoid moving into Regional disputes do not reflect lack of consensuspolitically driven dead ends. on economic policy as much as long-simmering

Tension has emerged in most of the reformiing ethnic tensions that have become more open withcountries between the strong central leadership political liberalization.needed to push through difficult reforms and the The difficulty of sustaining political and eco-broad participation and compromise needed to nomic reform will be exacerbated by the difficultensure widespread support for the program. Cen- international economic environment faced by thetral executive authority has been discredited by CEE countries. Temporarily higher world oilpast experience, and a new model of strong gov- prices, economic problems in the USSR, the trans-emmient with a legitimate role in a market system fornation of the CMEA trading system, and thehas not yet emerged. In fact the pendulum in disruption of trade withIraq (a significant tradingseveral countries is swinging in the opposite di- partner, especially for the CSFR and Bulgaria)rection, toward greater decentralization and au- have all placed extra strain on economies alreadytonomy for provincial and local governments; this burdened with the short-term costs of reform. Theis likely to complicate reform efforts in the short public will find it difficult to separate the impact

11

of reform from the impact of these external shocks. It is widely agreed that mnacroeconomic stabili-The course of reform will not only depend on zation is a prerequisite for structural reforms, and

political developments but may influence them. that it should be followed quickly (or concur-A crucial variable in this respect may be speed. rently) with price and trade reform (includingPolitical pressures that tend to arise in the course current account convertibility) to enhance compe-of a "go slow" approach argue for as rapid a tition and promote foreign investment. Also fol-process as possible. "Shock therapy" as in Poland lowing quickly should be tax reform and the intro-institutes a large set of reforms before strong duction of a system of unemploymnent insurance.opposition can coalesce, and possible resistance to Tax reform is needed to help maintain govern-reform by "old guard" managers and bureaucrats ment revenues while eliminating the ad hoc redis-is often cited as an argument for rapid enterprise tribution of profits that destroys enterprise incen-reform. While the high costs of rapid adjustment tives, while unemployment insurance (and moremay cause political instability if a quick ancd de- general reform of the social safety net) offsetsmonstrable payoff is not forthcoming, a slower social and political pressures to slow down theapproachalsohaspoliticalrisks. Failuretopursue reform process and contributes to its politicalreforms vigorously will be extremely costly in sustainability. Measures to encourage small pri-both economic and political terms. The experi- vate businesses and small-scale privatization canence of other countries suggests that reforms may and should proceed rapidly,sinceagrowingssmall-be easier to undertake the worse the prereformn scale sector is needed to help free up the distribu-situation; this would argue that short-run costs tion system, offset the impact on employment ofwould be borne more readily in Poland than, say, restructuring the larger statefirms,and strengthenin the CSFR. One can only speculate on these domestic competition. Responsibility for corpo-issues at this point; it is still too early to gather rate governance should be clarified and strength-lessons from experience. ened as soon as possible. Restructuring and pri-

vatization of medium-sized and larger firms canThe phasing of reforms begin early in the process but will take time,

particularly for less viable firms. The same holdsThe task of system transformation differs consid- true for effective institutional, legal, and regula-erably from that of policy reform within an estab- tory reforms. While institutional and regulatorylished economic system. The issue of sequencing reform in the banking system start early, fuDof individual reforms withina broad system trans- financial liberalization requires the restructuringformationhasarousedextensivediscussion. Mlost of bank portfolios, which will typically accom-analysts now agree that, although country-spe- pany enterprise reform (annex 4). Similarly, thecific factors will influence the pattern of reforms, pace of wage liberalization is set by that of enter-some components must precede or occur in tan- prise reform, which is needed to insure adequatedem with others. It has also become increasingly controls on the wage-setting process. Finally, fullclear that the components are tightly interlinked, convertibility of thecapital account can come laterand that clearly articulating a long-term strategy in the reform process. A stylized phasing ofand starting along many fronts is important from reforms along these lines, shown in figure 2, indi-thebeginning."B Because some reforms take longer cates also the degree to which reforms need to bethan others, tensions are inevitable. Certain re- carried out simultaneously on many fronts."' De-forms are only appropriate late in the process, bates concerning this pattern of phasing are dis-when market forces are well enough developed to cussed in box 1. In any case it is clear that no exactreplace administrative controls. In any case, al- pattern is preordained; country-specific factorsthough early reforms may yield some immediate will clearly influence the exact course taken in anybenefits (such as an increase in the availability of particular case.goods), rapid and sustainable economic growthshould not be expected until many reforms are Macroeconomic reformsimplemented on a significantly large scale, whichis likely to take several years. All of these propo- Internal balance. The experiences of Poland andsitionsgain force from theindifferent performaknce Yugoslavia show that stabilization measures canof the CEE countries in their earlier phases of reduce inflation, at least in the short run. Poland'spartial reform. monthly inflation during the six-month period

12

Figure 2 Phasing of reform over a 10-year period

Intense ContinuingMacrostabilization _

Price and narket reform

Goods and services:Most goods Some necessities (including housing)

Price reform

Remove QRs Adjust tariffs to moderate levelsTrade reform _ _umiinmim s

Privatization, demonopolizationDistribution __U- UI--- I-

Deregulatehiring and firing Liberalization of wage bargaining

Labor market _ _

Preparation ImplementationAutonomous banldng system __

Preparation ImplementationOther financial markets

Restructuring and privatization

Small-scale privatization and privatesector development

Revise regulationsForeign investment

Uarge-scale:Corporate ggovernance

From evaluation to implementationRestructuring and privatization

Redefining role of stateIntensive (tax reform, basicproperty, and commercial law) Continuing (other)

Legal reforms

Tax administration, budgeting,legal, regulatory institutions

Institutional reform

Emergency InstitutionalizationUnemployment insurance _

Intensive ContinuingOther social areas -__Time (years) - - - - - - - - - - - - - - - - - - - - -

0 1 2 3 4 5 6 7 8 9 10

13

Box 1 Points of debate on phasing

While the phasing of reforms shown in figure 2 probably Should large- privatization be 'quick and dirty' orattracts the greatest consensus within and outside reform- slower and more careful?ing countries (including within the Bank), there has beenintensive debate on several points: Quick Rapid privatization is of utmost importance. It

raises effidency, speeds restructuring, establishes a cxn-Should price reform come before or after enterprise re- stituency for further reforms, and weakens the traditionalform? power centers opposing reform.

Before: Enterprise reform and privatization will not Slow Sales revenues are needed by the government, andsucceed if the market cannot judge effidency and value preservingfairnessintheprocesuisvitalforpublicsupport;because prices do not reflect true costs; budgets cannot be thus restruchtring should precede privatization and firms"hardened" before introducing market prices. should not be given away hastily.

After: Freeing prices in the presence of monopolies will Must full-ale financial sector reform go hand-in-handlead to excessive prices and profits, thereby undercutlting with enterprise reform or can it come earlier?political consensus for reform; domestic competition policyshould be in place before price liberalization. Hand-in-hand. Competitive financial markets require

clean loan portfolios, and enterprise reform and bank port-Should trade liberalization come early and fast or bater folio restructuring are best accomplished simuitaneously;and slower? cleaning up loan portfolios is futile without enterprise re-

form.Early: It supports price reform by importing the wvorld

price structure and heightens competitive forces. Earlier Only independent financial institutions andliberalized finandal markets can play the critical role of

Later: It shocks the economy, in the right directions but allocating capital as enterprises are restructured.with excessive costs, and is risky until the econorny isstabilized.

from March through August 1990 was aboult 4 many European countries after World War II);percent, compared to 30 percent in the last months some excessive balances can also be absorbedof 1989. Yugoslavia's inflation fell from 64 percent through the later sale of public assets. Germanyin December 1989 to 10 percent for the entire! six- implemented a currency reform in 1990, whenmonth period from March through August 1990.? wages and pensions denominated in East GermanAs in market economies, internal stabilization in marks were converted 1:1 to Deutschmarks, andreforming socialist economies hinges on tight fis- most financial claims and liabilities were con-cal and credit policies. Yugoslavia maintained a verted 2:1. A currency reform may be preferablebudget surplus and allowed no growth in the to high inflation if the latter is avoidable,' al-nominal stockof net domestic assetsof thecentral though high inflation may create a sense of ur-bank. Poland turned its budget deficit of 8 percent gency and thus a strong political consensus forof GNP in 1989 into a surplus of over 5 percent in change.the first nine months of 1990 and kept credit ex- Socialist economies must also resort to admin-tremely tight in the first half of 1990 through strict istrativecontrolswheremarketsarelacking. Wagelimits on the nominal growth in net domestic controls in particular are needed in public enter-assets.2" prises because firms without active owners have

In addition to tightening fiscal and monetary little built-in incentive for wage restraint. Indeed,flows, stabilization may also require defusing the those working in such firms may face incentives toinflationary pressure of excessive stocks of money decapitalize them, particularly once reinvestment- the "monetary overhang." Excessive money in private activities is permitted. In January 1990,balances can be eroded through rapid inflation (as Poland implemented a high tax on any increase inin Poland) or reduced in nominal terms thrcugh the total nominal wage bill of an enterprise be-confiscatory currency reforms or blocking (as in yond a preset percentage& of the inflation rate in

14

thepreviousmonth,whileYugoslaviafrozenomi- and the possible collapse of the Soviet market duenal wages for six months at the start of its stabili- to internal difficulties. These and other tradezation program. Early experience points to the shocks are discussed below and in annex 1. Howpressures to raise nominal wages that will result to finance the current account deficits that arein the course of stabilization and that may derail expected if growth is to resume is among the mostreform efforts. In Yugoslavia, for example, official critical issuesfadngtheCEEcountries (seechapter 4).estimates of real wages fell some 45 percent from Stabilization may also require addressing aNovember 1989 to February 1990 but rose 25 heavy overhang of domestic and external debt.percent in the three months after the nominal On the domestic side, the magnitude will emergewage freeze was lifted in June. The resulting in the course of restructuring thebalance sheets ofmonetary accomnnodation, including renewed fi- the banking system and interenterprise credits.nancing of enterprise losses, led to a jump in Various options for dealing with the domesticinflation in the third quarter of 1990. In the GDR, debt overhang exist, as discussed in annex 4. Onthe absence of effective wage restraint allowed theinternationalside,Poland,Bulgaria,andHun-negotiated wage settlements to rise by over 25 gary took on heavy foreign debt burdens in thepercent in the summer of 1990, far out of line with 1970s and 1980s. Poland has recently benefitedproductivity. Official estimates of real wages in from extensive official debt relief, and BulgariaPoland fell 47 percent in the first half of 1990 has suspended interest payments and is likely tobefore rising somewhat in the second half to end begin debt negotiations soon with commercialthe year 30 percent down. creditors. Yugoslavia has actually reduced its

debt burden significantly through debt buybacks,Extenal balance. On the external front, stabili- froma high of $21 billion in 1987 to $163 billion by

zation may well require devaluation (whether to the end of 1990. A debt overhang raises uncer-a fixed or floating exchange rate) to complement tainty and reduces additional foreign capital flows.tight expenditure-reducing policies and trade lib- Continuedinternationalcooperationtoalleviatedebteralization. Hungary's 1990stabilization included burdens is needed for some CEE countries (seea 15 percent devaluation of the forint in addition chapter4).to tight fiscal and monetary policy. Poland andYugoslavia devalued sharply at the beginning of The costs of stabilization. Experience with1990, Poland by 46 percent and Yugoslavia by 20 stabilizations to date (as accompanied by adjust-percent, establishing fixed exchange rates that ment measures) suggests that a large short-runheld as nominal anchors for their stabilization decline inoutput is unavoidable. Poland's officialprograms throughout 19903V Theexperienceinall measure of output fell 14 percent in 1990,26three countries shows that exports can increase Yugoslavia's fell 3 percent, and Hungary's fell 65significantly in response to such measures.,, In percent, with further declines expected in 1991Hungary, convertible currency export volume (table 1). This high cost of stabilization (combinedgrew by 10 percent and the current account was with adjustment measures) results in part fromvirtually in balance in 1990 (an improvement of the absence of effective factor markets, whichsome 5 percent of GDP over 1989). With a 37 prevents macroeconomic pressures from rapidlypercent growth in export volume, Poland's trade being translated into efficiency improvements.surplus for 1990 reached about $3 billion, in con- Official data miss part of the picture, however,trasttothe$800milliondeficitexpectedatthestart While official measures of output and real wagesof the program. Yugoslavia's exports grew rap- fell dramatically in 1990, these data do not fullyidly in the first half of 1990 but slowed thereafter account for the vibrant growth in private sectorasinflationerodedtherealexchangerate. Imports activity, albeit from a small base. Furthermore, itgrew even faster as a result of real exchange rate has been argued that the standard of living of theappreciation during 1990, leading to a deteriora- average Pole fell less than wage data would sug-tion in the current account balance from a surplus gest because price reform eliminated queues andof more than 3 percent of GDP in 1989 to a deficit black markets. Govemments should make theof about 2 percent in 1990. costs of stabilization clear from the beginning to

The outlook for trade and current account bal- avoid unrealistic expectations, but they shouldances is darkened by the costs expected to result monitor the economy closely to avoid results be-from the demise of the CMEA system as of 1991 ing painted blacker than they actually are.2'

15

The level of the exchange rate affects both thecosts of stabilization and the speed (and resulting Box 2 Economic developments in eastshort-term costs) of adjustment. Poland's experi- Germany after economic unionence shows that a large devaluation, while per- EaGermyunderwentthemostextrn bgbang"haps helpful in achieving external balance, may hs ecmonoc union with West Germany on juy 1,raise the short-term costs of stabilization whilewihtSeomcunnwthes eraynlly1raise the short-term costs of stabilization while 1990. Prices were liberalized, the economy was openedslowing adjustment. A larger devaluation causes to international competition, a fixed 'exchange ratethe real money supply to contract more sharply, was inhtroduced, and factor markets were created over-leading to a tighter credit squeeze and a larger ifall night. Theeconomicconsequencesof thesudden switchin total output. In addition, it reduces interna- to an open market economy were more severe thantionalcompetitionandleavesnmorescopeformod- expected. Consumers switched from east to west Ger-erate inflation to continue to theextent thathealithy man goods to a far larger extent than anticipated. Indus-domestic firms -often monopolies-have room trial production in east Germany slumped by 50percent(even more in light industry) in 1990, and is expected toto raise prices. Some observers now believe ithat fail evenmorein 1991. GDPdedinedbyanestimated20Poland devalued too much in January 1990, a percent in 1990. The one-to-one conversion of eastlesson of experience that may prove useful to German to Deutschmark wages combined with high (25other CEE countries.23 Poland's 1990 fall in output percentandmore)coflectivelynegotiatedwageincreaseswas much greater than expected and is attributed in the summer of 1990 led to relatively high unit laborin large part to the severity of the initial devalua- costs. This, combined with unclear property rights, poor

tion ad the ubsequnt creit cruch tha aroseinfrastructure, and uncertain environmental liabfitbes,tion and the subsequent credit crunch that arose makes investment in the region even less attractive.due to nonaccomodating monetary policy. Fur- GDP is expected to drop a further 15-20 percent in 1991.thermore, Poland has continued to experience Unemploymentrose steadily to 750,000 (about 9 percentinflation since early 1990 of between 3 andl 8 of the labor force) in January1991 and coulddcimb to aspercent per month, as domestic prices of traded high as 2 million later in the year. In addition, thegoods have had room to move upward toward number of short-time workers rose to 1.9 milion in 1990international prices, and as prices of nontraded and is also expected to increase The "full-time equiva-

g have soared3 The large devaluation pro- lent' unemploymentratein 1991 couldreach 40 percent.goods As a result of the sharper than expected recession, public

vided "breathing space" for healthy Polish finns, revenues are falling and government spending on socialwhich did not feel intense competitive pressure as services is rapidly rising. Spending on the order of 50rapidly as many expected.w percent of east German GDP - some 13,000 per east

Thecaseof theGDRpresentsa sharp contrast to German resident -isexpected in 1991, two-thirds to bethat of Poland (see box 2). Most believe that the covered by fiscal transfers from west Germany and theimplicit and fixed "exchange rate" set at the time rest to be raised elsewhere. Given that east Germanof economic union with the FRG was too high. wage rates are unlikely to fail dramaticaUy and may inof economic union ~~~~~~~~fact continue to rise, continued fiscal transfer and aThe immediate opening to international competi- strong regional development policy are needed to stemtion thus put heavy pressure on domestic finns, further migration and inaeasing econonic disparityleading to enormous short-term declines in out- between east and west.put and employment. The GDR's experience wasunique, in that due to union with the FRG it didnot have to achieve internal and external balance; nancing enterprise losses once again. Inflationits decline in output was due to pressures of rose to over 7 percent in both September andadjustment rather than stabilization. The other October,beforebeing slowed againby tight creditCEE countries do not have this option. policies in November. Even after the 28 percent

Yugoslavia'sexperiencewasbetween these two devaluationat thebeginning of 1991,Yugoslavia'sextremes. It did not depreciate its real exchange currency is now considered to be significantlyrate as sharply at the beginning of its reform. overvalued due to the cumulative inflation inFirms were squeezed by the stabilization mea- 1990 of 119 percent.sures while imports provided competitive pres- Both the Polish and the Yugoslav experiencessure to hold down prices. By mid-1990 about 30 point to the difficulty of sustaining stabilizationpercent of Yugoslav firms reported difficulties, withanopen tradingregimeintheabsenceofrealwith many on the verge of bankruptcy.3 ' How- adjustment in the underlying economy. Whetherever, the absence of "breathing space" put early immediate breathing space is provided or not,pressure on the government, which relaxed mon- sooner or later enterprises will feel the pinch ofetary and credit policy after June and began fi- international pressures. If they are not rapidly

16

restructured to improve productivity, they are expanded access to the variety of goods availableeventually threatened with massive layoffs and on international markets. Price reform is the keybankruptcy. Resultingpoliticalpressurescancom- step in this process. For goods that are traded onpromise the government's commitmnent to stabili- international markets, price reform means mov-zation. ing to world market prices and liberalizing the

Firms react initially to the pressures of stabili- price-setting mechanism, either simultaneouslyzation policies by seeking other "safety valves." or sequentially. Such price reforms will typicallyInterfirm credits, for example, grew dramatically result in large increases in the official prices ofafter stabilization measures were taken in Poland "necessities" (such as staple foods, meat, and en-and Hungary. The combination of a weak legal ergy) heavily subsidized under central planning,framework to enforce credit obligations and the although it may also result in decreases in unoffi-lack of true ownership interests in firms means cial, or "black market," prices.mthat there are few endogenous constraints on the While Yugoslavia had gradually liberalizedgrowth of these credits. They weaken the enter- most pricesover many yearsprior to 1990, Polandprise sector in the medium run and raise the risk adopted the "bigbang" approachbyfreeingaboutof cascading bankruptcies over time. Govem- 90 percent of all prices simultaneously at the be-ments need to regulate interfirm credits in order ginning of 1990. Romania freed about 50 percentto have true control over the money supply and of prices on October 1, 1990, and Bulgaria freedprevent profitable firms from being dragged into prices covering some 90 percent of tumover onbankruptcy by unprofitable onesY February 1, 1991. The CSFR adjusted some ad-

ministered prices upward in mid-1990 and liber-Theinteractionofstabilization andsystem transfor- alized most prices (covering some 85 percent of

mation. The goals of stabilization and system production) on January 1, 1991. Its mid-1990transformation are often mutually supportive. reduction of price subsidies on food was compen-Price realignments to market levels lower con- sated by an across-the-board direct payment tosumer subsidies, while cuts in subsidies to loss- households based on average consumption lev-making firms, whether through the budget or the els, rendering these subsidy cuts approximatelybanking system, speed adjustment by forcing en- budget-neutral. Hungary followed a somewhatterprises to close or restructure. Replacing quan- more gradual process of price reform as the do-titative restrictions with tariffs raises revenues mestic pricing regime was progressively liberal-while helping to import a rational price structure ized after 1988. By the end of 1990, about 90from abroad. More generally, stabilization is not percent of consumer prices were free of govern-sustainable without real underlying adjustment, ment control.3as noted above. Experience to date shows that freeing prices

Sometimes, however, stabilization and adjust- and allowingfreeentryin distributioncanelicitanment goals can conflict. One example is the need immediate and dramatic increase in the availabil-to maintain public sector wage controls through ity and variety of goods in the market. In the spacethe stabilization phase despite the distortions this of a month or two after price reform, much of theprolongs in the labor market and the disincentives retail trade in Warsaw had moved from govern-it can create - noted in Poland - to increase ment shops to the less formal curbside market,output. Also, the needs of system transformation often operating out of trucks parked on maincan conflict with those of stabilization in the area streets. Queues had practically disappeared, andof tax policy, as revenue requirements confront government shops, progressively supplementedthe need for more transparent and less burden- by private retailers, started to offer a wider varietysome tax rules to spur private sector develop- of goods for sale. Direct interfirm transactionsment. The resolution of this dilemma requires a increased at the expense of the previous distribu-comprehensive tax reform, as noted in annex 5. tors, both domestically and internationally.

The freeing of prices needs to be accompaniedPrice and market reform by the development of competition policies to

offset the tendency of monopolists to raise pricesThe market for goods. Expanding the market for excessively. International competition may con-goods requires at a minimum free entry for pro- strain monopolists'behavior if trade is liberalizedducers and distributors, freedom of buyers and concurrently with price reform, if imports supplysellers to negotiate market-clearing prices, and a sizable share of the domestic market, and if the

17

exclhange rate is roughly competitive. This is (and cutting credit subsidies) over time is an im-unlikely to be sufficient in all cases, however, portant - and politically divisive - step in theespecially in larger countries (such as Poland, reform process, housing reform touches on manyYugoslavia, or particularly the USSR) where im- other issues as well (box 3).ports play less of a role. Domestic competitionpolicies designed to break up monopolies (in part International trade. In small or medium-sizedthrough appropriately structured privatization) countries such as those in Central and Easternand controlunfairtradingpracticesshouldcomple- Europe, price reforms for traded commodities canment international market forces. be introduced quickly by establishing currency

For nontraded goods, price reform may entail convertibility and opening the economy to for-reducing subsidies and eventually freeing the eign trade. As noted above, this enables countriesprice-setting mechanism. Many of these goods to "import" not only the international price struc-- including housing and certain services such as ture but also the benefits of international compe-medical care, child care, and education - have tition, lessening the need for domesticlong been considered as entitlements, and major antimonopoly controls. A realistic exchange ratepriceadjustmentsmayneedtobecompensatedlby (whether fixed or floating) is a minimum prereq-raising cash wages, effectively shifting a larger uisite for such a move. If the exchange rate is to bepart of consumption onto a market basis. There is fixed, adequate reserves are needed to defend it.high social and political resistance to these price Official reserves in Poland, for example, equalledincreases, and no country has yet made extensive four and a half months' imports in January 1990.reforms. CEE governments have long allocated Bulgaria, with very low reserves (as low as twostate-owned housing bureaucratically (with weeks' cover in mid-1990), opted for a floatingsubsidies typically in the range of 3-6 percent of rate when it moved to liberalize trade in FebruaryGDP), and some have also subsidized private 1991. Trade reform can accompany stabilizationhousing through low-interestloans. Private own- (as in Poland and Yugoslavia) or be introducedership has generally been limited to one or two more gradually (as in Hungary, which has pro-dwellings;averysmallprivaterentalrmarket exists gressively removed import licensing restrictionsin Poland and Hungary, but owners' rights are since 1988).limited. Rents for state housing typically aver- Unfortunately, the opening of these countriesaged only 2-5 percent of family income in the to international trade is taking place in an atmo-1980s, and those in the Soviet Union have not sphere of intense and somewhat unpredictablechanged since the 1920s. Although raising rents change in their trade regime with each other and

the USSR - the CMEA system. CMEA tradeshifted from bilateral clearing at administered

Box 3 Issues in housing reform prices to multilateral trade at world prices onJanuary 1, 1991. Although this shift is a logical

Housing sectors in CEE countries have been marked counterpart to domestic market-oriented reforms,by severe shortages that inhibit labor mobility and by it is expected to impose substantial terms-of-tradeever-expanding public subsidies that strain public bud- losses on the smaller CEE countries in favor of thegets and financial systems. Housing reform encom- Soviet Union. Estimates of these losses requirepasses many issues in addition to rent and subsidy judgments on the expected quality discount onreform and accompanying wage adjustment (as dis-cussed in the text. Establishing a market for housing East European manufactures and are sensitive torequires, for example, an overhaul of the system of the price of oil; recent estimates based on an oilhousing finance, with major implications for the finan- price of $21 per barrel suggest a terms-of-tradecial system in general. It also requires privatizing a shock of $11.4 billion for the five CEE countriessubstantial portion of the public housing stock, which excluding Yugoslavia, equivalent on average torelates to broader privatization and macroeconomic 4.4 percent of their GDP (see annex 1). Difficultiespolides. Housing markets require extensive legal ancd in the Soviet economy also make it harder toinstitutional reforms to enact and enforce zoning anclbuilding codes. Finally, extensive reform and restruc-tuing is needed in the construction industry to reorient multaneously, the GDR - in merging with Westincentives and improve productivity. Germany and adopting the Economic

_ ____ Community'sCommonTradePolicy-hasmoved

18

from being a maopr trading partner of most of the ThereformingcountriesarebeginningtoDmakeCMEA countries to being a competitor with pref- progress in reducing controls on labor marketserential access to important Western European and establishing principles of collective bargain-markets. Trade among former CMEA partners ing. Yugoslavia, for example, enacted a new labormight decline by 40 percent in volume terms in code in 1989 that established the right of firms to1991. Finally, trade sanctions against Iraq and transfer or release workers under conditions thatresulting losses in oil shipments (as payments in are progressively being liberalized. Several coun-kind for past credits) also impose heavy costs, trieshaveseenanincreaseinredundancies. How-particularly on Bulgaria and the CSFR. The diffi- ever, the process is too new to draw lessons.cult trading outlook for the reforming countriesposes a threat to the sustainability of reforms, Financial markets. The challenge of financialespecially against the background of declining market development in the CEE countries is tooutput in 1989-90, and heightens the urgency of create independent, market-oriented banks ableobtaining Western assistance. to mobilize savings, evaluate risk, and allocate

capital along efficiency criteria. As previouslyThe market for labor. Although anathema to noted, the absence of a market-based financial

Marxist ideology, labor markets existed in the system is costly even in the early stages of macro-CEE countries prior to reform. However, they economic stabilization, because no effective chan-operated under controls (constraints on pay, gen- nel exists to assure that macroeconomic policieserous benefit systems, and prevention of dismiss- - in particular the tightening of credit- supportals) and incentives (especially the absence of fi- microeconomic adjustment. Although allreform-nancial discipline) that inhibited efficient labor ing countries recognize the importance of startingallocation (see annex 6). immediately with financial system reform, it can-

Freeingup labor marketsmeansreducing rigid not be done overnight. Most countries have al-centralcontrolswhileinstitutingactivelabormar- ready broken up monolithic banking structuresket policies - education, training, job informa- into two-tiered systems consisting of a centraltion and counseling services, smallbusiness assis- bank and several commercial banks. Central andtance,government-providedunemploymentben- commercial bank legislation has been drafted andefits, and new mechanisms for collective bargain- is being revised as reform progresses. However,ing-topromoteefficent labor mobility.35 Many developing fully functioning and independentmeasures can be initiated early on; however, as banks requires extensive training and technicalnoted earlier, governments cannot fully release assistance in complex areas, many of which arecontrol over wage-setting until rarket controls new for the countries concemed. Banks mustexist as a substitute, and this is not likely to occur leam how to attract deposits, manage liquidity,until a large portion of the enterprises have been evaluate risk, and carry out payments functionsprivatized. However, tight wage control for an for commercial transactions, while bank regula-extended period of time also imposes costs, in- tors must be taught how to oversee asset portfo-creasingly divorcing wage scales from productiv- lios, evaluate liquidity, and judge the adequacy ofityand exacerbating social pressures that threaten bank procedures and management. Market-ori-fragile democracies. Setting wage policy in re- ented accounting systems must be developed con-formingsocialisteconomiesmeansbalancingsev- currently. Institutional and skill development iseralcompetingandoftencontradictoryobjectives. proceeding apace in all the countries but will takeIncreasingincentivesrequireswiderpaydifferen- time. Certain issues conceming the new systems,tials (particularly for skilled professionals), al- such as the ownership of banks and the desirablethough socially acceptable differentials may be scope of their activities, are not resolved (seenarrow relative to other market economies. The annex 4).bottom wage should be significantly above the Before banks can function independently andminimum level of social support, which cannot competitively, their portfolios must be restruc-easily be cut back from past levels. Yet real wage tured and their capital bases restored. As long asgrowth must be limited to avoid more extensive a large segment of client enterprises continues tounemployment and to constrain aggregate labor generate losses, the banking system will find itpurchasingpowerin linewithrealnational income. difficult to avoid taking on more bad debt. Re-

19

Box 4 World Bank support for private sector development: The example of Hungary

The World Bank group has been intimately involved in aiization, major subsidy reduction, tightened financial dis-advising and supporting CEE governments with private ciplineforenterprises,keyactionstowardenterpriseprivat-sector development. In the latter half of the 1980s in Hun- ization, the developmentof a modern accountingand audit-gary, for example, there was extensive dialogue on liberal- ing framework, and a strengthened macroeconomic frame-izing trade, expanding the scope for small-scale private work. In addition, an Enterprise Restructuring and Privat-activities, increasing enterprise autonomy, liquidating loss- ization adjustment loan is being appraised that wiDl supportmaking enterprises, facilitating foreign investment, imple- a comprehensive government program for ownership re-mentinga modern company law, and ultimately transform- form (including the transformation of aU state enterprisesing state enterprises into companies with mixed or private into company form and improved government exercise ofownership. This dialogue was supported by substantial ownership rights and duties), the goverrnment's ambitiousBank direct technical assistance as well as several Bank privatization program, and the selective restructuring ofloans for the industria sector, and it helped lead to rapid state enterprises. Other Bank activities include the 1990transformation of the framework for private sector activi- Finandal System Modernization Project and other efforts toties. further involve recently created cofmtmerdal banks in lend-

The dialogue has continued during 1990 and 1991. The ing to the private sector.first Structural Adjustment Loan has supported trade liber-

structuring the banks is integrally linked to the Private sector development, privatization, andrestructuring of the enterprises. Governmlents enterprise restructuringmust eventually assume many of the problemloans and inject new capital into the banking New investment. The most important spur tosystem; however, if done too early this may eocac- economic growth is likely to be the growth of newerbate fiscal strains. private businesses. Experience to date shows that

Full reform requires liberalization of interest new private small-scale business can develop rap-rates. At the start of reform, interest rates should idly in a supportive environment. In 1989 andbe adjusted to realistic levels to provide appropri- 1990 all of the countries of Eastern and Centralate signals to savers and borrowers, and banks Europe lifted their highly restrictive controls overmay be given some range of discretion to set rates private sector activity. New laws sought to placeon loans and deposits. But rates should nol be private enterprise on an equal footing with publicfully liberalized until a country has reasonable firns by equalizing tax treatment, removing re-macroeconomic stability, a sound and competi- strictions on private firms' size and activities,tive financial system, an effective system of ]pru- freeingprivateprocurementanddistribution,anddential supervision, and "hard"budgetconstrakmts reducingbureaucratic requirements for establish-for firms (see annex 4). Finally, achieving a sound ing new firms. The response was immediate.and competitive financial system is likely to re- Over half a million new sole proprietorships andquire extensive privatization of the banking sys- 30,000 incorporated companies registered in Po-ter. land in 1990; of the latter, about 20 percent were in

In addition to banking reform, several coun- manufacturing and the rest in trade and services.tries aremoving to establish stock and commodity In the CSFR, more than 500,000 potential entrepre-markets along Westemrn models. The Budapest neurs have registered for licenses (primarily inStock Exchange opened in June 1990, and the trade and services) with the newly formed Em-Hungarian Commodity Market - whose trade is ployers' Association since the new private enter-currently limited to cereals - was established in prise legislation was passed in April 1990. Hun-late 1989. Trading in both markets is small, but gary has been liberalizing private sector activitysecurities now account for about 10 percent of since 1982 and now has some 300,000 private soleHungary's financial assets. Poland and the CSFR proprietorshipsand several thousand privatelim-both plan to open stock exchanges in 1991. An ited liability companies. The share of workersearly start in developing securities markets is employed in the private sector in Hungary haswarranted (particularly in connection with pri- risen from 0.1 percent to an estimated 10 percent;vatization), but financial sector reforms are neces- however, more than half of those working in thesarily limited by developments in the underlying private sector do so while also maintaining theirreal sectors of the economy. jobs in the state sector. Although private enter-

20

prise has been permitted (with limitations) for a Privatization. Revitalizing theenterprise sectorlong time in Yugoslavia, a more liberal Law of will require restructuring and privatizing manyPrivate Business was passed in mid-1989. Nine existing enterprises, whether small or large, in-thousand new limited liability companies were dustrial, agricultural, or service-oriented. Experi-formed in the first half of 1990 alone, most in trade ence over the past 10 years suggests that the twoandservicesbutagrowingnumberinproduction. are intertwined - successful restructuring will

Private sector development continues to be require extensive privatization. State-owned en-constrained by many factors, however, including terprises can work efficiently in an economic sys-burdensome rules and regulations, limited credit teminwhichmostenterprisesareprivatelyowned.due to poorly functioning financial systems and But when the vast majority of enterprises arelimited collateral assets, weak domestic demand publicly owned, the institutional and competitivedue to tight stabilization policies, legal and politi- framework that stimulates efficient behavior iscal uncertainty (including that regarding land missing. Socialist firms in essence have no ownerownership), high taxes, and the de facto prefer- to defend the interests of capital and activelyences that continue to be enjoyed by public sector demand a good return on investment. A smallfirms. Private manufacturing firms are still con- minority of firms and some moderate ownershipfined to niches (often themselves monopolized) share in the remainder can stay in public hands,carved out in the few areas not dominated by state but for both economic and political reasons aenterprises. Despitegrowingprivateactivity,com- majority interest in a majority of firms needs to bepetition is still weak. There is a strong case for transferred to the private sector in the course ofbroad measures36 actively to encourage private system reform. This will by necessity entail mas-firms until the dominance of public enterprises is sive privatization in the CEE countries, whereeliminated. between 65and 90percentof GDPisaccounted for

Foreign investmentis also growing. Inl990the by state enterprises, as compared with about 10number of registered joint ventures in both Hun- percent on average in industrial countries and 15gary and Poland doubled from about 1,000 to percent in developing countries.more than 2,000. In the CSFR, registrations in- Yet ownership reform is proving to be perhapscreased from only 60 at the beginning of 1990 to the most contentious challenge in the entire re-500byOctoberl. EnterprisesinCEEcountriesare form process. While rapid privatization is theactively seeking joint venture partners, which of- goalinalmostallcases,animportantintermediatefermarketaccess, technology, and capital, seen as step (sometimes referred to as "corporatization")keys to survival. However, in terms of financial is to establish tangible ownership rights and cor-flows, foreign investment is unlikely to play as porate governance, possibly on behalf of the statelarge a role as many expected at the outset of the itself.37 This confronts years of decentralization ofreform process. Investors are wary of political control to managers and/or workers' councils,and economic risks and the uncertain legal and particularly in Yugoslavia, Poland, and Hungary,procedural frameworks. The average investment which have bestowed de facto ownership rightsisquite small; in Poland, joint ventures account for that are politically difficult to reclaim. Legitimateless than 2 percent of sales and employment, and claims of previous owners can complicate themost investors are emigres. Although average picture still further. In Hungary, the CSFR, Po-capital per joint venture is somewhat larger in land, and the formerGDR, for example,thosewhoHungary, foreign capital - mostly from Ger- owned enterprises, land, commercial real estate,many, Austria, the United States, and Switzerland and housing prior to the nationalizations of the- is still generally small, usually less than half of 1940s and 1950s are claiming rights to these as-total capital. However, foreign capital is not the sets.3Nonly goal; management expertise, familiarity with If these immediate constraints can be handled,export markets, and access to advanced technol- the general shape of a consensus on the means ofogy are also major benefits from foreign involve- privatization is now beginning to emerge (seement. Development of a well-structured legal annex 2). Rapid privatization will need to rely onframework and the institutions to support and a multitrack approach; no single approach canenforce it (discussed in the section on the role of provide the answer. It is clear from recent experi-the state) is critical to the growth of both foreign ence that privatizing small-scale firms, particu-and domestic private investment. larly in trade and services, is relatively easy. They

21

can be auctioned off by local governments (and insome cases returned to former owners) quite Box 5 Enterprise privatization in eastquickly and successfully. About one-half of GermanyPoland's state-owned shops were transferred toprivate hands in 1990 alone. Hungary and the GDR has encuntered serious difficulties since its incep-

CSFR have passed laws on 'small privatization" tion in mid-1990. It relies exdusively on sales to "quali-

and have begun to privatize retail trade and ser- fied buyers"; no firms will be sold through the existingvices through auctions to the highest bidder. stock exchange (where diluted share ownership or "un-

Large industrial firms present a more complex qualified buyers might emerge) or given away to citi-challenge. The one thing that is clear is that zens at large (although any "residual" from the entireprivatization of these firms is a very complex, privatization program will be distributed to east Ger-imperfect, and time-consuming process. liree mans). As of January 1, 1991, the state privatizationmansof privatizing -me-contanm usg privatiza. Inragency (the 1Treuhandanstalt") hadcondudedabout500means of privatizing- "spontaneous" privatiza- deals, almost exdusively negotiated case-by-case with

tion (or sales of firms or their assets "from be- west Germans and foreign buyers. Some deals involvedlow'), public sales (directed from "above" and entirefirms,whileothersinvolvedspinoffsofthe8,000orpossibly combined with liquidations), and free solargeenterprisestobeprivatized. Inaddition,aboutamass transfer - are all likely to play a role, al- third of the 11,00 small- and medium-sized enterprisesthough with a different mix in each country. Prof- nationalized in 1972 had been returned to their previous

itable ethe most prone to privatize "spon- owners, and some 7,000 smal shops had been leased toitable firms aret ist prong to own spon- private individuals as a step toward privatization.taneously" - that is, by issuing their own shares Experience to date offers several lessons. Valuation

to insiders with greater access to infonration and has proved very difficult, leading to widespread use ofpower - as cases in Hungary, Poland, and Yugo- 'incomplete contracts that provide for later determiina-slavia have shown. While previously sanctioned tion of the purchase price. Buyer interest has been lim-

by law, and still regarded by some as the easiest ited, particularly for firms producing tradable goods.means to an important end, spontaneous privat- This reflects the low competitiveness of east Germanizationhas suffered prominentcases of abuse,and industry due to backward techmology, inadequate infra-thebeliefthatmsufferednprominsi rent son lature,d structure, and high wages set by the high valuation of thethe belief that many insiders were "nomenidat-ura" East German Mark and by recent collective bargainingof the old regime has led to public outcry. Only agreements. Uncertain property rights and contingentHungary still plans to rely heavily on this means, environmentalliabilitiesresultingfromtheapplicationofwhich will be closely supervised by its State Prop- westGermanenvironmentalstandardsalsodampenbuyererty Agency. interest. It is now clear that there will not be any inter-

The two rnain alternatives to spontaneous pri- estedbuyersforalargenumber of enterprises. ManywiUlvatization for large firms are sales by the have to be financially and organizationally restructured

milent to the highest bidder and free distribution of to make them more attractive, and liquidation and sale ofment t the ighestbidde and fee ditributon of assets will have to play a larger role than expected. Theshares to citizens. The two are not mutuially Treuhandanstalt is willing to consider a negative pur-exclusive; some firms can be sold by the govern- chaseprice, that is, payingabuyer to takeon an unwantedment while others are distributed free.39 Many stateenterprise. EvenwithhundredsoftopwestGermananalysts have argued that sales are preferable to managers drafted from other companies, privatization is

free transfer, both because they lead to clear cor- going to be a slow and complex process.

porate control by interested "real" owners andbecause they add to public revenue. Yugoslavia tion is virtually impossible given the absence ofintends to rely primarily on public sales. Hungary capital markets.0 The second barrier is capital.issupplementingspontaneousprivatizationswith Domestic capital is inadequate, and sales to for-a programof "activeprivatization," ordirect sales, eigners are limited by political factors.41 The thirdby the State Property Agency. Poland plans to barrier is equity: "nomenklatura," blackprivatize many of its largest enterprises through marketeers, orbeneficiaries of current market dis-individual sales. Germany is relying exclusively tortions are seen as being likely domestic buyers.on public sales to privatize the state enterprises in Because of the depressed condition of the econo-the east (see box 5). mies and the high perceived risks, acceptable

Recently, however, the difficulties with exten- prices may be low and these buyers may reapsive public sales have become more and more "windfall" gains.41 The fourth barrier is time.evident. The first is valuation. The experience of Hungary has some 2,000 state-owned firms, and1990 has led many to believe that accurate valua- Poland over 7,500. Hungary's first program in

22

September 1990 involved 20 firms; Poland sold issue (see annex 3), there has not been widespreadonly five firms in its first public offering in January discussion on how to coordinate land reform and1991, compared with an initial target of 150.0 themoregeneraliprivatizationof stateassets. While

Given these drawbacks, the view is emerging the approach to property rights in land should bethat givingawaya large share of state assets to the consistent with property rights in other assets,public may be the fairest and quickest means to land should not be owned by widely dispersedwidespread privatization. The most discussed absentee shareholders as industrial enterprisesmeans of giving away assets is to issue citizens would be under the various voucher plans undervouchers that can be exchanged for the assets of consideration. Therefore, neither state nor collec-their choice. The CSFR first advocated such a plan tive farms should be included in the portfolios ofinearlyl990,andPolandandRomanialaterturned any intermediaries established to hold shares onin that direction. All three countries hope to behalf of the public.implement such a scheme in 1991.

Mass transfers have at least three major poten- Restructuring. Whatever the means chosen,tial drawbacks. The first is the fiscal cost associ- many firms will remain in public hands for a longated with forgoing sales revenues; thisonce seemed time, and many of these will need to be restruc-paramount but now may be somewhat less im- tured or closed. Some restructuring will be re-portant, in part because the alternative of sales quired prior to privatization, even if only to "pre-also appears unlikely to raise as much revenue as pare" enterprises for privatization. Beforeinitially hoped.44 The second is the fear that the privatizing individual firms, for example, gov-resulting ownership would be so widespread and ernments need to break up large monopolies,diluted that owners could not effectively assert tackle sector-wide issues of excess capacity (espe-control over management. The third is the con- ciallyinheavyindustryandsectorsaffectedbythecern that the public would lack the information demise of the CMEA system), and address thewisely to "invest" vouchers. Various plans at- politically tricky problem of mass redundancy.tempt to tackle the latter two problems by propos- Experience in Great Britain and elsewhere sug-ing intermediaries to hold and "own" assets in gests that these steps are easier to accomplish intrustforthepublic. Theintermediaries-whether public hands (perhaps with private-sector mana-domestic or joint venture holding companies, gerial assistance), especially if all parties knowmutual funds, or soon-to-be-privatized banks or thatprivatizationis imminent. Governmentsmaypensionplans-wouldownrelativelylargeblocks also need to "clean up" the balance sheets of someof shares in enterprises and would therefore have public firms prior to privatization, although theya greater ability and incentive than individual should resist bailouts when firms are dearly fi-citizens to play an active ownership role. nancially inviable in the longer run. Physical and

The various voucher plans have many attrac- managerial restructuring may also be needed,tive features and could well play a positive role in although incoming private managers can usuallyspeedingupandpromotingfairnessintheprivat- handle this better than the government if near-ization process. However, the plans are still in- term privatization is feasible.complete in many details. For them to be effective, The challenge in the CEE countries is on a scaleit is imperative that they be designed and imple- far larger than has ever been faced elsewhere.mented to insure effective corporate governance How can CEE governments, with limited exper-and to facilitate further sales of firms by interme- tise and resources, undertake so challenging adiaries. restructuring policy? The key challenge is institu-

Several countries are moving to privatize state- tional. Institutions and criteria are needed toowned or cooperative farms. Both Bulgaria and provide restructuring advice and finance, withRomania recently passed land reforn laws that appropriate safeguards to preclude bailout. Po-provide for the breakup of collective farms and land and Yugoslavia recently established restruc-the return of land to private ownership. In each turing agencies to provide technical assistance incountry claims of prior owners will be honored, designingandevaluatingrestructuringprograms.although the land returned will not necessarily be Specialized financial institutions have been cre-that taken away at collectivization. Although the ated to help these and other programs in Poland.need to restructure collective farms and redefine The other countries have not yet begun to tackleproperty rights in land is clearly an important the problem in earnest. Experience in east Ger-

23

many, where thousands of west German experts Two politically sensitive but necessary measuresare available to help with restructuring, shows are the removal of food subsidies and the restruc-that the process will be long and hard even in the turing (whetherbreakup or consolidation) of landbest of circumstances and suggests that many ownership. Producers are hostage to the pace offirms will have to be closed.'5 In the other reform- change in processing, marketing, and distribu-ing countries, where resources are scarcer, the tion, and reforms in these sectors (includingroad is likely to be even longer and harder. As delinking rural services from productive units)with privatization, one should expect a slow and have high priority. While the potential payoff isimperfect process at best. high, agricultural reform is more complex in the

Price, tax, and trade reforms facilitate the re- CEE countries than it was in China and is notstructuring process of both public and private expected to have the same power to lead overallfirms by improving incentive structures. How- reform. This and other comparisons of the Eastever, the experience in Poland and Hungary indi- European and Chinese experiences are furthercates that the supply response of public sector noted in box 6.firms to a change in the incentive structure is Hlikelyto be relatively slow. Not only is capital and The role of the statetechnology often deficientbut attitudes of manag-ers, workers, and government bureaucrats do not One of the most pressing challenges facing re-change immediately. To reiterate an earlier point, forming socialist economies is to redefine the roleprivatization and restructuring are integrally of the state. Its formerall-encompassing role mustinterlinked and must go hand-in-hand. be "unbundled" into separate ownership, financ-

Agriculture presents some of the most chal- ing, and regulatory roles. The first two must belenging issues in restructuring and in reforms reduced through privatization and financial sec-more generally. As noted in annex 3, some issues tor development and the third strengthened.in this sector are common to most CEE countries, Govemments have essential functions in marketwhile others vary due to diversity in climate, economies - to supply "public" goods such asnatural resources, and organizational legacies. national defense, infrastructure, and a legal frame-

Box 6 China's economic reform

China's reform program, initiated from the late 1970s on, in the role of the state. In the state enterprise sector, China'sled to dramatic improvements in economic performance reforms are more akin to earlier CEE moves toward marketfrom a low base toward levels more characteristic of East socialism, which sought to decentralize decisionmakingAsian market economies. During 1965-80 China's GDP withoutdismantlingstateownership. Chinamovedfarthergrewat 6Apercentper year; this rose to 10.4 percentpper year in agriculture and rural industry, where de facto ownershipin 1980-88. Improvement in per capita incomes and living rights were granted to individuals, albeit usually subject tostandards was especially marked in rural areas. Ernploy- extensivelocalgovernmentintervention. Insum,Chinahasment growth accelerated and, under the "open door" policy, not faced many of the challenges the CEE countries are nowthe dollar value of foreign trade rose five-fold from 1978 to trying to address.1988, with exports increasing from roughly 5 percent to 13 A further distinctive feature of China's reforms was thepercent of GDP. role of agriculture as a leading sector. With the restoration

Despite some similarities, there are very significant dif- of fainily-basedfarmingandmorefavorableprices,agricul-ferences between reform experiences in China and the CEE tural productivity and farm incomes rose sharply. Thecountries. Unlike several CEE countries, China did not have demand for consumer manufactures increased at the sameto initiate a determined macroeconomic stabilization effort time that release of surplus farm labor and a growing poolat the start of its reform (though it did later face a similar of savings made possible the establishment of rural town-problem of maintainingmacroeconomic balance in a decen- ship-village enterprises (TVEs). TVEs accounted for one-tralized socialist system). Its debt burden was low, amd it third of the growth of total material production in 1980-88,maintained a high savings rate. It also did not face the provided 90 million jobs, and by 1988 provided one-fifth ofdisruption oftradingrelationships and terms-of-trade shocks total exports. Reform of agriculture, and especially ofthat now loom so large in CEE. In addition, the current agroindustry, is a high priority in the CEE countries, forreforms in CEE countries go well beyond those initiated in reasonsthatincludeltspotentialforexportsandforcreatingChina in most dimensions, including price and mnarket jobs in associated trade and service activities. However, thereform, introducing domestic and international competi- sector cannot play the leading role in the CEE countries thattion, private sector development, and fundamental changes it did in China's reforms.

24

work; to correct for monopolies, "externalities" Labor law should set basic ground rules for em-(such as environmental costs), and other market ployment and industrial relations. Local govern-failures; to provide basic social services and a ment legislation needs to define the role and pow-safety net to alleviate hardship; and to finance ers of local governments vis-A-vis higher levels ofthese activities through the collection of taxes and government and the private sector. And well-other levies. functioning legal institutions need to ensure that

these laws are enforced reasonably reliably andInstitutional reform. Governments in Central efficiently.

and Eastem Europe face daunting institutional Thereformingcountries,especiallythosemorechallenges as they attempt to reorient their role to advanced, are making substantial - albeit some-fit the needs of a market economy. Not only must what ad hoc - progress in drafting new laws.they alter the administrative structure of govem- New constitutions, property laws, and companyment, but in many cases they need to reduce its and foreign investment laws have been or areoverall size, retrain many remaining civil ser- being drafted in all countries. These laws essen-vants, and maintain and if possible augment the tially permit full private ownership (including, insmall cadre of well-qualified policy analysts and some cases, 100 percent foreign-owned invest-decisionmakers.4 ' They must also face politically ment) and attempt to put it on an equal legaltouchy questions concerning the devolution ofpowers to regional and local levels. Most havemade a start. For example, most CEE govem- Box 7 Cleaning up the environmentmentshavedowngraded orabolished theirformer in CEE countnesplanning offices, consolidated single-industry CM countries al suffer masve pollution that com-miinistries into a smaller Ministry of Industry, and promises public health and uiposes heavy economicestablished privatization agencies. Many are set- losses. Air poUution (primarily from coal-burning and

ting up training programs for civil servants, often metallurgy) causes high rates of chronic bronchitis andwith international assistance. Top-level manag- asthma, and contaminated soil may affect food supplies.ers have generally been replaced, although some Much water is unfit for human consumption, and largemid-level managers with vested interests in the areas of forests have been irreversibly damaged. CEEformner regime remain.47 governments need to take an active role in promoting

Institutional concerns pervade every aspect of environmental d eanup through altered econoic incen-tives and newpublicinvestments. On the incentive side,

reform, and numerous examples appear through- raising energy prices and imposing (and rigorously en-out this paper. Three specific issues - legal forcing) reasonable fees and fines on poUuters are tworeform, fiscal reform, and reform of the social important steps that can be taken early. Poland hassafety net and social services - are summarized alreadyincreasedenergyprices350-(0percentbutneedsbelow. to raise them further to reflect economic cost. The CSFR's

energy is extremely underpriced, but the govenunent is

The legal framework. One of the most pressing preparing to raise pricesin thenearfuture. These alteredincentives will not have fuU impact, however, until enter-

needs is to design a legal framework for market prises are subjected to stict financial disdplne; thus

activities. Property laws should set clear rules of fundamental institutional change must accompany al-

ownership and control. Contract laws and related tered incentives. On the investment side, the needs areprocedures for dispute resolution need to estab- enormous, far beyond the financial resources likely to be

lish a framework for commercial bargaining and avaDlable. In east Germany alone, It has been estimated

ensure the fair enforcement of private contracts. that $100 bilion would be needed to achieve west Ger-Companyand foreign investment law should pro- man environmental standards over 15 years. Govern-ments must establish mechanisms to assess alternativesvide for relatively easy entry of new enterprises and set priorities, lookingcarefullyfor thoseinvestmentsinto the market,4u while bankruptcy law needs to that can achieve the most environmental protection atestablish a procedure for exit. Regulatory laws least cost. One obvious need is for investment to switch

should correct for market failures, whether inhib- away from coal and toward natural gas as a major energyiting the distortions of unregulated monopolies, sourceandtodeanupexdstingcoal-burningfacilitiesandforcing firms to disclose information needed by improve the safety of nuclear plants or in some cases

the market (as, for example, in the case of securi- decommission them. Responsibility for past environ-mental liabilities must also be dearly assigned to avoid

ties regulation), or providing incentives to "inter- inhibiting newbuyers from purchasing privatized firms.nalize" external environmental costs (see box 7).

25

footing with state ownership. The countries are complementary to private investment (see annexalso adopting modem antimonopoly and bank- 5). Privatization of the bulk of state firms produc-ruptcy laws, often drawing on industrial country inggoodsforpotentiallycompetitivemarketswilImodels. help to reorient public spending, as will price

However, these countries have paid insuffi- reform and the resulting decline in consumercientattentionto theinstitutional structuresneeded subsidies. There isa danger that, in reaction to theto bring the laws to life. Courts in socialist econo- past, the need for public investment will bemies have traditionally concentrated on crimninal underemphasized. In fact, the public sector has aand noncommercial civil cases (such as family very important role to play in improving the net-law), and few judges or lawyers are trained in work of roads, ports, water and sewer systems,commercial matters. Neither domestic nor for- telecommunications, and other infrastructureeign investors consider the formal legal process needed for private firms to function, even if somecompetent to handle complex commercial prob- of these functions can be partially privatized.lems. Although arbitration exists as an alterna- The tax changes needed to adapt to a markettive, the lack of a clear and reliable legal frame- economy are fundamental and systemic. Whilework, ably enforced by competent institutions, is socialist taxes were relatively rudimentary toolsa major constraint to investment. to capture surplus and were applied in a highly

Some outside observers recommend that the discretionary manner, new tax systems need to becountries of Central and Eastern Europe "adopt" transparent, predictable, and well-enforced. Taxwell-tried legal and institutional structures whole- design mustbalance severalconflicting goals. Sta-sale from other industrialized countries, particu- bilization programs require tight fiscal policies tolarly Western Europe. This would ensure com- controlbudgetdeficits. Meanwhile,revenueneedspatibility with the EC, an advantage for future could climb with unemployment and the result-possiblemembership.Suchanapproachmay wvork ing demands on social spending. Yet high taxwell in selected technical areas (such as negotiable rates are inimical to investment and growth, andinstruments or value-added taxation) but is not privatization will put an end to the old, reliablesuitable across-the-board. Laws in industrialized sources of revenue, the state-owned firms. In thecountries can themselves have serious flaws and early stages of reform and privatization, as the oldare often tied to particular historical events or revenue system is dismantled and before a newcultural attitudes. Even if these laws suffice on system is fully operative, there is a danger thatpaper, they will have no real meaning in the CEE revenues will fall sharply just when most urgentlycountries unless they are internalized through the needed. To avoid this, tax bases must be broad-law-making process - through trial-and-error, ened and changed to be more compatible with alearning, debate, and consensus-building. Many marketeconomy(forexample,reducingcompanydeveloping countries have borrowed industrial income tax rates while changing from turnover tocountry laws only to have them ignored in prac- value-added taxation), and administration musttice; this degrades the role of law and impedes the be reoriented to deal with hundreds of thousandsdevelopment of appropriate laws. Rather than of private firms and individuals. This requiresborrowing wholesale, the reforming countries techniques of selective auditing and tax enforce-should develop their own laws, drawing from ment, standard accounting practices, and a reli-first principles, their own prior statutes (often pre- able and objective legal framework for disputeWorld War II), and models from other countries resolution. Countries must also resolve complexwhere clearly appropriate.49 and often divisive issues of fiscal federalism with

regard to both taxing and spending authority (seeFiscal reform. Both spending priorities and annex 5), and theymust strengthen municipal and

means of financing government need major over- provincial fiscal systems as they strengthen na-haul as reforns proceed. The two should be tional ones.linked through a fiscal plan; medium-term tax Hungary was the first to reform its tax struc-and expenditure planning is needed even though ture, moving to a fairly traditional system of com-comprehensive central planning is discredited. pany, individual, and value-added taxation inPublic spending - both capital and current - 1988 and 1989. Despite the comprehensiveness ofneeds to be reoriented to supply social services, its reform, Hungary introduced many exemp-infrastructure, and other public goods that are tionsand exceptions thatwillbedifficultto change

26

given the vested interests that have formed. The force. Poland initially opted for an open-endedother CEE countries are in earlier stages of tax unemployment compensation scheme linked toreform. There are strong arguments to move early previous earnings that combined two principlesto reform the tax structure, both to set clear "rules - insurance for workers (being earnings-linked)of the game" for future investors and to avoid and welfare for the needy (being unlimited inpressures from vested interests created through duration). This proved not only to be expensiveexpanded private ownership. As with other legal but also to create a disincentive to job search forreforms, changing tax law is much easier than the newly unemployed. A preferable approachchanging tax administration. It is clear that none - and one recently adopted by Poland in theof the reforming countries has adequate adminis- amendments to its labor law - is to separate thetrative capacity. Because techniques are quite two functions, using earnings-linked unemploy-standard across countries, technical assistance ment benefits of limited duration for insurancefrom industrial countries in tax administration is purposes, and a low flat-rate welfare payment ofespecially valuable. unlimited duration for poverty-alleviation. Un-

employment benefits can be financed by a payrollThesocialsafetynetandsocialservices. One of the tax on employers, as in industrialized countries,

major accomplishments of the socialist systems of while welfare payments come out of general rev-Central and Eastern Europe was the relatively enues. Concerning implementation, the numberequal distribution of income they attained (see of social centers and workers in Poland proved toannex6). Low income inequality stemmed prima- beinadequatetohandle theproblemasitemerged.rily from guaranteed employment and low wage Furthermore, retraining was neglected, perhapsdifferentiation in the state sector, as economic and in part due to the absence of clear employmentsocial goals were often combined in socialist firms. alternatives. By August 1990, only 0.5 percent ofIn contrast, economic and social goals are typi- the unemployed were being retrained. Al CEEcally separated in market economies. Firms pur- countries need to concentrate more on active laborsue profits and pay wages accordingly, whereas market policies (including training and job place-the state helps those left out of the economy. The ment), given the extensive movement of labortransition to a market economy is virtually certain among jobs and sectors that is likely to be neededto lead to higher open unemployment. Moving over the coming years.toward an economy-wide safety net - therebyleaving firms to restructure to pursue efficiency- is an important task for the state in the transi-tion. Such a safety net would include unemploy- Box 8 The key role of pemsions inment insurance, social security (old-age and dis- economic reformability insurance), and retraining services.

Despite relatively equal incomes, there is evi- of the fiscal system, public pensions are a major item ofdence that poverty - particularly in urban areas public spending; the role of public as opposed to private- increased in several CEE countries during the pension systems goes far in determining the size of gov-economic slowdown of the 1980s. Income distri- emient. Whether funded by payroll taxes or privatebution is likely to widen and poverty (particularly contributions, pensions (publicorprivate) imposesignifi-in urban areas) to grow as these countries adopt cant burdens on firms and individuals; minimizing thismarket systems and cut subsidies on essential burden is important for effident private sector develop-goods.50 Generalized cash-based welfare systems ment. As part of the socdal safety net, pensions provide

frthe poor will thus also be needed. needed security for workers, yet their design should notfor the poor will thus also be needed. inhibit the ability of enterprises to restructure their workInstitutions to address the problem of emerg- forces. As financial intermediaries, pension institutions

ing unemployment have long existed in Yugosla- should play major roles in the development of the finan-via, but first appeared in early 1989 in Hungary dal system and in the privatization of state enterprises.and one year later in Poland and Bulgaria. Wel- Several countries are considering ways to use privatizedfare services to address poverty directly have assets to partially fund pension systems. Governments

existed until now only in Yugoslavia, and, to a must consider these many important dimensions whenThe Polish ~~~designking policies concerning the level, eligibility, financ-very limited extent, Hungary. The Polish experi- ing, and institutional control over pension assets.

ence is relevant because of the rapid rise in unem-ployment in 1990 to some 7 percent of the labor

27

Pension systems in Central and Eastem Europe the answer lies in separating social insurance fromtouch on many areas of reform (see box 8) and social assistance functions and limiting free orneed major overhaul. They have typically been heavily subsidized provision to the latter. In thecharacterized by low retirement ages, easy access area of education, curricula do not address manyto disability pensions (partly because of the ab- skills (such as accounting, management, market-sence of other programs for income support), and ing, and financial services) needed in a marketpension formulas biased toward short careers. economy. Furthermore, both academic and voca-These problems are compounded by the increas- tional training are highly specialized beginning atingly aging population. As a result, the number of an early age, and this limits labor flexibility andpensioners (estimated at up to one-half the num- mobility and threatens to exacerbate unemploy-ber of employees) and their financial burden on ment problems. Yet there is a real danger thatthe economy (generally 7-10 percent of GDP) are financial stringencies in both public and privatequite high compared with countries at sinmilar sectors could cause health and education servicesincome levels. Although various reform propos- to decline even further before they improve. Ad-als are being considered -including switching in dressing the many problems in social service de-part to funded and/or private systems to comple- signand delivery will clearly takea long time, andment state-run pay-as-you-eam ones - no re- reforms in this area have hardly begun.forms have yet been implemented. There is debate about the effects of economic

Privatization presents both problems and op- reform on women and children. Socialist coun-portunities for pension finance. The major prob- tries promoted increased economic participationlemconcernsthelossoftheirmajorfundingsource. by women through generous maternity benefits,Pension systems have until now been financed by extensive child-care facilities, and equal educa-very high (up to 50 percent) payroll taxes on state- tion opportunities. Rates of female literacy, edu-owned firms. Such taxes would 'put a heavy cation, and labor force participation were high.burden on-and would be very difficult to collect Movement to a market economy may lead to afrom - private firms. On the other hand, one reduction in these benefits. Furthermore, womenpossible way to move toward partially funded and younger workers may tend tobe the first tobepension systems would be to put a sizable share of dismissed as firmns face increasing market pres-privatized assets in the hands of pension plans. sures. On the other hand, certain structural char-Poland's current privatization plan includes a acteristics made these societies and economiesprovision to give 20 percent of all vouchers (and particularly difficult for women. The wage struc-thus of all privatized assets) to the state pension ture virtually forced families tohave two incomes,system, to be later divided into private pension and part-time work was rare. Women wereplans. An important question, given the demo- overrepresented in lower-paying jobs, and theygraphic profile of the CEE countries, is the share of continued to carry the major burden of child careincome and sales receipts from state assets that and housework. Asreformsproceed,theinformalshould be allocated to pension plans. In sDme sectormayopenupnewopportunitiesforwomen,industrialized countries, pension systems control as may the increasing flexibility in work assign-more than 50 percent of quoted stocks. ments - particularly increasing availability of

Finally, in addition to the narrow social safety part-time work - likely to emerge from marketnet discussed above, the state should concenbrate pressures. Furthermore, rising wage levels mayon reforming the funding and operation of viirtu- allowsomefamiliesbroaderchoiceregardingworkally all social services. Heavy subsidization of and child care options, and the emergence ofmedical care and over-generous sick leave have private education and child-care services mayresulted in high rates of absenteeism, shortage of enhance not only flexibility but also quality. Spe-medicines, and low quality of medical services. cial care might be needed to protect children dur-Health statistics are stagnant or declining in al- ing the transition, particularly with regard to ac-most all CEE countries. As with pensions, part of cess to food and medical care.

28

4Conclusion: The challenge to industrializedcountries

Although much progress has been made in the able. It is important that the CEE countriesCEE countries in the past year and a half in defin- strengthen their own capabilities to coordinateing goals and designing - and to some extent assistance programs.implementing - reforms, it is clear that the road Prior to the Paris Club decision to grant debtfrom socialism to a private market economy is relief to Poland, the current account deficit of theperilous and long. Unfortunately, the difficult CEE countries was expected to amount to someexternal environment compounds the political $10 billion per year over 1991-92. Taking intoand economic hazards. account the need to increase reserves (partly be-

Industrial countries have three important con- cause of the shift to convertible currency tradetributions to make in supporting reform efforts with the end of the CMEA regime), total financingand helping integrate CEE countries into the glo- flows were projected at about $14 billion per year.bal economy: technical assistance, financial assis- The noninterest current account was projected astance, and trade access. The Group of 24 (G-24) slightly positive, with deficits for Bulgaria, thecountries has established a number of programs CSFR, and Romania offset by surpluses for theto assist the CEE countries and encourage partici- other three countries.pationbyforeignbusiness. InJulyl989itinitiated Against this financing projection, gross finan-thePoland/HungaryAssistanceforEconomicRe- cial disbursements to the CEE countries are ex-structuring (PHARE) program This program, pected to total about $14.5 billion per year oncoordinated by the EC on behalf of the G-24, now average in 1991-92. Most will come from officialbenefits all six CEE countries. PHARE includes sources, whose disbursements are expected tofinancial assistance, technical advice, and trade total almost $10 billion per year. (World Bankconcessions.5 ' Other multilateral organizations lendingis projected at$2.5-3billion annually, andare also active, as are a range of bilateral pro- IMF lending at about $45 billion in 1991 and $2grams5 Apartfromtheirfinancingroles,theG-10 billion in 1992.)has recently reconfirmed the central role of the With this level of gross disbursements, netIMF and World Bank in designing and applying disbursements to the CEE countries (after amorti-appropriate economic conditionality.53 (World zation of debt) will be only about $5.5 billion perBank activity is summarized in annex 7, and an year, induding about $1.5 billion (correspondingexample of its wide-ranging support for system to gross flows of $7.5 billion) to the most heavilyreform is shown in box 9. Some of the Bankds indebted countries - Hungary, Poland, and Bul-activities also offer opportunities to involve assis- garia -and $4 billion (gross flows of $7 billion) totance from other sources.) A degree of competi- the CSFR, Romania, and Yugoslavia. Net dis-tion in the provision of assistance may be desir- bursements from official sources are expected to

29

Box 9 How the World Bank's first Struchuial Adjustment Loan supports system reformin Poland

In mid-1990 the World Bank loaned $300 millioni to * Financial sector rform: The loan required audits andPoland for structural adjustment. In addition to supporting diagnostic studies for numerous banks as the basis foran adequate medium-term macroeconomic frameworlt and restructuring, the adoption of adequate prudential regula-financingplan, individual SAL conditions weredesigned to tions and implementation of bank supervision, and thesupport three components of the government's Economic adoption of modern accounting and audtintg standards.Transformation Program:

a Social safety net: The loan helped the establshment ofEnterprise rest ructuring, privatization, private sector de- adequate unemployment benefits and the consolidation of

velopment: The loan supported changes in the legal frame- existing arrangements for means-tested cash benefits, insti-work (state enterprise, tax, bankruptcy, competition, and tutional care, and other benefits in kind.privatization laws) and the establishment of institutiorL forprivatization, liquidation, and restructuring.

be positive, on average almost $8 billion per year. medium term for the emerging private sector.However,netdisbursementsfromprivatesources Hungary is the only country of the three that hasare expected to be negative (about -$2.5 billion on continually serviced its debt, with interest andaverage per year), with small positive disburse- amortizationoncommercialloansexceedingcom-ments to the CSFR and Yugoslavia being rmore mercial borrowing by more than $1 billion annu-than offset by negative net disbursements to Hun- ally.`6gary and Poland. Net transfers (prior to any clebt Resolution of the debt problem is important torelief) average -$5 billion per year. Direct foreilgn encourage private sector development. Debt re-investment in the CEE region is expected to be lief clears away the impediment of a large over-about $1.5 billion annually, but this could rise hang of public sector debt and thusfacilitatesnewsharply if the environment is stable and hospi- lending to the private sector. In addition, debt-table.TM equity swaps can be readily used to facilitate both

Under this scenario, net disbursements of $5.5 debt relief and privatization; because the govern-billion and foreign investmentof $1.5 billion leave ment owns the assets offered for swap, the ad-a financing gap of about $7 billion per year for the verse macroeconomic side-effects that have arisenCEE countries. This "gap" must be filled by in some Latin American programs involving pri-changing the assumptions built into the scen,ario vate firms can be avoided. Debt relief programs- by a drawdown of (or failure to build tip) raise the secondary market price of remainingreserves, a larger trade surplus, larger gross dis- debt and thus the "cost" to the government ofbursements of foreign financing, or debt resched- debt-equity swaps; it is therefore desirable to con-uling. In mid-March the Paris Club agreecl to sider these components as part of an integratedgrant extensive debt relief to Poland, reducing the debt strategy.57net present value of Poland's future debt service The industrial countries also need to insurepaymentsby 50 percentand reducing debt service market access to support trade and correspondingeven more in the early years (including an 80 price reforms. In the long run, a major reallocationpercent reduction in interest payments over the of their trade, away from the ex-CMEA countriesnext three years).-' As Poland was not servicing, its and toward the industrial countries (particularlydebt, relief will have only a small direct impact on in Europe), is likely to be an important element ofactual international financial flows, but it iwill reform. TheEuropeanCommunityandtheUnitedsharply reduce the current account deficit and, States have lowered tariffs - granting MEN orconcurrently, the financing gap. Bulgaria has GSP status - on goods from Hungary, Poland,suspended interestpaymentsand is expected soon and the CSFR. Trade agreements between the ECtobeginnegotiations withofficialand commercial and Romania (1981), Hungary (1988), Polandcreditors for debt relief. Bulgaria has requested (1989), and the USSR, Bulgaria, and the CSFRrescheduling of its Paris Club debt (about $2 bil- (1990) provide for the gradual elimination of alllion) and is likely to ask commercial creditors for discriminatory quantitative restrictions (outsidelong-term rescheduling and further funds in the the textile, agricultural, and European coal and

30

steel sectors). The PHARE program has gone CEE countries, while moves toward a unifiedfarther,abolishingall specific quantitative restric- market in 1992 might result in some trade diver-tions and even suspending nonspecific quantita- sionawayfromextra-ECimportstowardintra-ECtive restrictions on Hungarian and Polish prod- trade. While membership of the CEE countries inucts, thereby granting more favorable treatment the EC or EFrA is not likely for some time, newthan that given other GATT trading partners. avenuesare needed forloweringremainingbarri-However, challenges to Western market access ers to trade and capital flowsa' and thus continu-remain. For example, the full entry of Spain and ing to integrate the CEE economies into the worldPortugal into the EC could increase the pressures economy.on certain exports (particularly agriculture) from

31

Annexes

33

Annex 1 Reform of the trade and payments For the CEE five, CMEA membership involvedsystem short-term gains from favorable pricing but long-

term costs from progressively deteriorating stan-Until 1991 the trade and payments system of the dards, technologies, and marketing skills. ThisCEE countries was composed of two distinct re- was reflected in a secular decline in exports togimes. TheCMEA or COMECON systemcovered convertible currency markets and the evolution oftrade and payments among the CEE countries, the a pervasive structural dependency among theUSSR, and several other members (with the ex- countries (table 1.1). The smaller countries wereception of Yugoslavia, which was not a member of particularly dependent on the USSR, which inthe CMEA). Systems also existed for so-called 1990 led the decision to phase out the system.convertible currency trade and payments with Despite its short-term costs the demise of thecountries outside the CMEA area. The main im- CMEA is a logical adjunct to the domestic reformsmediate concern for the progressof the reformns in taking place in the member countries. It repre-CEE is how it will be affected by the essential sents an important step in breaking away fromdissolution of the CMEA system as of the starlt of regional autarky and structural dependency and1991. reaping the gains from participating in global

markets.The legacy of the traditional CMEA system

The convertible currency regimeAlthough material balancing in the CMEA systbemnever quite represented a complete extension of In January 1990 Poland and Yugoslavia shifted tonational planning, the member countries coordi- free trade regimes with moderate tariffs for non-nated trade bilaterally. Payments involved bilat- CMEA trade. The CSFR did the same in Januaryeral clearing using the transferable ruble (which 1991. Hungary is moving rapidly in that direction;was not really transferable) as the common ac- in January 1991 the share of its industrial produc-counting currency. Trade composition was set in tion free of trade licensing increased from one-great detail, often with separate commodity sub- third to more than 70 percent. Bulgaria moved tobalances, and a major objective (accomplished in liberalize trade in February 1991. Most CEE coun-part through export quotas) was to avoid tin- tries have introduced some currency convertibil-planned trade surpluses. As the countries decen- ity, with Poland, Yugoslavia, and the CSFR mov-tralized their economies, trade was effected ing to full convertibility (in the Polish and thethrough state orders, and domestic and trading CSFR cases only for current transactions) and theprices were insulated by compensating taxes. The others adopting some variant of the retention-emergence of substantial imbalances in recent quota cum auction system. The world price sys-years resulted mainly from loss of central contrzol. tem therefore has a major influence now in most ofFor pricing, the CMEA generally used five-year the countries, at least as far as trade with marketmoving averages of observed world prices for economies is concerned. All CEE countries havesimilar goods, which imparted a bias against pro- also abolished the government monopoly on trade,ducers of "hard" or internationally tradable lllw and mosthavegivenenterprises full tradingrights.materials (whose prices were rising in the late Spurred by domestic contraction and exchange1980s) in favorof countries exporting "soft" manu- rate adjustments, the convertible currency exportsfactures of relatively low quality. CMEA strove of Poland, Hungary, and Yugoslavia rose by anfor regional integration through specialization estimated 34, 10, and 12 percent, respectively, inagreements, which aimed to realize scale econo- 1990. Table 1.2 presents summary information onmies; thus, Hungary exported articulated buses trade and payments with the convertible currencyand imported automobiles, and Bulgaria empha- area.sized electronics. The major exports of the USSRwere energy and raw materials. This pattern of The extemal shocks facing the reformingspecialization established monopolies and re- countriesmoved incentives to upgrade product and processtechnologies. It also resulted in extreme intercle- In addition to the shocks caused by changes inpendencies between individual countries and sLip- their domestic policies, the countries face simulta-pliers within the region. neously three extemal shocks, each of which could

34

Table 11 Structural dependence in the CMEA

Shares in non-CMEA world exports(percent)

Rfgion/gtroek aaey 1970 1980 1987

East European SixaTotal trade 6.8 4.5 3.0Engineering products 0.8 0.7 0.4High and advanced technologyengineering products 1.6 1.2 0.7

Asian NlCsb

Engineering products 2.1 9.3 14.7High and advanced technologyengineering products 1.0 3.9 6.3

a. Bulgaria, the CSFR, East Genmany, Hungary, Poland, and Romania.b. Korea, Taiwan, Singapore, and Hong Kon&Source ECE (1989).

Shares of CMEA in CEE exports, 1989a(percent)

CMEAgToTtb

Country (1) (2) USSR/CMEA c

Bulgaria 83 61 76Czechoslovakia 54 47 62CDR 42 38 62Hungary 39 40 64Poland 35 44 61Romania 38 17 59USSR 46 21 -

a. Non-CMEA trade includes a sizable portion of trade with developing countries. Although denominated In convertiblecurrency, it is partly conducted under bilateral clearing or countertrade agreements similar to those for CMEA trade rather thanon a market basis.b. Reported data for intraCMEA trade require adjustments to render them comparable with convertible currency trade data,but the method of adjustment has a large arbitrary element. Column (1) values trade at national transferable ruble/dollarcrossrates, and column (2) values trade at a uniform ruble/dollar crossrate of 2.c 1985 data.Source. United Nations data.

cause serious problems. The likely magnitude of 1. The CMEA shock. In January 1990 the USSRthese shocks is one of the main factors causing a announced its intention to terminate the CMEAsober reappraisal of the outlook for reform. The systemasof January 1991. The resulting shockhasUSSR, in contrast, is likely to emerge as a net two components:beneficiary,withitscapacitytoimportfromOECD * Terms-of-trade effects. World commoditycountries higher than it would otherwise have prices will differ from the five-year moving aver-been. agesused forCMEA trade."0 In addition, the "soft-

35

ness" of manufactured goods will be reflected for Trade and payments policy in the transitionthe first time in a quality discount relative toworld price levels for corresponding products. Two transitions are relevant in considering tradeEstimates of CEE terms-of-trade losses vis-i-vis and payments policies - the transition process inthe USSR are shown in table 1.3. The estimates for trading arrangements within the CMEA area, and1990 assume trade volumes at their 1989 levels, thetransition within the CEEcountriestoward thealthough trade volumes are expected to be signifi- private market economy. Especially followingcantly lower. In any case, the dissolution of the the changes in the CMEA, trade and paymentsCMEA (particularly given higher world oil prices) policies need to be approached on an overall basisrepresents a major shock. and within the parameters of system reform.

* Trade volume effects. USSR crude oil expo)rts Because of the complementarity of resourceto the CEE countries are expected to decline dra- endowments and the structural dependencies (in-matically in 1991, because of the USSR's falling cluding transportation networks) built up overproduction and its suspected policy decision to decades between the CEE and the USSR, main-consider the CEE area as the residual market. taining mutual trade among ex-CMEA countriesThis, combined with lower manufactured export is desirable, especially in the transition period.prices, is likely to lead to a sharp contraction in Although the length of this period is not clear, thetrade volumes. While trade contraction in 1990 USSR would probably prefer the shortest transi-was about 10 percent, informal Soviet estimates tion, while the five CEE countries could benefitfor 1991 suggest the possibility of trade with the from a slower transition (at least vis-a-vis thefive CEE countries declining to 50-60 percenlt of USSR). Because of the inevitable slowness ofthe 1989 level, and recent experience suggests the institutional change, the transition is likely todecline may be even greater. require bilateral arrangements between the CEE2. The Gulfcrisis shock. Iraq and Kuwaitare impor- countries and the USSR, perhaps through "indica-tant trading partners of most of the CEE countries. tive lists" for product trade.61 Although ex-CMEAIraqi debt to the five (excluding Yugoslavia) to- countries are likely to seek rules of settlement thattailed $4.5 billion in 1990, and imports of the five economize on the use of convertible currencyfrom Iraq in 1989 exceeded their exports to it by reserve balances, proposals for the creation of ansome 70 percent. CEE countries expected repay- East European Payments Union patterned afterment through expanded crude oil imports, which the European Payments Union of the 1950s are notwould have offset some of the costs of the CMEA likely to be adopted.dissolution. The experiences of Hungary, Poland, and Yu-3. The impact of Gernan economic and monetary goslavia in 1990 suggest considerable scope forunion. The former GDR was the most important increasing manufactured exports to Western mar-supplier of high-technology engineering prod- kets. The importance of access to Western marketsucts and chemicals within the CMEA and an im- is heightened by the impending contraction ofportant customer for consumer goods from the CMEA trade. Indeed, access has improved con-five CEE members. German unification means siderably in recent years. Between 1988 and 1990the likely loss of the GDR as a major market for the EC concluded bilateral agreements on coop-such goods. eration with each of the five ex-CMEA members,

Largely because of the above shocks, the out- and the EC has begun negotiations with Poland,look for the CEE countries' balance of paymen ts is Hungary, and Czechoslovakia on more far-reach-not bright. The UN Economic Commission for ing "agreements of association." The countriesEurope recently projected an aggregate current now benefit from MFN status and more recentlyaccount deficit of some $11 billion for 1991, most from the Generalized System of Preferences ofof which was expected to be financed by the both the EC and the United States. Agriculturalmultilateral financial institutions. Bank projec- trade is subject to the rules of the CAP, however,tions of thedeficits of the CEE countries,as shown and quotas remain on selected manufactures, al-in table 1.2,are similar. But themost severe impact though many are nonbinding. There appears toof the deteriorating external environment is likely be little immediate prospect of joining the EFrA orto be on output and employment. the EC.

36

Table 12 Convertible currency trade indicators for CEE countries, 1988-90(bilions of dollars)

Cumnt acct. Debt/ Debtl

Exports Currnt account Total debt Reserves prvjected CDP exprtsGDP (cono. curr.) (cono. curr.) (cono. curr.) (conv. cum.) (conv. cwr.) (percent) (percent)

Coury 1989 1990 1988 1989 1990 1988 1989 1990 1988 1989 1990 1988 1989 1990 1991 1990 1990

Bulgaria 20.3 22.4 3.5 3.1 25 -0.8 -1.3 -0.6 8.2 9.2 9.0 1.4 0.9 0.8 -2.0 40.2 360.0

Czchoslovakia 50.3 46.5 6.7 7.3 7.3 0.1 0.4 -0.5 7.3 7.9 7.7 1.8 2A 1.2 -2.4 16.6 105.5

Hungary 29.1 321 6.3 7.3 7.9 -0.8 -1.4 .0.1 19.6 20.6 20.0 2.0 1.7 1.1 -1.2 62.2 252.9

Poland 68.4 62.3 8.0 8.3 12.3 -0.6 -1.8 -1.5 39.2 40.6 46.3 2.2 2.3 6.9 -2.5a 74.3 375.8

Romania 53.5 35.5 6.5 6.0 3A 3.6 29 -1.4 3.1 1.4 2.0 0.8 2.0 0.7 -1.7 5.6 59.6

Yugoslavia 62.3 58.9 14.3 16.0 18.1 2.2 2.0 -1.1 19A 17.2 16.3 4.3 7.1 8.9 -0.7 27.6 90.0

Total 283.8 257.7 45.3 48.0 51A 3.7 0.7 5.2 96.8 97.0 101.2 12.6 16.4 19.5 -10.5 39.3 196.8

a. Priet,ed cunent acwcmt for 1991 does not indude impact of Paris Qub debt relief for Poland.Sowor World Bank data.

Table 13 Estimates of Soviet subsidies tlrough the CMEA(billions of current dollars)

1990a

(B) / GDPCountry/group 1982 1987 1988 1989 (A) (B) (C) (C)-(A) (pmcnt)

Hungary 2.6 0.1 -0.1 1.0 1.1 1.9 2.6 1.5 5.9

Bulgaria 3.7 0.2 -0.1 1.4 1.6 2.7 3.7 2.1 12.1

Czechoslovakia 4.9 0.2 -0.2 1.8 2.1 3.5 4.9 2.8 7 .0 3b

GDR 5.9 0.3 -0.2 2.2 2.5 4.2 5.9 3.4 -

Poland 4.3 0.2 -0.2 1.6 1.8 3.1 4.3 2.4 5.0

Romania 0.4 0 0 0.1 0.2 0.2 0.4 0.2 0.8

CMEA Six 21.7 1.0 -0.9 8.1 9.4 15.6 21.8 125 -

Excluding GDR 15.9 0.8 -1.1 5.8 6.8 11.4 15.9 9.1 4.4

a. Column (A) is based on an oil price of $15.80/barrel; column (B) is based on an oil price of ($15.80+$26.00)/2 = $20.90/barrel; and column (C) is based on an oil price of $26.00/barrel.b. Percentage of 1989 GDP.Sourmc OECD data.

An assessment of the future place of the CEE though labor costs in the CEE countries appear tocountries in the global trading system is outside be moderately low relative to the NICs at currentthe scope of this annex. Although the USSR. has market exchange rates, this may not be sustain-clear comparative advantage in resource-inten- able in the longer run.'2 One likely longer-runsive exports, the major competition in many areas implication of reform isa substantial reorientationof CEE production appears likely to come from of trade flows, away from former CMEA marketsthe newly industrialized countries (NICs). Al- and toward Western Europe.

38

Annex 2 Privatization of state enterprises ownership quickly and equitably but may alsocompromise efficiency and raises no revenue for

Private sector development in reforming socialist the government.economies involves two concurrent changes: au- Experience to date in the countries of Centraltonomous expansion of the private sector and and Eastern Europe indicates that they are likelyprivatization of the existing state sector. Autono- to follow different paths to privatization. This ismous expansion of the private sector is extremely due in part to differences in their starting points,important and may in the long run prove to be the including the political and social strength of vari-major engine of growth and transformation in ous groups (including workers, thethese economies.'3 This annex focuses on the "nomenklatura," and former owners), the exist-complex question of how to privatize existing ing degree of decentralization, and the history ofstate enterprises. The socialized sector accounts reformefforts. Not surprisingly, these differencesfor over 80 percent of value added in all of the arereflectedinthelegal frameworksforprivatiza-reforming socialist countries (table 2.1). There are tion.some 2,300 state firms in Hungary, 7,500 state In Hungary, the groundwork for privatizationfirms in Poland, and 26,000 socialized firms in was laid by the October 1988 Law on EconomicYugoslavia." Rapid and massive privatization is Association, which allowed state enterprises toessential for the development of a private market "corporatize," that is, convert themselves intoeconomy; there is a real risk that the processcould joint-stock companies. The Law also allowedbe paralyzed if momentum is lost. enterprises to issue shares and individuals to buy

After years of failure with market-oriented re- them. For self-managed firms (about 70 percent offorms of state enterprises that essentially permit- allenterprises),thedecisiontoconvertrestedwithted greater self-management but failed to impose enterprise councils. Because councils were gener-financial discipline, all of the reforming countries ally dominated by management, this led to a spurtnow share the central political goal of widespread of spontaneous privatizations, often at advanta-privatization. Smallenterprises-mostlyinretail geous terms for managers and outside investorstrade and services-arebeing privatized rapidly, they brought in. An interesting political coalitionmainly through local auctions.& Few large-scale supported this process - economic liberals, whofirms have been privatized to date, although many viewed spontaneous privatization as the quickestplans have been proposed and debated and many and easiest way to dismantle the state sector, andlaws passed. One factor that promises to acceler- "nomenklatura," who saw in the process an op-ate the speed of privatization - given the diffi-cultyof directly abrogatingacquired rightsof self- Table 2.1 State-owned sector as share of value-managernent - is the imposition of firmer finan- added in selected countries, in the mid-1980scial discipline on firms. More than 450liquidation (percent)procedures are under way in Hungary, including35 large industrial enterprises employing 57,000and 11 large state farms and cooperatives. Large Shareaofnumbers of Yugoslav firms face liquidation pro- Countr vdue-ddedceedings, which are to be triggered after theirarrears to banks or other firms reach 60 days. CSFR 97

Privatization has three key economic objec- GDR 97tives: to improve efficiency, to spread ownership USSR 96widely and fairly, and to raise fiscal revenues. Yet Yugoslavia 87in the case of medium and large enterprises, there Hungary 86are clear tradeoffs among them. Sale of assets by Poland 82the state may raise revenues but is likely to con- France 17centrate ownership in a few hands and to be so Italy 14slow that efficiency gains are modest in the short West Germany 11run. Spontaneous privatization initiated from United Kingdom 11Denmark 6below (by managers or outside investors) might United States 1raise efficiency quickly but does little to spreadownership fairly or raise public revenues. Massdistribution of shares to the public may spread Source: Milanovic (1989).

39

portunity tD acquire wealth. The Transformation mentary debate, the State Enterprises Privatiza-Law of 1989 was designed to address some of the tion Act was adopted in July 1990. It represents apreviousabusesofspontaneousprivatizationand compromise between different viewpoints;to establish more rigorous oversight of the pro- corporatization, and later privatization, can takecess. The State Property Agency was set up with place only with the consent of workers' councils.a mandate both to limit undervaluation of assets This law leaves intentionallyvague theprocedurewhentheprivatizationinitiativecamefrom below of privatization, allowing practically all schemes:and to initiate privatization from above. By the sales of entire firms, liquidation and asset sales toend of 1990, the SPA had approved 64 of the 77 private parties, free distribution of shares to citi-spontaneous privatizations proposed after Sep- zens, and establishment of holding companies totemberl990."1 In addition, in September it pre- own shares. The latest Polish plan envisages salessented its first list of 20 state enterprises to be of anumberofthelargestfirmsandmassdistribu-privatized under its own initiative, and in Decem- tion of ownership interests in hundreds more.ber a second list of 20 enterprises was approved Whatever the model selected, employees can buyfor "active" privatization. By combining super- up to 20 percent of shares at 50 percent discount.vised spontaneous privatization with SPA-initi- Foreign investors can acquire up to 10 percent ofated sales and sales initiated by investors, Hun- shares without explicit authorization of the gov-gary hopes to privatize up to one-half of state emient. A Ministry of Ownership Change hasproperty over the next three years. been established to oversee the process and spe-

Hungary's path is different in two ways from cialized financial institutions set up to facilitate it.that being proposed elsewhere. First, it is the only The sale to the public of five enterprises, com-countrythatcontinuestosupportandrelyheavily pleted in January 1991, was deemed a moderateon spontaneous privatization from below. The success. After a three-week extension of the offerother countries-most notably Poland but also to period, a total of 100,000 people applied to pur-some extent Yugoslavia and Bulgaria - have chase shares, and the issues for four of the fivetried to curtail the practice after brief experiences companieswereoversubscribed. A second groupwith its real and potential abuse. Second, Hun- of companies to be sold in this manner will begary(alongwithYugoslaviaandtheformer(GDR) announced shortly. In addition, several largestill rejects mass distribution of shares to citizens, companies have been sold to foreign enterprises,relying exclusively on sales of assets. Some! emi- and the assets of some 200 more have been soldnent Hungarian economists, including Janos after liquidation of the enterprises.Kornai, have argued strongly that the govern- The majorchallenge in any massdistribution isment has not only the budgetary need but also the to spread ownership widely while maintainingfiduciary duty to the public to sell state-owAmed some concentrated corporate governance capabil-assets at the highest possible price. Opponents of ity. The various means proposed to achieve this insales argue in turn that valuation is inherently Poland and elsewhere all envision the establish-impossible and thus arbitrary, and, more impor- ment of some sort of intermediary to hold sharestant, that relying on sales will restrict ownership in trust for the public (see box 2.1 for one Polishto those with money - primarily former plan). In the various plans the intermediariescan"nomenklatura," black marketeers, or foreigners. be either public or private. They are charged with

Poland started its privatization drive in a diffi- passively managing their portfolios as mutualcultposition. Previousreformsintheaftermathof funds, actively overseeing the firms as holdingmartial law had expanded the role of workers' companies,orrestructuringandsellingthemmorecouncils. Ownership rights had become ambigu- in the spirit of privatization agencies-'ous; workers and managers argued that autono- Although the other reforming countries alsomous enterprises could enter into any kind of support rapid privatization, plans are not as ad-legally permissible contract and could issue their vanced as in Poland and Hungary. The CSFR andown shares to any investor including themselves. Romania join Poland in favoring mass distribu-The waveof resultingspontaneousprivatizations tions. The CSFR's legislature has just passedin 1989 provoked public outcry. In early 1990 the privatization legislation that calls for widespreadstate tried to reclaim legal title to all assets in o1rder distribution of assets via vouchers as well as someto begin privatization from above, but it did not sales of shares or individual assets (upon liquida-succeed entirely. After several months of parlia- tion). Romania's law, passed by the legislature in

40

Box 2.1 A recent privatization plan for Poland

One innovative privatization plan for Poland envisions public would have little information on which to base agiving away a large share of state assets through several choice of intermediaries in the first round, several auctions"auctions." For each auction, vouchers would be distrib- would be held over time, providing the public with increas-uted as follows: 30 percent to the public, 20 percent to the ing information on intermediary perfornance. The inter-pension system, 10 percent to commercial banks, and 10 mediaries would develop into financial institutions, andpercent to workers; 30 percent would be held in reserve by every company would have widespread ownership and yetthe government. Any intermediary (such as a foreign joint some locus of oversight and controL Essentialy, the task ofventure) that wanted to enter would be allowed to advertise privatization would itself be privatized, with governmentfor vouchers, and citizens holding vouchers would entrust removed from the process.them to the intermediary of their choice. Intermediaries Some observers have criticized this plan as too complexwould then use their vouchers to bid for the block of firms (Sachs 1991). They suggest a simpler variant, in whichoffered at that particular auction. To ensure some concen- minority interests in state companies would be equallytration of ownership, 20 and 30 percent blocks of shares in distributed among several mutual ftmds. Citizens wouldeach company would be bid firsL To provide sound incen- then be assigned ownership interests in the funds on atives to the intermediaries, they wouldbepaidinproportion random basis. Remaining shares not distributed to theto the appreciation of the assets they held. Although the fundswouldbegiventobanks,pensionftmds,andworkers.

September 1990, proposes to distribute 30 percent hectareseach. It also gave workersoncooperativeof enterprise assets to the public at large and sell or state farms the right to buy land at reducedany remaining assets not specifically designated prices. The law was approved by Parliament butto remain state-owned.6" Bulgaria has produced wasdeclaredunconstitutionalbecauseitdiscrirni-five draft privatization laws, although no clear nated against other former landowners. Currentgoals orstrategy have emerged. It was previously plansare toprovidecompensationinnmoneyratherone of the most centrally planned economies, and than in kind. In the CSFR, a1aw passed in late 1990changes may proceed relatively slowly. provides for reprivatization of some 70,000 prop-

Yugoslavia has had to deal with the most firmly erties nationalized in the late 1950s, although howentrenched worker self-management of all the to do this is uncertain. The German privatizationreforming countries. Its strategy has been to try to program is being severely complicated by moreremove self-management rights while simulta- than one million property restitution claims filedneously providing firms with the legal means to by private individuals, plus 15,000 filings by localsell assets, preferably to their work forces (at a governments.discount of up to 70 percent). The 1988 Enterprise All of these countries are fornulating privat-Law and the 1989 Law on Social Capital limit self- ization plans in an environment of tremendousmanagement rights and allow self-managed firms political, legal, and institutional change and un-to be transformed into joint-stock companies at certainty. Although some of the most optimisticthe initiation of workers' councils. Initial results plans call for privatization of up to half of statehave been disappointing; few sales have taken assets in as little as three years, most observersplace and Development Funds supposed to over- expect the process to take far longer and to besee privatization and receive a share of the pro- fraught with difficulty along the way. Sales areceeds are only now being created. The role of inherently slow, and mass distributions, thoughtheseFundsdifferswidelybyrepublic. TheSerbian attractive in principle, may be difficult to imple-Fund, forexample,intendstoconcentratemoreon ment in practice. It is clear that many enterprisesrestructuring, while the Fund in Slovenia intends will remain in state hands for some time to come,to work exclusively as a privatization agency, especiallyinthetroubledheavyindustrialsectors.valuing and selling assets as rapidly as possible. If left alone in this atmnosphere of uncertainty, the

Claims of former owners have complicated the enterprise sector will do little to restructure. Al-privatization process, particularly in Hungary, though traditional state planning and control maythe CSFR, and the former GDR The ruling coali- be undesirable, active government involvementtion in Hungary agreed in July 1990 to a inoperatingandrestructuringenterprisesisclearly"reprivatization" law for agricultural land, which needed.gave owners dispossessed in 1947 the right to 100

41

Annex 3 Agriculture percent of GDP. Because other necessities such ashousing are subsidized even more, food accounts

Agriculture presents some of the most challeng- for about one-third of household budgets.ingissuesinthetransition. Agriculturalsectorsin Agroindustry is highly concentrated in mostCEE are quite large; for example, the sector em- countries, and huge state monopolies dominateploys 28 percent of the Polish labor force. Retail processing, distribution, and supply of inputs.food prices have historically been held down by The degree of vertical integration between pro-subsidies deeply embedded in political ancl eco- cessing and production varies; in Hungary, manynomic relations. Changes in agricultural price cooperatives have processing enterprises. CEEpolicies and in property rights over land --- an- agroindustry is hampered by poor incentives,other very sensitive issue - will affect income price controls, and low investment levels, and thedistribution and the future productivity of the quality of much processed food is below thatsector. required on competitive world markets.

The prereform legacy The challenge for reform

The CEE countries constitute a large and diverse Price reform and agroindustry linkages. As inagricultural region. In the northern countries other sectors, reform of agriculture involves liber-grains, roots, livestock, and specialty crops domi- alizing prices and markets, defining and chang-nate production. In the center, warmth and rnois- ing property rights, restructuring at all levels, andture are adequate for maize, oilseeds, and mixed defining a new role for government. Price reformgrain and livestock farming. Farther south, involves reducingorremoving subsidiesand so isviticulture, orchards, and tobacco become more consistent withmacroeconomic stabilization. Evenimportant, as does irrigation. Although these if compensated partially through transfers,'9 in-countries in the past shared a common ideology, creases in relative food prices tend to reduce de-differences in inherited agricultural policy, per- mand. Especially because of the monopolistic po-formance, and farm organization are substantial. sition of processors, this fall in demand can place

Large state and collective farms dominate the pressure on farm incomes, which cannot speedilyregion's agriculture. Poland (with 75 percent of be alleviated by turning to export markets be-land privately owned) and Yugoslavia are excep- cause of the weaknesses of the processing indus-tions. Although members of the collectives iFor- try. Producers are hostage to the pace of change inmally hold title to their land, there is in practice processing,marketing,anddistribution,andstruc-little difference between collective and state farns, tural reforms in these areas are therefore of theand both types are protected by soft budget con- highest priority. Deconcentration of plants andstraints. Most private production takes plao on the introduction of competition (for example,small plotsof aboutone-half hectare with nonlalbor through expanding small-scale private transport)inputs and services supplied by the large farm. are essential.There is thus a symbiotic, if inefficient, relation-ship between these two dualistic componenbs of Property rights. The definition and distributionproduction. of land property rights affects producers' incen-

Income per capita in agriculture (includling tives to manage land efficiently and invest in itsearnings from private activities) is on average futureproductivity. Howbesttorestructureprop-relatively high. Yields of grains and field crops erty rights in the case of the large state and collec-are lower than in Western Europebutcomparalble tive farms is a complex question. A range ofto those in many parts of the world. Productivity options exists, including transforming them intoin the livestock sector is often low by world slan- truecooperatives,expandingindividuallandhold-dards. Because of subsidized consumer prices ings while maintaining a cooperative core, or(especially for meat and dairy products), national shifting entirely to individual private farming orfood consumption is high in relation to per capita long-term leaseholds. The need to create smallerincome (see table 3.1). Price subsidies have tylpi- commercially viable farming units is widespreadcally equalled about 5 percent of GDP in CEE (except in Poland and Yugoslavia, where efficientcountries. In the USSR, they account for up to 12 farming may require some consolidation of small

42

Table 3.1 Per capita average food consumption, 1985(kdlograms annually, except where otherwise noted)

ProteinCalories (grams per Grain and

Country per day day) Meat Milka Eggsb Potato brad

Unweightedaveragefor 12 OECDcountriesc 3,324 98 79 134 14 75 8

Bulgaria 3,634 106 77 250 10 33 144Czechoslovakia 3,473 103 86 239 14 78 111GDR 3,800 113 96 - 12 143 99Hungary 3,541 102 77 175 13 54 110Poland 3,298 102 67 403 9 143 118Romania 3,358 104 60 - 12 - 143Yugoslavia 3,542 102 55 - 7 51 175USSR 3,394 106 62 295 10 104 133

Average 3,505 106 73 272 11 87 129

a. For OECD countries, excludes processed dairy products. For CMEA countries, includes milk equivalent of all dairy products.b. For CMEA, converted to weight at four kilograms/100 eggs.c. Data for calorie and protein intake are for 1984-86.Sources: FAO (1988); OECD (1988); and Wiener Institut f(r lntemationale Wirtschaftsvergleiche (1989,157-63).

farms). No single solution is ideal due to the absentee shareholders as industrial enterprisesdiversity in local conditions across the countries. would be under the various voucher plans now

Several countriesare moving to privatize state- under consideration (see annex 2). Therefore,owned orcooperative land. Poland has expressed neither state nor collective farms should be in-the desire to restructure its state farms (which cluded in the portfolios of any intermediaries thataccount for 25 percent of landholdings) and to may be established to "invest' vouchers or holdbreak up some and distribute their land to indi- shares in individual enterprises on behalf of theviduals, but procedures for doing so have not yet public.been worked out. Bulgaria and Romania passedland reform laws in early 1991 that provide for the Employment. Hidden unemployment in thebreakup of collective farms and the return of land agricultural sector appears to be substantial. Thisto private ownership. In each country claims of can be partially alleviated through attrition andprior owners will be honored, although the land retirement, as mnany workers are older than 55.retumed will not necessarily be that taken away at The reassignment of property rights toward pri-collectivization. Many questions remain with re- vate farms that use more labor would increasegard to implementation in each case. Hungary both labor intensity and productivity. If the cre-has also recognized claims of prior owners of ation of smaller farms and improved incentivesagricultural land, but they may be discharged (through decollectivization, leasing, or privatiza-through monetary compensation rather than in tion of land) should stall, agriculture will not bekind. able to absorb additional labor. The underdevel-

There has not been widespread discussion on oped rural service sector as well as a revitalizedhow to coordinate land reform and the more gen- processing industry offer longer-run prospectseral privatization of state assets. Although the foremploymentgrowth. Thereareampleoppor-approach to property rights in land should be tunities for technical assistance in this area, in-consistent with property rights in other assets, cluding assistance to develop rural finance andland should not be owned by widely dispersed export capability.

43

Progress to date A comparison with China

Retail food prices were liberalized in Poland in Decollectivization of agriculture and the growthAugust 1989. As real incomes declined and ex- of rural industries fueled a period of dynamicpendituresshifted,foodconsumptionisestimated economic growth in China's countryside afterto have fallen by 10-15 percent, even though the 1978. Although the potential payoff to agricul-share of food in total household budgets rose from tural reform in CEE countries is high and the39 percent to 45 percent. At first producers lwith- supply response may be substantial, agricultureheld stocks from the market because of price un- in these countries cannot be expected to play socertainty, but excess supply soon replaced short- dramatic and leading a role as it did in China. Oneage. Polish agroindustry is highly concentrated difference is technological. Agriculture in CEE isand its restructuring has barely begun, although far more dependent on modern services and pro-the scope of private marketing and transport has cessing facilities than in China, and restructuringincreased. The CSFR has undertaken price re- these areas will take time.fonns,butitsagriculture, like thatof Bulgaria and A more fundamental difference arises on thethe former GDR, remains highly collectivized. Its demand side. Reforms in China increased theprocessing sector is monopolized and technologi- demand for food. Rural incomes rose sharply,cally ill-equipped. Hungary's agricultural sector and this added to demand for simple manufac-has undergone many changes over the last thlree tured consumer goods and services. These coulddecades but is also still largely collectivized. Its be produced relatively rapidly using surplus la-processing and input supply industries are still borreleasedbythereformsandsavingsgeneratedconcentrated and are frequently linked with pri- by the higher incomes. In CEE, the majority of themary production on large farms. As in other population is no longer rural or employed incountries, the reorganization of property rights in agriculture, and it is likely that the demand shockHungary requires the separation of most process- caused by the removal of food subsidies will ini-ing and rural services from production in order to tially dominate productivity effects on the supplyfoster more competitive markets. Romania's an- side and dampen farming incomes. Land reformsnounced plan to privatize agriculture would, if in CEE are therefore more complex than in China,implemented, constitute the most dramatic and, because linkages do not operate as stronglydecollectivization program to date. Yugoslavia - or even in the same direction - as in China,has many private producers, but they are con- they are not expected to have the same power tostrained by processing and distribution systems generate economic growth.that favor the socialized sector. In the region as awhole, there has been little progress to date in landreform.

44

Annex 4 Financial system reform cial information. Accounting standards did notconform to generally accepted principles, and

In a market economy the financial sector stands at there was no tradition of independent audit. Thethe center of resource mobilization and allocation legal frameworks covering central and commer-and the pricing and allocation of risk. In a planned cial banking activities, securities markets, and theeconomy intermediation is largely performed clients of the financial intermediaries were gener-through the fiscal system, with a simple and pas- ally inappropriate to a market-driven system.sive financial system ignoring risk and accommo- From the late 1980s the CEE countries began todating to the credit demandsof the plan. Financial modifythisstructurebycarvingcommercialbank-sector reform and development is therefore vital ing activities out of the central bank and transfer-for system reform and must be addressed at the ring them to new commercial banks. These banksoutset. Indeed, all of the CEE countries have are still government-owned except in Hungary,placed financial system reform high on their agen- where enterprises hold almost 50 percent of theirdas and are actively implementing or designing shares, and in Yugoslavia, where enterprises havereforms. a large ownership interest. De facto regional or

Experience to date suggests that the absence of functional specialization and restriction of clientsa market-based financial system is costly even in to the use of a single bank have, in practice, se-the initial stage of macroeconomic stabilization, verely limited competition between these banks.because no effective channel exists to assure that Although the new banking laws typically allowmacroeconomic policies - in particular, tight the banks wide scope (following the universalcredit -improve resource allocation at the micro model) and permit entry of new banks,70 financiallevel. The limited structural change that has ac- systems are relatively undeveloped. Poland, forcompanied restrictive demand policies in Hun- example, has only one bank branch per 40,000gary, Poland, and Yugoslavia is at least partly people, compared with one per 10,000-15,000attributable to the underdevelopment of their fi- people in Western Europe. The financial sectornancial systems. accounts for only 0.9 percent of employment, its

Nevertheless, financial system reform is not an ability to handle large volumes of transactions isadequate lever to force the pace of overall restruc- limited, and clearing is slow by the standards ofturing of the productive sectors. Fully liberalized market economies.financial markets and privatized intermediaries Yugoslav banking evolved in a different pat-operating under tight budget constraints prob- tern. The breakup of the monobank system inably come later in, rather than at the start of, the 1971 led, by 1988, to some 360 banks, usuallyreform agrenda. Financial reform poses a number owned by groups of associated self-managed en-of unresolved issues, someof whichhavenotbeen terprises that were also their major clients. Theextensively analyzed. central banking system consisted of the National

Bank of Yugoslavia and eight regional NationalThe prereform legacy Banks.

Foreign exchange deposits grew substantiallyThe financial systems of most planned economies in the 1980s in Yugoslavia and in Poland.- Re-consisted of a central-cum-commercial bank ser- sponsibility for foreign exchange liabilities in thevicingenterprises,asavingsbankacceptinghouse- CEE countries generally rested with the centralhold deposits and lending to households largely bank or the foreign trade bank, because otherfor mortgages, a foreign trade bank handling all banks had no foreign-denominated loans on theirforeignexchangeactivities,andaninsurancecom- books. Devaluations were therefore to imposepany. All were state-owned. Interest rates were serious exchange losses corresponding to thosetypically very low, often lower on the deposit side liabilities. In Yugoslavia, the valuation lossesfor firms and on the lending side for mortgages. carried on the books of the National Bank haveSurplus funds in the savings bank were nonnally been estimated at 60 percent of total assets, andchanneled through the central bank toward the those of Bank Handlowy in Poland at some sevenenterprise sector. Risk management and pricing times its capital.and prudential considerations played no role in Another serious legacy of the past was thethe allocation of funds, in regulation and supervi- accumulation of decades of losses from the enter-sion, and in the organization and flows of finan- prise sectorand from subsidized household mort-

45

gage loans in bank portfolios. Those losses arose and independent auditing, as well as a suitableduring periods of slow growth but relatively 'high legal framework for debt recovery and other pur-investment. Comprehensive estimates of losses poses. Governments must develop prudentialare not yet available for any country, and indeed, regulation and supervision for financial institu-the full size and distribution of losses will con- tionsthatiscompatiblewithcompetition. Finally,tinue toevolve (and almostcertainly to worsen) as mechanisms to control monetary aggregates arethe economies adjust to reforms (including that of vital during the transition, but it is impossible tothe CMEA system). In certain countries inflation have effective macroeconomic control withouthas eroded the burden of domestic debts, but in resolving problems of monetary overhang, gov-others the available fragmentary information emnent and enterprise deficits, the proliferationpaints a frightening picture. It is probably safe to of bad debts, and the generation of foreign ex-assume that proper asset valuation would leave change losses.manybanksin thereformingcountries withnega- Many unresolved issues concern the futuretive capital, sometimes several times over, and structure of the system. Although governmentsthat in some cases losses could compare to those have given much thought to privatization in gen-experienced in major financial crises elsewhere.7 eral, they have given much less to the ownershipConsidering mortgage finance alone, in 1989 the of banks. Present arrangements, in which theinterest rate subsidy implicit in the stock of low- banks are often owned by the central bank or byinterest loans in Hungary was 2.3 percent of GDP. large clients, are questionable. They conflict with

Nonbank finance has been limited in the CEE the central bank's regulatory role and promotecountries, with the exception of interenterpiise insider lending and monopolistic practices. Thecredits, which increased in the 1980s with enter- alternative of grouping banks and enterprises to-priseautonomy. Interenterprisecreditsgrew r-p- gether into holding companies (the arrangementidly through the 1980s in Yugoslavia and ex- in Algeria) could also raise difficulties. It wouldceeded bank credits to enterprises in Polandl by be preferable for major financial institutions to bemid-1990. They also increased sharply in Hun- owned initially by special investment trusts ongarywhentightmonetarypolicywasimplemenlted behalf of the public, and for these later to beafter 1988. Although their growth has to sorne privatized.extent reflected that of normal commercial rela- Considering the reverse question, the owner-tionships, the absence of risk-based checks to the ship of firms by banks, most of the CEE countriesexpansion of such credits (especially because of are adopting banking models that permit thisthe prevalence of monopolistic trading links) ien- more readily than in most industrialized coun-ders them an impediment to macroeconomic sta- tries.?4 These models require careful consider-bilization and to the rationalization of the enter- ation; the corporate governance problem is notprise sector. They also increase the risk of sys- likely to be ameliorated by granting ownershiptemic insolvency. Securities markets began to rights to bankers who have relatively little experi-develop in the late 1980s73but their wider role'has ence with modern market institutions.been stifled by the absence of clear ownership Another issue concerns the separation of bank-rules and operational bankruptcy procedures. ing and other financial services, such as under-

writing, trading, and investing in securities andA framework for financial sector reform insurance. Historically, thermajorindustrial coun-

tries have maintained considerable specializationFinancial sector reform in CEE countries is more amongintermnediaries,althoughwithrecenttrendscomplex than in market economies, as it involves universal banks now offer a wide range of suchreshaping and to some degree recreating the sec- services in about half of the G-10 countries. Al-tor rather than just liberalizing it. In the area of lowing banks to provide a broad range of servicesbanking, existing payments systems are techni- can be problematic in an emerging financial sys-cally and organizationally inadequate and need tem, as both the management and supervision areextensive upgrading. Interest rate policies muist more difficult for universal banks than for special-be revised and the taxation of intermediation re- ized institutions.viewed. Instruments to mobilize funds must le The banking structures being put in place inenhanced and credit skills developed. Banks and certain countries also raise the question of thetheir clients need adequate information systems future contestability of financial markets and the

46

scale and management quality of internediaries. versals that inevitably will accompany the reformOn the oneextreme, most lending in Czechoslova- process. Foreign banks are extensively involvedkia will be concentrated in two regionally special- in assisting institutional reforms, primarily on aized institutions. On the other, there are so many consulting basis although some joint venturesbanks in Bulgaria and Yugoslavia that good man- exist.agement may be hard to find and scale economies One of the most pressing transitional issues ismay be lost. A related question is how best to how to address the problem of existing portfoliointegrate corporate lending and retail deposit- losses. Bank and portfolio audits as well as insti-taking. Governments might want to break up tutional diagnostic studies are well advanced insavings banks and integrate their branches with HungaryandareproceedinginPolandandYugo-the major commercial banks. There are alterna- slavia. In the interim, progress has been slow intive models, and the choice might differ among dealing with problem loans, due partly to the lackcountries. of incentives for intermediaries to recognize loan

The development of securities markets is im- losses. A range of holding actions can be man-portant given the desire of the CEE countries to dated to limit growth in the banks' exposure toprivatize ownership, develop competitive finan- problem borrowers.76 However, long-term solu-cial markets, and fund governmentand enterprise tions are dependent on further progress in thedeficits in a noninflationary way. However pri- broader economic reform program. If banks arevatization is conducted, the initial distribution of placed under a hard budget constraint (orshares is likely to be different from the desired privatized) before they are adequately capital-longer-rundistribution, and well-functioningsec- ized, perverse incentives will resul7. Yet theondary markets for securities may thus be vital. restructuring of loan portfolios and recapitaliza-Furthermore, as individuals assume greater re- tion of banks cannot be finalized prior to reformssponsibility for their own pensions and disability in the productive sectors and adjustment to majorinsurance, efforts should be made to develop con- shocks (such as the end of the CMEA system), astractual savings institutions. Thismightbelinked these will have a large impact on the ability ofwith theprocessofprivatization,ifpensionliabili- firms to service loans in the future. In the mean-ties are assigned to holding companies set up as time, there is little social value in pushing any ofenterprises are privatized. the state-owned banks into bankruptcy, given

Legalandinstitutionalchangestoaddressmany their crucial role and the need to expand financialof these areas are under way. Governments are services. Furthermore, caution is needed on therewriting central and commercial banking laws entry of new or foreign intermediaries whileexist-andestablishingtheinfrastructuretoregulateand ing banks carry a heavy burden of bad debt thatsupervise the new commercial banking systems. limits their ability to compete.Major investments in human capital are needed, Three important issues arise with regard to theboth in prudential regulation and supervision handling of problem loans during the transition.and in commercial banking (particularly credit The first is the role of banks in debt recovery. Inanalysis). Institutes to provide training in these most versions of financial restructuring, problemareas have been established in Hungary, Poland, loans are carved out of the bank portfolios andand Yugoslavia, in all cases with foreign involve- replaced by interest-yielding government bonds,ment. Governments and consultants are revising thus transferring the loss to the treasury. Theinformation systems, introducing standard ac- loans themselves are either placed in a specialcounts, and initiating independent audits. Hun- trust, staffed by specialists who will recover badgary, the most advanced of the CEE countries in assets, or left (below the line) with the banks,financial sector reform, is creating an interbank which then act as agents of the treasury to recoverclearing system with major investments in infor- assets. Each option has advantages and draw-mation technology. backs, and the choice will depend on a variety of

Reform requires fundamental changes in atti- country-specific legal and institutional factors, astude and extensive development of scarce skills. well as on the availability and distribution ofThesetaketimetoimplementandthereforeshould scarce skills in the area of workouts and restruc-be addressed from the outset of the reform pro- turing.?8 The outcome of the process is a "clean"gram.' To the extent possible, they should be bank, which, when adequately capitalized, canpursued through the periods of setbacks and re- compete actively and possibly be privatized.

47'

The second near-term issue is the distribution credit policy. Addressing this problem withoutofthelosses,whichrepresentaquasi-fiscaldefidt. segmenting financial markets may become anThere are five choices: (1) monetary reform, in- important issue as private sectors develop, andvolvingconfiscationofaportionoffinancialnlais, the experience of other countries should be re-(2) money creation, (3) tighter fiscal poliy, (4) viewed to determine the most appropriate wayspublic borrowing, and (5) the sale of public assets. of dealing with it.In practice, some mixture of these last four will Real interest rates have been raised to positiveprobably be used. The likely extent of the losses levelsinmostCEEcountries,buttheexperienceofmayjustifyearmarldnggovernmentrevenuesfrom financial sector reform elsewhere suggests thatasset sales rather than including them in general fullinterestrateliberalizationrequiresreasonablerevenues." macroeconomic stability, a sound and competi-

The third issue involves finance in the interim. tive financial system, and an effective system ofUntil the banks have hard budget constraints and prudential supervision and regulation. Guide-areresponsivetocompetitivepressures,theymight lines such as minrumum deposit and maximumnot have the incentive to seek out and develop loan rates are likely to be needed for some tinenew clients, particularly in the rapidly emerging afterpriceliberalization,andtheseshouldbecare-smaler-scale private sector. Yet the experience of fully monitored to maintain savings incentivesothercountriessuggeststhatthesesmallerprivate and reasonable intermediation spreads.clients will be the most vulnerable to tightening

48

Annex 5 Fiscal policy a modest surplus in 1990. Only Yugoslavia andRomania consistently achieved fiscal surpluses in

The CEE countries face enormous challenges in the late 1980s.reforming fiscal policy. They need to maintain Budgetdeficitswereonlyoneof several factorsfiscalbalanceforstabilizationwhilereducingand affecting macroeconomic stability in these coun-reorienting both public spending and taxation. tries. In Yugoslavia and Poland, for example,Public spending should focus less on potentially enterprises were extensively subsidized by thecompetitive activities in industry and agriculture bankingsystemthroughlow-interestloans.These(most of which will in time revert to the private subsidies, although contributing to monetizationsector) andmore on the provisionof public goods, and thus inflation in the economy, were outsideincludingbasic infrastructure, social services, and the budget altogether. In fact, in 1989 Yugoslaviawell-functioninglegalandregulatoryinstitutions. managed to have hyperinflation and a budgetTaxation should be more transparent and should surplus at the same time.create incentives for efficient production and con-sumption. Although the overall size of the public Public spendingsector should shrink, some central institutions ofgovernment - including those in charge of bud- Inrestment. One of the key features of socialistgeting and tax collection - need to be strength- economies was the high share of fixed invest-ened. ments in GDP, typically exceeding 30 percent and

sometimes as high as 40 percent.u1 The great bulkSize and balance of the goverrment budget - 80-90 percent - was controlled by the public

sector, whether government or state enterprises.Because of their large budgets, central govem- Although not all of this investment went throughments were the major financial intermediaries in thebudget, the government was often involved inthe CEE socialist economies. During the 1980s the major investment projects of state enterprises.consolidated state budgets accounted on average Indeed, one of the main advantages of socialistfor roughly 60 percent of GDP in these countries, systems was considered to be their ability to real-exceptinYugoslavia,wheretheconsolidatedbud- ize high planned saving and investment levelsget accounted for roughly 35 percent of GDP. and thus lay the groundwork for rapid growth.However,officialbudgetdataconveyonlypartial High investment was also stimulated by the "in-information on the pervasive role of goverrnent, vestment hunger" of semiautonomous enterprisesincepublic intermediationand redistribution can managers with access to cheap credit and withalsobe accomplished through the banking system little fear of bankruptcy if investments turned outor direct regulation (such as price and wage con- to be unprofitable.trols or regulation of enterprise investment). Many public investments were of poor quality.

Several CEE countries experienced deteriora- Projects were usually large, took a long time totions in their fiscal balances in the late 1980s, and complete, and often suffered cost overruns in partall have taken recent steps (primarily subsidy due to waste and pilferage. Investments werereductions and in some cases revenue increases) oriented toward heavy industry; social infrastruc-to improve them. Because of rising subsidies and ture, consumer durables, agroindustry, housing,declining real revenues during hyperinflation, and services were relatively neglected (althoughPoland'sl989deficitwasalmost8percentofGDP, investment in these areas, particularly housing,compared with less than 1 percent during 1983- increased somewhat in the 1980s).88. After stabilization in 1990, the budget went The major challenge of public investment re-into surplus. Hungary's deficit was about 3 per- form is to reorient spending and improve its effi-centof GDP in 1986 and 1987,before falling to only ciency. Whileinvestmentsinpotentially competi-about 1 percent in 1988 and 1989 (due to increas- tive sectors can be increasingly left to the privateingrevenuesin 1988 and subsidycuts in1989)and sector, public investment is urgently needed tobeing more or less in balance in 1990. Bulgaria's upgradedeterioratingbasicinfrastructure,includ-deficit rose to over 6 percent of GDP in 1988, ing roads, ports, public transportation, telecom-before falling toabout3percentin 1989. TheCSFR munications, irrigation facilities, and other ruralfaced a more modest but still significant deficit of systems.' Investment is needed to increase en-1.5 percent in GDP in 1989 but expected to register ergy efficiency and to switch progressively to

49

cleanerand safersources than the high-sulfurcoal diesonbasic goods modestly furthered this goal.aand nuclear power on which the CEE countries However,thebenefitsof certainsubsidies,includ-now depend. There is a risk that these countTies ingthoseonrailway transportand culture, tendedwill overreact to the centralization of the past by to be skewed toward higher-income groups, andreducing much-needed investments in "public the high-priced black market trade that accompa-goods" that complement private investment. nied price controls generated its own income dif-

ferentials. The negative effect of subsidies onSubsidies. Subsidies to consumers and enter- resource allocation has also been widely docu-

prises typically accounted for a large share of mented. The low cost of energy, for example,budgetary spending in socialist economies 1(see encouraged overconsumption, which led to envi-figure 5.1). In 1989, direct budgetary subsidies ronmental degradation and overinvestment inequalled 11 percent of GDP in Poland and Hun- the energy sector. Furthermore, low prices led togary, 16 percent in the CSFR, and 15 percent in long queues, hoarding whenever cheap goodsBulgaria. Consumer subsidies in CEE countries were available, and forced financial savings (ifweregenerallyonbasiccommodities(bread,nidlk, unable to purchase subsidized goods) that re-meat, sugar, heating fuel, pharmaceuticals) and duced work incentives.services (rental housing and mass transport). For Poland was the first CEE country to take deci-example, in the late 1980s Polish consumers had to sive moves to eliminate consumer price subsidies,pay only one-fifth of the production cost of milk, reducing most food subsidies in August 1989 andcentral heating, and state-owned rental housing; trimming or eliminating subsidies on many otherthe price of medicines did not change between goods and services (including transportation, en-1971 and 1989. Enterprises received both inpu.t- ergy, and housing) in early 1990. The share ofspecific subsidies (for example, on coal) and ad subsidies in GDP decreased from 14 percent inhoc grants. Export subsidies were also common, 1988 and 11 percent in 1989 to an estimated 6

percent in 1990 .4Figure 5.1 Consolidated govermnent Hungary has also moved quite rapidly sinceexpenditures in Eastern Europe as share of 1989, when the government adopted a four-yearGDP, 1982-90 schedule to phase out consumer price subsidies

and transfers to enterprises. In 1990 total subsi-IWo dies equalled about 9 percent of GDP, down from90 about 13 percent in 1989, and a targetof 6.8 percent80 is included in the 1991 budget. The CSFR elimi-~ 70 nated most consumer subsidies with its price lib-60 - Total expenditures eralization on January 1,1991, and Romania tookt 50! Fsteps in October 1990 to reduce subsidies by free-

- ing some consumer prices. Subsidies to loss-g 40 Sodal security and budgetary subsidies making firms still exist, however, in most CEE30 countries.20 Soda city' WhilemostCEEgovernmentsarestronglycom-10 mitted to further cuts, some subsidies are likely to

l . .. . . . . . remain for some time. Phasing out housing sub-1982 1983 1984 1985 1986 1987 1988 1989 1 !> sidies is particularly difficult in the short term;

Note: Figure shows unweghted averages for Bulgaria, he renters cannot easily shift to other housing givenCSIR, Hungary, and Poland. the thin housing markets, and compensating ana. Includes pension, maternity benefits, sick pay, and the increase in rents with direct cash transfers presup-newly introduced unemnployment benefits.Source Holzman (1990). poses the existence of a functioning welfare sys-

tem. Phasing out subsidies to firms ("harden-oriented either to CMEA trade (to assure the ful- ing" their budget constraints) should proceed infillment of centrally negotiated contracts) or to tandem with enterprise restructuring and privat-convertible currency trade (to compensate iFor ization.overvalued exchange rates).

Amajorobjectiveof consumer subsidies was to Social servues. Social indicators in CEE coun-provide basic goods at low cost and thus reduce tries are low compared with Westem Europe butdisparities in real income.- Indeed, some subsi- relatively high compared with other countries at

50

similar levels of per capita income. However, fects turnover tax revenues. Increased domestichealth statistics have been deteriorating in recent and international competition reduces monopolyyears, and poverty-related diseases such as jaun- rents and the tax revenues that result from themdice and tuberculosis are on the rise. Further- Privatization reduces government control overmore,educationalcurriculahavebeenoverlyspe- once-captive taxpayers and may require a reduc-cialized (sometimesonobsolete skills), asdictated tion in formerly confiscatory tax rates.O To avoidby a planned system. Many subjects indispens- a precipitous fall in revenue, governments mustable to a market economy, such as accounting, compensate for these effects by broadening theirmanagement, marketing, and finance, have been tax base. On the other hand, many tax instru-neglected. ments commnon in market economies are not use-

The CEE countries need to reorient public ful until reforms occur. A value-added tax makesspending on social services both to increase qual- little sense when prices are controlled, and a per-ity and to improve incentives. In the area of sonal income tax has little purpose when wagehealth, for example, medical insurance systems scales are set by the state. Similarly, rate-specificshould be developed, subsidies on pharmaceuti- corporation taxes have little meaning in the pres-cals reduced, and eligibility for sickness benefits ence of soft budget constraints.(liberally granted in the past) tightened. The Early tax reform is crucial now that the CEEdevelopment of private alternatives in service countries are seriously pursuing broad economicdelivery and funding for both health and educa- reforms. Poland, Yugoslavia, Hungary, the CSFR,tion should be encouraged. and (to a lesser extent) Romania have freed most

producer and consumer prices. It is now bothTaxes possible and desirable to introduce a broad-based

VAT that will replace the distortionary and com-Taxes had no independent role in traditional cen- plex turnover tax system and serve as the "work-trally planned economies. The government set horse" of the revenue system, compensating forpricesof inputsand outputsand wagerates. Taxes declining company taxes as firms are privatized.(primarily on turnover, company "profits," and HungaryalreadyintroducedaVATinl988(albeitpayroll) transferred any surplus to the state. As still with extensive price controls). Poland is nowsocialist firns gained greater autonomy in the in the process of designing a VAT, and the CSFR1960s and 1970s, taxes began to take on an inde- hopes to introduce one in 1992 or 1993.pendent role as needed to induce greater effi- Private sector development is being encour-iency or substitute for the reduction in central aged in all reforming countries. Reforms of in-

controls. Profit tax rates became somewhat more come taxes become increasingly important as theuniform in an attempt to spur efficiency, and private sector grows - to insure equal treatment,turnovertaxesbecamemoredifferentiatedastools to set clear "rules of the game," and to make the taxto regulate prices. Taxes on capital (or "divi- system more transparent, predictable, anddends") tried to simulate capital markets by re- nondistortionary. Hungary reformed its personalquiringa certain rate of return on assets, and taxes and company income tax system in 1988 and 1989.on"excess" wages tried to impose wage discipline Poland amended its company income tax law inin the absence of private owners and a fully func- 1989 to insure equal treatment of public and pri-tioning labor market. Similarly, special taxes cap- vate firms, and it plans to introduce a globaltured rents arising from CMEA trade. Any incen- personal income tax in 1991. The CSFR and thetive effects of these various taxes tended to be USSRbothintroducednewcompanyincometaxesmuted, however, by the ad hoc, discretionary, and in 1990, the former to be phased in by 1992 and theindividually negotiated nature of tax liabilities. latter to have taken effect in January 1991. Yugo-

The discretion of authorities to change tax rules slavia recognizes the need for tax reform, butat will - often after profits had been made - was plans are complicated by federal-republic dis-both a major cause of the soft budget constraint of agreements about taxing authority. Romania andfirms and an important disincentive to improved Bulgaria are beginning to consider tax reformperformance by firms. options.

Tax reform is closely intertwined with eco- All of these countries must face the trade-offnomic reform. On the one hand, reforms tend to between revenue needs and the goals of efficiencyeliminate mnany of the traditionally important and private sector development. The tax laws putsources of revenue. Changing relative prices af- in place so far have relatively high effective rates,

51

whether because of high statutory rates (for ex- Intergovemmental fiscal relationsample, the 25 percent basic VAT rate in Hungary)or because of limits on deductions. Although Theriseinregional political tensionsinmostof thethese high rates protect revenues," high income CEE countries is mirrored in the difficulties theytax rates can discourage investment and dampen are now encountering in resolving pressures foreconomic activity. These countries must also iface fiscal decentralization. Local and regional au-the trade-off between rate levels and targeted tax thorities are seeking authority over an ever-in-incentives; tax incentives sacrifice revenues un- creasing share of general government revenue.less compensated through higher general rates. This is most pronounced in Yugoslavia, where theAllof Hungary'snewtaxescontainmanytargeted federal govermnent controls only about one-thirdincentives (whether exemptions or reduced rates) of general government revenue, primarily fromto encourage certain activities or to protect certain indirect taxes and tariffs, and where some repub-types of income or consumption." These incen- lics are now refusing to tum over indirect taxestives are difficult to eliminate once granted; other collected by them. Bulgaria, the CSFR, Hungary,countries would be wise to adopt the broadest Poland, and the USSR are also facing increasingpossible tax bases and lower rates from the start. pressures for greater local fiscal autonomy. This

Although tax reform is important early on, issue has not been clearly resolved anywhere,institutional constraints arelikely to limit its effec- although various concrete proposals are emerg-tiveness in the short run. The reformingcountries ing. Hungary is perhaps the most advanced; itsare poorly equipped for the modern tax adminis- proposed reform involves transferringone-half oftration called for in a market economy. In socialist personal income tax revenues to the localitiessystems, tax administrators are part of the owner- where they originated and shifting most revenue-ship and control structure of government, and sharing onto a capitation grant system based on athey have unrestricted access to enterprise books predefined formula. While some degree of fiscaland records. State enterprises are few and large, decentralization is warranted, it is important toand the number of registered taxpayers tends to set dear and objective rules and to assure thatbe relatively small. Tax administration in a rmar- local administrations have adequate budgetaryket economy with many independent firms calls and expenditure monitoring capacity. Some cen-for different skills - for example, in accounting, tral safeguards (such as limits over foreign bor-selective auditing, dispute resolution, and tax rowing)arealsoneededtoensurefmacroeconomicenforcement - that will take some time to de- stability.velop in the reforming countries.

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Annex 6 Income distribution, poverty, The primary objective of enterprises in narketand social safety nets economies is to maximize profits, while those

individuals who for any reason remain outsideThe socialist legacy the system become the responsibility of the state.

In essence, firms in socialist economies fulfilledPerhaps the mapr accomplishment of the socialist both economic and social functions. Even whensystems of Central and Eastern Europe was the firms gained moreautonomyinYugoslavia, Hun-relativelyequaldistnbutionofincometheyattained. gary, and Poland, they still had a social role, aAs indicted by the Gini coefficients'9 in table 6.1, "duty" to provide employment to alleviate socialincome distnbution in Hungary, Poland, the USSR, problems in their respective regions. Firms tookand China was rore equal than in market econo- an active role in providing social services to em-miesexceptScandinavia in the 1970sand 1980s, and ployees." Government's social protection rolemuch more equal than in most middle-income de- consisted primarily of admninistering state-runveloping countries" Yugoslavia's income distribu- pension systems and generous programs of sicktionwasslightlylessequalthanintheothersocialist and maternity pay,"* and providing welfare ben-economies, mairny because of the great variation efits to marginal social groups, such as singleamong republics. Within Yugoslav republics, in- mothers, the handicapped, and the chronically illcome equality resembled that in the other socalist (includingalcoholicsanddrugaddicts).Suchben-economies. efits were often provided in kind (such as hot

Low income inequality in socialist economies meals,homenursingcare,orclothes),asfrequentlystemmedprimarilyfromguaranteedemployment happenswithchanitiesinnmarketeconomies. Cash-and low wage differentiation in the state sector. based welfare systems were not well-developed.Softbudget constraintsand the tendency to hoard Although rarely admitted by socialist govern-inputs, combined with government prodding to ments, "cradle-to-grave" state paternalism failedprovide jobs, led firms to hire workers even when to elininate poverty. As economies slowed in thethey had little use for themrand to rely lesson part- 1980s, a progressive decline in real wages and, to

me jobs (which typically account for a sizable a lesser extent, real pensions led to growing pov-share of low-paid labor) than in market econo- erty, especially in urban areas. Between 1977 andmies. 1988, the percentage of people living below an

Low wage differentiation in the state sector unchanged,inflation-indexed official povertyline(which, together with state pensions, accounted in urban areas increased from 8 to 21 percent infor 60-75 percent of total income) resulted fromeliminationofbothveryhighandverylowwages.' 2 Table 6.1 Gini coefficients for selectedAt the top of the income scale, the relative pay of countries and regionshighly skilled professionals was lower than inmarketeconomnies. Forexample,earningsinsome Country or region ci cogefllcntprofessions that are among the highest paid inindustrial countries - including doctors, engi- Hung 24.4neers, and lawyers - were state-controlled and Poland 24.3were notoriously low in socialist economies.'3 USSR 25.6Furthermore, the absence of a truly entrepreneur- China (urban) 23.9ial role meant that one of the functions most (rural) 23.1strongly rewarded in market economies, entre- Czechoslovakia 20.7preneurship, was absent. Wage rates were gener- Yugoslavia 32.1ally guided by government-determined norms Eastern Europe 25Athat imposed maximum ratios between pay of Latin America 49.5differentgradelevelsorprofessions. Wageswithin South Asia 423worker-managed firms were influenced by the Asian NICs and Japan 38.3firm's labor force, whose dominant coalition gen- Western Europe 31.4erally preferred reduced wage dispersion. Profit Uned States 205equalization between firns" reinforced egalitar- Norway 24.3ian tendencies already present within firms toinsure relatively equal wages throughout the Sourc. Milanovic (1990).economy.

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both Poland and Yugoslavia, and from 10 to 17 structured). Flat-rate benefits limited in time arepercent in Hungary. The share of urban poor in favored by many observers because they avoidthe total poor population increased in Poland the disincentive effects of income-tested schemesduring the 1980s from 48 to 70 percent, and in and are the easiest of the three approaches toYugoslavia from 25 to 50 percent. administer.

Of all the socialist economies of Central andReforming the social safety net Eastern Europe, only Yugoslavia has had a long

history (dating back to the 1950s) of open employ-The transition to a market economy is virtually mentand official unemployment insurance. Insti-certain to lead to higher unemployment and some- tutions to address the problems of newly emerg-what greater income inequality. This requires a ing unemployment appeared in Hungary in Janu-redefinition of the social safety net, in essence an ary 1989, and one year later in Poland and Bul-"unbundling" of the economic and social roles garia. In all cases, the earnings-related insurancepreviously assigned to enterprises. The main approach was chosen.objective of enterprises should be efficient pro- Polish unemployment rose from almost noth-duction, which not only generates economic ing to some 7 percent of the labor force duringgrowth but also protects existing jobs and creates 1990, compared with rates of 1-2 percent in Hun-new ones. Governments should be responsible gary and Romania and less than 1 percent infor protecting vulnerable groups - whether the Bulgaria and the CSFR. Only Yugoslavia's 9 per-unemployed, the elderly, the disabled, or others cent rate was higher. In Poland, unemploymentleft out of the productive economy - and provid- benefits were first offered in January 1990 as parting (directly or indirectly) basic social services of the reform package. They were open-ended insuch as health and education. Individuals should duration and were calculated as a declining func-in turn be responsible for finding jobs (with some tion of the duration of unemployment. Althoughassistance from the state) and keeping them many of the "unemployed" were actually newthrough satisfactory performance. entrants to the labor force (whether recent gradu-

ates or formerly nonworking spouses), almost allUnemployment benefits. The most pressing im- were by law eligible for unemployment benefits.

mediate need is for government programs of un- Total income-maintenance and training expendi-employment compensation and retraining to ease tures amounted to 0.6 percent of GDP in 1990 -the social costs of enterprise restructuring and still low by Western European standards - andprivatization. Each country must choose among were financed by a special 2 percent wage levythree basic concepts for calculating unempiloy- and direct budget subsidies.ment compensation: income-tested, eamings-re- The Polish experience illustrates the problemslated, or flat-rate. If income-tested and open- accompanying the initial introduction of unem-ended in time, unemployment compensation is ployment compensation in the reforming coun-essentially no different than other types of pov- tries. First, the number of unemployed was un-erty relief. It is clearly targeted to those in greatest derestimated, and the number of social centersneed and is therefore the cheapest alternative in and social workers has been inadequate from theterms of benefits provided.97 If earnings-related beginning.' Second, retraining was neglected dueand limited in tim.e, unemployment compensa- to its complexity. Labor offices concentrated al-tion resembles insurance.' It protects newly un- most entirely on registration of the unemployedemployed individuals from a precipitous fall in and distributionof benefits;by August 1990, onlyliving standard in the short run, and the time 0.5 percent of those registered were undergoinglinmitation avoids any disincentive to look for new training. Third, the initial design mixed the insur-work. It also avoids the "poverty trap" whereby ance and assistance principles by providing com-other members of a household may decide not to pensation linked to previous earnings (insurance)take a job if it means a loss in unemployment but open-ended in time (welfare). Proposedbenefits. However, because of the time limitation, amendments in the Labor Law limit the durationit addresses primarily frictional or cyclical unem- of benefits to one and one-half years. A separateployment and not the kind of structural and long- welfare system to be developed will in principleterm unemployment that may arise in the reform- provide a minimum means-tested floor incomeing countries (especially as heavy industry is re- open-ended in time. A similar solution was also

54

adopted in Hungary, where unemployment ben- should ideally be handled through poverty-ori-efits payable for one year (or two in exceptional ented welfare programs. Furthermore, pockets ofcases) are complemented with a universal welfare povertyuntouchedbyanyprogramremain. Givenscheme. the likelihood that unemployment will be high for

The introductionof unemploymentcompensa- several years, and that income distribution willtion in Poland triggered a revision in the defini- worsen in the move to a market economy, broad-tion and role of the minimum wage and the social ening the social safety net to include a more com-minimum (or "poverty line"). Before 1990 the prehensive income-tested scheme is an importantminimum wage was purely an accounting con- challenge for the future.cept used for the establishment of wage scales.Recently it has been raised to equal the official Pensions. Reformofold-ageanddisabilitypen-social minimum (for one person in a four-person sions is another critical complement to enterprisehousehold)10 and, as in mature market econo- restructuring and budgetary control. At presentmies, has been set as an obligatory floor wage for all the reforming countries have state-run pay-as-both the state and the private sector. The social you-earn (PAYE) schemes in which pensions areminimum, previously only an accounting con- financed out of current contributions. Pensioncept, has also gained new significance as the basis expenditures are quite high, necessitating highfor welfare claims. contributions,'03 in part due to the demographic

Thereformingcountriesneedtoavoidanoverly profile and in part due to generous eligibilitygenerous level of benefits that both discourage criteria. The retirement age in most of the reform-active job search and createan enormouspotential ing socialist countries is 60 for men and 55 forbudgetary burden. The generosity of some of the women, compared with the OECD average of 64existing plans may in part reflect political con- for men and 62 for women. In addition, pensionstraints, as the public may still not fully accept the formulas are biased toward short careers, andview that a reduction in job and income security is pensions are granted generously for invalidity oran unavoidable part of the move to a market early retirement, often in response to labor re-economy. For example, in one Yugoslav republic trenchment (in lieu of unemployment benefits).Y3the benefit is 100 percent of the previous wage for The total number of pensioners in the CEE coun-three months and thereafter 60 percent plus 1 tries has been estimated at approximately half thepercent per year of service (to a maximum of 90 total number employed, and real spending onpercent). In another republic, the benefit is 80 pensions is growing. Pension reform should be-percent of the previous wage. Workers can re- gin by tightening eligibility (including graduallyceive these benefits for up to two years - and raising retirement ages) and by revising the pen-indefinitely after 25 years of service."0" sion formula along actuarial principles.

Several countries are considering supplement-Welfare. Of all the CEE countries, Yugoslavia ing their PAYE systems with either funded public

hasthemostcomprehensivesocialwelfarescheme pension schemes (whereby individual contribu-targeted specifically at eliminating poverty."' Al- tions are directly linked to pensions) or manda-though some other CEE countries (most notably tory private pension plans along the model used,Hungary) have established welfare programs in for example, in Switzerland and Chile. Develop-recent years (often at the local level), these pro- ing a funded system can be problematic; in thegrams are not true entitlements, that is, based on beginning current employees must both pay fortransparent criteria, with assured funding of all current pensions and build up the fund fromwho qualify, and with regular administrative and which their own pensions will later be paid. Pri-appeals procedures. In all CEE countries, other vatization may present a unique avenue to miti-social programs - whether unemployment com- gate part of this problem, if a substantial part ofpensation, pensions, sick pay, and maternity leave the ownership of privatized firns can be vested in- are all bearing some excessive burden that pension funds as a source of funding!°s

55

Annex 7 The World Bank Group's support for anywhere in a comprehensive way before 1989-economic transformation in Central and 90. The main weakness of the policy frameworkEastern Europe was lack of competition, financial discipline, and

a clear exercise of ownership rights at the enter-Evolution of Bank Group activities prise level, which obviously did not provide the

necessary signals for economic restructuring andThe World Bank Group's involvement with Cen- behavioral change.tral and Eastern Europe (CEE) dates back many The IFC has been active in Yugoslavia sinceyears.106 The CSFR, Poland, and Yugoslavia were 1968, in Hungary since 1985, and in Poland sincefounding members of the Bank and the Fund at 1987. In Yugoslavia, there has never been a cen-their creation in 1945; however, the CSFR and tralizedownership,management,andinvestmentPoland ceased to be members within a few years. planning system. Instead, investment plans haveRomania joined the Bretton Woods institutions in been generated by the operating enterprises and1972, Hungary in 1982, and Poland rejoined in financed by a banking structure with some com-1986. In the fall of 1990, the CSFR rejoined, and petitive elements. Within this institutional con-Bulgaria became a new member. In addition, text, the IFC has made 36 transactions for a totalRomania, which had stopped borrowing from the commitment of about $700 million. As several ofBank in 1982 and prepaid its debt by early '1989, these transactions were package loans throughrestored full relations with the Bank and became local banks, IFC funding has gone to several hun-a member of the International Finance Corpora- dred enterprises. In Hungary, the IFC has under-tion (IFC) in 1990. In January 1991, Albania ap- takeneight transactions for$100 million (of whichplied for membership in the IMF, the World Bank, $22 million was in equity), including five jointand the IFC. An initial IMF mission to ascertain ventures in the productive sector, an agency lineconditions for membership took place in March of credit for small- and medium-scale private1991. enterprises in cooperation with a local Hungarian

To date, World Bank lending commnitments to bank, a joint venture bank, and an internationallythe region total a little more than $10 billion. Since distributed investment fund. In Poland, the IFC1945, Yugoslavia has received 99 loans from the has undertaken three operations with a total com-Bank for a commitment of $53 billion. Romania mitment of about $55 million: an export-oriented,had obtained 33 loans for $2.2 billion before it cooperative agro-processing enterprise, a flag-stopped borrowing from external sources and ship hotel joint venture, and an agency line ofstarted prepaying its foreign debt in 1982. Total credit for small- and medium-scale private enter-commitments to Hungary have slightly exceeded prises in cooperation with a local Polish bank It$2.8 billion for 30 projects. Since the beginning of has also provided advisory support to the govern-1990, Poland has obtained seven loans for $1.22 ment in three key areas: privatization, capitalbillion. market development, and the framework for for-

Except for the FY83 Yugoslavia SAL, the FY88 eign investment.Hungary Industrial Sector Adjustment Loan, andquick-disbursing components under the FY86-87 The transformation process and Bank GroupIndustrial Restructuring loans to Hungary, all supportpre-FY90 Bank lending to CEE was project-spe-cific, with the bulk of loans supporting investment With country-specific variations in terms of speedin infrastructure, industry,and agriculture. While and scope of effort, the reforming countries init is true in all countries that the effectiveness of CEE have decided to move toward market econo-project lending is hampered by distortions in mies with private ownership and the reduction ofmacroeconomic and sector policies, this is par- the state to a facilitating role. Long drawn-outticularly relevant in CEE countries, where short- reform efforts in Yugoslavia and Hungary and tocomings in economic performance have had a some extent Poland, which essentially aimed atdeeply rooted systemic dimension. In spite of a decentralization without exposing enterprises tomultiplicity of reform efforts in individual coun- financialdisciplinefromowners,creditors,orcom-tries during the l970sand 1980s, the systemic root petitors, suggest that gradual reforms - as op-causesofeconomicdifficultieswerenotaddressed posed to more radical systemic transformation-

56

are not effective. Bank lending into environments supply response through restructuring and pro-of partial reform in Hungary or Yugoslavia has gressive privatization of the existing productivealso been of only limited effectiveness. base and creating an enabling environment for

With the region's political events of 1989-90, development of new enterprises, particularlythe climate for a switch in economic policies has small- and medium-sized enterprises; (3) foster-dramatically changed toward comprehensive sys- ing the development of a modem, efficient infra-temic transformation. The Bank has begun to structure in telecommunications, roads, and rail-implement substantial programs of assistance to ways; (4) improving the efficiency of energy re-facilitate the transition. Over the next three years, source use and developing an adequate environ-the Bank proposes to lend an estimated $74 bil- mental policy framework; (5) modernizing andlion covering all six countries. To place this in restructuring the banking sector; and (6) facilitat-perspective, two years ago Bank lending was lim- ing the redeployment of labor and the develop-ited to Hungary and Yugoslavia and amounted to ment of a modem human resource base. This wiUroughly$500million. InFY90, theBanklentatotal also be the thrust of the assistance strategy in theof $1.8 billion to Hungary, Poland, and Yugosla- new countries.via (see tables 7.1,7.2, and 7.3 on the status of Bank TheEconomicDevelopmentlnstitute(EDI)hasGroup operations in those three countries). In the also expanded its activities in the region, focusingcurrent fiscal year, the Bank expects to lend about on macroeconomic and public sector manage-$2.5 billion to the three and to the new members, ment, industrial restructuring, labor market andBulgaria and the CSFR, and possibly to Romania. socialprotection,andenvironmentalmanagement.The Bank opened a resident mission in Warsaw in To stretch the EDI's limited resources and protectJuly 1990. institutionally weaker countries elsewhere, great

The World Bank has undertaken substantial emphasis is put on cooperative arrangements ineconomic and sector work (ESW) in support of a the regionand funding fromother (nontraditional)large and growing lending program. ESW in- sources.cluded country economic memoranda, with em- Both the need for and the interest in financialphasis on macroeconomic issues for most coun- and technical assistance from the IFC and the FlAStries, including members the CSFR and Bulgaria; have greatly expanded with reforms. In FY91 thetrade analyses for Hungary and Poland, with IFC opened representative offices in Warsaw,emphasisonCMEAissues;financialsectorassess- Budapest, and Prague. In conjunction with thements in Hungary, Poland, and Yugoslavia; in- IFC's joint venture investment operations anddustrial sector work in Hungary and Yugoslavia; related dialogue on foreign investment laws andenvironmental studies for Hungary and Poland; procedures, its capital markets group has assistedand far-reaching analyses of social sector issues in in the creation of new financial sector institutionsHungary and Poland. Moreover, in Poland a (banks, insurance companies, leasing companies,number of joint Bank-government task forcescov- and venture capital funds) and has provided ad-eredstrategicissuesinagriculture,housing,health, vice on the legal and regulatory infrastructure forand the legal and regulatory basis for the financial securities markets. The IFC's corporate servicessector. Future ESW will pursue similar priorities, group has advised onrestructuringand privatiza-with coverage expanding to the new countries. tion in Poland, Hungary, and the CSFR, and theFor Bulgaria and Romania, work on trade and IFC has established a Business Advisory Servicepublic expenditures is planned, given the severe in Poland where small- and medium-scale privateshortage of both foreign exchange and govern- enterprises can get advice.ment revenues. In Romania, work will also focus MIGA's focus, of course, is facilitating foreignon the social safety net. investors by providing political risk insurance on

TheBank'sfinancialassistanceduringCY1989- equity investments in these countries, and it is90 went to (1) supporting fairly comprehensive interesting that, relatively speaking, the highesttransformation programs through structural ad- demand for its services is emanating from CEE.justment loans (SALs) typically focused on policy To date, only one insurance transaction has takenand institutional measures to foster the private place in CEE: a $30 million reinsurance for ansector, a competitive environment, the financial investment project in Hungary. However, a num-sector, and a social safety net; (2) promoting a ber of projects in Poland and Hungary are under

57

Table 7.1 Status of Bank Group operations in Hungary

S'haint of Bink lons(as of May 1, 1991)

Gross commitments(kss aouincU)

Licn Fisca (milbns of doars)nwnber yar Brromwr Poject Ln Undisbwsed

Five loans and six B-loans fully disbursed 939.53Of which SECALs, SALs, and Program Loans: '

2965 1988 NBHb Industrial Sector Adjustment 200.003228 1990 NBH SAL [ 200.00 -2317 1983 ROHc Industrial Energy Conservation 109.00 0.102510 1985 NBH Integrated Livestock 80.O0 11.102557 1985 ROH Transport (Rail/Road) 75.00 2.802697 1986 ROH Powtne 64.00 24.202700 1986 NBH Industrial Restructuring I 100.00 14.202709 1986 NBH Indusrial Energy Conservation lI 25.00 3.902738 1987 NBH Crop Production 100.00 11.102834 1987 NBH Industrial Restructuring 11 150.00 51.002847 1987 NBH Telecommunications 70.00 18.802936 1988 NBH Agroprocessing Modemization 70.00 50.702966 1988 NBH Technology Development 50.00 31.103020 1989 NBH Industrial Restructuring m 140.00 120.803032 1989 ROH Transport II 95.00 76803055 1989 NBH Energy Development-Conservation 10.00 7.903056 1989 OKGTd Energy Development-Oil and Gas 100.00 91.903191 1990 NBH Finandal System Modernization 66.00 61.003229 1990 NBH Integrated Agricultural Exports 100.00 81.50B1lOb 1991 ROH Expanded Cofinancing Operation 200.00 200.003264 1991 HTC Telecommunications II 150.00 140.003313 1991 ROH Human Resources Development 150.00 150.00

Total gross commitments 2,642.92Of which repaid 263.39Total now held by the Bank 2,530.14Total tndisbursed 1,099.46

a. oved during or after FY80.b. National Bank of Hungary.c. Republic of Hungary.d. National Oil and Gas Trust.

active consideration, and inquiries from the CSFR ($300 million) during CY1990. There are someand Yugoslavia are numerous. common factors but also significant differences in

individual programs and the Bank's support. Yu-The thrust of Bank Group activities in selected goslavia and Poland faced hyperinflation in 1989,areas which was attacked through heterodox shock sta-

bilization programs, with the exchange rate andMacroeconornic policies toward stabilization and ad- wages as nominal anchors. Hungary's economicjustment. The Bank has extended quick-disburs- difficulties were of a more traditional nature, withing balance-of-payments support through SALs a growing balance-of-payments deficit but onlyto Yugoslavia ($400 million), Hungary ($200 mil- moderate inflation as a result of expansionarylion plus $200 million in cofinancing), and Po]land monetary and fiscal policies. The stabilization

58

Table 7.1 Status of Bank Group operations in Hungary (continued)

Statement of IFC investments(as of May 1,1991)

Gross conmitmentsFisal (mlions of dollars)year Obligor Type of business Loan Equity Total

1987 Unibank Capital markets - 3.03 3.031987 Agrofrem Hungarian- Food aid 8.55 2.70 11.25

Japanese Fermentation AgribusinessIndustry Ltd.

1988 Salgotarjan Glass Wool Insulation material 3.44 1.53 4.971989 Dunamon

Poliestirolgyarto Ltd. Chemicals 28.38 3.75 32.131990 Dexter Mold General manufacturing (plastic) 3.26 0.93 4.191990 Tetra Pak Packaging material 8.03 3.21 11.231990 First Hungary Fund Capital markets - 7.50 7.501990 FHIA Capital markets - 0.04 0.041991 NMBB Capital markets - 1.63 1.631991 FAHIC Insurance - 320 3201991 Agency Credit Fadlity Small and medium business 21.60 5.40 27.001991 Magyar Suzuki Automotive 0.70 6.60 37.30

Total gross commitments 103.95 39.52 143.46Less cancellations, terminations, exchange adjustments,

repayments, write-offs, and sales 11.44Total commitments now held by the IFC 132.02Total undisbursed 68.16Total disbursed 63.86

program, accordingly, relied on fiscal and mon- tion as a precondition for structural change whileetary restraint. All three programs also included also embarking on systemic transformation toimportant structural adjustment elements to ad- bring about behavioral change at the enterprisedress systemic root causes of economic difficulties level and thus to reinforce macroeconomic stabil-(pervasive subsidies and price distortions, mas- ity. SALconditionalityhasbeendesignedaccord-sive nontariff barriers to trade, blurred enterprise ingly, although continued govemment commnit-ownership, lack of financial discipline, and guar- ment is the ultimate answer to success.anteed full employment). The most comprehen-sive and rigorous approach was followed in Po- Marketization. Trade and price liberalization andland, with virtually complete price and trade lib- competition policy. "Marketization," that is, trans-eralization, important measures to tighten the formation from a command to a market economy,financial discipline of enterprises, financial sector is at the center of reforms in all CEE countries. Butreform, the start of privatization, demonopoliza- in some countries there is still debate or confusiontion of key industries, and the establishment of a as to the meaning and scope of a market economyrudimentary social safety net. Hungary's pro- in practice. In such an economy, resource alloca-gram tackled a similarly broad range of systemic tion is driven by relative prices rather than centralproblems, but price and trade liberalization has government decisions. It requires the free settingnot yet gone quite as far. Yugoslavia's program, of prices under reasonably effective competitionafter apromisingstart, becameavictimof political and factor (abor and capital) mobility. (In keydifficulties that prevented wage discipline and areas such as energy, a possible intermediate stepenergetic action in the enterprise sector. The Bank may be the adjustment of administrative priceshas encouraged comprehensive transformation toward efficiency levels before full liberalization.)programs that require macroeconomic stabiliza- The Bank has been supporting market reforms in

59

Table 7.2 Status of Bank Group operations in Poland

Statement of Bank loans(s of March 31, 1991)

Cross commitments

Loan Fvscal (mi1lio,s of delam)nwnber year Borrower Purpose Lean Undisbursed

3166 1990 National Bank of Poland[ Ind. exports development 260.00 248.113167 1990 National Bank of Polandl Agroind. exp. development 100.00 85.093190 1990 Republic of Poland Environment management 1800 17.363193' 1990 Republic of Poland Transport 4.75 4.753194 1990 Polish Railway Corp. Transport 145.00 141.833215 1990 Polish Oil & Gas Corp. Energy resources

development 250.00 231.31*3247 1991 Republic of Poland SAL I 300.00 22138

Subtotalb 1077.75 949.83Of which repaidc 0.00Total now outstanding 1077.75Amount sold 0.00Total now held by Bank' 1077.75Total undisbursed 949.83

Statement of IFC investments(as of March 31,1991)

Gross comnmitments(mzilions of lLaa)

Fiscal year Obligor Type of business Loan Equity Total

1989 Hortex Horticulture 17.12 17.121990 Export Devt. Bank Export credit 31.66 31.661991 Bristol Hotel Hotel developmenl 10.06 10.06

Total gross commitments 58.84 0.00 58.84Less cancellations, terminations,exchange adjustments, repayments, writeoffs, and sales 2.12 2.12

Total commitments now held by the IFC 56.72 0.00 56.72Total undisbursed 42.15 42.10Total outstanding 14.57 0.00 14.57

SAL, SECAL or "Program Loan."a. Two loans for one project.b. Exdudes loan of $120 million for a telecommunications project that was approved by the Executive Directors on April 23,1991, but has not yet been signed.c. Prior to exchange adjustments.

many developing countries, particularly through ments of all adjustment programs in the regiontrade liberalization as the most effective means to supported through Bank SALs, in CY1990. Thecreatecompetitionandstimulateefficiencyinsmall most radical approach was followed by Poland,economies. What makes CEE special is the high where prices for 90-95 percent of sales were liber-concentration of enterprises and the overwhelm- alized and the trade regime completely changed,ing ownership role of the state with blurred oTrn- with immediate abolition of all nontariff barriersership rights (see the enterprise section below). to imports and the establishment of relatively lowPrice and trade liberalization have been key ele- tariffs (these were actually suspended for a wide

60

Table 73 Status of Bank Group operations in Yugoslavia

SnWmnet of Bank Jnus(as of Man* 31, 1991)

Gross commitments

Loan Fiwal (Nffims of domlm)number year Borrower Projt La Ui

Eighty-four loans fully disbursed 3,402.84Of which SECALs, SALs, and Program Loans8

2326 1983 Udruz. Beogradska Banka Structural Adjustment Loan I 275.002410 1984 Vodjvodjanska Bank Fertilizer Sector Loan (SAP)

Subtotal of SECALS, SALs, and Program Lons 275.00

2307 1983 Udruzx Beogradska Banka Serbia Regional Development 94.00 2.82336 1984 Four Railway Orgs. Sixth Railway 10630 0.62338 1984 Eight Power Orgs. Third Power Transmission 115.00 91.42467 1985 Investiciona Banka Montenegro Regional

Titograd Development 40.00 16.62527 1985 Elektroprivreda Bosnia Visegrad Hydropower 125.00 042595 1985 INA-Naftaplin Petroleum Sector 55.00 12.12596 1985 Naftagas Petroleum Sector 35.00 9.22597 1985 Privredna Banka Sarajevo Petroleum Sector 2.50 1.62715 1986 Four Road Organizations First HighwaySector 121.50 1.52790 1987 Ljubljanska Banka Industrial Energy Conservation 90.00 60.62878 1988 Four Road Organizations Second Highway Sector 59.94 21.73068 l98 9b Four Railway Orgs. Seventh Railway 122.20 122.23069 1989 Istria Water Works and Istria and Slovene Coast Water

Pula Water Works Supply and Sewerage 28.00 2333070 1989 Rizana Water Works Istria and Slovene Coast Water

Supply and Sewerage 32.00 2&13187 1990 National Bank of Second Structural

Yugoslavia Adjustment Loan 400.00 250.63230 1990 Road Org.-Bosnia-Herz. Third Highway Sector 55.00 55.03231 199fc Road Org.-Croatia Third Highway Sector 75.00 75.03232 1990C Road Org.-Macedonia Third Highway Sector 22.00 22.03233 1990C Road Org.-Serbia Third Highway Sector 55.00 55.03234 1990C Republic of Slovenia Third Highway Sector 60.00 60.03235 1990y Road Org.-Vojvodina Third Highway Sector 25.00 25.0

Total gross commitments 5,12128Of which repaid 2,288.27Total now held by the Bank 2,833.01Total amount sold 9.20Of which repaid 920Total undisbursed 934.6

a. Approved during or after FY80.b. Not yet effective.c. Not yet signed.

array of products during the second half of 1990 to ing 1991. However, with high vertical and hori-increase competitive pressure). Hungary and zontal concentration of enterprises and numerousYugoslavia have also gone quite far in disman- regulatory constraints, deregulation and compe-tling quantitative restrictions, and Hungary will titionpolicyalsobecomeimportantcomplements.virtually complete the liberalization process dur- In the Polish program, demonopolization of some

61

Table 73 Status of Bank Group operations in Yugoslavia (continued)

Statement of IFC investments(as of Mardh 31,1991)

Gross commitmentsFiscal (mllions of doais)year Obligar Type of busimess Lon Equity Total

1970 InternationalInvestment Development finance - 2.00 2.00

1970 Zastava Motor vehicles and accessories 12.40 0.60 13.001973 Belisce-Bel Pulp and paper 70.86 - 70.861974 Zelezarana Iron and steel 10.00 - 10.001977 Tvornica Kartona

Cazin Pulp and paper 19.77 - 19.771977 Frikom RO Industrija Food processing 5.51 0.92 6.431978 Soko Most Hermetic compressors 7.00 - 7.001980 Investiciona Banka

Titograd Hotel rehabilitaticu 21.00 - 21.001980 Radoje Dakic Construction equipment 18.70 - 18.701980 Eight regional

Yugoslav banks Small-scale enterprise finance 30.23 - 30.231980 FAP FAMOS Motor vehicles ancl accessories 16.30 0.77 17.071980 RMK Machinery 50.00 - 50.001982-87 Institute Dr. Simo

M. Igalo Physical medicine! 19.15 - 19.151982 Trakori Ruen Auto Motor vehicles ancl accessories 10.63 _ 10.631983 Ljubljanska Banka Development finance 31.43 _ 31.431984 INA-Naftaplin Chemicals and petrochemicals 37.78 _ 37.781985-89 SOZD Iskara Telecommunications 33.88 - 33.881985 SOUR Energoinvest Power transmission 15.18 - 15.181985 Jugobanka Development finanice 35.80 - 35.801985 Ljubljanska Banka Development finance 69.84 - 69.841986 Unial-TGA Nonferrous metals 35.60 - 35.601986 TAM/DEUTZ Motor vehicles 35.98 0.87 36.851988 Sava Semperit Tires 26.20 2.55 28.751989 Vojvodjanska Banka Development finanice 87.00 - 87.001989 Salonit Anhovo GRP pipes 11.% - 11.961990 Anhovo Pulp and paper 5.23 - 5.231991 Delo Printing press modernization 4.64 - 4.64

Total gross commitments 722.07 7.77 729.78Less cancellations, terminations, exchange

adjustments, repayments, write-offs, arci sales 383.68 7.71 391.39Total commitments held by the IFC 338.39 - 338.39Total undisbursed 25.54 - 25.50Total disbursed 312.85 - 312.85

key industries has been an integral part from the petition and the share of free prices. With theoutset, while competition legislation and the cor- complete dismantling of quantitative restrictionsresponding institutional framework have been and the virtual abolition of price controls in Po-lagging in other countries. Regarding trade and land, the Bank-supported program has focusedprice liberalization, the Hungary and Yugoslavia more on the further rationalization of tariffs, with-SALs include explicit commitments with respect out formal conditionality. Romania and Bulgariato exposure of domestic industry to import corn- have undertaken initial price liberalization mea-

62

sures, and both are committed to further steps as includingthetransferabilityand mortgageabilitypart of their reform programs to be supported by of land, buildings, and other physical assets, thethe Bank aid the Fund. rights and privileges of enterprise employees,

and the difficulties inherent in valuing assets ofEnterprise reform, privatization development, and an enterprise operating in a highly distorted

priatization. As mentioned before, attempts to domestic market and a rapidly changing foreigndecentralize decisionmaking and some degree of market. Superimposed on the complexity of"marketization" were made during the 1970s and these issues is the scarcity of human resources in1980s in Hungary, Poland, and the CSFR, and this enterprises and govemment with the traininghas been a guiding principle of Yugoslav eco- and understanding to agree on a package ofnomic management since the 1950s. However, compromises that will allow a deal to go for-none of these attempts was effective because ward. Finally, on the foreign side, investors aregreater enterprise autonomy in practice trans- reluctant to risk a substantial equity commit-lated into blurred ownership rights and a lack of ment given current uncertainties, while on thefinancial discipline- or in Kornai's famous term, local side there is reluctance to sell local assets ofa soft budget constraint - which in Yugoslavia a previously public sector activity to foreignand Poland was an important cause of interests. An extended period of testing andhyperinflation. The Bank has been supporting adjustment will be required, with, at best, onlyHungarian enterprise reform and restructuring partial success for some time to come. What isfor a number of years through industrial restruc- evident is that continued debate without actionturing loans, but under inadequate macroeco- is unlikely to produce better results.nomic conditions prior to 1990 and without ad-equateenforcementof financialdiscipline through Social safety net and human resources develop-bankruptcy procedures and privatization. The ment. The social safety net and human resourcesprocesshasthusbeen slow and its successlimited. development are also central elements in theEven before the events of 1989/90, the Bank sup- Bank's policy dialogue and lending activities inported important legislative changes in various CEE. The social safety net encompasses pro-countries to prepare the ground for ownership grams and funds to provide income transfers tochange, financial discipline, and - ultimately - the old, the poor, and the unemployed; employ-behavioral change. Legislative and regulatory ment services; training and job creation andmeasures, as well as specific actions toward enter- promotion activities; and funding and provisionpzise restructuring, ownership reform, and pri- of adequate health services. One would also addvatization development, have become integral housing as an important dimension with impor-parts of the SAL-supported programs in Yugosla- tant implications for the functioning of the laborvia, Hungary, Poland, and - in the near future market. Human resources development also- in the CSFR and Bulgaria. This will soon be entails the efficient provision of education ser-followed with more specific sector operations in vices with adequate financing arrangements.Hungary and Poland. The legislative framework These concems are addressed through sectorfor privatization and competition in Bulgaria and work and project lending, but also in the contextRomania is currently under preparation. The of the above-mentioned SAL, where the adequacyBankhasalsosupportedthedevelopmentofsmall- of the social safety net has been an importantand medium-scale enterprises in Hungary and concern.Yugoslavia and is planning similar projects in During CY1990, sector studies and lendingPoland. activities for the social safety net and human

The IFC's individual transactions related to resource development were initiated in Hun-privatization have shown that overcoming exist- gary, Poland, Bulgaria, and Romania, and a newing obstacles is a time-consuming, complex un- division for this work was set up in the countrydertaking. Instability in the legal fabric requires department. Free-tanding loans were recentlythat each operation's contract have a self-con- approved for human resource development fortained legal framework to substitute for thebroad Hungary and for employment services and pro-business law framnework and judicial systems re- motion for Poland. Important analytical worklied upon in market economies. Added to the has also been done on the housing sector inlegal problems are issues of ownership rights, PolandandHungary,andlendingisunderprepa-

63

Table 7.4 Selected cofinancing operations(miElons of dola)

Worid Bsk Cofinoning

Fscal year 1990Yugodavia: Highway sector loan 292 190- EIBPoland: Railways project 153 30-EIBHungary SAL I 200 200 -Japan EXM Bank

Fiscal year 1991 (planned)Poland: Teleom l 120 80-E1B

District Heating 250 80-EIBHungary: Telecom ll 150 100-ElBJapan

SAL ! 200 Japan EXIM BankCSFR: SALI 450 Japan EXIM Bank

Note Before FY90, the EIB and the Bank partidpated regularly in paraUel finandng to Yugoslavia for infrastucture. Six B-loans to Hungary contributed $2 billion with a Bank participation of $135 million. in FY91, the Bankthrough the expandedcofinancing instrument, helped Hungary to mobilize $o00 mfllion.

rationinPoland. Inaddition,significantresources After the 1989 Paris Summit Meeting, the G-24 -are being allocated to sector work on labor mar- coordinated by the EC Commission - began tokets in Yugoslavia; human resources in Hungary; extend significant financial and technical assis-and health, social safety net, and employment tance to the reformingcountries inCEE. The Bankservices and promotion in Poland. The main is closely coordinating its activities with those ofissues expected to arise in these studies are the multilateral organizations (the EC, IMF, EIB,continuing rigidity of labor markets; the need to OECD, and EBRD). As a result of its collaborationdevelopprogramstoprovideunemploymentcom- with the IMF, the governments of Hungary andpensation and protect the poor; the desirability of Poland prepared medium-term frameworks withmore broad-based, multidisciplinary educational joint input from IMF and Bank staff.programs; and improvements in the provision There have also been substantial amounts ofand financing of health services. The focus will be cofinancing. The Hungary SAL was cofinancedon both the short-run transition and the systemic with the Japanese Export-Import Bank (JEX), andreforms required for the long term. the European Investment Bank (EIB) has

cofinanced infrastructure projects in YugoslaviaThe Bank Group and the international financial (for many years) and, more recently, in Hungary

community. Financial assistancebythe BankGroup and Poland. More operations with theJEXand thehas to be seen in the context of the six countries' EIB as well as the new EBRD are expected in theoverallexternal financingrequirementsand alikelty future. An important cofinancingeffort was madefinancing gap of several billion dollars per year. through the Expanded Cofinancing OperationBank Group assistance has to be subject to sound (ECO) to Hungary, which facilitated subsequentbanking principles. Poland's and Bulgaria's cred- issues in the Japanese bond market in the seconditworthiness are impaired by huge debt over- half of 1990 (see table 7.4 on cofinancing opera-hangs and debt servicing difficulties (which in the tions). The Bank is also closely coordinating withcase of Poland have persisted for a decade). Coin- bilateral donors (such as theUKKnow-HowFund,prehensive solutions to the debt problem have to the United States, and others) as well as with thebe an integral part of the respective adjustment Pentagonal group, covering a wide array of areasprogram; the Paris Cub debt workout for Poland and forms of assistance.is an important step in that direction. In other In addition to broad aid coordination, there arecountries, particularly Hungary, adequate bur- specific efforts in energy (through the Central andden sharing between the Bank and other creditors Eastern Europe Regional Energy Program) and inis a major concem. environment (through the Task Force set up by

The Bank's assistance, however, is part of a the Baltic Sea riparian countries and the Environ-broader effort by the international communite. mental Program for the Mediterranean).

64

Endnotes

1. In this paper, the term "Central and Eastern sons to believe that they overestimated actualEurope" is used to refer to Bulgaria, the Czech and growth.Slovak Federal Republic (CSFR), Hungary, Po-land, Romania, and Yugoslavia. The former Ger- 6. For a brief comparison with China, see box 6.man Democratic Republic (GDR) is also relevant,although its transformation process is shaped by 7. Open unemployment existed only in Yugosla-distinctive circumstances. The GDR or East Ger- via, in large partdueto the greaterautonomyof itsmnanyand the Federal Republic of Germany (FRG) self-managed firms.or West Germany refer in this paper to the coun-tries before their unification, east and west Ger- 8. That the problem was systemic rather thanmany to theregions of Germanyafter unification. narrowly technological is shown by the disap-

pointing results from importing Western equip-2. All dollars in this report are U.S. dollars or ment (Terrell, forthcoming).equivalent. In 1937, nominal national income percapita was estimated at $440 in Great Britain, and 9. If price controls prevent excess demand fromat $400, $340, $330, $306, $265, and $190 in Swe- drivingupprices,inflationissaidtobe"repressed.'den,Germany,Belgium,Netherlands,France,and The involuntary accumulation of money that re-Austria, respectively. The corresponding esti- sults because there is no way to spend it is calledmates for Czechoslovakia, Hungary, Poland, Ro- the "monetary overhang."mania, Yugoslavia, and Bulgaria were $170, $120,$100, $81, $80, and $75, respectively (Solimano 1991). 10. The newfound acquiescence of the Soviet Union

was of course a sine qua non for the transforma-3.YugoslaviawasnotaCMEAmember. Incertain tion.countnes, notably China, Yugoslavia, and theUSSR, there was also a tendency to encourage 11. Income levels reported on a purchasing-powerregional self-sufficiency. parity(PPP)basisnormallyexceed exchange-rate-

based measures by a margin that shrinks as the4. Estimates of hidden unemployment in the CEE level of income per capita increases. The margincountries varied, but visitors to industrial enter- appears to be especially large for socialist coun-prises suggested estimates of 20-30 percent. tries because of the extensive subsidization of

important nontraded goods, and possibly also5. The official growth rates reported by some because of quality differences in the tradablescountries were controversial, and there are rea- sector that are not fully captured in PPP estimates.

65

12. It should be stressed that these projections are plishing the major tasks indicated for the first yearhighly tentative due to thedata inadequacies noted in figure 2.earlier.

20. Inflation accelerated somewhat in both coun-13. Exchange-rate-based per capita incomes m ay tries after August.fall even further in the southern countries thanindicated in figure 1 as Romania and Bulgaria 21. Because of the sharp devaluation on January 1,open their economies and take concurrent steps 1990 and the strict credit limits, the real money(already taken by the northem countries) to de- supply actually fell by some 44 percent in the firstvalue their currencies. quarter of 1990.

14. Any such estimates are, of course, highly un- 22. The need to adjust relative prices may arguecertain because they depend on assumptions on for a substantial rise in the price level, and thisthe present quality of capital, future productivity may reduce the need for currency reform.growth rates, and the income level after restruc-turing. CEPR (1990) and Collins and Rodrik (1991) 23. Thirty percent in January, 20 percent in Febru-estimate that a relatively speedy transition (10-15 ary through June, and 60 percent thereafter.years) to West European income levels wouldrequire investment levels on the order of $200- 24. Yugoslavia devalued again by 28 percent on$400 billion per year, approximately equal to the January 1, 1991.entire GDP of the CEE countries. Such investmentlevels are clearly impossible, from the view of 25. Domestic economic contraction in the CEEeither resource availability or absorptive capac-ity. countries and the lowering of trade barriers in theTheunfoldingexperienceof eastGermany, though industrial countries also helped spur these in-shaped by distinctive factors, appears to confirm creases in exports in 1990.the magnitude of the task ahead.

26. Industrial output fell 30 percent.15. Because of its implications for the terms oftrade, the demise of the CMEA in 1991 also has an 27. Furthermore, because of fixed exchange rates,important macroeconomic linkage with external the wage rates of both Polish and Yugoslav work-balance (see annex 1). ers rose considerably in dollar terms during 1990

(from low starting points), allowing them to pur-16. Although moving rapidly to open trade, Hun- chase more imported goods.gary still has quantitative restrictions coverilngsome 30 percent of its production, and it has not 28. Itisimportant to keepinnmind thatchoosinganyet introduced full currency convertibilityon cur- appropriateexchangerateis extremelydifficultexrent account. ante, and that a substantial devaluation may be

important for the credibility of a program. Some17. The comnbination of large price increases and advisors to the Polish government reconmmendedlimits on nominal wages led to an estimated fal l in an even greater devaluation than the one actuallyreal wages of40-50 percent in the firstmonthof the taken.program.

29. Assuming that prices may be "sticky" down-18. In contrast, the usual prescription for policy wards, this moderate inflation does provide areform within an established economic system is means for a needed realignment in relative prices.to address distortions sequentially (the most se- In Poland, for example, prices of consumervere first), so as not to overload the reform pro- durableshaveincreasedrelativelymorethanpricescess. of most other goods, and prices of services have

increased the most of all, resulting in a significant19. As noted in the section on the current stage of realignment of relative prices.transformation, the CEE countries are at differentstages of this process. Poland made particularly 30. In fact, profit margins on sales actually in-impressive strides in 1990 in starting or accom- creased for many state-owned Polish firms in

66

1990. This was particularly true in heavy indus- ties of the firms. The goal is to identify a clear-cuttry, where domestic sales prices rose faster than owner who will ensure that enterprises are run ascosts, and where firms were able to increase ex- profit-maximizing commercial companies.ports dramnatically because of the favorable ex-change rate. 38. This issue of "reprivatization" to former own-

ers is becoming increasingly important and threat-31. By October about 800 enterprises had been ens to create a legal and economnic quagmnire. Forpushed into bankruptcy, compared to some 200 example, the CSFR recently passed a law callingduring all of 1989. for restitution to former owners of property con-

fiscated since 1948. Monetary compensation is an32. Yugoslavia has instituted payments rules to easier route than property restitution in manycontrol interfirm credit. Under these rules, made cases but may confront constitutional challenges,possiblebyacentralclearingsystemamongenter- as is now occurring in Germany.prises and banks, any firm that is 60 days overduein its payment obligations can be dedared bank- 39. However, combining the two modes also pre-rupt. It is not clear to what extent these rules are sents complex trade-offs. For example, selling thebeing enforced in practice. best companies and giving away the worst would

clearly tarnish any giveaway scheme. Another33. Controls ona few basic goods, such as bread or alternative - probably preferable but with itshome heating fuel, may need to be phased out own drawbacks - is to give away a minoritymore slowly for social reasons. interest and sell a majority interest in all firrns.

34. The political and administrative difficulties 40. The resultsof the few valuations carried outbyassociated with gradual price reform in an envi- major international accounting and consultingronment of highly distorted prices and large mac- firrns show these to depend on rather arbitraryroeconomic imbalances led the joint Soviet Study assumptions.team to recommend a modified "big bang" ap-proach. Gradual price reform is likely also to 41. It has been roughly estimated that Poles couldpromote hoarding, putting upward pressure on purchase only about 10-15 percent of Polish in-prices,whilerapidpriceliberalizationencourages dustry (if valued at book) with their existing sav-the liquidation of marketable inventories, putting ings.downward pressure on prices.

42. In fact, concerns over equity are so strong that35. Giventheirlegacyand theenormouschallenge they threaten to stall the entire privatization pro-of labor realignment they face, CEE governments cess.are likely to follow the more interventionist modelof Germany and Scandinavia rather than the less 43. Fewer than 1,000 firms were privatizedinterventionist model of the United States and throughout the world between 1980 and 1987.Canada. Some active labor market policies are The experience of other countries also suggests adiscussed in the section on the role of government tendency greatly to underestimate the time neededlater in the paper. for privatization. In addition to the time con-

straint, Poland's experience with direct sales in36. These might include, for example, not only the 1990 also suggests that the sale process is costly,elimination of unnecessary regulations but also with total fees and the like amounting to perhapsindicative targets for credit expansion, advisory 10-15 percent of sale receipts.and informnation services, and active measures toinvolve private firms in government contracting 44. Fiscal policy may also have to address theand to provide access to business premises. potentially inflationary wealth effect that could

arise from free distribution of assets.37. Corporatization includes establishing a clearequity structure, clearly vesting the government 45. It was initially estimated that some 70 percentin ownership of those shares, and appointing of East German industry would be competitivesuitable boards of directors to oversee the activi- after restructuring, but that number is falling

67

steadily. This is in part due to the relatively high ment (EBRD) also apply political conditionality tounit labor costs resulting from the 1:1 monetary their activities.exchange and collectivebargaining agreements in1990. 54. For example, a recent agreement between

Volkswagen and Skoda could involve direct in-46. On the one hand, the jobs of many civil ser- vestments in the CSFR totalling $9 billion in thevants have disappeared; the number of govern- 1990s.ment employees in the former GDR is expected tobe reduced by about 50 percent, or one million 55. In addition, individual creditors may provideworkers. On the other hand, some of the best civil additional relief or convert part of the debt intoservants are being lured away from government local currency obligations through debt-for-bywell-payingjobs in thenewlyeemergingpriivate equityordebt-for-natureswaps.TheUnited Statessector, and top policymakers are seriously has agreed on a 70 percent reduction (which in-overstretched. These govemnments badly need cludes some debt-for-nature swaps, makingmore well-trained analysts and decisionmakers. straightforward debt relief closer to 60 percent),

and the Italian government may do similarly.47. It is not clear to what extent the latter impederefonn,although mostobserversbelievethatctDm- 56. Hungary's debt has been trading in the 90s onmitment to reform within the overall bureaucracy the secondary market, Yugoslavia's in the 50s,is high, especially in Poland, Hungary, ancd the and Bulgaria's and Poland's in the 15-20s.CSFR.

57.Forexample,debt-equityswapswereincluded48. Under the old regimes, foreign direct invest- in Mexico's 1989-90 debt relief package. Argen-ments were govemed exclusively by joint venture tina linked debt-equity swaps with commitmentscontracts negotiated on a case-by-case basis. This to provide new money.contractual mind-set continues to be pervasiveand needs to be replaced by a generally applickable 58. In addition to flows of goods and capital, howlegal framework for foreign investment. to handle movements of labor is an issue that may

become more important as reforms proceed.49. Even with massive legal and technical assis- Honekopp (1991) surveys the available evidencetance (on a scale far exceeding that available to the on migratory movements from CEE countries toCEE countries), the west German legal system is Germany and Austria.now considered too complex to deal with many ofeast Germany's immediate problems. 59. The role of world prices within the ex-CMEA

area after January 1991 is not clear, due to the50. Income differentials are already widening in chaotic situation that has apparently followed thePoland, as evidenced by the opening of luxury car decision to shift to a convertible currency basis forshowrooms in Warsaw. trade within that area. Trade in raw materials (at

least with the USSR) is apparently still handled51. Among PHARE initiatives are a $1 billion mostly by central trading organizations. In themedium-term loan program for Hungary and a case of other commodities, world prices may in-stabilization fund for Poland. deed be playing a larger role.

52. These include German bilateral programs, in 60. In 1990, for example, the five-year average forparticular to Poland, Hungary, and the CSFR, and oil was only about $17 per barrel.the U.S. programs established under the Supportfor East European Democracy (SEED) Act of 1989. 61. One such list for Hungary-USSR trade antici-SEED programs include access to Overseas Pri- pates a trade volume of $3 billion for 1991, aboutvate Investment Corporation (OPIC) guarantees two-thirds the level of exports to the USSR in 1989.and enterprise funds to promote investment..

62. The CEE countries appear to have a greater53. The EC, European Investment Bank (EIB), and divergencebetweenpurchasing-power-parityandEuropean Bank for Reconstruction and Develop- exchange-rate-based measures of income than

68

market economies at comparable levels of devel- agency model, ownership is more concentrated,opment, in part because of extensive price con- but the income received from privatization istrols on important nontradables. They therefore spread widely.appear in the international context as relativelylow-wage countries, at least in the short run. 68. Certain "strategic" industries, such as weap-

ons, power, mining postal services, and rail trans-63. Althoughexactnumbersareelusive,itappears port, are designated to remain in state hands.that private entrepreneurship isemerging rapidlyas constraints are removed. There may now be 69. In July 1990 the CSFR raised food prices anone million small businesses (one-person or fam- average of 26 percent with limited lump sumily operations) and 2,000 to 3,000 larger firms in compensation.private hands, as well as perhaps 10,000 jointventures with foreign finns. However, the share 70. More than 400 new banks have been estab-of nonagricultural production in private hands is lished in the USSR since 1988.still small - perhaps 15 percent in Hungary,Poland, and Yugoslavia, and less in the other 71. In Poland they accounted for almost two-countries. thirds of M2 by the end of 1989.

64. The USSR has about 47,000 and China about 72. Accumulated losses in the banking crises of200,000 state-owned enterprises, most of medium Chile and the Philippines reached about 20 per-or large size. To appreciate the significance of the cent of GDP. For comparison, the accumulatednumber of firms, Chile's massive privatization losses of the U.S. savings and loan system areprogram from 1973 to 1989 involved some 470 perhaps 3 percent of GDP.enterprises producing 24 percent of value addedin the economy and employing less than 5 percent 73. By early 1989 the capitalization of Hungary'sof the workforce. Great Britain privatized about security markets equalled 10 percent of domestic20 firms, accounting for about 5 percent of value credit.added, during MargaretThatcher's tenureasPrimeMinister. In fact, between 1980 and 1987 fewer 74. Only in Germany do banks directly exert sig-thanl,O00flirnswereprivatizedthroughouttheworld. nificant ownership rights over firms, and even

these are restricted. Elsewhere, banks may own65. In Poland, for example, at least 20,000 outlets firms only through holding companies, with safe-have been sold, and about one-half of retail trade guards for the independence of credit decisions.is in private hands. In the CSFR, republican gov-ernmentsplantoauction some100,000smallbusi- 75. In the United States, for example, a minimumnesses in 1991-92, with the successful bidders of five years is required to train an examinerrequired to maintain services in the same loca- capable of dealing with the smallest and simplesttions for at least a year. Hungary plans to transfer institutions. Years of experience are similarlyownership of about 10,000 shops, restaurants, and needed for credit analysis, and there are limits tosmall-scale service establishments to private hands the degree of experience that can be transferredin 1991. "off the shelf." Existing training is mainly limited

to short courses and is more in the nature of66. Data on the total extent of spontaneous privat- "exposure" than training to international stan-ization are scarce. It is believed that slightly less dards. One of the dangers of current curricula isthan 5 percent of state assets had been privatized the tendency to include sophisticated topics suchby mid-1990. as currency swaps when the foundation of basic

credit skills is not adequate.67. These roles for intermediaries result in differ-ent ultimate ownership pattems. In the first two 76.Theseincludestrengtheningcreditprocessing,models, indirect ownership of firms is spread closely monitoring operating expenditures andwidely; in the case of a mutual fund, control is efficiency, and introducing appropriate loan clas-diffused, whereas it is more concentrated in the sificationcriteria,guidelinesforprovisioning,andcase of a holding company. In the privatization income accrual and capital adequacy criteria.

69

77. If a hard budget constraint is applied to the 83. In Poland, for example, subsidies for all prod-banks while their portfolios have a large share of ucts and services except transportation and cul-problemloans,theywillbeforced towidenspreads ture are estimated to have reduced inequality (asto good clients in an attempt to cover the losses on measured by Gini coefficients) by some 8.5 per-problem loans (as has happened in Yugoslavia); cent. Total consumer subsidies in Hungary arethis can lead to disintermediation and a further estimated to have reduced inequality by some 5loss of portfolio quality. With negative capital, percent.there is also little incentive for banks to forecloseon clients. Banks therefore cannot be used to force 84. Housing and energy account for most of thewidespread enterprise restructuring. remaining subsidies.

78. The experience of the GDR suggests the diffi- 85.Hungaryisconsideringadoptingaspecializedculties of rapid financial sector restructuring. The housing allowance program, possibly limited tosole commercial bank, Kreditbank, entered into Budapest (where most public rental housing isJoint ventures with two large West German com- located).mercial banks, leaving its entire portfolio of oldloans to a shell holding company with only 250 86. A prime example is payroll taxes, which haveemployees. This resulted in "clean" financial traditionally been levied at very high rates tointermediaries ready to serve the region of the finance the broad array of social benefits (includ-former GDR, but they had no direct interest in the ing pensions, health care, education, travel) pro-repayment of previous loans and there was no vided to workers. In Hungary, Poland, the CSFR,adequate institutional structure for their recov- and Bulgaria, social security contributions exceedery. At the same time, it is reported that the lack 40 percent of payroll and are charged primarily toof acceptable enterprise audits and legal uncer- the employer. This level of tax would be difficulttaintiesconcerningtheloans,collateralassets,and to impose on private firms. Reforms in socialsecurities are hindering the lending activities of benefits are discussed further in annex 6.the new banks.

87. For example, the company income taxes tend79. This is the procedure to be followed in the to have low straight-line depreciation rates, littleformer GDR. allowanceforlosscarryover,and nondeductibility

of some costs.80. These shares fell somewhat in the 1980s (par-ticularly in Poland, Hungary, and Yugoslavia) as 88. Although company tax reforms in Hungaryoutput stagnated, access to foreign borrcwing led to a decline in revenues, the sharply increasingtightened, and many large projects were aban- revenues from the new VAT more than compen-doned or trimmed. As in most countries, invest- sated.ment bore the brunt of spending cuts.

89. For example, foreign investors are eligible for81. The private sector might have a role in provid- very generous tax holidays and other tax benefitsing some basic infrastructure, notably telecom- under the company income tax. The personalmunication. income tax exempts an estimated two-thirds of all

personal income, including not only a generous82. Direct subsidies were only one of many av- tax-exempt amount, but also social security andenues for extensive redistribution within socialist other transfers, pensions, and most income fromeconomies. Redistribution began at the level of farming. The VAT exempts all financial, health,the enterprise, where individual wages were only education, sports, and cultural services, and "zero-loosely related to worker productivity (see annex rates" many goods, including processed foods,2) and where negotiated taxes, enterprise subsi- medicines and medical equipment, books anddies, and cheap credit reduced differences in af- periodicals, transportation services, and manyter-tax profits. Redistribution continued agrt the sources of energy.sector level via arbitrary prices, government capi-tal grants, and soft loans. Consumer subsidies 90. The Gini coefficient is the most common mea-represented only one link in the chain. sure of income inequality. It varies between 0

70

(perfect equality) to 100 (all income appropriated 99. Eligibility criteria were made more restrictiveby one recipient). as of January 1991.

91. The degree of inequality in the socialist coun- 100. In general the minimum wage should exceedtries may be somewhat underestimated due to the the social minimum to encourage work effort.omission both of unreported incomes and of somesegments of the population, most notably private 101. Bulgaria's initial benefit is 100 percent, de-businessmen and the military in Poland and the clining gradually to 50 percent in the sixth month.USSR. Theseomissionsalsooccurinmarketecono- Benefits are limited in time to nine months. Hun-miesbutgenerallyto alesserextent. Furthermore, gary offers initial benefits equalling 70 percent,monetary income alone is an imperfect yardstick declining over time; pursuant to new legislation,in socialist countries where shortages were com- the benefit period varies between eight monthsmon and certain social groups had special buying and two years, depending on the length of priorprivileges. On the other hand, the fact that many employment.basic necessities were subsidized was in itself aform of social protection, leading to higher real 102. In Yugoslavia, social assistance programs arepurchasing power for a given level of income. runattherepubliclevelor,withinrepublics,atthe

communal level. Although they appear to be92. State-owned enterprises in market economies reasonably well-designed, fundingmaybecomeaalso tend to compress wage distribution by reduc- serious impediment to coverage as long-term un-ing top wages. employment grows, particularly in the poorer

communities with smaller tax bases and a larger93. One of the first effects of reform is likely to be number of claimants. Greater financial supporta readjustment in pay scales in favor of skilled fromtherepublicanandfederalgovernmentsmayprofessionals. be needed.

94. As noted elsewhere, socialist governments 103. In Hungary, for example, social security taxesused an elaborate framework of largely ad hoc paidbypublicenterprisesareabout2.5timestheirtaxes, subsidies, and credit to extract profits from corporation income tax payments.successful firms and prop up loss-making firms.

104. For example, early retirement was liberally95.InPolandinthel980s,forexample,aboutone- granted during the Polish and Yugoslavfifth of all medical outlets belonged to enterprises. stabilizations of 1990, and Hungary and Bulgaria

grant full pensions for redundant workers at age96. Sickness benefits have generally been pro- 55.vided through social security institutions, with noemployer obligations. The number of sick days 105. The Polish privatization plan, for example,has far exceeded (often doubled) that in Western calls for the pension system to receive 20 percentEurope. Generous family allowances and lavish of share ownership in privatized firms. This is amaternity benefits (such as birth grants and three start but is not likely to fund a substantial share ofyears paid leave per child) have also been typical. pension liabilities.

97. This approach is taken, for example, in Austra- 106. Annex 7 was prepared by Country Depart-lia and New Zealand. It may not be the cheapest ment IV, Europe, Middle East, and North Africaalternative when administrative costs are taken Regional Office, and the Intemational Financeinto account. Corporation.

98. This approach is taken in most developedmarket economies.

71

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