Reflections on 20 years of transition in Eastern Europe

Milica UvalicUniversity of Perugia

Conference – Europe: 20 Years of TransitionVienna, 15-17 September 2010

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Issues 20 years of transition in post-communist countries in

Eastern Europe 1. The transition to a market economy 2. The model’s flaws 20 years later 3. Present challenges

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1. Transition in Eastern EuropeNovember 1989 (fall of Berlin Wall) Transition to a market economy and multiparty

democracy in Eastern Europe (EE) Unprecedented experiment: radical changes of systemic

features of EE economies creation of capitalism by design!

The typical transition model followed the main prescriptions of the “Washington consensus” (based on experience from Latin America in the 1980s)

Liberalization, Stabilization, Privatization [Peak of Reaganite and Thatcherite ideology]

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Transition in Eastern Europe

Transition required various measures in parallel (1) Macroeconomic stabilisation: liberalisation of

prices & foreign trade (2)Microeconomic reforms: rapid privatization,

microeconomic restructuring, reduction of subsidies (“hard budget constraints”)

(3)Institutional reforms: banking and financial sector, creation of capital and labour markets, radical fiscal reforms …

Results? Reality very different from initial expectations (generally too optimistic)

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Transition in Eastern Europe Transformational recession in early 1990s Very severe and prolonged

recession, fall in GDP of 18-80%, even more of industrial production... Economic recovery delayed, only in Poland and Slovenia in 1992-3...

Causes? Partly due to economic/trade disintegration (CMEA, USSR, CSSR, Yugoslavia) today 29 countries in the EE region (instead of 9)

Systemic vacuum: passage from a centralized administrative system to new market institutions disorganization and “chaos”

But also wrong economic policies the hyper-liberal model: Overshooting of stabilization programs: overly restrictive monetary &

fiscal policies Too rapid trade opening, frequently revoked and therefore premature Much faster capital liberalisation than in post-second World War

Europe Speedy privatization, without changes in corporate governance Non-progressive taxation of companies and households, as witnessed

by the widespread introduction of the “flat tax”

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Transition in Eastern Europe We dispose of an ample literature on what happened in EE in the

1990s, but the assessments greatly differ…Today, many EE considered “normal” capitalist economies (?) In the meantime, “good policies” have been applied also in

countries that were late reformers (e.g. the Balkans) Economic reforms: institutional convergence towards the

“ideal” model of a market economy (EBRD transition indicators) Many lessons not learnt from the experience gained in the

1990s prescriptions for the latecomers very similar to those in the early 1990s

Gradual integration with EU: trade, FDI, banking and finance 2004 & 2007 EU enlargement: 10 EE countries, Balkans on their

way... Increasing FDI throughout the region after 2000, not only in

Central Eastern Europe (as in the 1990s)

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Foreign Direct Investment (2001-08)

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0

5000

10000

15000

20000

25000

30000

35000

40000

2001 2002 2003 2004 2005 2006 2007 2008

Mill

ion

US

$

CEE & Baltics CIS Western Balkans Bulgaria & Romania

Transition in Eastern Europe Yet in many countries the “Washington consensus” has failed to fulfil

expectations of growth, development & increased welfare Social costs of transition greatly underestimated: it was assumed that

social policy and the welfare state are a luxury that must be sacrificed for the sake of transformation many negative consequences

“Jobless growth”: emergence (and persistence) of very high unemployment, particularly in the Balkans (40% - Macedonia, Kosovo)

Social differentiation, increasing poverty (esp. in Russia, CIS countries) A particularly flexible labour market, with weak trade unions and scarce

diffusion of collective bargaining (with very few exceptions) Inadequate systems of taxation (flat-tax rate) High popular dissatisfaction: EBRD Life in Transition (2007): only 30% of

respondents from transition region, on average, consider their households today are better off than before 1989

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Transition in Eastern Europe Institution building much slower than expected Informal economy (and informal institutions) remain important

in many countries, rule of law still not in place, widespread corruption, weak judiciary …

Slow catching up after the deep GDP fall in the early 1990s and subsequent reversals in growth

Ten years later, only Poland and Slovenia had attained the levels of GDP they enjoyed in 1989

By 2008, Poland had reached 178% of its 1989 GDP, Slovak Republic 164%, Czech Republic 142%, Hungary 136% …

But Russia only 108%, and similarly the Balkans by 2008, three countries had still not reached their 1989 level of GDP (Bosnia, Montenegro, Serbia)

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Real GDP growth in the Balkans, 1989-2008 (1989= 100)

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2. The model’s flaws 20 years later In 2007-08, average GDP growth in the transition region was

still high, only in last quarter of 2008 was there a drastic deterioration of main indicators

In late 2008, EE was severely effected by the global economic crisis, hit by two external shocks:

Financial sector: sharp reduction in foreign capital inflows (FDI, remittances, foreign loans)

Real sector: reduced demand for exports on EU/global markets Since early 2009, forecasts for 2009 have been changing

continuously, from positive to highly negative growth rates (exc. Albania, Poland)

2010: Recovery on its way but not in all countries + growth sluggish, 50-90% lower than in 2008

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Real GDP growth forecasts, 2010

-4,0

-3,0

-2,0

-1,0

0,0

1,0

2,0

3,0

4,0

Real GDP in 2010 (EBRD July 2010)

The model’s flaws Eastern Europe among the most severely hit regions! The global economic crisis revealed many structural

weaknesses of EE economies Factors of vulnerability of EE countries

Huge external imbalances, for years covered by massive foreign capital inflows (foreign loans, FDI, official assistance, workers’ remittances)

High dependence on trade with EU (more than many old EU member states) vulnerable to deteriorating conditions in EU

Banking and financial sector characteristics

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Current account deficits (Oct. 2008)(% of GDP)

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-10,1

-10,8

-13,8

-14,9

-15,8

-18,6

-24,4

-39,6

-15,1

-14

-10,5

-5,5

-5,1

-4,7

-4,7

-2,2

-45 -40 -35 -30 -25 -20 -15 -10 -5 0

C z ec h R

P oland

S lovenia

S lovak R

H ung ary

C roatia

Albania

E s tonia

R omania

F YR Mac edonia

L ithuania

L atvia

B os nia and H erz eg ovina

S erbia

B ulg aria

Monteneg ro

Gross external debt (2008) (% of GDP)

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19.7

30.2

37.7

40.5

48.1

48.9

49.4

49.4

54.2

62.7

64.2

77.2

88.4

94.2

103.5

108

111.3

129.5

0 20 40 60 80 100 120 140

AlbaniaR us s ia

C z ec h R

B iHP oland

UkraineS lovak R

R omania

F Y R Mac edoniaS erbia

L ithuania

Monteneg roC roatia

Hung aryB ulg aria

S lovenia

E s toniaL atv ia

The model’s flaws Characteristics of the banking and financial system Privatization of banks in EE sales to foreign (EU) banks, 75-

98% of banking assets in EE are in foreign ownership (Slovenia the only exception)

Foreign banks lending policies of easy credit credit boom, increased lending to private sector, many loans in foreign currency

Credit boom was followed by credit crunch foreign banks vulnerable to deteriorating conditions in home countries, reduced credit to local clients

2008-09: Depreciation of national currencies in EE causing many credit defaults, increase in non-performing loans

Liberalization of financial markets has also greatly stimulated cross-border borrowing directly from banks abroad

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3. Present challenges Global 2008-09 crisis a new course in developed

market economies: return to protectionism, state intervention, expansionary fiscal policies, more regulation

In EE: Which growth model for the future? Transition-related economic reforms hyper-liberal

model (fast trade opening, free capital inflows, weak social protection...)

Should EE countries also return to more state intervention, undoing what was done during the last 20 years?

Partly ...yes! More active government policies necessary in several important areas

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Present challenges... Global crisis the fragility of EE economies due to the model of

credit-driven growth and resulting dependence on foreign capital Global crisis more general flaws of the transition strategy, since

many problems were becoming unsustainable Consumption much higher than production, financed by foreign savings &

investment (increasing trade and current account deficits) High unemployment, limited restructuring, slow growth of new private

sector, mounting social problems Inadequate structural changes, favouring the fast expansion of primarily

services [linked to] Structure of FDI: frequently not in industry, but in services (banking,

telecommunications, real estate), therefore in non-tradables, not facilitating industrial restructuring, export-led growth, East-West industrial integration

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Present challenges... Today: need to change the target model of the hyper-liberal

market economy[In 2009, the best transition results (EBRD score 4) were attained in Estonia and Hungary, among

the most severely hit by the global crisis!] Changes in which direction? Further integration – certainly not

autarchy - but prudently Trade liberalization: not necessarily in all sectors (e.g. agriculture) Financial liberalization: too fast, ought to be in line with development of

financial markets (as in Western Europe) Improve the quality of government institutions to enforce laws, collect

taxes, supervise the financial sector ... Introduce a levy on the financial sector? Probably justified, but

since most banks are foreign owned, there is no direct political power to effectively negotiate a tax EU coordination is critical!

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Present challenges... Industrial policy: to promote investment, encourage innovation, quality standards,

enhance competitiveness (in line with the current EU approach to industrial policy) Despite remaining privatization opportunities, EE cannot count much on FDI over

the coming years, need to rely much more on own resources More effective employment policy, more elements of the European Social Model

which was not seriously considered by the EE countries (not part of the Acquis)so the model was “diluted” by the 2004/07 entry of New Member States

How to strengthen trade unions and social dialogue? Many lessons from the old EU member state

Increasing labour flexibility (Germany, France, Italy) has led not to greater international competitiveness, but to higher profit margins

Strong East-West interdependence: EE countries cannot solve current problems by themselves, as they are strongly integrated with the EU/global economy!

Necessitates coordinated action...

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