World Bank Discussion on Second-Generation Transition Issues:  Growth, Restructuring, Corruption

The World Bank's recent Annual Bank Conference on Development Economics (ABCDE) organized a discussion on "second-generation" transition issues.  The following are excerpts from the papers of themajor discussants participating in the meeting, which was moderated by Michael Bruno, Vice President (Development Economics) and Chief Economist of the World Bank.

Michael Bruno:  What Is Common, What is Different?

As is customary, our roundtable meetings are harbingers of the next year's World Development Report.  In 1996 the report will focus on the transition process and it will be produced under the direction of Alan Gelb.  The transition is now five years old, and there are lessons to be learned, not only for those countries that have left central planning and are heading toward a market economy, but also for those, throughout the world, that are ready to undertake profound institutional and economic reforms.

There is a range of divergence across transition economies.  They started from a largely common system, but with differing initial conditions.  And they have moved at different speeds.  Their macroeconomic indicators differ, as do their institutions, political developments, and culture.  One of the many challenges that will face the World Development Report will be to distill some common lessons across countries.

About half of the countries in Central and Eastern Europe have gone through an initial macroeconomic shock, and some are currently among the fastest-growing economies in Europe, notably the Czech Republic, Poland, and Slovenia.  Yet even these countries face problems, such as the composition and endurance of their fiscal and monetary balances, and the need to introduce further tough structural and regulatory measures.  In many of these countries markets are in a rather chaotic state, particularly financial markets.

Some early, so-called first-gener-ation debates focused on the speed of stabilization and liberalization. Much has been said and discussed about big bang versus gradualism. There is no clear conclusion, and to a large extent, these issues are behind us. But the interdependence between liberalization, stabilization, and growth, as well as the criteria of establishing sustainable macroeconomic policies, are still open questions.

Fierce debates are waged on whether the East European stabilization programs have undermined economic growth. Cumulative research shows that inflation rates above 30 or 40 percent are very harmful to growth. So should a country like Poland—which has a 30 percent inflation rate, but is doing very well on growth—aim to achieve single-digit inflation before doing other things? This is our first topic.

Our second topic deals with sequencing. Russia first privatized and is now in the process of what looks like macro-stabilization. The impact of mass privatization on restructuring is another major issue. Who controls the firms that have been privatized? Who are the real owners? Why is it that firms, once privatized, lag behind in restructuring?

Our final topic is the rule of law, the very existence of the state. We are all familiar with the alarming reports on corruption and organized crime. Empirical evidence, however, is irregular and sporadic. Is corruption intrinsic in transition economies? Is it the transition itself that generates greater opportunities for rent-seeking and increased corruption? Or is it the legacy of the old system, or the collapse of former restraints? Is corruption caused by too rapid or too slow a transition?

These three issues are separate but they are not selected randomly. Macroeco-nomic policy is not sustainable without structural adjustment, and the relationship between property rights and macroeconomic adjustment is equally important. Corruption can destabilize and even delegitimize the reform process, because it can weaken the political credibility of and trust in the government.

There are at least two interpretations of the title of this session on "second-generation issues in transition." We could be asking what we can tell the second generation of reformers—probably including Cuba and North Korea—based on the experiences of the first generation. Alternatively, we could be asking what problems face transition economies that have come through the first phase of reform and are now moving into the second stage of the transition process. I'll address both interpretations.

The truly important news in thinking about the transition process is that, according to official data, several transition economies are already growing: among them are the Baltic countries, the Czech Republic, Hungary, Poland, Croatia, Slovenia, and Slovakia. If we also include the performance of the unrecorded economy, presumably these countries started growth at least a year earlier, and perhaps other countries are growing too. One important lesson of transition is that stabilization is good for growth. It can almost be said that no transition country has begun to grow without first reducing inflation to the low single digit per month range. Romania is an exception, however, and did begin to grow while inflation was high. Nonetheless, there is a strong relationship between stabilization and growth—in both directions. Countries that have stabilized have generally seen growth a year or two later.

Evidence on these issues is convincingly demonstrated in a paper by Alan Gelb, Martha de Melo, and Cevdet Denizer. It confirms the inverse relationship between growth and lagged inflation; the lower the inflation rate, the higher the growth rate a year later. [The working paper, "From Plan to Market: The Patterns of Transition," is forthcoming as a World Bank publication.]

The paper also shows that countries that reform faster have a more rapid initial output decline than those that don't reform. But within three to five years the cumulative output loss proves to be lower than that of countries that have been slow to reform. Countries that have stabilized typically find themselves with inflation rates within the moderate range of 15 to 30 percent, and now face the same moderate inflation dilemma that countries such as Colombia, Chile, or Israel have faced in the past. Moderate inflation gives way to tight macroeconomic policy, supported by wage restraint and the use of an exchange rate anchor. But the last part of the journey to industrialized-country inflation rates is difficult. Policymakers have to be sure to take advantage of every favorable price shock to try to lock in inflation reductions and make continuing progress toward stabilization.

A key second-generation issue for those who have already embarked on transition is reform of the fiscal system. The decline in government revenue during transition is dramatic, and some governments have been able to maintain macroeconomic balance only by holding back budget funds (sequestering) or by building up arrears. The unintended consequence is credit creation through the central bank or arrears creation in the private sector. Rebuilding the fiscal system on both the expenditure and tax sides is a high priority. Specifically for taxes, this means moving away from enterprise taxation to indirect taxes such as the value added tax (VAT), customs, and tariffs, and later perhaps to direct taxes. On the expenditure side, it means the creation of a modern system of expenditure management and prioritization.

Another critical second-generation priority for those already in transition is reform of the financial system. The banks are not yet playing much of a role in financing investment in most of the transition economies. Unfortunately, there is a real chicken-and-egg problem here: the banks will not be sound if they lend to companies that are not sound, but the companies cannot develop without external finance. New bank-restructuring programs are needed to get that process off the ground.

Once, stabilization was unthinkable without an exchange rate anchor. But lately, several transition countries, such as Croatia and Kyrgyzhstan, have stabilized their economies without pegging the exchange rate. In general, I still would look to a temporary exchange rate anchor in trying to bring down inflation quickly. The Mexican experience has led many to believe this approach is very dangerous, but this is true only if the anchor is never moved. In Poland the initial peg was held for a year, in Israel for a little longer. But it becomes necessary at some point to adjust the rate, and perhaps also the exchange rate regime.

Finally, let me mention the most amazing phenomenon of transition. A few years back everyone was afraid of reversals in the postsocialist world: "If we don't support the Russians, the communists will come back, or if not the communists, then other extremists, and they will gain the upper hand all over Eastern Europe." Five years later, despite the fact that output declines have been far greater than anyone expected, and despite all the other difficulties of transition, the notion of returning to the previous system seems to be far from anyone's mind—except perhaps in some smaller, less—developed former Soviet economies. That is the most remarkable feature of what we have seen in this first generation of reforms: the political maturity of the public has ensured that the economic reform process has continued despite the difficulties they have experienced.

Does privatization, and in particular mass privatization, spur restructuring? Unlike most Western governments in the past, East European governments often privatize firms ahead of restructuring, leaving it to the new owners to initiate changes in product lines, export markets, company assets, and manufacturing technologies, and to stimulate changes in attitudes and behavior.

So far, three countries have done remarkably well in terms of speed and scope of mass privatization: the Czech Republic, Eastern Germany, and Russia. In the Czech Republic, in 1989, just 1.2 percent of labor and 2 to 4 percent of registered assets belonged to the private sector, which had a mere 1 percent share in GDP. At present, 80 percent of assets are privately owned, accounting for over 56 percent of GDP in 1994. No particular groups of investors were favored or restricted in the privatization process. Privatization proceeded smoothly, thanks to its transparency, good organization, and popular support. Investors or companies were able to choose among various methods of privatization; nonetheless, voucher privatization attracted most of the attention.

Nearly 80 percent of the adult population became shareholders in enterprises and banks. Insiders (managers, workers) ended up with less than 10 percent of the shares in a typical Czech company; still, privatization did not create overly dispersed ownership structures. A large majority of vouchers were bought up by investment privatization funds (IPFs). Thus, in more than half of the privatized companies, three or four large institutional investors own the qualified majority of 66.7 percent.

As restructuring of enterprises may take 10 years or even more, a year or two after mass privatization is much too early to assess results. But it is reasonably clear whether the process is heading in the right direction.

Aggregate data on the Czech economy, up to 1995, do not yet tell us much about bankruptcies, increasing unemployment, mergers and acquisitions, or typical forms of restructuring. But trade statistics are enlightening. While the former Comecon markets' share in Czech (and Slovak) republic exports dropped from more than 60 percent in 1989 to less than 20 percent by 1994, that of the European Union countries increased to 46 percent (even though the share of low-value-added products in total exports increased slightly in the past five years).

Although in the Czech Republic the unemployment rate is extremely low (it was only 3.6 percent in March), there has been a significant increase in labor mobility among companies, industries, and sectors. According to a survey we conducted among 50 manufacturing companies, between 1991 and 1993, two-thirds of the firms downsized labor by less than 50 percent, and 22 percent by more than 50 percent. Most firms, however, do not yet see labor as an important cost factor.

Investment funds have improved the financial and reporting discipline of enterprises. Even though most funds do not get actively involved in restructuring, they still control enterprise managers more effectively than the government would do in a state-owned company. Managers can benefit from the often conflicting interests of major institutional shareholders and from the limited skill of board directors (in many cases former state officials) who are tempted to trade lenient monitoring for higher fees and better perks.

The number of mergers, acquisitions, and takeovers and the sale of fixed assets have surged in recent months. Privatized Czech firms undergo major ownership changes through the private placements of company shares. Investment funds buy and sell huge blocks of shares, mainly to consolidate their overdiversified portfolio and get rid of their holdings in companies where rival institutional investors dominate. Also, new spin-offs had been set up from the best and most profitable assets of otherwise nonviable companies. And in some cases, parent companies have been transformed into financial holdings with their assets channeled to newly formed subsidiaries. The wide range of organizational changes prepares the field for more efficient restructuring.

Corruption thrives in rigid systems where monopoly power rests within the government and multiple bottlenecks impede the free flow of goods and services. A planned economy—where many prices are below market-clearing levels—provides incentives for payoffs as a way to allocate scarce goods and services. In such systems, transactions that would be open and legal in market economies become illegal as bribes are taken and payoffs are exacted. Excess demand for goods at official prices encourages those in command of scarce supplies—in addition to selling goods and services to those offering the highest bribes—to create additional bottlenecks as a way of extracting even more payoffs. Such systems are not only rigid, but arbitrary; consequently, in the former centrally planned economies, the requirements and irrationalities of these systems turned almost everyone into a lawbreaker.

Once authoritarian systems or centrally planned economies collapsed, one would have expected that illegal payoffs and other corruption would have declined and that legal, free market practices would have prevailed. This is not what happened. Corruption appears to be a common problem in the newly democratic states in Eastern Europe and the former Soviet Union. Why? Some would argue that rampant corruption is just one of the growing pains of transition. But if corruption becomes rampant, it could destroy the transition itself.

If pockets of state control remain, they may be the loci of payoffs and other inside dealings. Indeed, the privatization process, although it ultimately reduces corruption by lessening state involvement in the economy, may initially give rise to large payoffs as investors jockey for position. As the state is stripped of any clear lines of authority, the effectiveness of its legal system becomes questionable. And the people, trying to operate within new structures and to find a measure of certainty in their dealings, may try to achieve some control by paying off officials, declining to play by ambiguous rules. What the briber cannot know is whether other officials, observing the payoff, will create new bottlenecks that require further kickbacks. In the worst-case scenario, people opt out of the first economy, and instead rely on organized crime to provide protection from the state or anyone else who seeks to interfere. In this scenario the state is not just weakened; it becomes irrelevant.

Transition countries should try to establish the rule of law, without recreating the rigidities of the former state-controlled system. Doing so will require liberalizing their economies and reducing possibilities for rent-seeking by eliminating or reducing subsidies, trade restrictions, and preferential treatment in government purchases—in other words, transition countries must deregulate their economies as much as possible. Bribes will become irrelevant once legal pricing mechanisms take their place.

A danger is that less overt bribes may be paid for benefits to be delivered in the future. Corruption could take the subtle form of cozy personal relationships and exchanges of favors between officials and private individuals—a web of relationships and transactions that effectively blurs the line between public and private, further destabilizing the system. A clear remedy for this is a well-established legal system that reduces corruption by curtailing the discretion of officials. The rule of law can be supported by outside checks on the actions of public officials, including an independent prosecutorial and judicial system, a free press, and a dense network of nongovernmental organizations.