From Plan to Market: Patterns of Transition

by Martha de Melo, Cevdet Denizer, and Alan Gelb

Formerly communist countries are moving along the transition from a planned to a market economy with different speed. This article compares the progress made by individual postcommunist countries in liberalizing their economies. It concludes that economic liberalization, the cornerstone of early reforms, interacts strongly with growth and inflation. The higher a country's liberalization index, the better chance it has to speed up growth and check the inflation rate. The close relationship between economic liberalization and political freedom helps to explain why some countries moved quickly on reforms and others did not.

Liberalization leads to stabilization in a way that is not self-evident to those policymakers who are accustomed to socialist pricing and output conventions. For example, the attempt to maintain employment and output by fiscal and quasi-fiscal transfers to enterprises results in larger output declines than a policy of hard budget constraints introduced along with economic liberalization. Also, liberalization of prices results in lower inflation than do continued price controls.

Twenty-six countries of Central and Eastern Europe (CEE) and the former Soviet Union (FSU), as well as Mongolia, are analyzed in this article. China and Viet Nam—although distinct in many respects—are also included in the analysis for comparative purposes. The period covered is 1989 through 1994. The starting point is 1989, a pivotal year in the transition from communism to a market economy.

Measuring Liberalization

In order to explore the broad cross-country relationships between growth (annual changes in real, officially measured GDP), inflation (average annual changes in the consumer price index), and liberalization, the authors construct an annual liberalization index (LI) for each country over the 1989-94 period. This index—ranging from 0 to 1—classifies countries into different reform groups (advanced, intermediate, slow, and affected by war and embargoes). China and Viet Nam make up a separate, Asian country group. The index measures the progress of these twenty-eight economies in three areas:

• Liberalizing internal markets (freeing domestic prices, abolishing state trading monopolies).
• Liberalizing external markets (easing the foreign trade regime, including the elimination of export controls and taxes; currency convertibility).
• Facilitating private sector entry (privatizing enterprises, reforming the banking sector).

To indicate the duration and the intensity of reforms from 1989 onward, and factor in the institutional and other changes stimulated by prior policy reforms, a Cumulative Liberalization Index (CLI) has been developed, adding up the annual liberalization indexes of each country over the six year period. (It is interesting to note that the 1993/94 liberalization indexes of China and Viet Nam are lower than those of the advanced reformers, but their CLIs are rather high, reflecting the early introduction of important reforms.)

Liberalization—Stabilization—Recovery

The table on page five shows four country reform groups based on the CLI, plus countries affected by war and China and Viet Nam. Statistical analysis of the CEE and FSU countries indicates that cumulative liberalization has a positive effect on output changes within the overall context of a "transitional recession." Moreover, output recovery appears to require inflation to fall to more moderate levels—at least to less than 100 percent a year. Both advanced and high intermediate reformers had stabilized or returned to positive real GDP growth by 1993-94, but slower reformers continued to experience major output declines. An important reason for the association between liberalization and recovery is that capital and labor are able to flow from industry toward services, and economic growth can be fed by the expansion of previously repressed service sectors.

Analysis also supports the view that liberalization has been a crucial element of stabilization policy, even though its initial impact entails a spurt in prices, and even though it is by no means a sufficient condition for regaining stability. CEE and FSU countries that failed to liberalize experienced far higher inflation over the 1991-94 period than those that did liberalize. An important explanation is that liberalization makes the introduction of hard budget constraints—and hence fiscal and monetary restraint—more feasible by providing appropriate signaling of the costs and benefits of specific restructuring measures.

Democracy Nurtures Liberalization

What then determines the pace of liberalization? By matching country rankings of the cumulative liberalization index to a comparative index of political rights and civil liberties (Comparative Survey of Freedom for 1994, compiled by the Freedom House, New York), it is found that economic liberalization is typically associated with a similar degree of political change. The direction of causality is actually two-way, since economic liberalization is an essential step in breaking the power of established structures, especially line ministries that previously controlled industry and trade.

In CEE/FSU countries where former communist party leaders have held power continuously (Kazakhstan, Turkmenistan, Ukraine, and Uzbekistan), reforms have been slow and driven largely by macroeconomic pressures arising from the breakup of the Soviet Union and attempts to maintain the status quo. Those countries that made a clear break with the previous regime (the Czech Republic, Hungary, Poland, Estonia, Latvia, and Lithuania) have radically liberalized. The process has continued even though several postcommunist parties won in the last parliamentary elections (in Hungary, Poland, Estonia, and Lithuania). To date no attempts have been made to backtrack on liberalization policy.

Developments in China and Viet Nam appear to contradict the link between political and economic reform. The countries have liberalized economically while retaining strict controls on political rights and civil liberties. But in China political power was decentralized to provincial and local governments, and this has played an important role in economic liberalization since the start of agricultural reforms in 1978. In Viet Nam the 1989 "renovation" reforms were followed by implicit decentralization of economic decisionmaking through emphasis on initiative at the local level. In both cases the East Asia model of gradual, decentralized economic transition appears to have a political counterpart, even if it is not political freedom per se.

Policy Implications

The above conclusions have several implications for recent policy debates: • Rapid reforms are preferable. The close relationship between economic liberalization and political freedom more or less determines the reform policy of a given regime. To the extent that regimes do have options, however, rapid reform is preferable to slow reform, given the breakdown in the central planning apparatus. The status quo was not a viable option for CEE and FSU countries. Recorded inflation and output losses in countries that have managed to postpone adjustment are now far larger than in the more advanced reformers.

• Stabilization is a priority. There are strong interactions between liberalization, stabilization, and growth. Neither the effective functioning of markets nor renewed investment is possible with severe macroeconomic price instability; thus, stabilization becomes a priority for the resumption of growth. Without liberalization, subsidies and budget deficits cannot be eliminated, which in turn means continued lax fiscal and monetary policies. No country was able to return to positive growth without liberalizing first.

• Fiscal constraint is required. The transition recession and lags associated with the introduction of a new tax system typically lead to declining revenues in transition economies, while social expenditures are expected to increase. Nevertheless, in economies of advanced reformers, fiscal revenues and expenditures have tended to remain high relative to GDP, while fiscal deficits have been noticeably smaller than in those countries that delay reforms.

However, this does not mean that privatization of state enterprises which make up the traditional tax base, should be delayed. With the shift of structural demand and large changes in relative prices, many state enterprises have become loss-makers, without any taxable profit anyway. On balance, even if there are reasons, cultural, institutional, or structural—why the fiscal position is stronger in advanced reformers, there is no convincing evidence that a slower pace of reform has strengthened the fiscal position of intermediate and slow reformers.

• Anchor: money supply or exchange rate? Either a money supply anchor or an exchange rate anchor have been used in stabilization programs, often in combination with restrictions on public sector wages. Either approach can be effective, although the choice is likely to depend on the volatility of money demand, the adequacy of foreign reserves, and the effectiveness of the anchor in establishing credibility. The implications of the findings here are that any stabilization effort—whether exchange rate-based or money supply based—should be preceded by wide-ranging liberalization schemes, given their favorable impact on efficiency and credibility.

Martha de Melo is Acting Division Chief, Cevdet Denizer is Economist of the Transition Economics Division, Alan Gelb is Staff Director, World Development Report, 1996.

This article is based on the authors' identically titled forthcoming paper to be published in the Policy Research Working Paper Series. To order: the World Bank, PRDTE, Christopher Rollison, room N-9054, tel. (202) 458-4768.

Cumulative Liberalization—Cross-Country Indexes

Countries of Central and Eastern Europe, Mongolia, as well as those of the former Soviet Union, are listed and grouped into four categories according to the magnitude of their cumulative liberalization index (CLI):

1. Advanced reformers (CLI greater than 3): Slovenia, Poland, Hungary, Czech Republic, Slovakia.
2. High intermediate reformers (CLI less than 3, but greater than 2): Bulgaria, Estonia, Lithuania Latvia, Romania, Albania, Mongolia.
3. Low intermediate reformers (CLI less than 2, but greater than 1.3) Russia, Kyrgyzstan, Moldova, Kazakhstan.
4. Slow reformers (CLI less than 1.3) Uzbekistan, Belarus, Ukraine, Turkmenistan.
5. CLIs vary in a fifth category of countries affected by war: the former Yugoslav and Soviet republics that have experienced major and persistent internal conflicts during 1989-94 or, in the case of Armenia and FYR Macedonia, have been subject to conflict-related blockades.
6. A sixth category comprises East Asia's two socialist economies, China and Viet Nam.