Quite different initial conditions determined the countries’ distinct reform efforts, particularly in determining foreign trade, as well as adopting policies toward foreign investment: Hungary had high external debt, producing a precarious macroeconomic equilibrium; Slovenia, in contrast, was freed of the requirement to subsidize other republics of the former Yugoslavia. The challenge Slovenia faced was inflation and—in becoming an independent state—launching its own currency.

These differences set the stage for a different approach to institutional transition. Hungary came to the conclusion that rescheduling its high external debt would bring more harm than benefit. Consequently, the successive governments were ready to sell flagship companies to strategic, primarily foreign investors, in order to increase budget revenues. They were also willing to open up to foreign investors a large part of the industrial and service sectors, including telecommunications and banking. This resulted in a large influx of foreign direct investment—between 1990 and 1997 Hungary absorbed about one-half of the foreign capital invested in Central Europe. This development also helped to create effective corporate governance at the earlier state-owned enterprises.

In Slovenia, with macroeconomic stability quickly achieved and the economy rebounding, the sense of urgency to implement microeconomic reforms quickly evaporated. The main method of privatization was insider (management-workers) buyout, arising out of strong traditions of self-management. But this method carries several risks. Where there is a lack of well-developed product and capital markets, managers are not constrained by competition or through the fluctuation of the stock market, and this can lead to weak corporate governance. There is also a strong incentive to keep outsiders, or foreign investors, out.

The Slovene government has restricted foreign direct investment (FDI) in auditing agencies, investment companies that manage investment funds, and stockbro-kerages. Moreover, a majority of the directors in joint stock companies must be Slovene citizens. As a consequence of these and similar restrictions, Slovenia is attracting far less foreign capital than it should. (Considering Slovenia’s superb geographical location, and its high level of industrial development, FDI should be around 3–5 percent of GDP, instead of the present 1.5 percent.)

In Hungary joint ventures have been allowed since 1972, although under the communist regime, foreign equity couldn’t exceed 50 percent. Some multinationals established their presence early, even if they did not really invest until around 1990. Subcontracting links with Western firms had been building since 1968, so managers were accustomed to cooperating with foreigners. After the 1989 "revolutions," the only country that was attractive to international investors was Hungary, which had a good record in its relations with private and multilateral financial institutions. (Poland should have been a competitor, but for several years foreign investors avoided dealings there because of the country’s moratorium on servicing its external debt.) In 1998 firms with foreign capital were responsible for three-quarters of Hungary’s exports and imports.

By the end of 1997, cumulative FDI in Hungary since the start of market transition reached $17 billion, making it the only East European state with per capita FDI above $1,000. As of end-1997, 50 percent of the aggregate equity of Hungarian companies was in foreign ownership, and this proportion has risen since. Banking and processing have the heaviest foreign ownership presence, at more than 50 percent. According to data from the State Privatization Agency, the country’s most active foreign investors are from Germany, followed by the United States, France, and Austria. Hungary is the only country in the region to have attracted significant Japanese investment, which now surpasses $500 million.

Of the 50 largest multinationals, 40 are present in Hungary, providing more than 60 percent of total FDI. Multinationals produce nearly 25 percent of GDP, according to estimates. In the country’s small, open economy, the multinationals have developed an especially important role in the generation of exports. Just four multinationals—IBM, Philips, TDK, and Sony—account for roughly one-fifth of exports.

As part of a drive to encourage investment, the Hungarian parliament has approved tax allowances affecting large investment projects in high-unemployment regions. Companies with capital investment projects worth over 10 billion forints and which started up after December 31, 1996, have been made exempt from corporate taxes for 10 years, if their employee ranks increase by at least 500 over the 10-year period and annual turnover increases by at least 5 percent of invested value compared with the previous year. The exemption will be offered for the last time on the tax year 2011. One should note that these incentives have been made available to all investors, foreign and domestic alike.

Foreign Trade Dissimilarities

There have also been similarities in the evolution of the two countries’ foreign trade policies. The collapse of the old economic regime put an end to the state’s administrative micromanagement in both countries. Both were driven to liberalize under commitments to the World Trade Organization as well as regional trade agreements. Both countries are signatories to the Pan-European Cumulation Agreement (1997), and around 80 percent of their respective manufacturing imports are duty-free.

Hungary has fallen behind in dismantling vestiges of central planning. Nontariff barriers still abound, among them quantitative restrictions. Foreign investors can be shielded from these barriers, however, if they move to free trade zones, and take advantage of the so-called "duty drawback," claiming back the duty paid on the import content of the export. (By the end of 1998, this scheme will lose its attraction, as products from free-trade zones will lose their preferential treatment in the Pan-European markets, including EU and EFTA members.) As another vestige of the command economy, Hungary still applies an annual global quota on imported consumer goods (the level has fluctuated between $400 million and $600 million over 1994–98). Around 6 percent of Hungary’s exports are still subject to nonautomatic license requirements.

Both countries, however, have demonstrated that they have internationally competitive industrial capacities; and both countries are shifting from natural resource– and unskilled labor–intensive products to capital- and skilled labor– intensive products. This suggests that they will be able to integrate into the European Union at a higher end of the value added spectrum; in other words, despite gloomy predictions, Hungary will not become a provider of cheap, mass-produced goods.

Yet Hungary’s performance in EU markets excels that of Slovenia. The pace of change has been much faster for Hungary’s exports to the European Union, despite its seemingly more protectionist trade policies. Spectacular changes in Hungary’s export structure point to a massive emergence of "second generation" firms—primarily local branches of multinationals—demonstrating progress in industrial restructuring. Eighty percent of Hungary’s exports are directed toward the European Union. Between 1994 and 1997 the value of its exports to EU countries increased by 132 percent, as rapidly growing export earnings and an influx of foreign capital allowed an increase in imports, thereby providing higher-quality products for both consumption and investment. Hungary registered the highest export growth rates over 1995–97, compared with five other first-wave candidates. During this period the share of manufactured products increased from 71 to 85 percent.

In Slovenia the shift toward a more technology- and skilled labor–intensive export structure is progressing more slowly than expected. This is partly the result of a lack of new industrial capacities and "second generation" firms, and partly because of low FDI flows. The weak incorporation of local firms into global networks of production and marketing, especially in telecommunications and financial services, has slowed corporate restructuring.

In summary, the pattern of integration has defied earlier predictions. Both Hungary and Slovenia have demonstrated that their industrial and service sectors are able to withstand the competitive pressures of the European Union. However, FDI plays a crucial role in restructuring in transition economies; thus, attracting large amounts of foreign capital will help Hungary, with its high-value-added products, integrate into the European Union, while Slovenia’s restrictive policies governing FDI can make its integration efforts more difficult, despite initial advantages.

In the post-independence period, Slovene economic policy has concentrated more on achieving macroeconomic stability, in terms of external and internal balances, than on institutional reform. Slovenia has run a balanced current account since 1995 under a floating exchange rate regime, while the general government budget has also been more or less balanced for the past few years (a 0.3 percent of GDP surplus in 1995, and a 1.0 percent deficit in 1996 and 1997).

The current account balance has been achieved not only through floating the tolar but also by the introduction of capital account controls. Foreign capital has been discouraged informally from flowing into Slovenia in recent years because of the privatization program’s bias in favor of insiders. Foreigners were almost entirely excluded from participating. Slovenia formally introduced capital controls in the aftermath of the Czech currency crisis in the first half of 1997 to prevent appreciation of the tolar, and worsening of the current account in the balance of payment. Borrowers were required to deposit tolar in "custody accounts" in authorized Slovene banks. The inflow of foreign currency dropped significantly in the second half of 1997.

The restrictions were later relaxed somewhat, but the inflow of both foreign direct investment (FDI) and of short-term portfolio investments and credits to Slovenia did not increase significantly. In the first half of 1998, FDI was only $33 million, portfolio investments $190 million, and credits negligible.

This policy has, however, delayed restructuring of the financial and real sectors. The Slovene equity market is small and dominated by privatization coupons or shares. The capitalization of the Ljubljana stock exchange was about 15 percent in terms of Slovenia’s GDP in July 1998—approximately $2.5 billion. Foreign participation fell to almost zero in the second quarter. Thus, capital flight during and in the aftermath of the Russian crisis was inconsequential. The stock market index suffered noticeable losses in August and September, about 20 percent, but given the small size of the market this move of domestic investors from equity to cash is of little consequence for the economy as a whole. Bonds do not play a significant role in the financial system. Interest rates are indexed and have been falling in line with the continued trend of declining inflation in Slovenia—inflation for 1998 is expected to be 8 percent year-on-year, down from around 10 percent in 1996 and 1997.

The government undertook a costly rehabilitation of the banking sector in the mid-1990s, although there has been little transfer of ownership. Most of the sector remains state-owned—notably the largest bank, Nova Ljubljanska Banka, and the third-largest bank, Nova Kreditna Banka Maribor. The sector’s bad loans were transferred to the budget, allowing bank failures to be largely avoided. Hence, very little restructuring has been carried out. Consolidation of the banking sector and privatization of large state banks are expected to proceed very slowly.

The Hungarian government’s 1999 budget plan is tight, reflecting government concern about a downturn in export demand. Economy Minister Attila Chikan recently noted that the European Commission had reduced its forecast for EU GDP growth in 1999, to 2.4 percent from 2.8 percent, and warned that the 5 percent Hungarian growth target was conditional on EU growth remaining above 2 percent. Growth will be led principally by industry—September figures showed industrial output up some 14 percent year-on-year, despite the impact of the Russian crisis in reducing demand for products in some key industries.

Just in case, the government has created a special contingency fund of around 33 billion forints ($154 million) to cover the shortfall if Hungarian growth in 1999 is only 4 percent. The government is also concerned that the current account deficit may increase as a result of accelerating domestic demand. Its reluctance to cut taxes may be partly attributable to a wish to dampen demand.

The budget deficit target is 4 percent of GDP for 1999, compared with a projected deficit of 4.7 percent for 1998. (The budget deficit is due to fall to 3.5 percent of GDP in 2000 and 3 percent in 2001.) Overall, the government hopes to raise spending by some 2–3 percent in real terms in 1999, compared with 1998. The government has reduced by 1 percent its inflation forecast, to 10–11 percent for 1999. Real wages are expected to rise by around 2 percent. Current indications are that a thorough overhaul of the tax system will be attempted in 1999. However, the reforms being tabled for the 1999 budget are relatively modest.

The government will face growing fiscal pressures from two areas in particular over 1999: