Lessons from Economies in Transition from Central Planning

The Australian Economic Review, vol. 36, no. 2, pp. 25 52 For the Student Lessons from Economies in Transition from Central Planning Richard Pomfret* School of Economics The University of Adelaide Over the past decade more than 30 countries have been in transition from a centrally planned economy to a more market-based economic system. These countries exhibit a huge range in size and in income levels (Table 1), as well as in historical and cultural backgrounds and in resource endowments. 1 Despite the variety of initial conditions, the number and variety of countries provides us with a unique natural experiment of the effects of different approaches to establishing and organising a market-based economy. What is involved in transition? Administered resource allocation by central planners is replaced by allocation of resources in response to market signals. This requires (i) marketdetermined prices, and (ii) agents responding to market incentives or more succinctly: Transition = price liberalisation + enterprise reform A fuller menu of necessary reforms would include: emphasis on the interconnection between inflation and budget deficits; * The article is based on material in my book: Richard Pomfret, Constructing a Market Economy: Diverse Paths from Central Planning in Asia and Europe, published in 2002 by Edward Elgar, Cheltenham, United Kingdom. Other reviews of the transition experience include Wyplosz (2000), World Bank (2002), Havrylyshyn and Nsouli (2001), Aslund (2002), Roland (2000) and Blejer and Skreb (2002). the benefits of bringing domestic prices (including interest rates) in line with world prices; financial reform to remove constraints on enterprise formation and expansion, and to ensure the efficient allocation of capital; property rights as essential for a market (and enterprises) to function effectively according to the Coase Theorem the precise nature of the property rights is less important than their existence and enforceability; 2 enterprise reform not just privatisation, but removing soft budget constraints and facilitating the formation of new enterprises; 3 and welfare reform to provide a safety net for those unable to provide for themselves in the market economy. Some of these reforms are, of course, easier to implement quickly than others and almost everywhere the first stage of transition concerned the trinity of: liberalisation stabilisation privatisation The Big Bang (or Washington Consensus or shock therapy ) strategy emphasised the interactions and necessity of proceeding quickly and in sync; without meaningful relative prices and Published by Blackwell Publishing Asia Pty Ltd

26 The Australian Economic Review June 2003 Table 1 European and Asian Economies in Transition Population (million) mid-1992 GNP per capita ($US) 1992 Population (million) mid-2000 GNP per capita ($US) 2000 Central Europe Slovenia 2 650 2 10070 Hungary 10 2970 10 70 Estonia 2 2760 1 310 Czech Republic 10 250 10 920 Latvia 3 1930 2 260 Slovak Republic 5 1930 5 3700 Poland 3 1910 39 200 Lithuania 1910 2900 Eastern Europe Belarus 10 2930 10 2990 Russia 19 2510 16 1660 Ukraine 52 120 50 700 Balkan and Caucasus Bulgaria 9 1330 1510 Moldova 1300 00 Romania 23 1130 22 1670 Georgia 6 50 5 590 Armenia 70 520 Azerbaijan 7 70 610 Albania 3 LM 3 1100 Croatia 5 LM 510 Macedonia FYR 2 LM 2 1710 Yugoslavia 11 LM 11 LM Bosnia and Herzegovina L 1260 Asia Kazakhstan 17 160 15 1190 Turkmenistan 1230 5 0 Uzbekistan 22 50 25 610 Kyrgyz Republic 5 20 5 270 Mongolia 2 LM 2 390 Tajikistan 6 90 6 170 China 1162 70 1261 0 Laos 250 5 290 Vietnam 69 L 79 390 Cambodia 9 L 12 260 Other German Democratic Republic 17 LM na na North Korea 23 LM 2 L Afghanistan 22 L 27 L Myanmar L 6 L Notes: na = not available in the source. Since 1990 the German Democratic Republic forms the eastern Länder of Germany. Yugoslavia is defined here as Serbia, including Kosovo and Vojvodina, and Montenegro. In 1992 lower income (L) is less than $675 and lower middle income (LM) is $676 to $2695; in 2000, L is $755 or less, and LM is $756 to $2995. Sources: World Bank (199, pp. 162 3, 22) and World Development Indicators database (16 July 2001 update) at http:// www.worldbank.org/data/databytopic/pop.pdf.

Pomfret: Lessons from Economies in Transition from Central Planning 27 a stable absolute price level enterprise reform would not produce good resource allocation, but without enterprise reform there would be no necessary response to relative prices. Gradualists feared the adjustment costs, welfare losses and social disruption of Big Bang policies. In practice, the Big Bang versus Gradualism debate subsided because all agreed on the general nature of the list of needed reforms and nobody advocated major delay. The first stage transition was easier, while the second stage of institutional reforms was slower. Despite initial scepticism in some countries about free trade and the need for price stability, these two goals were accepted very quickly as prime targets. Acceptance of a liberal trade regime is reflected in almost universal acceptance of the principles incorporated in the World Trade Organization (WTO); by 2002 Turkmenistan was the only transition country not to have applied for WTO membership (Table 2). Fiscal balance was difficult to achieve, because government revenues fell, while demands for expenditures remained (or increased). Moreover, policy makers unacquainted with macroeconomics at first failed to appreciate the tight connection between budget deficits and accelerating inflation. Nevertheless, after initial hyperinflationary episodes, controlling inflation through monetary policy became a priority (Table 3). The growth record is hard to interpret because initial conditions, as well as policy choices, matter. Despite many attempts to identify patterns, no robust econometric relationship between the pace and depth of reform and economic performance has been established. The best Eastern European performer was rapidly liberalising Poland, while the best performer among former Soviet republics was gradual-reforming tightly controlled Uzbekistan (and not the more liberal Baltic countries). Eastern European countries generally did better than the Soviet successor states (in crosscountry regressions, distance from Düsseldorf is the strongest explanatory variable), although China and the Southeast Asian countries did much better than any others (Table ). Inequality and poverty increased dramatically in Eastern Europe and the former Soviet Union (Table 5); the picture in China and Vietnam is mixed, Table 2 WTO Status of Economies in Transition WTO status Central and Eastern Europe Czechoslovakia Original GATT signatory Poland Joined GATT 1967 Romania Joined GATT 1971 Hungary Joined GATT 1973 Slovenia Joined WTO 1995 Bulgaria Joined WTO 1996 Albania Joined WTO 2000 Croatia Joined WTO 2000 Macedonia FYR Negotiating (199) Bosnia and Herzegovina Negotiating (1999) Yugoslavia Negotiating (2001) Former Soviet Union Kyrgyz Republic Joined WTO 199 Latvia Joined WTO 1999 Estonia Joined WTO 1999 Georgia Joined WTO 2000 Lithuania Joined WTO 2001 Moldova Joined WTO 2001 Russian Federation Negotiating (1993) Belarus Negotiating (1993) Armenia Negotiating (1993) Ukraine Negotiating (1993) Uzbekistan Negotiating (199) Kazakhstan Negotiating (1996) Azerbaijan Negotiating (1997) Tajikistan Negotiating (2001) Turkmenistan Asia Mongolia Joined WTO 1997 China Joined WTO 2001 Cambodia Negotiating (199) Vietnam Negotiating (1995) Laos Negotiating (199) Notes: Yugoslavia joined GATT in 1966. When Slovenia, Croatia, and Bosnia and Herzegovina declared independence in 1991, the United Nations determined that the new Yugoslavia (Serbia, including Kosovo and Vojvodina, and Montenegro) could not claim successor status. In February 2001 the new Yugoslavia made a fresh application for WTO membership. The date in brackets is when the Working Party was established. Source: Up-to-date membership information is provided on the WTO website www.wto.org.

2 The Australian Economic Review June 2003 with inequality initially declining after 197 in China, but then increasing in the 1990s. Much attention has been paid to explaining the East Asian edge. The Chinese reforms, which began in the late 1970s, focused on first reforming agriculture, and then gradually adopting an open door policy, while smallscale local businesses (the township and village enterprises) were treated in a hands-off fashion by authorities in the more dynamic coastal regions. Initial conditions meant that China, and Vietnam, could follow comparative Table 3 Inflation (change in consumer price index) 199 1990 1991 1992 1993 199 1995 1996 1997 199 1999 2000 Albania 0 0 36 226 5 23 13 33 21 0 0 Bulgaria 6 26 33 2 73 96 62 123 102 22 1 10 Croatia 610 123 666 151 9 2 6 6 Czech Republic 1 10 52 11 21 10 9 9 9 11 2 Hungary 17 29 35 23 23 19 2 2 1 1 10 10 Macedonia 126 60 115 166 33 127 16 3 2 1 1 9 Poland 251 56 70 3 35 32 2 20 15 12 7 10 Romania 1 5 170 210 256 137 32 39 155 59 6 6 Slovakia 2 11 61 10 23 13 10 6 6 7 11 12 Slovenia 1306 550 11 207 33 21 1 10 6 9 Yugoslavia 129 60 115 9237 * 3 79 9 21 30 37 60 1991 1992 1993 199 1995 1996 1997 199 1999 2000 Armenia 27 136 3732 5273 177 19 1 9 1 1 Azerbaijan 107 912 1129 166 12 20 1 9 2 Belarus 9 971 1190 2221 709 53 6 73 29 169 Estonia 211 1076 90 29 23 11 3 Georgia 79 7 3125 15607 163 39 7 19 Kazakhstan 79 131 1662 192 176 39 17 7 13 Kyrgyz Republic 5 55 772 229 1 31 26 36 12 19 Latvia 172 951 109 36 25 1 5 2 3 Lithuania 225 1021 10 72 0 25 9 5 1 1 Moldova 9 1276 79 330 30 2 12 39 31 Russia 93 1526 75 311 19 15 6 2 21 Tajikistan 112 1157 2195 350 609 1 2 3 3 Turkmenistan 103 93 3102 17 1005 992 2 17 Ukraine 91 1210 735 91 377 0 16 23 11 2 Uzbekistan 2 65 53 156 305 5 59 29 1 50 19 199 1990 1991 1992 1993 199 1995 1996 1997 199 1999 Cambodia 1 10 3 15 China 19 1 3 6 15 2 17 3 1 2 Laos 61 36 1 10 6 7 20 13 2 91 129 Mongolia 270 57 9 37 9 Notes: 2000 = estimate. * the rate given for Yugoslavia in 1993 is 116 10 12. Blanks indicate that the data are not given in the source. Sources: European Bank for Reconstruction and Development (2001, p. 16); International Monetary Fund (2000, pp. 313, 35, 621, 709).

Pomfret: Lessons from Economies in Transition from Central Planning 29 Table Growth in Real GDP 199 2000 (per cent) 199 1990 1991 1992 1993 199 1995 1996 1997 199 1999 2000 Level of real GDP in 1999 (199 = 100) Albania 10 10 2 7 10 13 9 7 7 0 95 Bosnia and Herzegovina 21 6 0 13 9 10 Bulgaria 1 9 12 7 2 2 2 11 7 2 5 67 Croatia 2 7 21 12 6 7 6 7 3 0 7 Czech Republic 1 1 12 1 0 2 6 5 1 2 1 3 95 Hungary 1 12 3 1 3 2 1 5 5 5 5 99 Macedonia 1 10 7 9 2 1 1 1 3 3 5 7 Poland 0 12 7 3 5 7 6 7 5 122 Romania 6 6 13 9 2 7 6 5 3 2 76 Slovakia 1 3 15 7 5 7 6 6 2 2 100 Slovenia 2 5 9 6 3 5 5 5 5 109 Yugoslavia 1 12 2 31 3 6 10 2 19 11 3 199 1990 1991 1992 1993 199 1995 1996 1997 199 1999 2000 1999; 199 = 100 Armenia 1 7 12 2 9 5 7 6 3 7 3 6 59 Azerbaijan 12 1 23 23 20 12 1 6 10 7 11 7 Belarus 3 1 10 13 10 3 11 3 6 0 Estonia 7 1 1 9 2 11 5 1 6 77 Georgia 5 12 21 5 25 11 2 11 11 3 3 2 3 Kazakhstan 0 0 13 3 9 13 1 2 2 2 10 63 Kyrgyz Republic 3 5 19 16 20 5 7 10 2 5 63 Latvia 7 3 10 35 15 1 1 3 9 1 7 60 Lithuania 2 5 6 21 16 10 3 5 7 5 3 62 Moldova 9 2 1 29 1 31 1 1 7 0 32 Russia 0 5 15 9 13 1 5 57 Tajikistan 3 2 7 29 11 19 13 2 5 Turkmenistan 7 2 5 5 10 17 7 7 11 5 16 1 6 Ukraine 3 12 1 1 23 12 10 3 2 0 6 36 Uzbekistan 2 1 11 2 1 2 3 2 9 190 191 192 193 19 195 196 197 19 199 China Mongolia China Mongolia 1990 3 1991 9 9 1992 1 9 11 6 1993 13 3 1 6 199 13 2 16 6 1995 10 6 9 9 1996 10 2 12 3 1997 9 11 5 199 3 1999 7 Cambodia China Laos Mongolia Vietnam 1999; 199 = 100 Notes: 2000 = preliminary actual figures from official government sources. Blanks indicate that the data are not given in the source. Sources: European Bank for Reconstruction and Development (2001, p. 15); International Monetary Fund (2000, pp. 313, 35, 621, 709). 162 252 15 93 197

250 The Australian Economic Review June 2003 advantage (in labour-intensive manufactures) rather than having to transform an economy dominated by an inefficient manufacturing sector. Agriculture-first worked because agriculture was important (0 per cent of China s labour force in the late 1970s) and because small-scale rice-farming could be stimulated by changing ownership structure and price incentives (unlike wheat or cotton farming where key inputs like machinery or irrigation were indivisible and their availability was disrupted by the break-up of collective farms). Although China never adopted a Big Bang liberalisation and stabilisation strategy, monetary policy was sufficiently controlled never to permit inflation to stay above 20 per cent for long. The evidence about policies comes in two forms: lessons from policy makers learning curves and lessons from growth performance. Policy makers quickly learned that inflation can give short-run access to resources, but in the long run inhibits growth; low levels of inflation do not matter in this context, but a threshold of 13 to 1 per cent seems to exist. In the long run stabilisation requires fiscal balance, especially if the domestic capital market is thin; although foreign aid can help in the short run, in practice it seemed to delay necessary fiscal reforms (as in the Kyrgyz Republic or Mongolia). Policy makers also came to appreciate that openness has important benefits not just gains from trade, but also the introduction of appropriate relative prices, access to best quality inputs, and dynamic benefits from the transfer of ideas and techniques. Trade taxes were an attractive revenue source for new Table 5 Poverty Measures for Eastern Europe and the Commonwealth of Independent States, 197 199 and 1993 1995 Number (million) 197 199 1993 1995 Share of population (per cent) Number (million) Share of population (per cent) Bulgaria 0.1 2 1.3 5 Czech Republic 0 0 0.1 <1 Hungary 0.1 1 0. Poland 0.1 6 7.6 20 Romania 2.1 6 13.5 59 Slovakia 0 0 0.0 <1 Slovenia 0 0 0.0 <1 Belarus 0.1 1 2.3 22 Estonia 0.02 1 0.6 37 Kazakhstan 0. 5 11.0 65 Kyrgyz Republic 0.5 12.0 Latvia 0.03 1 0.6 22 Lithuania 0.0 1 1.1 30 Moldova 0.2 2.9 66 Russia 2.2 2 7.2 50 Turkmenistan 0. 12 2. 61 Ukraine 1.0 2 32.7 63 Uzbekistan. 2 13.3 63 Notes: The numbers indicate how many people in each country were living below a poverty line of 120 international dollars per month; international dollars means that values are estimated at purchasing power parity using 195 US dollars as the base. The late 190s data for Bulgaria and Romania are for 199, all other countries for 197. The 1990s data are for 1993, except that Lithuania and Romania are for 199, and Belarus, Estonia, Latvia and Ukraine are for 1995; Hungarian and Lithuanian data for 1993 9 do not include consumption in kind. Source: Milanovic (199, Table 5.1).

Pomfret: Lessons from Economies in Transition from Central Planning 251 governments because they are relatively easy to collect, but in the long run they are harmful. If openness is desirable, then so is convertibility of the national currency into foreign exchange for current account transactions; otherwise there are too many distortions hindering international trade. Capital account convertibility is more contentious; many transition countries quickly accepted it as a means of encouraging foreign investors, but it also increases potential volatility and several countries, such as the Czech Republic in 1997 and Russia in 199, experienced serious crises. The lessons from growth performance are murkier. There are diverse paths to establishing a market-based economy, just as there are many variants of market-based economies. Growth has come primarily from new enterprises, although they can take diverse forms (new private enterprises in Poland, township and village enterprises in China). For such enterprises to succeed the government must not be too heavy handed; the grabbing hand of the state can prevent the working of the invisible hand of the market. The extent to which governments can provide a helping hand is disputed; governments must provide law and order and other public goods, and address market imperfections, but whether they should go further in promoting new enterprises by providing training, subsidising credit, creating special zones and giving other tax benefits is doubtful. A corollary to the role of new enterprises in generating growth is that not much economic growth has come from the preexisting state enterprises, whether privatised or restructured in some other way. The only effective solution appears to be to establish a hard budget constraint and take the consequences. The World Bank s study Transition: The First Ten Years concludes that the success formula has been encouragement + discipline the former applied to potential new enterprises and the latter to pre-existing old enterprises. What have been the lessons from transition? The economic performance in Eastern Europe and especially in the former Soviet Union has been disappointing. 5 The simple formula of market-driven prices plus profit-seeking enterprises is insufficient to deliver sustained economic growth. Initial conditions were unfavourable as many enterprises were uncompetitive but mass closure was unthinkable, so subsidies led to budget deficits whose monetisation caused high inflation. Sustained growth requires controlling the budget deficit and hence inflation, so that relative price changes can be observed and financial markets can develop. Trade taxes, although relatively easy to collect, are an undesirable revenue source because an open trade policy is the best way to introduce appropriate relative prices (that is, world prices). Financial reform, and more general institutional reform the second stage of transition is necessary for private sector development, as well as improving macroeconomic policy options. So much is well known, but often forgotten, in established market economies. One of the most novel lessons is the significance of hard budget constraints; distinctions of ownership structure are subsidiary. Finally, economic reform has a political dimension; if the population is kept on side by compensating losers as well as fairly rewarding gainers then the process is more likely to be sustainable, and the economy likely to meet people s needs and expectations. May 2002 Endnotes 1. Many lower and middle income countries which had highly regulated, if not centrally planned economies, have been involved in similar systemic reforms over the last two decades. 2. The Coase argument focuses on allocative efficiency, ignoring distributional considerations. Who receives the property rights matters for equity, and when privatisation led to concentrated acquisition of former state assets, as in Russia, it undermined support for the reform process. 3. Janos Kornai coined the term soft budget constraint to capture the situation where state enterprise managers did not consider their financial constraints to be binding. Any losses would be underwritten by the central planners,

252 The Australian Economic Review June 2003 who would never allow enterprises to go out of business.. Higher inflation obscures relative price changes and hence undermines the signalling mechanism of a market economy, and inflation discourages financial market development. 5. The GDP estimates in Table must, however, be treated with caution, because of collection biases (in centrally planned economies managers tended to over-report output, but in the new environment producers hide output from the tax collectors eyes), index number problems (the bundle of goods in 2002 is far different from that in 199), and differences between output measures and well-being. All of these considerations cause GDP estimates to understate the benefits of transition, which also include greater consumer choice and less queuing. References Aslund, A. 2002, Building Capitalism, Cambridge University Press, Cambridge. Blejer, M. and Skreb, M. (eds) 2002, Transition: The First Decade, MIT Press, Cambridge, Massachusetts. European Bank for Reconstruction and Development 2001, Transition Update, April 2001, European Bank for Reconstruction and Development, London. Havrylyshyn, O. and Nsouli, S. (eds) 2001, A Decade of Transition: Achievements and Challenges, International Monetary Fund, Washington, DC. International Monetary Fund 2000, International Financial Statistics Yearbook 2000, IMF, Washington, DC. Kornai, J. 1992, The Socialist System: The Political Economy of Communism, Princeton University Press, Princeton. Milanovic, B. 199, Income, Inequality, and Poverty during the Transition from Planned to Market Economy, World Bank, Washington, DC. Roland, G. 2000, Transition and Economics, MIT Press, Cambridge, Massachusetts. World Bank 199, World Development Report 199, Oxford University Press, New York. World Bank 2002, Transition: The First Ten Years, World Bank, Washington, DC. Wyplosz, C. 2000, Ten years of transformation: Macroeconomic lessons, Policy Research Working Paper 22, World Bank, Washington, DC.