EU Eastern Enlargement and the Russian Transformation Crisis

EU Eastern Enlargement and the Russian Transformation Crisis

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Paul J. J. Welfens EU Eastern Enlargement and the Russian Transformation Crisis With 12 Figures and 25 Tables Springer

Prof. Dr. Paul J. J. Welfens University of Potsdam European Institute for International Economic Relations (EIIW) August-Bebel-Str. 89 14482 Potsdam Germany http://www.euroeiiw.de ISBN-13: 978-3-642-64299-9 DOl: 10.1007/978-3-642-60194-1 e-isbn-13: 978-3-642-60194-1 Library of Congress Cataloging-in-Publication Data Die Deutsche Bibliothek - CIP-Einheitsaufnahme EU eastern enlargement and the russian transformation crisis; with 25 tables I Paul J. J. Welfens. - Berlin; Heidelberg; New York; Barcelona; Hong Kong; London; Milan; Paris; Singapore; Tokyo: Springer, 1999 ISBN-13: 978-3-642-64299-9 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfllm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer-Verlag. Violations are liable for prosecution under the German Copyright Law. Springer-Verlag Berlin. Heidelberg 1999 Softcover reprint of the hardcover 1st edition 1999 The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Hardcover-Design: Erich Kirchner, Heidelberg SPIN 10728804 4312202-5 4 3 2 1 0 - Printed on acid-free paper

Preface Europe's economic and political landscape is changing dramatically. The demise of the socialist CMEA and the USSR has allowed eastern European economies to open up and caused Russia/the CIS to engage in a series of difficult reforms which have been supported by the G-7 and the International Monetary Fund plus the World Bank on the one hand, and, on the other hand, by the EU and the EBRD. While some of the (early) Visegrad countries apparently were rather successful in their transition attempt, systemic transition approaches in other countries - Romania and Bulgaria - and, above all, in Russia largely were a failure. Economic hardship, social unrest, political radicalization and the international spreading of criminal activities can be identified as problems from the failure of Russia's first transition attempt. This book deals - from an international perspective - with the postsocialist countries in Europe, i.e. there is a focus on eastern enlargement and on Russia on the one hand, on the other hand the topic is which international influences and effects will emerge from EU enlargement and the Russian transition. While chapter A exclusively deals with major problems of eastern enlargement and the policy options for dealing with this difficult problem, chapter B is devoted to the Russian transformation crisis. There the analysis has a focus on Russia in its own right but also on the potential negative spillovers of a Russian transformation disaster which could occur in the late 1990s. If the lessons from the failed transformation strategy of the period 1991-98 are not drawn a political and economic disaster is looming in Russia and the former CIS, respectively. In chapter C the focus is on the role of international organizations in regional crisis management - in particular attention is on the IMF, the World Bank, the OECD and the EU. Systemic transition has raised many issues and certainly brought some surprises for the Economics profession - Russia was the most apparent problem. Failure to assess the most important problems properly is obvious in many cases - there was even a book by an acclaimed advisor in Russia who wrote about the coming economic boom in Russia. Wrong and inconsistent policy strategies for Russia (including government failure to pursue a convincing reform and restructuring strategy) have led to economic hardship in Russia in 1998. The Russian economic crisis had immediate negative spillover effects to the Ukraine, Belarus and other CIS republics. Misjudgements by individual researchers hardly can be avoided but the profession should have efficient filter mechanisms which rule out systemic pitfalls and misjudgements. Unfortunately, even the network of many economists sometimes is slow in understanding that there were serious misinterpretations and inadquate policy support. It took the IMF seven years to understand that its basically macroeconomic oriented transition approach to Russia had failed. In late November 1998 a group of 20 researchers were invited to Washington to discuss

VI EU Eastern Enlargement and the Russian Transformation Crisis potential failures in the IMF strategy in Russia and to consider future strategies. The willingness of the IMF to reconsider the strategy for Russia deserves praise but it should have come much earlier - it also is unclear that the IMF will learn from the Russian transition disaster and become more effective in its work. Reconsideration of the IMF strategy would have come much earlier had the IMF set explicit indicator targets whose failure to achieve automatically would trigger outside review of the strategy chosen; moreover, it would have been useful to have an outside expert panel with a continuous and critical look at the IMF approach. One may also doubt an IMF-system in which no clear personal responsibilities for the huge Russian transition assistance have been assigned. Moreover, one must wonder about the wisdom of the leading international economic organization as it published less research papers on Russia than the Central Bank of Finland. The main problem in the transformation was not misguided external support but lack of reforms in the former CIS. Russian governments adopted rather illusory policy strategies and were slow to understand the needs for fundamental reforms. Russia's slow and hesistant reform policies in the late 19 th century point to historical problems of the political elite to undertake comprehensive and consistent reforms. However, in the 20 th century with the availability of broad external support of international organizations the options for broad reforms should be much better. There is, despite the beginning information age - with the internet available worldwide - a lack of a broader reform and transformation discussion in post-soviet Russia. Chapter B is a slightly revised version of a paper which I gave at an IMF seminar on October 26, 1998. The appendix contains the core of a paper whose main arguments I presented at a "brainstorming meeting" on Russia transformation - about 20 experts gathered at the IMF on November 30, 1998. Chapter C deals with problems of external liberalization in Russian transformation. Based on refined theoretical arguments we argue in favor of a "mixed tariff system" which would include free trade for certain products. Moreover, we advocate a new customs administration regime and emphasize the links between trade and foreign direct investment. Chapter D is devoted to strategic issues in regional crisis management and the role of international organizations. The issue is raised to which extent and under what conditions international organizations - such as the IMF, the OECD, the BIS or the EBRD - can successfully manage regional and global economic crisis. A sustained failure of systemic transformation has all ingredients of a major regional crisis which could carry negative global spillover effects. The international organizations and the G-8 have a big responsibility for efficient support of the transition process in eastern Europe and Russia. At the same time the young democracies must face their own decisions, choices and responsibilities. If there is sustained transition and economic catching-up the whole world economy will strongly benefit. In the end the European model of the social market economy could become more attractive again in the world economy where the rather unfettered capitalism of the US has become to dominate as a role model.

Preface VII However, neither EU enlargement nor sustained Russian transition will be achieved if the European Commission and major EU governments should not assign these topics a top political priority. While it is clear that Western support for eastern Europe and Russia cannot be given without conditions it also is obvious that the countries in the former CMEA area need both technical and financial assistance for quite some time. Poland and Hungary have been successful leaders in systemic transition, and they have done so on the basis of economic opening up and rejuvenization of government ministries and the central bank, respectively. This change of generation is stell pending in the Russian (or the Ukrainian) ministry of finance at the level of Directors. Moreover, the IMF, the W orid Bank and the EU obviously gave insufficient technical support for modernizing the Russian administration which is at least as important than financial support for the transition process. I am quite grateful to my research assistents RalfWiegert and Niels Theis at Potsdam University as well to Nadine Richter, Antje Wenk and Tim Yariing, Washington DC, who helped with the editing process enormously. I also particularly benefitted from discussions with Michael Intriligator, Padma Desai, Pyotr Fedossov and various colleagues at the World Bank and the IMF. The responsibility for the analysis presented is, of course, all mine. Paul J.J. Welfens Potsdam, April 1999

Table of Contents Preface V A Eastern EU Enlargement: Developments, Problems and Policy 1 1 Introduction 3 2 The Community Facing the Start of the Euro 4 3 Eastern Europe After the First Transition Stages 7 4 Agenda 2000 and Institutional Challenges for Accession Countries 11 5 Theory of Economic Integration and Application to Enlargement 13 5. 1 Basic Theoretical Aspects 14 5.2 Results from Simulation Analysis 17 5.3 Conflicts and Unsettled Theoretical Issues 21 6 Normative Perspectives: Policy Challenges and Options for EU-I5 23 7 EU Eastern Enlargement and Russia 25 7.1 Once More: Trade Creation and Trade Diversion in the Context of EU Enlargement 25 7.2 Economic Integration and Convergence in Europe 29 7.3 EU Accession Countries and the Impact of Russia's Transformation Crisis 33 B The Russian Transformation Crisis: Origins, Analysis and New Policy Requirements 37 1 Introduction 39 2 From Socialist Distortions to the Transformation Crisis 39 2.1 Misperceptions and Macroeconomic Adjustments in a Distorted Economy 43 2.2 The Russian Growth Puzzle: Towards a Theory of Transformation Crisis 47 2.2.1 Insufficient Competition and Lack of Structural Change 47 2.2.2 Privatization, Special Aspects of the Energy Sector and the Budget Problem 49 2.2.3 The Negative Value-Added Problem, Wage Arrears and Stagnation 54 2.2.4 Dollarization of the Economy and Monetary Dehydration 55 2.2.5 Eastern Europe and Russian Transition 59 3 Towards a Functional Institutional Framework 62 3.1 The Rule of Law and Institutions: Outsourcing, Transaction Costs and Growth 63 3.2 Optimal Political Governance in a Simple Model 66 4 Towards a New Transformation Strategy 68 4.1 Institutional Bottlenecks, Sequencing and Network Effects 69 4.2 Overcoming Dollarization via Banking Reform, Competition and Growth 73

x EU Eastern Enlargement and the Russian Transformation Crisis 4.3 Devaluation, Sequencing and the Significance of Structural Aspects in Capital Flows 74 4.4 Summary and Conclusions 76 Appendix B: Theory of Spatial Competition and Interdependency of Competition and Trade Liberalization 78 C Efficient External Liberalization in Russian Transformation 85 1 Introduction 87 2 Traditional and New Approaches for External Liberalization 89 2.1 Textbook Models and Traditional Liberalization Approach 90 2.2 Efficient Liberalization in the Presence of Distortions and Foreign Direct Investment 92 2.3 Structural Aspects offdi and FDI Dynamics 94 2.4 Optimum Tariff Issues 98 2.5 Some New Aspects of Trade Liberalization 99 3 Policy Conclusions for Russia 102 Appendix C 1 104 Appendix C2: Towards a New Russian Transformation Strategy - Lessons from Failed Transition and Ingredients for Sustainable Reform 106 D The Role of International Organizations 117 International Crisis Management: The IMF's Medicine for Asia and Russia 119 2 Economic Stability Aspects 125 3 New Issues in International Economic Relations: Liberalization of Telecommunication, Green Problems and Social Standards 129 4 International Organization and Sustainable Globalization l31 4.l Towards an 1-7 Meeting 132 4.2 Normative Conclusions 132 4.3 Conclusions l33 Appendix D: Towards a WTO Facility 135 References 139 List of Figures 149 List of Tables 151