The Continuing Challenge of Transition and Convergence, Remarks by Horst Köhler, Managing Director, IMF

November 6, 2000

00/13 Remarks by Horst Köhler
Managing Director of the IMF
at the Conference "Completing Transition: The Main Challenges"
organized by the Austrian National Bank
Vienna, Austria, November 6, 2000
As prepared for delivery

Let me first thank the National Bank of Austria and the Joint Vienna Institute (JVI) for putting together this conference and for the opportunity to speak to you tonight. It is fitting that we are discussing these issues here in Vienna, given Austria's front-line view of the transition process and its strong interest in and support for transition.

Ten years after the collapse of communism, we can conclude that most transition countries have passed the point of no return on the journey towards democracy and the market economy. Praise and admiration are well deserved for the successes that have been achieved, and the endurance, patience, and courage of the people and authorities of the transition countries. But any serious assessment would recognize the considerable differences among countries in the progress achieved. Some, like Turkemenistan and Uzbekistan, are still in the early stages of building market economy institutions, while others, such as Hungary, are now grappling with the second generation of reforms-how to make the market economy work more effectively and competitively.

Let me dwell for a moment on the record so far and the lessons to be drawn, before addressing the main challenges that I see ahead. First, what have been some of the successes?
    · Economic growth has resumed in almost all the transition countries in the past two years, and inflation is under control across the region.

    · In almost every country, prices, foreign trade, and exchange systems have been liberalized extensively. In just a few years, the transition economies have done what took decades for the industrial countries after World War II.

    · There has also been progress in many other areas of structural reform, including privatization. In a number of countries, the share of the private sector has risen to 70 percent or more. This is not too different from the western market economies.
At the same time, there have been disappointments. In many countries, key sectors of the economy are still in decline, leaving whole regions facing catastrophic unemployment. For the vast majority of people, measured per capita incomes remain lower than a decade ago. Indeed, the sharp decline in output associated with transition has also brought with it a severe increase in poverty and inequality. The World Bank estimates that the number of people living on less than US$2 per day has risen fivefold since the transition began (from 16 million in 1987 to 93 million in 1998). Even though we might acknowledge that data limitations could distort the result, the trend is obvious...and it is unacceptable.

From this experience, what lessons can be drawn? Let me highlight four.

First, commitment to both macroeconomic stability and structural reform-the two together-is decisive. This is plain if one compares the experience of Hungary or Poland with other transition economies. Countries must pursue both if transition is to be successful.

Second, the highest attention must be paid to building sound institutions and strong governance, at all stages of the transition. Poor governance and weak institutions create too many opportunities for corruption, undermining investor confidence and eroding public support for reform.

Third, in formulating policy, close attention should be paid to the social implications of the transition process. A certain minimum level of social security, healthcare, and education are essential to ensure that the benefits are shared by all. Otherwise there will be no sustained political support for reform.

Fourth, there are as many transition paths as transition economies: one size does not fit all. Every nation has found or needs to find its own path toward a market economy. Domestic ownership of the reform process is most likely to take root when the policy agenda is "homegrown" and reflects national preferences, culture, and institutions.

Taking these lessons into account, what are the main challenges ahead? I see three main areas: fighting corruption; defining an appropriate role of the state; and preserving hard-won macroeconomic and financial stability. Each of these is essential to ensure that the transition to the market economy benefits all.

First, fighting corruption. This is as difficult as it is essential. Transition is about building up new market-oriented structures in a context where power relationships are fluid and evolving, wherein some have much to gain from the fluidity or the preservation of the status quo. The abuse takes two forms:
    · The most visible is "grand corruption" wherein vested interests in effect "capture the state", and then use their power to preserve monopolies, hinder competition, and inhibit reform, including the establishment of the legal and regulatory system needed for a well-functioning market economy. Russia and the Ukraine have been unhappy examples over the years. In such situations, the authorities must be prepared to challenge the vested interests, in part by being fully committed to transparency in policymaking and public sector operations.

    · The other form is "endemic corruption" wherein those in positions of authority exact payment for their cooperation and thereby not only impose additional taxes on the economy, but undermine the rule of law, which is essential to a market economy. Fighting this form of corruption requires transparent legal and regulatory frameworks, strong law courts, trustworthy law enforcement agencies, and better trained, properly paid civil servants and judges.
Second, most transition countries still have state sectors that are too large, making it necessary to fashion a more market-oriented role for the state, again often in the face of strong vested interests. This process has several aspects:
    · The Government should be a regulator not a player in the market. The state needs to disengage from commercial activities and reorient itself to concentrate on providing public goods, like education, regulation, and law enforcement.

    · Shedding of commercial activities is difficult, involving as it often does the deep restructuring of old industries-mining, steel, agriculture. It is a process that requires determination, but also care to ensure that it is complemented by growth of new private enterprises, especially SMEs. These should be understood and encouraged as the driving force behind economic growth in transition.

    · The other dimension is the privatization of state enterprises. This is essential, but must be done with care. We have seen how insider buyouts and noncompetitive sales have failed to yield improvements in enterprise governance and performance. Therefore, it is critically important that the privatization process be transparent and competitive and that appropriate regulatory structures be in place. For instance, pro-competition laws are already on the books in many places, yet implementing regulations lag far behind, and regulatory agencies need to be made completely independent of the industries they are meant to oversee.

    · The success of transition also calls for effective, affordable social safety nets to cushion the effects of restructuring. The immediate challenge for most countries in the years ahead is how to design effective income support within limited budgets. As economies grow stronger, they will become able to deliver progressively more generous support. But they will continually need to make sure that these benefits do not overstretch budgets, or create disincentives to work or saving.
Third, as countries increasingly move into the growth phase of transition and "reform fatigue" comes to the fore, it will be as important as before to preserve external viability. A careful watch will have to be kept on external current account deficits and the rise in external debt levels. To this end, maintaining macroeconomic and financial stability calls for action in a number of areas:
    · Designing sound medium-term fiscal plans. This will involve difficult choices as it will require balancing necessary expenditures and tight financial constraints. On the expenditure side, these include bank and enterprise restructurings, strengthened social safety nets, improvements in public infrastructure, aging populations, and EU accession. These need to be weighed, however, in a context where tax burdens and debt ratios are already on the high side. The difficulty of reconciling these pressures is already evident in a number of national budgets, and one must be concerned that it might spill over into increased external vulnerability over the medium term.

    · Much work needs to be done to strengthen and restructure financial sectors to make them effective for the development of the countries. Effective regulation and supervision is indispensable. In several countries, the key issue in the near term is bank restructuring and reducing the role of state-owned banks, including through privatization. Some closures of insolvent banks may be unavoidable.

    · Those countries that are making more successful progress with transition may receive large capital inflows. New challenges for managing the economy will arise, including pressure on current account deficits and on domestic prices. Sound fiscal policy will be essential, to lessen pressures from such inflows and to reduce the risks of a disruptive reversal.

    · In some countries the management of external debt is the issue. The rise in external debt levels for some of the poorest countries of the former Soviet Union is particularly worrisome. Resolving it will require not only intensified adjustment but also support from creditors and donors.

* * * * *

The primary responsibility for meeting these challenges rests with the countries themselves. But the international community can also do a great deal to support the transition at this stage.

The advanced economies, particularly those in Western Europe, have a significant role to play. A dynamic Western Europe is key for the continued growth and expansion of the transition countries. The process of reform has picked up. But I believe that these countries can be even more ambitious with respect to structural change to underpin strong, sustainable growth. In particular, industrial countries should open their markets further, including for nascent export industries in the transition countries. These are measures that would benefit not only the transition economies, but the advanced economies as well, because of lower cost products and because of stronger demand for their own exports.

In my view, EU accession is a beacon that has already been guiding the reform process in several countries and can continue to play this role in the future for many others. The EU enlargement process must offer a credible and realistic path by which transition economies can, with time and appropriate policies, achieve their goal of membership. The clearer the membership criteria, the more effective will be the path to accession in guiding reform. Moreover, the membership criteria cannot be diluted without undermining the integrity of the enlargement process. This means that, for some countries, accession may take longer than they would like. Recognizing the very different circumstances that each candidate faces, I believe a case-by-case approach to membership is the right one. For Austria, an enlarged EU will place it at the center of a huge, increasingly integrated region, and on balance Austria can expect to benefit substantially in the years ahead.

For our part, the IMF will stay engaged with the transition countries, providing policy advice and offering technical and financial assistance when needed. But, just as the global economy is evolving, the Fund itself is changing to keep it effective in responding to new challenges. At the Annual Meetings in Prague, the IMF's Governors expressed strong support for reforming the Fund. I was greatly encouraged by the support that our membership gave for the key elements of my vision for the future of the Fund. The IMF should:
    · strive to promote sustained non-inflationary economic growth that benefits all people of the world;

    · be the center of competence for the stability of the international financial system;

    · work in a complementary fashion with other institutions established to safeguard global public goods; and

    · be an open institution, learning from experience and dialogue, and adapting continuously to changing circumstances.
In this vision, I see the IMF as an active part of the workforce to make globalization work for the benefit of all. This vision builds on an enhanced partnership with the World Bank, based on a clear sense of the complementarities of the two institutions.

The Fund's mandate of promoting domestic and international financial stability demands that it places crisis prevention at the heart of its activities. We are doing so by reorienting our activities, particularly surveillance and technical assistance. We should also pay increased attention in our advice, not only to national policies and their global effects, but also to issues of regional cooperation, including through regional surveillance.

We are contributing to the reform of the international monetary and financial system, by exercising stronger oversight of financial sectors, promoting standards and codes, and providing better information about the IMF's policies. Much of the international effort is still in its early stages, and the transition economies are in the vanguard of this work. Assessments of financial sector stability have been conducted or are planned in about 40 countries; at least six of these are in transition economies. And of the first 28 countries that have prepared reports about the observance of standards and codes, designed to promote transparency, 7 were written by transition economies.

We will continue to provide policy advice to members in the areas of our core competencies-monetary, fiscal, and financial sector issues. I believe that the Fund must be candid in conveying its professional analysis and judgment. In those cases where financial support is provided, conditionality will be necessary, but in a way that enhances ownership of the programs. I am convinced that ownership is promoted when it is tailored to meet the varying needs of our members and when it is focused on the measures needed to achieve macroeconomic stability and growth. This approach also requires more effective coordination with other international agencies, in particular the World Bank.

Finally, while here in Vienna, I would like to point out that technical assistance and training-especially through courses taught at the JVI-have been and will continue to be a key element of the Fund's involvement in the transition process. The development of human capital is extremely important for the long-term success of the transition economies, by building the institutions of a modern market economy. Many bilateral and multilateral agencies are able to offer technical assistance in support of different aspects of this process. In the future we, the international community, should find more effective ways of providing and coordinating technical assistance, while viewing the needs through the eyes of the recipient.

* * * * *

Before closing, permit me to turn briefly to Yugoslavia. The launching of democracy in that country is very welcome and we stand ready to cooperate fully with Yugoslavia as it seeks to recover from years of conflict. In fact, a mission has already gone to Belgrade to collect basic information, review issues related to membership in the Fund, and discuss policy intentions and technical assistance needs. Although we are still awaiting the formation of a federal government, we expect our involvement to deepen over the next few weeks and for the Federal Republic of Yugoslavia to become a member soon. We can now hope and expect that the reestablishment of Yugoslavia's links with the international community will be a significant boost to the region more generally.

* * * * *

The transition has yielded some notable successes. Some countries are quite close to convergence with the advanced economies. Others still face a long journey. The international community, and the IMF itself, should be ready to provide support wherever it is needed. In a very real sense, all countries-not just the transition economies-are "in transition". In today's world, all countries face the same challenge-how to continually adapt their economies to the demands of an increasingly globalized world economy to the benefit of all their citizens.


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