A quarterly magazine of the IMF

June 2002, Volume 39, Number 2

A decade after the dissolution of the Soviet Union in late 1991, some transition economies are performing far better than others. A recent World Bank study finds that poor incentives for the creation of new firms is the single biggest obstacle. But reducing barriers to entry is not enough—hard budget constraints must also be imposed on the old money-losing state-owned enterprises.

The 1990s witnessed one of the most dramatic economic transformations in modern times, as the countries of Eastern Europe and the former Soviet Union abandoned central planning. Initially, output declined sharply, followed by a period of recovery in the late 1990s. But progress was extremely uneven across countries. In Central and Southeastern Europe and the Baltics (CSB), real output fell 22 percent from its 1990 level before it recovered in 1993. In the Commonwealth of Independent States (CIS), it plummeted 50 percent, not to begin recovering until 1999. By 2000, countries in the first group had more than restored their original output levels, while those in the second group were still 35 percent below. Moreover, progress varied greatly even within each group. Bulgaria and Hungary experienced the same initial output decline but, by 2000, Hungary's output was 10 percent higher, while Bulgaria's was still 13 percent lower. Moldova and Armenia had a similar initial drop, but while Moldova's output remained stagnant at that level, Armenia's output almost doubled thereafter.

Why have some transition economies performed better than others? If reforms bring benefits, why have some governments been so reluctant to accept them? Should the policy prescriptions originally advanced now be revised, especially for those countries lagging behind? To answer these questions, the World Bank recently undertook a comprehensive study of the first 10 years of transition for this region. This article summarizes its findings.

Why some did better

By reviewing the economic literature, including additional econometric analysis undertaken for this study, we asked what explained the differences in economic performance: initial conditions, policy reforms, or external shocks, such as war and civil strife? Initial conditions were further disaggregated into several dimensions: the structure of the economy (share of industry, trade dependence on other communist countries), initial distortions (repressed inflation, black market exchange rates), and institutions (experience of markets and nationhood prior to transition). The extent of reforms was measured by combining the World Bank's liberalization index with the transition indicators of the European Bank for Reconstruction and Development (EBRD)—which include policies to increase the role of markets in resource allocation and reforms ensuring an efficient functioning of markets. What are the key findings?

• Initial conditions are more important in explaining differences across countries during the earlier period of output collapse than over the full 10 years of transition.
• Some initial conditions have a stronger impact at the start of transition, others at later stages. Initial distortions are better explanatory variables at the start of transition, while the strength of initial institutions is more important as time passes.
• Correcting for initial conditions and external shocks, reform policies do have a strong impact, particularly as the transition progresses, and they seem to operate with a lag, particularly in the CIS countries. In fact, in the CIS countries, reforms may even have a temporary negative impact on output—they can be seen as an up-front "investment cost," with payoffs in terms of growth later on.
• The speed of reforms seems to matter. The analysis shows that annual output is related to the level of the reform index—that is, cumulative policy reforms. The quicker that reform level is achieved and sustained, the sooner the economy can attain faster growth.

Next, we asked what was the driving force behind growth at the microeconomic level. Productivity trends show significant differences across sectors and enterprises in the early days of transition, fueled by the liberalization of prices, decontrol of the service sector, and opening up of foreign trade. Old enterprises in heavily subsidized and protected sectors—such as energy-intensive sectors consuming heavily underpriced energy—saw their profitability collapse. Old enterprises in less protected sectors were able to recover profitability after some restructuring and downsizing. New enterprises became highly productive.

Data from 10 economies covering leading and lagging reformers show that value added per worker was significantly higher in small enterprises (employing 50 or fewer workers), which are a good proxy for new enterprises. A survey conducted jointly by the EBRD and the World Bank comparing 4,000 old and new enterprises found that new enterprises outperformed old enterprises in the growth of sales, exports, investment, and employment.

These comparisons of value added per worker indicate that a transfer of resources from predominantly capital-intensive old enterprises to generally more labor-intensive new ones should be a key source of growth, the recovery of growth reflecting the interplay between old and new enterprises. However, simply having a small number of highly productive new enterprises is not enough. New enterprises cannot be just a passive receptacle of labor shed by old enterprises. These enterprises have to evolve into active competitors for resources and rapidly increase their share of employment to develop a critical mass, which is precisely what happened (see Chart 1). In many CIS countries where growth remained low until the end of the decade, the share of employment in small enterprises hovered around 20 percent. In fast-growing Central Europe, in contrast, that share reached 50 percent. In Russia, it remained virtually stagnant toward the end of the decade, while it almost doubled in Poland. The evidence suggests that new enterprises must reach a threshold of around 40 percent in their contribution to employment before becoming the engine of aggregate growth, echoing the findings of the econometric analysis that reforms may have to incur an initial cost before benefits appear.

Discipline and encouragement

How do policymakers encourage this transfer of resources? Discipline must be imposed by hardening budget constraints on old enterprises to shed resources—for example, by eliminating budget transfers and ensuring payments of bank debts and energy bills, introducing competition, providing exit mechanisms, and putting in place systems to monitor managerial behavior. At the same time, new enterprises should be encouraged to grow to a critical mass. This requires improving the overall investment climate—reducing high marginal taxes and regulatory procedures, establishing secure property rights, and providing basic infrastructure. How effective policies have been in imposing market discipline on all firms and encouraging the creation of new firms holds the key to understanding why some countries have grown more than others.

Can governments in the countries of Eastern Europe and the former Soviet Union try to promote growth by encouraging new firms while postponing the pain of liquidating the old sectors to a time when a cushion has been put in place? Is it possible to encourage new sectors and firms while protecting the old ones? The answer is no.

Take the banking sector. In Bulgaria and Romania, small enterprises have grown more slowly because the banking sector was originally used, to a great extent, as a conduit for loans to state-owned enterprises. Nonperforming loans represented one-third of total loans in Romania as late as 1998, compared with 4 percent in Estonia, 6 percent in Hungary, and 11 percent in Poland—countries where new enterprises grew fast. These loans to old enterprises, which were not being repaid, prevented the expansion of bank credit to the new, smaller, and politically less-connected firms.

In Belarus and Uzbekistan, the old sectors were protected through subsidized preallocations of foreign exchange and credit, the residual becoming available to new enterprises at much higher costs. As a result, small enterprises have been severely squeezed. In Belarus, the share of small enterprises in the total was a mere 26 percent—much lower than in the other CIS countries. Another example is protection of old, energy-intensive enterprises by allowing them to run arrears to energy utilities. This practice has been prevalent throughout most of the CIS countries. New, more efficient, and less energy-intensive firms were charged more to compensate for the revenue losses from nonpayment by the old sectors.

Why eschew a good thing?

If reforms underpinning discipline and encouragement are so beneficial, why have all countries not implemented them? Why have so many countries, particularly in the CIS, been stuck in a no-man's-land between plan and market?

Chart 2 describes the gains and losses in income accruing to three typical constituencies as reforms intensify.

• Workers in state-owned enterprises—particularly less skilled workers, who will have fewer chances of entering the new sectors—face a persistent decline in income as reforms tend to continuously downsize the old sectors.
• Potential new entrants—workers and managers with the skills to become workers or entrepreneurs in the new sectors. Their income also drops at the beginning of reforms as state-owned enterprises are downsized, but, as reforms progress, they increasingly benefit as they move to the new sectors.
• Oligarchs and insiders—individuals who began the transition with substantial de facto control rights over state assets and who kept close ties with the political establishment, maintaining privileged access to underpriced resources during the first stages of liberalization and privatization. They can reap significant rents from price arbitrage, tunneling, and asset stripping because of insufficient oversight by other owners, such as the state (in cases of partial privatization) or dispersed small shareholders. (Until recently, a classic example was strong opposition from powerful Russian entrepreneurs to Russia's Securities and Exchange Commission's efforts to strengthen and enforce legislation protecting minority shareholder rights and to legislation by the Duma that would strengthen the transparency and disclosure of enterprise accounts.) As additional reforms encourage further liberalization, competition, and better institutions for corporate oversight, these initial rents are dissipated. The result for this group is an inverted U-curve of benefits as the reform process moves forward.

Given these patterns of gains and losses, state workers prefer the status quo (R₀₎ and oppose all reforms. Oligarchs and insiders prefer a partial reform scenario, supporting reforms only up to level R₁. For potential new entrants, reforms would impose some temporary sacrifices, with the promise of increasing gains as reforms intensify.

The risk of getting stuck at R₁ depends both on the credibility of governments' following through with reforms and on the incentives of oligarchs and insiders to block them. The higher their peak income gain (particularly true in countries rich in natural resources and energy) and the sharper the reduction of those income gains as reforms accelerate, the stronger the power and incentives of this group to block reforms. And the less contestable the political system, the lower the costs to politicians of catering to a narrow but powerful constituency. In this situation, the economy will settle at a low-level partial reform equilibrium trap (R₁)—an equilibrium with liberalization but limited discipline and encouragement—as has been the case in many transition countries in the CIS and Southeastern Europe that embarked on transition without a broad social consensus on the goals of reform and where incumbent politicians formed alliances with powerful incumbent enterprises.

Can economies escape a partial reform equilibrium? Yes. Talented political leaders can maneuver countries out of so-called reform traps by mobilizing alternative coalitions and sparking collective action, in this case among smaller enterprises and those in the informal sector that suffer most from the poor investment climate and the discretionary nature of taxation and regulations, anticompetitive barriers, and payment of bribes. Chart 2 shows that once an economy is at R₁, only reaching a critical threshold level (R₂) through further reforms will generate additional gains among the new entrants to compensate for the losses of the other groups or generate the necessary political pressure to neutralize opposition to further reforms.

Breaking out of a low-level partial reform equilibrium trap requires that a new reformist team overcome the coordination dilemma associated with the opposition from powerful and concentrated (actual) losers and from highly dispersed (potential) winners during the reform process. This requires linking in the public mind—for example, by using the media and civil society—the rents enjoyed from partial reforms (in the form of evaded taxes and nonpayment of arrears) and the direct costs to society (in the form of delayed public sector wages and poor social services).

New policy priorities

In light of the lessons culled from our study and today's "new initial conditions," how should we proceed on the policy front?

• Improving the investment climate for the creation of new firms. The early emphasis on rapid privatization responded to the perceived need for creating a constituency for private ownership to help guarantee the irreversibility of reforms and stop abuses, such as asset stripping, by enterprise managers and other forms of "spontaneous privatization." These particular concerns weigh less heavily on policymakers today. Moreover, the evidence from the first decade of transition is that the emergence of vibrant new enterprises and sectors is associated with a return to sustained growth. Hence, emphasis should shift toward improving the investment climate for new firms. But "encouragement" alone will ultimately not be effective in the absence of discipline imposed through hard budget constraints and monitoring of managerial behavior—the two need to go hand in hand.
• Developing institutions to monitor managerial behavior. Creating incentives for managers to become effective stewards of enterprise assets has been more difficult than originally envisaged. Most transition countries have lacked effective institutions of corporate governance to protect the rights of minority shareholders and creditors. Privatization of firms to concentrated owners can overcome some of these problems. But the type of concentrated ownership matters as well. Strategic investors, particularly if they are foreign, have performed much better than holding companies or financial institutions. The selection of strategic investors matters, too. Enterprises sold through transparent tenders or auctions have attracted better owners, outperforming enterprises sold directly to politically connected parties. When strategic investors were unavailable, a difficult choice loomed between continued state ownership without the institutional capacity to prevent asset stripping by incumbent managers and privatization without effective corporate governance to protect minority shareholders from expropriation by the new owners. Countries made different choices. However, whatever view is taken about the appropriateness of past strategies, it will be critical, looking forward, to strengthen the legal rights of minority shareholders and creditors and enforce those safeguards effectively.
• Breaking out of a low-level partial reform equilibrium trap when a reformist team comes to power. Granting extraordinary decree-making powers to the executive branch to dissipate rents and level the playing field has not won against strong opposition from oligarchs and insiders. Breaking out of this trap requires giving "voice" to small, medium-sized, and second-tier enterprises; explaining the links between the different components of reforms to the citizenry; and using fiscal policy—both the tax system, to capture part of the rents accruing to early winners, and the reallocation of public expenditures to social programs and safety nets. Furthermore, local governments need to be given the resources and responsibilities to take over the social services previously provided by state-owned enterprises. The budget needs to be used much more actively as an instrument for social policy than it has been in the past. In Central Europe and the Baltics, the prospect of accession to the European Union has provided an external anchor for such reforms.

This article draws on the report, Transition—The First Ten Years: Analysis and Lessons for Eastern Europe and the Former Soviet Union (Washington: World Bank, 2002), which was prepared by a team led by the authors. The report is also available at www.worldbank.org.