I.  Introduction

The race to transform centrally planned economies into market economies has led, ten years later, to one group of countries approaching the finish line, others languishing at various points along the track, and a few barely off the starting blocks. Some Central and Eastern European economies (CEE) and the Baltics are knocking on the doors of the European Union. But in many economies in the Commonwealth of Independent States (CIS), including Russia, there has been uneven progress and prospects remain murky. (See Box 1 for the classification of transition economies used in this brief.)

Why have the CEE and Baltic economies outpaced those of the CIS? And what is the way forward for Russia and the others? These are the broad questions addressed in the following sections. The focus in the main text is on the countries in transition in Europe and the former Soviet Union; developments in China and transition economies of Southeast Asia are discussed only briefly but are also the subject of Box 2.

II.  The Ingredients of the Transition Process

The main ingredients of the transition process were agreed upon fairly early.¹ They were:

• Liberalization: the process of allowing most prices to be determined in free markets and lowering trade barriers that had shut off contact with the price structure of the world's market economies.

• Macroeconomic stabilization: primarily the process through which inflation is brought under control and lowered over time, after the initial burst of high inflation that follows from liberalization and the release of pent-up demand. This process requires discipline over the government budget and the growth of money and credit (that is, discipline in fiscal and monetary policy) and progress toward sustainable balance of payments.

• Restructuring and privatization: the processes of creating a viable financial sector and reforming the enterprises in these economies to render them capable of producing goods that could be sold in free markets and of transferring their ownership into private hands.

• Legal and institutional reforms: These are needed to redefine the role of the state in these economies, establish the rule of law, and introduce appropriate competition policies.

It was envisaged that the liberalization and macroeconomic stabilization could be undertaken fairly quickly, as could the privatization of small-scale enterprises. The privatization of large-scale enterprises and legal and institutional reforms would intensify at a later stage of the transition process and take a longer time.

III.  The Taming of Inflation and the Recovery of Output²

At the start of the transition, most economists agreed that, to get market price mechanisms working, liberalization and macroeconomic stabilization should proceed quickly, despite the economic hardship they might impose. The view was that the hardship would be temporary and less severe than if the process were dragged out over time.

The transition thus started in most economies with prices being rapidly liberated from artificially low levels, which led to an immediate burst of corrective inflation. The pent-up demand that had built up during the period of central planning sustained the inflation. Early in the transition inflation averaged 450 percent a year in CEE, nearly 900 percent in the Baltics and over 1000 percent in the CIS. By 1998, however, annual inflation had been lowered to the single digits in the first two groups and around 30 percent in the third.

Along with the burst in inflation, the transition began with another shock: output fell in all three groups of countries at the start of the transition, on average by 40 percent before it bottomed out, far more than was expected.

It is likely that the pre-transition level of output was overestimated by faulty statistics. If value added had been measured correctly at market prices, the pre-transition output, and therefore the collapse of output, would have been much lower. By 1998, output was growing in all three (as shown in Figure 1), though pre-transition levels of measured output had not been surpassed in most countries.

How was inflation tamed? Most of the early reformers adopted an explicit or implicit exchange rate peg.³ In other words, the country's government promised to stand ready to exchange its currency for a `hard' currency, an internationally held currency with relatively stable value. Since too rapid a rate of money expansion, e.g., due to excessive government spending, would make it difficult to maintain the peg, this was essentially a promise to follow tight macroeconomic policies.⁴ These policies, and the effect they had on the private sector's expectations of inflation, helped bring inflation down. However, mechanisms other than exchange rate pegs have also succeeded in lowering inflation. For instance, many countries adopted charters giving their central banks considerable independence to pursue tight monetary policies or accepted the discipline of IMF-supported macroeconomic programs. This too helped check inflation.⁵

Why did output fall initially and so markedly, why did the pattern of collapse differ across countries, and what explains the recovery of output? These questions have been the subjects of much econometric investigation. The results suggest that relatively little of the initial decline in output was due to the tight macroeconomic policies used to tame inflation. Instead, `disorganization'-associated with shocks such as the collapse of the Council for Mutual Economic Assistance (CMEA)-was an important factor. Disorganization refers to disruption in the production network, particularly in the provision of materials and intermediate inputs, resulting from the collapse of central planning and the dismantling of vertically integrated conglomerates that operated under the old system. Such disruption led to a loss in output.

'Adverse initial conditions' in some countries are generally invoked to explain why the pattern of collapse differed across countries. This is a reference to the fact that the characteristics of the economies differed at the start of the transition, and, in many countries, the characteristics made the task of maintaining economic activity difficult. For instance, there were differences in the ability to reorient trade toward the advanced market economies, the degree of industrialization (which reflected in part the role the countries had played under the Soviet system) and the share of agriculture in the economy, skill levels as reflected in secondary school enrollment, and the number of years under communism. Not surprisingly, countries where initial conditions were more adverse experienced a sharper initial decline in output.

What explains the subsequent recovery in output? One important factor was progress made in lowering inflation. Countries that tamed inflation quickly and sustained the gains experienced a speedier and stronger recovery in output.

This is illustrated in Figure 2, which shows the relationship between the change in output in a country, on the one hand, and the progress it made in reducing inflation, on the other. Each "diamond" on the graph represents a country; the country names are not listed on the graph to avoid cluttering it. Countries appearing in the lower right-hand corner of the graph had low inflation (relative to other transition economies) and experienced a recovery of output; countries appearing in the upper right-hand corner had high inflation and suffered output losses. In general, the graph shows that countries that kept a lid on inflation were better able to maintain economic activity than countries where inflation was unchecked.

Though progress with lowering inflation proved necessary for the revival of growth, it was not sufficient. Structural reforms were key in bringing about sustained recovery by facilitating the growth of the private sector. Where structural reforms were put in place early and firmly, new production networks developed quickly to counter the disorganization in the early years of transition.

This is illustrated in Figure 3. Output, relative to its pre-transition level, was higher in countries where structural reforms, as measured by an index constructed by the European Bank for Reconstruction and Development (EBRD)⁶, were the most far-reaching. These countries tended to belong to the CEE and Baltic groups. As in the earlier figure, each "diamond" on the graph represents a country. Countries appearing in the upper right-hand corner of the graph pursued structural reforms more vigorously (than other transition economies) and experienced a recovery of output; countries appearing in the lower left-hand corner of the graph lagged in the implementation of structural policies and suffered output losses.

As discussed in Box 2, the experiences of four Asian transition economies-Cambodia, China, Laos and Vietnam-are interesting in their own right and also offer in some respects a contrast to the experience of the `European' transition economies.

IV.  Privatization

As noted above, economists generally agreed on the need for speed in carrying out liberalization and stabilization. But on privatization of large enterprises, there was a debate on whether to have a rapid transfer of assets from the state to the private sector or to adopt a more gradual approach.⁷

Advocates of rapid privatization called for eliminating state ownership by giving assets to citizens, for instance through vouchers that gave their holders the right and means to purchase state-owned companies on sale. They were motivated by considerations of fairness, a desire to give ordinary citizens a stake in the economy. They also perceived a need to seize the window of opportunity that had opened for privatization before the state bureaucracies regrouped and resisted the process.

Others advocated a more gradual scaling back of state enterprises as new private sector firms emerged in the economy. They were in favor of the privatization of enterprises through the sale of assets to those likely to work on improving the performance of the companies. They also stressed the imposition of `hard budget constraints' on enterprises so that chronic loss makers would be forced out, leaving the more profitable enterprises to attract investors. Hungary followed this gradualist approach to privatization, and it appears to have proved more conducive to genuine restructuring of enterprises.

By contrast, experience has shown some of the pitfalls of the rapid privatization approach. In the Czech Republic, for instance, the assets transferred to millions of ordinary citizens in the first phase of rapid privatization were sold by the recipients and ended up being consolidated in investment funds. But there was no genuine restructuring of enterprises, either because the investment funds lacked the capital to develop them or because the funds were in turn controlled by state-owned banks that did not impose hard budget constraints. The weak growth performance of the Czech Republic in the late-1990s, relative to other CEE countries, is attributed in part to its weak enterprise reforms.

Rapid privatization fared even worse in Russia. The country's mass privatization program of 1992-94 transferred ownership of over 15,000 firms into private hands. However, contrary to expectations, insider privatization did not lead to self-induced restructuring of firms. It was hoped that secondary trading would introduce outside ownership, and that transparent methods would be used in the second wave of privatization of remaining firms still in state hands. Neither hope was fulfilled. Insiders were wary of relinquishing control; workers feared the cost-cutting that might occur under outside control, and managers found it easier to keep enterprises alive by lobbying the state for subsidies than to foster competitive performance through involvement of outsiders. The second wave of privatization, in particular the so-called "loans-for-shares" scheme, was non-transparent and systematically excluded foreign investors and banks in favor of parties with ties to government interests.

Overall, the experience of the transition economies suggests that privatized firms tend to restructure more quickly and perform better than comparable firms that remain in state ownership, but only if complementary conditions are met. These conditions include the presence of hard budget constraints and competition, effective standards of corporate governance, and an effective legal structure and property rights.⁸

In contrast to the mixed experience on privatization of large enterprises, the privatization of small-scale enterprises has been generally successful and has been completed in all but five countries.

V.  Capital Flows

The move to a market economy required substantial amounts of finance to facilitate the reallocation of investment into productive sectors, modernize antiquated machinery, enhance public infrastructure, and provide financing for emerging firms. But, it was difficult, in the initial years of transition, for governments in these countries to raise the requisite capital. A `Marshall Plan' for the transition economies never materialized. Rather, external assistance on a much smaller scale was provided primarily by the international financial institutions, the European Union, and individual countries.

Another factor contributing to a capital scarcity was that private capital fled the countries in response to the uncertain circumstances at the start of transition. However, once the direction of reforms was clearly established in many CEE and Baltic economies, private capital returned quickly. Chart 1 (see Appendix) summarizes the evidence by comparing average annual estimates of capital flight, the inflation rate, real GDP growth, fiscal balances and the quality of reforms in the initial years of transition with those in the later years.⁹ In the CEE economies, a decline in inflation and improvements in the quality of structural reforms were associated with a reversal of capital flows, from net outflows of $15 per capita to net inflows of $75 per capita. Likewise, progress in the Baltics on inflation and structural reforms, along with a check on fiscal balances, turned a net outflow of $30 per capita into a net inflow of $70 per capita. Russia's experience stands in sharp contrast. Several years into its transition, Russia is still experiencing massive capital flight. Though inflation has been brought under control, Russia has lagged in the implementation of structural reforms.

VI.  Inequality¹⁰

Inequality in incomes has increased, not surprisingly, over the period of transition. A commonly-used measure of inequality is the Gini coefficient for income, which takes on values between zero and one; a value of zero would indicate perfect equality of incomes. Pre-transition Gini coefficients were around 0.25, close to those of Scandinavian countries and far below that of the United States (0.4). Post-transition Gini coefficients have increased, ranging from 0.2 in Slovenia to 0.5 in Ukraine. Countries with better growth performance--as measured by cumulative GDP growth in the first eight years of transition--experienced a smaller increase in inequality, as shown in Figure 4.

The fact that the increase in income inequality has been modest in many countries does not mean that the process of transition has not generated winners and losers. The case of Poland proves this point. Poland did experience a substantial increase in inequality of labor earnings. But social transfers played a role in mitigating this shift, so that the rise in income inequality was far more modest. Interestingly, the transfers were targeted at the people who had lost or stood to lose the most from the transition. These people tended to be middle class rather than the poor; that is, they were not the ones who would have been targeted had the goal been to help those whose absolute need was the greatest. But they may have helped the reform effort by bolstering political support for the reforms among the people most likely to block them.

This brief discussion of inequality is by no means a complete account of the often wrenching social changes under transition. For instance, one major aspect of the increase in inequality is the deterioration in the relative position of retirees (although this was not the case in Poland). With the demographic pressures facing these countries, this is a very hard problem to address in the framework of existing pay-as-you-go pension systems. The pension reforms in most of these countries will improve the situation, but this will unfortunately be too late for the current generation of retirees. Furthermore, several other social indicators have deteriorated in some of the transition economies.

VII.  Whither Russia?

Commitment to macroeconomic stabilization, though late in coming and threatened by the 1998 crisis, appears to have taken hold in Russia. However, efforts at structural reform have been weak and privatization has been often mishandled. What is the way forward for Russia? There is a range of answers to this question reflecting differences of opinion about the reform process in Russia.

One vociferous view is that the reform approach taken in Russia, particularly with respect to privatization, was fundamentally flawed in emphasizing radical reform over gradual institutional development. To Joseph Stiglitz, for instance, the failure of rapid privatization in Russia "was not an accident, but a predictable consequence" of the absence of competition policies and the institutional and legal infrastructure needed to support a successful reform effort. ¹¹ According to him, Russia should now proceed very gradually with privatization (or re-privatization of any assets that may fall back into state hands), with due recognition of the need for establishing institutional pre-conditions, and making good use of such social and organizational capital as Russia possesses. Stiglitz suggests that Russia could learn in this regard from the "enormous success of China, which created its own path of transition, rather than just using a blueprint or recipe from Western advisors".

An opposing view, associated with some Russian observers and policymakers such as Boris Fedorov and Andrei Illarionov, is that the reform strategy was the correct one, but never implemented, in part because of the leniency shown by the advanced market economies and international financial institutions.¹² For instance, Illarionov writes that

" . . . the IMF's attitude towards economic policy carried out by the Russian authorities was and remains timid, inconsistent and subject to permanent compromise ... For several years, the Russian government and Russian society as a whole turned out to be effectively spoiled, as they have been granted unearned financial assistance. As a result, Russian economic policy has not only been inconsistent, but it has seriously diverged from the economic policy conducted in a majority of countries in transition . . ."

In a similar spirit, Fedorov's "recommendations for the West" are not to grant Russia "concessions, but rather apply the rules as you would to any country. Western capital should flow to the private sector, not the government. Only this will help to change the country, create jobs and increase efficiency."

While acknowledging that greater attention ought to have been given to institutional reforms, the view from the IMF is that the basic strategy pursued in Russia was sound but derailed by special factors. For instance, Fischer and Sahay write that the source of Russia's current problems lies largely in the "failure to drive ahead with reforms after the 1996 elections, when powerful vested interests strengthened their hold on political and economic power, deepening corruption". What is needed is not a fundamental change in reform strategy, but a decision by the political authorities "to renew reforms and improve governance." Evidence from CEE and Baltic countries, summarized earlier, suggests that once a commitment to reform takes root, capital returns to the country, providing a basis for sustained growth.¹³

Can the power of vested interests be overcome? Havrylyshyn and Odling-Smee hold out hope.¹⁴ The vested interests themselves might become willing to accept reforms if they decide that their future profits would be higher in an economy in "which property rights are protected and the rule of law obtains, rather than one ruled by lawlessness, like much of the CIS today. Such a shift from predator to conserver has been seen in market economies ...". Change could also come through the emergence of a strong leader willing to take on the vested interests, or from the political clout of a growing middle class, or pressure from foreign competitors and international financial institutions.

VIII.  A Summing-up

The transition has yielded notable successes. Though the focus of this brief has been on economic developments, the first major achievement is the widespread, though far from universal, commitment to democracy and to the establishment of a market-based economy. The transition to a market economy has been associated with increased political freedom in most countries. All but six of the countries are classified as "free" or "partly free" by the human rights organization Freedom House; periodic elections in these countries have served to give citizens a voice in the transition process. Politicians advocating a retreat from the path to a market economy have never captured power, though unreformed Communist parties have on occasion captured as much as a third of the popular vote.¹⁵ It appears, therefore, that despite the economic hardships imposed by the transition, citizens have viewed turning back the clock as a worse outcome.

Second, a commitment to macroeconomic stability appears to have taken hold, with inflation brought under control in most cases. An example of this is Russia's determination to prevent an inflationary spiral in the aftermath of the ruble's devaluation in 1998.

Third, many of the basic structural underpinnings of market economies have been put in place in most countries, at least in a de jure sense. These include bankruptcy procedures, competition policy and anti-monopoly regulations, improvements in accounting standards, and legislation for regulating financial markets.

In the countries of Central Europe and the Baltics, commitment to macroeconomic stabilization came sooner and implementation of structural reforms was firmer. These countries have re-joined the ranks of middle-income countries and can claim to have transitioned. These countries now face the challenges posed by accession to the EU, and, more generally, by the process of catching-up with the richer nations.

The mainstream view is that Russia and other countries of the CIS can and ought to follow a similar path, but there is increased appreciation of the difficulties of institution-building and of the power of vested interests to derail the process of reform in the interim.