The transition countries also display sharp contrasts in performance. Those that are the most advanced in the transformation process are now reaping the rewards of comprehensive reform and stabilization policies pursued with determination over several years. These include Poland, the Baltic countries, Croatia, the Czech Republic, Hungary, the Slovak Republic, and Slovenia. Most of these are experiencing relatively robust economic growth, moderate inflation, and promising progress in their reintegration into the world economic and financial system. In fact, several are now experiencing some of the policy challenges that come with successful reforms, including the need to manage large capital inflows, contain the associated external current account deficits, and deal with other signs of overheating. These problems can best be addressed by pursuing strong stabilization policies and continued structural reforms, including privatization and financial market reforms.

Those that are less advanced in the transition are struggling with a number of policy challenges. Several have made good progress, and in Armenia, Azerbaijan, Georgia, Kazakstan and the Kyrgyz Republic, inflation fell considerably and growth picked up in 1996 with prospects of continued expansion in 1997. In Russia and Ukraine, inflation has also fallen, but a clear turnaround in output has yet to emerge. All of these countries need to consolidate progress with stabilization, including by reforming tax systems, improving revenue performance, redefining public expenditure priorities, and dealing with the pervasive problems of arrears and nonpayment. Greater progress is also generally needed in structural reform, especially privatization, the establishment of market-based institutions, and the strengthening of property rights. Many of these countries also need to deal with fragile banking systems. Measures to address Bulgaria's serious financial crisis are now being implemented in the context of a stabilization program supported by the IMF.

The reintegration of the transition countries into the global economy through trade and financial flows is critical for the success of the transformation process. At the same time, reintegration is bound to take time. Most progress has been made in the liberalization of trade and payments arrangements, which has been reflected in a marked reorientation of trade flows. However, there has been considerable variation across countries in the pace and extent of trade liberalization, and in the ability to take advantage of new market opportunities. Progress in financial market integration is necessarily less far advanced and will require the establishment of a stable, investor-friendly environment. Even so, foreign direct investment already plays an important role in the most advanced transition countries and private portfolio inflows have also increased sharply in a number of cases.

Financial market integration provides both challenges and benefits for the transition countries. Increased financial linkages with the world economy tend to amplify the effects of sound policies by promoting capital inflows and lower interest rates. These benefits can be misused: a country may borrow more merely to increase consumption. But if there is such a lack of self-discipline in policies, open financial markets will eventually impose their own discipline, possibly at considerable cost. This threat should help promote necessary policy changes. Capital inflows also allow the countries in transition to sustain the high levels of investment needed to revitalize industries and replace obsolete capital equipment. At the same time, it needs to be recognized that large-scale capital inflows can complicate macroeconomic management and that there is a need to guard against excessive external current account deficits and changes in investor sentiment. Because of such concerns, liberalization of capital account transactions is likely to be gradual and will depend on progress in other areas.