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Future Development

Taking Stock of Transition: Enduring Lessons 25 Years Later

Brian Pinto

Enduring economic lessons have emerged from the transition in Central and Eastern Europe, not simply because certain things happened in defiance of the prevailing conventional wisdom, but because the insights have stood the test of time. I shall take privatization and stabilization as two prime examples, illustrated by events in Poland and Russia that I had the benefit of witnessing first hand. (I lived in Poland from 1990-1992 and in Russia from 1998-2001 as the economist for the World Bank.)

Privatization and Poland

Poland had serious macroeconomic challenges when its transition began: an external debt overhang, hyperinflation in the months leading up to January 1990, and a high black market premium on foreign exchange. But as I discuss in chapter 4 of my book How Does My Country Grow, these problems had been encountered elsewhere, especially in Latin America, with mixed results from various orthodox and heterodox policies. The big unknown was whether state enterprises in Poland would adapt. Failure would have had disastrous macroeconomic consequences because the state manufacturing sector accounted for 30 percent of GDP, 19 percent of employment, 85 percent of exports and 60 percent of fiscal revenues.

The prevailing wisdom was to encourage privatization as per this quote from David Lipton and Jeffrey Sachs: “Most important, Poland must begin a rapid process of privatization of state firms, not only to assure efficient resource use in the future, but to prevent the collapse of the stabilization itself in the medium term.”

But privatization of the large state-owned enterprises got mired in politics, and early analysis conducted by Roman Frydman and Stan Wellisz supported the misgivings of Lipton and Sachs: state-owned enterprises (SOEs) seemed incapable of coping with positive real interest rates on bank loans and competition from imports, while exhibiting a predisposition to decapitalize via asset sales and letting wages rise at the expense of profits. This only underlined the urgency of rapid privatization.

Yet, the fears, while reasonable a priori, proved unjustified. Even before they were privatized, large SOEs were in the forefront of Poland’s economic recovery, which began towards the end of 1991 and has been sustained to date. An enterprise-level investigation revealed three main reasons: uncompromising hard budgets, with credible signals from the Ministry of Finance that an enterprise had to make it on its own or go bust; competition from imports, which compressed profit margins and forced efficiency; and SOE directors’ desire to signal their managerial abilities in conjunction with their expectation that privatization, albeit delayed, was inevitable. There was a fourth factor: the switch to a flexible exchange rate 17 months after the transition began, which prevented a large real appreciation.

Poland’s experience was quite different from the mass privatization experiences of the Czech Republic and Russia, in which asset stripping rather than higher efficiency became the norm (see Tomas Richter’s 2011 article, Tunneling: The Effect—And The Cause—of Bad Corporate Law). A clear lesson emerges. Privatization will deliver the goods only if combined with hard budgets and competition.

Russia’s Failed 1998 Stabilization

Now let’s take Russia. Its 1998 exchange rate-sovereign debt-banking crisis occurred just a few months after achieving single-digit inflation. This was a surprise if you believed, as many influential economists then did, that lowering inflation in the transition countries along with privatization was sufficient to get growth going. But it was not a surprise if you realized that squeezing inflation out without hardening budgets for the government and privatized enterprises generated two consequences. It pushed real interest rates sky-high and it destroyed the microfoundations for growth by channelling managerial ingenuity into stripping assets instead of restructuring enterprises. Asset stripping happened because the economy was rife with subsidies, explicit and implicit, with plentiful opportunities for personal enrichment in the opaque system of barter, arrears, and noncash settlements that developed. Eventually, subsidies, tax arrears, high real interest rates and vanishing growth prospects led to default and devaluation in August 1998.

In another surprise, Russia rebounded considerably faster than predicted. The suspension of government access to the capital markets finally compelled it to harden budgets by dismantling the costly subsidy system while firms benefited from the massive real depreciation.

Policy Conclusions from the Russian and Polish Experiences

What can we learn from Poland and Russia’s transition experience? First, there is nothing purely macroeconomic, not even macroeconomic stabilization! Instead, inflation and growth outcomes are determined by an acute interdependence between the microfoundations of growth and the government’s budget constraint. Second, the contrasting transition experiences of Poland and Russia suggest that policies of hard budgets, competition and competitive real exchange rates (the underpinnings of strong microfoundations) will go a long way towards macroeconomic goals of faster growth and sustainable public debt as a by-product. This will facilitate catch-up growth. One does not need to fine-tune policies to focus on a particular sector like manufacturing, contra Rodrik’s plug for proactive industrial policy.

As the Russian economy struggles again to deal with sanctions and low oil prices, keep your eyes focused on the trio of hard budgets, product market competition and competitive real exchange rates. This is the biggest lesson from transition.

Author

B

Brian Pinto

Adviser - African Development Fund Policy Innovation Lab

This blog was first launched in September 2013 by the World Bank in an effort to hold governments more accountable to poor people and offer solutions to the most prominent development challenges. Continuing this goal, Future Development was re-launched in January 2015 at brookings.edu.

For archived content, visit worldbank.org »

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