The Socialist Legacy 2 Traditional Central Planning 2 Reform Socialism 3

P O L I C Y A N D R E S E A R C H S E R I E S 17 9896 Public Disclosure Authorized

THE TRANSFORMATIONOF ECONOMIESIN CENTRAL AND EASTERNEUROPE Issues, Progress, and Prospects Public Disclosure Authorized

ALAN H. GFLB AND CHERYL W. GRAY Public Disclosure Authorized

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PRS1 Adjustment Lending: An Evaluation of Ten Years of Experience Country Economics Department

PRS2 Tax Policy in Sub-Saharan Africa: A Framework for Analysis Zmarak Shalizi Lyn Squire

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THE TRANSFORMATION OF ECONOMIES IN CENTRAL AND EASTERN EUROPE

ISSUES, PROGRESS, AND PROSPECrS

ALANH. GELB CHERYLW. GRAY CouNrRy EcoNoMIcsDEPARTMENT

The World Bank Washington,D.C. Copyright i) 1991 The World Bank 1818 H Street, NW Washington, DC 20433,USA

Papers in the Policy and Research Series present results of policy analysis and research to encourage discussion and comment. To disseminate the findings with the least possible delay, the text has not been edited as would be appropriate to more formal publications, and the World Bank accepts no responsibility for errors. Citation and the use of such a paper should take account of its provisional character. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent.

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Alan Gelb is division chief and Cheryl Gray is a senior economist in the Socialist Economies Reform Unit, Country Economics Department, World Bank.

ISSN 1013-3429

Library of Congress Cataloging-in-Publication Data

Gelb, Alan H. The transformation of economies in Central and Eastern Europe: issues, progress, and prospects/Alan H. Gelb, Cheryl W. Gray. p. cm. - (Policy and research series. ISSN 1013-3429;17) Includes bibliographical references. ISBN0-8213-1870-5 1. Europe, Eastern-Economic policy. 2. Europe, Eastem-Economic conditions-1989-. 3. Mixed economy-Europe, Eastern. 4. Central Europe-Economic policy. 5. Central Europe-Economic conditions. 6. Mixed economy-Central Europe. I. Gray, Cheryl Williamson. 1954-. II. Title. III. Series: Policy and research series: 17. HC244.G367 1991 338.943-dc2O 91-20189 CIP Tableof contents

Introduction 1

1 The socialist legacy 2 Traditional central planning 2 Reform socialism 3

2 The task of economic transformation 6

The elements of transformation 7 The current stage of system transformation 8

3 Preliminary lessons of experience 11 The political dimension 11 The phasing of reforms 12 Macroeconomnicreforms 12 Intemal balance 12 External balance 15 The costs of stabilization 15 The interaction of stabilization and system transformation 17 Price and market reform 17 The market for goods 17 Intemational trade 18 The market for labor 19 Financial markets 19 Private sector development, privatization, and enterprise restructuring 20 New investment 20 Privatization 21 Restructuring 23 The role of the state 24 Institutional reform 24 The legal framework 25 Fiscal reform 26 The social safety net and social services 26

4 Conclusion The challenge to industrialized countries 29

.... Annexes 33

1 Reform of the trade and payments system 34 2 Privatization of state enterprises 39 3 Agriculture 42 4 Financial system reform 45 5 Fiscal policy 49 6 Income distribution, poverty, and sociallsafety nets 53 7 The World Bank Group's support for economic transformation in Central and Eastern Europe 56

Tables 1 Economic indicators for CEE countries, for selected years, 1970-91 4 2 Social indicators for selected countries, in the 1980s 5 3 Economic elements of system transforrnation 9 Figures 1 Growth in per capita output in Central and Eastern Europe, 1990-2000 7 2 Phasing of reform over a 10-year period 13 Boxes 1 Points of debate on phasing 14 2 Economic developments in east Germany after economic union 16 3 Issues in housing reform 18 4 World Bank support for private sector development: The example of Hungary 20 5 Enterprise privatization in east Germany 22 6 China's economic reform 24 7 Cleaning up the environment in CEE countries 25 8 The key ro e of pensions in economic reform 27 9 How tfie World Bank's first Structural Adjustment Loan supports system reform in Poland 30 Annex tables 1.1 Structural dependence in the CMEA 35 1.2 Convertible currency trade indicators for CEE countries, 1988-90 37 1.3 Estimates of Soviet subsidies through itheCMEA 38 2.1 State-owned sector as share of value-added in selected countries, in the mid-1980s 39 3.1 Per capita average food consumption, 1985 43 6.1 Gini coefficients for selected countries and regions 53 7.1 Status of Bank Group operations in Hungary 58 7.2 Status of Bank Group operations in Poland 60 7.3 Status of Bank Group operations in Yugoslavia 61 7.4 Selected cofinancing operations 64 Annex figure 5.1 Consolidated government expenditures in Eastern Europe as share of GDP, 1982-90 50

Annex box 2.1 A recent privatization plan for Poland 41 Endnotes 65 References 72

iv Acknowledgments

We would like to thank the followingpeople for their in-depth contributions:Martin Schrenk (annex 1), Karen Brooks(annex 2), BrankoMilanovic (annexes 3, 5, and 6), and Millard Long and SilviaSagari (annex 4). Annex 7 was prepared by Country DepartmentIV, Europe, Middle East, and North Africa Region,with input from the InternationalFinance Corporation's Department of Investments,Europe.

Produced at the PREDissemination Center

Introduction

ThecountriesofCentralandEasternEurope(CEE)l issues that have arisen and lessons of experience are now in the midst of a unique and historic to date in the transformation process. Six annexes transformation. Having replaced authoritarian explore selected topics - trade, privatization, regimes with pluralist democracies, they are in- agriculture, the financial sector, fiscal policy, and tentonmovingrapidlyfrommoreorlesscentrally poverty and social safety nets- in greater depth. planned socialist economies to largely private Annex 7 summarizes World Bank Group activi- market economies. The road is perilous - eco- ties in the CEE countries. While the entire paper nomicallyandpolitically-andlargelyuntrodden, draws heavily on the extensive experience of the although many individual elements of reform World Bank Group in the CEE countries, the pa- have been confronted before in other countries. per is intended to look "outward" to the chal- Still-fragile political systems must address the lenges facing the countries rather than look "in- challenges of complex economic and institutional ward" to assess the World Bank's role. Although reformsinanexternalenvironmentmoredifficult the emphasis is on the countries of Central and thanoriginallyenvisagedand,insomecases,amid Eastern Europe, other experiences are cited where rising ethnic and regional tensions. Widespread appropriate. Any conclusions must be regarded initial euphoria after political transitions in 1989 as tentative, because post-socialist system trans- has been replaced by a more sober assessment of formations are still at an early stage and many the task ahead. important issues remain unresolved. Neverthe- This paper first reviews the legacies of the pre- less, experience to date, especially in the more vious economic systems and analyzes the task of advanced reformers, does provide insights useful transformation toward aprivatemarket economy. in designing policies and assessing prospects for Against this backdrop, it then surveys important the future.

1 __~1,

The socialistlegacy

The current configuration of Central and Eastern Traditional central planning Europe emerged in the aftermath of World War I, which saw the collapse of the German, Hapsburg, In theory, central planning was a top-down pro- Czarist,and Ottoman empires. Theinterwar;years cess whereby detailed physical plans for state were a period of considerable economic turbu- enterprises were formulated at the center, typi- lence for much of the region, which needed exten- cally by the state planning commission, to allocate sive reconstruction and suffered terms-of-trade inputs and outputs to their various uses. In prac- shocks with the onset of the Great Depression. tice, however, the center invariably had less infor- Except for Czechoslovakia, the countries had a mationthantheenterprisesaboutproductionpos- largely agrarian economic structure (particularly sibilities; thus there resulted a hierarchical bar- in the Balkans, where agriculture generated over gainingprocessinvolvingcentralandbranchn-n- half of output on average), and incomes per capita istries and state enterprises. To facilitate control, were well below those in much of Western Eu- production and employment were concentrated rope.2 The region traded mostly with Western in large firms with highly oligopolistic or mo- Europe, in particular Germany. nopolistic market structures. WorldWarIIimposedenormouslossesofpopu- These systems relied little on markets, which, lation, infrastructure, and equipment on mrostof where present, were highlydistorted. Enterprises the countries, and Hungary was the only one to emphasized plan fulfillment rather than profit- return to its prewar territorial status. Communist ability. Product markets were distorted by perva- parties achieved dominance under the influence sive production, price, and trade controls that of the USSR, and the economies of Central and effectively insulated domestic prices from inter- Eastern Europe were reorganized along the lines national ones. Asset and capital markets were of the centrally planned Soviet economic system. almost nonexistent, with financial flows respond- By 1950,this process was largely completed, pri- ing passively to the demands of the plan. Labor vate sector activities had been marginalized, and markets were distorted by narrow administered almost the entire means of production hadl come wage structures and the prohibition of dismissals, under state ownership. Remaining private activi- so that labor movements only partially responded ties were small-scale, and agriculture was wridely to market scarcities. collectivized everywhere except Poland and Yu- Despite planners' desires to promote efficiency goslavia. In most countries, housing was the and productivity growth, the incentive frame- major private asset other than financial savings, work of central planning was in fact inimical to although private rental of housing was illegal. both. Growth was "extensive," relying on forced

2 savings and high investment levels. Severely dis- and little income from property, real incomnes torted input and output prices divorced resource were relatively equally distributed in the socialist use from resource costs. Plans overemphasized economies. Education and health levels were low heavy industry and energy sectors at the expense compared with industrial countriesbut quite high of consumer goods and services, and subsidized compared with middle-income countries (table prices encouraged the overconsumption of their 2). Extensive mnaternityand child-care benefits products. Distorted price structuresweresustain- facilitated high female participation in the labor able because of the relative autarkyof these econo- force. While housing appeared inadequate by the mies within their protected Council for Mutual standards of industrial countries, these countries Economic Assistance (CMEA) market.3 Com- avoided theurbanpovertyandhomelessnessseen pressed and arbitrary wage structures, job secu- in many market economies at similar income lev- rity, and extensive in-kind benefits poorly linked els. Nevertheless,socialindicatorsimprovedmore to productivity inhibited worker motivation. Yet slowly in the CEE countries over the past three withno "bottomline,"nmanagerstypicallyhoarded decades than in most comparable market econo- labor (as all other inputs) at the firm level, so that mies, and in recent years some may actually have open unemployment was negligible. Managers deteriorated. Forexample, from the early 1960sto and workers had few incentives for process or 1990 the (unweighted) average of life expectancy product innovation, resulting in slow technologi- at birth rose in the CEE countries from 68 to 71; calprogress. Finally,opendiscriminationagainst, during the same period it rose on average from 71 if not prohibition of, private activity inhibited to 76 in five industrial country comparators and entrepreneurship. Small firms were relatively from 59 to 67 in upper-mniddle-income compara- few, and entry and exit of firms rare; the planned tors. economy lacked the "creative destruction" char- Finally, a very important part of the planning acteristic of dynamic market systems. As a result legacy common to all countries was the absence or of these factors, the planned economies experi- weakness of core market-oriented institutions, enced abroad secular decline both in competitive- both inside and outside of government. Legal and ness (as evidenced in part by declining exports, accounting institutions were weak, standards did particularly of manufactured goods, to industrial not conform to those generally accepted in market countries) and in the growth of their net material economies, and there was no tradition of indepen- product (NMP), from a reported 9.6 percent in the dent audit. Enterprises were profoundly shaped recovery period of the 1950sto 6.7 percent in the by planning; for example, they lacked marketing 1960sand 5.2 percent in the 1970s. Growth rates and strategic planning capabilities and effective continued to fall in the 1980s,as shown in table 1. inventory controls, and they had little informa- Economic policies also undervalued natural tion on the relative profitability of the various resources and placed little value on environmen- products they were ordered to produce. CEE tal safeguards, which contributed to serious envi- governments had little expertise in indirect regu- ronmental degradation. The emphasis on heavy latory instruments, such as monetary policy, taxa- industry and low energy prices resulted in a level tion, competition policies, and the prudential su- of energy use per dollar of national income two to pervision of financial institutions. Without such three times that of market economies at compa- instruments, macroeconomic balance essentially rable income levels, and over three times that of rested on the sum of many microeconomic deci- Western Europe. Much of the energy was derived sions. from highly polluting and environmentally dan- gerous sources; for example, coal (much of it low- Reform socialism quality) accounted for more than 80 percent of Poland's primary energy use in the 1980s, com- A major impetus behind reforms within socialist pared with less than 25 percent in industrial coun- systems was the slowdown in growth. Some tries. Water use and water pollution in the CEE "reforms" aimed merely to improve the planning countries were also high compared with those of process by streamlining the bureaucracy, but oth- market economies. ers recognized the serious deficiencies in the ver- With full employment, narrow wage and pen- tical information flows required for planning and sion differentials, heavy subsidies on basic goods, attempted to decentralize decisionmaking and

3 Table 1 Economic indicators for CEE countries, for selected years, 1970-91

CDP Growthrates CurmntaccountlGDP (billion of (Percent) Inflation (convertiblecurrency) Exenl debtIGDP dollars) NMP CDP (prcent) (percent) (convertiblecurrency)

Country 1990 1970-80 1980-88 1989 1990 1989 1990 1989 1990 19 91 b 1990

Bulgaria 22A 7.0 4.4 -1.4 -10.2 6.3 100.0 -6.4 -2.7 -8.9 402 Czechoslavakia 465 4.7 2.0 1.3 -3.5 1.3 139 0.9 -1.0 -5.1 165 Hungary 32.1 4.5 1.3 -0.9 -6.5 18.0 30.0 -4.9 -0.2 -3.7 62.2 Poland 623 5.4 1.0 -0.5 -14.0 640.0 249.0 -2.7 -2.5 -4.0c 74.3c Romania 355 9.3 4.7 -5.8 -10.2 2.5 - 5.4 -3.9 -4.8 5.6 Yugoslavia 589 5.7 0.4 -7.2 -7.2 2,823.1 118.6 3.2 -1.9 -1.2 27.6 a. Official statistics in the past are believed to have overesthnated growth rates. Output statistics for 1990 may be biased downward due to the failure fully to indude the smaU but growing private sector. b. 1991 projected current account as a share of 1990 GDP. c. Does not indude effectof Paris Club debt relief. Souuc World Bank data. replace some of the command system with mar- discipline was therefore weak. Pervasive short- ket-oriented incentives. Yugoslavia decentral- age persisted and reduced the incentives for firms ized decisionmaking with worker self-manage- to raise product quality and service. Incentives to ment and relatively few price controls in the mid- innovate were weak, and technology levels fell 1950s. Hungary (after 1968) and Poland (in the farther behind those of the industrial countries. 8 1980s) also substantially decentralized decision- Rather than being clarified, property rights be- making concerning production and investment, came obscured as some of the prerogatives of albeit with more extensive price intervention. ownership were decentralized to managers and While reforms in Hungary and Poland iinitially workers. An important lesson to emerge from this delegated control toenterprise management, some phase of "market socialism" is that increasing degree of worker control via enterprise councils autonomy without making real reforms to define eventually evolved in about 70 percent of larger ownership rights, increase competition, and en- industrial firms. Bulgaria, the CSFR, and Roma- force financial discipline will have only limited nia maintained stronger central controls, as did success. the GDR. At the same time, these reforms exacerbated The major lessons of reform socialism in Cen- macroeconomic imbalances. Imbalances are more tral and Eastern Europe were negative.' Efforts to likely to occur in a decentralized socialist system increase efficiency and productivity through de- inwhichenterpriseshavemoreautonomytospend centralization and heavier reliance on mnarket without market-based accountability, and gov- forces met with onlylimited success in the absence ernments tend to accommodate with monetary of ownership reform or capital markets. Failure to expansion to avoid unemployment. Internal im- dismantle the traditional bureaucracy reinforced balance can result in either open or repressed the reluctance of the authorities to abdicalte their inflation (the latter associated with the emergence influence on microeconomicdecisionmaking. "In- of a "monetary overhang" depending on the ex- direct" regulation of firm behavior continued, tent and firmness of price controls).9 Poland and through the selection of managers, price controls, Yugoslavia embarked on their post-socialist re- and highly selective fiscal and credit policies that forms with the most severe open internal imbal- resulted from continued hierarchical bargaining. ances, as evidenced by inflation rates of 640 and Profits were redistributed between firms to pre- 2,800percent, respectively, in 1989. An underly- serve existing jobs7 and protect firms from exit. ing cause of inflation in both cases was the subsi- Pre-and post-redistribution profits were essen- dization of loss-making enterprises, in Poland tially unrelated, and the incentive for financial through the banking system and the budget (lead-

4 Table 2 Social indicators for selected countries, in the 1980s (mostrecent estimates)

AU upper- Cacho- Yugo- middle- Fed.Rep. of United Indiator Bulga sova Hungary Poland Romtnia slavis inwmea Austria France Spain Germany Kingdom

Populationb 9.0 15.7 10.6 37.8 23.1 23.7 4243 7.6 56.1 38.8 62.0 572

Labor force participation ratec Total na. 789 72.4 78D 79.6 55.8 n.a. 659 65.8 54.7 67.2 72.0

Female na. 73.6 61.7 70.6 na 429 na. 515 50.0 26.7 503 54.1

Health care Infant mortality rated 15.0 13.1 17.0 175 25.0 25A 469 9.9 7.6 10.0 83 9.1 Early 1960s 30.8 255 38.8 41.7 44.1 71.8 101.1 283 219 37.8 23.8 19.6 Life expectancy (years) 72.1 712 702 71.4 70.2 713 67.2 74.1 772 76.6 74.8 752 Early 1960s 69.4 68.7 695 693 67.8 65.8 58. 69.6 713 709 70.2 71.1

Education Primary educatione 103.0 100.9 98.0 101.0 97.0 87.0 1035 100.0 112.0 101.0 97.0 106.0 Secondary education' 100.0 815 70.0 80D 76.0 82.0 57.8 79.0 95.0 98.0 72.0 85D a. Indudes upper-ridddle-income countries in Europe, the Middle East~and North Africa region with per capita income levels comparable to those in Eastern Europe. b. 1989 estimates, millions. c. Ratio of the economicallyactive population (employed plus unemployed) to the worldng-age population (between 15 and 65 years). The estimates represent early to mid-1980s. d. Per thousand live births. e. Percentage of school-agegroup. Sowcf World Bank (1990)and World Bank data; IMF (1991). ingtoabudgetdeficitof8percentof GNPin 1989) evidenced by high foreign debt, were most pro- and in Yugoslavia through the banking system. nounced in Poland, Hungary, and Bulgaria (an- Polishinflationwasexacerbatedbysharpincreases nex 1, table 1.2). in controlled prices in late 1989. Hungary avoided The limited success of experiments with "mar- high inflation through somewhat tighter ket socialism" and the growing macroeconomic macroeconomic management, heavier reliance on imbalances they created helped to push CEE gov- price controls, and continued access to external ernments in the new direction of post-socialist finance;itsinflationratewasaround 10-20percent reform.'0 The experience with "market socialism" in the late 1980s. The CSFR,Bulgaria, and Roma- complicates current reform efforts because of the nia adopted fewer reforms toward "market social- pressures of vested interests, particularly those of ism" and maintained even more extensive price worker-managers. However, it also provides the controls. Major macroeconomic imbalances did advantage of greater familiarity with market pro- not arisein the CSFR;Bulgaria and Romania expe- cesses, including more extensive international rienced some degree of repressed inflation. On trade with market economies. the external front, macroeconomic imbalances, as

5 2

The task of economictransformation

Levels of income and physical and human capital racy, however, most observers believe that the fall differed considerably among CEE countries at the in output in 1990 was precipitous. Price levels beginning of the process of transformation to free increased in those countries where inflation had market economies in 1989 (table 1). Relative levels formerly been low, partly because of price liberal- were not much different from those in 1937 (see ization and cuts in subsidies; for example, in Hun- endnote 2)except forYugoslavia, which irmproved gary prices rose by 30 percent in 1990, up from 10 its position. Income estimates confront rriethod- percent in 1987. While the current account posi- ological difficulties, but GNP per capita in Central tion improved in some countries, the external and Eastern Europe is above that of Latin America environment for trade and capital flows has wors- and farbelow that of Western Europe. Purchasing ened recently, as discussed in the section on price power per capita in the CSFR is estimated at two and market reform and in annex 1. The initial to three times that in Romania, with other coun- years of the post-socialist transition are therefore tries falling in between." Physical infrastbructure ones of economic crisis for the CEE region. is better in the richer countries, particularly the The growth prospects for the CEE countries CSFR and Hungary, but much capital is either depend on several factors - the consistency with deteriorated or obsolete. Human capital endow- which they pursue their reform programs, the ments, when measured in education and skill impact of exogenous developments (including levels, are also higher in the richer couintries. the end of the CMEA trading system, discussed Romania appears to be the most lacking in both furtherin the section onprice andmarketreform), physical and human infrastructure. and the response of the industrialized countries in As shown in table 1, the persistent slow,dlownin providing technical assistance, finance (including growth that has marked the last two decades debt relief for some countries) and an open trad- sharpened in 1989, with GDP falling in all of the ing environment (see chapter 4). Recovery and CEE countries except the CSFR and inflation ris- growth are expected to be quite slow in the near ing to high levels in Poland and Yugoslavia. Offi- term because of the fundamental systemic and cial measures of outputcontracted furtherin 1990, institutional changes needed. In figure 1, the with GDP falling in all CEE countries and Poland, middle line shows the projected evolution of per Bulgaria, and Romania suffering declines of over capita output averaged for the six CEE countries 10 percent. It is important to note that these over the decade 1990-2000.12Following the sharp official measures may overstate the drop in out- drop in 1990, it is projected to decline further in put somewhat because they do not fully account 1991 and stay level in 1992 before the recovery for the vibrant growth in private sector activity, begins in 1993. Growth in per capita output is albeit from a small base. Despite the data inaccu- expected to improve to 3-4 percent in the second

6 Figure 1 Growth in per capita output This partly reflectsthe time needed to reestablish in Central and Eastem Europe, 1990-2000 market-based institutions and build the associated skill base.But it also reflectsinherent limits 3.2 on investmentcapacity. Enormousinvestments 3.1 are needed to rehabilitate, modernize, restruc- 3.0 North ture, and augment physical capital stocks in the 2.8 CEE countries, especiallyconsidering the pros- | 72.8 pz pect of major changesin trading patterns with the 267 All demise of the CMEA. Mostanalysis done to date o 2.6 **, suggests thataspeedier transition(say, over 10-15 2.4 .01solo years)would requireannual investmentsfarabove 2.3 . SoutX_X_ feasiblelevelsin termsof eitherresource availabil- 2.2 .j x-X X-X ity (discussed in chapter 4) or absorptive capacity 2.1 . IX-XX of these economies.4 2.0oSecond, systemreforms are unlikelyto proceed 1990 1992 1994 1996 1998 2000 smoothly,especially consideringtheir complex- Sourcr Officialcountry data and WorldBank projections. Note the ity and highly politicalnature. Setbackscan be data limitationsindicated in the text. expected and should not be prematurely inter- preted as failureof the entire reform process. It half of the decade, as the countries recover from will be important in the years ahead to maintain the disruptions of their current reform processes politicalwill, patience,and a long-termperspec- and as their economicefficiency and absorptive tive. capacityrise with restructuring.Output per capita is not projectedto attain its 1989level until late in The elements of transformation the decade; however, that market-determined output shouldbe achievedwith greaterefficiency All of the CEE countries have crossed a critical and associatedwith a higherlevel of socialwelfare hurdle-defining the ultimategoal of reform. All than the output of 1989. Despite unavoidable are now committed to changing their economnic short-termcosts, reforms set the stage for sustain- systemsto predominantlyprivate market econo- able growth in the medium and long run; without mies similar to those of Western Europe. The reform, the CEE economieswould continue to elements of such system transformationcan be stagnateinto the foreseeablefuture. grouped into four broad analyticalcategories, all The northern tier of countries - Hungary, of whichinteract stronglyin the process (table3) Poland,and theCSFR-is somewhatbetterplaced and all of which are being supported by Bank to take advantage of future opportunities for Group programs in the CEEcountries. The first growth becauseof the extensivereform measures concerns internal and external macroeconomic alreadyundertaken (particularlyin Hungaryand stabilization. This involvestightening fiscaland Poland)and generallybetter economic infrastruc- credit policiesfor governmentsand enterprises, ture. Figure 1 shows separateprojections for this andaddressingimbalancescreatedbyamonetary group and for the southerntier-Bulgaria, Roma- overhangor large bank losses. nia, and Yugoslavia. These projectionssuggest The second is the introductionof competitive that the incomegap between the north and south markets and attendant price reform. In the first is likely to widen considerablyover the next de- instance,price reform typically involvesdecon- cade. Whilethe north regainsits 1989level of per trolling and broadening markets for goods and capitaoutput by 1996,the southdoes not regain its services,which in tum requires a restructuring base levelby the year 2000.23 and demonopolizationof the trade and transport Two important general points emerge from sectors. The creation of factor markets, for both these projections. First,even under fairly favor- labor and financial resources, is also essential. able assumptionson externalfactors and domes- Reformof internationaltrade and payments sys- tic reforms,the period of catchup toward market tems is consideredan integralpart of pricereform economies with levels of income comparable to and competition policy."5 those of the industrial countries will almost cer- The third categoryof reform is enterprisere- tainly be measured in decades rather than years. formand restructuring. A first importantstep in

7 enterprise reform involves clarifying publicown- reformed its tax system extensively in 1988 and ership rights (and separating them from the regu- 1989,and Poland and Yugoslavia are planning to latory functions of government) and implement- do so soon. ing more effective control over the management In the other areas, reforms in these three coun- of existing firms, in part through widespread pri- tries are at an earlier stage. They have lifted vatization. Establishing secure private prolperty explicit restrictions on private activities, and this rights and facilitating the growth of new private has resulted in an impressive growth of small firms is also critical. Enterprise restructuring may private business. They have also progressed with involve breaking up large monopolies, removing small-scale privatizations; for example, in Poland or reassigning redundant labor, closingloss-mak- at least 50,000small shops have been privatized. ing operations and disposing of their assets, re- They have only begun to privatize larger enter- structuring balance sheets, or other actions aimed prises (see annex 2) and to undertake reforms in at improving the efficiency of existingenterprises. the agricultural sector (see annex 3). The Polish Finally, the fourth category of reform (closely government has privatized only five large enter- related to the others) involves reorienting the role prises through public offerings and several more of the state in the economy, away from direct through private placements, and the Hungarians ownership and control over production and to- are also proceeding on a relatively slow, case-by- ward an indirect regulatory role that promotes casebasis. Whilenumbersareuncertain, somel1- adjustment and private economic activity. This 15 percent of nonagricultural production might challenge has many dimensions. Privatization now be in private hands. will help reduce the role of govemment in direct Although progress has been made in revising production. Concurrent reforms are needed in the legal framework for enterprise activity, gov- the central institutions of government, including emments have not yet progressed far with enter- the central bank, tax administration, the expendi- prise restructuring. Some firms have taken such turebudget and control system, and policyma'king initiatives themselves, often through joint ven- bodies. Another important role for the state is to tures with foreign partners. The increasing num- redesign the social safety net to reduce the need ber of firms facing liquidation proceedings in all for enterprises to perform wider social functions, three countries suggests that financial discipline to make benefits "portable" to facilitate labor real- is beginning to take hold. However, restructuring location, and to cope with rising unemployment activities are not yet at the levels needed for struc- as firms become subject to greater financial disci- tural reforms in any of the three countries. As pline. The state also needs to provide a suitable discussed later and in annex 4, the pace of restruc- legal framework for collectivebargaining and pri- turing affects the pace for resolving the portfolio vate sector activity and to develop legal institu- problems of banks; the latter is thus still in the tions to implement and enforce it. early stages, although some aspects of banking and financial sector reform are well advanced, The current stage of system transformation particularlyinHungary. Unemploymenthasrisen to only moderate levels, and wage controls are still Poland, Hungary, and Yugoslavia were the first to needed pending enterprise reform. Effective fac- begin the transformation process and have gone tor markets are clearly some way off. quite far in the first two categories. In 1990, Activities to transform the role of the state have Poland and Yugoslavia embarked on drastic sta- intensified in these three countries over the past bilization programs that were particularly signifi- two years. They have made substantial progress cant because their methods also involved impor- in many areas of legislation and economic regula- tant elements of structural reforms. Hungary also tion and in reshaping public institutions. For implemented a determined stabilization connpat- example, all have set up privatization agencies, ible with a shift toward a private market economy. abolished or downgraded planning ministries, All three countries have liberalized most prcduct and instituted programs to address unemploy- prices. Trade reforms have complemented price ment. However, there are still many gaps, and liberalization,replacingquantitativecontrols with institutional capacity to implement the new legis- low to moderate tariffs and instituting current lation is severely constrained by the shortage of account convertibilityata unified exchange rate.16 experience and relevant skills. Programs to aug- To complement the shift to the market, Hungary ment the skill base (for example, by training bank

8 Table 3 Economic elements of system transformation

1. Macroeconomicstabilization 4nd controt Implementationof stabilizationprograms: Gvernment and enterprises: Fiscaltightening Tight credit policies Addressingexisting problems (money overhang, bank losses) Expenditure-switchingmeasures for externalbalance 2. Priceand market reform Goods and services:Domestic price reform Internationaltrade liberalization Distributionsystems (transport and marketingservices) Housingservices Labor: Liberalizingwages and labor market Finance: Bankingsystem reform Otherfinancial markets Interest rate reform

3. Privatesector development, privatization, and enterprise restructuring Facilitatingentry and exit of firms Enterprisegovernance Establishingprivate property rights Clarifyingand allocatingproperty rights: Agriculturalland Industrialcapital Housingstock and commercialreal estate Sectoraland enterpriserestructuring, including breakup of monopolies 4. Redefiningthe roleof the state Legalreforms: Constitutional,property, contract, banking, competition,and so on Reformof legalinstitutions Regulatoryframework for naturalmonopolies Informationsystems (accounting, auditing) Toolsand institutionsfor indirecteconomic management: Tax systemand administration Budgetingand expenditurecontrol Institutionsof indirectmonetary control Socialareas: Unemploymentinsurance Pension,disability Socialservices: health, education, and so on

supervisors and potential members of enterprise count transactions, and most international trade boardsin Poland) are under way but will take time wasliberalized. Legislation passed in 1990put the to have full effect. private sector on an equal legal footing with state The CSFR has recently taken several important enterprises, and the government has begun to steps toward system transformation and is now auction small shops to private owners. Like the about on par with the more advanced reformers in other three more advanced reformers, the CSFR theareas of macroeconomic stabilization and price has not moved as far in the latter two areas of and trade reform. It raised some food, transport, reform, but the government is actively reviewing and petroleumprices in 1990(withdirect compen- many options and is likely to take major steps in sation to consumers for the food price increases) 1991. and removed most price controls on January 1, Bulgaria and Romania began their transforma- 1991. Its currency was devalued for a second time tion processes more recently. Bulgaria took major in January and made convertible for current ac- steps in February 1991 to curb inflation (which

9 had risen from 6 percent in 1989 to about 60 outlinesofaprivatizationplanarebeingfinalized, percentin 1990)and promote structuralchange in and a privatizationlaw is expectedsoon to be sent the economy.It unified exchangerates and moved to Parliament.Significant privatization of agricul- to a floatingcurrency, liberalized most retail and tural land previouslyowned by cooperativeshas producer prices, adopted tight control on wages already taken place. The governments of both in the public sector,'7 and liberalizedmost foreign Romaniaand Bulgariaare stronglycommitted to trade (replacing quantitative restrictions with the reform process but still need to concentrate, moderate tariffs). The governmentis also taldng more than in the other CEEcountries, on consoli- importantsteps to redefineitsrole,in part through dating politicalreforms and gaining public sup- reforms in the budget and tax systems. Like the port for difficulteconomic measures. other CEEcountries, it has made less progress in The former GDR is undertaking many of the enterprise restructuringand privatization. same reformsas the others but with several sig- Romania has also undertaken significantre- nificantdifferences. Price reform was almostim- forms in the past few months.It freed many retail mediateupon creationof the economicand mon- and producer prices in November 1990and ad- etary union and subsequentunification with the justed many administeredprices upward in April Federal Republicof Germany (FRG),as was the 1991. It has ended foreigntrade monopoliesand change in the role of government. The country removed most quantitativerestrictions on trade, imported the FRG'slegal and regulatory frame- and it is expected to adopt a transitiondual ex- work, along with massivetechnical assistance to change rate mechanismas an intermediate step implementit. The inflow of skillsand financial toward a unified exchange rate. Like all ICEE assistance(estimated to amount to some $3,000 countries, it has removed restrictionson private per person per year) relaxessevere constraints on activitiesand is working hard to define an appro- the speed of reform.Nevertheless, enterprise pri- priate legalframework for privatesector activity. vatizationand restructuring,though proceeding Althoughlittle progress has been made with en- relativelyrapidly, promise to be a lengthy pro- terprise restructuringor privatization,the broad cess.

10 -~~

Preliminarylessons of experience

The political dimension run. The difficulty of carrying out political and economic liberalization simultaneously has been The events in Central and Eastem Europe are first noted in analyses of reform in other countries. In and foremost a historic political revolution, and the case of the CEE countries, proximity to West- the new political environment is still unsettled. It em Europe and the desire to integrate with it will is clear that the entire process of economic trans- help to set standards for both political and eco- formation depends crucially on political develop- nomic reform. ments. On the one hand, political legitimacy and Regional disputes over power sharing can fur- cohesion are clearly necessary for sustainable eco- ther threaten cohesion, compromise legitimacy, nomic transformation; for example, the major re- and impede the economic reform process. In the forms undertaken by the first elected Solidarity CSFR, the division of authority between the fed- government in Poland (with its relatively cohe- eration and the two republics over policymaking sive public support and strong legitimacy) con- and budgetary control is still unclear. The prob- trast sharply with the paucity of reforms in the lem is magnified in Yugoslavia and the USSR, USSR. But the complex and tumultuous process where reaching consensus on the political rela- of political change often constrains economic re- tions and distribution of power among the center form. Rather than setting out an optimal reform and republics is likely to be a prerequisite for path, economic analysts continually need to de- large-scale reforms and macroeconomic stability. velop feasible reforms that avoid moving into Regional disputes do not reflect lack of consensus politically driven dead ends. on economic policy as much as long-simmering Tension has emerged in most of the reformiing ethnic tensions that have become more open with countries between the strong central leadership political liberalization. needed to push through difficult reforms and the The difficulty of sustaining political and eco- broad participation and compromise needed to nomic reform will be exacerbated by the difficult ensure widespread support for the program. Cen- international economic environment faced by the tral executive authority has been discredited by CEE countries. Temporarily higher world oil past experience, and a new model of strong gov- prices, economic problems in the USSR,the trans- emmient with a legitimate role in a market system fornation of the CMEA trading system, and the has not yet emerged. In fact the pendulum in disruption of trade withIraq (a significant trading several countries is swinging in the opposite di- partner, especially for the CSFR and Bulgaria) rection, toward greater decentralization and au- have all placed extra strain on economies already tonomy for provincial and local governments; this burdened with the short-term costs of reform. The is likely to complicate reform efforts in the short public will find it difficult to separate the impact

11 of reform from the impact of these external shocks. It is widely agreed that mnacroeconomicstabili- The course of reform will not only depend on zation is a prerequisite for structural reforms, and political developments but may influence them. that it should be followed quickly (or concur- A crucial variable in this respect may be speed. rently) with price and trade reform (including Political pressures that tend to arise in the course current account convertibility) to enhance compe- of a "go slow" approach argue for as rapid a tition and promote foreign investment. Also fol- process as possible. "Shock therapy" as in Poland lowing quickly should be tax reform and the intro- institutes a large set of reforms before strong duction of a system of unemploymnentinsurance. opposition can coalesce,and possible resistance to Tax reform is needed to help maintain govern- reform by "old guard" managers and bureaucrats ment revenues while eliminating the ad hoc redis- is often cited as an argument for rapid enterprise tribution of profits that destroys enterprise incen- reform. While the high costs of rapid adjustment tives, while unemployment insurance (and more may cause political instability if a quick ancdde- general reform of the social safety net) offsets monstrable payoff is not forthcoming, a slower social and political pressures to slow down the approachalsohaspoliticalrisks. Failuretopursue reform process and contributes to its political reforms vigorously will be extremely costly in sustainability. Measures to encourage small pri- both economic and political terms. The experi- vate businesses and small-scale privatization can ence of other countries suggests that reforms may and should proceed rapidly,sinceagrowingssmall- be easier to undertake the worse the prereformn scale sector is needed to help free up the distribu- situation; this would argue that short-run costs tion system, offset the impact on employment of would be borne more readily in Poland than, say, restructuring the larger statefirms,and strengthen in the CSFR. One can only speculate on these domestic competition. Responsibility for corpo- issues at this point; it is still too early to gather rate governance should be clarified and strength- lessons from experience. ened as soon as possible. Restructuring and privatization of medium-sized and larger firms can The phasing of reforms begin early in the process but will take time, particularly for less viable firms. The same holds The task of system transformation differs consid- true for effective institutional, legal, and regula- erably from that of policy reform within an estab- tory reforms. While institutional and regulatory lished economic system. The issue of sequencing reform in the banking system start early, fuD of individual reforms withina broad system trans- financial liberalization requires the restructuring formationhasarousedextensivediscussion. Mlost of bank portfolios, which will typically accom- analysts now agree that, although country-spe- pany enterprise reform (annex 4). Similarly, the cific factors will influence the pattern of reforms, pace of wage liberalization is set by that of enter- some components must precede or occur in tan- prise reform, which is needed to insure adequate dem with others. It has also become increasingly controls on the wage-setting process. Finally, full clear that the components are tightly interlinked, convertibility of thecapital account can come later and that clearly articulating a long-term strategy in the reform process. A stylized phasing of and starting along many fronts is important from reforms along these lines, shown in figure 2, indi- thebeginning."BBecause some reforms take longer cates also the degree to which reforms need to be than others, tensions are inevitable. Certain re- carried out simultaneously on many fronts."' De- forms are only appropriate late in the process, bates concerning this pattern of phasing are dis- when market forces are well enough developed to cussed in box 1. In any case it is clear that no exact replace administrative controls. In any case, al- pattern is preordained; country-specific factors though early reforms may yield some immediate will clearly influence the exact course taken in any benefits (such as an increase in the availability of particular case. goods), rapid and sustainable economic growth should not be expected until many reforms are Macroeconomic reforms implemented on a significantly large scale, which is likely to take several years. All of these propo- Internal balance. The experiences of Poland and sitionsgain force from theindifferent performaknce Yugoslavia show that stabilization measures can of the CEE countries in their earlier phases of reduce inflation, at least in the short run. Poland's partial reform. monthly inflation during the six-month period

12 Figure 2 Phasing of reform over a 10-year period

Intense Continuing Macrostabilization _ Price and narket reform Goods and services: Most goods Some necessities (including housing) Price reform

Remove QRs Adjust tariffs to moderate levels Trade reform _ _umiinmims Privatization, demonopolization Distribution __U- UI--- I- Deregulate hiring and firing Liberalization of wage bargaining Labor market _ _

Preparation Implementation Autonomous banldng system __

Preparation Implementation Other financial markets

Restructuring and privatization

Small-scale privatizationand private sector development

Revise regulations Foreign investment Uarge-scale: Corporate ggovernance

From evaluation to implementation Restructuring and privatization

Redefining role of state Intensive (tax reform, basic property, and commercial law) Continuing (other) Legal reforms Tax administration, budgeting, legal, regulatory institutions Institutional reform Emergency Institutionalization Unemployment insurance _

Intensive Continuing Other social areas -__

Time (years) ------0 1 2 3 4 5 6 7 8 9 10

13 Box 1 Points of debate on phasing

While the phasing of reforms shown in figure 2 probably Should large- privatization be 'quick anddirty' or attracts the greatest consensus within and outside reform- slower andmore careful? ing countries (including within the Bank), there has been intensive debate on several points: Quick Rapid privatization is of utmost importance. It raises effidency, speeds restructuring, establishes a cxn- Should price reform come before or after enterprise re- stituency for further reforms, and weakens the traditional form? power centers opposing reform.

Before: Enterprise reform and privatization will not Slow Sales revenues are needed by the government, and succeed if the market cannot judge effidency and value preservingfairnessintheprocesuisvitalforpublicsupport; because prices do not reflect true costs; budgets cannot be thus restruchtring should precede privatization and firms "hardened" before introducing market prices. should not be given away hastily.

After: Freeing prices in the presence of monopolies will Must full-ale financial sector reform go hand-in-hand lead to excessive prices and profits, thereby undercutlting with enterprise reform or can it come earlier? political consensus for reform; domestic competition policy should be in place before price liberalization. Hand-in-hand. Competitive financial markets require clean loan portfolios, and enterprise reform and bank port- Should trade liberalization come early and fast or bater folio restructuring are best accomplished simuitaneously; and slower? cleaning up loan portfolios is futile without enterprise reform. Early: It supports price reform by importing the wvorld price structure and heightens competitive forces. Earlier Only independent financial institutions and liberalized finandal markets can play the critical role of Later: It shocks the economy, in the right directions but allocating capital as enterprises are restructured. with excessive costs, and is risky until the econorny is stabilized.

from March through August 1990 was aboult 4 many European countries after World War II); percent, compared to 30 percent in the last months some excessive balances can also be absorbed of 1989. Yugoslavia's inflation fell from 64 percent through the later sale of public assets. Germany in December 1989 to 10 percent for the entire!six- implemented a currency reform in 1990, when month period from March through August 1990.? wages and pensions denominated in East German As in market economies, internal stabilization in marks were converted 1:1 to Deutschmarks, and reforming socialist economies hinges on tight fis- most financial claims and liabilities were con- cal and credit policies. Yugoslavia maintained a verted 2:1. A currency reform may be preferable budget surplus and allowed no growth in the to high inflation if the latter is avoidable,' al- nominal stockof net domestic assetsof thecentral though high inflation may create a sense of ur- bank. Poland turned its budget deficit of 8 percent gency and thus a strong political consensus for of GNP in 1989into a surplus of over 5 percent in change. the first nine months of 1990 and kept credit ex- Socialist economies must also resort to admin- tremely tight in the first half of 1990through strict istrativecontrolswheremarketsarelacking. Wage limits on the nominal growth in net domestic controls in particular are needed in public enter- assets.2" prises because firms without active owners have In addition to tightening fiscal and monetary little built-in incentive for wage restraint. Indeed, flows, stabilization may also require defusing the those working in such firms may faceincentives to inflationary pressure of excessivestocks of money decapitalize them, particularly once reinvestment - the "monetary overhang." Excessive money in private activities is permitted. In January 1990, balances can be eroded through rapid inflation (as Poland implemented a high tax on any increase in in Poland) or reduced in nominal terms thrcugh the total nominal wage bill of an enterprise be- confiscatory currency reforms or blocking (as in yond a preset percentage&of the inflation rate in

14 thepreviousmonth,whileYugoslaviafrozenomi- and the possiblecollapse of the Sovietmarket due nal wages for sixmonths at the start of its stabili- to internal difficulties. These and other trade zation program. Early experience points to the shocksare discussedbelow and in annex 1. How pressures to raise nominal wages that will result to finance the current account deficits that are in the courseof stabilizationand that may derail expectedif growth is to resumeis among the most reformefforts. In Yugoslavia,for example,official criticalissuesfadngtheCEEcountries (seechapter 4). estimatesof real wages fell some 45 percent from Stabilizationmay also require addressing a November 1989 to February 1990 but rose 25 heavy overhang of domestic and external debt. percent in the three months after the nominal On the domesticside, the magnitudewill emerge wage freeze was lifted in June. The resulting in the courseof restructuringthebalance sheets of monetaryaccomnnodation, including renewed fi- the banking system and interenterprisecredits. nancing of enterprise losses, led to a jump in Various options for dealing with the domestic inflationin the third quarter of 1990. In the GDR, debt overhang exist,as discussedin annex 4. On the absence of effective wage restraint allowed theinternationalside,Poland,Bulgaria,andHun- negotiated wage settlements to rise by over 25 gary took on heavy foreign debt burdens in the percent in the summerof 1990,far out of line with 1970sand 1980s. Poland has recently benefited productivity. Officialestimates of real wages in from extensiveofficial debt relief,and Bulgaria Poland fell 47 percent in the first half of 1990 has suspended interest payments and is likelyto before rising somewhatin the secondhalf to end begin debt negotiations soon with commercial the year 30 percentdown. creditors. Yugoslaviahas actually reduced its debt burden significantlythrough debt buybacks, Extenal balance.On the externalfront, stabili- froma high of $21billion in 1987to $163billion by zation may well require devaluation (whetherto the end of 1990. A debt overhang raises uncer- a fixedor floatingexchange rate) to complement taintyand reducesadditional foreign capital flows. tight expenditure-reducingpolicies and trade lib- Continuedinternationalcooperationtoalleviatedebt eralization.Hungary's 1990stabilization included burdens is needed for some CEE countries (see a 15 percent devaluation of the forint in addition chapter4). to tight fiscal and monetary policy. Poland and Yugoslavia devalued sharply at the beginning of The costs of stabilization. Experience with 1990,Poland by 46 percent and Yugoslaviaby 20 stabilizationsto date (as accompaniedby adjust- percent, establishing fixed exchange rates that ment measures) suggests that a large short-run held as nominal anchors for their stabilization declineinoutput isunavoidable. Poland's official programsthroughout 19903V Theexperienceinall measure of output fell 14 percent in 1990,26 three countries shows that exports can increase Yugoslavia'sfell 3 percent,and Hungary's fell65 significantlyin response to such measures.,, In percent, with further declines expected in 1991 Hungary, convertible currency export volume (table1). Thishigh costof stabilization(combined grew by 10percent and the current account was with adjustment measures) results in part from virtually in balance in 1990(an improvementof the absence of effective factor markets, which some 5 percent of GDP over 1989). With a 37 prevents macroeconomicpressures from rapidly percent growth in export volume,Poland's trade being translated into efficiencyimprovements. surplus for 1990reached about $3 billion,in con- Officialdata miss part of the picture,however, trasttothe$800milliondeficitexpectedatthestart Whileofficial measures of output and real wages of the program. Yugoslavia'sexports grew rap- fell dramaticallyin 1990,these data do not fully idly in the first half of 1990but slowedthereafter account for the vibrant growth in private sector asinflationerodedtherealexchangerate.Imports activity,albeit from a smallbase. Furthermore,it grew even faster as a result of real exchangerate has been argued that the standard of livingof the appreciationduring 1990,leading to a deteriora- averagePole fell less than wage data would sug- tion in the current accountbalance from a surplus gestbecause price reform eliminatedqueues and of more than 3 percentof GDP in 1989to a deficit black markets. Govemments should make the of about 2 percent in 1990. costs of stabilizationclear from the beginning to The outlookfor trade and current accountbal- avoid unrealistic expectations,but they should ances is darkened by the costs expectedto result monitorthe economyclosely to avoid resultsbe- from the demise of the CMEAsystem as of 1991 ing painted blackerthan they actually are.2'

15 The level of the exchange rate affects both the costs of stabilization and the speed (and resulting Box 2 Economic developments in east short-term costs) of adjustment. Poland's experi- Germany after economic union ence shows that a large devaluation, while per- EaGermyunderwentthemostextrn bgbang" haps helpful in achieving external balance, may hs ecmonocunion with WestGermany on juy 1, raiseraise the short-term costs of stabilization whilewihtSeomcunnwthes while 1990.Prices were liberalized, the economy eraynlly1was opened slowing adjustment. A larger devaluation causes to internationalcompetition, a fixed 'exchangerate the real money supply to contract more sharply, wasinhtroduced, and factormarkets were created over- leading to a tighter credit squeeze and a larger ifall night.Theeconomicconsequencesof thesudden switch in total output. In addition, it reduces interna- to an openmarket economy were more severe than tionalcompetitionandleavesnmorescopeformod- expected.Consumers switched from east to westGer- erate inflation to continue to theextent thathealithy mangoods to a farlarger extent than anticipated. Indus- domestic firms monopolies-have -often room (eventrialproduction more in lightin east industry) Germany in 1990,slumped and is by expected 50percentto to raise prices. Some observers now believe ithat failevenmorein 1991. GDPdedinedbyanestimated20 Poland devalued too much in January 1990, a percentin 1990. The one-to-oneconversion of east lesson of experience that may prove useful to Germanto Deutschmarkwages combined with high (25 other CEE countries.23 Poland's 1990fall in output percentandmore)coflectivelynegotiatedwageincreases was much greater than expected and is attributed in the summer of 1990led to relativelyhigh unit labor in large part to the severity of the initial devalua- costs. This,combined with unclear property rights, poor tion and the subsequenttion ad the ubsequntcreditcreit crunchcruch thathat arosearoseinfrastructure, makes investment and uncertainin the region environmentaleven less attractive.liabfitbes, due to nonaccomodating monetary policy. Fur- GDPis expectedto dropa further15-20 percent in 1991. thermore, Poland has continued to experience Unemploymentrosesteadily to 750,000 (about 9 percent inflation since early 1990 of between 3 andl 8 ofthe labor force) in January1991 and coulddcimb to as percent per month, as domestic prices of traded highas 2 millionlater in the year. In addition,the goods have had room to move upward toward numberof short-time workers rose to 1.9milion in 1990 international prices, and as prices of nontraded andis alsoexpected to increaseThe "full-time equiva- ghave soared3 The large devaluationpro- lent'unemploymentratein 1991 couldreach 40 percent. goods Asa resultof the sharper than expected recession, public vided "breathing space" for healthy Polish finns, revenuesare falling and government spending on social which did not feel intense competitive pressure as servicesis rapidlyrising. Spendingon theorder of 50 rapidly as many expected.w percentof eastGerman GDP - some13,000 per east Thecaseof theGDRpresentsa sharp contrast to Germanresident -isexpected in 1991,two-thirds to be that of Poland (see box 2). Most believe that the coveredby fiscaltransfers from west Germany and the implicit and fixed "exchangerate" set at the time rest to be raisedelsewhere. Given that eastGerman to of economic unionof economic withunion the FRG was too high. ~~~~~~~~factwagecontinuerates are tounlikely rise, continued faildramaticaUy fiscal transferand mayand in a The immediate opening to international competi- strongregional development policy are needed to stem tion thus put heavy pressure on domestic finns, furthermigration and inaeasingecononic disparity leading to enormous short-term declines in out- betweeneast and west. put and employment. The GDR's experience was unique, in that due to union with the FRG it did not have to achieve internal and external balance; nancing enterprise losses once again. Inflation its decline in output was due to pressures of rose to over 7 percent in both September and adjustment rather than stabilization. The other October,beforebeing slowed againby tight credit CEE countries do not have this option. policies in November. Even after the 28 percent Yugoslavia'sexperiencewasbetween these two devaluationat thebeginning of 1991,Yugoslavia's extremes. It did not depreciate its real exchange currency is now considered to be significantly rate as sharply at the beginning of its reform. overvalued due to the cumulative inflation in Firms were squeezed by the stabilization mea- 1990 of 119 percent. sures while imports provided competitive pres- Both the Polish and the Yugoslav experiences sure to hold down prices. By mid-1990 about 30 point to the difficulty of sustaining stabilization percent of Yugoslav firms reported difficulties, withanopen tradingregimeintheabsenceofreal with many on the verge of bankruptcy.3 ' How- adjustment in the underlying economy. Whether ever, the absence of "breathing space" put early immediate breathing space is provided or not, pressure on the government, which relaxed mon- sooner or later enterprises will feel the pinch of etary and credit policy after June and began fi- international pressures. If they are not rapidly

16 restructured to improve productivity, they are expanded accessto the varietyof goods available eventually threatened with massive layoffsand on internationalmarkets. Price reformis the key bankruptcy.Resultingpoliticalpressurescancom- step in this process. For goods that are traded on promise the government'scommitmnent to stabili- internationalmarkets, price reform means mov- zation. ing to world market prices and liberalizing the Firmsreact initiallyto the pressures of stabili- price-setting mechanism,either simultaneously zation policiesby seeking other "safety valves." or sequentially. Suchprice reformswill typically Interfirmcredits, for example,grew dramatically result in large increases in the officialprices of after stabilizationmeasures were taken in Poland "necessities"(such as staple foods,meat, and en- and Hungary. The combinationof a weak legal ergy) heavilysubsidized under centralplanning, framework to enforce credit obligationsand the although it may also result in decreasesin unoffi- lack of true ownership interests in firms means cial,or "black market,"prices.m that there are few endogenousconstraints on the While Yugoslavia had gradually liberalized growth of these credits. They weaken the enter- mostpricesover manyyearsprior to 1990,Poland prise sectorin the medium run and raise the risk adopted the "bigbang"approachbyfreeingabout of cascading bankruptcies over time. Govem- 90 percentof all prices simultaneouslyat the be- ments need to regulate interfirmcredits in order ginning of 1990. Romaniafreed about 50 percent to have true control over the money supply and of prices on October 1, 1990,and Bulgariafreed prevent profitablefirms from being dragged into prices covering some 90 percent of tumover on bankruptcy by unprofitable onesY February 1, 1991. The CSFRadjusted some administeredprices upward in mid-1990and liber- Theinteractionofstabilizationandsystem transfor- alized most prices (covering some 85 percent of mation. The goals of stabilization and system production) on January 1, 1991. Its mid-1990 transformation are often mutually supportive. reductionof price subsidieson foodwas compen- Price realignments to market levels lower con- sated by an across-the-boarddirect payment to sumer subsidies,while cuts in subsidiesto loss- households based on average consumptionlev- making firms,whether through the budget or the els, rendering these subsidy cuts approximately bankingsystem, speed adjustmentby forcingen- budget-neutral. Hungary followeda somewhat terprisesto close or restructure. Replacingquan- more gradual process of price reform as the do- titative restrictions with tariffs raises revenues mesticpricing regime was progressivelyliberal- while helping to importa rational price structure ized after 1988. By the end of 1990,about 90 from abroad. More generally,stabilization is not percent of consumer prices were free of govern- sustainablewithout real underlying adjustment, ment control.3 as noted above. Experienceto date shows that freeing prices Sometimes,however, stabilization and adjust- and allowingfreeentryindistributioncanelicitan ment goalscan conflict.One exampleis the need immediateand dramatic increasein the availabil- to maintain public sector wage controls through ity and varietyof goods in the market. In the space the stabilizationphase despite the distortionsthis of a month or two after price reform,much of the prolongsin the labormarket and the disincentives retail trade in Warsaw had moved from govern- it can create - noted in Poland - to increase ment shops to the less formal curbside market, output. Also,the needs of systemtransformation often operating out of trucks parked on main can conflictwith those of stabilizationin the area streets. Queues had practicallydisappeared, and of tax policy, as revenue requirements confront governmentshops, progressivelysupplemented the need for more transparent and less burden- by privateretailers, started to offera wider variety some tax rules to spur private sector develop- of goods for sale. Direct interfirm transactions ment. The resolution of this dilemma requires a increasedat the expenseof the previousdistribu- comprehensivetax reform,as noted in annex 5. tors, both domesticallyand internationally. The freeing of prices needs to be accompanied Price and market reform by the development of competitionpolicies to offsetthe tendencyof monopoliststo raise prices The marketfor goods. Expanding the market for excessively.International competition may con- goods requires at a minimum free entry for pro- strainmonopolists'behavior if trade isliberalized ducers and distributors, freedom of buyers and concurrentlywith price reform,if imports supply sellers to negotiate market-clearingprices, and a sizableshare of the domesticmarket, and if the

17 exclhange rate is roughly competitive. This is (and cutting credit subsidies) over time is an im- unlikely to be sufficient in all cases, however, portant - and politically divisive - step in the especially in larger countries (such as Poland, reform process, housing reform touches on many Yugoslavia, or particularly the USSR)where im- other issues as well (box 3). ports play less of a role. Domestic competition policies designed to break up monopolies (in part Internationaltrade. In small or medium-sized through appropriately structured privatization) countries such as those in Central and Eastern and controlunfairtradingpracticesshouldcomple- Europe, price reforms for traded commodities can ment international market forces. be introduced quickly by establishing currency For nontraded goods, price reform may entail convertibility and opening the economy to for- reducing subsidies and eventually freeing the eign trade. As noted above, this enables countries price-setting mechanism. Many of these goods to "import" not only the international price struc- - including housing and certain services such as ture but also the benefits of international compe- medical care, child care, and education - have tition, lessening the need for domestic long been considered as entitlements, and major antimonopoly controls. A realistic exchange rate priceadjustmentsmayneedtobecompensatedlby (whether fixed or floating) is a minimum prereq- raising cash wages, effectively shifting a larger uisite for such a move. If the exchange rate is to be part of consumption onto a market basis. There is fixed, adequate reserves are needed to defend it. high social and political resistance to these price Official reserves in Poland, for example, equalled increases, and no country has yet made extensive four and a half months' imports in January 1990. reforms. CEE governments have long allocated Bulgaria, with very low reserves (as low as two state-owned housing bureaucratically (with weeks' cover in mid-1990), opted for a floating subsidies typically in the range of 3-6 percent of rate when it moved to liberalize trade in February GDP), and some have also subsidized private 1991. Trade reform can accompany stabilization housing through low-interestloans. Private own- (as in Poland and Yugoslavia) or be introduced ership has generally been limited to one or two more gradually (as in Hungary, which has pro- dwellings;averysmallprivaterentalrmarket exists gressively removed import licensing restrictions in Poland and Hungary, but owners' rights are since 1988). limited. Rents for state housing typically aver- Unfortunately, the opening of these countries aged only 2-5 percent of family income in the to international trade is taking place in an atmo- 1980s, and those in the Soviet Union have not sphere of intense and somewhat unpredictable changed since the 1920s. Although raising rents change in their trade regime with each other and the USSR - the CMEA system. CMEA trade shifted from bilateral clearing at administered Box 3 Issues in housing reform prices to multilateral trade at world prices on January 1, 1991. Although this shift is a logical Housingsectors in CEEcountries have beenmarked counterpart to domestic market-oriented reforms, by severeshortages that inhibitlabor mobilityand by it is expected to impose substantial terms-of-trade ever-expandingpublic subsidies that strainpublic bud- losses on the smaller CEE countries in favor of the gets and financial systems. Housing reform encom- Soviet Union. Estimates of these losses require passes many issues in addition to rent and subsidy judgments on the expected quality discount on reform and accompanyingwage adjustment (as discussed in the text. Establishing a market for housing East European manufactures and are sensitive to requires, for example,an overhaul of the system of the price of oil; recent estimates based on an oil housing finance, with major implications for the finan- price of $21 per barrel suggest a terms-of-trade cial system in general. It also requires privatizing a shock of $11.4 billion for the five CEE countries substantial portion of the public housing stock, which excluding Yugoslavia, equivalent on average to relates to broader privatization and macroeconomic 4.4 percent of their GDP (see annex 1). Difficulties polides. Housing markets require extensive legal ancd in the Soviet economy also make it harder to institutionalreforms to enact and enforcezoning ancl buildingcodes. Finally,extensive reform and restruc- tuing is needed in the construction industry to reorient multaneously, the GDR - in merging with West incentives and improve productivity. Germany and adopting the Economic _ ____ Community'sCommonTradePolicy-hasmoved

18 from being a maoprtrading partner of most of the ThereformingcountriesarebeginningtoDmake CMEA countries to being a competitor with pref- progress in reducing controls on labor markets erential access to important Western European and establishing principles of collective bargain- markets. Trade among former CMEA partners ing. Yugoslavia, for example, enacted a new labor might decline by 40 percent in volume terms in code in 1989 that established the right of firms to 1991. Finally, trade sanctions against Iraq and transfer or release workers under conditions that resulting losses in oil shipments (as payments in are progressively being liberalized. Several coun- kind for past credits) also impose heavy costs, trieshaveseenanincreaseinredundancies. How- particularly on Bulgaria and the CSFR. The diffi- ever, the process is too new to draw lessons. cult trading outlook for the reforming countries poses a threat to the sustainability of reforms, Financialmarkets. The challenge of financial especially against the background of declining market development in the CEE countries is to output in 1989-90,and heightens the urgency of create independent, market-oriented banks able obtaining Western assistance. to mobilize savings, evaluate risk, and allocate capital along efficiency criteria. As previously The market for labor. Although anathema to noted, the absence of a market-based financial Marxist ideology, labor markets existed in the system is costly even in the early stages of macro- CEE countries prior to reform. However, they economic stabilization, because no effectivechan- operated under controls (constraints on pay, gen- nel exists to assure that macroeconomic policies erous benefit systems, and prevention of dismiss- - in particular the tightening of credit- support als) and incentives (especially the absence of fi- microeconomic adjustment. Although allreform- nancial discipline) that inhibited efficient labor ing countries recognize the importance of starting allocation (see annex 6). immediately with financial system reform, it can- Freeingup labor marketsmeansreducing rigid not be done overnight. Most countries have al- centralcontrolswhileinstitutingactivelabormar- ready broken up monolithic banking structures ket policies - education, training, job informa- into two-tiered systems consisting of a central tion and counseling services, smallbusiness assis- bank and several commercial banks. Central and tance,government-providedunemploymentben- commercial bank legislation has been drafted and efits, and new mechanisms for collective bargain- is being revised as reform progresses. However, ing-topromoteefficent labor mobility.35Many developing fully functioning and independent measures can be initiated early on; however, as banks requires extensive training and technical noted earlier, governments cannot fully release assistance in complex areas, many of which are control over wage-setting until rarket controls new for the countries concemed. Banks must exist as a substitute, and this is not likely to occur leam how to attract deposits, manage liquidity, until a large portion of the enterprises have been evaluate risk, and carry out payments functions privatized. However, tight wage control for an for commercial transactions, while bank regula- extended period of time also imposes costs, in- tors must be taught how to oversee asset portfo- creasingly divorcing wage scales from productiv- lios, evaluate liquidity, and judge the adequacy of ityand exacerbating social pressures that threaten bank procedures and management. Market-ori- fragile democracies. Setting wage policy in re- ented accounting systems must be developed con- formingsocialisteconomiesmeansbalancingsev- currently. Institutional and skill development is eralcompetingandoftencontradictoryobjectives. proceeding apace in all the countries but will take Increasingincentivesrequireswiderpaydifferen- time. Certain issues conceming the new systems, tials (particularly for skilled professionals), al- such as the ownership of banks and the desirable though socially acceptable differentials may be scope of their activities, are not resolved (see narrow relative to other market economies. The annex 4). bottom wage should be significantly above the Before banks can function independently and minimum level of social support, which cannot competitively, their portfolios must be restruc- easily be cut back from past levels. Yet real wage tured and their capital bases restored. As long as growth must be limited to avoid more extensive a large segment of client enterprises continues to unemployment and to constrain aggregate labor generate losses, the banking system will find it purchasingpowerin linewithrealnational income. difficult to avoid taking on more bad debt. Re-

19 Box 4 World Bank support for private sector development: The example of Hungary

The World Bank group has been intimately involved in aiization, majorsubsidy reduction, tightened financial dis- advising and supporting CEE governments with private ciplineforenterprises,keyactionstowardenterpriseprivat- sector development. In the latter half of the 1980sin Hun- ization, the developmentof a modern accountingand audit- gary, for example, there was extensive dialogue on liberal- ing framework, and a strengthened macroeconomicframe- izing trade, expanding the scope for small-scale private work. In addition, an Enterprise Restructuring and Privat- activities, increasing enterprise autonomy, liquidating loss- ization adjustment loan is being appraised that wiDlsupport making enterprises, facilitating foreign investment, imple- a comprehensive government program for ownership re- mentinga modern company law,and ultimately transform- form (including the transformation of aU state enterprises ing state enterprises into companies with mixed or private into company form and improved government exercise of ownership. This dialogue was supported by substantial ownership rights and duties), the goverrnment'sambitious Bank direct technical assistance as well as several Bank privatization program, and the selective restructuring of loans for the industria sector, and it helped lead to rapid state enterprises. Other Bank activities include the 1990 transformation of the framework for private sector activi- FinandalSystem Modernization Project and otherefforts to ties. furtherinvolve recentlycreated cofmtmerdalbanks in lend- The dialogue has continued during 1990and 1991. The ing to the private sector. first StructuralAdjustment Loan has supported trade liber- structuring the banks is integrally linked to the Private sector development, privatization, and restructuring of the enterprises. Governmlents enterprise restructuring must eventually assume many of the problem loans and inject new capital into the banking New investment. The most important spur to system; however, if done too early this may eocac- economic growth is likely to be the growth of new erbate fiscal strains. private businesses. Experience to date shows that Full reform requires liberalization of interest new private small-scale business can develop rap- rates. At the start of reform, interest rates should idly in a supportive environment. In 1989 and be adjusted to realistic levels to provide appropri- 1990 all of the countries of Eastern and Central ate signals to savers and borrowers, and banks Europe lifted their highly restrictive controls over may be given some range of discretion to set rates private sector activity. New laws sought to place on loans and deposits. But rates should nol be private enterprise on an equal footing with public fully liberalized until a country has reasonable firns by equalizing tax treatment, removing re- macroeconomic stability, a sound and competi- strictions on private firms' size and activities, tive financial system, an effective system of ]pru- freeingprivateprocurementanddistribution,and dential supervision, and "hard"budgetconstrakmts reducingbureaucratic requirements for establish- for firms (see annex 4). Finally, achieving a sound ing new firms. The response was immediate. and competitive financial system is likely to re- Over half a million new sole proprietorships and quire extensive privatization of the banking sys- 30,000 incorporated companies registered in Po- ter. land in 1990;of the latter, about 20 percent were in In addition to banking reform, several coun- manufacturing and the rest in trade and services. tries aremoving to establish stock and commodity In the CSFR,more than 500,000potential entrepre- markets along Westemrnmodels. The Budapest neurs have registered for licenses (primarily in Stock Exchange opened in June 1990, and the trade and services) with the newly formed Em- Hungarian Commodity Market - whose trade is ployers' Association since the new private enter- currently limited to cereals - was established in prise legislation was passed in April 1990. Hun- late 1989. Trading in both markets is small, but gary has been liberalizing private sector activity securities now account for about 10 percent of since 1982and now has some 300,000private sole Hungary's financial assets. Poland and the CSFR proprietorshipsand several thousand privatelim- both plan to open stock exchanges in 1991. An ited liability companies. The share of workers early start in developing securities markets is employed in the private sector in Hungary has warranted (particularly in connection with pri- risen from 0.1 percent to an estimated 10 percent; vatization), but financial sector reforms are neces- however, more than half of those working in the sarily limited by developments in the underlying private sector do so while also maintaining their real sectors of the economy. jobs in the state sector. Although private enter-

20 prise has been permitted (with limitations)for a Privatization.Revitalizing theenterprise sector long time in Yugoslavia,a more liberal Law of will require restructuringand privatizing many Private Businesswas passed in mid-1989. Nine existingenterprises, whether small or large, in- thousand new limited liabilitycompanies were dustrial, agricultural,or service-oriented.Experi- formed in the firsthalf of 1990alone, most in trade ence over the past 10 years suggests that the two andservicesbutagrowingnumberinproduction. are intertwined - successfulrestructuring will Private sector development continues to be require extensiveprivatization. State-owneden- constrainedby many factors,however, including terprisescan work efficientlyin an economicsys- burdensomerules and regulations,limited credit teminwhichmostenterprisesareprivatelyowned. due to poorly functioningfinancial systemsand But when the vast majority of enterprises are limited collateralassets, weak domesticdemand publiclyowned, the institutionaland competitive due to tight stabilizationpolicies, legal and politi- framework that stimulates efficient behavior is cal uncertainty (including that regarding land missing. Socialistfirms in essencehave no owner ownership), high taxes, and the de facto prefer- to defend the interests of capital and actively encesthat continueto be enjoyedby public sector demand a good return on investment. A small firms.Private manufacturingfirms are still con- minorityof firms and some moderate ownership fined to niches (often themselvesmonopolized) share in the remainder can stay in public hands, carved out in the few areasnot dominatedby state but for both economic and political reasons a enterprises.Despitegrowingprivateactivity,com- majorityinterest in a majorityof firmsneeds to be petition is still weak. There is a strong case for transferred to the private sector in the course of broad measures36 actively to encourage private systemreform. Thiswill by necessityentail mas- firms until the dominanceof public enterprisesis sive privatization in the CEE countries, where eliminated. between65and 90percentofGDPisaccounted for Foreigninvestmentis also growing. Inl990the by state enterprises, as compared with about 10 number of registeredjoint venturesin both Hun- percent on averagein industrial countriesand 15 gary and Poland doubled from about 1,000 to percentin developingcountries. more than 2,000. In the CSFR,registrations in- Yetownership reform is provingto be perhaps creased from only 60 at the beginningof 1990to the most contentiouschallenge in the entire re- 500byOctoberl. EnterprisesinCEEcountriesare form process. While rapid privatization is the activelyseeking joint venture partners, which of- goalinalmostallcases,animportantintermediate fermarketaccess,technology, and capital, seenas step (sometimesreferred to as "corporatization") keys to survival. However, in terms of financial is to establish tangibleownership rights and cor- flows, foreign investment is unlikely to play as porate governance,possibly on behalf of the state large a role as many expectedat the outset of the itself.37This confronts years of decentralizationof reform process. Investors are wary of political control to managers and/or workers' councils, and economicrisks and the uncertain legal and particularlyin Yugoslavia,Poland, and Hungary, proceduralframeworks. The average investment which have bestowed de facto ownership rights isquite small;in Poland,joint ventures account for that are politicallydifficult to reclaim. Legitimate less than 2 percentof salesand employment,and claims of previous owners can complicate the most investors are emigres. Although average picture still further. In Hungary, the CSFR,Po- capital per joint venture is somewhat larger in land, and theformerGDR, for example,thosewho Hungary, foreign capital - mostly from Ger- owned enterprises,land, commercialreal estate, many, Austria,the UnitedStates, and Switzerland and housing prior to the nationalizationsof the - is stillgenerally small, usually less than halfof 1940sand 1950sare claiming rights to these as- total capital. However, foreigncapital is not the sets.3N onlygoal; management expertise, familiarity with If these immediateconstraints can be handled, export markets, and accessto advanced technol- the general shape of a consensuson the means of ogy are also major benefitsfrom foreigninvolve- privatization is now beginning to emerge (see ment. Development of a well-structuredlegal annex2). Rapid privatizationwill need to rely on framework and the institutions to support and a multitrack approach; no single approach can enforce it (discussedin the section on the role of providethe answer. It is clearfrom recentexperi- the state) is criticalto the growth of both foreign ence that privatizing small-scalefirms, particu- and domesticprivate investment. larly in trade and services,is relativelyeasy. They

21 can be auctionedoff by localgovernments (and in some cases returned to former owners) quite Box5 Enterprise privatization in east quickly and successfully. About one-half of Germany Poland's state-owned shops were transferred to private hands in 1990 alone. Hungary and the GDRhas encuntered serious difficulties since its incep- CSFRhave passed laws on 'small privatization" tionin mid-1990.It reliesexdusively on salesto "quali- and have begun to privatize retailtrade and ser- fiedbuyers"; no firms will be sold throughthe existing vices through auctions to the highest bidder. stockexchange (where dilutedshare ownershipor "un- Large industrialfirms presenta more complex qualified buyers might emerge)or givenaway to citi- challenge. The one thing that is clear is that zensat large (althoughany "residual"from the entire privatization of these firms is a very complex, privatizationprogram will be distributed to east Ger- imperfect, and time-consuming process. liree mans).As of January 1, 1991,the state privatization mansof privatizing -me-contanmusg privatiza. Inragency (the1Treuhandanstalt") hadcondudedabout500 meansof privatizing- "spontaneous"privatiza- deals,almost exdusivelynegotiated case-by-case with tion (or sales of firms or their assets "from be- westGermans and foreignbuyers. Somedeals involved low'), public sales (directed from "above" and entirefirms,whileothersinvolvedspinoffsofthe8,000or possibly combined with liquidations), and free solargeenterprisestobeprivatized.Inaddition,abouta mass transfer - are all likely to play a role, al- third of the 11,00small- and medium-sizedenterprises though witha differentmix in each country. Prof- nationalizedin 1972had beenreturned to theirprevious itablemost ethe prone to privatize "spon- owners,and some7,000 smal shops had been leased to itablefirms aret ist prong to own spon- privateindividuals as a step toward privatization. taneously" - that is, by issuingtheir own shares Experienceto date offersseveral lessons. Valuation to insiderswith greateraccess to infonration and hasproved very difficult,leading to widespreaduse of power - as cases in Hungary, Poland,and Yugo- 'incompletecontracts that providefor later determiina- slavia have shown. Whilepreviously sanctioned tion of the purchaseprice. Buyerinterest has been lim- by law, and still regarded by some as the easiest ited, particularlyfor firms producing tradable goods. means to an important end, spontaneousprivat- This reflectsthe low competitivenessof east German izationhas suffered prominentcases of abuse,and industrydue to backwardtechmology, inadequate infra- thebeliefthatmsufferednprominsirent son lature,d structure,and high wages set by thehigh valuation of the thebelief that many insiders were "nomenidat-ura" EastGerman Mark and by recent collectivebargaining of the old regime has led to public outcry. Only agreements.Uncertain property rights and contingent Hungary still plans to rely heavilyon this means, environmentalliabilitiesresultingfromtheapplicationof which will be closelysupervised by its StateProp- westGermanenvironmentalstandardsalsodampenbuyer erty Agency. interest. It is now clearthat there will not be any inter- The two rnainalternatives to spontaneouspri- estedbuyersforalargenumberof enterprises. ManywiUl vatization for large firms are sales by the have to be financiallyand organizationallyrestructured and saleof milentto the highestmenttbidder the ighestbidde and feefree ditributondistribution of assetstomake will themhave more to playattractive, a largerand role liquidation than expected. The shares to citizens. The two are not mutuially Treuhandanstaltis willingto considera negativepur- exclusive;some firmscan be sold by the govern- chaseprice,that is, payingabuyer to takeonan unwanted ment while others are distributed free.39Many stateenterprise.EvenwithhundredsoftopwestGerman analysts have argued that sales are preferableto managersdrafted from other companies, privatization is free transfer,both because they lead to clear cor- going to be a slow and complexprocess. porate control by interested "real" owners and because they add to public revenue. Yugoslavia tion is virtually impossible given the absence of intends to rely primarilyon public sales.Hungary capital markets.0 The second barrier is capital. issupplementingspontaneousprivatizationswith Domesticcapital is inadequate, and sales to for- a programof"activeprivatization," ordirect sales, eignersare limitedby politicalfactors. 41 The third by the State Property Agency. Poland plans to barrier is equity: "nomenklatura," black privatize many of its largest enterprisesthrough marketeers,orbeneficiaries of current marketdis- individual sales.Germany is relying exclusively tortionsare seen as being likelydomestic buyers. on public salesto privatizethe state enterprisesin Becauseof the depressed conditionof the econo- the east (see box 5). mies and the high perceived risks, acceptable Recently,however, the difficultieswith exten- prices may be low and these buyers may reap sive public sales have become more and more "windfall" gains.41 The fourth barrier is time. evident. The first is valuation. The experienceof Hungary has some 2,000state-owned firms,and 1990has led many to believe that accuratevalua- Poland over 7,500. Hungary's first program in

22 September 1990 involved 20 firms; Poland sold issue (see annex 3), there has not been widespread only five firms in its first public offering in January discussion on how to coordinate land reform and 1991, compared with an initial target of 150.0 themoregeneraliprivatizationof stateassets. While Given these drawbacks, the view is emerging the approach to property rights in land should be that givingawaya large share of state assets to the consistent with property rights in other assets, public may be the fairest and quickest means to land should not be owned by widely dispersed widespread privatization. The most discussed absentee shareholders as industrial enterprises means of giving away assets is to issue citizens would be under the various voucher plans under vouchers that can be exchanged for the assets of consideration. Therefore, neither state nor collec- their choice. The CSFRfirst advocated such a plan tive farms should be included in the portfolios of inearlyl990,andPolandandRomanialaterturned any intermediaries established to hold shares on in that direction. All three countries hope to behalf of the public. implement such a scheme in 1991. Mass transfers have at least three major poten- Restructuring. Whatever the means chosen, tial drawbacks. The first is the fiscal cost associ- many firms will remain in public hands for a long ated with forgoing sales revenues; thisonce seemed time, and many of these will need to be restruc- paramount but now may be somewhat less im- tured or closed. Some restructuring will be re- portant, in part because the alternative of sales quired prior to privatization, even if only to "pre- also appears unlikely to raise as much revenue as pare" enterprises for privatization. Before initially hoped.44 The second is the fear that the privatizing individual firms, for example, gov- resulting ownership would be so widespread and ernments need to break up large monopolies, diluted that owners could not effectively assert tackle sector-wide issues of excess capacity (espe- control over management. The third is the con- ciallyinheavyindustryandsectorsaffectedbythe cern that the public would lack the information demise of the CMEA system), and address the wisely to "invest" vouchers. Various plans at- politically tricky problem of mass redundancy. tempt to tackle the latter two problems by propos- Experience in Great Britain and elsewhere sug- ing intermediaries to hold and "own" assets in gests that these steps are easier to accomplish in trustforthepublic. Theintermediaries-whether public hands (perhaps with private-sector mana- domestic or joint venture holding companies, gerial assistance), especially if all parties know mutual funds, or soon-to-be-privatized banks or thatprivatizationis imminent. Governmentsmay pensionplans-wouldownrelativelylargeblocks also need to "clean up" the balance sheets of some of shares in enterprises and would therefore have public firms prior to privatization, although they a greater ability and incentive than individual should resist bailouts when firms are dearly fi- citizens to play an active ownership role. nancially inviable in the longer run. Physical and The various voucher plans have many attrac- managerial restructuring may also be needed, tive features and could well play a positive role in although incoming private managers can usually speedingupandpromotingfairnessintheprivat- handle this better than the government if near- ization process. However, the plans are still in- term privatization is feasible. complete in many details. For them to be effective, The challenge in the CEE countries is on a scale it is imperative that they be designed and imple- far larger than has ever been faced elsewhere. mented to insure effective corporate governance How can CEE governments, with limited exper- and to facilitate further sales of firms by interme- tise and resources, undertake so challenging a diaries. restructuring policy? The key challenge is institu- Several countries are moving to privatize state- tional. Institutions and criteria are needed to owned or cooperative farms. Both Bulgaria and provide restructuring advice and finance, with Romania recently passed land reforn laws that appropriate safeguards to preclude bailout. Po- provide for the breakup of collective farms and land and Yugoslavia recently established restruc- the return of land to private ownership. In each turing agencies to provide technical assistance in country claims of prior owners will be honored, designingandevaluatingrestructuringprograms. although the land returned will not necessarily be Specialized financial institutions have been cre- that taken away at collectivization. Although the ated to help these and other programs in Poland. need to restructure collective farms and redefine The other countries have not yet begun to tackle property rights in land is clearly an important the problem in earnest. Experience in east Ger-

23 many, where thousands of west German experts Two politically sensitive but necessary measures are available to help with restructuring, shows are the removal of food subsidies and the restruc- that the process will be long and hard even in the turing (whetherbreakup or consolidation) of land best of circumstances and suggests that many ownership. Producers are hostage to the pace of firms will have to be closed.'5 In the other reform- change in processing, marketing, and distribu- ing countries, where resources are scarcer, the tion, and reforms in these sectors (including road is likely to be even longer and harder. As delinking rural services from productive units) with privatization, one should expect a slow and have high priority. While the potential payoff is imperfect process at best. high, agricultural reform is more complex in the Price, tax, and trade reforms facilitate the re- CEE countries than it was in China and is not structuring process of both public and private expected to have the same power to lead overall firms by improving incentive structures. How- reform. This and other comparisons of the East ever, the experience in Poland and Hungary indi- European and Chinese experiences are further cates that the supply response of public sector noted in box 6. firms to a change in the incentive structure is Hlikely to be relatively slow. Not only is capital and The role of the state technology often deficientbut attitudes of managers, workers, and government bureaucrats do not One of the most pressing challenges facing re- change immediately. To reiterate an earlier point, forming socialist economies is to redefine the role privatization and restructuring are integrally of the state. Its formerall-encompassing role must interlinked and must go hand-in-hand. be "unbundled" into separate ownership, financ- Agriculture presents some of the most chal- ing, and regulatory roles. The first two must be lenging issues in restructuring and in reforms reduced through privatization and financial sec- more generally. As noted in annex 3, some issues tor development and the third strengthened. in this sector are common to most CEE countries, Govemments have essential functions in market while others vary due to diversity in climate, economies - to supply "public" goods such as natural resources, and organizational legacies. national defense, infrastructure, and a legal frame-

Box 6 China's economic reform China's reform program, initiated from the late 1970son, in the role of the state. In the state enterprise sector, China's led to dramatic improvements in economic performance reforms are more akin to earlier CEEmoves toward market from a low base toward levels more characteristic of East socialism, which sought to decentralize decisionmaking Asian market economies. During 1965-80 China's GDP withoutdismantlingstateownership. Chinamovedfarther grewat 6Apercentper year; this rose to 10.4percentpper year in agriculture and rural industry, where de facto ownership in 1980-88.Improvement in per capita incomes and living rights were granted to individuals, albeit usually subject to standards was especially marked in rural areas. Ernploy- extensivelocalgovernmentintervention. Insum,Chinahas ment growth accelerated and, under the "open door" policy, not faced many of the challenges the CEEcountries are now the dollar value of foreign trade rose five-fold from 1978 to trying to address. 1988,with exports increasing from roughly 5 percent to 13 A further distinctive feature of China's reforms was the percent of GDP. role of agriculture as a leading sector. With the restoration Despite some similarities, there are very significant dif- of fainily-basedfarmingandmorefavorableprices,agricul- ferences between reform experiences in China and the CEE tural productivity and farm incomes rose sharply. The countries. Unlike several CEEcountries, China did not have demand for consumer manufactures increased at the same to initiate a determined macroeconomic stabilization effort time that release of surplus farm labor and a growing pool at the start of its reform (though it did later face a similar of savings made possible the establishment of rural town- problem of maintainingmacroeconomic balance in a decen- ship-village enterprises (TVEs). TVEs accounted for one- tralized socialist system). Its debt burden was low, amdit third of the growth of total material production in 1980-88, maintained a high savings rate. It also did not face the provided 90 million jobs, and by 1988provided one-fifth of disruption oftradingrelationships and terms-of-tradeshocks total exports. Reform of agriculture, and especially of that now loom so large in CEE. In addition, the current agroindustry, is a high priority in the CEE countries, for reforms in CEE countries go well beyond those initiated in reasonsthatincludeltspotentialforexportsandforcreating China in most dimensions, including price and mnarket jobs in associated trade and service activities. However, the reform, introducing domestic and international competi- sector cannot play the leading role in the CEEcountries that tion, private sector development, and fundamental changes it did in China's reforms.

24 work; to correct for monopolies,"externalities" Labor law should set basic ground rules for em- (such as environmentalcosts), and other market ploymentand industrial relations.Local govern- failures; to provide basic social services and a ment legislationneeds to define the roleand pow- safety net to alleviate hardship; and to finance ers of localgovernments vis-A-vis higher levelsof these activitiesthrough the collectionof taxesand governmentand the private sector. And well- other levies. functioninglegal institutionsneed to ensure that these laws are enforced reasonably reliablyand Institutionalreform. Governments in Central efficiently. and Eastem Europe face daunting institutional Thereformingcountries,especiallythosemore challengesas they attempt to reorienttheir role to advanced,are making substantial- albeitsome- fit the needsof a market economy.Not only must what ad hoc - progress in drafting new laws. they alter the administrativestructure of govem- New constitutions,property laws, and company ment, but in many cases they need to reduce its and foreign investment laws have been or are overall size, retrain many remaining civil ser- being drafted in all countries. These laws essen- vants, and maintain and if possibleaugment the tially permitfull private ownership (including,in smallcadre of well-qualifiedpolicy analystsand some cases, 100 percent foreign-ownedinvest- decisionmakers.4 ' They must also face politically ment) and attempt to put it on an equal legal touchy questions concerning the devolution of powers to regional and local levels. Most have made a start. For example, most CEE govem- Box 7 Cleaningup the environment mentshavedowngradedorabolished theirformer in CEEcountnes planning offices, consolidated single-industry CMcountries al suffermasve pollutionthat com- miinistriesinto a smallerMinistry of Industry, and promises public health and uiposes heavy economic established privatizationagencies. Many are set- losses. Air poUution (primarily from coal-burning and ting up trainingprograms for civilservants, often metallurgy) causes high rates of chronic bronchitis and with internationalassistance. Top-level manag- asthma,and contaminatedsoil may affect food supplies. ers have generallybeen replaced,although some Much water is unfit for human consumption, and large mid-level managers with vested interests in the areas of forests have been irreversibly damaged. CEE formnerregime remain. 47 governments need to take an active role in promoting environmentald eanup through altered econoic incen- Institutionalconcerns pervade every aspect of tives and newpublicinvestments. On the incentive side, reform,and numerousexamples appear through- raising energyprices and imposing (and rigorouslyen- out this paper. Three specific issues - legal forcing) reasonable fees and fines on poUuters are two reform, fiscal reform, and reform of the social important steps that can be taken early. Poland has safety net and social services - are summarized alreadyincreasedenergyprices350-(0percentbutneeds below. to raise them further to reflect economic cost. The CSFR's energy is extremely underpriced, but the govenunent is The legalframework. One of the most pressing preparing to raise pricesin thenearfuture. These altered incentives will not have fuUimpact, however, until enter- needs is to design a legal framework for market prises are subjected to stict financial disdplne; thus activities. Propertylaws should set clear rules of fundamental institutional change must accompany al- ownershipand control.Contract laws and related tered incentives. On the investment side, the needs are procedures for dispute resolution need to estab- enormous, far beyond the financial resources likely to be lish a framework for commercialbargaining and avaDlable.In east Germany alone, It has been estimated ensure the fair enforcementof private contracts. that $100 bilion would be needed to achieve west Ger- man environmental standards over 15 years. Govern- Companyand foreigninvestment law shouldpro- ments must establish mechanisms to assess alternatives vide for relatively easy entry of new enterprises andset priorities, lookingcarefullyfor thoseinvestments into the market,4uwhile bankruptcy law needs to that can achieve the most environmental protection at establish a procedure for exit. Regulatorylaws least cost. One obvious need is for investment to switch should correctfor market failures,whether inhib- away from coal and toward natural gas as a major energy iting the distortions of unregulated monopolies, sourceandtodeanupexdstingcoal-burningfacilitiesand forcing firms to discloseinformation needed by improve the safety of nuclear plants or in some cases the market (as, for example,in the case of securi- decommissionthem. Responsibility for past environmental liabilities must also be dearly assigned to avoid ties regulation),or providing incentivesto "inter- inhibiting newbuyers from purchasing privatized firms. nalize" external environmentalcosts (seebox 7).

25 footing with state ownership. The countries are complementaryto private investment(see annex also adopting modem antimonopolyand bank- 5). Privatizationof the bulk of state firms produc- ruptcy laws, often drawing on industrialcountry inggoodsforpotentiallycompetitivemarketswilI models. help to reorient public spending, as will price However, these countries have paid insuffi- reform and the resulting decline in consumer cientattentiontotheinstitutional structuresneeded subsidies.There isa danger that, in reactionto the to bring the laws to life. Courtsin socialistecono- past, the need for public investment will be mies have traditionallyconcentrated on crimninal underemphasized. In fact, the public sectorhas a and noncommercialcivil cases (such as family very important role to play in improvingthe net- law), and few judges or lawyers are trained in work of roads, ports, water and sewer systems, commercialmatters. Neither domestic nor for- telecommunications,and other infrastructure eign investors consider the formal legal process needed for privatefirms to function,even if some competent to handle complexcommercial prob- of these functionscan be partially privatized. lems. Although arbitration exists as an alterna- The tax changes needed to adapt to a market tive, the lack of a clear and reliable legal frame- economyare fundamental and systemic. While work, ably enforcedby competentinstitutions, is socialisttaxes were relativelyrudimentary tools a major constraintto investment. to capture surplus and were applied in a highly Some outside observers recommend that the discretionarymanner, new tax systemsneed to be countries of Centraland Eastern Europe "adopt" transparent,predictable, and well-enforced.Tax well-triedlegal and institutionalstructures whole- designmustbalance severalconflicting goals. Sta- sale from other industrializedcountries, particu- bilizationprograms require tight fiscalpolicies to larly Western Europe. This would ensure com- controlbudgetdeficits.Meanwhile,revenueneeds patibility with the EC, an advantage for future could climbwith unemployment and the result- possiblemembership.Suchanapproachmaywvork ing demands on social spending. Yet high tax well in selectedtechnical areas (suchas negotiable rates are inimicalto investmentand growth, and instruments or value-added taxation)but is not privatizationwill put an end to the old, reliable suitableacross-the-board. Laws in industrialized sourcesof revenue, the state-ownedfirms. In the countries can themselveshave serious flaws and early stagesof reformand privatization,as the old are often tied to particular historical events or revenue system is dismantled and before a new cultural attitudes. Even if these laws suffice on system is fully operative, there is a danger that paper, they will have no real meaningin the CEE revenueswill fallsharply just when mosturgently countriesunless they are internalizedthrough the needed. To avoid this, tax bases must be broad- law-making process - through trial-and-error, ened and changed to be more compatiblewith a learning,debate, and consensus-building.Many marketeconomy(forexample,reducingcompany developing countries have borrowed industrial incometax rates while changingfrom turnover to country laws only to have them ignored in prac- value-added taxation),and administrationmust tice;this degrades the role of law and impedesthe be reorientedto deal with hundreds of thousands development of appropriate laws. Rather than of private firms and individuals. This requires borrowing wholesale, the reforming countries techniquesof selectiveauditing and tax enforce- should develop their own laws, drawing from ment, standard accountingpractices, and a reli- firstprinciples, their own prior statutes (oftenpre- able and objective legal framework for dispute World War II), and models from other countries resolution. Countriesmust also resolvecomplex where clearlyappropriate. 49 and oftendivisive issues of fiscalfederalism with regard to both taxing and spendingauthority (see Fiscalreform. Both spending priorities and annex5), and theymust strengthenmunicipal and meansof financinggovernment need major over- provincial fiscal systems as they strengthen na- haul as reforns proceed. The two should be tional ones. linked through a fiscal plan; medium-term tax Hungary was the first to reform its tax struc- and expenditureplanning is needed even though ture, movingto a fairlytraditional system of com- comprehensive central planning is discredited. pany, individual, and value-added taxation in Public spending - both capital and current - 1988and 1989.Despite the comprehensivenessof needs to be reoriented to supply social services, its reform, Hungary introduced many exemp- infrastructure, and other public goods that are tionsand exceptionsthatwillbedifficultto change

26 given the vested interests that have formed. The force. Poland initiallyopted for an open-ended other CEE countries are in earlier stages of tax unemploymentcompensation scheme linked to reform. Thereare strong arguments to moveearly previous earnings that combinedtwo principles to reformthe tax structure,both to set clear"rules - insurancefor workers (being earnings-linked) of the game" for future investors and to avoid and welfare for the needy (being unlimited in pressures from vested interests created through duration). This proved not only to be expensive expanded private ownership. Aswith other legal but also to create a disincentiveto job search for reforms, changing tax law is much easier than the newly unemployed. A preferableapproach changing tax administration. It is clear that none - and one recently adopted by Poland in the of the reformingcountries has adequate adminis- amendmentsto its labor law - is to separatethe trative capacity. Because techniques are quite two functions,using earnings-linkedunemploy- standard across countries, technical assistance ment benefits of limited duration for insurance from industrialcountries in tax administrationis purposes,and a low flat-ratewelfare paymentof especiallyvaluable. unlimited duration for poverty-alleviation.Un- employmentbenefits can be financedby a payroll Thesocialsafetynetandsocialservices.One of the tax on employers,as in industrializedcountries, majoraccomplishments of the socialistsystems of while welfare paymentscome out of generalrev- Central and Eastern Europe was the relatively enues. Concerningimplementation, the number equal distribution of income they attained (see of socialcenters and workersin Poland proved to annex6). Lowincome inequality stemmed prima- beinadequatetohandletheproblemasitemerged. rily from guaranteed employmentand low wage Furthermore,retraining was neglected, perhaps differentiationin the state sector,as economicand in part due to the absence of clear employment socialgoals were often combined in socialistfirms. alternatives. ByAugust 1990,only 0.5 percentof In contrast, economicand social goals are typi- the unemployed were being retrained. Al CEE callyseparated in market economies.Firms pur- countriesneed to concentratemore on activelabor sue profits and pay wages accordingly,whereas marketpolicies (including training and jobplace- the state helps those left out of the economy. The ment), given the extensive movement of labor transitionto a market economyis virtuallycertain amongjobs and sectorsthat is likelyto be needed to lead to higher open unemployment. Moving over the comingyears. toward an economy-widesafety net - thereby leaving firms to restructure to pursue efficiency - is an important task for the state in the transition. Such a safetynet would include unemploy- Box8 Thekey role of pemsionsin ment insurance, socialsecurity (old-age and dis- economicreform ability insurance),and retraining services. Despite relativelyequal incomes,there is evi- of the fiscal system, public pensionsare a majoritem of dence that poverty - particularlyin urban areas public spending; the role of public as opposed to private - increasedin several CEEcountries during the pension systems goes far in determining the size of gov- economicslowdown of the 1980s.Income distri- emient. Whether funded by payroll taxes or private bution is likely to widenand poverty(particularly contributions, pensions (publicorprivate) imposesignifi- in urban areas) to grow as these countriesadopt cant burdens on firms and individuals; minimizing this market systems and cut subsidies on essential burden is important for effident private sector develop- goods.50Generalized cash-based welfare systems ment. As part of the socdalsafety net, pensionsprovide frthe poor will thus also be needed. neededsecurity for workers,yet theirdesign should not forthe poor will thus also be needed. inhibitthe abilityof enterprisesto restructuretheir work Institutionsto address the problem of emerg- forces. As financial intermediaries, pension institutions ing unemploymenthave long existedin Yugosla- should play major roles in the development of the finan- via, but first appeared in early 1989in Hungary dal system and in the privatization of state enterprises. and one year later in Poland and Bulgaria. Wel- Several countries are considering ways to use privatized fare services to address poverty directly have assets to partially fund pension systems. Governments existed until now only in Yugoslavia,and, to a must consider these many important dimensions when ThePolish ~~~designkingpolicies concerning the level, eligibility,financ- very limited extent,Hungary. The Polishexperi- ing, and institutional control over pension assets. ence is relevantbecause of the rapid risein unemployment in 1990 to some 7 percent of the labor

27 Pensionsystems in Centraland EastemEurope the answer liesin separatingsocial insurance from touch on many areas of reform (see box 8) and social assistance functions and limiting free or need major overhaul. They have typicallybeen heavily subsidized provisionto the latter. In the characterizedby low retirementages, easy access area of education,curricula do not address many to disability pensions (partly because of the ab- skills(such as accounting,management, market- senceof other programsfor incomesupport), and ing, and financial services)needed in a market pension formulas biased toward short careers. economy.Furthermore, both academicand voca- These problemsare compoundedby the increas- tionaltraining are highly specializedbeginning at ingly agingpopulation. Asa result, the numberof an early age, and this limits labor flexibilityand pensioners (estimatedat up to one-halfthe num- mobilityand threatens to exacerbateunemploy- ber of employees)and their financialburden on ment problems. Yet there is a real danger that the economy(generally 7-10 percent of GDP)are financialstringencies in both public and private quite high compared with countries at sinmilar sectorscould cause healthand educationservices incomelevels. Althoughvarious reformpropos- to declineeven further before they improve. Ad- als are being considered-including switchingin dressing the many problems in social servicede- part to funded and/or private systemsto comple- signand deliverywill clearly takea longtime, and ment state-run pay-as-you-eamones - no re- reformsin this area have hardly begun. forms have yet been implemented. There is debate about the effects of economic Privatizationpresents both problems and op- reform on women and children. Socialistcoun- portunities for pension finance. The major prob- tries promoted increasedeconomic participation lemconcernsthelossoftheirmajorfundingsource. by women through generous maternity benefits, Pensionsystems have until now been financedby extensivechild-care facilities,and equal educa- very high (up to 50 percent)payroll taxeson state- tion opportunities. Rates of femaleliteracy, edu- owned firms. Such taxes would 'put a heavy cation, and labor force participation were high. burden on-and would be very difficultto collect Movement to a market economy may lead to a from - private firms. On the other hand, one reductionin these benefits. Furthermore,women possible way to move toward partially funded and youngerworkers may tend tobe the firsttobe pensionsystems would be to put a sizableshare of dismissedas firmnsface increasingmarket pres- privatized assets in the hands of pension plans. sures. On the other hand, certain structuralchar- Poland's current privatization plan includes a acteristics made these societies and economies provision to give 20 percent of all vouchers (and particularlydifficult for women. The wage struc- thus of all privatized assets) to the state pension ture virtuallyforced families tohave two incomes, system, to be later divided into private pension and part-time work was rare. Women were plans. An important question, given the demo- overrepresentedin lower-payingjobs, and they graphicprofile of the CEEcountries, is the shareof continued to carry the majorburden of child care income and sales receipts from state assets that and housework.Asreformsproceed,theinformal should be allocated to pension plans. In sDme sectormayopenupnewopportunitiesforwomen, industrializedcountries, pension systems control as may the increasingflexibility in work assign- more than 50 percent of quoted stocks. ments - particularly increasing availabilityof Finally,in addition to the narrow socialsafety part-time work - likely to emerge from market net discussed above,the state shouldconcenbrate pressures. Furthermore,rising wage levels may on reformingthe funding and operationof viirtu- allowsomefamiliesbroaderchoiceregardingwork ally all social services. Heavy subsidizationof and child care options, and the emergence of medical care and over-generoussick leave have private education and child-care services may resulted in high rates of absenteeism,shortage of enhancenot only flexibilitybut alsoquality. Spe- medicines,and low quality of medical services. cial care mightbe needed to protectchildren dur- Health statisticsare stagnant or declining in al- ing the transition,particularly with regard to ac- most all CEEcountries. As with pensions,part of cess to food and medical care.

28 4

Conclusion:The challengeto industrialized countries

Although much progress has been made in the able. It is important that the CEE countries CEE countries in the past year and a half in defin- strengthen their own capabilities to coordinate ing goals and designing - and to some extent assistance programs. implementing - reforms, it is clear that the road Prior to the Paris Club decision to grant debt from socialism to a private market economy is relief to Poland, the current account deficit of the perilous and long. Unfortunately, the difficult CEE countries was expected to amount to some external environment compounds the political $10 billion per year over 1991-92. Taking into and economic hazards. account the need to increase reserves (partly be- Industrial countries have three important con- cause of the shift to convertible currency trade tributions to make in supporting reform efforts with the end of the CMEA regime), total financing and helping integrate CEE countries into the glo- flows were projected at about $14billion per year. bal economy: technical assistance, financial assis- The noninterest current account was projected as tance, and trade access. The Group of 24 (G-24) slightly positive, with deficits for Bulgaria, the countries has established a number of programs CSFR, and Romania offset by surpluses for the to assist the CEE countries and encourage partici- other three countries. pationbyforeignbusiness. InJulyl989itinitiated Against this financing projection, gross finan- thePoland/HungaryAssistanceforEconomicRe- cial disbursements to the CEE countries are ex- structuring (PHARE) program This program, pected to total about $14.5 billion per year on coordinated by the EC on behalf of the G-24,now average in 1991-92. Most will come from official benefits all six CEE countries. PHARE includes sources, whose disbursements are expected to financial assistance, technical advice, and trade total almost $10 billion per year. (World Bank concessions.5 ' Other multilateral organizations lendingis projected at$2.5-3billion annually, and are also active, as are a range of bilateral pro- IMF lending at about $45 billion in 1991 and $2 grams5 Apartfromtheirfinancingroles,theG-10 billion in 1992.) has recently reconfirmed the central role of the With this level of gross disbursements, net IMF and World Bank in designing and applying disbursements to the CEE countries (after amorti- appropriate economic conditionality.53 (World zation of debt) will be only about $5.5 billion per Bank activity is summarized in annex 7, and an year, induding about $1.5 billion (corresponding example of its wide-ranging support for system to gross flows of $7.5billion) to the most heavily reform is shown in box 9. Some of the Bankds indebted countries - Hungary, Poland, and Bul- activities also offer opportunities to involve assis- garia -and $4 billion (gross flows of $7 billion) to tance from other sources.) A degree of competi- the CSFR, Romania, and Yugoslavia. Net dis- tion in the provision of assistance may be desir- bursements from official sources are expected to

29 Box9 How the WorldBank's first StruchuialAdjustment Loan supports system reform in Poland

In mid-1990the World Bank loaned $300 millionito * Financialsector rform: The loanrequired audits and Polandfor structural adjustment. In addition to supporting diagnosticstudies for numerous banks as the basis for an adequatemedium-term macroeconomic frameworlt and restructuring,the adoptionof adequateprudential regula- financingplan,individual SAL conditions weredesigned to tions and implementationof bank supervision,and the support three componentsof the government'sEconomic adoptionof modernaccounting and audtintgstandards. TransformationProgram: a Socialsafety net: The loanhelped the establshmentof Enterpriserest ructuring, privatization, private sector de- adequateunemployment benefits and theconsolidation of velopment:The loansupported changes in the legalframe- existingarrangements for means-tested cash benefits, insti- work (state enterprise,tax, bankruptcy,competition, and tutionalcare, and other benefitsin kind. privatizationlaws) and theestablishment of institutiorL for privatization,liquidation, and restructuring.

be positive, on average almost $8 billion per year. medium term for the emerging private sector. However,netdisbursementsfromprivatesources Hungary is the only country of the three that has are expected to be negative (about -$2.5billion on continually serviced its debt, with interest and average per year), with small positive disburse- amortizationoncommercialloansexceedingcom- ments to the CSFR and Yugoslavia being rmore mercial borrowing by more than $1 billion annu- than offset by negative net disbursements to Hun- ally.`6 gary and Poland. Net transfers (prior to any clebt Resolution of the debt problem is important to relief) average -$5 billion per year. Direct foreilgn encourage private sector development. Debt reinvestment in the CEE region is expected to be lief clears away the impediment of a large over- about $1.5 billion annually, but this could rise hang of public sector debt and thusfacilitatesnew sharply if the environment is stable and hospi- lending to the private sector. In addition, debt- table.TM equity swaps can be readily used to facilitate both Under this scenario, net disbursements of $5.5 debt relief and privatization; because the govern- billion and foreign investmentof $1.5billion leave ment owns the assets offered for swap, the ad- a financing gap of about $7 billion per year for the verse macroeconomic side-effects that have arisen CEE countries. This "gap" must be filled by in some Latin American programs involving pri- changing the assumptions built into the scen,ario vate firms can be avoided. Debt relief programs - by a drawdown of (or failure to build tip) raise the secondary market price of remaining reserves, a larger trade surplus, larger gross dis- debt and thus the "cost" to the government of bursements of foreign financing, or debt resched- debt-equity swaps; it is therefore desirable to con- uling. In mid-March the Paris Club agreecl to sider these components as part of an integrated grant extensive debt relief to Poland, reducing the debt strategy.57 net present value of Poland's future debt service The industrial countries also need to insure paymentsby 50 percentand reducing debt service market accessto support trade and corresponding even more in the early years (including an 80 price reforms. In the long run, a major reallocation percent reduction in interest payments over the of their trade, away from the ex-CMEA countries next three years).-' As Poland was not servicing,its and toward the industrial countries (particularly debt, relief will have only a small direct impact on in Europe), is likely to be an important element of actual international financial flows, but it iwill reform. TheEuropeanCommunityandtheUnited sharply reduce the current account deficit and, States have lowered tariffs - granting MEN or concurrently, the financing gap. Bulgaria has GSP status - on goods from Hungary, Poland, suspended interestpaymentsand is expected soon and the CSFR. Trade agreements between the EC tobeginnegotiations withofficialand commercial and Romania (1981), Hungary (1988), Poland creditors for debt relief. Bulgaria has requested (1989), and the USSR, Bulgaria, and the CSFR rescheduling of its Paris Club debt (about $2 bil- (1990) provide for the gradual elimination of all lion) and is likely to ask commercial creditors for discriminatory quantitative restrictions (outside long-term rescheduling and further funds in the the textile, agricultural, and European coal and

30 steel sectors). The PHAREprogram has gone CEE countries, while moves toward a unified farther,abolishingallspecific quantitative restric- market in 1992might result in some trade diver- tions and even suspending nonspecificquantita- sionawayfromextra-ECimportstowardintra-EC tive restrictionson Hungarian and Polish prod- trade. Whilemembership of the CEEcountries in ucts, thereby granting more favorabletreatment the EC or EFrA is not likelyfor some time, new than that given other GATT trading partners. avenuesareneeded forloweringremainingbarri- However, challengesto Western market access ers to trade and capital flowsa'and thus continu- remain. For example,the full entry of Spain and ing to integrate the CEEeconomies into the world Portugalinto the ECcould increasethe pressures economy. on certainexports (particularly agriculture) from

Annexes

33 Annex 1 Reform of the trade and payments For the CEE five, CMEA membership involved system short-term gains from favorable pricing but long- term costs from progressively deteriorating stan- Until 1991 the trade and payments system of the dards, technologies, and marketing skills. This CEE countries was composed of two distinct re- was reflected in a secular decline in exports to gimes. TheCMEA or COMECON systemcovered convertible currency markets and the evolution of trade and payments among the CEE countries, the a pervasive structural dependency among the USSR, and several other members (with the ex- countries (table 1.1). The smaller countries were ception of Yugoslavia, which was not a member of particularly dependent on the USSR, which in the CMEA). Systems also existed for so-called 1990 led the decision to phase out the system. convertible currency trade and payments with Despite its short-term costs the demise of the countries outside the CMEA area. The main im- CMEA is a logical adjunct to the domestic reforms mediate concern for the progressof the reformnsin taking place in the member countries. It repre- CEE is how it will be affected by the essential sents an important step in breaking away from dissolution of the CMEA system as of the starlt of regional autarky and structural dependency and 1991. reaping the gains from participating in global markets. The legacy of the traditional CMEA system The convertible currency regime Although material balancing in the CMEA systbem never quite represented a complete extension of In January 1990 Poland and Yugoslavia shifted to national planning, the member countries coordi- free trade regimes with moderate tariffs for non- nated trade bilaterally. Payments involved bilat- CMEA trade. The CSFR did the same in January eral clearing using the transferable ruble (which 1991.Hungary is moving rapidly in that direction; was not really transferable) as the common ac- in January 1991 the share of its industrial produc- counting currency. Trade composition was set in tion free of trade licensing increased from one- great detail, often with separate commodity sub- third to more than 70 percent. Bulgaria moved to balances, and a major objective (accomplished in liberalize trade in February 1991. Most CEE coun- part through export quotas) was to avoid tin- tries have introduced some currency convertibil- planned trade surpluses. As the countries decen- ity, with Poland, Yugoslavia, and the CSFRmov- tralized their economies, trade was effected ing to full convertibility (in the Polish and the through state orders, and domestic and trading CSFRcases only for current transactions) and the prices were insulated by compensating taxes. The others adopting some variant of the retention- emergence of substantial imbalances in recent quota cum auction system. The world price sys- years resulted mainly from loss of central contrzol. tem therefore has a major influence now in most of For pricing, the CMEA generally used five-year the countries, at least as far as trade with market moving averages of observed world prices for economies is concerned. All CEE countries have similar goods, which imparted a bias against pro- also abolished the government monopoly on trade, ducers of "hard" or internationally tradable lllw and mosthavegivenenterprises full tradingrights. materials (whose prices were rising in the late Spurred by domestic contraction and exchange 1980s)in favorof countries exporting "soft" manu- rate adjustments, the convertible currency exports factures of relatively low quality. CMEA strove of Poland, Hungary, and Yugoslavia rose by an for regional integration through specialization estimated 34, 10, and 12 percent, respectively, in agreements, which aimed to realize scale econo- 1990. Table 1.2 presents summary information on mies; thus, Hungary exported articulated buses trade and payments with the convertible currency and imported automobiles, and Bulgaria empha- area. sized electronics. The major exports of the USSR were energy and raw materials. This pattern of The extemal shocks facing the reforming specialization established monopolies and re- countries moved incentives to upgrade product and process technologies. It also resulted in extreme intercle- In addition to the shocks caused by changes in pendencies between individual countries and sLip- their domestic policies, the countries face simulta- pliers within the region. neously three extemal shocks, each of which could

34 Table 11 Structuraldependence in the CMEA

Sharesin non-CMEA worldexports (percent)

Rfgion/gtroekaaey 1970 1980 1987

East European Sixa Total trade 6.8 4.5 3.0 Engineering products 0.8 0.7 0.4 High and advanced technology engineering products 1.6 1.2 0.7

Asian NlCsb

Engineering products 2.1 9.3 14.7 High and advanced technology engineering products 1.0 3.9 6.3

a. Bulgaria, the CSFR,East Genmany,Hungary, Poland, and Romania. b. Korea, Taiwan, Singapore, and Hong Kon& Source ECE (1989).

Sharesof CMEA in CEE exports,1989a (percent)

CMEAgToTtb

Country (1) (2) USSR/CMEAc

Bulgaria 83 61 76 Czechoslovakia 54 47 62 CDR 42 38 62 Hungary 39 40 64 Poland 35 44 61 Romania 38 17 59 USSR 46 21 -

a. Non-CMEA trade includes a sizable portion of trade with developing countries. Although denominated In convertible currency, it is partly conducted under bilateral clearing or countertrade agreements similar to those for CMEA trade rather than on a market basis. b. Reported data for intraCMEA trade require adjustments to render them comparable with convertible currency trade data, but the method of adjustment has a large arbitrary element. Column (1) values trade at national transferable ruble/dollar crossrates, and column (2) values trade at a uniform ruble/dollar crossrate of 2. c 1985 data. Source. United Nations data.

cause serious problems. The likely magnitude of 1. The CMEA shock. In January 1990 the USSR these shocks is one of the main factors causing a announced its intention to terminate the CMEA sober reappraisal of the outlook for reform. The systemasof January 1991. The resulting shockhas USSR, in contrast, is likely to emerge as a net two components: beneficiary,withitscapacitytoimportfromOECD * Terms-of-tradeeffects. World commodity countries higher than it would otherwise have prices will differ from the five-year moving aver- been. agesused forCMEA trade."0In addition, the "soft-

35 ness" of manufactured goods will be reflected for Trade and payments policy in the transition the first time in a quality discount relative to world price levels for corresponding products. Two transitions are relevant in considering trade Estimates of CEE terms-of-trade losses vis-i-vis and payments policies - the transition process in the USSRare shown in table 1.3. The estimates for trading arrangements within the CMEA area, and 1990 assume trade volumes at their 1989 levels, thetransition within the CEEcountriestoward the although trade volumes are expected to be signifi- private market economy. Especially following cantly lower. In any case, the dissolution of the the changes in the CMEA, trade and payments CMEA (particularly given higher world oil prices) policies need to be approached on an overall basis represents a major shock. and within the parameters of system reform. * Tradevolume effects. USSRcrude oil expo)rts Because of the complementarity of resource to the CEE countries are expected to decline dra- endowments and the structural dependencies (in- matically in 1991, because of the USSR's falling cluding transportation networks) built up over production and its suspected policy decision to decades between the CEE and the USSR, main- consider the CEE area as the residual market. taining mutual trade among ex-CMEA countries This, combined with lower manufactured export is desirable, especially in the transition period. prices, is likely to lead to a sharp contraction in Although the length of this period is not clear, the trade volumes. While trade contraction in 1990 USSR would probably prefer the shortest transi- was about 10 percent, informal Soviet estimates tion, while the five CEE countries could benefit for 1991 suggest the possibility of trade with the from a slower transition (at least vis-a-vis the five CEE countries declining to 50-60 percenlt of USSR). Because of the inevitable slowness of the 1989 level, and recent experience suggests the institutional change, the transition is likely to decline may be even greater. require bilateral arrangements between the CEE 2. TheGulfcrisis shock. Iraq and Kuwaitare impor- countries and the USSR,perhaps through "indica- tant trading partners of most of the CEEcountries. tive lists" for product trade.61 Although ex-CMEA Iraqi debt to the five (excluding Yugoslavia) to- countries are likely to seek rules of settlement that tailed $4.5 billion in 1990,and imports of the five economize on the use of convertible currency from Iraq in 1989 exceeded their exports to it by reserve balances, proposals for the creation of an some 70 percent. CEE countries expected repay- East European Payments Union patterned after ment through expanded crude oil imports, which the European Payments Union of the 1950sare not would have offset some of the costs of the CMEA likely to be adopted. dissolution. The experiences of Hungary, Poland, and Yu- 3. The impact of Gernan economicand monetary goslavia in 1990 suggest considerable scope for union.The former GDR was the most important increasing manufactured exports to Western mar- supplier of high-technology engineering prod- kets. The importance of access to Western markets ucts and chemicals within the CMEA and an im- is heightened by the impending contraction of portant customer for consumer goods from the CMEA trade. Indeed, access has improved con- five CEE members. German unification means siderably in recent years. Between 1988 and 1990 the likely loss of the GDR as a major market for the EC concluded bilateral agreements on coop- such goods. eration with each of the five ex-CMEA members, Largely because of the above shocks, the out- and the EC has begun negotiations with Poland, look for the CEE countries' balance of paymen ts is Hungary, and Czechoslovakia on more far-reach- not bright. The UN Economic Commission for ing "agreements of association." The countries Europe recently projected an aggregate current now benefit from MFN status and more recently account deficit of some $11 billion for 1991,most from the Generalized System of Preferences of of which was expected to be financed by the both the EC and the United States. Agricultural multilateral financial institutions. Bank projec- trade is subject to the rules of the CAP, however, tions of thedeficits of the CEE countries,as shown and quotas remain on selected manufactures, al- in table 1.2,are similar. But themost severe impact though many are nonbinding. There appears to of the deteriorating external environment is likely be little immediate prospect of joining the EFrA or to be on output and employment. the EC.

36 Table 12 Convertible currencytrade indicators for CEE countries, 1988-90 (bilions of dollars)

Cumnt acct. Debt/ Debtl Exports Currnt account Totaldebt Reserves prvjected CDP exprts GDP (cono.curr.) (cono.curr.) (cono.curr.) (conv.cum.) (conv.cwr.) (percent) (percent) Coury 1989 1990 1988 1989 1990 1988 1989 1990 1988 1989 1990 1988 1989 1990 1991 1990 1990

Bulgaria 20.3 22.4 3.5 3.1 25 -0.8 -1.3 -0.6 8.2 9.2 9.0 1.4 0.9 0.8 -2.0 40.2 360.0 Czchoslovakia 50.3 46.5 6.7 7.3 7.3 0.1 0.4 -0.5 7.3 7.9 7.7 1.8 2A 1.2 -2.4 16.6 105.5 Hungary 29.1 321 6.3 7.3 7.9 -0.8 -1.4 .0.1 19.6 20.6 20.0 2.0 1.7 1.1 -1.2 62.2 252.9 Poland 68.4 62.3 8.0 8.3 12.3 -0.6 -1.8 -1.5 39.2 40.6 46.3 2.2 2.3 6.9 -2.5a 74.3 375.8 Romania 53.5 35.5 6.5 6.0 3A 3.6 29 -1.4 3.1 1.4 2.0 0.8 2.0 0.7 -1.7 5.6 59.6 Yugoslavia 62.3 58.9 14.3 16.0 18.1 2.2 2.0 -1.1 19A 17.2 16.3 4.3 7.1 8.9 -0.7 27.6 90.0 Total 283.8 257.7 45.3 48.0 51A 3.7 0.7 5.2 96.8 97.0 101.2 12.6 16.4 19.5 -10.5 39.3 196.8

a. Priet,ed cunentacwcmt for 1991does not indude impactof Paris Qub debtrelief for Poland. Sowor WorldBank data. Table 13 Estimates of Soviet subsidies tlrough the CMEA (billionsof current dollars)

1990a

(B) / GDP Country/group 1982 1987 1988 1989 (A) (B) (C) (C)-(A) (pmcnt)

Hungary 2.6 0.1 -0.1 1.0 1.1 1.9 2.6 1.5 5.9 Bulgaria 3.7 0.2 -0.1 1.4 1.6 2.7 3.7 2.1 12.1

Czechoslovakia 4.9 0.2 -0.2 1.8 2.1 3.5 4.9 2.8 7 .0 3b GDR 5.9 0.3 -0.2 2.2 2.5 4.2 5.9 3.4 - Poland 4.3 0.2 -0.2 1.6 1.8 3.1 4.3 2.4 5.0 Romania 0.4 0 0 0.1 0.2 0.2 0.4 0.2 0.8 CMEA Six 21.7 1.0 -0.9 8.1 9.4 15.6 21.8 125 - Excluding GDR 15.9 0.8 -1.1 5.8 6.8 11.4 15.9 9.1 4.4

a. Column (A) is based on an oil priceof $15.80/barrel; column (B) is based on an oil price of ($15.80+$26.00)/2= $20.90/ barrel; and column (C) is based on an oil price of $26.00/barrel. b. Percentage of 1989 GDP. Sourmc OECD data. An assessment of the future place of the CEE though labor costs in the CEE countries appear to countries in the global trading system is outside be moderately low relative to the NICs at current the scope of this annex. Although the USSR.has market exchange rates, this may not be sustain- clear comparative advantage in resource-inten- able in the longer run.'2 One likely longer-run sive exports, the major competition in many areas implication of reform isa substantial reorientation of CEE production appears likely to come from of trade flows, away from former CMEA markets the newly industrialized countries (NICs). Al- and toward Western Europe.

38 Annex 2 Privatization of state enterprises ownership quickly and equitably but may also compromise efficiency and raises no revenue for Private sector development in reforming socialist the government. economiesinvolves two concurrentchanges: au- Experienceto date in the countriesof Central tonomous expansion of the private sector and and Eastern Europe indicatesthat they are likely privatizationof the existingstate sector. Autono- to followdifferent paths to privatization. This is mous expansionof the private sectoris extremely due in part to differencesin their starting points, important and may in the longrun prove to be the includingthe politicaland socialstrength of vari- major engine of growth and transformationin ous groups (including workers, the these economies.'3 This annex focuses on the "nomenklatura,"and former owners), the exist- complex question of how to privatize existing ing degree of decentralization,and the history of state enterprises. The socializedsector accounts reformefforts.Not surprisingly,these differences for over 80 percent of value added in all of the arereflectedinthelegalframeworksforprivatiza- reformingsocialist countries (table 2.1). There are tion. some 2,300 state firms in Hungary, 7,500 state In Hungary, the groundwork for privatization firms in Poland, and 26,000socialized firms in was laid by the October 1988Law on Economic Yugoslavia."Rapid and massiveprivatization is Association,which allowed state enterprises to essentialfor the developmentof a private market "corporatize," that is, convert themselves into economy;there is a real risk that the processcould joint-stockcompanies. The Law also allowed be paralyzed if momentumis lost. enterprisesto issue shares and individualsto buy Afteryears of failurewith market-orientedre- them. For self-managedfirms (about 70 percent of forms of state enterprises that essentiallypermit- allenterprises),thedecisiontoconvertrestedwith ted greater self-managementbut failedto impose enterprisecouncils. Because councils were gener- financialdiscipline, all of the reformingcountries ally dominatedby management,this led to a spurt now share the centralpolitical goal of widespread of spontaneousprivatizations, often at advanta- privatization.Smallenterprises-mostlyinretail geous terms for managers and outside investors trade and services-arebeing privatizedrapidly, they brought in. An interestingpolitical coalition mainly through local auctions.&Few large-scale supported this process- economicliberals, who firmshave been privatizedto date, althoughmany viewedspontaneous privatization as the quickest plans have been proposed and debatedand many and easiestway to dismantlethe state sector,and laws passed. One factorthat promisesto acceler- "nomenklatura,"who saw in the process an op- ate the speed of privatization - given the diffi- cultyof directlyabrogatingacquired rightsof self- Table 2.1 State-owned sector as share of value- managernent- is the impositionof firmer finan- added in selected countries, in the mid-1980s cialdiscipline on firms. More than 450liquidation (percent) procedures are under way in Hungary, including 35 large industrial enterprises employing57,000 and 11 large state farms and cooperatives.Large Shareaof numbers of Yugoslav firms face liquidation pro- Countr vdue-dded ceedings, which are to be triggered after their arrears to banks or other firms reach 60 days. CSFR 97 Privatization has three key economic objec- GDR 97 tives: to improve efficiency,to spread ownership USSR 96 widelyand fairly,and to raise fiscalrevenues. Yet Yugoslavia 87 in the case of medium and large enterprises,there Hungary 86 are clear tradeoffsamong them. Saleof assetsby Poland 82 the state may raise revenues but is likely to con- France 17 centrate ownership in a few hands and to be so Italy 14 slow that efficiencygains are modest in the short WestGermany 11 run. Spontaneous privatization initiated from UnitedKingdom 11 Denmark 6 below (by managers or outside investors)might UnitedStates 1 raise efficiency quickly but does little to spread ownership fairly or raise public revenues. Mass distribution of shares to the public may spread Source:Milanovic (1989).

39 portunity tD acquirewealth. TheTransformation mentary debate, the State Enterprises Privatiza- Lawof 1989was designed to address some of the tion Act was adopted in July 1990.It representsa previousabusesofspontaneousprivatizationand compromise between different viewpoints; to establish more rigorous oversight of the pro- corporatization,and later privatization,can take cess. The State Property Agencywas set up with place only with the consent of workers' councils. a mandate both to limit undervaluationof assets Thislaw leavesintentionallyvague theprocedure whentheprivatizationinitiativecamefrombelow of privatization,allowing practically all schemes: and to initiate privatization from above. By the salesof entire firms,liquidation and assetsales to end of 1990,the SPAhad approved 64 of the 77 private parties, free distribution of shares to citi- spontaneous privatizations proposed after Sep- zens, and establishmentof holding companiesto temberl990."1In addition, in September it pre- own shares. Thelatest Polishplan envisagessales sented its first list of 20 state enterprises to be of anumberofthelargestfirmsandmassdistribu- privatizedunder its own initiative,and in Decem- tion of ownership interests in hundreds more. ber a second list of 20 enterprises was approved Whateverthe model selected,employees can buy for "active" privatization. Bycombining super- up to 20percent of shares at 50 percentdiscount. vised spontaneous privatization with SPA-initi- Foreigninvestors can acquire up to 10 percentof ated sales and sales initiated by investors,Hun- shares without explicitauthorization of the gov- gary hopes to privatize up to one-half of state emient. A Ministryof Ownership Change has property over the next three years. been establishedto oversee the process and spe- Hungary's path is differentin two ways from cializedfinancial institutions set up to facilitateit. that being proposedelsewhere. First, it is the only The sale to the public of five enterprises, com- countrythatcontinuestosupportandrelyheavily pleted in January 1991,was deemed a moderate on spontaneous privatization from below. The success. Aftera three-weekextension of the offer other countries-most notablyPoland but alsoto period, a total of 100,000people applied to pur- some extent Yugoslaviaand Bulgaria - have chase shares, and the issues for four of the five tried to curtail the practiceafter brief experiences companieswereoversubscribed.A secondgroup with its real and potential abuse. Second,Hun- of companies to be sold in this manner will be gary(alongwithYugoslaviaandtheformer(GDR) announced shortly. In addition, several large stillrejects mass distributionof shares to citizens, companieshave been sold to foreignenterprises, relying exclusivelyon sales of assets. Some!emi- and the assets of some 200 more have been sold nent Hungarian economists, including Janos after liquidationof the enterprises. Kornai, have argued strongly that the govern- The majorchallengein any massdistributionis ment has not only the budgetary need but also the to spread ownership widely while maintaining fiduciary duty to the public to sell state-owAmed someconcentrated corporate governance capabil- assets at the highest possibleprice. Opponents of ity. The variousmeans proposed to achievethis in sales argue in turn that valuation is inherently Poland and elsewhere all envision the establish- impossibleand thus arbitrary,and, more impor- ment of some sort of intermediaryto hold shares tant, that relying on sales will restrictownership in trust for the public (see box 2.1 for one Polish to those with money - primarily former plan). In the variousplans the intermediariescan "nomenklatura,"black marketeers,or foreigners. be either publicor private. Theyare chargedwith Poland started its privatizationdrive in a diffi- passively managing their portfolios as mutual cultposition. Previousreformsintheaftermathof funds, actively overseeing the firms as holding martial law had expanded the role of workers' companies,orrestructuringandsellingthemmore councils. Ownershiprights had becomeambigu- in the spirit of privatizationagencies-' ous; workers and managers argued that autono- Although the other reforming countries also mous enterprises could enter into any kind of support rapid privatization,plans are not as ad- legallypermissible contract and could issue their vanced as in Polandand Hungary. The CSFRand own shares to any investorincluding themselves. Romaniajoin Poland in favoring mass distribu- The waveof resultingspontaneousprivatizations tions. The CSFR's legislature has just passed in 1989provoked public outcry. In early 1990the privatizationlegislation that callsfor widespread state tried to reclaimlegal title to all assets in o1rder distributionof assets via vouchersas well as some to begin privatization from above, but it did not salesof shares or individual assets (upon liquida- succeed entirely. After several months of parlia- tion). Romania'slaw, passed by the legislaturein

40 Box2.1 A recent privatization plan for Poland

One innovative privatization plan for Poland envisions public would have little information on which to base a giving away a large share of state assets through several choice of intermediaries in the first round, several auctions "auctions." For each auction, vouchers would be distrib- would be held over time, providing the public with increas- uted as follows: 30 percent to the public, 20 percent to the ing information on intermediary perfornance. The inter- pension system, 10 percent to commercial banks, and 10 mediaries would develop into financial institutions, and percent to workers; 30 percent would be held in reserve by every company would have widespread ownership and yet the government. Any intermediary (such as a foreign joint some locus of oversight and controL Essentialy, the task of venture) that wanted to enter would be allowed to advertise privatization would itself be privatized, with government for vouchers, and citizens holding vouchers would entrust removed from the process. them to the intermediary of their choice. Intermediaries Some observers have criticized this plan as too complex would then use their vouchers to bid for the block of firms (Sachs 1991). They suggest a simpler variant, in which offered at that particular auction. To ensure some concen- minority interests in state companies would be equally tration of ownership, 20 and 30 percent blocks of shares in distributed among several mutual ftmds. Citizens would each company would be bid firsL To provide sound incen- then be assigned ownership interests in the funds on a tives to the intermediaries, they wouldbepaidinproportion random basis. Remaining shares not distributed to the to the appreciation of the assets they held. Although the fundswouldbegiventobanks,pensionftmds,andworkers.

September1990, proposes to distribute30 percent hectareseach.It alsogave workersoncooperative of enterpriseassets to the public at large and sell or state farms the right to buy land at reduced any remaining assets not specificallydesignated prices.The law was approved by Parliamentbut to remain state-owned.6"Bulgaria has produced wasdeclaredunconstitutionalbecauseitdiscrirni- five draft privatization laws, although no clear nated against other former landowners. Current goalsorstrategy have emerged. It was previously plansare toprovidecompensationinnmoneyrather one of the most centrallyplanned economies,and than in kind. In the CSFR,a1aw passed in late 1990 changesmay proceed relativelyslowly. providesfor reprivatizationof some70,000 prop- Yugoslaviahas had to deal with the mostfirmly erties nationalizedin the late 1950s,although how entrenched worker self-managementof all the to do this is uncertain. TheGerman privatization reformingcountries. Its strategyhas been to try to program is being severelycomplicated by more remove self-managementrights while simulta- than one millionproperty restitutionclaims filed neously providing firms with the legal means to by privateindividuals, plus 15,000filings by local sell assets, preferably to their work forces (at a governments. discount of up to 70percent). The 1988Enterprise All of these countries are fornulating privat- Lawand the 1989Law on SocialCapital limit self- ization plans in an environment of tremendous managementrights and allow self-managedfirms political,legal, and institutionalchange and un- to be transformed into joint-stockcompanies at certainty. Although some of the most optimistic the initiationof workers' councils. Initial results plans call for privatization of up to half of state have been disappointing; few sales have taken assets in as little as three years, most observers place and DevelopmentFunds supposed to over- expect the process to take far longer and to be see privatization and receive a share of the pro- fraught with difficultyalong the way. Salesare ceeds are only now being created. The role of inherently slow, and mass distributions,though theseFundsdifferswidelybyrepublic.TheSerbian attractive in principle,may be difficultto imple- Fund, forexample,intendstoconcentratemoreon ment in practice. It isclear that many enterprises restructuring,while the Fund in Sloveniaintends will remain in state hands for sometime to come, to work exclusivelyas a privatization agency, especiallyinthetroubledheavyindustrialsectors. valuing and sellingassets as rapidly as possible. If left alone in thisatmnosphere of uncertainty,the Claimsof formerowners have complicatedthe enterprisesector will do little to restructure. Al- privatization process, particularly in Hungary, thoughtraditional state planningand controlmay the CSFR,and the formerGDR The ruling coali- be undesirable,active governmentinvolvement tion in Hungary agreed in July 1990 to a inoperatingandrestructuringenterprisesisclearly "reprivatization"law for agriculturalland, which needed. gave owners dispossessedin 1947the right to 100

41 Annex 3 Agriculture percentof GDP.Because other necessitiessuch as housingare subsidizedeven more, food accounts Agriculturepresents some of the most challeng- for about one-third of householdbudgets. ingissuesinthetransition. Agriculturalsectorsin Agroindustry is highly concentratedin most CEEare quite large; for example,the sector em- countries, and huge state monopoliesdominate ploys 28 percent of the Polishlabor force. Retail processing,distribution, and supply of inputs. food prices have historicallybeen held down by The degree of vertical integration between pro- subsidiesdeeply embedded in politicalancl eco- cessingand production varies;in Hungary,many nomic relations. Changes in agricultural price cooperativeshave processingenterprises. CEE policiesand in property rights over land --- an- agroindustry is hampered by poor incentives, other very sensitive issue - will affect income pricecontrols, and low investmentlevels, and the distribution and the future productivity of the quality of much processed food is below that sector. required on competitiveworld markets.

The prereform legacy The challenge for reform

The CEEcountries constitute a large and diverse Pricereform and agroindustry linkages. As in agricultural region. In the northern countries other sectors, reform of agriculture involves liber- grains, roots, livestock, and specialty crops domi- alizing prices and markets, defining and chang- nate production. In the center, warmth and rnois- ing property rights, restructuring at all levels, and ture are adequate for maize, oilseeds, and mixed defining a new role for government. Price reform grain and livestock farming. Farther south, involves reducingorremoving subsidiesand so is viticulture, orchards, and tobacco become more consistent withmacroeconomic stabilization. Even important, as does irrigation. Although these if compensated partially through transfers,'9 in- countries in the past shared a common ideology, creases in relative food prices tend to reduce de- differences in inherited agricultural policy, per- mand. Especially because of the monopolistic po- formance, and farm organization are substantial. sition of processors, this fall in demand can place Large state and collective farms dominate the pressure on farm incomes, which cannot speedily region's agriculture. Poland (with 75 percent of be alleviated by turning to export markets be- land privately owned) and Yugoslavia are excep- cause of the weaknesses of the processing indus- tions. Although members of the collectives iFor- try. Producers are hostage to the pace of change in mally hold title to their land, there is in practice processing,marketing,anddistribution,andstruc- little difference between collectiveand state farns, tural reforms in these areas are therefore of the and both types are protected by soft budget con- highest priority. Deconcentration of plants and straints. Most private production takes plao on the introduction of competition (for example, small plotsof aboutone-half hectare with nonlalbor through expanding small-scale private transport) inputs and services supplied by the large farm. are essential. There is thus a symbiotic, if inefficient, relation- ship between these two dualistic componenbs of Propertyrights. The definition and distribution production. of land property rights affectsproducers' incen- Income per capita in agriculture (includling tives to manage land efficientlyand invest in its earnings from private activities)is on average futureproductivity.Howbesttorestructureprop- relativelyhigh. Yieldsof grains and field crops erty rightsin the caseof the large state and collec- are lowerthan in WesternEuropebutcomparalble tive farms is a complex question. A range of to thosein many parts of the world. Productivity options exists,including transforming them into in the livestocksector is often low by world slan- truecooperatives,expandingindividuallandhold- dards. Because of subsidized consumer prices ings while maintaining a cooperative core, or (especiallyfor meatand dairy products),national shiftingentirely to individual private farming or food consumptionis high in relationto per capita long-termleaseholds. The need to create smaller income(see table 3.1). Pricesubsidies have tylpi- commerciallyviable farming units is widespread cally equalled about 5 percent of GDP in CEE (exceptin Polandand Yugoslavia,where efficient countries. In the USSR,they accountfor up to 12 farmingmay require someconsolidation of small

42 Table 3.1 Per capita average food consumption, 1985 (kdlogramsannually, except where otherwise noted)

Protein Calories (gramsper Grainand Country per day day) Meat Milka Eggsb Potato brad

Unweighted average for 12 OECD countriesc 3,324 98 79 134 14 75 8

Bulgaria 3,634 106 77 250 10 33 144 Czechoslovakia 3,473 103 86 239 14 78 111 GDR 3,800 113 96 - 12 143 99 Hungary 3,541 102 77 175 13 54 110 Poland 3,298 102 67 403 9 143 118 Romania 3,358 104 60 - 12 - 143 Yugoslavia 3,542 102 55 - 7 51 175 USSR 3,394 106 62 295 10 104 133

Average 3,505 106 73 272 11 87 129 a. For OECDcountries, excludes processed dairy products. For CMEAcountries, includes milk equivalent of all dairy products. b. For CMEA,converted to weightat four kilograms/100eggs. c. Data for calorieand proteinintake are for 1984-86. Sources: FAO(1988); OECD (1988); and WienerInstitut f(r lntemationaleWirtschaftsvergleiche (1989,157-63). farms). No single solution is ideal due to the absentee shareholders as industrial enterprises diversity in local conditions across the countries. would be under the various voucher plans now Several countriesare moving to privatize state- under consideration (see annex 2). Therefore, owned orcooperative land. Poland has expressed neither state nor collective farms should be in- the desire to restructure its state farms (which cluded in the portfolios of any intermediaries that account for 25 percent of landholdings) and to may be established to "invest' vouchers or hold break up some and distribute their land to indi- shares in individual enterprises on behalf of the viduals, but procedures for doing so have not yet public. been worked out. Bulgaria and Romania passed land reform laws in early 1991 that provide for the Employment. Hidden unemployment in the breakup of collective farms and the return of land agricultural sector appears to be substantial. This to private ownership. In each country claims of can be partially alleviated through attrition and prior owners will be honored, although the land retirement, as mnanyworkers are older than 55. retumed will not necessarily be that taken away at The reassignment of property rights toward pri- collectivization. Many questions remain with re- vate farms that use more labor would increase gard to implementation in each case. Hungary both labor intensity and productivity. If the cre- has also recognized claims of prior owners of ation of smaller farms and improved incentives agricultural land, but they may be discharged (through decollectivization, leasing, or privatiza- through monetary compensation rather than in tion of land) should stall, agriculture will not be kind. able to absorb additional labor. The underdevel- There has not been widespread discussion on oped rural service sector as well as a revitalized how to coordinate land reform and the more gen- processing industry offer longer-run prospects eral privatization of state assets. Although the foremploymentgrowth. Thereareampleoppor- approach to property rights in land should be tunities for technical assistance in this area, in- consistent with property rights in other assets, cluding assistance to develop rural finance and land should not be owned by widely dispersed export capability.

43 Progressto date A comparison with China

Retail food prices were liberalizedin Poland in Decollectivizationof agriculture and the growth August 1989. As real incomes declined and ex- of rural industries fueled a period of dynamic pendituresshifted,foodconsumptionisestimated economic growth in China's countryside after to have fallenby 10-15percent, even though the 1978.Although the potential payoff to agricul- shareof food in totalhousehold budgets rose from tural reform in CEE countries is high and the 39 percent to 45 percent. At first producerslwith- supply response may be substantial,agriculture held stocks from the market becauseof price un- in these countries cannot be expectedto play so certainty,but excesssupply soon replacedshort- dramatic and leadinga role as it did in China.One age. Polish agroindustry is highly concentrated differenceis technological.Agriculture in CEEis and its restructuringhas barely begun, although far more dependent on modern servicesand pro- the scopeof private marketingand transporthas cessingfacilities than in China,and restructuring increased. The CSFRhas undertaken price re- these areas will take time. fonns,butitsagriculture, like thatof Bulgariaand A more fundamental differencearises on the the formerGDR, remains highly collectivized.Its demand side. Reforms in China increased the processingsector is monopolized and technologi- demand for food. Rural incomes rose sharply, callyill-equipped. Hungary's agriculturalsector and this added to demand for simple manufac- has undergone many changes over the last thlree tured consumergoods and services. Thesecould decades but is also still largely collectivized.Its be produced relativelyrapidly using surplus la- processingand input supply industries are still borreleasedbythereformsandsavingsgenerated concentratedand are frequentlylinked with pri- by the higherincomes. In CEE,the majorityof the mary production on large farms. As in other population is no longer rural or employed in countries,the reorganizationof property rightsin agriculture,and it is likelythat the demand shock Hungary requires the separationof mostprocess- causedby the removalof food subsidieswill ini- ing and rural servicesfrom production in order to tiallydominate productivity effects on the supply foster more competitivemarkets. Romania'san- sideand dampen farmingincomes. Land reforms nounced plan to privatize agriculture would, if in CEEare thereforemore complex than in China, implemented, constitute the most dramatic and, because linkagesdo not operate as strongly decollectivizationprogram to date. Yugoslavia - or even in the same direction- as in China, has many private producers, but they are con- they are not expectedto have the same power to strained by processingand distribution systems generateeconomic growth. that favorthe socializedsector. In the region as a whole,there has beenlittle progress to date in land reform.

44 Annex 4 Financial system reform cial information. Accounting standards did not conform to generally accepted principles, and In a market economy the financial sector stands at there was no tradition of independent audit. The the center of resource mobilization and allocation legal frameworks covering central and commer- and the pricing and allocation of risk. In a planned cial banking activities, securities markets, and the economy intermediation is largely performed clients of the financial intermediaries were gener- through the fiscal system, with a simple and pas- ally inappropriate to a market-driven system. sive financial system ignoring risk and accommo- From the late 1980sthe CEEcountries began to dating to the credit demandsof the plan. Financial modifythisstructurebycarvingcommercialbank- sector reform and development is therefore vital ing activities out of the central bank and transfer- for system reform and must be addressed at the ring them to new commercial banks. These banks outset. Indeed, all of the CEE countries have are still government-owned except in Hungary, placed financial system reform high on their agen- where enterprises hold almost 50 percent of their das and are actively implementing or designing shares, and in Yugoslavia, where enterprises have reforms. a large ownership interest. De facto regional or Experience to date suggests that the absence of functional specialization and restriction of clients a market-based financial system is costly even in to the use of a single bank have, in practice, se- the initial stage of macroeconomic stabilization, verely limited competition between these banks. because no effective channel exists to assure that Although the new banking laws typically allow macroeconomic policies - in particular, tight the banks wide scope (following the universal credit -improve resource allocation at the micro model) and permit entry of new banks,70financial level. The limited structural change that has ac- systems are relatively undeveloped. Poland, for companied restrictive demand policies in Hun- example, has only one bank branch per 40,000 gary, Poland, and Yugoslavia is at least partly people, compared with one per 10,000-15,000 attributable to the underdevelopment of their fi- people in Western Europe. The financial sector nancial systems. accounts for only 0.9 percent of employment, its Nevertheless, financial system reform is not an ability to handle large volumes of transactions is adequate lever to force the pace of overall restruc- limited, and clearing is slow by the standards of turing of the productive sectors. Fully liberalized market economies. financial markets and privatized intermediaries Yugoslav banking evolved in a different pat- operating under tight budget constraints prob- tern. The breakup of the monobank system in ably come later in, rather than at the start of, the 1971 led, by 1988, to some 360 banks, usually reform agrenda. Financial reform poses a number owned by groups of associated self-managed en- of unresolved issues, someof whichhavenotbeen terprises that were also their major clients. The extensively analyzed. central banking system consisted of the National Bank of Yugoslavia and eight regional National The prereform legacy Banks. Foreign exchange deposits grew substantially The financial systems of most planned economies in the 1980s in Yugoslavia and in Poland.- Re- consisted of a central-cum-commercial bank ser- sponsibility for foreign exchange liabilities in the vicingenterprises,asavingsbankacceptinghouse- CEE countries generally rested with the central hold deposits and lending to households largely bank or the foreign trade bank, because other for mortgages, a foreign trade bank handling all banks had no foreign-denominated loans on their foreignexchangeactivities,andaninsurancecom- books. Devaluations were therefore to impose pany. All were state-owned. Interest rates were serious exchange losses corresponding to those typically very low, often lower on the deposit side liabilities. In Yugoslavia, the valuation losses for firms and on the lending side for mortgages. carried on the books of the National Bank have Surplus funds in the savings bank were nonnally been estimated at 60 percent of total assets, and channeled through the central bank toward the those of Bank Handlowy in Poland at some seven enterprise sector. Risk management and pricing times its capital. and prudential considerations played no role in Another serious legacy of the past was the the allocation of funds, in regulation and supervi- accumulation of decades of losses from the enter- sion, and in the organization and flows of finan- prise sectorand from subsidized household mort-

45 gage loans in bank portfolios. Thoselosses arose and independent auditing, as well as a suitable during periodsof slow growth but relatively'high legalframework for debt recoveryand other pur- investment. Comprehensiveestimates of losses poses. Governmentsmust develop prudential are not yet availablefor any country,and indeed, regulation and supervision for financial institu- the full size and distribution of losses will con- tionsthatiscompatiblewithcompetition.Finally, tinue toevolve(and almostcertainly to worsen)as mechanismsto control monetaryaggregates are the economiesadjust to reforms(including that of vital during the transition,but it is impossibleto the CMEAsystem). In certaincountries inflation have effective macroeconomiccontrol without has eroded the burden of domesticdebts, but in resolving problemsof monetary overhang,gov- others the available fragmentary information emnent and enterprisedeficits, the proliferation paints a frighteningpicture. It is probablysafe to of bad debts, and the generation of foreign ex- assume that proper asset valuation would leave change losses. manybanksin thereformingcountrieswithnega- Many unresolved issues concern the future tive capital, sometimes several times over, and structure of the system. Althoughgovernments that in somecases losses could compare to those havegiven much thought to privatizationin gen- experiencedin major financialcrises elsewhere.7 eral, they have given much less to the ownership Consideringmortgage finance alone, in 1989the of banks. Present arrangements, in which the interest rate subsidy implicit in the stock of low- banks are often owned by the central bank or by interestloans in Hungary was 2.3percent of GDP. large clients,are questionable.They conflict with Nonbank financehas been limitedin the CEE the central bank's regulatory role and promote countries, with the exception of interenterpiise insider lending and monopolisticpractices. The credits, which increasedin the 1980swith enter- alternativeof groupingbanks and enterprisesto- priseautonomy. Interenterprisecreditsgrewr-p- gether into holding companies(the arrangement idly through the 1980s in Yugoslaviaand ex- in Algeria)could also raise difficulties. It would ceeded bank credits to enterprises in Polandlby be preferablefor major financialinstitutions to be mid-1990.They also increased sharply in Hun- owned initially by special investment trusts on garywhentightmonetarypolicywasimplemenlted behalf of the public, and for these later to be after 1988. Although their growth has to sorne privatized. extent reflected that of normal commercialrela- Consideringthe reverse question, the owner- tionships,the absenceof risk-basedchecks to the ship of firmsby banks,most of the CEEcountries expansion of such credits (especiallybecause of are adopting banking models that permit this the prevalenceof monopolistictrading links)ien- more readily than in most industrialized coun- ders them an impedimentto macroeconomicsta- tries.?4 These models require careful consider- bilizationand to the rationalizationof the enter- ation; the corporate governanceproblem is not prise sector. They also increasethe risk of sys- likely to be amelioratedby granting ownership temic insolvency. Securitiesmarkets began to rights to bankerswho have relativelylittle experi- develop in the late 1980s73but their wider role'has ence with modern market institutions. been stifled by the absence of clear ownership Anotherissue concerns the separationof bank- rules and operationalbankruptcy procedures. ing and other financial services,such as under- writing, trading, and investingin securitiesand A framework for financial sector reform insurance.Historically, thermajorindustrial countries have maintainedconsiderable specialization Financialsector reform in CEEcountries is more amongintermnediaries,althoughwithrecenttrends complexthan in market economies,as it involves universal banks now offer a wide range of such reshaping and to some degree recreatingthe sec- servicesin about half of the G-10countries. Al- tor rather than just liberalizingit. In the area of lowingbanks to provide a broad range of services banking, existingpayments systems are techni- can be problematicin an emergingfinancial sys- cally and organizationallyinadequate and need tem, as both the managementand supervisionare extensiveupgrading. Interest rate policiesmuist moredifficult for universalbanks than for special- be revised and the taxationof intermediationre- ized institutions. viewed. Instruments to mobilizefunds must le The banking structures being put in place in enhancedand credit skillsdeveloped. Banksand certain countries also raise the question of the their clients need adequate informationsystems future contestabilityof financialmarkets and the

46 scale and managementquality of internediaries. versalsthat inevitablywill accompany the reform On theoneextreme, most lending in Czechoslova- process. Foreignbanks are extensivelyinvolved kia willbe concentratedin two regionallyspecial- in assistinginstitutional reforms, primarily on a ized institutions. On the other, there are so many consulting basis although some joint ventures banks in Bulgariaand Yugoslaviathat good man- exist. agementmay be hard to find and scaleeconomies One of the most pressing transitionalissues is may be lost. A related question is how best to how to address the problem of existingportfolio integrate corporate lending and retail deposit- losses. Bankand portfolio audits as well as insti- taking. Governments might want to break up tutional diagnosticstudies are well advanced in savings banks and integrate their brancheswith HungaryandareproceedinginPolandandYugo- the major commercialbanks. There are alterna- slavia. In the interim,progress has been slow in tive models, and the choice might differ among dealing with problemloans, due partly to the lack countries. of incentivesfor intermediariesto recognizeloan The development of securitiesmarkets is im- losses. A range of holding actions can be man- portant given the desire of the CEEcountries to dated to limit growth in the banks' exposure to privatize ownership, develop competitive finan- problem borrowers.76However, long-term solu- cial markets, and fund governmentand enterprise tions are dependent on further progress in the deficits in a noninflationary way. However pri- broader economic reform program. If banks are vatization is conducted, the initial distribution of placed under a hard budget constraint (or shares is likely to be different from the desired privatized) before they are adequately capital- longer-rundistribution, and well-functioningsec- ized, perverse incentives will resul7. Yet the ondary markets for securities may thus be vital. restructuring of loan portfolios and recapitaliza- Furthermore, as individuals assume greater re- tion of banks cannot be finalized prior to reforms sponsibility for their own pensions and disability in the productive sectors and adjustment to major insurance, efforts should be made to develop con- shocks (such as the end of the CMEA system), as tractual savings institutions. Thismightbelinked these will have a large impact on the ability of with theprocessofprivatization,ifpensionliabili- firms to service loans in the future. In the mean- ties are assigned to holding companies set up as time, there is little social value in pushing any of enterprises are privatized. the state-owned banks into bankruptcy, given Legalandinstitutionalchangestoaddressmany their crucial role and the need to expand financial of these areas are under way. Governments are services. Furthermore, caution is needed on the rewriting central and commercial banking laws entry of new or foreign intermediaries whileexist- andestablishingtheinfrastructuretoregulateand ing banks carry a heavy burden of bad debt that supervise the new commercial banking systems. limits their ability to compete. Major investments in human capital are needed, Three important issues arise with regard to the both in prudential regulation and supervision handling of problem loans during the transition. and in commercial banking (particularly credit The first is the role of banks in debt recovery. In analysis). Institutes to provide training in these most versions of financial restructuring, problem areas have been established in Hungary, Poland, loans are carved out of the bank portfolios and and Yugoslavia, in all cases with foreign involve- replaced by interest-yielding government bonds, ment. Governments and consultants are revising thus transferring the loss to the treasury. The information systems, introducing standard ac- loans themselves are either placed in a special counts, and initiating independent audits. Hun- trust, staffed by specialists who will recover bad gary, the most advanced of the CEE countries in assets, or left (below the line) with the banks, financial sector reform, is creating an interbank which then act as agents of the treasury to recover clearing system with major investments in infor- assets. Each option has advantages and draw- mation technology. backs, and the choice will depend on a variety of Reform requires fundamental changes in atti- country-specific legal and institutional factors, as tude and extensive development of scarce skills. well as on the availability and distribution of Thesetaketimetoimplementandthereforeshould scarce skills in the area of workouts and restruc- be addressed from the outset of the reform pro- turing.?8 The outcome of the process is a "clean" gram.' To the extent possible, they should be bank, which, when adequately capitalized, can pursued through the periods of setbacks and re- compete actively and possibly be privatized.

47' The secondnear-term issue is the distribution credit policy. Addressing this problem without ofthelosses,whichrepresentaquasi-fiscaldefidt. segmenting financial markets may become an There are five choices:(1) monetary reform, in- important issue as private sectors develop, and volvingconfiscationofaportionoffinancialnlais, the experienceof other countries should be re- (2) money creation, (3) tighter fiscal poliy, (4) viewed to determine the most appropriate ways publicborrowing, and (5)the sale of public assets. of dealing with it. In practice, some mixture of these last four will Realinterest rates have been raised to positive probablybe used. The likelyextent of the losses levelsinmostCEEcountries,buttheexperienceof mayjustifyearmarldnggovernmentrevenuesfrom financial sector reform elsewhere suggests that asset sales rather than includingthem in general fullinterestrateliberalizationrequiresreasonable revenues." macroeconomicstability, a sound and competi- The third issue involvesfinance in the interim. tive financialsystem, and an effectivesystem of Until the banks have hard budget constraintsand prudential supervision and regulation. Guide- areresponsivetocompetitivepressures,theymight lines such as minrumumdeposit and maximum not have the incentive to seek out and develop loan rates are likely to be needed for some tine new clients,particularly in the rapidly emerging afterpriceliberalization,andtheseshouldbecare- smaler-scale privatesector. Yetthe experienceof fully monitored to maintain savings incentives othercountriessuggeststhatthesesmallerprivate and reasonableintermediation spreads. clients will be the most vulnerable to tightening

48 Annex 5 Fiscal policy a modest surplus in 1990. Only Yugoslavia and Romania consistently achieved fiscal surpluses in The CEE countries face enormous challenges in the late 1980s. reforming fiscal policy. They need to maintain Budgetdeficitswereonlyoneof several factors fiscalbalanceforstabilizationwhilereducingand affecting macroeconomic stability in these coun- reorienting both public spending and taxation. tries. In Yugoslavia and Poland, for example, Public spending should focus less on potentially enterprises were extensively subsidized by the competitive activities in industry and agriculture bankingsystemthroughlow-interestloans.These (most of which will in time revert to the private subsidies, although contributing to monetization sector) andmore on the provisionof public goods, and thus inflation in the economy, were outside includingbasic infrastructure, social services,and the budget altogether. In fact, in 1989Yugoslavia well-functioninglegalandregulatoryinstitutions. managed to have hyperinflation and a budget Taxation should be more transparent and should surplus at the same time. create incentives for efficient production and consumption. Although the overall size of the public Public spending sector should shrink, some central institutions of government - including those in charge of bud- Inrestment. One of the key features of socialist geting and tax collection - need to be strength- economies was the high share of fixed invest- ened. ments in GDP, typically exceeding 30 percent and sometimes as high as 40 percent.u1The great bulk Size and balance of the goverrment budget - 80-90 percent - was controlled by the public sector, whether government or state enterprises. Because of their large budgets, central govem- Although not all of this investment went through ments were the major financial intermediaries in thebudget, the government was often involved in the CEE socialist economies. During the 1980sthe major investment projects of state enterprises. consolidated state budgets accounted on average Indeed, one of the main advantages of socialist for roughly 60 percent of GDP in these countries, systems was considered to be their ability to real- exceptinYugoslavia,wheretheconsolidatedbud- ize high planned saving and investment levels get accounted for roughly 35 percent of GDP. and thus lay the groundwork for rapid growth. However,officialbudgetdataconveyonlypartial High investment was also stimulated by the "in- information on the pervasive role of goverrnent, vestment hunger" of semiautonomous enterprise sincepublic intermediationand redistribution can managers with access to cheap credit and with alsobe accomplished through the banking system little fear of bankruptcy if investments turned out or direct regulation (such as price and wage con- to be unprofitable. trols or regulation of enterprise investment). Many public investments were of poor quality. Several CEE countries experienced deteriora- Projects were usually large, took a long time to tions in their fiscal balances in the late 1980s,and complete, and often suffered cost overruns in part all have taken recent steps (primarily subsidy due to waste and pilferage. Investments were reductions and in some cases revenue increases) oriented toward heavy industry; social infrastruc- to improve them. Because of rising subsidies and ture, consumer durables, agroindustry, housing, declining real revenues during hyperinflation, and services were relatively neglected (although Poland'sl989deficitwasalmost8percentofGDP, investment in these areas, particularly housing, compared with less than 1 percent during 1983- increased somewhat in the 1980s). 88. After stabilization in 1990, the budget went The major challenge of public investment re- into surplus. Hungary's deficit was about 3 perform is to reorient spending and improve its effi- centof GDP in 1986and 1987,beforefalling to only ciency. Whileinvestmentsinpotentially competi- about 1 percent in 1988 and 1989 (due to increas- tive sectors can be increasingly left to the private ingrevenuesin 1988and subsidycuts in1989)and sector, public investment is urgently needed to being more or less in balance in 1990. Bulgaria's upgradedeterioratingbasicinfrastructure,includ- deficit rose to over 6 percent of GDP in 1988, ing roads, ports, public transportation, telecom- before falling toabout3percentin 1989. TheCSFR munications, irrigation facilities, and other rural faced a more modest but still significant deficit of systems.' Investment is needed to increase en- 1.5percent in GDP in 1989but expected to register ergy efficiency and to switch progressively to

49 cleanerand safersourcesthan the high-sulfurcoal diesonbasic goodsmodestly furthered this goal.a and nuclear power on which the CEE countries However,thebenefitsofcertainsubsidies,includ- now depend. There is a risk that these countTies ingthoseonrailwaytransportand culture,tended will overreactto the centralizationof the past by to be skewed toward higher-incomegroups, and reducing much-needed investments in "public the high-pricedblack markettrade that accompa- goods" that complementprivate investment. nied price controlsgenerated its own incomedif- ferentials. The negative effect of subsidies on Subsidies.Subsidies to consumers and enter- resource allocation has also been widely docu- prises typically accounted for a large share of mented. The low cost of energy, for example, budgetary spending in socialisteconomies 1(see encouragedoverconsumption, which led to envi- figure 5.1). In 1989,direct budgetary subsidies ronmental degradation and overinvestment in equalled 11 percent of GDP in Poland and Hun- the energy sector. Furthermore,low pricesled to gary, 16 percent in the CSFR,and 15 percent in long queues, hoarding whenever cheap goods Bulgaria. Consumer subsidiesin CEE countries were available,and forced financial savings (if weregenerallyonbasiccommodities(bread,nidlk, unable to purchase subsidized goods) that re- meat, sugar, heating fuel, pharmaceuticals)and duced work incentives. services(rental housingand mass transport).For Polandwas the first CEEcountry to take deci- example,in the late1980s Polish consumers had to sivemoves to eliminateconsumer price subsidies, pay only one-fifthof the production cost of milk, reducingmost food subsidiesin August 1989and central heating, and state-ownedrental housing; trimmingor eliminatingsubsidies on many other the price of medicines did not change between goods and services(including transportation, en- 1971and 1989. Enterprises receivedboth inpu.t- ergy, and housing) in early 1990. The share of specificsubsidies (for example, on coal) and ad subsidies in GDP decreased from 14 percent in hoc grants. Export subsidieswere also common, 1988 and 11 percent in 1989 to an estimated 6 percent in 1990 .4 Figure 5.1 Consolidated govermnent Hungary has also moved quite rapidly since expenditures in Eastern Europe as share of 1989,when the governmentadopted a four-year GDP, 1982-90 schedule to phase out consumer price subsidies and transfers to enterprises. In 1990total subsi- IWo dies equalledabout 9 percentof GDP,down from 90 about 13percent in 1989,and a targetof6.8 percent 80 is included in the 1991budget. The CSFRelimi- ~70 nated most consumersubsidies with its price lib- 60 - Total expenditures eralizationon January 1,1991,and Romaniatook t 50! Fsteps in October1990 to reduce subsidiesby free- - ing some consumer prices. Subsidies to loss- g40 Sodal security and budgetary subsidies making firms still exist, however, in most CEE 30 countries. 20 Soda city' WhilemostCEEgovernmentsarestronglycom- 10 mitted to further cuts, some subsidies are likely to l...... remain for some time. Phasing out housing sub- 1982 1983 1984 1985 1986 19871988 19891 !> sidies is particularlydifficult in the short term;

Note: Figureshows unweghted averages for Bulgaria, he renterscannot easily shift to other housinggiven CSIR, Hungary, and Poland. the thin housing markets, and compensatingan a. Includes pension, maternity benefits, sick pay, and the increasein rentswith directcash transfers presup- newly introduced unemnploymentbenefits. Source Holzman (1990). poses the existenceof a functioningwelfare system. Phasing out subsidies to firms ("harden- orientedeither to CMEAtrade (to assure the ful- ing" their budget constraints)should proceed in fillmentof centrally negotiated contracts)or to tandem with enterpriserestructuring and privat- convertible currency trade (to compensate iFor ization. overvaluedexchange rates). Amajorobjectiveofconsumer subsidies was to Socialservues. Socialindicators in CEE coun- provide basic goods at low cost and thus reduce tries are low comparedwith Westem Europebut disparitiesin real income.- Indeed, some subsi- relativelyhigh compared with other countriesat

50 similar levels of per capita income. However, fects turnover tax revenues. Increased domestic health statistics have been deteriorating in recent and international competition reduces monopoly years, and poverty-related diseases such as jaun- rents and the tax revenues that result from them dice and tuberculosis are on the rise. Further- Privatization reduces government control over more,educationalcurriculahavebeenoverlyspe- once-captive taxpayers and may require a reduc- cialized (sometimesonobsolete skills), asdictated tion in formerly confiscatory tax rates.O To avoid by a planned system. Many subjects indispens- a precipitous fall in revenue, governments must able to a market economy, such as accounting, compensate for these effects by broadening their management, marketing, and finance, have been tax base. On the other hand, many tax instru- neglected. ments commnonin market economies are not use- The CEE countries need to reorient public ful until reforms occur. A value-added tax makes spending on social services both to increase qual- little sense when prices are controlled, and a per- ity and to improve incentives. In the area of sonal income tax has little purpose when wage health, for example, medical insurance systems scales are set by the state. Similarly, rate-specific should be developed, subsidies on pharmaceuti- corporation taxes have little meaning in the pres- cals reduced, and eligibility for sickness benefits ence of soft budget constraints. (liberally granted in the past) tightened. The Early tax reform is crucial now that the CEE development of private alternatives in service countries are seriously pursuing broad economic delivery and funding for both health and educa- reforms. Poland, Yugoslavia, Hungary, the CSFR, tion should be encouraged. and (to a lesser extent) Romania have freed most producer and consumer prices. It is now both Taxes possible and desirable to introduce a broad-based VAT that will replace the distortionary and com- Taxes had no independent role in traditional cen- plex turnover tax system and serve as the "work- trally planned economies. The government set horse" of the revenue system, compensating for pricesof inputsand outputsand wagerates. Taxes declining company taxes as firms are privatized. (primarily on turnover, company "profits," and HungaryalreadyintroducedaVATinl988(albeit payroll) transferred any surplus to the state. As still with extensive price controls). Poland is now socialist firns gained greater autonomy in the in the process of designing a VAT, and the CSFR 1960sand 1970s,taxes began to take on an inde- hopes to introduce one in 1992 or 1993. pendent role as needed to induce greater effi- Private sector development is being encour- iency or substitute for the reduction in central aged in all reforming countries. Reforms of in- controls. Profit tax rates became somewhat more come taxes become increasingly important as the uniform in an attempt to spur efficiency, and private sector grows - to insure equal treatment, turnovertaxesbecamemoredifferentiatedastools to set clear "rules of the game," and to make the tax to regulate prices. Taxes on capital (or "divi- system more transparent, predictable, and dends") tried to simulate capital markets by re- nondistortionary. Hungary reformed its personal quiringa certain rate of return on assets, and taxes and company income tax system in 1988and 1989. on"excess" wages tried to impose wage discipline Poland amended its company income tax law in in the absence of private owners and a fully func- 1989 to insure equal treatment of public and pri- tioning labor market. Similarly, special taxes cap- vate firms, and it plans to introduce a global tured rents arising from CMEA trade. Any incen- personal income tax in 1991. The CSFR and the tive effects of these various taxes tended to be USSRbothintroducednewcompanyincometaxes muted, however, by the ad hoc, discretionary, and in 1990,the former to be phased in by 1992and the individually negotiated nature of tax liabilities. latter to have taken effect in January 1991. Yugo- The discretion of authorities to change tax rules slavia recognizes the need for tax reform, but at will - often after profits had been made - was plans are complicated by federal-republic dis- both a major cause of the soft budget constraint of agreements about taxing authority. Romania and firms and an important disincentive to improved Bulgaria are beginning to consider tax reform performance by firms. options. Tax reform is closely intertwined with eco- All of these countries must face the trade-off nomic reform. On the one hand, reforms tend to between revenue needs and the goals of efficiency eliminate mnany of the traditionally important and private sector development. The tax laws put sources of revenue. Changing relative prices af- in place so far have relatively high effective rates,

51 whether because of high statutory rates (for ex- Intergovemmental fiscal relations ample,the 25 percentbasic VAT rate in Hungary) or because of limits on deductions. Although Theriseinregionalpolitical tensionsinmostof the these high rates protect revenues," high income CEEcountries is mirrored in the difficultiesthey tax rates can discourageinvestment and dampen are now encounteringin resolvingpressures for economicactivity. These countries must alsoiface fiscal decentralization. Local and regional au- the trade-offbetween rate levelsand targeted tax thorities are seeking authority over an ever-in- incentives;tax incentives sacrificerevenues un- creasing share of general government revenue. less compensated through higher general rates. Thisis most pronounced in Yugoslavia,where the AllofHungary'snewtaxescontainmanytargeted federalgovermnent controls only aboutone-third incentives(whether exemptions or reduced rates) of general government revenue, primarily from to encouragecertain activities or to protectcertain indirecttaxes and tariffs,and where some repub- types of incomeor consumption." These incen- lics are now refusing to tum over indirect taxes tives are difficultto eliminateonce granted;other collectedby them. Bulgaria,the CSFR,Hungary, countries would be wise to adopt the broadest Poland, and the USSRare also facing increasing possibletax bases and lower rates from the start. pressures for greater localfiscal autonomy. This Although tax reform is important early on, issue has not been clearly resolved anywhere, institutionalconstraints arelikely to limitits effec- although various concreteproposals are emerg- tivenessin the short run. The reformingcountries ing. Hungary is perhaps the most advanced; its are poorly equipped for the modern tax adminis- proposed reforminvolves transferringone-half of tration calledfor in a marketeconomy. In socialist personal income tax revenues to the localities systems,tax administratorsare part of the owner- wherethey originatedand shiftingmost revenue- ship and control structure of government, and sharingonto a capitationgrant systembased on a they have unrestrictedaccess to enterprisebooks predefinedformula. While somedegree of fiscal and records. State enterprises are few and large, decentralizationis warranted, it is important to and the number of registeredtaxpayers tends to set dear and objectiverules and to assure that be relativelysmall. Tax administrationin a rmar- local administrationshave adequate budgetary ket economywith many independent firmscalls and expendituremonitoring capacity. Some cen- for differentskills - for example,in accounting, tral safeguards(such as limits over foreignbor- selective auditing, dispute resolution, and tax rowing)arealsoneededtoensurefmacroeconomic enforcement- that will take some time to de- stability. velop in the reformingcountries.

52 Annex 6 Income distribution, poverty, The primary objective of enterprises in narket and social safety nets economies is to maximize profits, while those individuals who for any reason remain outside The socialist legacy the system become the responsibility of the state. In essence, firms in socialist economies fulfilled Perhaps the mapr accomplishment of the socialist both economic and social functions. Even when systems of Central and Eastern Europe was the firms gained moreautonomyinYugoslavia, Hun- relativelyequaldistnbutionofincometheyattained. gary, and Poland, they still had a social role, a As indicted by the Gini coefficients'9in table 6.1, "duty" to provide employment to alleviate social income distnbution in Hungary, Poland, the USSR, problems in their respective regions. Firms took and China was rore equal than in market econo- an active role in providing social services to em- miesexceptScandinavia in the 1970sand 1980s,and ployees." Government's social protection role much more equal than in most middle-income de- consisted primarily of admninistering state-run veloping countries" Yugoslavia'sincome distribu- pension systems and generous programs of sick tionwasslightlylessequalthanintheothersocialist and maternity pay,"*and providing welfare ben- economies, mairny because of the great variation efits to marginal social groups, such as single among republics. Within Yugoslav republics, in- mothers, the handicapped, and the chronically ill come equality resembled that in the other socalist (includingalcoholicsanddrugaddicts).Suchben- economies. efits were often provided in kind (such as hot Low income inequality in socialist economies meals,homenursingcare,orclothes),asfrequently stemmedprimarilyfromguaranteedemployment happenswithchanitiesinnmarketeconomies. Cash- and low wage differentiation in the state sector. based welfare systems were not well-developed. Softbudget constraintsand the tendency to hoard Although rarely admitted by socialist govern- inputs, combined with government prodding to ments, "cradle-to-grave" state paternalism failed provide jobs, led firms to hire workers even when to elininate poverty. As economies slowed in the they had little use for themrand to rely lesson part- 1980s,a progressive decline in real wages and, to me jobs (which typically account for a sizable a lesser extent, real pensions led to growing pov- share of low-paid labor) than in market econo- erty, especially in urban areas. Between 1977and mies. 1988, the percentage of people living below an Low wage differentiation in the state sector unchanged,inflation-indexed officialpovertyline (which, together with state pensions, accounted in urban areas increased from 8 to 21 percent in for 60-75 percent of total income) resulted from eliminationofbothveryhighandverylowwages.' 2 Table 6.1 Gini coefficients for selected At the top of the income scale, the relative pay of countries and regions highly skilled professionals was lower than in marketeconomnies.Forexample,earningsinsome Countryor region ci cogefllcnt professions that are among the highest paid in industrial countries - including doctors, engi- Hung 24.4 neers, and lawyers - were state-controlled and Poland 24.3 were notoriously low in socialist economies.'3 USSR 25.6 Furthermore, the absence of a truly entrepreneur- China (urban) 23.9 ial role meant that one of the functions most (rural) 23.1 strongly rewarded in market economies, entre- Czechoslovakia 20.7 preneurship, was absent. Wage rates were gener- Yugoslavia 32.1 ally guided by government-determined norms EasternEurope 25A that imposed maximum ratios between pay of Latin America 49.5 differentgradelevelsorprofessions. Wageswithin South Asia 423 worker-managed firms were influenced by the AsianNICs and Japan 38.3 firm's labor force, whose dominant coalition gen- WesternEurope 31.4 erally preferred reduced wage dispersion. Profit Uned States 205 equalization between firns" reinforced egalitar- Norway 24.3 ian tendencies already present within firms to insure relatively equal wages throughout the Sourc. Milanovic(1990). economy.

53 both Poland and Yugoslavia,and from 10 to 17 structured). Flat-ratebenefits limited in time are percent in Hungary. The share of urban poor in favored by many observers because they avoid the total poor population increased in Poland the disincentiveeffects of income-testedschemes during the 1980sfrom 48 to 70 percent, and in and are the easiest of the three approaches to Yugoslaviafrom 25 to 50 percent. administer. Of all the socialisteconomies of Central and Reforming the social safety net Eastern Europe, only Yugoslaviahas had a long history(dating backto the 1950s)of openemploy- The transition to a market economy is virtually mentand officialunemployment insurance. Insti- certainto lead to higherunemployment and some- tutions to address the problems of newly emerg- what greater income inequality. This requires a ing unemploymentappeared in Hungary in Janu- redefinitionof the socialsafety net, in essencean ary 1989,and one year later in Poland and Bul- "unbundling" of the economicand social roles garia. In all cases,the earnings-relatedinsurance previously assigned to enterprises. The main approach was chosen. objectiveof enterprises should be efficientpro- Polishunemployment rose from almost noth- duction, which not only generates economic ing to some 7 percent of the labor force during growth but also protectsexisting jobs and creates 1990,compared with rates of 1-2percent in Hun- new ones. Governmentsshould be responsible gary and Romania and less than 1 percent in for protecting vulnerablegroups - whether the Bulgariaand the CSFR.Only Yugoslavia's9 per- unemployed, the elderly, the disabled, or others cent rate was higher. In Poland, unemployment left out of the productiveeconomy - and provid- benefitswere first offeredin January 1990as part ing (directly or indirectly) basic social services of the reformpackage. They were open-endedin such as healthand education. Individualsshould duration and were calculatedas a decliningfunc- in turn be responsiblefor finding jobs(with some tion of the duration of unemployment.Although assistance from the state) and keeping them many of the "unemployed" were actually new through satisfactory performance. entrants to the labor force (whether recent gradu- ates or formerlynonworking spouses), almost all Unemploymentbenefits. The most pressing im- were by law eligiblefor unemploymentbenefits. mediate need is for governmentprograms of un- Total income-maintenanceand training expendi- employmentcompensation and retrainingto ease tures amounted to 0.6 percent of GDP in 1990- the social costs of enterprise restructuring and still low by Western European standards - and privatization. Each country must chooseamong were financed by a special2 percent wage levy three basic concepts for calculatingunempiloy- and direct budget subsidies. ment compensation: income-tested, eamings-re- The Polish experience illustrates the problems lated, or flat-rate. If income-testedand open- accompanyingthe initial introduction of unem- ended in time, unemployment compensationis ployment compensationin the reforming coun- essentiallyno different than other types of pov- tries. First, the number of unemployed was un- erty relief. It isclearly targeted to thosein greatest derestimated,and the number of social centers need and is thereforethe cheapestalternative in and socialworkers has been inadequate from the terms of benefits provided.97If earnings-related beginning.' Second,retraining was neglected due and limited in tim.e,unemployment compensa- to its complexity. Labor officesconcentrated al- tion resemblesinsurance.' It protects newly un- most entirely on registrationof the unemployed employed individuals from a precipitous fall in and distributionofbenefits;by August 1990,only living standard in the short run, and the time 0.5 percent of those registered were undergoing linmitationavoids any disincentiveto lookfor new training.Third, the initialdesign mixed the insur- work. It also avoids the "povertytrap" whereby ance and assistanceprinciples by providingcom- other members of a householdmay decide not to pensationlinked to previousearnings (insurance) take a job if it means a loss in unemployment but open-ended in time (welfare). Proposed benefits.However, because of the timelimitation, amendmentsin the LaborLaw limit the duration it addresses primarilyfrictional or cyclicalunem- of benefits to one and one-halfyears. A separate ploymentand not the kind of structuraland long- welfare system to be developed will in principle term unemploymentthat may arise in the reform- provide a minimum means-tested floor income ing countries (especiallyas heavy industry is re- open-ended in time. A similarsolution was also

54 adopted in Hungary, where unemploymentben- should ideally be handled through poverty-ori- efits payable for one year (or two in exceptional ented welfareprograms. Furthermore, pockets of cases)are complementedwith a universal welfare povertyuntouchedbyanyprogramremain.Given scheme. the likelihoodthat unemploymentwill be high for Theintroductionof unemploymentcompensa- several years, and that income distribution will tion in Poland triggered a revision in the defini- worsen in the move to a market economy,broad- tion and role of the minimumwage and the social ening the socialsafety net to include a more com- minimum (or "poverty line"). Before 1990 the prehensiveincome-tested scheme is an important minimum wage was purely an accounting con- challengefor the future. cept used for the establishmentof wage scales. Recentlyit has been raised to equal the official Pensions.Reformofold-ageanddisabilitypen- socialminimum (for one person in a four-person sions is another criticalcomplement to enterprise household)10 and, as in mature market econo- restructuringand budgetary control. At present mies, has been set as an obligatoryfloor wage for all the reformingcountries have state-run pay-as- both the state and the private sector. The social you-earn (PAYE)schemes in which pensionsare minimum, previously only an accounting con- financed out of current contributions. Pension cept, has also gained new significanceas the basis expenditures are quite high, necessitatinghigh for welfare claims. contributions,'03in part due to the demographic Thereformingcountriesneedtoavoidanoverly profile and in part due to generous eligibility generous level of benefits that both discourage criteria. Theretirement age in mostof the reform- activejob search and createan enormouspotential ing socialistcountries is 60 for men and 55 for budgetary burden. Thegenerosity of someof the women,compared with the OECDaverage of 64 existing plans may in part reflect political con- for men and 62 for women. In addition, pension straints,as the publicmay stillnot fully acceptthe formulas are biased toward short careers, and view that a reductionin joband incomesecurity is pensionsare granted generouslyfor invalidityor an unavoidable part of the move to a market early retirement, often in response to labor re- economy. For example,in one Yugoslavrepublic trenchment(in lieu of unemploymentbenefits).Y 3 the benefitis 100percent of the previouswage for The total number of pensionersin the CEEcoun- three months and thereafter 60 percent plus 1 tries has been estimatedat approximatelyhalf the percent per year of service (to a maximumof 90 total number employed, and real spending on percent). In another republic, the benefit is 80 pensions is growing. Pensionreform should be- percent of the previous wage. Workerscan re- gin by tighteningeligibility (including gradually ceive these benefits for up to two years - and raising retirementages) and by revising the pen- indefinitelyafter 25 years of service."0" sion formula along actuarial principles. Severalcountries are consideringsupplement- Welfare.Of all the CEEcountries, Yugoslavia ing their PAYEsystems with either funded public hasthemostcomprehensivesocialwelfarescheme pension schemes(whereby individual contribu- targeted specificallyat eliminatingpoverty."' Al- tions are directly linked to pensions)or manda- though some other CEEcountries (most notably tory private pensionplans along the model used, Hungary) have established welfare programs in for example,in Switzerlandand Chile. Develop- recent years (often at the local level),these pro- ing a funded system can be problematic;in the grams are not true entitlements,that is, based on beginning current employeesmust both pay for transparent criteria, with assured funding of all current pensions and build up the fund from who qualify,and with regularadministrative and which their own pensions will later be paid. Pri- appeals procedures. In all CEE countries,other vatizationmay present a unique avenue to miti- socialprograms - whetherunemployment com- gate part of this problem, if a substantialpart of pensation,pensions, sick pay, and maternityleave the ownershipof privatized firns can be vestedin - are all bearing some excessive burden that pension funds as a source of funding!°s

55 Annex 7 The World Bank Group's support for anywhere in a comprehensiveway before 1989- economictransformation in Central and 90. The main weaknessof the policy framework Eastern Europe was lack of competition,financial discipline, and a clear exerciseof ownership rights at the enter- Evolution of Bank Group activities prise level, which obviouslydid not provide the necessarysignals for economicrestructuring and The World BankGroup's involvementwith Cen- behavioralchange. tral and Eastern Europe (CEE)dates back many The IFC has been active in Yugoslaviasince years.106 TheCSFR, Poland, and Yugoslaviawere 1968,in Hungary since 1985,and in Polandsince founding members of the Bank and the Fund at 1987. In Yugoslavia,there has never been a cen- their creation in 1945;however, the CSFR and tralizedownership,management,andinvestment Polandceased to be memberswithin a few years. planning system. Instead,investment plans have Romaniajoined the BrettonWoods institutions in been generated by the operating enterprisesand 1972,Hungary in 1982,and Poland rejoined in financedby a banking structure with some com- 1986. In the fall of 1990,the CSFRrejoined, and petitive elements. Within this institutionalcon- Bulgaria became a new member. In addition, text, the IFC has made 36 transactionsfor a total Romania,which had stopped borrowingfrom the commitmentof about $700million. As several of Bank in 1982and prepaid its debt by early '1989, these transactionswere package loans through restored full relations with the Bankand became localbanks, IFCfunding has gone to several hun- a member of the InternationalFinance Corpora- dred enterprises. In Hungary, the IFC has under- tion (IFC)in 1990. In January 1991,Albania ap- takeneight transactionsfor$100 million (of which plied for membershipin the IMF,the World Bank, $22 million was in equity), including five joint and the IFC. An initialIMF mission to ascertain ventures in the productive sector,an agency line conditions for membership took place in March of credit for small- and medium-scaleprivate 1991. enterprisesin cooperationwith a localHungarian To date, World Banklending commnitmentsto bank, a jointventure bank,and an internationally the regiontotal a littlemore than $10billion. Since distributed investment fund. In Poland, the IFC 1945,Yugoslavia has received 99 loans from the has undertakenthree operationswith a totalcom- Bank for a commitmentof $53 billion. Romania mitmentof about $55million: an export-oriented, had obtained 33 loans for $2.2 billion before it cooperative agro-processingenterprise, a flag- stopped borrowing from external sources and ship hotel joint venture, and an agency line of started prepaying its foreigndebt in 1982. Total creditfor small-and medium-scaleprivate enter- commitmentsto Hungary have slightlyexceeded prises in cooperationwith a localPolish bank It $2.8billion for 30 projects. Sincethe beginningof has alsoprovided advisorysupport to the govern- 1990,Poland has obtained seven loans for $1.22 ment in three key areas: privatization, capital billion. market development,and the frameworkfor for- Exceptfor the FY83Yugoslavia SAL, the FY88 eign investment. Hungary IndustrialSector Adjustment Loan, and quick-disbursingcomponents under the FY86-87 The transformation process and Bank Group Industrial Restructuring loans to Hungary, all support pre-FY90Bank lending to CEE was project-specific,with the bulk of loanssupporting investment Withcountry-specific variations in termsof speed in infrastructure,industry,and agriculture. While and scope of effort, the reforming countries in it is true in all countries that the effectivenessof CEEhave decidedto move toward marketecono- project lending is hampered by distortions in mies with privateownership and the reductionof macroeconomicand sector policies,this is par- the state to a facilitatingrole. Long drawn-out ticularlyrelevant in CEEcountries, where short- reformefforts in Yugoslaviaand Hungary and to comings in economic performance have had a some extent Poland, which essentiallyaimed at deeply rooted systemicdimension. In spite of a decentralizationwithout exposingenterprises to multiplicityof reformefforts in individualcoun- financialdisciplinefromowners,creditors,orcom- triesduring thel970sand 1980s,the systemicroot petitors, suggest that gradual reforms - as op- causesofeconomicdifficultieswerenotaddressed posed to more radical systemictransformation-

56 are not effective. Bank lending into environments supply response through restructuring and pro- of partial reform in Hungary or Yugoslavia has gressive privatization of the existing productive also been of only limited effectiveness. base and creating an enabling environment for With the region's political events of 1989-90, development of new enterprises, particularly the climate for a switch in economic policies has small- and medium-sized enterprises; (3) foster- dramatically changed toward comprehensive sys- ing the development of a modem, efficient infra- temic transformation. The Bank has begun to structure in telecommunications, roads, and rail- implement substantial programs of assistance to ways; (4) improving the efficiency of energy re- facilitate the transition. Over the next three years, source use and developing an adequate environ- the Bank proposes to lend an estimated $74 bil- mental policy framework; (5) modernizing and lion covering all six countries. To place this in restructuring the banking sector; and (6) facilitat- perspective, two years ago Bank lending was lim- ing the redeployment of labor and the develop- ited to Hungary and Yugoslavia and amounted to ment of a modem human resource base. This wiU roughly$500million. InFY90, theBanklentatotal also be the thrust of the assistance strategy in the of $1.8 billion to Hungary, Poland, and Yugosla- new countries. via (see tables 7.1,7.2, and 7.3 on the status of Bank TheEconomicDevelopmentlnstitute(EDI)has Group operations in those three countries). In the also expanded its activities in the region, focusing current fiscal year, the Bank expects to lend about on macroeconomic and public sector manage- $2.5 billion to the three and to the new members, ment, industrial restructuring, labor market and Bulgaria and the CSFR, and possibly to Romania. socialprotection,andenvironmentalmanagement. The Bankopened a resident mission in Warsaw in To stretch the EDI's limited resources and protect July 1990. institutionally weaker countries elsewhere, great The World Bank has undertaken substantial emphasis is put on cooperative arrangements in economic and sector work (ESW)in support of a the regionand funding fromother (nontraditional) large and growing lending program. ESW in- sources. cluded country economic memoranda, with em- Both the need for and the interest in financial phasis on macroeconomic issues for most coun- and technical assistance from the IFC and the FlAS tries, including members the CSFR and Bulgaria; have greatly expanded with reforms. In FY91the trade analyses for Hungary and Poland, with IFC opened representative offices in Warsaw, emphasisonCMEAissues;financialsectorassess- Budapest, and Prague. In conjunction with the ments in Hungary, Poland, and Yugoslavia; in- IFC's joint venture investment operations and dustrial sector work in Hungary and Yugoslavia; related dialogue on foreign investment laws and environmental studies for Hungary and Poland; procedures, its capital markets group has assisted and far-reaching analyses of social sector issues in in the creation of new financial sector institutions Hungary and Poland. Moreover, in Poland a (banks, insurance companies, leasing companies, number of joint Bank-government task forcescov- and venture capital funds) and has provided ad- eredstrategicissuesinagriculture,housing,health, vice on the legal and regulatory infrastructure for and the legal and regulatory basis for the financial securities markets. The IFC's corporate services sector. Future ESW will pursue similar priorities, group has advised onrestructuringand privatiza- with coverage expanding to the new countries. tion in Poland, Hungary, and the CSFR, and the For Bulgaria and Romania, work on trade and IFC has established a Business Advisory Service public expenditures is planned, given the severe in Poland where small- and medium-scale private shortage of both foreign exchange and govern- enterprises can get advice. ment revenues. In Romania, work will also focus MIGA's focus, of course, is facilitating foreign on the social safety net. investors by providing political risk insurance on TheBank'sfinancialassistanceduringCY1989- equity investments in these countries, and it is 90 went to (1) supporting fairly comprehensive interesting that, relatively speaking, the highest transformation programs through structural ad- demand for its services is emanating from CEE. justment loans (SALs)typically focused on policy To date, only one insurance transaction has taken and institutional measures to foster the private place in CEE: a $30 million reinsurance for an sector, a competitive environment, the financial investment project in Hungary. However, a num- sector, and a social safety net; (2) promoting a ber of projects in Poland and Hungary are under

57 Table 7.1 Status of Bank Group operations in Hungary

S'haint of Bink lons (asof May 1, 1991)

Grosscommitments (kssaouincU) Licn Fisca (milbns ofdoars) nwnber yar Brromwr Poject Ln Undisbwsed

Five loans and six B-loans fully disbursed 939.53 Of which SECALs,SALs, and Program Loans: '

2965 1988 NBHb Industrial Sector Adjustment 200.00 3228 1990 NBH SAL [ 200.00 - 2317 1983 ROHc Industrial Energy Conservation 109.00 0.10 2510 1985 NBH Integrated Livestock 80.O0 11.10 2557 1985 ROH Transport (Rail/Road) 75.00 2.80 2697 1986 ROH Powtne 64.00 24.20 2700 1986 NBH Industrial Restructuring I 100.00 14.20 2709 1986 NBH Indusrial Energy Conservation lI 25.00 3.90 2738 1987 NBH Crop Production 100.00 11.10 2834 1987 NBH Industrial Restructuring 11 150.00 51.00 2847 1987 NBH Telecommunications 70.00 18.80 2936 1988 NBH Agroprocessing Modemization 70.00 50.70 2966 1988 NBH Technology Development 50.00 31.10 3020 1989 NBH Industrial Restructuring m 140.00 120.80 3032 1989 ROH Transport II 95.00 7680 3055 1989 NBH Energy Development-Conservation 10.00 7.90 3056 1989 OKGTd Energy Development-Oil and Gas 100.00 91.90 3191 1990 NBH Finandal System Modernization 66.00 61.00 3229 1990 NBH Integrated Agricultural Exports 100.00 81.50 B1lOb 1991 ROH Expanded Cofinancing Operation 200.00 200.00 3264 1991 HTC TelecommunicationsII 150.00 140.00 3313 1991 ROH Human Resources Development 150.00 150.00

Total gross commitments 2,642.92 Of which repaid 263.39 Total now held by the Bank 2,530.14 Total tndisbursed 1,099.46 a. oved during or after FY80. b. National Bank of Hungary. c. Republic of Hungary. d. National Oil and Gas Trust. activeconsideration, and inquiriesfrom theCSFR ($300million) during CY1990. There are some and Yugoslaviaare numerous. commonfactors but also significantdifferences in individualprograms and the Bank'ssupport. Yu- The thrust of Bank Group activities in selected goslaviaand Polandfaced hyperinflationin 1989, areas whichwas attackedthrough heterodoxshock stabilizationprograms, with the exchangerate and Macroeconornicpolicies toward stabilization and ad- wages as nominalanchors. Hungary's economic justment. The Bank has extendedquick-disburs- difficultieswere of a more traditionalnature, with ing balance-of-paymentssupport through SALs a growing balance-of-paymentsdeficit but only to Yugoslavia($400 million), Hungary ($200mil- moderate inflation as a result of expansionary lion plus $200million in cofinancing),and Po]land monetary and fiscal policies. The stabilization

58 Table7.1 Statusof BankGroup operations in Hungary(continued)

Statement ofIFC investments (as of May 1,1991)

Grossconmitments Fisal (mlions of dollars) year Obligor Typeof business Loan Equity Total

1987 Unibank Capital markets - 3.03 3.03 1987 Agrofrem Hungarian- Food aid 8.55 2.70 11.25 Japanese Fermentation Agribusiness Industry Ltd. 1988 Salgotarjan Glass Wool Insulation material 3.44 1.53 4.97 1989 Dunamon Poliestirolgyarto Ltd. Chemicals 28.38 3.75 32.13 1990 Dexter Mold General manufacturing (plastic) 3.26 0.93 4.19 1990 Tetra Pak Packaging material 8.03 3.21 11.23 1990 First Hungary Fund Capital markets - 7.50 7.50 1990 FHIA Capital markets - 0.04 0.04 1991 NMBB Capital markets - 1.63 1.63 1991 FAHIC Insurance - 320 320 1991 Agency Credit Fadlity Small and medium business 21.60 5.40 27.00 1991 Magyar Suzuki Automotive 0.70 6.60 37.30

Total gross commitments 103.95 39.52 143.46 Less cancellations, terminations, exchange adjustments, repayments, write-offs, and sales 11.44 Total commitments now held by the IFC 132.02 Total undisbursed 68.16 Total disbursed 63.86 program, accordingly,relied on fiscaland mon- tion as a preconditionfor structuralchange while etary restraint. All three programs also included also embarking on systemic transformation to important structural adjustment elementsto ad- bring about behavioral change at the enterprise dress systemicroot causesof economicdifficulties leveland thus to reinforcemacroeconomic stabil- (pervasive subsidiesand price distortions, mas- ity. SALconditionalityhasbeendesignedaccord- sivenontariff barriers to trade, blurred enterprise ingly, although continued govemment commnit- ownership,lack of financialdiscipline, and guar- ment is the ultimate answer to success. anteed full employment). The most comprehensive and rigorous approach was followedin Po- Marketization.Trade and price liberalization and land, with virtuallycomplete price and trade lib- competitionpolicy. "Marketization," that is, trans- eralization, important measures to tighten the formationfrom a commandto a marketeconomy, financialdiscipline of enterprises,financial sector isat the centerof reformsin all CEEcountries. But reform, the start of privatization,demonopoliza- in somecountries there is stilldebate or confusion tion of key industries, and the establishmentof a as to the meaningand scopeof a marketeconomy rudimentary social safety net. Hungary's pro- in practice. In such an economy,resource alloca- gram tackled a similarlybroad range of systemic tion is driven by relativeprices rather than central problems, but price and trade liberalizationhas governmentdecisions. It requiresthe free setting not yet gone quite as far. Yugoslavia'sprogram, of prices under reasonablyeffective competition afterapromisingstart, becameavictimof political and factor (abor and capital) mobility. (In key difficultiesthat prevented wage discipline and areas such as energy,a possibleintermediate step energeticaction in the enterprisesector. The Bank may be the adjustment of administrative prices has encouraged comprehensive transformation toward efficiencylevels before full liberalization.) programs that require macroeconomicstabiliza- The Bankhas been supporting market reformsin

59 Table 7.2 Status of Bank Group operations in Poland

Statementof Bank loans (s of March31, 1991)

Crosscommitments

Loan Fvscal (mi1lio,sof delam) nwnber year Borrower Purpose Lean Undisbursed

3166 1990 National Bank of Poland[ Ind. exports development 260.00 248.11 3167 1990 National Bank of Polandl Agroind. exp. development 100.00 85.09 3190 1990 Republic of Poland Environment management 1800 17.36 3193' 1990 Republic of Poland Transport 4.75 4.75 3194 1990 Polish Railway Corp. Transport 145.00 141.83 3215 1990 Polish Oil & Gas Corp. Energy resources development 250.00 231.31 *3247 1991 Republic of Poland SALI 300.00 22138

Subtotalb 1077.75 949.83 Of which repaidc 0.00 Total now outstanding 1077.75 Amount sold 0.00 Total now held by Bank' 1077.75 Total undisbursed 949.83

Statementof IFC investments (as of March31,1991)

Grosscomnmitments (mzilionsof lLaa) Fiscalyear Obligor Typeof business Loan Equity Total

1989 Hortex Horticulture 17.12 17.12 1990 Export Devt. Bank Export credit 31.66 31.66 1991 Bristol Hotel Hotel developmenl 10.06 10.06

Total gross commitments 58.84 0.00 58.84 Less cancellations, terminations, exchange adjustments, repayments, writeoffs, and sales 2.12 2.12 Total commitments now held by the IFC 56.72 0.00 56.72 Total undisbursed 42.15 42.10 Total outstanding 14.57 0.00 14.57

SAL, SECALor "Program Loan." a. Two loans for one project. b. Exdudes loan of $120 million for a telecommunications project that was approved by the Executive Directors on April 23, 1991,but has not yet been signed. c. Prior to exchange adjustments. many developing countries, particularly through ments of all adjustment programs in the region trade liberalization as the most effective means to supported through Bank SALs, in CY1990. The createcompetitionandstimulateefficiencyinsmall most radical approach was followed by Poland, economies. What makes CEE special is the high where prices for 90-95percent of sales were liber- concentration of enterprises and the overwhelm- alized and the trade regime completely changed, ing ownership role of the state with blurred oTrn- with immediate abolition of all nontariff barriers ership rights (see the enterprise section below). to imports and the establishment of relatively low Price and trade liberalization have been key ele- tariffs (these were actually suspended for a wide

60 Table 73 Status of Bank Group operations in Yugoslavia

SnWmnet ofBank Jnus (as of Man* 31, 1991)

Grosscommitments

Loan Fiwal (Nffims ofdomlm) number year Borrower Projt La Ui

Eighty-four loans fully disbursed 3,402.84 Of which SECALs,SALs, and Program Loans8

2326 1983 Udruz. Beogradska Banka Structural Adjustment Loan I 275.00 2410 1984 Vodjvodjanska Bank Fertilizer Sector Loan (SAP)

Subtotal of SECALS,SALs, and Program Lons 275.00

2307 1983 Udruzx Beogradska Banka Serbia Regional Development 94.00 2.8 2336 1984 Four Railway Orgs. Sixth Railway 10630 0.6 2338 1984 Eight Power Orgs. Third Power Transmission 115.00 91.4 2467 1985 Investiciona Banka Montenegro Regional Titograd Development 40.00 16.6 2527 1985 Elektroprivreda Bosnia Visegrad Hydropower 125.00 04 2595 1985 INA-Naftaplin Petroleum Sector 55.00 12.1 2596 1985 Naftagas Petroleum Sector 35.00 9.2 2597 1985 Privredna Banka Sarajevo Petroleum Sector 2.50 1.6 2715 1986 Four Road Organizations First HighwaySector 121.50 1.5 2790 1987 Ljubljanska Banka Industrial Energy Conservation 90.00 60.6 2878 1988 Four Road Organizations Second Highway Sector 59.94 21.7 3068 l98 9b Four Railway Orgs. Seventh Railway 122.20 122.2 3069 1989 Istria Water Works and Istria and Slovene Coast Water Pula Water Works Supply and Sewerage 28.00 233 3070 1989 Rizana Water Works Istria and Slovene Coast Water Supply and Sewerage 32.00 2&1 3187 1990 National Bank of Second Structural Yugoslavia Adjustment Loan 400.00 250.6 3230 1990 Road Org.-Bosnia-Herz. Third Highway Sector 55.00 55.0 3231 199fc Road Org.-Croatia Third Highway Sector 75.00 75.0 3232 1990C Road Org.-Macedonia Third Highway Sector 22.00 22.0 3233 1990C Road Org.-Serbia Third Highway Sector 55.00 55.0 3234 1990C Republic of Slovenia Third Highway Sector 60.00 60.0 3235 1990y Road Org.-Vojvodina Third Highway Sector 25.00 25.0

Total gross commitments 5,12128 Of which repaid 2,288.27 Total now held by the Bank 2,833.01 Total amount sold 9.20 Of which repaid 920 Total undisbursed 934.6

a. Approved during or after FY80. b. Not yet effective. c. Not yet signed. array of products during the second half of 1990to ing 1991. However, with high vertical and hori- increase competitive pressure). Hungary and zontal concentration of enterprises and numerous Yugoslavia have also gone quite far in disman- regulatory constraints, deregulation and compe- tling quantitative restrictions, and Hungary will titionpolicyalsobecomeimportantcomplements. virtually complete the liberalization process dur- In the Polish program, demonopolization of some

61 Table 73 Status of Bank Group operations in Yugoslavia (continued)

Statementof IFC investments (as of Mardh31,1991)

Grosscommitments Fiscal (mllionsof doais) year Obligar Type of busimess Lon Equity Total

1970 International Investment Development finance - 2.00 2.00 1970 Zastava Motor vehicles and accessories 12.40 0.60 13.00 1973 Belisce-Bel Pulp and paper 70.86 - 70.86 1974 Zelezarana Iron and steel 10.00 - 10.00 1977 Tvornica Kartona Cazin Pulp and paper 19.77 - 19.77 1977 Frikom RO Industrija Food processing 5.51 0.92 6.43 1978 Soko Most Hermetic compressors 7.00 - 7.00 1980 Investiciona Banka Titograd Hotel rehabilitaticu 21.00 - 21.00 1980 Radoje Dakic Construction equipment 18.70 - 18.70 1980 Eight regional Yugoslav banks Small-scale enterprise finance 30.23 - 30.23 1980 FAP FAMOS Motor vehicles ancl accessories 16.30 0.77 17.07 1980 RMK Machinery 50.00 - 50.00 1982-87 Institute Dr. Simo M. Igalo Physical medicine! 19.15 - 19.15 1982 Trakori Ruen Auto Motor vehicles ancl accessories 10.63 _ 10.63 1983 Ljubljanska Banka Development finance 31.43 _ 31.43 1984 INA-Naftaplin Chemicals and petrochemicals 37.78 _ 37.78 1985-89 SOZD Iskara Telecommunications 33.88 - 33.88 1985 SOUR Energoinvest Power transmission 15.18 - 15.18 1985 Jugobanka Development finanice 35.80 - 35.80 1985 Ljubljanska Banka Development finance 69.84 - 69.84 1986 Unial-TGA Nonferrous metals 35.60 - 35.60 1986 TAM/DEUTZ Motor vehicles 35.98 0.87 36.85 1988 Sava Semperit Tires 26.20 2.55 28.75 1989 Vojvodjanska Banka Development finanice 87.00 - 87.00 1989 Salonit Anhovo GRP pipes 11.% - 11.96 1990 Anhovo Pulp and paper 5.23 - 5.23 1991 Delo Printing press modernization 4.64 - 4.64

Total gross commitments 722.07 7.77 729.78 Less cancellations, terminations, exchange adjustments, repayments, write-offs, arci sales 383.68 7.71 391.39 Total commitments held by the IFC 338.39 - 338.39 Total undisbursed 25.54 - 25.50 Total disbursed 312.85 - 312.85 key industries has been an integral part from the petition and the share of free prices. With the outset, while competition legislation and the cor- complete dismantling of quantitative restrictions responding institutional framework have been and the virtual abolition of price controls in Po- lagging in other countries. Regarding trade and land, the Bank-supported program has focused price liberalization, the Hungary and Yugoslavia more on the further rationalization of tariffs,with- SALs include explicit commitments with respect out formal conditionality. Romania and Bulgaria to exposure of domestic industry to import corn- have undertaken initial price liberalization mea-

62 sures, and both are committed to further steps as includingthetransferabilityand mortgageability part of their reform programs to be supported by of land, buildings, and other physical assets, the the Bank aid the Fund. rights and privileges of enterprise employees, and the difficulties inherent in valuing assets of Enterprisereform, privatization development, and an enterprise operating in a highly distorted priatization. As mentioned before, attempts to domestic market and a rapidly changing foreign decentralize decisionmaking and some degree of market. Superimposed on the complexity of "marketization" were made during the 1970sand these issues is the scarcity of human resources in 1980sin Hungary, Poland, and the CSFR,and this enterprises and govemment with the training has been a guiding principle of Yugoslav eco- and understanding to agree on a package of nomic management since the 1950s. However, compromises that will allow a deal to go for- none of these attempts was effective because ward. Finally, on the foreign side, investors are greater enterprise autonomy in practice trans- reluctant to risk a substantial equity commit- lated into blurred ownership rights and a lack of ment given current uncertainties, while on the financial discipline- or in Kornai's famous term, local side there is reluctance to sell local assets of a soft budget constraint - which in Yugoslavia a previously public sector activity to foreign and Poland was an important cause of interests. An extended period of testing and hyperinflation. The Bank has been supporting adjustment will be required, with, at best, only Hungarian enterprise reform and restructuring partial success for some time to come. What is for a number of years through industrial restruc- evident is that continued debate without action turing loans, but under inadequate macroeco- is unlikely to produce better results. nomic conditions prior to 1990 and without ad- equateenforcementof financialdiscipline through Socialsafety net and human resourcesdevelop- bankruptcy procedures and privatization. The ment. The social safety net and human resources processhasthusbeen slow and its successlimited. development are also central elements in the Even before the events of 1989/90, the Bank sup- Bank's policy dialogue and lending activities in ported important legislative changes in various CEE. The social safety net encompasses pro- countries to prepare the ground for ownership grams and funds to provide income transfers to change, financial discipline, and - ultimately - the old, the poor, and the unemployed; employ- behavioral change. Legislative and regulatory ment services; training and job creation and measures, as well as specific actions toward enter- promotion activities; and funding and provision pzise restructuring, ownership reform, and pri- of adequate health services. One would also add vatization development, have become integral housing as an important dimension with impor- parts of the SAL-supported programs in Yugosla- tant implications for the functioning of the labor via, Hungary, Poland, and - in the near future market. Human resources development also - in the CSFR and Bulgaria. This will soon be entails the efficient provision of education ser- followed with more specific sector operations in vices with adequate financing arrangements. Hungary and Poland. The legislative framework These concems are addressed through sector for privatization and competition in Bulgaria and work and project lending, but also in the context Romania is currently under preparation. The of the above-mentioned SAL,where the adequacy Bankhasalsosupportedthedevelopmentofsmall- of the social safety net has been an important and medium-scale enterprises in Hungary and concern. Yugoslavia and is planning similar projects in During CY1990,sector studies and lending Poland. activities for the social safety net and human The IFC's individual transactions related to resource development were initiated in Hun- privatization have shown that overcoming exist- gary, Poland, Bulgaria, and Romania, and a new ing obstacles is a time-consuming, complex un- division for this work was set up in the country dertaking. Instability in the legal fabric requires department. Free-tanding loans were recently that each operation's contract have a self-con- approved for human resource development for tained legal framework to substitute for thebroad Hungary and for employment services and pro- business law framneworkand judicial systems re- motion for Poland. Important analytical work lied upon in market economies. Added to the has also been done on the housing sector in legal problems are issues of ownership rights, PolandandHungary,andlendingisunderprepa-

63 Table 7.4 Selected cofinancing operations (miElonsof dola)

WoridBsk Cofinoning

Fscalyear 1990 Yugodavia: Highwaysector loan 292 190- EIB Poland: Railwaysproject 153 30-EIB Hungary SALI 200 200-Japan EXM Bank Fiscalyear 1991(planned) Poland: Teleom l 120 80-E1B DistrictHeating 250 80-EIB Hungary: Telecomll 150 100-ElBJapan SAL! 200 Japan EXIMBank CSFR: SALI 450 Japan EXIMBank

Note BeforeFY90, the EIBand theBank partidpated regularlyin paraUelfinandng to Yugoslaviafor infrastucture.Six B- loansto Hungarycontributed $2 billionwith a Bankparticipation of $135million. in FY91,the Bankthroughthe expanded cofinancinginstrument, helped Hungary to mobilize$o00 mfllion.

rationinPoland. Inaddition,significantresources Afterthe 1989Paris SummitMeeting, the G-24- are being allocatedto sector work on labor mar- coordinatedby the EC Commission- began to kets in Yugoslavia;human resourcesin Hungary; extend significantfinancial and technicalassis- and health, social safety net, and employment tanceto the reformingcountriesinCEE. The Bank services and promotion in Poland. The main is closelycoordinating its activitieswith thoseof issues expected to arise in these studies are the multilateral organizations (the EC, IMF, EIB, continuingrigidity of labor markets;the need to OECD,and EBRD).As a result of its collaboration developprogramstoprovideunemploymentcom- with the IMF,the governments of Hungary and pensationand protectthe poor;the desirabilityof Polandprepared medium-termframeworks with more broad-based,multidisciplinary educational jointinput from IMFand Bankstaff. programs; and improvements in the provision There have also been substantial amounts of and financingof health services.The focuswill be cofinancing. The Hungary SAL was cofinanced on both the short-run transitionand the systemic with the JapaneseExport-Import Bank (JEX), and reformsrequired for the long term. the European Investment Bank (EIB) has cofinancedinfrastructure projectsin Yugoslavia The Bank Group and the internationalfinancial (for many years) and, more recently, in Hungary community.Financial assistancebythe BankGroup and Poland. Moreoperations with theJEXandthe has to be seen in the contextof the six countries' EIBas well as the new EBRDare expectedin the overallexternalfinancingrequirementsand alikelty future. An importantcofinancingeffort was made financinggap of several billion dollars per year. through the Expanded Cofinancing Operation BankGroup assistancehas to be subjectto sound (ECO)to Hungary, which facilitatedsubsequent bankingprinciples. Poland's and Bulgaria'scred- issues in the Japanesebond market in the second itworthiness are impaired by huge debt over- half of 1990(see table 7.4 on cofinancingopera- hangs and debt servicingdifficulties (which in the tions). The Bankis alsoclosely coordinating with caseof Polandhave persistedfor a decade).Coin- bilateraldonors (such as theUKKnow-HowFund, prehensivesolutions to the debt problem have to the United States,and others)as well as with the be an integral part of the respectiveadjustment Pentagonalgroup, coveringa wide array of areas program;the Paris Cub debt workout for Poland and forms of assistance. is an important step in that direction. In other In additionto broad aid coordination,there are countries, particularly Hungary, adequate bur- specificefforts in energy(through the Centraland den sharing between the Bank and other creditors Eastern Europe Regional Energy Program) and in is a major concem. environment (through the Task Force set up by The Bank's assistance, however, is part of a the BalticSea riparian countries and the Environ- broader effort by the international communite. mental Programfor the Mediterranean).

64 Endnotes

1. In this paper, the term "Central and Eastern sons to believe that they overestimated actual Europe" is used to refer to Bulgaria, the Czech and growth. Slovak Federal Republic (CSFR), Hungary, Po- land, Romania, and Yugoslavia. The former Ger- 6. For a brief comparison with China, see box 6. man Democratic Republic (GDR) is also relevant, although its transformation process is shaped by 7. Open unemployment existed only in Yugosla- distinctive circumstances. The GDR or East Ger- via, in large partdueto the greaterautonomyof its mnanyandthe Federal Republic of Germany (FRG) self-managed firms. or West Germany refer in this paper to the countries before their unification, east and west Ger- 8. That the problem was systemic rather than many to theregions of Germanyafter unification. narrowly technological is shown by the disappointing results from importing Western equip- 2. All dollars in this report are U.S. dollars or ment (Terrell, forthcoming). equivalent. In 1937,nominal national income per capita was estimated at $440 in Great Britain, and 9. If price controls prevent excess demand from at $400, $340, $330, $306, $265, and $190 in Swe- drivingupprices,inflationissaidtobe"repressed.' den,Germany,Belgium,Netherlands,France,and The involuntary accumulation of money that re- Austria, respectively. The corresponding esti- sults because there is no way to spend it is called mates for Czechoslovakia, Hungary, Poland, Ro- the "monetary overhang." mania, Yugoslavia, and Bulgaria were $170, $120, $100,$81, $80, and $75,respectively (Solimano 1991). 10.The newfound acquiescenceof the SovietUnion was of course a sine qua non for the transforma- 3.YugoslaviawasnotaCMEAmember. Incertain tion. countnes, notably China, Yugoslavia, and the USSR, there was also a tendency to encourage 11. Income levels reported on a purchasing-power regional self-sufficiency. parity(PPP)basisnormallyexceed exchange-rate- based measures by a margin that shrinks as the 4. Estimates of hidden unemployment in the CEE level of income per capita increases. The margin countries varied, but visitors to industrial enter- appears to be especially large for socialist coun- prises suggested estimates of 20-30 percent. tries because of the extensive subsidization of important nontraded goods, and possibly also 5. The official growth rates reported by some because of quality differences in the tradables countries were controversial, and there are rea- sector that are not fully captured in PPP estimates.

65 12.It shouldbe stressedthat these projectionsare plishingthe major tasksindicated for the firstyear highlytentative due tothedata inadequaciesnoted in figure 2. earlier. 20. Inflationaccelerated somewhat in both coun- 13. Exchange-rate-basedper capita incomesm ay tries after August. fall even further in the southern countries than indicated in figure 1 as Romania and Bulgaria 21. Becauseof the sharp devaluationon January1, open their economiesand take concurrentsteps 1990and the strict credit limits, the real money (already taken by the northem countries)to de- supply actuallyfell by some44 percent in the first value their currencies. quarter of 1990.

14.Any such estimatesare, of course,highly un- 22. The need to adjust relative prices may argue certain because they depend on assumptionson for a substantial rise in the price level, and this the present qualityof capital,future productivity may reduce the need for currency reform. growth rates, and the incomelevel after restructuring. CEPR(1990) and Collinsand Rodrik(1991) 23. Thirtypercent in January,20 percentin Febru- estimate that a relativelyspeedy transition (10-15 ary through June, and 60 percent thereafter. years) to West European income levels would require investment levels on the order of $200- 24. Yugoslaviadevalued again by 28 percent on $400billion per year, approximatelyequal to the January 1, 1991. entireGDP of the CEEcountries. Such investment levels are clearly impossible,from the view of 25. Domestic economiccontraction in the CEE eitherresource availability or absorptivecapac-ity. countriesand the loweringof trade barriersin the TheunfoldingexperienceofeastGermany, though industrial countries also helped spur these in- shaped by distinctivefactors, appears to confirm creasesin exportsin 1990. the magnitude of the task ahead. 26. Industrial output fell 30 percent. 15. Because of its implicationsfor the terms of trade, the demiseof the CMEAin 1991also has an 27. Furthermore,because of fixedexchange rates, important macroeconomiclinkage with external the wage rates of both Polishand Yugoslavwork- balance (seeannex 1). ers rose considerablyin dollar terms during 1990 (from low starting points),allowing them to pur- 16.Although moving rapidly to open trade, Hun- chasemore imported goods. gary still has quantitative restrictions coverilng some30 percent of its production, and it has not 28.Itisimportant to keepinnmindthatchoosingan yet introducedfull currency convertibilityon cur- appropriateexchangerateisextremelydifficultex rent account. ante, and that a substantialdevaluation may be important for the credibilityof a program. Some 17. The comnbinationof large price increasesand advisorsto the Polishgovernment reconmmended limitson nominalwages led to an estimatedfal l in an even greater devaluationthan the one actually real wagesof40-50 percent in the firstmonthof the taken. program. 29. Assumingthat prices may be "sticky"down- 18. In contrast, the usual prescriptionfor policy wards, this moderate inflation does provide a reform within an establishedeconomic system is meansfor a needed realignmentin relativeprices. to address distortions sequentially(the most se- In Poland, for example, prices of consumer vere first),so as not to overload the reform pro- durableshaveincreasedrelativelymorethanprices cess. of most other goods, and prices of serviceshave increasedthe most of all, resulting in a significant 19. As noted in the sectionon the current stage of realignmentof relative prices. transformation,the CEEcountries are at different stages of this process. Poland made particularly 30. In fact, profit margins on sales actually in- impressive strides in 1990in starting or accom- creased for many state-owned Polish firms in

66 1990. This was particularly true in heavy indus- ties of the firms. The goal is to identify a clear-cut try, where domestic sales prices rose faster than owner who will ensure that enterprises are run as costs, and where firms were able to increase ex- profit-maximizing commercial companies. ports dramnaticallybecause of the favorable exchange rate. 38. This issue of "reprivatization" to former owners is becoming increasingly important and threat- 31. By October about 800 enterprises had been ens to create a legal and economnicquagmnire. For pushed into bankruptcy, compared to some 200 example, the CSFR recently passed a law calling during all of 1989. for restitution to former owners of property con- fiscated since 1948. Monetary compensation is an 32. Yugoslavia has instituted payments rules to easier route than property restitution in many control interfirm credit. Under these rules, made cases but may confront constitutional challenges, possiblebyacentralclearingsystemamongenter- as is now occurring in Germany. prises and banks, any firm that is 60 days overdue in its payment obligations can be dedared bank- 39. However, combining the two modes also pre- rupt. It is not clear to what extent these rules are sents complex trade-offs. For example, selling the being enforced in practice. best companies and giving away the worst would clearly tarnish any giveaway scheme. Another 33. Controls ona few basic goods, such as bread or alternative - probably preferable but with its home heating fuel, may need to be phased out own drawbacks - is to give away a minority more slowly for social reasons. interest and sell a majority interest in all firrns.

34. The political and administrative difficulties 40. The resultsof the few valuations carried outby associated with gradual price reform in an envi- major international accounting and consulting ronment of highly distorted prices and large mac- firrns show these to depend on rather arbitrary roeconomic imbalances led the joint Soviet Study assumptions. team to recommend a modified "big bang" approach. Gradual price reform is likely also to 41. It has been roughly estimated that Poles could promote hoarding, putting upward pressure on purchase only about 10-15 percent of Polish in- prices,whilerapidpriceliberalizationencourages dustry (if valued at book) with their existing sav- the liquidation of marketable inventories, putting ings. downward pressure on prices. 42. In fact, concerns over equity are so strong that 35. Giventheirlegacyand theenormouschallenge they threaten to stall the entire privatization pro- of labor realignment they face, CEE governments cess. are likely to follow the more interventionist model of Germany and Scandinavia rather than the less 43. Fewer than 1,000 firms were privatized interventionist model of the United States and throughout the world between 1980 and 1987. Canada. Some active labor market policies are The experience of other countries also suggests a discussed in the section on the role of government tendency greatly to underestimate the time needed later in the paper. for privatization. In addition to the time constraint, Poland's experience with direct sales in 36. These might include, for example, not only the 1990 also suggests that the sale process is costly, elimination of unnecessary regulations but also with total fees and the like amounting to perhaps indicative targets for credit expansion, advisory 10-15percent of sale receipts. and informnationservices, and active measures to involve private firms in government contracting 44. Fiscal policy may also have to address the and to provide access to business premises. potentially inflationary wealth effect that could arise from free distribution of assets. 37. Corporatization includes establishing a clear equity structure, clearly vesting the government 45. It was initially estimated that some 70 percent in ownership of those shares, and appointing of East German industry would be competitive suitable boards of directors to oversee the activi- after restructuring, but that number is falling

67 steadily. This is in part due to the relativelyhigh ment (EBRD)also apply politicalconditionality to unit labor costs resulting from the 1:1monetary their activities. exchangeand collectivebargainingagreements in 1990. 54. For example, a recent agreement between Volkswagenand Skoda could involve direct in- 46. On the one hand, the jobs of many civil ser- vestments in the CSFRtotalling $9 billion in the vants have disappeared; the number of govern- 1990s. ment employeesin the formerGDR is expectedto be reduced by about 50 percent, or one million 55. In addition,individual creditors may provide workers. On the other hand, someof the best civil additional reliefor convert part of the debt into servants are being lured away from government local currency obligations through debt-for- bywell-payingjobsin thenewlyeemergingpriivate equityordebt-for-natureswaps.TheUnitedStates sector, and top policymakers are seriously has agreed on a 70 percent reduction (whichin- overstretched. These govemnmentsbadly need cludes some debt-for-nature swaps, making more well-trainedanalysts and decisionmakers. straightforwarddebt relief closer to 60 percent), and the Italiangovernment may do similarly. 47. It is not clear to what extent the latter impede refonn,although mostobserversbelievethatctDm- 56. Hungary's debt has been trading in the 90s on mitmentto reformwithin the overallbureaucracy the secondary market, Yugoslavia'sin the 50s, is high, especiallyin Poland, Hungary, ancdthe and Bulgaria'sand Poland's in the 15-20s. CSFR. 57.Forexample,debt-equityswapswereincluded 48. Under the old regimes, foreigndirect invest- in Mexico's1989-90 debt reliefpackage. Argen- mentswere govemed exclusivelyby jointventure tina linked debt-equityswaps with commitments contractsnegotiated on a case-by-casebasis. This to provide new money. contractual mind-set continues to be pervasive and needsto bereplaced by a generallyapplickable 58. In addition to flowsof goodsand capital,how legalframework for foreigninvestment. to handle movementsof laboris an issue that may become more important as reforms proceed. 49. Even with massive legal and technicalassis- Honekopp (1991)surveys the availableevidence tance(on a scalefar exceedingthat availableto the on migratory movementsfrom CEEcountries to CEEcountries), the west German legal systemis Germany and Austria. now consideredtoo complexto deal with manyof east Germany'simmediate problems. 59. The role of world prices within the ex-CMEA area after January 1991 is not clear, due to the 50. Income differentialsare already widening in chaoticsituation that has apparentlyfollowed the Poland,as evidencedby the opening of luxurycar decisionto shiftto a convertiblecurrency basis for showroomsin Warsaw. trade within that area. Trade in raw materials (at least with the USSR)is apparently still handled 51. Among PHARE initiatives are a $1 billion mostly by central trading organizations. In the medium-term loan program for Hungary and a case of other commodities,world prices may in- stabilizationfund for Poland. deed be playing a larger role. 52. Theseinclude German bilateralprograms, in 60. In 1990,for example,the five-yearaverage for particular to Poland,Hungary, and the CSFR,and oil was only about $17 per barrel. the U.S.programs established under the Support for EastEuropean Democracy (SEED) Act of 1989. 61. One such list for Hungary-USSRtrade antici- SEEDprograms include access to Overseas Pri- pates a trade volume of $3 billionfor 1991,about vate InvestmentCorporation (OPIC)guarantees two-thirdsthe levelof exportsto the USSRin 1989. and enterprisefunds to promote investment.. 62. The CEE countries appear to have a greater 53.The EC,European InvestmentBank (EIB), and divergencebetweenpurchasing-power-parityand European Bankfor Reconstructionand Develop- exchange-rate-basedmeasures of income than

68 market economies at comparable levels of devel- agency model, ownership is more concentrated, opment, in part because of extensive price con- but the income received from privatization is trols on important nontradables. They therefore spread widely. appear in the international context as relatively low-wage countries, at least in the short run. 68. Certain "strategic" industries, such as weap- ons, power, mining postal services,and rail trans- 63. Althoughexactnumbersareelusive,itappears port, are designated to remain in state hands. that private entrepreneurship isemerging rapidly as constraints are removed. There may now be 69. In July 1990 the CSFR raised food prices an one million small businesses (one-person or fam- average of 26 percent with limited lump sum ily operations) and 2,000 to 3,000 larger firms in compensation. private hands, as well as perhaps 10,000 joint ventures with foreign finns. However, the share 70. More than 400 new banks have been estab- of nonagricultural production in private hands is lished in the USSR since 1988. still small - perhaps 15 percent in Hungary, Poland, and Yugoslavia, and less in the other 71. In Poland they accounted for almost two- countries. thirds of M2 by the end of 1989.

64. The USSR has about 47,000 and China about 72. Accumulated losses in the banking crises of 200,000state-owned enterprises, most of medium Chile and the Philippines reached about 20 per- or large size. To appreciate the significance of the cent of GDP. For comparison, the accumulated number of firms, Chile's massive privatization losses of the U.S. savings and loan system are program from 1973 to 1989 involved some 470 perhaps 3 percent of GDP. enterprises producing 24 percent of value added in the economy and employing less than 5 percent 73. By early 1989 the capitalization of Hungary's of the workforce. Great Britain privatized about security markets equalled 10 percent of domestic 20 firms, accounting for about 5 percent of value credit. added, during MargaretThatcher's tenureasPrime Minister. In fact, between 1980 and 1987 fewer 74. Only in Germany do banks directly exert sig- thanl,O00flirnswereprivatizedthroughouttheworld. nificant ownership rights over firms, and even these are restricted. Elsewhere, banks may own 65. In Poland, for example, at least 20,000outlets firms only through holding companies, with safe- have been sold, and about one-half of retail trade guards for the independence of credit decisions. is in private hands. In the CSFR,republican gov- ernmentsplantoauction some100,000smallbusi- 75. In the United States, for example, a minimum nesses in 1991-92, with the successful bidders of five years is required to train an examiner required to maintain services in the same loca- capable of dealing with the smallest and simplest tions for at least a year. Hungary plans to transfer institutions. Years of experience are similarly ownership of about 10,000shops, restaurants, and needed for credit analysis, and there are limits to small-scaleservice establishments to private hands the degree of experience that can be transferred in 1991. "off the shelf." Existing training is mainly limited to short courses and is more in the nature of 66. Data on the total extent of spontaneous privat- "exposure" than training to international stan- ization are scarce. It is believed that slightly less dards. One of the dangers of current curricula is than 5 percent of state assets had been privatized the tendency to include sophisticated topics such by mid-1990. as currency swaps when the foundation of basic credit skills is not adequate. 67. These roles for intermediaries result in different ultimate ownership pattems. In the first two 76.Theseincludestrengtheningcreditprocessing, models, indirect ownership of firms is spread closely monitoring operating expenditures and widely; in the case of a mutual fund, control is efficiency, and introducing appropriate loan clas- diffused, whereas it is more concentrated in the sificationcriteria,guidelinesforprovisioning,and case of a holding company. In the privatization income accrual and capital adequacy criteria.

69 77. If a hard budget constraint is applied to the 83. In Poland, for example, subsidies for all prod- banks while their portfolios have a large share of ucts and services except transportation and cul- problemloans,theywillbeforced towidenspreads ture are estimated to have reduced inequality (as to good clientsin an attempt to cover the losses on measured by Gini coefficients) by some 8.5 per- problem loans (as has happened in Yugoslavia); cent. Total consumer subsidies in Hungary are this can lead to disintermediation and a further estimated to have reduced inequality by some 5 loss of portfolio quality. With negative capital, percent. there is also little incentive for banks to foreclose on clients. Banks therefore cannot be used to force 84. Housing and energy account for most of the widespread enterprise restructuring. remaining subsidies.

78. The experience of the GDR suggests the diffi- 85.Hungaryisconsideringadoptingaspecialized culties of rapid financial sector restructuring. The housing allowance program, possibly limited to sole commercial bank, Kreditbank, entered into Budapest (where most public rental housing is Joint ventures with two large West German com- located). mercial banks, leaving its entire portfolio of old loans to a shell holding company with only 250 86. A prime example is payroll taxes, which have employees. This resulted in "clean" financial traditionally been levied at very high rates to intermediaries ready to serve the region of the finance the broad array of social benefits (includ- former GDR, but they had no direct interest in the ing pensions, health care, education, travel) pro- repayment of previous loans and there was no vided to workers. In Hungary, Poland, the CSFR, adequate institutional structure for their recov- and Bulgaria, social security contributions exceed ery. At the same time, it is reported that the lack 40 percent of payroll and are charged primarily to of acceptable enterprise audits and legal uncer- the employer. This level of tax would be difficult taintiesconcerningtheloans,collateralassets,and to impose on private firms. Reforms in social securities are hindering the lending activities of benefits are discussed further in annex 6. the new banks. 87. For example, the company income taxes tend 79. This is the procedure to be followed in the to have low straight-line depreciation rates, little former GDR. allowanceforlosscarryover,and nondeductibility of some costs. 80. These shares fell somewhat in the 1980s (particularly in Poland, Hungary, and Yugoslavia) as 88. Although company tax reforms in Hungary output stagnated, access to foreign borrcwing led to a decline in revenues, the sharply increasing tightened, and many large projects were aban- revenues from the new VAT more than compen- doned or trimmed. As in most countries, invest- sated. ment bore the brunt of spending cuts. 89. For example, foreign investors are eligible for 81. The private sector might have a role in provid- very generous tax holidays and other tax benefits ing some basic infrastructure, notably telecom- under the company income tax. The personal munication. income tax exempts an estimated two-thirds of all personal income, including not only a generous 82. Direct subsidies were only one of many av- tax-exempt amount, but also social security and enues for extensive redistribution within socialist other transfers, pensions, and most income from economies. Redistribution began at the level of farming. The VAT exempts all financial, health, the enterprise, where individual wages were only education, sports, and cultural services,and "zero- loosely related to worker productivity (see annex rates" many goods, including processed foods, 2) and where negotiated taxes, enterprise subsi- medicines and medical equipment, books and dies, and cheap credit reduced differences in af- periodicals, transportation services, and many ter-tax profits. Redistribution continued agrtthe sources of energy. sector level via arbitrary prices, government capital grants, and soft loans. Consumer subsidies 90. The Gini coefficientis the most common mea- represented only one link in the chain. sure of income inequality. It varies between 0

70 (perfect equality) to 100 (all income appropriated 99. Eligibility criteria were made more restrictive by one recipient). as of January 1991.

91. The degree of inequality in the socialist coun- 100. In general the minimum wage should exceed tries may be somewhat underestimated due to the the social minimum to encourage work effort. omission both of unreported incomes and of some segments of the population, most notably private 101. Bulgaria's initial benefit is 100 percent, de- businessmen and the military in Poland and the clining gradually to 50 percent in the sixth month. USSR.Theseomissionsalsooccurinmarketecono- Benefits are limited in time to nine months. Hun- miesbutgenerallyto alesserextent. Furthermore, gary offers initial benefits equalling 70 percent, monetary income alone is an imperfect yardstick declining over time; pursuant to new legislation, in socialist countries where shortages were com- the benefit period varies between eight months mon and certain social groups had special buying and two years, depending on the length of prior privileges. On the other hand, the fact that many employment. basic necessities were subsidized was in itself a form of social protection, leading to higher real 102.In Yugoslavia, social assistance programs are purchasing power for a given level of income. runattherepubliclevelor,withinrepublics,atthe communal level. Although they appear to be 92. State-owned enterprises in market economies reasonably well-designed, fundingmaybecomea also tend to compress wage distribution by reduc- serious impediment to coverage as long-term un- ing top wages. employment grows, particularly in the poorer communities with smaller tax bases and a larger 93. One of the first effects of reform is likely to be number of claimants. Greater financial support a readjustment in pay scales in favor of skilled fromtherepublicanandfederalgovernmentsmay professionals. be needed.

94. As noted elsewhere, socialist governments 103.In Hungary, for example, social security taxes used an elaborate framework of largely ad hoc paidbypublicenterprisesareabout2.5timestheir taxes, subsidies, and credit to extract profits from corporation income tax payments. successful firms and prop up loss-making firms. 104. For example, early retirement was liberally 95.InPolandinthel980s,forexample,aboutone- granted during the Polish and Yugoslav fifth of all medical outlets belonged to enterprises. stabilizations of 1990,and Hungary and Bulgaria grant full pensions for redundant workers at age 96. Sickness benefits have generally been pro- 55. vided through social security institutions, with no employer obligations. The number of sick days 105. The Polish privatization plan, for example, has far exceeded (often doubled) that in Western calls for the pension system to receive 20 percent Europe. Generous family allowances and lavish of share ownership in privatized firms. This is a maternity benefits (such as birth grants and three start but is not likely to fund a substantial share of years paid leave per child) have also been typical. pension liabilities.

97. This approach is taken, for example, in Austra- 106. Annex 7 was prepared by Country Depart- lia and New Zealand. It may not be the cheapest ment IV, Europe, Middle East, and North Africa alternative when administrative costs are taken Regional Office, and the Intemational Finance into account. Corporation.

98. This approach is taken in most developed market economies.

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