Assignment 1999-2000 in

THE EUROPEAN ECONOMY: EVOLUTION, TRADE AND

INTERDEPENDENCE

For

Dr. Valerio Lintner

Title: Critically discuss the process of transformation

in the East/Central European countries formerly under
Soviet Control

Written by Konstantinos Kostoulas 9910284

Msc in International Banking and Finance (F/T)

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The collapse of the socialist system in Eastern Europe and the Soviet Union is one of
the major events of this century, perhaps the most important of all. The transformation
now taking place is without any precedent in history.

The original development of capitalism was a process that lasted for centuries. The
almost total liquidation of capitalism in the countries ruled by Communist parties took
place - in historical terms - in a very short period of time, but it was carried out by
force and repressive methods. The transformation that has now begun is diverting
these countries back on to the path of capitalist development.
These revolutions in central and Eastern Europe in 1989 started a progressive move
towards political pluralism and parliamentary democracy, as well as a transformation
of centrally planned economies towards market economies. The systemic change has
been accompanied by macro-economic stabilisation programmes and a process of
integration into the world economy. In general, stabilisation has been relatively fast
and successful, but the transformation has been slower and more painful than
expected, and the restructuring is still in early stages.

In any case, the former socialist countries of Eastern and Central Europe are in the
midst of transforming their political and economic systems. Price liberalisation,
stabilisation, modernisation, industrial restructuring and integration in the world
economy are important steps in the process of transformation. These necessary
elements form the basis for a successful transformation: a stable domestic political
economy with strong social consensus; sound domestic macro-economic policies with
progress on structural adjustment; trade and capital liberalisation with increasing
export market shares; banking reform and substantial external financial and technical
assistance. Moreover, the pillars of the reform process are: diversification of the forms
of economic activity; decentralization of management decision making in the
economy and reducing the political monopoly of the single party by creating political
liberalisation with openness, more democratic rights and multiparty systems.

The initial results of stabilisation programmes have been encouraging, although the
initial price shock was larger than expected and has led to persistent inflationary
pressure. Balance of payments improvements should be seen as a temporary success.
The response of the productive system to the new price and incentive signals has been
rather sluggish. Poland, Czech Republic, Slovakia and Hungary suffered serious and
protracted recessions, as witnessed by rapid declines of national income, industrial
output, investment, living standards, and large-scale unemployment. The decline in
industrial production is estimated at 40% for Czechoslovakia (before becoming two
countries), thirty two per cent for Hungary, and 34% for Poland during the period
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1990-1992. Unemployment rapidly climbed and exceeded 14% in most areas, and
reached 20% in Hungary during 1993.Polish consumer welfare decreased
dramatically after a major stabilisation reform programme was initiated in January
1990.Poland began its transformation process at the beginning of 1990.Bold measures
were taken to free domestic prices from state control, eliminate trade barriers and
implement measures to stabilise the domestic economy.

Domestic demand and supply factors contributed to the sharp decline in output of the
large state owned enterprises. Other specific factors also had their impact, especially
the slow speed of structural adjustment, the delays in the privatisation, initial under-
and over-valuation of the exchange rate, and the unexpectedly high costs of
liberalisation.
In general, an exchange rate dynamics is crucially important for economies in
transition entering into the world economy. An overvaluation of national currency,
used in some cases from a number of countries in transition as an anti-inflationary
measure depresses national production, while devaluation brings about inflationary
trends.
The process of privatisation in Eastern and central Europe is crucial to the attainment
of a market-based economy. However, the speed at which privatisation is to take
place, its organisation and the structure which is to be attained are all controversial
issues.
It is worth to mention the comparisons between the rates of private sector growth and
the depth of the economic decline as a result of the transition. While in the years
1989-1993 the share of non- government sector in GDP increased by 180% in Poland,
3.6 times in Hungary, 8.7 times in Bulgaria, and more than ten times and Romania,
Slovakia and Czech Republic, in the terms of GDP the fastest was growth renewal in
Poland, the figures of Hungary are also positive. Meanwhile, in Romania and
Slovakia the process of stabilisation is quite slow, the economy of Bulgaria is still in
crisis. Recession stopped by the end of 1992 for the most east and Central European
countries formerly under Soviet control. GDP stabilised in all central European
countries and, with the exception of Slovakia, the economies grew by up to 3% during
1993. The private sector accounted for already more than 40% of GDP in Poland and
Hungary, and close to 20% over GDP in Slovakia and the Czech Republic in 1994.
Inflation declined significantly in 1993 and continued to come down the following
years. Foreign direct investment during 1992 exceeded four billion US dollars in
Hungary and two billion US dollars in the Czech Republic, close to 5% of their
GDP.The following charts illustrate both the GDP dynamics and the inflation in the
economies in transition:
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GDP in East and Central Europe

percentage growth rates

10
5
Bulgaria
0 Czech Republic
-5 Hungary
Poland
-10 Romania
-15 Slovakia

-20
1990
1991
1992
1993
1994
1995
1996
1997

Inflation in Economies
in transition, CPI,%
700

600 Bulgaria

500 Czech Republic

Hungary
400
Poland
300
Romania
200
Slovakia
100

0
1989 1991 1993 1995
1990 1992 1994 1996

While half of the first target of all stabilisation policies was inflation reduction, the
policy of monetary restrictions has exerted an inevitable negative influence on
economic and, primarily, investment activity. The growth of investment after the
dramatic decline in the East Europe by 37% in 1989 - 1993 has been restored in
Poland in 1992, in Czech Republic, Hungary and Romania - in 1994. However, due to
the fact that more than 40% of money mass since 1995 circulated out of banks and at
the end of 1997 about 50% of the M3 were represented by money in cash, monetary
system was hardly regulated. Thus it was much more difficult to be managed by
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traditional instruments. Moreover, 42% per cent of internal transactions in industry in

the end of 1997 have been done by barter that limited further the level of
manageability of the economy with monetary instruments. As a result, the efficiency
of monetary instruments was quite low, having a negative impact on economic
activity.

In Czech Republic, fast privatisation was advocated for political and economic
reasons, in particular it was seen as essential to quickly and irreversibly move away
from the hated communist system. Privatisation in Czech Republic has apparently
been very successful with 71 % of property marked out for privatisation actually
privatised by the summer of 1996.
However, some problems still remain. Besides domestic political difficulties after the
separation of the Czech and Slovak republics, there are two main economic problems
to be addressed. First, a fiscal crisis has emerged after the tax base of enterprise
profits eroded, and expenditures increased under social pressure; there is a need to
modernise tax systems and administrations, and to achieve budgetary discipline.
Second, inter- enterprise debts have accumulated, many of which are bad loans which
threaten financial stability.
In Poland, small privatisation was swiftly and successfully achieved at the start of the
reform process in the year 1990. Two main forms of privatisation were used, capital
privatisation i.e. sale at full (or significant) price and privatisation through liquidation.
Significant restructuring occurred despite the slow pace of privatisation. Polish
unemployment rising from 0% in 1989 - to 16.4% in 1993 suggests much structuring
took place. Significant numbers of new businesses were set up, including notable
Western firms. Polish entrepreneurs picked these assets up cheaply, fuelling the
growth of the new private sector.
A massive privatisation program was originally promised in the year 1991. Political
difficulties ensured a three-year hold-up pair as the details of the scheme were
debated. Finally the programme for a mass privatisation was agreed in the first half of
1994. The World Bank was losing patience with Poland's commitment to privatisation
so made the release of much of its proposed lending to Poland conditional upon
progress on privatisation. The aim was to promote and encourage privatisation and
shareholding among the Polish people. The mass privatisation programme finally
started in August 1995. Western involvement is hoped to bring Western management
expertise and attract Western investment. At the same time, the continuation of state
ownership has helped prevent spread the impact of restructuring in initially very
inefficient sectors. Future success clearly relies on the financial sector. The entry into
the European Union is likely to contribute to the success of the financial sector.

Since 1994 privatisation has been aimed in Poland to increase the management
efficiency. The main criterion of the privatisation success is an increase in economic
performance of the privatised enterprises. Government also reserved the privilege to
put certain conditions to new proprietors concerning the enterprise profile,
employment indicators, etc. The policy of equal competition of different forms of
property and equal approaches both to private and state enterprises were declared.

In 1996 the private sector produced about 60% of GDP, the majority of private
enterprises emerged as new investments. It means, that financial resources mainly
have been used not for the non-productive property change and further spending of
the money for current consumption, but for the increase of country's economic
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capacity. A massive privatisation started, when the economy was already growing.
This is probably the most significant reason of the fast renewal of investment growth
in Poland.

Let us now consider Romania and reforms after 1990. At the beginning of the '90s,
the country’s economy inherited from the socialist regime was characterised by
ubiquitous state ownership, excessive centralisation of the economy, rigid planning,
overdimensioned and energy intensive industrialisation, low efficiency. The main
elements of the process of economic reform undergone by Romania in the last years
included: the liberalisation of the prices and foreign trade; the privatisation of the state
enterprises; the development of a free-market finance and banking system. The
restructuring of the financial and banking system is an important part of the reforms
being made by the government in order to satisfy the requirements and objectives of
the transition towards a market economy. The development of the private sector has
been slow but noteworthy. In 1996, the private sector accounted for 52% of the GDP.
In 1997, there were forty banks operating in Romania and nine branches or
subsidiaries of foreign banks. The expansion of private activity is the result of two
phenomena: the transfer of the property from the state sector; and the development of
new enterprises. Today, all together there are about 800,000 private firms in Romania.

Where price liberalisation, fiscal restrictions, anti-inflationary measures and

privatisation were considered as the priority directions of economic strategy instead of
taking them as the means to create a system of market co-ordination, the performance
of these economies deteriorated. In the countries where government played the main
role in the reforms, process of reform was successful.
One of the main features of successful transformation strategies is the priority of
private economic subjects’ creation than the improvement of national producers'
position. Primarily, government economic policy is to be aimed to create a market
environment. That is, appropriate mechanisms, agents and institutions, only
afterwards charging them to manage the economy.
It is clear that the basic physical infrastructure required for a successful development
is not in place in much of Eastern and central Europe. Deficiencies in
communications, transport networks, power and water supplies are inhibitors of the
basic processes of production and service provision. The capital requirements are
huge here.
Many of the transitional economies have already begun to attract significant amounts
of foreign direct investment in the brief period since the collapse of the centralised
system. In the end of 1996,for example, the stock of inward direct investment in
Hungary was around 30% of the GDP.
At the outset of the transition period the countries of the East and central Europe
suffered from an increasingly obsolete capital stock, inadequate infrastructure and an
industrial structure in need of modernisation. Foreign investors have provided a vital
source of new physical capital, as it has been difficult to channel sufficient domestic
resources into investment. The following chart shows the cumulated inflows of
foreign direct investment in $ million for Czech Republic, Hungary, Poland,
Romania, Slovenia and Slovak Republic from 1989-1996:
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Cumulated Inflows of Foreign

Direct Investment 1989-1996,$ million

15

Czech Republic
10 Hungary
$ million

Poland
Romania
Slovenia
5 Slovak Republic

0
The vast majority of investments have gone to the Czech Republic, Hungary and Poland, three of the largest
transition economies and the earliest to begin liberalisation

In some countries, however, shortages of foreign currency reserves limited the ability
to import new products and equipment, as well as the ability to establish trading links
necessary to integrate fully into the world economy. The achievement of the radical
economical reform implies transformations which have a crucial impact upon the
whole population. The proceeds of the price liberalisation, based on the supply and
demand mechanism, have negative effects upon the standard of living of the
population. There are social and objective costs of the transformation. These ones are
due to the transition process and they are unable to be avoided. They refer to the
unemployment, inflation, price increases etc, being determined by the economy
restructuring process.
By all means, the economic reforms in the Eastern and Central European countries
formerly under Soviet control are in their embryonic period at present. The reform
programmes are on the road of endlessly searching for better ways in which the
government can help or stop hindering economic progress. But it is obvious, that there
will be no magic formula with which the Eastern European governments may find the
best policies for implementing a mixed market economy, or perhaps a mixed socialist
economy. There is no doubt that it will take time - associated with stability and
continuity of policies - for the governments in Eastern and Central Europe to establish
the legal framework of the economy, to determine the market economic stabilisation
policy, to affect the allocation of resources needed to improve economic efficiency,
and to establish programmes for the distribution of income.

In other words, the economic reforms will not change de facto the logic of the
economic system and remove all centrally planned controls and restrictions in Eastern
Europe in the medium term. For more than four decades the Eastern European
countries have spoken a different economic language to that of the Western European
nations. Therefore, it takes time to learn a new economic language and implement a
different economic system effectively.
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References:

Batt Judy,"East Central Europe from Reform to transformation”, 1991

Bryant and Mokrzycki,"The new great trasformation?: Change and continuity

in East Central Europe", 1994

Mason, David S., "Revolution and Transition in East-Central Europe”, 2nd

Edition 1997

Scott Julie, “Central and East European Transformation", 2nd rev.edition

1994

Bird Graham,” Economic Reform in Eastern Europe" Edward Elgar

Publishing Limited,1992

Schipfke Alfred, Alan M.Taylor,"The Economics of Transformation, Theory

and practice in the New Market Economies", Springer-Verlag 1995

Howell John,"Understanding Modern Europe, the context of Change”, Ernst

& Young 1994

Gros Daniel & Steinherr Alfred, “Winds of Change", Longman Group UK

Limited 1995

Edwards Vincent, "Proceedings of the Fourth Annual Conference on

Convergence or Divergence: Aspirations and Reality in Central and Eastern
Europe and Russia”, Buckinghamshire Chilterns, 1998

Buckley Peter, Ghauri Pervez, "The Economics of Change in East and

Central Europe”, Academic Press Limited, 1994