Transformation process in the Central and East European (CEE) countries. Classification of CEE countries Lecture 2

Learning objective The CEE countries before 1990 – central planned economy Stages of transformation process in CEE countries Economic and social costs of transformation Privatisation in CEE Classification of CEE countries

Market versus centrally planned economy Market Economy Centrally-planned Economy Dominant position of private property Market coordination (resources) Prices are determined by market forces High elasticity of economy (production is adjusted to the needs of customers Hard budget constraint: the principle of self-financing, companies covers expenditure of their income, entrepreneurs bear the risk Market forces competition fuel innovation Dominant position of the state ownership Bureaucratic coordination (resources) Prices are mostly set by government Low elasticity of the economy: central planning stiffens the functioning of the economy Soft budget constraint: companies can count on steady supply of funds, state covers shortages and losses Plans discourages entrepreneurs from innovative activities

The stages of transformation and development in CEE 1990-1993 - Initial Stabilization and Reforms 1994-1996 - Market Reforms 1997-2001 - Recovery 2002–2007 - Boom 2008-2013 - Crisis 2014 and Beyond

Centrally Planned Economy Main Characteristics Lack of competition, Lack of freedom, Lack of equilibrium.

How did central planned economy manifest? The nationalized economy (no private ownership), The prohibition of entrepreneurship (except small-family business and farming in some countries), Centrally planned economy, Non-existent market, no competition, Non-existent prices (centrally established), in result – not efficient allocation of resources), The external relation under CMEA, (Council for Mutual Economic Assistance) - trading arrangement between Soviet bloc economies, No floating exchange rate of currency Most of the communist countries had big foriegn debt. On the end of 80’ they are not able to pay it.

CMEA (comecon) (Council for Mutual Economic Assistance)  the pre-1990 trading arrangement between Soviet bloc economies, which was the Eastern Bloc's reply to the formation of the Organization for European Economic Co-operation in western Europe

The main goals of transformation To liberalize the economy To stabilize the economy To restructure the economy Legal and institutional reforms (support of all the changes)

Nobody knew how to transform The Economist (March 24-30, 1990) “Hundreds of books have been written on the transition from capitalism to communism but not the other way. There is no known recipe for unmaking an omelet.” Quote

Liberalization the process of removing regulatory restriction in business, allowing most prices to be determined in free markets and lowering trade barriers that had shut off contact with the price structure of the world's market economies Price liberalization (the end of shortage economy – Kornai) Trade liberalization Market entry liberalization

Stabilization To curb the inflation, liberalize prices and eliminate the shortages on the market To decrease national debt and make the budget deficit more balanced To open the economy to domestic and foreign competition Conflict, opossition beetwen some goals. How to curb the inflation and liberalize or deregulate the proces?

National Debt as % of GDP, Poland 1970-2016

Inflation, Poland 1970-2016

Restructuring the economy Privatization New Tax system (VAT, PIT, CIT) Independence of National Bank

Privatization in CEE All larger political parties in CEE countries on the beginning of transformation supported privatization. The reasoning behind were somewhat different in individual countries. Main reasons: – to create domestic middle class, - to establishe competition - to increase efficiecy - to finance budget deficit

Privatization methods Direct sales, Initial public offering (IPO), Public tender, Self privatization Auction, Coupon or voucher privatization, The Management-Employee Buyout (MEBO) method, Restitution, National Investment Founds, Special methods,

Direct sales Conducted by founding organs or commissioned agencies on behalf of government (Treasury – Poland, State Property Agency – Hungary). Goal – fast ownership changes of small and medium enterprises in good financial condition. The main recipients – mainly employees of state enterprises.

IPO – Initial Public Offering Two phases process. 1st phase – transformation the state enterprise to joint stock company or limited liability company. 100% of shares held by Treasury or special state agency. 2nd phase – sale of shares on domestic or foreign stock exchange. In cases of strategic importance of some companies, the Treasure kept the control packet (golden share), to ensure the state influence on the decisions.

Public tender The public invitation for the investors selected by the representative of the state. The state specify: the minimum price of the share, minimum number of shares the investor shall buy, minimum investment pledge and social commitments, The deadline for submission the offer, Negotiation an selection the best offer, Popular for privatization medium and large enterprises in Poland (banking sector, detergent, pharmaceutical, sugar companies). Public tender – przetarg publiczny

Self Privatization (tricky privatization) Merger of state and private enterprises and undervalue the state assets in the merger (Poland). Transfer property and financial assets to the private association (Hungary). In the initial phase of privatization, when the state conception did not exist, but some transition laws was already approved by parliament.

Auction called pre-privatization The sale of the state property on an auction. Small enterprises Popular on the beginning of the transformation process Most popular in Czech Republic and Hungary.

Coupon or voucher privatization Mass privatization The state assets were supposed to be handed over citizens, which could then be used to buy shares. Czech Republic, Poland, Hungary (compensation for nationalized lands in 1950), Romania, Slovenia. Not successful form – create corruption (Czech), unstable structure of ownership, devaluation of shares.

Management-Employee Buyout (MEBO) method The transfer of shares to employees through giveaways or sales at low prices. Special association for holding shares during the repayment period. Repayment period 3-5 years. Most popular in Romanian privatization. Giveaway - wskazówka

Restitution To give back to the original owner from whom it was taken during the nationalization However it turnout to be very complicate to find the original owner, to established the proper value especially when the property has gone through significant changes. In Czech Republic restitution claims were opened up in 1990 and moved about 100 000 properties (houses, farms, small businesses) to the private hands. In Hungary this form was applied to lands. In Poland problem is not solved up to this time. In other CEE countries it became more political matter. Restitution – zwrot mienia

Privatization dominating and most efficient methods in CEE countries were: direct sales, management-employee buyout

Private Sector Share of GDP Source: European Bank of Reconstruction and Development

Income from privatization

Transformation process in CEE countries Two ways of transformation: Big bang (shock therapy) Slow and steady (gradual or evolutionary approach)

Shock Therapy strategy that involves moving quickly to eliminate the old order and to replace it with new organizational and policy arrangements, i.e. markets; transition policies could be implemented rapidly. all at once and painful causes immediate, sharp economic collapse get it over with before it can be undone The window of opportunity for reform must be exploited It was often thought that markets would naturally emerge from decentralization as the state exited from its former dominant role. Poland, other Central European countries (Hungary, Czech, Slovenia, Slovakia) chose the big band strategy

Slow and steady transformation Emphasizes complexity of organizations; process of learning and adaptation required. This approach drew on the analogy of how markets and related organizational arrangements and policies emerged in Western industrialized economies, typically over extended periods of time. spread out and less painful avoids collapse, in principle takes longer The gradual approach believe that institutional change is path-dependent. Organizations are viewed as complex hierarchies within which participants pursue objectives while guided by incentives but subject to bounded rationality. “Bounded rationality” refers to the limits of information; the limits faced by decision makers and personal limitations (inadequate education). Hierarchy is an architecture in which there are superiors and subordinates. To an economist the hierarchical structure of an organization implies the principal-agent problem. Organizational change is sequential, path-dependent and evolutionary through a process of organizational learning and adaptation.

Slow or shock therapy?

Economic and social costs of transformation Consumer Price Index (Year 0 means the year of price liberalization) P – Poland, C – Czech R., S – Slovakia, H – Hungary, B – Bulgaria 1. Growing inflation – consequence of price liberalization.

Economic and social costs of transformation Employment trends in the CEECs, 1989-1999 (1989=100) 2. Falling employment and growing unemployment rate

Economic and social costs of transformation 3. Recession of transformation – falling GDP growth rate By the year 2000, only four countries managed to surpass the level of GDP in 1990. Poland - + 44% growth, Slovenia - +22%, Slovakia and Hungary - + 10%, Czech Republic - has just reached the GDP level of 1990 in 2000, Latvia has the poorest record with having in 2000 just 60% of its GDP level a decade earlier, Lithuania and Bulgaria were in 2000 about 20% below its GDP of 1990 (80% of GDP level frim 1990). The GDP Changes in Eastern Europe Czech PL Ukraina Hungary

The Transition Recessions in Post-Communist Countries

Other economic and social costs of transformation Growing dispersion of income Brake up of CMEA; search of new markets Growing structural unemployment

The Visegrad Group The Visegrad Group – 15 February 1991, established by heads of Hungary, Poland and Czechoslovakia in Visegrad. The initial goals were economic cooperation and mutual help for the promotion of the democracy and Euro-Atlantic integration. One of the most important achievements of the Group was the establishment of CEFTA (the Central European Free Trade Agreement). This, together with the coordination in economic, technological, industrial and agrarian policies in the area, enhanced cooperation between its members, via the establishment of a pre-EU-like economic environment. The Group also established the International Visegrad Fund in order to support scientific research and culture.

Towards EU After years of isolation from the Western economic system, and after the distortions and deprivations of the communist system, most citizens just wanted to live in a normal country with a normal economy, and, given their history and geography, that vision was captured in the allure of reintegrating with Western Europe. From the very beginning of transformation the main goals for all CEE countries was to become: a memeber of NATO; OECD, and finally EU. The historic offer from the European Union to countries in the region provided a gravitational pull that helped policymakers justify and implement difficult reform steps.

CEE countries in NATO March 1999 – Czech Rep., Hungary, Poland; March 2004 – Bulgaria, Estonia, Latvia, Lithuania, Romania, Slovakia, Slovenia, April 2009 - Croatia

CEE countries in OECD In 1989, the OECD started to assist countries in Central Europe (especially the Visegrád Group) to prepare market economy reforms. In 1990, the Centre for Co-operation with European Economies in Transition was established, and in 1991, the Program "Partners in Transition" was launched for the benefit of Czechoslovakia, Hungary, and Poland. This program also included a membership option for these countries. As a result of this, Czech Republic (1995), Poland and Hungary (1996), Slovakia (2000), Estonia and Slovenia (2010) as well as Latvia (2016) became members of the OECD. Other CEE countries which are not the members, expressed the interest to joint.

Steps of EU integration History 1951: The European Coal and Steel Community is established by the six founding members 1957: The Treaty of Rome establishes European Economic Community and common market 1973: The Community expands to nine member states and develops its common policies 1979: The first direct elections to the European Parliament 1981: The first Mediterranean enlargement 1985: Schengen Agreement – open borders 1993: Completion of the single market 1993: The Treaty of Maastricht establishes the European Union 1995: The EU expands to 15 members 2002: Euro notes and coins are introduced 2004: Ten more countries join the Union 2007: Romania and Bulgaria became EU members 2013: Croatia became EU member

Membership conditions for CEE countries to join EU European integration has always been a political and economic process that is open to all European countries prepared to sign up to the founding treaties and take on board the full body of EU law. According to Article 237 of the Treaty of Rome ‘any European state may apply to become a member of the Community. Article F of the Maastricht Treaty adds that the member states shall have ‘systems of government […] founded on the principles of democracy’.

The ‘Copenhagen criteria’ In 1993, following requests from the former communist countries to join the Union, the European Council laid down three criteria they should fulfill so as to become members. By the time they join, new members must have: Adherence - przestrzegać

Integration and enlargement of EU institutional framework to international business in Europe Four freedoms of the EU single market freedom of movements of people, goods, services, and capital - the single market – rules: mutual recognition – the principle that products recognized as legal in one country may be sold throughout the EU; harmonization of selected sectors – sectors in which EU has created common rules; subsidiary – the privilege to take the action by EU only if it is more effective than actions taken by local level (priority for decentralization). the euro -Maastricht Criteria (annual budget deficit not exceeding 3% of GDP, public debt under 60% of GDP, inflation rates and long-term interest rates within 1.5% of the three EU countries with lowest rate and the exchange rate stability and the lowest long-term interest rates)

Integration and enlargement of EU, timeline 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 The beginning of the transition The Copenhagen Criteria To set the political, economic And legislative criteria that applicants need to fulfill Negotiation The launch of Negotiations with Luxemburg group Entering EU Association Agreement The signing of Europe Agreements with Poland and Hungary Application for the EU Membership Poland and Hungary apply for the EU membership Accession Treaty The signing of

EU Accession Referendums in Central & Eastern Europe, 2003 The graph summarizes the results of referendums in 8 post-communist countries – the new members that entered EU on the 1st May 2004. The 2003 referendums were a huge victory for the European idea and the European integration project. Central and Eastern European citizenries expressed in this way their strong support for the idea of European integration.

The accession process The entry negotiations are carried out between each candidate country and the European Commission which represents the EU. Once these are concluded, the decision to allow a new country to join the EU must be taken unanimously by the existing member states meeting in the Council. The European Parliament must give its assent through a positive vote by an absolute majority of its members. All accession treaties must then be ratified by the member states and the candidate countries in accordance with each country’s own constitutional procedures. During the years of negotiation, candidate countries receive EU aid so as to make it easier for them to catch up economically. For the enlargement of the 10 countries in 2004, this involved a package of €41 billion aimed mainly at funding structural projects to allow the newcomers to fulfill the obligations of membership.

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