Reflections on 20 years of transition in Eastern Europe Milica Uvalic University of Perugia Conference – Europe: 20 Years of Transition Vienna, September

Issues 20 years of transition in post-communist countries in Eastern Europe 1. The transition to a market economy 2. The model’s flaws 20 years later 3. Present challenges 2

1. Transition in Eastern Europe November 1989 (fall of Berlin Wall)  Transition to a market economy and multiparty democracy in Eastern Europe (EE) Unprecedented experiment: radical changes of systemic features of EE economies  creation of capitalism by design! The typical transition model followed the main prescriptions of the “Washington consensus” (based on experience from Latin America in the 1980s)  Liberalization, Stabilization, Privatization [Peak of Reaganite and Thatcherite ideology] 3

Transition in Eastern Europe Transition required various measures in parallel (1) Macroeconomic stabilisation: liberalisation of prices & foreign trade (2)Microeconomic reforms: rapid privatization, microeconomic restructuring, reduction of subsidies (“hard budget constraints”) (3)Institutional reforms: banking and financial sector, creation of capital and labour markets, radical fiscal reforms … Results? Reality very different from initial expectations (generally too optimistic) 4

Transition in Eastern Europe Transformational recession in early 1990s  Very severe and prolonged recession, fall in GDP of 18-80%, even more of industrial production... Economic recovery delayed, only in Poland and Slovenia in Causes? Partly due to economic/trade disintegration (CMEA, USSR, CSSR, Yugoslavia)  today 29 countries in the EE region (instead of 9) Systemic vacuum: passage from a centralized administrative system to new market institutions  disorganization and “chaos” But also wrong economic policies  the hyper-liberal model: Overshooting of stabilization programs: overly restrictive monetary & fiscal policies Too rapid trade opening, frequently revoked and therefore premature Much faster capital liberalisation than in post-second World War Europe Speedy privatization, without changes in corporate governance Non-progressive taxation of companies and households, as witnessed by the widespread introduction of the “flat tax” 5

Transition in Eastern Europe We dispose of an ample literature on what happened in EE in the 1990s, but the assessments greatly differ… Today, many EE considered “normal” capitalist economies (?) In the meantime, “good policies” have been applied also in countries that were late reformers (e.g. the Balkans) Economic reforms: institutional convergence towards the “ideal” model of a market economy (EBRD transition indicators) Many lessons not learnt from the experience gained in the 1990s  prescriptions for the latecomers very similar to those in the early 1990s Gradual integration with EU: trade, FDI, banking and finance 2004 & 2007 EU enlargement: 10 EE countries, Balkans on their way... Increasing FDI throughout the region after 2000, not only in Central Eastern Europe (as in the 1990s) 6

Foreign Direct Investment ( ) 7

Transition in Eastern Europe Yet in many countries the “Washington consensus” has failed to fulfil expectations of growth, development & increased welfare Social costs of transition greatly underestimated: it was assumed that social policy and the welfare state are a luxury that must be sacrificed for the sake of transformation  many negative consequences “Jobless growth”: emergence (and persistence) of very high unemployment, particularly in the Balkans (40% - Macedonia, Kosovo) Social differentiation, increasing poverty (esp. in Russia, CIS countries) A particularly flexible labour market, with weak trade unions and scarce diffusion of collective bargaining (with very few exceptions) Inadequate systems of taxation (flat-tax rate) High popular dissatisfaction: EBRD Life in Transition (2007): only 30% of respondents from transition region, on average, consider their households today are better off than before

Transition in Eastern Europe Institution building much slower than expected Informal economy (and informal institutions) remain important in many countries, rule of law still not in place, widespread corruption, weak judiciary … Slow catching up after the deep GDP fall in the early 1990s and subsequent reversals in growth Ten years later, only Poland and Slovenia had attained the levels of GDP they enjoyed in 1989 By 2008, Poland had reached 178% of its 1989 GDP, Slovak Republic 164%, Czech Republic 142%, Hungary 136% … But Russia only 108%, and similarly the Balkans  by 2008, three countries had still not reached their 1989 level of GDP (Bosnia, Montenegro, Serbia) 9

Real GDP growth in the Balkans, (1989= 100) 10

11 2. The model’s flaws 20 years later In , average GDP growth in the transition region was still high, only in last quarter of 2008 was there a drastic deterioration of main indicators In late 2008, EE was severely effected by the global economic crisis, hit by two external shocks: Financial sector: sharp reduction in foreign capital inflows (FDI, remittances, foreign loans) Real sector: reduced demand for exports on EU/global markets Since early 2009, forecasts for 2009 have been changing continuously, from positive to highly negative growth rates (exc. Albania, Poland) 2010: Recovery on its way but not in all countries + growth sluggish, 50-90% lower than in 2008

12 Real GDP in 2010 (EBRD July 2010)

The model’s flaws Eastern Europe among the most severely hit regions! The global economic crisis revealed many structural weaknesses of EE economies Factors of vulnerability of EE countries Huge external imbalances, for years covered by massive foreign capital inflows (foreign loans, FDI, official assistance, workers’ remittances) High dependence on trade with EU (more than many old EU member states)  vulnerable to deteriorating conditions in EU Banking and financial sector characteristics 13

Current account deficits (Oct. 2008) (% of GDP) 14

Gross external debt (2008) (% of GDP) 15

The model’s flaws Characteristics of the banking and financial system Privatization of banks in EE  sales to foreign (EU) banks, % of banking assets in EE are in foreign ownership (Slovenia the only exception) Foreign banks lending policies of easy credit  credit boom, increased lending to private sector, many loans in foreign currency Credit boom was followed by credit crunch  foreign banks vulnerable to deteriorating conditions in home countries, reduced credit to local clients : Depreciation of national currencies in EE causing many credit defaults, increase in non-performing loans Liberalization of financial markets has also greatly stimulated cross-border borrowing directly from banks abroad 16

3. Present challenges Global crisis  a new course in developed market economies: return to protectionism, state intervention, expansionary fiscal policies, more regulation In EE: Which growth model for the future? Transition-related economic reforms  hyper-liberal model (fast trade opening, free capital inflows, weak social protection...) Should EE countries also return to more state intervention, undoing what was done during the last 20 years? Partly...yes! More active government policies necessary in several important areas 17

Present challenges... Global crisis  the fragility of EE economies due to the model of credit-driven growth and resulting dependence on foreign capital Global crisis  more general flaws of the transition strategy, since many problems were becoming unsustainable Consumption much higher than production, financed by foreign savings & investment (increasing trade and current account deficits) High unemployment, limited restructuring, slow growth of new private sector, mounting social problems Inadequate structural changes, favouring the fast expansion of primarily services [linked to] Structure of FDI: frequently not in industry, but in services (banking, telecommunications, real estate), therefore in non-tradables, not facilitating industrial restructuring, export-led growth, East-West industrial integration 18

Present challenges... Today: need to change the target model of the hyper-liberal market economy [In 2009, the best transition results (EBRD score 4) were attained in Estonia and Hungary, among the most severely hit by the global crisis!] Changes in which direction? Further integration – certainly not autarchy - but prudently Trade liberalization: not necessarily in all sectors (e.g. agriculture) Financial liberalization: too fast, ought to be in line with development of financial markets (as in Western Europe) Improve the quality of government institutions to enforce laws, collect taxes, supervise the financial sector... Introduce a levy on the financial sector? Probably justified, but since most banks are foreign owned, there is no direct political power to effectively negotiate a tax  EU coordination is critical! 19

Present challenges... Industrial policy: to promote investment, encourage innovation, quality standards, enhance competitiveness (in line with the current EU approach to industrial policy) Despite remaining privatization opportunities, EE cannot count much on FDI over the coming years, need to rely much more on own resources More effective employment policy, more elements of the European Social Model which was not seriously considered by the EE countries (not part of the Acquis)  so the model was “diluted” by the 2004/07 entry of New Member States How to strengthen trade unions and social dialogue? Many lessons from the old EU member state Increasing labour flexibility (Germany, France, Italy) has led not to greater international competitiveness, but to higher profit margins Strong East-West interdependence: EE countries cannot solve current problems by themselves, as they are strongly integrated with the EU/global economy!  Necessitates coordinated action... 20