July 15, 2008 - Looking back over the nearly 20 years since the fall of the Berlin Wall, it is clear to any of the 400 million people in the countries of Eastern Europe and the former Soviet Union that the transition from centrally planned to market economies has not been an easy ride.
Old trade patterns disintegrated overnight and over-subsidized state-owned enterprises that produced shoddy goods collapsed, while the people of the region lost what they thought were stable jobs and many fell into poverty. While the countries of Central Europe experienced a shallow recession, the Commonwealth of Independent States (CIS) countries saw their average incomes fall to nearly a half of their 1990 levels by the time of the Russian financial crisis in 1999.
While the first decade after communism was rough, the past decade has been kinder to the region that stretches from Tallinn and Tirana in the West to Vladivostok and Bishkek in the East. Today, only 10 years after the Russian financial crisis, the former Eastern Bloc is back on its feet - and for many countries in the region, the transition is over.
But while many countries of Eastern Europe and the former Soviet Union have put the crisis of the 1990s behind them, they need to innovate, include all their citizens in the development of their countries, and integrate with the broader global economy if they want to sustain growth, says a new World Bank report, Innovation, Inclusion, and Integration: From Transition to Convergence in Eastern Europe and the Former Soviet Union, launched this week in Brussels and presented at the World Bank-Bruegel conference on this topic.
Productivity Growth for Lasting Prosperity
According to the report, productivity growth – the only viable route to lasting prosperity – depends on there being a supportive business environment, specifically one that delivers competition, a deep financial sector, good governance, and superior skills and infrastructure.
It found that key aspects of the business environment, such as competition and finance, that shape the behavior of firms are maturing and converging towards or have caught up with those in the more developed market economies of Western Europe. This augurs well for their future prospects. This convergence is more pronounced in the new member states of the European Union. The Commonwealth of Independent States (CIS) are followers, though some distance behind.
"When it comes to the importance of competition for restructuring activities in firms, the transition economies are following in the footsteps of developed market economies,” said Pradeep Mitra, Chief Economist, Europe & Central Asia Region, World Bank and author of the report. “Their business and financial sectors are maturing as well, relying less on family and informal sources to fund fixed investments.”
However, employment growth has been sluggish almost everywhere, according to the report, and has reflected the interplay between (i) job growth in new private firms that were able to occupy market niches nonexistent under central planning; and (ii) downsizing in state-owned and privatized firms.
The report found that productivity growth and public transfers fed by rising fiscal revenue have moved 50 million people – out of 400 million – out of absolute poverty (those with an income of less than $2.15 a day in purchasing power parities) between 1998-99 and 2005-06. While nearly one in five people – or 85 million – lived in poverty around 1998/99, only one in twelve – or 35 million – did so around 2005/06.
Innovation
For its part, innovation is needed because boosting productivity requires firms either to innovate, developing knowledge new to the world, or to absorb knowledge generated elsewhere. Productivity growth is higher in firms when they face stronger pressure from domestic competitors to develop new products and markets, when they can access more developed financial sectors, and when rules and regulations are more predictable.
Inclusion
The notion of “inclusion” is key. While incomes across the region have grown rapidly, jobs have not done so except for recently in the new member states of the European Union. The study says that weak job growth in the EU8 and Southeastern Europe is the result of vigorous downsizing in state-owned and privatized firms more than offsetting strong job growth in de novo firms – those firms that were always private.
“Stronger competition,” said Mitra, “which would facilitate convergence in the CIS countries, would also accelerate downsizing in state-owned and privatized firms. Severance payments, retraining programs, and social safety nets for the displaced workers can facilitate convergence by reducing its social costs.”
Integration
Lastly, the countries in the region need to redouble their efforts at integrating with the global economy. While trade now accounts for 60 percent of GDP in the countries that joined the European Union in 2004, it pales at only 20 percent in the CIS countries. This calls for developing better trade facilitation and logistics in port efficiency, and undertaking customs reforms. And by lowering costs through liberalized banking, telecommunications, and transport services, this can make countries’ exports more competitive.
Domestic and external factors worked in harmony as the new member states of the European Union used the anchor of prospective EU accession to lock in the reforms of policies and institutions necessary for rapid productivity growth and deeper integration into the world economy.
“The Czech Republic, Estonia, Hungary, Poland, and the Slovak Republic,” said Mitra, “have attracted large amounts of foreign direct investment, and participate almost as heavily as developing East Asia in producer-driven global commodity chains, such as those for automotives and information technology and export capital and skilled labor-intensive products. In contrast, most CIS countries export natural resources and unskilled labor-intensive products.”
“Indeed,”Mitra added, “the extent to which countries without European prospects can use outside mechanisms – such as the European Neighborhood Policy, WTO accession, subregional agreements – to lock in the institutions conducive to a favorable business environment is an open question."
Demographics – the third transition
However, as if twin political and economic transitions of the past have not been challenging enough, according to the report, many countries in Eastern Europe and the former Soviet Union now face a third transition – aging populations. Demographic projections suggest that by 2025 the average Slovene will be 47 years old, giving the country one of the oldest populations in the world. One in five Bulgarians will be over 65. Ukraine’s population will shrink by a fifth, and Russia’s by more than a tenth. Aging will lead to the share of the working age population (15-64 years) in total population declining rapidly after 2015 – less than a decade from now – in the EU8, Southeastern Europe, and middle income CIS countries. This is similar to the change projected for the EU15, deeper than in the United States, shallower than in Japan.
Said Mitra, “The challenge posed to economic growth by rapidly aging populations in a large swath of transition countries in Central and Southeastern Europe, as well as Russia, Ukraine, and Belarus, is serious and systemic. Offsetting it requires, first, getting the most out of the existing capital stock and labor force – through all the reforms of the business environment needed for productivity growth. Second, it calls for using all and not just part of a country’s human resources by raising and equalizing the retirement ages for men and women and, where the fiscal situation allows, reducing taxes on labor that make hiring labor expensive. Third, it requires reform of pensions and health care systems, so that fiscal pressures do not crowd out desirable spending on infrastructure and social safety nets and the private investment for productivity growth.”
“Finally,”Mitra added, “international circular migration of labor that is coordinated between sending and receiving countries and respects migrants’ rights can supplement such a policy package. Migration involves complex political, economic, and social factors, and it is for this reason that policy experiments might be needed to improve the frameworks that regulate it.”
RSS