The Heritage Foundation

Backgrounder #893 on Europe

April 23, 1992

April 23, 1992 | Backgrounder on Europe

Economic Reform in Eastern Europe: A Report Card


(Archived document, may contain errors)

893 April 23,1992 ECONOMIC REFORM IN EASTERN EUROPE A REPORT CARD INTRODUCTION It is over two years since Poland became the first East Empean nation to adapt de cisive free market economic reforms. Since the n, all the other formerly communist na tions of Eastern and Central Europe have begun taking sfeps to transform their com mand economic systems into marketdriven economies. Czechoslovakia and Hungary already have had substantial success. In Romania and Al b ania, progress has come mure slowly. Transforming farmer communist economies into smoothly running mar ket systems is complex and daunting. Yet on its success rests the economic survival not only of Eastern Europe, but also of the states of the former Sov i et Union, which anxiously an watching Eastern Europe far clues to their own future. Ultimately the ad vanced industrial countries, the United States included, have a stake in Eastern Europes success, since the Wests short-term economic recovery and longer -tem eco nomic health inevitably will be jeopardized by serious economic distress ia the East.

Before Polands lunge toward a market economy, little was known about the best way to transform centrally planned economies into free market systems, since it nev er befm had been tried. Until 1990, nearly all the transforming had been in the opposite direction, from free markets to communism; and this was accomplished at the point of agun.

Profound Effects. Polands radical reform program, somewhat ominously called shock therapy is nothing quite so dramatic, but its effects have been equally pro found. The Polish model, which set the standard far the rest of Central and Eastern Eu rope and the former Soviet republics, emphasizes rapid transformation. Its basic ele m ents include: king prices, eliminating most barriers to trade, making local currency partially convertible to Western cmncy, slashing govemment subsidies to state indus tries, bringing down inflation, and reducing budget deficits 1 Czechoslovakia, Hungary and Poland generally are considered part of Central Europe, while the Balkan Owntries of ARmnia, Bulgaria, and Romania along with the Baltic states of Estonia, Latvia, and Lithuania constitute Eastern Europe he Baltic countries will be analyzed separately in a futumEacRgrounder.

Other Central and East European countries spent most of 199b closely watching the ate of dorms in Poland, preparing economic legislation, and fine-tuning their own re om plans based on what they saw.

The objective for Eastern Euro pe is no less than to replace old, inefficient state bminated economies with entirely new economies based on market relationships. Par ial transformations merely will leave these countries in economic limbo, with the iead weight of the remaining socialist elements a permanent drag on market forces md economic expansion. The measure of their success lies not in such economic indi atom-as-living standardsand production, which cannot-paint an-accurate picture dur ng a period of rapid transformation, but in ho w well the government is creating the mnditions for economic change by freeing markets. Only this leads to growth and osperity. Ultimately these effas must be taken as a whole, since success in one mi can be jeopardized by a failure to act in another. Exam p le: freeing prices without substantial privatization of state-owned enterprises and deregulation allows state pro iucers to exert temporary monopoly power, thereby hurting consumers and the newly merging private sector, which relies on the state sector fo r supplies The criteria for judging the economic performance of East European governments include Price Liberalization. Price liberalization, or an end to the communist practice df government-set prices, is a necessary precursor to the estab lishment of a m arket economy. A market cannot function without free prices, since price is the basic mechanism for mediating supply and de mand If prices are fixed by the government, there is no incentive to pro duce efficiently, and no competition-the lifeblood of free markets Monetary Policy. When the money supply is expanded irresponsibly through easy credit, subsidies, borrowing, and printing more money, the in escapable outcome is a rapid rise in inflation. Political pressures in Eastern Europe, fbr instance, from u n ions and legions of government workers, can be intense to finance budget deficits and raise state wages by printing and borrowing more money. Unless government officials resist these pressures and show'decisive restraint .in money supply, Eastern Europe w i ll face the destiny of many Latin American countries, which have struggled with hy perinflation and economic stagnation for years Currency Convertibility. For foreign businesses to invest in Eastern Europe, they first must believe that they can make a pro f it and take this profit home. This means, eventually, that they will be able to convert, or trade in local East European currencies for hard Western currencies, like the dollar and yen, that are usable on world markets. No East European country had a curr e ncy that was even partially convertible before 1990 Fiscal Policy. Even in free market economies, governments themselves are major economic players. In the U.S for example, estimated total gov ernment spending for 1992 accounts for approximately 25 percen t of total output, or gross domestic product GDP All Eastern European countries 2 inherited huge budget deficits from their communist governments. Fiscal deficits are a direct cause of inflation in Eastern Europe because govern ments generally pay for thes e deficits by printing more money. Deficits need to be eliminated, or greatly reduced, through massive cuts in con sumer ahd enterprise subsidies and other spending cuts that reduce the dis tortionav role of government in the economy.

The wrong way to redu ce budget deficits is through tax increases, which merely add to the already enormous tax burden on businesses and individu als thereby slowing economic gmwth by discokaginghard work, savings investment, and the production of goods and services. In fact, t ax increases in the long run could lead to declining tax revenues, because slower growth results in fewer businesses and individuals to tax. High taxes in developing economies also drive businesses into the informal, ar gray economy where they pay no taxe s Trade, Debt, and Foreign Investment. The experience of the AsianTi gers of Hong Kong, Singapore, South Korea, and Taiwan, has shown that the fastest way to growth and prosperity is via an economy open to the world Free trade allows foreign producers to c o mpete against domestic state monopolies, thereby increasing competition and lowering prices for consumers. Trade too incmses the amount of hard currency available to pay off foreign debt. A shortage of domestic savings and capital also makes it important f or East European countries to attract substantial amounts of foreign investment in order to modernize inefficient factories and build up decaying roads, airports, communications networks, and other infrastruc me Privatization and Legal Reforms. Among the m ost needed changes in all post-Communist countries is the privatization of state assets and estab lishment of clear, secure, and fully transferable private property rights. Pri vate property is the foundation of the market system. The more comprehen sive a nd rapid the privatization process in Eastern Europe, the sooner East ern Europeans can expect economic recovery. Only though private owner ship can they increase efficiency and competition, make managers respon sive to market rather than political forces , put resources to their most pro ductive uses, and cut the size of government. Other important legal refms are those that facilitate market activity. Laws on banking, bankruptcy, busi ness, and foreign investment must be adopted, and new commercial codes s hould be created as soon as possible In making the transition to market economies, some of the Central and East Euro pean countries have moved more quickly and decisively than others. The countries with the highest grades in this report card are on the cu t ting edge of economic reform and setting the pace for others to follow 3 m pb e Q m c I 3- 111 a I *I C E 8 4 HUNGARY Grade: B Thanks in part to free market Finance Minister Mihaly Kupa, Hungary last year abandoned its gradual approach to economic transfo r mation and now has overtaken Poland as the region's leading refma From 1968 to 1989, the communist Hungarian government enacted a series of mu tious.market:oriented reforms that did nothing structurally to break the state's stranglehold on the economy. En t erprise deci sion making was decentralized tax laws were changed to resem ble those in the West, foreign in vestment laws were somewhat liberalized, and limited private enterprise was legalized tion, the new Budapest govern ment moved slowly at first, and After Hungary's 1989 Evolu Economic Report Card for Hungary I 1 Good Price Liberalization and Monetary Policy Flscal Policy I Average Trade. Debt. Forelan Investment I Good Privatization and Legal Reforms I Good last year began its ambitious program to mo ve rapidly to a market economy. The gov 4ent has liberalized prices and trade, tightened monetary policy to reduce infla tion, begun privatizing state enterprises, eliminated nearly all enterprise subsidies, and cut the budget deficit.

Accarding to official statistics, red income fell 1.6 percent in Hungary in 19

90. Fig ures far 1991 are expected to show even further declines, although these statistics m misleading because they fail to measure much private sector income and improve ments in the quality and quantity of goods available to consumers. This year the e con omy likely will grow modestly, but could &row between 5 and 7 percent next year.

To be sure, the state sector of the economy in Hungary is in recession. Public sector production decreased by 18 percent last year, as inefficient state industries began t o fail. The private sector, by contrast, is booming, benefiting from fareign investment and increases in exports to the West. According to a erman study, production in the private sector increased by over 25 percent last year. Over the past year and a hal f over 500,000 private companies have been created in Hungary and forty private banks have opened, many with foreign partnen.

Price Liberalization and Monetary Policy. Much of Hungary's success is due to the end of price controls combined with effective co ntrol of the money supply. Price controls have been eliminated on 90 percent of goods, though controls remain on hous ing, heating oil, and a number of other items considered by the government as too PO litically sensitive to subject to market forces Y 2 " Hungmy's Impressive Mommce Deutsche Bank Economics Deqartment, Focus Ijastern Europe December 1991 5 As price controls have been lifted, the Hungarian government successfully has waged a full-scale battle on the resulting inflation. Prices jumped 39 perce nt last June due to cuts in subsidies to state enterprises and consumers, and higher energy prices.

However, a tight monetary policy and competition from lower-cost imports now are pushing inflation down. Real inflation in contrast to one-time price hikes resulting from removing state price controls and subsidies, is down to around 1.5 percent a month. flation and higherinterest rates: Savings are four-times higher than two years ago now equaling over 10 percent of earnings! The new savings are creating a pool of capital that will be available to finance new businesses and industries, sparking even higher growth rates.

Full convertibility of the Hungarian cumncy, called theforint, is expected by 1994.

To achieve this, monetary policy will have to be furthe r tightened to bring the black market rate, currently hovering around 85 to 90 forints to the dollar, more in line with the official exchange rate of 77 forints to the dollar. In mid-November 1991, the forint was devalued 5.5 percent against the Geman mar k.

Fiscal Policies. The Hungarian government was not as successful last year with fis cal policy as with monetary policy. The goal is to curb significantly the states oppres sive role in the economy. Currently, 64 percent of Hungarian GDP goes through the state budget; Hungarians want to cut it to 57 percent by 1994.

Due in part tb declining tax revenues from state enterprises, the Hungarian govern ment budget deficit is expected to s ass 100 billion forints for fiscal 1992, or about 1.3 billion at current exchange rates. Nevertheless, the government is trying to rein in spending. Overall, subsidies for state enterprises and consumen were cut from 13.4 percent in 1987 to 4.6 percent of GDP by the end of 19916 The governqent is facing rising political press u res to ease its plans for fiscal re straint. Increases in the cost of living have prompted calls from labor unions and mem bers of parliament far state-sector wage increases. If the government gives in to this pressure, however, it will raise the cost of d oing business and force fhs to cut costs driving up unemployment. There also m calls for a comprehensive, West European style social safety net in the farm of a massive spending program that further would jeopardize economic refarm and increase government s indebtedness.

Hungary has been refarming its tax system since 1987, thus giving it the most West ern-kented tax structure in Eastern Europe. The problem is that Hungaq has adopted some of the wqrst aspects of Western systems such as high, progressive inc ome taxes and corporate taxes filled with dozens of loopholes. Until very recently, Hungarys Swiss cheese approach to tax reform offered a host of tax incentives and concessions for preferred industries on top of high standard tax rates. The result was a c omplicated 3 Another side effect of the tight monetary policy is increased savings due to lower in 7 3 Nicholas Denton, Economic Progress: Ahead of Schedule, Financial Times, October 30,1991 4 fbid. p.In 5 Finance Minister Presents 1992 Budget Drafs MTI R a dio (Budapest December 10,1991 6 State Subsidy Removal Prockss to Continue, MTI Radio (Budapest), December 12,1991 6 and seemingly arbitrary tax structure. Until this year, domestic businesses faced steep prdits, payroll, and social security taxes, while businesses with foreign capital of at least 5 million forints, or around $66O,ooO, received a u) percent tax rate reduction.

Recently the government reversed course on its tax policy toward foreign investors.

In December the parliament passed legislation that would phase out tax incentives for foreigners. Between its complicated and inconsistent tax code, and shifting tax ground rules, Hungaxy has made it difficult for business to plan for the future, thus dimurag ing business development and investment. I nstead, Hungary should tax all individuals and businesses at low, uniform, flat xates ticularly bright spots in the Hungarian economy. An attractive foreign investment law Trade, Debt, and Foreign Investment. Trade and foreign investment are two par 100 8 0 80 40 20 0 that &rants tax preferences to foreign investors and allows companies to take profits out of the country without gov ernment authorization, com bined with a privatization program open to fureigners makes Hungary the most popular East European c oun try for foreign investors. Twe thirds of all foreign invest ment in Central and Eastern Europe, or over $2 billion has flowed to ~ungq.7 This foreign investment, together with a substantial increase in Western trade and tourism eamed $1 1 billion to $ 1 2 bil lion of hard currency for the As in the rest of Eastern Europe, the Hungarian econ omy was jolted sevedy by external economic shocks the collapse of the Soviet first three quarters of 1991 1 Chart 1 Prlvatlzatlon Needed In New Democracles State Sect or Dominated Economies in 80 8 State-Owned Sector of Eoonomy U.

8. Poland Yugorlavlr Brltaln Hungary Nota: Data la share 01 value-addad In mld-1080'a 8ourom: Alan Qalb and Cheryl Qrey, The Ttaneformeflon ol Economlas of Central and Eastern EWOD8,ThE World Bank.1881.

Horltago Datachart economy, the breakdown of the COMECON East bloc trading group, and Gulf war oil price rises. Economists estimate that these shocks wiped out nearly 30 percent of Hun gary's hard currency reserves, while the Gulf crisis accoun ted for $700 million in higher energy bills. Despite these shocks, Hungary's 1991 external trade perfmnance was strong. Reason: trade with the West grew by 40 percent the past two years, most of it driven by newly created small and medium-sized private Hu ngarian companies even as trade with the East dropped by 60 percenL8 As a result of the shift to Western 7 "Swqr: Hungary Financial Times. October 30.1991, p. 1 7osted a trade account surplus in the $300 million to $500 million markets, Hun range in 19

91. Trade with the West was aided by a cut in the avenge tariff rate'from 16 percent to 13 percent; 99 percent of applications for permission to import restricted Western consumer goods were granted in the fist half of 1991, and licenses now are required for only 10 percent of imports. Certain industries, however, continue to be protected from foreign competition by quantitative restrictions on imports ments on the 19.7 billion principal willrary between $2 billion and $3 billion from 1991 to 19

96. Howeve r, strong growth in hard currency exports has increased sub stantially Hungary's capacity to service its debt from foreign currency earnings." To date, the government has refused to reschedule this debt and so has retained the confi dence of private inves tors. Hungary spent $2.6 billion on debt payments last year.

Privatization and Legal Reforms. Laws important to the functioning of a market economy have been passed by the parliament. These include a Western-style bank ruptcy law, a new accounting law in l ine with European standards, and an intellectual property law protecting the form and structure of semiconductor designs and lower level inventions.

Privatization of state enterprises and other assets is moving somewhat faster in Hun gary than in other Ea st European countries. It still, however, must accelerate to realize the government's ambitious goal of privatizing 50 percent of the economy by 1995.

Thus far, only from 12 percent to 15 percent of state holdings have been privatized.

Government proceeds from the sales total a little over half a billion dollars. Privatiza tion has been most successful for small and medium-sized businesses. About 8,000 of the 10,ooO shops and restaurants up far privatization last year were sold.

Of the medium and large s tate enterprises, 330 out of 2,200 eligible have been sold to private owners. Most of these were sold in whole or part to foreign investors with access to the technology, managerial expertise, and foreign capital to make the enter prises more efficient an d ultimately profitable. The State Property Agency (SPA) re lies on a variety of approaches to speed privatization, including buyouts by employees and managers, privatization initiated by investors, stock offerings to the public, and di rect trade sales to investors.

The government is giving conflicting signals over the future of privatization in Hun gary. On the one hand, Budapest announced in October a new privatization method to speed sales of small enterprises. Termed "self-privatization," enterprises c an find in vestors themselves and then need only apply for approval to one of eighty state-ap proved privatization consultants, rather than through a centralized, bureaucratic agency. The process, in effect, excludes the SPA from the negotiation process, i ts only function being the approval or rejection of individual privatization proposals. The fist vp Hungary's foreign debt is the highest per capita debt in Eastern Europe. Annual pay 10 8 "Kadar PredictsTuming Point in Foreign Economy MTI Radio (Budapest December 18,1991 9 "Hungary's Impressive Performance-A New Panner in the International Economy Deutsche Bank Economics Department, Focus Eastern Europe Decembex 1991 10 "Fluctuations Noted in Repayable Foreign Debt Nepszubadsug (Budapest December 11,1991, p. 1 11 "Hungary's Impressive performance Deutsche Bank Economics Deparunent, Focus Eastern Europe December 1991 8 POLAND million.

However, a discouraging development is that Karoly Szabo, deputy director of SPA and a strong proponent of fast privatizatio n, resigned in late December over policy dif ferences with the government. According to Szabo, Prime Minister Joseph Antalls government favors ~e~ng-pro~i~ble~ate.etlterpri~~in-ssate hands as a means of earning =venue Grade: B Poland, the country that int r oduced economic shock therapy to the world in 1990 slowed its rapid pace of reform last year under tremendous pressure from such politi cal interest groups as farmers, trade unions, and state enterprises. Foreign investors are frustrated by myriad obstacl es and the once promising privatization program has been stalled for months. Nevertheless, Poland has made great strides in the last two years especially in the development of the private sector.

In January 1990, Polish Finance Minister Leszek Balcerowicz initiated a sweeping economic reform program. This included price and trade liberalization, monetary stabi lization, drastic cuts in subsidj rency convertibility, and a one- time massive devaluation of the Polish zloty from 700 zlotys to the dollar to 9,5 00 to the dollar.

This shock therapy brought immediate results. A $4.5 bil lion trade surplus was regis tered with Western Europe in 19

90. Inflation was brought under control, the budget was slashed, goods of all kinds s to state enterprises, a balanced budget, partial cur Economic Report Card for Poland Good Price Liberalization and Monetary Policy Fiscal Policy Average Trade, Debt, Foreign investment I Average I Average Privatization and Legal Reforms tn AnnA were in the shops and streets of Polish cit i es, and the private sector has boomed nomic transformation. Reform largely came to a halt following the October 28,1991 general election in Poland, when the two parties dominated by ex-communists, the Democratic Left Alliance and the Peasants Party, picke d up 21 percent of the Polish vote. The right-of-center coalition of parties now running the government, led by Prime Minister Jan Oleszewski, put furward an economic reform plan this February that reverses free market refarm in some areas by easing the fi g ht against inflation, as sisting ailing state industrial enterprises with subsidies and providing price and credit Despite these successes, however, political pressures threaten to derail Polands eco 9 subsidies to farmers. The plan was criticized heavily for opposite reasons by free mar ket liberals in the Liberal Democratic Congress Party and the former communists in the Democratic Left Alliance. It was rejected by the Polish parliament, the Sejm, in March. The government's wavering political commitment to economic refarm, cou pled with a wave of xenophobia, already is slowing the flow of critically needed for eign investment into the country.

Not surprishigly, the state sector is declining rapidly in Poland. Production in the state sector dropped 25 perc ent in 1990 and was down another 15 percent last year.12 Still, as in Hungary, official statistics exaggerate the real drop in production. Also as in Hungary, the drop in state output is made up to a large degree by a dramatic up surge of private business . Over 1.15 million new private small businesses and 30,000 private companies have been cxeated in Poland since market reforms were introduced.

In the first nine months of 1991, the number of small and medium-sized private busi nesses increased by almost 250 OOO, amounting to a 20 percent increase, and 110 pri vate banks now are operating up businesses and companies failed in 1990 and 199 1, but some have succeeded Ecluding agricul ure, the t o tal output of the private sector was 26 percent higher in 1990 than 1989. l4 Private sector retail sales soared by 4.5 times in 1990, while private sector industrial output increased 8 per cent.16 By the end of 1991, the private sector ccounted for 20 per cent of total indus trial sales and 45 percent of all employment.

Officially, unemployment now stands at 2 million, or about 11 percent of the work farce, but according to Polish economists only about half of the registered unem ployed actually have lost t heir jobs. The rest are private entrepreneurs trying to aug ment their incomes, or housewives supplementing family income with unemployment benefits. Demand for skilled labor remains strong, leading to almost zero unemploy ment in many of the largest citi e s Price Liberalization and Monetary Policy. Nearly all prices, including energy prices, now have been completely freed Inflation, which reached 600 percent in early 1990, was brought down to 60 percent last year by sharply slowing money supply growth. The new center-right coalition government puts much of the blame for Po land's lingering recession, however, on the tight money policy, and repeatedly has pledged to ease money supply growth. Such a policy would risk renewed inflation and therefore slow the g r owth of private enterprise and savings 13 As in the U.S many of these new s 19 12 "Poland Facing a Dual Economy as Elections Approach Deursche Bank Economics Department, Focus Eastern Europe October 7,1991 13 "planning OffEe Reports Private Sector Growth G uzeta Wyborcza, December 12,1991, p. 3 14 Poland: International Economic Report 1990l1991, World Economy Research Institute, Wmw School of Economics, 1991, p. 64 15 Most of the incmse came in trade, not production. Production output of the private sector g rew 8 percent in 1990 16 Paul Hare and IreneGrosfield Privatization in Hungary, Poland and Czechoslovakia Centre for Econanic Policy Research, Discussion Paper Series, No. 544, April 1991, p. 12 17 "Poland Facing a Dual Economy as Elections Approach Deuac h e Bank Economics Department, Focus Eastern Europe:,October7,1991,p. 1 18 lbid 10 Fiscal Policy. A growing budget deficit has emerged as one of the major economic issues in Poland and a source of conflict with the International Monetary Fund (IMF jeopardiz ing the IMF loans that Poland relies on heavily to support its economic pro gram. In the fist quarter of this year, the deficit was $1.6 billion, or 2 percent of GDP.

This would translate to an 8 percent year-end deficit. This is unacceptable to the IMF wh ich is threatening to halt loan payments. In an attempt to appease the IMF and keep the deficit to 5 percent of GDP, the Polish government announced in late March that it would increase taxes. If the government follows through with this plan, it will furt h er slow economic rGovexy by dsrsr_asbg savings ad inves.pnent Taxes in Poland already are very high. The social security tax was raised 2 percent age points in 1991, to 45 percent, and the Polish parliament is considering raising the top personal iqcome t a x rate to 50 percent. Private businesses must pay a 40 percent tax on profits 20 percent tax on wages paid, and a "turnover tax which is like a sales tax except it is levied at different rates depending on the product, ranging from 10 per cent to 20 perce n t Trade, Debt, and Foreign Investment. In 1990, Poland eliminated import quo tas, lowered duties to between zero and five percent, and eliminated tariffs on 58 per cent of all impbrts. This made it one of the economies in the world most open 6 im ports. P o land's trade liberalization increased competition in the state-dominated Pol ish economy and brought prices down for Polish consumers and exporters. Partly as a result of the lower trade barriers, which enabled Polish companies to buy cheap im ported comp onents and thus reduce costs, Polish businesses increased exports by 50 percent in 1990.

In April 1991, however, Poland =versed course and began enacting protectionist trade measures. The average tariff on agricultural goods was raised from 9.8 percent o 19.3 percent and duties on finished tobacco products from 30 percent to 60 percent.

New customs baniers went into effect this January 1, including a 35 percent tariff on cars and a 90 percent levy on cigarettes. Quantitative restrictions, or import quotas will apply to dairy products, and imports of hard liquor will be prevented altogether.

Computers, video record s, televisions, and cameras are now shielded with duties of 20 percent to 35 percent.

Polish state officials also have restricted foreign inves tment by preventing foreign investors from buying profitable state companies. Last year, the Polish government held up a deal with Volvo fur a truck factory until the company agreed also to take on a notoriously bankrupt truck factory in Starachowice. Far e ign purchases of land must be approved by the Interior Ministry, and it virtually is impossible to buy a company without approval from the undermanned Ministry, for Ownership Transformation. An other bar to foreign investment is Poland's failure to reach a greement on debt with the 2h 3 19 William D. Eggers A ~mwth Tax Reform Agenda for Eastern Europe Heritage Foundation Backgrounder No. 830, Mgr 23,1991 20 William D. Eggers A Five-Flank Program for Trade and Investment with Eastern Europe and the Former So v iet Republics Heritage Foundatiin Backgrounder No. 862, October 23,1991 21 "New CustansTariffs BecomeEffective Early in 1992 TWTelevision (Warsaw December 13,1991 11 secalled London Club creditors international banks which hold $10 billion in Pol ish debt s.

The Polish government has had considerable success in convincing the West to for give or postpone payment on its large foreign debt. In February of this year, for in stance, Germany forgave half of the $5.5 billion debt Poland owed the German govern ment.

Privatization and Legal Reforms. Municipal privatization of shops, stores, and restaurants has been carried out at a brisk pace. Around 80,000 formerly state-owned small businesses have bien privatized The government hopes to sell the remaining shops t his year. Over 50 percent of the distri ution network has been privatized and over 300,000 new stores have been opened.

Although Poland has privatized nearly all of its retail trade, the state sector still counts for more than threefourths of industrial p roduction. Only 10 percent of Po land's state-run industrial companies have been sold. Last year, only 200 of over 3,000 state enterprises with between 100 and 800 employees were turned over to the private sector, and only nine very large enterprises have been completely pri~atized.2 State enterprises are being privatized by a variety of approaches. These include direct sales to investdrs, buyouts of enterprises by management and employees, stock offer ings to the public, and a much-publicized mass privati zation program.

In the planned mass privatization program, Poland will ay an innovative approach to privatizing state companies. Poland will privatize 200 enterprises comprising one-fourth of Polish production through a complex privatization scheme that wo uld make 27 million Poles immediate shareholders. Controlling interests, in the farm of shares, are to be transferred to between 15 and 20 privatization funds that would resemble U.S. mutual funds. Each Pole born before 1974 then would be given or sold at a significant discount a share in each mutual fund. The mutual funds, man aged by Western investment firms, then would set about the task of restructuring and liquidating entixprises. After one year, shares in the mutual funds would be freely tradeable. T h e problem with Poland's mass privatization program is that too few com panies are included and the government has played too great a role in the farmation of the investment funds. The danger is that the investment funds simply could come to re semble stat e holding companies that the government would have to bail out at each sign of trouble 21 22 "lhe Progress of Privatization Radio Free EumpeWio Free Libeny Institute, SovieUEast European Report Vol. WII, No. 42, September 1,1991, p. 4 23 "Poland's Election s Put Ecaromic Refms to theTest Deutsche Bank Economics Department, Focus Eastern Europe November 1991 12 CZECH AND SLOVAK FEDERAL REPUBLIC Grade: 6 Czechoslovakia inherited from the communist era one of the strongest economies of the former East Bloc. The Czech communists left behind little inflation and a low for eign debt, but they also passed on little experience with markets and almost no legal base for a market economy. Since the 1989 velvet revolution, prices and trade have been liberalized, subsidie s slashed, and the legal groundwork laid down for privatiza tion. More needs to be done, however, to decrease the roleof ttie state and encourage private enterprise, such as tax cuts, large-scale privatization, and deregulation. This month, Czechoslovakia plans a mass privatization campaign. If successful, it could catapult Czechoslovakia to the top of its class in Eastern Europe.

Czechoslovakia waited until last year to embark fully on an ambitious economic re farm program, To be sure, the go nomic direction of Finance Min ister Vaclev Kim, enacted a few reforms in 19

90. Most food subsidies were eliminated, land prices and commercial property prices were liberalized, credit vernment of President Vaclev Havel, under the eco Economic Report Card for the Cze ch and Slovak Federal Republic Price Liberalization and Good to Monetarv Pollcv Excellent and fiscal policy were tightened and critical laws on joint ven tures, small business, and privati zation were passed. Neverthe less, compared to Polands shock thera py, Czechoslovakias initial approach was timid.

One reason for Czechoslovakias slow start was that the country enjoyed one of the highest living standards among the former East Bloc countries and a very low rate of inflation. This left little incentive to move as quickly, for example, as did Poland which was experiencing hyperinflation. Further, the government was split about the desired pace and extent of the transition to a market economy. The social democratic wing of the rulin g Civic Fmum government still talks about a third way between so cialism and capitalism, even as Klaus and his free market supporters argue for capital ism with no adjectives.

Klaus gained and still holds the upper hand, however, and in January 1991 Czecho slovakia introduced a radical economic reform package. Prices were liberalized, most non-tariff baniers such as quotas and licensing restrictions were eliminated,x the Czech currency, the crown, was made convertible into hard currencies far purposes of f oreign trade, and a sell-off of small, state-owned businesses began.

As in e rest of Eastern Europe, state industrial output dropped in 1991 by over 20 percent. Unemployment, however, remains low in the Czech lands, hovering at s 24 Although a prorectionis t 20 percent surcharge was imposed on imports 13 about 4 percent even in official statistics. This contrasts with 1 1 percent official unem ployment in Slovakia as of this January. The disparity is a source of political tension between the two republics. A s in other former East Bloc countries, rapid growth of the private sector is essential so jobs are available for displaced workers from faltering state factories. This appears to be happening, as Czechoslovakias unemployment in February registered 5.9 per c ent lower than in January grades. Prices on 85 percent of goods were freed January 1,1991, and in November prices.were liberalized on. another 5-percent including breadrmilk, and meat. Since July 1991, inflation has been near zero due to the governments r estrictive monetary policies. Interest rates still m high, at 22 percent, but down from last years 24 per cent rate.

A less wise government policy was to devalue the mwn three times in 1990: by 18.6 percent in January, 55 percent in October, and 16 percent in December. To stabi lize the exchange rate, the crown now is fixed relative to a weighted average of a num ber of Western currencies.

Fiscal Policy. The Czechoslovak budget was in surplus by 15.3 billion crowns in the first quartet of 199 1, and by Oct ober 3 1 the nation still had an 8 billion crown sur plus No budget deficit is foreseen fur this year, but there is little room for maneuver ing anc&roblems could arise if demands are met to spend more on social pro grams. While state subsidies to enterpr ises have been cut, the government has given in to political pressures and granted tax relief, debt write-offs, and additional credits to agricultural and industrial enterprises, thus simply delaying restructuring.

Very high taxes on private enterprise are slowing private sector development in Czechoslovakia. Taxes are so high that companies risk going out of business unless they find ways to avoid them. Entrepreneurs must pay a 55 percent tax on profits as well as payroll, social security, and turnover ta x es. As in the other East European countries, business taxes need to be cut drastically to give new entrepreneurs a chance to flourish. In December, taxes on incomes over 10,OOO crowns a month were raised from 27 percent to 33 percent. The only bright spot in tax reform in 1991 was a mod est rate reduction in the turnover tax.

Trade, Debt, and Foreign Investment. Czechoslovakia liberalized its trade in 1991, although a tempomy 20 percent import surcharge imposed in January 1991 Price Liberalization and Mone tary Policy. Here Czechoslovakia gets its highest greatly retaded import growth.

After initially trailing Hungary and Poland by a large margin, foreign investment is beginning to accelerate in Czechoslovakia. Foreign investment in the country last year to taled around $600 million. Foreign capital flow into Czechoslovakia is sure to accel erate greatly this year as the privatization program moves into full swing. Laws and 25 Czechoslovakias Big Bang Strategy-Looking Back on 1991, Deutsche Bank Economics De p aRment, Focus Eastern Europe Decemb 1991, p 2 26 Aggregate Budgets Show Surplus at End d October, Hospodarske Noviny, December 6,1991, p.l 27 Tomas Jezek, Privatization in Czechoslovaldahenty Months After, papr presented at the Mont Pelerin Society Meetin g , Prague, Novemb 5.1991 14 28 Ibid 29 me privatization minisvies are then charged with accepting the enterprise's plan for privatization or choosing an alternative approach Fureign debt, which was not a problem for Czechoslovakia two years ago, could reac h up to $10 billion in the next year because of heavy borrowing fiom international financial institutions Privatization and Legal Reforms. Around 600,OOO private businesses have been created since January 19

90. Although flourishing, Czechoslovakia's new p rivate sec tor has not made the gains of Hungary and Poland. One reason: unnecessary Mers to private business, including difficulty in obtaining credit from state banks, high taxes, and cumbersome government Iegulations.

For instance, credit to private bu sinessmen in 1990 amounted to only one-quarter of one percent of total credit in the Czechoslovak economy; in Poland, by contrast, cred its to the private sector were up to 10 percent of total credit in 1990 15 A recent suxyey by the Czech Statistical mic e finds that the current managers of most state enterprises would prefer privatization via sale to a foreign investor, instead of by voucher. Fully three-quarters all industrial state firms in the Czech republic are searching for a foreign partner?%'he Cze c h Privatization Ministry expects for eigners to purchase 22 billion crowns, or $733 million, worth of state property in 1992 Some 830,000 people have applied for compensation for land, housing, and private enterprises confiscated from them by the communis t s. Only a few claims have been settled thus fat. The claimants will receive special vouchers that can be used to buy land state~owned apartments, or businesses. The.maximum amount of compensation is 5 million crowns, or $166,OOO. Most claimants are expect e d to receive between 100,OOO and 500,000 crowns, or $3,330 to $16,660 BULGARIA Grade: C The speed and extent of Bulgaria's economic reforms in 1991 was one of the year's bestkept secrets in Europe. Bulgaria, alone among its Balkan neighbors, has had a pea c eful and sieady transition to democracy, with two free elections since the fall of communism. Bulgaria's main failure has been to adopt a radical privatization program to transfer state assets rapidly to the private sector Bulgaria too often is lumped in w ith Romania and Albania as the basket cases of the fmer East Bloc. This may have been true in 1990, when a political stalemate between the ruling socialist party and the opposition Union of Democratic Forces (UDF) delayed real economic reform. However sin ce the Dedmber 1990 forma tion of a coalition government with the UDF in charge of eco nomic policy, Pulgaria has moved rapidly with far-Itaching economic refms.

The economic situation inherited by the UDF-led coalition was bleak. Non-agricul tural output fell 20 percent in 1990 and the collapse of the Soviet market and the dis mantling of the Soviet-led COMECON trade bloc hit Bulgaria especially hard, due to its high reliance on COMECON trade. Another shock to the Bulgarian economy was the Persian Gulf cr i sis, which led to energy shortages and, in some places, 24-hour lines for fuel 30 "Czech companies say they want foreign investment PlanEcon, PlanEcon Business Report, June 26,1991 16 Against this backdrop, the government initiated a Polish-style reform p rogram at the beginning of 19

91. Prices were freed on almost all goods on February

1. Shops won filled with goods and lines disappeared in front of stores.31 This did not happen with out some hardship. Prices rose 123 percent in February, another 45 per cent in March and 3.5 percent in April before finally stabilizing in May. Cutting state subsidies in June spurred hother temporary surge in prices, but inflation was kept below 5 percent per month for the rest of 1991 due to restrictive credit and fiscal policies. Bulgaria also significantly liberalized trade barriers, resulting in increases in imports. This, too also helped tempr price inceases.

State output was down 19.5 percent in 1991, mainly because of shortages of raw and primary materials and decreased demand, but the private sector is growing. As of August 5, 1991, around 174,000 private businesses were registered in Bulgaria, of which 68 percent were sole proprietorships.

Price Liberalization Monetary Policy. Since January 1991, the Bulgarian gov ernment has maintained a strict monetary policy. Interest rates were raised from 4.5 percent to 45 percent and then hiked up to 52 percent in Jun e, therefore further imped ing money growth. Beginning this January, Bulgarian citizens were allowed to ex change up to 10,OOO lev, or about $417 each year into hard currencies. The lev has sta bilized at a rate around 24 lev to the dollar.

Fiscal Policy. Budget expenditures were cut by 35 percent in 19

91. One way Bul garia cut expenditures was by eliminating subsidies for oil and gas in June, causing a 50 percent to 70 percent increase in energy prices. In 1991, the share of Bulgaria's GNP ccounted for by government subsidies declined from 16.1 percent to 3.2 per cent. den on private business. In June 1991, the government exempted all companies with 50 or less people from taxes on profits for two years, and offered these firms state owned lots for const r ucting buildings and credits at pref entia1 rates to cover 50 per cent of electricity, water, and telecommunications costs? In February 1992, the ex emption on profits taxes was extended to three years and applied to all private busi nesses and joint-vent ures. State-owned enterprises do not enjoy the same tax breaks.

Trade, Foreign Investment, and Debt. Bulgaria was more heavily dependent on East European trade than any other former East Bloc country. Exports to countries in Eastern and Central Europe'fell70 percent in the fvst half of 19

91. In part the gap is being taken up by exports to the European Community, which increased by $62 mil lion, or 10 percent, in 19

90. The introduction of market farces also is changing the composition of Bulgarian trade. Exparts of machines and heavy equipment, which Bulgaria does not produce efficiently, fell fmm 60 percent of total trade in the first half of 1990 to 31 percent for the same period in 19

91. Meanwhile, exports of raw ma A 31 Bulgaria has moved the furthest of any East European country in easing the tax bur 31 However, unexpectedly in la

July and early August prices an sane foodstuffs such as bread, milk, and wheat increased shqly 32 "Bulgaria: A New Constitution and Free Elections RFE/RL Research Report 1991, Janualy 3,1992, p. 79 33 "New deal fa small business Planbn, PlanEcon Business Reporl, June 26,1991, p. 6 17 terials sind processed food products, in which Bulgaria has a competitive advantage, in creased from 14 percent to 28 percent of total expo r ts.34 The Sofia government also has taken measures to liberalize trade. Two hundred products were exempted from imptxt taxes, and the list of goods banned from export was slashed. While a positive step, these reforms do not go nearly far enough. Many good s still are banned from export, and th government has put price controls on ex ports of meat, dairy products, and timber A foreign investment law passed in November guarantees fareign investors equal rights with Bulgarians.'It also allows 100 percent f&eig ownkhip of new or exist ing companies. Late this January, the foreign investment law was further liberalized The previous limit of $5O,OOO on fareign investment has been removed and joint-ven ture companies now are allowed to change their profits into ha r d currency and export them Pkvatization and Legal Reform. The parliament has passed laws on commerce banking, companies, and accounting all designed to establish a legal framework for a market economy. Small-scale privatization began in June 1991 with the auctioning of stad-owned shops and restaurants to individual citizens. In mid-December 1991, shop owners deprived of their stores in the former communist government's final round of nationalization in 1975, were able reclaim their premises after refunding the money they received for the stores in 1975? Around 100,OOO Bulgarians are eligible to re claim st~res through this progmm.

The weakest aspect of Bulgaria's refm program is privatization of large enter prises. The privatization law is still being debat ed in the parliament and no enterprises have been turned over to the private seqtor Agriculture is the most important and most regulated sector of the Bulgarian econ omy. Privatization of this sector, which accounts for 40 percent of total economic out pu t , should be the government's highest priority. Instead, agricultural reform has lagged Bulgaria, once a net exporter of agricultural goods, now is a net impom. Bul garian agriculture is in a tailspin: milk output was 289 million liters less in 1991 than 1 9 90; egg production was also way down Government policies and the slow pace of agricultural privatization largely are to blame for the current agricultural crisis. Prices on such staples as grain continue to be held down artificially by the government, whi le prices for fertilizers and seeds have in creased steeply. The result: production is stifled and cooperatives hoard stocks and often pay salaries to workers in grain rather than in cash.

Bulgaria passed land ref- laws in early 1991 that in principle prov ide for the h&p of collective farms and the return of land to those who owned it before 1945 Over 400,OOO fanner owners already have applied to the government to get their land back In practice, implementation of the law has been slow. The government some f5 34 "Bulgarian Exports: MOR Foods and Raw Materials, Fewer Machines 168 Hours, BBN Sofia Vol.1 NOS September 16-22,1991, p. 8 35 "AmbitiousReform hgramme,GreatDifficulties 268 Hours, BBN Sofia Vol. 1, No.18, December 1622,1991 36 "Restitution of Nationa l ized Ropeay May Begin BTA Radio (Sofia December 12,1991 18 what unrealistically hopes to return 70 percent of the land to its former ownen by the fall of this year. Stalling the process are legal provisions preventing owners from sell ing the land for thr e e years and requiring the land to be used only for farming. Such re strictions, if not eliminated, will hamper the development of private farming because among other reasons, m y former owners now are very old or live in cities and are unable to farm the land All restrictions on selling or trading land should be re moved once it is returned to its rightful ownem.

If privatization begins soon and other reforms are continued, the long-term pros pects far the Bulgarian economy are.good. The government has sho wn a steely wm mi-t to economic refarm and the population is fairly optimistic. According to a re cent poll, 61 percent of Bulgarians believe that economic conditions will improve within five years and 65 percent say they can manage on their own without h elp fiom the ytate. Also encouraging is that 62 percent prefer high prices and well-stocked shops to the way things were before market refarms.

Though it is not likely to develop as quickly as the wealthier countries of Central Europe, if it continues reso lutely to pursue market liberalization, Bulgaria should expe rience steady growth in coming years w ROMANIA Grade: C The economic outlook for Romania is among the bleakest in Eastern Europe. For mer Romanian dictator Nicolae Ceaucescus policies of harsh a usterity and forced in dustrialization left the country utterly impoverished, Romanias per capita income is one uf the lowest in Eastern Europe. Ongoing political instability has stalled many needed reforms.

Last July, the government of former Prime Minister Petre Roman announced its first serious economic reforms, including cuts in taxes and customs duties, and a phase-out of all price controls by January 1992, except those on heating, electricity, and housi ng.

Some of these reforms, however, have sputtered in the face of opposition from labor unions and ex-communists. Each month it seems the government is confronted with a major bdustrial disruption OT strike? Nevertheless, the governments apparent deter min ation to push ahead with pervasive economic dorm is encouraging.

Industrial output in Romania fell around 20 percent in 1990 and 22 percent in 1991.

GDP was estimated to have declined by 12 percent to 14 percent. Because of the in itially slow pace of re forms, the private sector is not yet &rowing quickly enough to offset the collapse of the state sector. Romanias biggest problem is inflation, driven by wage increases of an average 100 percent over the past six months 37 Problems Noted in Implementing La n d Restitution, BTA Radio (Sofia December 25,1991 38 RomaniasToxtmusRoadtoReform, RFWRLResearchRejnm 1991 19 Wage ceilings imposed this January should temporarily delay the exorbitant in creases. However, proposals to index wages to inflation, if adopted, w ill set off yet an other inflationary wageprice spiral. This would ruin any chance the economic reform progmy has to succeed and further deter foreign investment. Understanding this Prime Minister Tdor Stolojan warned this January about the disastrous inf lationary consequences of repeated wage indexation, and said he would not compromise on ea nomic-reform.

Approximately 230,880 private en trepreneurs have registered in Romania There are about 75,000 commercial companies, of which 9,089 are at least partially financed with fareign capital.

Unemployment still is a relatively low 3.4 percent Price' Liberalization and Mone tary Policy. Beginning mid-1991, con trols on prices and wages were liberal ized in four steps: in November 1990 and then in April, in July, and in No vember 19

91. Now price controls re Economic Report Card for Romania I I Average 1 Price Llberallzatlon and Monetary Pollcy Average Fiscal Policy to Poor Trade Debt, Forelgn Investment Privatization and Legal Reforms main on only fourteen goo ds and services deemed by Bucharest to be basic necessi ties, including bread, milk, sugar, and butter. Consumer prices, which for many goods now have cleared market levels, are up 260 percent since October 19

90. The govern ment hopes to bring -1; underl ying inflation, as opposed to an initial temporary price surge due to the removal of price controls and subsidies, down to an annual rate of around 15 percent by further tightening money supply. The Romanian currency, the lei, was devalued three times and on November 11 most currency exchange controls were eliminated, thus making the lei partially convertible to hard currencies. In Janu ary 1992, however, the Romanian National Bank limited the amount of money that could be exchanged for had currency by its citizens to 50,OOO lei or about $250.

Fiscal Policy. Romania's government deficit is 65.5 billion lei or $330 million. A number of major tax changes were introduced in early 19

92. Previously business taxes were steeply progressive, rising all the way to 77 percent, thereby punishing success and encouraging tax evasion. Businesses now are taxed a flat 30 percent rate on prd its lower than a million lei and 45 percent on profits above one million. The tax rate on businesses should be unified and lowered s i gnificantly. The government also should consider repealing two taxes passed this year: a 10 percent dividend tax and a tax on company earnings from the sale of assets. Both taxes will eat away at business profits, thus resulting in lower wages far employe es, higher unemployment, and fewer goods and services produced.

Trade, Debt, and Foreign Investment. Bucharest has somewhat liberalized its trade labs, but and 30 percent mania registered a $1.4 billion deficit in foreign trade in 1991 imposes high barrier s. Tariff rates have been limited to between 10 39 "Ecanomic Slide Continues COSMOS, Inc Romania Ecobmic Newsletter, JulySeptember 1991, Vol. 1 No. 2, p. 7 20 Reason: trade fnrm East Em pean countries and the Soviet Union dmpped 75.3 percent in 19

91. On the bright side, ex ports to the West inmased by over 100 percent in 1991 com pared to 19

90. Romania does not have a substantial foreign debt to wcmy about.

Becasue of a fourth quarter surge, 1991 exports reached 19% levels and the trade deficit was reduced. Exports amounted to $3.5 billion in 19

91. The gov ernment hopes continued suc cess in trade with the West will stimulate the falling economy.

Recently, Romania's uncertain political climate and the poor state of its economy has kept foreign investment in Romania low. Between January and June last year, however, 2,128 for eign joint ventures were Chart 2 Foreign Investment in Romania Surges After Liberal i zation Law is Passed Mllllonr of Dollrrr Thoumando of CornDanlea 2 1.6 1 0.6 0 Flrrt Orcond Thlrd Fourth Qurrtrr Qurrtor Qurrlrr Quarter 1981 1881 1881 1881 Equlty lnveotment lour00 Romenle Economlc Newsletter. January-March 1992 Joint Vrntunr In Thourand o In Mllllono Hrrltagr DrtrChirt f totaling $51 million in investment capital.40 An April 3 law grants foreign in vestors such guarantees as the ability to transfer prdit out of Romania in a convertible currency, and an assurance that foreign capital will not be nationalized or expropri ated, and offers investment incentives like tax holidays and exemptions.

Privatization and Legal Reforms. The government has been slow to enact re forms to promote private enterprise, such as deregulation, lower taxes, and e asier busi ness licensing. There has also been little progress in establishing, defining, and protect ing property rights. A new constitution was adopted last November

21. It includes arti cles on private property protection, but these apply only to agricultural land.

The Romanian parliament approved a privatization bill in July 19

91. The bill calls for setting up five Private Ownership bds, which will take control of 30 percent of the capital of state companies. The fund will issue certificates of own ership to citizens valued at SO00 lei, or about $25 each Vouchers are to be given to all Romanian citi zens eighteen years of age and older. Vouchers then could ylconverted into shares in individual state enterprises and into shares in mutual funds. A lis t of 240 companies slated for privatization has been released 40 Ibid., p. 7 41 "Enteqnise Refann as Privatization: The Givaway Scheme," COSMOS, Inc Romania Economic Newsletter Apri1-J 1991, Vol. 1, NO. 1, p. 7 21 ALBANIA Grade: lncom plete Until recently, little economic refarm has taken place in Albania. All this may be about to change. The convincing victory of the anti-communist Democratic Party in Albania's March 21 national elections will mean greatly accelerated economic reform in the country. The De m ocratic Party, with 62 percent of the vote, scored a surpris ingly large victory over the Socialist Party, whichmxeived only 25 percent. Sali Ber isha, the'leadir of the Democrats and the likely future Albaiian president, backs an economic program of rapi d privatization and elimination of most restrictions on for eign investment.

The Demdats inherit an economy that makes Romania look like a par

ise. Strikes in the summer of 1991 para lyzed industry. The state sec tor ground to a virtual halt andis just be ginning to recu Average perate. Production is reported markets are non-existent, en ergy prices have skyrocketed and one estimate puts indus trial production for 1991 at only 15 percent of that in 19

90. Albania's major economic concern in 1991 was sim pl y securing food aid. As a result, the country'now is almost wholly dependent on for eign food supplies. In the face of this bleak economic situation, the Albanian parlia ment approved in the fall of 1991 a series of far-reaching economic reforms, includin g privatization, restitution of land, and price liberalization.

Price Liberalization and Monetary Policy. Prices were freed in January on all but twelve basic necessities.

Trade, Debt, and Foreign Investment. Albania is beginning to open up its long isola ted economy to fareign investment. According to government sources, foreign in vestors will be allowed to purchase state enterprises outright. Foreign investment is es pecially sought for agriculture, infrastructure, energy development, and tourism. Thus far only five foreign firms have pledged major investments in the country; three of theseareAmerican.

Albanian village was given land that now is being divided up into equal plots far every family. In many respects, all the government did was to legalize w hat already was occurring as former landowners and peasants toiling the fields began taking land back from the government last summer and fall. The bulk of agricultural land privatiza tion now has lieen completed. One problem is that the government will n o t allow land to be sold. This will prevent larger, more efficient farms from forming and weaken the incentive for f&mers to increase the value of the land Privatization and Legal Reforms. Land privatization began last September. Each 22 FORMER YUGOSLAVIA P rivatization of small businesses and transportation is set to begin this year. In the first stage, the government will auction off up to 25,OOO shops and most of the coun trys transport infrastructure like buses and trucks. The government also plans to pr i vatize 300,000 homes over the next year by selling them to their residents.

Laws on private property passed in the summer of 1991 are vague. One strong point, however, is that business licensing now is fast and automatic, unless disap proved by the statepl Despite much recent progress, Albania has a long way to go to catch up to i ts Balkan neighbors, Bulgaria and Romania. The thoroughly disastrous state of its economy;however, offers-a-powerful-stimulus for basic reform I Grade: Incomplete Yugoslavias civil war already has given birth to at least three new countries Croatia, Slove n ia and Bosnia-Herzegovina but also has obstructed needed eco nomic reforms even in the most reform-minded republics. United Nations peacekeep ing forces moved into Croatia this month to enforce the U.N.-sponsored truce of Janu ary 3 that ended seven month s of fighting. Meanwhile, bloody battles raged in Bosnia Herzegovina between the Yugoslav axmy and ethnic Serbs on one side, and Croat and Muslim Slavs on the other.

The tenitory that once was Yugoslavia embodies the wid est cultural, political and eco nom ic contrasts of any East European state. The Kosovo autonomous region in Serbia one-tenfi the Slovenian level of =und $79000* J3forts to has a per capita GNP only equalize economic develop ment through the 1960s and 1970s, mainly disguised ef forts by dom iqant Serbia to transfer wealth from the richer northern republics, succeeded only in increasing ethnic tensions.

For years, Western intellectuals considered Yugoslavia the showpiece of socialism and indeed it was rather prosperous compared to the rest of Eastern Europe. However the countrys civil war and Serbian leader Slobodan Milosevichs steadfast refusal to abandon communism, have wreaked havoc on the former Yugoslav economy 41 Bureau of National Affairs, BNAs Eastern Europe Reporter, January 6,1992, p . 17 23 The flow of goods, labor and capital throughout former Yugoslav territory has been almost completely blocked by civil war. Trade with the rest of the world has nose dived, and raw materials are impossible to obtain. Yugoslav GNP was down 10 per cen t in 1990 and was down an additional 45 percent in 19

91. In the first six months of 1991, hard currency earnings from tourism fell 30 percent over the same period in 19

90. Trade fell from a $500 million surplus to a $1.7 billion deficit in the first six months of 19

90. Unemployment is running around 9 percent Price Liberalization and Monetary Policy. Prior to the onset of the Civil war in 1990, controls.on prices and-trade were liberalized significantly, and in early 1990 in flation began to subside af ter =aching 2,700 percent in 19

89. Inflation again is out of control, however, due to a relaxed monetary policy, as the Belgrade government prints money to finance the war.

Internal convertibility of the Yugoslavian dinar, introduced late in 1989, has b een abolished in order to preserve foreign exchange resves. These reserves fell from $8.3 billion in Augist 1990 to $3.8 billion in June 1991 Political and economic crises have caused a run on hard currency savings from banks: over $1,5 billion was drawn from savings deposits in 1991 and $3 billion in 1990.These actions proved wise, because on July 18 1991, the Association of Banks of Yugoslavia

commended that banks suspend all payments of hard currency to de positors Fiscal Policy. Yugoslavias economic c ollapse and political breakup greatly have reduced tax revenues to the central government. Only 36 billion dinars, or $257 mil lion, rather than the expected 65 billion dinars, or $464 million, was raised by Yugo slav federal authorities in the first half of 19

91. Federal spending goes now only to support operations of the Peoples Army and the fedeml bureaucracy. The huge de creases in fedeml revenues forced federal authorities to cut the budget by 60 percent in 1991!3 Slovenla Slovenia, l+ated near prosp erous trading partners Italy and Austria, is the wealthi est of the former Yugoslav republics and has the brightest economic future. The coun try declared independence on June 25,1991, and seceded relatively peacefully on July 18,19

91. The war throughout Yugoslavia, however, has taken its toll on Slovenia, re ducing its GNP by 10 percent in 19

91. Still, this contraction is less than one-half the average for the rest of former Yugoslavia and much less than war-torn Croatia.

The governpent introduced Slovenias own currency, the tolar, on October 8,1991.

These were exchanged on a one-to-one basis for Yugoslav dinars. The Bank of Slovenia is offering interest-bearing accounts that are leading people to exchange for eign currencies into tolar-denominated accounts, thus bringing a fragile stability to the ne w currency. Foreign reserves stand at only $300 million at present, but plans to pri 42 TheYugoslav Economy: Economic Effects of Political Gsis and Civil War Deutsche Bank Economics Department, Fomr Eastern Europe:, November 1991 43 ZB Says Foreign Curremy Reserves Increased, Deb, (Ljubljana, Slovenia December 9,1991, p.3 24 co CLU vatize state-owned apartments and industries could increase this sum if foreigners are allowed ample participation in the sales Croatia The post-war economic prospects for Croati a are much dimmer than for Slovenia.

Pre-war living standards in Croatia were markedly lower than Slovenia, and its econ omy has been totally shattered by the war. Total war damage exceeds 260 billion di nars,-or around $264*million. Heavily hit have been the transportation, communica tion, and tourism industries. Foreign trade is at a standstill because of international sanctions and Serbian occupation.

Against this backdrop, Cmatia launched its own currency, the Croatian dinar, on December 24,19

91. The exchange rate of the new dinar is 1: 1: 1 with the Yugoslav di nar and the Slovenian tolar, and exchange will be possible at banks and post offices.

The prospects for improvement of economic conditions in Croatia and the other for mer Yugoslav vpublics a re bleak as long as civil strife continues and Serbia continues to destroy neighboring republics ION Although some countries are moving much faster than others, most of Central and Eastern Europe at least is moving steadily ahead with economic refcnm. In p articular most of these countries have achieved considerable success in instituting the macroe conomic measures needed to stabilize their economies: freeing prices on most trade able goods, balancing the budget, reining in inflation, adopting real interes t rates, and moving toward currency convertibility.

Reforms have come slowly, however, on the micro level, in enacting the struc tural and legal reforms needed for a free market economy to develop rapidly. Remov ing obstacles that block incentives for stim ulating production and investment is criti cal, yet often overlooked Regulations on private businesses still are burdensome, busi ness licenses are difficult to obtain, and privatization of large industries is occurring at a painfully slow pace. Tax syste m s, which are some of the most burdensome in the world for private businesses, need to be overhauled. Prohibitive tax burdens on busi ness slow economic growth and development by discouraging hard work, savings, in vestment, and the production of goods and services.

Also obstructing Central and Eastern Europes march to a free market are commu nist apparatchiks, who still are blocking reform at all levels of government. For in stance, Polands ambitious mass privatization plan was rejected last fall by the co m munist majorie in the parliaments lower house, the Sejm.

Astonishing Growth. Despite these obstacles, the private sector throughout the re gion has been growing at an astonishing rate. New private companies have reacted much more swiftly and flexibly to the breakdown in East European trade than state en terprises, in large measure by finding new markets in the West. The Central and East European governments, however, have been unable to measure most of the economic value added by the growing private sec t ors in their countries, making official statistics on output, national income, and unemployment misleading 25 Most of the new democratic governments now realize that the future well-being of their people will be determined by the growth of-the economy fro m the ground up Technological advances, better services, higher living standards, and vastly improved consumer goods all will result mostly fnnn the creation of dynamic private firms There now is much debate in Russia and other former Soviet republics abou t the pace and sequencing of their own economic reforms. The experience to date in Eastern Europe should largely have resolved this issue. The last two years in Poland and other Central and East European countries demonstrate that a host of reforms must be mp idly implemented simultaneously: priceand trade-liberalization, recognition of pmp erty rights, monetary stabilization, and privatization all are interdependent and cannot be introduced in isolation.

Lessons for the Developing World. The fate of reform during the coming year may well determine whether Central and Eastern Europe will achieve the rapid eco nomic growth of Southeast Asia, or wallow in debt, stagnation, and hyperinflation like South America. So far, there is reason for optimism. Hungaxy ha s turned the comer and soon should be experiencing steady growth. Most of the Central and East Euro pean governments recognize the importance of strict monetary discipline and the need to resist pressures for excessive wage increases in the public sector. Further, as in Southeast Asia, small private companies are growing rapidly, proving adept at finding export markets for their products and hiring away the best workers from the declining state sector.

There are many lessons here for Russia, other fmer Sovi et republics, and the rest of the developing world Growth and prosperity need not be limited to the major indus trial countries of North America, Western Europe, and Japan. Worldwide economic prosperity is attainable if governments only will get out of th e way and let the free market work its wonders.

William D. Eggers Policy Analyst Research Assistant Mar& Kamer and Interns Laurie Hemach and Todd Leeuwenburgh assisted in the preparation of this study 26

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