Transition in Crisis?

LONDON – Europe’s emerging markets have this year experienced their worst output collapse since the great “transitional recession” that followed the end of communism. Five countries are expected to suffer double-digit declines in GDP. Non-performing loans in the banking sector and unemployment continue to rise in many countries.

There is no doubt that the European transition region is in deep crisis. But is the transition from communism to a market economy itself in crisis? How have the institutions and policy frameworks that were the outcome of the transition process coped? Will the crisis lead to a backlash against market-oriented reforms?

While Central and Eastern Europe has been the emerging-market region to suffer the most in the crisis, it has generally avoided the currency collapses, systemic banking failures, and spikes in inflation that were the staple of previous crises. Given how deeply integrated the region has become with the rest of the world, this is remarkable.

That deep integration cuts both ways. On the one hand, it created economic ties and financial dependence that have made many transition countries highly susceptible to the crisis in the West. On the other hand, it mitigated the large capital outflows that were a destructive force in past crises, contributed to more mature institutions and domestic policy responses, and helped mobilize vigorous international support.

The two faces of integration (explored in the EBRD’s 2008 Transition Report) have been particularly visible in finance. Financial integration has been an important force for long-term growth in the transition region, and the presence of strategic foreign banks helped mitigate the impact of the crisis.

At the same time, integration into the wider European and global economy has no doubt contributed to excessively fast expansion in private-sector and foreign-currency debt, which has complicated the crisis in many countries. But the lesson from this experience is not that countries should attempt to reverse financial integration – to do so would be both unfeasible and unwise – but that they should reduce its risks.

Further east, resource-rich transition economies such as Russia and Kazakhstan are facing what is arguably an even bigger challenge. Like the financially integrated economies of Central and Eastern Europe, the commodity-rich countries have had to manage the complications of rapid inflows of foreign currency. But these capital inflows also seem to discourage institutional development.

In some areas, particularly macroeconomic management involving the accumulation and use of stabilization funds, resource-rich transition countries have performed fairly well. But the ultimate goal – diversification and associated improvements in economic (and political) institutions and the business climate – has mostly proved elusive.

The crisis has also tested ideas about the ultimate aims of transition. It confirmed the view that the transition from communism is about much more than building markets and shifting economic responsibilities from the state to the private sector. It also involves developing certain state functions, and improving how the state interacts with the private sector.

The crisis that began in 2008 underscored the importance of market-supporting policy institutions and policies, particularly in the financial sector. This does not necessarily mean more regulation, but it certainly means better regulation, focused on improving incentives.

A long agenda of institutional reform remains, particularly in Central Asia and some East European and Western Balkans countries. Moreover, significant sector-specific reforms are needed even in some Central European and Baltic countries, particularly in sustainable energy and energy efficiency, transport, and the financial sector, where regulatory and supervisory regimes require strengthening, financing of small and medium-sized firms needs to be improved, and local capital markets must be developed.

In light of today’s crisis, what is the likelihood of such reforms actually being implemented? Will this crisis act as a catalyst for more reform, or will it lead to a backlash against the market model?

One year into the crisis in the transition region, we can almost rule out the latter scenario. While the crisis clearly slowed the pace of new reforms, it has led to far fewer reform reversals than in 1998-1999, for example, following the crisis in Russia. Furthermore, government changes since early 2008 have either led to no change with respect to reform or favored pro-reform parties. But an acceleration of reforms also appears unlikely, with the possible exception of the financial sector.

Thus, while the global recession plunged the transition region into crisis, at the same time it demonstrated the resilience of the reforms and economic integration achieved over the last 15 to 20 years. It also highlighted the pitfalls of the development models that countries in the transition region have pursued. Yet it is clear that the way to address these pitfalls is to extend the transition agenda, not to replace it.

By Erik Berglof, is Chief Economist at the European Bank for Reconstruction and Development.

Post-Crisis World Institute