Trans eco 1

Transitional economy: That is moving from being a controlled economy to
being an open economy.


The problems of transition economies include:
Rising unemployment

Rising inflation


Lack of entrepreneurship and skills


Corruption


Lack of infrastructure


Lack of a sophisticated legal system


Moral hazard


Inequality




The main ingredients of the transition process were agreed upon fairly
early.1 They were:
Liberalization: the process of allowing most prices to be determined
in free markets and lowering trade barriers that had shut off contact
with the price structure of the world's market economies.
Macroeconomic stabilization: primarily the process through which
inflation is brought under control and lowered over time, after the
initial burst of high inflation that follows from liberalization and
the release of pent-up demand. This process requires discipline over
the government budget and the growth of money and credit (that is,
discipline in fiscal and monetary policy) and progress toward
sustainable balance of payments.
Restructuring and privatization: the processes of creating a viable
financial sector and reforming the enterprises in these economies to
render them capable of producing goods that could be sold in free
markets and of transferring their ownership into private hands.
Legal and institutional reforms: These are needed to redefine the role
of the state in these economies, establish the rule of law, and
introduce appropriate competition policies.



Transitional economies at Asian

The reform process began in the late 1970s in China in the aftermath of the
Cultural Revolution, and about a decade ago in the economies of Indochina.
The Asian economies started out, on balance, from more favorable initial
conditions than the European economies. Compared with the latter, their
political situation at the start of reforms was more settled; their
economies had larger agricultural sectors; they were less integrated with
the CMEA system; and they had a stronger memory of a market-oriented system
(particularly in Indochina). On the unfavorable side, the dominance of
agriculture meant that per capita incomes were low (with the attendant
problems of rudimentary infrastructure and weak administrative capacity)
and these countries were initially more isolated from the international
community.
As in the European countries, the initial years of the transition in
Indochina were associated with a burst of severe inflation. Tight
macroeconomic policies were successful in reducing inflation to moderate
levels. There was only limited use of exchange rate pegs as a nominal
anchor to reduce inflation; instead the monetary frameworks were varied,
and in the case of Laos relied on Fund-supported programs to enhance
credibility. China adopted a gradualist approach to stabilization. Though
inflation never rose above thirty percent, the country has gone through
cycles of low inflation followed by resurgence of inflationary threats.
These cycles have more to do with surges in aggregate demand than with
changes in the exchange rate regime.
In sharp contrast to the experience of the European countries, output
growth remained positive in the aftermath of the stabilization programs.
The resilience of output is attributed to the favorable supply response in
the agricultural sector. Important institutional reforms in agricultural
land use and ownership helped secure the favorable response.
In China, reforms included the adoption of a system in the early-1980s
which bolstered decision-making by agricultural households, granting
of medium-term leases on agricultural land and freedom in utilization
of surpluses (over the amount that was to be turned over to the
state).
In Vietnam, agricultural reforms improved the land tenure system and
permitted farmers to sell surplus production at free market prices in
the mid-1980s, and in mid-1989 farmers were allowed to open their own
sales outlets, and agricultural prices were fully liberalized.
The strategy chosen in the Asian transition economies could not easily be
replicated in the `European' transition economies, with their large
industrial state-enterprise sectors and smaller agricultural sectors.
Moreover, the strategy chosen in the Asian transition economies carries
some risks for the future: financial sector reform in these economies has
generally lagged behind the pace in the more advanced `European' transition
economies; reform of state-owned enterprises remains to be tackled; and the
strategy of developing the market economy in "enclaves", rather than in a
broad-based manner, may have run its course.

Rapid privatization in Russia. The country's mass privatization program
of 1992-94 transferred ownership of over 15,000 firms into private hands.
However, contrary to expectations, insider privatization did not lead to
self-induced restructuring of firms. It was hoped that secondary trading
would introduce outside ownership, and that transparent methods would be
used in the second wave of privatization of remaining firms still in state
hands. Neither hope was fulfilled. Insiders were wary of relinquishing
control; workers feared the cost-cutting that might occur under outside
control, and managers found it easier to keep enterprises alive by lobbying
the state for subsidies than to foster competitive performance through
involvement of outsiders. The second wave of privatization, in particular
the so-called "loans-for-shares" scheme, was non-transparent and
systematically excluded foreign investors and banks in favor of parties
with ties to government interests.
Overall, the experience of the transition economies suggests that
privatized firms tend to restructure more quickly and perform better than
comparable firms that remain in state ownership, but only if complementary
conditions are met. These conditions include the presence of hard budget
constraints and competition, effective standards of corporate governance,
and an effective legal structure and property rights.
About capital flows: Several years into its transition, Russia is still
experiencing massive capital flight. Though inflation has been brought
under control, Russia has lagged in the implementation of structural
reforms.


Whither Russia?

Commitment to macroeconomic stabilization, though late in coming and
threatened by the 1998 crisis, appears to have taken hold in Russia.
However, efforts at structural reform have been weak and privatization has
been often mishandled. What is the way forward for Russia? There is a range
of answers to this question reflecting differences of opinion about the
reform process in Russia.
One vociferous view is that the reform approach taken in Russia,
particularly with respect to privatization, was fundamentally flawed in
emphasizing radical reform over gradual institutional development. To
Joseph Stiglitz, for instance, the failure of rapid privatization in Russia
"was not an accident, but a predictable consequence" of the absence of
competition policies and the institutional and legal infrastructure needed
to support a successful reform effort. 11 According to him, Russia should
now proceed very gradually with privatization (or re-privatization of any
assets that may fall back into state hands), with due recognition of the
need for establishing institutional pre-conditions, and making good use of
such social and organizational capital as Russia possesses. Stiglitz
suggests that Russia could learn in this regard from the "enormous success
of China, which created its own path of transition, rather than just using
a blueprint or recipe from Western advisors".
An opposing view, associated with some Russian observers and policymakers
such as Boris Fedorov and Andrei Illarionov, is that the reform strategy
was the correct one, but never implemented, in part because of the leniency
shown by the advanced market economies and international financial
institutions.12 For instance, Illarionov writes that
" . . . the IMF's attitude towards economic policy carried out by the
Russian authorities was and remains timid, inconsistent and subject to
permanent compromise ... For several years, the Russian government and
Russian society as a whole turned out to be effectively spoiled, as they
have been granted unearned financial assistance. As a result, Russian
economic policy has not only been inconsistent, but it has seriously
diverged from the economic policy conducted in a majority of countries in
transition . . ."
In a similar spirit, Fedorov's "recommendations for the West" are not to
grant Russia "concessions, but rather apply the rules as you would to any
country. Western capital should flow to the private sector, not the
government. Only this will help to change the country, create jobs and
increase efficiency."
While acknowledging that greater attention ought to have been given to
institutional reforms, the view from the IMF is that the basic strategy
pursued in Russia was sound but derailed by special factors. For instance,
Fischer and Sahay write that the source of Russia's current problems lies
largely in the "failure to drive ahead with reforms after the 1996
elections, when powerful vested interests strengthened their hold on
political and economic power, deepening corruption". What is needed is not
a fundamental change in reform strategy, but a decision by the political
authorities "to renew reforms and improve governance." Evidence from CEE
and Baltic countries, summarized earlier, suggests that once a commitment
to reform takes root, capital returns to the country, providing a basis for
sustained growth.13
Can the power of vested interests be overcome? Havrylyshyn and Odling-Smee
hold out hope.14 The vested interests themselves might become willing to
accept reforms if they decide that their future profits would be higher in
an economy in "which property rights are protected and the rule of law
obtains, rather than one ruled by lawlessness, like much of the CIS today.
Such a shift from predator to conserver has been seen in market economies
...". Change could also come through the emergence of a strong leader
willing to take on the vested interests, or from the political clout of a
growing middle class, or pressure from foreign competitors and
international financial institutions.









Russia's economy

Russia still has a long way to go to reach the living standards of the most
advanced market-oriented

countries, despite clear improvements in the past decade (Figure 1).

Figure 1: Percentage GDP per capita gap compared with the upper half of
OECD countries



The GDP per capita gap relative to the upper half of the OECD narrowed
rapidly during the boom period

of 2000-08 (Figure 2), but the impact of the global crisis was deeper and
took longer to overcome than

in other emerging economies. Output growth has resumed, but the trend has
fallen to below 4%, and

remains excessively dependent on the revenues from natural resource
extraction (Figure 3). Moreover, the economy is not fully exploiting the
high skill level of the Russian people.

Figure 2. GDP per capita and labour productivity

As a percentage of upper half of OECD countries¹

Figure 3 Economic dependence on oil and gas extraction



Russia's relative strengths include very low public debt, high labour
force participation, and a larger proportion of high-school students going
on to tertiary education than in OECD countries. In areas like space
technology, Russia is a leader. On the other hand, the economy exhibits
low productivity levels, extreme inequality, poor health and environment
outcomes, low access to and use of ICT, and mixed educational results. The
business environment is undermined by weak rule of law and corruption.

- decline by 40 percent during the early part of the 1990s

- financial collapse in 1998; global economic crisis since 2008.

- Until 2008 Russia's economic development speed averaged 6-7% a
year, a favorable balance of trade and deficit-free state budget; Russia
took the third place in the world on the level of gold and forex reserves

- A strong economy results in ability to project power and influence

Quick Facts
Population:
142.9 million
GDP (PPP):
$2.6 trillion
1.3% growth in 2013
5-year compound annual growth 1.0%
$17,884 per capita
Unemployment:
5.8%
Inflation (CPI):
6.8%
FDI Inflow:
$79.3 billion
Public Debt:
13.4% of GDP


China and Russia

Initial conditions

The comparison[1] of initial conditions of the three countries shows that
China had the worst economic initial conditions when it first launched its
reform program in 1978, and that Russia in 1991 had the worst institutional
initial conditions

In macroeconomic terms, Russia, with an economy almost entirely based on
its strong natural resources and a high level of military spending (15% of
GDP), had inherited strong distortions from the 70 years of planned economy
regime that made it very difficult to quickly reach high level of
competitiveness. China in 1978 was already the world's biggest potential
market, and had experienced economic growth, but had the worst
macroeconomic initial conditions of the three countries, with a strongly
unequal geographical income distribution and one of the world's lowest GDP
per capita: $200. The country was still basing its economy on the
agricultural sector, with 80% of its labor force living in subsistence
conditions.

About institutions, In Russia, an institutional failure had already
happened after the implementation of Gorbachev's reforms between 1985 and
1991, because the economic system had become unable to provide basic goods
and services, while the central state was unable to control secessionist
pressures in some of the provinces. As citizen purchased their goods at the
black markets, experienced high criminal rates and suffered of a general
sentiment of political alienation, they did not trust the regulatory
framework anymore. In contrast, although in a geographically complex
country, the authoritarian regime in China was able to keep the situation
under control, thanks to strong military support, the absence of high
secessionist pressures and the absolute power of the Communist party. At
the same time, China had no tradition of written law, and therefore a
certain flexibility in implementing institutional changes.

Cultural mindsets in the Russia, outside the main towns, and above all
China, had limited external contacts and understanding of Western concepts
such as democracy and market economy.

Communication of goals

In Russia, a similar approach was followed by Yeltsin, who promised the end
of the transition after only one year of sacrifice for the Russian
population.

In China, political leaders never committed on a time horizon and on the
nature of the changes realized; instead, they promoted a plan of gradual
transformation of the country, also known as the "crossing the river by
feeling for stones at each step".

Russian approach put the whole transition process at risk by
underestimating the time and effort necessary to achieve a successful
transition. In contrast, the Chinese approach proved successful, since it
did not create expectations difficult to fulfill, and did not link the
political cycle to the assessment of the results achieved, thereby
protecting the system's political stability.

Implementation

In Russia, Yeltsin implemented a "big bang" program aimed at transforming
the country into an US clone in one year. The Russian implementation was
the one lacking most pragmatism, as reforms were designed by a team of
economists voluntarily cut off from the political scene.

In China, reforms were conducted following a "stop-and-go" approach that
permitted to test the effectiveness and usability of the changes and to get
the people used to them.

Reform of state and institutions

The two cases are very different: stability in China and disastrous change
in Russia. In Russia, Yeltsin decided an institutional "big bang" by
copying US constitution and applying western liberal rules for the
financial markets and banks. This provoked an enormous inflow of foreign
capital and, with the unregulated process of liberalization, this led to
the creation of powerful oligarchies that were soon beyond rules and
controls. Moreover, when civil riots and secessionist pressures from former
Soviet Republics became too difficult to manage, Yeltsin delegated public
security to private firms, thereby helping the mafia establish its
presence. Today, the Russian state seems unable to provide necessary public
goods and is widely mistrusted by citizens. In China, reform of the state
has not been among the leaders' priorities, in order to protect the
Communist party rule.

Macroeconomic stabilization

The program applied in Russia was defined by a team of economists chosen by
Yeltsin among the best on the academic scene. They were kept completely
isolated from the political scene to avoid pressures. Nonetheless,
political and lobby pressures proved stronger and forced the choice of an
incompetent central bank governor, nicknamed the "worst central banker in
history". At the same time, the probably excessive distance between the
economists and the Russian reality in 1999 caused a gap between the program
and the implementation: up to 70 different stock exchanges proliferated and
operated in the country, while the goal of a unique monetary policy was in
fact contradicted by the possibility given to central banks of former
Soviet Republics, outside Russia, to issue the rubble. The lack of control
of financial instruments increased volatility in the Russian market,
thereby discouraging investment in Russia, while the freedom to issue the
currency, linked with the crisis, drove the inflation to 2500%.

China pursued a tight monetary policy in order to control the growth, while
enabling an extensive micro credit program, to stimulate the private
sector. A central bank, yet not independent, was created in 1994. Fiscal
policy was delegated to the provinces, to allow an adaptation to local
conditions.

Prices and markets reform

The approach followed in Russia was similar: 80% of formerly state
controlled prices were released in one night. This, coupled with an
excessive money printing policy, caused a peak in inflation (2500%), the
devaluation of the currency and a drop of GDP of 30% in less than two
years.

China opted for a slow deregulation based on a dual track prices system,
first implemented in the agricultural sector. Under this system, a certain
amount of goods was purchased by the state at state-controlled prices,
while the rest could be sold on markets at an uncontrolled price. This
permitted to control the economic development while taming the inflation
since prices slowly adjusted to the increasing demand. Thus, China avoided
the costly adjustments experienced in Russia.

While FDI were stimulated in non strategic sectors, traditionally national
sectors still experience trade controls and monopolies to prevent the rapid
and purely speculative entry of foreign capitals. Nonetheless, China has
already today one of the strongest capital inflows, with $200 billion
reserves.

Build private sector economy

In Russia, the process was incredibly rapid and completely unregulated. In
about one year, all non-strategic SOEs were privatized, 51% being given to
employees, 29% being given to the public by means of vouchers and auctions,
and 20% remaining publicly held. Employees owning the companies had no
incentive to restructure, because they wanted to protect their jobs.
Moreover, the new owners were forced by the inflation to sell their assets
to buy food, and the vouchers were collected by a small business elite, the
"oligarchs". Once the inflation spiral had begun, the central bank, instead
of reducing money supply, increased it to avoid depressing growth,
provoking an enormous budget deficit and forcing the state to sell the
remaining, strategic SOEs to the oligarchs. This was anyway not sufficient
to prevent Russia from defaulting on its debt. The privatization process in
Russia has been referred to as "Embezzlement for a rainy day[2]". In fact,
it constituted an enormous value destruction.

While Russia concentrated their efforts in restructuring and privatizing
SOEs, China was the only country among the three to invest strongly in the
creation of small enterprises, thanks to a system of fiscal stimuli and low
rate credits decided by the provinces. This approach revealed to be a good
one because it permitted a steady growth with a "personalized" pace and the
formation of a domestic strong business environment, based on small private
enterprises and Township Village Enterprises (TVE)[3]. China gradually
opened to FDI in the non strategic sector in order to promote knowledge
spillovers while keeping its economy under control. This favored stable
economical cycles and the creation of a "self reinforcing" system where
small reforms brought small changes, creating consensus and supporting
supports bigger changes

Adjustments

China has really worked with a "trial and error" process. This can be
explained by the length of the overall program and the high capacity of
Chinese government to repress any opposition. Russia is still striving to
recover from their transition processes. Russia needs to solve its
political crisis and institutional instability and to deal with
secessionist pressures.













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[1] Brezis & Schnyter (2003) For these authors, the imprudent approach of
Russian leaders was opportunistic. In a game-theory analysis, they link
the choice of privatization path with the size of the government's
repressive apparatus. For them, in Russia and other Eastern Europe
countries, leaders knew that they did not enjoy a big enough repressive
apparatus to stay in control throughout the transition process. They
therefore chose a privatization path were they could "take the money and
run". Authors name this "Embezzlement for a rainy day". In contract, in
China and Vietnam, leaders knew that they would be able to stay in
control thanks to the size of the state's repressive apparatus, and they
chose the gradual "Market-Leninist" path to privatization.
[2] Community-owned industrial enterprises, based on a transitional form of
ownership and generally presenting low levels of risk