The transition to capitalism in Central and Eastern Europe – Part 2

by Ziad Ghanem

Since the imposition of a planned economy, Central and Eastern European economic evolution has been generally characterized by a growing re-integration into the world market, based on the contraction of large credits from the West and a shift in trade patterns toward the West. Thus, as with all debtor countries, negotiations with representatives of Western banks and the international financial institutions (IFIs)¹ became a regular feature of economic policy formulation throughout the 1980s.

It was therefore only natural that following the collapse of the communist regimes in 1989, the reintegration of the Central and Eastern European countries (CEECs)² into the world market would develop under the aegis of Western creditors. As with Third World countries, stabilization and liberalization measures were imposed by the IFIs to free up economic resources for debt servicing. However, another objective of Western creditors has also been access to the massive industrial base of the CEECs. Thus, through the imposition of more fundamental structural transformations, primarily the privatization of the formerly dominant state enterprises sector, Western capital is gaining ownership of the most profitable sectors while rapidly eliminating any potentially competitive sectors.

The collapse of CMEA trade

Within the Council for Mutual Economic Assistance (CMEA), trade was conducted through bilateral governmental agreements, with Central and Eastern European members shipping mainly manufactures in exchange for raw materials and energy from the Soviet Union. This trade was based on the systematic overvaluation of the value of manufactured goods relative to raw materials and standard intermediate products. Through this channel, the USSR had in effect been subsidizing its CMEA partners. Western estimates quantifying this subsidy have ranged from about $US 6 billion to $US 14 billion, based on 1989 trade flows and world prices.³

During the 1980s, CMEA trade suffered from serious disruptions as a result of the introduction of market mechanisms within the European member countries. Decentralization of economic decision-making began disrupting trade because it was no longer fully covered by annual trade protocols and state orders. In addition to these institutional changes, CMEA countries diverted planned deliveries of “hard” goods⁴ to the convertible currency area, further disrupting economic activities.

By 1987, policy makers considered the CMEA regime to be an obstacle to further economic reforms. The 1987 session of the Council of Ministers passed a resolution advocating that the CMEA shift from a “plan coordination” to a “market relations” framework. In 1990, CMEA members agreed to conduct trade on the basis of current world market prices with settlement in convertible currencies, in essence declaring the end of the CMEA.

As expected, the CEECs suffered very serious terms-of-trade losses – roughly a 30 percent deterioration with the USSR – as a consequence of the discontinuation of CMEA trade.⁵ The growth in convertible currency trade, however, was not enough to compensate for the collapse of the old CMEA markets, especially the Soviet Union. In 1991, it is estimated that the volume of East European exports to the Soviet Union declined by about 50-55 percent, and imports from the Soviet Union declined 35-40 percent.⁶

The balance of payments and debt servicing crises

Whether due to their large international debts or due to the collapse of CMEA trade, by the end of the 1980s, all the CEECs were facing a crisis in financing their debt servicing obligations and/or current account deficits. The total gross debt of the CEECs had increased from $US 4.2 billion in 1970 to $US 54.5 billion by 1980 and to $US 90.2 billion by 1990.

Throughout the 1980s, severe debt servicing problems had placed Hungary under IMF tutelage. And by 1990, both Poland and Bulgaria were no longer servicing their large international debts.

Czechoslovakia and Romania, although facing no debt problem were nonetheless confronted by a serious problem of financing their current account deficits. Romania, for example, started 1990 with no foreign debt and $1.5 billion in reserves. Yet according to the central bank’s present governor, Mugur Isarescu, due to the 1990 current account deficit of $US 2 billion, the country was “in danger of declaring a moratorium [on debt servicing payments] without having a foreign debt”.⁷

The rule of the IMF

In 1990, denied access to any additional loans from commercial banks or foreign governments, the CEECs were compelled to turn to the IMF. In return for balance of payments financing, the local governments had to comply with the implementation of the IMF’s prescribed stabilization programs. The core policy concerns of these programs were the restoration of market relations and the reintegration of the socialist countries into the world market.

One of the first comprehensive stabilization programs was introduced in Poland, at the beginning of 1990. This program called for a free price system, drastic cuts in consumer and producer subsidies, a free trade policy, convertibility of currency based on a devalued and fixed exchange rate, wage controls, a balanced budget, and a freeze on credit to state enterprises.⁸ By early 1991, all the CEECs were in the process of implementing similar IMF-sponsored stabilization programs; and all were in a deep economic recession with decreases in national product in the region as a whole reaching more than 25 percent between 1990 and 1992.⁹

Privatization

In the initial phase of the transition, the impact of the new market environment was to encourage management to break-up or liquidate state-owned enterprises (SOEs) as part of a privatization process based on management buy-outs (MBOs). For example, in the Czech Republic, in 1992, almost 90% of privatizations were the result of MBOs.¹⁰ Managers generally sought full financing for their acquisitions from the commercial banks, despite the fact that interest rates were very high. As a result, many MBOs carry such a high level of indebtedness that they face a constant threat of bankruptcy, or are unable to make any large investments.

The IFIs, however, were not content with the pace and character of these privatizations. Thus, IFI loan conditions included the imposition of mass privatization programs (MPPs) for which specific targets were set. For example, in 1995, the World Bank made the re-opening of credit lines to Romania conditional on the privatization of the 1500 largest enterprises by October 1, 1995. In essence, the Bank has been using the external financing difficulties of CEECs to engineer a massive giveaway of those states’ assets.

The Czech program set up the most extensive process of mass privatization by organizing the divestment of most large SOEs in two large waves over a two-year period. This included the privatization of almost half of Czech national assets through the distribution of vouchers to the population at large and the creation of investment funds as intermediaries. Typically of all the CEECs, the major banks formed the largest investment funds and have used the mass privatization programs (MPPs) and especially the voucher system to concentrate in their hands the ownership of most companies.

Another feature of mass privatization has been the development of secondary capital markets. The Czech MPP, for instance, also included the creation of the Prague Stock Exchange. Repeated experiences in CEECs have confirmed that at the close of a MPP, most small shareholders, faced with collapsing incomes, will sell their shares to finance their consumption, leading to a collapse in share prices and further concentration of ownership structures.

Overall, the massive privatization of state-owned assets has sharply increased the share of output produced by the private sector. In 1994, it is estimated that this share was in the range of 40 to 70 percent of GDP in the CEECs and was rising rapidly.

The banking sector

In all the transition economies, the economic recession has led to the rapid accumulation of bad loans in the commercial banks. Neo-liberal dogma held that the principal factor behind the sharp increase in bad debt was the continuing close relationships between state-owned banks and loss-making SOEs. Thus, the IFIs insisted on the introduction of strict bankruptcy legislation to severe this link. However, the real intent of the legislation, to shut down industrial production, became evident when the negative effects of the bankruptcies, turned out to be so serious and widespread that the loan portfolio of the banks deteriorated even further. Many banks became technically insolvent and their need to set aside more provisions resulted in even higher real interest rates as well as in a further decline in commercial credit to enterprises.¹¹

Recapitalization of the banks has usually been linked to the conversion of their operations to commercial criteria and to their privatization. The Czech and Slovak Federative Republic, CSFR, for example, recapitalized the commercial banks in 1991 with the equivalent of $US 5 billion paid for through cuts in public expenditure.¹² This cleared the way for the privatization of five major banks, representing 63 percent of the sector, as part of the 1992 MPP. The World Bank has also consistently promoted the swapping of debt for equity, providing another venue for increasing bank ownership of enterprises.

Local politicians initially claimed that all the financial institutions would be domestically formed groups. However, foreign banks are taking on a major role in the mass privatization process in the Czech and Slovak republics, reflecting a more generalized process of an increasing role for foreign banks. In Hungary, for example, the joint venture and foreign banks have taken a larger share of the market, rising from 5% to 40% of the market, a share which is generally expected to increase even further.

Thus, while the early period of market reforms can be characterized as the consolidation and extension of the power of managers over the real economy, the period of mass privatization corresponds to the increasing control of the banking sector, and especially of the foreign banks over the whole economy.

The economic collapse

One of the main effects of all these structural transformations on enterprises has been a dramatic decline in demand, leading to a generalized collapse in production. Furthermore, the persistence over many years of a harsh macroeconomic environment has also raised the weight of loss-making enterprises in the economy. In fact, all of the CEECs have been going through a process of deindustrialization. In the Czech Republic, generally considered the most successful transition economy, industrial output decreased by 40 percent in four years.¹³ In addition to these developments, the tight credit policies have led to a sharp fall in investment. Between 1989 and 1993, fixed investment in CEECs dropped by nearly 40 percent.¹⁴

The price of the transition to capitalism

From being virtually non-existent at the end of the 1980s, unemployment has already reached double-digit rates in all CEECs, with the exception of the Czech Republic. Overall, the unemployment outflows are very low, leading to the emergence of a large pool of long-term unemployed. Policies imposed by the IFIs have also resulted in an across the board decline in real wages in all of the CEECs.

Furthermore, the passion with which governments have cut consumer subsidies and liberalized prices left millions of people in the region exposed to poverty. In Bulgaria, for instance, over 70% of all households had incomes below the official social minimum by early 1991.¹⁵ Even in the Czech Republic, considered the showcase of the transition economies, the proportion of the population living in poverty increased from 4 percent in 1989 to 30 percent by 1991,¹⁶ a problem that was expected to increase as prices continued rising.

Finally, long-term growth has been undermined by decreasing investment and a shrinking labour force. In fact, the growing economic and financial dependence on Western imperialism is leading to the dismantling of the socialist welfare state, increasing poverty, and a loss of national sovereignty, presaging a headlong rush into the Third World.

Endnotes

1.IFIs refers primarily to the IMF and the World Bank.

2.By CEECs I am primarily referring to Bulgaria, Czechia, Hungary, Poland, Romania, and Slovakia.

3.IMF, The World Bank, OECD, and EBRD (1991), A Study of the Soviet Economy: Volume 2, Washington, D. C., p. 44.

4.Hard goods are goods that could be sold outside CMEA countries for convertible currency without a price discount.

5.Christensen, B. V. (1994), The Russian Federation in Transition: External Developments, IMF, Occasional Papers, Washington, D. C., p. 32.

6.Koves, A. and Oblath, G. (1995), “The regional role of the former Soviet Union and the CMEA: A net assessment”, in Hardt, J. P. and Kaufman, R. F. (Eds.) East-Central European Economies in Transition, Joint Economic Committee, Congress of the United States, M. E. Sharpe, Armonk, New York, p. 360.

7.Marsh, V. (1995), “’I have no illusions’: Profile: Mugur Isarescu, central bank governor”, Financial Times, May 25, p. 21.

8.Zajicek, E. K. and Heisler, J. B. (1995), “The economic transformation of Eastern Europe: The case of Poland – Comment”, The American Economist, vol. 39, no.1, pp. 84–88.

9.Bosworth, P. B. and Ofer, G. (1995), Reforming Planned Economies, The Brookings Institution, Washington, D. C., p. 121.

10.ECE (1994), Economic Survey of Europe in 1993-1994, United Nations, New York.

11.Bokros, L. (1994), “Privatization and the Banking System in Hungary”, in Akyuz, Y., Kotte, J. K., Koves, A., and Szamuley, L. (eds.) Privatization in the Transition Process: Recent Experiences in Eastern Europe, UNCTAD, Kopint–Datog, Budapest, pp. 305-320.

12.Borish, M. S., Long, M. F., and Noäl, M. (1995), Restructuring Banks and Enterprises: Recent Lessons from Transition Countries, World Bank Discussion Papers, no. 279, Washington, D. C., p. 16.

13.ECE, op cit., p. 167.

14.ECE (1994), Economic Bulletin for Europe, vol. 46, United Nations, New York and Geneva.

15.Beleva, I., Bobeva, D., Dilova, S, and Mitchovski, A. (1993), “Bulgaria: Labour market trends and policies”, in Standing, G. And Fischer, G. (Eds.) Structural Change in Eastern Europe: Labour Market and Social Policy Implications, Centre for Co-operation with Economies in Transition, OECD, Paris, p.51.

16.Nesporova, A. (1993), “The Czech and Slovak Federal Republic: Labour market trends and policies”, in Standing, G. And Fischer, G. (eds.) Structural Change in Central and Eastern Europe: Labour Market and Social Policy Implications, Centre for Co–operation with Economies in Transition, OECD, Paris.

Spark! #9, pg. 19-23