Download Policy Performance and Output Growth in the Transition Economies

American Economic Association
Policy Performance and Output Growth in the Transition Economies
Author(s): Marcelo Selowsky and Ricardo Martin
Source: The American Economic Review, Vol. 87, No. 2, Papers and Proceedings of the
Hundred and Fourth Annual Meeting of the American Economic Association (May, 1997), pp.
349-353
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/2950944
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Policy Performanceand Output Growth
in the TransitionEconomies
AND RICARDOMARTIN*
By MARCELOSELOWSKY
firms and sectors. Some reallocation of resources and X-efficiency gains have taken
place within state-owned firms, as they startto
face tight credit, competition, and improved
export prospects due to the liberalizationof the
trade regime. Most important has been the
growth of new private firms taking advantage
of the assets released when state-owned enterprises are downsized or liquidated (Brian
Pinto et al., 1993; Luca Barbone et al., 1996).
Between 1989 and 1995 the share of the private sector in GDP doubled in Poland, quadrupled in Hungary, and increased tenfold in
the Czech Republic.
As time passes, one would expect the share
of growth derived from improved resource allocation to diminish gradually.Growth will be
determined more by physical- and humancapitalaccumulation.Domestic investmentrates
and the ability of countriesto attractforeign direct investment (with embodied technical
change) will become the main sourceof growth.
The purpose of this paper is to estimate the
impact of improved domestic policies on
growth. The hypothesis is that improved policies influence the process of resource reallocation (the "first phase") and also the desire
to invest in the country, which will probably
become more important as time passes. As a
proxy for that "desire to invest," we use the
flow of foreign direct investment. A special
effort is made to test the dynamics of policies,
that is, whether or not they operate with a lag,
and to test whether the impact of policies differs according to the different initial conditions (e.g., CE vs. FSU countries).
Significant variability has begun to emerge
both in the policy track record and in the economic performance of the countries in transition of central Europe (CE) and the former
Soviet Union (FSU). Slovenia, Estonia, Poland, Hungary, and the Czech Republic have
experienced both sustained growth and a reduction in inflation and are attractingsignificant foreign direct investment. They all moved
early and forcefully on liberalizing and privatizing their economies and depoliticizing the
allocation of credit. Their privatesectors today
account for an average of two-thirds of GDP.
For other CE countries, Bulgaria, and Romania, progress in inflation and growth has been
more erratic. Privatizationand banking-sector
reform have been slower and the quasi-fiscal
deficit remains a source of inflationary pressures and crowding-out of the private sector.
Foreign direct investment has grown less and
so have the private sectors.
There is also variability in performance
across the FSU. The Kyrgyz Republic, Armenia, and Georgia have made significant
progress in reducing inflation and liberalizing
their economies. They are now growing and
are expected to achieve a 1996 GDP growth
rate of about 5 percent. By contrast, measured output is still declining in the three largest countries in Eastern Europe-Russia,
Ukraine, and Belarus. Until recently, Russia
advanced much faster in price liberalization
and privatization, although Ukraine is now
catching up. In Belarus there has been no policy progress.
The start of growth in the first group of
countries has come from improved resource
allocation, both at the firm level and across
I. Testingthe Influenceof Reforms
A. Growth
* The World Bank, 1818 H Street, N.W., Washington,
DC 20433. The views presented here are the authors' and
do not necessarily representthe views of the World Bank.
Several authors have by now tested the influence of reforms on growth in the transition
349
economies. Stanley Fischer et al. (1996)
found that progressin reforms,as measured
by the index of liberalizationpresentedin
Marthade Melo et al. (1996), was a significant factorexplainingannualratesof growth
for the period 1992-1994 in a sampleof 20
countries.JeffreyD. Sachs (1996) foundthe
same for growth in 1995 and for average
growthduring 1989-1995, when measuring
policies with an index of reformprogressdefinedfromtheEuropeanBankforReconstruction andDevelopment(EBRD) policy scores.
De Melo andAlanGelb(1996) foundthetypical growthprofilesassociatedwithreformand
nonreformperiods(as definedby a threshold
level of their index of liberalization)using
paneldatafor 20 countriesover 1989-1995.
We also use the liberalizationindex calculatedby de Melo et al. (1996) as the measure
of policy reforms,but we adjust measured
GDP growthto take into accountthe underreportingof private-sectoroutput. For that
purposewe use the EBRD estimatesof the
growthof the share of the privatesector in
these economies.'We have also estimatedall
equations with the unadjusted(observed)
GDPdata,andthesearereportedin footnotes.
The resultsarequitesimilar.
The followingequationwas estimatedwith
the combineddatafor 25 transitioneconomies
in the 1990-1995 period:2
(1)
GROWTHt=-10.65
(6.76)
+ 11.42LIBt- 15.70WARt
(4.17)
(6.07)
' The adjustment was based on the assumption that
private-sectoroutput each year was underreportedby onethird in FSU countries and by one-tenth in CentralEurope.
Thus, the rates of growth were calculated after increasing
GDP, by a fraction a,/3 (FSU) or a,/l0 (CE), where
a, = share of private-sectoroutputin GDP, (from EBRD's
TransitionReports).
2With unadjustedgrowth,
(1')
MAY 1997
AEA PAPERS AND PROCEEDINGS
350
+ 10.38 LIB, - 14.82 WAR,
GROWTH, =-11.36
(5.71)
(7.18) (3.77)
(149 observations;R2 = 0.24, SER = 9.7).
(149 observations; R2 = 0.27, SER = 9.65),
whereWAR, = 1 for countriesin conflictin
periodt, 0 otherwise,and where LIB, = aggregateliberalizationindex.3Althoughthe regressionexplainsonly a quarterof the total
variabilityin growth,it showsa strongimpact
It also indicates
of progressin liberalization.4
the high cost of the regionalconflictswhich
affectedmanycountriesduringthe period:on
averagethe outputloss of the "war" status
was 16 percentof GDP.
We need to go beyondequation(1) to explorethe dynamicsof the associationbetween
reformsandoutput,andto testwhetherpolicy
responseswereaffectedby thediversityof initial conditions(e.g., those in centralEurope
comparedwiththe countriesof the formerSoviet Union). Theshortlengthof thetimeseries
available(six years for most countries)precludesthe use of modelswithvariableslagged
more thana few periods,so we estimatedan
equationwithtwo laggedpolicy variablesand
one auto-regressioncoefficient,all of which
were allowedto differbetweenCE and FSU
countries.Afterdroppingvariableswhosecoefficientswere nonsignificant,we arrivedat
the followingequation:
(2)
GROWTHt
-12.58
(4.11)
-28.94 LIBt
(2.36)
+ 35.46 LIB,_, + 15.00 LIBt- 2
(2.59)
(2.00)
+ 45.47 CE X LIBt
(2.23)
- 45.18 CE X LIBt, -14.15 WARt
(2.03)
(5.31)
3The aggregate liberalization index is a weighted average of indexes of refonns in three areas:internalreforms
(price liberalization,elimination of state orders); external
reforms (foreign trade, exchange-rate regime); and
private-sector reforms (privatization, banking reform)
(see de Melo et al., 1996 pp. 403).
4 Of course the strong association does not prove causality. Chance association can be dismissed given the large
t ratios. An alternativeinterpretationcould be reverse causality (i.e., thatthe positive association comes from higher
VOL. 87 NO. 2
351
THE TRANSITIONFROM SOCIALISM
(100 observations;R2 = 0.58, SER = 8.62).5
There are several points of interest in these
results. First, they show that policy reforms
affect output growth over an extended period
(three years); the hypothesis that the effect is
entirely contemporaneous can be strongly rejected. Second, the cumulative impact of a
change in policy is much larger than that predicted by a static model. The complete transformation to a fully liberalized economy (i.e.,
increasing LIB from 0 to 1) is associated with
an increase of 21 percent of GDP in both FSU
and CE countries.6
Third, there are significant differences between FSU and CE countries in the shape of
the response of output to policy: the hypothesis of equal response can be strongly rejected.
A particulardifference is the immediate (contemporaneous) impact of reforms, which is
negative in FSU and positive in CE. This
means that liberalization has an up-front "investment cost" in the FSU countries. This is
consistent with the FSU countries' more distorted starting point (e.g., a higher share of
negative-value activities requiring vast reallocation of resources after liberalization), as
well as with intrinsic disadvantagesin achieving reallocation, such as physical size and distance to external markets,large and inefficient
company-town enterprises located in isolated
output making it possible [or easier] to reform the economy). But growth has been negative during most of the
period, and countries have persisted with reform despite
large declines in output.
' For unadjustedgrowth,
(2') GROWTH,= -12.27 - 32.75 LIB, + 35.33 LIB,_1
(4.06) (2.70)
(2.61)
+ 14.93 LIB,2 + 45.25 CE x LIB,
(2.02)
(2.25)
-
42.37 CE x LIB,_1 - 13.61 WAR,
(1.93)
(5.18)
(100 observations;R2 = 0.58, SER = 8.50).
6
The exact values (and standarderrors) are 21.5 (5.50)
for FSU and 21.8 (4.17) for CE. Note that the standard
errors are much smaller than those of the individual coefficients. With regression (2'), using unadjustedrates of
growth (footnote 5), the cumulative impacts and SE are:
17.5 (5.43) for FSU and 20.4 (4.12) for CE.
12
10
Strong Accelerationof
Reforms startingin 1997
8
Stagnant level of liberalization
6 _ (at 1995level)
0.
0
2
2
1 96
-2
-4
7
1
8
1999
2000
20 01
Actualgrowth
for1996;projecfions
for1997-2001.
Error
barsindicate
a 75-percent
confidence
interval.
-6
FIGURE 1. RUSSIA: PREDICTED OUTPUT RECOVERY
UNDER ALTERNATIVE REFORM SCENARIOS
regions due to strategic reasons, and stronger
political and constitutional turmoil inhibiting
business decisions.
We used equation (2) to simulate Russia's
future output growth under two alternativereform scenarios. In the first, the liberalization
index does not improve beyond its 1995 level.
In the second, reforms accelerate quickly, so
that by 1999 Russia reaches currentliberalization levels for Hungary and the Czech Republic. Figure 1 shows the results. Under stagnant
reform, positive growth is reached in 1997,
converging to a level of about 2 percent per
year. Accelerating reform postpones the bottoming out of outputfor anotheryear, but then
output growth quickly converges to about 7
percent (4 percent with unadjusted growth).
The figure clearly shows the extra years of low
growth, the "investment" under the reformacceleration scenario.
Obviously, the 7-percent growth to which
the recovery converges under the acceleratedreform case is a short-term or "transition"
convergence. To be sustained, it must be then
validated by enough capital accumulationand
productivity growth, the long-run sources of
growth.
B. Foreign Direct Investment
The flows of foreign direct investment have
accelerated recently in many countries in
352
4.5
transition,so there is now a reasonable amount
of data to test their link to policy improvements. The following regression was estimated with a cross-section time-series pool for
the 1990-1995 period:
(3)
MAY 1997
AEA PAPERS AND PROCEEDINGS
DFI =-0.86 + 1.01 OIL + 3.54 LIB
(4.90)
(1.75) (2.19)
4.0
3.5
2.5.a
10
U.
2.0
1.5
1.0
(104 observations; R2 = 0.18, SER = 1.67),
where DFI = direct foreign investment as
share of GNP (in percent), LIB = liberalization index, and OIL = 1 for oil/gas rich
countries, 0 otherwise. On average, full liberalization "is worth" 3.5 percent of GDP in
additional foreign investment. The sign of the
constant term implies a minimum thresholdof
reforms (around LIB = 0.24 for non-oil/gasrich countries) needed to attract foreign
investors.
As with the growth equation, we also estimated the equation with lagged values of the
variables, to explore the dynamic impact of the
reforms. Equation (4) shows the results:
(4)
DFIt = -0.44 + 0.69 OIL
(0.69) (1.38)
+ 1.83 LlBt + 0.73 DFIt_
(5.52)
(1.84)
(78 observations; R2 = 0.43, SER = 1.49).
The contemporaneous liberalization index is
still significantly positive (at a 7-percent
level), and the constant term is still negative,
although less statistically significant than before. In addition, the coefficient of the lagged
endogenous variable is quite significant. We
can only speculate aboutthe factors explaining
the effects of previous investment levels (e.g.,
investment projects may take several years to
implement, or there may be some learning
from previous projects in the country), but if
maintained,it indicates that the long-term impact of liberalization can be much larger than
the immediate impact: 3.6 times as large, according to equation (4).
The existence of a delayed response implies
that the speed of reforms is significant. Figure
2 compares the predicted levels of DFI for two
countries eventually reaching full liberaliza-
0.5
1
2
3
DFI- Slow Lib
- - - Lib.Index- Slow
5
4
6
7
DFI- Fast Lib
~
Lib.lndex -Fast
FIGURE 2. LIBERALIZATION AND
DIRECT FOREIGN INVESTMENT
tion. "Fast" refonners reach that level in three
years, while for "slow" reformers, it takes
seven years. As a result, cumulative foreign
investment in the latter is only half that in the
fast reformer, with annual flows still 25 percent lower in the slow reformereven at the end
of the reform period.
II. Conclusions
The earlier results show a strong and statistically significant impact of improved policies on growth and on the desire to invest
in the country, as signaled by foreign directinvestment flows. The impact of policies on
growth are significant for both CE and FSU
countries, although there may be a negative
initial impact for the latter. This may reflect
some more adverse initial conditions in the
FSU: a higher initial share of negative valueadded and military output, artificially
located industries far away from labor markets, and the lack of a legal framework supporting markets and private property. All
these make the resource-reallocation process
more difficult. However, it does not change
the general proposition that fast stabilization, liberalization, and privatization bring
benefits earlier.
The results also have implications for foreign assistance. The high return to policy re-
VOL. 87 NO. 2
THE TRANSITIONFROM SOCIALISM
form implies that such assistance must be
strictly conditional on policy progress but
should also be largely untied in order to maximize consumption-smoothing in the interim,
particularlyin the FSU countries where better
policies may have a temporary negative impact. There are some limits in trying to accelerate output recovery through targeted
interventionsto provide direct credit to the private sector, finance infrastructureprojects, or
speed up legal reforms ahead of progress on
the policy front. Such interventions first require a minimum amount of progress in stabilization, liberalization, and privatization so
as first to develop a demand for credit, a demand for infrastructureservices, and a demand
for the rule of law.7
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Barbone, Luca; Marchetti, Domenico and
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in Polish Industry." World Bank (Washing7 Here we quote from Cheryl Gray and Kathryn
Hendley (1995 p. 8), based on their work on Hungaryand
Russia: " [P] arties will have strong incentives to take advantage of legal rights and abide by legal responsibilities
primarily to the extent they depend on the market-and
their reputation in it-for survival. For example, banks
and other creditors may not avail themselves of the rights
provided underbankruptcylaws unless they are convinced
that state bail-outs are not likely to be available and thus
that aggressive debt collection is necessary for survival."
353
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No. 1624, July 1996.
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