Reform strategies in transitional economies: Lessons from Asia

Reform strategies in transitional economies: Lessons from Asia

World Development, Vol. 23, No. 7, pp. 1157-I 169, 199.5 Copyright 0 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0305-750)...

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World Development, Vol. 23, No. 7, pp. 1157-I 169, 199.5 Copyright 0 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0305-750)(/95-$9.50 + 0.00



Reform Strategies in Transitional Economies: Lessons From Asia PRADUMNA

Asian Development


Bank, Philippines

Summary. -To

date, with the possible exception of Mongolia, liberalization efforts have generally been more successful in the transitional economies of Asia (TEAS) than in Eastern Europe and the former Soviet Union. This paper argues that both initial conditions and policies were important in explaining the difference in economic performance. The TEAS (except Mongolia) placed microeconomic reforms ahead of macroeconomic ones. Similarly, there were differences in the approaches taken in areas such as enterprise reform, price deregulation and financial sector reform. The TEAS need, however, to supplement their reform program with fiscal, monetary and external sector reforms on an urgent basis. Without such actions. the successes acheived so far could be at stake. Some general lessons for transitional economies are also derived.



One of the most important developments of this century has been the sudden and dramatic collapse of the seemingly irreversible Soviet-style model. The process began with the experiments in “reform socialism” in some East European countries during the 1960s. It started in earnest with the remarkable liberalization in China after 1978 which comprised the dissolution of the agricultural communes and the development of township and village enterprises which became free from official price controls and central planning. As producers’ incentives greatly improved, output grew rapidly. Despite the substantial realignment of plan with market prices, inflationary pressures were contained at least during the first few years after the initiation of liberalization. Early successes of China encouraged Mikhail Gorbachev in 1985 fo embark on perestroika. Subsequently, other centrally planned economies in Asia, such as Vietnam and Lao PDR, began to adopt reform programs in the mid-1980s. Myanmar followed suit in 1988, although the interventionist bias of the State Law and Order Restoration Council (SLORC) slowed some aspects of its reform program, including some price reforms and the formation of public-private joint ventures. With the tearing down of the Berlin Wall winds of liberalization blew into Eastern Europe and eventually led to breakup of the Soviet Union in 1992. No socialist country has as yet, however, completed the full process of economic liberalization. This is mainly because the task of transforming a former

socialist economy is significantly more complicated than the issues facing a typical developing country. In many cases even rudimentary institutions that can be easily converted to market systems are lacking; and there is complete unfamiliarity with market concepts and terminology. What is required is not simply a transition to a new economic system but a fundamental transformation of the economy. Within the above framework, however, the transitional economies of Asia (TEAS) comprising China, Lao PDR, Mongolia, Myanmar and Vietnam (with the possible exception of Mongolia) have performed much better than their counterparts in Eastern Europe and the former Soviet Union (EEFSU). Whether this divergent trend is due to differences in initial conditions or deliberate choices of policies is hotly debated. One school of thought emphasizes policy issues including design and sequencing of policies.

* Senior Economist, Asian Development Bank. This article summarizes the results of a study on economic reforms in selected planned economies of Asia conducted by the Asian Development Bank the full version of which is in Rana and Hamid (1995). It has benefited from comments offered by numerous colleagues and seminar participants particularly those from F. Gerard Adams, P. S. Andersen, John Malcolm Dowling Jr., Gary Fields, Ronald M. McKinnon, Manuel Montes, M. G. Quibria, Jeffrey Sachs and two anonymous referees of this journal. Research assistance of Wilhelmina Paz IS gratefully acknowledged. The views expressed in the paper are those of the author and not necessarily those of the Asian Development Bank. Final revision accepted: January 25. 1995.




-5 - ---

China Lao PDR


Bulgaria __-Hungary ............... Poland - -Romania t-4








d t+3

ADB (1994); ADB, data on file; and World Bank, World Tables (1994). *r=year when the reform process started; China = 1978; Lao PDR and


Vietnam=1986; Myanmar= 1988; Eastern Europe=1989; and Mongolia= 1990. Figure I.

Growth of GDP in TEAS and Eastern Europe, prereform and postreform (percentage).

McMillan and Naughton (1992) and Perkins (1991) demonstrate the merits of “gradualism” and argue that China provides a strong case for evolutionary reform. Another view is that China was correct in starting reforms from agriculture and small enterprise (Singh, 1991). Others contend that China put economic reforms ahead of political reforms, while the order was reversed in EEFSU. Various OECD studies have also established the importance of policy design and execution (Kirkpatrick, 1994). In contrast, Sachs and Woo (1994a) argue that “it was not gradualism, nor experimentation, but rather China’s economic structure . . . that has proved so felicitous to reform.” The economic structure of EEFSU was such that it either augmented adjustment costs or enhanced the urgency of reforms. According to them, gradualism was, therefore, not feasible in the

EEFSU context. They advocate “big bang” reforms including rapid stabilization, liberalization and privatization for these countries. This paper hypothesizes that both initial conditions and policies are important in explaining the difference in economic performance between the TEAS and EEFSU.’ The rest of the paper is organized as follows. Section 2 compares the performance of the two regions during the early years of reform and describes the approach used by, at least, mosf of the TEAS or the Asian approach. Section 3 then goes on to argue that the Asian approach is not sustainable and will have to be supplemented by reforms in various macroeconomic areas. It suggests that the prospects for speedy implementation of the required reform measures are, however, not very encouraging as they require the reimposition of a certain amount of centralized


controls. Finally, although policy lessons are always hazardous, some broad lessons for transitional economies worldwide are derived.

2. COMPARATIVE ECONOMIC PERFORMANCE: TEAS VS. EEFSU The initial results of liberalization in EEFSU have been disappointing. While some signs of recovery have started to emerge in Poland, the Czech Republic and Hungary, aggregate output has generally declined (see Figure 1). Recent data from the International Monetary Fund (IMF) indicate that real GDP in EEFSU fell by an average of 11% per annum during 199&93. As expected, industrial production suffered more than agricultural production. Moreover, declines in output were accompanied by high, sometimes explosive, inflation, nowhere more evident than in Poland and Bulgaria. Emmerij (1994) argues that there is ample evidence that poverty has increased massively in the entire region. By contrast, output in the TEAS has generally continued to grow after liberalization at about the same rate as during the prereform period. By and large, price stability has also been maintained, although not always successfully in Myanmar, Lao PDR and Vietnam. Mongolia is an exception among the five TEAS. Output has declined and very rapid inflation rates were experienced. Its economic performance was severely affected by the adverse terms of trade resulting from the collapse of CMEA trade and financial arrangements in 1991. Both initial conditions and policies were important in explaining the difference in economic performance between the TEAS and EEFSU.

Table I

Size of the state

Lao PDR Mongolia Myanmar China Vietnam

sector in selected countries

Share of GDP

Share of labor force



15.0 90.0 21.7 57.0’ 23.7

2.0 45.4 7.7

97.0 96.5 65.2 81.7 89.9

94.2 70.0 71.5 -

(a) Initial conditions and exogenous factor-9 An important structural difference between the TEAS and Eastern Europe is the relative importance of their rural sectors (including agriculture) and heavy industry. Heavy industry played a major role in EEFSU which were overindustrialized at the cost of services, while agriculture was relatively unimportant. By contrast, the rural sector is dominant in Asia, including China which has a substantial industrial base (Hamid, 1995, and Sachs and Woo, 1994a). Based on relatively labor-intensive technologies, rural economies generally exhibit significant degree of selfsufficiency and are more resilient to change. Despite substantial collectivization, the household has remained an important basic unit in Asia’s agricultural production systems, and technology is geared to family farming. It has, therefore, proved relatively easier to promote competition, something not so readily achieved by the highly mechanized collective farms of the EEFSU. Moreover, decentralized rural economies have made an important contribution to the development of small-scale trading and craft activities, the local arteries of an emerging market system. Another important difference in the economic structures of the TEAS and EEFSU is the relative importance of central planning. First, available information suggests that in Lao PDR, Myanmar and Vietnam, the state enterprise sector was much smaller than in the Eastern European countries (see Table 1). Even in China and Mongolia, where state-owned industry played an important role, the share of heavy industries was smaller than in Eastern Europe (Rana, 1995b). Second, the specificity of state planning was more comprehensive in EEFSU than in the TEAS. For example, in principle, economic management in China was centralized and hierarchical, and was coordinated in the annual plan through a net of interlocking material balance tables, each specifying sources and uses of commodities in physical units from which

High l


0 Vietnam

Memorandum items: l

Czechoslovakia (1986) East Germany (1982) Hungary (1984) Poland (1985) USSR (1990)






Lao PDR 0


Degree of centralization Source: Rana ( I995a). * Industry sector only.

Figure 2.

Initial conditions in TEAS. Source: Rana (1995).



delivery plans were derived. In practice, however, the material allocation system was much less extensive than that of the former Soviet Union. Qian and Xu (1993) note that around 25 million commodities entered the Soviet economic plans, while in China, only around 1,200 commodities were included. Third, regional governments were given greater autonomy in the TEAS than in EEFSU. In China this process began in the course of the Cultural Revolution. The third difference between the TEAS and EEFSU relates to the interplay between political and economic reforms. Among the five TEAS, only Mongolia experienced a politicai transformation as dramatic as those in EEFSU. Mongolia, the world’s second oldest communist nation, had been intimately linked with the Soviet Union from the early 1920s and dramatic political change was an inevitable result of the changes that transformed its giant neighbor. While changes in economic policy in China, Lao PDR, Myanmar and Vietnam have been associated with shifts in the balance of political power, there has been substantial continuity in their basic political systems, with economic reform being introduced and managed by the existing political regime. The absence of a definitive political change in four of the TEAS may be taken as an evidence that some degree of political continuity can facilitate the implementation of economic reforms. In these countries, the elite were split between the reformists and the conservatives facilitating a more gradual approach to reforms. For example, the Chinese reform program has been variously described as “stop and go” and “step-wise” by Adams (1994). In contrast, the precipitate decline in the power of the communist party in most of Eastern Europe led to the weakening of centralized political control over the economy at large, which in turn led to the weakening of newly decentralized control over state-owned enterprises. The need for reforms was, therefore, more urgent. Eastern Europe wanted to “return to Europe” in the general sense of reestablishing cultural, scientific, political, familial, religious and economic ties that had been artificially sundered by the Cold War (Sachs and Woo, 1994b). Fourth, in China, Lao PDR and Myanmar, the importance of CMEA trade was marginal and its break-up of little significance. Although both Mongolia and Vietnam were severely affected by the decline of CMEA trade and the cessation of terms of trade subsidies from the Soviet Union, neither was dependent on these arrangements in the way that the heavily industrialized countries of Eastern Europe were. Fifth, the Chinese reform exercise has received an important boost from the offshore Chinese economy in Southeast Asia in the form of supplier know-how, management, financial and physical capital, and trade infrastructure. Similar linkages to international markets did not exist in the case of EEFSU (except in the case of the former East Germany).

Two important issues affecting the design of the reform programs in postsocialist economies are the extent of preexisting macroeconomic imbalances and the degree of centralized ownership and management of production units (Fischer and Gelb, 1991). These initial conditions are depicted in Figure 2. While comparative data are difficult to obtain, it is safe to assume that most EEFSU countries would have fallen in the upper right quadrant of Figure 2, with some (e.g., the former Czechoslovakia) falling in the lower right quadrant. Since prices were rigidly controlled, and budgetary data generally underestimated the fiscal deficit, it is difficult to assess macroeconomic imbalances in most postsocialist economies in the prereform period. Among the TEAS, however, it can be argued that monetary overhang and the overall fiscal deficit/GDP ratios were worst in Mongolia and best in China at the advent of reform. Vietnam was probably closer to China in this regard, and Lao PDR closer to Mongolia. The state sector was largest in Mongolia, whose economic system was not only modeied on the Soviet system, but was, if anything, more rigid and centrally controlled. By the end of the 1970s China too had a Soviet-type economy, but, as already noted, its material allocation system was much less extensive than that of the Soviet Union in both coverage and content. Vietnam and Lao PDR were heavily influenced by the Soviet approach to planning. Neither, however, was ever as centralized as the Soviet Union. While northern Vietnam adopted an orthodox Soviet model for a relatively long period beginning in 1954, southem Vietnam’s experience with central planning was relatively brief, and the private sector, although illegal, was never fully suppressed. In Lao PDR, despite a commitment made to central planning after 1975, effective state control was largely confined to the country’s small modern sector, and the economic situation of much of the population changed little. Although Myanmar was committed to a socialist path after 1962, there were important differences between the Soviet-style central planning and the “Burmese Way to Socialism.” Agricultural land was never collectivized; when agricultural land was nationalized in 1948, farmers continued to cultivate their fields as before, only as tenants of the state rather than as landlords. The government did try to direct the type of crops and the area to be sown for each piece of land, at least until the late 1980s. Effective state control of the economy never extended down to the level of the individual farm unit. Beginning in the 1960s agricultural output and exports were adversely affected by government control of procurement, domestic distribution and export; but these efforts to introduce central planning techniques were soon abandoned, in part because data were unreliable and in part because planners trained in Eastern Europe were often marginalized on returning home. Despite much dis-


cussion, Soviet-style credit and cash plans were never used (Than and Tan, 1990).

(b) The Asian approach: sequencing of policy reforms The differences mentioned above cannot by themselves explain the differences in economic performance between TEAS and EEFSU. An important reason for the success of Asia has been the differences in the sequencing of reforms. Among the countries in EEFSU, the Czech Republic, Estonia, Latvia, Poland and Slovania adopted the “big bang” approach to reforms (Sachs and Woo, 1994b). This approach comprised drastic macroeconomic stabilization, sudden full-scale price decontrol and trade liberalization. It also involved relatively quick transfer of property rights (including privatization) in intent, if not, always in practice. Reforms sought to convert the old centrally planned system into a free market economy in a short period of time. In such a context, the issue of how to sequence reforms was not very relevant. Other countries in EEFSU, such as Hungary, Romania and Bulgaria, adopted a more gradual approach emphasizing macroeconomic reforms (fiscal, monetary and foreign trade reforms).3 This subset of EEFSU adopted comprehensive stabilization programs that combined tight fiscal and monetary policies. The tightening of financial policies was accompanied by a growing reliance on market-based instruments of monetary control, such as changes in the cost and availability of central bank refinancing. In addition, there were far-reaching structural changes in government finances such as sharp cuts in consumer and producer subsidies. Although they removed restrictions affecting private business activity, formal restrictions, such as limited access to financial resources and inputs, are only gradually disapproving. These countries have also recently prepared or enacted legislation that establishes a framework for privatization. Privatization of small enterprises have begun, but privatization of large firms has proved to be considerably more difficult. The gradualism adopted by Hungary, Romania and Bulgaria is, therefore, macrofirst gradualism. Russia has adopted a combination of “big bang” rhetoric and mostly gradualist practice as a result of the unending struggle between reformers and conservatives (Sachs and Woo, 19C4b). In particular, Russia implemented a rapid libera’ization in 1992, and a rapid mass privatization of state industry in 1992 and a rapid privatization of state industry in 1993; but it failed to open the trading system, and more importantly, failed to undertake macroeconomic stabilization. China is the leading example of the Asian approach to sequencing reforms. In 1978, China began to reform the agriculture sector with the twin objectives


of improving the supply situation and alleviating poverty. It started to replace large agricultural communes with a system of small farm leases; as a result, farm output surged by over 8% per annum until the mid-1980s. In the early 198Os, the focus of rapid economic growth shifted to rural light industry, which began to absorb much of the labor force released by productivity improvements in agriculture. Although small-scale private traders flourished, hundreds of thousands of the new manufacturing enterprises (now simply called township and village enterprises or TVEs) were largely owned by local communities. The TVEs were market-driven and outside the web of price and output controls that still circumscribed activity in the old state-dominated heavy industry sector. Since 1978, partially successful attempts have been made to improve corporate management of the state sector. Step by step, the pricing and financial arrangements governing the old state enterprises have been rationalized. Although the pace of implementation has been quicker, Vietnam and Lao PDR’s experience in sequencing reforms is very similar to that of China. In both countries, agriculture was decollectivized beginning in the mid-1980s and was reverted to the household system by the end of the decade. In Vietnam, state-owned enterprises were temporarily allowed to market their output freely under a dual-price system similar to that employed in China. With the abolition of this system in Vietnam in 1989, and with the 1988 price reforms in Lao PDR, both countries completed the return of agriculture to family farming in a market environment and started to focus in the macroeconomic areas of reform. Efforts to improve corporate management of enterprises and promote the development of nonstate enterprises started in both countries in the early 1980s and were strengthened further as the decade progressed. From the discussion of the reform measures adopted in at least three of the five TEAS, a broadly Asian approach to sequencing policy reforms emerges. This approach involves implementing microeconomic reforms (price reform, agrarian reform, industrial enterprise reform except privatization, and reform of the legal framework under which enterprises operate) earlier than macroeconomic reforms (fiscal, monetary and foreign trade reforms) (see Table 2).1 This approach differs not only from the “big bang” approach but also from the approach of Hungary, Romania and Bulgaria, which like the “standard approach” of the World Bank and IMF, places macroeconomic reforms first. The Asian approach was instrumental in developing relatively efficient commodity markets and in eliciting quick supply responses by helping establish market-oriented enterprises capable of responding to market incentives. It has also reduced the social costs of adjustment by generating supply responses rather than demanding belt-



Table 2.

Status of economic reforms in the TEAS

Reforms MACROECONOMIC REFORMS Fiscal reforms Tax reform Tax administration: internal revenue service (IRS) Modem tax system

Expenditure reform

Monetary reforms Interest rate liberalization



* to **


No IRS; contracting system needs improvement

IRS instituted in 1990; tax sharing according to formula

Introduced direct (incl. personal income tax) and indirect (incl. value added taxes) taxes but still far from meeting basic requirements of modern tax system

Comprehensive tax reform undertaken in 1988 and 1989, but still no modem tax system

Subsidies partly reduced

Most subsidies eliminated. (coupon system for government workers phased out in 1989) ** Liberalized since 1989, but floor and ceiling rates still set by Central Bank Since 1988

** Not liberalized; real interest rates sometimes positive. No open market operation

Two-tiered banking system

Since 1985; banking system complex

Capital market development

Stock markets in two major cities ** Old two-tiered system unified in 1984. Reappeared with emergence of swap markets after 1895

No formal institutions ** Official exchange rate unified since 1988; small deviation between official and parallel rates

Controls over imports and exports

During 1984-1987, controls on trade management greatIy reduced

Restrictions on trade reduced significantly

Replacement of quantitative restrictions & tariff reductions

During 1991-1992 tariffs reduced on about 3,500 commodities

Trade reforms Exchange rate


Agricultural reforms

Non-agricultural enterprise reforms Corporate governance

Promotion of non-state enterprises

**to *** Two-track system, but more than 70% of retail prices and 85% of output prices of collectively owned enterprises are market determined *** Since 1978: by end of 1980s basically back to household agriculture *** Since 1978 (incl. profit retention); more intense after 1984 (incl. enterprise contract system) Since early 1980s

Privatization of small enterprises Reforms of the legal framework property law Bankruptcy law Anti-monopoly law Foreign investment law = Little action; * = Weak; ** = Moderate; *** = intense. Source: Rana (1994a).

*** Almost total deregulation since 1988

*** Since 1986: by end of 1980s basically back to household agriculture *** Since 1981, but more intense after reforms in 1986 and 1987 (incl. , introduction of socialist business accounting system) Since 1979, but intensified after 1982 and especially since 1987 Since 1990 Since 1990 Drafted but not yet implemented Since 1988








*to **


Existing IRS strengthened

IRS instituted in 1989 but not effective

In 1992 introduced personal income tax and custom duty, but still no modem tax system

Several new taxes introduced and laws amended, but still no modem tax system

Direct and indirect taxes since 1990 but still far from meeting basic requirements of modem tax system.

Subsidies reduced considerably

Subsidies continue

Subsidies reduced considerably

**to ** Administered rates increased but not liberalized; open market operation since 1992 Since mid-1991

* Some adjustments, but system of administered rates continues Since 1976

Administered rates have been increased on occasion, but not liberalized Since 1988

Stock market established in 1992

No formal institutions

No formal institutions

Floating exchange rate adopted in May 1993, prior to which the deviation between the official and parallel rates was high Restrictions on trade reduced significantly

Multiple exchange rates

Official exchange rates unified in 1989; the deviation between official and parallel rate is small

Since late 1988, restrictions on trade reduced significantly

Restrictions on trade have been reduced to some extent

*** Almost total deregulation since 1992

** Privatization of herds began in 1991; almost 50 per cent of herds privatized


* to ** Some price adjustment since late 1988

** Agriculture never collectivized; marketing largely deregulated



*** Two-track system until 1989, when almost total deregulation occurred

*** Since 1986; by end of the 1980s basically back to household agriculture ***

Since 1989; intensified after mid-1990

Since 1975, but remains weak

Since 1981, but more intense after reforms in 1987 and 1989 (incl. introduction of socialist business accounting system)

Since 1988; intensified after 1990

Since 1976; intensified in 1988

Since the early 1980s but intensified after 1989

Since mid- 1991 Since 1989 Since 1991 Since 1991 Since 1991

Since 1988

Since 1987; revised in 1990



tightening and restraint. By contrast, the “big bang” and the macro-first approach of the EEFSU has led to stabilization moves generally having a more pronounced impact on real aggregates rather than on prices. Although the TEAS did not adopt the standard prescription for sequencing, their reform programs have been fairly successful. Why? Like its socialist counterparts in Europe, China’s revenue share of GNP fell sharply (from 34.8% in 1978 to only 18.5% in 1991) and its actual fiscal deficit in 1990-91 was approaching 10% of GNP (Wong, 1995). China however, managed to avoid inflation despite the heavy borrowing of the government from the state banking system. McKinnon (1995b) identifies four ways in which China avoided resorting to the inflation tax.5 First, it liberalized and improved the terms of trade for agriculture and promoted nonstate industrial enterprises. After 1978, China moved swiftly to dissolve the communes in favor of smallholder agriculture, and this change in the incentive structure immediately boosted farm productivity. The increased output, together with adjustments in the procurement prices by state marketing agencies, improved the cash position of farmers which enabled them to selffinance their on-farm investments without borrowing from the state banking system. Further, the newly independent farmers began building up their cash reserves. This is reflected in the increase in savings from about 1.5% of GNP in 1978 to 6.3% in 1984. Similarly, the savings of the liberalized industrial sector also increased in the 1980s as a consequence of which the M,/GDP ratio increased from 37.5% in 1979 to 61% in 1984 to over 100% in 1992.6 The financial surplus of the newly liberalized sector could be used to finance fiscal deficits. The government was, therefore, able to collect seignorage without fuelling inflation. The second factor which was critically important for China’s macroeconomic stability was the hard budget constraint imposed by the government on the newly liberalized nonstate sector in both industry and agriculture. Many of the liberalized enterprises were encouraged to self-finance their investment projects. The government was, therefore, able to contain the mounting fiscal deficits that accompanied the reforms. Third, the government was largely successful in keeping interest rates on savings deposits positive in real terms. A major problem occurred in 1988-89, when inflation soared to 17-18% per annum. But the government responded by fully indexing some interest rates to make them positive in real terms. Indexing was discontinued when inflation subsided. Throligh a policy of keeping real interest rates positive, China was able to preserve the incentive for the nonstate sector to accumulate financial assets. Finally, the Chinese government retained price controls and financial support to the traditional softbudget enterprises at the same time that it was liberalizing prices for the non-state sector. The differential between the two prices was gradually reduced.

Although this system led to a certain amount of diversion of resources from the state to the nonstate sector, it, by and large, contributed significantly to an efficient allocation of resources and a stronger fiscal position. To a large extent, the experience of Vietnam and Lao PDR was similar to that of China. Since the dui moi restructuring began in 1986 in Vietnam, transfers from state enterprises to the government budget fell from 17.2% of GNP to 7.1% in 1990 (de Vylder and Fforde, 1995). According to official sources, the fiscal deficit increased from 5% in 1986 to 8% of GDP in 1990. Similarly, in Lao PDR current transfers to the government from public enterprises declined from 9.5% of GNP in 1986 to 1.7% in 1989, and the fiscal deficit increased to 17% of GDP (Vokes and Fabella, 1995). Reflecting the sizeable macroeconomic imbalance during the prereform period and the prospect of a rapid decline in CMEA aid, the inflation rates were higher in these countries than in China, with the monthly rate in Vietnam reaching a hyperinflationary level of 30% by early 1988. In 1989 however, the inflation rate fell sharply, reflecting the favorable supply response to the comprehensive reforms. These reforms included unification and deregulation of prices, unification and devaluation of exchange rates, and deregulation of interest rates. In both countries, however, the earliest reforms were broadly similar to those pursued by China. These included: (i)

liberalization and improvement of the terms of trade in agriculture and the promotion of nonstate enterprises. As a consequence, the household deposit/GDP ratio in Vietnam increased from 0.6% in 1986 to 3.4% in 1989, and in Lao PDR the demand deposit/GDP ratio increased from 1.2% in 1986 to 2.1% in 1990; (ii) imposition of hard budget constraints on liberalized enterprises. Credit to the liberalized nonstate enterprises in Vietnam declined as a ratio of GDP from 1.6% in 1987 to 0.7% in 1991, while in Lao PDR since 1989-90 the budget constraint on enterprise has been hardened considerably; (iii) retention (in Vietnam) of a dual-track pricing system; (iv) maintenance of positive real interest rates in Vietnam during 1989 and early 1990, and in Lao PDR during 1990 and 1991.

(c) The Asian approach: design of policy reforms In addition to the differences in the sequencing of reforms between the TEAS and EEFSU, there have also been differences in the design of policies in key areas such as enterprise, price and trade reforms.

REFORM STRATEGIES IN TRANSITIONAL ECONOMIES In designing enterprise reforms, the approach of the TEAS was first to encourage nonstate enterprises (including private businesses) while improving the governance of state enterprises through increased managerial autonomy. In China and Lao PDR, enterprise reform included the privatization of enterprise management (through the introduction of a contracting system) prior to the privatization of ownership. This contrasts with the Eastern European experience where privatization has been given increasing priority on the reform agenda mainly because of the lack of success with earlier efforts to commercialize state enterprises while retaining state ownership. The indirect approach adopted by the TEAS is similar to the approaches used by the East Asian countries, including the Republic of Korea and Taipei, China, and consistent with the idea that the inefficiencies of the state sector become less worrisome as the relative size of the nonstate sector increases. The strategy of first encouraging the nonstate sector and then progressively reforming the public sector allows the growing private sector to absorb laid-off state employees, and is thus a less painful way of reforming the enterprise sector. By and large, the TEAS have recognized that, at the initial stages of reform, a certain amount of industrial dualism (where the traditional “soft budget” enterprises coexist with the newly liberalized “hard budget” enterprises) is inevitable. They have also recognized that traditional enterprises become unprofitable as prices are decontrolled or rationalized. An understanding of the social consequences and economic costs of letting these enterprises collapse has led them to allow for a transitional period involving a two-track pricing system. This has been the approach adopted in China and Vietnam. Once state enterprises satisfied their delivery commitments to each other at centrally controlled prices, they could sell at the margin any excess production to rapidly growing nonstate enterprises at market determined prices. While China continues with this system, Vietnam unified and almost totally deregulated prices in 1989. Dual prices for identical products could lead to some divergence of resources from the controlled to the free market. McKinnon (199 1 and 1994b) argues, however, that price controls are necessary to anchor the producer price level when enterprise budgets are still very soft, and sufficient competition has not developed in the provision of raw materials or producer goods from a hard-budget nonstate sector. Contrast this cautious and gradual approach with rapid price decontrols in the EEFSU and Mongolia. Suddenly state-owned enterprises with a soft budget constraint could bid and negotiate prices freely for all goods and services, resulting in a price explosion at the producer level and very rapid inflation. China and Vietnam adopted cautious approaches to foreign exchange and commercial policy reform as


well. For example, in China, the central government initially allocated all foreign exchange at the official exchange rate, then gradually allowed an inter-enterprise swap market to develop at a variable but modest premium over the official rate. Through this policy, export enterprises were provided access to a realistic exchange rate, despite the general overvaluation of the local currency. Other export promotion policies adopted by China included the establishment of special economic zones (quasi-free trade zones), decentralization of foreign trade companies, export retention and foreign exchange contracting schemes. It was mainly the effective implementation of these export promotion policies which accounted for the dramatic increase in China’s foreign trade sector, from 5% of GNP in 1979 to 20% in 1992. The more direct “big bang” liberalization in Russia, which included price decontrol and the pursuit of current account convertibilty was followed by a tremendous increase in the ruble price of foreign exchange and a sharp contraction of export volumes.




(a) Policy agenda While the initial success of the TEAS should be applauded, it should be kept in mind that the process of reform is far from complete. Myanmar has lagged in reform efforts while Mongolia has adopted an East European approach to liberalization. Both of these countries can learn a good deal from the successful TEAS. While state enterprise reform and macroeconomic adjustment have proved difficult for all the TEAS, most have achieved considerable success in reforming agriculture and small industrial enterprises. Interestingly, this has been achieved mainly through the promotion of the nonstate sector rather than through rapid privatization. Success in reforming large state enterprises has been modest. In many cases, the steps taken at the early stages were marginal manipulations, and not sufficient to redress the problem. Later reforms (e.g., the introduction of the contract responsibility system in China and the “socialist business accounting” system in both Vietnam and Lao PDR) have been more comprehensive, but serious problems remain. A comprehensive restructuring program for state enterprises is, therefore, an urgent area of need. The major elements of such a program should be: the merger and/or liquidation of non-viable enterprises; the reform of enterprise ownership, including conversion into joint-stock companies and possibly privatization; and the further improvement of corporate governance. China has recently started the process of merging enterprises with a view to enhanc-



ing their viability; it is also considering the conversion of state enterprises into joint-stock companies with the state as a shareholder. Under the joint-stock company model, the financial performance of enterprise and the people’s assessment of its economic future will be reflected in the price of its stocks. Such transparency will promote a more efficient management system. One important, but difficult, set of institutional issues in enterprise reform relates to the question of property rights. In the early stages of reform, particularly with many ideological issues unresolved, there may be some virtue in a degree of ambiguity regarding the status of enterprise ownership and control. As the new economy emerges from the old, however, problems can be expected if enterprises operate in a sort of limbo between public and private ownership, with rights and responsibilities of management and ownership unclear in both practice and law. Perhaps the most fundamental requirement of a market economy is a legal framework that regulates the exchange of property rights, enforces contracts and sets rules governing the entry into and (generally more difficult) exit out of productive activities. Sachs and Woo (1994a) observe that property rights are more clearly established in EEFSU than in China. The stop-and-go approach to reform in China has led to an uneven growth path, while the high degree of experimentation (e.g., in establishing special economic zones) has contributed to regional imbalances. In the area of foreign trade, a certain amount of decentralization has been achieved. Significant reforms of tariffs and non-tariff barriers, however, have yet to occur. In the area of monetary reform, although the banking system is still complex, a two-tiered system has been in place since 1985. Still, despite frequent adjustments, interest rates have not been liberalized, and the tools needed for indirect monetary management have not yet been fully developed. The supervisory and the regulatory functions of the People’s Bank of China are still weak. In the fiscal area, China has made limited progress in implementing reforms. A central government agency to collect taxes has yet to be established, and the decentralized fiscal system which lead to negotiations and bargaining between the central and local governments is not very efficient. Although a number of direct and indirect taxes (including personal income tax and value added tax) have been introduced, their coverage and implementation need to be improved if they are to serve as a foundation for a modem tax system. The Chinese fiscal system still lacks buoyancy, equity, expediency, transparency and neutrality (Van Arkadie, 1995). There are multiple tax rates and schedules, unequal treatment of enterprises according to their ownership, and tax rates that differ across products and sectors. Taxes have largely replaced enterprise remittances as the major source of revenue, but the tax base remains overly concentrated in the industry sector.

The Chinese government cannot postpone macroeconomic reforms for much longer especially in view of the rapid inflation of recent years and the high fiscal deficit. The government cannot rely indefinitely on heavy borrowing from the liberalized sectors, because households are no longer undermonetized and the broad money supply to GNP ratio, which has reached a very high level, cannot continue rising forever. When (or even before) the ratio of household liquid assets to income reaches its peak, there could be a financial crisis that could put the great accomplishments of the reform process at risk. Both Lao PDR and Vietnam successfully implemented several important macroeconomic reform measures in the late 1980s and the early 1990s. While these measures were steps in the right direction, they have not gone far enough. Exchange rates have been adjusted and restrictions on trade management reduced, but tariff and nontariff reforms have yet to be completed. In the financial sector, while administered deposit and loan rates have been increased on occasions, deregulation has not yet occurred. In the fiscal sector, a number of new direct and indirect taxes have been introduced but more needs to be done to extend their coverage, streamline their administration, and improve tax buoyancy and elasticity. Prospects for effective implementation of macroeconomic reforms, however, remain difficult because they entail curtailing the powers of local governments and reestablishing a certain amount of central govemment controls. Unlike in the microeconomic areas where a significant amount of supply responses has taken place at the local level, the problems of macroeconomic reforms are not to get the government out of the way, but how the government’s management role through the manipulation of fiscal and monetary levers should be altered to fit the new decentralized economies. While local governments have been strong supporters of reform in the past, it should be emphasized that their proreform stance stemmed first and foremost from their opposition to central planning, which they saw as inimical to local development. They will likely resist reforms that are aimed at curbing their autonomy in investment and spending (Wong, 1995). For example, in China the pace of economic reforms accelerated sharply once again in 1992-93 after the retrenchment and political stalemate of 1989-91. Among the most important measures were reforms in the general area of price adjustment and liberalization. The government took steps to realign the prices of several key producer and consumer goods, including coal, crude oil, urban grain and edible oil, and housing. The government also further reduced the scope of administrative allocation so that by 1992 over 90% of retail sales were conducted at market prices, as were 80% of the sales of producer goods. In 1993, the major focus of economic policy making was “austerity” to rein in hypergrowth. Zhu Rongji



Two-trackenterprisepolicy in a modeltransitionaleconomy

Policy area

Traditional enterprises*

Liberalized sectort

Taxation policy

Surplus expropriated

Subsidies Deposits (domestic commodity convertibility)$

Continued but restricted

Uniform value-added tax Discontinued


Unrestricted interest-bearing

Credit eligibility

State banks


Government determined

Self-finance or nonbank capital market Market determined


Pegged with intramarginal delivery quotas

Market determined

Foreign exchange


Current account only (swap market at market rate)

Source: McKinnon (1995a). * Enterprise where output and pricing decisions are largely determined by a central government authority or a planning bureau with centrally allocated inputs and outputs and credits from the State bank. t Refers to both government-owned (i.e. “nonstate” sector) and private liberalized sector. f Commodity convertibility is the freedom to spend for domestic goods and services or to buy and hold domestic cash and currency. was given charge of the People’s Bank for this purpose. At the November Plenum of the Chinese Communist Party, however, the four-month-old austerity program was called off amid resistance of provincial officials eager to protect their pet projects. In its place, the leadership unveiled an ambitious lopoint package of fiscal, financial and state enterprise reforms to be implemented beginning in 1994 along the lines recommended in the paper. There has been considerable backsliding as the same potent mix of interest groups that scuttled the austerity program are also mobilizing against the new program. China has, therefore, entered into yet one more difficult phase in its transition to market economy.

(b) Lessons for transitional economies Without denying the great importance of the differences in initial conditions, the experiences of the TEAS, though tentative because the reform process is still on going, clearly contains several valuable lessons which could be useful for transitional economies worldwide. The purpose in deriving lessons is not to argue that EEFSU should blindly follow the Asian prescription, but that they should adopt it to the extent feasible depending mainly on the initial conditions of a particular country. First, the Asian experience shows that in countries with certain initial conditions (particularly greater reliance on agriculture and light industries), fiscal and monetary policies are less important in the near and medium term than standard policy prescriptions would make them appear. In the medium term, how-

ever, as macroeconomic instability develops effective fiscal and monetary policies are indispensable.’ The sequencing adopted by the TEAS, in which microeconomic reforms have been implemented prior to macroeconomic reforms, has encouraged the development of institutions capable of responding to market opportunities, eliciting quick supply responses and reducing the social costs of adjustment. Second, the experience of the TEAS suggests that gradualism can work.a Reforms in the TEAS were not doctrinaire but evolutionary and pragmatic. While the long-term objective of reform is to reduce the role of government, regulatory intervention can play an important role during the transition period. Similarly, dual pricing, exchange, fiscal and monetary systems may have to be maintained as long as enterprises with soft budget constraints and liberalized enterprises with hard budget constraints coexist (see Table 3). Third, the experience of the TEAS indicates that the dominance of agriculture and light industry is a definite advantage for reform. When a producing unit is a household or small enterprise, profit and income maximization comes about more or less naturally. Moreover, unlike large enterprises, households and small enterprises rarely enjoy soft budget constraints. At the early stages of the reform process, the TEAS moved quickly to replace collectivized agricultural units with family farms. This was accompanied by pricing reforms which strengthened market orientation. Improvements in efficiency and the unleashing of the latent energies of the small farm sector contributed to the expansion of agricultural output. Other aspects of the reform process, including trade reforms and the expansion of light industry in the nonstate sector, also



indirectly supported the growth of agriculture, as the ready supply of commodities provided a real basis for improvement in farm incentives. A fourth lesson is that it is wrong to presume that a free market will develop overnight if central planning is eliminated and the market freed. Scrapping the central planning system is obviously a necessary step toward the evolution of a market economy, but unless existing institutions can readily be converted to facilitate production and distribution under market conditions, the transition process will be difficult and lengthy. A major success of the TEAS has been in developing market-oriented institutions and, therefore, eliciting favorable supply responses. Efficient product and factor markets have evolved in the process. The “big bang” and the standard approaches to reforming postsocialist economies might eventually work but the adjustment costs would be higher than that of the supply-based Asian approach. Fifth, creating opportunities for nonstate enterprises (including small-scale private businesses) and

improving corporate governance of state-owned enterprises is more important than privatization as such. It is not entirely clear why the TEAS have been relatively successful in getting their enterprises to respond to commercial opportunities. Plausible explanations include the relatively greater importance of light industry, the looser hold exerted by the state planning system, the entrepreneurial skills of the citizens, and the greater emphasis on local control of enterprises. Finally, the experience of the TEAS clearly illustrates the advantage of outward-oriented trade policies. Once the TEAS embarked on reform, they moved relatively quickly to promote exports and realign exchange rates. This has resulted in a rapid expansion of exports in most cases. Among the TEAS, Myanmar alone has remained resistant to exchange rate realignment, with a significant cost to the economy. Reforms involving reduction of tariffs and removal of nontariff barriers, however, have lagged in all the TEAS.

NOTES 1. Naughton (1994) argues that “China did enjoy certain potential advantages that make the transition process easier, and that inclined the transition process toward a mote gradual, fragmented, and piecemeal approach. But the approach also turned out to be the ‘correct’ approach. Both initial conditions and approach to reform policy-making must be evoked to explain the China difference.”

4. See also Adams (1993) and Hanke and Walters (1993) for a similar view on China.

2. See also Sachs and Woo (1994a) and Naughton (1994) for excellent discussions of the contrasting initial conditions facing the TEAS and EEFSU.

7. The viability of the micro-first approach was discussed in section 2 (b).

3. For example, Kirkpatrick (1994) notes “. . stabilization has often needed to be pursued against the background of inappropriate institutions.” IMF (various issues) and Emmerij (1994) presents an excellent discussion of the approaches adopted by these countries.

8. Gradualism is, of course, a relative concept. The pace of reforms picked up speed in Vietnam and Lao PDR after 1989 but it is still acknowledged to be slower than in most EEFSU members. In terms of sequencing, the Vietnam and Lao PDR approach was the micro-first approach.


See also Sachs and Woo (1994a).

6. By contrast, the M,/GDP in the Soviet Union collapsed from 67.7% in 1990 to 16% in 1992 (Sachs and Woo, 1994a).

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