The challenges ahead

The record of the past decade is thus one of progress by the transition countries, but it also underscores the challenges that still lie ahead, as pointed out by IMF Deputy Managing Director Shigemitsu Sugisaki in his concluding remarks. Although these countries have generally managed to reduce inflation and to experience a recovery in output, their situation remains fragile. There is potential for a resurgence of inflation, a weakening of output performance, and an intensification of external sector pressures. In this regard, the main challenges that were identified at the conference included fundamentally transforming the role of the state, moving enterprises into the market economy, pursuing banking sector reform, addressing the sharp inequalities in income, and strengthening the macroeconomic situation.

First, the role of government needs to be radically transformed. As pointed out by Vito Tanzi, to function well, market economies need governments that are efficient and evenhanded in establishing and enforcing essential rules for promoting widely shared social objectives, for raising revenues to finance public sector activities, for spending these revenues productively, for bringing required corrections to and controls over the working of the private sector, and for enforcing contracts and protecting property. Governments will need to establish rules of the game that are appropriate to market economies as well as regulations in such areas as private pensions and competition while eliminating most discretionary regulations, which are often relics of the command economy. Such actions would create an environment conducive to the efficient functioning of market forces, and would therefore be critical to fostering the growth of the private sector and shrinking the underground economy. They would also reduce the perception of risk, thereby helping to attract foreign direct investment. The great difficulty of creating basic institutions should not be underestimated, however.

Second, the process of privatization has to be improved. A strong institutional framework, as well as openness and transparency, are the keys to success in this area. Numerous actions have to be taken to streamline privatization. Downsizing and restructuring could take place through a reallocation of ownership and control, which could be facilitated by involving foreign investors. The transfer of labor and social obligations of old firms to new owners would need to be avoided. These steps would have to be reinforced by reorienting the role of the state to promote market discipline and putting in place effective bankruptcy procedures, while ensuring that financing be made dependent on a well-regulated and supervised financial sector and on good business practices. Such actions would effectively harden the budget constraints on enterprises.

Third, financial sector reform is fundamental to promoting growth, by improving the intermediation process and increasing efficiency in the allocation of financial resources. The progress made in giving greater autonomy to central banks represents a step in the right direction. However, creation of a competitive system open to foreign financial institutions and the enactment and effective implementation of strong prudential regulations are key components that still need to be addressed in many transition economies.

Fourth, severe income inequalities have to be tackled. Over time, institutional change and increased competition should help reduce economic rents and income inequalities. This process will take time, however, and governments will need to put in place well-targeted social safety nets for the most vulnerable segments of their populations.

Fifth, macroeconomic stabilization is essential to underpin structural reform and the recovery of economic activity and sustained growth. The empirical evidence shows that lower inflation rates are, indeed, associated with faster economic growth. Moreover, transition countries with persistent moderate inflation, as well as other advanced transition countries, now enjoy favorable circumstances for further disinflation. The threshold above which inflation involves significant output costs is now comparable in the transition countries to what it is in the industrial countries; therefore, a commitment to slowing inflation to industrial country levels over the medium term would be appropriate, especially in those countries aspiring to join the European Union.

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