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Trade, integration and transformation in Eastern Europe.

With the annus mirabilis, the countries of Eastern Europe, and in some respects the East more generally(2) an to dismantle most vestiges of communist rule, including the one-party state and its planned economy and administration. One critical variable was the desire of the new political leaders, particularly in the smaller Eastern countries, to "return to Europe." This essentially meant integrating their economies - and societies more generally - into the concert of the evolving European Union (E.U.), formerly the European Community (E.C.). Despite the E.U.'s inherently discriminatory nature in relations with nonmember countries, Eastern policy makers have viewed it largely as a gateway through which they can merge their economies more fully with the world, both organizationally in terms of fuller, more constructive participation in multilateral organizations and through trade, finance and capital and labor mobility. This paper addresses the basic foreign-sector issues at stake and how various countries have sought to open up their economies.(3) I begin by reviewing the nature of trade for these countries under planning, including their links within the Council for Mutual Economic Assistance (CMEA). Next I summarize plans developed by policy makers with the advice of outside experts for reforming the foreign trade and exchange regimes, the policy measures embraced since 1989 and their results. I describe the strategy adopted in the planned economies in transition (PETs) for achieving export-led growth and explore whether the E.U. could lead them out of the recession. Because I am skeptical that this will succeed, I consider alternative trading relationships the PETS might cultivate, including those within Eastern Europe. The paper ends with some policy recommendations.

THE LEGACIES OF PLANNING UNDER COMMUNISM

In studying the present transition strategies and the feasible alternatives, it is of paramount importance to be aware of the initial conditions in individual PETs. I shall touch briefly only on three: (1) the experience with centralized planning in the one-party state; (2) the failed attempts to improve economic performance through administrative reforms and their legacies; and (3) the lack of clearcut, lasting results of regional integration within the CMEA context.

To grasp what is required to make domestic and external liberalization anchored to a convertible currency with a low-protection regime useful to the restructuring under way, the critical features of centrally planned economies and their obdurate legacies must be crystal clear.(4) After the Second World War, Eastern European countries sought to develop fairly autarkic industrialized economies. They insulated themselves as much as possible from foreign competition through special instruments and institutions. These included: (1) the monopoly of foreign trade and payments, which insulated home economic agents against any competition from abroad; (2) bilateral trade and payments agreements, which permitted administrative control over foreign economic relations; (3) price equalization with considerable segmentation of consumer from producer markets and of both from CMEA as well as world markets, which was required for policy autonomy; and (4) the formulation of economic decisions on a range of grounds, including non-economic ones, regardless of prevailing (and expected changes in) comparative advantages. In all this, prices and exchange rates, which were at best only remotely linked to trade prices, were largely notional. As a result, trade decisions were not as a rule reached on the basis of real economic scarcity indicators, trade did not form a coherent component of the planned economy, and a built-in bias tended to compress trade below levels normal for countries of comparable size and wealth.

Second, for more than 40 years the planned economies sought to buttress their domestic economic regimes by relying mainly on economic cooperation within the CMEA; this also enabled them to pursue more politically and strategically motivated ambitions. The relevant institutional framework was fashioned to facilitate domestic and regional development objectives. This strengthened the desire for national policy autonomy, mostly through autonomous planning, with an advanced type of market reservation anchored to the transferable ruble (TR)(5) and the trade, price and payment regimes that it supported, in spite of agreements to pursue so-called socialist economic integration. This was otherwise a misnomer, since whatever the CMEA members aimed at, voluntarily or under Soviet tutelage, was hardly socialist, economic or integrated: Each member maintained highly segregated markets at home and abroad, and national plans were insufficiently dovetailed to achieve optimal results under CMEA-wide constraints. Rather, the CMEA was for many years an instrument through which the former Soviet Union could exercise less blatant forms of hegemony in the region. The price it was willing to pay for this privilege was usually subsumed, rather simplistically, under the notion of implicit subsidies - that is, the difference between the low Soviet export price to the CMEA (and/or the high Soviet import price for products from the CMEA) and prevailing world prices. These resulted from the Soviet Union's willingness - in the sense that it had for years voluntarily agreed to such commercial ties - to import manufactures from the rest of the CMEA in volumes and at prices that they would not have fetched in world markets, in exchange for raw materials and especially fuels at prices nominally well below current world prices for most years after about 1973.

Thus CMEA trade - as well as that with other countries - was not based on genuine comparative advantages. But trade in the CMEA became structured more rationally over time, just like other trade ties, if only because exporters and importers who felt themselves to be subsidizing CMEA partners imposed constraints on the volume of goods available for export at "low" prices or on the volume of imports procured at "high" prices. Goods were traded at prices that reflected neither domestic costs, however factored, nor real scarcities abroad, and costs were as a rule not directly passed on to domestic agents. Eastern markets were captive, especially for goods built within the context of intergovernmental specialization agreements - mainly in support of machine building and chemicals - and of jointly financed investment projects, principally to shore up the exchange of Soviet fuels and raw materials for manufactures from the smaller countries. The resulting patterns of trade were adapted to economies that were sheltered from internal and external competition, that had leaders reluctant to engage in widespread redistribution of incomes within the region on any scale remotely comparable to what they felt was essential inside their own economies and that had their economic priorities set by the political and bureaucratic powers in place.

In spite of the built-in defects and drawbacks of CMEA relations, the TR regimes did support moderately buoyant trade for many decades. The system began to totter - and in the end collapsed - when the former Soviet Union, the key supplier of fuels and raw materials, ran into unanticipated perestroika teething problems that could not be remedied without radical economic transformation. The ramifications of having been embedded in the CMEA for so long are profound, if only because when the transition began neither macro- nor most microeconomic decision makers were aware of real comparative advantages, and the fixed economic structures in place are not suited to vibrant competition. These discrepancies between the existing (human and material) capital stock and the one that can be used profitably must be corrected at the earliest opportunity, even if at a very high sociopolitical and economic cost.

Finally, the experiments with administrative reforms conducted in the various countries, even when prematurely reversed, as happened so often, invariably left significant traces that have left an imprint on transition policies. Some of these experiences should facilitate the transition to the market, however. Countries that had a significant presence in Western markets and that had entrusted this trade to producers themselves, that implemented alternatives to administrative foreign-exchange allocation, and that tried to realign domestic prices with some broad world trends through a more realistic exchange rate have, on balance, found it easier to liberalize their domestic and external economic relations. Eastern economies that eschewed such modifications for the sake of attaining domestic policy autonomy through rigid market segmentation at virtually any cost have found reform more difficult. Macroeconomic stability also facilitated liberalization. Finally, countries without domestic ethnic or regional tensions have found it easier to proceed with far-reaching societal transformations than countries in which the very coherence of the national economy, and indeed polity, is at issue. Such factors must be taken into account when planning the speed, comprehensiveness, sequence, sectoralism and intensity of reform.(6)

THE ADVISED BLUEPRINT FOR TRANSFORMATION

The aims of the transition were loud and clear from the very beginning: establishing political pluralism similar to Western Europe's and dismantling the remains of administrative planning in favor of market-based decision making and speedy integration into the world economy. In some PETS that had not previously experimented seriously with economic decentralization, the dismantling of central planning was bound to be rather painful. In others, overcoming the legacies of administrative planning and bureaucratic bargaining under communist rule posed vexing problems. This was particularly true if they insisted on rapidly opening their economies to global competition through far-reaching trade and foreign-exchange liberalization (devaluation of exchange rates, internal convertibility, low tariffs and so on) in combination with the rapid and forcible breakup of regional ties and the general shortage of new capital. The latter problem could be alleviated through sizable inflows of foreign investment as well as other commercial and official transfers from the West, including from multilateral financial institutions and other aid organizations.

Integration into the world economy required basically two steps. One was to open up the PETs' domestic economies through a more orthodox commercial policy than that pursued under communism. The other was to obliterate quickly all vestiges of so-called socialist integration and the various TR regimes that had supported that endeavor. Furthermore, integration into the world economy was from the beginning associated with full participation in global economic regimes, including quick membership for those that did not already belong to the institutions entrusted with safeguarding these regimes. The latter task has been accomplished for all practical purposes, save in some of the successor states of the former Yugoslavia, which for now are prevented by political factors from joining the regimes that they had earlier embraced. Finally, it was evident that most PETS coveted membership in the European Community at the earliest opportunity. I shall treat the dissolution of the CMEA and the annihilation of the TR regimes and the movement toward closer integration with the European Union in the next two sections. Here I focus on the core features of a liberal trade and exchange regime.

How to transform the trade and payment systems of the PETS has been one of the most widely debated questions in designing comprehensive, speedy and properly sequenced transition policies. Policy makers in most PETS and their advisers have generally agreed on the need to disengage the PETS from the TR-based price, trade and settlement systems. Equally unanimous has been the advice to open up the PETS and expose them to price-based international competition through an effective exchange rate. Most economists, particularly the Western advisers and commentators, but also the better-informed economic policy makers of the PETs, have backed a quite liberal trade regime applicable to all authorized agents with few, if any, nontariff barriers and low, preferably uniform, tariffs.

The case for trade liberalization has been based on incontestable credentials in economic theory. It is expected to improve resource allocation in line with social marginal costs and benefits; to facilitate access to more advanced or better-suited technology, inputs and intermediate goods; to enable a country to achieve economies of scale and scope; to bolster competition in domestic markets; and to provide pro-growth externalities, in part by shaking up established transformation activities through more daring Schumpeterian ventures. Discussions about trade policy reform have at times left the impression that a liberal trade regime can work wonders, even though the record of the effects of trade liberalization on growth in developing countries is debatable at best.(7) These advantages may not be realized until the environment permits comparatively flexible adjustments to new demand and supply schedules, that is, after a functioning market economy has been erected. Early during the transition period, foreign competition may eliminate an inordinate share of domestic production, without the freed-up resources being mobilized for growth. Aggregate economic activity may plunge, reducing levels of living. Whether this occurs with trade liberalization depends on the availability of foreign exchange and the degree of flexibility on the supply side. Experience has shown that both are severely limited, thereby compressing economic activity.

It is in any case wrong, for reasons of both theory and actual policy making, to presume that economic interdependence must be rapidly destroyed.(8) As a matter of trade theory, it may sometimes be desirable to maintain in the short run at least some commerce that must be displaced through changes in commodity composition or the geographical orientation of trade once the transition is well on its way. There is, of course, no reason to believe that the optimal restructuring of trade would annihilate the ties forged over past decades. As a matter of political economy, a very rapid, forced compression of trade, and hence production, may stop a reform process in its tracks. Recent experience suggests that trade-related shocks to a planned economy in comprehensive transition can cause output to fall too quickly, undermining the credibility of transformation policies in the eyes of domestic actors, foreign investors and organizations that deliver assistance.(9)

Second, the orthodox case for trade liberalization in the PETS has largely invoked the neoclassical paradigm of quick and low-cost adjustment with relatively low protection and an exchange rate suitable to maintain equilibrium in the current account - at least over the medium run, barring unexpected shocks. Because the gap between pre-transition domestic and world prices is considerable, no single variation of the exchange rate can obviate potentially sizable adjustments in demand and supply. Because future export and import schedules are unknown, it is not obvious by how much the home currency should be devalued to sustain external balance at near-full employment. The extent of the devaluation and the management of the nominal exchange rate should therefore figure prominently in the debate from the time the transition begins.

Regarding the foreign-exchange regime, there can be no doubt that the perplexing multiplicity of exchange rates under planning must as soon as possible be replaced by a single or, at most, two rates (one for duly authorized commercial transactions and another for private trading). Whether the key commercial rate should be fixed or flexible is one of those either-or choices that many economists and inexperienced policy makers are fond of. In practice, the question is more what kind of crawling peg should be established and at what intervals the exchange rate should be adjusted to avoid damaging the currency's credibility and, by extension, the credibility of transition policies as a whole.

Another key issue is whether the initial choice of the exchange rate should be inspired more by what the market will bear or should be set closer to parity with purchasing power so as to avoid a sharp cut in the real value of wages and incomes. The latter policy may be attractive if there is presumptive evidence, as in postwar Western Europe, that the devaluation necessary to induce structural change may prove too strong, in the interim hampering, and perhaps bankrupting, economic activities that could survive on their own under normal market conditions. On the other hand, if the choice is for a market-based rate, should the exchange be undervalued to support exports and discourage imports or devalued just enough to anticipate the corrective inflation likely to ensue from price liberalization?

Unfortunately, there are no unambiguous answers to these questions. Most policy makers in the PETS opted for an undervalued fixed exchange rate. They did so prompted more by the desire to infuse some certainty into an exceedingly volatile sociopolitical situation than by solid economic arguments. On the latter ground, the choice is probably wrong. But it may be wise political economy provided it does not become a fetish. Insufficient attention has been allotted to the potentially destabilizing effects of an appreciating real exchange rate, as domestic inflation is bound to quickly hollow out the comparative advantage afforded by the initial devaluation. Yet an unstable real rate adds to the hazards of restructuring economic activities through trade liberalization. In other words, it is desirable to move nominal and real exchange rates in tandem, but their movements need not be fully synchronized. A managed nominal exchange rate would be preferable to a heavily undervalued fixed rate, such as has been introduced in several PETS since 1989.

At this point two other critical issues arise: currency convertibility and how best to phase in a liberal trade regime as a coherent part of other items of the transition's agenda. Fast and far-reaching liberalization of access to foreign exchange is crucial, though it may not be advisable to seek currency convertibility overnight.(10) If only to minimize capital flight, it may prove advisable to pursue the former course over some period of time (months rather than years, of course) by making foreign exchange accessible to all authorized agents (such as licensed traders). This is a distinct option in economies where policy makers can credibly seek to change the environment for economic decision making. In such auctions the nominal exchange rate for liberalized transactions must be flexible without moving to free floating, which tends to impart greater uncertainty into the economic environment than is desirable. Some measure of foreign-exchange control should be retained until policy makers can confidently set an exchange rate that can be sustained over some time (perhaps 6 to 12 months) and put into place the institutions and policy instruments necessary to manage the exchange regime, preferably according to a crawling peg or an otherwise adjustable exchange rate.

Third, on the question of the nature of protection through trade policy, as distinct from foreign-exchange policy and its implications, the debate has vacillated between a low uniform tariff and transitional protection. There is no dispute about the need to transform all nontariff barriers into explicit ad valorem tariffs as soon as possible. Whether the latter should initially remain rather high, possibly at the level that was implicit in the bewildering variety of trade-inhibiting institutions and instruments under administrative planning, or low, to permit effective competition and price transmission, has been a bone of contention. The opposing sides have focused either on forestalling the collapse of large segments of economic activities (especially the so-called value-subtracting or negative value-added firms) early in the transition or on the beneficial effect of market penetration from abroad on domestic competition and price formation. If only for the latter reasons, it would be counterproductive to erect formidable trade barriers or to maintain the inherited protective measures in a different guise, provided adequate revenues can be raised otherwise, including those that will finance temporary income transfers according to a predetermined schedule. This latter option will permit sectors potentially threatened by bankruptcy to operate below real cost, yet governments will not have to shoulder full unemployment claims. This should be part and parcel of a realistic industrial policy and good economic governance.

Fourth, trade liberalization is a necessary but by no means sufficient condition for achieving greater competition in the PETs' domestic markets. However useful as a goal on the way to market-based decision making, liberalization of trade and foreign-exchange regimes cannot by itself supply a competitive structure in the Eastern economies, particularly those, like Russia, whose geographical size, population and resource endowments give them a natural proclivity toward autarky. Direct foreign competition can influence relative prices in the first instance only for traded goods, whether finished or not. Even in goods markets, its benefits should not be exaggerated. If import demand collapses because of the sizable devaluation and the profound economic depression into which the transition plunges the country, import competition provides at best broad indications of how to correct relative prices of traded goods, particularly those whose volume has previously been artificially compressed. Relative factor prices are likely to change rather slowly, especially during the initial phases of the transition, when foreign competition could do most to bolster effective markets. Obstacles to domestic competition and price flexibility must be corrected mainly through domestic policies.

These arguments should not be read as a brief for protectionism. On the contrary, trade liberalization deserves to be promoted avidly, but only to the extent that its advantages are not hollowed out by the trade-related costs of the transition, which are far from zero. This is particularly true for economies, such as Russia's, that are relatively autarkic or whose exports

and/or imports consist chiefly of goods that national policy makers manage in world trade with the aim of promoting their own agendas. It is also especially important in the case of PETs that can no longer count on income transfers that were previously arranged primarily within the context of unitary polities.

Finally, even once the basic steps toward market systems have been taken, seeking to make currencies fully convertible in the PETs makes sense only if other criteria are met. Leaders in the PETs have been keen to muster substantial foreign investment to lower the costs of the transition and to identify a radically new development strategy that promises swift and sustainable growth. A market system with convertibility can realistically be installed only when reserves can cover any unexpected demand for foreign exchange. These can be secured through foreign assistance or by running a current-account surplus, which may be quite expensive under prevailing circumstances. Moreover, some measure of economic buoyancy -- that is, an economy in basic overall balance and with some measure of positive growth -- must be ensured with an appropriate amount of competitive exportables. Perhaps most important, the foreign-exchange and trade regimes must be liberalized to take advantage of the demand pull of a convertible currency and to change domestic economic structures according to real comparative advantages so that balance-of-payments equilibrium can be maintained over the medium run.

EXPERIENCES SINCE 1989

Markets have developed in the PETs much more slowly than earlier anticipated, in spite of bold ambitions and courageous policy declarations. My focus is on the previously discussed aspects of external liberalization. In all Eastern European PETs, save those embroiled in civil war, market-oriented reforms have entailed: (1) a marked devaluation of the exchange rate; (2) broader access to foreign exchange, possibly through free floating, in some cases moving toward current-transaction convertibility (known either as internal convertibility, as in Czechoslovakia and Poland, or a modified(11) currency board, as in Estonia); (3) abolition of the monopoly of foreign trade and its replacement by a tariff-driven trade regime, though many legacies of autarkic planning have lingered and new nontariff barriers have been established in virtually all PETs; and (4) the introduction of fairly low tariffs that were quickly either raised, as in Poland, or supplemented with temporary import surcharges, as in Czechoslovakia.

The foreign economic policies pursued by the PETs since 1989 have had five major consequences. First, regional trade and, in those countries that broke up into their constituent parts, interrepublic trade shrank markedly or abruptly collapsed. Second, the geographical direction of trade shifted sharply, usually in the West's favor, but trade diversion in the true sense (that is, the rerouting of trade flows previously earmarked for the East to the West) has been minimal, and these trade gains have not yet compensated for the loss of (formerly) domestic and regional markets. Third, exports to the West initially exceeded expectations. This stemmed in part from the consequences of domestic and external liberalization, including the sudden slack in domestic demand, the disarray in the CMEA, the guarded opening of Western markets and the entirely rational short-termist decision of state-owned enterprises (SOEs) to stress liquidity rather than return on assets. Unusual and temporary circumstances played a major role, including low-cost inputs available through a decumulation of inventories, currency undervaluation, comparatively easy access to inputs from other SOEs either on soft loans and/or through established procurement channels and newly gained temporary discriminatory preferences in Western markets, such as the lower tariffs under the Generalized System of Preferences, quota enlargements and tariff reductions. These were subsequently incorporated into the more formal provisions of the so-called Europe Agreements. Fourth, exchange rates have been harder to manage than was originally expected. In most PETs, the real exchange rate has appreciated, as policy makers have either held onto a fixed nominal exchange rate as an anchor or pursued a hard-currency policy in an effort to avert inflation after a devaluation. This has undermined apparent, competitiveness and thus factor-productivity performance, in the sense that the distorted trade indicators that enabled the PETs to bolster exports worsened as a result of the real appreciation of the exchange rate. Finally, Western Europe, and to some extent the United States, have raised barriers to market access, notably in the case of so-called sensitive products, whose entry into markets would be likely to displace vocal groups of workers.(12)

In what follows, I focus on: (1) the precarious foreign-exchange situation, (2) the collapse of CMEA economic relations, with an aside on the contraction of interrepublic trade, and (3) problems of global economic management. Let me start with the latter. Until early 1991, Western and also some Eastern policy makers, as well as managers of regional and international economic organizations, were optimistic about the management of global affairs in general and those of the East in particular. If the PETs could quickly adopt a more constructive role in the global economy, through new trade and financial ties as well as through more active participation in the multilateral economic dialogue, so the reasoning went, benefits would accrue to the global economy as a whole, to new trading partners able to position themselves quickly in the markets of the PETs, and indeed to the PETs in particular, thereby reducing claims on international assistance. It would also open up markets for other countries. The advantages would rapidly become visible in Western Europe. With more access for the PETs to European markets, favorable spillovers should also appear fairly soon for other partners who were willing and able to compete openly in such markets.

The exuberance aroused by the political changes in the East has since markedly waned and the nitty-gritty aspects of how best to conceptualize, implement and steer the transformations have come to dominate political discourse. It is now clear that change will come to the East at best very slowly. Claims on global assistance will continue to be sizable for some time to come. Benefits from trade and finance will jell for parties other than those directly involved in providing assistance only once a solid recovery in the East begins. Foreign investment will provide relief only once greater economic, political and social stability has been restored. The international community was woefully ill-prepared to assist the PETs in establishing functioning markets and holding adjustment costs within manageable limits, and to do so in a coherent manner. Adjustment costs in PETs will in the end be staggering, regardless of what happens to the sociopolitical consensus on which steady progress depends.

Second, the abrupt disintegration of the CMEA, its underlying trade and payment regimes, and indeed real economic intercourse among its members (including within now defunct federations) has been a real challenge. Although the collapse of the CMEA was formally acknowledged only in mid-1991, its effects on trade and payments (such as larger than expected trade imbalances, transactions at current world prices and in convertible currency against the explicit rules of CMEA trade, and violations of the delivery provisions of the then valid trade agreements) began to be felt already before the revolutions of 1989. They grew in 1990, as states in the vanguard of reform -- essentially those in Central Europe -- insisted on introducing so-called world-market conditions in CMEA relations and indeed on abolishing the CMEA altogether. The ongoing disintegration of the Soviet Union only exacerbated this economic calamity.

Enforcement of world-market conditions among former CMEA members entails in essence four things: Microeconomic agents must negotiate over goods and services on their own account. Exchanges must take place under market-clearing prices of a sort, given that there are not yet genuine markets in the East. Imbalances must be settled in convertible currency on a current basis or periodically (in the case of clearing). And East European traders, whether SOEs or private traders, must closely observe the customs of world trading, notably those concerning payment conditions (such as immediate payment for primary goods and short-term supplier credit for many manufactures).

These measures would, in the end, have brought greater rationality to the CMEA. But their implications must be made clear. First, any switch to market-clearing prices will modify prevailing terms-of-trade against fuel and raw material importers, and thus require adjustment. Particularly if economic activity cannot be kept at near full-employment levels, which depresses investment demand because of uncertainty and excess capacity already in place, it may also affect the volume of machinery traded. Second, demand and supply schedules will shift because independent agents, now acting in their own interest, are unlikely to emulate the earlier behavior of ministerial bureaucrats. The effects are bound to be asymmetric, largely because of differences in the pace and extent of reform and in trading patterns. Third, without the normal institutions that facilitate trade (such as banks, export-credit guarantees, insurance companies, rediscounting facilities and settlement institutions), institutional as well as commercial-policy and political barriers will hinder precipitate attempts to conduct transactions under world conditions. Finally, a jump must be anticipated in the demand for convertible currency for both transaction and precautionary purposes, while the supply is likely to be limited, particularly in countries incurring negative terms-of-trade and export volume effects.

In sum, without safeguards that would have supported a phased transition, the switch to world conditions, given the limited ability of economic actors in PETs to adjust swiftly in particular their supply response, inevitably led to the collapse of trade among former CMEA members. An even larger contraction could be anticipated for the trade among the newly independent states of the disintegrated federations, particularly the Soviet Union, upon the enforcement of world-market criteria. Furthermore, the PETs' ability to divert trade elsewhere without incurring sizable terms-of-trade and export-revenue losses was limited. These developments have considerably complicated the transition. Various proposals have been made for maintaining or reviving regional and interrepublic trade. None, not even the free trade initiative within the Visegrad process, has been embraced to date, and such trade has been reduced to rather murky bilateral deals that, in some cases, were simply instantaneous barter. In contrast, most observers in 1990 expected that obliterating TR ties would at most involve some modest contraction of trade and that it would in any case be preferable to bolster exports to Western countries, if only because of the potential size of their markets and their commercial infrastructure for accommodating exports from the PETs.

Finally, economic liberalization initially yielded sizable gains in foreign exchange and budget revenues. But these unanticipated benefits quickly eroded, leading to chronic budgetary and foreign-exchange problems in some countries (the Czech Republic seemingly being the exception). As far as foreign exchange is concerned, the export drive to the West petered out for a number of reasons. For one thing, the unusual circumstances that had bolstered it initially quickly vanished. Furthermore, much slower progress with economic transformation and the steep economic recession in these countries inhibited

the identification of new export opportunities, in part for lack of new investments, no matter whether of domestic or foreign origin. Of course, unfavorable external developments -- the oil crisis in 1990, the sanctions on Iraq(13) and rump Yugoslavia,(14) the disintegration of the Soviet Union and Yugoslavia and the latter's civil war, recession in Western Europe and Germany's difficult reunification -- have not made matters easier for the PETs. The economic recession now appears to be bottoming out throughout Central Europe (including Slovenia) but this stage, let alone a recovery, is not yet in sight elsewhere. Finally, in those production lines where the PETs hold a seeming comparative advantage, their export drive has quickly been stymied by developed countries' protectionism, which encompassed, among other sectors, agriculture, iron and steel, clothing and textiles, footwear and some chemicals. Though the impact of Eastern European exports on producers in Western markets remains minimal and this trade provides significant benefits to consumers,(15) escalating protectionism has become part and parcel of developed countries' response to larger and fiercer competition from abroad.

EXPORT-LED GROWTH: GATEWAY TO A NEW DEVELOPMENT PATH?

Given the experiences of the past four years and the depth of the economic depression throughout the East, how to revive growth has become the key policy issue. Some observers simply assert in magisterial fashion that "[n]obody doubts that any recovery in Central and Eastern Europe will be an export led growth."(16) Certainly, this would be highly desirable, if only to relieve the current situation. But this raises two key questions. One is whether export-led growth can be engineered with the developed world, notably Germany, in recession and with at best slow growth expected in the foreseeable future. Entry into Western markets on favorable, discriminatory terms, allowing the private sector and badly supervised SOEs to exploit their short-term advantages, and building up alliances with foreign capital may all ease the current situation. Something more is needed, however, to find an outward-oriented but self-sustainable path to growth.

Temporary relief, as opposed to letting the PETs compete on prevailing terms, while most welcome at this juncture, is unlikely to become a sustainable source of support for longer-term growth. Export opportunities for the PETs are currently rather limited. They are largely dominated by goods in which these countries are not likely to have a long-term comparative advantage, if they intend to become typical medium-level developed countries within the foreseeable future. In any case, these are goods for which there will not be much demand in developed countries, or which are apt to be excluded through managed-trade protectionism. Furthermore, SOES still produce most exported goods, and their interests will remain short-term until privatization and enterprise reform advance much further. The recent inflow of investment from abroad, where earmarked for material production, as in the Czech Republic and Hungary, and to a lesser extent in Poland, appears to be largely motivated by cheap labor and/or inexpensive raw materials. The development record of latecomers, such as those in East Asia, suggests that these forces cannot modernize a country by themselves.(17)

More general considerations also support this proposition.(18) Successful development must mean more than expanding physical capacity and labor inputs or orchestrating a temporary rise in output. It implies sustained gains in productivity and competitiveness through continual lowering of costs, improving product quality, better production techniques and higher value-added activities, continuing improvements in skills, and diversifying markets and products. In all these respects, success depends on reaching efficiency at the firm level, which requires the formation of extensive linkages in production, finance, research, trade and other sectors throughout the economy at home and abroad. Many such linkages will arise from the interactions of private agents. In other cases, when linkages have fractured as a result of neglect or not been established when required, good economic governance and some form of industrial policy will be needed to create them.

One may, of course, doubt the PETs' ability to escape their legacy of failures to modernize.(19) Is there really no alternative to the East's seemingly historic predicament? Perhaps there is, looking at the modernization approach successful latecomers have pursued. This revolves around policies explicitly designed to promote steady-state growth linked to selected indicators of how to compete in international markets, after a period of adjustments, thus yielding dynamic economic efficiency in the sense of ability to adapt to better-practice technology as the base for further growth. The sectors thus identified invariably involve industrialization through policy intervention rather than market-based policy instruments, in spite of pervasive discontent about the former among economists and policy advisers.(20) True, in some PETs the task is not just modernization, but destroying a good deal of the existing capital stock while establishing a new growth path. In others, modernization has yet to begin, because socialism did not really lift these countries out of economic underdevelopment. In principle, an export-led growth strategy exploits the economies of large-scale production through market forces, which are assumed to receive a big competitive impetus from trade liberalization. Relaxing import restraints lowers costs and provides incentives for production and exports, thereby fueling growth, diminishing the social costs of development, increasing economic efficiency, yielding higher incomes and, perhaps with some government coaching, yielding a more equitable distribution of income. All this should make policies, including those of governments, more responsive to changes in the economic environment.

The critical question, however, is how to render this model operational for countries seeking to develop. Neoclassical economists and adherents of the neoliberal agenda for fostering

growth have emphasized the need for trade liberalization, privatization and deregulation. The experience of latecomers, such as the Republic of Korea and Taiwan, which have succeeded in spite of a global emphasis on speedy liberalization and the homilies to unfettered market-based decision making, provides a welcome foil to these precepts. At most, their experience supports arguments for a qualified opening rather than liberalization for its own sake. If some time is required to build up production and exporting capacities and capabilities, which is a reasonable working hypothesis in the case of the PETs, the trade regime and corresponding incentives must be tailored to the longer term.

The purpose of liberalization must be to exploit scale economies and build up new, dynamic comparative advantages through the stimulus that external competition can provide to domestic and foreign investment. However, the benefits of liberalization cannot be assumed where imperfect competition prevails or capital markets are thin. The effectiveness of trade liberalization very much depends on the credibility of the government that introduces the measures, as well as on the measures' durability and consistency with other policies. If liberalization coincides with macroeconomic instability or with an unstable political climate, as in the East, tendencies toward underinvestment may be reinforced. Likewise, protectionism in major markets undermines the independent efforts of smaller economies.

In any case, sustainable development requires broader guidance mechanisms and incentives for individual agents than either the market or pervasive central intervention can provide. At the same time, market institutions must be maintained and upgraded, including through proper governance, as well as through private initiative within the overall macroeconomic framework governed by central policy makers. Likewise, government may play a crucial role by identifying and supporting a strategy for sustainable growth. This requires appropriate institutions and policies, including efforts to mobilize savings for capital-formation. There is no guarantee that the market by itself can fulfill this function, particularly when it is not well-developed, as in the East. Though endogenous growth does not obviate the need for competition and rivalry, more is needed deliberately to shape and make creative use of market competition, cooperation and coordination in order to channel resources into development, thereby generating new opportunities for private firms.(21)

ECONOMIC TRANSFORMATION AND EUROPEAN INTEGRATION

Since the revolutions, perhaps the most important foreign policy goal of the PETs, aside from obliterating the CMEA and seeking new security arrangements, has been integration with the E.U. Yet one may well ask whether moving closer to the Union can really improve the PETs' chance of economic recovery and self-sustainable growth, given what is feasible there and the commitments to integration already made in the E.U. Even if moving closer to the Union could provide a fillip to endogenous growth in the East, one must inquire whether the PETs will be enabled to join under provisions suitable for export-led growth.(22)

Ties with Western Europe can facilitate the transformation process in two ways. First, they can provide external assistance. Although useful, it would be far-fetched to bank on this as the basis for recovery. More important, trade and cooperation with the West can raise aggregate demand in the PETs, directly through expanding exports from the PETs, as well as indirectly through raising domestic incomes and consumer and investment demand. It will also elicit greater foreign investment and bestow greater credibility on transformation policies. Both sources of support obviously depend on the economic forces that determine demand and supply in Europe, as well as in the PETs individually or in concert. How policy makers, producers and consumers in Western Europe as well as the East react to liberalization, what the East presently has to offer and can realistically hope to offer in the next few years, and what they can gain from trade expansion will be critical in determining whether reforms succeed.

The sociopolitical revolutions in the East have produced an unprecedented shift in relations on the European continent. The latter offers an excellent opportunity to reassess the context of European integration and reinvigorate the movement. In addition to recasting the integration scenario in a much wider framework, reconciling the desirable with the feasible in the East may call for a different approach to all-European integration than assuming, as most policy makers have until now, that joining Europe will provide a magic growth wand. Although continent-wide economic union might be very desirable and may be considered a long range goal, it cannot be undertaken sooner than political conditions, governance capabilities and economic compatibility allow.

From the start, Western policy makers, particularly in what is today the E.U., have been nominally very supportive of the democratization and economic liberalization of the East. They have provided financial and other assistance to impart greater credibility and strength to reform. But they have yet to make an irrevocable commitment to ushering most of the East into the Union within a realistic time frame, as opposed to the Copenhagen declaration's assurances that the PETs can expect membership at some unidentified future point, when vaguely stated conditions have been met. Whether the E.U. will agree to widen itself, regardless of the speed and depth of the further integration its existing members desire, is not yet clear.

Even once such a decision is taken, and the changes needed to integrate current applicants for accession to the Union have been completed, practical issues of decision making within the E.U. will have to be faced anew. Consensual governance will become more difficult in a community of approximately two dozen members. Only another constitutional reform of Western Europe will allow representative government with dearly defined -- and separated -- executive, legislative and judicial branches to emerge. It is unlikely that the Twelve -- and soon the Fifteen or Sixteen if the current enlargement negotiations with Norway and the initialed agreements with Austria, Finland and Sweden are endorsed in national referenda and by the European Parliament -- will soon embrace such a drastic constitutional renovation. Even if they should accept such a mutation in principle (perhaps on the occasion of the Intergovernmental Conference on reviewing the Maastricht Treaty slated for 1996) putting it into practice, as experience has shown, will be an even more delicate and arduous task.

Finally, bringing new members into the E.U. will have economic consequences. Though the opportunities are favorable for trade creation and the diffusion of Western technology throughout the East, they cannot bear fruit immediately. Bringing poorer countries into a wealthy club dilutes the wealth of those asked to share the burden of leveling. In the past, the Union has invariably opted to spread the implied income distribution and costs of structural adjustments over a considerable period of time. Even if the Union were to consider such a solution for the PETs, despite the fact that there are no longer the same strategic and political reasons for burden-sharing, it is not likely to be adopted very quickly. The transfers from the agricultural, regional and structural funds required for the East to reach the median for Europe soon would stretch the patience of European taxpayers.(23)

The E.U. will have to accept a greater measure of burden-sharing. Its failure even to attempt to coordinate a response to German unification's effects on foreign exchange markets and monetary policies has already called into question the Twelve's commitment to shouldering the burden of further enlargement beyond the current four members of the European Free Trade Association. But promoting open markets in the East can succeed only if the E.U. also lowers its barriers to many Eastern products. Bringing the East into the Union would promote this goal. Gradual adjustment to the latter's regimes might be made one condition for eventual membership. Any lesser form of association than membership would have to recognize this explicitly. The tortuous negotiations of the Europe Agreements have demonstrated the root obstacles that the Union feels prevented it from relaxing its trade restraints and thereby encouraging the kind of adjustments that the East has been advised to undertake on a much more drastic scale.

The PET leaders have asserted a right to quick accession to the Union, or at any rate to the benefits from free trade its members enjoy. Can the Union grant this status? It should be crystal clear to Eastern leaders that the Union is manifestly not a free-trade area. Rather, it is a club with rules and regulations that can be changed, if at all, only over the long haul. Moreover, the club has reached a modus vivendi through which adjustments are made only gradually, with costs and benefits parceled out over the membership. For the East to join this club is not a realistic, or even helpful, scenario in the short run. Though market access would bring relief, even a special free-trade status would not necessarily extricate the PETs from operating at well below capacity, or place them onto an self-sustainable path to growth. Before the PETs can fully fuse themselves into the Union, they must revamp their entire frameworks of economic decision making.

Some compromise solution will necessarily have to emerge, lest the revolutions in the East fail through lack of political foresight and will. A combination of greater self-help by the PETs, individually and as a group, with a gradual, if bold, revision of the Union's philosophy offers the only realistic course. But whether such a cooperative strategy will allow the Eastern countries to adopt pluralistic market systems that enjoy a sociopolitical consensus remains to be seen. Strategic support from the E.U. for measures that assist the PETs to exploit self-help individually and especially in tandem would be one crucial means of lending their transformation strategies greater credibility. That in and of itself is worth striving for at the earliest opportunity.

RESTORING REGIONAL TIES

Given the lingering mutual interdependence of core industrial production in these economies, achieving a meaningful economic transformation when partner countries are in economic and political disarray is not at all an easy task. Yet inasmuch as balance of payments pressures on the PETs arise largely from the prevailing domestic disarray and the difficulty of raising exports to Western Europe, and in turn contribute to the latter two problems, it is important to consider how economic cooperation among Eastern European states can be revived. The PETs have refused even to consider any new mechanism for regional cooperation that would in any way infringe upon the basic elements of so-called world conditions, such as a partially soft borrowing facility, or that might even remotely interfere with quick de facto membership in the Union. It has evidently not sunk in yet that it is the very nature of the adjustments these countries face, together with the Union's unwillingness to share large sums of wealth, that prevents their participation. In spite of their obvious aversion to intragroup cooperation, reconfiguring the institutional infrastructure to tighten intragroup relations, now on standard economic grounds, should rank high on policy makers' agendas, at least as an interim stimulus to growth in the region. They must seek to maintain some trade, while restructuring its geographical pattern and commodity composition as part and parcel of strengthening market-based decision making, including by establishing necessary institutions.

Economically warranted trade among East European states should be shored up and new trade opportunities based on market relations fostered. Political and economic cooperation among the former members of the CMEA has been in chaos since early 1990; even the formal commitment to Central European cooperation in the Visegrad context or in the broader framework of the Central European Initiative has amounted to little more than formal diplomacy with useful exchanges of information, but few hard policy decisions. Yet the transition could be smoothed and integration into the international economy facilitated if the PETs were able to maintain and expand intragroup economic links based on market principles.

Many observers claim that the future of the PETs lies not in trading with their Eastern partners, which would allegedly suck them into a poor man's club,(24) but in fostering close, and nearly exclusive, ties with the West. But such arguments are simply not very credible in the short to medium run. One reason is geographical proximity. The goodwill built up through long-established trade and business contacts has recently been wasted in the haste of destroying the old without putting anything viable in its stead. Perhaps there is still time to reclaim some of that good-will. Furthermore, the PETs share many transition problems. Claims by one PET or another to be in a better starting position than its neighbors may be useful public relations, and some may indeed possess advantages (say, Hungary as compared to Poland). However, the vast majority of problems associated with the transition are common, including the need to revive demand: Much existing capacity lies idle. Finally, only some of the group's comparative advantages have been extensively exploited. (25) At present there is no active support for new or old agents in the PETs to prospect actively for new markets in Eastern Europe. There are political reasons for this state of affairs; policy makers shun intragroup dependence for security reasons as well as out of political apathy. But it is also true that the infrastructure to support regular trading relations is simply not available. Various foreign-exchange constraints, including those preventing the effective mobilization of available resources, are inhibiting the resumption of intragroup trade. Instruments and institutions other than those customary in world markets may bring temporary relief.

A multilateral clearing mechanism offering some external finance and constructive surveillance might provide one useful channel. Such a mechanism would not only supply liquidity to allow reserves to be mobilized for trade, but would also ease multilateral clearance and establish a framework within which economic devolution to the level of the individual microeconomic agent can succeed, which is especially important for the successor states of the Soviet Union. Perhaps most important, it would make it easier for the participating countries to coordinate their national economic policies. One crucial objective of coordination should be to minimize the costs of restructuring for all concerned. This would also necessarily entail moderate to far-reaching international surveillance. A European guarantee that such an interim solution will indeed be temporary rather than a prelude to keeping the East out, which is what PET leaders really fear, would be helpful in this respect. Of course, European involvement in managing and partly financing the mechanism would make it and its temporary nature even more credible to all concerned.

CONCLUSIONS

Inasmuch as the PETs desire to integrate themselves quickly and fully into the international economy, they must be careful to mold an appropriate and manageable trade regime. Anchoring more effective relative prices and rapidly strengthening competition in domestic markets are also essential to moving the transition forward at minimal cost. For that to take place, the trade and foreign-exchange regimes must be liberalized. However, rapid trade liberalization of rather rigid economic systems risks destroying much of the PETs' productive capacity, as recent events have amply demonstrated. Yet slowing down the transformation process too much through heavy protection would be counterproductive. Given the market defects in the PETs, judicious export promotion with all potential partners, perhaps in combination with some import substitution, is advisable, provided that appropriate governance capabilities can be mobilized at home and, one may hope, in the multilateral organizations as well.

(1.) The opinions expressed here are not necessarily those of the United Nations. (2.) In what follows, Eastern Europe denotes Bulgaria, Czechoslovakia, the German Democratic Republic (GDR), Hungary, Poland, Romania and the Soviet Union for events preceding 3 October 1990. Occasionally, I use the concept for the first six countries (or five, omitting the GDR), in which case the context makes it clear that I have that subgroup in mind. For more recent events, the successor states of Czechoslovakia and the Soviet Union are, of course, fully included. "East" is understood as Eastern Europe plus Albania and the former Yugoslavia (and now its successor states). (3.) I focus here only on desirable foreign trade, exchange and cooperation regimes as but one component of the transition agenda. For references to the broader framework of transition policies, see my following writings: Privatizing Eastern Europe--The Role of Markets and Ownership in the Transition (Dordrecht: Kluwer Academic Publishers, 1992); Unravelling the Ruble Regime (London: European Policy Forum, 1992); "The New East and Old Problems--About Neighbourly Trade and Payment Relations," Economies et Societes--Serie G: Economie Planifiee, no. 44 (1992), pp. 293-320; Industrial Policy in Eastern Europe - Governing the Transition (Dordrecht: Kluwer Academic Publishers, 1993); "The New East, Preferred Trade Regimes, and Designing the Transition," in The Political Economy of the Transition Process in Eastern Europe, Laszlo Somogyi, ed. (Aldershot: Edward Elgar, 1993) pp. 260-88. (4.) For a guide, see Jozef M. van Brabant, Economic Integration in Eastern Europe: A Handbook (Hemel Hempstead: Harvester Wheatsheaf, 1989). (5.) This was the accounting currency introduced in 1963 for keeping records at the International Bank for Economic Cooperation in Moscow of virtually all intra-CMEA commercial transactions and settling them in a multilateral clearing fashion. For a succinct discussion, see Jozef M. van Brabant, "The Transferable Rouble (TR)," in Peter Newman, Murray Milgate and John Eatwell, eds., The New Palgrave Dictionary of Money and Finance, vol. 3 (London: Macmillan, 1992) pp. 689-90; and "International Bank for Economic Cooperation (IBEC)," in ibid., vol. 2, p. 449. (6.) See Jozef M. van Brabant, "Governance, Evolution, and Economic Transition in Eastern Europe," in Kazimierz Poznaski, ed., The Evolutionary Transition to Capitalism (Boulder, CO: Westview Press, forthcoming); and Jozef M. van Brabant, "Lessons from the Wholesale Transformations in the East," Comparative Economic Studies, 1994, no. 1, forthcoming. (7.) For a useful review, see Rudiger Dornbusch, "The Case for Trade Liberalization in Developing Countries," Journal of Economic Perspectives, 6, no. 1 (Winter 1992) pp. 73ff. (8.) See Stanley Fischer, "Stabilization and Economic Reform in Russia," paper prepared for the conference "Eastern European Trade Policy Issues," organized by the European Bank for Reconstruction and Development (London, 25-27 March 1992). (9.) See Maxwell J. Fry and D. Mario Nuti, "Monetary and Exchange-Rate Policies During Eastern Europe's Transition: Some Lessons From Further East," Oxford Review of Economic Policy, 8, no. 1 (Spring 1992) pp. 2743. (10.) See Jozef M. van Brabant, Integrating Eastern Europe into the Global Economy - Convertibility (11.) This is because the 100 percent cover for domestic currency with automatic conversion applies only to authorized current commercial transactions. (12.) See Brian Hindley, "Helping Transition Through Trade? -- The E.C. and U.S. Policy Towards Exports from Eastern and Central Europe," EBRD Working Paper no. 4 (London: March 1993); Zhen Kun Wang and L. Alan Winters, "EC Imports from Eastern Europe: Iron and Steel," CEPR Discussion Paper no. 825 (London: October 1993) mimeographed; and L. Alan Winters and Zhen Kun Wang, "Liberalizing EC Imports of Footwear from Eastern Europe," CEPR Discussion Paper no. 836 (London: September 1993) mimeographed. (13.) Several of the smaller countries of Eastern Europe had extended sizable commodity loans to Iraq that would be settled in the form of oil deliveries, some had substantial contingents of workers on construction projects in the country that yielded badly needed foreign exchange, and Iraq was generally an important trade partner with the East. (14.) This is because of sizable trade ties, particularly among the southern countries, as well as transit points and the uncertainty engendered by the conflicts in the former Yugoslavia. (15.) See Jim Rollo and Alasdair Smith, "The Political Economy of Eastern European Trade with the European Community: Why So Sensitive?" Economic Policy, no. 16 (1993) pp. 139-66. (16.) See Istvan P. Szekely, "Economic Transformation and the Reform of the Financial System in Central and Eastern Europe," CEPR discussion Paper no. 816 (London: July 1993) p. 33. (17.) The once-popular interpretation that these countries were sucked into unimpeded world trade channels largely through the exclusive production of labor-intensive goods embodying low value-added has been increasingly called into question. For some of the arguments, see Alice H. Amsden, Asia's Next Giant: South Korea and Late Industrialization (New York: Oxford University Press, 1989); Manuel Castells, "Four Asian Tigers with a Dragon Head: A Comparative Analysis of the State, Economy, and Society in the Asian Pacific Rim," in Richard P. Appelbaum and Jeffrey Henderson, eds., States and Development in the Asian Pacific Rim (Newbury Park, CA: SAGE Publications, 1992) pp. 33-70; Robert Wade, "The Role of Government in Overcoming Market Failure: Taiwan, Republic of Korea and Japan," in Helen Hughes, ed., Achieving Industrialization in East Asia (Cambridge: Cambridge University Press, 1988) pp. 129-62; and Robert Wade, Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton, NJ: Princeton University Press, 1990). (18.) See Moses Abramovitz, "Catching Up, Forging Ahead, and Falling Behind," Journal of Economic History, 1986,46, no. 2 (June 1986) pp. 385-406. (19.) For one such invocation of historical precedent, see Eric J. Hobsbawm, "The New Threat to History," The New York Review of Books, 40, no. 21 1993) pp. 62-64. (20.) See Albert 0. Hirschman, "Industrialization and its Manifold Discontents: West, East and South," World Development, 20, no. 9 (September (21.) For an elaboration, see van Brabant, Industrial Policy in Eastern Europe, pp. 175-77. (22.) See Jozef M. van Brabant, The Transformation of Eastern Europe -- Joining the European Integration Movement (Commack, NY: Nova, forthcoming). (23.) While it is premature to estimate potential transfers, it is useful to be aware that fusing the Central European countries into the Common Agricultural Policy would require some 15 billion ecu -- roughly 20 percent of the current budget. At least as much would be claimed under the structural fund if the PETs were to receive the same treatment as the four less-developed Union members. The Union's budget by 1999 would expand by some 100 billion ecu (in 1992 prices), well above that which seems feasible. For useful estimates, see Thiemo W. Eser and Martin Hallet, "Der mogliche Beitrag der EG -- Regionalpolitik bei einer Ost-Erweiterung der EG: Hilfe oder Hindernis?" Osteuropa Wirtschaft, 38, no. 3 (September 1993) pp. 195-217. (24.) For the spurious arguments, see David Lipton and Jeffrey Sachs, "Creating a Market Economy in Eastern Europe: The Case of Poland," Brookings Papers on Economic Activity, no. 1 (1990), pp. 75-133; and Jeffrey Sachs, "Eastern Europe's Economies: What Is To Be Done?" The Economist, 314, no. 7637 (13 January 1990) pp. 21-26. (25.) For country details see, among others, Jozef M. van Brabant, Remaking Eastern Europe - On the Political Economy of Transition (Dordrecht: Kluwer Academic Publishers, 1990); Jozef M. van Brabant, Integrating Eastern Europe into the Global Economy: Convertibility through a Payments Union (Dordrecht: Kluwer Academic
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Title Annotation:Contemporary Issues in World Trade
Author:van Brabant, Jozef M.
Publication:Journal of International Affairs
Date:Jun 22, 1994
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