Tibor Palánkai
STABILIZATION
AND MODERNIZATION
IN CENTRAL EASTERN EUROPE
The Hungarian experience
ABSTRACT
The author analyses the processes of stabilization and modernization
in the CEE countries and Hungary at the end of the 1980s, in the period
after the fall of communism, the resulting deep economic crisis, and
recession. There was a fall in GDP and industrial output, and a decline in
private and public consumption. 1994 was marked by economic revival
both in the CEE countries and in Hungary. The author sees foreign
investment as the source of the re-surge in the Hungarian economy and in
this sense calls attention to the dual character of the Hungarian economy.
Key words: economic crisis, recession, direct foreign investment,
structural modernisation
The countries of CEE face the complex tasks of stabilization (short-term and long-
term) of their economies, (coping with economic and social crisis) and that of structural
and technological modernization .
A . The stabilization of economies
Patterns of the transformation crisis
The revolutionary changes in 1989 and 1990 were followed by an unprecendented,
deep crisis in the CEE region, which is historically matched only by the "Great De-
pression" of 1929-33 or the damages of a war . It was called a "transformation slump"
by professor János Kornai . Professor Béla Kádár, former Minister of Trade and Indus-
try, challenged the notion of "transformation crisis ." According to him, one can hardly
speak about a transformational crisis, as "the process of transformation, even if at
different speeds from year to year has been progressing continuously ." The economic
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Tibor Palánkai
disturbances of early 1990s were rooted in the "structural crisis" emerging since the
1970s (Kádár,1993) .
Growth of real GDP in CEE countries
(percentage changes, annual averages)
1981-86
	
1989 1990 1991 1992 1993 1994 1995
Czechoslovakia 2.3 1 .4 -0 .4 -16.0 -6.7 - - -
Czech Rep .	 7.1 0.9 2.6 4 .8
Slovakia 7.0 -4.0 4 .8 6 .5
Poland -0.8 0 .3 -11 .6 -8 .0 1 .5 4 .5 5.1 6.5
Hungary 1.5 -0.2 -3 .3 -11 .9 -4 .5 -2 .3 3.0 2.0
Slovenia - -1 .8 -4.7 -8 .1 -5 .4 1 .3 5 .0 5 .0
Croatia - - 9.0 -14.0 -9 .0 -3 .0 0.8 2.0
Central Europe* - - - -12.6 -9 .1 -1 .8 1 .9 5 .3
East Germany - - - -28.4 5.5 7 .1 7 .5 7 .0
Bulgaria 3.7 -1 .9 -11 .8 -23.0 -7.0 -4 .0 1 .4 2 .5
Romania 3.6 -5 .9 -8.0 -13.5 -15 .4 1 .5 3.9 4.5
Albania 3 .4 2 .0 -10 .0 -27.0 -10.0 11 .0 7 .0 6 .0
Estonia - - -8.0 -12 .6 -14.0 -3 .0 4.0 6.0
Latvia - - -0.2 -3.5 -33 .0 -25 .0 3.0 5 .0
Lithuania - - -5.0 -13.5 -39.0 -16 .0 2.0 5 .0
Former Yu 1 .1 0 .6 -8 .5 -15 .0 - - - -
Small Yu	 27.0 -30.0 6.5 -
Macedonia - - -9.5 -10.0 -14 .7 -14.0 -7.0 -3,0
Former SU 3.0 2 .5 -2 .3 -11.8 -17 .8 -13,7 - -
Russia - - -9.0 -11 .0 -20.0 -16 .3 -15.0 -5,0
Ukraine - - -3.0 -11 .0 -17.0 -14,0 19.0 -11,0
Belarus	 11 .0 -14,0 -22.0 -12,0
Azerbaijan - - - -0.4 -22.0 -13.0 -22.0 -6,0
Armenia - - - -11 .0 -42.6 -15 .0 0 .0 5,0
Kazakhstan - - - -10.0 -14.2 -12 .0 -25.0 -19,0
Uzbekistan - - - 0.9 -12 .9 -2.0 -3.0 -4,0
Twelves (EU) - - 2 .8 1 .4 1 .1 -0 .4 2 .6 2,8
USA - - 0 .7 -1 .2 2 .6 3 .0 3 .9 2,7
Japan - - 5.2 4.4 1 .3 0.1 0 .7 2,2
OECD total 2 .7 3 .3 2.5 0 .8 1 .5 1 .9 2 .9 2,8
The estimates of different sources .
*For 1995 CEFTA . National statistics, OECD Statistics and Economic Survey of Europe
in 1992/93, Geneva. CIS, Committee of Statistics . EBRD, WIIW.
In all countries of CEE, there has been a recession since the end of the 1980s, which
accelerated to double digit drop in real GDP after 1990-91 . The recession has been more
62 DR, Vol. XIV (1998) 26
STABILIZATION AND MODERNIZATION IN CEE
The Hungarian experience
moderate in the CEEcs . Till the end of 1993, the cumulative decrease in their GDP had
been about 20% (in Hungary 20-21 %, in Poland 18-19% and in CSFR 20-21 %) . According
to the Economic Research Institute (GKI Rt .) till 1992, the decrease of real GDP was 19%
in Hungary, but if we take "hidden economy" into consideration, it was only 15-16% . At
the same time, some historical statistical analyses indicate, that the volume of national
income in Hungary dropped only by around 10% in 1929-33 (Figyelõ, March 7, 1994, p .
17.) .
In some other countries (Bulgaria, Romania, Albania and the Baltic countries), the
fall of GDP reached 30-40% or more . In these countries the recovery also started in 1994
- after a sharp fall rapid growth occured in Albania already in 1993 - but as result of lack
of the appropriate structural changes Bulgaria, Romania and Albania, although in different
degrees, fell into financial crisis in 1996-97 (i .e . accelerating inflation, growing budget
deficit and indebtedness, etc .) . In most of the former SU and YU republics, the recession
continued in 1996 .
Effects of transformation slump in CEE
Fall of GDP
	
Fall of industrial
1989-94 1989-95** production* 1989=100
Czech Republic -18 -15 -38(1993)
Hungary -19 -14 -33(1992)
Poland -9 -3 -32(1991)
Slovakia -24 -16 -45(1993)
Slovenia -13 -6 -34(1993)
Bulgaria -29 -25 -55(1993)
Romania -33 -19 -51(1992)
Russia -45 -51 -51(1994)
Ukraine -54 -57 -44(1994)
Croatia -51 -16 -50(1994)
With the year of bottom of the slump in brackets .
National statistics . (Kunjunkturajelentés . Kopoint-Datorg . 1995/2 .)
**EBRD. Transition Report, 1995 .
It was unfavourable that paralelly there was a "crisis" in world econorny, in gen-
eral, and in Europe, in particular (1991-1993) . Since 1945, 1991 was the first year in which
the world aggregate GDP dropped by 0 .4%. The world economic crisis was accompanied
by the growth of the budget and the balance of payments deficits ; disproportions in
supply of financial resources ; dampened consumer demand, particularly in certain sectors
(industries) ; the growth of financial flows much faster than the growth of trade, leading
to greater vulnerablity to speculation on financial markets, growing gap between the
First and the Third World . The monetary and fiscal policies were holding back growth in
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TiborPal á nkai
most of the countries and the crisis has lead to growing protectionism as reaction to
constraints of globalization .
The recovery started in Europe in 1994, but on the long run, the growth of the EU
seems to stabilize on more moderate rate (2.5-3%), than before 1973, when it was around
5% .
In 1993, there was a recovery in Poland (4%) and the production levelled out in the
Czech Republic . Since 1994, there has been already a recovery in all CEcs (the Visegrad
Four, and Slovenia) . The growth rates reached 4-6% in most of the CEcs in 1994-96
and the relatively rapid growth (above 5%) continues in 1997 . In Hungary, (and war hit
Croatia) the growth has been more moderate (2%) . In the context of overcoming the
recession, the stabilization seems to progress successfully . Of course, it depends to a
great extent on world economic conditions . As it has been the case so far, CEE has to
implement its historically unprecedented transformation, "in a `cold' world economic
environment, without the external help of definite magnitude and with its own tough
and bitter sacrifices" (Endre Gömöri, Without Locomitives, Figyelõ, January 4, 1996, p .
17 .) .
The recession particularly effected investments, but the private and public con-
sumption also fell in all countries with different degrees . In Hungary, the private
consumption dropped by 10% and the investments by 30% between 1980 and 1992 . In
Bulgaria, the GDP fell by 20% and the investment by more than 40% between 1991
and 1993 . In Latvia, the investments fell back by more than 80%, the private consump-
tion by 60%, but public consumption increased by 40% between 1990 and 1994 . In
Romania, the drop of GDP was 26%, but the fall of investments was 55% between
1990 and 1992. In East Germany, the investments increased by 70%, the private con-
sumption by 17%, between 1991 and 1994 .
The 1994 recovery was based on an investment and export boom in most of the
countries. But only those countries have produced relatively high growth rates, where
paralelly the consumption has also increased . The growth of export of CEEcs (except
for the former Soviet republics) was 16.4% in 1994 and 26 .8% in 1995 . The same data for
the Baltic states were 13 .2% and 32 .9%, respectively .
In Hungary, there was a levelling out in investments in 1993, and then the invest-
ments increased by nearly 20% in 1994 and 7% in 1995 . Although, the private con-
sumption increased by 1-2% in 1993-1994, and the public consumption by 3-4% in
1992-94, due to the restrictive measures in March of 1995, the private consumption fell
by 4% in one year. As a result, inspite the rapid growth of export (17 .6% in 1994 and
21 .5% in 1995), the general growth of Hungarian GDP was only around 2% both in 1994
and 1995 . The growth of import was only 7% in 1995 .
In the Czech Republic, on the other hand, the consumption played an important role
in the recovery after 1994-95, although it has been based on import to a large extent .
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The Hungarian experience
Between 1993 and 1995, the growth of export slowed down from 20% to 14% and then to
9%, the annual import growth accelerated from about 3% to nearly 20% both in 1994 and
1995 .
In Slovenia, the private consumption increased by 20% between 1993-1995, while
the export by less than 10% .
The recovery was accompanied by rapid productivity growth . In this respect, Hun-
gary seems to play a leading role by increasing its industrial productivity by 50% in 3
years between 1993-95 . As Mr. Surányi, the president of the HNB noted, "the economy
has shown a high degree of responsiveness to market signals . The speed of response
surprised me" (Financial Times, October 31, 1995) . The about 15% annual growth of
productivity, to a large extent, was the result of the intensive modernization and the
reconstruction of foreign owned companies . As Chuck Pieper, GE Lighting Europe's
chief executive officer noted, the key to Tungsram's good performance lies in "double
digit productivity gains for each of the last five years" since 1990 (Financial Times,
November 21, 1995) . In this respect, the relatively large amount of foreign investment
seems to yield its fruit . Between 1994-95, the annual growth industrial productivity was
14% in Poland, around 10% in Slovenia, 7% in Czech Republic and 6% in Slovakia .
One of the sectors of economy most severely hit by recession was industry . In
CEE, while the GDP dropped by around 20% during crisis years, the fall of industrial
production reached about 35-40% . In Hungary, the industrial production fell back to
70.6% compared to 1987 (100%) (engineering industry to about 55%) til11992 . Accord-
ing to the Ministry of Trade and Industry, the volume of industrial production in Hungary
shrank to half between 1988 and 1992 (Figyelõ, March 30,1995) . In some other countries
the industrial production has been halved and dropped even more. The manufacturing
sectors were most exposed to shrinking demand of domestic and former export markets
(collapse of CMEA) and to the increasing foreign competition due to opening . Hungarian
industry has lost about 44% of the domestic market . The sectors most severely hit were
the engineering, electrical instruments, vacuum technology and the transport equipment,
which in the West enjoyed a rapid growth .
However, in most of the countries, industry was the first to get out of recession with
relatively high growth rates . The recovery already started in 1993 in Poland, and some
countries (Poland, Hungary, Romania) produced relatively high industrial growth (7-
8%) in 1994 and in 1995 .
There has also been a deep crisis in the agriculture of the CEEcs (it somewhat
delayed the recovery at least in some countries, for example in Hungary or some of the
former YU and SU republics) . The sharp drop in agricultural production between 1990
and 1993 reached rnore than 1/3 in Hungary, and in 1992 the value of investments in
Hungarian agriculture was only about 20% of that of 1985. This has lead to breakdown
of productive capital .
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Tibor Palánkai
In Hungary, the agriculture, particularly after the 1960s, developed more favourably
than in the other CEEcs . Instead of exploiting the agricultural sector, there have been
substantial investments and the food shortages have been mostly eliminated . The re-
forms and the loose forms of cooperative created favourable market atmosphere and
helped the growth of production. The CMEA markets, particularly the Soviet Union
secured big outlet for export .
Inspite of recovery in general, the agricultural production in Poland also fell by 1 %
in 1993, while in Slovakia the agricultural production was 6 .7% and in Hungary 10 .2%
less than in 1992 (Világgazdaság, February 23, 1994) . In 1994, the recovery started
in agriculture as well, and most of the countries of CEEcs produced already a positive
growth in the following years .
At the same time, it was encouraging that the service sectors have managed to
produce much better performances . In Hungary between 1986 and 1993, the share of
trade increased from 9 .4% to 14.1 %, and the non-material services from 15 .1 % to 31.8%
of the GDP. In Hungary, while the number of total employed population fell by about
26% between 1990 and 1995, the number of employees in the non-material services
increased by 58% in the same period . This meant 650,000 new jobs in a period when
unemployment increased from less than 100,000 to almost 500,000 unemployed persons .
Main factors of the crisis and the recovery
It is not easy to exactly analyse and identify the main causes of the transformational
crisis in CEEcs . Most of the experts agree that the process was multicausal, and the
controversies were rather about ranking the different factors .
There is a broad agreement, that the structural factors played an important role in
the recession . The structure of economy, enforced by central planning and excessive
military production, did not correspond to the demand structure of a market economy,
where the formerly supressed comsumer needs played dominant role . And, it appeared
not only in relations of sectors of material production and the services, but they were
reflected also in the internal distortions of the supply of manufacturing products, par-
ticularly concerning certain consumer goods . This can be the explanation of the phe-
nomenon, that although the production has been shrinking, the demand, particu-
larly for certain products has been rapidly growing in the early years of 1990s . As it
was noted by the Economist : "In normal countries, consumption and production move
more or less in step . Yet loosing this production did not affect consumption" (March 13,
1993) . The sales of cars, PCs and many products of consumer electronics and telecom-
munication have been expanding rapidly, which largely explains the dicrepancies be-
tween production and consumption, output and turnover . It was typical, while the retail
sales in CSSR rose 16% in 1992, the GDP fell by 10% . In some cases, the supply was
simply met by the newly liberalized import, but in dynamic demand sectors, the domestic
output was also rapidly expanding . Paralelly taking into account the West European
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STABILIZATION AND MODERNIZATION 1N CEE
The Hungarian Experience
recession, it was not by chance, that the sharp fall in GDP concentrated on the years of
1991-1992 .
There was also a dichotomy between the rapid growth of small and medium-size
companies (mostly private ones) and the crisis and shrinkage of large enterprise
sector . Even in the reform economies, the small and medium-size company sector
remained underdeveloped, while large companies, created formerly on the ground of
political and bureaucratic considerations survived almost unchanged . The latter ones,
although they were mostly small compared to their Western counterparts, which evolved
on economic rationals (economy of scale or rational business structures), now fall apart,
due to their outdated production base and output structure . They were hit by the lack of
financial sources for their modernization by the state, which still owns them, or the lack
of interest of private investors . At the same time, the small business sector was flour-
ishing, despite the entries to the market have been accompanied by large number of
exits .
Another dichotomy, characterizing the macro-economic developments in CEEcs, in
fact, closely connected with the above ones, was between the state-owned and the private
sectors . The state sector suffered the "pre-privatization agony" (high debt, lost markets,
large-scale bankrupcies, weak and hesitant management under uncertainty of his future),
while the private enterprises produced rapid growth . In Poland, the manufacturing and the
construction industry recovered to a great extent already after February 1992, which was
result of rapid growth of the indigenous private sector . In the Czech Republic the construction
sector showed an impressive growth from 1992 and the same dynamic growth characterized
the private services and trade sectors . "In most of the countries of Eastern Europe, output
of private companies is growing by 15-25% a year," while the state-owned part of the
economy shrinks fast . In Poland, the private manufacturing firms are growing by 25% a
year. The economy has been split into two tiers : a fast-growing private sector and the ailing
state industry (The Economist, March 13, 1993 ; December 3, 1994). So far, private sector
growth has been largely self-financed . These largely offset the effects of the collapse of
state-owned firms . According to the EBRD, the private sector was growing about 10-
40% in the CEE region, in 1993 (EBRD Transition Report, 1993) .
The "natural selection" and the Schumpeterian "constructive destruction" is a nor-
mal and natural phenomenon of the cyclical correction mechanisms of market economy .
"In our transformational recession, this process is more intensive and complex" (Kornai,
1993: 580) . Therefore, it takes time, for the positive tendencies to become overwhelming
and able to counterbalance the consequences of the collapse of the old system .
Many analysts feel, that the recession was due to a great extent to the shrinkage of
the external markets . No doubt, that many sectors and companies, sometimes even
with viable capacities, have bankrupted simply because of the sudden collapse of CMEA
markets, which was then coupled by the drop of domestic consumption . On the other
hand, others stress, that the effects of the collapse of CMEA should not be overesti-
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TiborPalánkai
mated and particularly the CEcs have been successful in increasing and redirecting their
trade to OECD (EU) markets, particularly betveen 1989-91 .
The value of import of OECD from CE increased by 16% between 1989 and 1991 .
Poland increased its export by 63%, CSFR 59% and Hungary "only" by 48% . Between
1989 and 1992, Hungarian export grew annually by an impressive 14% . The export
increased by 1-2% (to developed countries by 15%), while import dropped by 8% in
1992 .
The liberalization and marketization of foreign trade have released great
enterpreneurial energies, and the cheaper import inputs, due to liberalization, have im-
proved competitiveness in many fields, particularly in CEEcs . The other countries has
been less successful .
The performance was less impressive in terms of volume of foreign trade . Ac-
cording to UN statistics, the volume of export of "economies in transition" fell by 9.8%
in 1990,29.7% in 1991 and 8% in 1992 . In Hungary, the volume of export decreased by
20% between 1990 and 1993, which roughly corresponds to the fall of GDP.
The export performances, however, deteriorated after 1992, and the impacts of
European recession could not have been avoided . This effected particularly the export
of CEEcs in 1993, when the shrinkage of European markets cumulated . Hungary was
especially hit by the recession of the main importers (Germany, Italy and Austria), by
high wages and by overvalued forint . The volume of Hungarian export fell back by
13.1 % in 1993, which meant the worst year of the recession in this respect .
The reasons for deterioriation were more complex, however, than simply recession
in the economies of West European partners . The effects and advantages of liberaliza-
tion (import of cheap inputs) and the diversion of trade from the East to the West have
been rapidly exausted and therefore the drop in export from the end of 1992, was
inevitable in most countries . The first export "successes" in 1989-91 were results of the
domestic recession, and therefore, could have been only transitory . Another one of the
main reasons according to the Hungarian government, was the lack of proper export
financing (HVG, July 17, 1993) .
It was also known, that the export to the West has been conducted with loss by most
of the companies, and this could have been compensated only transitorily by living up
the assets . It was very discouraging and negative, that the Hungarian industrial firms
made loss in their export . In 1991, the export prices were about 4% bellow the costs, and
according to official statistics there was no improvement in 1992 . The profitability of the
whole export was nearly zero in Hungary for 1993 (Népszabadság, October 16, 1993) . At
the same time, in Hungary, there was an approximately 3-4% improvment in terms of
trade, which indicates the selection toward the more competitive exporters .
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The Hungarian experience
The recovery proved to be particularly rapid in terms of export, and since 1994, there
has been a positive cumulation in this respect . In Hungary, after a 13% fall in export
volume in 1993, the increase was about 11% in 1994, 21 .5% in 1995 and about 23% in
1996. The first two years of recovery have been mostly characterized by export-led
growth in CEE. The domestic demand started to increase in most countries only in 1995 .
In Hungary, however, due to monetary and budgetary restrictions, the real wages fell by
about 10% and the private consumption by 4% in 1995 . It meant that in Hungary, the
moderate growth of 2% was entirely based on export .
Due to the consequences of transformation and the need for structural and techno-
logical modernization, all the CEEcs are characterized by relatively (some extremely)
high import propensity . This has unavoidably lead to growing trade and payment
deficits . The value of import of OECD from CEE increased by an impressive 40%
between 1990 and 1994, but the export at the same time grew by 80% . While the
volume of Hungarian export fell by 20% between 1990 and 1993, the import increased
by 5%. The positive or favourable trade balances of CEEcs turned to deficits in 1993-
94 in all countries (except Russia), and this deficits seem particularly high in some
countries (Poland, Czech Republic, etc .) . The CEEcs accumulated growing deficit in 1995
and 1996, except Hungary, which was the only country that managed to cut back its
relatively high trade deficit ($3,853 million in 1994 to $2,859 million in 1996) after the
March 1995 measures .
As the data indicate, the other East European countries have produced a much
unfavourable foreign trade performance than CE . Many countries have suffered seriously
of "trade implosion," which means a destruction of trade by lack of monetary relations
leading to substantial output collapse . (The term was introduced by G . A. Calvo and F.
Coricelli in a 1992 conference material .) These countries have been less successful in
compensation of trade losses due to the collapse of CMEA on OECD markets .
One very important reason of recession and sharp drop in the investments has been of
financial nature . In Hungary, for example, the interest rates were relatively high (about
35-25%) during 1991-93 and they were discourageing productive investments until recently.
The high interest rates have been accompanied with high investment guarantees, while
most of the companies had to work with negative profit margins, particularly in 1990-1992 .
The state sector managements have been long proceeding with their "using up" - policies,
which meant maintaining un- or non-profitable activities and the financing losses by selling
the assets of the company or at least refraining from any investments . The banks have
mostly been in trouble (burdened by bad loans) and only after they are cleared, can we
expect the reduction of interest rates and the easing of guarantees .
The tax burdens have been gradually increased, and therefore, there have been
strong incentives, that the investments have not moved into the legal sectors (first
economy), which meant that the suboptimal allocation and utilization of resources re-
mained unchanged . The deficits in the domestic budgets were financed mostly from
domestic savings and strong "crowding out" effects could be experienced toward pro-
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Tibor Palánkai
ductive investments. In Hungary, while the treasury bonds and securities offered 30-
35% returns, one could hardly expect that the financial resources would be channeled
to productive sectors .
After 1993-94, the recovery of investments has been based to a large extent on
external financing. As the capital flows have been gradually liberalized (as part of
convertibility, liberlization in capital account), the domestic companies turn to foreign
financial markets, offering credits on much lower interest rates than it was available at
home. In Hungary after 1992, while the external state debt increased only because of
unfavourable exchange rate changes, about half of the increase in national debt fell on
the commercial sector (domestic companies and banks) . This debt increased from al-
most nil to about $6 billion between 1992 and 1996 .
In some countries, particlarly in Hungary and Poland, the direct investments of
foreign companies also played an important role . This explains the improvement of the
structure and competitiveness of exports, particlarly in terms of the rapidly growing
manufacturing exports of the Visegrad countries . Therefore, the export boom after 1994
was based to a large extent on the transfer of external financial resources, particularly in
CEEcs .
One of the main causes of the recession - according to Professor Kornai - was the
transition from "sellers" to "buyers" market . The recession was closely connected to
the fundamental change from the supply constrained to the demand constrained economy,
which needed costly adjustment and reallocation of resources . "In Hungary, the growth
of production had slown down long before the system changed, and then it was fol-
lowed by long stagnation . If we want to transit from over-demand to over-supply under
such circumstances, then slowing down of the growth of demand, and particularly its
absolute fall (in volume), unavoidably carry along the supply, which in their mutual
effects as vicious circles contribute to the deepening of the recession . The postsocialist
economy, when it transits from one permanent market regime, the sellers' market, to an
other permanent market regime, the buyers' market, then it does not get into an ideal
equilibrium situation, but it tips over" (Kornai, 1993) .
Another factor of recession, which is strongly stressed by Professor Kornai, was
the "disturbances of coordination." It took time, until the new rules and pattern of
market behaviours were established . Great number of new enterpreneurs were unexperi-
enced, while there was broad "risk aversion," sometimes keeping back people from
rational behaviour. "There is a paradox situation . Large amount of liquidity has been
accumulated in the banking system, but it remains 'stuck there. On the one hand, the
commercial banks are hesitant to lend them out as credits, but the enterpreneurs are
also abstaining from claiming these credits, because they feel that they are too risky"
(ibidem: 584) .
The old market institutions were only slowly replaced by the new ones, and impor-
tant acts of legislation have too long been delayed . In some sectors (agriculture,
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The Hungarian experience
infrastuctures etc .), specific institutions and regulations would have been needed, and
in some cases, this had strong enough effects to postpone rapid growth .
There have been several external shocks after 1990, which imposed addititonal
costs on transforming CEE economies and hindered the recoveries of their economies .
The Gulf War in 1990-91 negatively effected most of the CEE economies by causing a
loss of important market or credit repayments and there were only minor compensa-
tions to these countries. Most of the neighbouring countries have suffered losses due to
the Yugoslav civil war (loss of foreign trade, transit fees or unpaid debt), but the same
applies to the local conflict in former SU . Between the June of 1992 and early 1995, the
losses of Hungary, due to the Yugoslav embargo have increased to about $2 billion .
(Világazdaság, April 13, 1995), which reach about $2 .5billion till the end of 1996 . Similar
losses have occrued for Romania and Bulgaria . Hungarian agriculture was hit by 3 major
draughts in 5 years, which have lead to an approximately 150 billion forint loss . The
losses for the Czech Republik and Slovakia have been due to the collapse of CMEA
(new oil and energy prices), the failure of main debtors of these countries (Romania,
Bulgaria, Irak and Siria), and the problems of shrinking arms export . The Gulf war in 1990
cost about $4,7 billion for CSFR .
The transformation in most countries have been managed relatively peacefully so
far, and the threats of social tensions, leading to political turmoil, have not been
realized in CEEcs, inspite of high unemployment and worsening living standards . Al-
though, the situation is gradually improving, these dangers, are not totally eliminated
by the recovery . In some countries, the governments are coping with a growing num-
ber of strikes, which may lead to a wage-price spiral . In Hungary, the number of people
leaving under the poverty line doubled (from 800,000 to 1,600,000) between 1989 and the
middle of 1992 (about 16% of population), which coupled with high level of unemploy-
ment is a threat to the social stability enjoyed so far (Népszabadság, July 20, 1993). Due
to the restrictive measures, the real wages dropped by an unprecedented 10% in 1995
and no substantial improvement can be expected even in the following years up to 1996-
97 either. That leaves open the possibility of populist, extremist and autocrative forces
seizing power, particularly in the Eastern European countries .
Changing imbalances
The crisis has contradictory effects on the internal and the external balances of the
economies .
Due to the drastic cuts in subsidies and tax reforms after 1989-90, transitorily
there have been great improvements in budgetary balances in most of the coun-
tries . The crisis, however, has lead to rapid shrinkage of budgetary revenues (taxes),
and the deficits re-emerged on a greater scale than before in many countries. The increase
in the budgetary deficits reflected the costs of transformation and restructuring, and in
some countries they proved to be one of the constraining factors of long-term growth
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and recovery . Paralelly with recovery, there have been slow improvements in budget
balances of most of the countries .
Hungary had a budgetary surplus in 1990, which turned to a deficit of 5% of GDP
in 1991 . The originally planned (and approved by the IMF) deficits have been overpassed
and corrective new budgets had to be approved by the Parliament almost each year .
The deficit graudally increased above 8% for 1994, which created crisis situation of
financing for early 1995 . The main aim of the drastic austerity measures (devaluation,
introduction of import surcharge, cuts in expenditures, etc .) of March 1995 (Bokros
package) was to improve that balance and financially stabilize the country . As result of
the tough restrictions (mini shock therapy), the Hungarian budget deficit decreased to
3.3 % of the GDP for 1996 .
Similar developments characterized many of the other countries . In Poland, the
1990 surplus turned to a 4% deficit (in GDP) by the end of 1991 and it further increased
to about 5 .5% in 1992 . Then it was gradually brought down to approximately 3% in 1996 .
We could experience similar trends in Slovakia . Due to lack of restructuring and the
increasing debt, the deficit remains around 10% in Bulgaria .
In the Czech Republic the balance of budget went into deficit only during the last
quarter of 1992, but a balanced budget has been maintained since that . The balanced
budget was maintained in Slovenia, Estonia and Latvia and in this respect, these coun-
tries can easily meet the Maastricht criteria.
The budgetary problems of CEEcs are complex and diverging :
The postcommunist "fiscal trap" asserted itself in many countries (Hungary, Po-
land, Slovakia, Bulgaria etc .) and the budget deficits have spiraled after 1991-92 (cf .
Kolodko, 1991 ; Kornai, 1992) . First, these countries have achieved improvements due to
cuts in subsidies and increase in taxes in their budget, and some of them could even
produced surlpuses . But very soon they suffered gradual worsening due to squeezing
state entreprises by recession and growing number of bankruptcies . This have lead to
substantial decline of tax receipts, which was coupled by the falling rate of inflation . At
the same time, the recession was accompanied by rising unemployment benefits and
other social demands and the re-increase of subsidies of some firms in trouble . The
costs of restructuring were growing burdened the budgets .
According to András Vértes (director of Economic Research Institute), there was
an approximately 100-150 billion forint "system-related" deficit built in the Hungarian
budget, which was due to the delay of radical budgetary reform (still 60% of GDP was
redistributed) and the costs of transformation . The reform of state "household" has
been postponed and was started only in 1995 .
In Hungary, the interest burdens of accelerating public debt have grown to be
the major factor of budget deficit . These expenditures were around 350 billion forint in
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The Hungarian experience
1994, while the whole deficit was only 330 billion forint . The delays in marketization and
privatization of banks and the costs of "debt-consolidations" have been the major
contributing factors . The Hungarian and Bulgarian budgets are heavily burdened by the
foreign indebtedness . In Hungary, the debt servicing took about 8% of GDP in 1996,
which meant more 4% surplus should be achieved in the primary budget . The deficits in
Hungary have been so far financed from high domestic savings, but this may not be the
case for the future . This situation has strongly contributed to high interest rates, hindering
investrnents and growth ("crowding out effects") .
The increasing indebtedness first external, then domestic, seemed to be one of the
major constraints of recovery and particularly of long-term growth . Hungary could
have easily been forced into a "stop-go policy cycle ." After a 3 % growth in Hungary in
1994, only an approximately 2% growth was achieved both in 1995 and 1996 .
The emerging private sector is avoiding tax to a great extent, while the collapsing
state sector is not only cutting drastically its tax payments, but leads to increased social
costs (unemployment benefits) . The shift of economic activity to a less extensively
taxed and taxable private sector means not only a sub-optimal allocation of resources,
but it is one of the major source of budgetary imbalances . The tax evasion costs about
150-200 billion forint revenue loss a year in Hungary . The estimated share of black
economy is about 1/3 of GDP in Poland and Hungary, and 12% in the Czech Republic .
The crisis have had contradictory effects on balances of trade and payments . As
shown before, the trade liberalizations (first 1989-90 opening, then EU associations)
and the requirements of transformation and modernization have lead to the rapid in-
crease of import, which have only been partly and transitorily compensated by export
successes of CEEcs. The balance of payments have been improved by capital inflows
(mostly Hungary, the Czech Republic and Poland) . Since the end of 1992, the external
balances of most of the countries seem to have been deteriorating, and the indebtedness
of some of the countries may worsen again . The process may aggravate as the liberalization
committments under Europe Agreements come into force for the associated CEEcs in
1995. To defend their balance of payments, most countries have to introduce transitory
import restrictions (import surtaxes, increased tariffs) or devaluations .
The main question mark about trade deficits is, how far they are due to structural
weaknesses or results of modernization . The modernization deficits could be transi-
tory (results of import needs of restructuring investments or simply that of FDIs), and as
the export capacities are built (and the local value added increased), the trade balances
may improve. If this is not the case, then deficits lead to further aggravation of indebted-
ness .
The prospects of a long-term stabilization even for CEEcs is open for questions .
Poland, with its rapid growth rate, may achieve the pre-1989 level in 1996-97 . For
Hungary, if the moderate growth prevails (2-3%), this could take years beyond 2000 .
According to the WIFO (Austrian Economic Research Institute), till 2000, most of the
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CEEcs will be by about 15% above 1988 levels of GDP (Poland with 25%, but Hungary
just reaching), while Bulgaria and Romania will remain 25% bellow, and in Russia and
the Ukraine the production level will be only half of 1988 the levels (Figyelõ, July 6,
1995). Some prognozes are optimistic, some less, but it is clear that the prospects de-
pend on many internal and external facors . As the WIIW 1995 Report noted, "there are
no tigers in the Central and Eastern European cage ." The prospect of a 10% inflation and
a 6% growth of GDP is, however, a realistic medium-term possibility for stabilizing CEcs
(Finance Ministry of Hungary, Világggazdaság, September 28,1993) . The Czech Republic
did already meet that expectation in 1995, others can meet it only later . After long
recesssion, according to Anatoly Chubais, former deputy prime minister and architect of
market reforms, the growth of Russian economy may reach an annual growth of 10-12%,
after 1997 . But the full catching up of CEE may take a long time . According to the Rhein
Westfalische Wirtschaft Institute in Essen, for the CEEcs, it may take about 50 years to
reach the level of EU (Handelsblatt, Világgazdaság, August 1, 1995) .
The stabilization is crucial from points of view of joining Euro-Atlantic institutions
of integration. Although, the Maastricht convergence criteria have not been directly
set as conditions of joining EU by the CEEcs, but it is clear, that they have to take them
into account . In fact, it is their national interest to rnake maximal efforts to converge
with the EU economies notwithstanding what the realistic prospects of early joining
are. The meeting of Maastricht convergence criteria might be subject for competing for
accession among the CEcs into EU. The official Czech arguments claim that the coun-
try is well prepared for EU membership on those grounds (even more well prepared
than the present members) . According to the 2000 package, Poland would reduce its
inflation to 5%, the budget deficit to 1 .5% and unemployment below 10% .
In terms of budgetary balances and public debt, most of the CEE countries fare
not badly, and they have good chances (sometimes better chances and positions than
the present members) to meet the Maastricht criteria . Inflation is, however, another
question. R. Dornbusch and S . Fischer speak about a "moderate inflation," which should
be between 12-18%, and can be seen as a sustainable and tolerable level, which the
countries can live with (The World Bank Economic Review, 1993, No . 1, p . 1-44). Most of
the CEE candidates fall already into this category and some (Czech Republic, Slovakia
and Slovenia) managed to bring inflation bellow 10% already by the mid-1990s . The
prospects of around 10% inflation are not irrealistic indeed, as the stabilization and
transformation programs are completed in the near future . According to Nomura Re-
search Institute, the average inflation of CEFTA countries (Slovenia included) will slow
down from 21 .9% to 18.7% from 1995 to 1996 (Világgazadaság, January 18, 1996). Of
course, these countries have a long way to go to achieve the level of inflation required
by Maastricht or the "desirable level of inflation," which can be set around 2-3% . Taking
into account the about 10-15 years of transition period, which the future CEE members
probably could enjoy, the elimination of inflation in these countries is not irrealistic. Of
course, it depends on many factors, it would require a fundamental adjustment and a
structural modernization .
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The Hungarian experience
B. Structural modernization
The CEE countries missed the technological revolution of 1970s (renewal of produc-
tion bases, rapid innovation, computerization of organization, management and admin-
istration, revolution of infrastucture, particularly telecommunication and transport, etc .)
and face the tremendous problems and costs of reparation of damages caused by former
negligent policies toward environment .
The systemic deficiencies (lack of interest in innovation and technological modern-
ization) have been aggraveted by harsh restrictive policies and the gradual reduction of
investment ratios since the end of 1970s . The share of investments in GDP was about
30% (with worsening ICOR already since the 1960s), which gradually fell below 20%
to early 1990s (in 1991 it was 19% and in 1992 17-18%) in Hungary . Although, it
corresponded to the level of industrial countries, it is insufficient in the light of mod-
ernization needs .
Structurally a complex duality characterizes the CEE economies (very similar to the
DCs) :
- developed and underdeveloped sectors and regions in terms of effiency and
competitivity ;
- high technologies used in certain fields, while outdated technologies with outworn
capacities in others ;
- the contrast of the dynamic private and sluggish state sectors, illegal and "black"
(second and third) economies .
The main problems and directions of structural modernization are :
1 . The replacement and renewal of production capacities and technologies .
2. Reduction of the relatively high energy and material intensivity of production and
the restructuring of economy accordingly .
3 . Modernization of outdated infrastructures, on micro and macro-economic levels
as well .
4. Basic institutional reform of the public services sectors (health, education and
social systems). This is an important part of the marketization programs .
5. Restoration of the environment, which has been polluted beyond the expectations
and previous estimates . (Some believe that this is as important as the whole complex of
structural modernization .)
The Copenhagen criteria for CEE candidates sets that they have to "meet competi-
tion" on the European market. Structural modernization is a basic pre-condition of that .
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Tibor Palánkai
C. Role of foreign capital investments in modernization
1. The main characteristics of joint venture developments
and foreign investments in CEE
The joint ventures and foreign investments play startegic role in integration of CEE
into the global world economy . Therefore, their development, which have been un-
folding since the end of 1980s, tells lot about their transformation and integration .
1 . Till the end of the 1980s, the interest of foreign capital was limited toward the
region, and an acceleration started only after 1989 . The big blue chip investors already
came to Hungary in 1989-90 . The investments have been concentrated mostly to
Budapest and Western Hungary (Figyelõ, August 18, 1994) . Foreign investments in
CEE grew from $2.3 billion to $56 billion between 1990 and 1996 . In Hungary, up to 1988
only 50 joint ventures had been set up, only with about $250 million capital . By the end
of 1996, the cumulative amount of direct capital invested in Hungary has exceeded $15
billion in more than 20,000 ventures . Between 1989 and 1996, about $12 billion, in Poland
and $7 billion in Czech Republic have been invested .
Volume of FDIs in CEE in 1992 and 1996
(million dollars)
Till 1992
	
At end of 1996
Hungary 3,300 15,200
Poland 1,500 12,300
Czech Republic 1,570 7,000
Slovenia 880 2,200
Slovakia 231 900
Croatia - 1,600
Romania 540 2,200
Bulgaria 330 600
Russia 2,850 6,500
Ukraine 480 1,000
Estonia 300 1,500*
Lituania 220 -
Latvia 180 -
Albania 62 262*
Total FDIs 11,000-12,610 56,000
in CIE;
China 21,300***
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STABILIZATION AND MODERNIZATION IN CEE
The Hungarian experience
*Baltic States together.
**By the end of 1994 .
***Till the end of 1993 .
Sources: UN, EEC, 1993, Geneva . Business Eastern Europe -Világgazdaság, February 16,
1994. Estimates of WIIW. World Investment Report, 1993, UN, New York, 1993 . East-
West Investments and Joint Ventures News, UN ECE, Geneva, 1989-93 . Világgazdaság,
April 4,1995 .
In some other countries, the investments have caught up only after 1990-1991, or
some of the troubled regions have attracted only limited interest so far (Southern Eu-
rope or some former Soviet republics) .
2. The volume of the capital invested in CEE has remained marginal compared with
other regions of global economy . Until 1992, from the $1,900 billion global FDIs only
about $8 billion (with former SU about 12 billion, i .e . 0 .4% - 0.6%) had come to the CEE
region (about 80% goes to OECD) and they are far behind some of the NICs . Some big
investor countries, like Japan, are still mostly uninterested and reluctant to come . At the
same time, in early 1990s, while the share of Hungary in international flows was I%, its
share in world trade was only 0 .2%. In per capita terms, Hungary was one of the first
countries in the world (equal to Malaysia) .
According to the Institute for International Economics in Washington DC, the for-
eign capital, which would be needed to raise the amount of productive capital per worker
in CEE and former SU to that of the West within ten years, would be about $1 .5 trillion
a year. The most favourable assumption is $90 billion and the "best guess" is $55 billion
a year (The Economist, July 6, 1991) . So far only half of that has been invested, and in
five years .
3. The role of foreign companies in the national economies is still far from the
proportions characteristic of (small) Western countries (25-40% in GDP) . For 1995, in
most of the countries this share in GDP was around only 1% (Bulgaria, Croatia, Po-
land, Romania and Slovakia) and it reached 5 .6% for Czech Republik and 5 .8% for Estonia
(EBRD; Népszabadság, April 14, 1997) . Even in Hungary, where the share of foreign
investments is the highest in the region, it was estimated about 12% in GDP and 24% of
employment in business sector by the end of 1995 . At the same time, 39% of value
added, 38% of investments and more than 70% of exports of Hungary fell to that sector
in 1996. The per capita value added of foreign owned companies was 67% above the
average (Népszabadság, February 1, 1997) .
4. Until recently, Central Europe (Hungary, Czech Republic and Poland) have been
the most favoured direction of investments . At end of 1996, these three countries have
absorbed about half of all foreign direct investments coming to the region . So far, Hungary
has been receiving about 1/3 of foreign investments in the whole CEE region, but this
trend is seemingly changing . Hungary was favoured by because of more advanced
legislation and banking system, and exemplary debt servicing .
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5 . The joint ventures are dominated in terms of number of entities, by German and
Austrian firms, but in terms of volume of invested capital, the American companies
have better positions . The German and the American are the number one investors .
In Hungary, in recent years, a specially balanced diversification of external eco-
nomic relations has emerged . "One third of direct investments coming to Hungary is
American, one third of credits is Japanese, and two thirds of foreign trade is conducted
with the states of EC and EFTA. That has a stabilizing effect on Hungarian economy"
(Figyelõ, March 17, 1994) . Although the Suzuki company has a major investment in
Hungary, the Japanese investors have been generally very cautious in CEE so far, but
this may change in the future . In Hungary, the "origin" of almost 1/4 of foreign investments
is unknown .
By 1995, in Hungary, France have become the third largest investor after Gemany
and USA, and about half of French investment to CEE have come to Hungary . The
French companies have invested in energy sector, infrastructure (highway construc-
tion) and pharmaceutical industry .
6. So far, the flows have had a "one way" character . Investments in the opposite
directions have remained marginal . There are only few CEE transnationals (Moscow
Narodny Bank, Hungarocamion, Tungsram, etc .) . There are, however, more than 1500
Hungarian joint ventures abroad with about $200 million investment . 70% has been
invested in the CEEcs . The average amount of invested capital per company is around
6 million forint ($50,000) .
7. The volume of the capital invested per company is marginal, particularly if we do
not take into account the few number of larger investments .
Although some large investments were implemented, the average foreign capital
per venture were only $300,000 in 1991-1992 in Hungary . In 1991, 37% of new ventures
was established only with a I million forint capital ($12,500) . Some of them were considered
as "shelll ventures" (for exploiting tariff preferences, tax regulations or for exporting
capital through profit repatriation etc .) . In CSFR, at the beginning of 1991, there were
1,600 companies with foreign participation . 3/4 with less than 1 million krone, and only 28
with more than 10 million krone . Substantial investments have only been made in 3
companies (Skoda-VW, BAZ Bratislava-VW and Skounion Teplice-Glareibel) .
On the other hand, large transnationals seek presence in the region . From the 50
largest industrial companies 35 have already invested in Hungary . The 100 leading
transnational companies of the world are represented in CEE in some forms .
8 . The capital flows have been concentrated on "green field" investments, and in
some periods and sectors there has been rather limited interest in privatization, particu-
larly as assets of state firms are growingly devaluated . Some critics claim that the cream
of the state sector has been rapidly skimmed by foreigners (tobacco, sugar, paper or beer
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The Hungarian experience
industries) and only the ailing sectors were left for the domestic incvestors . In Hungary,
between March of 1990 and October of 1993, the proportion of new investments was
more than 60% in the whole, and only 40% went to privatization . In Hungary, 1995 was
an exception, when from the more $4 billion only $1 .2 billion fell on direct investment,
and the remaining greater part went to privatization of the huge energy and telecommu-
nication companies. Alltogether, the share of green field investments and privatization
has been about 50-50% till the end of 1995 .
In the Czech Republic, the approximately $3 billion direct investment was accompa-
nied by the sarne amount of portfolio investment until the end of 1994 . The same propor-
tion was $8 billion to $800 million in the case of Hungary (Világgazdaság, August 9,
1995) .
9. Joint ventures and foreign capital investments concentrate on certain sectors (to
industry, but trade and services are also favoured targets). Larger scale investments are
limited only to certain fields (vehicles, consumer electronics, food processing, energy
etc .) . In Hungary, 35% of industrial investments went to food processing . The main
automobil manufacturers (GM, Suzuki, Ford, Audi, VW and Fiat) set up footholds in
the region . Between 1990 and 1995, about $4 billion has been invested into the automobile
industries of the region . According to the prognozes of the automobile industry, about
10% annual increase can be expected in terms of car sales in CEE till 2000 .
2. The macro-economic effects of FDIs
1 . Foreign investments and direct company contacts with Western partners can
promote technological progress and the transfer of modern technologies as well as
structural change. The technological and structural modernization could help to reap
enormous benefits once the market is adjusted . The FDIs tend to create improved and
more balanced economic structures . It was stated on invested American capital : "They
have introduced new technologies and contributed to the development of Hungarian
industry" (Világgazdaság, August 31, 1993) . The same applies to the company structures,
through investing in small and medium sized companies as well . There were examples,
when foreign investors were closing down formerly developed research (pharmaceuti-
cal companies), and there was a lack of transfer of technology .
2. In theory, foreign investments generate economic growth . In reality, this depends
on several factors . In this respect, the typical example of the contradictory role of FDls
is Hungary, which has attracted the largest amount of foreign investments, but it has
produced the lowest rate of growth in the Central European region . The slow Hungar-
ian growth follows from the special circumstances and economic policies (high debt
and the related restrictions), but the directions flow of external resources also count . In
case of privatisations, the inflow of capital simply buys property or concessions and
ends up on government accounts. Sometimes, substantial amount of capital is needed
for consolidation of the company or the monies did not flow to productive investments .
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According to the Hungarian National Bank, it is difficult to identify to what extent and in
what forms, the investments and the profits are recycled through informal channels .
"Only about 25-30% of foreign capital has flown into the exporting sectors . The ex-
pansion of the Hungarian economy was served mostly by green field investments in
vehicle and electronic component manufacturing and by privatised firms in machinary
and chemical industries . The new owners of privatised companies often maintained the
links to former domestic suppliers, while in case of green field investments, the role of
Hungarian contrators is still small" (Népszabadság, November 6, 1996) .
3. FDIs have positive effect on employment . Since 1989, the employment in Hungary
fell to 87% in general, but at the same time, the number of workers employed by joint
ventures increased continously . Part of joint ventures meant licensed work contracts
and were based on reserve capacities, when there were no investments, and in fact, the
work force was reduced .
4. The FDIs help to create a monetary stability through their positive effects on the
balance of payments . In Hungary, it is estimated, that the aproximately $3 billion deficit
of balance of payments was in 70% covered by foreign investments in recent years .
5. FDIs promote export, they are more export oriented, and seem to be less effected
by the collapse of CMEA trade . In 1992, the companies with foreign participation sell
roughly 40% of their products on foreign markets, while the corresponding share for
domestic companies was only 20% in Hungary . While the share of foreign companies
was 1/3 in industrial output and 1/5 in employment, they give about 1/2 of industrial
export of Hungary, in 1994 . In the case of Poland, foreign companies concentrate much
more on the domestic markets (Világgazdaság, August 9, 1995) .
The export generating and modernizing effects can be indirect . In Hungarian Suzuki,
share of Hungarian value added (components) increased from 35% to more than 50% till
the end of 1993 and with the 10% EC content, Suzuki easily meets the 60% "local content"
requirement of the association agreement. At the same time, in the Audi engines, which
are manufactured in Gyõr, Hungary, the Hungarian value added was only 6% in 1996 .
"So far the Hungarian manufacturing industry has not yet reached the technological
level upon which they can become suppliers of engine and component manufacturers
demanding extremely high material quality and precision" (Miklós Somai, Autóipar itthon
és a világban (Motor industry at home and in the world, VKI, Kihívások, No . 72, World
Economic Institute of Hungarian Academy of Sciences) .
There are some negative experiences and phenomena, when foreign investors were
cutting down the domestic production in order to eliminate the competition and the
export is marginal . Several companies have simply bought monopolistic market positions
(RFE/RI. Research Report, November 6, 1992) . About 1/3 of foreign investments went
to monopolistic sectors (construction, food processing, paper indsutry, and some
consumer goods). Once settled, foreign investors often press for protectionist mea-
sures .
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The Hungarian experìence
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Akos, B .P., A magyar gazdasági rendszerváltás finanszírozásáról (About financing the
Hungarian system change .), Aula, No . 2, 1992, p . 9 .
Aslund, A., Post-Communist economic revolution, How big a bang? Washington DC, 1992 .
Ellman, M ., Shock therapy in Russia : Failure or partial success? RFE/RL, Research Report .
No. 34 . 1992 .
Kádár, B ., Gazdaságpolitika válságban (Economic policy in Crisis), Külgazdaság, No . 8,
1993, p . 6 .
Kornai, J., Transformation recession, Közgazdasági Szemle, July-August, 1993, p . 577 .
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