Transitional Success: USSR to EU
Transitional Success: USSR to EU
The Czech Republic
Transitional Success:
USSR to EU
Public finance policy issues during the political
economic transition from centrally planned socialist
economics to free market democratic capitalism.
V550 Dr. Mikesell
November 20, 1996
Rick Ferguson rfergus@indiana.edu
Eric Martin emartin@indiana.edu
Dmitri Maslitchenko dmitri@mailroom.com
Table of Contents
I. Introduction
II. Political Summary: Restructuring for Transition
III. Transition to Market Economy: 1990 - 1991
IV. Problems of Transitional Monetary Policy and the Financial Sector: An
Overview
V. Macro Economic Stability: 1993 - present
VI. Monetary Policy: 1993
VII. Intergovernmental Financial Relations
VIII. Budgetary Overview: 1993 - present
IX. Tax Reform
X. Current Political Economic Considerations: 1996
XI. The EU and NATO
XII. Conclusions
XIII. References
Introduction
In 1989, after nearly 40 years of Soviet control, Czechoslovakia once again
became an independent nation, the Czech and Slovak Federalist Republic.
This transition from Soviet socialism to democracy culminated throughout
Central and Eastern Europe with the literal collapse of the Berlin Wall in
East Germany, the heroic Gdansk Shipyard Strikes in Poland. The student and
worker protests in Prague and Budapest were no less important.
The Czechoslovakian revolution took place peacefully and over a much longer
period of time than events in other former Soviet Union or Warsaw Pact
nations. Hints of major reform in Czechoslovakia began as early as 1968.
Czechoslovakian officials, under Soviet power, moved incrementally to begin
the long road towards decentralization and independent Czechoslovakian
rule. Their increasingly effective efforts became known as the Prague
Spring, a time of growth, change and development.
Success was, of course, neither immediate nor easy to achieve. The Cold War
reached a pinnacle in the Eighties and the winds of change began to blow in
Central and Eastern Europe. The CEE nations endured many hardships. Soviet
oppression, though waning by this time, became largely unbearable. Change
in Czechoslovakia came from the ground up; dissidents quietly began to
return to popular power. The revolution gained momentum by 1989.
‘Revolutionists’ began to demand sweeping economic and political reform.
They were backed by well organized and very timely strikes and protests.
After a two hour general strike on November 27, 1989, proving the immediate
and widespread power and cohesion of the revolution, the Soviet controlled
authorities finally agreed to negotiate.
Through the negotiation process and threat of further massive general
strikes, former dissidents assumed officially sanctioned ‘concessional’
positions. Within months, they gained near complete (and very real) control
of the Federal Assembly. On December 29, 1989, Mr. Havel, a very famous and
popular Czech dissident, became President of Czechoslovakia (renamed the
Czech and Slovak Federalist Republic).
This initial political victory represents only half of the nation’s
success. Within the first three years of self rule, harsh economic (and
subsequent political) realities forced the nation to divide once again. The
nation as a whole was unable to accommodate the vast discrepancies between
the western Czech and eastern Slovak regions. Massive economic reforms
brought this to the popular agenda as Slovakia suffered greatly while their
Czech counterparts seemed to benefit from reform.
The government in Prague wished to move swiftly to further reform efforts.
Slovakia hindered Czech success and in turn suffered greatly by this Czech-
led reform. Slovakia simply could not move as rapidly toward a market
economy due to the economic configuration left to them by years of Soviet
planned economics.
Political Overview: Restructuring for Transition
In 1992, Vladimir Meciar, a very strong nationalist was elected prime
minister of the Slovak Republic, while Vaclav Klaus, a moderate federalist,
was elected in the Czech Republic. Unfortunately, these two leaders were
unable to agree on common economic and political strategies to govern the
CSFR. Klaus’s reform plans, now legendary, were simply inappropriate for
the fledgling Slovak regions. Slovakians felt alienated from the government
reform in Prague. Within a short time it was very clear that the Czech
regions could not completely support their Slovak countrymen through the
transition. The two leaders agreed to divide the Czech and Slovak
Federalist Republic (CSFR) into the Czech and Slovak Republics on January
1, 1993.
Federal assets and liabilities were split between the two nations in a two
to one ratio. The Czech Republic received the larger portions reflecting
both size and population. Again, the split was achieved peacefully, without
massive debate. The two countries agreed to form a customs union. They
implemented identical foreign policies with respect to third countries, and
forbid tariffs or ‘bans’ between themselves. They also formed a temporary
monetary union, which collapsed within months as both countries
unexpectedly experienced a massive drain on foreign reserves during this
time. To more fully understand the current developments in the Czech
Republic, one must examine the historical economic decisions made before
the break-up in 1993 as outlined below.
Transition to Market Economy Overview: 1990-1991
CSFR economic reformers went to work immediately following the collapse of
Soviet rule. The reform package included near complete liberalization of
prices, a complete reversal of former exchange and trade systems and an
impressive preparation for massive and rapid privatization. These efforts
were supported by financial policies including a “pegged” exchange rate,
currency devaluations, and restrictive fiscal, monetary and wage policies.
Monetary Policy
Although monetary policy is discussed in a separate section, it needs to be
briefly addressed here to understand the conditions in which the transition
occurred. Monetary policy in the initial stages of transition ensured that
inflation remained in control throughout currency devaluations and price
liberalizations. The CSFR devalued its currency by 20 percent in 1991 after
several smaller devaluations before hand. Taken as a whole, these
devaluations reduced the value of the currency by half within six months.
Generally, monetary policy remained tight throughout the entire period.
Fiscal Policy
Undoubtably, the goals of the CSFR economic reformers were to drastically
reduce government spending. The former centrally-planned, output-driven
economic policies were no longer effective for the new capitalist
democracy. Restructuring government expenditures was a key component of
reform. The main changes, aside from massive privatization discussed below,
forced reduced subsidies wherever possible. Every sector of society, with
the exception of health, welfare and education, saw an abrupt end to
government subsidies. In 1991 alone, for example, officials reduced
government spending by 12 percent to reach 47 percent of GDP. This trend
continued throughout the transition. Massive government spending, a
hallmark of socialism, ended virtually overnight.
Areas where government spending remained high would remain so throughout
the reform process. Health and welfare for poor, elderly, unemployed and
children is a very difficult situation in any government, especially one in
transition. Reformers focused primarily on industry and energy in the
initial stages, leaving the areas of greater uncertainty to be dealt with
in a more stable political environment.
Price Liberalization
As an almost immediate measure, subsidies to foodstuffs and energy were
reduced by nearly 50 percent. Retail prices for most household items
increased by nearly 25 percent literally overnight. By the end of 1991,
the Czech government controlled only 6 percent of prices in the country as
compared with 85 percent in early 1990. Only basic necessities, oil, and
agricultural products remained under state control. To offset some of these
shocks, wages increased, though only slightly and not nearly enough to meet
the increased cost of living. Politically powerful trade unions prevented
the passage of even more drastic reform measures. Plans in 1991 to increase
the price of electricity, heating oil and coal by nearly 400 percent and
rent by 300 percent were delayed until 1992 and 1993.
Foreign Trade and Investment
After an initial currency devaluation of nearly 50 percent, the government
adopted an adjusted exchange rate connected to a “basket” of convertible
hard currencies. Internal convertibility of hard currencies was established
in 1991. These two measures combined to foster trade and investment.
Initially, the CSFR set a 20 percent surcharge on imports coupled with a 5
percent tariff. These obstacles soon ended as major provisions were passed
to more actively encourage trade and investment. Initial steps toward
private property rights and the dissemination of publicly owned lands
further enhanced the investment environment.
Privatization
Privatization is by far the most critical and complicated development the
CSFR had to address. Speed was critical. The ‘default mechanism’ ensured
that current managers and persons of powers would assume control and create
their own joint venture agreements with foreign entities.
State firms that were nearly completely vertically integrated needed to be
desegregated by form and function. And the process had to be done well, for
flailing industries would simply increase state expenditures. Failures did
not decrease expenditures in compliance with the transitional reform
strategy. The CSFR privatization plan was threefold. Small-scale
privatization was the easiest. Retail stores, restaurants and small service
or industrial workshops were sold to the highest bidders in weekly public
auctions. Where no CSFR buyers were found, a second round of auctions
allowed foreigners to bid.
Property restitution was more difficult. The government needed to equitably
redistribute land that had been taken nearly 40 years earlier. This is a
difficult and involved issue. CSFR citizens are allowed to claim land taken
from them, though the burden of proof is on them. Where no proof exists,
special arrangements can be made for state assistance. In areas of
conflict, the issue will be brought to the courts. A large part of the
country was not in private hands before Soviet rule. Some of this land can
be used as an offering to parties where disputes over ownership exist.
Also, lands that have been improved (shops, developments, houses, etc.) are
sold at specially determined rates to the former property owners. Prices
and possible alternative compensation for those owners who do not wish to
purchase these ‘improvements’ are again settled by a special court
arrangement.
Large-scale privatization progressed swiftly. Some state-owned firms were
sold outright to private interests while others remained under indirect
state control until buyers were found, legal or economic concerns settled,
or parliamentary debate resolved.
Social Policy
The strong tradition of labor unions and their political strength proved
crucial to social security reforms throughout CEE. The CSFR was no
exception. Labor unions were instrumental in keeping CSFR unemployment at
very low levels and social safety net benefits quite high. Essentially the
state guaranteed incomes at a minimal level to meet the ‘cost of living’
for the unemployed or the under-employed. Pensioners and parents of
children received benefits adequately covering bare essentials. Further
benefits for health care were distributed at the local level as the health
system still remained under state control.
Problems of Transitional Monetary Policy and the Financial Sector
Since the introduction of reforms, monetary policy played a key role in the
economic stability of the Czech Republic throughout the transition.
Inflation remained surprisingly low (though relatively high in 1989 and
1990), exchange rates were relatively stable (after initial fluctuations),
and external reserves stayed strong throughout the period (spurred by
unusual and unexpected outside interest in the Czech Republic as the first
reformer to prove its success).
What is perhaps most impressive are the obstacles Czech officials overcame
in developing an effective monetary policy. First, the entire CMEA trading
block was virtually dismantled. Reform and transition would be difficult
even with stable trading partners. In the CMEA, all of the countries were
experimenting with and adjusting prices, exchange rates and policies. It
was very difficult to set monetary conditions correctly, in real or
absolute terms.
Second, within just a few short years, the CSFR itself broke apart for
economic and political reasons. This was largely unexpected and proved
difficult in the policy making arena. As the break-up drew near, officials
had a difficult time determining which policies should be enacted based
upon which of many scenarios might occur in the CSFR.
Third, after finally establishing the terms of the CSFR split and
negotiating a seemingly effective customs and monetary union between the
two new countries, the monetary union failed miserably. Within a few
months, the union caused significant drains on much needed foreign reserves
in both countries and had to be abandoned.
Finally, the Czech tax system had to be completely overhauled.
Additionally, the banking system needed massive reform. Large spreads in
interest rates were common and overall the banks were simply reluctant to
lend on any long term basis, a major impediment to domestic investment and
growth.
All of these massive changes occurred within just a few years. Throughout
these developments, monetary policy remained extremely tight. At the onset
of the reform period, it was at its tightest, with a minor break late in
1991, once the political economic dust had settled. Otherwise, the next
monetary reprieve didn’t occur until the second half of 1993. By 1994,
broad money grew at 30 percent compared with growth of 15 percent a year
earlier. More important than doubling growth figures is that the economy
was able to withstand this growth by 1994!
Interest rates were high throughout the period, and continue to remain high
by most western standards (over 9 percent). Interest rates were not
directly controlled but were subject to central bank reserve requirements
and discount rate announcements. Liquidity was further controlled through
regular auctions of treasury bills.
Bank reform focused primarily on establishing the legal framework for
transactions between the central bank and newly established commercial
banks. Weaknesses still remain in reporting and accounting and the
reluctancy for banks to lend. Several commercial banks have had to come
back under government control to prevent major economic problems.
Macro Economic Stability 1992 - present
By 1992, the CSFR began to show significant signs of success. Though they
were in fact more disadvantaged than many other countries in the CEE, they
fared well. Their export market consisted almost entirely of former members
of the Council for Mutual Economic Assistance (CMEA) who were in the same
transitional position as the CSFR, impeding efficient trade. Fortunately,
inflation on the whole in the CSFR remained remarkably low when compared to
the rest of the CMEA, as did external debt. Inflation did jump just before
the CSFR breakup into the Czech and Slovak Republics. Experts suggest this
occurred in part due to the fear of instability during the breakup and in
part due to an anticipated VAT. As expected, in 1993 (in the Czech
Republic), inflation rose again after introduction of the VAT.
In 1993, free from its less advantaged Slovak counterpart, the Czech
Republic better targeted its economic recovery plan. The plan encompassed
three main elements:
1) A balanced state budget that encompassed sweeping tax reform;
2) A tight monetary policy to reduce the inflation caused by VAT and other
lesser effects (which also improved its external position for trade and
investment); and
3) Moderate wage increases (adjusted to inflation) and a stable exchange
rate.
This reform policy was backed by an IMF “stand by” arrangement as a
precautionary measure. The IMF would assist if the Czech Republic needed
financial assistance. This happened once early in 1993 and Czech officials
repaid the loan before it came due (much to the delight of the IMF).
Unemployment remained remarkably low in the Czech Republic at 3 percent in
1993, while Poland’s figures (another major success story in CEE) still
remain in double digits. Low, virtually non-existent unemployment certainly
contributes to greater political and popular acceptance of the above fiscal
and monetary policies.
Many attribute a major setback in the Polish “Shock Therapy” reform efforts
to the political demands of the labor unions. The Polish President, Lech
Walesa, understood the need to keep wages low to implement the reform. But
he feared for his political power and caved in to labor pressures by
granting wage increases. By doing so he nearly destroyed the entire
economic reform process. He claimed that had he not, the entire political
reform process would have crumbled.
Czech officials didn’t face this obstacle as unemployment throughout the
transition remained low. The political reform process was slightly
segregated from the economic reform process. The small Czech population
(roughly 10 million) was easier to organize than Poland’s 40 million.
Regional differences were less and political factions less pronounced.
Regardless, by 1993, the Czech Republic had a very cohesive popular
political support base which facilitated the economic reforms.
By 1994, foreign trade increased substantially, with much of the growth
occurring between EU member nations. Tourism in Prague, now a “must see” on
any European vacation, contributed to increased trade to maintain a strong
balance of payments and a surplus in the current account. Though FDI by
1994 had decreased (after very high initial investments in 1992 and 1993),
the
capital account maintained high inputs due to the rise in borrowing of
Czech firms (which proved even better for Czech long term economic
success).
GDP began to rise slightly after a period of decline from 1991-1993 of
nearly 20 percent. Privatization entered its second round in 1994 for
enterprises being privatized through voucher programs. The first wave of
privatization is considered a remarkable success (a model to be used
farther east). As this first wave ended in 1993, the Prague stock exchange
began trading and the banking system went though increased and improved
reforms. The Czech Republic was a leader in the CEE in trade and
investment. Economic reform efforts, coupled with the above mentioned
political support, put the Czechs at the forefront of CEE success.
Industry
Industrial output by 1993 declined by nearly 21 percent compared with 1991
figures. This can partially be explained by increases in the service
sector, as investment soared in service sectors and dropped dramatically in
the industrial sector. Also, the industrial sector was the most inefficient
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