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Re-energising transition 25 years after the fall of the Berlin Wall

By Erik Berglof

© Creative Commons/Lear 21

Over the 25 years since the fall of the Berlin wall the economies of Central and Eastern Europe have undergone an amazing transformation. Yet one of the ultimate goals of transition – achieving the income levels of advanced market economies – remains elusive. In fact, the speed of income convergence towards the levels of the core EU economies has slowed down markedly since the 2008/09 financial crisis.

Throughout the 2000s, the average rate of growth of transition economies was comparable to the emerging markets average – a remarkable achievement taking into account that transition economies have quickly become richer than an average developing economy. In recent years though the growth rate dropped to barely half of other emerging markets, for the first time since the transition recession of the early 1990s, and on current projections this gap will persist.

In large parts the success of the 2000s was the result of the harvest of the low-hanging fruit of transition. The countries started the process with very low levels of total factor productivity as capital, labour and natural resources had been combined inefficiently within and across firms and sectors under central planning. As market forces drove the reallocation of these factors, the economies enjoyed fast growth. By the time the global financial crisis hit, the levels of total factor productivity in the region had converged to the levels of other emerging markets with comparable levels of income. Improving productivity further is far more challenging.

Emerging Europe, like many other emerging markets, has also benefited from an initial pool of relatively skilled yet underpaid labour. As wages rose, this advantage has been gradually eroded. Little or no growth has come from an increase of the labour force, and due to lack of investment the contribution from the improved quality of human capital has been small. Labour is still the most important asset of most of these countries, but they have to invest more in upgrading skills to stay internationally competitive.

Productivity improvements during the 2000s were also to a large extent underpinned by foreign direct investment (FDI), mainly from the core EU countries. It supported capital formation, the transfer of technology, improvements in corporate governance and growth. Since the 2008/09 crisis these FDI flows have weakened, and prospects of their return to pre-crisis levels look bleak given the challenges the core European economies are facing. Moreover, a significant part of domestic investment was financed by banks that relied on cross-border funding. This, too, has stopped, as parent banks have been deleveraging since the crisis.

On top of all this we now have the geopolitical uncertainty related to the crisis in Ukraine and sanctions against Russia. Apart from the immediate spill-over effects, this risks eroding the transition peace dividend by forcing governments to channel scarce budget resources to military spending, but also by distorting trade and investment. It will also raise the costs of energy supply as economies seek to diversify from strong dependence on Russian gas and redundance is built into the energy infrastructure.

What can countries do to re-energise transition? The good news is that a recent survey of over 16,000 firms in the region, the Business Environment and Enterprise Performance Survey by the EBRD and the World Bank, shows that in all economies, no matter how difficult the operating environment, one finds firms as productive as best comparators in advanced markets. The challenge is to help other firms adopt and adapt products and processes available on the global market, but they also need to innovate to move closer to the technological frontier. That way, productivity improvements within firms will add up to overall productivity growth.

There is no silver bullet here: it will take liberalising services sectors, opening up to new sources of FDI, investing in skills in partnership with private firms, improving economic institutions and leveraging competition between regions within states. Together, this will help the economies to undergo further structural transformation – and raise people’s incomes.

There is also scope for policies directly targeted at promoting innovation, but such policies must recognise that innovation is a very broad concept, particularly when applied to emerging markets.

Innovation in emerging markets is not only, or even primarily, about introducing products and processes which are new to the global market. More importantly, innovation in these countries is also about adopting and adapting existing products and processes to local conditions.

An examination of innovation policies by the countries in emerging Europe suggests that they are all very similar and very little has been done to reflect where most sectors in these countries are relative to the world technology frontier. To raise productivity growth these countries must not only adopt, but also adapt, the policy frameworks of advanced economies. Indeed, they need genuine innovation in policy instruments to accelerate economic convergence.

This sounds like a tough challenge – but, surely, not one beyond a people who pulled off the miracle of 1989.

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