Economic & static Project.

International Trade and Economic Growth in Post-Communist Central and Eastern Europe

ECON 479, Senior Seminar in Economics

Dr. Terry Olson

07/25/03

The break up of the Soviet Union and the collapse of the Communist rule presented the liberated or newly established independent states of Central and Eastern Europe (CEE) with a demanding challenge of establishing democratic institutions of political governance and transforming their centrally planned economic systems to market economies. On the economic front, different countries chose different strategies. Some adopted the “Washington Consensus” shock therapy reforms prescribed by the IMF and the World Bank, such as the prompt liberalization of prices and commercial transactions, privatization of large state owned enterprises, and establishment of effective bankruptcy laws (Aslund, 2001). Others chose a more gradual approach and implemented those reforms more slowly or chose other avenues of action (Kramer, 1999).

As a consequence, the countries in the region have produced examples of both economic success and economic failure. For example, according to the European Bank for Reconstruction and Development (EBRD), the size of the economy in Hungary increased by 2.5 percent annually from 1992 to 1998 while in Moldova it fell by 8.5 percent per year during the same period. Ukraine despite its proximity to Europe, large market, educated workforce, and a good balance of agriculture and industry saw a vast economic decline over the time period under consideration. Meanwhile, Poland, one of the most unstable countries economically in the 1980s, emerged as a regional economic power in the 1990s (Frye, 2002).

There are many relevant studies that try to explain these striking differences in terms of different domestic and international economic policy choices made by the countries in the region. With regards to exogenous possible influences, trade policy reform still remains one of the most important economic decisions that need to be accounted for and explained (Sachs and Warner, 1995). Indeed, it is one of the more frustrating, and yet intriguing endeavors in the field of economics to explain why, despite the near consensus that free trade benefits a country, trade barriers continue to persist. Central and Eastern Europe is a good case in point. As of 1999, only 57% of the 26 post-Communist countries rated by the EBRD achieved a liberalization ranking that indicated full liberalization of their trade and foreign exchange system, and only 27% reached the standards and performance norms of advanced industrial economies at any point between the period of 1991 to 1999 (Kennedy, 2002).

The primary goal of this study is therefore to test a possible relationship between a trade policy choice and economic growth rates in the countries of Central and Eastern Europe and the Baltic States over the last decade. The countries in the region are good cases to study, since they all made fundamental trade policy choices over the years after the fall of the Soviet rule and they have all experienced divergent paths of economic success.

The paper will proceed in five parts. Firstly, I will explore some theoretical implications of foreign economic policy, namely exports, imports and Foreign Direct investment (FDI) and political factors on the levels of economic growth in Eastern Europe and the Baltic states of the former Soviet Union. Secondly, I will define an econometric model and conceptualize the dependent and independent variables. Further, the model will be estimated using various econometric techniques in order to test the expectations set forth in the literature review. Finally, I will discuss the study’s findings and offer some conclusions.

Literature Review

In the context of transition to market economy, trade policy reform is one of the key areas to be accounted for. As Sachs and Warner (1995, p.2) point out:

The international opening of the economy is the sine qua non of the overall reform process. The liberalization not only establishes powerful direct linkages between the economy and the world system, but also effectively forces the government to take actions on the other parts of the reform program under the pressures of international competition. For these reasons, it is convenient and fairly accurate to gauge a country’s overall reform program according to the process of trade liberalization.

Many models of economic development suggest that poorer countries tend to grow more rapidly than richer countries, and thus the rich/poor gap should close over time (Frenkel and Romer, 1999). This is due to the fact that poorer countries can import capital and modern technologies from wealthier countries, reaping the “advantages of backwardness.” However, such a convergence has yet to appear globally. The gap between the theory and reality is easily explained by the fact that poorer countries have also tended to shun trade liberalization and remained closed to the world economy (Sachs and Warner, 1995). In the post-Communist world, where adoption of new technologies and management of ideas is essential for the restructuring of the state planned economy, trade takes especially important role in economic growth.

Exports and Economics Growth

In particular, export promotion may be one of the key strategies to foster the domestic economic improvement. According to Ram (1987) through an export oriented development strategy a country can raise its factor productivity and increase the rate of technological innovation. In addition, as the economy expands, the country tends to be integrated into international markets, which may increase its capacity utilization and gains from the economies of scale. The pressure of competition in the world market may also lead to better product quality by forcing the domestic industries to reduce inefficiencies.

As Aslund (2002) notes, however, in the case of post-communist transition in Central and Eastern Europe it was precisely the liberalization of the export sector that was controversial and more complicated than liberalization of imports. The latter was almost considered as a given:

Shortages prevailed in all socialist economies. Many products were not available at all, while others, notably cars and consumer electronics, were exorbitantly expensive. Therefore, the liberalization of imports enjoyed strong popular support. Furthermore, initially extremely low real exchange rates in the transition countries made all imports so expensive that price competition was out of question.

In fact, in a few cases, the International Monetary Fund (IMF), World Trade Organization (WTO), and the European Union (EU) had to encourage prospective Eastern European and Commonwealth of Independent States (CIS) members to raise their tariffs. The IMF viewed tariffs as means of raising revenues for the new regimes. The European Union required prospective members to raise their tariff rates to match those of the Union as a whole. WTO viewed some level of tariffs necessary so these countries are able to negotiate their lowering in the future.

The liberalization of imports, however, may not have a significant effect on economic growth in the long run. Indeed, Cernat and Vranceanu (2002) found no significant relationship between the level of protectionism on imports and economic growth rates in Central and Eastern Europe in the 1990’s. Such may be the case because the foreign direct investment (FDI) may have played a far more important role of fostering industrialization and capital development in the region than the process of import substitution, which has been well utilized by some Asian countries (Yaghmanain, 1994).

With respect to export liberalization, as mentioned above, the post-communist countries under analysis have performed very differently. As Aslund (2002) notes, a great divide erupted between East-Central Europe, including the Baltics, and the CIS countries. The latter continued to regulate exports heavily. The domestic prices of major export commodities - energy, metals, agricultural produce, chemicals, and lumber - stayed low but at the heavy expense to government and taxpayers. Social costs due to such regulation were further exacerbated by the inefficient production and corruption. Moreover, due to such inefficiencies and restrictions that they incurred from the European Union the CIS countries continued to trade primarily only amongst themselves and hence the market for their exported goods was relatively small and not expanding.

The East-Central European countries, on the other hand, were determined to “return to Europe” and to clearly break from the old socialist system (Kramer, 1999). As a result they promptly deregulated their exports and established stable exchange rates. Moreover, most of these countries became the prospective members of the European Union by concluding the accession agreements with the EU in the early 1990’s. These so called Europe Agreements provided for free trade in industrial goods within ten years, with the EU reducing protectionist measures faster than the East-Central European countries (Aslund, 2002). Such an expansion of market for their goods in Western Europe coupled with the fact that their currencies were still greatly depreciated, which made their exported goods cheaper abroad and imported goods more expensive at home, allowed the East-Central European countries to receive significant fiscal boost from their exports along with all other advantages stemming from the outward-oriented development strategy mentioned above (Fisher, Sahay, and Vegh, 1996).

Bearing in mind the fact that, as mentioned in the introduction, the post-communist countries of Central and Eastern Europe have enjoyed very divergent paths of economic success in the last decade of their transition and the information discussed above, the primary expectation of this study is that there should be a positive relationship between the amount of exports and economic growth rates in countries of Central and Eastern Europe and the CIS under analysis. The empirical results will show whether the findings of the similar studies about the experiences of other countries in different regions of the world hold in the case of the post-communist transition. For example, Balassa (1985) estimated a linear export equation for a sample of forty-three countries using the difference between actual and predicted exports as a measure of trade orientation and found a positive correlation between more outward-oriented trade policies and economic growth rates. Similarly, Feder (1983) has also found a positive correlation between exports and growth in developing countries.

Foreign Direct Investment and Economic Growth

Since the primary focus of this study is on economic growth as a function of external economic factors, another variable often cited in literature relevant to economic growth theory is Foreign Direct Investment. Here it serves as an alternative variable to the above considered export variable. Based on the series of studies compiled by Fabry and Zeghni (2001) and other analyses, it is reasonable to expect that FDI should have a positive effect on the growth of an economy. Such may be the case for several reasons.

Firstly, FDI is generally associated with transfer of technologies and know-how to the recipient country. In such way, Fabry (2001) argues, FDI upgrades the recipient country’s economy by creating better allocative and productive efficiencies. Secondly, FDI brings fresh investments to the recipient’s economy and thus stimulates it through the aggregate expenditures multiplier effect.

Some, however, note that in the short run FDI can also have a detrimental economic effect. It pulls away qualified workers from public state owned enterprises to the private ones by offering them higher benefits than the government can (Mickiewicz, Rodasevic, and Varblane, 2001). Such process may cause high levels of structural unemployment. Yet, others argue that such short-term costs are far outweighed by the long-term benefits that FDI brings to the recipient country by enhancing the privatization of exactly such inefficient state owned enterprises (Cernat and Vranceanu, 2002). The rough numerical figures of economic development and FDI inflow’s in Central and Eastern European countries show that such countries as Hungary, Czech Republic and Poland, which attracted almost 60% of FDI in the whole region also developed the fastest. Bearing this possible correlation in mind combined with the information discussed above, it is thus reasonable to expect that there should be a positive relationship between FDI inflows and economic growth rates in East-Central European countries under analysis.

Democracy and Growth

However, the ability of the transition country to implement market reforms, to attract FDI and hence foster the country’s long-term economic growth may greatly depend on the domestic political factors. With particular relevance to the post-Communist experience, Hellman (1998), for example, argues that the main obstacles to the market economy reforms in the transition countries may stem from the early winners, dominant group of elites, who benefit from the market distortions of the transition and try to block further reform at high social cost. These, so called rent seekers, benefit from high tariff walls, export licensing, and artificial exchange rates as well as from state subsidies and regulation rather than profit in competitive markets. Therefore, Hellman (1998) suggests that robust political competition and diverse governing coalitions are essential to prevent the early winners from taking control of the state and sidetracking further reform. In similar words, Aslund (2001, p.5) notes:

The political goal of market reform is to impose the interests of the majority on the small rent-seeking elite, which amounts to a transition from dictatorship to democracy. Conversely, the main drama of the post-Communist transformation has been a struggle between radical market reformers and rent seekers, and the containment of rent seeking has been the chief reform task.

It is thus reasonable to expect that there should be a positive relationship between the higher degree of democracy and economic growth rates in Central and Eastern European countries under analysis. Those political systems which provide avenues for pro-reform coalitions and other groups to gain power, allow competition among the elites and interest groups, and hence are more likely to prevent particular industries or groups from “capturing the state” and in this way implement the needed economic reforms such as deregulation of exports, privatization of large state owned enterprises, and liberalization of prices should be more likely to attract FDI and foster their long-term economic growth.

Methodology

Based on the literature review, the following regression model will be estimated and the Ordinary Least Squares (OLS) and other correcting statistical tests will be run to determine the significance and direction of relationships among the variables of the study:

The data period will comprise the years from 1993 to 1999 and will include the following sample of 21 post-communist countries making the total number of cases (N) 147:

Dependent Variable

GDPGROWTH will be measured as a percentage change of the real Gross Domestic Product in the countries under analysis. The data based on the report of the European Bank for Reconstruction and Development (2000) is obtained from Aslund (2002, p. 115).

Independent Variables

EXPORTS will be measured as the annual exports (in US dollars) from a given country divided by the real GDP of the respective country (in US dollars) for a given year. The ratio is then multiplied by one hundred in order to obtain percentage change figures from year to year. The data based on the United Nations Conference on Trade and Development World Investment Report (1999) and the European Commission (2000) report is obtained from Aslund (2002, p. 179).

LogFDI will be measured as a natural log of total Foreign Direct Investment in millions of dollars to countries under analysis. The data for this independent variable based on the figures published in the Transition Report of the European Bank for Reconstruction and Development (1999 and 2000) is obtained from Fabry and Zeghni (2001, p. 5).

DEMOCRACY is a measure of inclusiveness and accounts for a degree to which citizens in general and groups not represented in the legislature can freely voice their opinions about government policies. It also accounts for the degree to which the government powers are democratically determined by such factors as free and fair elections. The Freedom House Index will be used as a proxy for this variable. The index's score ranges from 1 to 6, with the lower score indicating a higher degree of civil liberties and democratic government and the higher score the lower degree of civil liberties and democratic government. The data for the countries under analysis for different years is available online at http://www. freedomhouse.org.

To control for unmeasured exogenous economic conditions, dummy variables for each year are included. Such inclusion is important because countries in the region were exposed to similar exogenous shocks from the international economy. However, to control for unmeasured factors specific to individual countries, such as institutional legacies and the composition of the economy the dummy variable for each country is also included. Including fixed-effect dummy variables reduces concerns for omitted variable bias and thereby gives greater confidence in the results.

Finally e accounts for an error term for variables that were not included in the model but can explain variance in the dependent variable. Examples of such variables are inflation, income per capita, unemployment, etc.

Expectations

As established by the literature review, the following results are expected:

1.