The International Dimension of Transition Trade and Foreign Investment in Central and Eastern Europe

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The International Dimension of Transition Trade and Foreign Investment in Central and Eastern Europe - Tim Gould and Paolo Miurin

Introduction

In Europe, after World War II, foreign economic relations were determined more by politics than by economics. As Europe divided itself into two competing blocs, countries that had historically enjoyed strong reciprocal trading relations found themselves on different sides of the ideological divide and were forced to sever previous economic links. Trade was diverted by the communist central planners and later, albeit less dramatically, also by the architects of the European Economic Community. Since 1989 and the collapse of political barriers, there have been widespread expectations that 'natural' economic links would re-assert themselves. These expectations were strengthened by the conviction that the system of the Council of Mutual Economic Assistance (CMEA) - a system for inter-locking foreign economic relations of the Soviet Union and its satellites - would have to change. The direction of this change remained, however, unclear: on the one hand, CMEA members were keen to maintain at least some of the existing economic relationships, particularly if these could include energy supplies at prices below world market levels; on the other hand, they were worried by the political implications of maintaining 'socialist' economic ties. Poland, the CSFR and Hungary in particular looked with distaste at membership in any system that would imply formal Soviet or Russian influence over their affairs.

Hence the roots of the choice between 'big' integration into the world economy, including immediate moves towards currency convertibility and free trade, and 'small' integration through a re-elaboration -at least for a temporary period -of CMEA trade and payments arrangements. The ultimate aim of Central and Eastern European countries (CEEC) - if not necessarily of Russia which still had some hegemonic aspirations - was full participation in the global economy. The question remained whether a swift move in this direction was a sound decision in the short term, when these countries had to face the rude shock of the transition from plan to market. A sudden exposure to foreign competition might have exacerbated, instead of attenuated, the problems related to the structural adjustment of their economic systems.

This article aims to demonstrate that the choice made by some CEEC in favour of rapid trade and payments liberalisation was fundamentally sound, and that the problems in terms of external equilibrium that these countries are now facing as a result of this choice are only partially due to their incapacity to build up in time and manage efficiently an apparatus for internal macro-economic control. A certain timidity of the western partners in dismantling the protectionist components of their own systems, and a substantial insufficiency - in quantitative and qualitative terms - of western financial flows towards CEEC contributed significantly to these problems. Drawing lessons from the past, we will single out some policy measures that might in the future enhance the intensity and the utility of East-West trade and investment relations. In order to reach these conclusions, we will start by analysing possible post-CMEA trade arrangements and the reasons that led Central European countries (CEC) and the former constituent Republics of the Soviet Union (CIS) to make different choices in the organisation of their foreign economic relations (Section 2). We will then examine the economic consequences of these choices and the relative responsibilities of East and West for the present difficulties (Section 3). A minimal agenda for future initiatives to be taken by entrepreneurs and politicians in the East and in the West will be proposed in Section 4.

2. What after CMEA?

2.1 THE END OF CMEA

Prior to the end of the 1980s, CEEC pursued policies of national self-reliance and trade aversion. This inwardly oriented strategy sought to spur industrialisation through policies that replaced imports, as far as possible, with domestically produced goods. Imports played the residual role of filling excess demand gaps for machinery, equipment and, to a lesser extent, consumer goods. Exports sufficient to pay for these imports were then identified without any reference to comparative advantages or price elasticities. Trade relations were controlled by sectoral Foreign Trade Organisations, which would arrange negotiations, terms, pricing and the handling of foreign currencies. Exporting firms had little or no control over the amount of goods to be sold abroad nor over their foreign currency earnings. In these circumstances, producers had few incentives to expand production of goods for which there was strong international demand and to sell in the international market.1

Arrangements under CMEA2 crystallised this model of inefficient trade and divided the foreign economic relations of CEEC into two blocks: 1) relations within the CMEA area, where trade took place in manufactured goods of poor quality, energy and raw materials - the latter two types of goods being provided essentially by the Soviet Union; 2) relations with the Western world where, on the import side, machinery and equipment, and, on the export side, raw materials, energy and semi-finished products were traded.

CMEA arrangements were facing a deep crisis well before their formal demise in 1991: Table 1 shows the intensity of the fall in trade flows among members in the years 1970-89. These arrangements, however, survived as long as the following three conditions prevailed; first, the Soviet Union extended a strong ideological and political influence on the area; second, the Soviet Union remained willing - as a counterpart - to supply other CEEC with unlimited quantities of energy and other inputs at prices well below world levels3; and third, it was possible for CEC to settle these imports and other reciprocal trade in non-convertible currency (transferable rubles). The first condition faded in Autumn 1989: the lack of reaction to the fall of the Berlin Wall indicated that the Soviet Union was not any longer willing or capable of imposing its hegemony on its close partners. The other two conditions disappeared in January 1991, when the decision was taken to move prices of traded goods gradually towards world market le.vels and to shift payments from transferable rubles to convertible currencies. This decision, imposed by Moscow, demonstrated that the Soviet Union, faced with internal difficulties and a growing mass of foreign debts, could not any longer bear the costs connected with the imposition of ideological leadership on its satellites. It also revealed the economic foundations of Soviet passivity vis-a-vis the Berlin events.

For CEC, trade of poor quality manufactured goods to be settled in convertible currencies became an economic nonsense. At the same time, there was little reason to concentrate purchases of energy and raw materials in the Soviet Union when, at world market and dollar prices, these goods could have been obtained from any other external source. These considerations led to the formal dismantling of CMEA during the last meeting of this organisation in Budapest, in June 1991.

2.2 NEW TRADE AND PAYMENTS PATTERNS FOR CEEC

The immediate consequences of the end of CMEA were a collapse of trade among CEEC and a serious contraction of the volume of industrial production. These developments led some (Eastern and Western) analysts and policy-makers to believe that a continued exposure of CEEC to world competition and dollar settlements could have devastating effects on their economic structures, well in excess of those deemed opportune in the framework of a normal - and long overdue - process of industrial restructuring. Even enterprises viable in the long term, after the completion of a more gradual adjustment process, would have been left in the short term without markets and in danger of premature and unjustified closure.

On the basis of these considerations, a discussion began on the opportunity of organising new CEEC trade and payments arrangements capable of softening the landing in the realm of free trade and currency convertibility. The debates concentrated on the creation of a privileged trade and payments area for CIS, to which the CEC could also be aggregated. The case for specific trade arrangements within the CIS was particularly strong: the geographical distribution of industrial activity created for the Soviet Union by the original planners under the direct influence of Stalin was economically insane and dictated only by political considerations. The purpose was that of preventing any constituent Republic from disposing of a relatively autonomous input-output structure; this was intended to discourage separatist temptations and forcibly keep the Union together. This structure was never corrected and, still at the end of the 1980s, for Republics other than Russia inter-republican trade accounted on average for more than 50% of GDP; for Russia this proportion was 18% (Bofinger and Gros 1992).

The extension of trade arrangements to CBC was also considered opportune: although trade among these countries and between these countries and the CIS had already been drastically reduced, a further contraction would have had cumulative effects and would have exacerbated the difficulties of economic transition.

The model that inspired the discussion about a Central and Eastern European Payments Union (CEEPU) was the European Payments Union (EPU), a multilateral clearing system for international payments which operated in Western Europe from July 1950 until December 195 8. EPU was successful in keeping high levels of trade in a period of acute dollar shortage, and in bringing participating countries smoothly to the external convertibility of their national currencies. When convertibility was declared (January 1959), EPU arrangements were wound up. Notwithstanding the important differences between post-war Western Europe and post-communist Central and Eastern Europe, arrangements of EPU type were considered a useful temporary device for countries in transition, where foreign exchange reserves are scarce and industry has to be deeply restructured before it can become competitive in international markets.

As soon as discussion started on a CEEPU, CBC called themselves out of the exercise and made an immediate choice in favour of trade liberalisation, integration in western markets and currency convertibility (Drabek 1992). Political reasons, connected with the desire to secure the irreversibility of transition, were not absent from this choice. The main arguments, however, were of an economic nature: trade liberalisation introduces from the outset strong competitive pressures into the economy and stimulates enterprises to restructure production towards the most viable and profitable sectors. This facilitates export growth and, making internal output more suitable to satisfy internal demand, contains imports. At the same time convertibility, based on stable and 'non-accommodating' exchange rates, introduces an immediate 'hard budget constraint' for the enterprises and forces them to cut wasteful use of resources and unnecessary imports; it also forces monetary and fiscal authorities to pursue sound macro-economic policies. Finally, liberal access to foreign currencies is an essential condition for attracting foreign investment. Acting coherently with this approach, CEC dismantled previous Foreign Trade Organisations which monopolised trade, lowered import duties and export taxes considerably, and abolished quantitative restrictions to trade. The most advanced tariff reductions took place in the CSFR and in Poland, where border protection became lower, more uniform and more transparent than that accorded by many OECD countries to their domestic producers in the late 1980s (Messerlin 1992).

Due to the closer economic integration of the former Soviet Republics, the idea of a payments union found more fertile ground in the CIS. Practical work on setting the foundations for a privileged trade area started in early 1992 and culminated in an agreement at the Minsk summit of CIS heads of state in January 1993. This agreement contemplated the creation of an 'Interstate Bank' which would have acted as a multilateral clearing institution using as unit of account the Russian ruble. Every transaction among participants would have been registered and cumulative balances settled every two weeks. Countries running a deficit within the system could have access to a credit line equivalent to one month of export receipts, after which payment would have to be made in rubles or in convertible currencies. Russia was granted fifty percent of the votes in the Bank's governing body, where decisions had to be taken with a three-quarters majority.

The major attraction of a payments union for the CIS was that, in the absence of convertibility, it represented the best way of maintaining trade flows. Gros and Steinherr (1995) estimated that the Interstate Bank would have made it easier to sustain a volume of trade of around 3% of CIS GDP, with the benefits mainly accruing to countries other than Russia. This would not have been sufficient to reverse the decline in output, but would certainly have reduced its severity. Operation of the system would also'have meant considerable savings of scarce foreign currency, whose use could have been concentrated on settling extra-union trade.

However, the fate of the Minsk Agreement turned out to be the same as so many other CIS documents; it was never implemented. The reasons for this failure are a combination of flaws in the design of the agreement and of broad political and economic factors.

A crucial and damaging decision was the one to use the Russian ruble as unit of account. Even strong advocates of the Bank's role had advised against this decision on economic grounds; Gros and Bofinger (1992) had warned that the ruble or any other republican currency would not be stable enough to provide international monetary functions in the former Soviet area. Secondly, there were legitimate doubts about the willingness and ability of the Russian government to support the Bank's operations. Russia, given the large trade surplus that it enjoyed with the rest of the CIS, had the least to gain in relative economic terms from the payments union. As guarantor of the system Russia was being asked to bear the costs of its establishment and functioning, yet the benefits of easier international payments would have been shared by all.

A third and related weakness was the inadequate credibility of sanctions for breaching the credit ceilings. Given the prospect of large Russian trade surpluses, this could have been a source of immediate tensions. Successful operation of the system rested upon the assumption that member states would value the medium term benefits of stable payments over the short term temptation to simply use up all available (Russian) credit. In the uncertain atmosphere of post-Soviet disintegration, this assumption was very fragile; combined with ineffective sanctions, this would have allowed Member States to 'free ride' on Russia's commitment to the preservation of the union.

Two further non-technical arguments were introduced against a post-Soviet payments union. The first argument was raised by some reformist figures who were worried that the introduction of the payments union would have prevented movements towards trade liberalisation and convertibility. There were concerns that an interim arrangement would become a permanent instrument for diverting trade towards the former Soviet area, which could hinder the long-term objective of integration into the world economy. The second argument was purely political: many of CIS, especially Ukraine and Moldova, were reluctant to participate in any initiative that risked to institutionalise Russian hegemony in the former Soviet area.

The comparison with the western European Payments Union (EPU) therefore loses some of its validity. This is not to say that a payments union for CIS would have been undesirable; on the contrary, a credible agreement to open trade according to the terms of a union would have encouraged restructuring while retaining the viable economic links within the system. The differences lie rather in the structural conditions of the two areas at the departure and in the long-term aims of the entire exercise. Post-war Europe consisted of countries with long-established market economies based on sound institutions and rules oflaw; EPU was part of a broader process of European integration, with the ultimate goal of an ever-closer reciprocal cooperation. In the CIS, conditions were the opposite: the legal framework and market institutions were weak or absent, and the dominant paradigm was that of disintegration.

The failure to establish a payments union should have left trade liberalisation and convertibility as the main options for CIS governments, but these avenues were not taken. These governments have retained a high level of interference in foreign trade and in foreign exchange transactions: import tariffs, export quotas and other quantitative restrictions were not eliminated and are still present; access to foreign currency for importers is subject to controls and exporters are required to sell on the foreign exchange market all or part of their export earnings.

Slow progress in economic and institutional reforms have stifled other attempts to restore trade amongst CIS countries. Various trade agreements have been signed, at multilateral and bilateral level. However, key products are often excluded from such agreements; operation of the 'free trade' accord between Ukraine and Russia has been plagued by a high number of such exclusions. A more ambitious initiative is the customs union of Russia, Belarus, Kazakstan and the Kyrgyz Republic, but there are reasons to doubt that this forms an optimal trading bloc since the relatively high external tariff envisaged for this customs union will inevitably have 'trade diversion' effects.

2.3 THE NEO-PROTECTJONIST WAVE IN CBC: ORIGINS AND END

The preceding analysis shows that CIS and CEC entered into economic transition with different attitudes towards future trade regimes. But while CIS remained largely faithful to a policy of bureaucratic controls, CEC introduced-in the course of the last eight years -substantial changes in their attitude toward trade liberalisation. The initial slashing of barriers in 1990-91 was followed, in 1992-93, by a wave ofneo-protectionism4, which was succeeded by a return to free trade policies from 1994 until the present. Political and economic considerations were at the base of the return to protectionism in 1992-93. Among the first, of paramount importance was the re-orientation of CEC societies towards some traditional communist values after the first painful effects of economic transition began to be felt. Even in countries like Hungary and the CSFR where the neo-communists did not achieve full control of political levers, there was a general tendency to lend a favourable ear to the requests for protection coming from the old industrial lobbies which had been hit hard by import competition.

Economic reasons for protectionism were essentially related to stabilisation and anti-inflationary concerns in CEC, which induced monetary authorities to keep relatively rigid foreign exchange rates after the initial strong devaluations of 1991-92 (IMF 1997). In the presence of stable or falling inflation, this policy implied a substantial real appreciation of the exchange rate, which hampered exports and stimulated imports. At the same time, the absence-in the early stages of transition -of adequate monetary and fiscal instruments of macro-economic control shifted the task of preventing excessive foreign competition and balance of payments crises onto trade restrictions. Fear of losing the sympathies of the EU, which in 1991-92 was elaborating plans for incorporating the CEC in a large European free trade area, was not a sufficient deterrent. In reality, the scope of these plans was limited (see later about Europe Agreements), while the strength of the lobbies of producers and bureaucrats was very vigorous.

This neo-protectionist wave ended in 1994, when most of the barriers erected in the previous three years were gradually dismantled. The seeds of political involution had lost strength; thanks to the improved capabilities in managing the macro-economy, foreign exchange policy became more elastic; EU trade plans, albeit still scarcely generous in terms of trade concessions, started to be interpreted in a more constructive way, i.e. as a temporary and necessary step in the long march towards full European integration. Trade and payments liberalisation moved up the agenda again.

3. Trade liberalisation and economic performance

Table 2 shows a strong correlation between exports and GDP growth. In CEC, export acceleration after 1993 generated conspicuous rates of economic recovery for the whole area, and especially for Poland. In the CIS, developments were less favourable but they still show a link between export and economic performance: GDP contraction was much less pronounced in countries in which exports fared better (the only exception was Russia, where a fall in GDP was associated with a high rate of growth of exports; this is explained by the peculiar type of goods that constitute the bulk of Russian sales abroad; energy sources and raw materials with which the country has large endowments and for which foreign demand was buoyant).

Turning to unemployment and inflation (Table 3), we observe that these variables developed more favourably in countries with higher export growth. In CEC, support to aggregate demand from sales abroad was crucial in keeping acceptable levels of productive capacity utilisation and in softening the task of entrepreneurs to adjust labour/output ratios. In turn, higher labour and plant utilisation was essential in supporting labour productivity, in containing unit labour costs and in impressing a downwards trend to unemployment and inflation. In CIS, on the contrary, where export growth has been slower than in CEC, we observe rates of unemployment which are still rising. This is the sign that bureaucratic controls on trade and insufficient integration in western markets have delayed industrial restructuring and the inevitable adjustments in labour/output ratios: unemployment in CIS will have to increase further before it can fall thanks to the achievement of optimal long-term economic structures. The burden of high unit costs, due to 'excessive' unemployment and to the survival of obsolete plants, in turn explains the structurally high levels of inflation in CIS. The recent downward trend reflects sounder monetary management more than real improvements in the economic potential of these countries.

Shifting the analysis from macro-economic variables to the current account of the balance of payments, the picture changes. Table 4 shows for the whole area of CEEC a deficit of considerable importance which, in the years 1994-97 has increased nearly 5 times. Imbalances, however, are more pronounced in CEC, where - compared to GDP -they have reached worrying proportions: 10% in the Slovakia, 6.1% in the Czech Republic, 4% in Poland and 3.5% in Hungary. In CIS countries other than Russia deficits are smaller and practically compensated by the Russian surplus.

The dynamics of imports provide the first explanation for these developments: due to liberalisation they rose more than exports in CEC5, while, thanks to the bureaucratic controls, they remained sluggish in the CIS. But, before we consider the different intensity of the deterioration of the current account of the balance of payments as the revenge of those who advocated a more gradual approach to trade liberalisation, we must analyse other important factors: 1) the trade policies adopted by CEEC' s trading partners; 2) the role of foreign direct investment; 3) the size and quality of financial flows towards CEEC coming from official and private foreign sources.

3.1 EUROPEAN UNION TRADE ARRANGEMENTS WITH CEC

For countries in transition, changes in trade policies leading to an increase in export potential would be of little value of the markets if their main partners remained closed. 'Gravity models' of trade suggest that the EU will be their principal market (Gros and Steinherr 1995). With the declared intent of facilitating CEC integration in this market, the EU negotiated with each of them in 1991-92 a series of Europe Agreements (EA), whose main purpose is the establishment - after 10 years from their signature - of a free trade area for merchandise. 6 In the interim period the EU extends the following concessions:

- agriculture: abolition of specific quantitative restrictions and inclusion of CEC exports into the normal 'import levies' system.

- industry: abolition of quantitative restrictions and gradual reduction of tariffs, with the exception of five 'sensitive sectors' (textiles, apparel, iron, steel, chemicals), for which a structure of quotas is maintained.

As counterpart to these concessions, the EA include: 1) a general 'safeguard clause' which allows EU member states to revoke liberalisation in case of "serious disturbances in any sector of their economies or difficulties which could bring about serious deterioration in the economic situation of a region"; 2) strong anti-dumping provisions; 3) strict 'rules of origin' which limit the above mentioned liberalisation to exports of goods manufactured with a high content of national or EU inputs (on average this content is equal to 60%, which limits inputs from non-EU sources to 40% of production).

These EA have been beneficial to CEC only in general terms: they have given formal support to the advocates of free trade in CEC and they have helped to generate confidence in the irreversibility of the transition process. But in practice they have not given CEC exports the boost that was expected and needed. Supplies of agricultural products were seriously hindered by the application of the infamous import levies system, up to the point of falling by 12.5% between 1991 and 1993. Exports of manufactured goods suffered from the fact that the most heavily protected goods (the 'sensitive' ones) accounted for up to 50% of global CEC exports. In total, between 1991 and 1993, CEC exports to the EU increased by 17%, while their imports from the EU increased by 26%.

These developments confirmed the impression, shared by many CEC and EU analysts immediately after the conclusion of the EA, that the EU gave a parsimonious welcome to its fellow Europeans from the East and that it remained very sensitive to any potential source of rapid import growth (Rollo and Smith 1993). In reality, as correctly observes Messerlin (1992), " ...t he EA may have aimed more at unifying EU trade policy vis-a-vis the CEC than at opening EU markets to CEC exports."

3.2 EUROPEAN UNION TRADE ARRANGEMENTS WITH CIS

In 1994-95 the EU and a number of CIS countries signed Partnership and Cooperation Agreements (PCA) which, in the domain of trade liberalisation, foresee the abolition in both areas of quantitative restrictions to imports and exports, with some exceptions for sensitive sectors. The PCAs, however, have failed so far to produce tangible results, essentially because of the slowness of CIS in implementing their liberalisation engagements, which prevents the EU from implementing its own trade concessions. The situation practically puts CIS trade with the EU in the same institutional conditions as those prevailing in CIS trade with the rest of the world.

3.3 REST OF THE WORLD TRADE POLICIES TOWARDS CEEC

Since the beginning of transition, trade policies of non-EU members of OECD have been based on the principle of non-discrimination: tariff levels are set according to the 'most favoured nation' status and many CEEC also benefit from the 'general system of preferences"7 Membership in the World Trade Organisation has been extended to nearly all CEC, while Russia's and other CIS countries' applications are under examination. "Nonetheless substantial barriers, particularly import quotas, remain for many CEEC's exports of sensitive goods, such as agricultural products, iron and steel, textile and apparel and footwear, all of which are goods in which the transition countries would reasonably be expected to have comparative advantages vis-a-vis the advanced economies. Transition countries' exports also continue to be affected by anti-dumping actions, which often in effect penalise firms that are most successful at exporting" (IMF 1997).

3.4 FOREIGN DIRECT INVESTMENT IN CEEC

The ability of transition countries to encourage private investment is the key to how fast they will come to stable paths of economic growth. In particular, foreign direct investment (FDI) has the potential to accelerate transition by bringing fresh capital along with new technologies and sound management techniques. A consistent inflow of FDI was one of the great expectations of CEEC when they took the road to radical economic reform. These expectations were frustrated: Table 4 shows that FDI in CEEC has remained very modest, both in absolute terms and as a percentage of total FDI outflows from the main industrial countries; this percentage is also slightly inferior to the proportion of transition countries' GDP to world GDP. Moreover, the distribution of FDI among these countries is highly irregular: pointing to the two extreme cases, we can see that Hungary, with a population ofless than 3% of the whole area, has attracted-between 1991 and 1996 - 30% of total FDI, while Russia, with nearly 40% of the population, has attracted only 15 % of total FDI. This means that on a per capita basis Hungary has enjoyed an amount of FDI nearly 35 times higher than that of Russia (Figure 1).

The reasons currently invoked to justify the fact that FDI remained below the expectations and needs of CEEC are mainly related to internal problems of these countries; political instability, poor legal framework, unreliable bureaucracy, uncertain currency convertibility regimes, and corporate governance based on insiders' control. These problems undoubtedly exist, but they must not distract attention from other distortions for which the Western world is responsible. Among these distortions, of paramount importance is the reluctance to remove protectionist barriers, especially in sectors in which CEEC could be most competitive. The prospect of having to face barriers

for exports obtained by shifting lines of production to CEEC is a strong disincentive for potential investors. This seriously damages not only the growth prospects of transition economies, but also the optimal trans-national allocation of resources. With their endowment of skilled and relatively cheap labour, CEEC are ideally suited for manufacturing intermediate-technology goods, part of which can be used to feed the still undernourished internal market, while the other part can be sold competitively abroad. For the EU in particular, times are ripe for a strategy based on a gradual transfer of intermediate production to the East and on a concentration of EU resources in new high-technology sectors. This strategy is not unknown nor impracticable: it was theorised by R. Vernon in 19668 and practised by the United States during the last thirty years.

3.5 FINANCIAL FLOWS TOWARDS CEEC

The complex machinery set up by Western countries at the start of transition for channeling financial flows towards CEEC was based on the following principles: 1) no "free lunch" of the type organised for post-World War II Europe by the Marshall Plan;9 2) shift of official flows from bilateral to multilateral institutions, whose structure was reinforced by the establishment, in April 1991, of the EBRD; 3) enhanced role of flows from private financial institutions which would lend at market rates; 4) creation of a small grant component for 'technical cooperation' with funds to be managed by the Commission of the EU. Actual financial flows between 1991 and 1996 behaved according to these principles: Table 6 shows that bilateral lending is gradually disappearing, that multilateral institutions are gradually increasing their role (albeit only partially compensating for the fall in official bilateral financing); that private sector lending is becoming the principal provider of funds and that a certain amount of grants has been conceded.

These flows, however, remain quantitatively insufficient and qualitatively flawed.

On the first aspect, the global amount of 160.9 billion US dollars represents, in relative terms, less than I 0% of the flows directed in the same period towards developing countries. Some experts have tried to estimate the net flow of resources theoretically required by CEEC countries in order to reach standards of quality comparable to those prevailing in Western economies. The results of these studies differ slightly, but they all show a sizable resource gap. One of these studies - referring to CIS alone - indicates net resource requirements of 50 billion US dollars per year in 1998-2001; the gap would then diminish and reach negligible proportions in 2005 (G iustiniani et al. 1992). Even with all the caveats that necessarily accompany exercises of this type, it appears evident that resource requirements of this magnitude cannot be met in to to by the Western community.

One factor that might help in squaring the circle is technical cooperation, i.e., grants aimed at improving human capital and institutional infrastructure. Initiatives of this type can increase endogenous capabilities in CEEC, enhance the marginal efficiency of other financial flows and, in the medium tenn, reduce the size of the resource gap. Unfortunately, as Table 6 shows, grants for technical assistance do not yet constitute a very consistent part of total financial flows towards CEEC. These figures also point to a second qualitative shortcoming; the scarce support provided to the development of new and efficient physical infrastructures. This is the consequence of having put the burden of finaJ?.cial intermediation in favour of CEEC mostly on the shoulders of the private sector, and of having created an international financial institution (the EBRO) which cannot dedicate more than 40% of its investments to physical infrastructure. The World Bank, the classical purveyor of infrastructure financing, invested in CEEC in 1991-96 only about 10 billion US dollars. Forcing the countries in transition -which have to absorb rapidly the principles and the rules of the market -to face private international investors directly and from the outset was not a wrong strategy; but it should have been clear that, without a substantial effort in favour of human capital and physical infrastructure from official multilateral sources, these countries would have been caught in a vicious circle: investors are discouraged by the lack of appropriate infrastructures, but the consequent low level of foreign financial flows prevents the economic progress needed for internal funding of these infrastructures (Miurin and Sommariva 1994).

The analysis conducted in this section has demonstrated that integration in western markets is the correct trade policy for the countries in transition. The serious balance of payments problems now faced by the countries which chose this policy are only partially due to the import surge that followed liberalisation and to delays in dealing decisively with the knot of industrial restructuring. The balance of payments problems can also be attributed to trade policies in the Western world-which were less generous than expected -and financial flows -which were quantitatively and qualitatively insufficient. In the next section we discuss the perspectives of East-West economic relations and we will propose some initiatives that might brighten these perspectives.

4. The future of East-West economic relations

When considering the prospects of East-West economic relations, it is first necessary to make a distinction between the CIS and the CEC. Without the prospect of membership or very close integration in the EU, the most promising policy for the CIS is to seek more intense and liberal trade relations with each other, in the framework of a more active participation in world trade. Membership in the World Trade Organisation would represent an important step forward by providing an anchor for sound transition policies and by facilitating access to international markets. A complementary approach is provided by the Partnership and Cooperation Agreements between individual CIS and the European Union. Although less ambitious than the Europe Agreements signed with CBC, they do contain a general commitment to future free trade. Relations between the CIS and the EU will also benefit from the progress in integration between the EU and CBC. By bringing the borders of the EU closer to the countries concerned, this progress will increase the interest of the EU in ensuring the security and prosperity of the whole region.

Important questions, however, remain about future patterns of trade and investment in CBC, particularly in view of the perceived implications for the EU of further market opening (linked or not to future membership). In the last years this area has been the subject of a variety of studies, whose conclusions differ widely about the potential dangers of increased competition from CEC for the mature and labour-intensive sectors still largely present in EU economies. The most recent studies, however, tend to converge towards a more serene assessment of these dangers. They are based on evidence that CEC are moving their industrial and export structure towards intermediate or higher technology sectors. This implies thatthe majority of trade between EU and CBC would be intra-industry trade, which tends to have fewer disruptive effects in terms of dislocation of economic activity than inter-industry trade (in which CBC would have clear advantages due to their lower labour costs). At the same time, in terms of increased competition on third markets (which also is a consequence of closer integration in the EU), the risks are considered minimal because EU exports are concentrated in high technology sectors, where price competitiveness is relatively unimportant. All this would make the distributional effects widely dispersed and not concentrated in specific regions or sectors, thereby reducing the social and political resistance to trade concessions.10

It has, however, to be noted that these perspectives rest upon two main assumptions, neither of which can be taken for granted. The first assumption is that, after the initial leap forward, the CBC can continue to ascend the technological ladder. Using various indicators of technology and skill availability, Halpern (1995) comes to the conclusion that in the medium term there are no clear prospects of rapid catch-up and that the competitive advantage of CEC will remain concentrated in labour-intensive sectors. The second assumption is that the price sensitivity of the EU's exports is low. A recent econometric study concerning the most advanced 14 members of the OECD demonstrates that relative prices do matter: the overall price elasticity of these countries' exports is such that an improvement in prices of 10% can lead to an increase of 2. 7 % in their share of world markets. Moreover, the same study shows that exports of some high technology industries (like electrical and non-electrical machinery) have price elasticities above the average (Carlin et al. 1998).

The risk then exists that, at least in the medium term, present EU members would have to face increased competition from CEC, both on internal and world markets. The challenge here is not to try and eliminate the risk by delaying the opening of the markets, but to adopt initiatives that can transform the risk into new opportunities for both areas. These initiatives should be founded on the revitalisation of the flows of FDI towards CEC. Foreign direct investment operations can in fact improve the technological content of CEC production and exports, and, in so doing, confer a real intra-industry character to reciprocal trade. At the same time, FDI allows EU enterprises to 'occupy' the standardised sectors and to attain in this way the double goal of controlling competition on home markets and of increasing competitiveness on third markets (Vernon 1966).

Such an increase in FDI implies moving from the 'spontaneous' approach, which has prevailed thus far, towards an organic strategy for investment in central Europe. This strategy requires fundamental changes in the behaviour of three main actors. The enterpreneurial class in the EU must widen the scope of its relations with CEC up to the point of encompassing, on equal footing, trade and industrial cooperation. Only in this way can the short term benefits of larger markets be combined with the long term benefits of an optimal allocation of resources on a truly European scale. The political classes in both East and West have to do their part in providing, respectively, an improved legal/ institutional framework and some specific financial incentives for FDI. The international financial institutions must concentrate their interventions in the areas where the market alone may not provide adequate resources. This means a new effort for financing physical infrastructure and technical assistance suitable to develop human resources. Only by complementing the efforts of the private sector, instead of duplicating them, can the international financial institutions play a vital role in the success of the transition process.

5. Conclusion

Even if investment is lagging behind, trade in Europe is gradually returning to 'natural' patterns after the collapse of communism. Those countries that have made the strongest progress in the transition to the market have also been those that have seen the most dramatic re-orientation of trade from East to West.

The question remains whether the international aspects of transition have been managed as well as they could have been. At least in the case of the CIS it is clear that numerous opportunities have been missed, in trade policy as elsewhere, to reduce the declines in output and welfare since 1991. The failure to create a mechanism for smooth international payments is one such example, but one that has been compounded by the incapacity to establish effective free trade arrangements and the unwillingness to part with the habits of state trading economies. In CEC, historically different industrial and commercial traditions, together with the encouragement provided by prospects of integration (leading to membership) in the EU, led to very liberal trade policies - more liberal than was expected by western analysts and in some cases also more liberal than would have suited countries in the initial stages of transition. The severe economic disruption that accompanied the start of transition in CEC was exacerbated by the radical way in which their markets were opened up.

It seems then that in both areas, CIS and CEC, the international aspects of transition could have been better managed, Without a doubt, however, the path chosen by CEC has produced better results. The shock of opening up to the world economy did not bring with it social unrest or political reversal, and exports now play an important role in supporting economic growth in CEC. These facts provide an important vindication of the choices made and a useful example to other economies in transition. They also constitute a challenge for the western world, which now has the responsibility to provide the sensible trade and investment policies that can accompany the further international integration of all these economies.

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