III. INITIAL CONDITIONS, ECONOMIC LIBERALIZATION AND PERFORMANCE 1 Explaining the Relationships
III.4 The Relative Importance of Policies and Initial Conditions
The performance equations also provide a rough indication of the relative importance of initial conditions versus policies. By construction, PRIN1 and PRIN2 have ranges and standard deviations that are three to four times larger than the range for LIB. With respect to the variance of growth, the regression results suggest that PRIN1 and PRIN2 separately exert a smaller effect on growth variance than reforms, but that their combined effect is comparable in size to the effects of reforms.21 In the inflation equation, the effect of PRIN1 is particularly strong and even dominates the effects of liberalization policies.
To derive more accurate estimates of the explanatory power of initial conditions relative to policies, special factors and interaction terms, we follow a methodology developed by Schmalansee (1985) which uses the adjusted R2 to set plausible bounds for the variance explained by different groups of coefficients. To calculate these
bounds, we estimate three models. The first is the full model, which includes as
regressors contemporaneous and lagged liberalization, interactive terms, initial
conditions, and regional tensions. The adjusted R2 shows the percent of total variance in performance explained by our full set of regressors. Next, we estimate the model, restricting the coefficients to zero for a set of factors. By subtracting the adjusted R2 from this regression from the adjusted R2 from the first regression, we compute a rough measure of the total variation explained by these factors. Finally, we estimate the model, restricting to zero the coefficients not in the given set. Its adjusted R2 provides a second crude measure of the amount of total variation explained by the included set of factors.
21 This is based on the properties of variances assuming the regressors are independent random variables.
The results of this procedure are presented in Table 7. We find that policies have the highest explanatory power among all sets of factors in the growth equations, accounting for 35 to 40 percent of the variation in growth that is explained by the model. Initial conditions are also important contributing 19 to 30 percent of the
explained variance and PRIN1 has a higher explanatory power than PRIN2. Interaction terms play a relatively less important role. In the inflation equation, initial conditions dominate with PRIN1 being especially important. Interaction terms come second with 22 to 25 percent of the explained variance in inflation.
We do the same exercise for policy as a dependent variable and find that political change has the highest explanatory power accounting for 38 to 90 percent of
the explained variance. PRIN2 may also be important; however the range of the estimate for its explanatory power is wide.
III.5 The Influence of Initial Conditions over Time
We next explore the time profile of the relationships between initial conditions, reforms and performance. As described above, we interact the two principal
components with the year dummies using the principal components in year 1 as control group. Results are presented as equations 6.6, 6.7 and 6.8. With respect to
liberalization (Eq. 6.8), the signs and the magnitudes of the coefficients suggest convergence over time; less developed transition economies and those with more severe macroeconomic distortions start slowly but gradually catch up. The evidence for convergence with respect to performance is less conclusive. PRIN1 continues to have a negative impact on growth throughout the period, but this impact is diminishing over time as the coefficients exhibit an increasing trend and tend towards zero. Only the coefficient for the interaction term in year 3 (PR1Y3) is not statistically significant.
The signs of the coefficients for PRIN2 are also negative throughout the period but their magnitudes do not exhibit any particular trend. Also, none of the coefficients is
statistically significant. The results for the inflation equation are similar. Countries with more severe initial macroeconomic distortions continue to suffer from higher inflation rates throughout the period, although the negative impact of PRIN1 is diminishing over time. The time profile of the coefficients for PRIN2 is less clear and none of the
coefficients is statistically significant.
As implied by our model, initial conditions have a direct effect on performance as well as an indirect one through their impact on policy choices. It is instructive to
compare the two effects and derive their evolution over time. The total effects are calculated by adding the direct effect of initial conditions on performance from
equations 6.6 and 6.7 and the indirect contemporaneous and lagged effects of initial conditions on performance through their effect on liberalization, obtained by multiplying the coefficients for PRIN1 and PRIN2 from equation 6.8 with the LIB and DLTALIB coefficients from Eq.6.6 and 6.7. The results are shown in Table 8 for Growth and Table 9 for Inflation. As the results indicate, adverse initial conditions continue to have a negative, although diminishing, impact on performance throughout the period.
Second, the direct effects are stronger in magnitude than the indirect effects operating through the liberalization channel for both PRIN1 and PRIN2. A third observation is that the effects of PRIN1 on performance exhibit a more pronounced trend than the effects of PRIN2.
The results shown in Table 6 can also be used to decompose the performance (growth and inflation) and reform paths22 of transition economies into components reflecting the influence of liberalization and initial conditions over time. We present results only for growth in Fig.3 using the average values for the FSU countries as illustration. The picture clearly shows the positive and growing impact of liberalization
22The decompositions of the reform path is based on the following equation: Lib=0.072+0.62Lib(-1) - 0.09Prin1+0.06Prin2+0.02PR1Y2+ 0.03PR1Y3+0.05PR1Y4+
0.10PR1Y5-0.02PR2Y2-0.03PR2Y3-and the diminishing negative impact of DLTALIB on growth. Convergence with respect to PRIN1 is illustrated by the decreasing distance between the PRIN1 line and the horizontal axis. It can also be seen that the positive effect of liberalization overtakes the negative impact of DLTALIB in year 2.
The decomposition of the reform path of transition economies, again using average values for FSU, is presented in Fig. 4. At early stages of transition, a lower level of past liberalization and higher initial macroeconomic distortions limit the extent of liberalization. Political change, however, at this stage is more dramatic and largely drives the policy choices. Over time, the effect of the accumulated stock of reforms, as measured by the lagged liberalization index, grows in importance simultaneously with a decreasing negative influence of initial macroeconomic distortions. The diminishing effects of initial conditions over time is shown by the convergence of PRIN1 and PRIN2 to the zero line.
Finally, an interesting question is whether these results continue to hold if using the contemporaneous sample 1989-96 for all transition economies. In essence, this sample is unbalanced with respect to the length of the pre- and post-reform periods for different sub-groups of countries. We find that our main results are supported by this dataset.
0.07PR2Y4-0.08PR2Y5+0.05 Freedom.
I V. CONCLUSIONS
Casual observation suggests that transition countries fall into three broad groups: the sharply-recovering countries of CEE; the slower-adjusting FSU countries;
and the East Asian countries which responded to reforms with accelerated growth rather than initial contraction. In this paper we depart from previous research that focussed on the relationship between policy and performance to analyze the sources of cross-country variation in both reform policy choices and economic performance. A special focus is given to the role of initial conditions, as well as to the role of political developments. We also include a variable to represent regional tensions
--noneconomic events such as wars and blockades that can have a major economic impact.
Countries may differ in many dimensions, but we find that most of the variation across 11 initial conditions can be summed up in their first two principal components.
The first can be interpreted as measuring macroeconomic imbalance and unfamiliarity with market processes (market distortions); the second represents the level of socialist development and its associated structural distortions (overindustrialization). Countries cluster into four broad groups. Those in the FSU all started from deep market
distortions, but the Slavic countries were far more developed than those in Central Asia, and had more serious structural distortions. Countries in CEE had lesser market distortions but, being relatively more developed, had severe structural distortions.
China and Vietnam, and to a lesser extent Albania, formed the final group of countries with lower structural and market distortions.
Linkage between initial conditions, policies and performance is then specified as an equation system and tested to ensure recursivity. Policy reform, which is
represented by economic liberalization, depends on initial conditions, political change and regional tensions. Economic performance, measured in terms of growth and inflation, depends on initial conditions, economic policies and regional tensions.
Cross-section equations suggest that initial conditions are indeed important, both for performance and the speed of economic liberalization; also that political reform, in particular, affects the speed of economic liberalization. Belarus and Uzbekistan offer examples of countries where political change and economic liberalization proceeded relatively slowly.
Comparing actual and predicted economic liberalization provides a new ranking of countries. Mongolia and the Kyrgyz Republic, for example, reformed more rapidly than would have been expected given their initial conditions; Bulgaria and Romania reformed more slowly. The Czech Republic, which is normally thought of as a very rapid reformer, is only average once its unusually favorable initial conditions are taken into account.
Moving to estimates using panel data, regressions confirm that adverse initial conditions are associated with slower economic liberalization. This may be because governments are reluctant to accept upfront costs of sharp reforms on top of the losses
they are experiencing from the dissolution of the old system. Indeed, very sharp
economic liberalization is associated with an output contraction, but this is a temporary phenomenon, as the effect is speedily offset by the positive cumulative effect of past liberalization efforts. As in other studies, the relationship between economic
liberalization and performance is highly non-linear over time.
The explanation that difficult conditions are associated with slow reforms
because they diminish the effectiveness of reforms is not supported by the regressions.
Unfavorable initial conditions discourage reforms but effectiveness of reforms is not reduced once they are implemented. Moreover, countries cannot avoid the costs of non-reform, especially if deeply embedded in a disintegrating economic and political system. Those fortunate enough to have exports that can be redirected to market economies -- such as Uzbekistan with its gold and wool -- can of course cushion a more gradual reform process more easily than the others. Having potential exports on the other hand, such as natural gas which cannot be exported due to problems of
accessing pipelines, may delay essential reforms and deteriorate performance;
Turkmenistan offers an example.
Regressions confirm the adverse effect of macroeconomic and structural distortions on performance. A typical country in CEE benefits over the first five years by some 5 percent per year relative to the Slavic states of the FSU; China and Vietnam benefit by some 14 percent per year from their more favorable initial conditions. A possible objection to this large estimate is that it includes a range of
factors not captured in the initial conditions but nevertheless important in differentiating East Asian from European experience. An out-of-sample estimate of the growth bonus for China and Vietnam, estimated using the sample of CEE and FSU countries only, still suggests a growth bonus of 7% per year. East Asian structural characteristics have been important, no matter how you look at them.
Nevertheless, applying the procedure due to Schmalensee (1985) shows that policy is still the most important factor determining growth differences between the 28 countries in the sample. Initial conditions dominate in the inflation equation. And political reform emerges as the most important single determinant of the speed and comprehensiveness of economic liberalization.
The final question addressed in the paper is whether the influence of the initial conditions on performance grows or diminishes in the course of transition. Results suggest that their influence diminishes, a conclusion that might be surprising in the light of cross-country growth regressions that show a persistent impact of variables such as location that are included in the initial conditions. Many of the conditions woven into the principal components are, however, themselves modified in the course of transition.
Monetary overhangs are dissipated through inflation; the industrial overhang is eroded as plants shut down, and market memory returns through experience.
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Figure 1. Ranking of Transition Economies by the First Two Principal Components
-3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5
-1.6 -1.1 -0.6 -0.1 0.4 0.9 1.4 1.9
PRIN2
PRIN1
Czech Rep
Slovak Rep Slovenia
Croatia Poland Hungary
Albania
China
Viet Nam
Bulgaria Romania
Russia Estonia
Latvia
Lithuania
Armenia
Belarus Ukraine
Georgia
Azerbaijan Moldova
Tajikistan
Kyrgyz Rep Kazakhstan Turkmenistan
Mongolia
Uzbekistan FYR Macedonia