SWP579 Economic Reform in Socialist Countries The Experiences of China, Hungary, Romania, and Yugoslavia Peter T. Knight WORLD BANK STAFF WORKING PAPERS Number 579 MANAGEMENT AND DEVELOPMENT SERIES Number 6 WORLD BANK STAFF WORKING PAPERS Number 579 MANAGEMENT AND DEVELOPMENT SERIES Number 6 z4 Economic Reform in Socialist Countries The Experiences of China, Hungary, Romania, and Yugoslavia Peter T. Knight . i JoinL LcLy The World Bank Washington, D.C., U.S.A. Copyright © 1983 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. First printing July 1983 All rights reserved Manufactured in the United States of America This is a working document published informally by the World Bank. To present the results of research with the least possible delay, the typescript has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. The publication is supplied at a token charge to defray part of the cost of manufacture and distribution. The views and interpretations in this document are those of the author(s) and should not be attributed to the World Bank, to its affiliated organizations, or to any individual acting on their behalf. Any maps used have been prepared solely for the convenience of the readers; the denominations used and the boundaries shown do not imply, on the part of the World Bank and its affiliates, any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries. The full range of World Bank publications is described in the Catalog of World Bank Publications; the continuing research program of the Bank is outlined in World Bank Research Program: Abstracts of Current Studies. Both booklets are updated annually; the most recent edition of each is available without charge from the Publications Distribution Unit of the Bank in Washington or from the European Office of the Bank, 66, avenue d'Iena, 75116 Paris, France. Peter T. Knight is a senior economist in the Country Policy Department of the World Bank. - Library of Congress Cataloging in Publication Data Knight1, Peter t. Economic reform in socialist countries. (World Bank staff -rorking papers ; no. 579. Manage- ment and development subseries ; no. 6) Bibliography: pO 1 China-Economic policy-1949- 20 Hungary-- Economic policy=1968- . 3. Romania--Economic policy. 4, Yugoslavia-Economic policy--1945- 5. Central planning-Communist countries-Case studies. I, Title. II, Series: World Bank staff wrorking papers no, 579O 1I1. Series: World Bank staff working papers, Management and development subseries ; no, 6. HC427.9,K48 1983 338.9'009171'7 83-14656 ISBN 0-8213-0229-9 ABSTRACT Since the early 1950s, most countries that adopted Soviet-style central planning have attempted to reform this system. Despite considerable differences among these countries in the timing, extent, and persistence of the reforms, certain commonalities stand out: the thrust of the reforms has been to decrease the role of centralized planning in physical terms and to increase the autonomy of enterprises or subnational entities (such as industrial associations and local governments) in determining investments, wages, hiring, input purchase, product mix, and the conduct of foreign trade; the economic authorities have relied primarily on the price system and financial mechanisms to guide enterprise decisionmaking; the reforms have linked the earnings of managers and workers more closely to enterprise and individual performance; and a constructive role for the private sector, especially in agriculture but also in small-scale service and industrial activities, has been recognized. At the same time that they have considered reform, however, the Soviet-style centrally planned economies have been remarkably resistant to change. With the exception of Yugoslavia, reforms originally proposed have been more comprehensive than those eventually approved, those implemented have fallen short of those eventually approved, and many already implemented reforms have been reversed. Experience suggests that the success of reform depends largely on the strength of political support, the comprehensiveness and internal consistency of the reforms, the length of time they are pursued without interruption, and the availability of some economic slack (for example, in the form of foreign exchange reserves, stocks of key materials, or access to foreign credit or aid) to help the country cope with the initial disruption and increase in imports that almost always occur when far-reaching changes are introduced. It is instructive to examine the model the reformers have been trying to change alongside the pressures for reform, principal loci of resistance, and issues in reform design. Useful case studies of reform implementation are provided by Romania, China, Hungary, and Yugoslavia since their current economic systems span the range of decentralization in the socialist countries. Topics of particular interest here are how the reforms affected ownership of the means of production, the locus of decisionmaking, price formation, incentives to workers and managers, and the degree of competition--interrelated factors important for reform success. ACKNOWLEDGMENTS The author gratefully acknowledges helpful comments on earlier drafts by Bela Balassa, Suman Bery, William Byrd, Armeane Choksi, Francis Colaco, Hazel Denton, Basil Kavalsky, Frederick Kilby, Mark Leiserson, Eugen Scanteie, Mary Shirley, Gabriel Siri, Borje Tallroth, Gene Tidrick and Adrian Wood. Papers in the Management and Development Series 10 Agarwala, Ramgopal0 Price Distortions and Growth in Developing Countries. World Bank Staff Working Paper no. 575. 2. Agarwala, Ramgopal0 Planning in Developing Countries: Lessons of Experience. World Bank Staff Working Paper no. 576. 3. Cochrane, Glynn0 Policies for Strengthening Local Government in Developing Countries0 World Bank Staff Working Paper no. 582. 4. Gordon, David0 Development Finance Companies, State and Privately Owned: A Review0 World Bank Staff Working Paper no0 578. 5. Gould, David J., and Jose A0 Amaro-Reyes0 The Effects of Corruption on Administrative Performance: Illustrations from Developing Countries0 World Bank Staff Working Paper no0 580O 6. Knight, Peter To Economic Reform in Socialist Countries: The Experiences of China, Hungary, Romania, and Yugoslavia0 World Bank Staff Working Paper no0 579. 7. Kubr, Milan, and John Wallace0 Successes and Failures in Meeting the Management Challenge: Strategies and Their Implementation0 World Bank Staff Working Paper no0 585. 8. Lethem, Francis Jo, and Lauren Cooper0 llanaging Project-Related Technical Assistance: The Lessons of Success. World Bank Staff Working Paper no0 586. 9. Ozgediz, Selcuk. Managing the Public Service in Developing Countries: Issues and Prospects0 World Bank Staff Working Paper no0 583. lOo Paul, Samuel0 Training for Public Administration and Management in Developing Countries: A Review0 World Bank Staff Working Paper no0 584. 11 Rondinelli, Dennis A0, John R0 Nellis, and Go Shabbir Cheema. Decentralization in Developing Countries: A Review of Recent Experience0 World Bank Staff Working Paper no0 5810 120 Shinohara, Miyohei, Toru Yanagihara, and Kwang Suk Kim0 The Japanese and Korean Experiences in Managing Development0 Ed0 Ramgopal Agarwala0 World Bank Staff Working Paper no0 574. 130 Shirley, Mary M. Managing State-Owned Enterprises0 World Bank Staff Working Paper no0 577. Foreword This study is one in a series of World Bank Staff Working Papers devoted to issues of development management. Prepared as background papers for the World Development Report 1983, they provide an in-depth treatment of the subjects dealt with in Part II of the Report. The thirteen papers cover topics ranging from comprehensive surveys of management issues in different types of public sector institutions (for example, state-owned enterprises, the public service, and local government agencies) to broad overviews of such subjects as planning, management training, technical assistance, corruption, and decentralization. The central concern underlying these papers is the search for greater efficiency in setting and pursuing development goals. The papers focus on the role of the state in this process, stress the importance of appropriate incentives, and assess the effectiveness of alternative institutional arrangements. They offer no general prescriptions, as the developing countries are too diverse--politically, culturally, and in economic resources-- to allow the definition of a single strategy. The papers draw extensively on the experiences of the World Bank and other international agencies. They were reviewed by a wide range of readership from developing and developed countries inside and outside the Bank. They were edited by Victoria Macintyre. Rhoda Blade-Charest, Banjonglak Duangrat, Jaunianne Fawkes, and Carlina Jones prepared the manuscripts for publication. I hope that these studies will be useful to practitioners and academicians of development management around the world. Pierre Landell-Mills Staff Director World Development Report 1983 Glossary BOAL Basic Organization of Associated Labor CIFER Community of Interest for Foreign Economic Relations (Yugoslavia) CMEA Council of Mutual Economic Assistance COAL Contractual Organization of Associated Labor (Yugoslavia) COI Community of Interest (Yugoslavia) ICOR Incremental Capital Output Ratio NEM New Economic Mechanism (Hungary) SOLW State Office for Labor and Wages (Hungary) VVB Associations of People-Owned Enterprises (East Germany) Table of Contents Page I. Introduction ...................................................... 1 II. Traditional Central Planning .. ...... .............................. 2 A. Ownership of the Means of Production ......................... 3 B. The Locus of Economic Decisionmaking .......................... 3 C. Price Formation ........... . . .................................. 4 D. Incentives to Producers . ... . ........... o.. .*. .... O.. ...4 E. Competition ........................................................ 5 III. An Overview of the Economic Reform Movement ....................... 6 A. Pressures for Reform - ..... ... ................................. 9 B. Resistance to Reform ......... . .. . . . .......... *so ..... .......... . 19 C. Reform Design ....................... ............................... 21 Policy Compared With Systemic Changes .........oo.oo ..... 21 Three Types of Decentralization o . ........23 Implementation Strategy ...... . .............. ... .... . .. . 24 IV. Implementation Experience ...... o.....ooo..... .... . . . ...... . . ... .26 A. Romania o.o..... o .o.o .o.o. o . ..o* o.... o ....oo .o..ooooo................26 The Locus of Decisionmaking .......o .... .... ..28 Price Formation..o. o. o .... ...o ..o ..o.ooo..o ...o.. . 34 Incentives ..o.o... .o.... oo.ooo.o.oo .... oo..o................38 Competition .....o..._ ........ ..o ..*..o............. oo ...o... 41 Conclusion s ... * ... ... ........... ......... .. .. ... 42 B. China ..oo..o.oo..o....o.oooo....o.....o...o.o....oo.o.....42 Ownership of the Means of Production . . . 45 The Locus of Decisionmaking and Incentives. . .....o .... 46 Price Formation ... o...... ..oo...o..o..o..o..o.o..o..o.o...........56 Competitiono..oo.... s o ..o.oo.............. * .o ..o.o.o .... o..... o60 Conclusions.. .o.. .. ... .. 61 C. Hungary ..... ..........0 - .00 .9.0- . ... - .... 0 .0 ................62 Ownership of the Means of Production ........ .... oo .... 66 The Locus of Decisionmakingo ....o ...... o.... o ..... ooo. .67 Price Formationo...oo..ooo ...................o ........ 70 Incentives ... o . .o...o.... -.. .- o- -..76. . ._,0 0 Competition . .o o . . .. .o o . o. . . . .o......... oo 78 viii - D. Yugoslavia0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 00 0 0 0 0 0 0 0 0 0 O 0 0 0 0o 0 .0 ...0 0 0 O O 0 0 0 0 o 82 Ownership of the Means of Productionoo0000000000000000000087 The Locus of Decisionmakingooo0000000 0000 0000000000 000000088 Price Formation0.0.0.00 00.000. 00 000. 0 0 00 0 0 00 0 0 0 0 0 0 0 0 00 0 000095 Incentives O O O O O O 0 0 0 0 0000000 0 ... 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 101 Competition .00000000000000000000000000000000000000000000 104 Conclusions o00000000000000000000000000000000000000000000105 VO Lessons of the Reform Experience to Date0oooooooooooo.oooooooooo-107 VIO Priority Areas for Researcho 000000-000 0 000 ... 00. .0..0.000000o000 14 Bibliography .o..ooo .....oo...o.ooo...oo.oooo...ooo.o.o ....oooo.o.117 Tables Table 1: Romania: Sources of State Centralized Investment Funds, 1969-80 0 000000000000000000000000000000000 033 Table 2: China: Gross Fixed Investment, 1977-82 o . o ..... o52 Table 3: China: State Capital Construction Investment, By Source of Finance, 1977-82 0000000oo00o0000o00o000o00o00o0 - 53 Table 4: China: Price Indexes, 1978-81 o.o.oo ...... ooooooo.ooo...58 Table 5: Hungary: Distribution of Enterprise-Initiated Investments in the Socialist Sector By Source of Funding, 1976-81 ooooooooooooo oooooooooooooo69 Table 6: Hungary: Investments Realized in the Socialist Sector as a Percentage of Annual Planned Investments, by Decisionmaking Power, 1970-81 ooo.oooooooooo.oooooooooooo71 Table 7: Yugoslavia: Investment in Fixed Assets by Source of Finance, Selected Years, 1952=80 ocoooooooooooo9 Table 8: Yugoslavia: Composition and Function of Self-Managed Organizations O O O O O O 0 O O O 0 0 o O O 0 0 O 0 O O O O O 0 0 0 0 0 0 0o91 I. Introduction After the Second World War, the newly established socialist states of Asia and Europe adopted, with few modifications, the system of centralized physical planning practiced in the Soviet Union. Attempts at reform of this system began in the 1950s and have continued since that time. By and large, they have stemmed from the perceived need to increase economic efficiency, except in Yugoslavia, where political considerations have been a primary cause of reform. The reforms vary from country to country in their timing, extent and persistence, but they also have certain elements in common. The role of centralized planning in physical terms has decreased, while the autonomy of enterprises or subnational entities (such as industrial associations and local governments) in determining investments, wages, hiring, input purchase, product mix and the conduct of foreign trade has increased. The economic authorities have relied on the price system and financial mechanisms to guide enterprise decision-making. The reforms have linked the earnings of managers and workers more closely to enterprise and individual performance, and they have provided a constructive role for the private sector, especially in agriculture but also in small-scale service and industrial activities. Existing alongside the reform movement in the Soviet-style cen- trally planned economies, however, has been a strong resistance to change. Implemented reforms have often been reversed. In view of the partial and shifting nature of the reforms in most countries--not to mention the exogenous -2- changes in the international economic environment and the limitations of the data available--it is hard to determine whether the reforms have indeed spurred economic efficiency. Nevertheless, the general movement toward change is quite clear, as this paper illustrates. The analysis begins with a brief description of the model that reformers have been trying to change, as a prelude to the discussion of the pressures for reform, the principal loci of resistance,, and the main issues in reform design0 The evidence for change comes primarily from the reform experience of China, Hungary, Romania, and Yugoslavia--all of which are members of the World Bank and the International Monetary Fund (IMF), and whose current economic systems are quite diverse, spanning the range of decentrali- zation found in socialist countries--and to a limited extent from that of Bulgaria, Czechoslovakia, the German Democratic Republic (GDR), Poland, and the USSR. Of particular interest are the various changes in ownership of the means of production, the locus of decisionmaking, price formation, incentives to workers and managers, and the degree of competition. In addition, some lessons from the reform of these countries are noted that may be relevant to future efforts at improving the efficiency both of socialist economies and state sectors of mixed economies. The discussion concludes by indicating some important areas for research0 II. Traditional Central Planning The following description of what may be called traditional central planning does not correspond perfectly to any particular national economic systemo Rather it refers to a simplified abstraction or model0 - 3- A. Ownership of the Means of Production In industry, all significant means of production are state owned. In agriculture, there are three types of ownership: cooperatives, which are the dominant form, and are under strict state control; state farms, which are owned and operated on the same principles as industrial enterprises; and private farms on individual household plots, assigned to, but not formally owned by the families which cultivate them. B. The Locus of Economic Decisionmaking Economic decisions on both macro- and microquestions of resource allocation are in the hands of the state authorities. The central plan specifies a large number of value aggregates and physical inputs and outputs in the economy; in this system money plays a passive accounting role. The structure of the plan is strictly hierarchical, so that the lower levels are formally subordinated to those above. Decisionmaking is concentrated near the top. Different levels in the hierarchy bargain over production assignments and the allocation of resources to carry them out. The plans are enforced by rationing the means of production--materials through administrative orders; labor via controls over the size (and sometimes distribution) of wage expendi- tures; and capital through the allocation of investment funds, construction materials, machinery, and equipment. In principle, households retain freedom of choice with regard to consumer goods and services on one hand and occupa- tion on the other; the result is a consumer goods market and a labor market in which state control is exercised by indirect means (price and wages policy). In practice rationing of goods and services and the administrative allocation of manpower are relied on frequently and in China are still routine practices. =4- C0 Price Formation Since capital is centrally allocated, investment funds are generally provided in the form of grantso Basic wages and salaries are regulated by fixed wage scales established for different categories of skill and effort. Prices for other goods and services are set administratively and changed now and then to facilitate plan elaboration and help monitor plan implementa- tion. Industrial producer prices are fixed on a branch-wide cost-plus basis, so as to enable most branches and enterprises to cover current (but not necessarily capital) costs and show a small profito Enterprises that cannot cover costs plus planned profit receive subsidies; those whose profits are higher than planned are taxed, as are most commoditieso Agricultural producer prices are fixed centrally, usually at low levels relative to the price of industrial inputs to agriculture (Marer 1982)o As a result, direct controls (compulsory delivery quotas) and sometimes coercion have been needed to obtain supplies. Consumer prices are supposedly set at market-clearing levels0 In practice, the retail price level is frequently lower and thus gives rise to persistent shortageso Relative retail prices often differ substantially from the structure of producer prices owing to the pervasive use of taxes, subsidies, and nonuniform planned profit rateso The exchange rate plays no significant role in domestic price formationo Foreign trade is carried out by special export-import firms, and domestic prices are separated from international prices by a plethora of taxes and subsidies0 Producing firms have no direct contact with foreign customers or suppliers. D. Incentives to Producers Although material incentives are widely used, they are limited by the extent to which policymakers are willing to tolerate personal income differentials. Piecework systems are frequently coupled with basic wages, and management bonuses are generally linked to the degree of fulfillment of obligatory plan targets, usually defined in physical or gross value terms. A multiple-tier price system in which prices are higher for above-quota deliveries may be used in agriculture. The reward and penalty system for managers leads them to be cautious about overfulfilling the plan by too large a margin, since production levels in one period will be the planners' basis for setting targets in the next period. This behavior of planners--combined with the signals provided by cost-plus pricing and the free availability of capital, material, and labor up to rationed levels--leads to predictable kinds of behavior among enterprise managers. Many managers, for example, pay insufficient attention to controlling cost, productivity, and quality; decide to produce output assortments unsuited to the needs of customers; attempt to hoard capital, materials, and labor; hide some reserve capacity from superiors; and exert strong pressure to obtain additional investment. There is little incentive to innovation. E. Competition In general enterprises interact "vertically" through their respec- tive hierarchies rather than "horizontally" through the market. Production and distribution enterprises tend to be large and many have regional or country-wide monopoly in their specified activities. Enterprises are seldom liquidated as a result of inefficient production. By and large, competition is limited to efforts at plan fulfillment and overfulfillment, except for a small (legal, semilegal, and illegal) private market for some goods and services. In the labor market, enterprises compete for workers; in part by offering nonwage benefits such as access to housing. - 6 - III. An Overview of the Economic Reform Movement In its home country and in the countries that adopted it, Soviet- style central planning produced significant achievements: the industrializa- tion of backward countries, the buildup of military power, survival in a hostile environment, victory in war; impressive improvements in standards of education, health, social and private consumption; full employment of labor; price stability; and the development of natural resources, science, and technology (Nuti 1981)o But the system has also had its drawbacks, as is well documented (Wiles 1962; Nove 1969; Kaser 197O)o One fundamental problem that has been cited is that "o-0the center is out of touch with popular wishes. 'Democratic centralism' is in theory the central execution of decisions democratically reached, but in practice turns into 'voluntarism', the arbitrary pursuit of the wishes of the leadership of the day, as each new leader reveals to have been the case with his predecessor" (Nuti 1981b, po 11)o The drawbacks of the Soviet-type model have been felt sooner and more deeply in the socialist countries of Eastern Europe than in the USSR itselfo Unlike Russia in 1917, these countries had already reached a higher level of economic development, social diversity, and growth of democratic institutions when they adopted traditional central planning. The first country to make fundamental changes in the traditional model was Yugoslavia, after its expulsion from the Cominform in 1948. The economic reforms begun in that country in 1950 were regarded by their designers as part of a broader attempt to build a selfmanaged socialist society distinctive from Soviet-type state socialism. The role of the state was to be gradually curtailed in favor of self-managed enterprises that would increasingly respond to market forces rather than state directives. Since - 7 - 1950 this process has continued, though not without fluctuations. In 1965, a major step in this direction put an end to central planning in Yugoslavia. Its socialist market system--which underwent another major change in the 1970s in an attempt to develop a form of planning compatible with the concept of self-management as well as extensive guidance by market forces--remains unique. At present Yugoslavia is again moving toward greater reliance on market forces to guide enterprise decisionmaking. In the rest of Eastern Europe and in China, economic reform has been basically an outgrowth of the quest for greater economic efficiency, although some reforms can be traced to broader movements of political change. Even the most radical "blueprint" for reform, that of Czechoslovakia in 1968, upheld the principle of central planning, which was to become more efficient and better adapted to economic needs through a regulated market mechanism (Brus 1980). Economic reform within the Soviet bloc appears to have come in three waves, during 1953-60, 1964-70, and from the late 1970s to the present. Since the first wave of reform was relatively weak, this paper concentrates on the latter two. At one stage or another, every East European country--the Soviet Union (1965) included--has announced the intention to proceed with decentrali- zation of economic decisionmaking and wider use of market instruments. But for various reasons, some of which will be discussed below, all but two countries, Yugoslavia and Hungary, turned back, (if not fully, at least basically) to the traditional model. Hungary introduced its New Economic Mechanism (NEM) in 1968. After some backsliding during the period 1972-78, Hungary renewed its reform thrust in 1979. Since 1968 Hungary has been the most market-oriented economy within the Council of Mutual Economic Assistance 8- (CMEA)o 1/ Although Romania's reforms have fit the general East European patterns since 1979 this country has clearly moved toward aligning domestic prices with world market prices which could facilitate Hungarian-style reforms in the future should the Romanian authorities decide to take this courseo China's system of central planning was created in the 1950s, and the central control resource allocation continued for the next two decades. Since the late 1950s, however, central planning (in the sense of a medium- to long- term plan) has been practiced only infrequently owing to the disruptions caused by the Great Leap Forward (1958-60) and the Cultural Revolution (1966- 76). A debate in the mid-1950s on the role of planning and the market led to a few experiments with the use of market forces to guide enterprise-level decisionmaking, but not to serious reforms. Some significant efforts at administrative decentralization were made between November 1957 and October 1958, but most of them were reversed by 1961 (Brus 1980; Solinger 1981)o No fundamental reform was attempted during the 1960s and early 1970s, though periodic moves away from centralization occurred. Since 1977 system reform has again become an issue of debate, but now criticism is directed at the performance of the economy, particularly the slow improvement in the general standard of living (despite high levels of investment) in the two decades fol- lowing the completion of the socialist transformation in the late 1950S, and the persistent poverty in some parts of the country (World Bank 1981a). Since 1979 China has experimented with market mechanisms and greater enterprise autonomy on a large scale in both agriculture and industry, and has given considerable attention to foreign experience, particularly that of Hungary. / The CMEA currently includes Bulgaria, Cuba1, Czechoslovakia, GDR, Hungary, Mongolia, Poland, Romania, the USSR, and Viet Namo -9- A. Pressures for Reform Traditional central planning was first applied in the USSR in the 1930s to achieve rapid industrialization and military power in a large but relatively backward country with ample supplies of unskilled labor and exten- sive natural resources. This economic system and the policies typically asso- ciated with it--taut planning for high growth, import-substituting industri- alization under virtually total protection, high rates of investment, full employment, price stability, and limitations on income inequality--were adopted by the East European countries and China in the late 1940s and early 1950s. High rates of investment were attained by holding down the level of consumption and squeezing the agricultural sector. The labor force expanded as more women and previously unemployed men began to work outside the home, and industrialization was rapid. In addition, foreign economic relations were reshaped, and income was redistributed in the direction of equality. Important social advances were registered in education and health. Among the East European countries, Czechoslovakia and the GDR were already relatively industrialized at the end of World War II and had rela- tively little surplus labor in agriculture which could be shifted to indus- try. Poland and Hungary were less industrialized, but still more advanced than Albania, Bulgaria, Romania, and Yugoslavia, which did have large under- utilized agricultural labor forces. Unlike the USSR, these countries were very small and lacked both the resource base and potential internal market for pursuing indiscriminate import-substituting industrialization. Hence, they were much more dependent on foreign trade than the USSR or China. In following the Soviet example, they met with serious economic problems, which first became evident first in the more developed countries of this bloc. - 10 - By the late 1950s and early 196Os, economic returns had obviously begun to diminish, particularly in the more industrialized countries, including the USSR' Falling growth rates and increasing incremental capital- output ratios (ICORs), chronic shortages of some producer and consumer goods accompanied by increasing stocks of unsalable manufactured goods, and poor agricultural performance were some of the outward manifestations of this economic malaise (Bornstein 1977; Wilczynski 1972; Gamarnikow 1974)o Following political de-Stalinization in 1956D economists began to perceive and express the need for economic reform. They cited economic ills such as overcentralization of decisionmaking, excessively detailed planning and rigid procedures in the allocation of materials, the lack of material inputs and incentives in agriculture, the suppression of local initiatives, unsound price structures and overambitious plan targetso The growing pressures from below to increase consumption eventually helped to ignite political explosions in Poland and Hungary in 1956 and underlay the first wave of economic reforms in Eastern Europe including the USSRo By the late 1950s , most of the East European economies were suffi- ciently industrialized to overcome absolute scarcities and move from the classic sellers- market to a limited buyers' market. Gamarnikow (1974) argues that at this point the inherent inadequacies of the arbitrarily directed command economy began to be felt in earnest. The most obvious symptom of inefficiency and wastefulness of traditional central planning was "the objectively unexplainable phenomenon of overproduction of unsalable and unwanted goods in the midst of still-prevailing scarcities" (Brus 1962, cited in Gamarnikow 1974 p0 165)o That phenomenon was a result of the transition from an era in which investment determined by the central planners dominated demands to one in which consumers began to affect. - 11 - Decentralization of economic decisionmaking was needed to make the transition, as the reformers saw it, from "extensive" to "intensive" economic development. Extensive development, they said, was based largely on quantita- tive increases in the factors of production, a drastic transformation of the economic structure, and reorientation of foreign trade to other centrally planned economies; "intensive" development depended more on qualitative factors such as technological change, organizational improvements, and better product quality--in general increased efficiency. This formulation was politically opportune. The reformers could argue for change without con- demning the traditional system (with which the Communist party leadership was intimately involved) by asserting that different conditions called for a different system of economic planning and management. Thus, the low rate of population growth would hold down the expansion of the labor force, the rate of growth of investment would have to be lower to accommodate the demand for better living standards, heavy investments in land would be required to bring into production the little unusual agricultural land remaining, and farm labor productivity would have to be improved before labor could be released from agriculture. Bornstein has summarized the call for reform well: More decisions should be made at lower levels in the hierar- chy, on technical-economic rather than political grounds. However, to be sound, such decentralized decisions must be guided by more rational prices and by more appropriate per- formance indicators. Product mix and product characteristics should respond more closely to consumer demand--for consumer goods as well as producer goods, and especially for exports. The coercion and ideological appeals used to mobilize resources in the extensive phase should yield to more emphasis on incen- tives to promote the efficient production of the correct out- puts. Finally, they advocated a new approach to foreign trade, recognizing its importance as a source of innovation in technology and products, as a means of competition to disci- pline highly concentrated domestic producers and as a way to obtain economies of scale beyond the capacity of the internal market. (Bornstein 1977, p. 105) 12 - An early attempt at reform came in Poland in 1956 following Gomulka's rise to power and considerable public debate on the drawbacks of central planning. The autonomy of enterprises and their managers was considerably increased; workers' councils formed spontaneously and were legalized, reinforcing initiative at the enterprise level; land was sub- stantially de-collectivized; and markets were somewhat reactivated. Already in 1958, however, recentralization was taking place (Nuti 1981a). In 1957, the Soviet Union, under Khruschev, abolished most of its industrial ministries--which were viewed as overcentralized agencies prone to autarkic tendencies--and set up 105 regional economic councils (sovnarkhozy), organized on the territorial principle, to which the larger industrial and building enterprises were directly subordinated (Nove 1969)o These new institutions were expected to be closer to local needs and more efficient than the abolished ministries5, 1/ but in practice they merely reproduced and enhanced at the regional level the problems of the centralized Soviet system (Nuti 1981b)o The power of the sovnarkhozy was steadily undercut by centralized authorities and their number reduced almost from the time they were established. They were abolished in 1965. Nove (1969, pO 73) provides an example of one kind of inefficiency: "For instance, there could be a workshop in Sverdlovsk which supplied factories of the Ministry of Heavy Machine Building in Minsk and Kiev, while other ministries had identical workshops in Minsk and Kiev, supplying, inter alia, these ministries' factories in Sverdlovsk. This produced numerous instances of unnecessary cross-hauls on the already overloaded railways. In other words, both horizontal and vertical integration was stimulated or limited by ministerial boundary lines, rather than by economic forces. The maintenance of separate supply offices in all the areas by every ministerial system caused much duplication and therefore waste." - 13 - The next period of reform began in the second half of the 1960s. Throughout the 1960s, the CMEA countries of Eastern Europe found some support for economic growth through increased trade with the USSR. This trade centered on a rapidly growing exchange of Soviet raw materials and energy for East European machinery and other manufactured products that frequently lacked the quality necessary to compete on the world market. Yugoslavia obtained similar support through increased trade and some aid from the West, while Albania obtained it from China. By the mid-1960s, however, the Soviet Union recognized that large increases in its exports of energy and raw materials in exchange for "soft" manufactures were no longer advantageous because domestic costs of extraction and transportation from Siberia had increased, and because detente provided new opportunities to export these products to the West in exchange for grain and technology not available in Eastern Europe (Marer 1982). In 1965, after Khruschev's fall, Kosygin abolished the sovnarkhozy and, endorsing the ideas of Yevsei Liberman (see Liberman 1962 in Nove and Nuti 1972), restored the industrial ministries. At the same time, this reform sought to increase the powers and functions of directors at the enterprise level. Many compulsory plan indicators were abolished, and the role of profits (or rather the rate of profit on capital) in the computation of managerial bonuses was enhanced. Subsequent history was one of virtually continuous retreat from the principles of the 1965 reforms (Nove 1981). East Germany had introduced a kind of sectoral administrative decentralization and vertical integration as early as 1958, but went considerably further in the late 1960s and early 1970s when it formed. Associations of People-Owned Enterprises (VVB) that managed, coordinated, and controlled the enterprises placed under them. In 1970, there were 80 to 90 - 14 - VVBs (Granick 1975)o Usually below the VVBs, but sometimes in their place, came another form of organization, called the combine (kombinat), a group of enterprises engaged in closely-related economic activities which, unlike the VVB, is an operating body rather than a purely administrative organ. The combines eventually absorbed many of the administrative functions of the enterprise, leaving them as purely production units, and at the same time displaced the VVBs. By the late 1970s most the VVBs had been dissolved and very large combines formed, generally linking 20=40 companies with combined labor forces of 5,000-70,000. In early 1980 there were 129 combines in industry, including construction (Cornelson 1981)o Each combine (or previously, VVB) is operated as a centrally planned economy in its own right, producing not only products for final use, but also most of its own components and intermediate products (Melzler 1981)o The East German model has been copied in part by other countries, notably Bulgaria, Poland, Romania, and the USSR, but its improvement over the Soviet-type system has been questioned: Instead of correcting the autarkic tendency of Soviet-type industrial Ministries, the East German model has pushed it to its extreme limits. The economic reform has given a measure of autonomy to enterprises within an industry, and by reducing the volume of interindustry transactions it has reduced the size of the informational and organizational problems of central planning. Since these problems increase with the square, or even the cube, of the size of the system, this reorganization has had some success in rationalizing produc- tion and normalizing supply, maintaining East German performance above average. This model, however, affords only a modest improvement on the Soviet-type system, in the special circumstances of a heavily industrialized, diversified and relatively small economy. (Nuti 1981b) Realization that competitive manufactures would be increasingly needed on the world market helped motivate Romania to - 15 - undertake partial decentralization in 1967 and Hungary to launch major reforms in 1968 that abolished the system of detailed physical planning from the center. These reforms relied on prices and some other indirect *'economic regulators" such as interest rates, exchange rates, taxes, and subsidies to guide enterprise behavior. Reform in Hungary--a small, resource-poor country which can ill-afford to ignore the benefits to be reaped from specialization and international trade--appears to have been a pragmatic rsponse to a complex of economic problems: frequent balance of trade deficits in the early 1960s, shortages of labor that could be transferred out of agriculture to industry, exhaustion of the possi- bility of increasing labor force participation ratios, mismatches between the structure of supply and demand (including the quality and variety of goods), excess demand for investment goods, rising capital- output ratios, slow growth in labor productivity, and a general lack of innovation and technical progress (Portes 1977). Above all, Hungary needed to improve the competitiveness on international markets of the industrial goods and processed agricultural products that account for some three-quarters of its total exports. To do so, it had to establish more direct contact between the producing enterprises and the foreign markets in order to speed up decisionmaking, the firms involved had to be able to implement their decisions rapidly with a minimum of bureau- cratic obstacles, and managers and workers needed stronger incentives to meet the demanding test of exporting without special subsidies. Meanwhile, the movement toward a decentalized, market- oriented, self-managed economic system in Yugoslavia generated serious criticism when economic growth slowed down in 1961 and 1962 and severe - 16 balance of payments difficulties arose in the following years. The object of major attack was the system of administrative controls on prices0 The "1965" Yugoslav reforms (which were actually introduced over the period 1964-67) were designed to: give greater autonomy to the enterprises and limit the role of the state and its planning agencies in the economy; correct long-standing distortions in relative prices and thus improve the pattern of output and investment; and, by a major devaluation and trade liberalization, integrate the economy more closely with the world economy and exert pressure on enterprises in Yugoslavia to increase their productive efficiency (Dubey 1975)o After these reforms, Yugoslavia increasingly used the market as the general and most efficient mechanism for resource allocation. A new concern in the early 1970s, however, was that enterprises and banks were acting without suf- ficient coordination and often with little regard for national economic and social objectives. Authorities became increasingly convinced that: ex post coordination through the market mechanism is inherently wasteful; a high degree of ex ante coordination or planning can assure a rational use of scarce resources and redress structural imbalances (such as regional inequalities); and planning and self-management can be reconciled. The 1974 constitution and subsequent reforms gave expres- sion to these concerns, accepting the market as a constituent element of the economic system, but in a more restricted form more consistent with the principles of socialism and self-management (Schrenk, Ardalan, and El Tatawy 1979)o By the late 1960s, then, most East European socialist countries had formally adopted some sort of program of economic reform, - 17 - the notable exception being Albania. Except in Yugoslavia and Hungary, the reforms did not lead to any fundamental change in traditional central planning and many of them were eventually diluted or reversed. The next decade, however, brought new pressures for change. When, in the 1970s, the annual increase of Soviet energy and raw material exports to Eastern Europe slowed, and the absolute volume began to stagnate, the terms of trade in these interchanges turned strongly against Eastern Europe--though with a lag generated by the CMEA pricing formula, which is based on a five-year moving average of world prices (Marer 1982). This development intensified the economic pressure on the East European CMEA countries. Even Romania, a major oil producer, had to import crude in 1970 as demand outstripped domestic supply. After 1976, the cost of imported crude exceeded by increasing amounts the value of refined product exports, adding further pressures, especially after the second international oil price shock. During these years the East European countries were helped by Western official and private credits in the West. But in 1981, Poland was forced to reschedule, followed by Romania in 1982, and by the end of 1982 Yugoslavia, Romania, and Hungary had all negotiated IMF standby agreements. Net lending to the Eastern European countries has now come to an almost complete halt, partly because of political reasons, while at the same time the depressed state of the world economy has made it difficult for them to further increase exports. As Marer (1982) notes, none of the mechanisms that supported the growth performances of the East European countries from the late 19409 until the late 1970s (for example, large increases in investment resources generated by squeezing - 18 - agriculture and consumption during the 1950s and later in countries such as Romania and Bulgaria; a special kind of economic integration with the USSR during the 1960s and well into the 1970s; and a large net inflow of resources from the West during the last decade) is likely to be avail- able during the 1980s Marer goes on to point out that: Servicing their large outstanding debt and financing a possible further deterioration in terms of trade with the USSR will require a net outflow of resources from Eastern Europe at least until the second half of the 1980s0 During this period, the external economic and political environment may well remain difficult for them in other ways also. Under the circumstances, the most readily available mechanisms these countries could tap to halt or reverse deteriorating economic performance would be to improve economic efficiency. That, however, will require comprehensive reforms of their centrally planned economic system. A common denominator in the economic pressures Eastern Europe faces is a critical shortage of convertible currencyo The root cause of this shortage is the insufficient competitive- ness of their manufactured products on the world market. This is partly a consequence of their earlier excessively paced industrialization, building up often inappropriate branches and products, and partly of the shortcomings of their centrally planned economic system which provides neither adequate incentive nor sufficient flexibility to enterprises to adjust to changing conditions on the world market on a timely basis0 High interest rates, the prolonged recession in the West, and other external disturbances are contributing factors but not the fundamental causes of the problem. The most immediately observable outcomes of the new situation are drastic reductions in growth rates (in some countries absolute declines), intensified pressures on the convertible currency balance of payments, and the birth of another (the third) economic reform wave0 Pressures for reforms have intensified, but so have the economic and political difficulties of carrying them out. (Marer 1982) Hungary, Poland, and to a lesser extent Romania, did initiate new reforms in the late 1970so In the post-Brezhnev period in the Soviet Union, meanwhile, a continued decline in economic growth rates--despite improving - 19 - terms of trade and continued high rates of investment (Pitzer 1982) 1/ --has led to renewed calls for economic reform. Yugoslavia, an oil importer, faces similar pressures to increase economic efficiency--which did not seem to improve with the reforms of the mid-1970s (World Bank 1983c)--and is currently strengthening the role of international prices, market forces, and financial discipline in guiding enterprise decisionmaking. China's current reforms, meanwhile, are being shaped by the strong pressure to increase consumption, by the recognition that future development must be based on more efficienct use of resources rather than on mobilization of resources as in the past, and by an awareness that maintaining growth and modernization are difficult to maintain in isolation from international technological development. The normalization of relations with most Western countries in the 1980s also offers China a much more favorable opportunity to increase its participation in international trade, but such participation requires a more flexible economic system (World Bank 1981a). B. Resistance to Reform 2/ For various reasons, all socialist countries have been resistant to reform, despite strong pressures for it. Some political leaders and ideo- 1/ This source gives the following average annual percentage growth rates for the five-year plan between 1950 and 1980: 1951-55 5.5 1956-60 5.9 1961-65 5.0 1966-70 5.2 1971-75 3.7 1976-80 2.7 2.! This section and the subsequent one on reform design draw heavily on Bornstein (1977). - 20 logues have argued that reliance on the market, capital and land charges, production for profit, and material incentives are incompatible with socialism. This view prevailed during the Cultural Revolution in China, for example. Others have feared that systemic reforms would mean loss of Party control over the main directions of the economy and that liberalization in the economic sphere might lead to demands for liberalization in the cultural, social, and even political spheres0 Such fears clearly prompted the Soviet invasion of Czechoslovakia in 1968, which effectively aborted one of the more comprehensive reform projectso Inflation, which could affect income distribution and popular atti- tudes toward the regime, and unemployment have been the most feared economic consequences, understandably so because centrally planned economies typically operate under conditions of repressed inflation and full employment0 Market forces merely add fuel to these fears since industrial organizations tend to be monopolistic or oligopolistic, and large and persistent balance of payments problems militate against introducing meaningful import competition (Marer 1982). Unemploymemt, it is feared, might arise or increase as a result of profit maximization, more autonomy in the use of wage funds, or the curtail- ment of budget subsidieso Curtailment of unprofitable production and greater freedom for managers to determine wages can lead to at least frictional and possibly structural unemployment, despite a national macroeconomic policy of full employmento This possibility has been a clear concern in Hungary. In Yugoslavia open unemployment is permitted and has increased notably since the recent recession in Europe closed off the safety valve of migration. Certain interest groups tend to reaont the reforms. The Party apparatus and ministerial bureaucracy believe (covrectly) that they would lose - 21 - power if enterprises were free to respond to market forces. Managers selected more for their political reliability than their entrepreneurial skills are less than enthusiastic about reforms that require them to sell products in a competitive buyers' market. Workers (and their unions), meanwhile, want to know how price changes associated with reforms will affect their real incomes. "Rationalization" of the consumer price system could reduce or eliminate prevalent subsidies for some basic consumer goods and services such as food, mass transportation, heating fuel, and housing. Such a process is taking place today in Hungary. C. Reform Design Given the pressures for and resistance to reform, the designers of reform proposals have had to contend with several important issues: choosing an appropriate mix of systemic and policy changes, defining the nature of the decentralization of decisionmaking to be sought, and identifying the appropriate strategy to implement the reforms. Policy Compared With Systemic Changes. Economic reforms may involve changes in the economic system, changes in economic policy, or both. The economic system can only be changed through the insitutional and decision- making framework that handles economic questions and flow of information and through incentive mechanisms used to influence economic decisions. Systemic changes seek to improve economic performance, for example, by transferring from planning offices and ministries to firms the authority and responsibility for decisions on the composition of output, the use of inputs including labor, or the nature of the new investment. Indirect means such as price policy rather than direct orders may be used to guide enterprise behavior, and market forces may be allowed to influence prices so as to better reflect scarcities - 22 of inputs and outputso The principal criterion for evaluating enterprise performance may be changed from output or sales to profits, and managerial incentives accordingly related to profit. Finally, so that prices may effectively reflect relative scarcities and profit may be an accurate measure of enterprise performance, competition in product and factor markets may be increased by such means as breaking up large monopolistic firms, liberalizing imports, and allowing liquidation of unprofitable enterprises0 In contrast, changes in economic policy involve the instruments by which objectives are attained within a given economic system: decisions on the growth rates of major components of the national product (such as consumption, investment, and exports), the distribution of investment by sector and branch of the economy or by geographic regions, the distribution of income among social groups, and the direction and composition of external trade and financial flows0 Price changes may be used to achieve policy objectives, but the m2chanism may vary according to the system--for example, prices may be determined directly by market forces (including international market forces) as modified by taxes and subsidies, or they may be directly changed by administrative actions of a central price bureau. Policy and systemic reforms are frequently linked in practice0 Altering important features of the economic system is itself a major economic policy decision0 And changes in the economic system may be chosen as the best means of accomplishing some policy decision0 Hungary, for example, chose to increase enterprise autonomy to make investments, allow enterprises to respond to price signals in making production decisions, and increase competitive - 23 - pressures for enterprise efficiency as the means to implement a policy decision to increase exports of manufactures to Western markets so as to permit imports of energy and technology. Three Types of Decentralization. A central concept in systemic reform is decentralization of decisionmaking. Three kinds of decentralization may be distinguished: administrative, economic, and intrafirm decentrali- zation. Administrative decentralization involves partial devolution of authority over selected decisions from higher to lower tiers within the administrative hierarchy--for instance, from the ministry to the intermediate "association" level (such as the Romanian "centrals" or East German VVBs) or even to the actual producing enterprise. The objective is to "rationalize" the existing mechanisms for administering the economy by transferring to lower levels some of the more difficult decisions regarding the composition of output, on one hand, and production methods, on the other. Such a tranfer could reduce the burden of decisionmaking at higher levels, freeing them to concentrate on such matters as investment allocation, living standards, and foreign economic policy. Economic decentralization, in contrast, involves a greater role for domestic and foreign market forces--and a correspondingly smaller one for central planning and administrative control--in determining the composition of output, the allocation of resources, and the distribution of income. Enter- prise activities are coordinated horizontally through market links rather than vertically along an administrative chain of command. Supply and demand, operating through flexible domestic prices, which in turn are influenced (among other things) by world market prices, guide decisions on outputs and - 24 inputs. Under these conditions profit can be the appropriate measure of enterprise performance and the basis for rewarding its personnel. The state authorities still control the "main directions and proportions" of the economy through macroeconomic policy instruments (taxes, subsidies, credit), provide collective consumption and intervene to deal with externalities. Within this regulatory framework the market influences the microeconomic decisions of enterprises about what to produce and how to produce it. Intrafirm decentralization involves the devolution of authority within the firm to subfirm units (as in Yugoslavia-s post- 1974 Basic Organi- zations of Associated Labor), or to its wsorkers directly or through elected repre- sentative bodies (for example, workers' councils and other self-management bodies in Yugoslavia, shop stewards' councils for certain decisions in Hungary). Only Yugoslavia in 1965, Hungary in 1968, and Czechoslovakia in its aborted reform attempt of 1967-68 envisioned a considerable degree of economic decentralizationo Yugoslavia has clearly gone the furthest along this road. In the other East European countries, the USSR, and China, the reforms have stressed administrative decentralization. The reforms of price and exchange rate systems in these countries were to improve the economic efficiency of decisions at various levels in the hierarchy rather than be key components of a market mechanismo As for intrafirm decentralization, it was implemented to a large degree only in Yugoslavia, although the 1967=68 Czech reform blueprint envisioned an important role for workers' councils0 Implementation Strategyo Once a decision is made to carry out an economic reform, four basic issues have to be addressed by the implementation strategyo First is whether to introduce all proposed reforms simultaneously, or phase them in some sequence over a period of time, perhaps several yearso - 25 - Some reformers have argued that the phased approach is less disruptive, allows learning by doing, and provides time for the preparation of more technically difficult reforms (such as price reforms) while gaining momentum for the reform process. Opponents of this approach believe that simultaneous introduction of mutually supporting measures--particularly in the case of economic decentralization--is necessary for success. The second question is whether reform measures, phased or simultaneous, should be "tested" by applying them for a trial period in a limited number of enterprises, or whether they should be adopted uniformly, at least in the industrial sector. Despite the potential advantage of improving the reform measures on the basis of a limited test, a basic problem is asses- sing the outcome. The representativeness of the enterprises selected may be debated. More important, how could any "pilot" group of firms really operate on the new system if the rest of the economy--including suppliers and customers and the prices of inputs and outputs--were not also reformed? By arguing for such experiments, reform opponents have often delayed or avoided more significant reforms. Both phased and "experimental" reforms for a limited sample of enterprises may be considered "piecemeal" or partial reforms, in contrast to global or comprehensive reforms. Piecemeal reforms have not generally been successful. They may even have reduced economic efficiency by combining the negative features of centralized and decentralized systems. According to Balassa (1982a p. 308): These adverse consequences, leading to subsequent abandonment of the reforms, reflected a failure to recognize the interrelationships of decentralized decision-making, the use of prices as signals for resource allocation, incentives at the production level and competition among producing units. - 26 - Thus, in the absence of scarcity prices, delegating decision- making power to regional authorities and introducing profit criteria for firms a la Liberman did not bring the desired results in the Soviet Union. In turns, barring the improbable case of solving an all-encompassing economic model on a giant computer, one cannot establish the appropriate scarcity prices for individual commodities unless decision-making is decentralized, supply and demand are equated and competition is ensured. Nor would the shadow prices derived in the model ensure conforming behavior on the part of producing units if appropriate incentives are not provided0 A final question is whether reform measures should be continuously evaluated and modified to alleviate unforseen problems, or whether they should be maintained for an extended period so as not to weaken management confidence in the authorities- commitment to the reforms. For example, if under a reform wages and management bonuses are made to be a function of after-tax profits, but then in order to maintain macroeconomic balance the profit tax rate is raised sharply in midyear, the incentive effect in future years is likely to be diminished. On the other hand, if the country does not have a cushion of international reserves, it may have no choice but to react to changed circum- stances0 even at the cost of reducing the intended impact of the reforms0 IV. Implementation Experience This review of economic reforms in Romania, China, Hungary and Yugoslavia is highly selective and cannot do justice to the great complexity of the reform process in each of these countrieso Rather, it examines the most salient features of these reforms and compared them with the reforms in other countries0 - 27 - A. Romania One of the least developed countries of eastern Europe before World War II, Romania has experienced a major economic transformation since then. At the center of Romania's development strategy are high rates of saving and investment and a broad industrial base that is able to provide both capital and consumer goods. Industry accounted for 12 percent of employment and 47 percent of the social product in 1950--by 1980 the corresponding figures were 35 percent and 65 percent. Over the same period agricultural employment declined from 74 percent of the labor force producing 26 percent of the social product to 29 percent of the labor force producing 12 percent of the social product. 1/ In 1981 GNP per capita was $2,540. 2/ Reluctance to make any fundamental changes in a highly centralized system that permitted an average GNP growth rate of 9.9 percent from 1950 through 1978 has led to piecemeal modification of existing practices rather than comprehensive reform, as in Hungary and Yugoslavia. The two distinct surges in Romania's reform process involved limited administrative decentrali- zation; the first began in 1967 (after some two years of debate within the Party) and the second in 1979. The mid-1970s appear to be a period of recentralization. At no point did the reforms involve any significant changes in ownership of the means of production. As in Bulgaria, the reforms initiated in Romania in 1967 were not preceded by any severe economic difficulties, but rather emerged during a / As in most socialist (and many nonsocialist) countries, relatively high prices for industrial goods exaggerate the importance of industrial output relative to that of agriculture. 2/ According to World Bank Atlas methodology. = 28 period of rapid and apparently smooth growth (Romania and Bulgaria had the highest rates of industrial growth in Europe at this time) Nor were there strong political pressures for reforms as in Czechoslovakia and Yugoslavia. Apparently the principal motive was to increase economic efficiency in order to preserve the prevailing high rates of economic growth in the face of rising ICORs and the pressures to maintain or expand consumption on one hand (Spigler 1973) , and the need to adapt industrial output to the highly competitive conditions prevailing in Western markets, on the other (Gamarnikow 1974)o The New Economic Measures of 1979 were inspired by growing net imports of energy and increasing international indebtedness. They were to improve economic efficiency by increasing the responsibility of enterprises for implementing financial plan targets thPough greater financial autonomy and greater financial rewards for successes and financial penalties for failure. The major changes in prices and foreign exchange introduced were supported by a three-year IMF standby agreements the objective of which was to link foreign and domestic prices. Efforts are now being made to increase material incen- tives to work effort through revisions in the wage system and to encourage more efficient use of capital by instituting capital charges and reducing the proportion of investments financed from budget grants as opposed to bank loans and retained earnings. Romanian authorities regard the New Economic Measures as a corollary of the gradual change from an "extensive" to an "intensive" development strategy necessitated by the success of the previous strategy and changing external conditionso The Locus of Decisionmaking0 The 1967 reforms became official in a set of directives for "improving the management and planning of the national economy" adopted by the Central Committee of the Romanian Communist Party in - 29 - October of that year., The directives were to be implemented by the end of 1969, but delays and watering down of what was proposed slowed down the reform process. The most significant change was to be the establishment of an intermediate-level economic organization called a "central" (Romanian singular centrala, plural centrale), between state enterprises and their supervising ministries. This model of administrative decentralization was similar to that introduced in the GDR, Bulgaria, Poland, and later in the USSR. The centrals were supposed to assume some of the microeconomic planning functions and most of the operational prerogatives previously exercised by ministries. Ten centrals were established on an experimental basis in April 1969, but they did not exercise the authority stipulated by a model statute enacted that same month. Previously established rules and laws governing investment financing, profit sharing, foreign trade, and other activities were not changed to reflect the model statute provisions, and ministries continued to intervene in the day-to-day operations of the centrals, regarding them merely as new administrative links that were to be ruled as enterprises had been previously. Furthermore, the ministries continued to intervene directly in industrial enterprises. Some 200 centrals were established in the fall of 1969, and they were eventually brought under a new law on the organization and management of state enterprises adopted by the National Assembly in October 1971. That law excluded independence in financial planning, did not allow the centrals to modify annual and quarterly plans of component enterprises, fix independently their production targets, or exercise any independent financial function. In practice, neither the centrals nor the enterprises were permitted to deviate from a lengthy set of mandatory indicators (plan targets) imposed by the - 30 - central planners (though these were subject to frequent change and could be influenced by negotiation), nor were they allowed to carry out foreign trade directly. A detailed investigation of decisionmaking in Romania's industry (Granick 1975) concluded that from a the large number of indicators (in some cases as many as 80, ranging from the global value of production to the number of railway cars to be used) that enterprise and central management had no clearly delineated objective function: Economic decisions at their level are kept to a minimum. Since, even where such choices are made, very little prior analysis is carried out, the consequences must frequently be quite different from what the unit's management had expected. Instead, the attention of centrala and enterprise managers has been almost exclusively centered on improving technical efficiency--what Leibenstein has called "X- Efficiency0" It is rather-at the branch ministry level that economic decisions in Romanian industry are centralized. Daspite the fact that centrale in 1970 were large units averaging some 8,000 employees, the functions of their top managers were much more comparable with those exercised by foremen and junioz managers in Western capitalist firms than with the functions exercised by top or even middle management in these western companies0 ...Either economic decisions are prepared and taken in the ministries or higher bodies, or they are not taken at all. (Granick 1975, pp. 127, 128) Bornstein (1977) notes, moreover, that the only real autonomy of the centrals proved to be in scheduling production among their plantsO In 1972 most of the rights of the centrals were formally rescinded and in 1974 their number was reduced to 102 to facilitate closer control by the ministries0 President Nicolae Ceausescu, noting in July of 1974 that the staffs of the centrals had been cut from 34,000 to 15,000, made it clear that the regrouping was part of a reassertion of the dominion of the central government in planning and management (Kaser 1975)0 - 31 - Although the New Economic Measures of 1979 provided for increased enterprise autonomy, they maintained the potential for central guidance and control. The planning process, for example, now begins through the negotia- tion of forward delivery contracts between supplying and receiving enter- prises, but these may be corrected later in the process if the sum of individual choices proves inconsistent or unfeasible or contradicts criteria used by central planning bodies. A new standardized system of accounting was introduced to help enterprises perceive correctly and quickly the difference between the actual course of events and plans and the impact of this dif- ference in terms of financial rewards and penalties (discussed below under incentives). At the same time, the new system allows integrated computerized data to be used as an element of central control. Another innovation has been the establishment of a fourth level--consisting of production units, several of which constitute an enterprise--in the administrative chain headed by the supervising ministry. In this way, incentives and rewards can be assigned to smaller and technologically more homogenous units within which the problems of productivity and efficiency can be addressed more effectively, by both management and the organized workers collective on that unit, than in the enterprise as a whole (World Bank 1980). As for investment decisions, all investments in Romania must be included in the central plan. Recommendations can be made by enterprises, which submit their proposals (including financial requirements and proposed sources of finance) to the centrals. They in turn submit their own proposals (which may or may not incorporate the enterprise proposals, possibly revised) to the supervisory ministries, which again submit consolidated ministrywide proposals to the State Planning Committee. Project appraisals are based on a - 32 = large number of technical and economic Critariao The weights assigned to given criteria may be changed from project to project according to plan priorities (Tsantis and Pepper 1979). To the extent that the prices used in evaluating costs and benefits differ from border prices, the real net benefit cannot be easily determined. Plans must be approved by higher governmsntal and Party bodies, ending with the National Assemblyo No long-term data are available on the extent to which projects approved for execution are those proposed by the enterprises (or any higher level body, much less the extent to which they may have been modified by higher authorities. The financial plans indicating what resources will be use to fulfill the physical plans are prepared by the same process as the five-year and annual development plans. The New Economic Measures of 1979 provided for increased self- financing of investment by enterprises and a further expansion of the role for bank credit, thus making investment expenditure more amenable to monetary control. Financing from the state budget was to be limited to major projects and treated as an interest-free loan that would be repaid , not to the state but to the centrals and ministries, and used for further reinvestment credits (World Bank 1980)o NonethelessD most investment in Romania (over 90 percent since 1977) is still financed from state centralized funds (see Table 1), and the state budget has remained the largest single source of funds, though its contribution fell sharply from 59o3 percent in 1969 to a low of 40 7 percent in 1970D when the combination of retained profits and bank credits reached 2108 percent, presumably at the height of the decentralization. With the exception of 1976, the share of the state budget rose steadily through 1979 and since then has been falling. In the second half of the 1970a, retained profits and depreciation tended to decline in importance, while bank credit - 33 - o o4 o 0o oo cs 0 L . . . . C. -4 0, {i -s 0 co U0 (TN c) c4 0 1% e C C o ^ o o >~~~~~~. _ 0% c'S 0 0% N. 0 0 ca4 U C' 0o z LAN ~'. 0A CY 0 W 4 b X < < o %S o 4 0 '-4 U, ) -4 0-4 in c'j 0 0c ..~~~~~~~~ . C C 0% U, °~ 0 < N e -4 0 Ns -4 U, CD '4 0 C N -' 0 00^ W~ ~ ~ 4 XW o -t 0 e~~~~~~ 0 ~~0 0.- 4 4 O - 0 - N. 00 co -4~~ ') .- 4J c/) 0 lu cn~~~4.) - ~ 1 (V. c'. 0). 4 C C C C C s oo., t '. C' .- o0 0 1-4 -4 Ct C') -4 0) 4 -T cn ~~~4-4 -4 64 o$4 , 0 0 O en U,r '.0 0 l t Ct -4 -tC'.) 0~~~~~~~~~~~~~~~- o *-i* -# r- C'! 0 ~~~~~~0 c w 1~~~ 0 0 0. 4i ~ ~ 0 to 14 -H w 0o r- 0)~~~ CO444*. "H q4 '. ~~J 0 01410 '% - 34 - increased. But the source of funding does not necessarily reflect the decisionmaking authority under Romania's highly centralized systemo Enterprises may propose reinvestment of after-tax profits or depreciation allowances, but unlike their counterparts in Hungary, they do not have the right to make such investments. Price Formation. Most domestic prices are set by the State Committee on Prices. Enterprises can freely set prices for only about 20 percent of output, but the authorities expect this proportion to rise0 Enterprises are now allowed to increase prices to reflect increased costs of imports and energy products0 In agriculture, premia ranging from 40 to 50 percent are paid for above quota deliveries by production units0 In the early 1970s planning authorities in ROmania relied on many different 'indicators" in setting targets for ministries, centralsD and enterprises because pricesD and the profits resulting from planned transactions at such prices, bore little relation to the priorities of the plannerso Prices did not change between 1963 and 19740 Producer prices during that time took into account depreciation as a cost1, but no other capital charges0 No charges for the use of capital stock were incorporated since funds for these purposes were generally provided through the state budget0 Then a major price revision was carried out during 1974-760 As part of a producer and delivery price reassessm2nt a (6 percent) charge on capital1 which was considered a cost of production, was introduced0 It was to stimu- late more efficient use of fixed assets and to prevent overcapitalization of enterpriseso In January 1977, however, this tax was abolished, purportedly because of administrative difficulties, but most likely because it reduced if not eliminated the profitability of the larger enterprises within the revised - 35 - price system (Tsantis and Pepper 1979). The capital levy was replaced by a profits tax on profits in excess of planned levels. The issue of capital taxes on investment financed from the state budget or retained earnings is currently under study by the authorities, as is the question of amortization schedules on bank loans, which appear excessively long. Bank credit has been available to finance fixed investment since 1970 (see Table 1). Projects financed must have been included in the plan and their production must be profitable enough to cover repayment within ten years. In addition, somewhat under half of enterprise working capital is financed by short-term credit. The government's decision to substitute certain financial for fiscal flows recognized competing demands for capital and its cost. Over time, interest rates for credits have increased and have generally been positive in real terms. The government views interest payments as a device to increase the efficiency of resource use. A higher penalty rate is charged on overdue credits. The sharp increase in the price level in 1982 (when consumer prices, fanned by food and energy prices, shot up 18 percent after negligible changes for several years) helped to push up interest rates. The inflation was caused largely by increases in the prices of energy and related products intended to make them reflect opportunity costs, and by exchange rate devaluations designed to promote international competitive- ness. Nominal interest rates were raised in January 1983, and in view of the fact that further price adjustments will be required in this year, further adjustments in interest rates will be taken to restore them to positive levels in real terms. In the past, producer prices in Romania have been more important in implementing plans than in determining the allocation of resources, which has 36 primarily been a function of the planning processo Now that allocation is increasingly made by indicators of value, presumably the overall structure of producer prices has become more consistent with the country-s development objectiveso Nevertheless, domestic price revisions were relatively infrequent before 1981D despite more updating since 1977. In 1981) a major effort to bring domestic prices into closer alignment vith international prices, especially for fuels, was initiated in connection with an IMF standby agreement and 1981-85 plan objectives of promoting more "intensive" growth as well as conservation and domestic production of energyo Prior to 1973, there was no link between domestic and foreign prices in the form of a generalized exchange rate. The profitability of foreign trade was determined primarily through shadow pricing exercises carried out largely within the planning processo Profits and losses on foreign transac- tions by trading companies were absorbed by a price equalization fund, supple- mented when necessary from the state budget. In 1973, a trading exchange rate was established with approximately the weighted average of all actual exchange rates for export and import transactions over the previous three years. This was the first major step in allowing international prices to have a bearing on the allocation and use of resourceso Significant revaluations occurred in 1978 and 1981, but since the structure of relative prices did not correspond to the international price structure1, the compooition of foreign and domestic prices could only serve as the starting point in determining whether certain goodo should be traded or not. Such comparisons still had to be complemented by a comprehensive shadow pricing operationD and the profitability of trade was also calculated by costing all inputs (traded and nontraded) in inter- national priceas These calculations were made first in studies prepared in - 37 - connection with investment proposals and then were repeated annually or more often by the foreign trade enterprises. Whenever such analysis showed export to be economically justified, even though the implicit exchange rate was below the trading rate, exports could be authorized and the difference paid to the enterprise from a price equalization fund: For exports, standard foreign prices are established annually, calculated on the basis of external prices obtained by enterprises in the previous period, and updated to account for the expected world market situation... .Their major operational role is to serve as a benchmark for determining the division of foreign exchange receipts between the enterprise and the state: that is, the price equalization fund. In the case of goods that are exported profitably--when the price obtained is higher than the domestic price converted at the trading rate-- the producing enterprises receive the domestic price in lei, and the difference between the standard foreign price and the domestic price is paid into the equalization fund: that is, the profit from trade accrues to the state. Where the enter- prise secures an actual price above the standard price, it receives all of the difference as a bonus. Conversely, if it can secure only a price lower than the standard price, the enterprise must pay the difference into the equalization fund....Thus, the standard foreign price serves as an incentive for firms to seek the most profitable market. (Tsantis and Pepper 1979, p. 65). Foreign trade companies have an incentive to seek high prices for producing enterprises because their commission is a percentage of the price. Imports are regulated by a similar system in conjunction with tariffs and import licenses. Since 1981 this system has been progressively modified with the objective of instituting a unified effective exchange rate in the context of the IMF standby agreement. On January 1 of that year the exchange equaliza- tion fund was abolished. On January 1, 1982, further steps were taken to reduce both the number of multiple exchange rates and the spread between the highest and lowest rates. On January 1, 1983, the number of rates was further - 38 - reduced, the spread further narrowed, and the leu devalued. Full unfication of the exchange rate is expected by July 19830 Recent devaluations have been insufficient to prevent an appreciation of the effective import and export rates of the leu owing to the increase in domestic inflation occasioned by the devaluations and sharp increases in the price of energy productso Incentives. Although the October 1967 directives on improving the management and planning of the national economy sought to reduce the number of success indicators used to assess enterprise performanceD little progress has been made in this direction. The system of indicators, as already suggested, is extremely complicated. It includes a wide variety of basic indicators transmitted by the state plan and complementary indicators set at the centrala and enterprise level0 In addition to gross output (which until 1979 was the most important), frequently used indicators include various productivity measures, gross profit, capacity utilizationD exports, new products introduced, sales, product mix in physical terms, and material use coeffi- cients. Thus the system has been heavily criticized for its many overlaping elements, excessive complexity, mixed quantitative and qualitative success indicators, emphasis on physical results, and use of indicators that are potentially inconsistent (therefore forcing management to make tradeoffs between the achievement of those the mnistries deemed more important against others regarded as less so)1, and so onO For discussions of these issues in Romania context see Spigler (1973) and Granick (1975)o After 19791, gross to net production (value added net of deprecia- tion) replaced gross production as the most important single achievement indicatoro Since producer prices are established essentially on a cost-plus basis, the use of gross output tended to encourage enterprises to raise the - 39 - use of material inputs and labor, or to use expensive material inputs if they had any choice. Furthermore, valuing output at sales prices encouraged production regardless of the match with demand. Net production--if based on realized sales and associated with an appropriate incentive system linked to the size of net production--tends to avoid these distortions. Other value- based indicators have also been redefined from a gross to a net basis. "Productivity," for example, is now defined as net production per worker, and "efficiency" as net production per 1,000 lei of fixed assets. But physical targets are still used in conjunction with net output, because without such targets enterprises might seek to maximize salaries and performance per worker by maximizing net production regardless of the level of output. The 1967 reforms were to reduce the role of bonuses and premiums, linked to fulfillment of plan targets, as supplements to basic wages and salaries. Such extra payments averaged about 20 percent of income for both workers and managers and were paid from enterprise wage funds (Spigler 1973; Granick 1975). According to Granick (1975), the system was revised because it failed to provide any real incentive. Since the entire industrial labor force participated in the system and since bonuses were such a substantial portion of income, it was regarded as politically impossible to avoid paying bonuses regardless of the degree of plan underfulfillment. A similar situation has occurred in China. The kinked nature of the bonus function (rarely was anything extra given for overfulfillment) also reduced the incentive. A new system was implemented gradually, beginning with limited experimentation in 1967 and 1968; it became generalized in 1970 and was codified at the end of 1971. The previous bonuses were incorporated into basic wages and salaries, which then averaged 88-95 percent of total remuneration, and an incentive scheme introduced to reward performance above 40 plan targets and penalize shortfallso The maximum effect on wages and salaries of this scheme was plus or minus 20 percent (Tsantis and Pepper 1979)o The wage and salary increases or decreases were usually determined mainly on the basis of the fulfillment or underfulfillment of four indicators- -planned output targets, exports (where applicable), labor productivity, and material costs per 1 000 lei of marketable output-which were generally given equal weights. Nevertheless, individual ministries and centrals could establish other indicators and might give varying weights to the different indicators (Tsantis and Pepper 1979)o A complex system of end-of-year bonuses also exists. The bonuses amount to 2 percent of the wage fund and can be augmented up to 8 percent if profits exceed the planned level. Individual bonuses may reach up to three months of wage or salary. Part is paid in proportion to basic wages and salaries and part in recognition of individual performance. Top managers and sometimes other workers have received bonuses from special ministerial funds constituting Ool percent of the wage fund for the ministry as a whole and allocated at the discretion of the minister rather than in accord lith any specific plan indicatorso In 1969 and 1970 these bonuses averaged 4-9 percent of annual salary (Granick 1975)o For a detailed description of the overall incentive system at different points in time see Spigler (1973)D Granick (1975)D and Toantis and Pepper (1979)o Although none of these observers has been able to determine the actual impact of the system, it seems to operate quite differently from one ministry, central and enterprise to another. In any case, the 1979 New Economic Measures did demonstrate official concern over incentives, which is also evident in the new bonus system introduced in agriculture, whereby the price paid to the production unit ls an - 41 - increasing function of yields above some target level (in cooperatives, 70 percent of personal incomes will be related to the level of production and only 30 percent will be fixed basic wages). A harbinger of change in this are is Secretary General Ceausescu's speech to the plenary meeting of the Central Committee of the Romanian Communist Party on March 24, 1983, in which he announced several measures intended to "enhance-Ehe working people's sense of responsibility as owners, producers and consumers." The share of total remuneration derived from profit sharing and bonuses is increased relative to basic wages in order to increase material incentives, bringing remuneration closer to work accomplished. The state will continue to guarantee the right to work in accordance with each person's qualifications and abilities. Incomes, however, will no longer be guaranteed for anyone without work. Workers will be allowed to purchase "social shares" which, for all workers, may amount to up to 30 percent of the capital of any given enterprise. These will bear an interest rate of 6 percent, which may be increased up to 8 percent if the enterprise concerned exceeds the planned level of profits. This measure is expected to increase the rate of personal savings and channel them into a form that will not increase the liquidity of the population. Competition. The new system of forward contracting introduced in 1979 implies a form of indirect competition in that enterprises can express their preference with regard to supliers and customers. Their preferences may or may not include explicit price considerations. But even at a given set of centrally determined prices, any choice will contain a genuine element of competition if more than one input or more than one supplier can satisfy the requirements and demand is moderate enough to provide a "buyers' market." Although initial forward contracts may thus exceed or fall short of any given - 42 - enterprise's production capacity and thereby require adjustment by planners above the enterprise level, the initial imbalances can be important signals for investment planning by suggesting priority for expansion of enterprises whose output tends to be overcontracted. Depending on the sytem of import tariffs and licenses, the liberalization of the exchange system and closer linking of domestic with international prices may help introduce an element of competitive pressure from imports. Conclusion0 Despite the reform measures implemented to date, comprehensive central planning--based on material, value, and labor balances-- continues to be the legally binding guide for enterprise behavior in Romaniao Productivity incentives are used as supplementary tools to support the achievement of obligatory production targetso Most prices are still set by the authorities and strictly controlled. Although incentives have been increasingly related to individual productivity and enterprise profitability, competition between enterprises remains limited. Nonetheless, the reforms that have been put in place may also be viewed as paving the way for more comprehensive economic decentralization in the future, perhaps along the lines followed by Hungary, should Romania choose to move in this direction0 B. China China's economic system combines a largely urban state economy, similar to that of other socialist countries, with a rural commune economy of its own invention. The state economy is characterized by public ownership, centralization of economic decisionmaking, strictly hierarchical control, and little reliance on markets or prices. To a greater degree than in East - 43 - European countries, people's jobs and consumption patterns are chosen for them by the state (World Bank 1981a). In the commune economy, land and most capital are owned and used collectively by production teams of 30-40 households, which generally correspond to small villages. Each team is part of a brigade, each brigade part of a commune; these higher level units organize land improvement projects, run industrial and other enterprises, and deliver education and health services. They also pass down instructions from the planners and perform a number of governmental functions. In general, however, production and investment decisions in the commune economy are less subject to central direction than those in the state economy; and markets and prices play a larger role (World Bank 1981a). Despite the disruption caused by the Great Leap Forward (1958-60) and the Cultural Revolution (1966-76), industrialization has been very rapid, largely as a result of the unusually high rate of investment, virtually all of which has been financed from domestic savings. In real terms, per capita consumption is estimated to have risen at an annual rate of about 1.9 percent in 1957-79, but (because of a spurt in the last two years) at only about 1.3 percent in 1957-77--barely above the average for other low-income countries (1.2 percent in 1960-78). GNP per capita in 1981 was $300. 1/ Despite the slow growth of the average level of consumption, China's remarkable achievement since 1949 has been to make low-income groups far better off in terms of basic needs than their counterparts in most other poor countries (World Bank 1981a). 1/ According to World Bank Atlas methodology. - 44 - The post-1978 Chinese reforms have sought to improve the management and efficiency of lower level administrative and economic units by: giving them greater responsibility and autonomy; linking incomes and rewards more directly with output and production; and relying less on administrative measures and more on the market and indirect economic instruments to influence their activities. A peculiarity of the current reform process is that the first steps beyond traditional central planning coincided and interacted with measures to restore and improve the quality of central planning and coordination in the wake of the disruption caused by the Cultural Revolu- tion. The reform process has also paralleled the implementation of policies that the Chinese call "readjustment," which is aimed at improving living standards by increasing the share of consumption in national incomes giving greater emphasis to light over heavy industry, and seeking greater benefits from foreign trade0 Problems in managing the reforms and adjustment policies led to macroeconomic imbalances in 1979 and 1980, when the greater autonomy given to lower level units failed to reduce investment as planned, and make room for increased consumption. Budget deficits were unexpectedly large as a result0 Although these budget deficits were related to excess investment demand, the principal cause lay elsewhere - producer price increases for agricultural products had not been accompanied by offsetting increases in the corresponding consumer prices. The producer price increases were decided by the central governmento Price increases effected by production within units (after they were given greater flexibility-see the section on price formation) exacerbated inflationary pressure but did not necessarily worsen the budget deficit0 - 45 - A major stabilization program launched in 1981 sharply cut investment, a restored budgetary balance, and moderated currency and credit expansion. The stabilization program relied heavily on direct administrative measures, price controls, and restrictions on the ways in which economic units could use their financial resources, which ran against the thrust of the economic reforms. In 1982, however, there was a resumption of more rapid growth, a higher level of investment, and a renewed emphasis on reform in the speeches and pronouncements of Chinese leaders. The reforms have involved both administrative decentralization and a limited amount of economic decentralization. Both extensive experimentation and a gradual, phased approach have been used. To date no major reform "blueprint" has emerged, though in a report to the 12th Party Congress on September 1, 1982, Party General Secretary Hu Yaobang indicated the need to work to "consolidate and perfect the initial reforms in economic administra- tion and work out an early overall plan for reform and the measures for its implementation" (Far Eastern Economic Review, October 15, 1982). Ownership of the Means of Production. Although there has been no major change in formal property rights, profit-seeking individual and small collective urban enterprises (which had nearly disappeared by the mid-1970s) have been rapidly expanded. In 1980 alone, the number of people operating individual enterprises increased to 810,000, compared with 300,000 in the previous year (World Bank 1981a), and in 1981 it passed 1.1 million. Likewise. in 1980, employment in urban collectives grew twice as fast as that in state enterprises. In agriculture, the area available for cultivation as private household plots, which during the Cultural Revolution averaged 6.4 percent of cultivated land, was increased to 15 percent of the total by 1982. No figures - 46 - are available on the current percentage actually used for private plots0 Restrictions on what could be produced on private plots and in sideline activities were substantially eased. Previously, one pig per family per year was the usual limits but by early 1980 all restrictions on the raising of pigs had been abolished in most provinces. Thereafter, private raising of sheep and some cattle was permitted in some provinces (Khan and Lee 1983)o Data collected from 18,529 peasant households throughout China by the State Statistical Bureau show that 42 percent of agricultural income was derived from private household plots and sideline activities in 1981o The corresponding figure for 1978 was 29 percento 1/ Such plots are characterized by intensive cultivation and the production can be marketed at freely negotiated prices without any tax obligation or payment to the commune (Balassa 1982a)0 The Locus of Decisionmaking and Incentives. In agriculture, in addition to the expansion of household plots on which production by family members for market or self-consumption is allowed, the major reform has been the introduction of "production responsibility systemso" The first changes came in 1979 when collective units at all levels (commune, brigades and production team) were encouraged to implement the principle of distributing income in proportion to work accomplishedo But in 1980, the system of assigning responsibility for production to households was officially deemed as being suitable for certain areas of Chinao / This figure, howeverD was based on a sample of only about 8,000 households. - 47 - A wide variety of systems have been designed to suit specific local conditions: I/ In some areas where rural development is relatively advanced in terms of systems and technologies, the collective economy well established and economies of scale probably quite significant, collective farming is still being retained but with an emphasis on specialized contracts and compensation being linked to output. Under such a system, teams, groups, households or individuals enter into a contract with higher level collective units that stipulates labor contributions, area to be cultivated, expenditures and output targets. Workpoints are set for the contracted output and there are bonus or penalty workpoints for surpluses or shortfalls, but accounting and distribution remain collectivized. Another type of system is in use in some of the intermediate areas, where grain production is the major activity but development is not as advanced and the collective economy may not be as strong. In such cases emphasis is placed on dividing the land into small plots for farming by individual households, and contracts are signed to cover output targets, inputs and work points. There may be bonuses or fines for surpluses or shortfalls, but accounting and distribution are still effectively collectivized. Yet another system (sometimes called the household total responsibility system) is in use in many other areas, especially the poorer areas. Fields and sometimes draft animals and implements are all divided among households, frequently according to household size and usually for a specified period. Households may farm the land as they wish but must guarantee to contribute agreed amounts to the state (in the form of taxes and state procurement) and to the collective (for welfare and other expenses). There is no system of unified distribution, and households retain whatever they produce beyond their obligations to the state and to their collective. Such obligations now account for about one third of a household's total production. The proportion of teams implementing different types of system varies greatly among provinces, among counties within a / By the middle of 1982, Sichuan Province, for example, had eight specific forms of the responsibility system in operation (Khan and Lee 1983). - 48 - province, and even among the communes and teams within a county. At the end of 1982, 92% of all production teams in China had implemented some form of production responsibility system and 78% of teams had implemented some form of household responsibility system (iOeO, some form of the second or third type of responsibility system discussed above)o" (World Bank 1983a, pp. 49, 50) Establishment of the responsibility systems has been accompanied by some easing of regulations on areas that must be planted to specific crops, some reductions in procurement targets, and, most notably, substantial increases in agricultural procurement prices. Consequently, the effects on production of changes in the collective system are difficult to separate from the effects of other changes in agricultural policy. Although responsibility systems are still being widely tested, their initial impact can be evaluated to some extent from gross agricultural output, which increased at an average annual rate of 600 percent over the period 1978-82, roughly double the average rate for the previous twenty years (World Bank 1983a)0 Even after allowance is made for the increase in retail prices in the countryside, the average annual increase in real per capita income of the rural households between 1978 and 1981 was 10-12 percento At the same time, the new systems have had their share of problems. One concern has been how to preserve some of the strengths of the traditional commune system, which has done so well in assuring that basic needs are met, other social services provided, and labor mobilized for construction and maintenance of community infrasetructure. Another is how to avoid weakening incentives for population control in areas where land is allocated to families according to household size or the number of able= bodied workers0 Some government officials are also concerned about the potential impact of the new systems on procurement programs, especially food - 49 - procurement, and the possibility that land, water, and timber reserves will be abused in the pursuit of short-term income gains. Another major reform now appears to be in gestation, with consider- able experimentation taking place in three counties of Sichuan Province. Already the communes have been stripped of all political, administrative and non-economic powers and functions, and such action is now provided for in the new constitution adopted in December 1982. This reform in Sichuan has virtually abolished the three-tiered rural organization (commune, brigade, team) that existed there for more than a quarter of a century. The communes have ceased to exist. Their administrative and political functions have been taken over by new governmental units and their economic functions reorganized in the form of corporations. The economic enterprises at the brigade level have also been formed into corporations or companies. The three levels have effectively been de-linked and the teams have been converted into autonomous cooperatives. The adoption of the new constitution, with the provision for nationwide replication of the three-county experiment in Sichuan, may signal another wave of sweeping change in rural China in the coming years (Khan and Lee 1983). In industry profit retention schemes have been widely introduced for state enterprises: In 1978 the Government reinstated an enterprise fund scheme in which some enterprises fulfilling plan targets were allowed to retain profits amounting to 5% of their wage bill. Starting in 1979, some experimental enterprises in industry and transport were permitted to keep a share of base profits and a larger share (10-30%) of incremental profits. The retention rates varied by industry and even by firm, depending on overall profitability, and there were fewer restrictions on the use of these funds. By mid-1980, experimental enterprises numbered about 6,600 and they accounted for 44% of state industrial output and 57% of profits. In the past two years, - 50 other schemes have been introduced to permit partial retention of the value saved when enterprises reduce losses, retention of a large share of profits above a target quota, profit sharing controlled by a bureau (eogo, the Shanghai Textile Bureau) rather than by individual enterprises1, and a scheme in which 460 state-owned enterprises pay taxes rather than sharing profits. By the end of 1981, over 80% of all state industrial enterprises above the county level were under some form of responsibility system0 (World Bank 1983a, pp.56, 57.) Over the period 1979-81, the various schemes have allowed enter- prises to retain more than Y 28 billion, an amount equivalent to roughly 6 percent of net material product generated by industry over the same period. The amount of retained funds, which reportedly reached Y 17 billion in 1982 alone, indicates a rapid growth over time. In addition, enterprises have been allowed to retain a larger share of depreciation funds0 Depreciation funds accruing to state enterprises in all sectors now amount to more than 20 billion yuan (this is equivalent to some 20 percent of gross fixed investment in 1981). Retained profits may, within limits, be disposed of at the discre- tion of individual enterprises0 In general1, however, no more than 40 percent is to be used to pay worker bonuses based on individual or group performance, and to improve worker amenities, such as housing. The remaining 60 percent is to be used for investment to improve, modernize, and expand the enterprise's productive capacity. It is not clear to what extent state enterprises may use retained profits and depreciation allowances to make investments fully of their own choosingo In industry, the process by which investment proposals are approved depends on the project size, its location (some provinces have more autonomy)1, and the type of financial resources required (state budget, local funds, - 51 - retained earnings, domestic loans, foreign loans, and so on). Large-scale projects must be approved by the State Planning Commission in consultation with other national commissions. For other projects, the threshold of referral varies by sector and region. An attempt has been made to involve the banking system more and to increase the use of credit in financing fixed investment projects. Since 1978, the government has had difficulty in controlling the overall level of investment, particularly a category labeled "other" invest- ment, which includes investment in renewing and transforming industrial enter- prises (most of which is now financed from retained earnings and bank loans), urban and rural collective investment, and individual investment. "Other" investment accounted for 56.1 percent of gross fixed investment in 1981 and it has been growing twice as fast as state capital construction investment (the other major category) over the period 1977-81 (see Table 2). Problems have arisen even in controlling state capital construction investment, in part because fiscal and state enterprise reforms have left enterprises and local governments with increased financial resources that can be used for capital construction investment. Since 1978, there has been a sharp rise in the share of state capital construction investment financed by local funds and other sources, which include foreign and domestic loans (see Table 3). In general, with increased access to retained profits, depreciation allowances, and multiple sources of loans, enterprises have sought to invest far more than desired by the planning authorities, and to some degree they have succeeded. Similar problems have arisen in Hungary and Yugoslavia. Most of the cutbacks in the 1981 stabilization program therefore had to come from large centrally financed projects, especially in key infrastructure sectors - 52 - Table 2: CHINA: GROSS FIXED INVESTMENT,) 1977-82 (Current prices) Average Annual growth rate (x) Amount of investment (Y billion) 1977- 1977- 1977 1978 1979 1980 1981 1982 /a 81 82 Gross fixed investment 75.6 92.2 98.4 106.2 10203 n.a. 6.4 noao State capital construction investment 36.4 4800 5000 53.9 4208 52.5 4o1 7.6 Other investment 39.2 44.2 4804 42.3 59.5 n.a. 803 n.a0 /a Estimate. Source: World Bank (1983a),5 Table 207D pO 160 like energy and transport. This situation may have harmed China's future growth potential0 But investment in these sectors bounced back in 1982D and the central government has established new levies on extra budgetary funds that will be earmarked for investment in energy and transportation. One of the principal reasons for excessive investment is that firms are not really held responsible for losses resulting from bad investment decisionso Very few loss-making enterprises have been closed down, and as a rule losses have been offset by fiscal subsidies, or neutralized by bank loans0 Another outstanding problem is the lack of formal economic analysis of projects and objective criteria against which proposed projects can be measured. Since prices often do not reflect supply and demand (see the section on pricing), they may not only be inappropriate guides for decision - 53 - Table 3: CHINA: STATE CAPITAL CONSTRUCTION INVESTMENT BY SOURCE OF FINANCE, 1977-82 (Percentage share) 1977 1978 1979 1980 1981 1982 la Total 100 100 100 100 100 100 By Sector Energy 21 24 22 21 21 n.a. Other heavy industry 32 27 23 20 21 n.a. Light industry 7 6 6 9 10 n.a. Agriculture 12 12 13 10 7 n.a. Transport/Communications 15 15 13 12 9 n.a. Other 13 16 23 28 32 n.a. By Type of Investment Productive 83 83 73 66 59 57 Housing 7 8 15 20 26 26 Other nonproductive 10 9 12 14 15 17 By Source of Finance State budget 81 83 79 /b 52 49 37 Local government and enterprise funds 19 17 21 30 33 34 Domestic bank loans - - - 8 10 29 Foreign loans - - - 10 8 /a Estimate. /b This figure probably includes some capital construction financed from domestic and foreign loans, amounting to about 4% out of the 79%. Source: World Bank (1983a), Table 2.8, p. 17. - 54 - making, but may also make profits a poor indicator of enterprise efficiency0 The decentralization of investment decisionmaking to the enterprise level, where financing from retained profits is allowed, will not necessarily improve and may reduce overall economic efficiency in these conditions0 Under the reforms, state enterprises have been given more control over what they produce. In part, this has been accomplished through greater discussion and negotiation of plan quotaso More tangibly, enterprises are now allowed to choose, in the light of demand and comparative advantage, what to produce once plan quotas are met0 About 15 percent of industrial production was involved in 1980 and allocated by the market or marketlike mechanisms0 The monopoly of the Ministry of Foreign Trade over foreign trade transactions has effectively been ended0 Ministries, new territorially based trading companies, and in many cases, enterprises themselves may now import and exporto In addition, provinces, large organizations, and in some terri- torial units may retain part of their foreign exchange earnings in the form of quotas that entitle them to buy foreign exchange to purchase imports under certain conditions0 The scope of the foreign exchange retention system was expanded in 1981, but was scaled down in 1982. Many types of products con- sidered essential in the domestic economy no longer receive foreign exchange retention quotas0 A limited and tightly controlled foreign exchange market has been instituted by the Bank of China, in which enterprises with unneeded foreign exchange quotas sell them to enterprises that require but do not have access to foreign exchange0 In 1981, some 1,500 transactions totaling US$217 million took place under this so-called "foreign exchange coordination systemo" (World Bank 1983a)0 - 55 - The main change in the wage system has been the increased use of bonuses and a greater use of piece rates. The "responsibility system" has even been extended to the Peking opera theater, which, since April 1981, has guaranteed only 70 percent of performers' salaries and based the remainder on the company's earnings (Economist, March 5, 1983). Bonus payments, however, have generally been distributed in proportion to base wage and salaries and depend on enterprise rather than individual performance. Enterprises reaching targets with respect to output, profits, quality, consumption of raw materials, and labor productivity have been permitted to pay bonuses, which in 1982 averaged more than one month's pay for workers in state enterprises and are restricted to two months' pay normally, or three months' pay in exceptional circumstances (World Bank 1983). The government is planning, however, to link future bonuses more closely to labor productivity and to smaller work units within the enterprise. Basic wage scales are set by the state but vary by geographic area (owing to cost of living differences), among industries and occupations in the same place, and within industries according to the size of the enterprise and the level of government that controls it. The scales have a maximum range on the order of 15 to 1 from the highest paid administrators to the lowest paid workers, though the effective range is usually much smaller. Most labor is allocated by central and local labor bureaus, and each enterprise is obliged to employ the number of people specified in its annual labor plan. In the past, enterprises have had little choice about whom to hire; they had to take whomever the labor bureau sent. A growing number of people in urban areas may now seek jobs independently of labor bureaus, while some enterprises have been given more choice about whom (though not how many - 56 - workers) they hire. Despite some talk about allowing enterprises to fire unproductive or undisciplined workers, it remains difficult to discharge workers no matter how unsatisfactory their conduct0 Price Formationo Because of the heavy reliance on administrative control, prices play only a limited allocative role; even household expendi- ture patterns have been shaped partly by rationing. But prices have had a great effect on various aspects of income distribution. First, they are one of the principal determinants of industrial and ccmmercial profits, and hence of the share of budget revenues in national incomeo Second, the relative prices of agricultural and industrial goods affect the living standards of farm as compared with nonfarm households0 Third, the relative prices of different consumer goods affect the pattern of living standards among households with varying money incomes. Prices of the most important goods in China continue to be set by the government, through a hierarchy of price bureaus at the national, provin- cial, and county levels. The prices of agricultural and industrial goods of national importance (accounting for about two thirds of total production) are subject to central control, as are transport tariffs on major national routes. The prices of other important goods and services are controlled at the province or county level. Industrial and commercial prices are in principle set on a cost-plus basis, but many have remained unaltered for decades and are thus now in an arbitrary and variable relation to costs. In recent years there has been a significant move toward decontrol of prices on a number of minor products--both complete decontrol and partial decontrol, under which fluctuations are allowed within opecified upper and lower limits. Per- haps the most important area in which ouch decontrol has taken place is machinery. - 57 - In the past Agricultural prices were set mainly with a view to extracting the agricultural surplus from the peasantry, but now increasingly influenced by concern with rural living standards. The present system involves the establishment of a basic procurement quota for each production team, which must be fulfilled at a basic price per unit fixed by the state. Next, there is normally an additional quantity specified (a secondary quota that must also be fulfilled) for which a higher purchase price is offered. The premium on this secondary quota is 50 percent of the basic procurement price for grains and oilseeds, and 30 percent for cotton. A third category of sale to the state after the first two are fulfilled involves a negotiated price; some officials claim that there is yet another quota for this kind of sale (Khan and Lee 1983). Finally, after fulfilling the procurement quotas, the seller can dispose of any remaining surplus in the free market. There is by now an extensive network of such markets in both urban and rural areas. According to Khan and Lee (1983), prices in the free market are substantially higher than the basic procurement price and significantly above the premium procurement price. The volume of sales in these markets has grown rapidly in recent years. In most cases, "negotiated sales" to the state have become practically indistinguishable from the free market. Domestic prices have been insulated from world prices and the exchange rate has played a very limited role. Only for goods-that have no domestic equivalent (about 20 percent of imports) are domestic prices determined by converting the foreign price at the official exchange rate and then adding import duty, taxes, and fees. A prominent characteristic of Chinese prices has been their relative stability, but significant increases have occurred since 1978 (see Table 4). Prices for industrial products set at the time a product was introduced were - 58 - sometimes reduced once production costs had fallen, especially in the case of machinery; in other cases, however, they were not changed, and profits were allowed to provide revenues for the state budget. Prices were seldom raised in response to increases in costs so as to avoid inflation as Balassa (1982a po 319) has pointed out, Thus, some firms changed their product composition, with little consideration given to their saleability. They could do so, even though inventories accumulated, since profits are measured on the basis of production value rather than sales. There were further cases When the firm raised prices by replacing existing products with new ones that had a higher price. Finally, there were instances of lowering product quality. Table 4: CHINA: PRICE INDEXES, 1978-81 (1965l100) 1978 1979 1980 1981 Retail price index 101 0 103.0 109o1 111 7 Cost of living of staff and workers 104.1 106.3 114.0 116.9 Agricultural procurement price index 115.7 141.3 151.4 159.7 Rural market price index 128.0 122.2 124.7 132.9 Industrial products sold in rural areas 92.7 9208 93.7 94.6 Source: Calculated from World Bank (1983a), Statistical Appendix Table 11010 The most important change since 1978 has been the sharp increase in agricultural procurement prices-2201 percent in 1979, followed by 7.1 percent in 1980, and 5.9 percent in 19810 The terms of trade for rural inhabitants - 59 - improved by nearly 36 percent. The increased prices, implemented as part of the "adjustment" designed to improve rural living standards, have by and large not been passed on to urban consumers, but rather absorbed by budget subsidies. In recent years much greater use is being made of administered rela- tive price changes to correct distortions that affect profitability and production decisions. Changes in official prices have almost always been based on production costs or changing supply-demand conditions, except in the case of basic consumer goods from the agricultural sector and those having a large agricultural raw material component. Significant distortions in levels of relative prices remain both within and between sectors. Some price flexibility has been introduced as part of the reforms-- above-plan output of consumer goods, for example, can be sold at prices negotiated directly between buyers and sellers, and there is also considerable downward price flexibility for producer goods in excess supply. Stricter price controls imposed as part of the 1981 stabilization program have reduced the momentum of price reform. Prices appeared to remain under control in 1982, when the cost of living rose by only about 2 percent, though the prices of some commodities, however, have risen much faster than the average. An important policy change was the introduction in January 1981 of an internal settlement rate for all trade, which was set at about a 75 percent premium over the official rate at that time. The premium fell to 44 percent by the end of 1982, however, since the official exchange rate is pegged to a basket of currencies, whereas the internal settlement rate is pegged to the US dollar (World Bank 1983a). - 60 Other significant changes in China include greater reliance on the banking system to finance fixed investment and working capital, and increased autonomy in decisionmaking by banks0 The banking reform has also involved greater use of interest rates to influence economic decisionmaking at the microlevel0 Interest rates paid on personal bank deposits were raised in 1979, 1980, and 1982, and rates have been maintained significantly above the rate of inflation0 In January 1982, rates on loans were increased signifi- cantly, and their structure rationalized0 As well, by way of experimentation, a few lower-level bank branches have been allowed some flexibility in setting interest rates. Also in 1982, enterprises and organizations were for the first time permitted to hold time deposits, which earn higher rates than demand deposits. As an additional means of encouraging enterprises to use capital more productively, taxes on the fixed assets and circulating capital of state-owned enterprises were also imposed in 19820 The rates vary from 204 percent to 9.6 percent per year for fixed assets (based on their original value) and from 205 percent to 7.2 percent for circulating capital (World Bank 1983a). CompetitionO Significant competition now exists in rural markets where the produce of private plots and above-quota production under the family total responsibility system may be sold, and in the markets where the goods and services of urban collectives and individual enterprises are sold0 Competition is also generated through above-plan sales of state industrial enterprises. Since strict control of rural/urban migration is maintained, a labor market has not been allowed to develop0 Most urban employment decisions are determined by labor bureaus rather than by workers and their employers, whose basic wages and salaries are fixed by law0 The price of capital is fixed by administrative means, but access to it is now in part determined by - 61 - successful pursuit of profits. To a limited extent access to foreign exchange for imports is determined by the ability to export, but the effective exchange rate is fixed administratively. Conclusions. The reforms implemented to date in China appear to have been most successful in agriculture. In industry a great variety of reforms--profit and foreign exchange retention schemes, increased use of credit to finance investment, capital taxes, greater use of bonuses and piece rates, and experiments with more flexible pricing and marketing arrangements-- have been introduced, but many changes have been made in all of them. There is little systematic evidence that these reforms have been successful in increasing economic efficiency. The estimated ratio of current input consump- tion to gross output value in Chinese state industry fell from 0.650 in 1978 to 0.632 in 1981. If the increase in agricultural prices is taken into account, the improvement in efficiency by this measure becomes more strik- ing. But labor productivity has stagnated, inventories have not fallen drastically, and capital productivity has declined (Byrd 1982). Moreover, the reforms appear to have reduced central control over aggregate investment. To reap the full benefits of reforms undertaken to date, China may have to consider deeper and more comprehensive reform. A much more extensive price reform, for example, appears to be critical, since decentralized decisionmaking requires that prices reflect scarcity values in the economy. Inappropriate relative prices, through their effect on profits, cause inequities in material rewards for different economic activities, and they tend to distort the incentives arising from the reforms. Furthermore, markets function poorly in disequilibrium and some price flexibility is required to achieve a balance between demand and supply. But price flexibility in turn - 62 - requires greater competition among enterprises, and may necessitate breaking up some large monopolistic firms and forcing producers to bear more responsi- bility for their decisions through some meaningful budget constraint and the possibility of liquidation. Breaking up monopolistic firms is less likely to be necessary in China than in Eastern European countries because of the large size of the market and the fact that China has many small enterpriseso Probably more important in China are measures to allow freer trade between localities. In view of the complexities of price reformD the magnitude of the changes that will be needed, and the importance of extensive preparatory work, the government has decided that it will not be able to implement comprehensive price reform until after 19850 Other reforms that appear desirable include improving the quality of investment appraisal and planning, and devolving more decisionmaking authority to producing units0 C. Hungary Between 1960 and 1981, Hungary's GDP grew at an annual average rate of 5 percent, and growth dropped below 4 percent in only one year before 1979. Over the same period the country's population grew at only 035 percent a year, reaching 107 million in 19810 Rungary's relatively small population is 96 percent Magyar, or Hungarian, and the remaining 4 percent consists of national minorities that speak Hungarian. This ethnic and linguistic homogeneity facilitates economic decisionmaking. Hungary is highly trade dependent, more than 40 percent of GDP being internationally traded on two distinct markets--with socialist (primarily CMEA) countries and with nonsocialist countries. In 1981 induatry accounted for 41 percent of GDP, over 41 percent of employment and 75 percent of - 63 - exports. Rapid GDP growth has led to considerable improvement in the living standards of the population. Per capita GNP in 1981 was $2,100. 1/ Social welfare conditions in Hungary are generally better than those of other Eastern European countries and in some cases are comparable with those of Western industrialized countries; this situation is largely the result of deliberate government policies, and the consolidation of these achievements is an important objective for the future. Life expectancy at birth is now 70.4 years, only 3 years less than in OECD countries, excluding the Southern European members. Infant and child mortality have declined rapidly in recent decades, and health care indicators are very high by inter- national standards. The adult literacy rate was 98.5 percent in 1980, and the levels and quality of educational services (that is, primary school enrollment and pupil-teacher ratios) are good, although secondary school enrollment has lagged behind. Per capita calorie consumption (largely in the form of cereals) is above that in Western industrialized countries, reflecting a deliberate policy objective. Although, on the whole, the population enjoys a standard of living higher than many countries in Eastern Europe, wage levels remain low, the choice of consumer goods is relatively limited, and housing is still inadequate, as are potable water and sewerage facilities, particularly in rural areas (World Bank 1983b). In November 1956, immediately after the October uprising, the Hungarian authorities ratified limited experiments with economic decentraliza- tion in the agricultural sector initiated by the fallen Nage government. One of the objectives was to gain acceptance from the rural population. The 1/ According to World Bank Atlas methodology. - 64 - system of compulsory deliveries was replaced with voluntary contracts, and prices paid for deliveries by collective farms were set higher to provide an incentive for private farmers to join the collectives0 In December 1956, the Central Committee of the Hungarian Socialist Workers party set up a committee of experts to draft a comprehensive economic reform, building on the intellec- tual contributions of a number of leading Hungarian economists published in the years following Stalin's death. Working in eleven subcommittees, this group began its work in January 1956 and by June had prepared a report recom- mending reforms very similar to those implemented in 19680 The major dif- ference was that in the committee's reform blueprint all investment would still be financed from the state budget, whereas the 1968 reforms allowed enterprise-initiated investments to be financed from retained profits and bank loans. The committee's proposal was rejected, reportedly because of opposition from the Soviet Union and the Kadar's government rapid consolida- tion of its political position that reduced pressure to pursue a radical economic reform to gain domestic political support0 Limited administrative reforms, including extensive mergers of industrial enterprises in the late 1950s and early 1960s and the establishment of trusts operating something like the East German VVBs, were attempted. but did not produce any significant changes other than leaving a high degree of industrial concentration. In agriculture, however, the authorities learned to rely on the price mechanism (albeit prices set from the center) and on fiscal policy instruments to implement planning in agriculture. The success of the price mechanism in assuring self-sufficiency and a net export surplus in foodstuffs helped convince the political leadership to rely to a greater extent on market mechanisms in other sectors as well0 - 65 - Unlike other Eastern European countries--notably Poland, Czechoslo- vakia, and Bulgaria--Hungary had a 'top political leadership that was, on the whole, genuinely committed to the cause of market-oriented economic reforms and amply demonstrated the political will to implement them (Gamarnikow 1974). At the end of 1964, the Central Committee took steps that led to a comprehensive set of reforms involving significant economic decentraliza- tion. This time, as mentioned earlier, the motive to pursue the reforms was apparently economic, largely generated by the need to improve the competitive position of Hungary's industrial exporters. Early in 1965, eleven special committees of economic experts were once again set up to prepare the reforms, which were eventually called the New Economic Mechanism (NEM), and in May 1966 the Central Committee approved the reform program together with a timetable of organizational and legal groundwork necessary to implement the reforms as of January 1, 1968. The timetable was met and the reforms initiated simultaneously, except that a phased approach was adopted for price reform. Toward the end of 1972, a segment of the working class expressed discontent with the implications of the reforms for job security and income distribution. This led to a major shakeup in the Central Committee. Advocates of economic reform suffered a serious setback at the hands of party conservatives, and subsequently the authorities began a process of recentrali- zation, which accelerated after the first oil price rise as the government sought to cushion both enterprises and the population from the impact of external shocks. Recentralization was accompanied by a rapid expansion of foreign borrowing, which allowed GDP growth to continue at an average of 5.8 percent annually over the period 1973-78, despite a growing trade deficit in convertible currencies. - 66 - By 1978, serious balance of payments problems helped convince the authorities in Hungary that a permanent structural adjustment could not be postponed (in that year, the current account deficit was equivalent to 807 percent of GDP)O Future economic development1, they believed1, needed to be based more on improved productivity and rapid technological development as well as an adjustment to higher real energy prices. On January 1, 19801, following some preparatory domestic price rises in 1979, a new set of reforms was launched0 Their objective was to help transform the economy's productive structure, increase overall economic efficiency, and increase international competitiveness0 Ownership of the Means of Production. Neither the 1968 reforms nor those beginning in 1980 fundamentally changed the dominance of state owner- ship0 In 1980, state enterprises produced 63.5 percent of GDP, cooperatives operating as enterprises produced 16.5 percent and small private enterprises, including households producing agricultural goods on private plots, 9.5 percento The remaining 1O5 percent was government services (104 percent provided by government agencies and associations and 0 1 percent by coopera- tives)0 The 9.5 percent private share estimated by the Central Statistical Office does not include significant but unmeasured private activity in the so- called second economy0 But in an effort to bring a greater part of such private activity into the open and recognize its social usefulness, laws enacted in 1981 provided for a wider variety of private enterprises, some of which may employ up to fifteen persons0 These laws provided urban workers with more legitimate income sources outside the state sector. They Were inspired in part by the success of private economic activity in agriculture, as a complement to social sector production. New forms of small cooperatives, quasi-private enterprises in which groups of workers can undertake productive - 67 - activities using the assets of state enterprises and cooperatives under contract with them (sometimes using employees who are not members of the parent enterprise or cooperative), have also been authorized (Varga 1982). It is too early to judge how numerous or successful these new types of enterprises will be. The Locus of Decisionmaking. The 1968 reforms concentrated on eliminating detailed physical planning and the consequent "breaking down of the Plan," that is, the handing down by central planners of fixed input allo- cations and mandatory output targets--outputs expressed in physical tel-m. The Plan has continued to play a crucial role in determining the bruad direc- tion of economic activity. But Plan objectives are often achieved through the manipulation of economic regulators, including taxes and subsidies, interest rates, selective credit provided through the banking system, wage regulation, exchange rate policy, and price policy. The principal guidelines for the application of these regulators are set out in five-year plans and annual plans, but in practice the authorities have frequently altered the regulators in pursuit of short-term objectives. The reforms attempted to make enter- prises responsive to market signals by partly freeing prices of industrial producer, consumer, and to a lesser extent, agricultural goods (see the section on price formation below). Enterprises were given more autonomy on investment decisions, drawing both on a portion of their depreciation allowances (currently 60 percent) and after-tax profits, which could also be allocated to enterprise reserve funds and/or a "sharing fund" used to increase the earnings of workers. Allocations to the sharing fund are, however, subject to steeply progressive taxation. - 68 - About 90 percent of investment in Hungary is carried out within the socialist sector (government agencies, state enterprises, and cooperatives)0 Over the 1970s, roughly 55 percent of this amount has been in the form of "enterprise initiated investments" and 45 percent state investments. In addition to investments in physical and social infrastructure by government agencies, state investments include large projects of importance to the entire economy in areas such as mining, energy, transportation, and the production of key raw materials and intermediate inputs. These types of projects are planned from the center and require the approval of the Council of Ministers, as do "central development programs" in such strategic areas as electronics and pharmaceuticals. Individual projects within approved central development programs may be approved by the responsible ministry, and many are in the category of enterprise-initiated investments. Of the enterprise-initiated investments, depreciation and retained profits have financed an increasing proportion of the total in recent years, rising from 52 percent in 1976 to 69 percent in 1981, while state grants fell from 16 percent to 6 percent and credits from the National Bank of Hungary from 27 percent to 20 percent (see Table 5). The figures suggest greater autonomy of enterprises in making investments, as does the consolidation at the end of 1980, the three ministries that controlled the industrial sector into a single ministry, with half the total staff0 Then, in 1981, the Ministry of Labor was disbanded and replaced by the State Office for Labor and the former staff0 These structural changes have reduced the ability of the central state to intervene directly in enterprise affairs (Knight 1983b). It must be noted, however, that the autonomy of the state enter- prises remains strongly limitp, - 2=y are owned by the very state that - 69 - Table 5: HUNGARY: DISTRIBUTION OF ENTERPRISE-INITIATED INVESTMENTS IN THE SOCIALIST SECTOR BY SOURC7aOF FUNDING, 1976-81 (percentage) 1976 1977 1978 1979 1980 1981 Enterprise resources 52.2 54.0 57.6 57.4 64.6 69.0 National Bank of Hungary credits 26.7 24.6 21.8 22.1 19.1 20.1 State Development Bank loans and Cooperative Subvention Fund 1.9 2.9 4.6 4.6 4.6 3.0 State budget allocation 15.9 15.1 13.3 13.3 8.7 5.9 Other sources 3.3 3.3 2.6 2.6 2.8 2.0 Total Enterprise- Initiated Investment (as percentage of total Socialist Sector investment) 100.0 100.0 100.0 100.0 100.0 100.0 (54.2) (56.0) (56.8) (54.4) (54.2) (57.1) /a Components may not add to total because of rounding. Source: Knight (1983b) regulates them: their managers are appointed by the branch ministries, which evaluate their performance; the wages they can pay are limited by centrally determined rules. The prices they pay for inputs or earn for their outputs may be determined by the National Board for Materials and Prices; and their investment plans frequently require external finance, which is provided almost exclusively by two major state banks. Cooperatives, on the other hand, have considerably more autonomy, private enterprises and the new hybrid forms still more. - 70 - Despite these controls, the authorities have had considerable dif- ficulty in controlling the level of investment, particularly of enterprise- initiated investments, which averaged 13.5 percent above the level programmed in annual plans over the twelve-year period 1970-810 Although they were partly offset by shortfalls in state investments in seven years, total socialist sector investments exceeded the annual plan level in nine out of twelve years (see Table 6). In part, the investment hunger of the enterprises is caused by the lack of a "hard budget constraint" (Kornai 1980a)o With rare exceptions, enterprises have not had to face the prospect of bankruptcy and liquidation because of unprofitable investments. Usually they have been able to negotiate favorable treatment by the price authorities, tax breaks, loans at favorable interest rates, or direct subsidies that reduce the discipline of the marketplace. Or they have been merged with more profitable firmso In 1983, measures were introduced to increase economic pressure on unprofitable firms (see the section on competition below). Price Formation0 Prior to 1968, prices served mainly an accounting function, as in most other centrally planned economieso After the 1968 reforms, prices were to reflect market demand and state preferences: although prices for most consumer goods and key production inputs remained tightly controlled (about 75 percent of consumer goods and 30 percent of producer goods), the rest became "free" prices set by the enterprises, albeit under detailed guidelines elaborated by the National Board for Materials and Prices0 Central allocation of materials was also dismantled in 1968, although initially certain materials, semimanufactures, and foodstuffs remained subject to quotas0 The intention of the reformers was to extend the scope of market forces in determining both producer and consumer priceso Progress was - 71 - Table 6: HUNGARY: INVESTMENTS REALIZED IN THE SOCIALIST SECTOR AS A PERCENTAGE OF ANNUAL PLANNED INVESTMENTS, BY DECISIONMAKING POWER, 1970-81 State Enterprise-initiated Total socialist investments investments sector investments 1970 100.5 131.9 115.7 1971 102.3 125.2 114.3 1972 97.4 102.0 99.8 1973 94.3 103.3 98.7 1974 93.9 115.1 104.8 1975 104.9 119.7 112.7 1976 93.7 109.0 101.4 1977 96.9 124.4 110.7 1978 98.4 117.8 108.6 1979 101.8 99.4 99.5 1980 104.5 102.0 103.1 1981 78.4 111.9 100.4 12-year average 97.3 113.5 105.8 Source: World Bank (1983b), Vol. I, Table 3, p. 16. consistent in the first few year after the 1968 reforms, but government policy also aimed at keeping consumer prices stable. The two objectives proved incompatible. The deterioration in Hungary's terms of trade, starting in 1974, provided another opportunity for those who favored a more centralized model of economic decisionmaking to reassert their views on economic ques- tions. An extensive system of taxes and subsidies on trade was used to reduce the impact of foreign inflation on domestic prices. The structure of domestic 72 producer prices became increasingly isolated from world market prices and reflected increased interventions on an industry-by-industry and firm-by-firm basis. The scope of quantitative regulations (purchase quotas and central allocations) also increased. Furthermore, production taxes, set on a firm-by- firm basis, were increasingly used, while enterprises that considered them- selves adversely affected by central interventions bargained for budgetary subsidieso To limit increases in consumer prices, the authorities did not fully transmit the rise in domestic producer. prices to consumer prices. Con- sumers thus had little incentive to adjust their consumption patterns to changes in world market prices, particularly petroleum prices0 Nor were pro- ducers induced to save energyo As a result, energy-intensive pattern of pro- duction was maintained in agriculture as well as manufacturing (World Bank 1983b)0 The 1979-80 price reforms introduced the concept of "competitive prices," that is, producer prices influenced by world markets either directly through actual export and import prices, or indirectly through specific rules and regulationso The changes were intended to promote efficiency in input utilization and to assist in the process of structural transformation0 They included measures to link domestic and international prices more closely (especially for manufactures and energy). If such measures are to be fully effective, however, it is necessary that the impact of these price changes be fully reflected in measured enterprise profitability. Because of the existence of a wide range of subsidies, it is not clear that this is yet the caseo Similarly, the principle of linking domestic prices of industrial commodities with their international counterparto io a move in the right direction0 It is evident, however, that there are practical problems in the application of the principle. The problems arise in part from the difficulties in arriving at a strict concordance between a domestically produced commodity-for example an - 73 - article of clothing or a specialized machinery item--and a comparable internationally traded commodity and its price. In part, difficulties arise from accounting conventions which are to be applied to compute the profitability of exports. Both of these factors lead to bargaining on a case-by-case basis between the controlling authorities and enterprises. The price system under which enterprises operate thus becomes as much a function of their bargaining skills as it is of objective economic criteria. Finally...the existence of a wide range of subsidies and taxes constitutes a major inter- vention in the price system, and makes measured profitability an unreliable indicator of either financial or economic per- formance. The authorities have intervened to prevent enter- prises from making what are considered to be excessive profits. The lack of precision of the measurement of profita- bility in the Hungarian case might result in the unfortunate penalizing of precisely the more efficient and profitable enterprises whose rapid development is necessary for struc- tural transformationof the economy. By the same token, inefficient firms, whose reorganization or demise may be necessary in the structural transformation process, may continue to survive and even thrive. (World Bank 1983b, Vol. 1, p. 42.) Other objectives of the 1979-80 price reforms were to reverse the prevailing negative relationship between consumer and producer prices, to introduce greater flexibility in prices, and to provide greater scope for enterprises in price setting. But general guidelines exist for overall increases in prices and considerable supervisory control is still exercised. For details on the rather complex nature of the present system as well as its evolution since 1968 see Marer (1982). The 1979-80 price reforms increased the proportions of both producer and consumer prices that were freely established. Whereas in 1979, 57 percent of producer prices and 45 percent of consumer prices were freely established, in 1980 these proportions had increased to 67 percent and 55 percent, respectively. Among the producer pricing categories, 100 percent of those in metallurgy, engineering, light manufacturing, food industry and trade were 74 - free. But only 7 percent of energy, 10 percent of transport and communica- tions, and 13 percent of construction prices were in this categoryo Consumer prices are either "fixed," "flexible within officially set limits," or free. In 1980, these categories represented 16 percent, 29 percent and 55 percent, respectively of consumer prices (World Bank 1983b)o Despite the authorities' declared intention to reverse the negative differential of 4-6 percent between producer and consumer pricesD as part of the price reforms they increased consumer price subsidies between 1979 and 1981 from 604 percent of CDP to 8 percent of GDP. This rapid increase in consumer subsidies was largely the result of the authorities' decision to mitigate the effects on consumers of the alignment of domestic energy prices with those prevailing in international markets. Consumer price subsidies are only one part of the total price support expenditures from the budget0 Assistance to enterprises represented 9.5 percent of GDP in 1981 (a decline from 12.6 percent of GDP in 1978 and 1979) and support for agro-cooperatives another 1.2 percent of GDP (increasing from 0.9 percent of GDP in 1978 and 1979). Total price subsidies thus amounted to 1807 percent of GDP in 1981 (down from 20 percent of GDP in 1978 and 1979) (World Bank 1983b)o The Hungarian authorities are moving to reduce the subsidies. In July and August 1982, prices were increased by 10=30 percent for certain construction materials, by 15-20 percent for some services, by 40 percent for some cereal products, and by 100 percent for long distance transportation. These measures, and the depreciation of the forint in July and December brought the inflation rate to 802 percent in 1982. In the first quarter of 1983 further sharp price increases were announced, for rents, passenger transportation, and gasoline and household fuels0 The continuation of these - 75 - measures is necessary both for reductions in budget subsidies and for improvements in economic efficiency. A capital tax, introduced to encourage enterprises to use capital more efficiently, was abolished in 1980 for reasons that are not clear. But interest rates on bank loans to enterprises have been maintained at positive levels in real terms in recent years (4-5 percent in 1981, rising to 6-7 percent in the latter part of 1982, both in real terms), while budget grants have been reduced sharply for enterprise-initiated investments (see Table 5), and even for state investments, where they fell from 63 percent of the total in 1980 to 47 percent in 1981. Partial rebates of interest charges if invest- ments achieve certain goals are used to help channel investments (including a substantial amount of that financed in part by enterprise resources) toward areas given priority by the planners. At present these include export promotion, import substitution, energy conservation, waste recycling and technological innovation. The rebate--which is 45 percent of the nominal rate, which in turn averages about 14 percent for most loans--would place the real rate for such loans close to zero. Rebates are given, however, only if the priority objectives of loans are achieved. A uniform rate of exchange was introduced in October 1981, culminating a process of reform begun in 1968. The basic principle on which exchange rate policy from 1968 through mid-1982 was conducted was to limit the effects of international inflation on the domestic price level. In adjusting the exchange rate, however, authorities have given some consideration to the profit situation of exporting enterprises. Thus, adjusted for relative rates of inflation, the effective exchange rate index relative to the currencies of Western trade partners shows no overall trend during the 1970-81 period; - 76 - periods of depreciation (1970-74 and 1977-79) alternated with periods of appreciation (1975-76 and 1980-81)o At the same times a marked deterioration in export price competitiveness during 1980-81 virtually offset the improve- ment recorded during 1977-79, and this trend continued in early 19820 Since July 1982, devaluations have been used more aggressively to stimulate exports and discourage imports. Incentives0 Hungary's system of wage and personal income regulation has four major objectives: to control the growth of purchasing power so as to maintain the planned macroeconomic balance; to keep earning differentials within socially acceptable bounds; to support living standards; and to increase productivity. Admittedly, these objectives are contradictory in many respects, and since 1968 many changes have been made in the highly complex regulations designed to mediate among them, as the balance of priorities has shifted and experience has been gained with the system. Already in 1969, for example, the bonus system for managers had to be changed because of a strong protest on the part of the unions, which claimed that managers were benefiting disproportionately in comparison with workers. In recent years changes have generally sought to increase income differentials to stimulate productivity (Knight 1983b). Since 1968, labor income in Hungary's socialist sector has had three major components: basic wages, productivity-related and other wage supple- ments, and annual distributions from after-tax profits0 In state enterprises, the precise level of the basic wages and the rules governing the earning of productivity-related supplements as well as the distribution of profits are set annually in collective agreements negotiated between the managers of an enterprise and enterprise-level trade unions. The negotiations are carried out within a complex system of wage regulations which, together with an indi- - 77 - cator of enterprise performance in most cases, has a strong influence on the level of each employee's total earnings and the level of employment. The State Office for Labor and Wages (SOLW--formerly the Ministry of labor) is the agency charged with formulating and monitoring the implementation of these regulations, and this is done in close collaboration with other government agencies and interest groups, in particular the National Council of Trade Unions. The basic wage ranges for different categories of manual workers, nonmanagerial white-collar workers, and managers are established by decrees of the Council of Ministers. For any category of worker, the range of the basic wage may vary considerably--usually the top of the range is 60-80 percent higher than the bottom. For manual workers, the upper end of the highest category in mid-1982 was six times as high as the lower end of the unskilled category. The upper end of the range for general managers was 9.6 times the lower end of the unskilled manual labor category and 3.8 times that of the lowest level of a production foreman (Knight 1983b). Annual collective agreements specify the rules to be used in award- ing productivity-related wage supplements, although allowances for overtime, shiftwork, language skills, and so on, are fixed centrally by the SOLW. This component of wages is generally a higher percentage of total wages when indi- vidual productivity can be clearly measured (as in the case of piecework); in such cases the basic wage may be set toward the lower end of the range. The supplements may sometimes exceed the basic wage. In the Ministry of Agricul- ture's Crop Protection Service, for example, the performance-related component of a pilot's wages averaged 55-60 percent of total wages in 1982. For the top managers in a state enterprise, the level of bonuses has been determined by 78 - the relevant branch ministry, and bonuses have been taken from profits after payment of taxes and compulsory allocations to the reserve fundo For mana- gerial personnel, the bonuses have averaged some 30-35 percent of salaries0 The final component of a worker's earnings in the socialist sector consists of that portion of after-tax profits distributed through the sharing fund. In 1980, sharing fund distributions averaged 5 percent of total earn- ings. It is common for distributions from the sharing fund to be related to total wages, but other factors such as seniority may also play a role. The precise rules for the allocation are spelled out in the collective wage agreement. Competition. Although in principle there has been competition between profit-seeking enterprises has existed in Hungary since 1968, in practice this has been limited by the relatively high degree of concentration in the industrial structure0 A wave of industrial mergers in the first half of the 1960as, intended in part to increase efficiency through the consolida- tion of suboptimal units, reduced the number of enterprises from 1,570 in 1960 to 812 in 19700 The number of enterprises fell by an additional 15 percent by 19800 In 1977, 23 trusts0 comprising 350 enterprises0 were in existence0 21 of which were horizontal in nature. Eighty-four percent of the industrial labor force is employed in enterprises having more than 1,000 workers; and about one-third of the industrial work fo£ce Is concentrated in 38 firms, each employing more than 5,000 workers. Only 56 enterprises employed fewer than 100 workers. By international standardo, industrial concentration in Hungary is much higher than in other small industrial economies such as Belgium, Denmark, and Sweden (World Bank 1983b). - 79 - Since 1980, at least 137 new firms have been created by breaking up horizontal trusts and large firms (Balassa 1982b); in manufacturing, only four trusts--one each in aluminum, farm equipment, paper products, and metallurgy-- remain (World Bank 1983b). Current topic of debate is whether some of the larger or multiplant enterprises should not be broken up to increase domestic competition, especially since the extreme scarcity of foreign exchange expected over the next few years suggests that competing imports cannot be relied on as primary means of forcing improvements in enterprise efficiency. In any case, the formation of small private, quasi-private, and cooperative enterprises is being encouraged as a complement to large state enterprises. Many exporting firms may now choose among foreign trade firms, and since 1982 about 120 state enterprises and cooperatives have had given direct export rights (Balassa 1982b). Further reductions in cost-plus pricing practices and a greater willingness of the authorities to permit the decline and possibly the closing down of enterprises that make consistent losses could make competition a more effective spur to efficiency. Beginning in 1983, the failure of an unprofit- able enterprise to improve efficiency will trigger an automatic sequence of adjustment measures, including an obligation to change the structure of production, to improve management, and to release manpower. Credit to such enterprises will be sharply restricted. Enterprises do compete for access to limited credit from two state banks, which apply economic analysis in choosing projects to finance, albeit within different specialized lines of credit. The extent of enterprise profits also affects their ability to expand. Although Hungary does not have a true capital market, state enterprises and corporations are now allowed to - 80 invest in subsidiaries. Since 1983D firms have been allowed to issue bonds through financial institutions, the latitude of financial institutions to participate in the capital of enterprises has been widened, and rules are being elaborated to permit some mobility of capital among enterprises. In the labor market there has been strong competition for the best workers, as mani- fested by high turnover rates, but it has been difficult to dismies workerso Nevertheless, since 1976 the proportion of separations initiated by the enterprises rather than by individual workers has been rising, and this change suggests that a growing percentage of workers leaving an enterprise are being fired or laid off0 Beginning in 1983, appointment of managers has been subject to competition, extensions of their contracts now depend on their performance, and their authority to manage their enterprises independently has been strengthened. Conclusions. The economic reforms in Hungary have provided for significant economic decentralization and are widely perceived as a model for other socialist countries that want to retain a significant degree of central planning while they rely to a greater extent on indirect instruments to guide enterprises in responding to market forces. The Hungarian experience suggests that external economic shocks may be used both to retard (1973) and to promote (1978/79) the process of economic reform0 but that the critical factor In pursuing reform is the extent of political consensus that the reformers can develop. Although the 1968 economic reforms apparently helped to accelerate economic growth somewhat0 the results were not really impressive. GNP growth averaged 508 percent over the five-year period 1968=72, compared with 5o3 percent in the five years between 1963-67. Balassa (1982c), however0 - 81 - mentions an unpublished study by Marton Tardos at the Hungarian Institute for Market Research showing that the growth rate of total factor productivity more than doubled between 1962-67 and 1976-72. In the same paper Balassa notes that inventory ratios fell as firms economized on stock holding and that betweens 1968 and 1973 Hungary's exports to market economies increased considerably faster than any other socialist country, except oil-exporting Romania. Nonetheless, it is difficult to find firm statistical evidence indicating that the reforms have succeeded in increasing economic efficiency. On the contrary, industrial efficiency--as measured by ICORs, gross production per unit of productive fixed assets, and the ratio of profits to total assets--appears to have declined over the 1970s. These results may be explained in part by the retreat from reform during the better part of this period, but again it is difficult to prove causality. The acceleration of the reform process beginning in 1979 coincided with a deterioration in interna- tional economic conditions and a domestic stabilization program that have brought GNP growth almost to a standstill and left capacity underutilized. Thus, here too, it is hard to judge the effect of the latest reforms at the macrolevel despite the general consensus of most informed Hungarian and Western observers that the reforms have had a positive impact on efficiency. Hungary's experience illustrates the complexities of introducing international market signals into a centralized decisionmaking system while maintaining strong equity objectives. External shocks to the system during the process of comprehensive economic reforms enormously complicate the job. The structural transformation that the reforms seek to promote requires that substantial parts of the capital stock be replaced because they have been rendered obsolete by technical change or fundamental changes in prices, - 82 - pmTticularly energy prices. At the same time, new investment is required to move into products and industries with competitive promise in the interna- tional markets of the future. Thus, there is an immediate increase'in the demand for imports, while exports cannot be expected to increase as rapidly. This situation puts an immediate strain on the balance of payments. If there is no "slack" in the economy (either unused productive capacity or interna- tional reserves) and external financing is not available, domestic consumption must be choked off in order to meet short-term balance of payments constraintso If consumption were repressed such action would likely have negative political implications; on the other hand, if necessary investment were postponed, still longer delays would be experienced before fruits of reform uare reaped. The reform process, by providing greater material incentives to successful producers, is also likely to increase personal income differentialso Since in the early stages of reform fiscal instruments such as the personal income tax are generally underdeveloped, in an equity-oriented system this situation creates social pressures for recentralizationo If the benefits of reform cannot be demonstrated in a tangible manner, and the costs are apparent to all, there is a risk that political forces opposed to the reformo will be able to reassert themselves, stalling or even reversing the reform process, as they did in the mid-1970a0 D. Yugoslavia The economic development of Yugoolavia over the pest two decades has been characterized by rapid economic growth and impressive structural trans- formation0 Between 1952 and 1981, GDP grew at an average annual rate of about 6 percent in real termoo The share of investm2nt in GDP has been high throughout the period, above 30 percent in reenat years0 Inasmuch as popula- - 83 - tion has grown been only 1 percent a year, real per capita income has more than doubled during the period. Per capita GNP in 1981 is estimated to be US$2,790 at 1981 market prices. 1/ The social sector (which includes government, public agencies, and enterprises), in particular industry, has been the driving force of the economy; the share of industry in GDP is now around 42 percent while agriculture has declined to about 12 percent. The period from 1950-80 has also witnessed the growing integration of Yugoslavia into the world economy. Between 1960 and 1981, merchandise exports and imports grew at an annual rate of around 6 percent and 8 percent in real terms, respectively. Although much of this trade was with markets in the convertible currency area, Yugoslavia's export performance to the industrial market economies has recently shown increasing signs of weakness, over the past decade, particularly since 1973. Despite impressive overall growth performance, large regional disparities persist. The republics of Bosnia-Herzegovina, Macedonia, and Montenegro, each with two-thirds of the national average per capita output, and the autonomous province of Kosovo, with one-third, are officially designated as less-developed regions (LDR). The difference between the most developed region, Slovenia, and the least developed, Kosovo, is 6 to 1. In addition to these interregional disparities, within regions differences in per capita income between communes are as high as 10 to 1. These disparities are related to several factors, notably the greater incidence of low-productivity agriculture in the LDRs and their higher population growth rates, which averaged 1.2 percent annually during 1971-81. Since 1965, sizable conces- 1/ According to World Bank Atlas methodology. 84 sionary credits (with about 50 percent grant element)--equal to about 10 percent of the social product of the LDR--have been transferred to the LDR through the Federal Fund for the Accelerated Development of the Less Developed Regions, which is financed through a tax on all social sector enterprises in the economyo In addition, the federal budget provides supplementary resources for social sector expenditures in the LDRso Together these resources account for about 10 percent of the social product of the LDRo Another problem is to provide adequate employment opportunities in the modern sector. Since 1954, employment in the modern social sector has increased by around 4 percent a year, and this has facilitated rapid outflows from the agricultural sector. Even so, substantial productivity and income differentials remain between the modern (mainly social) and the traditional (predominantly private) agricultural sectors, and are the cause of the high demand for modern sector employment on the part of the rural labor forceo Large numbers of Yugoslavs have sought temporary employment abroad since the late 1960so At its peak in 1973, Yugoslavia had about 1l1 million external migrantso Since 1973, however, this trend has been reversed , and returning migrants have added to the pressure on the social sector to create new work placeso Unemployment rates have risen rapidly from about 7 percent in 1971 to more than 12 percent in 19820 1/ The incidence of unemployment is highly regionalized; in 1982 unemployment rates ranged from 29 percent in Kosovo to 2 percent in Slovenia. 1 These rates are not directly comparable to those in other countries0 They represent the ratio of registered job-seekers (including some cur- rently employed) to the social sector labor force. The ratio of regis- tered job seekers to the total resident labor force was about 9 percent in 19820 - 85 - In the first years after World War II, Yugoslavia, more than any other Eastern European country, copied Soviet institutions and practices (Milenkovitch 1971). Yugoslavia's expulsion from the Cominform in June 1948 was the first step toward the economic reform that has given the country a unique form of highly decentralized market socialism based on the principles of worker self-management within a three-tiered federal political system. When the Soviet Union and other East European communist countries boycotted trade after June 1948, Yugoslav imports from these countries dropped from 56 percent of the total in 1947 to nothing in 1950 (Dubey 1975). The break with the Cominform gave the Yugoslav communists an oppor- tunity to reconsider their ideological position. Their primary motive for establishing workers' self-management was the need to resolve dissatisfaction with an emerging administrative class that conflicted with the ideals of a revolutionary movement with strong populist and egalitarian elements (Schrenk, Ardalan, and El Tatawy 1979). The desire for greater regional autonomy also was a motive for decentralization. What developed was a Yugoslav version of socialism with a strong anti-statist element. Yugoslavia's reforms clearly promote economic as well as political decentralization, but they go beyond the reforms of any other socialist country in their to include a strong reliance on intrafirm decentralization. In the Yugoslav ideology, nationalization of economic resources and their management by the state are perceived as the pre- cursors to "state capitalism" that must be replaced by social ownership and control of the means of production. The concept of social ownership was developed in recognition of the right of workers to manage the means of pro- duction and dispose of the product. Many political and economic decisions were decentralized from the federal government to republics, autonomous provinces, communes, and enterprises in order to accommodate the diverse needs - 86 - and aspirations of the various nationalities of Yugoslaviao To make self- wanagement a reality, authorities reduced central planning and control and placed greater reliance on markets as a guide to the allocation of resourceso The planning function was also decentralized to the republics, communes, and enterprioeso Workers' councils were established on an experimental basis in 215 selected enterprises in late 1949. In June 195O0 the Workers- Self-Management Act was adopted by the Wetional Assembly marked the formal beginning of the long process of reform that continues today. Since then at least four periods of change have occurred--first, a movement away from traditional central plan- ning during 1950-53D then elaboration and consolidation of market socialism during 1954-64D, axzimum reliance on market forces with only indicative planaing during 1965-74, mad a period of more restricted use of markets accompanied by the development of new forms of "self-management planning" from 1975 to the presento The aim of the new planning system is to overcome the nagative aspects of centralized (top-down) and decentralized (bottom-up) planning. Even within thGoe periods the process of reform has never ceasedo The prineipal reorms were all preceded by a period of serious balance of payEntO difficulties that the reforms were supposed to help alleviate, but political considoadctions were also important. ThGE@ 6Oaotieutional changes in 1953D 1963, and 1974 formalized occial, poRoitiReGD ad economic changes of the preceding periods; each also Gotnbligohd aow inotRtutiono that departed significantly from the previous oeatiscG It io Rposible to convey the richness and complexity of the Do?ogz poaooO and tJmo continual evolution 0g tho Yugoslav economic system l Iooo an icm godnntion to tha vQat 1itGTatUTQ O tUi subject, the - 87 - interested reader may consult Milenkovitch (1971); Dubey (1975); Horvat (1976); Schrenk, Ardalan, and El Tatawy (1979); Schrenk (1981); and the references they cite. This section provides but a glimpse of the main elements of the system and the steps by which it evolved. Ownership of the Means of Production. 1/ In 1952, the control of all state enterprises was formally transferred to the workers' councils, which were regarded as trustees for the fixed capital provided to them by the Yugoslav state. Social ownership of the means of production--whereby workers have the right to control and use, but no one, not even the federation, holds the full set of rights and obligations normally associated with ownership--was enshrined in the constitution of 1953 as one of the basic principles under- lying Yugoslavia's social and political system. Since then the nature of the rights and obligations of the councils and governmental units at various levels of the federation have been continually redefined, but the basic concept of social rather than state ownership has remained, and this mode of property ownership has been the dominant one. In 1981, 61 percent of the total labor force (which includes migrant workers abroad and the unemployed) was employed in the social sector, up from 43 percent in 1970. The social sector accounts for 85 percent of GDP. Private ownership remains important in agriculture, where a process of partial decollectivization initiated in 1953 has permitted private holdings of up to 10 hectares. In 1970 the private agricultural sector employed 43 percent of the total labor force, and 96 percent of the agricultural workers / mThe data in this section are taken from Dubey (1975) and World Bank (1982b). - s - held 70 percent of the total farmland, and produced 71 percent of the agricultural produce and 56 percent of marketed production. Ten years later the private sector was still responsible for 71 percent of production and 92 percent of the jobs in agriculture. Outside of agriculture, small-scale activities (employing up to five salaried workers) are permitted in any area of activity, and private enter- prises may associate in the form of cooperatives while retaining rights of private ownership over their assets. Private nonagricultural employment rose from 3 percent to 4 percent of the total Yugoslav labor force between 1970 and 19810 Since 1976, "contractual organizations of associated labor" (COALs)D which bridge the social and private sectors, have been allowed. In a COAL individuals pool their financial resources with each other, with socially owned resources, or both0 The Locus of Decisionmaking. A general principle of reform in Yugoslavia is that decisionmaking power should be devolved as far downward as practicable and the state removed from the management of economic and socio- economic matters to the largest possible degree. Table 7 illustrates this principle by indicating the extent to which the state withdrew from investment finance over the period 1952-700 Self-finance by work organizations increased rapidly in the 195Ns, while the role of banks expanded in the 1960S and became predominant by 1970o The 1965 reforms decreased the influence of governmental units and increased that of enterpriseo in the allocative decisions of banks. In general, the 1965 economic reforms emphasized the autonomy of enterprisesD shifting much decisionmaking power from state organs to - 89 - Table 7: YUGOSLAVIA: INVESTMENT IN FIXED ASSETS BY SOURCE OF FINANCE, SELECTED YEARS 1952-80 (% of total) 1952 1955 1960 1965 1970 1975 1980 State 98 64 62 27 16 3 2 Work organizations 2 35 37 37 3 53 50 Banks - 1 1 36 51 44 /a 48 /a Including the Federal Fund for the Accelerated Development of the less developed regions and resources of sociopolitical communities. Source: Dubey (1975) Table 1.1, p. 34, and Table 9.11, p. 221; and Statistical Yearbook of Yugoslavia, 1981, Tables 110.2 and 110.3, p. 186. enterprise management, while devolving considerable amounts of the remaining state, involvement from the federal level to the republics and communes: These processes involved, among other things, the abandonment of centralized investment allocation in favor of autonomous decision taking by commercial banks, the replacement of mandatory plans by a system of indicative planning, consider- able devolution of fiscal authority away from the federal level and an increased role for the price system and the market in resource allocation. In its actual workings, the "economic model" of 1965 soon displayed certain weaknesses. The devolution of authority over public expenditure and investment decisions deprived federal institutions of the most powerful instruments previously utilized by them to direct resources into areas of social priority. While this role was in theory to have been assumed by market forces, in practice the operation of the market was severely abridged. The mobility of investable funds through the banking system was limited and highly regionalized. The more powerful enterprises were able to preempt investment resources, and the financial accountability of enterprises remained limited. Additional distortions were created by the fact that certain prices remained administra- tively determined while others were liberalized. As a conse- - 90 - quence of these shortcomings, certain negative trends in the economy became of growing concern to Yugoslav policymakers in the late 1960s and early 1970so These included the emergence of considerable overt inflation, adverse balance of payments trends and a decline in the efficiency of investment. In addition, there was concern that the system afforded too much power to the managerial structures of the society and thereby weakened the social and ethical goals of self-management. (World Bank 1983c, Vol. II, ppo 1,2) Growing awareness of these difficulties promoted further changes in the system of economic management, which began with a series of constitutional amendments in 1971. The new system was more broadly defined in the constitution of 1974, and further elaborated by important legislation on planning and associated labor in 1976. The objective of these measures was to reconcile decentralized decisionmaking and self-management with the need for coordinated national action through the development of new proceduresD particularly in the area of investment planningo To facilitate the operation of self-management, the process of decentralization was extended below the enterprise level. The basic organization of associated labor (BOAL), the smallest operating unit capable of producing a marketable output, was established as the basis on which higher levels of economic organization, including but not limited to the enterprise, would be constructed (see Table 8). Within every BOAL and enterprise there are three layers of management: workers' councils elected by secret ballot from within the working community; executive organs elected from among the members of the workers' council; and management organs composed of one or more professional managers. The workers' council, the assembly of the commune, and the union organization of the work unit select jointly managers from among candidates responding to public advertisements for the position. The manage- ment organ has the right to give directions to workers so as to implement the - 91 - Table 8: YUGOSLAVIA: COMPOSITION AND FUNCTION OF SELF-MANAGED ORGANIZATIONS Organization Composition Function Basic organization All workers who Atomizes economic decision- of associated join in an "asso- making to the smallest labor (BOAL) ciation of labor" technically distinguishable unit producing a marketable output Enterprise BOALs Links associated BOALs that jointly realize income in an "association of labor and resources" Association Enterprises in a Forum for discussing common branch matters, horizontal coordina- tion, and decisions binding consenting members Chamber of the All associations Forum for discussing common economy matters and for broad vertical coordination Reproduction Vertically linked Integrates medium-term plans entity enterprises for output and capacity; not a legal entity Composite organi- Vertically or Integrates medium-term plans zation of horizontally for output and capacity; a associated labor linked legal entity enterprises Community of Enterprises and Links suppliers and users of so- interest other social cial or productive services for sector the joint regulation of organizations supply, demand, and financing Cooperative Individuals in Links private individuals for the private joint production in agricul- sector ture, crafts and productive services Contractual or- Individuals and Links private workers and ganization of workers owner-operators with social associated labor resources in hybrid private (COAL) and social enterprise Bank Enterprises and Work community for pooling BOALs as de- the resources of members for positors and financing the investment of borrowers members Source: Schrenk, Ardalan, and El Tatawy (1979), Table 3.1, p. 51. - 92 organization-s plan and business policy, but is excluded from all forms of personnel policy, including hiring and firing. Although it is normally appointed for four years and may be reppointed, the management organ is subject to recall at any time--for negligenceD incompetenceD legal misconduct, or the failure to maintain cordial relations with other bodies. Dismissal proceedings can be initiated by the workers' councilD the assembly of the commune, or the trade union0 Every major decision of a larger legal entity comprising a group of BOALs must be agreed to by all constituent BOALsD and each BOAL has a right to split off from its broader organizational unit, as long as that separation does not endanger the survival of the remaining BOALs. Mechanisms exist to enable BOALs to communicate and coordinate their interests in larger organi- zations without violating the principles of direct control0 Two new legal instruments were introduced in an effort to make plan- ning and self-management compatible: social compacts and self-management agreements. These instruments enable all economic agents to participate in the formulation of macroeconomic policy while maintaining decentralized responsibility for policy implementation0 Beginning with the medium-term plan for 1976=80, these instruments have been used extensively particularly in the areas of prices, incomes, and employment. Social compacts are concluded by the assemblies of sociopolitical communities (the federation, republics or communes) and, in many instances, by trade unions, chambers of economy and associations of enterprises (see Table 8)o Their functions have been summarized as follows: - 93 - Social compacts regulate rights and obligations affecting broader economic issues and policies: the priorities of social plans; the principles and criteria of policies for prices, employment and foreign trade; and the functional distribution of income between personal income and capital accumulation. Frequently the social compacts lay down obligatory provisions and ground rules for specific self- management agreements that are subsequently concluded. Sociopolitical communities in many instances initiate the conclusion of social compacts. Although their legal format makes social compacts appear to be tantamount to civil--that is, microeconomic--contracts, they often set out macroeconomic policies. In these instances, they take the place of policy measures that in most other countries would be regulated either by law or traditional economic policies and carried out by government agencies without the direct participation of affected parties. Once concluded, social compacts have, for practical purposes, the force of law. They cannot be abrogated before the specified time of expiry, unless that abrogation is agreed upon by all parties to the compact. Self-management agreements regulate almost all relations in, among, and between economic organizations: the formation of BOALs, enterprises and banks; the distribution of jointly earned income among BOALs in an enterprise or among enter- prises integrated in reproduction entities; the delivery contracts and principles for establishing transfer prices among associated BOALs or enterprises; the criteria for distributing net income of BOALs between personal income and accumulation; the use of generated investment resources in BOALs and the pooling of those resources in enterprises or reproduction entities....Depending on the subject matter, self-management agreements may be concluded for a specific period of time or for a specific purpose regardless of time. In many instances the five-year plan period determines the time horizon. Parties to self-management agreements may default on their obligations only because of changes in priorities or condi- tions beyond their control. Such defaults nevertheless are severly penalized by provisions for financial compensation to other parties to the agreement. (Schrenk, Ardalan, and El Tatawy 1979, pp. 50, 52) This quotation together with Table 8 should give some idea of the uniqueness and complexity of the new institutional arrangements within which economic decisionmaking now takes place in Yugoslavia. Self-management agreements, however, are similar to civil contracts in most other societies. - 94 The 1974 constitution also introduced a new framework for economic and social planning, designed to reconcile decentralized decisionmaking with consistent and coordinated actiono The system of planning seeks first to establish a national consensus on the most important medium-term goals for the economyo Thereafter, plan formulation is based on participation on a non hierarchical basis of all economic and social unitsD including government bodies. An exhaustive (and often exhausting) interchange of information is required to achieve consistency among the plans of economic units concurrent with broader social objectives0 Once consistency is achieved , economic units are supposed to enter into legally binding medium-term agreements on supply, demand, and investment intentions. In case agreements cannot be reached by the prescribed date, the state is permitted to intervene, but only on a temporary basis. In practice, reliance on a system of multilateral negotiations among planners, banks, enterprises, and political bodies, rather than the use of realistic capital pricing (for instance through appropriate interest rate policies) as the primary mechanism for rationing capital has had a high cost0 Through lobbying, enterprises and communes ware able to gain approval for too many projects, including a good number that were not well-conceived or fully financedo In consequence, the size of the investment program launched between 1977 and 1979 overwhelmed the administrative and financial capacity of the country: investment resources were spread too thinly over too many projects, and the capacity of the local construction and equipment supply sectors was overstretched0 The result was escalating cost overruns and delays in project completion, and were exacerbated by shortages of foreign exchange and domestic funds toward the end of the last plan. - 95 - As part of a stabilization program beginning in 1980 and suported by a three-year IMF standby arrangement that took effect in January 1981, a number of measures have been taken to improve the quality of decisions made on new investments in the economy in a fashion consistent with decentralized decisionmaking. For one thing, the institutional framework for appraising and initiating investment projects has been strengthened, and moves made toward a more realistic pricing of capital. These measures, together with others designed to increase the accountability of enterprises for their decisions, should improve the efficiency of investment decisions. Price Formation. 1/ Yugoslavia's economy, as noted earlier, is based on the principles of market socialism. Prices are said to have a legit- imate role in allocating resources, but not to the detriment of other systemic goals such as intergroup or interregional equity. In consequence, rules of price formation are complex, and a large group of allocation decisions are taken outside market channels. For goods and services the price system has never been totally free of administrative interventions since the reform process began. Until 1965, the most rigid price controls applied to raw materials and agricultural products. Two main objectives of the 1965 economic reforms were to align domestic with international prices and to allow subse- quent price adjustments in response to changing market conditions. The second objective was not vigorously pursued. Prices of many goods and services were again fixed, and a large proportion of producer and retail prices remain under various degrees of social control to the present day. The height of the price / This section draws heavily on a background note for WDR VI by Suman Bery (1982). - 96 - liberalization was probably reached in 1971 when producer prices for about 57 percent of industrial output and 76 percent of commercial turnover were freed (Marsenic 1973, cited in Schrenk, Ardalan, and El Tatawy 1979)o In the system developed since 1971, market arrangements range from complete liberalization to complete bilateral (or multilateral) negotiation between affected interest groups. In addition, jurisdiction over price control is distributed between commune, republic (or province) , and federa- tion, depending on the good in question. Certain illustrations may help to convey the flavor of the resource allocation process, which is too complicated to summarize. Four broad types of transactions may be distinguished. One class of transactions includes those that have been explicitly removed from market determination and placed under a unique institution called the Community of Interest (COI)o COIs provide a forum for all suppliers and consumers of the service or commodity in question. Both groups make decisions jointly and on an equal footing on all matters affecting current supply and demand (including prices) as well as on investment matters (including all long-term financial transactions among the members) related to investment in the particular area of activity. COIs were initially introduced for social services (like health, education, science, social insurance, and so on)0 The concept was then extended to public utility services such as electric power generation and distribution, water supply and sewerage, railways, and highway construction and maintenance. More recently the concept was further extended to the allocation of foreign exchange and import rights. The geographic level at which the COIs operate differs by activity; usually they operate at the communal level for social services and at the republican level for economic aervices and foreign exchange. The legal form of agreements reached by COIs is normally a social compact0 - 97 - Another class of transactions comprises interenterprise (or inter- BOAL) transactions. These are regulated by self-management agreements as described above. They determine both physical deliveries and criteria by which the internal or transfer prices are to be established, frequently as part of a wider cooperation agreement. Common considerations of such agreements are risk-sharing, relative personal incomes in the contracting entities, and international prices for the commodity in question. Third, for certain goods and services that are regarded as basic or strategic, prices are controlled administratively, although in most instances the affected parties participate in the proceedings that lead to the determi- nation of prices. In such cases, international prices frequently provide an important point of reference, although considerations of costs, personal income levels, and so on, also play their role. Since 1980, the elaboration of price policy has been decentralized through the formation of communities of interest for prices at the republican-provincial and communal as well as the federal levels. With the rapid inflation of recent years, a number of serious price distortions have accumulated, particularly in the critical energy and transportation sectors. Under the 1980 price law, if the stability of the market, fulfillment of the social plan, or other public interest so warrant, sociopolitical communities at each level of the federation can take steps to regulate the prices through the appropriate price community. At the end of July 1982, in accord with an exceptional provision of the 1980 price law, the Federal Executive Council suppressed the functioning of the republican-provincial and local price communities and mandated the Federal Community for Prices to fix ceiling prices for all goods and services except those sold in farmers' markets as part of the stabilization program. - 98 - During the subsequent six months, the Federal Community for Prices had the sole authority to grait price ceiling increases for the controlled goods and services. The selective price freeze was extended for a further six months in January 1983, but authority to grant price increases for some products was restored to the republican and provincial price communities0 In accord with a social compact signed in January 1983, the number of goods and services subject to price ceilings is being progressively reduced, and long-term price policies are being prepared in a number of key sectors, including energy, ferrous and nonferrous metallurgy, basic chemicals, agriculture, and rail transport. These long-term price policies should be established by the end of July 1983 and amendments to the 1980 price law will be passed to increse the role of world market prices and market forces in domestic price formation, and to reduce the number of commodities subject to review by the republican and provincial price communities. The fourth category of prices pertains to the goods and services (including, for instance, sales by the private sector of its farm and handicraft output) said to be completely free. The situation regarding the allocation of factors of pr tion is, if anything, even more complex0 The philosophical and political premises of self-management socialism do not permit labor to be treated as a commodity to be "sold" at a market-determined wageo Thi philosophical position carries practical implications for the recruitment and dismissal of workers, and for the conventions governing the payment of personal incomes to workers0 Wages in the conventional sense do not exist. Instead workers hold a claim to receive remuneration as a share of a residual arrived at after deducting material costs and depreciation from revenues0 Thus personal incomes - 99 - fluctuate according to enterprise performance. Although workers' councils must approve the relative remuneration levels of all those employed within a BOAL, there is considerable stability in the interfirm and intersectoral structure of wages, suggesting that elements of convention play a substantial role in determing relative wages. In Yugoslavia the concept of capital as an independent factor of production, to be allocated by an anonymous, smoothly functioning capital market is strongly criticized on philosophical grounds. In line with Marxian analysis, the autonomy of capital is denied since it is seen merely as "past labor." In the Marxian scheme, alienation over the surplus created through past labor by the direct producers (workers) is lost. This critique occurs when control has serveral practical implications. First, it has tended to keep capital underpriced relative to labor, both through low (generally negative in real terms) interest rates and a resistance to imposing capital charges on self-financed accumulation. The negative real interest rates and lack of capital charges on reinvested profits have contributed to excess demand for investment (posing difficulties for macroeconomic management) and reduced the creation of new opportunities. Second, under the current system, BOALs are required to pool their investable resources rather than to "sell" them in a capital market. Third, the notion that any surplus value created should remain permanently under the direct control of the workers' collective that created it affects the status and role of banks. Banks are considered to be service organizations for enterprises rather than autonomous profit-making entities. Thus, banks are owned by their "members" (enterprises that use the services of the bank as depositors or as borrowers). The banks perform - 100 - services for these members and have no mandate to generate a profit in their own right. In the case of foreign exchanges a complex system of de facto multiple exchange rates was replaced by a formally unified and periodically devalued exchange rate in 1961. But a system of quotas and licenses, export premiums and subsidies, and foreign exchange retention quotas was employed. The 1965 economic reforms attempted further liberalization by abolishing various means used to promote exports other than exchange retention quotas. Other forms of export subsidies soon reappeared, however, in mid-19733 fixed exchange rates were abolished in favor of a closely managed float, but exchange retention quotas, subsidized credit, and product-specific export premiums have continued to be used as incentiveeo A new system designed to apply the principles of the 1974 constitu- tion came into operation in 19780 The main institutional development here was the establishment of communities of interest for foreign economic relations (CIFERs) at the republican and federal levels. They are composed of enter- prise representatives organized by industrial branch and constitute the forum for articulation and coordination of views and plans on a variety of topics concerned with foreign economic relations. Among their functions is the distribution of available foreign exchange among member enterprises, in accord with a complex system of quantitative restrictions and self-management agreements among member enterprises. This foreign exchange allocation system has resulted in regionally fragmented quasi markets for foreign exchange and a plethora of effective exchange rates in recent years, given that demand has exceeded supply at the official rate (World Bank 1982b). This situation has negative implications for efficiency in the allocation of foreign exchange0 - 101 - The Law on Foreign Exchange Allocation was substantially amended on December 1982 with a view to promoting interregional foreign exchange mobility along sectoral lines. However, the practical effects of the new law are difficult to gauge at this time. Incentives. The relative level of personal incomes by type of job within a BOAL is determined by the self-management agreement that establishes the BOAL and that must be approved by its workers council. The normal practice is to establish points for education, experience, responsibility, working conditions, and other objective factors. Certain legal limits and the realities of the labor market (that is the scarcity of certain technical skills) are taken into account. Essentially the same system has been used since the 1950s. Until 1977, there was a maximum income level of four to five times the average within the enterprise. This has been eliminated, except in Bosnia, which retains a legal maximum for nonproductive activities (World Bank 1981b). Piecework systems and other means of relating relative earnings to individual productivity can be established with the agreement of the workers council, but by and large the differences between those doing similar types of work within a BOAL tend to be minimized. Once the relative structure (including any individual productivity incentives) is set, hours worked and individual performance for the year known, each worker's claim on the net income of the BOAL allocated to this purpose (as opposed to accumulation and various required funds) can be calculated at the end of the year. Normally, monthly or weekly advances are made during the year depending on the projected level of the fund for personal income and final adjustments made once the final results for the year are known. Even when two enterprises have the same relative pay scales, absolute - 102 - levels of pay for the same work may vary according to the overall profita- bility of the enterprise and any variation in the percentage of net income allocated to personal incomes. According to a recent study (World Bank 1981b), many Yugoslav managers think that differences based on productivity in the same line of work and those based on the premium attached to technical and professional skills are too narrow and need to be widenedo On the other hand, they think that the differentials between similar kinds of work in different enterprises or industrial branches are too wide and should be narrowed, since they create a sense among workers that income levels are essentially out of their control and simply reflect the luck of the draw as to which enterprise they were able to get a job in, and how the market for that enterprise's products has evolved. In Yugoslavia, open unemployment has been allowed to exist since the reform process began, so in principle the prospect of dismissal may serve as a negative incentive. Indeed, unemployment in 1981 was 5S1 percent of the total labor force and would have been worse were it not for the fact that another 801 percent of the labor force was employed outside the country, mainly in Western Europe. In 1972, the respective figures were 201 percent and 1103 percent (World Bank 1982b)o But in practice1, once employed by a social sector enterprise, the risk that a worker will be dismissed is minimal, though it is fairly common for managers to be released if they lose the confidence of the self-management organs with the BOAL or enterprise. The normal way in which a Yugoslav enterprise responds to a decline in net income is to reduce personal incomes across the board rather than to fire workers0 Loss-making BOALs, that those that cannot afford certain minimum personal income payments, may have recourse to reserve funds at the BOAL or enterprise level, or solidarity funds at the supra-enterprise level. - 103 - In the past, BOALs which have incurred losses 1/ have had recourse to a wide variety of sources for covering the losses -- not only their own reserves, but also reserves of other BOALs with which they are linked by a self-management agreement; "solidarity contributions" from other enterprises to which they are not linked by such an agreement, but which are important suppliers and customers; pooled reserves at the commune and republican provincial level; bank loans and reschedulings; writeoffs of debts; and postponement or cancelling of tax and contribution obligations to sociopolitical communities and communities of interest. In addition, enterprises have been able to obtain credit by paying for goods and services with promissory notes and other forms of deferred payment that they have not always executed when due. Total losses shown on the annual financial reports of social sector enterprises in 1981 amounted to about 1.4 percent of Yugoslavia's Gross Material Product in 1981. At the time these reports were prepared (early 1982), 1,277 BOALs, accounting for 4.5 percent of the social sector labor force, had uncovered losses. During the year 1982, 12.5 percent of the uncovered losses were covered with non-reimbursable funds; 66.6 percent with rehabilitation credits from other BOALs, common reserve funds, banks and other sources; and the remaining 20.9 percent was still uncovered at the end of the year (Knight 1983a). /1! BOAL is regarded as having incurred a business loss if, according to its annual balance sheet, it has not received sufficient income to cover amounts spent on personal incomes provisionally accounted and paid out, or to pay statutorily guaranteed personal incomes for the accounting business period for which personal incomes have not been provisionally accounted or paid, or for which statutorily guaranteed personal incomes have not been paid. - 104 - In 1982, only fourteen BOALs with 1,306 workers initiated bankruptcy procedures. Even when liquidation of an enterprise is necessitated by continued losses, it normally takes the form of absorption into a more successful enterprise, and it or the commune will generally find jobs for the workers of the liquidated enterprise. An amendment to the 1980 law on rehabilitation and bankruptcy, under consideration in April 1983, would require mandatory initiation of bankruptcy proceedings for any enterprise still having uncovered losses at the end of the year for which they were declared on the annual financial reporto Other amendments to this law would strengthen the role of banks and other external sources of finance in the design, execution, and monitoring of rehabilitation programs. The Social Accounting Service, which has the power to block payments of personal Incomes in excess of the levels set in approved rehabilitetion programs, would closely monitor their finance and execution (Knight 1983a)0 Competition. Competition in the goods, labor, capital, and foreign exchange markets is greater in Yugoslavia than in any of the other socialist countries considered, but it has been moderated in recent years by the new self-management planning system, which reduces the reliance on pure market transactions to guide economic decisionmakingo The proponents of this still- evolving system hope to balance the operation of market forces and competition with quasi political negotiations between all interested paties to a given issue and at all levels of the economy and the society. The harmonization of diveree interests is sought through a series of bottom-up, top-down, and horiontal interactions that seek to make BOAL-level plans consistent with those at the federal, republican, and commune levels. The resulting transparency of BOAL and enterpriose plans and the mechanisms for - 105 - price setting and allocation of investment funds through self-management agreements and social compacts can, however lead to collusion more often than competition. Competition also seems to have been affected by the trend toward regional self-sufficiency, favored by the reforms of the 1970s. The main defense against cartel-like behavior has been an attempt to encourage confrontation of countervailing economic interests, such as suppliers and consumers, but this effort seems to have been insuffient. Likewise, the sociopolitical communities at different levels of the federation are supposed to reconcile their interests to those of the country as a whole, but the existing mechanisms appear to favor regional autarchy over efficiency. Conclusions. Yugoslavia has experienced and rejected the inflexi- bility, remoteness, and hierarchical control of traditional central planning. Yugoslavia-s system of regional and enterprise-level decentralization allowed rapid economic growth and accommodated the desire for autonomy of the country's diverse ethnic and linguistic groups. After two decades of increasing economic and political decentralization, however, the system had to be reevaluated. Its fundamental failure was its lack of macroeconomic control, manifested in accelerating inflation, burgeoning balance of payments difficulties, persistent interregional disparities in Income, and a decline in the efficiency of investment. Part of the problem, it might be argued, was that the economic decentralization was still incomplete -- in particular it lacked scarcity pricing for capital and foreign exchange, price controls, and any form of true market discipline over the investment behavior of enterprises. In decentralization Yugoslavs also saw a threat to their socialist ideals, for example, through excessive concentration of power in banks and the technical managerial strata within enterprises. - 106 - The new system of self-management planning was designed to transcend- the principles and practices of earlier periods and create a genuinely new and creative response to the challenges of social, political, and economic development. The result is a unique systems, the complexity of which almost defies description and makes analysis of its workings very difficult. The difficulty is compounded by the deteriorating international economic environment that has interacted with the latest phases of the reform processo As in so many other countries confronting two successive oil shocks and international recessions, Yugoslavia first sought to maintain economic growth through foreign borrowing and a greater emphasis on import substitution. But neither the reforms of the 1970s nor this economic strategy have been able to control the inflationary process, solve the balance of payments problems, or improve the interregional income disparities. And the available evidence suggests that capital efficiency (as measured by ICORs, especially in the sectors selected for priority in the 1976-80 plan) has deteriorated, while the rate of increase of total factor productivity has declined (World Bank 1982b)o It is now generally accepted in Yugoslavia that the key to any suc- cessful and durable adjustment lies in the performance of exports, which has been hindered by excessive autarchic developm2nt (sometimes carried to the republic level or beyond) and increased insulation of the domestic market from the forces of competition. In recent months, a high-level Stabilization Com- mission has recommended a greater use of product and factor markets and of international competition to induce greater efficiency in the Yugoslav economy, while recognizing that this may imply increased unemployment and bankruptcies0 Thus, it is possible that Yugoslavia's current economic dif- ficulties may lead to yet another round of economic reforms, this time in the direction of further economic decentralization. - 107 - V. Lessons of the Reform Experience to Date Economic reforms in socialist countries, particularly reforms involving economic decentralization, are not easy to carry out. Since they involve changes in the locus of decisionmaking, the process of price formation, the structure of incentives to producers, the degree of competition, and in some instances the ownership of the means of production, such reforms inevitably influence the distribution of power and income. They thus threaten powerful vested interests and require strong political backing if they are to be implemented successfully. Since the elements of reform are highly interrelated, they should be mutually consistent, and in principle this argues for simultaneous implementa- tion of an internally consistent and comprehensive package. If managerial incentives are keyed to profits, for example, but lack competition or admin- istrative price setting does not allow prices to reflect scarcities, the impact of the incentives on economic efficiency will be open to question. If there is any priority, it would appear to be reform of the price system so that it can link the various aspects of decisionmaking by providing a compre- hensive and mutually consistent expression of relative values that can be used to evaluate alternatives in production, consumption, and investment (Bornstein, 1977). But price reform other than periodic revisions of admin- istered prices has proved to be very difficult to implement, particularly in view of the market power of many industrial firms and the scarcity of foreign exchange that helps limit import competition. To achieve maximum impact on productive efficiency, reforms must be pursued over long periods--preferably measured in decades rather than years or months--so that they can guide transformation of the stock of physical and 108 - human capital used in the productive process as well as the use made of pre- existing plant, equipment, and labor force. Energy inefficient planto and vehicle fleets cannot be made instantaneously and drastically more efficient by instituting scarcity pricing and linking managerial rewards to profits rather than output, even though some immediate savings are possible through eliminating waste. Workers may not respond to profitsharing schemes or take the risk of establishing small private firms or cooperatives until there is sufficient evidence that the rules of the game will remain reasonably stableo Nor can factory managers accustomed to taking orders or bargaining with official agencies to obtain preferential treatment be converted into dynamic, customer-oriented entrepreneurs overnight. Successful implementation of reforms also depends on the linking up of political support, technical consistency, and E reasonably long time. Without continued political support, even a series of consistent reforms may not survive long enough to provide m2asurable benefits in terms of improved economic efficiencyo Inconsistent reform may generate obvious inequities oE inefficiencies that threaten political support, halting or reversing the reform proceso before the inconsistencies can be eliminated0 In practice, reforms have not been implemented in a fully consistent fashion over a period of many years, even in Yugoslavias Internal resistance, external shocks (economic or political), and inconciastencies in the reforms actually implemented have resulted in numerous adjustmento and periods of retrogression which, even when reversed, further lengthen the time required to achieve positive resultso These factors may help explain why it is so diffi- cult to find convincing evidence that socialist economic reforms to date have had a significant impact on economic growth rateB or other indicators of macroeconomic performanceo - 109 - Nevertheless, pressure for and attempts at reform persist, and the general thrust of the reform movement is in the direction of economic decentralization, which appears to be the best way to induce increasingly complex economic systems to respond more efficiently to domestic and foreign consumer demand in a rapidly changing international economic environment. This is perhaps the most significant finding emerging from this review. Experience to date suggests that economic decentralization requires a reduction in the power of central bureaucracies (including cuts in their staff) in favor of enterprise managements, the substitution of indirect .economic regulators" for direct controls, closer linkage of performance indicators to overall financial results rather than physical targets, and a price system that allows substantial scope for the operation of market forces and significant competition among production units. These factors appear more important than changes in the formal ownership of the means of production. Difficult as it is to generalizae on the basis of very different national experiences, a few points can be made about factors that might help economic reform in socialist countries to succeed. But note that the complexity of reforms involving entire economic, political, and social systems is such that similar stimuli may provoke opposite responses--particularly in the case of economic stress. 1. Serious economic stress--as manifested through declining economic growth rates, increasing ICORs, and persistent balance of payments deficits that threaten future growth-- almost always plays a role in initiating or renewing a reform process, - 110 - 20 Once a reform process begins, its continuation is favored by unified and stable political support from top Party officials and popular understanding of the desirablility of the reforms. Hungary and Yugoslavia have done particularly well at mobilizing and maintaining the necessary support, but even in these countries, strategic retreats and ad hoc interven- tions from the center have been commonplace in response to political pressures, and certain measures were rejected from the outset. In Hungary, for example, a decision was made not to replace old-style factory managers with strorg party ties so as to avoid creating a strong group opposed to the reforms. Changes were made in the managerial bonus system and other aspects of the wage system as early as 1969D and to a greater extent in 1972 in response to union opposition to grouing income differentialso 3. Once decided upon, a reform process can develop more smoothly if external economic conditions are favorable and if there is some economic slack (for example0 in the form of foreign exchange reserves, stocks of key materials, or access to foreign credit or aid) to help the country cope with the initial disruption that almost always occurs when far-reaching system changes are introduced. Strong external shocks such as the first oil price rise and the ensuing world inflation and recession appear to have contributed to backsliding on the reform path. In Hungary0 for example0 the phased introduction of price system reforms under the New Economic Mechanism - ill - presupposed a stable world market, not a sharp deterioration in the terms of trade. In Poland, inflation in the world market raised import and export prices, but the unstable internal political situation led the authorities to attempt to maintain price stability through an increase in subsidies on imports and import substitutes while measures were taken to extract windfall gains from exporting enterprises. In these and other socialist countries, various kinds of direct controls, taxes, and subsidies were used to cushion the external shock. Postponement of structural adjustment in Eastern Europe (excluding Yugoslavia and oil-exporting Romania) was facilitated by Soviet willingness to supply petroleum at subsidized prices according to the Bucharest formula. 1/ In most of the Eastern European countries loans from Western banks had a similar effect. 4. Appropriate policy instruments are needed to ensure consistency between enterprise-level decisionmaking and macroeconomic objectives, as has been demonstrated in Hungary and more so in Yugoslavia. Some reform advocates believe that centralized decisionmaking on such crucial matters as major investments (for example, in Hungary through approval of loans by the National Bank of Hungary and the State Development Soviet restrictions in the amount to be supplied and the unfavorable impact of the Bucharest formula (five-year moving average of world prices) in a period when world prices have begun to fall after a steep rise are now rapidly reducing the subsidy element. - 112 Bank) can do that job, but perhaps the right policy instru- ments would be more effective, including flexible price and wage determination systems responsive to market forces, monetary and fiscal instruments for controlling aggregate demands and an appropriate exchange rate policy. Such instru- ments might allow greater decentralization of investment deci- sions and allow competing commercial banks to play an effec- tive role in mobilizing and allocating investment resources. 5. If adjustment to external shocks cannot be slowed w-ith the help of external resources, then the need for adjustment may lead to renewed reforms or a return to more traditional central planning and rigid controls. The outcaie may depend both on domestic political factoTs and the incentives (both positive and negative) to Teform or retrogression offered by international political and econoeic actors. 60 For CMEA countries, the attitude of the USSR and other partners placeo limits on the eatent of reform. It is easier to achieve bilateral and multilaterci production, trades and investment relations within C E A if the member countries' internal planning and manogement cyetmse are essentially similaro Given the partial and minor nature of reforms attempted in the USSR9 moot CEA eountriei haev not Imple- mented compreheneive economdc reformso Reforme in these countries would be easier to implement if they were done simultaneouslyo Should the USSR embaErk on a new effort at reform, a major constraint would be eca@d. - 113 - 7. The reforms must be designed to be ideologically and politically acceptable to the political forces that have effective control over their implementation. In the case of Yugoslavia, Western military and economic assistance and the strong popular support enjoyed by the Yugoslav leaders deterred Soviet intervention. The intervention of Warsaw Pact forces in Czechoslovakia in 1968 showed that the USSR would not tolerate an economic reform in Eastern Europe (outside Yugoslavia) that gave market forces a dominant role in guiding the economy, introduced workers' management, and substantially weakened the Party's control of economic, political, and social life. Hungary's reform, though involving comprehensive economic decentralization, proved acceptable to the USSR because it excluded workers' management, retained the unified Party's leadership role in society, and assured the primacy of the Soviet Union and other CMEA countries in Hungary's external political and economic relations (Bornstein 1977). Romania has followed a more independent line in its foreign political and economic relations, but its reforms to date have been largely confined to partial administrative decentraliza- tion. Experience to date suggests that relative independence from the Soviet Union in one of these two spheres (domestic economic system and foreign relations) may be acceptable, but not both. - 114 - VI. Priority Areas for Research This review of the reform experience in socialist countries suggests certain areas that warrant special attention by researchers. Parallel studies in these areas in several socialist countries might yield insights useful for the policymakers of more than one country , and possibly for some countries with mixed economies and a large sector of state enterprises. 10 A major objective of the reforms has been to increase economic efficiency. Recognizing the paucity of evidence showing the extent to which specific reforms achieve that objective, an effort could be made to document the impact of specific reforms at the enterprise level through detailed case studies that combine interviews with empirical data0 1/ Such studies might then lead to simplified methodologies that could be applied on larger samples of enterprises in various sectors0 20 A second area that appears critical to the success of reforms is the nexus between exchange rates, commercial policy, fiscal systems, and prices. If one of the objectives of the reforms is to increase the ability of enterprises to compete in world markets, the way in which foreign prices are translated into domestic ones and vice versa needs to be understood. This is a thorny area indeed1, but is an absolutely essential one to explore0 A collaborative research project now underway between the World Bank and the Chinese Academy of Social Sciences is a good example of this kind of research 0 - 115 - 3. Banks are playing a greater role in investment decisions in most socialist countries. To what extent do these banks apply economic analysis in project appraisal? What shadow pricing techniques, if any, are used? What steps are or can be taken to improve the quality of economic analysis done by socialist banks? How can the mobility of capital out of sunset and into sunrise activities be promoted in ways consistent with socialist principles? 4. Several different aggregate enterprise performance indicators have been used--gross value of output, net output, profits, and profit rates being the most common. What are the advantages and disadvantages in practice of these different performance indicators? What kinds of enterprise performance indicators have been or could be used to recognize the achievement of social objectives given priority in a socialist system (such as equity)? 5. Most socialist incentive systems involve some combination of job-specific income, productivity-related individual incen- tives, and collective incentives based on group or enterprise performance. What considerations have led to specific combinations of the three in different countries, sectors, and branches? Which one has worked best? If improved efficiency is the objective, can anything systematic be said about the optimum combination of the three? 6. Making enterprise managers (and perhaps other employees) bear a greater amount of risk for investment decisions and general = 116 = enterprise economic performance can help eliminate excess demand for investment resources and improve the efficiency of operations. 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