hmaft Economic Development Institute "X9
<M;, of The World Bank
Trade Reform
and External Adjustment
The Experiences of Hungary,
Poland, Portugal, Turkey, and
Yugoslavia
Alan Roe
Jayanta Roy
AN EDI POLICY SEMINAR REPORT * NUMBER 1F I L E C  P Y



Policy Seminar Reports numbers 1 through 7 are    7    Export Policies and Administration.
available from the Economic Development Insti-         Randi B. Greenblatt with Joaquin A.
tute of the World Bank, 1818 H Street, N.W.,            Cottani and Domingo F. Cavallo. EDI
Washington, D.C. 20433, attention: Ms. Edith            Catalog no. 400/047.
Pena.                                          The following titles may be purchased from the
1    Transport Policies inFrancophone Sub-  Publication Sales Unit, World Bank, 1818 H
Saharan Africa: Issues and Options.   Street, N.W., Washington, D.C. 20433.
Hernmn Levy. EDI Catalog no. 705/016.    8    The Political Economy of Reform in
IF   Les politiques de transport en Afrique         Sub-Saharan Africa. Ravi Gulhati.
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Probkmes et choix. Herndn Levy. EDI            Saharan Africa. Hernan Levy and Pat-
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EDI Catalog no. 505/003.                       Latina. Hernan Levy.
3    AgriculturalPolicyandItsRelationship      11   Managing Financial Adjustment in
to Food Policy in Sub-Saharan Africa.          Middle-Income Countries. Alan Roe
Sakwa Bunyasi. EDI Catalog no. 070/            and Paul A. Popiel.
001.                                     12   FinancingHigherEducation in Franco-
3F   Lapolitique agricole et ses rapports avec      phone West Africa. Angela Ransom.
la politique alimentaire en Afrique      13   TheRole ofCommunity Participationin
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Catalog no. 070/001.                           Management. Michael Bamberger.
4    Development Policy Analysis. David G.     14   Korea's Experience with the Develop-
Davies. EDI Catalog no. 420/043.               ment of Trade and Industry:Lessons for
Latin America. Silvio de Franco, Al-
5    Management Training and Research for           berto Eguren, and David Baughman.
African Development. J. Price Gittin1    ecoomic  ad                in algera,
ger. EDI Catalog no. 430/008.            15   Economic Adjustment in Algeria,
Egypt, Jordan, Morocco, Pakistan, Tu-
5F   La formation et la recherche en gestion        nisia, and Turkey. Alan Roe, Jayanta
pour le developpement de l'Afrique . J.        Roy and Jayshree Sengupta.
Price Gittinger. EDI Catalog no. 430/    16   Trade Reform and External Adjust-
008.                                           ment: The Experiences of Hungary,
6    Land and Water Resources Manage-               Poland, Portugal, Turkey, and Yugosla-
ment. Jacques J. Kozub, Norman Mey-            via. Alan Roe and Jayanta Roy.
ers, and Emmanuel D'Silva. EDI Cata-
log no. 070/003.



AN EDI PoLIcY SEMINAR REPORT * No. 16
Trade Reform
and External Adjustment
The Experiences of Hungary, Poland, Portugal,
Turkey, and Yugoslavia
Alan Roe
Jayanta Roy
WorldBank
Washington, D.C.



Copyright e 1989
The International Bank for Reconstruction and Development / THE WORLD BANK
1818 H Street, N.W.
Washington, D.C. 20433, U.S.A.
All rights reserved
Manufactured in the United States of America
First printing July 1989
Second printing August 1990
The Economic Development Institute (EDI) was established by the World Bank in 1955 to train
officials concemed with development planning, policymaking, investment analysis, and project im-
plementation in memberdeveloping countries. Atpresentthe substance of the EDI 's workemphasizes
macroeconomic and sectoral economic policy analysis. Through a variety of courses, seminars, and
workshops, most of which are given overseas in cooperation with local institutions, the EDI seeks to
sharpen analytical skills used in policy analysis and to broaden understanding of the experience of
individual countries with economic development. In addition to furthering the EDI's pedagogical ob-
jectives, Policy Seminars provide forums for policymakers, academics, and Bank staff to exchange
views on current development issues, proposals, and practices. Although the EDI's publications are
designed to support its training activities, many are if interest to a much broader audience. EDI ma-
terials, including any findings, interpretations, and conclusions, are entirely those of the authors and
should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members
of its Board of Executive Directors or the countries they represent.
Becauseof the informality of this series and tomake the publication available with the leastpossible
delay, the typescript has not been prepared and edited as fully as would be the case with a more formal
document, and the World Bank accepts no responsibility for errors.
The backlist of publications by the World Bank is shown in the annual Index ofPublications, which
is available from Publications Sales Unit, The World Bank, 1818 H Street, N.W., Washington, D.C.
20433, U.S.A., or from Publications, Banque mondiale, 66, avenue d'Iena, 75116 Paris, France.
Alan Roe is professor of economics at the University of Warwick, United Kingdom.
Jayanta Roy is principal economist in the National Economic Management Division,
Economic Development Institute, the World Bank.
Library of Congress Cataloging-in-Publication Data
Roe, Alan.
Trade reform and external adjustment: the experience of Hungary,
Poland, Portugal, Turkey, and Yugoslavia: report of a seminar held
in Laxenburg, Austria, June 6-8, 1988 / Alan Roe, Jayanta Roy.
p. cm. -- (An EDI policy seminar report ; no. 16)
ISBN 0-8213-1178-6
1. Commercial policy--Congresses. 2. International economic
relations--Congresses. I. Roy, Jayanta, 1943-  . II. Title.
III. Series.
HF 1410. 5. R64  1989                                 89-5449
382' .3--dc 19                                        CIP
EDI Catalog No. 400/063                                           ISSN 1012-490X



Foreword
This document is one of a series reporing on policy seminars organized by the Economic
Development Institute of the Wodd Banlk. Policy seminars provide a forum for an informal
exchange of ideas and experiences among policymakers from different countries, leading expens in
development, and Wodd Bank staff with respect to major issucs of deveopment policy.
Policy seminar reports focus on issues raised dunng semina that may be of interest to a wider
audience. They are not intended to be comprehensive proceedings. Tey seek, however, to convey
the essence of the discussion that took place and to bring out any principal areas of agreement or
disagreement that emerged among those paricipang
Christopher R. Willoughby
Dbector
Eonomic Development Institute
of The World Bank






Contents
1. Introduction  1
2. The Origins of the Need for Adjustment 2
3. The Nature of the Necessary Adjustments 4
4. The Role of Trade Reform in the Adjustment Process 6
5. What Are the Special Trade Reform Problems
in Socialist Countries? 9
6. The Policy Content of Adjustment and
the Role of Devaluation 11
7. Sequencing and the Characteristics
of Successful Trade Liberalization 13
8. The International Environment for Trade Reform 18
9. The Leading Issues 21
Participants and Resource Persons 23
v






Introduction
The seminar brought together Ministers and other senior officials of five middle-income
countries from Eastern and Southern Europe which form a part of the World Bank's Europe,
Middle East, and North Africa (EMENA) region. These five were Hungary, Poland, Portugal,
Turkey, and Yugoslavia. In addition, the resource persons attending the seminar included Dr.
Garrett Fitzgerald, former Prime Minister of Ireland, who provided an in-depth assessment of the
trade reform issues both in his own country and in the European Community more generally, and
Mr. Chulsu Kim, Assistant Minister of Trade and Industry in South Korea, who provided detailed
analysis of the evolution of Korean trade policy. The broad objective of the seminar was to provide
a forum in which senior policymakers from a variety of countries could discuss both the progress
of, and the constraints on their own respective trade reforms, and exchange ideas on these matters
both among themselves and with officials from the World Bank in an environment of considerable
informality.
The seminar was directed by Mr. Jayanta Roy of the EDI and moderated by Mr. Roger
Chaufournier, a former Vice-President of the World Bank. It was introduced by Mr. Parvez Hasan,
Chief Economist for EMENA, who spoke about the experiences of structural adjustment and trade
liberalization in the 1980s. Thereafter it was informed by seven main presentations, namely by
Messrs. 0. Havrylyshyn on Approaches to Trade Liberalization in East Europe, M. Nuti on the
Trade Regimes and External Adjustment Experiences of Hungary, Poland and Yugoslavia, M.
Finger on recent developments with respect to the Uruguay Round, and by Dr. Fitzgerald, Mr.
Kim, Mr. Silva Lopes and Mr. H. Ersal, on the evolution of trade policies in Ireland, South Korea,
Portugal, and Turkey respectively.
One of the major points of interest in the seminar was to establish the sense in which centrally
planned economies face a fundamentally different set of problems when trying to reform trade
policies than do market economies. As the comments under several of the headings below indicate,
there were many issues where participants generally saw these differences as relatively minor, and
others where the problems were seen as radically different.
This summary paper attempts to synthesize the major issues which arose from the seven
presentations as well as from the lively discussion from the floor of the seminar which characterized
each of its sessions. This is done by reference to seven broad themes which together encapsulate
much of the discussion which took place. 1 On some of these such as the first theme on the Origins
of the Need for Adjustment (Section 2 below) there was considerable unanimity of view across the
very diverse set of countries whose experiences were recounted. On others, such as whether trade
reform is a substantively different problem in socialist as compared to capitalist systems, there were
a number of different perspectives which were not reconciled by discussion. The present synthesis
merely attempts to capture the tone of these differences.
In the spirit of informality which characterized the seminar the paper makes no attribution of
particular comments to individual participants other than those which were incorporated in the
seminar papers themselves.
1. It can be noted that of the seven main presentations already referred to, five were supported by written
papers. The two presentations not supported in this way were those by Dr. Fitzgerald and Mr. H. Ersal.
I



2
The Origins of the Need for Adjustment
In his introductory remarks, Parvez Hasan noted that since 1979 the world economic
environment has changed not only in the sense that growth is generally much slower, but also in the
sense that greater volatility in, for example, exchange rates and commodity prices has made that
environment far more uncertain. Whereas many countries adjusted to the difficulties of the mid-
1970s by taking advantage of easy access to ample external capital at low interest rates, this easy
option is no longer available. Furthermore, the easy availability and low price of credit in the mid-
1970s had encouraged many countries to use capital extensively, in some cases to invest in major
white-elephant projects, and to be generally unaware of the consequences of mistakes in investment
decisions. The higher interest rates and reduced external resources of the 1980s had changed this by
giving rise to a need for structural adjustment in which the focus of policy has had to be the search
for more intensive use of capital and greater efficiency of resource use in general.
Two factors in particular had generated this pressure for adjustment. The first was the major
reduction in the net resource transfers from abroad resulting both from the generally lower
availability of funds from the banks, and from the pre-existing large debt/GDP ratios which act as a
severe discouragement to new lending. In some of the East European economies such as Hungary,
principal and interest payments on debt are pre-empting up to 70 percent of the countries' hard
currency earnings. In the middle-income countries as a whole these sorts of pressures have resulted
in a fall in the current account deficit from an annual average of $72 billion in 1980-82, to an
average of only $12 billion in 1986-87.2 The second factor has arisen in cases where public sector
deficits, both from the general budget and public enterprises, have been a major part of the problem.
Increasingly in such cases, governments have found it more difficult to extract the necessary
resources by monetizing their deficits and instead have had to pay higher real interest rates to
domestic as well as foreign savers in order to gain access to the necessary resources.
Participants from Yugoslavia and the other East European countries were quick to emphasize
that these fundamental changes in the imperatives regarding the efficient use of capital applied with
fuRll force to their own countries. Whereas two decades ago there had been plenty of resources but
no recognition of the need to adjust, now the degree of recognition was high but unfortunately was
accompanied by a situation in which the resources to provide the headroom for fundamental reform
were extremely limited. They also added substance to another of Hasan's propositions, namely that
adjustment had been less rapid and generally less successful than had earlier been expected. In the
case of Hungary, for example, it was noted that the successful stabilization of the extemal payments
deficit from 1981 to 1984 has been "stabilization without adjustment," in that the massive fall in
investment arising from that program had precluded any real prospect of strengthening productive
potential in those sectors which should have responded to the new and more intemationally oriented
price structure. Hence the composition of Hungarian exports, and her export-dependence on
imported raw materials and intermediate goods was little changed. In Hungary as in many other
middle-income countries the disappointingly low growth rates of the 198Os3 seemed set to
continue, not least because of the decline in the investment rate (from a 26 percent average for
middle-income countries as a whole in 1979 to 21 percent in 1985), which has characterized recent
2. The change in the non-interest current account deficit is larger than this, and most heavily indebted
countries were running suipluses on the non-interest current account by 1986-87.
3. Though the performance in Turkey was a notable exception from this point of view among the countries
at the seminar.
2



Hungary, Poland, Portugal, Turkey, and Yugoslavia   3
stabilization effects. In addition, external debt burdens have generally risen rather than fallen in the
1980s4 as higher real interest rates and cross currency exchange effects, notably the fall in the US
dollar relative to the DM, have offset the benefits of domestic austerity and reduced deficits. It was
noted that for most countries represented at the seminar these factors together mean that the burden
of necessary adjustment will remain considerable; that the non-interest current account will have to
remain in surplus to service debt and reduce the debt overhang; and that the pre-emption of domestic
savings for this purpose will continue to restrict investment levels. Hence the continuing process of
adjustment will of necessity have to give high priority to the productivity of investment, while
improved import capacity will be heavily dependent on the success of exports. It is these facts of
economic life in the late 1980s which together place so much importance on appropriate trade policy
both as a critical source of pressure for improved investment efficiency, and as the key element in
generating improved export performance.
4. For the highly indebted countries the ratio of external debt to GDP has risen from 33 percent at the end
of 1982 to 55 percent at the end of 1987. Turkey, Hungary, and Poland are close to or above this average.
Portugal, starting from a much higher figure a few years back, has seen a considerable improvement in her
debt situation.



3
The Nature of the Necessary Adjustments
It was noted that at one level, adjustment is merely the accounting task of balancing a country's
books. This can occur in a variety of ways and will certainly happen one way or another with or
without active policy. It can, for example, be achieved in the short term merely through stabilization
programs supported by various forms of disorderly adjustments such as intensified restrictions on
imports. However, this form of adjustment is inherently short-term in its focus and is unlikely to
provide a country with the improved efficiency in its resource-use needed to achieve long-term
sustainable growth. Real adjustment is a far more complex matter which involves first of all a
substantial change in the existing patterns of resource-use to eliminate inefficiencies and establish a
structure of production more closely attuned to the prevailing international patterns of relative prices,
interest rates, and other conditions. Thereafter it needs a sustained flexibility of policies to enable
resources to be reallocated at the margin relatively rapidly in response to the evolution of
intemational and other conditions.
In the centrally planned economies, and also in other countries, this view of an adjustment
program implies that it necessarily has to be extremely broad in its scope. Its components will
certainly include changes in the relative prices of energy, factors of production, foreign exchange,
and other commodities to better reflect their true opportunity costs. Although relatively
straightforward in concept, these changes will not be an easy matter to implement especially where
the gaps between actual and scarcity prices have been allowed to become extremely large.
Yet more difficult will be those components of an adjustment program which call for far-
reaching institutional reform to support and deliver the more realistic pricing of resources.
Participants from each of the three East European economies noted at various stages that while the
institutional reforms ideally required to facilitate adjustment in such countries needed to be
pervasive, they were at the same time politically difficult to design and implement. A central
question to which many of their comments related and which generated a good deal of controversy
is whether it is possible to move away from the centralized planning of resource allocation which
has been fundamental in socialist countries without reneging on the high priority traditionally
attached to equity and distribution issues (see also section 5 below). 0. Havrylyshyn in his paper
argued that not only is such a separation possible but that without it and without a more liberal
approach to resource allocation, the faimess principles of socialism will themselves be threatened by
systematic further declines in efficiency and growth rate (see also section 5). The Yugoslav team
noted that there are three fundamental questions posed by a commitment to structural adjustment,
namely: who are the main agents of the adjustment - the state or individual enterprises?; what are
the criteria to guide such adjustment - the maximization of output growth or the needs of the
population?; and what are the mechanisms - market mechanisms or control? The Yugoslav
representatives argued in relation to the third of these questions that policymakers in East Europe
had already conceded the need for prices to be set in a competitive market-oriented fashion. But this
was a most difficult matter in practice, not least because the interconnectedness of markets meant
that liberalization at one point (e.g. imports) would soon provide a need for liberalization elsewhere
(e.g. in foreign exchange allocation).
Similarly, the Hungarian participants referred to the need for their economy to become a
"socialist market economy" in which goods, labor, and capital markets would become progressively
more liberal, new forms of ownership would progressively provide competition for the erstwhile
state monopolies, and where even managers of state enterprises would increasingly behave as
though they were owners of such enterprises. This would involve a clear retrenchment of the state
4



Hungary, Poland, Portugal, Turkey, and Yugoslavia   5
not only as regards the ownership and control of productive resources, but also as regards the level
of subsidies and other supports for poorer groups in society. But while accepting the need for this,
they saw no guaranteed connection between its successful implementation and sustained
improvement in the country's external situation or other aspects of the macroeconomic position.
In his own remarks, Parvez Hasan drew some of these ideas together by suggesting that there
are basically three components of a successful adjustment effort, namely, a more liberal trade and
price regime designed to reduce factor-price distortions and align domestic prices more closely to
their international levels; institutional reforms to improve the effectiveness of those government
interventions which remain necessary, and to ensure that price signals can help enterprises adjust
more correctly and flexibly to rapidly changing conditions; and a realistic macroeconomic
framework which above all will eliminate the macro-imbalances (e.g. excessive domestic demand
leading to high inflation) which can compromise the success of the other components of structural
reform.
On a somewhat narrower issue, Havrylyshyn linked the nature of the adjustment, which might
reasonably be anticipated in particular countries, to the realities of the world economic environment
discussed in the previous section. Specifically, on the basis of the figures presented in Table 1, he
observed that a return to high growth rates could be achieved in a number of ways. One would
involve the re-establishment of the higher investment rates of the 1970s but with efficiency rates
akin to those experienced in the 1980s (i.e. Scenario 1). This seemed unlikely given the future
prognosis for investment rates already explained. It would in any case produce growth rates which
were only modest. An altemative would be to seek no major change in investment rates but a set of
policies to extract greatly enhanced efficiency from such investment (i.e. Scenarios 2 and especially
3). If successful, as Table 1 shows, they would produce growth rates even better than those
achieved in the 1970's.
Table 1. Investment, ICORS, and Growth Rate in Middle Income
Investmentl                         Growth Rate
GDP                                of GDP
(percent)          ICOR             (percent)
Outcomes
Before the 1980s crisis:                 24                 4                6.0
Situation in the 1980s                   20                 5                4.0
Possible Scenarios
1) Modest Investment Increase           22                  5                4.4
2) Modest Efficiency Increase            20                 4                 5.0
3) High Efficiency Increase                                  3(i.e.)
20                   Asian          6.5
levels)



4
The Role of Trade Reform in the Adjustment Process
It was of course a central purpose of the seminar to assess the role of trade policy reform as a
key element in the overall adjustment program. Ideas on this were articulated by several participants
but especially in the paper by 0. Havrylyshyn. He noted in particular the very important role of
trade liberalization as the main mechanism for disciplining local productive enterprises and
transmitting the efficiency levels established internationally to domestic production. Given that the
majority of the economies of East Europe are relatively small, he argued that greater liberalism in
international trade may be a more effective disciplinary mechanism than the alternative often
discussed by socialist reformers of forcing a break-up of concentrated and vertically integrated
enterprises. It is also important to note that while trade reform may initially be introduced to improve
the current account of the balance of payments, this should not be regarded as its fundamental raison
d'etre. The alternative idea of using it as a stimulus for productive efficiency is a radical one in the
East European context where trade has normally been cast in the role as a residual to handle
domestic shortages or deficits, rather than as a motive force for realizing the benefits of the
comparative advantage of domestic industry.
If it is accepted that trade's disciplining role for productive efficiency is indeed the raison d' etre
for greater liberalization, then it also needs to be acknowledged that the benefits will fail to be
realized if sound trade policies are not allowed to transmit the correct signals from abroad because of
a variety of other inappropriate policies. A variety of distorting interventions which can pervert the
benefits of liberal trade were mentioned during the seminar as being important in East Europe. Four
matters in particular were elaborated by Havrylyshyn.
First, by contrast with the situation in recent years in both Turkey and Portugal, the use of
nominal exchange rate adjustments in the East European context has often been hesitant. With the
exchange rate also being looked upon as a major instrument to restrain inflation, nominal
devaluations in countries such as Hungary have often been insufficient to prevent a real appreciation
of the exchange rate. In the first five years of the 1980s, for example, the Hungarian real exchange
rate appreciated by 11 percent while that of Poland appreciated by 30 percent.5 Over the same
period the Yugoslavian currency showed a major real depreciation. The result was that Hungary and
Poland's share of total imports into industrial countries remained extremely small and sharply lower
than the historical highs achieved by those countries in the 1970s. An associated point is that real
devaluation will not work well if other factors causing. an anti-export bias such as import
restrictions, price controls, and administrative allocation of raw materials and foreign exchange, are
perpetuated in such a way as to inhibit increased exports and reduced imports. While the general
pessimism in some parts of East Europe about the benefits of exchange rate policy partly stems from
these other factors which limit its effects, the fact remains that trade policy reform cannot play its
disciplinary role without reasonably active exchange rate policy and the abandonment of other anti-
export policies.
Second, it is a tendency in East European economies to use compensatory administrative
intervention to encourage exports as an altemative to a more liberal trade stance which would give
incentives to exporters more directly through a non-discretionary system. Countries such as Turkey
and South Korea, which have enjoyed some successes in adjustment, have continued to pursue
policies of compensatory export-support. But Havrylyshyn argued that in both these cases export
5. The more recent experience of policy in Poland, however, is of real devaluation which has boosted
export performance in the past two years.
6



Hungary, Poland, Portugal, Turkey, and Yugoslavia   7
compensation policies were pursued simultaneously with reduced import restrictions and real
devaluations, and were gradually phased-down as import liberalization made them progressively
less necessary. In East Europe, by contrast, the use of compensatory export-supports as a primary
tool of trade reforn is a poor second best since it leaves too much influence with the administrative
authorities, for example, to restrict imports it often encourages an underlying selectivity in export-
supports which are themselves distorting; and it greatly complicates the achievement of a central
objective of trade reform, namely the establishment of equalized incentives as between products for
exports and those for the home market.
The third difficulty in the way of making liberal trade an effective transmittor of the general
changes in international standards of efficiency, is the so-called "soft-budget problem." In a
nutshell, what this amounts to is that there is little point in providing enterprise with the "carrot" of
positive incentives to resource reallocation and improved efficiency via more open trade, if the
"stick" to punish inefficient firms is not available or is insufficiently used. If the sanction against
inefficiency is not enforced then the incentive for enterprises to be efficient and work hard to find
the best profit-making opportunities will be seriously diluted, and inertia and complacency will
continue to thrive whatever trade regime is in place. A quote from the Wall Street Journal about
Israel and cited by Havrylyshyn makes the point very clearly,".. .It appears that the best business
strategy is to get into as much debt as possible and threaten to dismiss as many workers as possible.
If you reach that happy state, members from every party will line up for the right to use taxpayers'
money to keep you artificially alive." (Wall Street Journal, April 1986)
The presentation by Jose da Silva Lopes on Portugal emphasized that the soft-budget problem
is not only a East European phenomenon, and in recent years has certainly been of significance in
Portugal and Turkey as well. In general, if a problem of financial failure at the enterprise level is not
addressed by the closure or restructuring of the enterprise, some burden will be imposed
somewhere in the economic system and this is certain to have distortionary effects. If the burden is
passed to the Central Bank, distortionary effects will arise if the Bank is able and willing to use
inflationary methods to finance the cost of it. If it is left with commercial banks, as in Portugal, by
relaxing the normal banking sanctions against enterprises failing to service loans, then the capital of
the banks and their own financial viability is threatened. This in turn damages and distorts their
ability to properly discharge their resource-allocating function.
If the banks, again as in Portugal and in Turkey, pass the problem on to other clients through
higher margins between lending and borrowing rates, then efficient units in the productive system
are effectively taxed to finance the failure of the inefficient. Ultimately if the decision is made to
allow the survival of failed firms in order to protect jobs or for other good social reasons, then the
only sound approach is to reflect the cost in the government budget and finance it through general
taxation. But governments are generally loathe to see their own deficits rise and have not
infrequently sought a variety of ways to avoid the transparent treatment of the "social losses" in
normal budgets. Silva Lopes and Havrylyshyn both developed this point into an extremely
important set of propositions about the interconnectedness between trade liberalization, fiscal
deficits, and inflation.
In brief, large fiscal deficits and extemal deficits go hand in hand, especially in planned
economies where the large public investment projects characteristic of the 1970s have directly
boosted both expenditures and imports. While it is often argued by the critics of trade reform that
liberalizing trade in the face of large extemal deficits is dangerous because of a likely surge of
imports, this view is far from unassailable even by reference to conventional arguments. But in the
context of the argument that trade reform is a disciplinary mechanism, it misses a further crucial
point.



8 Trade Reform and External Adjustment
Trade reform will show up the failures of domestic investment in a way that could not happen in
a protected administered scheme.6 If the soft-budget constraint is simultaneously allowed to harden
as protection is removed, the subsidies and support for weak enterprises will be partly reduced and
so too will the magnitude of the government's financing/borrowing requirement. The benefits of
this lower deficit can then be appropriated either in the form of reduced foreign borrowing by the
govemment which will imply a reduced current account or external deficit or in the form of a lower
rate of monetization of the deficit and lower inflation. Some weighted average of a lower external
deficit and lower inflation is an obvious third possibility. But the main conclusion is clear: trade
liberalization combined with a wiUlingness to allow the soft-budget constraint to harden, enables
countries to avoid the trade-off between an improved current account and worsened inflation which
applies when the size of the public sector deficit is fixed.7 The fourth difficulty which potentially
obscures the signals from trade reform was identified as the administrative setting of prices in the
East European economies and the typical failure of such approaches, even where they attempt to do
so, to replicate the price signals which would emerge in a less controlled system. This point is dealt
with further in the next section.
In general, and by way of summary, participants in the seminar did not have any fundamental
difficulties with the concept of trade liberalization as a powerful disciplinary force. There were
however a variety of critical comments about the practicality of exploiting the benefits of such a
discipline especially in the somewhat complex institutional trading situations found in East Europe.
Most of these comments are taken up in the next sections.
6. Most mnistakes in investment decisions in Portugal according to Silva Lopes occurred when there was
high protection of the industries concemed.
7. The explanation of this trade-off is set out very clearly in a recent discussion paper which was made
available to all participants. See M. Corden, "Macroeconomic Adjustment in Developing Countries," IMF
Working Paper, WP/99/13, February 1988.



5
What Are the Special Trade Reform Problems
in Socialist Countries?
It would indeed be convenient to assume that a recipe for trade reform that had been shown to
be successful in market or mixed economies could be applied without major adaptation to socialist
planned economies. The seminar discussion on this issue however demonstrated a considerable gulf
between convenience and reality and also that there were considerable divergences of view among
participants on this matter. The debate essentially occurred at two levels. The first was concerned
with the underlying philosophy of the socialist form of organization and, in particular, with those
components of the socialist model which might reasonably be dispensed within the interests of
greater efficiency of investment and resource-use, more generaUy. The second related to practical
issues associated with the special trading ties of the East European economies into the CMEA area
and the constraints on liberalization as normaly understood which these ties are likely to cause.
On the first of these issues, the presentation by Havrylyshyn observed that planned socialism
had proved to be a relatively effective system from the viewpoint of mobilizing resources (e.g.
investment/GDP ratios were typically high), but relatively poor in terms of resource efficiency. It is
poor performance in this second area which is the basic source of most of the contemporary
pressures for reform. Furthermore, philosophicaly and historically, socialist thinking has been far
more concerned with distributional issues, and with forms of asset ownership that precluded
excessive concentration of ownership in the hands of a limited set of individuals, than with planning
in the sense of tight centralized control over resource-use. Planning can be regarded more as a
means to an end and to the extent that it has not served the function well, it can be dispensed with,
in his view, without destroying the fundamental basis of a socialist state.
Judged by the experiences of a number of East European economies it appeared that the
attempts to set prices administratively in a manner which simulated free markets had not been very
successful and that this was not the way to achieve improved resource allocation. Reform therefore
needed to be more fundamental and to allow markets to be established and function largely free of
administrative guidance. From their point of view the similarities between the necessary reforms in
socialist and market economies were greater than the differences. The solution to the adjustment
problem in both cases involves greater discipline at both the government and the enterprise level,
greater use of the exchange rates to stimulate trade, more flexibility of price signals and, above all,
more open and central trade policy. The partial nature of reforms to date-partial above all because of
a misguided effort to retain central control of resource-use-had generated only limited success
because they had not provided an adequate mechanism of carrot and stick incentives, equivalent to
that found in most capitalist systems.
Although these propositions were not extensively debated, there was considerable
documentation in Nuti's paper about the extent to which price and market systems in Hungary,
Poland, and Yugoslavia had deviated from the model of liberalization advocated by Havrylyshyn.
One undercurrent of concern was the extent to which it was technically possible to establish
effective markets without substantially giving up on social control of the means of production.
Nuti's presentation suggested that continued social control of assets was not necessarily inconsistent
with the delegation of a great deal of power to decentralized markets. However, the practical issues
involved in this were not developed.
On the narower issue of the institutional trading arrangements in East Europe, several points
were made. The Polish participants noted that in the 1940s, Poland had to re-orient politically and
9



10 Trade Reform and External Adjustnent
economically, and a high degree of dependence on trading links within the Eastern CMEA trading
system was unavoidable. Some 60 percent of Poland's trade still took place within this trading
block, which has very specific arrangements which are fundamentally alien to the idea of liberal
trade in its normal sense. The major factor militating against moves to diversify trade and establish a
greater interaction with Westem trading partners was the uncertainty about extemal relations and the
very real risks attached to revamping not only the direction of trade but also, by implication, the
institutional arrangements which such a change would imply. Hungarian participants made similar
points and stressed, in particular, the inherent difficulties of buying in the CMEA area and selling in
OECD markets. What was needed was some built-in assurance about Lhe stability of possible new
trading relationships to reduce the risks of liberalizing to establish those new patterns.
By way of partial denial of the significance of these problems, it was observed that the German
Democratic Republic functions quite well as a socialist economy but is also integrated into trade
with the European Community. However, it was quickly pointed out that East Germany is a very
special case, having access to the EEC through West Germany and being in a fundamentally
different situation because of the common language and industrial standards than that of other
Eastern bloc countries. It is almost the 13th member of the EEC from many viewpoints. The
Hungarian participants, for example, pointed out that by contrast with East Germany, there is no
sector where Hungary is exporting to the EEC which is free from restrictions such as voluntary
export restraints, and the protection levels and restrictions of the Common Agricultural Policy. East
European participants left the seminar in no doubt that the particular institutional circumstances
which the Eastern bloc countries face in Western trade certainly do reduce the benefits and so the
enthusiasm for trade liberalization (see also Section 8 below).
Nuti's presentation elaborated on this line of discussion by noting that not only are the East
European countries subject to trade restrictions in the EEC, but they do not even enjoy free access
for their products into East Europe. Since in part this is due to the absence of a convertible currency
unit in the Eastern bloc-not even the so-called "transferable rouble" was really convertible-there
was a desperate need to create such a unit. This was technically quite feasible and would certainly
stimulate a considerable expansion of trade within East Europe. While a necessary condition for its
success would be an enhanced degree of policy coordination within the CMEA area, this need not
amount to a full coordination of all policies, but it would need reasonably convergent rates of
inflation. In this context, the Hungarian participants noted along with others that the role of
monetary policy had been underestimated in the East European economies generally, but that such
policies now needed to be used not only actively but in a coordinated manner to enhance the
prospects for improved trade integration.
Finally, on this subject of the institutional differences of the East European countries, it was
noted that prices within the trading baskets of the CMEA system are negotiated values not much
influenced by any of the conventional pressures of supply and demand. The negotiations are
conducted largely to preserve the overall terms of trade between the different trading partners. But
this necessarily makes individual prices somewhat arbitrary and so blurs the efficiency performance
of individual exporters and slows down adjustments, where a need in other systems is signaled by
changes in individual prices.
In summary, the discussion of these matters largely confirmed that, notwithstanding recent
reforms in individual countries and the proposed reforms of the CMEA system itself, the
institutional factors conditioning the basis of trade in the East European countries were sharply
different from those generally encountered in the West. In the absence of major changes in such
institutional arrangements, the market economy model of trade liberalization did not guarantee
equivalent results in the EasL



6
The Policy Content of Adjustment and the Role of Devaluation
The seminar discussed a variety of policy changes which together would constitute an effective
program for trade adjustment. Discussion earlier in this paper has already focused on the need to
inject greater financial discipline so that the stimulus to efficiency coming from trade reform would
be effective at the enterprise level. Subsequent discussion also noted that this would involve
removing the barriers to the exit/closure of individual firms since this has been largely untouched by
Eastern bloc reforms up till now. In addition, World Bank participants noted that explicit programs
would be needed to aid the restructuring of key enterprises and sectors to enable them to respond to
new circumstances. It was worth noting that in few market economies did markets work well
enough to generate such restructuring without some intervention. These programs would need to
facilitate the entry of new, and especially smaller firms, both to create alternative jobs to replace
those lost in declining industries, but also to improve the system's overall capacity to respond to
technological and market changes. This would also require a range of functional supports to
industry including measures to broaden access to new technologies and to ensure that the relatively
high R and D spending of the socialist economies was translated into effective gains in technological
capacity across a broad range of industries. All such policies raised a variety of questions, the
answers to which were not immediately apparent and where discussion in the seminar was relatively
limited. In particular, how can a socialist system based on extensive public ownership incorporate
some of the characteristics of "owner interest" in such enterprises, and is it necessary to do so in
order to gain improved performance? Similarly, in relation to technological upgrading, can the
socialist systems make the necessary progress when their access to international technology is
severely restricted by arran8ements such as that of the CoCom.-the co-ordinating committee to
control technology transfer?T
Not surprisingly in a seminar focused on trade reform, a policy issue receiving central attention
was the role of exchange rate devaluation in the reform process. At an early stage of the seminar,
one of the Hungarian participants asked whether the successes of the Turkish adjustment really
supported the view that devaluation, which has been systematically used in the Turkish case, is a
decisive element in reform or merely one element among many. This question received a variety of
answers from several quarters during the course of subsequent discussions. Dr. Fitzgerald, for
example, in commenting on recent Irish experiences, observed that for economies such as Ireland
which export capital-intensive and high technology products, the benefits of devaluation in terms of
a possible lowering of real wage costs were not particularly important. Similarly, for any products
which have managed to gain a quasi-monopoly position internationally because of a high reputation
for quality (e.g. German cars), the systematic use of devaluation to safeguard continuous price
competitiveness is not crucial. In these cases, the exchange rate can certainly be given more
prominence as an anti-inflationary weapon. Even in Portugal, which still exports a wide range of
products which do need to compete on price, there were reservations from the Portuguese
participants about giving industrialists a long-term guarantee of ongoing devaluation to protect their
competitiveness. Their concem was that such guarantees necessarily reduced the emphasis on the
need to improve productivity, which was an equally good way to defend competitiveness.
Nuti's presentation directed a good deal of attention to the effectiveness of exchange rate
devaluations in a centrally planned system, and to the contention frequently advanced that these are
ineffective and inflationary because of the low elasticities of relevant supplies and demands. He
8. The membership of which is broadly co-ternninous with the membership of NATO.
1I



12 Trade Reform and External Adjustment
noted that the residual nature of exports in the planned economies means that improved export
performance is conditioned more by measures to restrict absorption to make room for exports, than
by the degree of competitiveness which in principle at least is capable of being amended by
devaluation. Thus it is in circumstances where demand is deficient that the issue of an appropriate
exchange rate mostly arises.
Further, while it is true that devaluation in the planned economies can lower real demand and so
imports by raising prices, this effect could equally well be achieved, if it was thought to be
politically acceptable, through more direct measures to restrict domestic demand. It does not
necessarily need devaluation. He went on to suggest that the critical elasticities governing the
success or otherwise of devaluation in these economies are probably the elasticity of demand for
imports and the elasticity of supply of exports (their sum must exceed unity for devaluation to
succeed). A low export supply elasticity could for example be caused by an excessively high level
of domestic absorption. Thus in various ways policies to reduce absorption would be a critical
complement to devaluation and a major factor determining its success.
A more specific problem, however, arises in the case of Yugoslavia because of its system of
labor-managed firms. The theoretical literature suggests that price increases in such a system,
including those brought about by devaluation, may lead to perverse results because the maxima and
in the case of labor-managed firms (namely output per man rather than profit), is achieved by
lowering output, employment, and exports in response to price increases, rather than by raising
them. The Yugoslav participants noted that, notwithstanding the theory, their own studies had
suggested some positive effects of devaluation on the balance of payments implying that, in the
medium-term, the supply elasticity will be sufficiently positive. They also noted, however, that in
the case of Yugoslavia, export growth was now also a matter of quality/design changes which, if
achieved, would enable some switch of export supply to the EEC markets.
In summary, the conclusions from this part of the discussion were largely to the effect that
devaluation could achieve some of the results traditionally ascribed to it but that this would only
happen if the policy was supported by other complementary measures. Nuti laid considerable
emphasis on the need to accompany devaluation by measures of domestic demand restraint to
reduce absorption and argued that the pessimism about the effects of devaluation in East Europe
were often disguised political statements about the political feasibility of austere economic policies.
Havrylyshyn, as already noted, argued that the effects of devaluation would be at best muted if
devaluation was applied in the face of other pervasive anti-export policies which gave strong
incentives to production for the home market. Silva Lopes and other Portuguese participants drew
attention to Portuguese industry's rapid response to real devaluations during the main stabilization
episodes of 1977 and 1983. He pointed out that these successes owed a good deal both to the
simultaneous enactment of contractionary domestic policies, and to the supportive role of incomes
policies and associated real wage flexibility. This last point was also of considerable importance in
that incomes policies had helped confine the effects of devaluation to price and wage levels and had
helped avoid major declines in employment levels.
But other comments were made which emphasized the costs and the risks of a sustained policy
of real devaluation as practiced, for example, in Turkey since 1980. In particular, continuing
nominal devaluations in excess of a country's inflation differential may succeed in boosting growth
and exports but, for a given real interest rate and non-interest current account deficit, it will also
boost the foreign debt burden as reflected in the ratio of debt/GDP.9 Turkey in the 1980s, for
example, has achieved very high growth rates of exports and a decline in the debt/export ratio.
However, the debt/GDP ratio has risen rapidly to a current level of 58 percent, which is regarded by
9. This point is explained fully in a paper which was distributed to seminar participants. See Sweder van
Wijnbergen, "External Debt Inflation and the Public Sector. Towards Fiscal Policy for Sustained Growth,"
World Bank (mimeo), March 1988.



Hungary, Poland, Portugal, Turkey, and Yugoslavia 13
Turiish officials as close to the limit of what is acceptable. The implication is that future export
growth must rely much more on quality and on product upgrading and not on selling price alone.
Nominal devaluation to compensate for inflationary differentials will continue to be used but
support policies to encourage product upgrading, and better quality and design will be needed to
take the place of further real devaluations.



7
Sequencing and the Characteristics of Successful
Trade Liberalization
The presentations on Ireland, Portugal, Turkey, and South Korea were all of considerable
interest in demonstrating the importance of some of the historical policy foundations which
ultimately helped to ensure a successful liberalization of trade. In the case of Portugal, Silva Lopes
noted that Portugal's EFTA membership from 1958 and association with the EEC from 1973, had
given the country a relatively long period during which industry had been encouraged to look
outwards for its markets. EquaUly, with the notable exception of agriculture, the country has had a
relatively long tradition of low protection and limited anti-export bias in trade policies. In the 1960s
and early 1970s the policies of relatively free trade were successful in that exports were able to
expand at a rate of 11 percent per annum which was substantially higher even than the then high
rates of growth in industrialized countries generally.°0 This had not only helped sustain very rapid
growth of overaU GDP but it also led to the rapid development of the supply capacity of industries
such as textiles, clothing, electronic products, wood pulp, and tomato paste. On the other side of the
account, the relaxation of controls against EFTA country products certainly led to a diversion of
imports from other sources and to a relatively fast growth of imports in total. However, import
competition did not create major difficulties for Portuguese industry since there was not much
industry at the time and many of those industries which were emerging were explicitly export-
focused.
By contrast, the years after 1974 were traumatic for Portugal characterized as they were not
only by the oil-price shock-which itself caused a 6 percent loss of GDP-but also by decolonization,
the loss of major preferential markets, and the return of several hundred thousand colonists from
Mozambique and Angola. The initial responses to these problems were characterized by a strongly
protectionist policy involving import surcharges, a serious overvaluation of the escudo and a major
emphasis on building up heavy public sector industries behind high protective barriers. However,
when recovery began in 1976 and 1977 it was driven once again by policies which removed many
protective barriers and gave central prominence to active use of exchange rate policy, and the
general reduction of the anti-export bias. Similarly, after a further period of inappropriate policies in
the early 1980s, a stabilization program which gave a central role to real depreciation again
generated a rapid recovery of exports. Thus in spite of all the difficulties in the 1970s and early
1980s, Portugal still managed to achieve a growth rate of exports in the period 1973 to 1986 which,
at 6.5 per cent per annum, was still superior to the average in the industrialized countries as a
whole.
Silva Lopes' comments and subsequent discussion identified several key elements of Portugal's
relatively successful record of stabilization and adjustment. Some of these indicate some further
difficulties for the reform programs in East Europe while others suggest certain possible lessons for
the East. First, as one of the Hungarian participants noted, Portugal chose to undergo her major
liberalization in the 1960s when world market conditions were much better than now and
international prices were far less distorted. Second, Portugal's development of export industries has
undoubtedly benefited criticaUy from the easy access to EFTA markets after 1958 and the EEC
which severely limits the scope for the development of Hungarian and other East European export
industries (see also Section 8 below). Third, the rapid responsiveness of exports to the major
10. The Portuguese export growth rate during theperiod l959 to 1973 was 11 percent per annum as
against 8.9 percent per annum for the industrialized countries.
14



Hungary, Poland, Portugal, Turkey, and Yugoslavia 15
stabilization programs in both 1977 and in 1982 owed a great deal to the fact that industries were
already quite well diversified by these dates with managements well-attuned to the requirements of
intemational marketing. Therefore the foundations of the 1960s were important to the success of the
trade reform of the late 1970s and 1980s. Fourth, building on the comments of Nuti discussed
earlier, a number of complementary policies were extremely important to the success of the
exchange rate and other trade policy reform. In particular, in both the 1977 and the 1982 episodes,
the extemal policies were accompanied by contractionary policies to restrict domestic absorption and
incomes policies to bring about relatively large falls in real wages. Trade unions in Portugal have
shown themselves to be more concemed to protect jobs than the levels of real wages, and
significant falls in real wages have been possible and have been a vital element in preserving
Portuguese competitiveness in spite of a labor market which in other ways is very rigid. Finally, in
spite of considerable extemal borrowing in the late 1970s which encouraged, as in other countries, a
variety of very poor investment decisions, Portugal has managed to avoid an extemal debt problem.
Possibly, the major factor here was the 50 years of very conservative policies which preceded the
1974 Revolution, and the fact that the reserves accumulated during this time were held mainly in
gold, which governments of all political colors had been very anxious, albeit irrationally, to hold on
to, rather than to spend.
In the case of Ireland, circumstances were somewhat different in that after the formation of the
state in 1927, the economic war with Britain and an aspiration for self-sufficiency had generated a
general move towards autarky in trade policies which became particularly marked in the 1930s.
Although there were obvious problems caused by this approach, the fact remained that it did
establish the basis for an Irish industrial sector. Indeed, although the industries which made up this
sector were relatively unspecialized, inefficient and highly dependent upon imports, they did give
the country rapid industrial growth for a number of years. The situation changed in the 1950s
when, largely as a consequence of cheap food policies in the U.K., Irish agricultural trade suffered
very badly and the economy as a whole stagnated. Beginning in the late 1950s, this was partly
responsible for stimulating a fundamental change in its industrial policies. More specifically, the
country was opened up to what turned out to be massive foreign direct investment, which was
encourafed by generous incentives including the extremely favorable taxation of profits on
exports. 1 These policies resulted not only in a major expansion in exports but also to a situation
where the formerly heavy dependence on the U.K. market has been replaced by a situation where
today two-thirds of exports go to non-U.K. destinations. The rapid growth of direct foreign
investment now also means that 45 per cent of the jobs in Ireland's manufacturing sector are
attibutable to foreign-owned firms. They have been attracted not only by the generous incentives
but also, in Fitzgerald's view, by Ireland's extremely good and cost-effective educational system.
In relation to the points about the disciplinary effects on trade made by Havrylyshyn, he noted that
Ireland, in advance of her entry into the EEC in 1973, had decided to establish free trade with the
U.K.-her major import trading partner in order to expose industry to the "stick" of free trade before
getting the "carrot and stick" effects of EEC membership. Although this had created difficulties for
some parts of domestic industry, the situation was broadly similar to that in Portugal in that the
foundations of industry established many years before, were such as to generate a generally good
response. Ireland's more recent problems stem back to the euphoria of 1976 and the massively
inflated spending by the government initiated at that time. By contrast with Portugal, these problems
have mainly needed to be addressed by policies to hold back domestic absorption. The low labor-
intensity of much of Irish industry has meant that the real devaluations and lower real wages policies
practiced by the Portuguese, have not been a realistic approach in the Irish case.
11. Ireland has an agreement with the EEC to hold the tax rates on carporate profits on exports to only 10
percent until the year 2000.



16 Trade Reform and External Adjustment
In the case of Turkey, Mr. Ersel drew attention to the very successful stabilization program of
1980 and the subsequent rapid growth of exports which almost quadrupled by 1987. A number of
factors were suggested by way of partial explanation of Turkey's successful trade perfornance. The
first was the progressive evolution of an incentive system which unwound import protection,
refined the explicit incentives for exports, and above all offered exporters sustained real
devaluations to boost their competitiveness. This did not receive much in-depth discussion during
the seminar. However, it is discussed and analyzed at length in a paper circulated to participants.1
The second were certain developments in Middle Eastern markets which favored Turkey and
especially the Iraq-Iran war. The third was the pernissive factor that Turkey's earlier
industrialization efforts superimposed on the macroeconomic difficulties of the late 1970s, which
meant that there was considerable excess capacity available in industry at the moment when the
reform program began.
One Bank participant noted that to encourage the conversion of this excess capacity for export-
use required both a continued limitation on domestic demand as wel as a sufficient degree of
credibility about the longevity of outward-looking policies to persuade industrialists to develop the
new markets. Turkish policy had succeeded in establishing credibility in this respect by a relatively
high degree of consistency both of government pronouncements and action about the permanence of
the export support. By contrast, he noted that Poland's hesitancy in these directions, for example in
1982 and also early in 1988, had lacked conviction and consequently had failed to gain credibility.
One reason why the apparently strong incentives for exports in Poland had not resulted in good
export performance was that production for the domestic market continued to be helped in various
ways and not least thrugh the operation of the soft-budget option.
The final point about Turkey was that its program had been extremely comprehensive and had
required a great deal of external assistance: specifically $1.6 billion of SAL and project lending. It
had also been very important to the overall sustainability of the program for the governments to be
able to show some early successes. This had been possible because of the strategic decision to build
an incentive structure for exports and good export growth performance in advance of a fully fledged
liberalization of imports. This probably had lessons for other countries and Silva Lopes and others
wondered whether it might be possible to develop programs to replicate this sequencing elsewhere.
In particular, would it be possible for revenues from continued import protection to be partialy
assigned to the promotion of exports? Above aU though the Turkish experience demonstrated the
willingness and ability of the World Bank, and the aid community more generally, to sustain large
resource transfers and long-term commitment to a country when that country's own commitment to
major reform is unambiguous and itself sustained.
Mr. Kim in his paper and presentation about trade policies in South Korea provided a detailed
description and assessment about the evolution of policies. This gave rise to a varied range of
questions and discussion of which the following points were among the most important. First, the
Polish participants noted that many of the instruments used by South Korea in her import-
substitution phase in the 1960s such as import controls, sector-specific guidelines, and heavy export
subsidies, are interventions generally frowned upon by the World Bank and the GATT. They
wondered how the World Bank would evaluate a program incorporating such elements if it were to
be invoked today in the Polish or other country contexts. Second, a number of questions arose as to
the role which the Import Substitution Industrialization program and the subsequent heavy-industry
program in the 1970s had played in South Korea's ultimate emergence as a powerful industrial
nation-were they essential or were they now perceived as a mistake? Kim responded by noting that
the limited economic base of the country at the end of the 1950s had meant that there really was little
alternative for the Import Substitution Industrialization emphasis of the 1960s and so this had been
12. See B. Mlanovic 'Export Incentives and Turkish Manufactured Exports, 1980-1984," World Bank
Staff Working Paper No. 768 Washington D.C., 1985.



Hungary, Poland, Portugal, Turkey, and Yugoslavia 17
essential for ultimate success. As regards the later focus on heavy-industry the situation was
different because there was still considerable controversy within the country about that phase of
policy. Undoubtedly there were some major mistakes and the costs of these had been high, but in
his view the policy had been correct on balance: many of the industrial success stories of the 1980s,
such as automobiles, would have been much harder to achieve without the heavy-industry push in
the 1970's. Equally that push would itself have been more difficult to achieve in the 1980s.
Third, the Yugoslav participants asked what the mechanisms had been for the abandonment of
specific policies such as preferential interest rates and multiple exchange rates, which at one stage
had been key elements of policy. Kim had no specific answer to this but did note that policies in
South Korea were constantly reviewed at the highest level, and there was no fundamental difficulty
in abandoning policies when they had ceased to serve the central objectives of sound resource
allocation and strong export performance.
Fourth, a number of participants enquired about the significance of the planning process in the
Korean system. Kim noted that successive development plans had been extremely important in
setting the policy priorities of the country until the 1980s. However, as the economy had become
progressively more sophisticated, the role of planning had changed and had become far more
indicative in nature and more concemed with social issues as opposed to resource allocation per se.
But even in the early periods of the country's development it was noted that plans had been
extremely flexible and targets had been revised: often as frequently as every 12-18 months. In
particular, planners had consistently underestimated export growth performance with the result that
certain investments which had been planned largely for the purposes of import substitution
materialized ex post as significant export earners. When the Korean steel industry was set up, for
example, it was competitive enough to export about half its output from the beginning and Korean
engineering companies were never pressured to buy local steel. Again the key to the country's
ability to use the same capacity to serve different markets in this way lay in the explicit neutrality of
the trade regime as between export and domestic markets.
Finally, there was a certain amount of discussion about South Korea's policies towards
technological upgrading of industry and its attitude towards the support of newer and less labor-
intensive industries. Kim noted that the pressures on real wages and the emerging industrial
relations problems in the country made it certain that the relative importance of labor-intensive
production would decline and that some less automated plants in, say, the textile sector would need
to close. Whereas Korea's tradition in relation to the technological upgrading of industry had been
heavily based on imported technology, that was now changing. The current development plan, for
example, envisaged a major increase in domestic R and D spendipg and was targeting a rise in the
ratio of R and D expenditure to GDP of from 1.6 percent to 2.5 percent by 1990. The need for this
switch of emphasis to higher quality products which this reflects was being intensified by the strong
extemal trading position of the country and the growing pressures from trading partners of Korea to
forgo the aggressive use of exchange rate policy to bolster her intemational competitiveness.
Indeed, the currency had been subject to an 8.7 percent real appreciation in 1987 and seemed set to
experience a further appreciation of that magnitude in 1988. Although in the past Korea had
certainly provided selective support to particular industries, there was no longer serious effort to
"pick the winners" in this sense. And it was now categorically not the case that Korea subsidizes
her industries either selectively or in general. In general, it was moving toward a relationship
between government and industry far closer to that existing in the West and away from the more
interventionist model of a few years ago.



8
The International Environment for Trade Reform
As was noted in the earlier sections, several participants from the East European countries
expressed concern about the international institutional background against which trade reform was
being considered. These comments emerged most systematically in the discussion of the paper by
Michael Finger on Prospects for the Uruguay Round of Trade Reform. There were essentially four
main issues which emerged, namely the adequacy of the overall growth rate of world trade; the
implications of the more recent developments in GATT for liberal trade in general; the specific
problems of the East European countries in relation to international trade restrictions, and the
relevance of the evolving policies of the European Comnmunity especially as regards the prospective
single European market by 1992.
As regards the first of these, there was general agreement that the 1980s was not such a
favorable time for liberalizing as were the previous two decades. However, Parvez Hasan argued
that the apparently unfavorable world trade environment should not cause developing countries to
turn away from an export-led strategy. It was certainly true that the growth of manufactured exports
from developing countries had slowed down in the 1980s (to 8.4 percent, 1980-86) but this still
remained nearly three times the growth rate of incomes in industrial countries. It was also the case
that the share of developing countries in total industrial country consumption of manufacturers was
only about 2 percent, while the prospects for intra-developing country trade remained good. The
sound policies of a number of liberalizing countries, including Turkey and Portugal in Europe, had
been rewarded by the achievement of extremely high rates of export growth in the 1980s as indeed
had the policies of several non-European countries such as South Korea, Taiwan, Thailand,
Malaysia and China. China had achieved a growth rate of exports averaging 11 percent during the
1980-86 period and although the sheer size of that country precluded the possibility of exports being
a major engine of growth, the leadership there clearly did see expanded foreign trade as a way of
providing better market signals for domestic industry and for transmitting new ideas about
production techniques and products. It was worth noting that the East Asian economies already
accornted for manufactured imports of almost half the level of lhe U.S., and three times the level
achieved by Japan. Thus their further growth would ensure a healthy growing market for other
developing countries whatever happened to trade prospects in other regions.
In his presentation about the Uruguay Round of GATT negotiations, Mr. Finger provided a
discussion of progress in the six negotiating groups of most relevance to developing countries.
These are the groups concerned with tariffs with non-tariff barriers; with natural-resource based
products; with tropical products; with safeguards; and with the functioning of the GATT system
itself. In relation to non-tariff barriers he noted that the relative inexperience of GATT parties in
negotiating on these matters has encouraged an approach based on getting things going and the
submission of bilateral or multilateral proposals or offers. This in tum has generated considerable
divergence of approach and not least on the question of how far tariff and non-tariff concessions
should be linked in formal negotiations. In relation to agricultural trade, he noted that the Uruguay
Round seemed set to achieve greater liberalization than had the previous Tokyo Round of the
1970s. In particular, several of the national proposals had argued for the elimination of agricultural
subsidies, and especially export subsidies, and measures to improve market access for imports.
Particularly encouraging was the fact that although different, there was significant overlap in the
proposals emanating from the U.S., the EEC, and from other European countries.
His comments on GATT procedures stimulated considerable interest in the seminar because
these emphasized the potentially wide gulf between reduced protectionism in GATT terms and the
18



Hungary, Poland, Portugal, Turkey, and Yugoslavia 19
aspirations in IMF and World Bank terms, for genuinely freer trade. In particular, he noted that
GATT negotiations and procedures were concerned to define controls on the limits to trade
restriction and not to ban them. Provided governments used only approved instruments of trade
restriction, applied to them in a non-discriminatory manner, and subjected all existing protection to a
long-term process of binding obligations, then its GATT obligations were satisfied. Unfortunately,
the trade remedies which GATT allows, when they are embodied in national laws, have proven
perfectly capable of generating a proliferation rather than a reduction of measures designed to
restrict trade. The multifold expansion of anti-dumping cases (1,288 in the year 1980-86),
following the definition of the GATT anti-dumping code, is a very clear example. The general
message which participants were encouraged to draw was that, although important, they should not
rely on the GATT system alone as a source of international pressure to moderate the restrictions
most obviously inhibiting to their own export expansion.
This proposition led on rapidly to an extended discussion of the third issue, namely the
disadvantaged position of state-trading countries in relation to protectionist policies in the West. The
Hungarians, in particular, asserted that they were treated extremely inequitably, especially by the
EEC. Some 15 years ago the EEC had made a commitment through GATT to progressively reduce
quantitative protection against Hungary but only 5 percent of such protection had been dismantled in
that time. A small country such as Hungary, which M. Nuti noted accounts for only a fraction of
one percent of total EEC trade, has argued that they have no economic muscle and had to rely on
legal processes through the GATT and other organizations. These are presently not working in a
manner which is conducive to a freer-trading approach in the country, especially since, together
with the other East European economies, Hungary does not enjoy free trade access into Western
Europe. Dr. Fitzgerald agreed with several other commentators in noting that there were severe
weaknesses in the manner in which the EEC dealt with the East European countries. In particular,
the EEC was not facing up to the consequences of the East European economies moving to a freer
trade system. In logic this should eliminate the main reason for the Community's applying
differential protection against state-trading countries but this has not happened in practice.
Furthermore, the EEC as an organization has no official position on extemal debt. This means that
arguments of the type emerging at the seminar about the need for more liberal trade, as an element in
the correction of difficult debt situations, cut little ice in Brussels. The EEC countries need education
about this at a political level and this is probably the only way to move decisionmaking itself to a
higher level witiin the system.
As regards the effects of the further development of the EEC market, Dr. Fitzgerald made
several points. On the general issue of protectionism he noted that the EEC system was certairny not
a market system and that it unquestionably operated in a way that made access to third countries
extremely difficult. As the Yugoslavian participants were quick to confirm, the problems of access
were most severe in relation to agricultural products, where West Germany, for example, currently
enjoyed protection equivalent to at least a 20 percent tariff. Although the agricultural pricing system,
instituted mainly to support high cost products in West Germany, was well-known to encourage
massive surpluses, rapid downward adjustments of prices to remedy their situation was not
potentially feasible. However, the alternative arrangement of production quotas, as applied, for
example, in the case of milk, was an obvious encouragement to inefficiency. Thus problems in this
area were likely to persist.
As regards the establishment of the single European market by 1992, Fitzgerald noted that for
20 years the severe nontariff baniers to trade in the Community-such things as frontier controls,
national industrial standards, limits on capital movements-had not received serious attention. Now
there was an extremely serious effort to address these matters. While it was going on, the EEC
would probably be rather too preoccupied to deal with matters of external relationships including
those with East Europe. However, if it was possible that the integration of the market led to faster



20 Trade Reform and External Adjustment
overall growth, then this would be a factor likely to reduce the need for protectionism against these
countries. However, this was by no means certain to occur. The Yugoslav participants noted their
conviction that countries on the periphery of the EEC would have little bargaining power in the new
single market and would need to adapt to it. Yugoslavia was already preparing for the changes and
strongly encouraging its industry to adopt EEC standards. There was some argument over
Fitzgerald's suggestion that quotas against third country exports might usefully be reformed from a
national to a Community basis. In short, the Community as a whole would seek to keep out a
specified volume of goods rather than leaving decisions on this to national govermments. He felt that
this would result in generally lower protection against East Europe but this was disputed by the
Hungarian and other participants who thought that, if anything, protection would rise as a result of
that reform. In general, there was a perception that 1992 might well involve leveling external
barriers up to the level of the most highly protected members of the EEC rather than down to the
level of the lowest protected.
A critical element in the proposed integration of the market was the proposed liberalization of
capital movements. Fitzgerald noted that with free trade, free capital movements, and a fixed
exchange rate in each member state, the scope for independent fiscal and monetary policy in any one
country was removed. This opens up the obvious danger that growth could concentrate on the
strong central countries of the market at the expense of periphery countries such as Greece and
Portugal. The proposed doubling of the EEC structural funds represented a possible offset to this
concentration of economic activity. However, even with this increase, the volume of structural fund
transfers would remain really quite smaU, certainly less small than the volumes found in most full
political federations. Once again the problems arising from this would be smaller if the Community
as a whole was able to achieve relatively rapid overall growth.
Finally, on the subject of the possible enlargement of the Community, two substantive points
were made. First, in relation to the 1986 enlargement to include Portugal and Spain, it was noted
that membership had had a strongly beneficial effect in providing for greater stability in policies in
Portugal than had been the case in the preceding 12 years. The major residual problem found by
Portugal was the continuing large public sector deficit and the difficulties this posed for accepting
any real fixity of the exchange rate in the context of the European Monetary System. Second, in
relation to Turkey, Dr. Fitzgerald noted that this possible enlargement would put the interface
between the economic and defense roles of the Community on the agenda more squarely than ever
before.



9
The Leading Issues
The complexity and diversity of the issues discussed at the seminar makes the presentation of a
concise summary extremely difficult. However, a number of key issues certainly did emerge during
the course of the two days and it is useful to highlight a few of these by way of conclusion.
First and foremost, the discussion illustrated a clear recognition on the part of participants from
all countries of the analytically sound case for freer trade as a vital element in encouraging more
efficient use of scarce investment and other resources. Less well recognized at the outset but clearly
communicated during the discussion was the vital importance of complementary policy reforms to
ensure that the disciplining signals from freer trade were fully communicated down to the enterprise
level. There was some willingness as well to accept that policies to harden the "soft-budget option"
were particularly important in this regard to ensure that enterprise inefficiency was properly
penalized. Clearly the soundness of the transitional policies-not much discussed at the seminar-
would also be extremely relevant to ensuring the credibility of this type of reform. Underlying this
was an acceptance on the part of many participants that properly functioning markets would
increasingly be needed to set prices and allocate resources, and that the administrative simulation of
such processes rarely worked well.
However, the reasonably broad-based agreement about the analytical correctness of the case for
free trade and the reasonably clear implications it logically generated about supporting policies
contrasted markedly with the relative untidiness and the significant disagreements associated with
the practical consequences of adopting such policies in East Europe. While there was little dispute
that South Korea, Turkey, Portugal, and Ireland had all benefited significantly from the ultimately
liberal trading postures which they had adopted, there were serious doubts expressed about the
replicability of these successes in the East Eumpean context. These doubts have two main aspects.
The first concerns the philosophical basis of the socialist economic system and its ability to
absorb a free-trading stance in its external policies. The implications of such a reform would run
through the system as a whole and, in particular, would inevitably undermine any attempts to
continue to centrally control the allocation of resources. The unanimous agreement among
participants that tight central control of resources had not been successful in achieving efficiency of
resource-use, did not seem to translate into an equal degree of unanimity about the feasibility and
desirability of the wholesale replacement of such a system. The reasons for this are complex and
difficult to untangle but probably relate in part to doubts about whether the pre-eminent
distributional and ownership concerns of a socialist system could really be maintained if control
over resource allocation were to be delegated to free markets. Certainly some participants were in
little doubt that some deterioration in the relatively egalitarian income distribution which East
European economics have achieved would be an unavoidable consequence of more liberal market
arrangements.
The second aspect concems the high degree of skepticism expressed about the present
intemational trading environment and the unique position of the East European countries within it.
The point was made in several ways that a freer trading posture would be easier to achieve for many
countries if trade arrangements within the CMEA area itself could be reformed to provide a more
market-oriented environment. In particular, several participants argued for an enhanced degree of
currency convertibility within the CMEA area and for a greater role for prices and efficiency in
determining trade flows. As regards trade with the West, the seminar discussion suggested several
reforms which are required to encourage the East European economies to bite the bullet of freer
tbade.
21



22 Trade Reform and External Adjustmcnt
The first would be for the EEC, to honor existing commitments on the removal of trade
restrictions. A second and more general reform would be for the EEC, in particular, to recognize the
logic of its own trading policies and agree to unwind its discriminatory restrictions against the
Eastern bloc as the East European countries progressively moved in the direction of greater
liberalism. Finally and most important, the Eastern bloc countries as a whole require credible
intemational assurances that if they make the difficult effort to re-orient trade along Westem lines,
they will find the long-term access to markets which would justify the economic and political costs
of this major readjustment. The analytical economic merits of the case are unlikely to win the day in
the absence of international political commitment along these lines.



Participants
Senior Policy Seminar on Trade Reform and External Adjustment
Laxenburg, Austria June 6-8, 1988
Hungary                                       Mr. Andrzej Dorosz
Vice Minister
Mr. Akos Balassa                              Ministry of Finance
Asst. Vice President                          Pul. Swietokrzysak Str. 12
National Planning Office                      100-916 Warsaw, Poland
Roosevelt ter 7/8
1051 Budapest, Hungary                        Dr. Janusz Kaczurba
Vice Minister
Mr. Istvan Major                              Foreign Economic Relations
General Manager                               Wiejska 10, 00-950
Ministry of Trade                             Warsaw, Poland
Honved u. 13/15
1880 Budapest, Hungary                        Mr. Andrzej Olechowski
Director
Mr. Istvan Racz                               World Bank Cooperation Bureau
General Manager                               National Bank of Poland
International Monetary Dept.                  Swietokrzyska 11121, Skr. Poct. 1011
National Bank of Hungary                      00-950 Warsaw, Poland
Szabadsag ter 8/9
1850 Budapest, Hungary                        Portugal
Mr. Furenc Furulyas                           Dra Teodora Osorio Pereira Cardoso
Director General                              Director of Research
Tariff Policy & International                 Banco de Portugal
Economic Organizations DepL                  Rua Febo Moniz
Ministry of Trade                             4-1 100 Lisbon, Portugal
Budapest, Hungary
Mr. Antonio Jose Mendonca Pinto
Mrs. Bella Ronaszeki                          Director
Senior Deputy General Manager                 Economic Studies Department
Ministry of Finance                           Ministry of Finance
Postafiok 4811 1/Jozsefuador ter 2-4          Avenida Infante D. Henrique
1369 Budapest, Hungary                        1100 Lisbon, Portugal
Poland                                        Mr. Carlos Tavares
Economic Advisor
Mr. Krzysztof Szwarc                          Ministry of Finance
Pres. of the Board of Management              148 Rua do Comercio
Export Development Bank                       Lisbon, Portugal
Warsaw, Poland
23



24 Trade Reform and External Adjustment
Turkey                                       Resource  Persons
Europe, Middle East
Mr. Hasan Ersel                              and North Africa Regional Office
Dir. Gen. Research                          (EMENA)
Research, Planning and Training
Central Bank of Turkey
Ataturk Bulvari No. 40                       Mr. Parvez Hasan
Ankara, Turkey                               Chief Economist
Yugoslavia                                   Mr. Philippe Nouvel
Division Chief, (EM4CO)
Prof. Dr. Oscar Kovac
Minister in the Govemment of SFRY            Mr. Anil Sood
Federal Executive Council                    Division Chief (EM4IE)
Belgrade, Yugoslavia
Mr. Michael Lav
Mr. Srdan Savic                              Senior Economist (EM4CO)
AssL Sec. for Foreign Trade
Miadinski Brigada I                          Mr. Branko Milanovic
Belgrade, Yugoslavia                         Economist (EM4CO)
Mr. Branko Dragas
Vice Gov., Foreign Exchange                 International Economics Department
National Bank of Yugoslavia
Bulevar Revolucije 15                        Mr. Michael Finger
1 1.000 Belgrade, Yugoslavia                 Lead Economist (IECM
Mr. Cedomir Segrt                            Economic Development Institute
Undersecretary
Federal Executive Council                    Mr. Jayanta Roy (EDIEM)
Bul. Lenjina 2                               Seminar Director
N. Belgrade, Yugoslavia
Mr. Suman Bery
Mr. Andrija Jovicic                          Division Chief (EDIEM)
Asst. Director
Federal Bureau for Prices                    Mrs. Jayshree Sengupta
Belgrade, Yugoslavia                         Consultant (EDIEM)
Mr. Zivko Kazimir Pregl                      Others
Exec. Sec. for Econ. Affairs
Central Com. of League of                    Mr. Roger Chaufoumier
Communists of Slovenia                     Moderator
61000 Ljubljana, Tomsiceva 5                 Former Vice President
Yugoslavia                                   Europe, Middle East, North Africa
The World Bank



Hungary, Poland, Portugal, Turkey, and Yugoslavia 25
Mr. Alan Roe
Rapporteur
Prof., University of Warwick
Dept. of Economics
Coventry, England
Mr. Mario Nuti
Head of Economics Dept.
European University Institute
Florence, Italy
Mr. Oli Havrylyshyn
Chairman, Dept. of Econ.
The George Washington University
Washington, D.C.
Mr. Chul Soo Kim
Asst. Minister
Ministry of Trade and Industry
Seoul, Korea
Mr. Grt Fitzgerald
Former Prime Minister and Foreign Minister
Fonner Pres. of EEC Council of Ministers
3h1and



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EDI Policy Seminar Reports make available summaries of EDI policy seminars that are of particular
interest and importance to readers concerned with public affairs. The reports seek to convey the
essence of the discussions and to bring out the principal areas of agreement or disagreement among
the participants, who represent a wide range of governmental, academic, and professional back-
grounds.
WORLD BANK PUBLICATIONS OF RELATED INTEREST
Exchange Rate Misalignment in Developing Countries.
Sebastian Edwards. The Johns Hopkins University Press. World Bank Occasional Paper 2, New
Series.
Managing Financial Adjustment in Middle-Income Countries.
Alan Roe and Paul A. Popiel. EDI Policy Seminar Report 11.
The World Bank's Lending for Adjustment: An Interim Report.
Peter Nicholas. World Bank Discussion Paper 34.
Adjustment Lending: An Evaluation of Ten Years of Experience.
World Bank Policy & Research Series 1.
The Alleviation of Poverty under Structural Adjustment.
Lionel Demery and Tony Addison. In English and German.
Macroeconomic Policies and Adjustment in Yugoslavia: Some Counterfactual Simulations.
Fahrettin Yagci and Steven Kamin. World Bank Discussion Paper 16.
Korea's Experience with the Development of Trade and Industry.
Silvio de Franco, Alberto Eguren, and David Baughman. EDI Policy Seminar Report 14.
Horticultural Trade of the Expanded European Community: Implications for
Mediterranean Countries.
Malcolm D. Bale, editor.
Exports of Developing Countries: How Direction Affects Performance.
Oli Havrylyshyn, editor.
Structural Adjustment in Lowinca: A Case Exercise in Economic Policy Analysis.
P,aul G. Clark and others. EDI Development Policy Case Series, Teaching Case 1.
Economic Reform in Socialist Countries: The Experiences of China, Hungary, Romania,
and Yugoslavia.
Peter T. Knight. World Bank Staff Working Paper 579.
Poland: Reform, Adjustment, and Growth.
Volume 1: The Main Report, The Economic System.
Volume 2: Reports on the Principal Sectors.
Export Incentives and Turkish Manufactured Exports 1980-1984.
Branko Milanovie. World Bank Staff Working Paper 768.