Transition report 2013

Transitionreport2013 Stuck in Transition? Presentation at the Higher School of Economics 12 December 2013 Stuck inTransition? Jeromin Zettelmeyer Deputy Chief Economist Alan Rousso Managing Director, External Action and Political Affairs Jeromin Zettelmeyer Deputy Chief Economist

Motivation: will convergence resume? Real GDP growth y-o-y, per cent: Growth

This Transition Report in a nutshell Jeromin Zettelmeyer • Worries about permanently lower growth in the future compared to 1997-2005 are justified. Reinvigorating growth requires additional reform and better economic institutions. • Two sets of factors shape the quality of economic institutions: • Broad political institutions: democratisation • International integration, human capital and local political reform • Fortunately, democratisation itself becomes more likely as a result of economic development and market reform • Transition to market can spur (or at least stabilise) democratic transition, which in turn spurs more reform. Alan Rousso

Why convergence may slow Everyone focuses on slower capital flows. But this a cyclical phenomenon which will lose importance in the medium term. Better reasons to worry about convergence are: The end of productivity catch-up related to early transition Stalled reforms, even in less advanced transition countries

Convergence driven by growth of total factor productivity Total growth of real GDP (PPP) from 1993 to 2010: Growth 1993-2010 Source: Penn World Tables 8.0

… but this productivity catch-up may now be complete Total factor productivity (log) Income per capita (log) Source: Penn World Tables 8.0

Reforms have stagnated since mid-2000s Average of 6 country-level transition indicators: Economic Transition Source: EBRD

With current policies, convergence will slow… GDP per worker as a share of EU15 average, actual and projected: Income as a share of EU15 income Source: EBRD calculations

…unless reform efforts can be reinvigorated GDP per worker as a share of EU15 average, actual and projected: Income as a share of EU15 income Source: EBRD calculations

This Transition Report in a nutshell • Worries about permanently lower growth in the future compared to 1997-2005 are justified. Reinvigorating growth requires additional reform and better economic institutions. • Two sets of factors shape the quality of economic institutions: • Broad political institutions: democratisation • International integration, human capital and local political reform • Fortunately, democratisation itself becomes more likely as a result of economic development and market reform • Transition to market can spur (or at least stabilise) democratic transition, which in turn spurs more reform.

Democracy is strongly correlated with reform 2012 Polity2 score (x-axis) and average country-level transition indicator (y-axis): Economic Transition Level of democracy Source: Polity IV database and EBRD

Democratic reversal impedes reform Average of 6 country-level transition indicators: Economic Transition Source: EBRD

Democratisation has propelled reform – but not always Average of 6 country-level transition indicators: Economic Transition Source: EBRD

Improving economic institutions for a given political system • International integration and external anchors • Both trade and financial integration; EU effect • “Feasible political reform”: • Particularly at the local/regional level • Exploiting political windows of opportunity • Relatively small political improvements (1-2 points on Polity scale) can open a window of opportunity for reform • Improving human capital • Improves institutional capacity in normal times; ability to exploit critical junctures; spreads fruits of reform

What we mean by “economic institutions” Economic Institutions • Worldwide Governance Indicators (survey based) • Doing Business “distance to the frontier” (laws and regulations) • EBRD transition indicators (cumulative market reform)

International integration comes with good institutions Factors explaining institutional quality difference between top and bottom transition countries, using WGIs as measure of institutions : Explanatory power Financial Trade Source: EBRD calculations

Large variation in business environment at regional level • e.g. corruption as a business obstacle in Russian regions. Source: Banking Environment and Enterprise Survey 2012

Windows of opportunity leading to better economic institutions: Slovak Republic and Georgia Polity2 (left axis) and average worldwide governance indicator (right axis): Level of democracy Quality of institutions Source: Polity IV database and World Bank

Missed opportunities: Romania (1995), Ukraine (2004) Polity2 (left axis) and average worldwide governance indicator (right axis): Level of democracy Quality of institutions Source: Polity IV database and World Bank

Factors shaping the success of windows of opportunity Early transition histories – where powerful vested interests arose after the collapse of central planning, they impeded reform. Political Polarisation – restricted reformers’ ability to initiate and sustain change. Leaders’ priorities – in some countries foreign-educated leaders backed reformist agendas and tackled corruption. External anchors and support – the prospect of EU membership spurred reform, as did foreign financial and technical assistance

Political polarisation was an obstacle in Romania and Ukraine Index of political polarisation. Average score 1990-2004. Political Polarisation Source: Frye 2010

In transition region, tertiary education is the issue… Comparison of human capital in Advanced and Transition countries: Quality of education Number of Source: EBRD calculations, National Science Foundation, WIPO

…. but returns to education are also critical • Better institutions improve returns to tertiary education • Key to people acquiring education and to retaining them Brain drain* *Stock of high-skilled immigrants minus the stock of high-skilled emigrants abroad, as a percentage of high-skilled workers, 2000: Source: EBRD calculations based on Artuc et al. (2013)

This Transition Report in a nutshell • Worries about permanently lower growth in the future compared to 1997-2005 are justified. Reinvigorating growth requires additional reform and better economic institutions. • Two sets of factors shape the quality of economic institutions: • Broad political institutions: democratisation • International integration, human capital and local political reform • Fortunately, democratisation itself becomes more likely as a result of economic development and market reform • Transition to market can spur (or at least stabilise) democratic transition, which in turn spurs more reform.

Since the end of the Cold War, democracy has resumed a secular upward trend Average polity score Proportion of democracies Source: Polity IV dataset

What drives democracy? • Modernisation (Lipset, 1959) • Democratic beliefs and culture (Almond and Verba, 1965) • Convergence of interests and equality (Dahl, 1971) • Critical junctures (Acemoglu and Robinson, 2006) • Immobility of assets and the creation of a ‘rentier state’ can impede progress towards democracy (Mahdavy, 1970)

Economic development and reforms help democracy • Economic development – measured in terms of growth in per capita GDP, expansion of the middle class, industrialisation, urbanisation – has led to advances in democracy both globally and in the transition region (with diminishing returns). • Reform can help democracy: • By making societies richer and building constituencies for democratic reform • By creating competition and weakening special interests opposed to democracy • By fostering growth of the private sector and small business

Early reforms help to predict democracy … Average country-level transition indicator 1992 (x-axis) and Polity2 score 2012 (y-axis) : Democracy in 2012 Economic reform levels in 1992 Note: relationship holds controlling for initial levels of democracy. Source: Polity IV database and EBRD

…but natural resources may hold it back. Log per capita income 1992 (x-axis) and Polity 2 score 2012 (y-axis): Not oil producing Oil-producing Level of democracy in 2012 Income in 1992 Income in 1992 Source: Polity IV database and IFS

Demand for democracy • Evidence from the EBRD/World Bank Life in Transition Survey (LiTS) shows that support for democracy may be affected by: • Employment – employees of government agencies or state-owned entities are less likely than private sector workers to support democracy • Education – better educated people are more likely to support democracy (even if they work in the state sector) • Upward mobility – people who believe themselves to be better off than four years ago are more likely to support democracy.

Less democratic countries tend to have higher levelsof state employment Democracy, 2012 State-sector employment, 2010, per cent Source: LiTS (2010) and Polity IV

The case of Russia • Big Bang in 1991/92 (following years of gradual reform under Gorbachev). • Experience in the 1990s (distorted reforms, corruption and state capture, inequality) eroded public support for democracy. • Yet, Russia has grown significantly since the 1998 crash – roughly 4% p.a. between 1998 and 2012, GDP doubled, large middle class. • Russia is less democratic than its level of economic development would predict. Why? • State-dominated middle class • Demographic distribution of pro-reform segments • Reliance on natural resource rents and side payments

Conclusion • Time is on the side of democracy and reform • But the process can be slow, and some factors – like natural resource abundance – can hold it back. • In the meantime, countries can: • Foster international integration • Improve transparency and accountability at local levels • Improve human capital • International community can help by: • Promoting international integration (trade and financial) • Supporting diversification • Supporting education

Transition report 2013