Productivity Growth and Job Creation in Eastern Europe

Productivity Growth, Job Creation and Demographic Change in Eastern Europe and the Former Soviet Union Pradeep Mitra Chief Economist Europe and Central Asia Region Lunchtime Presentation at the 12th Dubrovnik Economic Conference in Dubrovnik, Croatia, June 28 – July 1, 2006

The Presentation • GDP Growth and its Components • Growth of Labor Productivity and its Correlates • Job Creation and its Correlates • The Business Environment facing Firms • The Demographic Challenge • Conclusions

Growth in GDP per capita from 1998 to 2003, the most rapid for CIS countries recovering from a deep transitional recession, owes more to growth in labor productivity (GDP/EMPL) than improved employment rates (EMPL/Working POP) or favorable demography (Working POP/POP) (Growth in GDP/POP) = (Growth in GDP/EMPL) +(Growth in EMPL/Working POP) + (Growth in Working POP/POP) Average annual growth in GDP per capita and its components, 1998-2003 Working age population covers the age range 15-64 Source: ILO LABORSTA database, World Development Indicators

Real wage growth, reflecting gains in labor productivity, outpaced net employment growth in transition economies World Bank (2005a)

Indeed the employment rate (EMPL/Working POP) continued to fall in many countries after 1998. Slack labor markets are manifest in either open unemployment, falling labor force participation or low-productivity employment. While the employment rate is generally higher in CIS countries, (compared to the EU-8 countries where it falls short of the Lisbon target of 70%) many jobs in the CIS are in low-productivity occupations partly because . . . . Employment Rates: Early Transition, 1998 and 2003 Note: The earliest years (blue bars) for each country are as follows: 1990:Azerbaijan, Belarus, Bulgaria and Estonia 1992: Hungary, Russia 1993: Armenia, Czech Republic, Kazakhstan, Poland and Slovenia 1994: Albania, Lithuania, Romania and Slovak Republic. 1995: Moldova and Ukraine. Source: ILO LABORSTA database, World Development Indicators Note: The employment rate in Moldova between 1998 and 2003 shows a decline based on LFS but an increase based on household survey data (previous slide) on account of a likely more restrictive definition of informal sector employment in the LFS.

. . . . de-industrialization in low income CIS (e.g. Kyrgyz Republic) has been accompanied by a large labor transfer into agriculture in the absence of adequate social safety nets. Not so in Central Europe (e.g. Czech Republic), where over-industrialization has been corrected through a reduction in agricultural and industrial employment, with jobs moving to market services, but with high open unemployment and/or low labor force participation in some countries. Kyrgyz Republic Czech Republic Source: World Bank (2005b)

Since value added per worker is the lowest in agriculture, a shift in employment away from agriculture and into services in EU-8 and middle income CIS has been productivity-enhancing. While EU-8 countries approached or exceeded levels of productivity typically observed in middle-income developing countries (e.g. Colombia. Turkey), the middle income CIS and SEE lagged significantly. And low income CIS exhibit levels and patterns of productivity typical of low-income developing countries (e.g. Vietnam). EU8 Countries Czech Rep, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia SEE Countries Albania, Bosnia, Bulgaria, Croatia, Macedonia, Romania, Serbia and Montenegro Middle Income CIS Belarus, Kazakhstan, Russia, Ukraine Low Income CIS Armenia, Azerbaijan, Georgia, Kyrgyzstan, Moldova, Tajikistan, Uzbekistan World Bank (2005a)

The change in aggregate labor productivity is decomposed into (i) within-firm, (ii) between-firm, and (iii) cross components1/, and the contribution of (iv) entrant and (v) exiting firms. The decomposition shows that . . . . Sources of Productivity Growth in Transition, Emerging, and OECD Countries Labor Productivity decomposition shares – Manufacturing Five-Year Differencing, Real Gross Output For Hungary and Romania the decomposition refers to a three-year differencing which, given significant learning and selection by new entrants, underestimates the contribution of entry to productivity growth. 1/ The cross term reflects gains in productivity from expanding employment shares in high productivity-growth firms or shrinking employment shares in low productivity-growth firms Source: Staff estimates based on Bartelsman, Haltiwanger and Scarpetta (2004)

. . . . firm entry and exit are more important in transition countries, contributing between 20 to 45 percent of productivity growth, as against between 3 and 35 percent in developed and other developing countries.

In the low income CIS, 40 percent or more of the labor forceis engaged in agriculture. Land distribution from collective farms to poor rural households in low income CIS – Armenia and Georgia (early ’90s), Kyrgyz Republic (mid 90s)’, Azerbaijan and Moldova (late ’90s) – led to important gains in labor productivity and, because of the high labor intensity of agriculture, to growth in household farming and reduction of potential unemployment Factor Intensity and the Growth of Household Farms Source: Macours and Swinnen (2004), World Bank (2005a)

Increasingly dynamic labor markets were reflected in a dramatic rise in job reallocation (the sum of job creation1/ and job destruction2/ rates) in transition countries from less than 10% of the workforce in the late ’80s to more than 20-25% in the ’90s, indeed to levels equaling or exceeding those in developed countries and lagging slightly below those in developing countries 1/ Employment gains during a year divided by average employment during the year. 2/ Employment losses during a year divided by average employment during the year.

Job destruction generally surged first but it was the response of job creation which varied across countries – catching up rapidly with job destruction in leading reformers but staying lower than job destruction for prolonged periods in lagging reformers

Firm entry contributed strongly (25% to 50%) to job creation. But their contribution was even higher in the earlier years and declined over time except in Russia and Ukraine – both late reformers – where the role of firm entry in job creation increased in the second half of the 1990s. In contrast to the behavior of entrant firms, existing firms resorted on average to “defensive restructuring”, i.e. improved productivity by downsizing and shedding redundant labor.

The business environment has been improving steadily in the transition countries, but is generally still more difficult than in the cohesion countries of Western Europe, with labor regulations a notable exception The business environment was assessed on a scale from 1 (no obstacle) to 4 (major obstacle) Cohesion countries include Greece, Ireland, Portugal and Spain Transition countries include Albania, Armenia, Azerbaijan, Belarus, Bosnia, Bulgaria, Croatia, Czech Republic, Estonia, Georgia, Hungary, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Macedonia, Moldova, Poland, Romania, Russia, Serbia and Montenegro, Slovakia, Slovenia, Tajikistan, Ukraine, Uzbekistan Cohesion countries include Greece, Ireland, Portugal and Spain Source: EBRD-World Bank Business Environment and Enterprise Performance Surveys 1999, 2002, 2005

Unbundling by ownership category reveals that business environment in 2005 more difficult for de novo than privatized and state firms in areas such as regulation and institutions protecting property rights, as well as taxation . . . . The business environment was assessed on a scale from 1 (no obstacle) to 4 (major obstacle) Source: EBRD-World Bank Business Environment and Enterprise Performance Survey, 2005

. . . . particularly with respect to customs and trade regulations and business licensing and permits, within the overall area of regulatory constraints . . . . Source: EBRD-World Bank Business Environment and Enterprise Performance Survey, 2005

. . . . as well as with respect to judiciary and corruption, within the overall area of institutions. Hence business environment is more difficult for de novo firms which are critical for productivity growth and job creation. Source: EBRD-World Bank Business Environment and Enterprise Performance Survey, 2005

Moving from entrant firms to potential exiters, while the fraction of firms with arrears has been falling and those receiving subsidies is virtually unchanged between 2002 and 2005 (although note that the fraction of subsidized firms in SEE and CIS is already lower than in the cohesion countries) . . . . Source: EBRD-World Bank Business Environment and Enterprise Performance Surveys, 2002, 2005

. . . . subsidies from all levels of government to a higher fraction of state and privatized firms compared to de novo firms in 2005 retard the exit of the former . . . . Source: EBRD-World Bank Business Environment and Enterprise Performance Survey, 2005

. . . . and arrears owed by a higher fraction of state and privatized firms compared to de novo firms in 2005 on utility payments and taxes as well as to employees and suppliers also retard the exit of the former. The business environment was assessed on a scale from 1 (no obstacle) to 4 (major obstacle) Source: EBRD-World Bank Business Environment and Enterprise Performance Survey, 2005

While the population is expected to decline by over 15 percent by 2025 in Ukraine, Bulgaria and Georgia on account of aging, it is expected to expand by over 30 percent by 2025 in Turkey, Turkmenistan, Uzbekistan and Tajikistan Percentage Change in Population in ECA Countries, 2000-2025 Source: UN Population Prospects

The share of working age population to total population is expected to decline rapidly after 2015 in the EU-8, Southeastern Europe and the middle income CIS countries, a pattern similar to that in the EU-15, better than Japan but worse than USA Working Age Population to Total Population in Selected Country Groups, 1950-2050 EU8 = Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia Middle Income CIS = Belarus, Russian Federation, and Ukraine SEE = Bosnia, Bulgaria, Croatia, Macedonia and Romania Source: UN Population Prospects 2004; WB staff estimates

Maintaining the share of working age population in total population in 2025 at current levels through extra immigration alone would require increases in the share of the immigrant population outside the range of historical experience, particularly in Central Europe, Bosnia, Bulgaria and Romania Changes in Migrant Share of Population Required to Maintain the Share of the Working Age Population to Total Population in 2025 at current Levels Source: UN Population Prospects, 2004, International Migration, 2002

Maintaining the share of working age population in total population in 2025 at current levels by intensifying labor force participation alone would require very large increases in the labor force participation rate, particularly in Central Europe and Croatia Change in Labor Force Participation Rates Required to Maintain the Share of the Working Age Population to Total Population in 2025 at current Levels Source: UN Population Prospects, , Labor Force Survey (LABORSTA)

Conclusions • Economic growth and poverty reduction in the transition countries since 1998 have been driven more by increases in real wages, reflecting growth in labor productivity, than job creation • Entry of new firms and exit of obsolete firms are important for the growth of labor productivity in the transition countries. • Entry of new firms is important for job creation as well as productivity growth in the transition countries. Whereas new firms have expanded employment, existing firms have, on average, improved productivity by downsizing and shedding labor (“defensive restructuring”).

Conclusions (cont.) • While the business environment has been improving in the transition countries as a whole, it continues to be more challenging in the transition countries (esp. SEE and CIS) than in the cohesion countries of the EU, and particularly so for those firms which are important for productivity growth and job creation, viz, de novo firms compared to state and privatized firms. • The business environment also potentially retards the exit of state-owned and privatized firms relative to de novo firms through higher tolerance of arrears and subsidies, also impeding productivity growth. • Looking ahead, continued improvements in the business environment, particularly a level playing field for de novo firms, as well as exit mechanisms for obsolete firms, will be critical for productivity growth and job creation and call for reform of competition policy, the regulatory regime and institutions, such as the court system, which protect property rights.

Conclusions (cont.) • Redistribution of land still under collective farms/agricultural enterprises to peasant farms, together with on-farm technology transfer and better integration of the rural economy into labor and credit markets, will be required to improve yields and agricultural labor productivity in the low income CIS countries. • Rapid aging of the population in Central and Southeastern Europe, as well as Russia and Ukraine, if not offset by accelerated growth in labor productivity, will require policies to facilitate a combination of, rather than sole reliance on additional immigration, intensification of (currently low) labor force participation and delayed retirement. Failure to do so and also to boost labor productivity growth through new investment will derail convergence towards EU-15 living standards.

References • Erik Bartelsman, John Haltiwanger and Stefano Scarpetta (2004), Microeconomic Evidence of Creative Destruction in Industrial and Developing Countries, World Bank Policy Research Working Paper No. 3464 • David Brown and John Earle (2004), Economic Reform and Productivity Enhancing Reallocation in the Post-Soviet Transition. Upjohn Institute for Employment Research, background study for World Bank (2005b) • EBRD-World Bank Business Environment and Enterprise Performance Surveys 1999, 2002, 2005 • Karen Macours and Johann Swinnen (2004), Rural Poverty in ECA, background study for World Bank (2005a) • World Bank (2005a), Growth, Poverty, and Inequality: Eastern Europe and the Former Soviet Union • World Bank (2005b), Enhancing Job Opportunities: Eastern Europe and the Former Soviet Union • World Bank (2006), The ThirdTransition: From Red to Gray (forthcoming)

Productivity Growth and Job Creation in Eastern Europe