Eastern Europe: More than a flash in the pan?

Investing in transition economies of eastern Europe was a heady trend of the early 1990s that promised so much but ended in disappointment and loss for many western companies. But there are signs of a healthy recovery in the region, including among home-spun enterprises. It may be time to take transition countries more seriously again.

For the second year in a row, the transition economies of eastern Europe have outperformed western Europe and indeed the OECD countries as a group. But is this good performance simply the inevitable bounce-back from a long bout of poor economic performance or the start of more enduring growth?

One development that points towards a sustainable expansion is the steady increase in foreign direct investment in transition economies. Investment that brings with it new products or better ways to produce existing ones is fundamental if the transition economies are to shed their communist legacy, to boost their productivity and to raise living standards towards OECD levels. Domestic investment has also made a significant contribution to aggregate demand growth in the ongoing expansion in the region.

The experience of transition, however, has been too much wasted investment and too little quality investment and innovation. Resistance to adapt to market pressures has been strong and governments all too often have conspired with vested interests to impede this process. The result has been a relatively poor business environment in the region beset by arbitrary taxation and business regulation, corruption and poor legal systems. In this environment, businesses have often been preoccupied with extracting privileges, grabbing assets and manipulating markets rather than with innovating and investing in the future.

Doubts clearly remain about the quality of the business environment and the evenness of playing field in the transition economies, especially as one moves south and east beyond the front-runners for EU accession.

But change in these areas is especially difficult to assess across 27 countries. That is why the European Bank for Reconstruction and Development and the World Bank have launched an unprecedented survey to listen to the firms of transition economies – through 10,000 face-to-face interviews – and hear their own assessments of the obstacles they face. The results are surprising.

The 1999 and 2002 rounds of the survey show that some aspects of the region’s business environment have improved significantly, especially in countries of south-eastern Europe and the Commonwealth of Independent States (CIS) that remain neglected by most foreign investors. Discriminatory practices that favoured the old socialist dinosaurs over small firms and start-ups have begun to diminish. Tax regimes have improved. Finance and infrastructure are less of an obstacle.

Even corruption is starting to diminish, as fewer firms report paying bribes. And those that do, pay less as a share of their annual sales revenue – an average of 1.5% in 2002, down from 2% in 1999, when the first round of the survey was conducted. Moreover, obstacles faced by small, entrepreneurial firms are starting to come down. In 1999, the “bribe tax” paid by these firms was almost four times that paid by large, state-owned enterprises; in 2002 the gap was reduced significantly – but not eliminated.

Notwithstanding these improvements, a degree of scepticism about the sustainability of recent growth and good performance in the region is understandable. Have the vested interests whose sustenance came from rent seeking seen the advantages of innovation and investment in the future? Have political institutions and cultural norms become more effective constraints on this rent seeking behaviour?

Part of the answer lies in two important areas where the survey results show that progress continues to disappoint: business regulation and the judicial system. Onerous regulation and arbitrary bureaucratic interference in business decisions continue largely unabated in many countries of the region. Courts still have a long way to go in providing timely enforcement of property rights and contracts. Moreover, many aspects of the business environment remain tilted against entrepreneurial firms.

Part of the problem comes from states still too weak to rein in their own officials or to enforce their own rules and laws. Just as important are relationships between politicians and powerful firms and individuals that are still too cosy and too opaque, creating incentives to keep taxation, regulation and the courts in arbitrary and weak condition.

These developments point to a cautious assessment about the region’s future. The encouraging news from the survey is the positive changes in several countries once thought to be trapped in a no man’s land between central planning and a market economy with insecure property rights, arbitrary state intervention and Wild West corruption. Moreover, those countries that are relatively advanced in transition – the front-runners for EU accession and Croatia – are attracting greater inflows of foreign direct investment and achieving resilient macroeconomic performance.

But if policymakers across the region want to encourage dynamic new firms, to draw in much-needed foreign investment, and to attract back some of the billions of dollars that their own businesses have parked abroad, then they need to build on recent successes. They need to hear the voice of their own businesses and entrepreneurs, highlighting the considerable progress of the past few years, but pointing out the still substantial challenges that remain.

Despite the vulnerabilities, prospects for the region have clearly brightened and have sparked growing investor interest. The current period of resilient growth, however, should not give rise to complacency. There are both pressing medium-term challenges to maintain macroeconomic stability, and longer-term challenges to build sound market supporting institutions necessary for catch-up growth. This latter challenge, particularly in south-eastern Europe, Russia and other CIS countries, will be the most difficult test of transition.

Details of this year’s Business Environment and Enterprise Performance survey are highlighted in the EBRD’s Transition Report 2002 and in forthcoming EBRD and World Bank working papers. In three years’ time, the two institutions will listen again to hear from the region’s businesses if the current period of growth was used to redouble reform efforts, or as an excuse for complacency and drift.


EBRD (2002), Transition Report 2002, London. 

©OECD Observer No 235, December 2002

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