A transition economy or transitional economy is an economy which is changing from a centrally planned economy to a market economy. Transition economies undergo a set of structural transformations intended to develop market-based institutions. These include economic liberalization, where prices are set by market forces rather than by a central planning organization. In addition to this, trade barriers are removed, there is a push to privatize state-owned enterprises and resources, state and collectively run enterprises are restructured as businesses, and a financial sector is created to facilitate macroeconomic stabilization and the movement of private capital. The process has been applied in China, the former Soviet Union and Eastern bloc countries of Europe and some Third world countries, and detailed work has been undertaken on its economic and social effects.
The transition process is usually characterized by the changing and creating of institutions, particularly private enterprises; changes in the role of the state, thereby, the creation of fundamentally different governmental institutions and the promotion of private-owned enterprises, markets and independent financial institutions.Falke, Mike. Community Interests: An Insolvency Objective in Transition Economies? , No. 01/02, Frankfurter Institut für Transformationsstudien In essence, one transition mode is the functional restructuring of state institutions from being a provider of growth to an enabler, with the private sector its engine. Another transition mode is change the way that economy grows and practice mode. The relationships between these two transition modes are micro and macro, partial and whole. The truly transition economics should include both the micro transition and macro transition. Due to the different initial conditions during the emerging process of the transition from planned economics to market economics, countries uses different transition model. Countries like the People's Republic of China and Vietnam adopted a gradual transition mode, however Russia and some other East-European countries, such as the former Socialist Republic of Yugoslavia, used a more aggressive and quicker paced model of transition.
The term "transition period" is also used to describe the process of transition from capitalism to the first stage of socialism, preceding the establishment of fully developed socialism (aka communism).
Transition indicators The existence of private property rights may be the most basic element of a market economy, and therefore implementation of these rights is the key indicator of the transition process.
The main ingredients of the transition process are: Liberalization – the process of allowing most prices to be determined in free markets and lowering trade barriers that had shut off contact with the price structure of the world's market economies. Macroeconomic stabilization – bringing inflation under control and lowering it over time, after the initial burst of high inflation that follows from liberalization and the release of pent-up demand. This process requires discipline over the government budget and the growth of money and credit (that is, discipline in fiscal and monetary policy) and progress toward sustainable balance of payments. Restructuring and privatization – creating a viable financial sector and reforming the enterprises in these economies to render them capable of producing goods that could be sold in free markets and transferring their ownership into private hands. Legal and institutional reforms – redefining the role of the state in these economies, establishing the rule of law, and introducing appropriate competition policies.
According to and Thomas Wolf of the International Monetary Fund, transition in a broad sense implies: liberalizing economic activity, prices, and market operations, along with reallocating resources to their most efficient use; developing indirect, market-oriented instruments for macroeconomic stabilization; achieving effective enterprise management and economic efficiency, usually through privatization; imposing hard budget constraints, which provide incentives to improve efficiency; and establishing an institutional and legal framework to secure property rights, the rule of law, and transparent market-entry regulations.Havrylyshyn, Oleh; Wolf, Thomas. Determinants of Growth in Transition Countries, Finance & Development Magazine, June 1999, Volume 36, Number 2 by the International Monetary Fund
Edgar Feige, cognizant of the trade-off between efficiency and equity, suggestsFeige, Edgar L. Perestroika and Socialist Privatization: What is to be Done? and How? , Comparative Economic Studies Vol. XXXII, No.3 Fall 1990] that the social and political costs of transition adjustments can be reduced by adopting privatization methods that are egalitarian in nature, thereby providing a social safety net to cushion the disruptive effects of the transition process.
The European Bank for Reconstruction and Development (EBRD) developed a set of indicators to measure the progress in transition. The classification system was originally created in the EBRD's 1994 Transition Report, but has been refined and amended in subsequent Reports. The EBRD's overall transition indicators are: Large-scale privatization Small-scale privatization Governance and enterprise restructuring Price liberalization Trade and foreign exchange system Competition policy Banking reform and interest rate liberalization Securities markets and non-bank financial institutions Infrastructure reformEBRD's 1994 Transition Report
Context
The economic malaise affecting the Comecon countries – low growth rates and diminishing returns on investment – led many domestic and Western economists to advocate market-based solutions and a sequenced programme of economic reform. It was recognized that micro-economic reform and macro-economic stabilization had to be combined carefully. Price liberalization without prior remedial measures to eliminate macro-economic imbalances, including an escalating fiscal deficit, a growing money supply due to a high level of borrowing by state-owned enterprises, and the accumulated savings of households ("monetary overhang") could result in macro-economic destabilization instead of micro-economic efficiency. Unless entrepreneurs enjoyed secure property rights and farmers owned their farms the process of Schumpeterian "creative destruction" would limit the reallocation of resources and prevent profitable enterprises from expanding to absorb the workers displaced from the liquidation of non-viable enterprises. A hardening of the budget constraints at state-owned enterprises would halt the drain on the state budget from subsidization but would require additional expenditure to counteract the resulting unemployment and drop in aggregate household spending. Monetary overhang meant that price liberalization might convert "repressed inflation" into open inflation, increase the price level still further and generate a price spiral. The transition to a market economy would require state intervention alongside market liberalization, privatization and deregulation. Rationing of essential consumer goods, trade quotas and tariffs and an active monetary policy to ensure that there was sufficient liquidity to maintain commerce might be needed.Padma Desai, The Soviet Economy: Problems and Prospects, 1990, Oxford: Basil Blackwell, pp. xiii-xxii and 164 In addition to tariff protection, measures to control capital flight were also considered necessary in some instances.Michael Kaser on Privatization in the CIS in Alan Smith (editor), Challenges for Russian Economic Reform, 1995, London: Royal Institute for International Affairs and Washington DC: The Brookings Institution, p. 122.
Transition in practice The most influential strategy for the transition to a market economy was that adopted by Poland launched in January 1990. The strategy was strongly influenced by IMF and World Bank analyses of successful and unsuccessful stabilization programmes which had been adopted in Latin America in the 1980s. The strategy incorporated a number of interdependent measures including macro-economic stabilization; the liberalization of wholesale and retail prices; the removal of constraints to the development of private enterprises and the privatization of state-owned enterprises; the elimination of subsidies and the imposition of hard budget constraints; and the creation of an export-oriented economy that was open to foreign trade and investment. The creation of a social safety net targeted at the individual to compensate for the removal of job security and the removal of price controls on staple goods was also part of the strategy.Alan Smith, Introduction in Alan Smith (editor), Challenges for Russian Economic Reform, 1995, London: Royal Institute for International Affairs and Washington DC: The Brookings Institution, p. 5.
The choice of the transition strategy was influenced by the critical state of most post-socialist countries. Policy-makers were persuaded that political credibility took precedence over a sequenced reform plan and to introduce macro-economic stabilization measures ahead of structural measures that would by their nature take longer to implement. The "credibility" of the transition process was enhanced by the adoption of the Washington Consensus favoured by the IMF and the World Bank. Stabilization was deemed a necessity in Hungary and Poland where state budget deficits had grown and foreign debts had become larger than the country's capacity to service. Western advisers and domestic experts working with the national governments and the IMF introduced stabilization programmes aiming to achieve external and internal balance, which became known as shock therapy. It was argued that "one cannot jump over a chasm in two leaps".Marie Lavigne, The Economies of Transition: From socialist economy to market economy, 1995, London: Macmillan, pp. 117–119, 121
The many foreign advisers from, principally, the United States, the United Kingdom and Sweden were often under contract to the international financial institutions and bilateral or multilateral technical assistance programmes. They favoured free trade and exchange rate convertibility rather than trade protection and capital controls, which might have checked capital flight. They tended to support privatization without prior industrial restructuring; an exception was to be found in Eastern Germany where the Treuhand (Trust Agency) prepared state-owned enterprises for the market at considerable cost to the government.Michael Kaser on Privatization in the CIS in Alan Smith (editor), Challenges for Russian Economic Reform, 1995, London: Royal Institute for International Affairs and Washington DC: The Brookings Institution, pp. 122–123. Western technical assistance programmes were established by European Union – through the Phare and TACIS programmes – and other donors (including the US AID, the UK Know-how Fund and UNDP) and by the IMF, the World Bank, EBRD and KfW, which also advanced loans for stabilization, structural adjustment, industrial restructuring and social protection. Technical assistance was delivered through the exchange of civil servants and by management consultants, including Agriconsulting, Atos, COWI, Ernst & Young, GOPA, GTZ, Human Dynamics, Idom, IMC Consulting, Louis Berger, NIRAS, PA Consulting, PE International, Pohl Consulting, PwC, and SOFRECO.