WDP- 142

World Bank Discussion Papers

RestructuringSocialist Industry

Poland's Expenrence in 1990

Homi J. Kharas

... :--..A

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Recent World Bank Discussion Papers

No. 84 Implementing Educational Policies in Ethiopia. Fassil R. Kiros

No. 85 Implementing Educational Policies in Kenya. G. S. Eshiwani

No. 86 Implementing Educational Policies in Tanzania. C. J. Galabawa

No. 87 Implementing Educational Policies in Lesotho. T. Sohl Thelejani

No. 88 Implementing Educational Policies in Swaziland. Cisco Magalula

No. 89 Implementing Educational Policies in Uganda. Cooper F. Odaet

No. 90 Implementing Educational Policies in Zambia. Paul P. W. Achola

No. 91 Implementing Educational Policies in Zimbabwe. 0. E. Maravanyika

No. 92 Institutional Reforms in Sector Adjustment Operations: The World Bank's Experience. Samuel Paul

No. 93 Assessment of the Private Sector: A Case Study and Its Methodological Implications. Samuel Paul

No. 94 Reaching the Poor through Rural Public Employment: A Survey of Theory and Evidence. Martin Ravallion

No. 95 Education and Development: Evidencefor N'w Priorities. Wadi D. Haddad and others

No. 96 Household Food Security and the Role of Women. J. Price Gittinger and others

No. 97 Problems of Developing Countries in the 1990s. Volume I: General Topics. F. Desmond McCarthy, editor

No. 98 Problems of Developing Countries in the 1990s. Volume II: Country Studies. F. Desmond McCarthy, editor

No. 99 Public Sector Management Issues in Structural Adjustment Lending. Barbara Nunberg

No. 100 The European Communities' Single Market: The Challenge of 1992for Sub-Saharan Africa. Alfred Tovias

No. 101 International Migration and Development in Sub-Saharan Africa. Volume I: Overview. Sharon Stanton Russell,Karen Jacobsen, and William Deane Stanley

No. 102 Intemational Migration and Development in Sub-Saharan Afiica. Volume II: Country Analyses. Sharon Stanton Russell,Karen Jacobsen, and William Deane Stanley

No. 103 Agricultural Extensionfor Women Farmers in Africa. Katrine Saito and C. Jean Weidemann

No. 104 Enterprise Reform and Privitization in Socialist Economies. Barbara Lee andJohn Nellis

No. 105 Redefining the Role of Govemment in Agriculturefor the 1990s. Odin Knudsen, John Nash, and others

No. 106 Social Spending in Latin America: The Story of the 1980s. Margaret E. Grosh

No. 107 Kenya at the Demographic Turning Point? lypotheses and a Proposed Research Agenda. Allen C. Kelleyand Charles E. Nobbe

No. 108 Debt Management Systems. Debt and International Finance Division

No. 109 Indian Women: Their Health and Economic Productivity. Meera Chatterjee

No. 110 Social Security in Latin America: Issues and Optionsfor the World Bank. William McGreevey

No. 111 Household Consequences of High Fertility in Pakistan. Susan Cochrane, Valerie Kozel, and Harold Alderman

No. 112 Strengthening Protection of Intellectual Property in Developing Countries: A Survey of the Literature. Wolfgang Siebeck,editor, with Robert E. Evenson, WiMliam Lesser, and Carlos A. Primo Braga

No. 113 World Bank Lendingfor Small and Medium Enterprises. Leila Webster

(Continued on the inside back cover.)

(iii)

ABSTRACT

This paper reviews Poland's industrial restructuring experience in 1990.It finds four principal reasons for the higher than anticipated fall inindustrial output. First, the fact that industry had been oversupported duringthe socialist period implied that some restructuring towards services wasessential and desirable; as this occurred, industrial output fell, while theservices sector grew. Second, there were a spate of demand shocks. As theeconomy moved from shortages and queues to a market system, inventories were rundown and hence production declined. Third, the implementation of tight domesticfiscal and monetary policies to stabilize prices and the exchange rate wascontractionary. Fourth, the principal market for exports--members of the formerCMEA--collapsed as many countries simultaneously entered into a period of reform.The evidence does not support other hypotheses advanced for the rapid decline inoutput, such as a credit crunch, an intermediate inputs price supply shock, ora monopolist induced stagflation.

The paper concludes that from an overall perspective, the problem ofdomestic monopolies has not been crucial. Competition from international tradenad from close substitutes domestically has prevented monopoly power from beingexercised. Industrial subsectors have responded appropriately to relative pricechanges and to cost increases. The response to the new set of market prices,however, has been slow. First, considerable bureaucratic inertia exists infirms, largely because of the absence of any true owners. Second, although thegovernment has tried to impose a hard budget constraint on firms to forceefficient restructuring or closure, firms have been able to circumvent this overa period of at least 18 months, because of windfall profits made on inventoriesand foreign exchange holdings after the stabilization program was implemented.Third, firms have not been faced with a hard labor supply constraint, because ofthe poor functioning of the domestic labor market.

The government has used three types of tools to encourage restructuring.First, fiscal and monetary tightness has reduced the flow of public funds tofirms. Second, a variety of tax measures, including a corporate income tax, anexcess wage tax and a dividenda were used to soak up firm liquidity./ These havebeen only partially effective. The dividenda in part has not served itsanticipated role as a signal of good performance. Third,, there has been afledgling competition policy, exemplified by anti-monopoiy activities.

The government has been less successful in a number of other areas, whichpartially accounts for the limited supply response. Privatization and a changein management incentives is one key area where progress has been slow.Procedures, planning and implementation of public infrastructure investment hasalso been neglected, with the result that public investment has collapsed,damaging conditions for new private foreign or domestic investment. Last, thegovernment has failed to construct channels through which the significant amountsof foreign assistance can be mobilized to support needed investments.

I

.142 w 1=1World Bank Discussion Papers

RestructuringSocialist Industry

Poland's Experience in 1990

Homi J. Kharas

The World BankWashington, D.C.

Copyright C 1991The International Bank for Reconstructionand Development/THE WORLD BANK1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing December 1991

Discussion Papers present results of country analysis or research that is circulated to encourage discussionand conmnent within the development community. To present these results with the least possible delay, thetypescript of this paper has not been prepared in accordance with the procedures appropriate to formalprinted texts, and the World Bank accepts no responsibility for errors.

The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) andshould not be attributed in any manner to the World Bank, to its affiliated organizations, or to members ofits Board of Executive Directors or the countries they represent. The World Bank does not guarantee theaccuracy of the data included in this publication and accepts no responsibility whatsoever for anyconsequence of their use. Any maps that accompany the text have been prepared solely for the convenienceof readers; the designations and presentation of material in them do not imply the expression of any opinionwhatsoever on the part of the World Bank, its affiliates, or its Board or member countries concerning thelegal status of any country, territory, city, or area or of the authorities thereof or concerning the delimitationof its boundaries or its national affiliation.

The material in this publication is copyrightec. Requests for permission to reproduce portions of it shouldbe sent to Director, Publications Department, at the address shown in the copyright notice above. TheWorld Bank encourages dissemination of its work and will normally give pernission promptly and, when thereproduction is for noncommercial purposes, without asking a fee. Permission to photocopy portions forclassroom use is not required, though notification of such use having been made will be appreciated.

The complete backlist of publications from the World Bank is shown in the annual Index of Publications,which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, andcountries and regions. The latest edition is available free of charge from the Publications Sales Unit,Departrnent F, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or fromPublications, The World Bank, 66, avenue d'lena, 75116 Paris, France.

ISSN: 0259-210X

Homi J. Kharas is principal economist in the Country Operations II Department of the World Bank's AsiaRegional Office.

Library of Congress Cataloging-in-Publication Data

Kharas, HomiJ., 1954-Restructuring socialist industry: Poland's experience in 1990 /

Homi J. Kharas.p. cn. - (World Bank discussion papers; 142)

Includes bibliographical references.ISBN 0-8213-1966-31. Privitization-Poland. 2. Industry and state-Poland.

3. Industrial productivity-Poland. 4. Economic stabilization--Poland. 5. Poland-Economic policy--1981- 6. Post-communism--Poland. I. Tide. II. Series.HD4215.7.K47 1991338.9438-dc2O 91-36499

CIP

(v)

Foreword

This study reviews the developments in Polish industry one year after theintroduction of radical reforms in the economy. The paper is based on publishedmaterial collected by the Polish Statistical Office. In addition to providingdetailed descriptions about the evolution of industrial sector trends, the paperassesses the cause of industrial decline from both a macroeconomic and a firm-level perspective. The overall assesment as to whether or not efficientrestructuring is occurring, and at what pace, differs according to theperspective taken. Thus care should be taken in deriving firm conclusions basedon any one set of data. The effectiveness of macroeconomic policies andmicroeconomic interventions by the government is also considered. The paper endswith a brief overview of priority areas for the medium term which, it is argued,have been receiving short shrift due to the strong short term focus of thecurrent environment.

Given the strong interest in the Polish experience, the study should be ofinterest to academics, policymakers and other practitioners of industrial policyin those countries seeking to change from planned to market economic structures.

Gautam S. KajiDirector

Country Department IIAsia Region

I I

(vii)

TABLE OF CONTENTS

Page

I. Introduction. 1

II. Recent Developments in Industrial Structure ....................... 2

The share of industry in GDP ................................ 3The share of the private sector ............................. 4Industrial concentration and monopolies ..................... 6External trade ........... ................................... 8

III. Market Prices and Enterprise Behavior ............................. 10

Responses to market forces ................ .................. 11Relative output changes: theory of a socialized enterprise 16Energizing enterpises .................. ..................... 27Summary ..................................................... 36

IV. Government Indirect Assistance for Restructuring .................. 37

Public investment and infrastructure spending .... ........... 37Mobilizing foreign assistance ............................... 41

V. Concluding Remarks . ............................................... 43

References ............................................................ 46

I

I. Introduction

One of the few positive legacies of decades of state socialism in Polandis a vast stock of physical capital in the industrial sector, built up throughyears of high, albeit inefficient, investment. Improving the use of theseresources, as well as of the flow of new investments, is the enormous task thatfaces policymakers concerned with industrial restructuring'. In addition tothese efficiency concerns, there is an international strategic agenda thatindustrial policy must address, involving a "return to Europe". From a politicalstandpoint, there is a need for Poland to integrate with Europe, while from aneconomic perspective new trading relations with the West must be constructed inplace of the disintegrating Comecon structure.

The challenge of industrial restructuring is all the greaterfor the countries of East and Central Europe because, unlike macroeconomicstabilization, there is no accepted road-map to follow. The OECD countries whichhave provided the models in other areas, have taken widely differing approachesto industrial policy. The only common element seems to be that all have decidedthat some support for industry is desirable, partly for "economic efficiency'reasons and partly to ensure an equitable distribution of the fruits of economicgrowth.

In Europe, industrial policy is clearly viewed as a necessary counterweightto the market forces unleashed by market integration. Supranational EC funds,such as the Regional Development Fund and the Social Fund, have been rapidlyexpanded as 1992 draws closer. The growth in these funds reflects recognitionof the idea that the gains from market integration will be unequal, and that someform of intervention is necessary to ensure that all regions of the communitybenefit from closer integration. Experience in the EC since 19732 points to thefact that private capital and skilled labor have tended to move from poorer toricher regions as markets become more integrated, exacerbating initial economicdisparities. This also appears to be happening in the former East Germany.

In the West, the tendency is to try to balance these forces throughcountervailing official capital inflows into depressed areas. But this is notan option for Eastern Europe given the history and legacy of over-indebtedness.More emphasis has to be placed on structural factors in creating a specialized,competitive industrial base which would survive and prosper when the politicalgoal of integration with the West is achieved by the end of this decade.

1 As Kornai says, 'State property must not be squandered by distributing itto one and all just out of kindness.. .the prime consideration is not legalentitlement to the property but ability to run it well.'

2 See Commission of the European Communities (1987).

-2-

Industrial restructuring must be considered as part and parcel of theoverall process of economic reform which started with the stabilization programin January 1990. Budgetary necessities limit the options for industrial policy.As experience in the former East Germany has shown, there is a trade-off betweenthe speed of restructuring and the up-front budgetary cost. A speedyreallocation of labor and capital means more bankruptcies in existing industrieswhich in turn impose more demands on the budget for unemployment compensation;creating a competitive environment requires budgetary expenditures forinfrastructure, worker retraining and modernization of equipment. Theseexpenditures cannot now be contemplated in Poland on a large scale withoutballooning fiscal deficits. On the other hand, too slow a pace for industrialrestructuring could be equally threatening to the stabilization program. Vitalelements of the credit and incomes policy, such as the excess wage tax, cannotbe sustained indefinitely, nor can the sacrifices of reduced consumption becontinued without clear indication of a recovery process in the making. But thissupply response will not be forthcoming unless industrial restructuring isspeeded up. The main strategic element of industrial policy, then, involvesfinding the balance between these forces.

In this paper, the key components of the emerging industrial policy inPoland are reviewed. Section II reviews recent developments which, despite theshort time frame, already give some insights on the pace and nature ofrestructuring. Section III turns to a discussion of the strategy that has givenrise to these developments: first, government efforts to create a competitiveenvironment, and firm level responses to the new signals; and second, efforts atthe microeconomic level to change corporate cultures and make enterprises wantto restructure. Section IV highlights the importance of efforts to assistenterprise restructuring indirectly through improving infrastructure andmobilizing foreign grants and credits. Section V offers some concluding remarks.

II. Recent Developments in Industrial Structure

It is common to think of communist economies as being over-industrialized,with the industrial sector characterized by too high a degree of public ownershipand of concentration relative to a free market economy. Furthermore, thepatterns of socialist trade do not conform to economic principles of comparativeadvantage. In the section below, the nature and pace of restructuring is gaugedby reviewing quantitative changes along these four highlighted dimensions, todemonstrate the degree to which the non-market characteristics of the socialiststructure have changed in the first year of reform.

-3-

The share of industry in GDP

According to the World Bank, the share of industry in Poland's GDP in 1989was 51.7 percent, while the average for countries in similar income brackets anddegree of urbanization was 39 percent. Even the highly industrialized middleincome nations of East Asia only had a 43 percent industry share. Largely thisreflected the undeveloped nature of the services sector in Poland: shops,restaurants, housing, financial services and tourism are notorious examples ofcommunist neglect. The UN reports3 that only 3.4 percent of total employmentin Poland was in the retail trade sector, compared with 11.7 percent in Ireland,9.1 percent in the Netherlands and 7.3 percent in France. There were only 7restaurants per 10,000 inhabitants in Poland in 1987. The Polish census for 1988showed that the number of households exceeded the number of dwellings by 12percent, and this measure of the shortage is likely to be a significantunderestimate because many dwellings are substandard, and the number ofhouseholds may increase as the possibilities for finding housing increase. Giventhese starting conditions, restructuring during 1990 should have witnessed ashift of resources from industry to service branches.

Actual developments cannot be accurately determined because Poland'sstatistical system is geared towards measurement of the socialized sector,whereas one would expect most of the new service sector activities would havebeen undertaken by private entities. The official data show a clear decline inindustrial output of 23 percent in 1990 over 1989, compared with a GDP fallestimated at 12 percent4. As agriculture was essentially flat, these numberssuggest that service sector output also remained unchanged; so the share ofindustry may have fallen to 45% of GDP in 1990, while the service sector sharewould have risen from 37.7Z to 42.8Z.

Only wild guesses can be made as to the true evolution of the servicesector. Even the housing stock is hard to deduce: completion of dwellings in thesocialized sector fell by 12 percent in 1990, but there are wide reports ofconsiderable unmeasured private housing construction, especially in rural areas.The potential for profits in the housing sector seems high; one study suggeststhat the free market price of apartments exceeds construction costs by a factorof two or more5. Private builders have leased large amounts of additionalequipment from state-owned construction companies, but the share of the privatesector in the building industry is estimated to have risen only from 29 to 35percent in 1990, suggesting that much housing may be unreported.

3 See the "Economic Survey of Europe, 1988-89", United Nations, 1989.

4 The first quarter of 1991 has seen a continuation of this fall inindustrial production, by 4.5% relative to the first quarter of 1990, and 15Zrelative to the fourth quarter of 1990.

5 See "Housing and Labor Market Distortions in Poland: Linkages andPolicy Implications'. Stephen K. Mayo and James I. Stein, Report INU 25, theWorld Bank, June 1988.

- 4 -

Retail trade is another area where statistical problems may cloudsubstantial restructuring. Trade in Poland has traditionally been measured asan essentially functional output: the storage, shipping and selling of goodsproduced by the agricultural and industrial spheres. In the market economy ofPoland in 1990, much of the trade activity was oriented differently: providingcustomers with choice, ease of access, more attractive displays, reliability ofsupplies, etc. for which payment was happily rendered. Officially, the overallvolume of retail trade in Poland fell by 16% in 1990 (although big increases ofup to 4500 percent were posted by the nascent private sector, albeit from a low1989 base) but this cannot be taken as a good proxy for the value added in thesector, as it ignores the quality and range of other services rendered byretailers. Thus, the official data probably significantly underreports valueadded in trading activities6.

Many of the arguments madle above for the retail trade sector are equallyvalid for other service sectors, such as banking, restaurants and hotels, andforeign trade. In all these areas, price increases to generate valuable servicesare statistically measured as inflation. Between December 1989 and December1990, the average price for consumer services rose by 535.5 percent, while forconsumer goods the rise was only 327.7 percent. At least in part, these pricedifferentials reflect further restructuring of the economy and a shift towardshigher quality.

The share of the private sector

Most of the increased private sector activity in Poland in 1990 is believedto have taken place in the service sector. Officially, employment in the non-agricultural private sector rose from 12 to 15.7% of the workforce, representinga growth rate of private sector jobs of 27Z, or a total of 400,000 jobs. Incontrast, employment in the socialized sector fell by about 760,00. Over 100,000private economic subjects were registered in 1990 as units undertaking foreigntrade activities, but these have been largely small traders, particularly inconsumer goods. Large socialized foreign trade organizations continued toaccount for 75Z of the total value of registered trade in 1990. Considering thatlegal measures to abolish the exclusive rights of the FTOs to trade wereintroduced in the early 1980s, with follow-up measures in 1988 to break upadministrative barriers, the pace and degree of restructuring in this sector mustbe considered small.

The most rapid growth of the private sector came in the retail trade area.Through a program of privatization of shops and other small assets, the privatesector grew to control almost one third of food and non-food retail trade,compared with about 5 in 1989. Almost all of the pure public retail stores are

6 Compounding the problem, the poor measurement of trade services mayalso serve to hide real industrial production. Because the turnover tax onproduction (20Z) is higher than that on services (5%), companies can reducetheir tax obligations by sellinlg manufactured goods at a low price to tradesubsidiaries; the higher mark-up in the trading firm would normally bemeasured as higher value added in trade, but this may not be captured in thePolish statistics.

-5-

now operated by private individuals, largely through extensive use of leasingschemes. The remainder of public stores are managed by cooperatives which aresubject to different legal arrangements and where the pressure for privatizationis not as great. Over half the trucks in the country are also in private hands,and gas stations are also being leased. The strong trend of conversion fromcooperative rental housing to private ownership and private cooperatives is alsocontinuing (Table 1).

Table 1: Public and Private Ownership of Small Assets(t)

1989 Stock Estimated '90 privatizationPublic Private No. of units Z stock

Shops 83 17 16,000 13Gas Stations 76 24 n.a.Housing 54 46 200,000 2Trucks 48 52 70,000 7

Notes: 1. 65% of public shops are operated by cooperatives2. 80 of private gas stations are leased from CPN

Although most of its activity was in services, the private sector also madesubstantial inroads in industrial production, almost doubling its share from 7.4to 13.4 percent, clearly demonstrating that the supply of entrepreneurs has notbeen a bottleneck to restructuring. But the bulk of this increase has come fromthe fall in production of state enterprises of 25%; the output growth of theprivate sector itself was a more modest 8%. But official statistics may bemisleading; over 18,000 net new private sector firms were formed during 1990,bringing the total number of private firms to 30,000. This largely reflects newenterprises, mostly of small size7. Firms with less than 5 employees areestimated to account for 60% of private sector sales in 1990, heavilyconcentrated in timber, metal, food and clothing. Unlike in the services sector,the slow growth in private sector output in industry reflects the slowness intransferring assets from the state to the private sector; the privatization ofexisting large firms was slow to develop and barely extended beyond the stage ofplanning and introducing the legislative and implementation framework. Only fivelarge companies had been sold through public share offerings by the end of theyear.

7 Poland had a system of "agency' schemes, initiated in 1983/84, whichallowed enterprises to lease out assets to former employees. Regularizationof these arrangements has led to a reclassification of production from thesocialized to the private sector.

-6

Table 2: Private sector employment share by sector(%)

1989 1990

Industrial production 7.4 13.4Building 29.0 35.0Transport 6.8 9.9

Total nonagriculture 12.0 15.7

Source: Polish Press Agency

Industrial concentration and monopolies

One of the legacies of the failed experiments with decentralized socialistreform was, paradoxically, an increase in the degree of concentration ofindustry. In the original command structure of the economy, there was a stricthierarchical control over enterprises, required in order to fulfil the centralplan targets. The line of authority passed from the Central Planning Committeeto Branch Ministries to branch units or cartels and thence to individualenterprises. Over time, the number of branch ministries gradually declined, fromabout 50 in 1950 to 30 in the 19170's to 10 by the end of the 1980's. In 1982,the branch units (or cartels) were also dissolved. To facilitate administrativecontrol which was still exercised through operational programs and governmentcontracts, the remaining ministries encouraged the formation of larger enterpriseunits. As a result, by 1989, two-thirds of Poland's output and employment wasin establishments with more than 1,000 workers. The small and medium-scalesector, which has provided the bulk of output and employment in many capitalistcountries, remained pitifully unLdeveloped in Poland, with a tiny share of justover one percent (Figure 1) working in firms with 50 - 100 employees and 19percent in all firms with 50-500 employees8.

During 1990, the number of enterprises in socialized industry mushroomedas firms began to spontaneously reorganize into more efficient units, or wereencouraged to split through Ministerial decree (Table 3). The major branchministries created an additional 500 enterprises out of the old conglomerates,partly as a precursor and aid to subsequent privatization or liquidation andpartly in response to a desire to reduce monopolies. In all, the number of stateenterprises grew by more than 1100 (15.2%) during 1990.

8 See Hansson (1991). By comparison, in 1966 83.5% of Japaneseindustrial employment was in establishments with less than 300 workers.

-7-

Figure 1

Where Workers Work(Distibuion by s2e of cetd,Iishrnent)

0.9

0.03

0.7

0.5

0.5

0.4.

0.3

0.2

0.1

France ~~Denmark Unitnd Klnqdcrn

RM<50 50-1 00 100-200 jZJ 200-1 000 IKS]~ > I 0o

Note: Categories for France arnd Denmfark are 200-500 and > 500.Source: Hansson (1991)

- 8 -

Table 3: Enterprise division in 1990(number of enterprises)

originally after division

Ministry of Industry 56 185Ministry of Construction 21 74Ministry of Home Market 12 43Ministry of Transport 11 298Ministry of Agriculture 86 171Ministry of Forestry 2 13

Total 188 771

Source: Anti-Monopoly Office, Warsaw

One of the great fears of policymakers at the time of price liberalizationin 1990 was that the domestic monopoly position of many firms would allow themto raise prices and profits while reducing output, thereby negating the benefitsof liberalization. Based on an analysis of 2,000 industry branches, the Anti-Monopoly Office estimated that 702 of the products made in Poland were made byjust one or two companies in each branch. These monopolists accounted for 252of all enterprises. In practice, the fears of damage caused by monopolies wereexaggerated. Openness to international trade provided the competition that thedomestic sector lacked. The presence of substitutability in demand also meantthat the true degree of market power was lower than that measured byconcentration ratios. In fact, ',chaffer (1990a) computes four-firm concentrationratios at the three digit industry level, and finds only a minority of industriescompletely dominated by a few enterprises. Based on a similar degree ofaggregation, concentration in Pclish industry is similar to that in Chile, Braziland Indonesia.

External trade

In 1989, Poland was a relatively closed economy, with an export/GNP ratioof about 15%. About 41% of both exports and imports were with CMEA partners, alevel which Collins and Rodrik (1991) estimate is rrnre than twice as high aswould be expected under normal trading arrangements (Table 4). During 1990, theartificiality of these trading arrangements became clear. Exports to the CMEAfell by 11Z, while exports to the West rose by 45%. A rise in exports to theWest was registered in every major sector. In volume terms, the biggest gainsto the convertible currency zone were registered by plastics (229.2Z), footwear(202.2), coke (195.3), rolled steel (171.7Z), cattle (133.0Z) and sulphur(131.4Z).

- 9 -

Table 4: Exports and imports

(million dollars) (million rubles)Convertible Nonconvertible

1989 1990 1989 1990

Exports 8531 11892 12211 11356

Electro-engineering 2042 2726 7505 6747Fuels and power 1028 1272 870 767Metallurgical 1334 2048 375 194Chemical 952 1420 1195 1618Light industry 558 823 449 245Food industry 1162 1380 174 161Agricultural products 444 727 268 136

Imports 7767 8094 10106 6569

Electro-engineering 2423 3123 4750 3349Fuels and power 455 1500 2678 1577Metallurgical 684 560 741 402Chemical 1454 999 721 426Light industry 682 584 365 224Food industry 980 710 241 176Agricultural products 705 187 23 72

Source: Statistical Information Bulletin, January 1991.

Imports also show a similar pattern of switching from the non-convertibleto the convertible zone. Although some private imports may not be recorded, afall in aggregate (convertible plus nonconvertible) imports is likely to haveoccurred. Importantly, imports of capital goods, which are the basis for firm-level restructuring, probably rose, with capital goods imports from the Westrising by 39Z, offsetting the fall in capital goods imports from the non-convertible zone of 40.3Z. Overall, the trade figures indicate that asubstantial opening and reorientation of the economy has happened.

The exceptional export performance in 1990 was surely, due to improvedcompetitiveness arising from the devaluation. But part of the rise wasartificial, dependent on the availability of cheap raw materials from the SovietUnion. Internal prices in Poland were not set equal to the marginal world price,but were computed as the weighted average of cheap Soviet imports and importsfrom the West (Table 5). In addition, important subsidies for coal andelectricity were maintained, albeit at reduced levels. In 1991, these remainingsubsidies were eliminated and export competitiveness will correspondinglydecline; nevertheless, in the first half of the year, exports to the West stillgrew by an impressive 23%.

- 10 -

Table 5: Selected producer price subsidies in 1990(zlltonne)

World price Enterprise price Z subsidy

Crude petroleum 1,240,000 710,000 43Natural gas 865,000 700,000 19

(zl/'000 m3)Pig iron 1,140,000 764,000 33Iron ore 63,000 52,000 18Rolled steel 3,230,000 2,750,000 15

Note: Enterprise price is for the second half of 1990.Source: Estimates of Ministry of Foreign Economic Relations

For now, exports largely reflect the existing industrial structure which,as Collins and Rodrik show, is highly distortionary. As a ratio of per capitaworld production, Poland produces 22 times as much frozen fruit, 11 times as muchrubber footwear, 8 times as much glass, and 6 times as much canned meat, crudesteel and electric locomotives. On the other hand, it produces much less thanthe average of plywood, newsprint and paper products, bricks or metal workingpresses. This production surely does not reflect Poland's comparative advantagewhich, in the long run, will be based on the availability of highly educated,relatively low cost labor close to the heart of the EC. But in the short run,the existing resource allocation patterns will dominate trade flows.

III. Market Prices and Enterprise Behavior

One of the main prongs of the industrial restructuring strategy in Polandhas been first to create an overall environment where market signals guideenterprise decisions and then to make enterprises want to restructure byhardening their budget constraint. The actual and potential success of thisstrategy has been vigorously debated, depending in large measure on unknownassumptions about how enterprises would respond to market forces. Given theabsence of management and marketing experience, of domestic competition, and ofa well defined ownership structure, there were fears that macroeconomicstabilization, unaccompanied by microeconomic change, would only createstagflation (Kolodko, 1989). This section reviews the links between enterpriserestructuring and macroeconomic policies and developments.

- 11 -

Responses to market forces

The introduction of market forces occurred swiftly in Poland. The exchangerate was unified, devalued and made convertible on January 1, 1990. Foreignexchange rationing for current account transactions was abolished. Quotas onimports and licences for importers were largely removed. Tariffs were suspendedat modest levels, averaging about 5%, but with almost 60% of the items zerorated.

The output response within industry in 1990 was quite varied (Table 6).All the socialized industrial sectors report a decline in sales production,ranging from 10 percent for the power sector to 40 percent for textiles. Ingeneral, the heavy industries -- basic and non-ferrous metals and metallurgy --

did better than the light industries -- textiles, leather, wearing apparel andfood. The reasons for this are to be found in price and cost developments,changes in the structure of demand and in the nature of competition. The way inwhich enterprises reacted to these changes sheds some light on the extent towhich they retained their "socialized' character during the transition.

Aggregate output developments. The extent of the fall in industrial outputhas surpassed expectations and bears examination. Several theories have beenproposed, emphasizing alternatively "demand" and "supply" shocks. The puzzle isthat other countries, such as Bolivia, which have stabilized from ahyperinflation using traditional methods of tight credit, balanced budgets anda pegged, devalued nominal exchange rate, have rarely experienced deeprecessions. The plethora of supply-side explanations that have been advanced byanalysts to account for Poland's recession stem from this discrepancy between thePolish and other country experiences.

Calvo and Coricelli (1990) argue that firms were subjected to a seriouscredit crunch that generated reduced output and higher prices. In this view,firms lacked working capital, and were therefore unable to finance the rawmaterial and other inputs needed as a precondition for production. Theirresponse was to lower output to levels consistent with available finance.

This argument is based on the undisputed fact that the enterprise accessto funds, measured as the real value of bank credits, firm deposits in thebanking sector and interfirm credits declined substantially in the first fewmonths of the stabilization program. The issue is whether this decline was acause or a result of the fall in output. CC argue that it was a cause, citingpolicy decisions to control credit, the fragmented nature of the financialmarkets which made firms heavily reliant on bank finance, and the uncertaintyover firms' creditworthiness in the new environment (especially the avowedhardening of the enterprise budget constraint) which led to a reduction in realterms-of the interenterprise credit market.

- 12 -

TABLE 6: SELECTED SUBSECTORAL INDICES, 1990/1989(percentage)

-------------------------------------------------------------- __-------------__-------

Industry Output Costs Employment Profitability Producer Dividendaprice

---------------------------------- _--------------------------__--------------__--------

Power 90.0 85.7 101.8 284.1 153.1 402.2Precision instr. 83.2 105.0 89.7 86.5 78.8 47.5Basic metals 83.1 95.0 94.4 118.6 111.7 94.0Engineering 80.6 100.0 89.2 98.2 96.4 70.4Metallic prods. 80.3 103.3 90.6 99.5 97.4 72.5Electrical engin. 78.7 110.9 92.0 72.2 86.7 62.6Fuel 78.5 100.2 99.7 179.3 131.9 122.1Paper 77.3 102.1 92.3 83.2 103.6 119.7Building mats. 76.8 95.4 93.2 123.7 99.3 176.3Non-ferrous 76.3 86.2 97.2 150.6 131.4 31.6Wood 75.6 114.6 89.8 46.0 84.5 67.1Chemical 75.3 98.4 93.9 98.2 109.1 81.3Food 74.3 87.7 98.2 93.3 83.5 63.4Pottery 74.1 118.8 97.0 61.9 87.8 96.9Transport equip. 73.9 103.5 91.5 86.7 98.5 72.3Glass 72.4 109.8 94.6 70.7 103.2 25.0Coal 71.6 84.2 91.8 28.2 134.7 810.1Wearing apparel 69.4 117.3 89.2 48.8 62.7 33.2Leather 66.3 129.4 90.1 28.8 67.0 38.3Textiles 59.5 130.4 88.9 34.6 73.9 59.6

Source: Monthly Statistical Bulletin

- 13 -

While analytically appealing, the credit crunch thesis does not squareneatly with other developments in the economy. Usually, following a creditcrunch, firms look for other means of raising finances. Investment programswould be slashed (instead, they actually fell by an estimated 9Z only) andcredits for investment would dry up faster than (normally safer and moreprofitable) operating credits. The opposite occurred; investment credits rosefourfold in nominal terms, while operating credits rose by less than threefold.In a credit crunch, enterprise deposits would be quickly drawn down; wage and taxarrears would mount; employment would be quickly shed; curb markets woulddevelop, as they had for foreign exchange in Poland in the previous year; andreal interest rates would soar to high levels. Yet none of these signs appearedin Poland.

It is also puzzling that the interenterprise credit market did not explodein volume, as it had done in Yugoslavia, if the credit crunch had been thatsevere. What is more, the proposition that output is very responsive to creditdeclines should also work in the reverse direction. But when credit was easedin the second half of 1990, the output response was small. Furthermore, firmsaccumulated significant profits throughout the year which they paid out in wages;behavior that is inconsistent under most assumptions if firms could obtain highshort run returns through using this liquidity to expand production.

There are other inconsistencies between the credit crunch hypothesis andactual events in Poland in 1990. It seems odd that firms having trouble withgetting enough liquidity to finance production would be willing and able toincrease exports to the West by 40% in volume terms. On the contrary,difficulties in production should have affected supply to all markets equally.If anything, one would expect domestic markets to be favored over exportsbecause, typically, exports require more access to credit than domestic sales(because of lags in collection of payments). In fact, many countries in the restof the world emphasize the creation of special export credit financing agenciesand discount mechanisms for exporters, precisely because of the difficultiesexporters face in getting working capital relative to producers for the domesticmarket. The strong performance of exports across the board surely indicates thathigher domestic sales were not possible or profitable (demand effects) in 1990.Last, one should note that the scarce evidence that exists on inventoriessuggests that finished goods as a ratio of sales increased throughout 1990, againsuggesting that supply constraints were not binding on firms.

McKinnon (1991) offers a different view of the supply shocks that Polishindustry faced. His argument is based on the premise that the heavily distortedprices for inputs paid by Polish firms have created a heavy material intensity9

that cannot be adjusted in the short-run. At world prices for inputs and output,production could be unprofitable at any wage level. (-iven this, he argues that

' Hughes (1990) suggests that Poland's economy is between two and a halfand three times more energy intensive than that of comparable developingcountries.

- 14 -

Polish firms were unable to comlpete with imports when protective barriers wereremoved and prices liberalized. The policy prescription is to construct a systemof cascading tariffs, which would be phased out over time.

The counterargument to this is twofold. First, imports did not muchincrease in volume terms. Official data (although unreliable'0) suggest a fallof some 12 percent; and those! sectors where production was most seriouslyaffected, in light industry, were also the sectors with the largest fall inimports. Second, firms did not go bankrupt, nor was their profitability sharplyreduced. Quite the reverse, hiealthy profits seem to have been recorded, andtotal unemployment from mass dismissals (i.e. bankruptcies or major plantclosings) amounted to only one percent of the economically active population bythe end of 1990. Of course, some industrial branches will undoubtedly prove tobe uncompetitive over time", but there is little reason to suppose that Polishindustry is facing an across-the-board meltdown because of an inability tocompete with Western imports.

In place of the supply-side theories, the standard argument of a demandcontraction must be given the most weight in explaining the decline in output ofPolish industry. Through budget consolidation and real wage declines, domesticdemand certainly fell sharply in Poland. This is also true for other countriesundergoing stabilization. What is particular about Poland is the transition froma shortage to a market economy. This would be expected to lead to a sharpreduction in aggregate inventory holdings, by both firms'2 and households.Anecdotal evidence suggests this did in fact occur. Another specific unfavorablefactor affecting Poland was the demand shock coming from reduced exports to theCMEA. This largely offset the export gains to the West. Hence, unlike in othercountries, the stimulus to industrial production from net exports was small,perhaps 62 of output and possibly much lower if imports have been underestimated,as is commonly believed.

An output decline associated with low aggregate demand is not an argumentfor a reflation of the economy. This would only be justifiable if there were i)substantial slack in labor and capital utilization and ii) some stickiness innominal wages. But wages have been historically flexible, both seasonally andover a period of several years; there are no institutional reasons to believe intheir rigidity (Table 7). Nor is it the likely that the current level of

10 Exports to Poland reported by the major european trading partners weretwice reported Polish imports from these countries; previous years show aclose approximation between the two series.

"1 The steel industry, for e!xample. was widely believed to beuncompetitive before the reform program was initiatecl. and surprised mostanalysts by recording strong profitability during 1990. But as cheapmaterials from the Soviet Union have disappeared, profits in steel have beensliding and modernization plans have had to be delayed for lack of funds.

"2 Although the ratio of inventories to sales increased, firms total realinventory holdings declined as sales fell.

TABLE 7: Real Wage Adjustment in Poland, 1985-91 1/

------------------------------------------------------

1986 1987 1988 1989 1990 1991Ql

Real wage level (Av.1985-87=100) 102.8 98.8 113.0 126.0 86.7 87.6

January real wage change -22.1% -30.3Z -23.0% -43.3% -42.9% -11.5%

(January over previous month)Ql real wage change -14.6% -17.9% -12.7% -22.0X -37.4Z -15.3Z

(Ql over Q4 previous year) n

Source: Monthly Statistical Bulletin.

1/ The real wage represents the nominal wage excluding bonuses from profits in the

five main socialized industrial sectors deflated by the consumer price index.

- 16 -

unemployment, at 7% of the labor force, is an indicator of less-than-fullemployment. Indeed, surveys show that private sector firms still place lack ofappropriate manpower as a key constraint on their expansion. The unansweredquestion for Poland is the level of 'equilibrium' unemployment that will berequired for structural change to occur rapidly enough. The evidence from Spainand Chile, where unemployment rose beyond 20% during the period of structuraladjustment, suggests that Polish rates are still uncommonly low.

Relative output changes: theory of a socialized enterprise.

The interpretation of the character of the 1990 shock to Polish industrydepends on a particular view cif how firms behave. If the profit maximizingparadigm is inadequate, the interpretations above may be faulty. The majoralternative paradigm, the theory of the socialized firm (Ward, 1958), presupposesthat firms are run by worker-insiders for their own benefit. Under theseassumptions, there are three key propositions that differentiate the socializedfirm from the capitalist firm. In the former, output in the short-run goes downin response to an increase in prices; output goes up in response to an increasein fixed costs and other taxes; and wages are firm-specific and rise as producerprices rise. In each case, the reverse response would be expected from a profitmaximizing firm.

The propositions for socialist firm behavior follow quickly fromconsidering the solutions to the socialized firm maximization:

max w = (pQ - H)/L subject to Q = f(L), QL > 0, and QLL < 0

where w is wages, p the producer price, Q output, L employment, and H fixed cost.In the maximand, workers choose L in order to maximize their wages, which consistof all surplus from production. The labor supplied, L, may be thought of eitheras numbers of employed or, more realistically, effort spent on the job. It iscommon in socialist firms for workers to get paid even if they do not show up forwork or if they hold other part time jobs elsewhere. Hence, the number of peopleemployed is not a measure for the quantity L. The fixed cost, H, consists of thestandard overheads in operating a3 firm as well as the 'dividenda", the tax on thevalue of the capital stock, thaLt all firms pay to the Treasury regardless oftheir performance each year.

In the case of Poland, an important tax on the increase in the wage andsalary bill was introduced in 1990. This tax has proven to be quantitativelysignificant, and needs to be introduced into the maximization above. Althoughthe precise formulation of the excess wage tax is complex, as a firstapproximation it can be taken as a simple increasing function of the labor input,with higher tax rates at higher levels of L.

T = T(L), TL > 0, TLL > 0

- 17 7

The maximand is amended to:

max w = (pQ - H -T)/L with first order conditions:

dL/dp = (Q/L - QL)/(PQLL - TL) < 0

as the numerator is positive (average product greater than the marginal product),while the denominator is negative.

dL/dH = - l/L(TLL - PQLL) > 0 as QLL < 0; TLL > 0.

dL/dT = l/L(TLL + TL/L - PQLL) > o.

dw/dp = QL + (PQLL - TLL)dL/dp > 0.

The intuition behind the results is simple. In socialized firms, it is thepresence of fixed costs and other taxes that forces workers to adapt. When fixedcosts are high, there is pressure to increase labor supply so as to broaden thedistribution of these costs. Hence, when fixed costs or the wage tax rise,employment and output both go up (dL/dH > 0; dL/dT > 0). When the product pricerises, on the other hand, the pressure imposed by fixed costs is reduced, andemployment and output fall (dLjdp < 0). Workers do, however, benefit handsomelyfrom an increase in the price of the good they produce and both nominal and realproduct wages rise (dw/dp > 0).

Note that these predictions about firm behavior are diametrically opposedto the predictions of how a neoclassical (capitalist) firm would behave. There,output would go up if prices went up, while it would go down if fixed costs andtaxes went up. Last, changes in relative prices would not lead to changes inrelative wages because the labor market would equate wage levels amongst firms.In what follows, the actual experience in 1990 of how relative output changed inmajor industrial subsectors in response to prices, costs and taxes is used toassess enterprise motivation.

Prices and costs. Higgins (1990) reports that considerable changes inrelative prices accompanied the liberalization of trade and price setting inJanuary 1990. Interestingly, relative prices in 1990 appear to be closer tothose prevailing in 1988 than those of 1989. It seems that the high inflationand hyperinflation in 1989 seriously distorted relative prices and that thechanges in 1990 were largely corrections for the anomalous movements in 1989.With this interpretation, the fact that the heavy industry sectors performedrelatively better in 1990 can be explained in terms nf catch-up from a dismalperformance in 1989 when basic metals sales fell by 87O and fuel sales by 10%.In fact, there is some statistical basis for linking output and relative pricechanges across 20 industrial sectors (Table 8): the regression coefficient onprices is positive and significant, suggesting that firms faced with higherprices did increase output.

Table 8: Output, Prices and Costs in Polish Industry

- Degrees of

Dependent Variable Independent Variables R2 Freedom

Change in Price Change in Costs Change in Dividends

Change in output -0.414* 0.363 18

(0.129)

Change in output 0.208* 0.307 18

(0.074)

Change in output 0.032 0.092(0.024)

Change in price -1.43 ? 0.611 18

(0.269)

Change in 1.016 -1.306 0.424 17

profitability (0.741) (1.358)

Note: Standard errors in parentheses* Significantly different from zero at 52 level

? Opposite of expected sign

- 19 -

Producer prices did not just follow costs of production, but led to realchanges in profitability. There had been some concern that firms might be ableto pass through cost increases to customers without consequences on demand andoutput, if, as quasi-monopolists, they faced highly inelastic demand curves. Asone journalist put it: "(monopolists) always show that they are working on theverge of profitability or that they even engage in unpaid work, so there isalways a deficit. They raise prices because of increased costs, wlhich go upbecause the enterprises are inefficient. What's more, a recession always meansincreased costs. "13 This version of the socialized firm suggests that highcosts would make prices rise and output fall.

In fact, however, it was the textile and leather sectors--non-monopolisticlight industries-- which suffered the fastest rise in material costs and the mostrapid reduction in output in 1990. Again, regressions suggest that cost squeezeswere important determinants of relative output change (although there is noevidence that at an aggregate level material and wage costs increased faster thanproducer prices). Importantly, there is no significant impact of costs on priceincreases across sectors, suggesting that market forces, not institutionalpeculiarities, are affecting prices for industrial goods. This is partialconfirmation of the hypothesis that the monopoly problem was overstated andlargely addressed through open trade. Falling output in industries whererelative costs rise is exactly what would be expected in a market economy.

Apart from material costs of production, the government affected fixedcosts through its tax take from enterprises in the form of "dividends", paymentsmade on the basis of each enterprise's capital stock. The total value of suchdividends increased from 2.1 to 12.95 trillion zlotys between 1989 and 1990, adecrease in real terms of about 14 percent. But a sizeable amount of thedividenda came from the mining sector; for the manufacturing sectors, the fallin the real value of the dividends paid to the government was steeper. Lookedat across broad industrial sectors, the change in the level of dividend paymentsdoes not seem to have had any significant effect on explaining changes in output.In fact, this is not surprising. At the aggregate level, the government hadanother claim on value added, in the form of a tax on the increase in wages andsalaries. This totalled 16.5 trillion zloties in 1990, larger than the dividendapayments. Overall, the real tax take from enterprises therefore increasedmarkedly, and would be expected to raise output, under the assumptions of thesocialized firm model outlined above.

These aggregate data do not support the presumption that firms have beenmotivated to maximize the surplus per unit of labor supply. In fact, there hasbeen very little labor shedding, which the theory would imply, despite the fallin demand. On the contrary, there has been a marked decline in laborproductivity. Nor is there any evidence that the monopolistic structure offirms, or the possibility that behavior is governed b- some alternative motives(such as maintaining jobs), has introduced anomalolus behavior. At a broadsectoral level, output changes correspond to what neoclassical theory wouldpredict, rising in response to higher prices, and falling in sectors faced withhigher costs and taxes.

13 See "100 Heads of the Dragon", Warsaw Voice, January 20, 1991

- 20 -

Wages. One important area where there has been a departure from standardpractice is in wage determination. It does appear to be the case that workersand managers are able to expropriate much of the surplus of their firms.Figure 2 shows the relationship between wages and profitability in industry.There is clearly a strong positive relationship in 1990, in contrast to the moreeven pattern of wages in 1989.

Two points about these wage developments bear emphasizing. First, the factthat the more profitable firms had higher wage growth, and higher wage levels,while less profitable firms had lower wage growth and lower wage levels, suggeststhat competitive pressures were felt and understood at the enterprise level, andthat budget constraints faced by enterprises had hardened. Unprofitable firmscould not, and did not, simply raise wages while relying on the government or oncredits from the banking system to provide the financing. This situation is verydifferent from that prevailing during 1989, when workers in poorly performingenterprises did not suffer any wage erosion because of the complex system oftaxes and subsidies that equalized cash flow positions across firms (Schaffer,1990). In 1989, net subsidies per worker averaged more than 50X of the nominalwage for the 18X of workers in enterprises with profit rates below twenty percent(Table 9). But in 1990, the level of subsidies fell to just 30% of the previousyear's level, as the government cut back on expenditures. Most of these went tothe sensitive coal sector. In manufacturing, subsidies were almost completelyeliminated, averaging only 8.5% of the previous year's levels. Meanwhile,corporate income tax revenues were maintained at the same real level. As aresult, the government apparatus for balancing firms' cash flows and hence wages,was destroyed.

The second key point ahout 1990 wage developments is that without effectivecontrols on enterprises--via labor markets or real owners representing theinterests of capital--wages quickly became more differentiated, according to firmprofitability. Enterprises themselves had neither the ability nor willingnessto hold the line on wages. This has created a serious problem of how to controlthe growth in real wages. Unlike in a capitalist economy, high real wage growthis not indicative of the best performers reaping the highest rewards. Instead,the process is generally perceived as unfair. The most profitable firms have notbeen those which have been the most competitive, but rather those with thelargest and most modern capital stock and those benefitting from specialcircumstances, such as access to low priced raw materials from the Soviet Union,for example. In capitalist economies, workers of similar skills earn similaramounts in firms with completely different amounts of capital, because thereturns to capital are paid out to equity and debt holders. In Poland, theabsence of any claims on capital stems from a combination of factors: first, theabsence of rules governing payments to equity, resulting from uncertainty overownership rights and the collapse of centralized structures detailing howfinancial surpluses should be allocated; and second. the low real value ofenterprise debt, which had been signiificantly eroded by the hyperinflation of1989. Workers, who through their councils have many of the rights of ownerselsewhere, are therefore able to benefit from profits.

- 21 -

Fil .2:WAGES AND PROFITABILIT'Y' IN POLAND

I^ 2o

20%

710%-

Ul~ ~~~~~~~~~~~~ 90i t.I 0to

-0O5 antd m-ore | U to 5 | )l 5 | 20 to 25 | 30t50 -

-5 to 0 5 to 10 15 to 20 25 to 30 50 ail(J rTlUal e

PJrofit,ibility roite of fitrn

1939 + 1-990

TABLE 9: NET SUBSIDIES AND WAGE DISPERSION

Enterprise Employment Monthly Wage Net subsidy/ lNet subsi-.a04(zloty) worker

net profitability class 1989 1990 1989 1990 1989 1990 1989 1990

-5 and more 4191 72341 196571 722661 38849 180829 19.76118. 5.0-5 to 0 28314 45435 204125 742633 522167 94625 255.81°. 1. 7L,0 to 5 40483 175643 197790 797517 249609 291775 126.200 ,5o 5 to 10 86160 267231 178647 839586 530936 -65552 297.20,1 -81of10 to 15 193253 370669 176532 903674 276726 -224842 156.761, BE" ,15 to 20 201645 362145 168410 952991 90827 -358773 53.93, -.?.65,20 to 25 277935 304038 165958 954580 -19606 -536115 -11.811 :5616!25 to 30 323693 258013 169782 990145 -21552 -761832 -12.691 -?6.9430 to 50 1099731 761732 178813 1020216 -125793 -1139576 -70.35, -111.?CK50 and more 873574 582403 195214 1164188 -152764 -2327973 -78.25, -149.9?'

Total 3128979 3205218 180358 978675 -48727 -853234 -27.02,c -S'.1SSource:---------------------------- Monthly Statistical Bulletin

Source: Monthly Statistical Bulletin

- 23 -

The fact that the growth in wages would be driven by firms' internal cashflow necessitated a government policy on wages. The case for this interventionrested first, on fairness in avoiding unwarranted wage dispersion and second, onthe presumption that firms' cash flow would exceed their long-run sustainableprofits, and that therefore wage payments based on cash flow would exceedcompetitive levels, and disrupt the macroeconomic targets on inflation and thebalance of payments.

The government used three main instruments to attempt to moderate wageincreases. First, it introduced an excess wage tax. All firms paying in excessof a certain norm threshold for wage increases, had to pay a tax, ranging from100% to 500% of the wage increase. The norm itself was adjusted monthly by 60%of the CPI inflation rate. This restricted firms' ability to pay out surplusesdirectly in the form of wages. But the initial value of the norm did not fullytake into account the seasonal reduction in wages that occurred in January 1990,as it had done in previous years (Table 7 above). By allowing the norm toaccumulate over time, enterprises were able to build up "surpluses" under thenorm (Figure 3); by running down these surpluses, wages could outstrip priceincreases without triggering a wage tax penalty. Nevertheless, by the end ofDecember 1990, over 2,000 firms had, taken together, paid more than 16.5 trillionzloty in excess wage taxes.

Second, the government introduced a corporate income tax at a flat 40%.The effective tax rate (actual collections divided by the profit tax base) wasclose to this level (37Z). In this way, some of the surplus was absorbed intothe Treasury, but the effectiveness of this instrument was reduced by theweakness of the accounting system and the ease with which enterprises could hideprofits. One major culprit has been high depreciation allowances, oftenunjustified in economic terms, such as for outmoded and technologically obsoleteequipment, which nevertheless can be revalued by the inflation rate for thepurposes of depreciation. In 1991, accounting changes allowing firms to writeoff receivables in arrears has further weakened the link between profits and cashflow. If two firms barter with each other, and both book the sales asreceivables in arrears, then both get tax deductions relative to the situationwhere each paid the other in cash.

Third, the government raised the "dividend" tax, fixed payments made to theTreasury based on an inflation adjusted value of fixed capital assets. Butbecause the revaluation was inadequate, the real receipts from the dividendadeclined. The dividend was supposed to be a prime tool for monitoring firms'financial performance. Arrears on the dividend payments would trigger bankruptcyor liquidation proceedings. In practice, however, the dividend has been unableto play this role. Only 4 enterprises under the Ministry of Industry had beenforced to stop production by June 1990, and only -ne had been placed intoliquidation. Partlv this was because the size ot the dividend was small,averaging only about 9.5% of industry gross profits (or about one-quarter ofwages); partly it was because other possibilities existed for generating cashflow and staying current on dividend payments, and partly it was because thedividend trigger could be overruled where the firm was deemed to have good

- 24 -

FIGURE 3

Foland: Wage PolicyUlnused cumulative norm

600

4200 ..................................

2400 .........

-200 .................................................

-800a I 1 2 3 4 5 6 7 8 9 10 11 12

1 90

in thousand zlotys per worker

- 25 -

fprospects"; that is, wherever special circumstances, other than poor firmmanagement, accounted for the arrears. But by creating a bargaining, case-by-case procedure for liquidation, the government undercut the role of the financialtriggers controlling enterprise behavior.

The three government measures have not been altogether successful inkeeping down the level or dispersion of wages. Not surprisingly, the excess wagetax is amongst the most unpopular of all government interventions. It is scornedby liberals on the grounds that it interferes with the creation of labor marketsand is an unjustified intervention in enterprises, while doing little to battleinflation (seen as a monetary phenomenon, rather than a wage cost phenomenon);and it is attacked by socialists who view workers as the natural owners of thereturns to capital. Workers have fought hard against the erosion of the reallevel of the wage norm, and in important cases the government has had to makespecific exceptions and recalculations of the norm to avoid unrest. Yet, withoutthe excess wage tax, and the other measures to absorb enterprise surpluses, itis certain that the level and dispersion of wages would be far higher than it istoday.

Paradoxically, flexibility in wages has been both a strength and a weaknessof Polish industrial performance. A strength, in that downward real wageflexibility kept many firms afloat, reducing the number of bankruptcies. Aweakness, in that by doing so, the process of real restructuring has been slowed.Instead of resources moving to where they are most productive, the returns to theresources have simply adjusted. Firms with high wage rates face a reducedincentive to expand. They cannot have a two-tier wage structure, differentiatingbetween old and new workers; and they find it difficult to force their lessefficient domestic competitors to close. Furthermore, the signals being givenin the labor market, based on current profits affected by short-term and volatilefactors, are not the appropriate ones for governing the reallocation of laborresources.

Macroeconomic factors. In January 1990, the government devalued the zlotyand pegged it to the US dollar as a way of creating a nominal anchor that wouldhelp stabilize price increases. The size of the exchange rate devaluation wasbased in part by what was thought to be required to boost industrialcompetitiveness. Relative to 1988, the real exchange rate in official marketswas devalued by 24Z in January 1990. But price increases since then havesteadily eroded this competitive edge; for all of 1990, the real exchange ratewas little changed relative to 1988.

The devaluations of December 1989 and January 1990 did not create lastingimprovements in competitiveness because they created huge surpluses and liquidityin enterprises, which were then translated into wage increases. First, therewere transitional profits for firms. Producer prices rose more rapidly thancosts, so profitability soared. For the year as a whole, accounting profits forthe socialized industrial sector averaged 24% of sales revenue; but the gainswere heavily concentrated in the first half of the year. By June 1990, sales hadgrown 55% faster than costs; by November, the two had converged. Second, manyfirms had built up large inventories in 1989 on which they realized significantgains when prices and the trade regime were liberalized. These gains translated

- 26 -

directly into extra cash, because with the emergence of a market economy, firmshad less need to maintain large inventories. In fact, the real value ofinventories (proxied by nominal values deflated by the producer price index) fellby more than 55% during 1990.

The fact that workers have been able to recoup in wages part of theliquidity and profits generated for firms by the devaluation has complicated thetask of macroeconomic management. It has meant that the rate of growth of wagesand, hence, of prices has been mnore rapid than otherwise, and the competitivegains from the devaluation have been quickly eroded. This has compromised thesustainability of the nominal exchange rate, and threatens to jeopardize thestabilization gains achieved to date. It has also meant that firms have beenable to escape temporarily the discipline of the market place. Firms have beenunder less pressure to restructurie because the devaluation has provided them withcash flow relief.

Of course, there were differences amongst firms in the extent to which theywere able to benefit from these forces, but the aggregate level of thedevaluation was important in creating enterprise liquidity in the face of tightmonetary policy. Inter-firm credits grew steadily during 1990 in nominal terms(from 47.4 to 103 trillion zloty) as a mechanism for firms to bypass the monetarysystem. Although this was largely related to voluntary trade credits, which thedomestic banking sector was unable to supply in sufficient quantities, interfirmcredits have been an important mechanism for unilateral reallocations ofenterprise cash flows. Legally, firms are entitled to take reluctant payers tocourt, but in practice, this would be a long process and, given the tightsupplier links that prevail, forcing a supplier into bankruptcy might haveeconomic costs for a firm that outweigh the gains from collecting on theircredits.

Interfirm credits are a mechanism for reallocating enterprise liquidity;they do not create net new liquidity14. This can only be done through thebanking system, which was subjected to credit controls as part of the package tocontain overall inflation. But the credit limits on enterprises turned out tobe less strict than first envisaged, because the budget in the first half of 1990was unexpectedly in surplus. The Central Bank, finding that the government'scredit needs were below expectations, was able to increase credit to enterpriseswithout excessive creation of net domestic assets.

In a testimony to the ability of firms to continue functioning even whenmaking economic losses, only 183,00 workers were listed as unemployed due tocollective dismissals in all of 1990, equivalent to just 1.4Z of the end-1989nonagricultural labor force. Flexible wages, devaluation, budget surpluses and

14 Although in some cases, if firms bypass the banking system and lend toeach other, velocity will rise because there are no reserve requirementsassociated with these transactions, which would have drained liquidity fromthe system if the money had first been deposited in a bank and then onlent toanother firm.

- 27 -

inter-firm arrears have been the principal reasons for the low level ofbankruptcies in 1990. But these have been transitory factors, and each is undergrowing pressure. Wages in unprofitable firms have already fallen 25Z below theaverage for the economy, and are approaching the poverty line, at which pointworkers may prefer bankruptcy and social welfare to continued work in the firm.A turn-around of performance based on further wage reductions in these firms istherefore unlikely. The devaluation has been eroded in real terms and will onlybe used by the government as a last resort, given the importance of continuingthe fight against inflation15. Budget surpluses are in the past, and interfirmarrears are no longer increasing, partly because sources of supplies have beendiversified. Thus, it has been fully eighteen months after the introduction ofnew prices and a hard budget constraint that enterprises are starting to feel thefull burden of the squeeze. This lag between the introduction of a policy andits effects is important in considering the phasing of reforms. It suggests thatmacroeconomic tightness must be pursued over a relatively long period of time,and that supply responses to new prices are likely to be slow.

At the end of 1990, the Ministry of Industry estimated that 552 enterprisesout of a total number of 17,252 firms in Poland were faced with potentialinsolvency. These firms employed 674,000 workers. The Ministry forecast thatdismissals during 1991 would total 150,000, primarily in the machine tools,electronic, building, textile and transport sectors. If accurate, these figureswould represent about 2.2Z of the labor force, a significant but not overwhelmingnumber. The point is that bankruptcies and lay-offs are not likely to be a forcefor the restructuring of labor resources, as in other capitalist economies. Theimplicit labor hoarding by ex-socialist firms is a force that slows downindustrial restructuring, while at the same time alleviating some of the socialcosts of macro contraction. However, reliance on individual firms to perform thesocial function of providing a safety net is probabaly inefficient.

Energizing enterprises

Macroeconomic tightening will force firms to adjust one way or another.But there is no guarantee that this adjustment will be in a positive direction.The first instinct of firms has been to apply political pressure on thegovernment to loosen the macroeconomic corset; requests for subsidies, for tariffprotection, for looser monetary policy, for elimination of the excess wage tax(or reappraisal of the norm) and for devaluation (or a crawling peg) have beenincreasing during 1991. The coalition advocating a loosening has steadilybroadened to include managers, workers, academics and even some government

15 The government did in fact devalue the zloty by 14.4Z on May 21, 1991to counteract the erosion in the real effective exchange rate due to the USdollar appreciation against the Deutsche Mark and other key Europeancurrencies; but this has left unaffected the zloty price of German goods, forexample, compared to their previous year level.

- 28 -

ministers'6. The second instinct of firms is to sell off or lease assets.Although in theory the proceeds from such transactions cannot be used to maintainpayrolls, but must be placed in a capital account, in practice there isconsiderable leakage between accounts. Already in 1990, this was a growingphenomenon, at least for minor assets and premises.

The sale or lease of assets has both positive and negative sides to it.On the positive side, the assets sold will probably be used efficiently. On thenegative side, however, these sales can provide financing to allow unproductiveand negative value added activities to continue, by breaking down the financialdiscipline the government is attempting to exert over firms. The concern is thatthe real positive value of firms will be cashed in through such manoeuvers anddissipated. If continued, this will contribute to a decline in enterprise andhence national savings, and a fall in the resources available for retooling. Thedanger, then, with relying too heavily on macroeconomic policy as a tool forforcing enterprise restructuring is that the politics may jeopardize thestabilization effort. Complementary policies at the microeconomic level arerequired.

Internal enterprise organization. Wiy haven't enterprises responded morepositively to the changing economic circumstances? One reason relates to theinternal organizational structure within firms. There are multiple controls inmost large Polish enterprises--ministry founding organs, enterprise directors,worker councils and trade unions all wield considerable power. Polish firms alsotend to be very hierarchical, with internal structures geared towards thefulfillment of output targets. Management has been largely concerned withcontrolling the physical production process and avoiding theft, resulting in ahierarchical pyramid. Western management consultants report that the low laborproductivity in many Polish firms is caused by too many middle managers -- blue-collar worker/fixed capital ratios are closer to equivalent Western plants --whose functions are unproductive, related largely to control of the productionline. On the other hand, departments of strategic planning, market surveys,financial analysis, and systems of accountability are missing. There are,therefore, few internal organizational procedures which allow the firm to processexternal information and translate it into management decisions affecting thefirm's operations. In this environment, even the presence of correct marketsignals will only affect firms' 'behavior itn a slow and limited way. What ismore, the kind of organizational change that is needed, in terms of jobdefinition and total numbers of jobs, is essentially managerial--a process whichis vigorously resisted by existing managers.

Management resistance to change can be seen in a number of different areas.Privatization has been slowed in some cases by lack of cooperation of managersfaced with the possibility of losing jobs or seniority. Some managers, even whenfaced with a situation of a catastrophic collapse in the market for their

16 Jerzy Eysmont, Minister in charge of the Central Planning Office, isan avowed proponent of looser monetary policy. See the Financial Times,Friday May 3, 1991.

- 29 -

products (such as has occurred with several firms dependent on exports to theSoviet Union), have been apathetic about participating in government sponsoredconsultancy projects17. And some managers have been grouping together to lobbygovernment, obtain favorable terms for management buy-outs and other actionswhich would leave them in control of the company18.

Governance. The key to more effective corporate governance is first, toestablish an owner whose wishes must be respected, and second to build amanagement structure which can bring the whole enterprise around in support ofa restructuring project. In Poland, the primary vehicle for improving governanceis commercialization--transformation of a firm into a joint-stock or limitedliability company with a board of directors, representing the owners of shares,with the authority to appoint the chief executive officer--followed byprivatization.

Although there is widespread agreement on the desirability ofcommercialization, there is considerable debate on the government's role inaccelerating the speed. Despite powerful government incentives forcommercialization, including exemption from the excess wage tax and preferencesin credit, only a limited number of large firms have expressed interest. ByMarch 1991, only about 35 large firms with over 1000 workers had beencommercialized, and the vast majority of these had in mind some linkage with aforeign partner. As a result, the government has decided to adopt a programcalling for mass commercialization of large companies in 1991, involving at least100 firms with more than 1,000 workers"9. However, political difficulties overthe implementation of such a privatization scheme remain a major constraint.

The reluctance of the government to take a more active role incommercialization initially was related to the perceived dangers of areconcentration of economic power in the hands of the center. Not only wouldthis have been politically dangerous, but it would also have required the Stateto intervene in hundreds of companies, a task for which it was ill equipped. Ifthe most bankrupt enterprises opted for commercialization as a means of returninginto the protective hands of the state, there would be considerable budgetarypressure for bail-outs.

'7 The government has implemented a highly successful program of training"company doctors", aimed at staff of the Agency for Industrial Development andspecialized Polish consultants, financed through the British Know-How Fund, toassist firms in developing restructuring plans. Other technical assistanceprograms also exist. But the government has found few firms willing toparticipate in these programs, even amongst those worst affected by thedecline in orders from CMEA countries.

18 A typical attitude is illustrated by an interview with the manager of"Exbud" in which he says "Exbud is me. . ." Polish Press Agency, March 1991.

19 See Lipton and Sachs, 1990b for a lucid description of theprivatization program.

- 30 -

The current program for mass privatization avoids the pitfall ofcentralization by allowing several financial institutions (including commercialbanks, mutual funds and pension funds) to hold shares, as well as the statetreasury. In this fashion, a greater number of interests are to be representedon the board of directors of each large firm.

By March 1991, commercialization had become a routine function. TheMinistry of Ownership Change had put in place procedures to be followed, and hadstarted a process of training potential board members. The board members weremostly volunteers, highly motivated and focused on a single firm, althoughlegally an individual could sit on a total of three company boards. Despite someearly tendency for the boards of comnercialized firms to micromanage, bypassingthe formal management structure, the introduction of boards appears to have beenreadily accepted by workers as natural successors to worker councils.

Existence of a board does not automatically lead to improved governance.There has already been a notorious case involving the Krosno glass works, acompany privatized through a public offering, which shortly thereafter ran intosevere financial difficulty as a result of unsustainable wage increases voted onand approved by the board.

Over time, experience and the introduction of foreign financial institutionmanagers should improve the performance of boards. Another instrument that isunder consideration is the use of stock options to tie management and boardcompensation to enterprise profit performance. It is also hoped that commercialbanks, owning both equity and debt of a company, will play a positive role inorganizing financial work-outs and long-term financing for a company.

Although the large companies dominate production and employment in Poland,it is the small and medium sized companies, where the governance problem iseasier to resolve than in large companies, which have been most responsive to thenew environment in terms of willingness to commercialize, and adapt new productlines and marketing strategies. For these companies, existing management oftenhas clear ideas of what needs to be done, and is able to bring the rest of thefirm behind its proposals. The preferred procedure of privatization is for thefirm to be "liquidated" (formally struck off the register of state enterprises),and its assets sold, in whole or in part, to another legal entity. In Poland,this is the route through which imanagement and worker buy-outs have occurred.By January of 1991, 31 such deaLs had been completed and a further 300 wereslated for the remainder of the year. To accelerate the process, whole branchesmay be liquidated, especially in food processing and distribution, where thereare close links with farmers and other private entities.

Competition. The prime tool of competition policy in Poland has beenopenness to international trade. Foreign exchange is not rationed, and tariffand nontariff trade barriers are few. Arbitrage has been facilitated by vastlyexpanding the number of licensed importers and exporters, and in 1991 foreigncompanies were also allowed to participate in foreign trade. But althoughopenness to international trade provides a considerable spur to competition, itis a blunt instrument whose effects are uneven across sectors. Internationaltrade is most effective when tastets (or goods) across countries are homogeneousand economies of scale lead to efficient production allocations across countries.

- 31 -

In practice, few markets fit this description. Consumer goods industries,especially food-based products and other light industry goods, may be madecompetitive through trade, but in consumer durables, pharmaceuticals, producergoods and of course nontradables, international trade is less significant. Inthese sectors, restrictive practices can build up, just as they do in othermarkets, with a dominant producer or supplier acting as a price leader.

Experience in the EC is instructive in this regard. The EuropeanCommission examined prices for about 90 goods sold throughout the Community andconcluded that the standard deviation of price differences was about 27% of theaverage price. That is, the most expensive 17% of locations had prices averagingabout double the cheapest 17Z of locations20. The Commission determined thatonly about one-quarter of this price dispersion could be attributed to tax andnon-tariff barriers, while the remainder was attributable to monopolistic pricingbuilt up through trade marks, restrictive practices, exclusive sales contractsand the like.

In Poland, the slow approach of producer prices to international levels in1990 is one indication of the limits of free trade in creating domesticcompetition. In an environment of pure competition, prices would have convergedinstantaneously to world levels. In reality, the speed of approach depended onthe type of product and the existence of appropriate distribution networksdomestically2 l. For many administratively set service prices, producer goodsand goods procured by the public sector, there is little effective competitionfrom abroad.

The government is developing a more active policy aimed at broadening therange of goods subject to competition22. The institutional umbrella is the newAnti-Monopoly Office, with a staff of about 140 headquartered in Warsaw, but with8 regional branches. The AMO is legally responsible for demonopolization throughstructural and regulatory means. The President of the AMO is appointed by thePrime Minister. In its first seven months, the AMO reviewed 1500 cases, andissued 71 decisions; 11 cases were tried in court (of which 2 were lost). Unlikein Western countries, the AMO is responsible for all monopolistic practices notjust those involving large companies. To some extent, this peculiarity stemsfrom the perceived danger of nonmenklatura control, extending to the villagelevel, which the government is concerned to root out.

The structural component of the anti-monopoly policy is to break upmonopolies and control mergers and the formation of new companies. The forciblebreak up of large companies is desirable in cases where the monopoly structureis the product of the old administrative set-up, but in other cases, large

2 See Geroski (1989).

21 See Pinto (1990).

a See The Competition Development Project, Anti-Monopoly Office, Warsaw,March 1991.

- 32 -

enterprises have resulted from an economic rationale (for example, economies ofscale in car production). Ex ante, these cannot be differentiated, so a case-by-case approach has been adopted, starting with the food industry, and laterencompassing agricultural inputs and other raw material processors anddistributors. In addition to breaking up existing structures, the AMO reviewsmergers and restructurings in light of their competitive impact. In the firstyear, 15 decisions preventing mergers were issued, out of some 200 casesconsidered.

In assessing the case for t-he merger or break up of companies on the basisof market share, the AMO is foilowing the traditional practice of Westerncountries. This practice, however, is founded on a link between economicstructure and performance which has become weaker everywhere as internationaltrade extends and blurs the definition of an economic market beyond nationalboundaries. What is more, the recent theoretical emphasis on the role ofpotential entry in determining firm behavior means that historical market sharecannot be relied on as a reliable index of concentration, but only as an upperbound. There is some danger, then, that the AMO might slow up rather thanaccelerate restructuring and privatization by excessive concern for marketstructure based on outmoded Western practice.

There may be a silver :Lining to the problem of excessively largeenterprises in Poland. Large firms permit economies of scale, which will becomeincreasingly important as the scope of the market expands with a free tradeagreement with the EC. They also internalize issues of where to cut capacity indeclining industries. European and Japanese examples suggest that plant closuresin declining industries are linked as closely to industrial structure as toefficiency. Often, small inefficient firms will tend to remain in operation,while more efficient plants close in the presence of an inverse correlationbetween size of firm and cost of closure23. Last, foreign investors can moreeasily establish a significant presence in the domestic market by taking over oraffiliating with a large domestic firm. Small manufacturing firms in segmentedmarket niches can face great difficulty in adjusting to a competitiveinternational market, a point exemplified by the recent Greek experience24.

On the regulatory side, the! AMO acts on prices and on contracts. The AMOhas identified 103 companies (almost all of which are in the Top 500 list) whichhave 80X of total production capacity in an industrial branch, and an asset valuegreater than 5 billion zloty. These monopolists are subject to price regulation,in that they must obtain prior approval from the Ministry of Finance beforeraising prices. In a popularized case involving the FSO car company, the AMOordered a roll-back of price increases, on the grounds that FSO was exploiting

23 See, for example, Baden-Fuller (1989).

24 See Mardas and Varsakelis, 1990. They note that Greek manufacturers,with an average of 4.5 employees per establishment, have first gone through aprocess of domestic merger activity, followed by foreign acquisitions.

- 33 -

its monopoly power. On appeal, however, the ruling was reversed. The example,nevertheless, illustrates the extensive price regulatory function that thegovernment still employs.

Increasingly, the AMO must turn its attention towards firms' actions insetting contracts. Attempts have already been made to set up exclusivecontracts, price discriminate amongst customers, force linkages between sales andloans or other agreements, renegotiate contracts ex post, and dumping to gainmarket share. These are areas where firms commonly exploit their market power,particularly with respect to small suppliers or purchasers. Other areas ofcompetition policy where the AMO has yet to act are in the liberalization ofpublic procurement practices, regulation of private monopolies in infrastructureprovision and debundling in the provision of social services to allow competitionat different stages of the production chain.

New business growth. Although considerable importance is attached to therole to be played by small businesses in restructuring industry, there is nocomprehensive official plan to foster small business development. Compared tocapitalist countries, there are few barriers to entry in Poland: technology iswidely shared across enterprises and brand names, patents, advertising and othermeans for product differentiation are not as important. Also, unlike in othermarket economies, the large size of incumbent firms may not be a deterrent to newentrants because there is no presumption that large firms are effectivelyexploiting economies of scale.

There are, however, a range of barriers to new business growth, not facedin other market economies. Business infrastructure is very weak; problems extendfrom getting premises and telephones, to the inadequacy of financial andinsurance services, tightness in the skilled labor market, and high cost ofinformation on markets, competitors and R&D results. In many countries, thesekinds of problems, which are endemic to small businesses, are resolved throughencouraging industry associations which can internalize many of theexternalities. In Japan, for example, the central and local governments supportsmall business associations which then sponsor development of industrial parksfor joint production, processing, storage distribution and procurement; help setproduct specifications, design and quality standards; and disseminate the use ofmodern equipment. In Poland, however, there is a strong antipathy to suchassociations because of their history as agencies of central control andnomenklatura privilege under the comnunist system. Other major barriers to newbusiness growth are uncompetitive procurement practices in the public sector andin nomenklatura dominated state enterprises, and lack of protection ofsubcontractors through rigorous enforcement of contracts.

Despite these drawbacks, new business is thriving, largely in nichescreated by the inefficiencies of state firms and in the development of newproducts and processes. There are piecemeal incentives given to new business:tax holidays for joint ventures and new firms: exemption from the excess wagetax; and, increasingly, administrative preferences in credit allocation. Thegovernment is intent on limiting the adverse affect of its tight credit, anti-

- 34 -

inflation policy on the private sector by limiting the share of credit going topreferential sectors (agriculture and housing) and centrally-approved investmentand by encouraging banks to increase loans to the private sector much faster thantotal credit. In fact, implementation of this policy gave rise to differentialinterest rates in early 1991; loans to the private sector carried lower ratesthan loans to the state sector w%here supply was more tightly rationed.

Other schemes to funnel funds and technical assistance to the privatesector have been set up, but the delivery systems are untested. The PolishAmerican Enterprise Fund has set aside $13 million for small loans of up to$20,000 dollars available to private businesses; but disbursement is undertakenthrough state banks and requires documentation of planned cash flows, incomes andcosts, with which many applicants are unfamiliar. Similar problems affect ECcredits for small business. The Polish Development Bank will also startoperations in 1991, with credits and venture capital targeted specifically atsmall and medium enterprises.

Schemes involving direct government loans or government guarantees havealso been hard to implement. Once the government is involved, it requiresfeasibility and market studies for guaranteed credit lines. These prudentialprocedures do not match with private sector needs and abilities; consequently,loans that are disbursed through the banking sector, such as the World Bank'sIndustrial Export and Agricultural Development Loans, have had slow rates ofdisbursement.

Foreign investment. Foreign investment in Poland has been small. The Lawon Joint Ventures, introduced in 1989 to encourage foreign investors, met withonly partial success. During 1989, about 949 foreign and joint venture firmswere reported in operation, but these were mostly small, employing just 108,500workers, and accounting for only 2.5% of total industrial sales. In general, theforeign firms were marginally less profitable than the average for all Polishindustry, paid a wage premium of 10%, and were heavily concentrated in largeurban areas.

During 1990, a further 1935 permits were issued to foreigners for sole andjoint venture operations, but only 60% of these led to actual company start-ups.By the end of 1990, a total of 1653 companies were in operation, with a foreigncapital contribution of $200 million. The average foreign capital participationof $121,000 shows that most of the investments were small. It is only recentlythat large foreign investors (Asea Brown Boveri, Coca Cola, Levi Strauss andFiat) have decided to come to Poland. So far, German firms have showed thegreatest interest, with 981 new companies and 41% of total foreign capital in1990, followed by Swedish firms (256 companies, 9.5% capital), US (214 companies,7Z capital) and Austrians (200 companies, 7% capital).

The low stock and limited inflow of foreign investment in Poland is a majorconstraint on industrial restructuring. Foreigners are considered the primesource of managerial and financial talent, technological know-how, marketingskills, and capital required for restructuring the economy. But foreign investor

- 35 -

commitments to Poland were less than one-third those going to Hungary, and a tinyfraction of the billions attracted by Spain, Malaysia, Indonesia and other middleincome countries. Actual foreign direct investment flows into Poland in 1990were estimated at only $350 million and while more is anticipated for 1991, itwill still fall short of expectations.

The importance of foreign investment in linking Poland to the West can begauged by contrasting the experiences of Spain and Greece, both trying torestructure upon accession to the EC. Spain had attempted to prepare for entryinto the EC by a program of restructuring behind significant trade barriers. Butprivate domestic investment never recovered from the low levels to which it hadfallen as a result of the high interest rates in Spain, used to fight inflation,and restructuring and growth were minor in this period. After accession in 1986,Spain engineered a major liberalization of its trade regime. Intra-EC tariffsfell by 22.5 percentage points, quantitative barriers were removed and theprotection given by the indirect tax system was eliminated. Nevertheless,investment soared, led by foreigners. Since 1986, foreigners are estimated tohave accounted for one-third of all investment in Spain's manufacturing sector,and industrial growth and enterprise level restructuring are buoyant. The formof restructuring has been to develop competitive areas within narrow subsectorcategories, so that each subsector emerged stronger. Even subsectors thought tobe sensitive to foreign import penetration--chemicals, machine tools andelectrical plant and machinery--have witnessed an influx of foreign capital. Asexpected, labor-intensive sectors where Spain has a comparative advantage forexporting to the rest of Europe have also gained--for example, ceramics, footwearand toys.

In Greece, on the other hand, there has been very little investment andconsequently growth in industrial output has been only one-third of that inSpain. Foreign investment in Greece has been negligible. The pattern of tradein Greece following accession has been to reinforce exports of consumer goods andagricultural products while importing other manufactures. Greece has yet toachieve a significant restructuring of its industry.

Poland is making a stronger effort to attract more foreign investment bylegal and institutional changes. A new Law on Joint Ventures will allow fulltransfer of profits and capital. It reduces the involvement of the ForeignInvestment Agency in issuing permits for business set-up and operation.Permission will only be required in areas of national importance--defence,railways and sea transport, large scale power, heating, electricity and gas, andtransport in large urban areas. The $50,000 minimum size for foreignparticipation will be abolished, but small firms (with less than $2 million ECUcapital) will not be eligible for the three year tax exemption offered to otherfirms. The Foreign Investment Agency itself will be made less bureaucratic bytransforming it into a state enterprise under the Ministry of Ownership Change.

These legal changes on their own are unlikely to bring in major amounts offoreign money. Poland's problems run deeper, extending from uncertainty overpolitical and macroeconomic conditions, to cumbersome local bureaucracies to theundeveloped infrastructure, especially telecommunications, and the absence of a

- 36 -

good banking system. The lack of banks in small towns, in particular, restrictsforeign firms to locate in larger, highly congested urban areas, raising costs.Because Poland still does not have the infrastructural links with the rest ofEurope, foreign investors are looking more for opportunities to penetrate thelocal market, rather than for re-export. This balance must be addressed to avoida looming balance of payments crisis. The government must enter into partnershipwith the private sector in creating a better environment for foreign investment.

Sununary

In this section, both macroeconomic and microeconomic developments havebeen assessed. Output in Poland contracted by more than in other nonsocialistcountries undertaking stabilization, largely because of the structure of foreigntrade. The base of exports to the West was small, and demand for exports fromthe CMEA countries declined at just the same moment as domestic demand. Itappears that the concerns with monopoly structure and socialized firm reactionswere overblown. Once faced with market signals, the response of firms in Polandwas generally in line with what would be expected from capitalist firms. Not allmarkets, however, developed evenly. The labor market especially has beenfragmented and this has limited restructuring. In product markets, too, newentrants have been hindered, most evidently in international trade. But theproblem is not one of conventional monopoly power exercised through market size,but rather created by a network of long-term interfirm contracts and creditlinks, and the absence of accepted norms in the conduct of business relations.The development of a competition policy to redress such barriers is only juststarting to take effect.

Although there was a major demand reduction as part of the Polish program,the effects on firms were not fully felt for a period of over a year. Firms hada cash-flow cushion stemming from extraordinary gains resulting first from theerosion of their debts during hyperinflation and then from capital gains on goodsin inventories following devaluation. Coupled with selected subsidies, thesegains enabled firms to survive and even show accounting profits. However, thebreathing space that was provided to firms was lost. Two reasons stand out forthis. First, internal resistance to change by managers was evident, especiallyin the largest firms. Second, there was insufficient progress in supportingsmall firms and foreign investors. More and quicker government action in boththese areas would have been desirable, through, for example, the introduction ofnew forms of corporate governance, and of more mandatory requirements formanagers to prepare restructuring; programs and business plans and participate inmanagerial technical assistance programs. Instead, the pressure to restructurehas been left almost exclusively to macroeconomic forces, leading to a dangerouscoalescing of political opposition to the stabilization program.

- 37 -

IV. Government Indirect Assistance for Restructuring.

There are two principle areas where the government has an indirect role inassisting restructuring: developing a public investment and infrastructureprogram that, will help revitalize Polish industry; and mobilizing the foreignassistance necessary to finance restructuring on a large scale. At present, thepublic investment program is in disarray. Capital expenditure in the Statebudget fell from 3.3 to 2.6 percent of GDP between 1989 and 1990, as the oldsystem of centrally planned and approved projects was abandoned, withoutalternative procedures to replace it. But the government cannot leave largeinfrastructure development completely in private sector or state enterprise handsand expect sufficient investment in this sector.

The government has also taken a hands-off approach towards foreign creditflows into the country, with a cautious attitude towards granting creditguarantees or easing disbursement bottlenecks. Its approach can be characterizedas agnostic: if a good project is prepared by a firm and accepted by a bank, itshould be financed without need for government intervention; if not, then macroconsiderations should not be introduced to artificially interfere with projectanalysis. In this way, the government has tried to keep from becoming involvedin foreign credit issues. But this attitude cannot be sustained over a longperiod of time because, regardless of the official policy stance, privatedecisions will affect the budget in major ways. As long as enterprises and banksare still socialized, the government continues to bear commercial risk anddirectly suffers from any bad project, whether or not it has extended a guaranteeon the foreign credit. Thus, to make the basic approach work two operationalissues must be addressed: the public role in project identification, analysisand implementation; and the public role in mobilizing foreign assistance.

Public investment and infrastructure spending

The waste and inefficiency of the old centralized investment planingprocess has led to its complete abandonment in Poland, and a decentralization ofinvestment decision-making. For most products, this was appropriate, given thegenerally positive response by firms to market signals. But some goods, notablyin infrastructure, the environment, and social areas have a "public goods"nature, where there are many members of the public who benefit from the projectat the same time, but where it is neither possible nor desirable to charge thefull cost to the consuming public; sometimes because it is difficult to establishbeneficiaries, and sometimes because the process of charging requires setting upadditional high-cost mechanisms (such as toll booths) which act as a deadweightloss to society. Most countries, but not Poland today, have a systematic planfor projects in these areas. The public sector must define and play a new,active role in the identification, analysis, financing and implementation ofprojects 'public goods" projects. With this centralization, public procurementpractices must also be opened up to ensure that investments are efficiently made.

- 38 -

Infrastructure is perhaps; the largest neglected sector in Poland. Thereis growing evidence that without public sector investment in infrastructure,private sector investment in all sectors will lag. Although many advancedcountries are turning to private participation in infrastructure, via Build-Operate-Transfer schemes for example, in most countries it is governments whichmust initiate infrastructure investments because private companies, unable tocharge enough for the service, will not do so. In Poland, state enterprises willnot undertake infrastructure investments on their own unless the government paysthem to do so, or supports them financially in some way.

In Poland, establishing a growth-oriented public sector role in developinginfrastructure is particularly important as local financial markets are not welldeveloped, and do not allow for a careful tailoring of financing payments tocash-flow receipts, as in advanced developed countries. Infrastructure projects,with their long gestation and uncertain revenue stream, are particularly hard tofinance without government participation. In these circumstances, leavinginvestment up to enterprises will result in an ad hoc collection of projects, andsignificant underinvestment in infrastructure from a social standpoint. Indeed,the aggregate amount of infrastructure investment being proposed for Poland seemstiny in comparison with other countries, and relative to the needs of theeconomy. Most rapidly growing rniddle-income developing countries spend in therange of 6-10Z of GDP on infrastructure annually, just to prevent bottlenecks togrowth from emerging. In Polan,d's case, there is also a backlog of spendingbecause of the wastage of the past.

Infrastructure is also likely to be the glue that cements Poland's newtrade relationships with the West. Without an adequate infrastructure base,especially in telecommunications and industrial parks with modern businessfacilities, Poland cannot hope to attract foreign investment or halt the outwardflow to advanced regions of domestic investment and skilled labor as has happenedto other backward Western European regions. The EC offers direct investmentsubsidies to offset the disadvantages of backwardness. New foreign capitalinvestments in export-oriented mianufacturing projects located in Portugal, forexample, receive in subsidies almost 502 of the investment cost. But mostexplanations of why backward regions fail to attract new inflows of capital inan environment of liberal trade emphasize the interaction of economies of scaleand "transport" costs (including all the direct and indirect costs of exporting).If transport costs can be made sufficiently low through investment ininfrastructure, then the backward region stands to gain as companies exploit itscheap labor25.

In the past, public investment in Poland took the form of projects actuallycarried out by the government, and centrally sponsored projects for which directtransfers from the budget and credit guarantees would be given. Governmentprojects were largely restricted to the social areas. including education, whilecentrally sponsored projects included the core infrastructure and industry areas:

25 See Krugman and Venables, 1990, as an example.

39 -

for example, mining, electricity generation, water and urban transport. Budgettransfers to centrally sponsored projects were only one (typically minor) sourceof finance; in addition, enterprises provided their own finance and obtainedcredits from the banks, guaranteed by the budget.

By 1990, centrally sponsored investment became limited to those projectswhere continuation to completion was economically justified. New start-ups wereexcluded, both because of budgetary limits and because of a philosophy ofdistancing the government from investment. In this way, industrial and majorinfrastructural investment has become decentralized to the enterprise level.Enterprises must decide directly on viable projects, and finance and implementthem themselves. The result has been a sharp fall in investment in 1990, and analmost total absence of direct government financing and participation ininvestment projects, or vetting of projects through the budget.

In the Ministry of Industry and the Central Planning Office, thisminimalist public approach is being modified by efforts to sway the orientationof enterprise projects in particular directions. The government established aCommission for the Coordination of Foreign Assistance and Credits, which in 1990reviewed some twenty large projects with about $700 million in foreign exchangecosts, in order to recommend whether or not a government guarantee should begiven (the Economic Committee of the Council of Ministers makes the finaldecision). The Central Planning Office, acting as the secretariat for theCommission, has established priority guidelines for recommending extension of aguarantee. These guidelines, based on macroeconomic criteria, aim to boostexports, modernize the energy sector, and rationalize key heavy industry andtransport sectors. The CPO has estimated that the Polish economy can absorbloans amounting to about $6 billion over the coming 3-4 years. This estimationis not, however, based on microeconomic project analysis, but on a sketchymacroeconomic medium term scenario of investment prospects.

Each enterprise project for which a guarantee is requested must beaccompanied by the appropriate documentation including: a feasibility study bythe commercial bank providing the domestic loan; a second independent feasibilitystudy; a project evaluation prepared by the NBP on the balance of paymentsoutlook; a macroeconomic evaluation prepared by the CPO; and a budgetaryevaluation prepared by the Ministry of Finance. Ten of the twenty reviewedprojects were rejected. In addition, several of the approved projects have notbeen implemented because of deteriorating profitability conditions in the steelindustry and the financial weakness of the enterprises. Thus, there is noindication that implementation of large projects will soon lead to a fullutilization of foreign credits and guarantees.

In order to rationalize policy, the Ministry of Industry is supporting anumber of subsector studies (energy, textiles, heavy chemicals, steel, cement andcomponents and packing industries have been identified as priority areas) toidentify the kind of projects worthy of public support (perhaps by selective useof public guarantees). Such an introduction of government "preferences' forcertain types of projects is insidious. But the emergence of this trend is an

- 40 -

indication of a vacuum that currently exists in defining the appropriate role ofthe government. The minimalist approach cannot survive the pressures buildingfrom all sides: foreign donors who are keen to see new projects started; domesticpoliticians keen to restart growth; and state enterprises who see a potentiallyattractive source of credit in foreign assistance lines.

Even where projects are directly financed by the budget, the existingprocess is not efficient. At present, each Ministry presents a separate wishlist of projects which is then pruned to meet the restricted dictates of thebudget. Given their limited expectations for project financing, the Ministriesmay not even submit a comprehensive list of desirable projects. Currentinvestment planning procedures only coordinate each Ministry's investment programin a cursory fashion; neither intersectoral resource allocations nor the overallfinancial needs of the economy are adequately assessed. These functions arecarried out in most other countries as part of the budgetary process.

One implication of the present system is that the budget is almostincidental to investment spending. As a result, appropriate budget proceduresfor handling investment have not been developed, and the government role inproject identification, selection and implementation is ineffective. Acomprehensive public investment program, focused on infrastructure, environmentalimprovements and rural development investments, to be implemented by thegovernment and by state enterprises, should be the centerpiece of a new approach.

Public sectors throughout the world have traditionally used investmentprogramming to support macroeconomic goals. For example, governments throughoutEast Asia have used large infrastructure programs to provide a competitive edgeto private sector firms. In Taiwan in the early 1970s, the Ten Major Projectsgave a clear indication of the scope and direction of public intervention in theeconomy. At the same time, commitment to an infrastructure program provided atangible indication of the government's growth orientation and a boost for theprivate sector. Even earlier in the 1950s and 1960s, Taiwan used its extensiveforeign aid largely (about two-ithirds) for infrastructure and human resourcedevelopment. Poland now faces a similar opportunity to use foreign finances foran expanded public investment program: debt reduction would free up resources forthe domestic financing costs, while new foreign credits would finance the foreignexchange costs.

Institutionally, improving the public sector's ability to identify, analyzeand implement infrastructure projects should be given high priority. Theprojects could be phased in a three-year rolling investment program withindicative financing sources assigned to each project. Many countries preparejust such a list; the bureaucratic requirements to prepare it are not tooonerous. The three year program allows a review of the overall size of thepublic investment program over time, to ensure that the stream of projects isrelatively smooth; otherwise there is a danger that a few large projects cancreate a lumpy investment profile that can generate undesirable macroeconomiccycles. The public investment program also provides an instrument for reviewingintersectoral resource allocations (for example, environmental improvement versustelecommunications).

- 41 -

Although the amounts that could be spent on a public investment programwould have to be built up from a detailed list, it seems evident thatenvironmental improvements and infrastructure needs are enormous. Given thenecessity to integrate with Europe, 61 of GDP should be considered a minimumpublic investment target in Poland; the foreign exchange requirements from thislevel of investment would be on the order of 2 billion dollars a year, wellwithin the range of already comnitted official funds. Spending of amounts ofthis magnitude would require the institution of improved public procurementpractices and project monitoring and management capabilities.

Mobilizing foreign assistance

Poland received offers of over US$10 billion in assistance from the Westin 1990, in the form of grants (1.1 billion), official loans (3.8 billion),export credit guarantees (over 4 billion), and stabilization and balance ofpayment support loans (1.7 billion). Only $257 million in grants and $428million in loans was actually disbursed in 1990 (Table 9); these figures are inlarge part a reflection of a gap between the willingness of the West to assistPoland's jump to a market economy, and the current absence of channels to linkthese funds with investment projects. Poland can ill afford to leave these fundssitting idle: they can be better employed for building infrastructure andmodernizing industry in an effort to integrate the Polish economy with the EC.

It is natural to expect a low level of disbursements in the periodimmediately after major new commitments have been made, while new projects arebeing initiated. As projects mature, there will surely be some increase in thelevel of disbursements during 1991. The current macroeconomic frameworkenvisages an increase from $428 million of gross MLT loan disbursements in 1990to $1.1 billion in 1991. These projections, however, are rough estimates oftargets: they are not based on a detailed examination of investment projects orthe demand for foreign funds. Conversely, the size of the public investmentprogram has been determined independently of the strategy towards using foreignfinancing. As a result, the working assumptions for using foreign assistance aretoo modest relative to the potential and too optimistic relative to the likelyoutcome if current investment and project financing procedures are leftunchanged.

Because there is no separate capital budgeting process, the demand forforeign financing for government investment projects is very low. Indeed, theonly source of foreign assistance to enter the budget is counterpart funds fromthe World Bank's Structural Adjustment Loan, which is not linked to projectfinancing at all. In contrast, most other countries use a sizeable portion ofofficial loans and credit guarantees to fund public infrastructure projects.Poland cannot do this because big ticket items like telecommunications, airportsand the like are enterprise investments, not government investments. Publicinvestment in the budget is only about 3% of GDP; more than half of this isdirect transfers to district and local governments, and other importantcomponents relate to transfers to enterprises for central investment projects andrepayments to banks of guaranteed credits. Consequently, the central governmentitself spends very little directly on imported goods. Hence, relative to othercountries, government demand for foreign project financing is minimal.

- 42 -

Enterprise demand for foreign funds has also been low. There appear to bea number of factors behind this. First and foremost, total investment in Polandhas been low because of the macroeconomic situation. Most of the foreign creditsare for investment purposes, yet total imports of capital goods from the West in1990 was only about 1.2 billion dollars. This is tiny compared to Poland's needsfor modernization and suggests that structural factors are impeding investmentand disbursements of foreign credits.

The immature state of the banking sector reduces possibilities for foreignproject financing. Most of the foreign credit guarantees require thecounterguarantee of a recognized Polish bank or, in the case of large Hermescredits and US Ex-Im credits, the Ministry of Finance. Currently, the BankHandlowy is the preferred guarantor for the foreigners. But the Bank Handlowyclient base consists of major trading enterprises rather than producers. Hence,most of the Bank Handlowy business is in trade finance, whereas a sizeableportion of foreign assistance is for project finance. The investmentrequirements of the trading enterprises are limited, while the Bank is unwillingto expand its client base to include producers because at present it has littleexperience in project evaluation and no hard information on the commercial statusof new clients. Thus, the easiest route by which to access foreign funds,through Bank Handlowy, is underutilized.

One way around this obstacle would be for Bank Handlowy to guarantee aforeign credit for a project financed by another Polish bank. But this is alsorare. Banks in Poland have little experience with fee-based services such asguarantees. There are no guidelines on how much capital reserve would beallocated to such a transaction. And the allowed margins on foreign credits, ofup to 3Z, are low, so introduction of another tier of intermediation, charginga guarantee fee, makes the loan unattractive to the originating bank. The lowfee also makes it more profitable for banks to lend in zloty, where margins aremore typically 7Z, rather than in foreign currency. Given the presence ofconvertibility, the borrower has no difficulty in funding imported equipmentpurchases with zloty loans.

Large investment projects carry additional risk for the banks. The moreinnovative banks, such as the Export Development Bank, do not have the capitalbase to finance large projects, especially where the equity of the borrowing firmis small and its financial status uncertain. There is limited experience inPoland with risk-sharing amongst banks, through syndicated loans for example.So for large projects, there is increasing pressure from domestic and foreignbanks for a guarantee from the MoF or NBP.

It is clearly in the national interest to use preferential credits to thefullest extent possible. The Spanish loan is fully committed in the Alcatel andother deals; more than half of the Italian credit offering 1.75Z interest over20 years has also been committed; but the 2% French credit for Polish/Frenchjoint ventures and the US PL480 credit have been slower to move because of a lackof market interest. Few French investors have been active in Poland; and thegrain and rice that are eligible for PL480 financing have received littledomestic interest. Where preferential credit is extended, donors request Polishgovernment endorsement of the project as being in line with national priorities.

- 43 -

Improving project financing. All projects that appear in the publicinvestment program could be eligible for a government guarantee even if theimplementation is to be left to enterprises. As far as possible, the governmentwould want a local bank to give a guarantee as well. But it must be recognizedthat few infrastructure projects yield high returns or positive cash flow in theearly years. As commercial propositions they are not very attractive and bankswill be unlikely to provide guarantees (except under pressure from the MoF orNBP). In addition, many enterprises undertaking infrastructure projects (suchas the Airport authority) lack an adequate basic financial structure and arequite limited in their capacity to raise domestic counterpart funds for localproject costs and operation and maintenance expenditures. So governmentinitiation of projects may have to be combined with budgetary appropriationsbeyond the simple guarantee of an external loan. Savings from debt serviceobligations could be used for this purpose.

The government can also assist private firms in taking advantage ofavailable foreign credits where these do not involve guarantees. First, itshould provide better information to firms on the availability and conditions offoreign loans. At present, the information flow is sparse. Individual loans andcredit guarantees are gazetted, and individual banks put out lists of loans inwhich they participate. But no banks participate in all loans, so there is noreadily available summary of what is available. The NBP ought to publish sucha summary and circulate it to the banks and the chief financial officers of thetop 500 firms with updates every quarter. Second, the government could use thesubstantial amount of external technical assistance it receives to help firmsutilize foreign credits better. The foreign (and local) experts in the PolishAgency for Industrial Development should be made aware of external financialassistance and factor its availability into their restructuring advice. Now,there is a complete division between the technical assistance and financialassistance programs. In this way, technical difficulties in preparingappropriate market or feasibility studies could be overcome. Third, thegovernment could eliminate systematic differences in the spread allowed the banksin their onlending of foreign and zloty currencies. Given the convertibility ofthe zloty there is no reason for the three percent onlending cap on foreigncurrencies that is currently imposed.

V. Concluding Remarks

This review of industrial developments in Poland in 1990 suggests thatthere has been a significant amount of real restructuring of industry when viewedfrom a macroeconomic perspective. This experience has exploded many myths of howsocialist economies would behave when faced with market signals and pressures.Foremost amongst these myths are:

. that there are no entrepreneurs to exploit the efficiency gains frommarkets allowing arbitrage, trade and free production. In Poland, the growth ofthe private sector has been rapid and a myriad of new businesses have beencreated.

- 44 -

that it would be impossible to export to the West because (i) firms didnot respond to the profit motive and would not seek out new markets; (ii) laborand capital were immobile; (iii) monopolists would seek to exploit domesticmarkets and (iv) quality was too poor for Western tastes. In fact, Polishexports to the West have grown faster than those from any other country in theworld.

. that major bankruptcies would occur and cause social unrest if firms wereexposed to international competition. Thanks to devaluation and wage control inPoland, quite the opposite has happened; bankruptcies have been few, althoughthey are likely to accelerate as firms are faced with additional price and demandshocks from the disintegration of the CMEA trade bloc.

. that the oligopolistic position of many industries would createstagflation. In fact, inflation appears to have aligned domestic prices withforeign prices. Domestic profitability margins have been very flexible.

. that stabilization would starve enterprises for cash and halt neededmodernization investments. E:nterprise domestic investment was relativelyprotected during stabilization, and imports of investment goods from the Westhave grown rapidly.

The restructuring news has not, however, been all good and several painfullessons have been learned. It has proven difficult to import many Westernmechanisms for managing the industrial transformation. Efforts to imposefinancial performance criteria (the dividenda) on enterprises as a tool formanaging them from the center, which may be successful where there are few statefirms operating in a largely private sector economy, have been ineffective inPoland. There are too many leakages in the system for such financial tools toreflect the true position of enterprises. Meanwhile, the large number ofenterprises precludes more detailed central evaluation.

Privatization is another area where Western techniques have been tried, butfailed to live up to expectations. Case-by-case valuations have been expensive(in terms of the time of professional management and legal counsel) and slow.Foreign investor interest has also been low. High hopes were pinned on foreignprovision of cash and expertise. But it is clear that foreign investment willwait for stability and improved physical and financial infrastructure. It mayaccelerate restructuring once the basis for long-term recovery is in place. Butforeign investment is not likely to be an instrument for initiating industrialchange. Equally, it has been hard to disburse the significant amounts of foreigncredits made available to Poland, because of the absence of true commercialbanking in the country. Ironically, the development of new businesses which isat the heart of the restructuring process cannot be easily supported by Westerncredits because the creditworthi.ness of new borrowers is less than that of theknown state enterprises and trading organizations.

- 45 -

At a microeconomic level, there is much less evidence of restructuring.Productivity has fallen, labor has proven to be immobile, the labor market hasfragmented, and management in large enterprises has systematically resistedchange. One important lesson is that enterprise organization and culture,especially in the large enterprises, have been unresponsive to new marketsignals. Politically, the government has been unable to distance itself fromenterprise performance, and has remained under pressure to use macroeconomicinstruments and case-by-case interventions to bail out firms. However, despitethis, the government has been reluctant to mandate any changes in enterprisebehavior, through privatization, development of time-bound restructuring andbusiness plans, and participation in managerial technical assistance forinstance. This reluctance stems from the desire to avoid charges of centralizedcontrol over firms, which had been blamed for the crisis under the previousregime; but managerial autonomy without clear financial separation of the statehas hampered restructuring.

Strategically, the government remains ambivalent in its industrial policy.On the one hand, it has acted as a support to existing business: the drivetowards enterprise closure and deconcentration has been slow; sector studies,modernization credit guarantees and the like are evidence of a commitment tosupport firms; and privatization has remained on a voluntary basis. The essenceof this strategy is to keep profitability high through macroeconomic means,allowing enterprises to accumulate capital and restart growth.

On the other hand, the government has acted as a force for change:preferential credits have been granted to the private sector while squeezingstate enterprises; a new competition policy has been initiated; and there is acommitment to mass privatization. This strategy emphasizes the growth of newfirms and the strangulation of existing state enterprises. These two forces arefundamentally opposed; the likelihood is that industrial policy will have severalstop-go periods as it evolves as a balance between the two. But the experienceof countries such as Taiwan and Korea shows that growth and dynamism can bestcome about by favoring new firms; it is not necessary that existing firmssuddenly turn around and prosper. Indeed, if what are now state enterprises canbe simply constrained, to continue as they are without absorbing more resources,it is almost sure that new firms will create adequate industrial growth.

The basic task of industrial restructuring in Poland is enormous, but notwithout parallel: "in an economy which had no real tradition or experience in thebasic aspects of democratic capitalism, it was necessary to carry through a broadprogram, breaking down old control structures on the one hand while at the sametime building legislative and ownership foundations upon which a competitive,private enterprise economy could be established."26 These words are asapplicable to Poland today as they were to Japan in 1949. The Japanese miracleshows that the tension between the disruption caused lv a radical reorganizationof industry and the stability required for industrial rehabilitation can bemanaged successfully.

26 Economic and Scientific Section, U.S. Occupation Forces, Japan, 1949.Quoted in T.A. Bisson (1954).

- 46 -

REFERENCES

Baden-Fuller, C.W.F. (1989) "Exit from Declining Industries and the Case ofSteel Castingsh The Economic Journal, 99, 949-61.

Bisson, T.A. (1954) 'Zaibatsu Dissolution in Japan".

Calvo, G. and F. Coricelli, (1991) "Stagflationary Effects of StabilizationPrograms in Reforming Socialist Countries: Enterprise-side vs.Household-side Factors', mimeo, World Bank.

Collins, S. and D.Rodrik, (1991) "Eastern Europe and the Soviet Union inthe World Economy,' mimeo, Institute for International Economics,Washington D.C.

Commission of the European Communities (1987), "The Regions of theEnlarged Community: Third Periodic Report", Luxemburg, Office forOfficial Publications of the European Community.

Economic Commission for Europe, (1989) "Economic Survey of Europe in1988-89", United Nations, New York.

Geroski, P.A. (1989), "European Industrial Policy and Industrial Policy inEurope" Oxford Review of Economic Policy, Vol.5 No.2.

Hansson, A.H. (1991), "Are East European Industrial Enterprises Too Big orToo Small?', mimeo, World Institute for Development Economics Research,Helsinki.

Higgins, M. (1990), "Consumer Prices and Inflation in Poland", mimeo, WorldInstitute for Development Economics Research.

Hughes, G. (1990), "Energy Policy and the Environment in Poland, EuropeanEconomy, Commission of the European Communities.

Kolodko, G. (1989) "Stabilization Policy in Poland - Challenges andConstraints', Institute of Finance, Working Paper No. 3, Warsaw.

Kornai, J. (1990), 'The Road to a Free Economy", W.W.Norton and Co., NewYork.

Krugman, P.R. and A.J. Venables (1990), "Integration and theCompetitiveness of Peripheral Industry"; Center for Economic PolicyResearch, Discussion Paper 363.

Lipton, D. and J. Sachs (1990a), "Creating a Market Economy in EasternEurope: The Case of Poland", Brookings Papers on Economic Activity,1:1990, 75-133.

- 47 -

Lipton, D. and J. Sachs (1990b), "Privatization in Eastern Europe: The Caseof Poland," Brookings Papers on Economic Activity, 2:1990

Mardas, D. and N.Varsakelis (1990), "Greece" in European Economy: SocialEurope, Commission of the European Coimmunities.

Mayo, S.K. and J.I.Stein (1988), "Housing and Labor Market Distortions inPoland: Linkages and Policy Implications", Report INU 25, The WorldBank.

McKinnon, R.I. (1991), "The Order of Economic Liberalization: FinancialControl in the Transition to a Market Economy, Johns Hopkins UniversityPress, Baltimore.

Nuti, D.M. (1990), "Internal and International Aspects of MonetaryDisequilibrium in Poland", European Economy, Commission of the EuropeanCommunites.

Pinto, B., F. Coricelli and L.F. de la Calle (1990) "Poland: MacroeconomicPolicy in the Second Phase of the Reform Program" mimeo, World Bank.

Schaffer, M.E. (1990), "State-owned Enterprises in Poland: Taxation,Subsidization and Competition Policies", European Economy, Commissionof the European Communities.

Ward, B. (1958), "The Firm in Illyria: Market Syndicalism," AmericanEconomic Review, 68, 566-89.

United Nations, (1990), "Economic Survey of Europe, 1988-89", New York,United Nations.

Distributors of World Bank PublicationsANGINTINA fINAND MR3cO SOUT AFRICA, BOTSWANAC04Y ILid, SEL A _ KkIAhpp INPOTBC F-i.81.1mGimCiCum P.. am la Aputid Po" 224O U twd Umwu PhamFlud 144, 40 Ra 4/4I45 S540BI I4tOiOTWp2^,MedwD.F. Saibma AM..133351 AWA A1m10 PA. li 1141

MOROCCO Cuam £w7AUSTRALIA. PAPUA NMW GUI4 FPRANC saddEhd >1Mea" bacg.iFIlLSOLOMON ISLANDS. Wu Sa kPutUaiu. i2 maMiagi. Sd. rdAia Fatawqi &.VANUATU, AND WEStERN SAMOA 41. .wid'I Ci_bla= hadaatai b Aa1peaaSa kmDA.Ids&J Aw*b MIlIPuB P?O. DM 41095M5Wli_bm SA NETHIRLANDS CGIklM nnm 3120 GERMANY hAPulibbt... b.a 324VIdwia UNO-YVid P.O. Baa 14

tppdwf ADM SS 72f1 BA Lad. YAWAUSTrIUA DIXW Do= I MmdW-m,u tAb SACmdd i Ca NEW ZEALAND Cmb 37Groab31 CGSE N HM. UbmTy d bdla So, 5 F0 MadidA.i0i1wim KMO Puive Be

24. iaAmougS,0 71.1. Balom New. Maiki Lbredi blw..idaad AEOBAHRAIN AfIhuu0S Auddlid C-0 deCaL 301

Wrai Raew.h aid Comdi= OCBI u idAoaa td. GUATUDALA NiGRIA

PO 1aa 27 LUbrb. Piedr SlS UDDvwAy Pr tiaUtad S LANKA AND tHE MALIDVlSM m T*317 11 CilIk6 TbaaCu dIdajid LAS Nia Raa&abop

ZIa1 PFwvamAItBYSS rfOHb.244BANGLADESH CuaInMd C* d. lts. irQitmpdamA.Mini biWA DidapuAI GwdhMwatba

Am7 9dgy(M14 HONG IONC MACAO NORWAY 2He.m4. Said 14 Ads ltd. Ninsm. hiluba CAtitDia" 1Arm 44 Mydlw. _ 5a _ D 'aiNda SWEDENDbal 12t WIAl Caam PLO. O 6S 125 Ea*uMd Frsa.g 1ilm

sd ROW N41GO *0 Pi D FF&bo1mfanmg4oSmkoobw Ca,in1 H..4 ICaa6 Sqr m 12. SB 16356M Raid OMAN SK1w 7 .oihbdato"id"Co MDIA MRARBdim SicmoN aikl.* 3M Aid PuiAwni Pdtve lid. P.O. Boxaa 3. SebAkprt rwa. m.daa

751 Moaid AD" damu W e_WjihaAB76. XDA Aam. Madm. EWEOKUM&v PAKISTAN S10E 55eckh'A.

Fw_A 4fw Mini Sbk AgiyBEGIUM 15 I N. HNia MN$ ISI 5k bu. SWITzERLANDJew .e Lama SLl RiN PEO. iNO 720 mFiAv. du OLX 9-132 a) q-EOGe L*a.i3 IhinIaPryok101 Inomb 1. ,m cfa.

13/14 IA Aid PESOF C Fmpavi.361CANAOA Naw O-. I10to EWibiui DualDSA CH1U31 GC IIlaA.amt Apwtaa3024C.F.K1WSDI Awa. 17 0Ckway4m Avm Lim Fdwabawo awdaSuidmaidla v iLiAti.-7w072 t_&bPkJ 5RI FHIlIIP4U Swn deAmwamM

ayIdta Hmeadh 1" besawRlaN BookC C_paad3J12CWIA SO. Main Rad CadhihP FM ai. bpip. Uk Buidin CRItluswmCUM RUM"lil & RAsn $"dew- 540D M Ayii Aviut Mai

FWM*ftHa... Hdasaada TANZANIA%mosioDn iia 31329 Xad.WAada Cie Saoid Od Fd IW.Wi*yhui3*6 Hydw*md -50UP POLAND A SO I=S

ORPAN OwesaiSiaCOLOMBIA Pm*a RFa 2Sd Fair rai ICasNy I Naa1Wa-mii la1 N _eTbakmuS. Ni wW, r9_r Wa0 Wi THAIIANDAwd 3AD310 Amidbid -J3000 Gel DnawI=_ S

eagsDi. PORTUGAL 3xmSaidPada Houm L1wi PtA B_

COTB IVIOIS IAA k Ma LIM Do CA"" 074Caard'sdin amdDWmdom A1= - 2310 121Iiki TRDOAD& ,TOSAGO ANTIUA

AMCdo(CRDA SARSI7DA69ARSAMOS01.F. 541 INDONESIA SAUDI ARABLA. QATAR DOUWIA. GRENADA, GUYANA.Abdjia4C m Ft blN. I_dla J Back r SB u JAMAICA, MONTSEBAT. ST.

IL Sm R 3A7a P JO.i 3191 ZIvi NSI ST. WCIA.Cyr" ?.Oam Ile Slyid 11471 ST.VDWINET&GSRNADINEStDANS wumiN..Suo1m JibeN hadSueSabW

Nlam ITALY S_IAwCin. alaSsaida SFA AIAhaSWi Tbd.Wmdlm

DWMARU Vlr 1Du CAlih 120/0 Al Osa CmDSiAedAl Cwi PiibIlNR Pdi Paw UNIED ARA" EMIRATES

Mismp"D C 3125Fui r?.Li1 Id aW^iAN

DOMWNICAN RJSUSTC SN4uaSkSDv 4ANdSAl AimaI.dingUlI_ TmSm C pw 24 HwpaCD ly_ a 1 13 K1 lid ftem WNIIW IANGDOM

Si..mrad a b*h CadRe T31Td PAD. So 3UM_ I. Aptmd* Prd 2110 Disa PO. Li 3S_oonD_ XBWA AL1 _ HmWii..G34 25G

Akas S uv (BA)L 3Lid. ruMd NmmAw_dSNiASCU:Ar, AR SWVXSLC 01 PW an 4S PDA LiEaAl AM Ni )idd& V1ULAAlGaii__" thwIaa d EdmCa. NORRa.RstiUCO SDNGAFORXTAIWAN, Ap0.7

FM 11... BeiN C.pwoael MANMA2,111UNIA C.MIWO.TIml id San D A an 101. Ewegwhms bomaii. Pubrs_.41. u11 b Rd SmA Pdvua tLd VUJGSLAVU

Ca. 09411.1 fl P.1-F~~a Read 1a,m0. KajKUWAIT Sub PAReS

ELUALVADOR XMAdRSinmi Reak 24 Noaw Ihudu Ra TISipuRN.Piid Pr.e La SW Sp16PO 153 nS4Avwidu MioMi LriN1mA,m# i3

E4SO.SA.b.. FluMALAYSS

.dr UA- lid

PAL 117.7 Ja P

Recent World Bank Discussion Papers (continued)

No. 114 Using Knowledgefrom Social Science in Development Projects. Michael M. Cernea

No. 115 Designing Major Policy Reform: Lessonsfrom the Transport Seaor. Ian G. Heggie

No. 116 Women's Work, Education, and Family Welfare in Peru. Barbara K. Herz and Shahidur R. Khandker, editors

No. 117 Developing Financial Institutionsfor the Poor and Reducing Barriers to Accessfor Women. Sharon L. Holtand Helena Ribe

No. 118 Improving the Perfornance of Soviet Enterprises. John Nellis

No. 119 Public Enterprise Reform: Lessonsfrom the Past and Issuesfor the Future. Ahmed Galal

No. 120 The Information Technology Revolution and Economic Development. Nagy K. Hanna

No. 121 Promoting Rural Cooperatives in Developing Countries: The Case of Sub-Saharan Africa. Avishay Braverman, J. LuisGuasch, Monika Huppi, and Lorenz Pohlmeier

No. 122 Performance Evaluationfor Public Enterprises. Leroy P. Jones

No. 123 Urban Housing Reform in China: An Economic Analysis. George S. Tolley

No. 124 The New Fiscal Federalism in Brazil. Anwar Shah

No. 125 Housing Reform in Socialist Economies. Bertrand Renaud

No. 126 Agricultural Technology in Sub-Saharan Africa: A Workshop on Research Issues. Suzanne Gnaegy andJock R.Anderson, editors

No. 127 Using Indigenous Knowledge in Agricultural Development. D. Michael Warren

No. 128 Research on Irrigation and Drainage Technologies: Fifteen Years of World Bank Experience. Raed Safadi andHerv6 Plusquellec

No. 129 Rent Control in Developing Countries. Stephen Malpezzi and Gwendolyn'Ball

No. 130 Patterns of Direct Foreign Investment in China. Zafar Shah Khan

No. 131 A New View of Economic Growth: Four Lectures. Maurice FG. Scott

No. 132 Adjusting Educational Policies: Conserving Resources While Raising School Quality. Bruce Fuller and Aklilu Habte,editors

No. 133 Letting Girls Learn: Promising Approaches in Primary and Secondary Education. Barbara Herz, K. Subbarao,Masooma Habib, and Laura Raney

No. 134 Forest Economics and Policy Analysis: An Overview. William F. Hyde and David H. Newman, with a contributionby Roger A. Sedjo

No. 135 A Strategyfor Fisheries Development. Eduardo Loayza

No. 136 Strengthening Public Service Accountability: A Conceptual Framework. Samuel Paul

No. 137 Deferred Cost Recoveryfor Higher Education: Student Loan Programs in Developing Countries. Douglas Albrechtand Adrian Ziderman

No. 138 Coal Pricing in China: Issues and Reform Strategy. Yves Albouy

No. 139 Portfolio Performance of Selected Social Security Institutes in Latin America. Carmelo Mesa-Lago

No. 140 Social Security and Prospectsfor Equity in Latin America. Carmelo Mesa-Lago

No. 141 China's Foreign Trade and Comparative Advantage: Prospects, Problems, and Policy Implications. AlexanderJ. Yeats

The World Bank i)

Headquarters European Office Tokyo Office 4 sR1818 H Street, N.W. 66, avenue d'Iena Kokusai Building i______

Washington, D.C. 20433, U.S.A. 75116 Paris, France 1-1 Marunouchi 3-chomeChiyoda-ku, Tokyo 100,Japan a

Telephone: (202) 477-1234 Telephone: (1) 40.69.30.00Facsimile: (202) 477-6391 Facsimile: (1) 40.69.30.66 Telephone: (3) 3214-5001Telex: wui 64145 WORiDBANK Telex: 640651 Facsimile: (3) 3214-3657

RCA 248423 WORLDBK Telex: 26838Cable Address: INTBAFRAD

WASHINGTONDC

0

a)

0

C-

ISBN 0-8213-1966-3 9