Eastern Europe: Donor Assistance and Reform Efforts

Published by the Government Accountability Office on 1990-11-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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GAO                                       Report t,o the Chairmen, Committee on
                                          Foreign Relations, U.S. Senate, and
                                          Comtiittee on Foreign Affairs, House of

                                          EASTERN EUROPE
                                          Donor Assistance and
                                          Reform Efforts

---   8
National Security and
International Affairs Division


November 30,lQQO

The Honorable Claiborne Pell
Chairman, Committee on Foreign Relations
United States Senate

The Honorable Dante B. Fascell
Chairman, Committee on Foreign Affairs
House of Representatives

As East European countries move toward democratically elected governments and market
economies, U.S. decisionmakers are faced with determining appropriate U.S. assistance for
the region. This report provides information on international economic assistance to five
East European countries.

Western and Asian democracies, and the European Community, World Bank, and
International Monetary Fund, have made commitments of $8.5 billion to Poland and Hungary
and are planning assistance to other East European countries. Although conditions in the
region vary by country, economic growth in each is highly dependent upon private sector

We are sending a copy of this report to the Secretary of State and other interested parties.
Copies will also be made available to others on request.

This report was prepared under the direction of Allan I. Mendelowitz, Director, International
Trade, Energy, and Finance Issues, who may be reached on (202) 275-4812, and Harold J.
Johnson, Director, Foreign Economic Assistance Issues, who may be reached on (202) 275-
5790. Other major contributors to this report are listed in appendix I.

Frank C. Conahan
Assistant Comptroller General
Executive Summ~

                   The extraordinary and rapid developments in Eastern Europe represent
Purpose            a major turning point in Europe’s postwar history. As East European
                   countries now move from centrally planned economies to decentralized
                   market-based economies, the United States and other countries are pro-
                   viding assistance. To help decisionmakers in determining appropriate
                   US. assistance for the region, GAO is providing information on interna-
                   tional economic assistance to five East European countries-Poland,
                   Hungary, Czechoslovakia, Bulgaria, and Romania. Specifically, GAO'S
                   objectives were to determine (1) which countries and multilateral donors
                   are providing economic assistance, (2) what assistance is being pro-
                   vided, and (3) what the socioeconomic problems and opportunities are in
                   these five countries.

                   Because communist countries have never before made the transition
Background         from a planned economy with a one-party political system to a market
                   economy with a democratically elected government, there is no model
                   for doing so. However, East European countries are beginning to take
                   such steps as establishing market-based prices, reviving the private
                   sector, and restructuring the public sector. The United States and other
                   countries are providing assistance to facilitate economic and political
                   change and help maintain peace and stability in the region. Both the
                   public and private sectors in donor countries are providing assistance
                   through bilateral and multilateral arrangements.

                   The United States, Germany, Japan, Italy, France, and the United
Results in Brief   Kingdom are providing about three-fourths of the $8.5 billion in aid
                   committed to Poland and Hungary as of May 1990. Aid commitments are
                   in the form of grants, loans, credits, advice, and in-kind benefits. This
                   assistance covers a wide range of activities in such fields as economics,
                   finance, education, agriculture, and the environment. In addition, aid is
                   needed to encourage political reform.

                   Donor countries have moved quickly to provide assistance to Poland and
                   Hungary and to make plans for other East European countries. In addi-
                   tion, multilateral organizations, such as the World Bank, the Interna-
                   tional Monetary Fund, and the Organization for Economic Cooperation
                   and Development, have begun to provide aid.

                   Some of the major economic problems facing East European countries
                   are declining gross national products, large foreign debts, antiquated
                   industrial bases, and over-reliance on the Soviet Union, Conditions vary

                   Page 2                                         GAO/NSIAD-91-21   Eastern   Europe
                             Executive   Summary

                             by country, but all have economic growth potential. Growth, however, is
                             highly dependent upon substantial foreign investment. The region has a
                             large and relatively highly educated, low-paid work force and is highly

Principal Findings

Bilateral and Multilateral   Over 30 U.S. government agencies are providing almost $700 million in
Donors Provide Many          assistance to Poland and Hungary in areas such as economic stabiliza-
                             tion and structural adjustment; private sector development: trade and
Types of Aid                 investment; and educational, cultural, environmental, and democratiza-
                             tion efforts.

                             The European Community and other donor countries are assisting
                             Eastern Europe in the areas of agricultural and environmental develop-
                             ment, training, and investment. Multilateral assistance includes estab-
                             lishment of (1) the $1 billion Polish Stabilization Fund to support
                             Poland’s currency as the government undertakes economic reforms and
                             (2) the European Bank for Reconstruction and Development, which will
                             provide loans for private sector projects, infrastructure development,
                             and environmental efforts.

                             Poland and Hungary both have economic stabilization arrangements
                             with the International Monetary Fund. The arrangement with Poland
                             was completed in February 1990 and authorizes purchases up to $723
                             million to support the government’s economic program aimed at
                             decreasing the rate of inflation and promoting a market economy. The
                             arrangement for Hungary, approved in March 1990, authorizes
                             purchases up to $206 million to support the government’s efforts to
                             reduce domestic and external economic imbalances during the process of
                             restructuring the economy.

                             The World Bank has provided $781 million in project loans to Poland,
                             primarily for environmental, energy, and transportation activities and
                             to support private sector export promotion and agroprocessing indus-
                             tries. The Bank has provided Hungary with three project loans,
                             amounting to $366 million, to support Hungary’s structural adjustment
                             program and to modernize and expand agricultural enterprises and the
                             banking system.

                             Page 3                                        GAO/NSIAD-91-21   Eastmn   Europe

Economic Problems and   Enterprises in the East European centrally planned economies were
Opportunities           organized as large, state-owned monopolies. In the traditional centrally
                        planned economy, virtually all the means of production are turned over
                        to state ownership. The state’s central authorities plan for the inputs
                        and outputs of state-owned enterprises, with inputs generally being cen-
                        trally allocated. Virtually all prices are fixed by the central planners,
                        and foreign trade is controlled by state-owned organizations. These
                        industries suffer from outdated technology, lack of competitive incen-
                        tives, and shortages of production materials, resulting in low produc-
                        tivity rates. The East European countries have had little experience
                        with commercial banking and securities markets, and their currencies
                        have been nonconvertible, thus limiting trade and investment.

                        Reforms are underway, but the process of developing the financial sys-
                        tems that can aid domestic economic growth will be slow. Most of the
                        countries in Eastern Europe-particularly   Poland and Hungary-have
                        large foreign currency debt levels which severely limit their ability to
                        resolve domestic economic problems.

                        The countries also face massive infrastructure needs. Roads, telecommu-
                        nications, railways, and port facilities are inadequate for expanded
                        international trade. Years of depending on heavy industry for develop-
                        ment, relying on environmentally damaging high-sulphur coal for power,
                        and refusing to control or treat hazardous wastes have extensively dam-
                        aged vegetation and water resources and have begun to affect health.
                        Pollution-related cancers and infant mortality are increasing, as are the
                        number of people dying from environmentally induced diseases. Health
                        standards in general are considerably lower throughout the region than
                        in Western Europe.

                        Per capita gross national product of the East European countries
                        remains considerably below that of the United States, and standards of
                        living are far below those of most West European countries. Key indica-
                        tors of availability of common consumer goods show that East European
                        standards parallel those of Greece and are a bit ahead of some Latin
                        American countries.

                        Although conditions vary by country, the combination of comparatively
                        low pay and high skill levels in a large labor pool of relatively highly
                        educated workers offers opportunities to attract development capital.

                        Despite the immediate socioeconomic costs in undertaking economic
                        structural reform, the East European countries must undertake certain

                        Page 4                                         GAO/NSIAl%Bl-21   Eastern   Europe
                  Executive   Summary

                  fundamental measures if they are to succeed in establishing and sup-
                  porting a market economy. The success or failure of donor assistance to
                  these countries depends at least as much on the host governments’
                  implementing economic reform measures as on ensuring the effective-
                  ness of the assistance strategies. The countries must place greater reli-
                  ance on market-based prices, revive their private sectors, establish
                  financial markets, and improve their infrastructures. Over time, the suc-
                  cess of these efforts will undoubtedly vary among the countries, sug-
                  gesting that a long-term perspective will be needed to assess the success
                  or failure of donor assistance.

                  In this report GAO provides information on bilateral and multilateral
Recommendations   assistance to five East European countries. GAO is making no

                  GAO   did not obtain written agency comments on a draft of this report.
Agency Comments   However, during the course of the work GAO discussed its findings with
                  officials of the Department of State who have been charged with coordi-
                  nating all U.S. government assistance to East European nations. GAO has
                  incorporated their comments in this report where appropriate.

                  Page 6                                          GAO/NSL4B91%1EastemEurope

Executive Summary                                                                                        2

Chapter 1                                                                                                8
Introduction             Objectives, Scope, and Methodology                                             10

Chapter 2                                                                                               12
Donor Assistance and     U.S. Bilateral Programs and Efforts
                         European Community Assistance
Investment               Other Multilateral Programs and Efforts                                        22

Chapter 3                                                                                               27
Socioeconomic            Economic Overview
                         Economic Potential
Conditions and           Future Steps Necessary                                                         36
Reform Efforts in East
European Countries
Appendix                 Appendix I: Major Contributors to This Report                                  40

Tables                   Table 2.1: Donor Aid Commitments to Poland and                                 13
                         Table 2.2: Type of Donor Aid Commitments to Poland and                         13
                         Table 2.3: SEED Fiscal Year Appropriations and                                 15
                         Table 2.4: Western Joint Ventures in Eastern Europe                            20
                         Table 3.1: Annual Growth in Real Output                                        30
                         Table 3.2: Hard Currency Debt of Five East European                            33
                         Table 3.3: Availability of Consumer Goods                                      34
                         Table 3.4: Estimates of 1989 Per Capita Gross National                         34
                         Table 3.5: Measures of National Health                                         35

Figures                  Figure 1.1: Five East European Countries                                        9
                         Figure 3.1: Gross Domestic Product Growth in Five East                         28
                              European Countries
                         Figure 3.2: Labor Productivity in Five East European                           29

                         Page 6                                          GAO/NSIADBl-21   Eastern   Europe


AID        Agency for International Development
CMEA       Council for Mutual Economic Assistance
EBRD       European Bank for Reconstruction and Development
EC         European Community
ECU        European Currency Unit
GAO        General Accounting Office
GDP        gross’ domestic product
GNP        gross national product
IMF        International Monetary Fund
OFKD       Organization for Economic Cooperation and Development
OPIC       Overseas Private Investment Corporation
SEED       Support for East European Democracy
U,N,       United Nations

Page 7                                       GAO/NSIAD-91.21   Eastern   Europe
Chapter 1                                                                       ,


               The long-term goal of U.S. policy in Eastern Europe is to encourage the
               region’s economic and political integration into the democratic world
               and thus end the division of Europe that followed World War II. The
               policy is being pursued by providing assistance to East European gov-
               ernments on an individual basis.

               The extraordinary and rapid developments in Eastern Europe (see fig.
               1.1) in 1989-90 constitute a major turning point in Europe’s postwar his-
               tory. Most of the peoples of Eastern Europe have made it clear that they
               wanted a radical and decisive change in the way their political and eco-
               nomic affairs were conducted. As a result, the ruling Communist parties
               were compelled to share or to relinquish power in Poland, Hungary,
               Czechoslovakia, Bulgaria, Romania, and East Germany, which are now
               moving, at varying rates of progress, towards pluralistic forms of gov-
               ernment and decentralized, market-based economies.

               At the beginning of 1989, only the governments of Poland and Hungary
               were committed in principle to far-reaching changes, and even they were
               hesitant to implement significant aspects of the reforms they had prom-
               ised. Governments in the other countries either had promised reforms
               that were only being implemented on a piecemeal basis or had denied
               the need for reform whatsoever. By the end of 1989, the drive for
               reforms had accelerated rapidly in Poland and Hungary, and most of the
               other countries were committed to some transformation of their eco-
               nomic and political structures, Economic and political changes in
               Eastern Europe occurred for many reasons, including declining stan-
               dards of living and disappointment in the progress of economic reform;
               a desire for democratic, pluralistic governments; and the withdrawal of
               Soviet political and military support for the indigenous Communist

               Page 8                                         GAO/NSIAD-91-21   Eastern   Europe
                                           Chapter 1

Figure 1.1: Five East European Countries


                                           Note: The US government has not recognized the incorporation of Estonia, Latvia, and Lithuania into
                                           the Soviet Union. Other boundary representation is not necessarily authoritative.

                                           Throughout 1990, the East European countries faced a formidable array
                                           of problems, including the need to restore political and social stability
                                           while implementing economic stabilization and structural adjustment
                                           programs. While the political changes were dramatic and rapid, the pace
                                           of economic change is inherently slower. Because of variances in their

                                           Page 9                                                          GAO/NSIAD-91-21      Eastern   Europe
                        Chapter 1

                        economic and political situations, each government undertook a some-
                        what different approach in implementing necessary economic reforms.
                        The reforms generally included a number of measures to convert from a
                        planned to a market economy, such as

                        establishing market-based prices,
                        reviving the domestic private sector while encouraging foreign
                        restructuring the public sector,
                        establishing financial markets and improving financial systems, and
                        integrating their economies with international markets.

                        At the same time, these governments are also faced with the needs of
                        wide-ranging infrastructure restoration, which includes rebuilding tele-
                        communications and transportation systems and undertaking costly
                        environmental cleanup measures.

                        Our objectives were to determine (1) which countries and multilateral
Objectives, Scope,and   organizations are providing economic assistance to five East European
Methodology             countries, (2) what assistance is being provided, and (3) what socioeco-
                        nomic problems and opportunities exist in Poland, Hungary, Czechoslo-
                        vakia, Romania, and Bulgaria. The availability of information
                        concerning donor assistance and socioeconomic conditions varies for
                        each country. Statistics are often unreliable and/or unavailable and are
                        gathered and reported differently than in the United States and other
                        industrialized countries. East European data have often been modified
                        for political considerations. However, we believe that the data can indi-
                        cate general trends and thus are of some use.

                        We did not include East Germany in our review since German reunifica-
                        tion makes its economic and political situation unique. Also, we have
                        retained the term “Eastern Europe” rather than the frequently used
                        “Central and Eastern Europe” because Germany is part of Central
                        Europe and would be an exception to virtually every generalization
                        about the economic condition of the region.

                        In undertaking our assessment, we reviewed documents and interviewed
                        officials of the Departments of Commerce, State, and the Treasury and
                        the Agency for International Development (AID) concerning their
                        involvement in setting policy and planning and coordinating assistance
                        for Eastern Europe. We also interviewed officials of the Federal Reserve
                        Bank of New York to determine their assessment of western financial

                        Page 10                                        GAO/NSIAD-91-21   Eastern   Europe
Chapter 1

institutions’ investment in the region. We obtained information from
U.S. embassy officials in Bonn, Warsaw, Budapest, and Prague. In Buda-
pest, we interviewed Hungarian officials to obtain their opinions on
their reform efforts and assistance needs.

We interviewed officials of the European Community (EC) in Brussels,
the Organization for Economic Cooperation and Development (OECD)in
Paris, and the International Monetary Fund (IMF) and International Bank
for Reconstruction and Development (World Bank) in Washington, DC.,
to determine what assistance is needed by European nations and what
role and aid their respective organizations are providing. We also spoke
with officials from the U.S. missions to the EC and the OECDto obtain
their assessment of the economic and political changes occurring in
Eastern Europe and to get information on U.S. efforts to coordinate
donor assistance to the region.

Representatives of U.S. and West German institutions and foundations
provided us with their opinions on U.S. and West European geopolitical
and economic goals in Eastern Europe and shared the results of their
research on the economies and reform efforts of the region. Similarly,
representatives of U.S. commercial and investment banks provided their
views on the outlook for lending and investment activities in Eastern
Europe. We analyzed documents, studies, books, and reports on the East
European economies and reform efforts.

We did not obtain written agency comments on a draft of this report.
However, during the course of the work we discussed our findings with
officials of the Department of State, which has been charged with coor-
dinating all U.S. government assistance to East European nations, and
incorporated their comments where appropriate. Our audit work was
conducted from November 1989 through July 1990 in accordance with
generally accepted government auditing standards.

Chapter 2                                                                        I

Donor Assistance and Investment

               Eastern Europe is receiving many types of assistance from public and
               private sectors in the United States and other countries through bilat-
               eral and multilateral arrangements. The aid takes the form of grants,
               loans, credits, advice, and in-kind benefits and covers a wide range of
               activities in economic, financial, educational, training, food, medical,
               agricultural, and environmental areas. While most of the aid is currently
               being provided to Poland and Hungary, other East European countries
               are expected to be eventual recipients as well.

               In addition to the United States, many major industrial nations have
               given aid to Eastern Europe; multinational organizations and institu-
               tions such as the Organization for Economic Cooperation and Develop-
               ment and the European Community have been instrumental in
               developing and coordinating assistance programs. As of May 2 1, 1990,
               the donor countries had committed $8.51 billion in assistance to Poland
               and Hungary, and the EChad committed $1.02 billion (see table 2.1). In
               addition, of the approximately $8.51 billion committed, $3.94 billion, or
               46 percent, is in the form of export credits and project financing (see
               table 2.2). Although overall U.S. assistance is less than that being pro-
               vided by Germany and Japan, State Department officials noted that
               other bilateral donors are providing most of their assistance in the form
               of loans or tied aid and that the United States is the largest donor of
               grant assistance. A high-level U.S. official said that the United States is
               attempting to convince other bilateral donors to provide more grant

               Page 12                                         GAO/NSIADBldl   Eastern   Europe
                                                   Chapter 2
                                                   Donor Assistance    and Investment

Table 2.1: Donor Aid Commitments to
Poland and Hungary (as of May 1990)                Dollars in millionsa
                                                                                     Commitment8         Commitments              for Poland
                                                   Donor nations                       for Poland          for Hungary         and Hungaryb          Total
                                                   Germany                                   $1,729                 $1,134                $22       $2,005
                                                   Jacan                                        742                    643                  18       1.403
                                                   United States                                261                     37                377          675
                                                   Italy                                        484                    146                 28          657
                                                   -_---      -..-                              581                      0                   0         581
                                                   United Kinadom                               161                     28                   0         190
                                                   Othersc                                      621                    310                170        1,100
                                                   European Community                           236                    761                 26        1,023
                                                   Total                                    $4.815                  $3.059               $641       $8.514
                                                   aThe aid commitments     represent amounts reported to the European Community.

                                                   bThis category consists of commitments made jointly to both Poland and Hungary and is separate from
                                                   commitments made solely to Poland or Hungary.

                                                   CThe 18 other countries contributing aid to Poland and Hungary are Australia, Austria, Belgium, Canada,
                                                   Denmark, Finland, Greece, Iceland, Ireland, Luxembourg, the Netherlands, New Zealand, Norway, Por-
                                                   tugal, Spain, Sweden, Switzerland, and Turkey.
                                                   Source: European Community Commission Directorate General for External Relations, May 21, 1990.

Table 2.2: Type of Donor Aid Commhments to Poland and Hungary
._   .- in mrllronsB
                . .~   ~~~-..-.-_ - ..-.
                                           Grants and      Percent of           Export credit/        Percent of      Other      Percent of
Donor nation5                                    loans       total aid         project finance          total aid      aidb        total aid          Total
Germany                                         $1,528                53                 $1,331                46       $25                 1       $2,885
Japan                                              144                10                   1,258               90          0                0        1,402
United States                                      371                55                     143               21        161               24          675
ita&                                               260                40-                    290               44       107                16          657
France                                              83                14                     383               66        115               20          581
United Krngdcm-.                                   157                83                      17                9         16                9          190
bthersC                                            264                24                     514               47       322                29        1,100
European Community              .---               733                77                       0                0       230                23        1,023
Total                                          $3,601                 42                 $3.936                46      $977                lid      $8,514
                                                   aThe figures below represent aid commitment amounts reported to the European Community.

                                                   bThis category represents foreign assistance not specified in the form of grants or loans, such as some
                                                   forms of environmental assistance and technical training.

                                                   CThe 18 other countries contributing aid to Poland and Hungary are Australia, Austria, Belgium, Canada,
                                                   Denmark, Finland, Greece, Iceland, Ireland, Luxembourg, the Netherlands, New Zealand, Norway, Por-
                                                   tugal, Spain, Sweden, Switzerland, and Turkey.

                                                   dPercentages may not total 100 due to rounding.
                                                   Source: European Community Commission Directorate General for External Relations, May 21, 1990.

                                                   Page 13                                                            GAO/NSIAD91-21      Eastern   Europe
                       Chapter 2
                       Donor Aeeistance   and Investment

                       The*Support for East European Democracy (SEED)Act of 1989,author
US. Bilateral          ized funding for U.S. aid to Poland and Hungary. With the Department
Programs and Efforts   of State coordinating efforts, a council of more than 30 agencies is
                       focusing on aid to Eastern Europe. Some U.S. government agencies are
                       also reassigning staff to activities related to East European needs. Given
                       the scale of these needs, it is generally believed that private sector
                       investment will be a necessary complement to official assistance. The
                       U.S. government has instituted some programs to provide funds and
                       information to the private sector to facilitate investment.

SEED Act of 1989       The SEEDAct was enacted “to promote political democracy and economic
                       pluralism in Poland and Hungary by assisting those nations during a
                       critical period of transition and abetting the development in those
                       nations of private business sectors, labor market reforms, and demo-
                       cratic institutions; to establish, through these steps, the framework for a
                       composite program of support for East European Democracy.” The SEED
                       Act authorized over $900 million in funding for fiscal years 1990-1992.
                       Congress appropriated up to $418 million and provided $240 million in
                       guarantees for 1990, as shown in table 2.3.

                       Page 14                                        GAO/NSIALHJl-21EastemEurope
                                    Chapter 2
                                    Donor Assistance      and Investment

Table 2.3: SEED Fiscal Year
Appropriation8 and Authorizations   Dollars in millions
                                                                                                                1990              1990-92
                                    Program                                                            Appropriation         Authorization
                                    Polish Stabilization Fund
                                    --                                                                              200.0
                                                                                                                       __-~         __- 200.0~
                                       ~--_. Enterprise Fund                                                          45.0b             240.0
                                    -______~~_____Enterprise Fund                                   .-.--____-.---     5.0   -            60.0
                                    --_------ farmer  aid to Poland       ~-__                                        10.0                    0
                                    ---                   program for Poland                                .--____     1 .o                  0
                                    Educational and cultural programs
                                    _----                                                                               3.0                12.0
                                    --.---~~    exchanges        -__~                                                   2.0
                                                                                                             ___.---________               10.0
                                    Labor    support
                                    --__________                                                           ____-        1.5                 5.0
                                    Technical training                ~-                  --____-~-~                    2.0                 0.5
                                    Democratic institutions                                                            4.0     ---~       12.0
                                    _--._----_                                                                        lO.Ob         --___ 0
                                    Medical supplies for Poland                                                         2.0                 4.0
                                    Environmental programs
                                    --~.-~-            -~-.                                                   ---       3.3                10.0
                                    Energy programs            ___---                   -                             10.0                30.0
                                    Food aid for Poland                                 -__           --            125.0                1250a
                                    --.       Corps
                                             _____.-~-                                                      --~         2.0                 6.0
                                    -      _~.-. Development
                                             and        -- .__- Program                                                 2.0                 6.0
                                    Total                                                                          ti7.ac               72O.!V
                                    aFiscal year 1990.

                                    bThe Urgent Assistance for Democracy in Panama Act of 1990 (P.L. 101-243)authorized $10 million for
                                    democratization efforts in Eastern Europe. These funds were reprogrammed from the $45 million appro-
                                    priation for the Polish-American Enterprise Fund.
                                    cDoes not include (1) $40 million in guarantees for an Overseas Private Investment Corporation program
                                    for Poland; (2) $200 million in guarantees under the Trade Credit Insurance Program; and (3) December
                                    1989 emergency aid to Romania in the form of $500,000 through the International Red Cross and
                                    $250,000 for medical supplies.

                                    The SEED Act focuses on five elements of assistance: (1) economic stabili-
                                    zation’ and structural adjustment2 programs to assist implementation of
                                    economic refbrms; (2) private sector development through loans, grants,
                                    guarantees, equity investments, technical assistance, and training;
                                    (3) trade and investment programs to encourage U.S. private sector
                                    investment; (4) educational, cultural, and scientific activities, which

                                    ‘Policies that are designed to lead to short-term internal (employment and inflation targets) and
                                    external (equilibrium in international payments) balance, such as the adjustment of the exchange
                                    ‘Policies that lead to long-term internal and external balance, such as divestiture of unprofitable
                                    public sector enterprises.

                                    Page 16                                                            GAO/NSIAD-91-21      Eastern   Europe
    Chapter 2
    Donor Aesbtnnce    and Investment

    include publicly and privately funded scholarships; and (6) other pro-
    grams, to include environmental, health, food aid, and development of
    democratic institutions.

    The administration has proposed a new policy standard that would
    tailor U.S. assistance to the specific needs of each East European
    country as it shows progress toward political pluralism and economic
    reform, enhanced respect for internationally recognized human rights,
    and a willingness to build a friendly relationship with the United States.
    To achieve these objectives and to concentrate U.S. efforts on areas
    where the United States can have maximum impact, the administration
    sees the need for assistance in four general areas:

l Democratic initiatives. This effort would support institution building,
  including parliamentary structures, political systems, and free media
. Technical training and assistance. This effort would include support for
  market-based financial and economic institutions.
l Environment. This category would provide assistance in cleaning up the
  environment and establishing model projects.
. Transitional economic support. This category would include stabilization
  and structural adjustments as well as support for privatization through
  public sector-sponsored funding mechanisms as a means of aiding
  investment in the private sector.

    In some cases, U.S. assistance has been part of multilateral assistance
    programs. For example, the SEEDAct authorized $200 million, which was
    appropriated, to support Poland’s Stabilization Fund,3 seeking to lessen
    the variability of the Polish currency after a sharp devaluation and to
    encourage its convertibility into western currencies. The IMF endorsed
    the creation of this fund, and other industrial countries joined the
    United States in contributing to it.

    Domestic changes in Eastern Europe have prompted a reevaluation of
    U.S. export control policy. Before the dramatic changes in these coun-
    tries, the United States, in cooperation with allied countries, severely
    limited the export of a variety of equipment and technology that could
    be of military or economic benefit to communist countries or other
    “unfriendly” nations. These restrictions have been enforced through the

    3An internationally supported fund to support the Polish currency.

    Page 16                                                         GAO/NSIAD91-21   Eastern   Europe
                          Chapter 2
                          Donor AssMance    and Inveetment

                          Coordinating Committee on Multilateral Export Controls.4 Committee
                          members have agreed to significantly relax licensing requirements for
                          machine tools, telecommunications, and computers. Most commonly
                          available personal computers and some mainframes are now decon-
                          trolled. In addition to aiding the nations in Eastern Europe, relaxing
                          export controls will also benefit U.S. companies that manufacture these
                          items by providing a new market for their products.

Coordination of U.S.      The Department of State is the lead agency for coordinating U.S. assis-
Assistance                tance to Eastern Europe. The Deputy Secretary of State is the coordi-
                          nator for the U.S. program and chairs the coordinating council of the
                          over 20 government agencies providing assistance to Eastern Europe.
                          The U.S. effort focuses on technical training and assistance, environ-
                          mental assistance, democratization efforts, and support for private
                          sector development. Every 2 weeks, the State Department publishes a
                          periodic update of US. assistance efforts to Eastern Europe, called
                          Focus on Eastern Europe.

U.S. Agency Funding and   Most of the funds under the 1989 SEEDAct were allocated to specific
Staffing                  programs and, within particular programs, to particular projects. As a
                          result, some agencies that either did not receive SEEDact funding or
                          received funding only for specific purposes are using funds from their
                          own program budgets for projects they view as important but that were
                          not identified in the SEEDact. Some agencies, such as the Departments of
                          State, Commerce, the Treasury, and Agriculture, are also reassigning
                          staff to handle East European assistance needs. For example, the State
                          Department reported that it has reassigned over 100 staff to Eastern
                          Europe from other posts. The Department of Commerce is sending For-
                          eign Commercial Service officers to Eastern Europe and has reassigned
                          Washington, D.C., staff from other areas to East European initiatives.
                          The U.S. Information Agency is using some of its own funds to promote
                          democratization efforts, and the Departments of Commerce and Labor
                          are using their own funds to encourage private sector investment and to
                          provide training programs for Eastern Europe.

The Enterprise Funds      To promote the development of the private sector in Poland and Hun-
                          gary, the United States has established the Polish-American Enterprise

                          4Cnmmittee member countries include Japan, Australia, and North Atlantic Treaty Organization
                          countries except Iceland.

                          Page 17                                                       GAO/NSIAD-91-21    Eastern   Europe
                         chapter 2
                         Donor Amistanee   and Investment

                         Fund and the Hungarian-American Enterprise Fund. These funds are
                         intended to provide assistance through grants and loans, equity invest-
                         ments, support for feasibility studies, training, and technical assistance.
                         In general, the funds will act as development banks and will engage in
                         various activities, such as making direct loans to private entrepreneurs,
                         lending to venture capital funds, taking an equity position in private
                         companies, issuing bonds, buying stocks and bonds, and working with
                         retail banks.

                         The 1989 SEEDAct authorized $240 million dollars for the Polish-Amer-
                         ican Enterprise Fund and $60 million for the Hungarian-American
                         Enterprise Fund over a 3-year period. The fiscal year 1990 appropria-
                         tion was $46 million for Poland6 and $6 million for Hungary. Polish- or
                         Hungarian-owned firms or proposed joint ventures with U.S. firms may
                         apply for funding, and the funds will support establishing new firms as
                         well as privatizing existing firms. The funds will operate under the
                         overall supervision of a binational board of directors, while day-to-day
                         activities will be handled by professional management teams, hired by
                         and responsible to the respective boards.

The Overseas Private     The Overseas Private Investment Corporation’s (OPIC) purpose is to pro-
Investment Corporation   mote economic growth in developing countries by encouraging private
                         investment. The agency assists U.S. investors by (1) insuring investment
                         projects against a broad range of political risks and (2) financing invest-
                         ment projects through direct loans and/or loan guarantees. The agency
                         also sponsors investment missions that are designed to introduce senior
                         US. business executives to key business leaders, potential joint venture
                         partners, and high-ranking government officials in the host country.

                         In October 1989, OPICsigned bilateral agreements with Poland and Hun-
                         gary and has since sent several investment missions to those countries.
                         In January 1990, OPIC issued political risk insurance covering General
                         Electric’s joint venture with a Hungarian lighting company and is con-
                         sidering other investor-proposed projects. The agency has developed
                         several new initiatives to better serve the needs of Eastern Europe,
                         including (1) the East European Growth Fund, which has a target
                         funding level of $200 million and is designed to raise private capital to
                         fund new enterprises and make equity investments; (2) the Small Busi-
                         ness Loan Guaranty Program, which will provide loans up to $500,000

                         %lO million was reprogrammed
                                                   under public Law 101-243 for   supportof democratic institutions   in
                         Eastern Europe.

                         Page 18                                                   GAO/NSlAD91-21      Eastern   Jhrope
                       Donor Asebtanee   end Investment

                       to small business investors; and (3) the Environmental Investment Fund,
                       which has a target funding level of $100 million and which is directed
                       toward investments in environmentally sound, natural resource

The Eastern Europe     In an effort to provide interested investors with data on Eastern Europe,
Business Information   the Commerce Department established an information center in January
                       1990. The Eastern Europe Business Information Center serves as a cen-
Center                 tral clearinghouse for information on business opportunities in Eastern
                       Europe and on U.S. government programs supporting expanded private
                       enterprise, trade, and investment.

                       The Center has received thousands of inquiries from potential U.S.
                       investors and receives, on average, about 200 calls per day. Most of the
                       information the Center provides consists of economic reports, some
                       market research, and lists of contacts within the various countries. The
                       majority of the information provided is on Poland and Hungary,
                       although information on other East European countries is available. The
                       Center is preparing a bulletin with lists of contacts at OPIC, AID, and
                       other relevant agencies, along with reference information on investing in
                       the region.

                       The Center also provides information on joint ventures between U.S. and
                       Central or East European firms or enterprises. According to Commerce
                       officials, the majority of investments in Eastern Europe will be joint
                       ventures. Most countries in the region have laws that stipulate that com-
                       panies must invest in, or with, East European fu-ms.

                       As an indication of the importance of foreign investment in joint ven-
                       tures, table 2.3 shows the numbers and types of joint ventures, as of
                       May 1,1990, in Eastern Europe, as well as the legal conditions governing
                       them. Currently, Hungary has the most liberal investment laws in the
                       region in the areas of currency, exports, taxation, and repatriation of
                       profits laws. While Poland has the most joint ventures with western
                       partners, Hungary has the most joint ventures with U.S. partners.

                       Page 19                                       GAO/TVSIAIb91-21   Eastern   Europe
                                            chaptm 2
                                            Donor Aatd&ance   and Investment

Table 2.4: Western Joint Ventures in Eastern Europe
                              Total JVs* ~t$.$
                           with western
Country                         partners    pat&s       Major sectors                           Legal conditions
Poland                             666            60    Food processing and construction        100 percent repatriation of export earnings.
                                                        materials                               100 percent foreign ownership allowed
                                                                                                Access to foreign exchange.
Himgary                       600-700            140    Consumer goods, services. Light         100 percent foreign ownership allowed.
                                                        manufactunng                            Easy licensing procedures. 100 percent
                                                                                                repatriation of domestic and foreign profits.
Czechoslovakia-                      32            1    Manufacturing,   tourism                Repatriation of profits for hard currency -
                                                                                                exports only. Allows for majority ownership.
                                                                                                JVs have lower tax rate.
Bulgaria                            60            IO    Food processing, footwear,              Repatriation not guaranteed, must be
                                                        chemicals, electronics                  through export earnings. 100 percent
                                                                                                foreign ownership allowed.                -
Romania                                 5          1    Data processing, chemicals              Romanian partner must have majority
                                            aJV denotes joint venture.
                                            Source: Eastern Europe Business Information Center, Department of Commerce, May 1, 1990.

                                            The European CommunityG Commission, the executive arm of the EC, is
European Community                          leading efforts to coordinate international assistance to Eastern Europe.
Assistance                                  To do so, the ECCommission has begun hosting a series of meetings with
                                            donor countries and organizations such as the IMF, the World Bank, and
                                            the OECD. The State Department is the primary U.S. representative at
                                            these meetings, although representatives of other agencies also attend
                                            as appropriate.

                                            In July 1989, the donor countries signed an agreement to provide assis-
                                            tance to Eastern Europe and at the same time gave the EC Commission
                                            the role of acting as a clearinghouse for this international assistance.
                                            According to one U.S. official, the EC is well suited for this role because,
                                            as an institution, it has (1) authority and prestige, (2) funds and
                                            resources, (3) skillful administrators, and (4) a nonmilitary orientation.

                                            The EC Commission has two roles with regard to aid to Eastern Europe:
                                            (1) to direct and oversee specific EC assistance to Eastern Europe and
                                            (2) to act as a clearinghouse for bilateral assistance to the region. As a
                                            result, the Commission has direct authority over EC assistance but relies
                                            on voluntary cooperation in coordinating bilateral aid.

                                            “The EC consists of 12 member states: Belgium, Denmark, France, Greece, Ireland, Italy, Luxembourg,
                                            the Netherlands, Portugal, Spain, the United Kingdom, and Germany.

                                            Page 20                                                        GAO/NSIAD91-21      Eastern   Europe
                    chapter 2
                    Donor Ae&tance   and Investment

                    As donor countries move from providing emergency aid to longer-term,
                    more complex technical assistance, the EC clearinghouse approach is
                    proving less effective, according to EC and U.S. officials. EC officials
                    stated that a natural tension exists when a multilateral organization
                    attempts to coordinate bilateral assistance efforts. For example, some
                    countries do not report all their assistance projects to the EC working

EC Working Groups   The EC Commission has established working groups on agriculture,
                    training, environment, and investment to (1) develop priorities for assis-
                    tance, principally to Poland and Hungary, (2) act as a clearinghouse for
                    bilateral assistance from the donor countries, and (3) develop and imple-
                    ment ECassistance programs. The ECCommission provides aid to
                    Eastern Europe using criteria that require recipient countries to have
                    pluralistic political systems with no institutionally favored party, to
                    make movement toward free market economies, to have free labor
                    unions, and to demonstrate respect for human rights.

                    In late 1989 and early 1990, the working groups sent fact-finding mis-
                    sions to Poland and Hungary to assess the two nations’ needs. Based on
                    the missions’ assessments and other information, each working group
                    began planning assistance efforts for the two countries.

Working Group on    The agriculture working group, established in August 1989, has prima-
Agriculture         rily focused on Poland but has provided some aid to Hungary and some
                    emergency food assistance to Romania. Agricultural assistance to
                    Poland consists of immediate food aid and longer-term agricultural help.
                    The working group has coordinated donor assistance by matching bilat-
                    eral aid to Polish requests.

                    Donated food provided to Poland is sold through state stores at market
                    prices. Revenues from these sales are given to the Polish government to
                    help fund technical agricultural projects that will improve and expand
                    Poland’s agricultural sector.

                    Hungary has a surplus of agricultural products, so food aid has not been
                    needed. Instead, Hungary has requested technical assistance to update
                    and improve its agricultural sector. Hungary is particularly interested in
                    sending students to the West to study advanced agricultural methods
                    and practices.

                    Page 21                                        GAO/NSJ.AD-91-21   Eastern   Europe
                       Chapter 2
                       Donor Assistance   and Investment

Working Group on       The training working group was established in September 1989 because
Training               of Polish and Hungarian requests for training in a wide range of areas-
                       banking, agriculture, language, civil service, environment, and voca-
                       tional training. The EChas proposed the creation of a European Founda-
                       tion for Vocational Training in West Berlin and a university exchange
                       program for teachers and students. The university exchange program
                       will target teachers and students in key fields, such as management and
                       business administration, applied economics, applied technologies, lan-
                       guages, agriculture, and environmental protection.

Working Group on the   The environmental working group began meeting in September 1989. It
Environment            serves primarily as a clearinghouse and coordinating mechanism for
                       assistance provided by donor countries through bilateral agreements to
                       Poland and Hungary. These two countries have requested help with air
                       pollution reduction, hazardous waste removal, waste management, and
                       water treatment. Potential projects include developing a hazardous
                       waste incineration plant, a water desalinization plant, and an energy
                       conservation plan for the Polish food processing industry.

Working Group on       The investment working group was convened in November 1989 in
Investment             response to Polish and Hungarian requests for assistance. The group has
                       two major objectives: (1) to act as a clearinghouse on foreign private
                       investment activity in the two countries and (2) to develop a data base
                       that will include information on tax and investment treaties, national
                       commercial laws, and issues, concerns, and successes of foreign corpora-
                       tions doing business in the region. This information will be made avail-
                       able to private investors interested in the investment climate in Eastern

                       Donor countries have used other multilateral organizations and institu-
Other Multilateral     tions, in addition to the IX and the ECCommission, to provide assistance
Programs and Efforts   to Eastern Europe. This multilateral assistance takes the form of sup-
                       porting economic stabilization and structural adjustment programs, pro-
                       viding vocational and management training, assessing environmental
                       concerns, and promoting foreign investment. Two primary examples of
                       multilateral aid are the Polish Stabilization Fund and the European
                       Bank for Reconstruction and Development (EBRD).While Poland and
                       Hungary have received the bulk of donor aid, the European Community,
                       the OJXD,the IMF, and the World Bank are also providing assistance to
                       other East European countries.

                       Page 22                                       GAO/NSIAD-91-21   Eastern   Europe
                           Donor Assistance and Investment

The Polish Stabilization   Under the 1989 SEEDAct, Congress authorized a $200 million contribu-
                           tion to the Polish Stabilization Fund. The Fund was endorsed by the IMF
Fund                       and supported by other donor countries. The US. Treasury took the lead
                           in conducting negotiations with Poland on how the Fund would work
                           and on establishing rules concerning its use, repayment schedules, and
                           initial contributions.

                           The $1 billion fund was established to accomplish two reforms: (1) to
                           support a relatively fixed exchange rate for the zloty (the Polish cur-
                           rency) after sharp devaluation and (2) to help ensure that the zloty is
                           convertible for current account transactions, i.e., to allow residents to
                           freely purchase currency through authorized foreign exchange banks.
                           These reforms officially went into effect January 1, 1990.

                           When the Stabilization Fund was set up, there was neither a foreign
                           exchange market nor any way to transfer funds from one bank to
                           another, unless the currency was physically transported from one bank
                           to another. Therefore, in order to implement the Stabilization Fund,
                           Poland must thoroughly restructure its banking system.

                           International donors have provided various types of contributions to the
                           fund. For example, the United States and the United Kingdom have pro-
                           vided grants; Germany and France have provided lines of credit; Japan
                           has provided a loan with a below-market interest rate; and Canada has
                           provided a “no interest, reimbursable grant.” Before the monies could be
                           deposited in an account (held by the New York Federal Reserve Bank),
                           Treasury negotiated specific agreements with the donor nations to
                           account for their laws and the fluctuations in the various exchange

The European Bank for      In 1990, the French      proposed creating a multilateral development bank,
                           the European Bank        for Reconstruction and Development. The purpose
Reconstruction and         was to demonstrate       the commitment of the donor countries to East
Development                European countries       committed to making political and economic

                           The Articles of Agreement establishing the bank were signed on May 30,
                           1990. With up to 42 members, the bank is headquartered in London, its
                           president is a former adviser to the French President, and it is scheduled
                           to be operational in 1991. The United States will be the largest indi-
                           vidual shareholder, with a 10 percent share. The ECcountries individu-
                           ally, the European Community as an organization, and the European

                           Page 23                                           GAO/NSL4D-91-21   Eastern   Europe
                    chapter 2
                    Donor AssLetance and Investment

                    Investment Bank will together control 51 percent of the shares; other
                    European countries, 12 percent; the Soviet Union, 6 percent; the East
                    European countries, 7 percent; and other nonregional countries, 14 per-
                    cent. The capital base will be 10 billion in European Currency Units
                    (ECU)~($11.7 billion in U.S. dollars), with 30 percent in paid capital and
                    70 percent on call.8

                    For the first 5 years, at least 60 percent of the bank’s lending (in aggre-
                    gate and by country) will be devoted to projects in the private sector.
                    The balance will be available for infrastructure or environmental loans
                    that support the development of the private sector or for public enter-
                    prises that operate in a competitive fashion. It is intended that the bank
                    coordinate its efforts with the IMF and the World Bank.

The International   The International Monetary Fund is a multinational organization with
Monetary Fund       151 member countries. If a member country is having balance of pay-
                    ment problems, it can request a standby arrangement with the Fund,
                    which typically lasts 12-15 months. Under the standby arrangement, the
                    IMF provides to a country a line of credit in return for the country’s
                    agreement to undertake economic reform. The IMF emphasizes policies
                    that reduce demand, focus on increasing exports and hard currency bal-
                    ances, and promote currency stabilization. The IMF sets quarterly goals
                    and criteria in order to monitor a country’s performance and timely
                    compliance with the program.

                    Poland and Hungary both have standby arrangements with the IMF. The
                    arrangement with Poland was signed in February 1990 and authorizes
                    purchases up to $723 million over 13 months to support the govern-
                    ment’s economic stabilization program. This program aims at decreasing
                    the rate of inflation and promoting a market economy. Hungary has had
                    four arrangements since May 1988. The arrangement approved in March
                    1990 authorizes purchases up to $206 million over a 12-month period.
                    This arrangement supports the government’s economic and financial
                    program, which hopes to reduce domestic and external economic imbal-
                    ances during the process of restructuring, reforming, and liberalizing the

                    7The E%lJ serves as a common basis for determining exchange rate parities and as a means of settle-
                    ment for the 12 member nations of the EC.

                    ‘With a 10 percent share of the EBRD, the United States will have a funding commitment fixed in
                    dollars of $360 million for paid-in capital and $817 million available on call. This sum translates into
                    an annual commitment of $70 million of budget authority for paid-in capital and $163.4 million of
                    program limitations for subscriptions to callable capital.

                    Page 24                                                            GAO/NSIAD-91-21      Eastern   Europe
                            chapter 2
                            DonorAh&ance andInvertment

                            The IMF also provides economic assistance through an extended fund
                            facility, which is designed to be of a longer duration (3-4 years) than
                            standby arrangements. It is expected that the current standby arrange-
                            ment with Poland will evolve into an extended fund facility, due to the
                            ambitious nature of the economic changes that Poland is making.

The World Bank              During fiscal year 1990, the World Bank extended five project loans
                            totaling $781 million to Poland. The projects focus on (1) providing tech-
                            nical assistance for dealing with environmental problems; (2) restruc-
                            turing the transportation sector; (3) improving energy conservation,
                            pricing, and environmental impact; (4) supporting private sector export
                            promotion; and (5) modernizing and expanding agroprocessing

                            The Bank has provided Hungary with                   three project loans amounting to
                            $366 million to (1) support Hungary’s                structural adjustment program,
                            (2) modernize and expand the export                 capabilities of agricultural enter-
                            prises, and (3) modernize and expand                the banking system.

                            During fiscal year 1990, no project loans were extended to the other
                            East European countries. However, Czechoslovakia has applied for
                            membership in the Bank, Bulgaria has expressed interest in joining, and
                            Romania has been a member since 1983.

Organization for Economic   The Organization for Economic Cooperation and Development is an
Cooperation and             international group of 19 European countries? the United States,
                            Canada, Japan, Australia, and New Zealand. Its mission is to achieve
Development                 high economic growth and development, and financial stability among
                            member nations and, thus, to contribute to the development of the world

                            All East European countries except Albania have requested OECD assis-
                            tance in one form or another. For example, the government of Poland
                            has asked that the OECD undertake a detailed review of its economy,
                            including identifying what measures are needed for reform. As a result
                            of these requests, the Secretary General of the OECD organized a special
                            task force to address issues related to increased involvement with

                            ‘European membership consists of Austria, Belgium, Denmark, France, Finland, Germany, Greece,
                            Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland,
                            Turkey, and the United Kingdom.

                            Page 26                                                         GAO/NSIAD91-21 Eastern Europe
Donor A.m&tance   and Investment

Eastern Europe and, in September 1989, issued a series of options on
how the organization could respond to requests for technical assistance.

The OECDis also developing the Center for Cooperation with European
Economies in Transition. The Center will be the focal point for all OECD
contacts with East European countries, will respond to requests for
information and documentation from these countries, and will initiate
and coordinate OEXDanalyses and activities related to Eastern Europe.
In addition, the Center will organize visits from, and OECDexpert mis-
sions to, Eastern Europe; will organize or help arrange seminars, work-
shops, and conferences on issues related to social and economic reform;
and will coordinate the OECD'Sefforts with those of other international
bodies, such as the EC,IMF, and World Bank.

Page 26                                       GAO/NSIAD-91-21   Eastern   Europe
&&economic Conditions ad Refom Efforts in
East European Countries

                    The East European countries have been undergoing severe economic dif-
                    ficulties since the early 1970s and are now in a state of economic
                    decline. Poor growth in gross national product (GNP); economic isolation
                    from the international economy; an antiquated industrial base and infra-
                    structure, and environmental problems; and large foreign debts are some
                    of the major problems confronting the region. Standards of living remain
                    far below those of most Western European countries.

                    The East European countries vary in their natural, capital, and human
                    resource bases but all have growth potential if the requisite economic
                    structural adjustments are undertaken. There appears to be general
                    agreement that the primary catalyst for growth in the region must be
                    through domestic private sector initiatives, supplemented by private
                    sector investment from industrialized countries and by economic assis-
                    tance from the United States, Western Europe, Japan, and international
                    financial institutions.

                    Enterprises in the East European centrally planned’ economies were
Economic Overview   organized as large, state-owned monopolies. These industries suffer
                    from outdated technology, lack of competitive incentives, and shortages
                    of production materials, resulting in low productivity rates. In most of
                    these countries, central planners controlling the state firms failed to
                    properly coordinate supplies of labor, material, and productive capacity.
                    Long production lead times meant that equipment was outdated by the
                    time it was actually installed and operating.

                    For the most part, economic expansion in state-owned industries was
                    brought about by massive increases in material and labor inputs and not
                    by improvement in productivity. These production inefficiencies were
                    hidden by massive government subsidies and by arbitrarily set prices
                    that masked true costs. The subsidies created a large “hidden inflation”
                    that strained national budget and banking resources when central gov-
                    ernments had to increase subsidies to cover rising real costs. In addition,
                    the central planners, lacking profit incentives, imposed no hard financial
                    discipline on the state-owned operations, and unprofitable firms were
                    not allowed to go bankrupt. (Fig. 3.1 shows the average gross domestic
                    product (GDP) growth for the periods 1961-73,1974-82, and 1983-88,
                    and the annual average for 1989 in the five countries we reviewed.)

                    ‘In the traditional centrally planned economy, virtually all the means of production are turned over
                    to state ownership. The state’s central authorities plan for the inputs and outputs of state-owned
                    enterprises, with inputs generally being centrally allocated. Virtually all prides are fixed by the cen-
                    tral planners, and foreign trade is controlled by state-owned organizations.

                    Page 27                                                            GAO/NSIAD-91-21      Eastern   Europe
                                         Chapter 3
                                         Socioeconomic Conditions and Reform
                                         Efforts in East European Countriee

Figure 3.1: Qroso Domestic Product
Growth in Five East European Countries   7   (Numbers In parcent)

                                             r---l    1951-73

                                         Source: International Monetary Fund. 1989 figures are from Central Intelligence Agency estimates of
                                         gross national product.

                                         Lacking a pricing mechanism that properly related supply to demand,
                                         producers could not make rational decisions about what to produce.
                                         Instead, the central bureaucracies made decisions based on their prefer-
                                         ences for producing specific goods and services and used prices as a
                                         method for redistributing income. This system led to inefficient pricing
                                         decisions and a sometimes seemingly irrational waste of resources. For
                                         example, it has been reported that some East European farmers ended
                                         up selling grain to the state, then buying subsidized bread to feed live-
                                         stock because bread was cheaper to use than the unsubsidized grain
                                         from which the bread was made.

                                         While it is difficult to measure economic output in these economies,
                                         there is general agreement that absolute productivity was lower than

                                         Page 29                                                           GAO/NSIAD-91-21     Eastern   Europe
                                         chapter 3
                                         Soctoeconomic Conditions and Reform
                                         Efforts in East European Countries

                                         reported and that the labor productivity trend, as defined as percentage
                                         of change in output per worker, had been declining throughout the
                                         region, (See fig. 3.2.) For example, a steel plant in Poland employed
                                         30,000 workers to manufacture the same amount of steel as a U.S. plant
                                         employing 7,000 workers.

Figure 3.2: Labor Productivity in Five
East European Countries                  10   (Percentage chrngr In output par rmployu)

                                         Source: Institute of international Finance

                                         As table 3.1 demonstrates, the annual growth rates for the economies of
                                         East European countries have varied greatly during the mid- to late
                                         1980s. Estimates of their growth in 1989 indicate that many of these
                                         countries actually suffered declines or minimal growth in real output.

                                         Page 29                                          GAO/NSIAD-91-21   Eastern   Europe.
                                          Socioeconomic     Conditions    and Reform
                                          Efforta in EastEuropean        Countrles

Table 3.1: Annual Growth in Real Output
(Percent Change)                          Country                                                   1985       1988       1987      1988      198ga
                                          Polandb                                                      3.6       4.2        2.0        4.1      -3.0
                                          Hungaryb                                                   -0.2        1.5        4.1        0.4        0.6
                                          Czechoslovakiab                                              3.0       2.6        2.2        2.5        2.0
                                          Bulgariaa                                                    1.8       5.3        5.1        2.4      -0.4
                                          Romaniab                                                     5.5       6.1        4.6        3.3        1.7
                                          United Stat&                                                 3.6       3.0        3.5        4.4        2.8d
                                          FranceC                                                      1.7       2.1        2.3        3.4        3.5d
                                          ltalyC                                                       2.9       2.9        3.1        3.9        3.ld
                                          West GermarV                                                 2.0       2.3        1.9        3.4        4.9*
                                          bGross national product

                                          ‘Gross domestic product.
                                          *Figures for second quarter 1989, year-to-year change.
                                          Source: Figures for East European countries from the Institute of International Finance. Figures for other
                                          countries are from the UN. Economic Commission for Europe.

Economic Isolation                        The East European countries largely isolated themselves from the inter-
                                          national marketplace by trading primarily among themselves for the
                                          past 40 years. Much of their trade occurred within a single trading bloc,
                                          the Council for Mutual Economic Assistance (CMEA), also known as
                                          Comecon. As a result, their economies lacked the dynamic impetus of
                                          competition provided by the world economy.

                                          Trade within the CMEA relied upon barter-style arrangements to balance
                                          trade among its members. When forced to obtain goods outside their
                                          trading bloc, most East European countries developed unfavorable trade
                                          balances, exacerbated by their nonconvertible currencies2 One result for
                                          some of these countries was a serious external debt problem that per-
                                          sists today.

                                          Another result of the relative isolation from the international trading
                                          community was the insulation of East European industries from foreign
                                          competition. This insulation reduced the availability of consumer goods
                                          and lessened the incentive for improving product quality. This insularity
                                          also reduced opportunities for obtaining economies of scale available to
                                          higher exporting countries, as well as the general benefits of interna-
                                          tional trade, such as access to greater quantities of goods and services or
                                          the opportunity to benefit fully from specialized production. Moreover,

                                          2A nonconvertible currency cannot be freely exchanged against another currency.

                                          Page30                                                              GAO/NSJAD-91-21      Eastern   Europe
                          Chapter 3
                          Lbchecanondc    Conditiona and Reform
                          Efforts ln East European Countries

                          diminished contact with the international trade and finance centers lim-
                          ited East European countries’ access to foreign sources of capital.

                          Another problem resulting from past reliance on trade within the CMEA
                          is that moving away from the former trade patterns will be costly for
                          the East European countries. Initially, the CMEAtrade system was
                          advantageous to the Soviet Union, since it was able to receive goods
                          from other CMEAcountries at prices that were lower than prices pre-
                          vailing outside the trading bloc. Following the increases in oil and
                          energy prices in the 197Os, however, the advantage shifted, and East
                          European countries were able to buy Soviet oil and natural gas below
                          world prices.

                          Recently, however, the Soviet Union has proposed that CMEAcountries
                          pay world prices for oil, using hard currencies. It will be difficult for the
                          East European countries to raise hard currencies, however, since many
                          of their potential exports are not competitive.

                          In addition, East European countries have had little current experience
                          with commercial banking or with securities markets. Until recently, for
                          instance, private ownership of the means of production generally was
                          not allowed, so the need for stock markets did not exist. Banking was
                          conducted by state institutions. In addition, the currencies of these
                          nations were nonconvertible, thus limiting trade.

                          Reforms are underway, but the process of developing the financial sys-
                          tems that can aid domestic economic growth will be slow. Poland, for
                          instance, has introduced a banking system that includes privately
                          owned banks under central bank regulation. The absence of an efficient
                          mechanism to clear checks or transfer money between banks, short of
                          physically withdrawing money from one bank and redepositing it in a
                          second, however, will limit the development of financial markets. Hun-
                          gary has introduced a stock exchange, but few trades occur.

nadequateInfrastructure   Roads, telecommunications, railways, and port facilities in Eastern
                          Europe are not adequate to aid greater levels of trade with Western
                          Europe. Transportation systems, for instance, are oriented to trade
                          within the CMEAbloc, principally the Soviet Union. Also, telecommunica-
                          tions systems generally cannot easily be adapted to more modern
                          Western technologies.

                          Page 31                                          GAO/NSIAD-91-21   Eastern   Europe
                          Chapter 3
                          Socioeconomic Conditions and Reform
                          Efforts ln East European Countries

Environmental Situation   Eastern Europe has severe environmental problems. Years of depending
                          on heavy industry for development, relying on environmentally dam-
                          aging high-sulphur coal for power, and refusing to control or treat
                          wastes have extensively damaged vegetation and water resources and
                          have begun to affect health. Throughout the region, forests and
                          croplands have been heavily contaminated. For example, it is reported
                          that one-third of Bulgaria’s forests have pollution-related damage, one-
                          half of Czechoslovakia’s forests are damaged or dying, and much of
                          Poland’s farmlands have been hurt by high acid levels and metals.

                          Eastern Europe’s air and water resources have been similarly devas-
                          tated. Much of Hungary’s population breathes air with pollution levels
                          higher than its own national maximum safe-level limits, and drinking
                          water in the southern part of the country is reportedly seriously con-
                          taminated with arsenic. Poland produces a reported 6 times more air
                          pollution per unit of output than does Western Europe, and 95 percent
                          of its rivers are severely polluted. Seventy percent of Czechoslovakia’s
                          rivers are polluted.

                          The health of East Europeans has also suffered from ecological misman-
                          agement. It is reported that pollution-related cancers and infant mor-
                          tality are increasing in Czechoslovakia, a growing number of Hungarians
                          die from environmentally induced diseases, and pollution-related heart
                          disease and infant mortality are at high levels in Romania.

                          The World Bank estimates that 10 percent of Poland’s gross national
                          product is lost through employee illness and industrial problems related
                          to contaminated water. Officials in Hungary calculate that illnesses
                          caused by pollution take up over 13 percent of that nation’s health
                          budget. The West German Institute for Economic Research has projected
                          that $200 billion would be needed over the next 20 years to clean up
                          industrial pollution in Eastern Europe.

External Debt             Most of the countries in Eastern Europe-particularly     Poland and Hun-
                          gary-have large hard currency debt levels, as shown in table 3.2.
                          These debts severely hinder their abilities to resolve their domestic eco-
                          nomic problems.

                          Page 32                                        GAO/NSIAD-91-21   Eastern   Europe



                                           Chapter 3
                                           Socioeconomic   Conditions and Reform
                                           Efforts in East European Countries

Table 3.2: Hard Currency Debt of Five East European Countries
Dollars in billions U.S.
Country                                        1980        1981
                                                          -___.       1982     1983     1984    1985       1988      1987    1988’ -- 1989’
Poland                          ..- .-.         25.0         25.5      24.7
                                                                      --__--    26.4     26.8    29.3       33.5     39.2      38.5         39.5
Hungary                                           9.1-__----------_
                                                               8.7       7.6     8.2      8.9     11.8      15.1      17.8     18.0         20.7
Czcchoslovakla                                    5.0          4.6      3.9      4.0      3.6      3.8--     4.5       5.8      6.1          7.8
Bulgana                                           3.5          3.1      2.8      2.4 .-__ 2.3      3.7       4.9      6.2      7.5
                                                                                                                      ______--__            10.0
Romania                                           9.4        10.1       9.7      8.7      7.1      6.6       6.4       5.1      2.2          0.4

                                           Source: U.S. Central Intelligence Agency

                                           During the 1970s the East European countries borrowed heavily on the
                                           international financial markets to finance industrial investment. How-
                                           ever, poor investment decisions, economic inefficiencies, mediocre
                                           export competitiveness with resulting low foreign exchange earnings,
                                           and high interest rates on their external debt created severe economic
                                           and financial difficulties. Problems were compounded after 1985 when
                                           East European countries tried to shift domestic polices toward economic
                                           growth and investment that relied heavily on imports from nonsocialist
                                           countries. Their current account balances3 worsened, and external debts

Standards of Living                        Standards of living throughout Eastern Europe remain far below those
                                           of most West European countries. Key indicators of availability of
                                           common consumer goods show that East European standards parallel
                                           those of Greece and are a bit ahead of some Latin American countries.
                                           (See table 3.3.)

                                           3The difference between exports and imports of goods and services, minus net transfer payments
                                           made to foreigners.

                                           Page 33                                                         GAO/N!XAD-91-21   Eastern   Europe
                                          Socioeconomic  Conditiona andReform
                                          Efforta in EastEuropeanCountries

Table 3.3: Availability of Consumer
Qoodr                                     Number per 1,000 persons
                                          ----                                           Automobiles       Telephones          Television se6
                                          ------.--___-.                                            105              118                    85
                                          Hungary                                                   145              134                  275
                                          -----                                                     173              226                  122
                                          Bulgaria                                -                 120              200                    96
                                          ---.___-.-_---..- .._._
                                                               --                                    11              130                   ixa
                                          United States                                             572              650                  621
                                          Japan                                                     235              535                  250
                                          Germany                                                   446              641                  377
                                          Argentina                                                 127              100                  213
                                          -_-___-__--------                                          76               90                  184
                                          Mexico                                                     65               90                  108
                                          Greece                                                    127              373                  158
                                          ‘NA denotes not available.
                                          Source: Building Free Market Economies in Eastern Europe, Institute of International Finance.

                                          Per capita GNP of the East European countries remains considerably
                                          below that of the United States. Table 3.4 shows that only Czechoslo-
                                          vakia has achieved as much as one-third the estimated 1989 U.S. per
                                          capita GNP of $21,036.

Table 3.4: Estimates of 1989 Per Capita
Gross National Product                    U.S. dollars ----____
                                                                                                                          Percent of U.S. per
                                                                                               Per capita gross         capita gross national
                                          Country                                              national product                      product
                                          Poland                                                           $4,565-                         22
                                          Hungary                                                           6,108                          29
                                          Czechoslovakia                                                    7,878                          37
                                          Bulgaria                                                          5,710                          2?
                                          Romania                                                           3.445                          16
                                          Source: U.S. Central Intelligence Agency.

                                          Health standards are considerably lower throughout Eastern Europe
                                          than in the more industrialized nations. The relatively high mortality
                                          rates, which recently have increased for the first time since World War
                                          II, are a manifestation of the generally low quality of health care. How-
                                          ever, East European statistics do compare favorably with those of Latin
                                          America. (See table 3.5.)

                                          Page 34                                                           GAO/NSUD-91-21
                                         Chapter 3
                                         Socioeconomic   Conditions and Ref’orm
                                         Efforts in East European CWntrie~

Table 3.5: Measures of National Health
                                                                          Persons er       Annual mortality per         Infant mortality per
                                         Country                            physic k n        1,000 population             1,000 population
                                         Poland                                      490                         IO                           18
                                              -                                      310                        14                            17
                                         Czechoslovakia                              280                        12                            13
                                         Bulaaria                                    280                        NAa                           15
                                         Romania                                     570                         11                           25
                                         United States                               470                          9                            10
                                         Japan                                       660                          5                            6
                                         Germany                                     380                          7                            8
                                         Argentina                                   370                          9                           32
                                         Brazil                                    1,080                          8                           63
                                         Mexico                                    1.240                          6                           47
                                         Greece                                     350                          10                            13

                                         BNA denotes not available.
                                         Source: World Health Organization, 1989 World Health Statistics: World Bank, World Development
                                         Report 1989; and International Institute of I-lnance.

                                         While the East European countries confront an array of economic
Economic Potential                       problems, they all have economic growth potential. This growth, how-
                                         ever, is highly dependent upon substantial foreign investment. Although
                                         conditions vary by country, the region generally offers a large labor pool
                                         of relatively highly educated but low paid workers. The region is highly
                                         industrialized, but these industries need considerable modernization.

                                         For the present, the combinations of comparatively low pay and high
                                         skill levels of East European workers offer opportunities to attract
                                         development capital. A leading economic forecasting group reports that
                                         the average hourly manufacturing wage in Hungary, Poland, and Yugo-
                                         slavia in 1988 was between $1.36 and $1.71, including fringe benefits
                                         and pension costs; in Czechoslovakia, it was between $2.05 and $3.08.
                                         The group also reports that the percent of the labor forces in Hungary,
                                         Poland, and Czechoslovakia with secondary/high school educations or
                                         industrial equivalents was 23.9, 21.9, and 21.9 percent, respectively. In
                                         addition, between 7.0 and 9.9 percent of these countries’ workers had a
                                         college or university education, and highly skilled personnel, such as
                                         scientists and engineers, are available at relatively low costs.

                                         Page 36                                                          GAO/NSJAD91-21      Eastern     Europe
               Chapter 3
               Socioeconomic conditione    and Reform
               Efyorta In East European   Countries

               The East European countries need to take numerous measures to trans-
Future Steps   form their centrally planned economies to functioning market econo-
Necessary      mies. Economic experts generally agree on the steps needed for reform,
               but there is no consensus on how to approach implementation. Some
               countries in the region have started to establish the foundations for
               market-based economies, but they differ in regard to their commitment
               to reforming their economies, the type of reform measures needed, and
               the status of these reform efforts.

               Assistance from donor countries, including the United States, will prob-
               ably be an essential element in the success or failure of these reform
               efforts. Investments in Eastern Europe by domestic and foreign private
               investors will also be essential, according to most experts. In providing
               assistance and making investment decisions, however, it is important
               that the donor countries and investors understand the nature and mag-
               nitude of the changes that the East European countries must undertake.

               Economic reform in the region is not new. For much of the 40-plus years
               in which centrally planned economies dominated the region, govern-
               ments experimented with different approaches for reforming central
               planning mechanisms and introducing some elements of free markets
               and private ownership. There was a general realization that the tradi-
               tional model of the centrally planned economy had been unsuccessful.
               The changes made to economies during these previous attempts at
               reform have modified most East European systems so that they no
               longer have planned economies as classically defined.

               The economic reform movement currently under way in Eastern Europe
               is a complex process. The OECDreported, for example, that the reforms
               combine previous efforts at modifying centrally planned economies with
               a new principle of liberalizing the economy while concurrently democra-
               tizing the government. While retaining certain elements of previous
               attempts at reform, the new process is more radical in that its objective
               is the complete transformation of the system’s economic and political
               structures, At the same time, these reform efforts impose costs on the
               East European countries. Phasing out administrative allocation of
               resources, closing inefficient operations, and removing guarantees of
               employment are difficult steps.

               Experts agree, however, that the countries of Eastern Europe must
               undertake certain fundamental measures if they are to succeed in estab-
               lishing and supporting a market economy. While there is no agreement
               on the ideal way to undertake the reform efforts or the order in which

               Page 36                                        GAO/NSLAD-91-21   Eastern   Europe
  Chapter 3
  Socioeconomic   Conditions and Reform
  Efforta in East European Countries

  they should be implemented, the success or failure of donor assistance
  to these countries depends at least as much on implementing these mea-
  sures as on ensuring the effectiveness of the assistance strategies. Nec-
  essary steps that the OECDand others have identified are

9 Greater reliance on market-based prices: Under central planning, prices
  are not based on true costs or scarcity of goods. Frequently, prices of
  key goods, such as food or housing, reflect the subsidies provided by the
  state rather than the ability of companies or nations to produce goods
  efficiently. As subsidies and price controls are removed, increased prices
  for many goods and services are inevitable. In the view of most experts,
  essential components of these reforms will be breaking up inefficient
  state-owned monopolies, eliminating subsidies, and removing or sub-
  stantially reducing the power of the central planners, thereby transfer-
  ring the ability to make decisions to the individual firm or enterprise.
  Furthermore, as prices become efficient market signals, it will be impor-
  tant that economic policies avoid inflation that would distort these
. Revival of the private sector: While there remains considerable debate
  over the future role of governments in the economies of Eastern Euro-
  pean countries, most experts believe that it will be necessary to turn a
  large share of production over to a revived private sector. The govern-
  ments of these countries will have to take a number of steps to do this,
  including establishing the legal basis for private ownership, encouraging
  private investment, and altering their tax systems to reflect these
  changes, Most experts also believe that restrictions on foreign invest-
  ment will have to be relaxed or removed. Foreign investment will bring
  needed capital as well as access to western technology and innovations
  in management and worker training.
. Improvements in infrastructure: Eastern Europe now lacks the infra-
  structure needed to transform its economies. Current telecommunica-
  tions systems, for instance, must be upgraded to support advances in
  financial services. Transportation and goods-handling systems, such as
  roads and port facilities, must also be improved.
. Establishment of financial markets: In economies with a greater reliance
  on markets to set prices, financial markets and systems will be more
  important. Investment and business decisions depend largely on access
  to capital and on the ability to receive timely payment for the goods and
  services that are produced. These decisions also depend on knowledge
  that the institutions that provide capital and a payments mechanism are
  safe and sound. Finally, financial markets are essential to development
  of market-based interest rates, the mechanism by which capital can be

  Page 37                                        GAO/NSIADQl-21   Eastern   Europe
E3odoeconomic  ConditionsandReform
Efforta in EastEuropeanCountries

allocated most efficiently, replacing current reliance on central planners
to allocate investment funds.

The outcome of these reform efforts will likely be uncertain for several
years to come. Changing political leadership and differing economic con-
cerns and reform goals will influence the ultimate results. Over time, the
success of these efforts will undoubtedly vary among the countries, sug-
gesting that a long-term perspective will be needed to assess the success
or failure of donor assistance.

Page38                                           GAO/NSIADI)l-21EasternEurope

                        1   /
                                ,,   ..:,

Page39   GAO/NSIADol%lEasternEurope
i Major Contributors to This Report

                            James M. McDermott, Assistant Director
  National Security and     Debra M Crowe   Adviser
  International Affairs             ’ Forg;, Adviser
                            John D. De
  Division,   Washington,   Jean-Paul Reveyoso, Evaluator
                            Rona H. Mendelsohn, Editor

                            John R. Schultz, Assistant Manager for Planning
  European Office             and Reporting
                            Kurt W. Kershow, Evaluator-in-Charge
                            Mary A. Needham, Evaluator

  (486018)                  Page40                                       GAO/NSIAD-91-21
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