Preface

The transition process has confronted the former centrally planned economies with new challenges: the need to extensively restructure their national economies and put them back on a sustainable growth path; to renew demand for labour and raise employment; and to fight against unemployment, poverty and social exclusion of vulnerable social groups. In order to cope with these difficult tasks in the field of employment, all the transition countries substantially amended national labour legislation, restructured or newly established national labour market institutions and introduced a wide range of labour market policies, both passive and active.

However, the results gained so far are mixed: while some countries have succeeded in reversing negative trends in employment, unemployment and underemployment, others have still failed. Moreover, several countries achieved certain progress but have not been able to sustain it. One reason for this unsatisfactory development can be found in the lack of coordination and sometimes even inconsistency between employment policy and economic and social policies. The capacity of labour market institutions to effectively promote employment and combat unemployment also needs to be strengthened in many countries. Similarly, a lot is to be done to improve the design, targeting, implementation and funding of labour market policies, in order to increase their impact on the national and regional labour markets.

This report gives a comparative analysis of labour market problems in ten transition countries - Azerbaijan, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Kazakhstan, Poland, Russian Federation and Ukraine - selected to represent a good cross-section of Central and Eastern Europe and the Commonwealth of Independent States. It examines the main economic and social constraints on improving their employment performance and assesses and compares their institutional and policy responses to employment problems. Findings of this comparative analysis serve as a basis for recommendations concerning changes in national employment policies as well as desired institutional reforms. The report was prepared for and discussed at the Regional Tripartite Consultation on the Follow-up to the World Summit for Social Development for Transition Economies, held in Budapest on 26-28 January 1999.

The report benefited from five country reports on employment and labour market policies. The Bulgarian report was written by Iskra Beleva, Iren Russinova-Dimitrova and Vasyl Tsanov, the Czech report by Miroslav Pribyl, Zdenek Prouza, Jiri Rusnok, Tomas Syrovatka and Ruzena Vintrova, and the Croatian one by Sanja Crnkovic-Pozaic and Boris Vujcic. Raul Eamets and Kaia Philips were authors of the Estonian report and Mieczyslaw Socha and Urszula Sztanderska of the report on Poland. The report further used information and findings from the ILO Country Employment Policy Reviews for Hungary and Ukraine.

The following specialists from the ILO Employment and Labour Market Policies Branch, Geneva and from the ILO Central and Eastern European Multidisciplinary Team, Budapest made valuable contributions to the report: Alexander Samorodov was co-author of chapter 1 and contributed information on Azerbaijan, Kazakhstan and the Russian Federation to several parts of the text, Guiseppe Casale was co-author of parts 4.4 and 5.4, Maarten Keune prepared parts 3.2 and 5.2.2 and Markus Ruck was author of parts 2.4.2 and 5.3.2. Gek-Boo Ng, Rolph van der Hoeven, Mohammed Muqtada, Peter Richards, Alexander Samorodov and Oscar de Vries Reilingh provided helpful comments on the manuscript.

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Preface

• Introduction 1

• The continuing problem of unemployment and low wages 4

2.1 Persisting sluggish demand for labour 4

• Constraints on improving the employment situation 22

3.1. Macroeconomic and structural barriers 22

• Institutional and policy responses to employment problems 36

4.1 National employment policies 36

• Towards further improvement of national employment policies 54

5.1 Concertation of employment, economic and social policies 54

5.2 Promotion of business and job creation 55

5.3 Promotion and protection of human development 60

5.4 Strengthening of social dialogue 62

5.5 Refinement of labour market policies 64

5.6 Capacity building of labour market institutions 68

5.7 Conclusions 70

Annex I 71

Annex II 77

1. Introduction

Commitment 3 of the Copenhagen Declaration adopted by the World Summit on Social Development in 1995 states: "We commit ourselves to promoting the goal of full employment as a basic priority of economic and social policies, and to enabling all men and women to attain secure and sustainable livelihoods through freely chosen productive employment and work. "The participating countries also undertook to promote respect for core ILO standards. Commitment 4 urges the promotion of social integration by fostering societies that are stable, safe and just and that are based on the promotion and protection of all human rights, as well as on non-discrimination, tolerance, respect for diversity, equality of opportunity, solidarity, security, and participation of all people, including disadvantaged and vulnerable groups and persons.

The ILO has been engaged in a number of follow-up activities to the World Summit. In order to give effect to the commitment to full employment, a Task Force on Full Employment and Sustainable Livelihoods was set up in 1995, giving the ILO a coordinating role. In early 1996, the Task Force called for seven country reports on employment and social policy. One of the seven selected countries was Hungary. Drawing on lessons from the country policy reviews, a synthesis report was prepared and presented in April 1997.

The synthesis report noted that, in judging the commitment of countries to full employment and sustainable livelihoods, it was necessary to look not only at their official proclamations but also at their policy framework. Employment objectives should be consciously considered in economic policy, which should lead to poverty reduction through generating productive, remunerative and sustainable employment. The report emphasized the importance of involving the social partners and other members of civic society in the formulation and implementation of economic policies. This is clearly the spirit in which the Action Plan adopted at the Social Summit for the pursuit of full employment recognized the 'centrality of employment in policy formulation' with 'the full participation of employers, trade unions and other parts of civic society'.

The report considered that the keys to sustained labour absorption in any economy were to promote the demand for labour through economic growth and to ensure the continuous adjustment of economic and employment structures to respond to external and internal pressures. In order to expand employment, improve its quality, and thus to achieve sustainable livelihoods, a good choice of policies in a number of areas is crucial. A well-balanced approach would include: (i) policies designed for macroeconomic stability and fiscal and monetary balance; (ii) sectoral policies promoting employment-intensive growth through market-consistent incentives; (iii) policies and institutions encouraging an efficient and equitable functioning of the labour market; (iv) policies aimed at enhancing human resource development; and (v) well-targeted programmes alleviating poverty and combatting social exclusion.

In addition to stressing the importance of social dialogue in employment promotion, the report also emphasized the importance of democratic policy-making. This implies a policy-making process based on universal representation and respect for the constitutional procedures, laws and practice. This in turn requires transparency in decision making, wide sharing of information and encouragement of public debate, accountability of political leaders and high officials, and the acceptance of criticism.

The Conclusions concerning the achievement of full employment in a global context, adopted by the 1996 International Labour Conference in Geneva, stipulated the objective of full, productive and freely chosen employment through high and sustainable economic growth as a major goal of economic, social and employment policies within the joint responsibility of governments, employers and trade unions. The objective of full employment, i.e. employment for all those who are able to work, wish to be employed and actively look for a job, remains fundamentally valid for all countries. The Conclusions call for effective arrangements to overcome problems associated with the increasing globalization of financial markets, such as rapid growth of volatile short-term flows which can easily destabilize emerging market economies, with negative impacts on employment. At its March 1997 session, the Governing Body asked the ILO to launch a series of country employment policy reviews (CEPRs) between 1997 and 1999. The objective of CEPRs is to assist governments and social partners in the selected countries to make an appropriate choice of economic, social and institutional policies to promote the goal of full employment and improve the quality of working life. Among the transition countries, Ukraine was selected as the subject for a CEPR. The Ukraine report was drafted in close collaboration with the Government and the social partners and its policy recommendations were discussed and adopted at a national tripartite seminar in Kyiv in October 1998.

ILO Convention No. 122 on Employment Policy binds the ratifying countries to pursue an active employment policy designed to promote the goal of full, productive and freely chosen employment. This Convention has been ratified by the majority of transition countries, with the exception of Albania, Bulgaria, Estonia, Lithuania and Turkmenistan. Countries which have ratified the Convention report to the ILO on their labour market developments and on the changes made in national employment policy in response to the identified needs. The ILO advises on how countries might strengthen their labour market institutions and make employment policies more effective.

An International Consultation concerning follow-up on the World Summit for Social Development will be held in Geneva early in November 1999. This high-level tripartite meeting of policy makers will review actions taken at national level to fulfil the commitments of the Copenhagen Declaration and study their results. It will examine the reasons for their success or failure as well as the constraints inhibiting employment generation, and identify measures to be taken to support the policy and institutional reforms leading to the desired employment goals. In order to make the International Consultation most productive, it was decided to hold preparatory meetings at regional level. These meetings discussed the issues mentioned above in the regional context and have helped the Office and the constituents in their search for the policy options which will best reflect regional constraints and lead to solutions.

One of them was held for selected transition economies and this report was prepared for the meeting. Apart from the introduction, the report consists of four chapters. Chapter 2 is an overview of labour market problems in transition countries since 1990. It points out that the main barrier to an increase in employment is the persisting sluggish demand for labour, not only in countries which have not yet recovered from the transition crisis but also in those which have achieved some economic growth. The chapter also analyses changes in the sectoral composition of employment, in the forms of employment and the quality of newly created jobs. The weak demand for labour results in a decline in participation rates, and in persistent high unemployment. Long-term unemployment is very high and there are large regional disparities in unemployment in all the countries studied. During the transition crisis, real wages and incomes fell sharply and income differentiation has widened. Moreover, wage arrears have reached astronomic figures in many transition economies. High unemployment and forced economic inactivity, combined with a significant erosion of wages and incomes and reduced access to quality health care and social protection, have led to widespread poverty.

Chapter 3 analyses economic and social constraints which make it difficult to improve the employment performance of transition economies. In most of these countries, macroeconomic development is still characterized by serious internal and external imbalances, while there are substantial delays in the restructuring of enterprises to make them more efficient and competitive. The financial sector is also very weak. Technologies in many sectors are obsolete and a sufficiently high fixed capital formation is needed to stimulate economic growth and job creation, but investment in many transition economies is much below the pre-transition level. Poor wages and incomes, as well as low profits, depress the domestic demand for goods and services in many transition countries, with adverse effects on economic growth and employment. In most countries of the region the contribution of small enterprises to job creation remains limited. Increasing skill mismatches in the labour market are not adequately addressed by reforms of national education and training systems. The health status of the population has also deteriorated in many transition countries.

Chapter 4 assesses institutional and policy responses to employment problems. First, the achievements and failures of different national approaches are discussed with respect to the objectives of promoting employment and combatting unemployment. The labour market policies implemented in individual transition countries are compared as to their scale, design, targeting, implementation and funding. Attention is also paid to their impact on the labour market, although such evaluations are still rather scarce. An assessment is made of the capacity of national labour market institutions to address the need for labour market reform. The chapter also reviews the involvement of the social partners in employment policy formulation and implementation. It discusses the scope and quality of social dialogue concerning employment, wages and social issues at various levels - national, sectoral, regional and enterprise.

Chapter 5 builds on the findings of the comparative analysis and suggests appropriate changes in national employment policies. It pleads for the concertation of policies on employment, economic issues and social questions so that employment goals may be given the highest priority. Employment policy should thus be considered as a comprehensive, multidisciplinary policy approach towards employment-related problems. The demand for labour can recover only when national economies are able to generate and sustain sufficiently high growth rates. The chapter identifies some basic elements of an economic policy which would promote demand for labour and guide employment restructuring. Consideration is given to the reform of national education systems and social protection. There is a need for activating labour market policies and improving their design, targeting and implementation to address the real needs of the labour market. The tripartite mechanism for social dialogue as a tool for reaching consensus on social and economic issues has to be strengthened. Finally, special attention has to be paid to building the capacity of national labour market institutions.

2. The continuing problem of unemployment and low wages

At the beginning of transition, the labour markets of the former centrally planned economies of Central and Eastern Europe and Central Asia were characterized by full employment. There were even labour shortages in certain sectors, regions and occupations, although the first symptoms of emerging tensions in national labour markets were already visible, particularly in Central Europe. Open unemployment existed only in Yugoslavia but its extent was limited. However, full employment was achieved at the cost of low wages. Poor wages and limited income differentiation, loosely dependent on effort and productivity, did not motivate workers to improve their work performance. Together with a sub-optimal organization of work, this led to heavy losses in working time and high absenteeism. There was widespread overstaffing and labour hoarding in many sectors and labour productivity was low.

A high share of industry in total employment was another characteristic of the command economies. The extraction industries and the defence industry played a major role in production and employment, while services were largely underdeveloped. Big state-owned enterprises dominated industry, agriculture and services. ⁽¹⁾ The private sector was practically non-existent or played only a limited role in most countries of the Eastern Bloc (e.g. in Hungary or Bulgaria). The exceptions were Yugoslavia and Poland. Yugoslavia had a system of self-managed state enterprises co-existing with a private sector, which consisted of a large number of small firms; in Poland, agriculture was based on small private family farms.

This initial labour market situation changed rapidly after the introduction of political, economic and social reforms between 1989 and 1991. Events during this period revealed the hidden problems as well as new ones which emerged as a consequence of abrupt changes in internal and external economic conditions. The section below analyses labour market developments in the transition economies and identifies the crucial issues to be tackled by national employment policies.

2.1 Persisting sluggish demand for labour

Political, economic and social reforms have completely reshaped the labour markets of all the transition countries. The immediate reaction to economic uncertainty was a sharp decline in demand for labour. External shocks such as the break-up of the USSR and the collapse of the common market of the former Eastern bloc occurred during the same period as internal shocks caused by economic reform and stabilization programmes. This combination resulted in sharp production losses and pulled the national economies of these countries into a dragging transition crisis. There was a certain delay before the effects on employment were felt, as enterprises were at first reluctant to dismiss redundant workers, assuming that the economic recession would be a short-term crisis. As economic pressures intensified, the effect on employment in the different countries was determined by a number of factors, such as the scale of initial imbalances, the speed of reform, the type of privatization and the progress made, proximity to Western countries, and entrepreneurial tradition. Employment losses accelerated in the first years of economic transition in Central and South-Eastern Europe, but they were less pronounced in the countries of the former USSR.

In Central and South-Eastern Europe, employment reduction was a direct consequence of the transition crisis hitting those industries which partly or entirely lost their traditional Eastern markets. Macroeconomic stabilization policies, based on restrictive monetary and fiscal measures and accompanied by tax-based income policies, suppressed real wages and incomes and reduced enterprise profits. Domestic demand fell sharply, first for consumer goods and services and then for investment goods. Moreover, domestic products were increasingly confronted with competition from imported goods and were losing their share of the domestic market. Direct subsidies to enterprises were significantly reduced and indirect subsidies in the form of special prices for production inputs were gradually removed. Enterprises were thus under increasing pressure to minimize production costs, including labour costs, in order to become more competitive and improve labour productivity. The resulting redundancies first concerned working pensioners and later other workers, particularly those considered less productive by employers, i.e. young workers with limited experience, members of certain ethnic minorities such as the Roma, and women. In order to make labour markets more flexible, the amended labour legislation simplified layoff procedures, shortening the period of advance notice and offering severance pay to workers who lost their job.

These employment effects had been expected before the introduction of political and social reforms. It was presumed that workers released from overstaffed sectors and declining industries, as well as new labour market entrants, would mostly be absorbed by sectors which were beginning to expand, particularly services and some industrial branches. Although this reallocation of labour did indeed occur, the number of newly created jobs was much lower that the number of jobs lost, due both to supply and demand restrictions in the market. On the one hand, the absorption capacity of services, particularly in the formal sector, was fairly limited owing to depressed incomes and profits. On the other hand, enterprises, including new firms, were seriously constrained by lack of capital and difficult access to credit in their endeavour to develop new production. As a result, net employment losses became considerable. In Bulgaria, Hungary and Poland, job losses exceeded GDP losses in percentage terms as many enterprises attempted to remain competitive by reducing labour hoarding and increasing labour productivity. In others, employment shrank much less and labour productivity declined further. This was often connected with delays in enterprise restructuring as a result of persisting soft budget constraints for enterprises and delays in privatization, or it was linked with the disadvantages of privatization based on the voucher method. However, some positive stimuli were also generated by the newly launched policies which partly relieved labour market tensions.

The employment situation in these countries, however, did not significantly improve even after economic recovery was achieved. As demonstrated by Table 2.1, for example, the Polish economy returned to economic growth in 1992, but the decline in employment was halted only in 1994 and since then very limited employment gains have been achieved. In Hungary, economic growth was associated with employment contraction until very recently and a negligible increase in employment began only in 1998. In other countries, such as Bulgaria, both economic and employment growth were renewed but not sustained.

One reason for economic growth without employment creation is the persistence of extensive labour hoarding in many enterprises. This makes it possible to increase production without increasing the number of workers. If enterprises want to become competitive they have to reduce total labour costs and redundant labour. ⁽²⁾ Also many new technologies which are indispensable for the manufacture of competitive and good quality products, are labour-saving. At the same time, the number of new jobs created so far in services and in some industries is not sufficient to absorb unemployed jobseekers in the market .While large enterprises are permanently reducing their workforce, the capacity of small enterprises to create employment has been rather modest. Similarly, employment gains in agriculture in some countries are in subsistence farming.

Table 2.1 Production and employment trends in selected transition economies, 1990-1997 ( total increase (+) or decline(-) over the respective period in %)

The CIS countries and at this stage also the Baltic States, experienced a fairly slow decline in employment in the first years of economic transition, despite large production losses. This may be explained by the paternalistic approach of enterprise managers towards employees. In their desire to maintain social peace in their enterprise and local society, they preferred to keep redundancies to a minimum at the cost of lower wages and lower utilization of production capacity or sale of part of the enterprise. Quite often, this social approach was used to mask the intention of managers to get a stake in privatization through management/employee buy-out and later to gain full control of the enterprise. Also, many enterprises wanted to avoid offering severance pay and preferred to keep workers, first by using the measures mentioned above, and later by sending them on administrative leave or short-time work or by not paying wages, even for extended periods. As health care, childcare, recreation, the provision of goods not available in shops and even housing were delivered by enterprises, the workers themselves did not want to lose access to these services and opted to stay on the payroll even if they received only a part of their wages or were not paid at all. The reluctance of unprofitable enterprises to lay off redundant workers was reinforced by state authorities which gave concessions to such enterprises for keeping redundant workers. Thus, employment tensions in the CIS countries were hidden behind formal employment statistics.

ILO surveys, carried out in 1994 and 1995, revealed that 36 per cent of establishments in Russia and 37.3 per cent in Ukraine could produce the same output with fewer workers. Surplus labour in the Russian Federation was estimated at 9.6 per cent of total employment and at 10.5 per cent in Ukraine. It is striking that private enterprises in both countries reported overstaffing (38 per cent in Russia and 44.3 per cent in Ukraine) more often than state enterprises (28.6 per cent and 35.5 per cent respectively). The proportion of surplus labour in total employment stood at 9.2 per cent in Russian private enterprises and at 11.7 per cent in the Ukrainian private sector compared with state enterprises (5.9 per cent and 8.6 per cent respectively). ⁽³⁾

The continuing economic crisis sharply reduced the financial capacity of enterprises and local authorities to maintain this situation for long. Many workers were not prepared to continue with this quasi-social solution, particularly when enterprises started to transfer the provision of services to the local authorities or cancelled them altogether. At this point workers who were on unpaid leave left their enterprise. The ability of large enterprises to offer employment was declining, and the new small-scale sector was too weak to generate enough jobs or, for economic and tax reasons, it could create employment only in the informal sector. This meant that a rising proportion of unemployed persons could not find a regular job and many were forced into subsistence farming on their small plots of land or earned a living in casual work, usually in the informal sector. Therefore in all CIS countries, the net decline in employment accelerated after 1995. ⁽⁴⁾

Job losses were thus partly reflected in open unemployment, and partly in economic inactivity. Many working pensioners had to withdraw from the formal labour market, and the most acceptable solution for older workers was early retirement, rather generously offered by many countries in spite of its high cost. Many young people extended their studies either as a response to improved earning possibilities in higher-skilled jobs or in order to escape increasing youth unemployment and postpone their labour market entry. There is also a small but increasing number of people who have voluntarily given up economic activity and live on income from renting out their houses or on returns to capital. However, most economically inactive people left the labour market when they lost any hope of finding a regular job with reasonable remuneration and acceptable working conditions, at an accessible distance from their home. Some could not solve childcare problems or faced other obstacles in finding employment.

As a consequence, labour market participation rates declined sharply in all the countries listed in Table 2.2. There are significant gender-related differences: except in Poland, female participation rates fell more than male rates, showing a weaker position of women workers in the labour market. Women are disadvantaged because of maternity and childcare. Employers are often prejudiced against women, considering them to be less reliable, less productive and less competent than men, and they often face direct discrimination in recruitment and layoff. As a result, less competitive groups of women often withdraw from the labour market.

Many formally inactive persons had to seek an income in the informal sector as social transfers were rapidly losing their real value and in many countries they were not paid on time. Informal activity also became important for employed people as a second job, and for those on unpaid leave or registered jobseekers because wages, incomes and unemployment benefits rapidly declined in real terms. Without supplementing their meagre income by additional informal earnings many families would have fallen into poverty. The informal sector has grown significantly since 1990 and its share in employment (taken as the main activity) is estimated between 6 per cent and 10 per cent, while second jobs in the informal sector may reach much higher figures. ⁽⁵⁾ Although there is no reliable comparison of the size of the informal sector it is generally believed to be larger in the CIS countries and South-Eastern Europe than in Central Europe and the Baltic States. For example, surveys in Ukraine indicate that some 8.5 - 9 million persons, i.e. around one-third of the active population, receive an income from some type of informal economic activity. ⁽⁶⁾ Around 3 million of these are estimated to work full time in the informal sector while the rest conduct informal activities as a second job, in addition to their formal employment.

Table 2.2 Decline in participation rates by gender in selected transition countries (ratio of economically active population to population aged 15 and over in % if not otherwise stated)

Considering both formal and informal economic activities, the actual decline in labour input has been less dramatic than appears from the official statistics. While some informal jobs provide higher incomes than the formal sector as remuneration may include money saved from unpaid payroll taxes, they offer little employment security, give no entitlement to social security, social assistance or health care. Many informal jobs are of a casual type, poorly paid, often performed under detrimental working conditions, and with no guarantee of regular earnings. A majority of informal job holders would thus prefer to return to the formal labour market.

2.2 Changes in employment structure and conditions of employment

2.2.1 Rapid deindustrialization

The transition process brought fundamental changes to the composition of employment by sector and branch (see Table 2.3). The most serious employment losses were experienced by the industrial sector in most countries. Except in the Czech Republic, Estonia and Hungary job losses in industry were heavier than in any other sector. This decline would be even deeper for the CIS countries if people on administrative leave and those on short-time work were properly considered. Industrial branches with higher value-added, such as mechanical and electrical engineering (including the defence industry), textiles, clothing and leather and often wood and metal processing were hardest hit by economic recession. Mining, metallurgy, energy production and food processing suffered lower production and employment losses and recovered earlier. The extraction industries have increased their share of production and employment in most countries. However, in Central Europe the higher value-added industries have been recovering to some extent, due to foreign direct investment or outward processing commissioned by firms from economically advanced countries using cheap skilled labour in these countries.

Table 2.3 Changes in employment composition by sector in selected transition economies

(% shares of sectors in total employment in respective years)

The contribution of agriculture to employment has become rather controversial. The share of agriculture in total employment has rapidly declined in countries which have been able to renew economic growth and where the rural population can find major sources of income outside agriculture, i.e. in Central Europe and Estonia. The only exception is Poland where agriculture is based on small family farms which have low productivity, are heavily subsidized by the state and protected against imports. In other countries, agriculture has become a buffer for unemployment through an increase in subsistence farming as the only or the main source of income for many people who have lost their jobs in large agricultural enterprises or in other economic sectors. In these countries, the share of agriculture in total employment has increased in relative and sometimes even in absolute terms.

The service sector has increased steeply in Central and South-Eastern Europe and in the Baltic States as most new jobs have been created in services, particularly in financial and producer services, in state administration, and in trade, tourism and other consumer services. Education and health care have mostly maintained their contribution to total employment. In contrast, the CIS countries have not experienced substantial employment gains in services, apart from state administration and the financial sector; in many of these countries the tertiary sector has even reduced its share of total employment. However, these figures relate only to formal employment while many services are performed as an informal activity for tax reasons. In addition, certain services are still provided by enterprises and these are included in the industry figures relating to the main activity of the enterprise, thus reducing the share of services in statistics. As a result of declining real incomes, the population can no longer afford to buy many consumer services, and this has a negative impact on the further development of the sector. The extent of the statistical distortion is not known.

2.2.2 Deteriorating conditions of employment

Economic pressures as well as insecure markets have forced many enterprises to turn to more flexible forms of employment. First, newly recruited persons are offered fixed-term and short-term contracts and the permanent contracts of long-serving staff are often changed into contracts for a limited duration in order to avoid severance pay and legal obstacles (such as the protection period for certain groups of workers, compulsory notice period) when the enterprise wants to reduce staff. In the past, fixed-term contracts were offered only to managers, researchers and a few other white-collar workers, and to seasonal workers in agriculture and food processing, but their share in total employment has increased and they have become more frequent among blue-collar workers. In the Czech Republic 7.1 per cent of employed persons worked on fixed-term contracts in 1997. In Bulgaria, many people are engaged on so-called civil contracts, which are attractive to employers as they are not liable for payroll taxes.

Second, although full-time employment is still by far the prevailing form, preferred by most employers and employees, the share of part-time jobs is increasing (in 1997, they accounted for 5.9 per cent of jobs in the Czech Republic, 5 per cent in Hungary and 12.2 per cent in Ukraine). According to labour force surveys (LFS), part-time employment is not the choice of most workers but a resort for those who cannot find a full-time job. While women might prefer to work part-time for a certain period, in order to take care of small children, the present economic situation of their families does not allow many of them to do this because they cannot afford the loss of income. A trend towards an increase in part-time employment is, however, clear. As already mentioned, administrative leave and short-time work are widespread in many CIS countries, and they are also used in some other countries, such as Bulgaria or Croatia. In Ukraine for example, 21.9 per cent of all workers were put on administrative leave in 1997, almost one-third of them for more than one month, while another 16.1 per cent worked short-time.

Third, the formerly very rigid national labour legislation preventing workers from resigning has been amended. Dismissal was rather exceptional and used as a punishment for misconduct. However, in some countries procedures in the case of dismissal or resignation have been made too easy for either the employer or the worker. In Ukraine, for example, the Labour Code does not stipulate a required notice period for contract termination by the employer, unless workers are being laid off because the enterprise has economic problems. This may lead to unjustified immediate dismissal due to health problems or inadequate skills. In Bulgaria, only two weeks notice from the worker is required by law; particularly in the case of highly skilled specialists, the employer may find it difficult to recruit a replacement in such a short time. On the other hand, attempts to protect certain groups of workers against dismissal (pregnant women, women with small children, disabled persons etc.) have often turned against them as employers discriminate against such workers in recruitment or find ways to bypass the regulations. The level of severance pay as a compensation for lost income and other hardships has also been reduced in many transition economies. However, particularly in the CIS countries, employers cannot afford to give severance pay to redundant workers and therefore they put them on administrative leave or short-term work, without compensation for lost income.

Although little statistical information is available on the quality of newly created jobs, many sociological surveys show their polarization as to skill requirements. On the one hand, new jobs in the financial sector and other producer services, as well as in public administration, require high-level skills. On the other hand, jobs in distribution and consumer services and in industrial processing for foreign companies usually require only low levels of skill. Similarly, an increase in subsistence farming means a significant fall in the quality of employment in agriculture and a substantial de-skilling of persons who have lost more qualified jobs in other sectors of the economy or in large agricultural enterprises.

A considerable amount of evidence has been collected by national labour inspectors on deteriorating working conditions in many enterprises which economize on protective aids and occupational safety. Confronted with the threat of unemployment, many employees do not protest about hazardous conditions. In small private enterprises particularly, due attention is not paid to health and safety and workers are often using badly maintained and obsolete equipment for long hours. This explains why the number of occupational accidents has increased in some transition economies since 1990. ⁽⁷⁾

2.2.3 Increasing self-employment

In 1989, self-employment was fairly negligible in the CIS countries and former Czechoslovakia (0.4 per cent of total employment in 1989) while it played a limited role in other CEE countries (6.1 per cent in Hungary and 9.1 per cent in Bulgaria). Only Poland recorded one-quarter of all employed persons as self-employed, mainly due to agriculture based on small private family farms; self-employment was also considerable in Yugoslavia. ⁽⁸⁾ These figures relate only to persons having self-employment as their main activity while many more work on their own account in their second activity, often informally.

In the first years of economic transformation, self-employment accelerated as many people started their own business. Due to lack of seed capital, new small firms developed mainly in occupations which were not capital intensive, such as consumer and production-oriented services, handicrafts, the liberal professions, transport and construction, supplying mostly local and regional markets. While certain informal activities from the pre-transition period were legalized in new economic conditions, others occurred as independent entities during the process of restructuring large state enterprises (through privatization, splitting-up, closure etc.) or as completely new entities. The small private sector was also stimulated by the so-called small privatization (of shops, hotels, restaurants or small production units) and by the return of nationalized property to the former owners or their heirs, which facilitated the access of small entrepreneurs to cheap premises, equipment, bank credits and markets.

Surveys reveal that self-employment has resulted from both pull and push factors. After political changes many people became own-account workers to exploit new opportunities and in anticipation of high demand for previously underdeveloped services and goods in short supply. While a number of self-employed people succeeded and some were even able to expand their firms, others failed due to lack of experience and low market demand. Another group of persons became self-employed because of push factors, (lack of salaried or reasonably remunerated jobs), with the aim of avoiding unemployment and raising family income. Typical own-account jobs are concentrated in low skill services or small-scale production; they require high flexibility and mobility, but frequently fail to provide sufficient job security or adequate employment conditions, and therefore many are on the border between the formal and the informal sectors. Due to the underdeveloped infrastructure, including telecommunications, modern forms of self-employment such as teleworking are practically unknown. Table 2.4 gives an idea of the extent of self-employment in the formal sector and its development during the transition period.

Table 2.4 Development of self-employment in selected CEE countries in the 1990s

(in % of total employment, data from the LFS)

The table reveals three features of self-employment in transition economies. First, Poland represents one extreme - a very high share of self-employment in total employment, due to agriculture (non-agricultural self-employment accounted for 12.8 per cent of total Polish employment in 1996, a figure in line with most other CEE countries). Second, in most countries of Central and Eastern Europe, the percentage of self-employed people did not increase significantly between 1993 and 1996; in the Czech Republic, Poland and Russia their share even decreased. It seems that modest personal incomes and low enterprise profits are resulting in depressed demand for goods and services at home (external demand is less important for small firms). For this reason the absorption capacity of the small private sector has been exhausted for the time being, at least in the formal economy. Moreover, many self-account workers are being pushed out of the market by large firms or multinationals in wholesale and retail trade, hotels, restaurants and tourism.

Third, another reason for the modest share of self-employment in CEE countries lies in the national systems of social protection. In some countries self-employed persons are not covered by unemployment insurance or social assistance and they do not have access to certain types of benefits (e.g. disability benefits or pensions) unless they give up their business licence. In view of such risks many people prefer to be employed as salaried workers, and to work independently in their second job. Moreover, to be licensed for a second activity is advantageous financially as it reduces income tax. In addition, certain expenses are tax deductible.

2.3 Unemployment characteristics

2.3.1 The magnitude of unemployment

Open unemployment, practically non-existent before 1990 except in the former Yugoslavia, accelerated after the introduction of economic reforms in all transition countries. However, very soon a clear difference emerged between two groups of transition economies. In Central and South-Eastern Europe unemployment rates reached two figures within the first three years of economic transformation (the only exception being the Czech Republic). ⁽⁹⁾ More as a result of restrictions in unemployment compensation systems than because of a recovery in demand for labour, unemployment rates decreased later and in Central Europe they became relatively stable at a level slightly above 10 per cent, with some seasonal fluctuations (see Table 2.5). The need to overcome serious economic imbalances resulting from delayed restructuring of the enterprise sector is now pushing unemployment in the Czech Republic closer to that of neighbouring countries. In contrast, the labour market situation is significantly worse in South-Eastern Europe mainly as a consequence of armed conflict there, but also due to other economic factors, which are discussed in more detail in the following chapter.

Table 2.5 Registered unemployment rates in selected transition economies: 1991-1998

(end-of-period rates in % of the labour force)

Until 1996, the CIS countries recorded very slow growth in registered unemployment, which did not exceed 5 per cent for most countries; it has recently started to grow more significantly in some countries while in the Russian Federation registered unemployment has again declined. The current financial crisis there, however, will reverse this recent trend and accelerate unemployment again.

The very low rate of registered unemployment in the CIS countries has more to do with the fact that many jobseekers do not turn to labour offices for assistance, than with a small number of jobseekers as such. ⁽¹⁰⁾ Indeed, as shown in Table 2.6, the LFSs reveal a much higher level of open unemployment, several times greater than the registered rates. Moreover, as already mentioned, in addition to non-registered unemployment, these countries suffer from hidden unemployment in the formal sector as redundant workers are frequently sent on administrative leave, mostly without pay, or forced to work shorter hours. There are also huge wage arrears in all CIS countries which may be considered a form of hidden unemployment as people are working for nothing because their enterprise cannot pay their wages. ⁽¹¹⁾

During the first phase of economic transformation, the Baltic States shared many labour market characteristics with the CIS countries, notably a fairly slow increase in registered unemployment while economic inactivity grew faster. But later on, labour markets in the Baltic States followed trends typical for the non-CIS countries: open unemployment started to accelerate and has recently stabilized with a slight downward trend. LFS data for these states indicate much higher levels of open unemployment than the levels shown by administrative data.

Table 2.6 Comparison of unemployment rates from administrative data and LFS

(in % of the labour force)

As a rule, countries with high registered unemployment have lower unemployment when measured by the LFS; this is true of Hungary and Poland, although the difference is not so great and is narrowing in time. The explanation is that some registered jobseekers are actually either working (usually in the informal or semi-formal sector) or do not meet all the conditions for the ILO definition of unemployment. ⁽¹²⁾ Conversely, countries with low registered unemployment usually have much higher unemployment revealed by the LFS, as in Estonia and the CIS, the main reason being that jobseekers often do not register with the employment service.

2.3.2 Characteristics of unemployment

In all transition countries, regional disparities in unemployment are high and still increasing. The difference between the highest and the lowest rates of registered unemployment often exceeds 20 percentage points. There are numerous communities in each country where unemployment is several times higher than the national average. Unemployment tends to be lowest in big cities, regions with a diversified industrial economy, regions offering good opportunities for tourism and leisure, and areas bordering on more developed countries, where people can commute for work or live by smuggling goods or providing cheaper services. ⁽¹³⁾ In contrast, those hardest hit by unemployment tend to be rural or monostructural regions where the main industry is suffering from economic recession, and regions with little potential for economic development because of poor infrastructure, low educational level of human resources, and a poor attitude to private enterprise. The problem of regional disparities in unemployment is aggravated by very low territorial mobility due to lack of reasonably priced housing, shrinking public transport connections and increasing fares as many people cannot afford to use their car.

The national labour markets are also characterized by low turnover in unemployment, the consequence of which is high long-term unemployment (for more than one year). The share of long-term unemployment in total unemployment ranged from 28 per cent in the Czech Republic to 64 per cent in Bulgaria in 1997 (Table 2.7). Table 2.7 also shows that in some countries, e.g. Bulgaria and the Czech Republic, there is little difference between male and female long-term unemployment, while in others, like Poland and Russia, women are more affected by long-term unemployment. Hungary has the opposite experience. Older workers tend to suffer more from long-term joblessness while young people are less affected because of their greater flexibility. However, in some countries, such as Bulgaria, prime-age workers are, rather surprisingly, hardest hit by long-term unemployment.

There are widespread skill mismatches in the labour market. Many skills have become obsolete due to changes in production structures, advanced technogies and new forms of work organization; workers with obsolete skills need to be retrained as newly required skills are often undersupplied. However, in some transition economies an opposite trend has already emerged: education and training are so extensively provided for professions formerly in short supply, such as economists, lawyers, managers and secretaries, that the labour markets are flooded with such specialists while previously oversupplied technical and craft occupations are missing. Reform of the national education and training systems has not progressed sufficiently to make them more flexible in responding to changes in demand for skills. This is one of the reasons why many school leavers cannot find suitable jobs and have to be immediately retrained (to be discussed in detail in Chapter 3).

Table 2.7 Long -term unemployment and its composition by age and gender (LFS data of 1997/Q2 if not otherwise stated, in % of total unemployment and gender- or age-specific unemployment respectively)

The social groups most exposed to unemployment are young people, particularly school leavers with no work experience and school drop-outs with only basic education, older workers, disabled persons and people with health problems. In Central and Eastern Europe, workers with low or obsolete skills have difficulty in finding new jobs while in the CIS countries highly educated workers are more hit by unemployment. Members of some ethnic minorities suffer disproportionately from unemployment, notably the Roma in Central and South Eastern Europe, Turks in Bulgaria, the so-called "small nations" in the Russian Federation, ⁽¹⁴⁾ or Russians in non-Russian countries of the former USSR.

For women, the picture is not clear. According to LFS data, women experience higher unemployment than men in the Czech Republic, Poland, Bulgaria and Croatia, but their situation is quite opposite in Hungary, Estonia, the Russian Federation and Ukraine. This can be explained by several factors. First, women more often prefer withdrawal from the labour market to unemployment, even though they then rely more on assistance from labour offices than men who opt for other channels in their job search. Therefore in Estonia, Kazakhstan, the Russian Federation and Ukraine there are more women registered as unemployed. Second, employment and unemployment of women depend on the share of female-dominated industries and sectors in the national economy and their economic situation. When light industry and services, both offering more jobs for women, are well-developed in a certain country, the labour market situation of women tends to be better and vice versa. Prejudice against women workers may also play a role as employers often discriminate against them in recruitment and layoff on the grounds of their alleged lower labour productivity. ⁽¹⁵⁾

2.4 The fall in wages and high incidence of poverty

2.4.1 Declining real wages

The European and Central Asian economies in transition inherited low levels of money wages and rather low wage differentials. This was due to their fairly rigid central pay systems, which set wages more as a function of the industry and type of work than of skill requirements, individual work performance of the employee and economic performance of the enterprise. ⁽¹⁶⁾ Economic reforms gradually replaced centralized wage tariff systems with wage determination based on collective bargaining in the enterprise sector while maintaining a universal tariff system in the budget-funded sector. Nevertheless, in many countries the state still controls the development of tariff wages through the minimum wage which is often only partly indexed to prices. The minimum wage serves as a basis not only for the wage tariff system in the budget-funded sector but also for enterprise tariff systems and often also for calculating minimum social benefits. ⁽¹⁷⁾ In many countries, the minimum wage has fallen well below the subsistance minimum, thus losing its social and economic role.

In line with economic reforms, the governments introduced economic stabilization programmes in which the key role was attributed to a tax-based income policy, controlling wage increases above a specified level through a punitive tax. There were two main variants of this policy: (i) direct control of the overall wage fund of the enterprise; and (ii) control of the average wage of the enterprise. The aim of this policy, imposed in most countries on state-owned enterprises, was to bring down inflation by imposing a rate of wage growth which was lower than inflation and to link wage increases more with enterprise performance, as it was believed that managers in public enterprises are less resistant to wage pressures from workers than managers in private enterprises. In 1990, Poland introduced a very strict progressive tax on the total enterprise wage fund, known as the "popiwek". A year later it was changed to variant (ii), then progressively reduced and finally abolished in 1995. In the Czech Republic, wage regulation was introduced in 1991 with the aim of stimulating exports and making them more competitive through low labour costs; domestic demand was to be reduced by a sharp fall in real wages and mass unemployment was to be avoided. Wage regulation was abolished only in 1995. A similar, increasingly restrictive tax-income policy was implemented in the Russian Federation (until January 1996) and in Ukraine. In Bulgaria, the policy was modified several times to partly compensate for inflation and to take account of changes in productivity.

The direct consequence of this tax-based income policy was a sharp fall in real wages as seen in Table 2.8. The income policy was moderated and finally abolished, especially in the Central European countries, leading to a more rapid recovery of real wages, but so far only the Czech Republic has been able to exceed the 1989 level of real wages. However, any new austerity package, such as that introduced in Hungary in 1995, the establishment of the currency board in Bulgaria in 1997 and the stabilization programme in the Czech Republic in 1997, again impose limits to wage growth with a direct negative effect on real wages. ⁽¹⁸⁾ In the CIS countries, the overall trend has been negative so far, resulting in real wage levels dropping to a fraction of their pre-transition levels.

Table 2.8 Real wage trends in selected transition economies (1989 = 100)

There were many other negative effects of wage regulation, such as the disconnection of wages and productivity, as more profitable enterprises were not allowed to increase wages while enterprises which were performing badly could (and in most cases did under the pressure of workers) increase them up to the limit. Moreover, monopolistic enterprises mainly in the extraction industries, metallurgy and energy, converted their profits, which were artificially inflated by price increases, into higher wages. This accelerated inflation in the national economy and increased wage differentiation. Wages in these industries have been growing much faster than in other industries, regardless of actual productivity. Low wages have delayed economic and employment restructuring as more productive industries and enterprises could not attract workers by offering them significantly higher wages. Low wages also helped maintain redundant workers in large enterprises and had adverse effects on their performance and productivity. As direct control of wages was easy particularly in the budget-funded sector, the wage gap between the enterprise and the budget-funded sectors, inherited from the past, has widened further, leading the most qualified workers to leave the sector. As a result, the quality of education, health and social care is deteriorating. Several undesirable phenomena have begun to appear, such as corruption or uncontrolled private payment for public medical and social services, which undermines the access of poor perople to health care and public welfare.

Since official statistics on real wages refer to contracted wages and not to actual remuneration, the real situation is even more dramatic. ⁽¹⁹⁾ This is the case particularly in the CIS countries due to widespread non-payment of wages, both in the enterprise and the budget-funded sectors. The extent of wage arrears in Ukraine amounted to more than 5 billion hryvnya in January 1998, which is equivalent to more than six months' wage bill for the country. In the Russian Federation wage arrears equalled some USD 10 billion at the official exchange rate in early 1998 while in Kazakhstan they reached 40 per cent of the country's GDP in summer 1998.

These huge wage arrears seem to derive from many factors. The first is the collapse of demand. Sales and financial difficulties have resulted in mounting debts between suppliers and customers, leading to the insolvency of enterprises and the replacement of cash payments by barter trade. Many enterprises are forced to pay their workers in kind. It is difficult for governments to pay public employees because of low tax revenues. The second contributory factor is heavy taxation of enterprises which limits resources for wages. (Heavy taxation is sometimes a pretext for managers who prefer to invest money elsewhere rather than pay wages to workers.) Enterprises in the energy and raw-material sectors set prices on supplies of inputs to other enterprises, leaving no margins for profits and wage costs. Finally, the restrictive monetary and fiscal policies aimed at curbing inflation have clearly aggravated wage arrears as they sharply reduced enterprise access to credit and also restricted government expenditure, including that on wages for public employees.

The erosion of real wages, due in part to the wage tax, has coincided with and helped induce a restructuring of incomes in most countries of the region. As a result, the proportion of wages to total income has decreased while other monetary and non-monetary sources have both increased. For example, in Poland the proportion of wages in total income fell from 46.7 per cent in 1989 to 30.3 per cent in 1995; in Bulgaria from 54.8 per cent in 1989 to 42.5 per cent in 1994; in the Russian Federation from about 60 per cent in 1993 to 34 per cent in 1995; and in the Czech Republic from 66.5 per cent in 1989 to 46.1 per cent in 1995.

It should also be noted that labour markets in transition countries, as in other parts of the world, increasingly tend to be structured in such a way as to control and limit access to good, well-paid jobs. This keeps wages from equalizing and restricts the effect of market forces. As a result, in those segments of the labour market where access to jobs is easier, "overcrowding" pushes wages downwards, generating the working poor.

Low wages also contribute to the rapid growth of the informal economy. On the one hand people have to supplement their meagre wages by earnings from second or third jobs. On the other hand, they are forced to buy cheaper goods and services on the black market in order to reduce spending. The adverse effects of low wages on consumption levels have direct consequences for production and employment. In addition, they reduce the funds available for social issues because of lower tax revenues. Poor wages, low incomes and social transfers have reduced a considerable proportion of the population in transition countries to poverty.

2.4.2 Increasing poverty in transition economies

Table 2.9 illustrates some basic characteristics of the social situation in selected countries of Central and Eastern Europe

Table 2.9. Basic demographic and social characteristics of selected transition countries

Rising unemployment coupled with falling real wages and other components of household income (even if partly compensated by informal sector activity and income), has caused poverty to increase rapidly. The Visegrad countries (Czech Republic, Hungary, Poland) ⁽²⁰⁾ have on average less poverty than their neighbours, Poland having the highest poverty rate within this group. A much higher incidence of poverty exists in South-Eastern Europe (Bulgaria), and the highest levels occur in the countries of the former Soviet Union (Estonia, Kazakhstan, Russia, Ukraine). In all countries, however, poverty has increased significantly. The dramatic rise in poverty in Bulgaria and all the countries of the former Soviet Union is not only the result of an overall decline in income but also of very unequal income distribution (see Table 2.10).

Table 2.10 Inequality and poverty in selected transition countries

Particularly important are changes in the distribution of poverty between different groups. In the past, poverty among the elderly in most countries of the region was higher than the average for the total population. Table 2.11, based on the results of a UNICEF inquiry, shows that this pattern is changing in some countries at least. In the Czech Republic, Bulgaria, Hungary and Poland, the incidence of poverty among the elderly was lower from 1992 to 1994 than the average. Only in Azerbaijan (slightly) and Estonia (significantly) was it higher than for the total population.

Table 2.11 Poverty among the elderly and non-elderly (1992-1994)

These trends signal important policy problems. First, a new type of poverty is emerging in transition countries: poverty among the younger, working-age population - including the unemployed, those affected by the non-payment of wages, and low earners. Second, at least in some countries, social protection systems have been more effective in alleviating poverty among the elderly than in alleviating the new poverty emerging among working-age households. In part, this reflects the design of social protection systems. Pension systems and social assistance benefits for the elderly and disabled were in place before economic transformation began, while unemployment benefits and income-related social assistance began to be implemented only after 1990. However, the new poverty also reflects local attitudes. The elderly are seen as the most vulnerable group, and there is still reluctance to support those who can work - even if they are not able to find a job or have to accept wages far below the subsistence minimum.

3.1 Macroeconomic and structural barriers

All the former centrally planned economies started their transition to a market system under rather unfavourable conditions. They inherited badly balanced economies characterized by high depressed inflation, a shortage of many goods and services and heavy debt. The close integration of their economies in terms of production and trade rapidly turned into a serious handicap after the collapse of their common market and the break-up of the USSR. This resulted in an increase in the price of energy and raw materials, the conversion of mutual foreign trade to hard currency payments, the fixing of new exchange rates and the introduction of new currencies. Enterprises were often cut off from their former suppliers of raw materials and intermediate products and had to find external markets for their products. These new markets were usually more demanding than the traditional outlets. Enterprises also faced harsh competition from imported goods in the shrinking domestic market. This was particularly difficult for newly independent states of the former Soviet Union. Only 20 per cent of output in Ukraine consisted of goods and services for final use, while the rest were intermediate goods supplied to enterprises in other ex-Soviet republics, which in many cases ceased to pay for deliveries.

The national economies were further destabilized by the introduction of economic reforms. These consisted of price liberalization, relaxation of controls on foreign trade, devaluation of national currencies, privatization of state-owned enterprises, reduction of subsidies to enterprises and subsidized prices for the population, in a highly monopolistic environment. Sharply increasing prices for energy and raw materials were passed on to the prices of goods in the shops and inflation accelerated, reaching the dimensions of hyperinflation particularly in the CIS countries. In order to curb inflation, many governments attempted to impose strict monetary and fiscal policies, while regulating an anticipated escalation of wages in the public sector by rigid income taxation. Bulgaria, Ukraine and the Russian Federation first tried to protect the population from some of the price shock by indexing wages and incomes but this soon had to be cancelled or reduced because of aggravating the government deficit. For the same reason governments were forced to cut back on social programmes.

High inflation accompanied by a restrictive incomes policy (with or without indexation), together with the reduction in social programmes, led to a sharp fall in real wages and incomes with an immediate detrimental effect on consumer demand and retail trade. Enterprises thus faced large losses in sales revenues in both the domestic and external markets, while being forced to pay higher prices for inputs. Enterprises adjusted first by reducing their demand for investment, later by selling off parts of the enterprise and by externalizing or giving up ancillary production and services. Despite these measures, they were still confronted with mounting financial problems and were unable to pay their suppliers while they were often not paid by their own customers. Insolvency was aggravated by increasingly difficult access to bank credit and by a heavy tax burden. This led to an accumulation of inter-enterprise debts, tax arrears and tax evasion, resulting in the demonetization of national economies as barter trade increased rapidly, and in growing government deficits. The non-payment of wages was another consequence of financial problems in enterprises.

As a consequence of these external and internal shocks, production rapidly declined and the economies fell into a deep transition crisis. Its depth and duration varied by country depending on many factors. First, the initial conditions were significant, i.e. the level of suppressed inflation, the amount of internal and external debts as a proportion of GDP and exports, the structure of economy in terms of its diversity and the share of industries dependent on Eastern markets, etc. Second, industrial and entrepreneurial traditions, were important, particularly those gained before so-called socialist industrialization. Third, previous exposure to competition on world markets under the command economy played a role in transition; enterprises in Central Europe and the former Yugoslavia were able to benefit from their former experience and adjust more rapidly to new market conditions. Fourth, the existence of the private sector and the general attitude to private enterprise facilitated further development of the private sector. Fifth, a geographical location of the country in proximity to economically advanced countries played a stimulating role. Sixth, political factors were also significant, particularly the war in the former Yugoslavia which affected not only the belligerents but also their neighbours. Seventh, the commitment of governments to economic reforms and sound economic policies had a strong influence on economic and social developments.

For all these reasons, the Central European countries - Poland, Czech Republic, Hungary, Slovakia and Slovenia - were most successful in returning their economies to economic growth fairly quickly, followed by Croatia and the Baltic States (see again Table 2.1) while other countries of the region are still trying to stabilize their economy and sustain economic growth, which has only recently been achieved.

Poland was the front-runner in using shock therapy on the national economy and was also the first to renew economic growth in 1992. Due to high and so far sustained growth in production, GDP exceeded its 1989 level in real terms in 1996. Economic growth has been driven primarily by accelerating exports and by high domestic demand for investment, while consumer demand has lagged behind. This is mainly because of a sharp contraction of real wages in the early years followed by only modest increases later. Domestic demand has accelerated recently as a result of rising consumer confidence, reflected in spending and investment. The recovery of domestic demand, however, has further boosted imports and the trade balance has run increasing deficits. Although capital flows into the country are very high at present, the economy may easily overheat. Structural reforms are urgently needed in extensive, low-productive agriculture, in the overstaffed and to a large extent unprofitable coal mining sector as well as in banking, in order to sustain present favourable economic developments.

Hungary started its economic reforms while still under the communist regime and in 1989 it had already achieved progress in liberalizing prices, in introducing a market-oriented tax system and in reforming the banking system. Its credibility among Western investors was high, stimulating substantial inflows of foreign direct investment (FDI). On the other hand, it was handicapped by a high foreign debt. Hungary therefore opted for a more gradual approach in the transition to a market system. When the economy recovered from the transition crisis, driven by high domestic demand for investment and consumer goods, internal and external economic imbalances deepened so much that in March 1995 the Government felt obliged to introduce restrictive economic measures in order to stabilize the economy. This painful treatment was successful, and after two years of sluggish growth and a severe drop in living standards, Hungary has returned to fairly high economic growth rates, based on a strong increase in industrial production and expansion of exports.

The Czech Republic followed the Polish model one-and-a-half years later. Its initial situation was favourable, characterized by low internal and external disequilibrium. Owing to this favourable state and to a deep devaluation of the national currency and a sharp fall in real wages, the enterprise sector was able to recover fairly soon. It managed to expand exports to new markets and, after the recovery of domestic demand, national enterprises also supplied the home market, while gaining time for adaptation. This approach avoided excessive loss of production capacity and prevented a sharp increase in unemployment, but on the other hand it slowed down the restructuring of production as the budget constraints on enterprises remained rather soft, with negative impacts on their productivity and competitiveness. The main reason for slow transformation was the inefficient ownership structure which resulted from voucher privatization. The new owners and managers were not sufficiently motivated to strive for the long-term economic prosperity of their enterprises, concentrating instead on short-term economic gains. This failure to properly adjust to new market conditions was found to be critical after the positive impact on exports of devaluation and low labour costs had been exhausted. Since 1996, there have been increasing trade and current account deficits, destabilizing the whole economy. Austerity treatment seemed necessary in order to improve economic performance and build a sound foundation for renewed economic growth. The two stabilization packages adopted in 1997 dampened domestic demand and reduced disequilibrium resulting, however, in a significant slowdown of economic growth. In 1998, the national economy even ran into a decline of between 1.5 per cent to 2 per cent. In the long run, economic recovery and sustainable growth will largely depend on a profound restructuring of the enterprise and banking sectors.

Croatia's post-communist macroeconomic experience differs from that of other Central European countries for several reasons. First, it inherited a more open and market-oriented system, which meant a closer integration into the world economy, relative independence for enterprises and less distorted prices. Second, its transition towards a fully-fledged market economy was hampered by the war. Besides direct damage and the occupation of part of its territory, the conflict also brought a large number of refugees into the country and paralyzed the most important Croatian export industry - tourism. Third, the private sector was quite large. Moreover, thousands of Croatians worked in Western Europe and contributed substantially to their country's development through their remittances. In October 1993, the Government introduced an economic stabilization programme which stopped inflation very fast, restored confidence, maintained the balanced development of public finances, fueled the inflow of foreign direct investment and quickly renewed economic growth. Nevertheless, the sustainability of the current economic situation is threatened by a sharply growing current account deficit which had reached 11.8 per cent of GDP in 1997. The deficit was caused mainly by sharply increasing imports as a consequence of a rapid expansion of domestic demand for investment and consumer goods. Also the restructuring and privatization of large and unprofitable state-owned enterprises is still pending. Moreover, the reconstruction of regions affected by the war remains a formidable burden on the economy.

Economic growth in South-East European countries also recovered fairly quickly, despite unfavourable external conditions, including the war in former Yugoslavia. However, they failed to sustain growth because of delays in the structural adjustment of enterprises, inconsistencies in macroeconomic policy and a very weak financial sector. Growing internal and external imbalances resulted in an economic and political crisis in 1996 and 1997. In response to the severe financial crisis, a sharp decline in production and accelerating inflation, the Government of Bulgaria introduced the currency board in July 1997, with the aim of stabilizing the economy and initiating sound economic growth. Significant progress in restoring macroeconomic stability has been achieved through curbing inflation, bringing down the state budget deficit and earning a small surplus in the foreign trade balance. Foreign direct investment has also increased. However, progress in enterprise restructuring and privatization has been disappointing, while the decline in production is deeper than expected.

The CIS countries were even more seriously hit by economic crisis following the break-up of the highly integrated economy of the former USSR. The newly independent states inherited distorted economic structures, disrupted production and broken trade links which made it difficult for enterprises to adjust to new economic conditions. The abrupt liberalization of prices and foreign trade in economies which were dominated by large rigid monopolies and characterized by widespread shortages resulted in galloping inflation. This had a devastating effect on savings, real wages and the incomes and profits of enterprises, sharply reducing domestic demand for both consumer and investment goods. The deteriorating economic and social situation generated strong pressure on national governments to soften their reform policies. The frequent changes in legislation and in decision making, and the inability of national institutions to meet the challenge of the new market environment discouraged investment, fueled a huge capital flight abroad and had a negative effect on business development.

These were the main reasons why economic activity declined so much. It was only in 1997 that these countries were able to put a halt to economic recession and achieve a positive, but modest, economic growth of 1.1 per cent, compared to 1996. While the majority of smaller CIS countries recovered slightly earlier and have already recorded quite high rates of economic growth, in the Russian Federation the rate became positive only in 1997 while the second largest economy, Ukraine, was still slightly declining. However, this promising economic recovery was short-lived. The fall in world commodity prices in 1998 had a negative impact on the export earnings of Russia and other CIS counries which export primary commodities. This factor, together with financial turbulence in Russia in May and June 1998, followed by the debt crisis in mid-August, have drawn the Russian economy back into crisis. The crisis very quickly affected some other CIS economies, which depend on trade with the Russian Federation. As a result, the 1.2 per cent economic growth for the whole CIS forecasted in April 1998 turned into a 2.6 per cent economic decline, according to the October 1998 forecast. ⁽²¹⁾

The positive, though very limited growth of 0.8 per cent in the Russian economy during 1997 was mainly driven by the recovery in manufacturing. This was boosted by rising domestic demand while its export performance, having grown very fast over the whole transition period, slowed down mainly due to falling oil prices. The recovery of domestic demand was fueled by a marked increase in real wages, accompanied by some payment of back wages, which led to a significant increase in private consumption for the first time since 1991. At the macroeconomic level, the Russian economy achieved substantial progress in its stabilization as inflation fell to 11 per cent in 1997. The foreign trade and current account balances remained positive and the capital account deficit turned to surplus. In spite of this remarkably positive development, there remain many uncertainties concerning future economic growth. Substantial enterprise restructuring is still urgently needed to improve competitiveness but this has been seriously hindered by a persisting fall in investment. The financial sector is also extremely weak because it is dominated by an excessive number of small, under-capitalized banks which are heavily burdened by bad loans. The weakness of the fiscal system and heavy dependance on external financing make the Russian economy very vulnerable to external disturbances, as was the case in 1998. As a consequence, although in the first half of 1998 economic growth still moved around zero, the annual rate has probably fallen to around -5 per cent. The August 1998 devaluation of the Russian rouble clearly revealed that even though the immediate cause of the crisis is the chronic imbalance in public finances, the real cause is the failure to make sufficient progress in important microeconomic reforms. Changes need to be introduced urgently in the institutional framework, the corporate sector and the banking system, as pointed out above. The UN Economic Commission for Europe argues that the Russian fiscal crisis was actually aggravated by the approach adopted in 1995, based on a tight monetary policy and a stable exchange rate. While this policy had a positive effect on inflation, it raised interest rates, leading to higher costs of debt service and a greater fiscal burden. Corporate profits were falling, fixed investment also continued to decline and enterprises and regions were forced to resort to barter trade, extending the demonetization of the economy. This policy has clearly proved counterproductive and requires a significant reappraisal. The UN ECE concludes that "...the Russian crisis has revealed the crucial importance of the interactions between transformation policy, institutions and the incentives working for economic stability. In the absence of an adequate institutional framework, an otherwise coherent macroeconomic policy mix may generate perverse incentives which, in turn, may not only erode the efficiency of the policy process but may in fact - due to their distortive impact - be counterproductive for economic stability and growth in the longer run." ⁽²²⁾ The same conclusion is valid for other countries in transition, particularly the CIS.

In Ukraine, the stabilization programme introduced at the end of 1994 brought some positive results, curbing inflation to 10 per cent in 1997, cutting the state budget deficit and practically halting the economic decline. The foreign trade balance was converted from a large deficit to a modest surplus in 1997. However, economic stabilization should only partly be attributed to sound economic policies, because to a certain extent it was achieved at the cost of non-payment of wages, pensions and benefits. While real wages were still declining in 1997, total real incomes had already recovered, contributing to growing domestic consumer demand and increasing retail turnover. However, the downward trend in gross fixed investment continued, undermining the sustainability of future economic growth. In the first half of 1998 Ukraine finally achieved a modest economic growth of 0.5 per cent, but the Russian financial crisis has reversed this growth - the official forecast for 1998 is now -1.5 per cent. ⁽²³⁾

Transition in Azerbaijan was considerably delayed by the war and economic reforms were not launched effectively until 1995. The country suffered one of the most severe economic declines in the CIS area; in 1995 its GDP stood at 37 per cent of the 1989 value. The negative trend was reversed in 1996 and in 1997 GDP achieved 5.8 per cent growth, primarily driven by an investment boom in the oil sector (mostly financed by foreign investors). There was rapid growth in other economic activities supporting the oil industry, such as construction, transport and some other services. However, excessive reliance on the oil industry is also the weakest point of the national economy as other industries are neglected if they are not directly connected to the oil sector. This may turn against the national economy during downswings in oil prices. Therefore, a balanced industrial policy is important for the country's long-term economic development.

Kazakhstan was also late in overcoming the transition crisis. In 1996 the GDP growth rate was only 0.5 per cent, rising to 2 per cent a year later and the forecast for 1998 was twice as high. However, this expectation did not materialize because of the financial crisis in the Russian Federation, the main trading partner of Kazakhstan. Economic growth for 1998 will probably be the same as in 1997, i.e. 2 per cent. As in Azerbaijan, the driving force behind economic recovery has been the oil and gas industry while other economic branches have continued to decline, particularly engineering. The Kazakh government has developed an ambitious long-term programme for the exploitation of its rich natural resources, relying mostly on foreign capital. To date, the inflow of FDI to Kazakhstan has been impressive, having reached the highest per capita level among the CIS. Nevertheless, the restructuring of enterprises and banks is seriously delayed, leaving the country too dependent on oil revenues which fluctuate according to prices on the world oil market. The Baltic States were even more seriously hit by the break-up of the USSR than many CIS countries due to their small size and serious structural distortions. For both economic and political reasons, Estonia opted for an even stricter shock therapy than Central European countries, introducing the currency board system, eliminating price controls on tradeable goods, liberalizing foreign trade and rapidly privatizing state enterprises and banks; subsidies to enterprises were cut down. The consistent economic policy of the government, together with a large inflow of foreign capital, resulted in a slowdown of inflation and a fairly rapid restoration of economic growth in 1995. Growth was based primarily on accelerating exports and on booming domestic demand for investment and consumer goods, while public finances remained relatively healthy. In 1997, the Estonian economy achieved double-digit economic growth, but at the cost of rapidly deteriorating trade and current account balances. The current account deficit has reached the critical level of 12 per cent, although this is still more than counterbalanced by a surplus on the capital account. Also, as quite a high proportion of foreign trade is still with the Russian Federation and other CIS countries, the Estonian economy is in acute danger from the Russian crisis.

This short review of economic developments in the transition economies shows that although most have already made major systemic, institutional and economic changes, their economic position is still very weak. They remain vulnerable to external shocks and internal imbalances. This has much to do with slow progress in enterprise restructuring. Many enterprises have outdated machines and equipment and obsolete technologies, which are energy- and material-intensive. They produce commodities which can compete on world markets only if they are sold at prices that hardly cover production costs. They usually lack capital for a substantial upgrading of their technological level and product innovation, and bank credits for investment are difficult to obtain because of high interest rates or undercapitalized domestic commercial banks. Foreign banks are cautious about lending money to enterprises in many transition countries, learning from negative past experience. Other barriers to investment arise from uncertainties due to frequent changes in legislation and economic policies and the fear of a reversal in political and economic development. Further obstacles are the excessive tax burden and the lack of transparency of enterprise taxes; unfair competition in the market; and excessive regulation which holds back business development.

It is well known that foreign capital inflows, when accompanied by technology transfer and management development, can significantly stimulate investment and economic growth, beyond the domestic resource constraints. However, their beneficial effects depend on the capacity of the economy to absorb foreign capital efficiently, otherwise capital inflows may lead to inflationary pressures, declining international competitiveness due to changes in the real exchange rate, and to a negative impact on the current account balance. Many transition economies lack the capacity to absorb foreign capital because of their weak banking sector, an economic climate that is hostile to business, and political uncertainty. This has discouraged foreign investment in the less economically stable countries of the region, despite the availability of labour that is relatively highly skilled and cheap. It even stimulates huge capital flights particularly from the CIS countries to safer regions of the world. Only the Central European countries and Estonia have attracted relatively high foreign direct investment - the most advantageous form of foreign capital inflows - compared with the rest of the region. Moreover, FDI may slow down in the near future as the economic outlook becomes more uncertain because of the Russian crisis and a probable slowdown of economic growth in the European Union, which is the most important trading partner for CEE economies in transition.

These are the reasons why investment flows are inadequate in many of these countries, insufficient for them to improve the competitiveness of their output and reduce production costs. Among the economies in transition, again only the Central European countries and Estonia have been able to exceed the pre-transition level of real gross fixed capital formation (see Table A2 in the Appendix). This makes economic growth unstable and unsustainable in the longer-run. In addition, as already mentioned, the majority of transition economies are running high current account deficits, which are largely financed by foreign capital inflows. However, the share of short-term capital in deficit financing increased significantly in 1998, making these countries much more vulnerable to turmoil in the international financial markets. The danger of abrupt economic disturbance caused by volatile international capital flows has become more acute in light of the Russian financial crisis. Many countries will probably find it increasingly difficult to negotiate foreign credits. This will force them to tighten their financial policy in order to reduce current account deficits, and put another constraint on their economic growth.

Persistent weak domestic demand, due to poor wages and incomes as well as low enterprise profits is another factor hindering economic growth and employment creation, at least in the formal sector, forcing many people to turn to the black market. Increasing inequality in incomes has a similar negative effect on economic growth as upper income groups prefer imported goods while the poor cannot afford to buy many goods and services and have to rely on the black market or on their own household production. The black market is mostly supplied with smuggled goods, and domestic producers cannot compete against these.

3.2 Obstacles to employment creation in small enterprises

3.2.1 The importance of small enterprises for employment generation

In most countries of the world, the small enterprise sector has become a major player in the past decades. ⁽²⁴⁾ Its actual role in the various countries, including its success in promoting economic growth and employment creation, is however quite diverse, and depends to a large extent on specific local characteristics. In western countries the small and medium enterprise sector started to gain importance at the beginning of the 1970s. Its growth is associated with various developments, including the shift towards services, decentralization and down-scaling of large companies, combined with increased outsourcing and externalization of ancillary activities, and the formation of regional agglomerations of small firms. Small enterprises are flexible and can respond to these changes, incorporating new technologies and production strategies, offering innovative products and services, and developing new types of inter-firm cooperation and coordination. Still, there is a substantial group of people who are more or less forced to become self-employed in less attractive, low-skilled jobs, because of the lack of employment alternatives. Today the overwhelming majority of enterprises in western Europe, the USA and Japan are small or medium-sized enterprises, and their shares in GDP and employment are generally between 50-70 per cent.

In Central and Eastern Europe the small enterprise sector experienced explosive growth in the first years of transition and many small new private businesses were established. They have grown rapidly, especially in Central Europe. For example, in Hungary, with a population of 10.2 million, in mid-1996 there were 633,427 active small businesses (meaning they submitted tax declarations), 96 per cent of which had up to 10 employees. Thirty-four per cent of these enterprises were engaged in retail trade and repair, 21.4 per cent in real estate and business services, 16 per cent in manufacturing, 8.6 per cent in construction, 4.2 per cent in agriculture and the rest in other sectors. ⁽²⁵⁾ In the Czech Republic, figures for the end of 1997 showed the number of private small businesses, including self-employed persons, as 1,323,364, around two-thirds of whom submitted tax declarations. The composition by branch of activity was similar to that of Hungary: 33.4 per cent of small businesses were in trade, 17.3 per cent in real estate, 14.4 per cent in manufacturing and 12.1 per cent in construction, and under 10 per cent in other sectors. In comparison, in the countries of the former USSR the small business sector is still rather tiny and growth has not met expectations. Ukraine had 93,091 registered small enterprises in 1996, 3,179 production and consumer cooperatives, 35,353 small private farms and slightly less than one million self-employed persons by the end of the year (all figures relate to registered and acting businesses). The distribution by sector was again very similar to the two countries described above. Most small firms were in services (around 60 per cent), particularly in trade (34.1 per cent), while industry and construction accounted for 20.6 per cent and 17.3 per cent, respectively. ⁽²⁶⁾ The Russian Federation had registered 844,400 small enterprises by 1 October 1997. In Kazakhstan, the number of small enterprises (up to 50 employees) equalled 103,915 and there were 202,839 sole-proprietors on 1 October 1998. SME activity was distributed as follows: 72 per cent in trade, 7.5 per cent in industry, 4.8 per cent in construction, the rest in other sectors.

These figures refer only to the formal sector, while many SMEs and self-employed people operate in the informal sector. Research has shown a strong indirect correlation between the share of the new private sector (i.e. recently established private firms not including those which were previously state-owned and which have been privatized) and the share of the informal economy in the GDP of transition economies. The proportion of the two sectors in total GDP (i.e. GDP produced both in the formal and the informal parts of the national economy) was 37.5 per cent : 19 per cent in the CEE countries, including Bulgaria, Czech Republic, Hungary, Poland, Romania and Slovakia, and 46.7 per cent : 22.9 per cent in the three Baltic States, 21.7 per cent : 44.8 per cent in the CIS (excluding Central Asia and Armenia) and 25 per cent : 20.4 per cent in Kazakhstan and Uzbekistan in 1995. ⁽²⁷⁾ These estimates demonstrate that many small firms are hidden in the informal sector in all transition countries but with a particularly high proportion in the CIS. The small private sector is actually much larger in the CIS than the statistics indicate, and could even exceed the level of CEE countries.

Small businesses are generally considered an essential element of the transition to a democratic, market-based system. They are a vehicle for free choice in socio-economic activities, they open up possibilities for initiative, provide an element of competition in the economy and decrease the monopoly of (former) state enterprises, and they may act as a buffer against poverty in difficult times. Transition would also seem to provide good opportunities for small business. When economic transformation began the output of large state enterprises and the traditional trade relations of the former socialist countries quickly came under pressure, leaving important gaps which could potentially be filled by SMEs.

It is somewhat difficult to speak of the small enterprise sector as a single entity. In any country we observe it is extremely heterogeneous and has many facets with different economic and social dimensions. As size is the common denominator, the sector has a very mixed sectoral composition as already indicated. Likewise, small enterprises include innovative, high-technology enterprises in expanding industries and low-technology/low-productivity/low-pay enterprises in stagnant industries. Different small enterprises may also have different goals or aspirations, with some aiming at growth and reinvesting profits in the enterprise, and others being a vehicle for consumption or survival for the owner's family. In the Russian Federation for example, on the one hand small enterprises generated one-third of total enterprise profit before the recent financial crisis, while on the other hand the majority of self-employed persons did no more than support themselves and their family.

3.2.2 Obstacles to growth of the SME sector

Notwithstanding the diverse character of