Introduction
This is the first time that a Transition Report has focused on economic inequality and inclusion. The thinking on transition has evolved significantly since the first Transition Report was published back in 1994. Initially, much of the emphasis was on the extent and structure of markets and policies that fostered price and trade liberalisation, privatisation, macroeconomic stability, competition and the development of the financial sector. It was clear that market economies outperformed planned economies and that, even if the path towards capitalism involved short-term pain, this was a price worth paying.
Transition for all: Equal opportunities in an unequal world
This is the first time that a Transition Report has focused on economic inequality and inclusion. The thinking on transition has evolved significantly since the first Transition Report was published back in 1994. Initially, much of the emphasis was on the extent and structure of markets and policies that fostered price and trade liberalisation, privatisation, macroeconomic stability, competition and the development of the financial sector. It was clear that market economies outperformed planned economies and that, even if the path towards capitalism involved short-term pain, this was a price worth paying.
In some countries, those reforms were indeed rapid and successful. They managed to create market economies and democratic political systems, and economic growth resumed after only a brief decline in income. Other countries suffered deep and protracted recessions that delayed further reforms – and in some cases, initial reforms were even reversed.
The Transition Report 2013, entitled “Stuck in Transition?”, studied these experiences and identified important patterns. It established that countries which managed to ensure that the benefits of reforms were shared widely across society retained democratic political institutions and continued on a pro-market path. In sharp contrast, countries where the majority of people perceived reforms to be designed for somebody else’s gain saw the reversal of both political and economic transition. In these countries, anti-reform populists took over and built institutions of crony capitalism. Although the initial “short-term pain, long-term gain” logic was correct, these opportunistic politicians managed – by dismantling political checks and balances and suppressing freedom of speech and civil society – to prevent pro-reform parties from challenging them in fair elections.
Thus, even if reforms are beneficial in the long run, they still may not succeed. The benefits of reforms may not materialise if economic gains are not delivered to the majority of the population straight away. What is more, this applies far beyond the EBRD’s countries of operations. Indeed, today many developed countries are also struggling with the appeal of populist politicians. While nativists and Eurosceptics offer no constructive solutions, they do highlight an important problem. Namely, although globalisation and technological progress have delivered great benefits for developed and developing countries on average, they have also resulted in “job polarisation”. In rich countries, automation and globalisation have benefited highly skilled professionals. The industries in which those professionals work have enjoyed access to cheaper inputs and exploited economies of scale in selling their products and services to global markets. Income growth has also created low-skilled jobs – in sectors where jobs could not be automated or outsourced to other countries.
At the same time, many middle-skilled jobs have been either outsourced or automated. The former holders of those jobs have either left the labour force entirely or moved down the skills pyramid – thus enduring reduced pay and further depressing the wages of low-skilled workers. Through this mechanism, globalisation and technological progress have hollowed out the career opportunities of a substantial percentage of the middle class in OECD countries.
Post-communist transition economies have not suffered from job polarisation. In those countries, globalisation has created – not destroyed – high-value-added jobs in exporting sectors. However, as this Transition Report shows, those countries have also suffered from rising inequality and a lack of inclusion. In many countries, inequality rose substantially at the start of transition. The experience of such transition countries has shown that reform processes can get stuck, or even go into reverse, in the absence of sufficient inclusion. If mainstream politicians want to withstand the challenge presented by opportunistic populists, they need to design reforms that do more than just deliver growth on average in the long run. Reformers need to ensure that they enjoy the support of the majority at all times.
Indeed, a well-functioning market economy should be more than just competitive; it should also be inclusive, well-governed, environmentally friendly, resilient and integrated. This is necessary in order to ensure that reforms are politically sustainable: reforms should deliver benefits to the majority of the population in both the short and the long term, preventing populism both in times of crisis and in normal times.
The evaluation of progress in these areas requires new measurement tools. This is why the EBRD has, since 2006, complemented its Business Enterprise Environment and Performance Survey (BEEPS – a survey of business executives) and its Banking Environment and Performance Survey (BEPS – a survey of bank managers) with the Life in Transition Survey (LiTS – a survey of households). In late 2015 and the first half of 2016, the EBRD carried out the third round of the Life in Transition Survey in cooperation with the World Bank, surveying more than 51,000 households in 34 countries (29 post-communist countries, plus Cyprus, Germany, Greece, Italy and Turkey). The analysis of these LiTS data lies at the heart of this year’s Transition Report, allowing us to look beyond average GDP per capita figures and investigate the precise details of individual transition experiences. The report’s four chapters focus on the key aspects of inclusion: the distribution of income and wealth; the impact that the transition from planned to market economies has had on people’s well-being; equality of opportunity; and financial inclusion. The report identifies large sections of society that have suffered – rather than benefited – as a result of pro-market reforms and are excluded from the opportunities that a market economy offers.
Inequality of opportunity is especially important in this regard, since it is ultimately the root of all inequality. Chapter 3 shows that there are no countries with high levels of inequality of opportunity but low levels of inequality of income. Inequality of opportunity is inefficient, as it means that talented individuals cannot achieve their full potential. Also – and most importantly – inequality of opportunity is unfair, and it is regarded as such by the majority of people. Consequently, economic reforms that increase inequality of opportunity are not sustainable in the longer term.
Inequality of opportunity at birth does not necessarily have to result in inequality of outcomes (such as income or wealth inequality). Redistribution of income (through inheritance taxes or wealth taxes, for instance), equal access to education and health care, and geographical mobility all reduce income and wealth inequality for the next generation, even if the previous generation faced high levels of inequality of opportunity. And that decline in inequality of income and wealth then reduces inequality of opportunity for the generation after that. This is why Chapter 1’s analysis of the evolution of inequality over the last 25 years is so important. Unfortunately, that analysis shows that levels of inequality have risen dramatically in most post-communist countries. In many of those countries, economic growth has mostly benefited the rich minority (in some cases, just the top 10 or 20 per cent of households), while the middle class and the poor have lagged behind in terms of income growth. In the EBRD’s newer countries of operations, however, the picture is very different. In those countries, growth has been far more inclusive. In Turkey, for example, it is the middle 80 per cent who have benefited the most from the last 25 years of economic growth.
Chapter 2 shows that the transition experience has indeed been highly traumatic – especially the early years. It shows that people born around the beginning of the transition process have grown up to be an average of around 1 cm shorter than their older and younger peers, indicating that the early years of reforms were a period of substantial socioeconomic deprivation. Interestingly, this pain has eventually been overcome, with the result that these people are now actually happier than their younger and older counterparts in other countries. This is attributable to the increased access to education that has been brought about by the transition process. Education also features prominently in the analysis in Chapter 3, which shows that inequality of opportunity is still higher in post-communist transition countries than it is in western Europe – and that much of the inequality of opportunity seen in those countries is due to parents’ level of education.
Chapter 4 looks at inequality in access to financial services. Financial inclusion remains a major challenge in many countries where the EBRD invests – especially the poorer ones, where substantial gender gaps persist in terms of access to finance. In richer EBRD countries of operations, gender gaps continue to be observed for older generations, but they have been eliminated for younger people.
While this analysis of inequality in the EBRD region results in many worrying findings, there are also a number of reasons for optimism. Chapter 2 shows that the notorious “transition happiness gap” has finally been closed. In the past, residents of post-communist countries used to report significantly lower levels of life satisfaction than their counterparts in non-transition countries with similar income levels. Academics argued that the transition happiness gap was driven by the dramatic events of the early years of the transition process, so the negative impact on subjective well-being should be temporary, rather than permanent. This prediction has finally come true, with residents of post-communist countries now expressing just as much satisfaction with their lives as their peers in other countries.
Although this Transition Report focuses on distributional aspects of the transition process and looks beyond growth in average income, this does not mean that the EBRD believes inclusion to be a substitute for growth. A successful market economy must have both. Without inclusion, pro-growth reforms are not politically sustainable. Without growth, however, inclusion policies become a zero-sum game – redistributing the pie, rather than growing it – and therefore result in conflict. Thus, growth remains at the heart of the EBRD’s work and will be studied in detail in future Transition Reports.
Sergei Guriev
Chief Economist, EBRD
About
The EBRD seeks to foster the transition to an open market-oriented economy and to promote entrepreneurship in its countries of operations. To perform this task effectively, the Bank needs to analyse and understand the process of transition. The purpose of the Transition Report is to advance this understanding and to share our analysis with partners.
The responsibility for the content of the report is taken by the Office of the Chief Economist. The assessments and views expressed are not necessarily those of the EBRD. All assessments and data are based on information as of late October 2016.
Highlights
Convergence and inequality
The EBRD region has achieved an impressive amount of income convergence with the living standards of advanced economies since the start of the transition process. However, people’s individual experiences of growth and convergence differ vastly depending on their position on the income ladder. Only a minority of people in post-communist countries – the top 27 per cent of the income distribution – have actually experienced average income growth for their country. Meanwhile, those in the bottom 23 per cent of the income distribution are still worse off today than they were in 1989. Although the resulting income inequality remains moderate by international standards, wealth is more concentrated among the very rich than it is in comparable economies elsewhere in the world. People are also overwhelmingly of the view that inequality levels are high and rising.
The impact of transition on well-being
This chapter re-evaluates the impact that the transition process has had on well-being, finding that residents of post-communist countries are no longer less satisfied with their lives than their counterparts in comparator countries that have not experienced transition from a planned to a market economy. Nevertheless, there is also clear evidence of the high social cost of early transition reforms: cohorts born during transition are shorter than their older and younger peers, pointing to major deprivation in the early years of the reform process. However, those cohorts are also better educated and happier with their lives today than their peers. These results suggest that the transition process has been a dramatic experience, but its negative impact on well-being has, on the whole, finally been overcome. While this optimistic message holds for an average resident of post-communist countries, this chapter also identifies certain vulnerable groups who are still suffering the ill-effects of the initial transition shock.
INEQUALITY OF OPPORTUNITY
In a well-functioning market economy, opportunities to receive an education, have a good job and earn sufficient income should not be limited on the basis of a person’s gender, race, place of birth or parental background. Inequality of opportunity in the EBRD region in terms of education, jobs and income remains higher than in western Europe, but is lower than in Brazil, India and the United States of America. Parental background is the most important determinant of inequality of opportunity across the region, followed by gender. Meanwhile, inequality of opportunity is higher in terms of getting a good job than it is in terms of getting a job in general. And in countries where inequality of opportunity is high, people express less support for market economics and democracy.
FINANCIAL INCLUSION
An inclusive financial system can reduce both inequality of opportunity and, ultimately, inequality of outcomes. While access to financial services is reasonably high in richer parts of the EBRD region, it is not so good in less developed economies. In these poorer countries, financial access is also distributed unevenly. In particular, many women, young people and rural populations remain disconnected from the financial system. The reasons for such exclusion vary depending on the circumstances of the household or individual, with many young people being discouraged by onerous documentation requirements, while older people are often deterred by long distances to the nearest bank branch. While foreign banks’ entry into local markets has improved competition – and with it, access to financial services – in many countries, evidence suggests that these gains have been uneven, with less educated and lower-income households continuing to have less access to such services.
macroeconomic OVERVIEW
Following four consecutive years of deceleration, the average annual growth rate in the region where the EBRD invests fell further to stand at 0.5 per cent in 2015. It is expected to pick up modestly in 2016 and 2017. Low commodity prices and the continued recession in Russia are weighing on the economic performance of both Central Asia and eastern Europe and the Caucasus. At the same time, decreases in the cost of energy imports are benefiting the economies of central and south-eastern Europe as well as Turkey, where growth momentum has been sustained. Those economies have also benefited from accommodative policies in the eurozone, although expectations of monetary tightening in the United States of America have led to a decline in capital flows to the EBRD region.
STRUCTURAL REFORM
Political and economic challenges persist across the region, and governments are continuing to respond with a variety of approaches. On balance, policy responses remain positive, with many countries pursuing ambitious reform objectives. New analysis focusing on the development of small and medium-sized enterprises shows that providing non-bank financing to such firms and helping them to acquire better business skills are particular hurdles for many countries in the EBRD region. Updates to regional inclusion gap scores point to some improvements in the area of inclusion, particularly in more advanced countries, but also some stagnation and backtracking. This highlights the remaining challenges of building more inclusive societies, especially in eastern and south-eastern Europe, Central Asia and the southern and eastern Mediterranean region.
Highlights
Convergence and inequality
The region has achieved an impressive amount of income convergence since the start of the transition process. Furthermore, significant progress has been made in terms of reducing poverty. However, people’s individual experiences of growth and convergence have differed vastly depending on their position on the income ladder.
In post-communist countries, average income growth corresponds to the experience of someone in the top 27 per cent of the income distribution. Furthermore, only 44 per cent of people in those countries have personally experienced income convergence – that is to say, long-term income growth above the average level in the G-7 economies. The shifts seen in income patterns over the last two-and-a-half decades reflect both broader globalisation trends and experiences unique to the region – a legacy of the wage decompression and deep recessions seen in the early years of the transition process, as well as the very fast shift from manufacturing and agriculture-based economies to a more service-oriented model.
Before the start of the transition process, levels of inequality in the region were very low by international standards. Although inequality has increased sharply, it remains moderate in comparison with other parts of the world. Despite this, people are overwhelmingly of the view that inequality levels are high and rising. These perceptions may, to a significant extent, be guided by the fact that wealth is strongly concentrated among the very rich – even when compared with other emerging market economies. In contrast with advanced economies and emerging markets elsewhere in the world, the richest individuals in the EBRD region derive their wealth predominantly from commodity rents and related sectors, as opposed to IT-based innovation or competitive manufacturing.
The fact that wealth is strongly concentrated among the very rich across the region calls for higher standards of governance, transparent processes for privatisation and public procurement, the disclosure of detailed information on contracts and revenue management in extractive industries, as well as consistent enforcement of competition law and efforts to diversify economies away from excessive dependence on natural resource rents. The taxation of wealth could also play a more prominent role as a source of government revenue. Meanwhile, at the bottom of the income distribution, the reduction of poverty requires targeted, well-designed social transfer programmes. Tackling broader inequality requires a combination of redistribution through taxation and public spending and measures to reduce inequality of opportunity in society (as discussed in Chapter 3).
The impact of transition on well-being
In the last 25 years, people living in formerly communist countries have seen their economic, political and social institutions undergo dramatic changes. In the early years of the reform process, they also suffered severe economic recessions. Chapter 2 of this report uses newly available data from LiTS III to analyse the impact that the early years of the transition process had on the well-being of people in those countries.
Previous studies have identified a “transition happiness gap”, with residents of post-communist countries reporting significantly lower levels of life satisaction than their counterparts in non-transition countries with similar income levels. However, data from LiTS III show that this gap has finally closed, with residents of formerly communist countries now expressing just as much satisfaction with life as their peers in other countries.
This optimistic finding comes with three caveats, though. First of all, that “happiness convergence” is only partially explained by increases in satisfaction in those transition countries; declining life satisfaction levels in non-transition countries such as Germany and Italy have also played an important role.
Second, such happiness convergence does not mean that the acute social costs incurred at the start of the transition process were any less painful. Anthropometric measures made available by LiTS III data indicate that the early years of that process were a period of substantial deprivation, with permanent physical effects. Indeed, people born around the start of the transition process are an average of 1 cm shorter than their older and younger peers, pointing to the significant hardship that their families endured as a result of those reforms. However, data also show that those people have gone on to enjoy better lives: they are, on average, now better educated and more satisfied with life than their peers.
Third, while residents of post-communist countries have, on average, overcome the dramatic experience of transition, specific sections of society have been left behind. People born to families with lower levels of education and income have proved to be more vulnerable to the changes experienced during the transition process, and they are still lagging behind in terms of both objective and subjective well-being.
INEQUALITY OF OPPORTUNITY
People’s circumstances at birth – their gender, place of birth, ethnicity and parental background – often have a significant impact on their educational qualifications, the type of job they get and, ultimately, their earnings. Such inequality of opportunity is both inefficient and unfair. It prevents people from making the best use of their skills or realising their entrepreneurial ideas, and that can, in turn, negatively affect a country’s long-term growth, leading to persistently high income and wealth inequality. A lack of opportunities can also result in a loss of confidence in the key economic and political institutions that underpin market-based economic systems, eventually resulting in reform reversals.
Inequality of opportunity in the EBRD region remains higher than in western European countries such as Germany, according to estimates based on LiTS III data. It accounts for an average of 20 to 50 per cent of total income inequality in many EBRD countries of operations. Parents’ level of education is the key factor determining inequality of opportunity, followed by gender and place of birth. Inequality of opportunity is also strongly correlated with inequality of observed incomes: all countries with high levels of inequality of opportunity also have high levels of income inequality.
Inequality of opportunity is substantially higher in terms of getting a good job – one that provides a stable income stream of sufficient size – than it is in terms of getting a job in general. Moreover, when it comes to education, inequality of opportunity appears to have increased, since it is estimated to be significantly higher for people who started school after 1989 relative to older cohorts. High levels of inequality of opportunity in society reduce people’s support for open markets and democracy. In contrast, inequality of outcomes does not have such an effect and may actually strengthen support for market economics and democracy, provided that differences in outcomes are driven by differences in effort, rather than circumstances at birth.
Economic policies can play an important role in reducing inequality of opportunity and levelling the playing field, for instance by improving access to tertiary education (through targeted scholarship programmes, for example), by strengthening links between secondary education and employment, by improving infrastructure links and by increasing the availability of affordable childcare.
FINANCIAL INCLUSION
An inclusive financial system can reduce both inequality of opportunity and, ultimately, inequality of outcomes. While access to financial services is reasonably high in richer parts of the EBRD region, it is not so good in less developed economies. In those poorer countries, financial access is also distributed unevenly. In particular, many women, young people and rural populations remain disconnected from the financial system.
The reasons for such exclusion vary depending on the circumstances of the household or individual in question, with many young people being discouraged by onerous documentation requirements, while older people are often deterred by long distances to the nearest bank branch. While gender gaps in terms of access to bank accounts have nearly been eliminated in richer parts of the EBRD region, they persist in poorer countries across all age groups. There are also significant differences between rural and urban areas of poorer countries in terms of access to bank accounts, with rural women having the worst access. While foreign banks’ entry into local markets has improved competition – and thus access to financial services – in many countries, evidence suggests that these gains have been uneven, with less educated and lower-income households continuing to have less access to such services. Many of these households do not normally apply for loans – and when they do, they receive fewer loan offers than their peers.
Governments can stimulate the use of bank accounts and encourage more people to connect to the formal financial system by introducing digital payments for wages and transfers. At the same time, banks can design financial products that better meet the needs of excluded groups, such as “no-frills” accounts and mobile banking, as well as tailoring documentation requirements to the realities of younger and poorer individuals. Focusing efforts on improving access to finance in rural communities, where the social benefits of financial inclusion are considered to be high, can help to foster the economic integration of this important segment of society, which is currently underserved in the region.
Meanwhile, participation in credit markets can be encouraged by establishing credit registries, fostering the expansion of branch networks (and thus competition) in underserved areas, publicising the interest rates available in the local area using official comparison websites and promoting financial literacy campaigns.
macroeconomic OVERVIEW
Following four consecutive years of deceleration, the average annual growth rate in the region fell further to stand at 0.5 per cent in 2015, down from 1.9 per cent in 2014. Growth is expected to pick up modestly in 2016 and 2017. Low commodity prices and the continued recession in Russia are weighing on the economic performance of both Central Asia and eastern Europe and the Caucasus. At the same time, decreases in the cost of energy imports are benefiting the economies of central and south-eastern Europe, as well as in Turkey, where growth momentum has been sustained. Those economies have also benefited from accommodative policies in the eurozone. At the same time, monetary tightening in the United States of America has led to a decline in capital flows to the EBRD region.
Declining revenue from tourism, partly owing to security concerns, has negatively affected the outlook for Turkey and countries in the southern and eastern Mediterranean region. Meanwhile, Ukraine’s economy, which contracted by almost 10 per cent in 2015, is expected to return to positive growth in 2016 and 2017 as structural reforms are gradually implemented. The UK’s vote to leave the European Union is expected to have only a limited direct impact on countries where the EBRD invests.
The economic outlook for the EBRD region is subject to major risks relating to geopolitical tensions in and around the region and a general weakening of investor confidence with regard to emerging markets in general.
STRUCTURAL REFORM
Political and economic challenges persist across the region, and governments are continuing to respond with a variety of approaches. On balance, policy responses remain positive, with many countries pursuing ambitious reform objectives. New analysis focusing on the development of small and medium-sized enterprises shows that providing non-bank financing to such firms and helping them to acquire better business skills are particular hurdles for many countries in the EBRD region. Updates to regional inclusion gap scores point to some improvements in the area of inclusion, particularly in more advanced economies, but also some stagnation and backtracking. This highlights the remaining challenges of building more inclusive societies, especially in eastern and south-eastern Europe, Central Asia and the southern and eastern Mediterranean region.
The EBRD is investing in changing people’s lives and environments across a region that stretches from central Europe to Central Asia, the Western Balkans and the southern and eastern Mediterranean.