Slovakia's Economic Reforms

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This morning, while watching the market absorb the latest employment numbers, I perused some recent issues of Institutional Investor. The February edition talked about some of the reforms coming out of Slovakia recently. The list is fairly impressive. From what it says in the article, other countries in the region have taken notice and Slovakia's actions may drive reforms in the region. The results have been good so far:

An economic turnaround is now evident. In 2002, GDP grew by 4.4 percent--twice the rate of that in the Czech Re public--and expanded by an estimated 4 percent in 2003. In 2002, Slovakia drew $3.7 billion in foreign direct investment--six times more than Hungary. From 1998 to the end of 2003, foreign investment totaled an estimated $9.3 billion. A hefty share of this investment is going into auto manufacturing, an industry in which Slovakia is emerging as the regional powerhouse, much to the chagrin of Czechs, Hungarians and Poles (see box, page 70). "Slovakia is becoming the biggest recipient of FDI per capita in the region," says Nora Szentivanyi, a London-based economist for J.P. Morgan Europe.

Most noted here in the U.S. has been the introduction of the 19% flat tax on individuals and corporation. Some of the others haven't received the same attention but are just as important. One is pension reform:

Yet another key economic shift under way is pension reform. Up until now, the pension system has operated as a state-run, debt-ridden, pay-as-you-go scheme, with all retirees receiving the same income. "Over the next three years, the system will basically reflect what a contributor puts into it," says Bank ING economist T6th, who follows pension reform closely. Moreover, the retirement age, which was 55 for women and 60 for men, has been raised to 62 for both sexes.

Beginning in January 2005 the state-run system will be supplemented by a second pillar--a privately funded system administered by foreign and domestic asset management companies, including financial firms and insurers. Of the 19 percent of an employee's income slated for pension contributions, half will go into the state-run system and the other half into the private system. Under the private system, money will be invested in three types of portfolios, ranging from a stock-heavy one more appropriate for younger contributors to a government-bond-dominated one for older people, with a more balanced mix of equities for those in between. Initially, at least, half of all funds must be invested in Slovak stocks and bonds, says Economy Minister Rusko, "because we want to strengthen the local capital markets."

To help pay for the transition, they have sped up privatization of state-owned industries. This aspect is particularly impressive, that is if they follow through, in that there are few restriction placed on minimum bids and country of origin of the bidders:

The government is spending about half the revenue from the privatization of state companies, or about $1.6 billion thus far, to help cover the transitional costs of pension reform. Privatization revenue is expected to rise sharply in the next few years because of the passage in August of yet another key economic reform. Previously, the government had to maintain at least a 51 percent interest in strategic enterprises, such as the fixed-line telephone, gas and electricity monopolies. Now up to 100 percent of those companies can be sold to the private sector.

The most closely watched prospective privatization involves electricity monopoly Slovenske Elektrarne, or SE. Slovakia has approached the sale of this strategic industry with more flexibility than its neighbors. For example, in the Czech Republic the privatization of electricity monopoly CEZ has stalled because the government was dissatisfied with the bids. "But there is no insistence by the Slovak government on a minimum price for SE," says Peter Mitka, the Prague-based lead manager for PricewaterhouseCoopers, which has been hired as the consultant for SE's privatization. "And most important, the government is neutral with respect to any bidder--whether Russian, German, French or even Czech."

These are great reforms to get through especially considering that the ruling government has such a small coalition:

The wonder is that the government has encountered so little opposition as it steamrolls ahead with painful reforms. The coalition of four center-right parties barely has a working majority in Parliament--only 78 out of 150 seats, including three fence-sitters who say they will support the coalition on a case-by-case basis. Issues such as abortion rights and the wiretapping scandal have threatened to tear the coalition asunder. "But most tensions in the government coalition have been due to noneconomic issues," says J.P. Morgan's Szentivanyi. "On the economic reforms all four parties strongly agree."

At the same time, the opposition parties are even more divided than the ruling coalition. The Movement for a Democratic Slovakia, the party of authoritarian former prime minister Meciar, still holds the largest parliamentary bloc--36 seats. But it is in decline, having fallen from 27 percent of the popular vote in 1998 to 19.5 percent in 2002. The center-left Smer, the party with the most public support in recent opinion polls, is uncomfortable with the notion of forming a government with Meciar and rejects outright an alliance with the Communists. Smer officials offer only tepid criticism of the economic reforms. Legislator Igor Sulaj, Smer's leading economic expert, worries that pension reform will force pension savings abroad because local capital markets are too underdeveloped. He calls for public projects to provide jobs in regions where unemployment is high. And, turning to the most controversial of the economic reforms, he decries the unfairness of the flat tax rate for allegedly benefiting only the affluent, but then adds, "We would like to see the flat tax rate introduced more gradually."

Hilton Root was a visiting professor last year at Pitzer College and, unfortunately, I missed the talk he gave us one afternoon on his work. However, somebody summed up an idea he presented which is interesting; the size of the winning coalition is important to economic reform. The Slovokian experience runs counter to this argument especially when one considers that the coalition is shrinking and not growing. I couldn't find any of his articles where he talked about this, but did find an interview with whom he worked to develope the idea, Bruce Bueno de Mesquita. He can explain it better than I:

Q: Why is that so?
A: To understand why countries reform their policies and institutions, we must understand the institutional context of political competition within sovereign nations. The rules by which a country determines its leadership will also determine how the economy is managed and in whose interests it is managed. The key to governmental responsiveness lies in part in the relationship between the selectorate - the subset of the population that chooses the country's political leadership - and the size of the winning coalition that keeps the incumbent in office. The size of the governing coalition will affect how different are the interests of the country's political leadership from those of citizens at large.

Incumbent leaders select and implement public policies that have public or private components. They can put everything into public policy that benefits everyone or into private goods consumed only by members of the winning coalition. They can also provide any mix of public and private benefits to their followers and to the citizens at large.

Q: What happens when the winning coalition grows in size?
A: Then the incumbent is able to offer less in the way of private benefits to particular members of the coalition. To ensure a focus on public policy, the winning coalition must be so large that its members can gain very little from private allocations because those allocations would have to be spread too broadly to be financially attractive. Challengers may come along to offer alternative policies in order to attract voters. Leaders must compete by offering the majority of the selectorate better policies. Policy-based competition in which ideas matter is characteristic of polities dominated by large winning coalitions.

Going back to the original article, it seems like the government had little choice than to enact reforms. More than anything, they were probably pushed into them by desperation than anything. Wages are below any of their neighbors and the countries has a corruption problem. This is something that often pops up when reform occurs; they had no choice; circumstances forced their hand. My guess is that Root and Bueno de Mesquita would argue that 'size of the coalition' enables a government to enact the needed reforms before the siutation gets to the point of pain.

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Pls post me regularly on the economic reform programme taking place in the Slovakia. We want to undertake similar reform in the Republic of Liberia. I am a former member of the Liberian Senate and candidate the Liberian presidency.


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