Introduction

The title of this year’s Transition Report – “The State Strikes Back” – reflects both the trend towards growing acceptance of state involvement and the increased expectations that are now being placed on the state. That is to say, the title is a statement of fact, rather than a value judgement. For libertarian free marketeers, “The Empire Strikes Back” might have been a more suitable title, while for those on the left, the renewed strength of the state may be more akin to “The Return of the Jedi”. This report does not engage in such ideological “star wars”, instead using data to signal emerging trends, explain their core drivers and identify policy implications.

Foreword

The end of communism in eastern Europe in the late 1980s and the subsequent collapse of the Soviet Union seemed to be the ultimate justification for reducing the state’s role in the economy. In the decade and a half that followed, privatisation, deregulation and measures aimed at freeing enterprises and banks from state interference were the order of the day.

Since then, however, three countervailing forces have triggered calls for a stronger economic role for the state. First, it has become evident, particularly in light of the global financial crisis of 2008-09 and the economic recession that followed in its wake, that financial markets will not always produce socially optimal outcomes when left to their own devices. Second, the climate change crisis has made it clear that government intervention is required at national and international level to prevent coordination failures, boost green innovation and address market failures. And third, growing economic inequality (documented in the Transition Report 2016-17) and the shifting of economic risks onto the very individuals who are least able to shoulder them have further increased calls for greater state intervention in the economy.

New survey data in this Transition Report show that 45 per cent of people living in postcommunist economies where the EBRD invests are now in favour of expanding government ownership of business and industry. What is more, the ongoing Covid-19 crisis has accelerated that trend, highlighting citizens’ growing expectations regarding the state’s ability to contain the health and economic risks that individuals face.

The title of this year’s Transition Report – “The State Strikes Back” – reflects both the trend towards growing acceptance of state involvement and the increased expectations that are now being placed on the state. That is to say, the title is a statement of fact, rather than a value judgement. For libertarian free marketeers, “The Empire Strikes Back” might have been a more suitable title, while for those on the left, the renewed strength of the state may be more akin to “The Return of the Jedi”. This report does not engage in such ideological “star wars”, instead using data to signal emerging trends, explain their core drivers and identify policy implications.

The report begins with an in-depth analysis of the size and capabilities of the state across the EBRD regions, followed by chapters looking more closely at the role that state-owned enterprises and state banks play in the modern economy. A separate chapter then looks at the role of the state in the transition to a green economy.

This report shows, perhaps surprisingly, that state-owned enterprises continue to account for around half of all public-sector employment in the EBRD regions. State-owned firms tend to be concentrated in the energy, utilities and transport sectors, often providing subsidised services to people living in remote areas and low-income households. Moreover, in many economies state-owned enterprises continue to act as automatic stabilisers, providing a relatively stable source of employment during economic downturns. Indeed, a new household survey conducted by the EBRD and the ifo Institute in August 2020 reveals that employees of state firms were less likely to lose their job or see their income reduced in the early months of the Covid-19 crisis. At the same time, however, this report also highlights the fact that, precisely because state-owned enterprises target a variety of different objectives, governments often struggle to manage them effectively. To the extent that the Covid-19 pandemic will result in increased state ownership of enterprises, such governance issues will become even more salient.

The banking sector is perhaps the area where the state has struck back most clearly in recent years. State banks have become increasingly important in many economies in the EBRD regions, growing their assets almost twice as fast as private banks. This report discusses both positive and negative aspects of that development. On the one hand, state banks have sometimes displayed a greater appetite for risk, for instance by providing credit to young firms that have not yet established long credit histories and have been shunned by private-sector banks. On the other hand, however, state banks can also be susceptible to political interference in their lending decisions, resulting in less efficient allocation of funding and weaker economic growth.

One of my predecessors as EBRD Chief Economist, Lord Nicholas Stern, has described the failure to tackle climate change as the greatest market failure that the world has ever seen. The guiding hand of the state is desperately needed in that area. This report argues that, in the short term, countries’ responses to the Covid-19 crisis should ideally seek to foster a transition to the green economy by providing state support for greener industries and firms, and by supporting labour-intensive projects with clear environmental benefits, such as the retrofitting of buildings and investment in public transport infrastructure. In the medium term, the focus will need to shift towards addressing the barriers which are currently impeding that transition process. And in the longer term, more creative destruction will be called for, while the green economy will need to be supported using incentives, targeted subsidies and regulation.

Overall, this Transition Report sets out a challenging agenda for emerging economies, both in the EBRD regions and beyond. Its implementation will depend crucially on the quality of institutions and public governance. If institutions are weak, there is a danger that the grabbing hand of the state will siphon off resources intended for people in need, give jobs to political allies and family members, and use state banks for political gain. Firms that cannot operate profitably in the new low-carbon economy may be kept alive as “zombie companies”, and firms that are nationalised during the Covid-19 crisis may never be privatised. If governance is improved, however, the caring hand of the state can guide economies through the transition to a green economy, providing essential support in a transparent manner and adopting forward-looking policies. The governance of state enterprises and banks can be significantly enhanced by clearly defining the objectives of state ownership, clarifying the managerial responsibilities of government entities, separating those entities’ managerial and regulatory functions, making the boards of such firms and banks more autonomous, and reducing political interference in operational decisions.

The economies of the EBRD regions stand at a crossroads, with decisions on policies and institutions that are taken now potentially determining their paths for decades to come. The current period of crisis and upheaval triggered by the global pandemic represents a valuable opportunity to lay the foundations for a wealthier, fairer and greener future. Let us hope that those economies do not allow this opportunity to pass them by.

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Beata Javorcik
Chief Economist, EBRD

Highlights

HOW BIG IS THE STATE?

HOW BIG IS THE STATE?

The response to Covid-19 has highlighted high levels of demand for the socialisation of risks, which are partly a response to the fact that economic risks have increasingly been shifted onto people with low earnings and less tolerance of risk. The crisis has also revealed increasing expectations regarding the services that the state should provide.

state-owned enterprises

state-owned enterprises

State-owned enterprises have historically played an important role in the EBRD regions. Today, they provide almost half of all public-sector employment in those economies and are increasingly concentrated in the energy, utilities and transport sectors, where their services are often subsidised to ensure universal affordability. While private firms are able to supply such services under public service obligations with the support of compensation schemes, governments often opt for direct provision through state enterprises, particularly where administrative capacity is limited.

state banks on the rise

state banks on the rise

State-owned banks have grown in importance across the EBRD regions since the mid-2000s, expanding their assets almost twice as fast as private banks and accounting for a growing percentage of bank branches. Today, state banks own more than half of all banking assets in a number of emerging market economies (including Belarus, China, India, Russia and Ukraine).

the state and the green economy

the state and the green economy

Economies in the EBRD regions have made significant progress in reducing greenhouse gas emissions relative to the levels seen in the 1990s. However, the emission targets set by those economies under the Paris Agreement are not yet sufficiently ambitious, given the reductions that are needed to keep global temperature rises well below 2°C relative to pre-industrial levels.

structural Reform

structural Reform

This section of the report presents updated transition scores for individual economies, assessing developments over the last year, as well as changes over the period 2016-20. It focuses on six key qualities of a sustainable market economy, looking at whether economies are competitive, well-governed, green, inclusive, resilient and integrated.

Highlights

HOW BIG IS THE STATE?

HOW BIG IS THE STATE?

The response to Covid-19 has highlighted high levels of demand for the socialisation of risks, which are partly a response to the fact that economic risks have increasingly been shifted onto people with low earnings and less tolerance of risk. The crisis has also revealed increasing expectations regarding the services that the state should provide.

While most governments have seen increases in their fiscal space, the administrative capacity to deliver on citizens’ growing expectations varies considerably. The expansion of the state’s role in the economy may take the form of increased government spending on goods, services and transfers, and the state may also become an increasingly important employer and provider of goods and services.

Patterns in terms of the state’s expansion following major crises have varied over time and across countries on account of differences in citizens’ preferences. Since the mid-19th century, state spending has risen as a share of GDP, reflecting the increasing importance of providing education, healthcare and social safety nets. While state employment has also risen over the longer term, it peaked in the 1980s and has since declined somewhat on account of privatisation and automation, despite government spending continuing to rise.

In post-communist economies, the state’s share of total employment declined from around 45 per cent in the mid-1990s to 24 per cent in the mid-2010s, but remains 7 percentage points higher than the levels seen in other economies with similar characteristics. Meanwhile, government spending in post-communist economies is consistent with that of their peers at around 35 per cent of GDP.

Even as the state’s share of employment has declined in recent decades, public support for state ownership of businesses and industry has grown – probably in response to rising inequality. Surveys in post-communist economies suggest that 45 per cent of people favour an increase in public ownership. Analysis also shows that women, older people, highly educated individuals and people who are more risk-averse are all more likely to work in the public sector.

state-owned enterprises

state-owned enterprises

State-owned enterprises have historically played an important role in the EBRD regions. Today, they provide almost half of all public-sector employment in those economies and are increasingly concentrated in the energy, utilities and transport sectors, where their services are often subsidised to ensure universal affordability. While private firms are able to supply such services under public service obligations with the support of compensation schemes, governments often opt for direct provision through state enterprises, particularly where administrative capacity is limited.

State enterprises can also act as automatic stabilisers, providing more stable employment during downturns and in disadvantaged regions. Employees of state firms were less likely to have their pay reduced in the early months of the Covid-19 crisis, according to a household survey conducted by the EBRD and the ifo Institute in August 2020. Similarly, levels of public sector employment are higher in regions with higher unemployment. More stable employment in the face of economic and technological shocks can help to reduce negative externalities associated with rising inequality and the erosion of social cohesion and trust. State-owned enterprises can also play an important role in winding down stranded assets in sunset industries.

However, governments often struggle to manage state-owned enterprises effectively. For instance, state-owned firms in the EBRD regions are half as likely to innovate as private-sector counterparts. Meanwhile, the goals of state ownership are often not clearly defined, with managerial responsibilities being spread across multiple government entities with conflicting interests. Management of state enterprises is often seen as an exercise in compliance, with little attention paid to strategy or risk management. Equally, state support is extensive but not transparent, reducing accountability.

As discussed in Chapter 1, the Covid-19 crisis may boost support for state ownership. This will further increase the importance of improving the governance of state-owned firms – for example, by defining the objectives of state ownership, clarifying the managerial responsibilities of government entities, separating those entities’ managerial and regulatory functions, and increasing the autonomy of firms’ boards.

state banks on the rise

state banks on the rise

State-owned banks have grown in importance across the EBRD regions since the mid-2000s, expanding their assets almost twice as fast as private banks and accounting for a growing percentage of bank branches. Today, state banks own more than half of all banking assets in a number of emerging market economies (including Belarus, China, India, Russia and Ukraine).

Private-sector banks are increasingly regarding state-owned banks as major competitors, particularly because state banks tend to have less stringent lending requirements, operate with a lower interest margin (the difference between the rates that are charged on loans and paid to depositors) and tolerate higher levels of non-performing loans. Indeed, state banks’ average annual return on assets in the period 2010-19 was 1.1 percentage points lower than that of similar private banks, while their average non-performing loan ratio was 1.6 percentage points higher than that of private-sector counterparts.

State banks’ greater appetite for risk can soften the impact that economic shocks have on households, small businesses and specific regions, playing a particularly important role when it comes to serving small young firms that lack collateral and/or a sufficient credit history.

While state banks can exert a stabilising influence on economic performance and support financial inclusion, this comes at a cost, with firms that choose to borrow from state-owned banks demonstrating less innovation and weaker productivity growth. This partly reflects the fact that state-owned banks may be more susceptible to political interference in lending decisions (which can result in misallocation of resources, with finance being channelled away from more productive firms towards more connected ones, thereby reducing aggregate growth). Indeed, a 5 percentage point increase in state banks’ share of branches in a particular region is associated with a 10.5 per cent decline in that region’s aggregate productivity.

Explicitly defining the non-commercial objectives of state banks’ lending and improving their corporate governance can help to minimise the economic costs that are associated with state banks’ relative inefficiency and political interference in their day-to-day decisions.

the state and the green economy

the state and the green economy

Economies in the EBRD regions have made significant progress in reducing greenhouse gas emissions relative to the levels seen in the 1990s. However, the emission targets set by those economies under the Paris Agreement are not yet sufficiently ambitious, given the reductions that are needed to keep global temperature rises well below 2°C relative to pre-industrial levels.

All countries have adopted green laws and policies that can help reduce CO2 emissions relative to output. However, the enforcement of such measures is key, and that is where the EBRD regions are lagging behind. Green policies and laws in those regions have reduced CO2 emissions by 12 per cent over the period 1997-2016 relative to the levels that would otherwise have been seen. That is encouraging, but much more is needed to accelerate the shift to a green economy.

In the short term, countries must build the transition to a green economy into their post-Covid-19 recovery plans. Happily, many of the government investment projects that are necessary for that transition are also effective ways of boosting the economy. Such measures must prioritise industries and firms that have a zero-carbon future, without propping up zombie firms that will struggle in the green economy.

In the medium term, the state must address the market and policy failures that are impeding the transition to a green economy. The key here is to get prices right, which means removing fossil fuel subsidies, putting a higher price on carbon and applying that higher price to more emission sources. Additional incentives, subsidies and regulation are also needed to encourage resource efficiency, leverage the network effects of green investment and ensure access to capital for firms with green investment plans.

In the longer term, the state must facilitate the “creative destruction” that this transition process will unleash, while supporting workers and communities that are adversely affected. Environmental policies must be integrated into a broader industrial strategy fostering clean growth, in order to encourage private-sector investment in the green economy.

structural Reform

structural Reform

This section of the report presents updated transition scores for individual economies, assessing developments over the last year, as well as changes over the period 2016-20. It focuses on six key qualities of a sustainable market economy, looking at whether economies are competitive, well-governed, green, inclusive, resilient and integrated.

Successfully implementing structural reforms is more difficult during economic downturns, when policymakers’ focus shifts from addressing longer-term issues to tackling immediate challenges. At the same time, however, the economic and social fallout from the Covid-19 pandemic has emphasised the need for further structural reforms across the EBRD regions to ensure that economies recover quickly and become more resilient to external shocks.

Governments across the EBRD regions have implemented a wide range of measures in response to the pandemic. Those actions, which have been unprecedented in terms of their scope and the speed of their implementation, have ranged from the provision of liquidity to the banking system and moratoriums on loan repayment to various tax breaks for businesses and cash transfers to households.

Many countries have continued to carry out structural reforms over the last year, with reform measures including the strengthening of governance frameworks for state-owned enterprises, anti-corruption measures, the digitisation of government services, the expansion of technical and vocational education and training programmes, and the enhancement of frameworks governing public-private partnerships. Many of those reforms were initiated before the pandemic, but in most cases their implementation has continued despite the challenging environment. However, some reforms have been delayed, with Kazakhstan, Romania and Ukraine, for instance, all postponing the privatisation of major assets.

Over the last year, increases in transition scores have been observed primarily in eastern Europe and the Caucasus, south-eastern Europe and Central Asia. At the same time, declines have tended to be moderate, have been concentrated in scores for green transition and governance, and have been seen primarily in central Europe and the Baltic states and south-eastern Europe.

Events

Online, 10 November 2020

Transition Report 2020-21: The State Strikes Back

Presentation by Beata Javorcik, EBRD Chief Economist

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.