The absence of a well-functioning financial sector is a major obstacle to the rapid economic transformation of Central and Eastern Europe. Banks are expected to cope with inherited bad loans, to participate actively in the restructuring and privatization of enterprises and exercise control over their management, to increase the efficiency of credit allocation, and to support small and medium-sized firms in order to reduce the market concentrations inherited from central planning. The financial sector is also charged with collecting the savings needed to finance restructuring, which will require the creation of a modern retail banking sector and the rapid expansion of branching networks.

In Discussion Paper No. 816, Research Associate István Székely investigates whether this sector can fulfil these high expectations and contribute dynamically to the recovery through a rapid increase in its shares in GDP and employment. He identifies conditions necessary to the development of a competitive and innovative financial system and argues that this can only contribute to transformation and long-term development if market conditions force it to do so. The financial sector will only compete if it secures adequate access to resources, production technologies and appropriate infrastructure and operates in a legal environment that supports the necessary innovation in products and technology.

Székely proposes that economic transformation in the region requires several steps, which need not be separated in time, in which financial institutions will play important roles. He outlines a possible grouping of these steps: dealing with the legacies of the past; establishing and maintaining a stable macroeconomic environment; laying the foundations of a market economy and competitive economic environment; restructuring and expansion of production; and reorientation of foreign trade and integration into the European and world economy.

Economic Transformation and the Reform of the Financial System in Central and Eastern Europe
István P Székely

Discussion Paper No. 816, July 1993 (AM)