The Message From Mexico Comes Through Loud And Clear

For most of the past year, newly-elected governments in Hungary and Poland took a "softly, softly" approach to economic reform. Despite promises to better manage their economies while preserving the safety net, former communist technocrats got bogged down in fights over privatization and spending. Then came Mexico. That debacle opened the eyes of foreign investors to Central Europe's troublesome economic and political realities. Says Nick Wergan, Central European analyst at Smith New Court Inc. in London: "Mexico reminded everyone that macroeconomic conditions can't be ignored."

Now the ex-communists themselves are beginning to pay attention. On Feb. 7, Hungary's Socialist Prime Minister, Gyula Horn, asked two avid market reformers, Lajos Bokros and Gyurgy Surnyi, to take on the key jobs of Finance Minister and central banker, respectively. In Poland, on the same day, Prime Minister Waldemar Pawlak, who had come under fire for blocking reform, bowed to pressure from President Lech Walesa to resign. Pawlak agreed to step aside in favor of Jozef Oleksy, an eager reformer. The moves show that leaders in both countries recognize the need to smash through political logjams and come up with convincing policies to complete Central Europe's economic transition.

AUSTERITY. Investors responded with cautious enthusiasm. "I can't think of better appointments," says Michael Carter, president of the First Hungary Fund. Bokros is chairman of Budapest Bank Ltd., while Surnyi is a private banker who served as central banker in 1990-1991. In Poland, the stock market rose 14.5% in anticipation of Pawlak's resignation, then dropped slightly (chart). "We will have a much more positive and pragmatic approach to the reforms," predicts Thomas Stadnik, an attorney in Warsaw.

Now, markets are watching to see how well the newly appointed technocrats follow through. In Hungary, where economic pressures seem to be driving political decisions, the reformers must attack the budget deficit, which is nearly 7% of GDP, and the dangerous $3.7 billion current account deficit. The deficits are heavily funded by foreign holders of government bonds, $3.5 billion of which must be rolled over this year.

The reformers' first step may be a devaluation of the Hungarian forint. Such a move would help boost exports and bring in much-needed foreign exchange. Bokros also plans an economic austerity program. And Horn may soon appoint a minister to put privatization back on track. In January, Horn rejected a deal to sell a state-owned hotel chain to a U.S. investor because opponents thought the price was too low. That provoked Finance Minister Lzl Bekesi to quit abruptly.

In Poland, where the financial crisis is not so urgent, the politicians are busy maneuvering in advance of November's presidential elections. Walesa wanted to shake up the government now to improve his flagging rating in the polls. The political skirmish produced one positive result for economic reform: It gave the reformers in the ruling coalition the boost they needed to push Pawlak out.

PENSION PLETHORA. If Oleksy wins the approval of Walesa and the parliament, he will be expected to speed up reform. Poland's GDP grew a healthy 5% last year, but inflation still hovers around 30%. Oleksy will have to tackle ballooning spending and rebuild the country's pension system. Poland is saddled with 9 million pensioners, whose pensions equal nearly 70% of the average wage. As a result, social spending is an unsustainable 23% of GDP.

Meanwhile, Poland's bank system still favors state-owned enterprises run by former Communist Party members. And Pawlak delayed mass privatization, exempting major sectors such as the sugar, oil, and chemical industries. "We've wasted a year," complains Stanislaw Gomulka, a government economic adviser and architect of the country's 1990 shock reforms. "Poland's long-term economic health," he adds, has been "hostage to the political situation."

Across Central Europe and in other emerging markets, economic reform has often suffered while the politicians battled. But one lesson of Mexico was that markets can quickly spin out of control if the pols ignore economic warning signs. Slowly, Hungary and Poland may be getting the point.