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Pricing and exchange rates in planned economies: How such economies cope with external disequilibria

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International Monetary Fund. External Relations Dept.
Published Date:
September 1984
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Policy responses to external disequilibria

Toma Gudac

There is no theory that permits the analysis of the consequences of an external imbalance in the institutional environment of a planned economy. Yet by drawing from the collective experience of some East European economies it is possible to show that relative prices and the exchange rate have a role to play in planned economies if an unsustainable deficit exists.

The framework

The role of prices and the exchange rate in a planned economy needs to be seen in the context of the development objectives and strategies of the authorities. Typically, these attach high priority to social and economic objectives that, they believe, would not ensue from the free operation of market forces. Specifically, several East European economies aim to reallocate resources and employ them in ways that resemble those allocations in the most advanced industrial countries, in order to accelerate development and enhance future international competitiveness. Reallocation to stimulate investment in industries believed to be growth-promoting is achieved by manipulating sectoral imbalances in demand and supply and relative prices.

The growth-promoting potential of an economic activity is considered to depend on its requirements for skilled labor, research and development, complex equipment, and technology. Thus, higher investment than would be financed voluntarily is concentrated in industries that are intensive in capital and skilled labor. This means that the modern manufacturing sector is typically favored over the traditional sector (agriculture and labor-intensive manufacturing). In general, the state-operated sector providing nontradable services is also promoted; education, culture, health, and administration raise the quality of the labor force, and, since they are relatively labor intensive, provide an outlet for the residual employment of educated labor.

Distortions occur because the pursuit of this strategy requires the authorities to maintain relative prices consistent with their targets instead of prices that reflect current demand and supply conditions. Distortions are maintained by instruments that range from preferential allocation of inputs to multiple exchange rate practices. Where the economy is managed through detailed physical planning, emphasis is given to nonprice policies, including the involvement of political leadership in the selection of priority projects and the direct allocation of cheap, but rationed, credit and critical inputs. Thus, capital-intensive investment in the manufacturing sector is often financed through cheap credit and scarce but undervalued foreign exchange, while the traditional sector may be “rationed out” of investment credits and essential imported inputs.

In orthodox planned economies, planners elaborate the equivalent of an ex ante input-output model of the economy, which is translated into compulsory tasks for individual enterprise managers. Precise specification of physical input entitlements and output objectives substitutes for both the relative price structure and the micro-economic decision making of a market economy. Although wages are usually paid in money, material incentives are frequently used and consumer goods are generally distributed through the market; for enterprises, prices and costs have little impact on allocation. The allocation of resources is changed by direct decisions when planners respond to severe quantity imbalances. While they will act to reduce the sharpest imbalances in order to ease the economic and social frictions and politically harmful consumer dissatisfaction, the planners’ main role is to design and manipulate a pattern of sectoral and subsectoral imbalances favoring the priorities of the plan. Thus, far from being an accidental by-product of imperfect planning, sectoral imbalances and price distortions are perpetuated by the tautness and inconsistency of the plan targets and by subsequent strictness in implementing some of them.

To reduce the rigidities and allocative inefficiencies associated with the detailed specification of input entitlements and delivery tasks, most planned economies have moved from an orthodox to a modified system where the market is regulated or otherwise manipulated, but agents are allowed to respond to such engineered incentives. This means extensive use of selective price, fiscal, credit, and incomes policies to induce producers to act in accordance with the plan’s objectives. The exchange rate, interest rate, and other prices typically remain distorted to ensure profitability in the modern manufacturing sector. Direct control over certain economic decisions (such as major investment projects and top management appointments in banks and large enterprises) is always retained.

The external sector

Internal imbalances are observable both at the level of final consumption, when severe shortages of some goods are accompanied by large stocks of others, and in the production process, when supplies of inputs are inadequate for the desired degree of capacity utilization. Once the tensions arising from these imbalances become politically harmful, the authorities often attempt to bridge them through higher imports. Unless accompanied by substantial adjustment in other policies, however, this opening to foreign trade may result in a large external deficit because the size of domestic imbalances in a planned economy may prove incompatible with a sustainable external position.

The management of the external sector in these economies mirrors the domestic use of nonprice and price policies to influence resource allocation. In orthodox planned economies, foreign trade is conducted by a state monopoly. Such a monopoly imports equipment and other product inputs and essential consumption goods, and procures export goods from domestic producers at the prevailing domestic wholesale price in quantities according to the export plan. When it sells the goods abroad, it gives the foreign exchange receipts to the state bank in return for the domestic currency equivalent at the official exchange rate. The loss or gain of the foreign trade enterprise from the transaction is routinely covered by a payment to or from a price equalization fund. There is, strictly speaking, no foreign exchange market: the official exchange rate is only relevant for settling accounts between the state bank and the foreign trade enterprise, and trade losses and gains are concentrated in the foreign trade enterprise (and are directly subsidized or taxed). This procedure implies not only a wide range of effective exchange rates from commodity to commodity but also different effective exchange rates for the same commodity, depending on the ratio between the foreign and domestic price obtained for each transaction.

When the authorities assign a greater role to net income or profit as a performance criterion for enterprises, but retain distorted relative prices at home, the desired expansion of capital-intensive manufactured exports, for instance, cannot be sustained at a uniform exchange rate. To avoid the major reallocation of resources and changes in the composition of foreign trade that a liberalization would entail, the authorities often proceed cautiously by replacing price equalization with export subsidies, import taxes, and/or multiple exchange rate practices, which vary according to the degree to which the authorities allow domestic prices and development patterns to be influenced by world market prices.

Institutional features of planned economies

Planned economies vary widely in the degree of centralization of and direct control over their economic processes, but standard features include state ownership of most natural resources and the capital stock; a relatively important role for the plan and centralized distributive arrangements; and certain basic rules on income distribution affecting, inter alia, the system of taxation and the level and structure of wages. These institutional characteristics can be regarded as the parameters of the system, within which economic objectives are pursued.

In all planned economies, there is a close association between political and economic functions, but there are important differences among these economies regarding the role of specific economic management instruments. Most “orthodox” planned economies are subject to detailed central planning and physical distribution of inputs and final goods; “modified” planned economies, on the other hand, pursue economic aims in a market-like framework through partly decentralized activities manipulated by largely regulated prices. The latter group of planned economies has more flexible planning, greater use of incentives rather than directives to produce the desired levels and composition of output, and more leeway permitted to decision making by individual enterprises. By definition, even the most market-like planned economy uses significant, if concealed, nonprice measures to allocate resources, inputs, and final goods.

These trade distortions support a pattern of domestic relative prices that transfer the surplus of the comparatively competitive traditional sector (generally agriculture) to infant manufacturing industries. The authorities extract the surplus by fixing prices for the output of the traditional sector at a level that depresses the sector’s real wages and savings below levels achievable at international market prices. An overvalued exchange rate and the accompanying policies are also instrumental in raising real wages in the modern manufacturing and nontradable sectors. In the modern manufacturing sector, the unfavorable impact that an overvalued exchange rate may have on export competitiveness is more than offset by export subsidies and/or retention quotas, by import restrictions that support a high domestic price for its output, and by prices of material inputs that are depressed through an overvalued exchange rate for imported inputs and by controlled prices for local inputs. Moreover, the pressure to raise nominal wages in the sector is eased by depressed prices of imported staple consumer goods (food, transportation, energy), which also boost the real wage for the urban population employed in the non-traded sector.

The multiplicity of traded commodities, permanent and often significant changes in world market prices, and the political cost of introducing and increasing export taxes make constant adjustments in foreign trade taxes and subsidies unwieldy and inefficient. A number of planned economies have therefore undertaken a liberalization of prices and foreign trade for some traded goods, while continuing controls on others. Although the very existence of a fixed-price traded good reduces the effectiveness of adjustment in these modified planned economies, it represents a compromise between the social and economic losses the authorities perceive to result from opening the economy to international market forces and the economic and political gains that result from improved allocative efficiency and the reduced external deficit. In terms of the country’s comparative advantage, the traditional sector is a major earner of foreign currency and would be the main beneficiary from price and trade liberalization, whereas the modern manufacturing sector stands to lose from paying higher prices for inputs, receiving lower domestic relative prices for its output, and exporting at a more uniform and less favorable exchange rate than the rate previously provided through selective export subsidies and/or retention quotas. (Retention quotas implicitly raise the effective exchange rate for exports, because import restrictions ensure a high domestic price for imported goods.)

In 1968 Hungary introduced changes in its management of foreign trade that implied manipulating profit incentives through exchange rate adjustments. Similar changes were introduced in Poland in 1971. These changes were intended to promote a more efficient allocation of resources by allowing relative prices and foreign trade opportunities to affect decision making at the enterprise level more directly, making exporters and importers more sensitive to prices, consumer tastes, and technical developments abroad. Nevertheless, the transmission of worldwide inflation, particularly the sharp rises in raw material prices in the early 1970s, was considered politically unacceptable. The authorities’ response was to subsidize imports of essential production inputs and consumption goods. Higher export prices increased revenue and the purchasing power of exporters; to suppress the resulting distributional impact, the authorities introduced various export taxes.

Role of exchange rate policy

The authorities in planned economies see several disadvantages to equilibrium pricing and exchange rate policies. Specifically, they believe such policies would jeopardize (1) the dynamic gains from the development strategy incorporated in the plan; (2) the distributional benefits derived from previous pricing policies; and (3) the advantages associated with the social and political arrangements pertaining to past policies. On the other hand, they also see some benefits: namely, an economic and political gain from improved immediate (rather than long-term) allocative efficiency and from reduced imbalances, which would make it possible for them to relax coercive redistribution.

However, the assessment of negative effects of an overvalued exchange rate and multiple exchange rate practices suggests that the trade-off is largely misconceived; the three ostensible advantages of maintaining a distorted regime cannot, in fact, be assured by manipulating relative prices and the exchange rate. In several East European countries, such policies were instrumental in forcing changes in the economic structure, increasing the share of the modern manufacturing sector and spreading the application of capital- and skill-intensive techniques in 1960s and 1970s. But this changed structure failed to accomplish the ultimate objectives of the development strategy, namely, to maintain rapid growth, high and steadily rising real wages, and a sustainable external position simultaneously.

Persistent and extensive violation of allocative efficiency through direct controls on and price distortions in domestic and international transactions lead to a situation akin to structural disequilibrium in market economies. On the export side, the distorted incentives give rise to a “salability illusion,” which leads the planners to overestimate the amount of manufactured products that can be sold in advanced economy markets. The persistence of the illusion may be due to the fact that the planners view improvement in the quality of exports as a stationary goal, whereas technology, design, performance, and marketing standards in trading competitors evolve. Hence export performance is persistently below targets. While concealed export subsidies may create an illusion of competitiveness and of a favorable composition of trade, expanding manufactured exports through large effective subsidies and substituting for imports through extensive import controls may lead to worsening factor terms of trade, given the inferiority of design and quality of manufactured ex-portables that tends to persist in a protected environment.

Whereas unsold exportables are easily absorbed by domestic markets, imports are hard to repress. When ex ante export plans are not fulfilled, ex ante balanced trade becomes an ex post deficit, explaining the unplanned portion of the rapid rise in the external debt of planned economies. Depressed prices and real wages in the traditional sector eventually deplete the potential for forced savings. This reduces the scope for redistributive measures to obscure the adverse income effects of allocative inefficiencies resulting from pervasive price distortions. With high net investment, stagnating incomes due to inefficiencies, and limited savings extractable by the price and tax mechanism, the macro-economic imbalance and external deficit are akin to those caused by excess absorption in market economies.

To be sure, there may be market imperfections or externalities, which mean that some viable goals would not be adequately pursued by pricing in a free market. But these call for domestic tax-cum-subsidy measures that directly address the market distortion. Trade or exchange restrictions used for this purpose entail considerable and increasing efficiency costs to the economy, and adversely affect the achievement of other objectives. The export competitiveness of the whole economy suffers from the noncompetitive quality and high prices of protected modern manufactured producer goods. The economy also suffers from sectoral imbalances between supply and demand, and from productivity losses due to misallocation of investment and high effective protection from imports. Experience with protectionist practices in developed market economies suggests that, whereas the welfare loss to consumers can be outweighed by the importance of noneconomic social objectives and the limitations of fiscal policy, losses of allocative efficiency, which give rise to structural weaknesses, increase over time.

Once the potential for extracting the surplus from the traditional sector is eroded, choices among policy options in planned economies increasingly resemble those in their market counterparts. For instance, the rate of growth and the prospects of medium-term increases in employment and real wages can be sustained by a combination of reducing income losses from allocative inefficiencies on the supply side and limiting the gross wage bill (net wage and public sector services) and investment in the modern manufacturing and non-tradables sectors on the demand side. In principle, the adjustment can be undertaken by a variety of alternative policies that include (1) adjustment in the plan and directives for its implementation; (2) reform of taxes and subsidies; (3) incomes policy; and (4) price reform supported by the unification of the exchange rate and a reduction in other distortions to foreign trade.

Irrespective of the instrument, the shift in supply policy has to emphasize the efficiency of resource use in terms of maximizing present income at world market prices. This is promoted better by incentives to managers and workers in a market-like framework than by plan directives geared to long-term structural and social objectives whose attainment may require a resource allocation that violates short-term efficiency criteria. The political cost of price adjustment needed to eliminate misallocations and restore macroeconomic balance should therefore be compared with the efficiency and political costs of additional taxation and/or lower nominal wages in the modern manufacturing and nontradable sectors.

External adjustment requires that a greater share of resources is allocated to the most efficient exports and import substitutes. Inefficient, and therefore oversized, import-substituting sectors have to be restructured and reduced. To bring about this adjustment, authorities need to alter the weights they attach to conflicting economic objectives, emphasizing economic efficiency rather than economic security and an immediate reduction of imbalances in preference to achieving certain preconceived sectoral and factor proportions. The pressing political cost of economic disequilibrium may prompt the authorities to undertake partial measures deemed unavoidable without revising more fundamentally the development strategy and associated allocative policies that lead to the imbalances. However, the nature of difficulties in some East European economies discussed above suggests it would be better to remove price distortions—to reduce trade restrictions on the one hand and adjust and unify the exchange rate on the other. Corrections of relative prices have to be complemented by restraints on aggregate demand to support the resource reallocation according to the new prices. If the accumulated imbalances are large and deeply rooted and the adjustment has to be accomplished in a short time, overcoming various rigidities in the economy and in external demand will require a sharp change in relative prices supported by devaluation. To be sure, these measures can be effective only after prices rise, income is redistributed, and consumption constrained in ways often perceived to be socially undesirable. However, such changes are necessary in planned economies suffering from unsustainable imbalances and competitive weakness in order to enhance both the short- and long-term efficiency of resource use, economic growth, and factor returns.

While the institutional arrangements of planned economies reflect fairly inflexible political parameters and development strategies, there is nevertheless scope for evolution while maintaining the same final objectives of growth and international competitiveness. To the extent that certain features of economic management are better suited to the pursuit of certain objectives, the shift in emphasis among short-term economic objectives will also have an impact on the evolution of economic organization and management. Greater emphasis on allocative efficiency and balance of payments adjustment, for example, requires greater use of decentralized economic decision making based on economic incentives provided by market-related relative prices and the exchange rate, and trade policies consistent with such prices. The required improvement in microeconomic allocation will follow only if decision makers in enterprises fully bear the consequences of the financial outcome of their operations within the “rules of the game” that, once revised, remain stable. This implies substantial reduction in and/or accountability for political interference with economic life (related to decisions in investment and distribution within the enterprise sector in particular), which may prove incompatible with the authorities’ perception of their responsibilities. Progress in this direction will depend on economic necessity and especially on the authorities’ assessment as to whether and to what extent political fundamentals must be compromised in the process.

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