V Policy Challenges Facing Transition Countries

International Monetary Fund. Research Dept.
Published Date:
October 1995
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For the first time since the late 1980s, recorded output is growing in most countries in transition. In some, such as Albania. Poland, and Slovenia, real GDP has already surged far above its trough. In others, including Armenia, the Baltic countries, Bulgaria, Croatia, the former Yugoslav Republic of Macedonia, Moldova, Mongolia, and Romania, economic recovery materialized later but is becoming more broadly based. At the same time, inflation is under better control in most transition countries, including Ukraine, Belarus, and most countries of central Asia and the Transcaucasus. Output performance continues to be bleaker in Russia, Ukraine, Belarus, and most of the countries of central Asia and the Transcaucasus, with further large declines in real GDP expected in 1995.

Correspondingly, the policy challenges now faced by the countries more advanced in the transition differ from the challenges confronting countries that started later or moved more slowly. The priority for the former group is to sustain growth and disinflation and to make further progress with structural reforms, particularly with respect to the deepening of market-oriented principles. For the latter group of countries, consolidating or even achieving macroeconomic stabilization remains paramount, and much is still to be done to set up the institutions of a market economy.

A central feature of successful market economies is a well-functioning financial system. In almost all countries in transition, however, financial systems suffer from deep-seated weaknesses. In several countries, banking crises have erupted into the open. In others, crises have been contained, but contingent fiscal liabilities have been building up at a disquieting pace, Rank failures endanger stabilization gains, and slow progress with financial sector reform is impeding improvements in corporate efficiency in the enterprise sector. At the same time, insufficient restructuring and financial discipline in the enterprise sector continue to burden banks with nonperforming loans, undermining the stability of the financial sector.

Sustaining Disinflation and Growth in Countries More Advanced in the Transition

The countries that started earliest and moved most decisively with stabilization and structural reforms have made considerable progress. Disinflation has generally been fairly swift after the initial price jumps associated with decontrol. Output is expanding at a median rate of 4–5 percent. The main policy challenge now facing these countries is to ensure the sustainability of disinflation and growth.

Annual inflation rates have been brought down significantly from the triple-digit levels prevailing in the early phase of the transition. In Albania. Croatia, the Czech Republic, and the Slovak Republic, annual rates of inflation have approached or reached single-digit levels (Chart 27). Nevertheless, inflation remains stubbornly high in most countries, typically fluctuating in the 20–40 percent range. In Hungary, inflation has even picked up anew. The persistence of high inflation is mainly due to the spread of indexation mechanisms and enduring fiscal imbalances (Table 15).42 But it is also related to continuing relative price adjustments. with prices of nontradables rising faster than prices of tradables (Box 5).43

Chart 27.Countries More Advanced in the Transition: Inflation

(Twelve-month percent change in the consumer price index)

Inflation has come down but generally remains high.

Table 15.Countries More Advanced in the Transition: General Government Budget Balance1(In percent of GDP)
Czech Republic11.4-1.3-2.4-1.0
Slovak Republic-7.6-1.5-3.0-2.4
Sources: National authorities; and IMF staff estimates.

Defined as total expenditure (including extrabudgetary funds) plus net lending minus total revenue and grants.

Central government balance.

Excludes concessional external financing of development projects on the order of 6-8 percent of GDP.

Sources: National authorities; and IMF staff estimates.

Defined as total expenditure (including extrabudgetary funds) plus net lending minus total revenue and grants.

Central government balance.

Excludes concessional external financing of development projects on the order of 6-8 percent of GDP.

Unexpectedly large capital inflows have been one of the challenges associated with relatively successful stabilization. These inflows are a welcome sign of the confidence of foreign and domestic investors in the economic prospects of the recipient countries.44 However, the inflows have also added to inflationary pressures, most notably in the Czech Republic and Poland but also in Albania, the Slovak Republic, and Slovenia. In the Czech Republic, where the exchange rate is fixed, external borrowing by enterprises, foreign portfolio and direct investment, and short-term borrowing by banks have all contributed to a surge in official reserves, which were equivalent to nearly six months of imports by the end of August 1995. Similarly, in Poland, in the context of a crawling peg, a rapid accumulation of official reserves took place as a result of buoyant exports and, as in the Czech Republic, of expectations that the exchange rate would be revalued. In both cases, restricted exchange rate flexibility coupled with limited scope for sterilization led to rapid money supply growth.45

The ensuing inflationary pressures cannot be durably contained by administrative measures. Price controls, for example, such as the caps on energy prices introduced in Poland, risk delaying structural adjustment. A reintroduction of restrictions on capital flows would also represent a setback to the liberalization and opening up of the economy and deter foreign direct investment. Rather than imposing new restrictions, measures should be implemented to remove distortions in domestic financial markets that might encourage external borrowing or discourage capital outflows. The Czech Republic has announced tighter regulation of short-term borrowing by banks, effective August 1, 1995, in view of the threat that capital inflows have posed to monetary control, while at the same time a draft foreign exchange law would further liberalize outflows of foreign direct investment. Macroeconomic policies, however, have a key role to play in reducing inflationary pressures stemming from large capital inflows. In particular, it may be appropriate to tighten fiscal policy more than planned to reduce the pressures on inflation and interest rates. In some cases, it may even be appropriate to achieve a fiscal surplus. With due regard for competitiveness considerations, it may also be desirable to allow some exchange rate appreciation or to slow down the predetermined rate of depreciation, as has been done in Poland.46

Most of the countries that achieved a fair measure of financial stability early on in the transition have subsequently enjoyed vigorous growth. In 1995, real GDP is projected to exceed its trough by 29 percent in Albania, 19 percent in Poland, and 11 percent in Slovenia. Strong recoveries have helped arrest and in some cases reverse the sharp increases in open unemployment rates that characterized the early stages of the transition (Chart 28). In accordance with the experience of other countries, the contribution of growth to job creation will depend on the degree of flexibility of new and emerging labor market institutions, particularly with respect to wage setting (Box 6).47 Even under favorable conditions, however, high unemployment will remain a major problem in the years ahead in most of the transition countries.

Chart 28.Selected Countries in Transition: Open Unemployment Rates

(In percent of the labor force)

Unemployment rates may have peaked in several countries.

Box 5.Price Liberalization and Inflation Dynamics in Transition Economies

Price liberalization allows the structure of relative prices in transition economies to adjust and move toward that characterizing market-oriented economies with similar levels of per capita income.1 Accordingly, the variability of relative prices is large in the early phase of the transition but declines as prices are realigned closer to market levels.

In Russia, for example, a relatively comprehensive price liberalization took place at the beginning of 1992, causing major shifts in relative prices. After a few months, however, relative price variability had declined substantially (see chart). Price liberalization was more gradual in the transition countries of central Asia. In Kazakhstan, for example, many prices remained administered until late 1994. Before they were decontrolled, these prices were adjusted infrequently and by large amounts, resulting in many spikes in relative price variability.2 The pace of liberalization varied across types of items: in most transition countries, prices for tradables were freed first, and more or less across the board, although the prices of some staples often remained controlled; prices for services were freed last and more gradually. Relative price variability for services thus remained much higher than for tradable goods. As the relative price structure starts to resemble that in comparable market economies and as agents seek to adjust to chronic open inflation, price setting will tend to become increasingly synchronized.

In addition to the ongoing adjustment of relative prices, high and stubborn inflation in most transition countries also reflects the reliance on the inflation tax whereby money creation is used to finance persistently large fiscal and quasi-fiscal deficits.3 In 1993–94, the ratio of the change in base money to GDP—a measure of seigniorage—averaged 1 percent in Poland and the Slovak Republic, 3½ percent in Hungary, 7 percent in Romania, and 9 percent in Russia. The scope for extracting seigniorage diminishes, however, as the demand for money drops in response to higher inflation. Moreover, the efficiency losses caused by high inflation and the inflationary erosion of tax receipts associated with tax collection lags offset seigniorage as a source of off-budget fiscal revenue. If, for example, tax payments are collected with a one-month lag and tax revenues represent 30 percent of GDP, a monthly inflation rate of 10 percent would imply a loss in real fiscal revenue amounting to 3 percent of GDP (assuming no penalties for late payment). Persistent inflation may also reflect the more widespread use of indexation mechanisms, affecting the formation of wages and pensions, and the design of financial contracts. Indexation may help to reduce some of the costs of high inflation, but it causes inflation to become more entrenched. Disinflation under such circumstances requires decisive fiscal adjustment. The reduction of inflation may be facilitated by measures to reduce the inertia in the inflation process stemming from indexation. Institutional reforms enhancing the credibility of financial policies, such as conferring more independence to the central bank, can also reduce inflationary inertia and speed up disinflation.

Russia and Kazakhstan: Relative Price Variability1

(In percent)

1 Measured as a weighted average of the variance of monthly inflation rates for specific items.

See Paula De Mast and Vincent Koen, “Price Convergence in Transition Economies,” IMF Working Paper (forthcoming).

See Mark De Broeck. Paula De Masi, and Vincent Koen. “Inflation Dynamics in Kazakhstan,” IMF Working Paper (forthcoming).

See Rudiger Dornbusch and Stanley Fischer, “Moderate Inflation,” World Bank Economic Review, Vol. 7 (January 1993), pp. 1-44.

To a large extent, robust output growth has thus far been driven on the demand side by a rapid expansion of exports, especially to western Europe but increasingly also to other transition economies (Chart 29). However, even if the revival of east-east trade continues (Box 7), it may be difficult for these economies to sustain rapid export growth without substantial investment to rebuild largely obsolete capital stocks inherited from the command system. Investment is generally beginning to recover and in many cases is rising rapidly from relatively depressed levels. High rates of domestic saving are essential to sustain the pickup in investment. This is an important reason why steady reductions of fiscal deficits will be needed to prevent the crowding out of needed private investments. Provided their macroeconomic consequences are taken into account in the overall policy stance, as discussed earlier, capital inflows, including the return of flight capital, can also help to finance investment. As suggested by the experience of developing countries, foreign direct investment may be particularly helpful to raise overall investment levels, strengthen productivity, improve management practices, and foster export-oriented activities.

Chart 29.Selected Countries in Transition: Growth in GDP and Exports of Goods and Services

(In percent, average for 1994–95)

Exports have contributed substantially to output growth.

1Based on value in U.S. dollars.

2Merchandise trade.

The continued process of transformation also requires further progress with enterprise restructuring, financial sector reform, and institution building. Although much of the formal framework of a market economy is now in place in the countries that are relatively advanced in the transition,48 corporate efficiency, management practices, and business ethics still have a long way to go to meet international standards, especially among state-owned enterprises. Moreover, in several countries, including Hungary, Poland, and the Slovak Republic, the pace of privatization has remained too slow. Lastly, some of the institutions of a market economy remain to be established, such as well-functioning housing markets, reliable systems of commercial courts, and efficient financial systems. In the longer run, increases in productivity, output, and living standards will be commensurate with improvements in those areas.

Box 6.Changing Wage Structures in the Czech Republic

Recent evidence suggests that wage structures in the Czech Republic are moving toward those observed in market economies.1 Under central planning, the goal was to encourage the expansion of the goods-producing sector, and in particular heavy industry, and discourage activities in the service sector and most intellectual activities outside of the hard sciences. In designing national wage structures in the early postwar period, central planners took account of education, experience, the attractiveness of jobs, and other factors. However, relative wages were mainly set to allocate labor in accordance with the production goals of the central plans. Accordingly, vocational education was emphasized over advanced academic training. Average economic returns to schooling in central European countries therefore tended to be lower than in most market economies. Thus, the labor force of central European economies began the transition with overinvestments in vocational training and underinvestments in university education.

With the end of central planning, wages in a large number of occupations were free to adjust to market forces. Data from employment and labor force surveys conducted between June 1988 and November 1993 in the Czech Republic suggest that wage structures appear to be moving toward those typically associated with a market economy. Since 1988, for example, it is estimated that average returns to schooling and wage inequality have increased, suggesting a reversal of some of the wage distortions created under central planning. New private firms seem to be playing a leading role in changing the wage structures. For example, returns to university education have increased, and these gains have been particularly noteworthy in the private sector. The survey data also indicate that workers with a vocational degree are no longer guaranteed higher wages than workers with a primary school degree. Although state enterprises and recently privatized state enterprises have mostly retained the old relative wage structures, there may have been some changes—such as increases in the returns to high school and university education—because of labor market competition from the new private sector.

Adjustments in relative wages and the central role of the private sector in bringing about these changes are not unique to the Czech Republic. Estimates of the returns to schooling and wage inequality have increased in Poland and in Hungary, for example. In Romania, by contrast, which has yet to develop a significant private sector, returns to education appear to have changed very little. In a number of transition countries, workers with vocational training have experienced falling relative wages and disproportionately higher unemployment.

Robert J. Flanagan, “Wage Structures in the Transition of the Czech Economy,” Staff Papers (IMF, forthcoming).

Countries Less Advanced in the Process of Stabilization and Restructuring

The key lesson from the countries more advanced in the transition process is that stabilization of prices and resumption of output growth require sound macroeconomic policies coupled with comprehensive structural reforms. In light of this experience, almost all the countries that initially put off fundamental adjustment policies or moved less boldly have more recently been making headway with reforms. Natural disasters and armed conflicts have hindered or undermined the implementation of stabilization and reform policies in a number of countries, Armenia has suffered from the aftermath of the 1988 earthquake, while Moldova endured a severe drought followed by storms with hurricane-force winds. Other countries were set back by the economic disruption and destruction of war, as in Armenia, Azerbaijan, Bosnia-Herzegovina, Georgia, and Tajikistan. Alongside the deleterious effects of such developments, the relatively poor starting point of some countries has tended to exacerbate the adjustment costs associated with the transition. Longer histories of central planning in many of these countries, and lack of basic understanding of market economy principles, have also inhibited the political support for the reform process. Many of these obstacles have gradually been overcome and reforms are under way. There are now visible signs of genuine progress in all but a few countries.

Despite a slow start, the stabilizing effects of tight financial policies are clearly apparent in Moldova and the Kyrgyz Republic. In Moldova, these policies, initiated in late 1993 and steadfastly adhered to since, reduced monthly inflation to less than 1 percent by March 1995 (Chart 30). Real output is expected to bottom out in 1995, harvests permitting (Chart 31). These achievements are particularly impressive in light of the adverse shocks the Moldovan economy has endured since independence, including the armed conflict following the unilateral secession of the Trans-Dniester region and a series of natural disasters. The Kyrgyz Republic, which initiated similar policy measures in late 1993, has reduced monthly inflation to low single-digits and arrested the depreciation in the nominal exchange rate. Real output is expected to begin to turn around during 1995.

Chart 30.Selected Countries in Transition: Inflation

(Monthly percent change in consumer price index)

Inflation has slowed considerably during the first half of 1995.

Chart 31.Selected Countries in Transition: Real GDP1

(1991 = 100)

The decline of output appears to have bottomed out in a number of countries.

1 Official national accounts data through 1994 and IMF staff projections (blue shaded areas) for 1995.

Following a relatively early start with reforms, progress with stabilization has lagged in Romania and Bulgaria. Since 1994, Romania has tightened financial policies and significantly slowed inflation, while the recovery of output has continued to strengthen. During the first half of 1995, however, the current account deficit widened considerably, partly due to a surge in imports related to devaluation expectations. In Bulgaria, inflation also slowed considerably during the first half of 1995, but, as in Romania, an ailing banking sector and the failure to enforce hard budget constraints on state-owned firms threaten to reverse disinflation.

Clear signs of stabilization have recently become visible in a number of other countries, although progress is still fragile. Following the implementation of tight financial policies, monthly inflation has reached low single-digit levels in Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, the former Yugoslav Republic of Macedonia, and Uzbekistan. Emerging or existing problems in each of these countries, however, jeopardize the success achieved thus far: in Armenia and Belarus, large capital inflows have complicated monetary policy; in Azerbaijan, output has continued to decline, partly reflecting ongoing disruptions of transportation routes and the conflict in Chechnya; in Georgia, external financing needs remain very high and public finances are particularly weak; in Kazakhstan, where large capital inflows have also made monetary policy more difficult, insufficient financial discipline in the enterprise sector could still derail progress in stabilization; in Uzbekistan, stabilization needs to be solidified and recent efforts to speed up structural reform will need to gain momentum to improve growth prospects; and in the former Yugoslav Republic of Macedonia and in Uzbekistan, the limited scope and slow pace of structural reform continue to dampen growth prospects.

Efforts to bring inflation under control continue in Russia. Notwithstanding the tightening of monetary and fiscal policies since early 1995, inflation barely declined during the second quarter, continuing at a pace exceeding 1½ percent a week, corresponding to annual rates of over 100 percent. Russia’s somewhat disappointing inflation performance through mid-1995 is in part due to a decline in the effective reserve requirement ratio, and to the surge in base money resulting from intervention on the foreign exchange market aimed at containing the nominal appreciation of the ruble. Inertia in the inflation process may also reflect lingering doubts about the stance of financial policies, and the memory of earlier failures to stabilize. Meanwhile, there are some signs that output has begun to recover, although measured real GDP is still expected to show a significant further decline in 1995.49

Tight financial policies implemented in Ukraine since October 1994 and in Belarus since early 1995 brought inflation down below Russian levels by the second quarter of 1995. In both countries, the nominal exchange rate stopped depreciating while inflation was falling. Inflation nevertheless remained high and the real exchange rate appreciated substantially against the U.S. dollar and other western currencies. The exchange rate appears to have remained competitive, however: in May 1995, for example, monthly wages stood at less than $50 in Ukraine and at about $65 in Belarus, compared with $70 in Russia and more than $150 on average in the Baltic countries.

Box 7.Trade Among Transition Countries

With the collapse of central planning, foreign trade among the transition countries declined sharply during 1989–93. Previous trade patterns determined by central plans became less relevant in an environment of trade based increasingly on comparative advantage. Some of the more rapidly reforming transition economies found new markets for their goods in the west, but many struggled to establish trade links based on market principles with their former partners. Recent evidence suggests that intraregional trade flows have recovered somewhat among a number of transition countries.

Trade with the east picked up in 1994 for some of the central European countries, including the Czech Republic, the Slovak Republic, Hungary, and Poland, albeit from very low levels. The strongest gains were in Poland: in 1994, Polish exports to other transition countries rose by 34 percent, with food and manufactured items accounting for more than half of the total, while Polish imports from transition countries increased 21 percent, mainly in fuels, chemicals, and intermediate manufactured products such as iron and steel (see table). Economic recovery in central Europe and multilateral trade arrangements have contributed to the revival of east-east trade. The Central Europe Free Trade Agreement (CEFTA), enacted in 1994 by the Visegrád countries—the Czech and Slovak Republics, Hungary, and Poland—mandates that all trade barriers on industrial products be removed by the year 2001. Slovenia became a full member of CEFTA in 1995. Recently, Poland became the last of the Visegrád countries to sign a separate agreement with Slovenia abolishing all import duties over the next two years.

For the Baltic countries, Russia, and the other countries of the former Soviet Union, the collapse of central planning has meant a gradual disappearance of bilateral interstate barter clearing and settlements through correspondent accounts in central banks. In many countries, these outmoded practices have been replaced by settlements in national currencies through correspondent accounts in commercial banks, forming the basis for expanded international trade.

Poland: Foreign Trade by Direction
Value (In millions of dollars)Percentage Change from Previous Year
Total Exports17,240722
Industrial countries12,9911222
Transition countries2.499-834
Developing countries1,750-26
Total Imports21,569IS15
Industrial countries16.2122513
Transition countries3,063-221
Developing countries2,294719
Sources: National authorities; and IMF staff estimates.
Sources: National authorities; and IMF staff estimates.

The Baltic countries have successfully established trade links with other transition countries, especially with one another. In 1994, intra-Baltic trade rose about 30 percent, reflecting the impact of the Baltic Free Trade Agreement, which eliminated all trade barriers, and the geographic proximity of these countries. More recently, in an effort to expand trade relations further, Estonia and Ukraine have been negotiating a bilateral free trade agreement that covers all products.

Trade among the Baltic countries, Russia, and the other countries of the former Soviet Union has also started to pick up. After a number of years of sharp declines, Russian exports to the Baltic countries increased strongly in 1994, as did exports of gas and diesel fuel to Ukraine and Belarus in 1995, In the past two years, Russia has signed free trade agreements with many of the countries of the former Soviet Union waiving import duties and, in some countries, export taxes. In particular, Russia and Belarus have agreed to create a customs union with a common system of external tariffs. Trade among most of the central Asian and Transcaucasian countries has yet to recover owing to ongoing payments difficulties (resulting in mounting arrears) and continued declines in domestic demand and production.

Tajikistan—until recently the last country other than Russia still using the ruble as legal tender—introduced its own currency, the Tajik ruble, in May 1995. A temporary freeze on bank credit and other emergency measures initially helped support the new currency, but the scope for exchange rate stabilization is limited by the paucity of foreign exchange reserves and foreign financial assistance. In recent months, inflation in Turkmenistan has been much higher than in the other central Asian countries, fueled by an expansionary monetary policy and general hesitation to pursue decisive adjustment and reform policies.

Although success with economic stabilization has varied substantially across the countries less advanced in the transition process, fiscal performance, despite some improvements, remains a serious source of concern in all of these countries (Chart 32).50 As budget deficits are financed in large part through money creation, failure to achieve fiscal consolidation threatens to undermine progress in reducing inflation. The persistence of deficits stems from chronic problems impeding revenue collection and expenditure restraint. To some extent, revenue collection can be bolstered by strengthening tax administration, expanding tax coverage to include the emerging private sector, eliminating tax exemptions, and broadening tax bases. In a number of countries, however, the inability to collect sufficient revenues is due more to political than to economic considerations. In Russia, for example, there has been substantial political resistance to increases in taxing oil production, and tax revenues from the natural gas sector have remained low by international standards. Another source of revenue loss in Russia and in many other countries is tax arrears of unprofitable enterprises. These arrears are unlikely to be repaid in full and, in effect, represent financial transfers from the budget to) enterprises (Box 8).

Chart 32.Selected Countries in Transition: General Government Expenditure, Revenue, and Deficit1

(In percent of GDP)

Deficits are generally narrowing but remain large.

1 Expenditure equals total expenditure (including extrabudgetary funds) plus net lending; revenue equals total revenue plus grants. Blue shaded areas indicate IMF staff projections.

2Central government.

Gaining better control over expenditures requires considerable changes in the budget process and in the financial management of government operations. Establishing a treasury system centralizing payment and cash management can markedly improve the allocation of government resources.51 Although such a system is being introduced in some countries, including Belarus, Kazakhstan, the Kyrgyz Republic, Russia, and Turkmenistan, it will take time before new procedures yield more effective control over spending. Other pressing expenditure issues merit immediate attention. For example, many countries still rely on cash rationing as an expedient to contain expenditures. Running up arrears, however, is an unsustainable way to achieve budget balance. Off-budget expenditure categories, and especially subsidies, are also difficult to control and therefore should be more carefully monitored. Downsizing and restructuring of the civil service, and more effective targeting of social benefits, are areas where budget savings could be realized.

Implementation and perseverance with sound macroeconomic policies are necessary, but not sufficient, to bring about sustained growth. Structural reforms and in particular price liberalization and privatization are also critical for a durable recovery of output. The different experiences of transition countries indicate that delaying these reforms, as with delaying macroeconomic stabilization, at best postpones output declines and is likely to make them larger. The process of structural reform is relatively advanced in Armenia, Georgia, the Kyrgyz Republic, Kazakhstan, and Russia, but severely lagging in the former Yugoslav Republic of Macedonia, Turkmenistan, and Tajikistan.

Box 8.Subsidies and Tax Arrears

The scale of direct budgetary subsidies to enterprises in the transition economies was sharply reduced when prices were liberalized. In the Visegrád countries—the Czech and Slovak Republics. Hungary, and Poland—for example, subsidies dropped from 15-25 percent of GDP before liberalization to 3-5 percent of GDP after liberalization. Large declines in direct subsidies also occurred in most other transition countries.

The curtailment of subsidies paid out of the government budget to firms is one of the ways in which hard budget constraints are established. Progress, however, has been slower than what the contraction of budgetary subsidies may suggest. Other forms of explicit or implicit transfers to enterprises—such as arrears, guarantees for bank credit, interest rate subsidies, licenses, quotas, multiple exchange rate arrangements, and tax exemptions—have not declined to the same extent, or have even increased. In particular, arrears on tax payments (including VAT, excises, profit, and excess wage taxes) and social security payments have risen to levels comparable with those of direct budgetary subsidies.

Because eventual payment of most tax arrears may not be enforced, and because inflation erodes the real value of taxes that are paid late, tax arrears often represent a financial transfer from the budget to the enterprise sector.1 Around 1993, the stock of tax arrears was about 5-10 percent of annual GDP in the Visegrád countries, while the flow of tax arrears typically hovered in the neighborhood of 2 percent of GDP,2 The flow of tax arrears also averaged 2 percent of GDP in Russia in I994.3 These estimates far exceed write-offs of uncollectible taxes in most industrial countries: in the United Kingdom, for example, write-offs are typically about ½ of 1 percent of GDP.

Survey evidence for Hungary and Poland suggests, not surprisingly, that the bulk of the tax arrears are owed by the least profitable firms. Balance sheet data for Polish firms show that the losses of financially distressed enterprises were covered mainly by increases in tax liabilities, and much less by increases in trade or bank credit. Paying suppliers and workers thus appears to be given priority. Because bank credit is scarce, the government ends up absorbing a large portion of the losses. As long as no bankruptcy procedures are initiated by the government or other creditors, enterprises can avoid immediate closure by running up arrears.

The tax authorities may have several reasons not to pursue these firms into bankruptcy. First, their net value may be so low that a lengthy and costly bankruptcy procedure would not yield much revenue for the budget in the short run. Second, local tax authorities may face political pressures to resist layoffs and maintain the status quo; moreover, they may hope or expect that the firms will be rescued by the government, that a debt workout scheme will be implemented by bank creditors, or simply that the firms may become viable in the context of a general economic recovery. Partly reflecting such concerns, a scheme has been introduced in Russia allowing the settlement of tax liabilities by oil companies through deliveries of fuel to the agricultural sector.

A full accounting of government aids to enterprises should thus incorporate tax arrears alongside budgetary subsidies and other quasi-fiscal transfers. Hard budget constraints are increasingly ruling most of the financial relations among banks, enterprises, and households in the transition economies. However, effective budget constraints have proven to be harder to impose on obligations between governments and enterprises. Transfers that have disappeared as subsidies have resurfaced as tax arrears.

Penalties For late payment, insofar as they are paid, mitigate the inflationary erosion of tax receipts.

See Mark E. Schaffer, “Government Subsidies to Enterprises in Central and Eastern Europe: Budgetary Subsidies and Tax Arrears,” in Tax and Benefit Reform in Central and Eastern Europe, ed. by David M. Newbery (London: Centre for Economic Policy Research, 1995).

See Gilles Alfandari and Mark Schaffer, “On ‘Arrears’ in Russia,” paper presented at a Joint Conference of the World Bank and the Ministry of Economy of the Russian Federation, St. Petersburg, Russia, June 12-13, 1995.

Price liberalization is necessary to improve the efficiency of resource allocation. All countries have implemented significant price reforms in the markets for domestic goods and services, even though much remains to be done in a few countries such as Turkmenistan. The prices that remain controlled, typically for selected staples, rents, and other services, are periodically adjusted with the objective of full cost recovery in the longer term. Concomitantly, budgetary subsidies in most countries have declined sharply as a share of total expenditure since 1991.52 Nevertheless, numerous off-budget and indirect subsidies persist. In Russia, for example, these subsidies include foreign trade regulations keeping domestic energy prices excessively low, credits carrying below-market interest rates, and tax exemptions. These hidden subsidies are sources of distortion and will need to be cut further as part of the effort to reduce broadly defined fiscal deficits.

The decontrol of domestic prices and quantities must be accompanied by similar measures on the external side. These measures include exchange rate unification and liberalization, abolition of open and hidden import subsidies, harmonization of import tariffs, and elimination or at least streamlining of quotas, licensing requirements, and export tariffs. Progress in some of these areas has been slow, but reforms are proceeding. The Kyrgyz Republic and Moldova have accepted the obligations of Article VIII of the IMF Articles of Agreement, thus marking their transition to convertibility for current account transactions. Postponing reforms in this area only fosters rent seeking and corruption, generates capital flight, and provides a fertile ground for growth of vested interests strongly opposed to further structural reforms.

Privatizing the bulk of state-owned enterprises and improving enterprise management and corporate efficiency are also essential for these economies to realize their growth potential. In addition, legal structures safeguarding market-based incentives must be established and activated, including legislation governing property rights, contracts, bankruptcy, banking, competition policy, and foreign investment. Russia has made the most headway with privatization. In 1992, the Russian government launched a mass privatization program that in eighteen months shifted ownership of a large proportion of state enterprises to the private sector.53 Restructuring, however, has typically lagged the transfer of title. While many Russian privatized enterprises are still overstaffed, handicapped by obsolete technologies, and poorly managed, survey evidence points to improvements in product lines, marketing capabilities, employment levels, and wage structures.54 However, the leasing of land, dwellings, and industrial premises is still often carried out on an administrative basis, giving local authorities scope for discretion and discrimination.55

In Kazakhstan, privatization has advanced more slowly, but the ongoing mass coupon privatization scheme is expected to transfer the ownership of at least 150 large- and medium-scale enterprises each month in 1995. Although initially off to a slow start, efforts are now under way to accelerate the privatization process in Armenia, Georgia, the Kyrgyz Republic, the former Yugoslav Republic of Macedonia, and Moldova. Other countries are moving very slowly in this area: in Bulgaria, high unemployment, resistance from state-owned enterprise workers and managers, and a myriad of bureaucratic obstacles have severely hindered progress; similar difficulties exist in Belarus, Croatia, Romania, Turkmenistan, and Ukraine.

Agricultural reforms are equally necessary in all transition countries. The share of agriculture in employment and output is typically much larger than in industrial countries, approaching one third in Moldova and one half in Albania. Overall growth performance will be significantly affected by the speed with which this sector is revitalized and modernized. In many cases, however, the pace of structural change has tended to be slower in agriculture than in industry and services.

Financial Fragility and Macroeconomic Stability

A sound banking system is indispensable for resources to be efficiently allocated as well as for the protection and encouragement of domestic saving. A healthy financial sector can also contribute to the improvement of corporate governance in the enterprise sector. Through these various channels, financial sector deepening will contribute to higher growth of output and living standards.

Banking systems in most economies in transition, however, are very fragile, as illustrated most recently by crises in Latvia and Russia. Saddled with a legacy of poor assets, but also with more recently committed nonperforming loans, many banks throughout the transition countries either have been closed or are vulnerable to adverse shocks. The fragility of the financial system poses a major risk for the recovery of activity and may exacerbate fiscal imbalances, and thereby increase inflation pressures.

The main functions of financial institutions under central planning involved payments and accounting rather than risk evaluation, allocation of financial resources, and monitoring of borrowers. In the 1980s, the nonobank system still prevailing in many countries was split up and some commercial incentives were introduced. In the early 1990s, when the transition to a market economy started in earnest, small banks proliferated and other financial institutions emerged, including private insurance companies, pension funds, mutual funds, security firms, and equity and bond markets.56 In Poland, for instance, 60 new commercial banks were started in 1990–91. In Latvia, the number of banks soared from 6 in 1990 to 63 by 1993. Russia had over 2,500 banks by the end of 1994.

The pre-existing establishments inherited several handicaps, including a lack of experience in credit operations and an excessive dependence on a small number of state-owned enterprise borrowers. Bad loans carried over from the old regime were less of a problem in countries like Poland, where high inflation wiped out their real value, than in countries like the Czech Republic and the Slovak Republic, where inflation was better controlled. The new banks were often set up with a minimal capital base.57 A number of them—the so-called pocket banks—were little more than the financial subsidiaries of state-owned enterprises, serving as a conduit for directed credits (and sometimes as a channel for tax evasion and capital flight). Prudential regulations and supervision were almost everywhere insufficient to deal with the rapid development of the financial system.

Many banks accumulated new bad loans during the early years of the transition, sometimes at the behest of the government. State-owned enterprises faced with abrupt cuts in demand turned to banks to obtain credit, allowing them to defer adjustment. In the face of a rapidly increasing portfolio of nonperforming loans, banks often preferred to acquiesce, including through the capitalization of interest or the extension of fresh loans to debtors in arrears, rather than to record a loss. In many countries, the agricultural sector managed to continue to obtain soft loans and debt forgiveness from state banks. Often, banks tried to preserve revenue by augmenting spreads, thus exacerbating moral hazard and adverse selection problems, and crowding out some economically viable projects in the new private sector. Outright fraudulent behavior was also rife: bank shareholders, for example, often took out loans worth substantially more than the value of their shares, sometimes with the collusion of bank managers, with little intention of repaying.

As a result, numerous banks became virtually or openly insolvent. In Poland. 15 out of the 73 private banks were near bankrupt in early 1994. and close to 700 of the 1,660 cooperative banks were in crisis or subject to recovery programs. In Russia, the stock of overdue loans increased from 12 percent of bank credit at the end of 1993 to over a third in early 1995, and the central bank has already revoked the licenses of 160 banks since 1993. In Kazakhstan, a recent asset quality survey showed that 40 percent of all loans were effectively lost and should be fully provisioned. In the Kyrgyz Republic, half of the commercial banks had negative net worth in early 1995. In Turkmenistan, 7 out of the 18 commercial banks closed between February and May 1995. In Georgia, 65 of the 229 banks have had their licenses suspended, and all of the state banks have negative net worth. There have been similar developments in Armenia, Bulgaria, Ukraine, and most other countries in transition.

A large-scale banking crisis erupted in Estonia in late 1992 when three of the major commercial banks, holding deposits accounting for almost 40 percent of broad money, suddenly turned out to be insolvent. The three banks were promptly closed down. Two of them were recapitalized with public funds and merged, and the third was liquidated. Although there was not a run on the healthy banks, the public’s confidence in the banking system was shaken, causing some disintermediation. In the wake of the banking crisis, and as capital requirements were increased, the number of commercial banks in Estonia halved. A second banking crisis occurred in 1994, when a large bank became insolvent. Despite some equivocation on the part of the authorities, the systemic repercussions of this bank failure were contained as well.

A major banking crisis also surfaced in Latvia. The largest commercial bank collapsed, after a few other banks had gone bankrupt or lost their licenses. This bank in particular had been offering extremely high interest rates to attract money to finance ventures with questionable prospects. The bank failed to complete its 1994 audit, and customers started to withdraw deposits. The government stepped in and took over the management of the bank. The economic court has appointed an administrator to determine the fate of the bank, including possible liquidation. The confidence crisis also affected the foreign exchange market, where there were large capital outflows and calls for a devaluation of the lat before monetary policy was tightened and the situation calmed down.

More recently, signs of the underlying weaknesses in Russia’s banking system have become visible. During the last week of August 1995. the inability of a few banks to honor interbank obligations led to a sharp rise in overnight interest rates to as high as 1.000 percent a year and to a virtual standstill in interbank trading. In response, the government stepped in to provide liquidity, but emphasized that this action was a temporary measure and that the government would not directly intervene to support any ailing bank. In the aftermath of the crisis, interbank market activity has gradually resumed, starting with trading among a group of large banks, and interest rates have generally returned to previously prevailing levels. By early September, the payments problem appeared to be confined to a small number of banks. Nevertheless, these events have highlighted the need to improve banking supervision and accelerate the structural reform of the banking system.

Preventing such crises and the associated macroeconomic disruptions requires a number of precautionary measures. Supervision—both on-site examination and off-site monitoring—needs to be considerably strengthened in virtually all transition countries. Accounting standards have to be adapted so that enterprise performance can be assessed on the basis of market criteria. Banks should be allowed to deduct provisions for bad loans for tax purposes. Minimum capital requirements should be raised, which would help to consolidate an often overly fragmented banking sector.58 Deposit insurance is desirable to protect savers but should not be unconditional and unlimited, so as to encourage caution on the part of depositors. Insolvent banks ought to be liquidated rather than kept alive through implicit or explicit subsidization schemes. State guarantees on loans should be avoided because of the potential cost to the budget and to ensure that loans finance economically viable projects. Limits on insider lending need to be tightened, and malfeasance investigated more thoroughly and punished. Finally, the entry of foreign banks should be facilitated to spur the modernization of banking practices in domestic institutions.

Banking crises once they emerge should be dealt with promptly and vigorously, and in a way that will prevent their recurrence. As the experience of Estonia has shown, taking a tough line and proceeding with liquidations need not lead to a broader systemic crisis. Recapitalization in particular should be conducted as a one-time rescue operation and not as a prelude to future bailouts, as turned out to be the case in Hungary where several rounds of capital injections took place at considerable budgetary cost. To the extent possible, recapitalization should be combined with privatization. When government rescue operations involve state banks, recapitalization should be accompanied by commercialization. To safeguard financial stability, the fiscal costs of capital replenishment should lead to added restraint in other public expenditures, as was done in the former Czechoslovakia.59

Successful crisis management also requires that the central bank, or, more generally, the supervisory authorities, be given the legal powers to act decisively. Close coordination between the central bank and the government is also needed. Crisis management will be more effective the better is the authorities” prior knowledge of the dimension and distribution of the bad loans problem, including the quality of collateral, the extent of state guarantees, and the magnitude of the provisioning associated with nonperforming loans.

The soundness of the financial system also has implications for corporate efficiency in the nonfinancial sector. Weak banks are not in a position to act as agents of restructuring and of strengthened management principles in nonfinancial enterprises. Shaky investment funds are also unlikely to impose much discipline on enterprise managers. Conversely, for financial institutions to monitor enterprises effectively, the incentives facing enterprises need to be changed. For example, large state enterprises should no longer be led to expect that they can induce the state to force banks to roll over loans that are not serviced. Indeed, reforms in the banking sector alone are insufficient to ensure financial discipline in the nonfinancial sector. Structural reform efforts must also include improvements in corporate efficiency through comprehensive enterprise reforms and social safety net restructuring. Reforms in these areas will, in turn, help to strengthen banks by increasing the number of economically viable borrowers.

* * *

Half a decade into the transition, the main challenge facing the countries more advanced on the path to a market economy is to safeguard macroeconomic stability while maintaining or, where possible, increasing the momentum of structural reform. While substantial stabilization has been broadly achieved, numerous rigidities remain that could undermine disinflation and growth performance. Particularly worrisome in this regard are signs of backtracking, as observed in the Slovak Republic with respect to privatization. It is also important to streamline social safety nets further, for fiscal as well as for efficiency reasons. The prospect of closer relations with the European Union, and perhaps eventual membership, provides added encouragement for many of these countries to persevere with their reform efforts.

While much progress with stabilization has been accomplished recently by most of the other countries, the risk of setbacks is higher than in the more advanced countries. The main challenge, therefore, is to make stabilization stick, particularly by persevering with fiscal adjustment efforts. The recent quickening of structural change noticeable in a number of these countries is encouraging. Sufficient and timely external financial assistance is also crucial, particularly in countries such as Armenia and Georgia that have undertaken courageous adjustment policies, but where the success of these policies is contingent on external assistance.

In most of the transition countries, structural change in financial systems has been substantial, helped by assistance from international institutions. Nonetheless, financial sector reforms still have a long way to go. Financial fragility poses a major risk in many countries. The way bad debt problems are handled is key: covering up bad debts by rolling over hopeless loans will increase the ultimate costs of addressing this problem. A large-scale banking crisis would spoil the fruits of past adjustment efforts and intensify pressures to soften budget constraints. It is essential to recognize and cope with the issue of nonperforming assets early on, to tackle the distortions contributing to the weakness of bank balance sheets, and possibly to spread out the implied financial burden over time, rather than to let the problems grow into a full-fledged crisis.

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