Chapter

Chapter II. Macroeconomic Developments and Systemic Reforms in Eastern Europe and the U.S.S.R.

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1991
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In most of Eastern Europe, and to a lesser extent in the U.S.S.R., a broad consensus has recently emerged on the need to move toward market-based economies.16 While the extent of reform has varied considerably across countries, there has been a general trend during the past year to accelerate the process of systemic change. After two decades of partial reforms, Hungary and Poland have taken significant steps to speed up the transformation of their economic systems and Yugoslavia has intensified reform efforts. The Czech and Slovak Federal Republic (Czechoslovakia), Bulgaria, and Romania have begun to implement comprehensive programs designed to achieve a rapid transition from a highly centralized system to a market economy. Market-oriented reforms are, however, considerably less advanced in the U.S.S.R. The “Guidelines for the Stabilization of the Economy and the Transition to a Market Economy” (Presidential Guidelines) that were announced by the President of the U.S.S.R. and approved by the Supreme Soviet in October 1990 recommend a relatively gradual transition, and to date there has been little progress with the implementation of systemic reforms.

In the majority of countries, severe economic dislocations have emerged as the traditional system of central planning has largely collapsed and market-based coordination mechanisms are only beginning to develop. Moreover, the adjustment of relative prices to conditions prevailing in world markets generally requires far-reaching restructuring of enterprises and industries. While this restructuring eventually will result in a more efficient allocation of resources, it is likely to entail substantial losses in output and employment in the short run.

Most countries have begun the transition to a market economy in a relatively unfavorable macroeconomic and external environment. The economic policies pursued in the recent past have left many countries in Eastern Europe and the U.S.S.R. with a legacy of large domestic and external imbalances, including substantial amounts of excess liquidity. At the same time, regional trade has begun to decline, reflecting the impact of economic dislocations in most countries in the region, notably the U.S.S.R., and the dissolution of trade arrangements among the members of the Council for Mutual Economic Assistance (CMEA), which entails considerable terms of trade losses for the Eastern European countries. These initial conditions complicate the process of transition and require tight financial policies to avoid a rapid acceleration of inflation and unsustainable external deficits. The next section of this chapter reviews macro-economic policies and developments in Eastern Europe and the U.S.S.R., the following sections examine recent progress with systemic reforms in the domestic economy and in the external sector, and the final section provides a summary and conclusions.

Macroeconomic Conditions: Recent Developments and Prospects

Stance of Policies

Faced with a sharp acceleration of inflation during 1989, Poland and Yugoslavia adopted comprehensive stabilization programs that combined tight fiscal and monetary policies with fixed exchange rates and controlled wages as nominal anchors.17 Both programs were initially successful in bringing down inflation, but in mid-1990 slippages occurred as wages and credit to the non-government sector increased considerably faster than planned.18 In Hungary, the emergence of large domestic and external imbalances prompted a substantial tightening of financial policies in 1990. Czechoslovakia continued to pursue cautious fiscal and monetary policies, and began the transition to a market economy in a relatively stable macroeconomic environment without a large monetary overhang. By contrast, in Bulgaria and Romania financial policies were not sufficiently tight to reduce existing imbalances and excess liquidity remained substantial. Macroeconomic imbalances remained particularly severe in the U.S.S.R., despite a reduction of the fiscal deficit from 11 percent of GDP in 1988 to 8¼ percent in 1990. The rapid expansion of credit to the enterprise sector added to the existing monetary overhang, which is now estimated at about one third of the stock of financial assets.19

In most countries in the region, it is recognized that macroeconomic policies need to be tightened further in 1991 to contain the impact on inflation and the external balance of recent price and external sector liberalizations, including in particular changes in CMEA trade arrangements, which imply large terms of trade changes in favor of raw materials (including energy) and against manufactures.20 Following sweeping price liberalizations, Bulgaria, Czechoslovakia, and Romania earlier this year adopted tight financial policies and wage controls to prevent an inflationary wage-price spiral. Hungary has maintained a tight policy stance, and recently Poland has again tightened policies to bring down inflation. However, in Yugoslavia and particularly in the U.S.S.R., stabilization efforts remain seriously hampered by differences between federal and republican authorities and by the lack of progress with structural reforms in the enterprise and banking sectors.

In most countries, the recent tightening of financial policies has been accompanied by a growing reliance on market-based instruments of monetary control, such as changes in the cost and availability of central bank refinancing.21 In addition, there have been far-reaching structural changes in government finances, such as sharp cuts in consumer and producer subsidies,22 a significant reduction of the financing of investment outlays through the budget, rising budgetary expenditures for social security, and a rationalization of tax systems, including substantial reductions in the taxation of enterprise profits.23 These changes are generally reflected in substantial declines of government expenditures and revenues as a percentage of GDP. In the U.S.S.R., however, the share of government expenditure in GDP remained largely unchanged, while the share of subsidies actually increased through 1990.

Output and Employment

Following virtual stagnation in 1989, output in Eastern Europe and the U.S.S.R. declined by nearly 4 percent last year (Table 6). The decline affected all countries in the region and reflected a combination of domestic and external factors, including the dislocations resulting from the disintegration of the existing economic system; the restructuring necessitated by substantial changes in relative prices and greater exposure to foreign competition; the short-run effects of tight financial policies; falling exports to other CMEA countries; disruptions in oil supplies from the U.S.S.R.; and the economic impact of the events in the Middle East.

Table 6.Eastern Europe and the U.S.S.R.: Macroeconomic Indicators, 1988–96(Annual percentage change, unless stated otherwise)
198819891990199119921993–96
Eastern Europe1 and U.S.S.R.
Real GDP4.31.9-3.8-4.1-2.11.2
Consumer prices11.130.934.145.618.2
Fiscal balance2-8.0-6.7-6.5-4.2
Eastern Europe1
Real GDP1.2-0.9-8.6-1.52.84.4
Consumer prices44.3139.0149.778.013.3
Fiscal balance2-0.2-0.1-1.8-0.6
Current account balance346.73.0-1.3-10.0-11.2
Of which:
Convertible currency2.70.7-2.8
Debt service ratio4519.218.514.918.516.8
Of which:
Convertible currency34.729.218.1
External debt34697.998.4105.0110.2118.3

Output losses in 1990 were particularly severe in Bulgaria, Poland, Romania, and Yugoslavia. In Poland and Yugoslavia, output contracted sharply in early 1990 and recovered only moderately when financial policies were relaxed later in the year. In Bulgaria and Romania, the disruptions of trade with Iraq and the CMEA countries, particularly the U.S.S.R., exacerbated severe domestic dislocations. By contrast, in Hungary strong growth of convertible currency exports partly offset the contraction of ruble exports and domestic demand, while in Czechoslovakia domestic demand helped to contain the decline in output in the face of adverse external developments. Based on official estimates, output losses in 1990 were relatively moderate in the U.S.S.R., although a rapid expansion of nominal incomes was accompanied by persistent shortages. In all countries, output losses were concentrated in the state sector; activity in the private sector, which is not adequately reflected in official output statistics, expanded rapidly, notably in Hungary, Poland, and Yugoslavia, but it is estimated that this had little impact on the overall level of activity, given the small size of the sector.

In most Eastern European countries, output is expected to continue to decline in 1991, albeit at a slower rate than last year. This decline would reflect the further dissolution of traditional trade patterns among the CMEA countries, sharp increases in the cost of imports, accelerating industrial restructuring, and further tightening of financial policies. From 1992 onward, output is projected to recover gradually as the private sector expands and efficiency begins to improve. Of course, this projection hinges critically on the assumption that the necessary systemic reforms will be implemented without delays and that tight macroeconomic policies will succeed in controlling inflation and containing external imbalances. In this regard, the prospects are considerably less favorable in the U.S.S.R. than in the Eastern European countries. In the absence of a marked reorientation of economic policies, output in the U.S.S.R. is likely to continue to decline.

In all Eastern European countries and in the U.S.S.R., unemployment has begun to rise. Nonetheless, the decline in employment has tended to lag behind the fall in output, and unemployment rates are generally still considerably lower than in Western Europe. In Poland, unemployment rose from a negligible level in late 1989 to 6 percent of the labor force in late 1990. At the same time, the unemployment rate in Yugoslavia, which was already high, rose further to over 12 percent. While unemployment also has increased in Hungary, Romania, and the U.S.S.R., unemployment rates in these countries have remained in the range of 1 to 2 percent in 1990. Unemployment is projected to increase further this year as the process of enterprise restructuring accelerates; particularly large increases are expected in Bulgaria, Czechoslovakia, and Romania where the process of structural transformation has started only recently. Over the medium term, as the Eastern European economies begin to recover, unemployment rates are expected to decline gradually in all countries, except the U.S.S.R.

Prices, Wages, and Exchange Rates

The weighted average annual rate of inflation in Eastern Europe rose in 1990 but is expected to decline this year reflecting the impact of recent stabilization programs in Poland and Yugoslavia.24 In both countries inflation fell rapidly during the first half of 1990—in Poland from a monthly rate of nearly 80 percent in January to 3½ percent in June, and in Yugoslavia from 64 percent in December 1989 to zero in April 1990. Inflation picked up later in the year following a relaxation of financial policies and sharp price increases for oil imports, but the recent acceleration has been relatively moderate, and it is expected that both countries will be able to avoid a return to very high inflation. While in Czechoslovakia the impact of the recent price liberalization on the overall price level appears to have been relatively moderate, price liberalizations in Bulgaria and Romania have resulted in sharp increases in the price level owing to a large monetary overhang. However, financial policies have been tightened substantially in these countries, and it is not expected that the initial price adjustments will lead to a permanent increase in the rate of inflation. In the U.S.S.R., the consumer price index is likely to rise substantially this year as a result of recent adjustments in administered prices. Moreover, as price controls remain pervasive and shortages persist, registered price increases substantially understate the severity of domestic imbalances.

Wage restraint plays a key role in current stabilization efforts in the Eastern European countries. All countries have adopted some form of incomes policy, either by directly limiting or by taxing excessive wage increases. As a result, measured real wages stagnated or declined in 1990 in all countries, with the exception of Romania and the U.S.S.R., where nominal wages rose considerably faster than the official retail price index.25 In Poland and Yugoslavia, a sharp compression of real wages in early 1990 was later partially offset by substantial wage increases.

Since late 1989, all Eastern European countries and the U.S.S.R. have substantially depreciated their nominal exchange rates, in most cases to boost competitiveness and support external sector liberalization. However, in several countries, notably in Poland, Yugoslavia, and Hungary, price increases subsequently outpaced the magnitude of the nominal devaluations and real effective exchange rates appreciated significantly. Nonetheless, with wage increases lagging price increases, it appears that in most cases the impact on competitiveness was considerably less severe than indicated by the real exchange rate indices, which are based on consumer prices.

Trade and Current Account Balances

In 1990, the external payments positions of the Eastern European countries and the U.S.S.R. were strongly affected by the decline in intra-regional trade volumes, the expansion of trade with the convertible currency area, and by oil price developments. The disruptions in intra-regional trade were caused mostly by the virtual collapse of trade with east Germany and by the economic dislocations in the U.S.S.R. A 6 percent decline in Soviet oil output resulted in a fall in oil exports that triggered a matching fall in the volume of Eastern European exports to the U.S.S.R. In a number of countries, export volumes to former CMEA members may have declined by 20 to 30 percent last year. The impact of these disruptions on total trade and economic activity is related to the degree of dependence of each country on the markets in CMEA countries, particularly the U.S.S.R. (Table 7). Extensive trade liberalization pursued by several countries also unsettled the established channels of foreign trade and contributed to a reorientation of trade toward the convertible currency area. As a result, trade with the convertible currency area expanded rapidly.

Table 7.Eastern Europe: Shares of Exports to CMEA Countries and to the U.S.S.R. in 19891(In percent of total exports)
Share of Exports

to CMEA Countries
Share of Exports

to the U.S.S.R.
Bulgaria83.065.8
Czechoslovakia53.730.5
Hungary41.025.1
Poland34.320.5
Romania235.821.4
Yugoslavia34.320.0
U.S.S.R.55.2
Source: National authorities and staff estimates.

Despite the sharp rise in oil prices in the second half of the year, the value of total Soviet exports was broadly unchanged in 1990, owing partly to a decline in the volume of oil exports and the considerable lag in the adjustment of intra-CMEA oil prices to world market levels (Table 8). The shortfall of oil supply from the U.S.S.R. forced the Eastern European countries to buy oil on the world market at much higher prices, adding significantly to their import bill in convertible currencies.

Table 8.Soviet Petroleum Exports to Eastern Europe in 1989–911
19891990219913
(In millions of barrels)
Volume483343258
(In billions of U.S. dollars)
Value44.22.94.9
Value58.37.54.9
Source: Soviet authorities and staff estimates.

The shift in the aggregate current account position of the Eastern European countries in 1990 reflected primarily dramatic changes in the balances in convertible currencies (Chart 19).26 The combined current account position in convertible currencies of Czechoslovakia, Romania, and Yugoslavia deteriorated sharply in 1990 largely because of a very large increase in imports. By contrast, the combined current account position in convertible currencies of Hungary and Poland improved, in large part because of a favorable export performance. The impact of regional trade disruptions on current account positions in nonconvertible currencies was small because the fall in the value of Eastern European imports was matched by a corresponding decline in exports. The current account position of the U.S.S.R. deteriorated substantially in 1990, both in convertible and in non-convertible currencies.

Chart 19.Eastern Europe: Current Account Balances1

(In billions of U.S. dollars)

1 Excluding the U.S.S.R. Total current account data include nonconvertible currency transactions converted into dollars at national TR/U.S. dollar cross-exchange rates. See Footnote 4 to Table 4.

Predicting developments in trade and payments for 1991–92 is unusually difficult owing to considerable uncertainty about the impact of prospective changes in the regional trade and payments arrangements and of continued economic dislocations. The transition to world market prices with settlement in hard currencies in 1991 will generate a large deterioration in the terms of trade of the Eastern European countries, as their trade with the U.S.S.R. is dominated by imports of energy and raw materials whose relative prices in terms of manufactures were previously well below world market levels.

The impact of this deterioration on aggregate trade balances is projected to be mitigated by a likely decline in the region’s demand for imported oil. Intra-regional trade is projected to contract further this year as the transition to world market prices is likely to amplify the impact of economic dislocations throughout the region; in some cases the trade volumes are expected to decline by as much as 50 percent in 1991.

According to staff projections, the aggregate current account deficit of the Eastern European countries will reach about $10 billion in 1991 and $11 billion in 1992, reflecting the widening of external deficits with the traditional convertible currency area, and deteriorating trade balances vis-à-vis the U.S.S.R. The current account deficit of the U.S.S.R. with countries outside the CMEA grouping is unlikely to decline significantly in 1991. The overall current account deficit, however, could be considerably reduced in 1991 to the extent that the U.S.S.R. is able to run a trade surplus with the CMEA countries. This will depend on the financing available to these countries and on the disposition of their accumulated transferable ruble claims on the U.S.S.R.

External Financing and Debt

The marked widening of current account deficits in Eastern Europe in 1990 required substantial amounts of additional financing to support the stabilization and reform programs adopted by individual countries. The Fund has played an active role in designing the adjustment programs and has collaborated with the European Community in coordinating financial and technical assistance. During 1990, the Fund approved arrangements for Hungary, Poland, and Yugoslavia with total commitments amounting to $1¾ billion. In 1991, over $5 billion financing under the stand-by and extended financing facilities have already been approved for Bulgaria, Czechoslovakia, Hungary, Poland, and Romania, with additional access of up to $2 billion for higher cost of oil imports under the compensatory and contingency financing facility. In addition, up to $1.5 billion in possible contingency financing will be available to offset the impact of unexpected external shocks in these countries. By early 1991, large amounts of external financing had also been committed by the Group of 24 (OECD area countries) to Eastern Europe. By contrast, there were virtually no new syndicated credit commitments from commercial banks; only the U.S.S.R. received $3 billion worth of commitments in 1990 that were guaranteed by the governments of the creditor banks. Czechoslovakia. Hungary, and the U.S.S.R. borrowed $l½ billion in the bond markets.

The total external debt of Eastern Europe amounted to $105 billion at the end of 1990, an increase of almost 7 percent over the previous year (Table 6). The largest increase was accounted for by Poland which continued to incur payments arrears. During 1991–92, the debt of Eastern Europe is projected to increase to $118 billion, reflecting in part large borrowings by Czechoslovakia and Romania. The debt-service ratio is projected to increase from 15 percent in 1990 to 18½ percent in 1991 (Chart 20), but is expected to fall over the medium term as a result of the anticipated debt restructurings in some countries and improved export performance.27

Chart 20.Eastern Europe: Debt and Debt Service Ratios1

1 Excluding the U.S.S.R.

2 Based on debt service actually paid.

3 Excludes liabilities to the Fund.

Systemic Reforms in Domestic Economy

Key Issues

The recent move toward systemic reforms aiming at a complete transformation of the economic system into a market economy marks a significant departure from previous partial reform efforts in countries such as Hungary and Poland, which sought to combine administrative coordination and market mechanisms. These earlier reforms greatly reduced the role of direct central planning, but left intact elaborate mechanisms of indirect administrative influence over resource allocation, production and distribution, and generally failed to impose financial discipline on enterprises. As a result, there were only marginal improvements in efficiency while financial control became increasingly difficult.

Current reform efforts throughout Eastern Europe suggest that there is a broad consensus on the main elements of the domestic reforms that are required to establish a market economy. These include the development of a competitive private enterprise sector and price liberalization; the creation of efficient financial institutions and the liberalization of financial markets; the deregulation of labor markets, and the establishment of a social safety net. Views differ on the appropriate timing of specific measures in key areas such as price liberalization, the transformation of the state enterprise sector and the liberalization of the external sector, but there is a growing recognition that a relatively rapid and broad-based approach to systemic reforms is required. Although the gradual introduction of financial discipline and market-determined prices may limit the cost of adjustment in the short run, it is likely to involve considerably higher cost in the longer run as the persistence of rigidities and price distortions would prevent significant efficiency gains, while the lack of financial discipline would jeopardize macroeconomic stability. Moreover, given the linkages between the distortions in different areas, rapid progress in one particular area is unlikely to yield significant results, and may even be harmful, if it is not accompanied by reforms in other areas.

Reform of Enterprise Sector

While earlier reform efforts in Hungary and Poland entailed a gradual liberalization of the regulations governing private economic activity, private enterprises remained constrained by numerous formal and informal restrictions, including limits on size, discriminatory taxation, and limited access to credit and inputs. During the past three years, however, efforts to remove restrictions affecting private business activity on the part of residents and nonresidents have been intensified throughout Eastern Europe, Poland, Hungary and, more recently, Bulgaria, Czechoslovakia, Romania, and Yugoslavia have eliminated legal restrictions on the establishment of private enterprises and have passed legislation placing private and state enterprises on an equal footing. Despite the recent changes in the legal framework, however, informal restrictions, such as limited access to financial resources and inputs, are only gradually disappearing. In the U.S.S.R., most economic activity outside the state sector has been in the form of cooperatives, which have been subject to periodic waves of harassment.

In most countries, the removal of restrictions on the private sector has stimulated the creation of small firms that had been all but absent in the formerly centrally planned economies in which highly concentrated industrial sectors predominated. While this trend is important for the development of an efficient and competitive market economy, it is unlikely to have a significant impact on the structure of the enterprise sector in the short and medium run given the dominant role of the state enterprises, which in most countries still account for over 90 percent of industrial output.28 Transformation of the state enterprise sector has thus become a major focus of systemic reforms in all countries. As previous attempts to enhance efficiency without changing the basic ownership structure have proven unsuccessful, it has become widely accepted that fundamental changes in ownership rights are required.

Czechoslovakia, Hungary, Poland, and Romania, and, to some extent, Yugoslavia have recently prepared or enacted legislation that establishes a framework for privatization.29 This framework generally provides for a variety of privatization techniques, depending on the size of the enterprises involved. Small enterprises, mainly in the services sector (retail, catering, and other services), are to be sold through direct tender or public auction. Privatization of these enterprises has begun and is expected to be completed within two years in Czechoslovakia, Hungary, and Poland. Bulgaria has recently established a framework for the privatization of small enterprises.

By contrast, the privatization of large state enterprises is expected to be considerably more difficult. A key issue in the current debate about privatization is whether enterprises should be restructured and rationalized before ownership changes. While restructuring would facilitate proper valuation of the enterprises30—a difficult task under current circumstances—it would also substantially delay the process, given the large scale of the envisaged privatizations.31 It is estimated that in Poland, for example, approximately 8,000 state enterprises will change ownership whereas in the United Kingdom fewer than 20 public enterprises were privatized between 1979 and 1989. Current privatization plans in Czechoslovakia, Hungary, Poland, and Romania emphasize a relatively rapid process and do not require a major restructuring of the companies involved. In most cases, enterprises are expected to transform into joint stock companies prior to privatization; large conglomerates will be split up into separate entities. Hungary and Poland began to break up large state enterprises several years ago, and Czechoslovakia has recently adopted a similar approach.

Another important issue in the debate on privatization is whether shares in enterprises should be sold or distributed to the population. While the distribution of shares is generally considered more equitable and is believed to strengthen public support for privatization,32 asset sales can be used to absorb excess liquidity, which, in some countries, notably the U.S.S.R., Bulgaria, and Romania, is estimated to be substantial.33 Current privatization plans in Hungary, Poland, Czechoslovakia, Romania, and Yugoslavia focus on sales, but except in Hungary and Yugoslavia, they also envisage some form of distribution of shares to the population. In Czechoslovakia and Romania, a certain fraction of the equity of most enterprises will be distributed, with the remainder available for sale to other parties.34 The government agency overseeing the privatization program is generally expected to start the privatization process, but in Czechoslovakia, Hungary, Poland, and Yugoslavia privatization can also be initiated by a state enterprise. Hungary’s privatization laws also permit privatization through corporate takeover initiated by an interested buyer. In Hungary and Poland, the privatization of large state enterprises has already begun.

Even though the privatization programs involve expeditious procedures, it is expected that the privatization of the bulk of the large state enterprises will take several years.35 In the short run, commercialization of the enterprises that remain in the state sector is therefore an important task in all Eastern European countries and in the U.S.S.R. Operating state enterprises on a commercial basis requires the introduction of financial discipline and autonomy in decision making. Most countries have begun to tighten enterprises’ budget constraints by limiting budgetary support and bank credit, and by placing restrictions on inter-enterprise credit. At the same time, enterprise autonomy has increased as central planning has been abandoned. In the U.S.S.R., however, lack of financial discipline in the state enterprises remains a matter of serious concern, while state orders and central allocation of certain inputs continue to play an important role.

The commercialization of state enterprises will require restructuring or liquidation of those firms that are no longer viable. Most countries have taken steps to facilitate this process. Hungary, Poland, and Yugoslavia have strengthened bankruptcy procedures and have begun to expedite the process of liquidation and restructuring;36 Bulgaria, Czechoslovakia, and Romania are expected to introduce or revise bankruptcy legislation this year.

Price Liberalization

The transition to a market economy cannot succeed without a general decontrol of prices and the removal of the comprehensive systems of direct and indirect taxes and subsidies that distort relative prices in the formerly centrally planned economies. It has been argued that owing to the lack of competition, full price liberalization at an early stage of the transition process would lead to excessive price increases.37 However, the experience with gradual price liberalization in Hungary and Poland during the 1980s has shown that a step-by-step approach does not necessarily avoid inflation. Tight financial policies, which are the key to controlling inflation, are difficult to implement without significant cuts in subsidies and hence far-reaching price liberalization. Moreover, a competitive and efficient enterprise sector, which is essential for the proper functioning of the price mechanism, is unlikely to develop as long as severe price rigidities and distortions persist.

Most countries in Eastern Europe have recognized the importance of rapid price liberalization and have recently made considerable progress in this area. In Poland, the share of sales at market determined prices in the total value of sales was raised from 50 percent in 1989 to 90 percent in early 1990. Hungary has achieved a similar degree of price liberalization although as a result of a more gradual process. Czechoslovakia freed most prices in early 1991, thereby increasing the share of sales at free prices in the value of sales to 85 percent. More recently, Bulgaria and Romania have introduced comprehensive price liberalizations.38 In most countries only the prices of a few basic food staples, of some key inputs, and of public utilities remain controlled.39 In the U.S.S.R., however, government intervention in the process of price determination remains pervasive even after the partial price reform in April 1991. Enterprises have only very limited influence on prices through negotiated contract prices for certain commodities, and the Presidential Guidelines of October 1990 recommend a relatively gradual approach to price liberalization.

Financial Sector Reform

Competitive financial institutions that ensure the efficient allocation of savings are essential for the functioning of a market economy. Yet earlier reform efforts in Poland and Hungary paid relatively little attention to the financial sector, which, as in other Eastern European countries, continued to play a passive role by accommodating the financing needs of the state enterprises and the government. Since the late 1980s, however, financial sector reforms have begun to assume a more prominent role in Eastern Europe and the U.S.S.R.40

In recent years, all countries in the region have introduced a two-tier banking system by reorganizing the commercial functions of their central banks into separate entities as a first step toward the creation of a competitive commercial banking sector. They have also removed most restrictions limiting the regional proliferation of branch networks, the range of activities that individual banks can perform, and the enterprises’ choice of bank services. However, in most countries, competition among banks is hampered by a continuing high degree of specialization along regional or industry lines, and by the effective segmentation of household and enterprise related banking business. Moreover, newly established private banks, as for example the cooperative banks in the U.S.S.R., frequently play a minor role, and licensing of foreign banks has until recently remained restricted in most countries.41

While still lacking a fully fledged competitive banking system, most countries have taken steps to liberalize interest rates. In Poland, banks are now largely free to determine deposit and lending rates, and Yugoslavia has introduced market-determined rates. Bulgaria and Romania liberalized interest rates earlier this year. In Hungary, many interest rates have been free for some time and the remaining ceilings on deposit rates are expected to be removed this year. Interest rates in Czechoslovakia have also been liberalized but the government has been monitoring developments to protect depositors and borrowers in view of a highly monopolistic commercial banking system that was established only recently. A number of countries, notably Hungary and Poland, have also taken steps to reduce interest subsidies for special activities.

The lack of financial discipline in the state enterprises has left banks in all Eastern European countries and the U.S.S.R. with a legacy of large portfolios of non-performing assets, which is a major impediment to the development of efficient financial institutions.42 Yugoslavia has begun to institute a program of bank liquidation and rehabilitation and is simultaneously beginning the restructuring of enterprises to avoid renewed accumulation of bad loans. Following an evaluation of banks’ balance sheets. Hungary has begun to prepare a program that addresses deficiencies in the financial sector; Czechoslovakia and Poland have begun to evaluate banks’ balance sheets with a view to injecting, if necessary, new capital. Several countries have started to introduce or strengthen prudential regulations and banking supervision to prevent banks from extending new credit to avoid losses on nonperforming loans.

In most Eastern European countries and in the U.S.S.R., the range of financial instruments has essentially remained confined to bank deposits and loans as a result of restrictions previously placed on other types of instruments. Only Yugoslavia and Hungary have developed rudimentary markets for a limited range of short- and long-term securities. More recently, however, several other countries have begun to broaden the range of financial instruments. The government of Poland began to issue treasury bills in late 1989; Bulgaria issued treasury bonds in late 1990; and there is a small but growing market for securities in the U.S.S.R. Czechoslovakia has recently legalized the issuance and trading of bonds. As the privatization of state enterprises proceeds, securities markets are expected to play an increasingly important role.

Labor Market Deregulation and Social Safety Nets

A well-functioning labor market requires the freedom for employers and employees to make employment decisions within a clearly defined legal framework but without government interference. However, the move in past years toward greater enterprise autonomy in several Eastern European countries and the U.S.S.R. generally did not significantly reduce restrictions regarding hiring and firing.43 In addition, inadequate housing and retraining facilities have severely hampered labor mobility. As a result of these distortions and the existence of soft budget constraints, labor hoarding has been widespread in all countries.

The recent tightening of enterprises’ budget constraints in countries such as Poland, Hungary, and Czechoslovakia has required greater freedom for enterprises to dismiss employees. Unemployment in these and in other countries has begun to rise and is expected to increase substantially as the restructuring of the enterprise sector advances. All countries in Eastern Europe and the U.S.S.R. have recently begun to develop the essential elements of a social safety net, including basic systems of unemployment benefits. In most countries, these schemes are currently financed by budgetary transfers, which can give rise to a serious fiscal burden. However, Hungary has introduced an insurance scheme based in part on contributions by employers and employees, and Bulgaria has increased social security contributions by employers to an extra-budgetary fund. Poland has established a fund for unemployment benefits and retraining, which is financed by employers’ contributions and budgetary transfers.

Most countries have abandoned detailed intervention in the process of wage determination and have accepted the principle of wage bargaining. However, there is a broad consensus that an incomes policy is essential to avoid an inflationary wage-price spiral at the initial stage of the transition process when macroeconomic imbalances still prevail and prices are being liberalized. Poland, Hungary, Czechoslovakia, and, more recently. Romania have adopted tax-based incomes policies and imposed a punitive tax on excessive wage increases, while Bulgaria plans to place direct limits on enterprises’ wage bills.

Systemic Reforms in External Sector

Key Issues

The anticipated benefits of broader participation in the world economy have prompted the Eastern European countries to make external sector liberalization one of the key elements of their transformation to market-based economies.44 External sector liberalization involves the phasing out of quantitative restrictions and the reduction of implicit or explicit taxes and subsidies on international transactions. This requires steps toward currency convertibility, that is, the removal of restrictions on the use of domestic currency for international transactions, and trade liberalization, that is, the reduction or elimination of direct barriers to international trade.

In several Eastern European countries, notably Yugoslavia, Hungary, and Poland, current efforts to liberalize the external sector were preceded by some 20 years of gradual economic reforms in which the transformation of the external trade and payments regime was generally more advanced than reforms in other areas of the economy. The reforms involved a gradual dismantling of the state monopoly of foreign trade, the unification of exchange rates, and the introduction of linkages between domestic and foreign prices of traded goods. In the late 1980s, several countries established foreign exchange retention schemes, which allowed exporters to keep a certain percentage of their foreign currency earnings, and introduced foreign exchange auctions. In addition, licensing requirements for certain classes of imported and exported goods were effectively removed.45 However, because these measures were not accompanied by far-reaching domestic reforms, the countries could not fully benefit from the degree of external liberalization that was achieved.

While the current move toward currency convertibility and trade liberalization in the Eastern European countries is part of a comprehensive reform effort comprising all sectors of the economy, many of the reforms in the domestic economy that are necessary to realize the full benefits of external sector liberalization, notably those enhancing the responsiveness of domestic enterprises to market signals, are typically only beginning to take place. Nonetheless, all countries have begun to introduce external sector liberalization at an early stage of the reform process in order to reap the anticipated benefits of “importing” competition and a more rational structure of relative prices. Following the experience of the industrial countries, external sector liberalization has begun with the current account while restrictions on capital account transactions remain generally in place.46 In the U.S.S.R., however, there has been only limited progress with the liberalization of the domestic economy and external sector liberalization is proceeding relatively slowly.47

Convertibility

By early 1991, all Eastern European countries with the exception of the U.S.S.R. had established the essential elements of currency convertibility. There are, however, significant differences in the practical implementation of external sector reforms, which are largely related to the specific economic situation and, in particular, the availability of foreign exchange. The differences include the degree of the unification of exchange rates, the restrictions on convertibility for the non-enterprise sector, the determination of exchange rates, and the scope of restrictions on profit remittances and capital account transactions.

Most countries have established a unified official exchange rate for commercial transactions, although some temporary restrictions remain in place.48 In Hungary, Poland, and Yugoslavia, official exchange rates for trade with the convertible currency area were already largely unified in the 1980s, and various exchange subsidies, the level of which was dependent on the user of foreign exchange, were gradually eliminated.49 In Bulgaria and Czechoslovakia, all exchange rates for commercial transactions were unified between December 1990 and February 1991. The U.S.S.R. maintains a fixed commercial rate that applies to a specified range of transactions and an auction-determined market rate. Romania still retains a dual exchange rate system in which an official rate, set by the central bank, applies to purchases of foreign exchange for imports of a limited number of goods (for example, energy) and for certain central government transactions.

There are considerable differences across countries in the way exchange rates are determined. Poland and Yugoslavia have pegged their exchange rates to a single foreign currency, while Czechoslovakia and Hungary have tied their currencies to a basket.50 In Bulgaria and Romania, the (free) exchange rate will be determined by market forces. In early 1991, Bulgaria introduced a decentralized framework of foreign exchange allocation based on the interbank market where commercial banks are permitted to buy and sell foreign currencies at free market rates.51 In Romania, a temporary system of foreign exchange retention accounts, which can be used freely for current account transactions and for sale in the interbank market, has been introduced in early 1991 and functions in parallel with an interbank foreign exchange market.52 In the U.S.S.R., the existing auction system is likely to be broadened; in the interim the retention quotas for exporters will be raised.53

In the majority of countries convertibility is limited to the enterprise sector, and in most countries limits on travel allowances have been maintained. In Poland, however, individuals may acquire foreign exchange in the parallel market at the going rate. In Czechoslovakia, Hungary, and Poland, residents are authorized to hold foreign currency accounts and to use them freely. In Yugoslavia, internal convertibility was achieved in January 1990, but various restrictions were reintroduced toward the end of the year. All countries allow foreign investment, but with the exception of Czechoslovakia and Hungary, they restrict the repatriation of profits. In Czechoslovakia, entities participating in foreign trade will be allowed both to receive and to extend trade-related credits; current laws allow for a liberal repatriation of capital and transfers of shares in the event of liquidation of the enterprise.

Trade Liberalization

All Eastern European countries have effectively eliminated the state monopoly of foreign trade and have drastically reduced import restrictions, although various degrees of tariff protection are still in place. In some countries, such as Hungary and Yugoslavia, up to 90 percent of imports are free from quantitative restrictions.54 In Poland, most nontariff restrictions were removed in 1990, and in Bulgaria import licensing requirements were practically eliminated in February 1991. As a means of mitigating the impact of rapid liberalization on the domestic industry, tariff protection is still given to some categories of goods in Poland, and a temporary import tax was introduced in Bulgaria and Czechoslovakia.55 In January 1991, Romania eliminated various discriminatory features in its tariff code, such as the dependence of tariff rates on the end-users, and cut the highest tariff rates. A new tariff structure will be introduced in mid-1991, with a limited number of tariff rates ranging from 10 to 30 percent, depending on the type of product and the stage of processing. In the U.S.S.R., according to the Presidential Guidelines, the external sector reform will emulate measures introduced in Hungary and Poland during the 1980s. The guidelines envisage a further reduction of state involvement in foreign trade and the introduction of a new tariff schedule.

Important measures were also introduced to liberalize exports. Export subsidies have been largely removed and export licensing has been significantly reduced in the majority of countries. In Poland, all export quotas except those imposed as a result of agreements with third countries were removed by October 1990. In Bulgaria and Czechoslovakia, export restrictions and licensing remain in place for foodstuffs and raw materials to prevent production disruptions during the adjustment process. However, the existing export premium scheme was abolished. Romania will maintain export licensing only with regard to products that are subject to domestic price controls or those that are imported at the official exchange rate.

Changes in Regional Payments Arrangements

External sector liberalization in Eastern Europe and the U.S.S.R. has been facilitated by recent changes in bilateral payments arrangements. In January 1990, at the meeting of the CMEA in Sofia, the Eastern European countries and the U.S.S.R. agreed that starting from January 1, 1991, their mutual trade will be based on convertible currencies and world market prices. Existing arrangements were to remain in force until the end of 1990.

Notwithstanding the expected cost resulting from the reorientation of trade and significant changes in the terms of trade,56 the Eastern European countries view the switch to convertible currency and world market prices as important elements of their external sector liberalization. In order to limit immediate trade disruptions, all countries have been negotiating agreements aimed at maintaining some minimum trade levels with the U.S.S.R. and other regional partners.57 Trade relating to these agreements is expected to be balanced on a bilateral basis, but like all other trade among the CMEA countries, it is to be conducted at world market prices and settled in convertible currencies. In some cases, particularly in trade with the U.S.S.R., the agreements would include lists of commodities and manufactured goods to be exchanged for the agreed quantities of energy imports, although the scope of such barter arrangements is uncertain. Some agreements are expected to permit the use of accumulated trade surpluses to pay for future imports. Hungary, for example, has agreed with the U.S.S.R. that its accumulated trade surpluses denominated in transferable rubles will be converted into dollars and repaid over time. The shift to convertible currency settlements and unrestricted trade arrangements among the CMEA countries is expected to be completed by the end of 1991.

Summary and Outlook

Since 1989, the Eastern European countries have begun to implement comprehensive reform programs that aim at transforming the formerly centrally planned economies into more efficient market-based systems. All countries have introduced sweeping price liberalizations and have taken significant steps toward currency convertibility and trade liberalization. There has also been considerable progress in the implementation of the legal and institutional reforms that are necessary to transform the enterprise sector and to create efficient financial institutions. All countries have liberalized the framework for private sector activity and have begun to prepare, or have enacted, legislation for the privatization of state enterprises. In some countries, notably in Hungary and in Poland, privatization is already under way. Nonetheless, it is recognized that the development of a competitive enterprise sector and the creation of efficient financial institutions will take time.

There is a broad consensus that these systemic reforms are unlikely to succeed if the macroeconomic imbalances, which most countries had inherited as a result of the policies pursued in recent years, are allowed to persist. In addition, the dissolution of existing trade arrangements in the CMEA has resulted in a sharp contraction of intraregional trade and significant terms of trade losses for the Eastern European countries. In response to these domestic and external conditions, all Eastern European countries have taken steps to tighten financial policies in order to contain inflation and limit external imbalances.

By contrast, the U.S.S.R. has to date made relatively little progress with macroeconomic stabilization and systemic reforms. The Presidential Guidelines approved by the Supreme Soviet in October 1990, while endorsing in principle the transition to a market economy, signal a relatively gradual approach to systemic reforms, particularly in the area of price liberalization.

The structural transformation of the Eastern European countries requires substantial external support in the form of technical assistance and financing. The Fund, in cooperation with other international institutions, has assumed a major role in providing technical assistance, in financing, and in helping mobilize additional financial resources. In addition, the World Bank, the European Community, and other members of the Group of 24, as well as the European Investment Bank and the European Bank for Reconstruction and Development, are committed to provide substantial support. However, while external support can greatly facilitate the reform process in the Eastern European countries, the key to a successful transition to a market economy remains a sustained effort of systemic reform and macroeconomic stabilization.

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