Back Matter

Back Matter

Peter Doyle, and Carlo Cottarelli
Published Date:
August 1999
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    Appendix I Relation Between Inflation and Output in Transition Revisited

    Christoffersen and Doyle (1998) recently published new panel data estimates of the relationship between GDP growth and inflation in 22 transition economies between 1990 and 1997. They aimed to address three key shortcomings of the existing research. First, the collapse of major export markets was clearly key for a number of BRO countries, but it had been ignored. Second, econometric studies had not attempted to identify if disinflation had compounded output declines, as many feared would happen at the time. Third, the earlier studies imposed the assumption that inflation impairs output at all rates, rather than only above a threshold. Empirical literature on market economies has found that this understates the output costs of high inflation and overstates those of low inflation. Sarel (1996), using a panel of industrial and developing countries, finds that inflation above 8 percent significantly impedes growth, while growth is unaffected by inflation below that; Ghosh and Phillips (1998) also find a significant threshold, which they estimate in the low single digits.26 Using the same functional form to model the threshold, the authors sought to identify if similar results held in the transition context.

    Econometric Estimates

    Data and Variable Construction

    The panel is unbalanced, and the longest series runs from 1990–97. Christoffersen and Doyle obtained annual real GDP data, population, and the share of exports in GDP from IMF desk officers (with their estimates for 1997), data on the transition reform index from De Melo and others (1997), and updated it using the data from EBRD transition reports, and information on the direction of trade to 1996 from the Direction of Trade Statistics of the IMF. A war dummy was kindly provided by Berg and others (1998), and is described in their paper. Following Sarel (1996), two negative 12-month inflation rates were converted into small positive numbers to allow logs to be taken.

    The export market growth series for each country in the panel was constructed as follows. Three export markets were defined: the Central and Eastern European countries; the Baltics, Russia, and other countries of the former Soviet Union; and the rest of the world. The growth of each as an export market was represented by the growth of its GDP. These growth rates were weighted according to the share of each in the exports of goods for each country in the panel. That share was taken from the earliest annual direction of trade statistics data available for each country in the sample from 1990 onwards.27 The resulting export market growth series were then multiplied by the average ratio of exports to GDP for each country in the panel to control for openness.

    Several approaches to estimating the association between growth and disinflation were examined. Dummies were defined taking the value 1 when 12-month period end inflation fell by at least 20 percent (note, this is not percentage points) from the previous year. The exercise was repeated for inflation falling by at least 50 percent from the previous year. The former gave 84 disinflation episodes, while the latter gave 56 episodes. In a further exercise, disinflation dummies were defined according to the disinflation episodes identified by Fischer and others (1996).28

    In all cases, these disinflation episodes were divided into episodes in the context of fixed exchange rates—defined as fixed, de facto fixed, or currency board arrangements—and other exchange rate regimes. The fixed exchange rate dummy is reported in Christoffersen and Doyle (1998). The definition of a pegged exchange rate is strict, and excludes a number of cases where some suggest that de facto pegs were operated.29

    All observations for Tajikistan, Turkmenistan, and Uzbekistan were discarded, either because data on the direction of trade were unavailable or because the data seemed unreliable, even by the not very exacting standards of the rest of the data set. This left a panel of 22 CEE and BRO countries.


    The dependent variable, growth per capita, was selected in preference to GDP levels on the grounds that unrecorded activity may affect officially reported output levels more than growth rates. All regressions used 149 observations, and incorporated country fixed effects.

    Sarel's (1996) approach to modeling a kinked relationship between inflation and output was adopted. Thus, two inflation terms are used: log inflation, and log inflation less a threshold. This second series is set to zero below the threshold. Ghosh and Phillips (1998) find that the log formulation of the twin inflation terms is accepted by their data, and it was adopted on that basis.

    Following Sarel, the threshold in the second term was estimated using a grid search. The value of the threshold that maximizes the explanatory power (R-squared) of the overall equation determines the value of the threshold. If, after the grid search over R-squared, the second term in the regression that maximizes the explanatory power of the equation is insignificant, there is no nonlinearity apparent in the data. If, however, the second term is significant and negative, while the coefficient on log inflation is insignificant, then the threshold identifies the point above which the output costs of inflation become apparent in the data.

    The assessment of output costs associated with disinflation controls for structural and other factors affecting output. The decomposition of the disinflation dummies into pegged and other exchange rate regimes allows some insight into the association between the exchange regime and the sacrifice ratio (the percentage loss of output per each point of reduction in inflation).

    The first step was to replicate the key findings of the earlier work, and, if possible, encompass it. The second step was to investigate how disinflation affected output, as described above. Robustness tests, checking how parameter estimates were effected by inflation outliers, and by the exclusion of countries one at a time from the panel are reported in Christoffersen and Doyle (1998).

    Results (I): Replication and Encompassing

    GDP growth per capita was regressed on log inflation, the transition index, the change in the transition index, the war dummy, and country-specific fixed effects. The results are reported in Table 13 as regression 1. This replicates earlier findings associating low inflation and structural reform with growth (see Section III).

    Table 13.Regression Results
    The dependent variable is the percentage growth rate of GDP per capita.
    The p-values use White heteroskedasticity consistent standard errors and covariance.
    Independent variables
    1 inflation-0.93-0.311.251.741.241.260.840.87
    1 inflation - 1 threshold-2.00-2.28-2.04-2.06-1.56-1.64
    Change transition-2.17-1.47-1.42-1.42-1.39-1.19-1.41-1.38
    Disinflation (>20 percent)1.21
    Disinflation (>50 percent)-0.45
    Disinflation (Fischer)-1.76
    Disinflation (>50 percent, peg)-3.63-3.70
    Disinflation (>50 percent, other)0.48
    Inflation threshold13.
    Number of inflation observations below the threshold361036403636
    Adjusted R-squared0.6120.6470.6520.6510.6490.6520.6520.654
    Standard error6.7466.4356.3956.4036.4196.3926.3906.366

    Then, export market growth was added to this regression, with results reported as regression 2. In this regression, inflation appears insignificant, while export market growth appears highly significant and powerful. This suggests that the earlier results concerning inflation may have been distorted by the omission of the export market growth variable.

    To complete the encompassing exercise, we then added the term for log inflation less log threshold to regression 2. This is reported as regression 3.30

    The key results are:

    • Export market growth, adjusted for the share of exports in GDP, is significant at the 1 percent level, and is strongly associated with growth;

    • The inflation-output threshold appears at 13 percent. The output losses associated with inflation above that level are significant at just above the 1 percent level and the term on log inflation is positive but insignificant;

    • The transition index is significant at the 1 percent level and is strongly associated with growth, though not as strongly as is implied in regression 1;

    • The estimate on the change in the transition index is negative, is highly significant, and is large, though not as large as in regression 1;

    • The war dummy is significant at 1 percent, and is large; and

    • The range of individual country error terms is large. For example, Georgia and Armenia have large negative errors in years of conflict, as do Albania, Bulgaria, and Romania in 1996–97 during the financial crises in those years.

    Hence, regression 3 encompasses the earlier findings in regard to the effect of inflation on output. It also suggests lower output costs from the change in the transition index and a weaker relationship between the level of the transition index and growth than is implied by the approach adopted by earlier researchers. Hence, the short-run output costs and long-run benefits of structural reform, while substantial, appear to be lower than earlier reported.

    Results (2): Impact of Disinflation on Output

    The various disinflation dummies were added in turn to regression 3.

    First, the disinflation dummy for a decline of more than a fifth in the 12-month rate of inflation, along with its one-year lag, were added to regression 3. The latter was insignificant and was dropped. The regression was then rerun, and is reported as regression 4. This suggests no evidence of output loss arising from disinflation, either in the year that disinflation occurs or the following year. When the dummy was split into episodes with fixed exchange rates and other regimes, and the regressions rerun, both dummies had insignificant coefficients.

    This exercise was repeated for disinflations where inflation more than halved in one year. The results are reported as regression 5. Again, the estimate is insignificant, though eliminating the slower disinflations (of between 20 percent and 50 percent) has changed the sign on the parameter to negative. The results using the Fischer and others (1996) disinflation dummy are reported as equation 6. Again, there is no significant evidence of output loss associated with these disinflations.

    When we split the dummy for disinflations of more than half into pegged and other exchange rate regimes, however, significant and large output losses were found in the presence of exchange rate pegs. This result is reported as regression 7. This regression was rerun eliminating the “nonpeg” dummy. The results are reported as regression 8.

    As a final exercise, the dummies for disinflations of more than one-half were decomposed by the inflation rate being stabilized. Thus, the disinflation dummies were decomposed by prior year inflation: the first dummy included all disinflations of prior year inflation of more than 10 percent, the second included all disinflations of prior year inflation of more than 25 percent, and dummies for prior year inflation of more than 50 percent, more than 100 percent, and more than 500 percent were also formed. Regression 8 was rerun with each of these dummies included one at a time, with each dummy decomposed into pegged and other exchange rate regimes. In all cases, the nonpegged dummy was insignificant and was eliminated. The results from all the regressions indicated that as the prior year inflation cutoff increases, the negative output effects associated with pegged exchange rates decline sharply, becoming insignificant for stabilizations of inflation above 500 percent. This implies that the output losses during disinflations with pegged exchange rates tended to occur most with disinflations of more moderate inflation.

    On this evidence, rapid stabilization in the presence of pegs has been associated with a large loss of output that is not accounted for by other regressors, except where high inflation was stabilized. Equally rapid stabilization of similar inflation rates under other monetary regimes has not been associated with a similar loss of output.

    Discussion and Assessment

    Export-Market Growth

    The association of export-market growth weighted with output is marked and robust. Given the dominant role of Russia as an export market for many of the BRO countries, these findings reflect the importance of developments there for many countries in transition. Earlier studies failed to reflect this feature of transition, and as a result, missspecified the relationship between inflation and output. This omission also causes the short-run output costs of structural reform and its long-run benefits to be overstated.

    Structural Reform

    Notwithstanding the importance of external developments, there is evidence of a strong positive association between progress in transition and output growth, though structural reform is associated with immediate output losses.


    Evidence is found of loss of output at inflation rates above the threshold that is estimated in the low teens for the full sample, but at somewhat higher rates when the inflation outliers are excluded. As reported in the Appendix Table, one-fourth of the inflation observations occur below the estimated threshold. Accordingly, the estimate is not simply the artifact of a small number of low-inflation observations. However, the procedure does not define the confidence intervals around the identified threshold, and this counsels against overemphasis on the particular number identified as the threshold.

    For the full panel, the output losses associated with inflation above the threshold are lower than has been found in other studies of transition as well as for market economies. For the latter, Sarel (1996) finds that doubling inflation, above the threshold, reduces GDP growth by 1.7 percentage points; and Ghosh and Phillips (1998) find it reduces growth by 0.5 percentage points. In contrast, these results for the full panel imply that doubling inflation above the threshold is associated with reduced growth of 0.2 percentage points. While inflation outliers and measurement problems with stockbuilding may be downwardly biasing this estimate, it is not economically negligible. Recall that Russia halved inflation seven times, and Armenia nine times between the peak and end-1997 inflation rates. Disinflation on this scale is associated with a boost to annual GDP growth rates of 1.4 percentage points and 1.8 percentage points, respectively, according to this estimate.

    These findings—on the output costs of inflation above the inflation-output threshold and on the level of the threshold—should be interpreted with considerable care, however. First, correlation is not causation. While there are output costs of inflation, output can also affect inflation through the output gap and political economy factors. Second, even if the correlation does reflect causation from inflation to output, these estimates could understate the output costs of inflation now. These estimates reflect the average behavior of transition economies since 1990, and the output costs of inflation may have been rising over time. Planning mechanisms, still in place early in the panel, made poor use of information on relative prices. This suggests that when inflation obscured this information, the associated output losses were relatively low. Any losses that occurred may also have been offset if inflation eased growth-boosting relative price changes in the presence of downward nominal rigidities. But with planning mechanisms now absent and the largest of the one-off relative price changes completed, the output cost of inflation may be higher than it was on average in the period covered by the panel. For these reasons, as transition takes root, these economies could be expected to behave more like other market economies, including exhibiting greater output costs from inflation and having lower thresholds above which output costs of inflation begin to appear.


    No systematic evidence that disinflation was associated with declines in output was found. The low inertia of inflation and the determination of the country authorities to stabilize extremely high inflation contributed to making the stabilizations highly credible, when undertaken. Even disinflations of moderate inflation do not generally appear to have incurred output costs, possibly because labor productivity and real wages are often rising rapidly, providing an ideal context for further stabilization (Deppler, 1998). There is no general evidence here to suggest that the output costs of further disinflation now would outweigh the case for further reductions in inflation.

    The only evidence found of output costs from disinflation arose when moderate inflation was more than halved in the presence of pegged exchange rates. Interpreting this result is not straightforward. Output losses would occur during disinflation from moderate inflation with overdepreciated pegs. In such circumstances, stabilization would normally be expected to fail (and hence would not be picked up by the disinflation dummies) because the domestic price level would rise to eliminate the undervaluation. Only if policy directly counteracted this response, by inducing a recession, would pegs be associated both with disinflation and with output losses. This combination of outcomes seems less likely for stabilizations of high inflation with pegged exchange rates. In these cases, inflation could still fall sharply (by more than one-half), while remaining sufficiently above partner country levels to correct the undervaluation in the peg, without the need for a fall in output to render disinflation consistent with this.

    On this interpretation, output losses are not due to pegs per se, but reflect the rate of inflation being stabilized, the rate at which pegs are set, and the supporting policies. Perhaps significant output losses are found because a number of stabilizations with formally pegged exchange rates were undervalued. However, it proved impossible to test this interpretation of the results directly for lack of a tractable data set on the extent of undervaluation of exchange rates.


    There is evidence that the simple dummy for war is insufficient. Restricting conflicts to have the same impact on output is a strong assumption, and it is not even always clear when conflicts are affecting activity. For example, on the one hand, Bulgaria suffered heavily from the blockade of the former Yugoslav Republic Macedonia during that country's conflict, without itself being drawn into the conflict.31 On the other hand, Albania may have accrued substantial rents by violating that blockade. The individual country error terms and the robustness tests suggest that the data reject the assumptions underlying the war dummy, even though they find that overall, war is highly costly. While the war dummy may be less innocent than it appears, the robustness tests suggest that its problems do not appear to be distorting the estimates of other parameters greatly.

    Appendix II Financial Stability


    Staff studies indicate that financial soundness is improving in most transition countries, though in only a few cases is the situation now comfortable. A staff study of overall Baltics, Russia, and other countries of the former Soviet Union country rankings for bank supervision places Belarus, Tajikistan, and Ukraine in the countries that have made least progress. These countries have also made least progress on bank restructuring, along with Turkmenistan and Uzbekistan. The report places all other countries into “moderate progress” and “substantial progress” groups. In the Central and Eastern European countries, the financial systems are generally most robust in moderate inflation countries, and weakest in countries with high or low inflation. This could be coincidental—moderate inflaters, such as the Czech Republic, Hungary, and Poland, have implemented more vigorous banking reforms.

    Despite this progress, the soundness of the banking system remains a cause for concern for the medium-term inflation outlook. Most transition countries occupy the broad middle ground between achieving international standards of financial soundness and outright financial collapse. Further progress is needed. Moreover, assessments of financial fragility based on summary statistics are inevitably subject to major qualifications. Summary statistics, including risk-weighted capital and nonperforming credits, can mislead when accounting practices, supervision, and legislation are lacking; it is difficult to assess interest, exchange rate, or market risks at an aggregate level, though these risks may be particularly high in a transition environment where many financial institutions may be unfamiliar with them.

    The Baltics, Russia, and Other Countries of the Former Soviet Union

    A study prepared by IMF staff for the group of central banks providing technical assistance to transition countries concludes that since commencing transition, all the Baltics, Russia, and other countries of the former Soviet Union, except Tajikistan, have developed at least “adequate” prudential regulations, though some countries, such as Estonia, surpass this minimal standard. However, in important areas, including corrective action and market exit, implementation is still generally lacking.

    There has been good progress in building bank supervisory capacity in Armenia, the Baltics, Kazakhstan, the Kyrgyz Republic, Moldova, and Russia, including the increase in numbers of supervisory staff in all Baltics, Russia, and other countries of the former Soviet Union, except Belarus. The key remaining supervisory weakness identified is the absence of clear accounting rules—on consolidation of balance sheets, rules for loan classification, loan-loss provisioning, and income recognition—the consequences of which include compromised off-site supervision.32

    Bank restructuring, however, remains urgent. Of the Baltics, Russia, and other countries of the former Soviet Union with international accounting standards, the median ratio of nonperforming loans to total loans is estimated at 18 percent, and the largest share of bad debts is concentrated in large—often former state-owned—banks that dominate their banking systems. Many new private banks are also in difficulty due to poor management. Nonetheless, progress has been made. While the number of banks remained broadly unchanged in the Kyrgyz Republic, Latvia, Lithuania, Moldova, Turkmenistan, and Ukraine, 13 percent of banks in the Baltics, Russia, and other countries of the former Soviet Union were closed during 1996; the number increased only in Tajikistan. Formal restructuring strategies have been developed in Azerbaijan, Georgia, Kazakhstan, the Kyrgyz Republic, and Moldova. Others, including Armenia, Tajikistan, and Russia, are proceeding on a more ad hoc basis. Russia is focusing on strengthening its capacity to monitor its largest banks, which, unusually, are mostly new commercial banks.

    Central and Eastern European Countries

    The Macedonian and Slovenian authorities are alone in initiating efforts to address financial fragility as part of their disinflation programs, though the problems in the former case were also particularly severe. The Macedonian authorities recapitalized Stopanska Banka, which accounted for a little under half of deposits in the banking system; they assumed all Paris and London Club debt; and they assumed all households' foreign currency deposits. But M2 was only just over 10 percent of GDP, which limited the threat to disinflation posed by financial fragility. Following disinflation, Stopanska Banka continues to absorb public resources, but its bad debts, like those elsewhere in the banking system, are fully provisioned. Financial sector policy is now focused on stimulating growth and competition, and strengthening the financial sector. In Slovenia, bank rehabilitation dates from late 1991, in respect of the three most troubled banks, which held 65 percent of banking sector assets, but the procedure was not completed until 1997. Up-grading financial sector legislation has been similarly protracted, with the focus now on meeting EU norms. Banks report capital of over 20 percent of risk-weighted assets, with bad debts well below 10 percent of credit, but the authorities consider these data to be somewhat over optimistic.

    In the Central and Eastern European countries, major restructuring of the banking systems in Hungary and Poland during the mid-1990s led to sharp reductions in the share of nonperforming loans in bank portfolios to 14 percent in Poland, and 11½ percent in Hungary at the end of 1996. In Poland, some progress has been made to privatize the banking system, while in Hungary, this progress has been even more marked. Hungary maintains capital and reserves well over double the Basle minimum risk-weighted capital adequacy guideline and nearly double the minimum guideline of 12 percent for developing countries.

    While nonperforming loans in the Czech and Slovak Republics have also declined relative to credit, they remained at just below 30 percent in 1997, and at about one-third in the largest banks that dominate both financial systems. In the Czech Republic, this reflects both the slow growth of overall credit and the deliberately limited adoption of bad debts by the state. As a result, bank capital is only marginally above the Basle minimum guideline and is below the guideline for developing countries, and bank profitability is low and falling. In Slovakia, the three largest banks have capital of below 5 percent of risk-weighted assets, though smaller banks are usually well above the 8 percent minimum. Efforts to strengthen the regulatory framework and to privatize the main banks have recently been accelerated in the Czech Republic.

    Several regional banks in Croatia suffered badly during the hostilities, and restructuring did not start in earnest until late 1995, well after disinflation. Several banks have been recapitalized, and the restructuring of the major troubled bank, Privredna Banka, which held about 20 percent of deposits in 1996, has thus far included recapitalization and bad debt write-offs. As a result, banks report capital in 1996 of just below 20 percent of risk-weighted assets, but there are considerable doubts about the accounting practices underlying these data. Efforts to strengthen banking supervision and accounting regulations continue.

    In the three cases where disinflation has been reversed—Albania, Bulgaria after the first stabilization, and Romania—financial fragility has been severe. In Romania, while the banking legislative infrastructure is generally appropriate and most banks report capital in excess of the Basle minimum guide-line, implementation and enforcement have been weak. By the end of 1995, nonperforming loans had risen to 35 percent of credit, underprovisioning was substantial, and pyramid schemes have flourished and (inevitably) collapsed. Two bank failures in 1996 highlighted these weaknesses and led to a relaxation of monetary policy.

    In Bulgaria, a pervasive “soft-budget” constraint culture culminated in banking crisis in 1996, and in hyperinflation in early 1997. Poor lending throughout the 1990s led to negative net worth of the banking system estimated by the IMF at 10 percent of GDP in 1995, with 75 percent of loans nonperforming at that time. Attempts to avert a loss of confidence in banks from late 1995, including management changes, a new deposit insurance scheme, and bank closures, failed. Widespread runs on banks ensued, and subsequent bank closures accounted for just below 30 percent of bank deposits. However, only relatively healthy banks have survived, so the system is now considerably stronger. In Albania, 27 percent of loans made in the 18 months to the end of 1994 (post-transition) were nonperforming, in addition to the much larger nonperforming portfolio that commercial banks inherited. Initiatives to privatize the state-owned banks have made little headway in practice, and, in this environment, an informal market, including pyramid schemes, flourished. The latter collapsed spectacularly from the end of 1996 amid riots, causing a sharp depreciation in the currency. By September 1997, 39 percent of loans by state-owned banks were nonperforming.

    The disinflations in Central and Eastern European countries during 1990–92 have been discussed in Bruno (1992).

    The term “inflation stabilization” is used here to indicate a stable decline of inflation below the 60 percent threshold (see foot-note 1 in Table 2 for a more precise definition). While this threshold is arbitrary, few countries that managed to break it experienced major inflation reversals. Moreover, the results discussed in this review are quite robust to the choice of the threshold. The term “disinflation” is instead used to indicate the overall process of reduction in inflation, including in the poststabilization period.

    This partly reflects its gradual price liberalization during the 1980s and, in comparison to some transition countries, its generally cautious monetary policy in that period and thereafter.

    The stabilization initiation dates adopted by Fischer, Sahay, and Vegh (1996) have been used to construct Table 2. Most stabilization dates coincide with the starting date of an arrangement with the IMF. When multiple attempts were made (as occurred in six of these countries), “the most serious attempt” was taken. Fischer, Sahay, and Vegh stress that the judgment about the seriousness of the stabilization program was not based on eventual inflation performance, but rather on an evaluation of the policy package associated with the stabilization effort.

    The marked volatility of inflation throughout the transition area is reflected in findings that lagged inflation has been relatively unimportant in explaining inflation in transition economies (Cottarelli, Griffiths, and Moghadam, 1998; and Coorey, Mecagni, and Offerdal, 1998).

    The upward biases in inflation measurement identified by the Boskin report for the United States may be larger in transition economies, given the faster rate of introduction of new products and the proliferation of new retail outlets (Ŝkreb, 1998). On the other hand, lagged adjustments of the weights for goods subject to administered pricing tend to cause inflation to be understated when administered prices rise relative to market prices.

    The “transition index” referred to in Figure 1 and elsewhere is drawn from various European Bank for Reconstruction and Development (EBRD) transition reports and from De Melo, Denizer, and Gelb (1997). It is a composite of scores for eight institutional characteristics, ranging from privatization to price liberalization to banking reform and interest rate liberalization. The eight scores are weighted together to yield the aggregate “transition index” for each country. The highest scores indicate institutional structures similar to those prevailing in fully fledged market economies.

    Policy credibility is a key factor in affecting the output cost of disinflation. If a disinflation package is credible, inflation expectations will decline rapidly, bringing down nominal interest rates and nominal wage growth. This will reduce the risk that disinflation is accompanied by an initial rise in real wages and real interest rates and the output losses associated with that. Of course, another factor at play is the duration of wage and lending contracts. If this duration is short, as it is likely when inflation is high, wage and interest rate dynamics can react more rapidly to changes in inflation.

    Those from the Baltics, Russia, and other countries of the former Soviet Union that continued the Soviet era practice of linking social payments to the minimum wage did not thereby establish de facto backward-looking indexation, as adjustments of the minimum wage were ad hoc in scale and timing.

    Bulir (1998) finds evidence from a large sample of developing countries that high inflation increases economic inequality. Evidence on the drop in real pensions and its relation with inflation in 11 transition economies can be found in Cangiano, Cottarelli, and Cubeddu (1998). Other aspects of inequality in transition are discussed in EBRD (1997).

    In Belarus and Ukraine, administered price adjustments spurred inflation, as did energy and other price increases in Romania alongside liberalization of the exchange rate in early 1997. Administrative price changes were most important in Hungary in the early 1990s, and again in 1995—96, when increased energy prices stimulated a renewed acceleration of inflation.

    In some cases, however, the additional financing option provided by new securities may have facilitated increased fiscal deficits. Ukraine through 1997 may be one example of this.

    Qualitative assessments provided by IMF desk economists, summarized in index form (see Cottarelli, Griffiths, and Moghadam, 1998) also indicate significant progress in developing financial markets: on a 1–10 scale (10 indicating the degree of development of government securities markets in industrial countries), the index for the Baltics, Russia, and other countries of the former Soviet Union improved from 2.1 in 1993 to 5.5 in 1996, while that for Central and Eastern European countries improved from 4.4 to 5.6. As this index reflects subjective assessments, it should be taken as indicative of the direction of change, rather than for cross-country comparisons.

    Focusing on the relationship between inflation and primary balance is important as the latter is not affected by the fall in interest expenditure that accompanies disinflation. This fall makes it more difficult to interpret the causal link between decline in the overall deficit and decline in inflation (see footnote 1 in Box 2).

    The table uses an interest rate-growth rate differential of 2 percentage points, as in the studies on transition economies by Budina and van Wijnbergen (1997) and Begg (1998).

    For example, the pension reforms approved in 1996 in Kazakhstan reduced future public liabilities without greatly affecting the current fiscal balance, and the reduction in arrears by the pension fund in the following year caused a deterioration in the measured fiscal balance.

    Furthermore, receipts from privatization can also ease the solvency condition, especially when privatization greatly increases the productivity of the privatized assets.

    See Begg, Hesselman, and Smith (1996), and Begg (1998) for Central and Eastern European countries, and De Broeck, Krajnyák, and Lorie (1997) for the Baltics, Russia, and other countries of the former Soviet Union. Van Elkan (1998) discusses the case of Hungary. Anderson and Citrin (1995) discuss the response of money demand to inflation.

    Russia floated in August 1998.

    In Table 11, the former Yugoslav Republic of Macedonia is classified as having a pegged exchange rate because the authorities announced their commitment to a certain exchange rate level. Croatia is similarly classified because it announced an exchange rate floor at the beginning of the disinflation.

    Latvia introduced a fixed exchange rate some 18 months after initiating stabilization.

    Transition economies have only recently begun to consider and to adopt formal inflation targeting frameworks. The Czech Republic adopted this framework informally in late 1997, and formalized it in early 1998. Poland introduced inflation targeting in late 1998.

    Transition factors have been found to add to the speed of real appreciation in oil-rich countries of the Baltics, Russia, and other countries of the former Soviet Union, such as Azerbaijan (Rosenberg and Saavalainen, 1998).

    This factor played a role in the Baltics and in the countries of the former Soviet Union closely integrated with Russia as its real exchange rate rebounded during 1994–96. In this context, such countries that did not respond to the ruble appreciation with offsetting appreciations against “hard” currencies experienced substantial overall real effective depreciations, and consequently high import price inflation. This delayed disinflation.

    As indices reflect subjective views, they should be taken as indicative of direction of change, rather than of relative positions across countries. Following more rigorous methodology—which focuses only on legal independence—Cukierman, Miller, and Neyapti (1998) conclude that the level of legal independence of transition economies is even higher than in developed economies and is broadly the same on average for the Baltics, Russia, and other countries of the former Soviet Union and Central and Eastern European countries.

    Import volume growth was not used due to weak data on this for transition countries.

    Where data on the shares were available over several years, the weights were defined only on the basis of the share in the first year for which data were available.

    In this case, when a stabilization program was reported to be implemented in the first five months of a year, one was assigned to that year. But it was assigned to the following year if the stabilization was introduced later than May. This rule was an attempt to capture possible delayed effects on disinflation on output.

    Fischer and others (1998) suggest that de facto pegs operated as of 1995 in Armenia, Azerbaijan, Georgia, Kazakhstan, and the Kyrgyz Republic during the sharp disinflations in that year. How-ever, while nominal bilateral exchange rates with the U.S. dollar were relatively stable in these cases during 1995, they moved markedly in all cases except Georgia thereafter.

    If the primary balance of general government is included in this regression, the parameter estimate is small and positive, but statistically significant. However, it was excluded on the grounds that it is mis specified and is therefore difficult to interpret economically.

    We are indebted to Luc Everaert for pointing this case out to us.

    Other deficiencies noted include the following: seven coun-tries had not introduced internationally acceptable accounting standards for commercial banks by 1997; Belarus, Moldova, and Russia had not yet introduced consolidated supervision; there were no limits on equity participation of banks in Moldova, Tajikistan, and Turkmenistan; and licensing procedures needed close surveillance, especially in Belarus and Tajikistan.


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