Chapter

II Background to Reform

Author(s):
Bijan Aghevli, Eduardo Borensztein, and Tessa Van der Willigen
Published Date:
March 1992
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Preparations for reform began in earnest under the new Government in early 1990.2 The interim Government acted quickly in several relatively uncontroversial areas, developing a comprehensive strategy of reform and building a consensus around it. Extensive discussions within the interim Government culminated in the adoption in May of a resolution setting forth a program of rapid reform, particularly in price and trade liberalization. This resolution was subsequently endorsed by the new Government, formed following the June elections, and the program was further elaborated in the “Scenario of Economic Reform,” submitted to Parliament in September, which outlined “a comprehensive set of measures involving price liberalization, liberalization of imports and internal convertibility [that is, unrestricted access by businesses to foreign exchange for current account transactions], promotion of the growth of the private sector, macroeconomic anti-inflationary policy and the policy of social guarantees and social protection.” A target date of January 1, 1991 was set for launching the radical phase of the reform program.

Policy Measures in 1990

In 1990, various preparatory measures were put in place. The new Government allowed two measures that had been prepared under the previous regime to come into force on January 1, 1990. First, a two-tier banking system was created by breaking up the State Bank; as an adjunct to the new banking structure, a discount rate was established—initially at 4 percent—for banks seeking to refinance. Second, a mixed system of centralized and decentralized prices was introduced. Under the new system, prices ranged from centrally determined to “contract prices,” but even in the latter case prices remained subject to central intervention, so that in practice 1990 saw very little price liberalization.

The new Government also acted quickly to signal the new orientation of macroeconomic policy by declaring the need for fiscal and monetary austerity. The 1990 state budget, prepared under the previous Government, was withdrawn, and a new, tighter budget was presented, which showed a surplus of ½ of 1 percent of GDP. At the same time, tight credit ceilings were imposed on the commercial banks. In addition, the new Government took a first step toward addressing the foreign exchange imbalance. The commercial and noncommercial exchange rates for the koruna were unified on January 8, 1990, at a level of Kcs 17 per U.S. dollar, representing sizable depreciations of both rates. A “tourist” exchange rate was also introduced, at a still more depreciated level.

Although prices remained essentially controlled throughout 1990, the new Government took steps to address some of the most glaring price distortions. On July 9, armed with the public mandate it had received from the elections, the Government raised retail food prices by an average of 25 percent, so as to eliminate retail subsidies amounting to over 3 percent of GDP. The population was compensated for these price increases by monthly income transfers of Kcs 140 (close to 5 percent of the average wage) a person. Some further administrative price adjustments, notably in transportation, were implemented in the following months to reduce subsidies even more.

A second set of crucial price adjustments was also initiated in July, this time in response to adverse external developments. As a result of the deepening economic crisis in the former U.S.S.R., the source of almost all its oil imports, Czechoslovakia was forced to purchase oil on the world market, at prices that were then inflated by the Middle East crisis. In an effort to reduce consumption, the retail prices of gasoline and diesel were raised between July and October, eventually to double their levels of early 1990. In effect, as far as retail prices of gasoline and diesel were concerned, the price adjustments that would be made necessary by the collapse of the CMEA in January 1991 had been completed in advance.

As the year progressed and the strategy of radical reform took shape, expectations of inflation and of devaluation spread—the latter boosted by some open discussion of various devaluation options in the Scenario of Economic Reform. The discount rate was raised to reach 8.5 percent by the end of the year, while deposit rates rose to 7-14 percent and lending rates to 15-22.5 percent. These moves, however, did not stanch the hemorrhaging of foreign exchange in anticipation of devaluation, as enterprises stocked up on imports and prepaid debt by any means available. On October 15, the commercial exchange rate was devalued by a further 35 percent, to Kcs 24 per U.S. dollar.

Throughout 1990, considerable efforts were also devoted to laying the legislative and institutional basis for the establishment and growth of a market economy in general and of private enterprise in particular. Among the most important legislative changes, a law on private enterprise was adopted allowing private sector participation in virtually any economic activity, the monopoly of foreign trade corporations on external trade was abolished, and the joint venture law was amended to allow for 100 percent foreign ownership. In addition, much of the planning apparatus was dismantled, the process of restructuring state enterprises into smaller and more independent joint stock companies was begun, and steps were taken to develop indirect instruments of monetary management.

The economic situation in 1990 was dominated by deepening difficulties in trade with the former U.S.S.R. and with other former CMEA countries undergoing adjustment and by the response to the very first steps of reform (Table 1). Net material product is estimated to have fallen by 3 percent, and the balance of payments to have deteriorated substantially, leaving gross international reserves at the end of the year equivalent to just over one month of imports. Consumer prices rose by 18 percent over the course of the year, largely as a result of the administrative price adjustments; producer prices, which toward the end of the year were permitted to adjust to reflect part of the impact of the October devaluation, rose only slightly less. The Government recorded a surplus of approximately 1 percent of GDP,3 and, despite the substantial price increases, credit to the nongovernment sector rose by only about 1½ percent over the course of the year.

Table 1.Selected Economic and Financial Indicators
First Half
1991
1987198819891990Estimated
Real sector (change in percent)
Real GDP2.12.51.4-0.4-9.2
Consumer prices
Period average0.10.22.310.8
End period0.10.61.518.449.1
Industrial wholesale prices
Period average0.1-0.74.4
End period-0.716.653.3
Public finance (percent of GDP)
General government1
Revenue57.958.062.160.247.42
Expenditure358.759.564.560.146.72
Surplus/deficit3-0.7-1.5-2.4-0.10.82
Money and credit (end period, percent change)
Net domestic assets6.510.51.14.76.5
Credit to enterprises and households3.33.1-2.71.413.1
Broad money6.011.53.50.55.6
Interest rates (percent)
Credit to enterprises and cooperatives5.15.15.76.519.5
Household savings deposits4.04.04.04.313.0
Balance of payments (billion U.S. dollars)4
Merchandise exports15.715.114.311.74.7
CMEA9.69.07.85.71.6
Other6.16.16.56.03.1
Merchandise imports15.814.714.013.25.0
Trade balance-0.10.30.2-1.5-0.3
Current account0.81.50.3-1.3
Gross international reserves of the banking system (end of period)1.51.72.31.21.7
In months of following-year imports in convertible currencies3.64.24.91.2
Sources: Czechoslovak authorities; and IMF staff estimates.

Includes federation and republics, local authorities, and extrabudgetary funds. Excludes National Property Funds, subsidized organizations, and funds of the ministries. Data for 1989 and 1990 are consistent with the Government Finance Statistics methodology.

Revised budget for 1991.

Excluding stock adjustments (mainly takeover of export credits and transfers to the banks on account of devaluation profits and losses).

Transactions with former CMEA members in transferable rubles before 1991 converted at cross rates.

Sources: Czechoslovak authorities; and IMF staff estimates.

Includes federation and republics, local authorities, and extrabudgetary funds. Excludes National Property Funds, subsidized organizations, and funds of the ministries. Data for 1989 and 1990 are consistent with the Government Finance Statistics methodology.

Revised budget for 1991.

Excluding stock adjustments (mainly takeover of export credits and transfers to the banks on account of devaluation profits and losses).

Transactions with former CMEA members in transferable rubles before 1991 converted at cross rates.

External Environment

The launching of the radical reform phase on January 1, 1991 was to coincide to the day with a major deterioration of the external environment associated with the shift in trade arrangements among the members of the former CMEA to pricing at world market prices and to settlement in convertible currencies. Evaluated at cross-exchange rates, CMEA trade accounted traditionally for over half of Czechoslovakia’s exports and imports.4 The shift to world prices represented both a large inflationary impulse and a major terms of trade shock, while the shift to convertible currencies would inhibit exports.

Up to 1990, almost all trade with the CMEA was denominated in transferable rubles. Prices in transferable rubles did bear some relation—discussed more fully below—to world prices, but this relation was based on the official exchange rate of the transferable ruble against the U.S. dollar, of TR 1 = US$1.60 (known as the IBEC exchange rate, for the Moscow-based International Bank for Economic Cooperation). Against the Czechoslovak koruna, on the other hand, the transferable ruble was valued at Kcs 9, equivalent on average in 1990 to $0.50 and after the December devaluation of the koruna to only $0.32. Abstracting from disparities between old transferable ruble prices and world prices, therefore, the abolition of the transferable ruble would have meant a fivefold increase in koruna prices of CMEA imports and exports.5

In addition, the move to world prices worsened Czechoslovakia’s external terms of trade. Czechoslovakia’s imports from the CMEA consisted mainly of raw materials and energy, and its exports to the CMEA mainly of capital goods and other manufactured products. Within the CMEA, the pricing systems for these two types of goods were different: prices of raw materials (at the IBEC exchange rate) were explicitly linked to a moving average of recent world prices, through the so-called Bucharest formula, whereas prices of manufactured goods were set on the basis of bilateral negotiations. Over time, the relative prices of manufactured goods had risen. In Czechoslovakia, it was estimated that—with transferable rubles converted into U.S. dollars at the IBEC rate—the move to world prices would reduce the dollar prices of imports from the CMEA by perhaps 5 percent and the dollar prices of exports to the CMEA by about 25 percent. As a result, the terms of trade with the CMEA would deteriorate by over 20 percent. The estimated terms of trade developments are plotted in Chart 2.

Chart 2.Terms of Trade

Sources: Czechoslovak authorities; and IMF staff estimates.

With the shift to settlement in convertible currencies, Czechoslovak products stood to lose an important advantage that they had enjoyed in competing for CMEA markets with products from other countries. This loss of competitiveness put additional pressure on export prices. Moreover, the clearing system had been instrumental in sustaining trade flows within the CMEA, as shortages of foreign exchange were felt throughout the region-most notably in the former U.S.S.R.—and the abolition of the clearing system thus brought with it the risk of a decline in export volumes. Exports to the former U.S.S.R. were likely to decline in any event as a result of the economic crisis in that country, and exports to the other former CMEA members would also come under pressure as economic reform and adjustment cut into these countries’ ability to import.

For a time, it seemed that the rise in international oil prices owing to the Middle East crisis would further worsen the difficult external environment in which Czechoslovakia was determined to embark on its radical reform program. The fall in oil prices in early 1991 removed this aggravating circumstance. Nevertheless, the collapse of the CMEA and the contraction of some of its major export markets were sufficient to present Czechoslovakia, for the first time in years, with a need for a serious stabilization effort, at the very same time that the crucial phase of reform was being launched.

The unfavorable external circumstances at the time the reform program was launched were bound to complicate further the transition to a market economy.6 However, the advance setting of January 1, 1991 as a fixed and nonnegotiable deadline for launching the program was instrumental in coalescing the political forces and pushing through the necessary reforms without delay. Without the strong commitment to a specific date, pressures might have mounted regarding details not yet worked out, thereby delaying or even stalling the reform process.

For further insight on the preliminary steps for economic reform, see Dyba and Svejnar (1991) and Klaus (1990).

Abstracting from certain stock adjustments relating to export credits to the former U.S.S.R. and to devaluation losses of the banks.

As discussed below, the use of cross rates underestimates the weight of the CMEA in total trade.

This comparison assumes that the exchange rate of the transferable ruble against the koruna would otherwise have remained unchanged; another counterfactual would yield a smaller impact of the abolition of the transferable ruble, but a larger impact of the devaluation of the koruna.

It is interesting to note that the unfavorable external environment itself was to a large extent a part of a wider trend to economic reform—the collapse of the CMEA being an integral part of the reform of the former centrally planned system, and the loss of export markets being due in part to reform efforts in neighboring countries.

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