Chapter

III Reform Program of 1991

Author(s):
Bijan Aghevli, Eduardo Borensztein, and Tessa Van der Willigen
Published Date:
March 1992
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The comprehensive reform program that was implemented on January 1, 1991 comprised a major liberalization of domestic prices and of external trade and a rapid privatization program following an initial preparatory phase. The very unfavorable external environment made it even more pressing to proceed promptly with the reform measures but, at the same time, worsened the prospects for inflation and the balance of payments. To minimize the risk of financial instability in the critical initial phase of reform, the structural policies were supported by a mutually reinforcing package of financial policies comprising a pegged exchange rate and restrictive fiscal, monetary, and wage policies.

Policy-Sequencing Problem

The extent of the economic reforms to be undertaken raised an important issue of strategy, namely, the order in which the multiple reforms should be implemented.7 Does it make sense to free markets (to liberalize prices and foreign trade), while production and trade are still in the hands of a few monopolistic state enterprises? Should price and trade liberalization be attempted simultaneously, or should the opening to foreign trade be postponed until enterprises are in a stronger competitive position?

For the most part, the answers to these questions derived not from advantages to be obtained by following a particular sequencing strategy, but instead from major economic and technical roadblocks—in the way of alternative paths. Postponing market liberalization until privatization had been completed would have implied a major delay in launching the reform process. For largely technical reasons, it is virtually impossible to transfer a major part of the state enterprise sector to private control in less than two or three years. The problem with this delay is that the intervening period could witness a major economic collapse, as the economy would find itself in a “no-man’s-land” in which the central planning system has lost its ability to function (even at its normally poor level of efficiency), but new market-oriented initiatives are choked by price controls and economic restrictions. The situation in the former Soviet Union in the past few years, with its breakdown of traditional economic relations and multiplication of shortages, exemplifies the perils of delay. Moreover, this kind of sequencing would further complicate the sale of public enterprises, because their true market value would be even more difficult to assess; even a short experience under liberalized markets can provide some basis for evaluating the potential profitability of state enterprises.

Several considerations are germane to the question of whether foreign trade liberalization and the introduction of limited currency convertibility should be postponed in order to give enterprises more time to adjust. First, a staggering of price and trade liberalization entails successive waves of relative price adjustments, with each wave imposing additional adjustment costs on enterprises—involving, for example, investments, personnel, and technical changes. By contrast, a simultaneous liberalization of prices and trade allows the new “equilibrium” relative prices to be established quickly, thus minimizing the adjustment costs. Second, a postponement of trade liberalization would risk the creation of vested interests—for example, in import-competing sectors—that could make the process of opening up the economy politically more difficult. Finally, foreign trade liberalization is the only way of rapidly injecting substantial competition into a severely monopolized system and of avoiding abuses of market power. In so doing, trade liberalization also allows international prices of traded goods to serve as guidelines for the adjustment of all domestic prices, and a fixed exchange rate can become a strong anchor to hold down domestic inflation.8

Thus, it was considered that the only feasible strategy was to proceed to price and trade liberalization in a “big bang” fashion while imposing hard budget constraints on state enterprises and undertaking the process of privatization as rapidly as possible. Aggregate demand policies were designed to be on the tight side in order to ensure the success of stabilization and to enforce financial discipline on state enterprises. For the first time, state enterprises were to find that their very existence depended on maintaining a viable financial position. Price subsidies were kept to a minimum, and a strengthened—though broad, in the absence of adequate targeting mechanisms—social safety net used instead to alleviate the effect of price increases on the lowest-income segments of the population. Foreign exchange was made freely available to businesses for their current account transactions, and direct restrictions and barriers to trade were minimized. Under these conditions, price and performance signals would begin to function as indicators of the potential market value of enterprises, facilitating their privatization.

Price Liberalization

A cornerstone of structural change in Czechoslovakia was the liberalization of prices, which had been administratively set for the previous forty years. On January 1, 1991, prices of goods and services representing about 85 percent of the total value of sales were freed, both at the producer and retail levels. Prices of public utilities, transport, and rents remained under regulation, as did a few products of vital importance, such as medicines (these items accounted for 6-8 percent of total turnover in the economy). In addition, temporary price guidelines were introduced for a list of specified goods, such as foodstuffs and intermediate goods of critical importance, in order to discourage speculative price rises. The concern was that in the absence of established competition and traditions of price setting, the monopolistic structure of many industries could lead to unwarranted price increases in the period immediately following the liberalization. These temporary price guidelines were eliminated by November 1991.

The liberalization of prices was reinforced by the removal of consumer subsidies. Following the earlier removal of retail subsidies on food, subsidies on industrial products were eliminated on January 1, 1991. After an initial postponement, subsidies on almost all energy products were eliminated in May 1991; as a result, coal prices rose by 240 percent, gas prices by 100 percent, and heating rates by 320 percent. Partial compensation for these price increases was granted to pensioners and families with children in the form of monthly income support of Kcs 80 a person (about 2 percent of the average wage). Thus, budgetary subsidies, which as recently as in 1989 had amounted to about 16 percent of GDP, were reduced to about 7 percent of GDP. Among the remaining items were agricultural subsidies (amounting to about 3 percent of GDP), partly to support minimum producer prices for a number of products; transport subsidies (a little over 1 percent of GDP) for the railway, intercity road transport, and urban transport; housing subsidies (about 1 percent of GDP) for maintenance of state-owned rental apartments and for low-interest loans; and small subsidies to oil- and gas-fired heating plants, which are more costly to operate but less damaging to the environment than the coal-fired plants.

The price structure was expected to change drastically in early 1991, not only because of the liberalization and the continued reduction in subsidies, but also because of external factors, including changes in the CMEA trading arrangements and the rise in the international price of oil. As a result of these external factors—which would raise prices of some raw material imports by as much as 300 percent—as well as the devaluation, prices of tradable goods were expected to rise substantially in early 1991. A precise quantification of the once-and-for-all impact of these external factors was impossible, but rough calculations suggested that, at a minimum, they would raise the price level by 25 percent. In addition, prices of goods that had been in short supply under central planning were expected to rise.

An important challenge in the early stage of reform was to ensure that the initial jump in prices did not give rise to an inflationary spiral. The formulation of fiscal and monetary policies was therefore based on the very conservative targets of limiting the initial price jump to 25 percent and the subsequent underlying inflation in the remainder of the year to an annual rate of 5 percent. These tar-gets were clearly ambitious, even allowing for the absence of a major monetary overhang, such as that observed in the other centrally planned economies. But it was recognized that an overestimation of the initial price jump in the formulation of fiscal and monetary policies could in fact become self-fulfilling. Of course, aggregate demand policies based on an underestimated initial price increase could adversely affect economic activity, but it would be far easier to take corrective action in such a case than to err in the other direction and be forced to control runaway inflation or a balance of payments crisis in the midst of a program of fundamental structural reform.

Exchange and Trade Liberalization

The opening of the economy to international competition was the second cornerstone of the reform program. In order to infuse competition and bring the domestic price structure into line with international prices, virtually all restrictions on businesses’ current account transactions were removed on January 1, 1991, while a full foreign exchange surrender requirement was imposed. Capital account transactions remained subject to control to minimize the risk of destabilizing capital outflows, particularly in view of the limited level of foreign reserves. Under the new system, the annual foreign exchange plan was abandoned, and trade activities by all registered businesses (state or private) were freely allowed. Only a few strategic imports remained subject to import licensing. Subsequently, profits and dividends were made fully remittable (in February), and the annual entitlement to foreign exchange for individuals traveling abroad was raised to Kcs 5,000 from Kcs 2,000 (in April). In addition, the system of levies and subsidies, which bridged differences between domestic and international prices, was abolished on January 1, as was the export premium scheme, which subsidized exports to the convertible currency area. Export-licensing requirements on a large number of products were removed.

An important adjunct to trade reform was the dismantling of the CMEA trade and payments arrangements. Effective January 1, 1991, trade with CMEA members was to be conducted on the basis of world prices and payments to become due in convertible currencies, replacing bilateral and multilateral arrangements. However, already prior to that date and increasingly as 1991 progressed, it was evident that trade within the CMEA was in danger of collapsing on the new basis; exports to the former Soviet Union, in particular, appeared to be hardly feasible on a convertible currency basis because importers were unable to secure the necessary foreign exchange. To avoid the loss of these markets, which, owing to the specificity of most manufactured exports, would be difficult to replace in the short run, some temporary arrangements were necessary. These took the form initially of dollar-denominated clearing arrangements under which goods on the “indicative lists”—which defined areas of trade of mutual benefit—could be traded; later in 1991 a framework for clearing ac-counts denominated in national currencies was also created.

With the liberalization of imports, there was concern that pent-up demand for consumer goods might lead to a surge in imports in early 1991. Thus, in order to contain pressures on international reserves, the authorities imposed, on a temporary basis, a 20 percent surcharge on virtually all imports of consumer goods. This surcharge was reduced to 15 percent by mid-1991 and is likely to be eliminated in the near future in conjunction with a planned restructuring of the tariff system. Since the planning system relied on the foreign exchange plan to regulate imports and protect domestic industries, the present tariffs are generally low, averaging about 5 percent. The authorities have accordingly decided to review and modify the tariff structure beginning in 1992, with a view to providing domestic industries with appropriate protection, in particular in light of subsidies given by some neighboring countries to the agricultural sector.9

Foreign investment has been promoted in the context of the structural reform in general, and the privatization program in particular. The Joint Ventures Act, as amended in 1990, together with the Foreign Exchange Act, has established a framework for joint ventures and foreign-owned companies, under which these companies could be subject to less restrictive regulations than those applicable to domestic enterprises regarding foreign exchange accounts abroad and borrowing from foreign banks. In addition, foreign investors may freely repatriate capital. Moreover, bilateral agreements that would guarantee even more favorable conditions for foreign investors have been reached or are under negotiation with most western industrial countries.

Exchange Rate Policy and Reserve Management

A critical aspect of the stabilization program was the choice between aflexibleor a pegged exchange rate, which raised a number of issues. Under a flexible regime, the determination of the level of the exchange rate would be left to market forces. Such a regime entailed substantial risk, however, given the absence of an established foreign exchange market, as well as the substantial uncertainty relating to changes in both the price structure and the trade patterns in the aftermath of price and trade liberalization. A major concern was that, under those circumstances, a freely floating system would be very fragile, and the initial price jump or an initial surge in imports would trigger a vicious circle of sharp speculative depreciation of the koruna, domestic inflation, and accompanying wage increases. The risk of speculative attacks on the koruna was heightened by the low level of international reserves. The uncertainty relating to the extent of intervention necessary to stabilize the exchange rate, as well as the authorities’ relative inexperience in managing a floating exchange rate, was expected to reduce the availability of foreign exchange resources from both official and private sources.10

Against this background, the authorities decided to unify the commercial and tourist exchange rates at a competitive level and to peg the rate to a basket of currencies of major partner countries in the West. The pegged rate, together with restrictive fiscal, monetary, and incomes policies, was designed to provide an effective anchor for stabilizing prices in the period following their liberalization. The commitment to a pegged rate was also expected to enhance the authorities’ credibility in putting in place restrictive aggregate demand policies and therefore discourage speculative capital outflows. Furthermore, in the absence of futures markets or hedging facilities, a pegged regime would facilitate trade by reducing exchange rate volatility.

In order to ensure the viability of the pegged regime, it was critical that the initial exchange rate parity be set at a level that was both consistent with a sustainable current account position over the medium term and credible from a short-term perspective. In setting this rate, it was therefore necessary to anticipate a substantial erosion in external competitiveness in early 1991 owing to large domestic price increases of other origin, which were difficult to project accurately. This consideration, together with a precarious level of international reserves, dictated that any error in setting the exchange rate be on the side of overdepreciation. Although it was recognized that any such overdepreciation could by itself amplify the initial price increase, it was feared that a small devaluation would induce large capital outflows, given strong speculation by the public that the koruna would be devalued by a large amount. Accordingly, on December 28, 1990, the exchange rate of the koruna was set at Kcs 28 = US$1; this action represented a devaluation of the koruna (at the commercial rate) by about 15 percent, implying a total devaluation of over 45 percent during 1990 (Chart 3).

Chart 3.Exchange Rates

Sources: Czechoslovak authorities; and Schweizerischer Bankverein.

Notwithstanding the substantial devaluation of the koruna in 1990, it was recognized that a structural transformation could be attained only after a time lag and that, in the meantime, the trade and payments position was likely to deteriorate.11 Thus, a sound financial program in the context of a pegged exchange rate required an adequate level of reserves at the outset. In this context, large-scale financial support from the IMF was indispensable. Access to IMF resources in the amount of up to $1.8 billion was provided under a stand-by arrangement and the compensatory and contingency financing facility. Of this amount, about $0.7 billion was disbursed in early January to boost the initial level of reserves to about one and a half months of imports. Support from the IMF provided a respite while other financial support could be arranged. Subsequently in 1991, commitments of about $1 ½ billion were made by the European Community, the other industrial countries of the Group of 24, and the World Bank—of which about half is expected to be disbursed in 1991 and the remainder in 1992.

Fiscal Policy

Fiscal policy was designed to achieve two broad aims: to further the disengagement of the state from the economy and to help stabilize the economy in the turbulent period following the big bang and the terms of trade shock. With the former objective in mind, the rates of tax on profits were reduced by 10-20 percentage points and largely unified; the myriad rates of turnover tax (sales tax) were reduced to three (in addition to a zero rate); and, as explained above, subsidies were drastically reduced.12

To further the stabilization objective, fiscal policy for 1991 was aimed at an overall budget surplus of about 1 percent of GDP (Table 2).13 The implied improvement of less than 1 percent of GDP in the budget balance (over 1990) substantially understated the adjustment effort. In particular, the ratio of revenue to GDP was—again conservatively—estimated to fall by about 10 percentage points, owing in part to policy decisions, but principally to exogenous factors, including the expected difficulties of enterprises and the projected fall in employment and real wages. Furthermore, proceeds from privatization were not to be included as budgetary revenues but were to be blocked in the accounts of the National Property Funds with the banks. Consequently, the envisaged budget surplus required considerable expenditure restraint. Even under the conservative target of a 30 percent price increase in 1991, all components of expenditure would decline substantially in real terms, lowering the ratio of government spending to GDP by about 11 percentage points. The most severe cuts fell on subsidies, and the least severe on the social safety net. Public investment, recognized to have a crucial role to play in the face of urgent infrastructural needs, was cut only slightly more than government consumption expenditure.

Table 2.Fiscal Operations
1991
BudgetJan-JuneRevisedJan-Sept.
19901Actual2Budget3Actual2
(In billions of koruny)
Central government (federation and republics)
Revenue399.2403.1220.1482.5344.8
Individual income taxes0.339.818.256.140.7
Profits taxes93.491.781.3136.8105.1
Payroll tax481.490.134.2107.270.1
Taxes on goods and services147.8154.363.5141.991.7
Taxes on international trade25.88.05.48.88.5
Other50.519.217.531.728.5
Expenditure and net lending387.6395.1203.0478.5340.0
Current transfers248.1216.2109.0297.5206.9
To enterprises and cooperatives103.244.825.764.645.3
To subsidized organizations3.24.52.011.45.5
To local authorities33.49.810.563.044.2
To households108.3157.270.7158.4111.8
Unemployment benefit and retraining9.81.29.82.3
General income support12.732.912.832.0
Other95.6114.556.7116.6
Other current expenditure86.5139.576.8138.2102.1
Capital expenditure7.216.04.814.38.3
Capital transfers45.127.612.933.220.2
To local authorities30.214.18.215.211.9
Other14.813.54.718.08.3
Net lending0.7-4.3-0.5-4.72.5
Surplus/deficit11.68.017.14.04.8
Stock adjustments5-54.416.913.916.9
Adjustment for complementary period6-9.88.25.55.7
Local authorities-0.93.17.9
Revenue162.486.254.395.6
Of which: transfers from central government63.623.918.778.156.1
Expenditure163.386.251.295.6
Extrabudgetary funds-0.20.30.6
Overall surplus/deficit-53.78.045.624.936.0
Excluding stock adjustments0.78.028.78.019.1
Sources: Czechoslovak authorities; and IMF staff estimates.

Figures for 1990 are not comparable with those for 1991 because of changes in the division of revenues and expenditures between central and local government.

Revenue and expenditure adjusted for off-budget transactions.

Methodological changes compared to the original budget consist of the transfer of certain own revenues of the local authorities (individual income taxes and payroll tax; full-year total Kcs 44.4 billion) to the central budget, with an equivalent increase in transfers to the local authorities; and the transfer of certain “other” current expenditures (full-year total Kcs 6.8 billion) to subsidized organizations.

Nonfinancial state enterprises only.

Includes transfers related to devaluation losses and profits of banks and foreign trade organizations and takeover of export credits.

Adjusts the fiscal balance of central government from an accrual to a cash basis.

Sources: Czechoslovak authorities; and IMF staff estimates.

Figures for 1990 are not comparable with those for 1991 because of changes in the division of revenues and expenditures between central and local government.

Revenue and expenditure adjusted for off-budget transactions.

Methodological changes compared to the original budget consist of the transfer of certain own revenues of the local authorities (individual income taxes and payroll tax; full-year total Kcs 44.4 billion) to the central budget, with an equivalent increase in transfers to the local authorities; and the transfer of certain “other” current expenditures (full-year total Kcs 6.8 billion) to subsidized organizations.

Nonfinancial state enterprises only.

Includes transfers related to devaluation losses and profits of banks and foreign trade organizations and takeover of export credits.

Adjusts the fiscal balance of central government from an accrual to a cash basis.

The fiscal stance in early 1991 was substantially tighter than envisaged, reflecting a temporary surge in profit tax receipts owing mainly to capital gains on inventories (high penalties on late payment of taxes—of ½ of 1 percent a day—ensured that tax payments ranked among enterprises’ highest priorities). In addition, expenditures were deliberately limited with a view to bolstering the anti-inflationary stance in the crucial first few months of the year; thus pensions and government wages were increased with a significant lag following the price jump, and payments over which the Government had discretion—notably subsidies and capital transfers—were postponed. Altogether, the overall budget surplus in the first quarter amounted to about 2½ percent of (annual) GDP.14

The exceptionally strong fiscal performance of the first quarter was not expected to endure. In particular, most sources of revenue were expected to be adversely affected by the economic decline, while government spending relating to the social safety net would increase owing to the rise in unemployment. In addition, expenditure allocations for some sensitive services (notably health and education) had to be revised upward as a result of the higher-than-expected price jump, but this revision was not approved until July. In light of very weak domestic demand, the authorities were concerned that the unwinding of the tight fiscal stance might be too slow. Thus, to give both a signal and an immediate boost to domestic demand, the rates of turnover tax were lowered by 1-3 percentage points in mid-1991.

Expectations of a turnaround in the fiscal position were confirmed in the third quarter. After a small additional surplus in the second quarter, the Government recorded a deficit of about 1 percent of (annual) GDP in the third quarter. As the windfall gain on the profits tax subsided, all the major sources of revenue began to show the effects of declining economic activity, and the lags in expenditures began to unwind. For the year as a whole, the overall fiscal position is expected to be broadly balanced—somewhat weaker than originally budgeted, as the effects of the sharp drop in activity offset the initial windfall gain on the profits tax. With the revision of expenditure allocation in July, nominal spending exceeded the original budget but, in real terms, the spending cuts were significantly larger than originally envisaged. This tight fiscal stance has proved instrumental in checking price rises and alleviating pressures on the balance of payments, although it has inevitably contributed to the weakening of domestic demand. It should be noted, however, that the dependence of the 1991 fiscal results on the windfall gain on the profits tax and on favorable lags foreshadows the even greater challenge that will face the authorities in maintaining an appropriately anti-inflationary fiscal stance in 1992.

Monetary Policy

Monetary policy, like fiscal policy, was designed to be restrictive so as to bolster the exchange rate anchor and help stabilize prices. A tight credit policy was intended to ensure that the initial price jump did not trigger a process of protracted inflation.

The velocity of broad money was expected to increase, reflecting the greater availability of non-monetary assets, including consumer durables and equity obtained through the privatization of small-scale enterprises in early 1991 and of larger enterprises (albeit on a limited scale) later in the year. Thus, the monetary program had to allow for a shift in savings from monetary to real assets, which would reduce the demand for money. In line with the projected increase in velocity and the targeted balance of payments, the financial program envisaged a tight credit policy, particularly in the period immediately after the liberalization of prices (Table 3). The envisaged decline in net credit to the Government corresponding to the budget surplus, together with the expected proceeds from privatization (to be held by the National Property Funds), would provide adequate room to meet the credit needs of the nongovernment sector under the credit ceilings. In the event, the price jump turned out higher than anticipated, and the financial program was revised accordingly.

Table 3.Monetary Survey
1991
19891990MarchJuneSept.
(In billions of koruny)
Net international reserves117.8-4.3-12.8-9.6-2.0
Foreign assets237.827.732.841.358.8
Foreign liabilities20.032.045.650.960.8
Net domestic assets530.0555.0558.5593.5628.1
Domestic credit583.6640.2656.0667.3702.2
Net credit to government5.954.237.98.618.2
Net credit to Property Funds0.00.0-0.9-4.2-11.7
Credit to enterprises and households577.7586.0619.0662.9695.7
Credit to enterprises530.8536.0567.8611.3642.6
Credit to enterprises530.8536.0567.8611.3642.6
Broad money547.8550.7545.7583.9626.1
Money311.1291.2279.9294.3324.7
Currency outside banks68.073.772.976.280.7
Demand deposits243.1217.5207.0218.1244.0
Households107.5103.395.792.092.0
Enterprises3135.6114.2111.3126.1152.0
Quasi money236.7259.5265.8289.6301.4
Time and savings deposits232.5231.7240.2254.0259.1
Households170.2167.4171.3180.1188.1
Enterprises362.364.368.973.971.0
Foreign currency deposits14.227.825.635.642.3
Households1.79.812.616.321.0
Enterprises32.518.013.019.321.3
Other items, net453.685.297.573.874.1
Memorandum items:(Change in percent of broad money at beginning of year)
Broad money3.50.5-0.96.013.7
Money0.3-3.6-2.10.66.1
Quasi money3.24.21.15.57.6
Net international reserves2.6-4.0-1.5-1.00.4
Net domestic assets0.94.60.67.013.3
Domestic credit7.710.32.94.911.3
Other items, net-6.9-5.8-2.22.12.0
Sources: State Bank of Czechoslovakia; and IMF staff estimates.

End of period. At current exchange rates through 1990, and at end-December 1990 rates for subsequent periods.

Assets from 1990 are strictly comparable to international reserves at endperiod exchange rate. Earlier data use state bank valuation of monetary gold.

Including insurance companies.

Including net nonconvertible assets and long-term assets of Obchodni Bank.

Sources: State Bank of Czechoslovakia; and IMF staff estimates.

End of period. At current exchange rates through 1990, and at end-December 1990 rates for subsequent periods.

Assets from 1990 are strictly comparable to international reserves at endperiod exchange rate. Earlier data use state bank valuation of monetary gold.

Including insurance companies.

Including net nonconvertible assets and long-term assets of Obchodni Bank.

Credit policy was to be implemented mainly through direct ceilings on commercial banks. While such ceilings inevitably create inefficiencies and distortions, the rudimentary nature of financial markets made it impossible to rely on reserve money management and other indirect instruments. The State Bank, however, introduced a number of measures to move toward a system of reserve money management. These include the requirement that interbank accounts be settled in the State Bank’s books—a prerequisite for state bank control over reserve money; a change in the reserve system to one based on an average monthly holding period to smooth the operation of the new interbank settlement system; and the introduction of reserve requirements and refinance auctions. The authorities intend to take further steps in this direction, including the introduction of a treasury or state bank bill, so as to allow for the implementation of monetary policy through market-based instruments. In addition, new banking laws are to be introduced, which should promote the independence of the State Bank and further the development of a competitive banking system (including through the entry of foreign banks).

As in the case of fiscal policy, credit conditions in early 1991 turned out to be considerably tighter than planned (Chart 4). Several factors appear to have constrained the supply of credit. On the technical side, the reliance on direct credit ceilings proved inefficient because margins not used by certain banks could not be used by other banks; furthermore, the State Bank and, in turn, head offices of commercial banks built significant safety margins into their ceilings. More fundamentally, the banks were reluctant to lend in the highly uncertain environment in view of the changing prospects facing enterprises and also of the banks’ own inexperience in credit risk assessment. The deficiencies of the banks’ balance sheets, owing to their low capital-asset ratios and their poor loan portfolios, compounded this reluctance to lend. With the encouragement of the State Bank and helped by the stabilization of the macroeconomic situation, credit picked up after the first quarter, but remained tight—as evidenced for instance by a sharp increase in interenterprise payment arrears. While the tight stance of credit policy, especially in the early months, helped avoid the onset of an inflationary spiral and of pressures in foreign exchange markets, it may have added to the weakness of aggregate demand and the contraction in output.

Chart 4.Nominal and Real Money Supply

Source: Czechoslovak authorities.

Debt Overhang of Enterprises

A major obstacle to an efficient functioning of the banking system has been the legacy of large amounts of bank credit extended to enterprises under government direction over many years, a situation described as the “soft budget constraint” (Kornai (1986)). A large portion of bank credits is of questionable value, as enterprises may not be in a position to repay them. These loans are not only burdensome to banks, but in some cases may financially choke enterprises that could be profitable on current operations, but that are saddled with large debts incurred through arbitrary price setting and investment decisions under central planning. From the point of view of banks, the carryover of these debts distorts the allocation of credit and increases the spread between deposit and lending rates. Moreover, given the weak capital and reserves position of commercial banks, this situation threatens the stability of the emerging financial system, highlighting the need both to put the commercial banks on a sound footing and to introduce proper prudential banking supervision.15

To the extent that bad debts are owed by enterprises that are not viable and need to be liquidated, the solution—recapitalization of the banks—is fairly clear cut. However, to the extent that the debt overhang also pertains to enterprises that are potentially profitable, it is not possible to devise a “clean” solution. A comprehensive auditing of banks and enterprises to identify the proper action in each individual case would take time and create serious moral hazard problems in the interim. Moral hazard will also arise if, in an attempt to avoid overestimating the size of the problem in the face of a need for quick action, a debt-relief operation is conducted in installments, with no clear signal that it is the last such operation. Moreover, debt write-downs should target enterprises that have the greatest potential for improving their performance and increasing their investment, which means that very good and very bad enterprises should be excluded; the scheme should be carefully designed in this respect because, from the point of view of banks, it is debt write-offs for the worst enterprises that most help their balance sheets. Finally, not only will a debt-relief operation be complicated, but it will also be costly if it is to be comprehensive enough to have an impact on the performance of the economy. This cost, however, should not be overestimated. For enterprises that are to be privatized through direct sales, debt relief will presumably be reflected in higher sale prices. Moreover, to the extent that the authorities wish to protect deposit holders, the bad debt overhang already implies a financial liability for the state, albeit a contingent one. If enterprises are unable to repay banks, and banks become unable to repay depositors, it will be up to the state to cover the resource gap.

As a first step in addressing the banks’ portfolio problems, measures were taken in March to carve out of the banks’ balance sheets a large part of permanently revolving credits for inventories (TOZ credits). These credits, which had originally been extended at 6 percent interest and with no maturity date, were officially abolished at the beginning of 1991, but problems arose when banks and enterprises attempted to negotiate replacement loans with longer-term maturities and at commercial rates. A new agency, the Consolidation Bank, was created to take over the bulk of TOZ loans—some Kcs 110 billion, equivalent to almost one fifth of the stock of bank credit to enterprises—with eight-year maturities and at an interest rate of 13 percent (corresponding to its average cost of funds). On its liability side, the Consolidation Bank took over from the commercial banks a portion of their liabilities to the State Bank and of the deposits by the savings banks. By removing a number of questionable loans from commercial banks’ portfolios, the establishment of the Consolidation Bank was a first step in the direction of improving the efficiency of the banking system. However, the operation was very partial, and a large number of nonperforming loans remained on banks’ books. Moreover, the beneficial impact on both banks and enterprises was quite limited: banks gave up low-cost liabilities of a similar value, and, since no provisions were made for write-offs or write-downs, enterprises continued to carry TOZ debts on their books.

Further measures were undertaken in October 1991, when it was decided to transfer to the commercial banks Kcs 50 billion in bonds issued by the National Property Funds. Of this amount, Kcs 10-15 billion was earmarked for capitalization of the banks, thus providing some cushion against the effects of the inevitable bankruptcies. The rest was to be used to compensate banks for writing off loans of enterprises with large debts but good economic potential. Given the uncertainties surrounding estimates of the amount of bad and doubtful loans outstanding, it is not clear whether this operation alone will resolve the issue.

Interest Rate Policy

Czechoslovakia’s financial markets are not adequately developed to generate autonomously a market-clearing interest rate. The banking system is still in an infant stage, besides being saddled with weak balance sheets and strong oligopolistic elements. Furthermore, the instruments and markets that would enable the central bank to manage conditions in financial markets are still in a rudimentary state. Thus, interest rate policy was to be designed fairly independently of the targets for domestic credit, albeit with a consideration not to worsen existing disequilibria in financial markets.

The first important issue was the determination of interest rates for the first few weeks of 1991, when prices were expected to jump sharply. Interest rates in the final months of 1990 had not been high enough to prevent large-scale hoarding and capital outflows in anticipation of devaluation and price increases, but with the price jump in early 1991, an entirely new scenario would unfold. Should one attempt to maintain, ex post, positive real interest rates, or should one set interest rates in a forward-looking way with reference only to the expected inflation—and other factors—after the price jump had taken place? The authorities chose the latter course of action for a number of reasons.

First, raising interest rates would do little to reduce the size of the price jump. As argued above, the price jump was essentially caused by a number of supply-side factors, such as the adjustment of raw material prices and of the exchange rate. On the demand side, interest rates would not affect significantly the behavior of consumers. On the one hand, purchases of what had been shortage goods would be unlikely to be reduced or postponed because of the opportunity of earning an ex post real interest rate of a few percentage points during January-February. On the other hand, with the widespread knowledge that prices would jump on and after January 1, purchases for purposes of stocking up would have been largely completed prior to that date; besides, expectations of inflation during the price jump could be low or even negative, as the public, who had little prior experience of inflation, might at any time after January 1 expect that the price jump had worked itself out or even overshot.

Second, unduly high interest rates would have a number of undesirable consequences. Higher interest costs, with widespread cost-plus pricing, would in fact magnify the price jump. A rise in interest rates to levels rarely seen in Western European countries could give a wrong signal that inflation would persist, thereby leading to ingrained inflationary expectations. Finally, a short period of ex post negative real interest rates would contribute to reducing the inherited high indebtedness of enterprises and to eliminating any existing monetary overhang.

Nevertheless, interest rates needed to be high enough to protect the balance of payments position. Although controls on capital flows were to remain in place, it was clear that, as elsewhere, these controls would not prevent large capital outflows should domestic assets not bear an appropriate premium. In this context, it was of course crucial that the entire economic program be credible, in particular, that the exchange rate be judged adequate to withstand the expected adjustment of prices. On the basis of these assumptions, a premium of a few percentage points over foreign interest rates was judged to be sufficient to make domestic deposits attractive, and interest rate policy was geared to this objective.

The problem of the weakness of banks’ balance sheets posed an additional problem in the determination of appropriate lending interest rates. On the one hand, high lending rates would end up worsening the debt overhang problem for some enterprises and, more important, it would unjustly (and inefficiently) penalize all new investment projects for the “sins” of years of central planning. On the other hand, both the riskiness of loans to highly indebted enterprises and the weak financial position of banks called for relatively high lending rates. The permissible interest rate spread started relatively high, but was later narrowed in stages, reflecting mainly the authorities’ concern over the oligopolistic structure of the banking system, and anticipating steps to remove doubtful loans from banks’ portfolios. The reduction in the spread may, however, have made it more difficult for some of the riskier borrowers—including the emerging private sector—to get access to credit.

Although banks were formally granted some leeway in determining interest rates, the State Bank kept close control over rates with the aid of three instruments: the discount rate, a maximum lending rate, and moral suasion in the matter of deposit rates. The discount rate plays a large role in the determination of the banks’ cost of funds because the large banks rely heavily on State Bank refinancing. Initially, the discount rate was set at 10 percent (somewhat above its level of 8½ percent at the end of 1990), the maximum lending rate at 14 percentage points above the discount rate, and the notional target for deposit rates at a few percentage points above the discount rate. One-year deposit rates settled in the range of 13-16 percent, with lending rates ranging from 17 percent to 24 percent (Chart 5). Apart from loan risk considerations, the high spread between deposit and lending rates reflected high costs associated with the inefficiency of the banks; the oligopolistic structure of the banking system contributed to keep lending rates close to their maximum authorized level. The maximum lending interest rate was later reduced in successive stages to 17 percent by September, and the discount rate was lowered to 9½ percent.

Chart 5.One-year Interest Rate1

Source: Czechoslovak authorities.

1One-year deposit rate.

Developments in the first part of 1991 largely confirmed the validity of the assumptions on which Czechoslovakia’s interest rate policy was built. There was no evidence of capital outflows on a significant scale. Foreign currency deposits rose only moderately, reflecting a sharp deceleration relative to the growth in this type of deposits during 1990.16 In addition, interest rates did not unduly stimulate demand early in the year as both investment and consumer demand were in fact very weak during the first quarter.

Incomes Policy

An integral element of the anti-inflationary program was the containment of wage growth. To this end, the General Agreement concluded in January by the Government, employers, and trade unions established a cap on wage increases during 1991 consistent with a decline in real wages of 10 percent compared with December 1990—following an earlier decline of about 10 percent over the course of 1990. Wage increases in excess of this guideline would be penalized by prohibitive taxation of enterprises (the so-called excess wage tax), except in the case of those with fewer than 25 employees.

In practice, wage increases were contained well below the levels permitted by the General Agreement, reflecting the unfavorable financial position of enterprises and the weak bargaining power of labor in an environment of rising unemployment. Nominal wages in the second quarter are estimated to have been some 12 percent above their level at the end of 1990, implying a fall of over 20 percent in real terms (Chart 6). In the wake of these deep cuts, nominal wages were expected to increase somewhat during the remainder of 1991, but they should remain well within the agreed guidelines.

Chart 6.Average Employee Compensation1

Sources: Czechoslovak authorities; and IMF staff estimates.

1Includes wages, bonuses, and other payments.

Also as part of the General Agreement, a minimum wage of Kcs 2,000 a month was established in January—well above the previously existing lowest wages in the economy. The authorities are concerned that this minimum wage may contribute to the rise in unemployment and have resisted pressures for its indexation.

The wage restraint policy has served two important objectives. The first and more immediate objective has been to contain inflationary tendencies arising from the jump in prices that followed their liberalization. But a second important objective is to reinforce other efforts to strengthen financial discipline and to preclude excessive wage increases by state enterprises, particularly those with uncertain prospects. The current excess wage tax virtually excludes the whole emerging private sector because it does not apply to enterprises with fewer than 25 employees, and the Government is considering explicitly exempting all private sector firms from the excess wage tax in the near future.

Privatization

Privatization is the most challenging and, perhaps, the most critical of the economic reforms being undertaken. Czechoslovakia finds itself in the tenuous situation in which the central planning system has been dismantled, but the lack of widespread private property and of a clear profit motive places it some distance from a full-fledged market system. State enterprises account for virtually all economic activity. Their managers are unfamiliar with and untrained for a market system; moreover, their perception of a highly uncertain tenure creates perverse incentives for excessive wage and bonus payments, low investment, and squandering of the assets of the enterprises.

Compared with the divestment of large enterprises, the privatization of small enterprises is relatively simple, and began in January 1991. The “small privatization” program consists of sales of small businesses through auctions in which all resident Czechoslovak citizens can participate and for which bank financing has been provided. Auctions are being held as often as four times a week throughout the country and over 20,000 small enterprises—mainly but not exclusively retail outlets—had already been privatized by this method by November. Small enterprises are generally sold without their debts, which are repaid out of the proceeds of the auctions; but in a number of auctions held later in the year, some enterprises (typically somewhat larger ones) were sold with their liabilities. In addition, large numbers of small enterprises, which were expropriated after 1948, are being returned to their previous owners.

As regards privatization of larger enterprises, the authorities were determined to proceed at once, even at the risk of difficulties arising from the sheer scale of the effort and the lack of adequate expertise and developed markets, lest the inefficiency of the system of public enterprise management and control blunt the progress of all reforms. But the question was how to proceed with privatization. It was recognized that conventional sale methods could have only a limited role for a number of reasons, including the near impossibility of obtaining a meaningful valuation of the enterprises, the lack of domestic savings, equity and political considerations, the absence of sophisticated financial instruments and specialists, and the realization that foreign investors would be interested in only the “elite” of the enterprises. Therefore, the idea of free distribution of equity to the public through a “voucher scheme” was elaborated as a necessary method in terms of speed and comprehensiveness, and a desirable one on grounds of equity and political acceptability.

The voucher scheme is a plan to transfer the ownership of a major portion of the large enterprises of Czechoslovakia to the public in general. Every Czechoslovak citizen over the age of 18 will be entitled to acquire a voucher book that will endow him or her with 1,000 investment points. These points can be used to bid for shares of the enterprises being offered or, alternatively, can be tendered in exchange for shares in mutual funds. The mutual funds (“investment privatization funds,” or IPFs) can be established with few requirements beyond a minimum capital and a charter. The IPFs must make their investment objectives publicly known, in order to facilitate the decisions of individuals on the use of their vouchers. The IPFs will permit individuals to avoid getting involved in financial analysis of enterprises and to increase their possibilities for a convenient portfolio diversification.

Three successive “waves” of voucher privatization are envisaged, with the first one beginning in early 1992. A potential11½million individuals will be able to purchase and register a voucher book at a cost of Kcs 1,000 (about $33, or a week’s average wages). In a preliminary round, individuals will have the opportunity to pledge their vouchers to one or several IPFs. (The smallest denomination of vouchers is 100 investment points, so that an individual could opt for 10 different investments.) Next, the first of as many as five rounds of bidding for shares of enterprises will start, with enterprises being offered prices proportional to their book values. The system will not be a full-fledged auction in the sense of reaching market-clearing prices in the vouchers-for-shares exchange. For example, some trades will be concluded in the first rounds while further price changes will take place in later rounds. Thus, part of the equity of some enterprises may be sold at the price offered in the cur-rent round, while the remaining shares are offered again at an adjusted (lower) price in later rounds. Also, individual bids will be given some preference over IPFs’ bids in order to simplify the process: thus, it is expected that as soon as individuals’ demands are satisfied, it will be possible to auction the remaining enterprises among a few IPFs in a less complicated way. The final round will follow some—as yet undecided—mechanism either to allocate all remaining investment points or to determine what value, if any, unused investment points retain.

The basic structure of the voucher privatization scheme is probably the only one that can achieve privatization on such a major scale in a short period of time. Moreover, the scheme has clear political advantages in that it spreads private property widely and avoids favoring the old privileged classes. There are, however, some unavoidable trade-offs between these advantages and some of the shortcomings of the voucher scheme.

A central problem is related to the effectiveness of corporate governance under very diffuse ownership (spanning millions of small shareholders). Enterprise managers would be subject to little effective supervision by owners, with the result that the control of the enterprises would have changed little after privatization. Effective corporate governance requires the presence of at least one large shareholder. Two basic approaches to this problem have been proposed: a complete hands-off attitude, in the expectation that large active shareholders will spontaneously appear in the context of extensive profit opportunities for “corporate raiders,“17 and an active involvement for the state in designing and organizing financial intermediaries to exercise management supervision on behalf of the public.18 The Czechoslovak scheme lies somewhere in between these two polar approaches in the sense that, although the state does not take any initiative in designing structures of corporate governance, the creation of financial intermediaries, in the form of IPFs, is encouraged.19

There are some doubts, however, as to whether the IPFs will fulfill the role of active supervisors of management. In some cases, the IPFs may in fact serve as vehicles for management/worker buyouts, with employees of an enterprise creating an IPF for the purpose of acquiring stock in their company. But in the rest of the cases, IPFs may limit themselves to providing the possibility of portfolio diversification and other financial services to individuals; while not legally prevented from becoming active shareholders, the IPFs may not naturally tend to assume that role, because that may not be their normal line of business and they may not find it a particularly profitable activity. In addition, there is no mechanism to guarantee the creation of large shareholders, for example by selling shares in large blocks to IPFs.20

Aside from problems relating to corporate governance, voucher privatization is subject to various other complications. There may be serious difficulties in achieving “convergence” in a small number of iterations in the process of allocating shares to voucher investment points, and very inequitable situations may arise if the initial prices must be changed substantially in later rounds. Moreover, shares in many of the privatized companies may turn out to be a very illiquid investment for individuals, since it is unlikely that the stock market will comprise a very large number of actively traded stocks.

But perhaps the largest obstacle to a successful privatization is the debt overhang of enterprises, discussed above. Since the financial sector has not operated under market conditions, it is quite possible that some enterprises have negative net worth, which will make their privatization impossible even if they are given away. Even ignoring such extreme cases, highly leveraged positions may cause a large number of failures among the newly privatized enterprises under the prevailing conditions of large structural changes and contraction in aggregate demand.

Not all large enterprises will be privatized through the voucher method. The Government attaches importance to attracting foreign investment and the attendant capital, expertise, technology, and access to markets; at a minimum, those enterprises for which there is definite foreign investor interest (expressed in specific offers) are likely to be excluded from voucher privatization. Still, the scale of voucher privatization will be massive: it might involve some three fourths of the total of approximately 2,500 large enterprises in the first wave. Some further 10 percent to 15 percent are expected to be privatized through direct, standard methods mostly to foreign investors or, in some cases, to managers and workers. The remaining enterprises will require liquidation or, perhaps, restructuring; to facilitate the liquidation process, a bankruptcy law was adopted in July 1991.

As is the case for small enterprises, the laws on restitution of property provide for restitution or compensation for ownership of larger enterprises expropriated after 1948. In order to spare the privatization process from further complications, strict time limits have been set for both applications for restitution and the resolution of claims, and the law has granted the state the option to compensate the claimant in cash (or in equity shares) rather than with the actual property. Enterprises against which restitution claims are pending will not be entered into the privatization process. Any further liabilities that might arise as a result of the restitution process will be liabilities of the state, rather than of the new owners of an enterprise.

Despite the substantial difficulties still remaining, considering both its scale and its advanced stage of preparation, the privatization effort in Czechoslovakia appears to be one of the most advanced in Central and Eastern Europe. While Poland and Romania have passed legislation to sup-port voucher-type mass privatization, they are far behind Czechoslovakia in implementation.21 Hungary has embarked on a slower process of selling off enterprises on a case-by-case basis, while Bulgaria has yet to decide which method to adopt. The former German Democratic Republic has privatized a substantial fraction of industrial enterprises, but this process is becoming far lengthier and more difficult than had been expected, despite the favorable conditions associated with its integration in the Federal Republic of Germany (and the European Community).

See Calvo and Frenkel (1991a), Dornbusch (1991), and Fischer and Gelb (1991) for more general treatment of the sequencing problem in the Eastern European context.

Conditions for a successful convertibility are discussed by Portes (1991) and—more specifically for the case of Czechoslovakia—by Hrncir and Klacek (1991).

In July 1991, pending this tariff restructuring, the Government imposed temporary import quotas on certain agricultural products, in order to stem subsidized imports from neighboring countries.

See Aghevli, Khan, and Montiel (1991) for general considerations on the choice of an exchange rate regime.

The requirement of external support for reform programs is certainly a common feature in the formerly centrally planned economies. For a general assessment, see Collins and Rodrik (1991) and Diwan and Saldanha (1991).

As in other socialist economies, the tax system in Czecho-slovakia was highly distortionary, with extremely high profit tax rates. See Tanzi (1991).

The overall budget comprises the budgets of the Federal Government, the two republics, and the local authorities, as well as extrabudgetary operations. It does not include operations of the National Property Funds, to which the proceeds from privatization accrue.

All references to the fiscal balance in 1991 exclude certain stock adjustments that were carried out to adjust the distribution of assets and liabilities between the Government and other parts of what was formerly the state. These are listed in Table 2.

Foreign currency deposits of enterprises remained at about their level of December 1990, but were constrained by the new foreign exchange surrender requirements.

See, for example, Hinds (1991).

See, for example, Lipton and Sachs (1990).

The trade-offs involved in different mass privatization schemes are discussed in Borensztein (1991).

Moreover, with a view to furthering the risk-spreading role of the IPFs, the authorities are considering regulations that would limit their ability to acquire a very large interest in any given company or to concentrate their interests in only one or a very few companies.

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