IV Economic Developments During the Stabilization Phase

Bijan Aghevli, Eduardo Borensztein, and Tessa Van der Willigen
Published Date:
March 1992
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The reform program was expected to have a considerable impact on the evolution of prices, output, and the balance of payments, through both the effects of the macroeconomic stabilization process and the transformation of the productive structure demanded by the creation of a market economy. Developments on the price and balance of payments fronts have been very encouraging, indicating that the reform program is progressing solidly. Although the decline in output was larger than anticipated, it is partly explained by the fall in demand for Czechoslovak exports from the members of the former CMEA.

Price Developments

Price developments following the big bang fell into two well-defined stages: the initial price “jump” in the first few weeks after price liberalization and the subsequent stabilization stage. The magnitude of the price jump widely exceeded the (optimistic) working assumption utilized in the formulation of policies. The price jump, as argued below, reflected primarily supply factors and had little to do with the stance of aggregate demand policies. The first surge in prices worked itself out in the first two months of the year and, after March, inflation was rapidly brought under control. This harnessing of inflation is perhaps the greatest success of the stabilization efforts that were part of the radical reform program of 1991.

The initial price jump came as no surprise. The collapse of the CMEA and such policy actions as the change in the exchange rate, changes in administered prices, and the removal of subsidies on certain goods had been expected to generate a large rise in the price level. In addition, there was likely to be a direct effect of price liberalization, as relative prices shifted in favor of goods previously in short supply.

At a macroeconomic level, the size of such a price jump is also related to the extent of “monetary overhang,” or the monetary disequilibrium existing at the controlled price level. Although the precise concept—and even more so the measurement—of monetary overhang is elusive, a desire of the population to reduce its holdings of money can stimulate an increased demand for goods and thus amplify the price jump. However, the adjustment of prices to the disequilibrium in the money market is probably a much slower process than the price response to direct measures, such as a devaluation of the exchange rate or the removal of subsidies. Moreover, indications in Czechoslovakia were that, owing to prudent policies in the past, any monetary overhang was small, and a sharp fall in retail sales as early as January (by over one fourth in real terms, compared with a year earlier) suggests that this assessment was correct.

During January-February, at the producer and retail level, prices jumped on average by about 45 percent. This increase was relatively small when compared with the increases in other previously centrally planned economies that had recently undergone price liberalization, especially considering that liberalization in Czechoslovakia coincided with the move to world prices in CMEA trade. This indicates that the shortages and monetary disequilibrium in Czechoslovakia were less severe, and that the need for an adjustment in relative prices, such as the exchange rate, was smaller.

Prices continued to increase after February, but at a rapidly decelerating pace. The prices of some of the important energy products were increased in May. Moreover, the initial price increases set off a chain reaction of cost increases in other sectors that took some time to work their way through the economy; this process included the partial indexation of wages permitted under the Government’s agreement with enterprises and trade unions. These secondary waves of price increases explain a good portion of the inflation in months after the price jump, but prices rapidly stabilized nevertheless (Chart 7). Between March and June, producer prices increased by 4 percent and consumer prices by 11 percent; in the four months from June to October, industrial producer prices fell by 0.5 percent and consumer prices rose by only 0.2 percent. The higher persistence of inflation at the consumer level is in part explained by a slower adjustment of prices at the retail level, as the initial increase was also more moderate in consumer prices than in producer prices.

Chart 7.Evolution of Prices

Source: Czechoslovak authorities.

Output Developments

In Czechoslovakia, as in all the other formerly centrally planned economies, output fell sharply following the structural reforms. In the first half of 1991, industrial output fell by 17 percent, construction activity by 26 percent, and the volume of retail sales by almost 30 percent, compared with the same period in 1990. For 1991, the fall in GDP may reach 12-15 percent. These figures may exaggerate the actual decline in output and sales owing to underrecording of private sector activity and, in the case of retail sales, of personal imports. In addition, output figures must be interpreted with caution, given the questionable value of some of the output produced under central planning. However, it is unlikely that the overall picture would change materially if it were possible to correct fully for these factors.

The contraction in output in state enterprises also caused a steady increase in unemployment from the beginning of 1991, with the rate of unemployment reaching 6 percent in October. Layoffs accounted for 90 percent of the approximately fifty thousand workers who became unemployed every month. Reflecting important structural changes in production, the regional disparities are sharp and increasing (Chart 8). In the region of Prague, for example, the unemployment rate was below 1.5 percent in October, while in most parts of Slovakia, where much of the industrial base is becoming obsolete with the changes in the pattern of international trade, unemployment already exceeded 10 percent.

Chart 8.Unemployment Rate1

Source: Czechoslovak authorities.

1End of period.

The decline in output was associated with a number of factors—some of them quite independent of the reform process—the relative magnitude of which is not easy to assess. The paper examines in turn the external shock associated with developments in the CMEA, the changes in structure of production, the combination of the price jump and restrictive policies, and the fall in domestic demand owing to uncertainty.

External Shock

The Czechoslovak economy suffered a double external shock from developments in the CMEA area. First, exports to the former CMEA area fell precipitously as the economic crisis in the former U.S.S.R. worsened and other Eastern European economies faced difficult adjustment processes. Moreover, as CMEA trade moved to a convertible currency basis, some of Czechoslovakia’s competitive edge was blunted and difficulties were experienced in trading under the new system. Despite some recovery after the first quarter of the year, the volume of exports to the former CMEA is estimated to have fallen by about two thirds for the year as a whole, and could account for a decline in output of 8 percent. Second, the switch to international pricing in CMEA trade meant a terms of trade deterioration for Czechoslovakia: the several fold increase in prices of energy and other imported industrial inputs could, by itself, account for a significant contraction in output, especially in energy-intensive sectors.

Changes in Structure of Production

Starting from a widely distorted position, the move to a market system together with the lifting of barriers to international trade necessarily implies large changes in the structure of production. Consumers, free from the “forced substitution” regime that made them buy whatever was available, will turn away from noncompetitive products in favor of imports or more acceptable domestic substitutes. It should thus be expected that many enterprises—and some entire production branches—would decline and perhaps not survive under the new system. This effect, per se, does not imply a fall in output, but only a change in its composition. An asymmetric speed of adjustment is to be expected, however, in the reallocation of production, because an expansion in the productive capacity of an enterprise requires time for planning, investment and recruitment, building of structures, and so forth, while a reduction or interruption of production can be effected almost immediately, especially under financial distress. Furthermore, the privatization prospects and uncertainties about the new environment may discourage enterprises from undertaking any long-term commitments to increase or restructure productive capacity, making their response even more sluggish.

Restrictive Policies After the Price Jump

Although a sudden price increase in the first weeks of 1991 was unavoidable, a tight and nonaccommodating stance for financial policies was thought to be essential to avoid the emergence of an inflationary process. In these conditions, it has been suggested22 that tight credit conditions, in conjunction with increased costs of raw materials and other inputs, would generate an aggregate supply contraction. The actual price jump was much higher than assumed when the (deliberately conservative) targets for fiscal and monetary aggregates were established, and financial policies were adjusted with some delay to accommodate the higher price jump. Moreover, for a number of reasons explained above, the policy stance was even tighter than planned, particularly in the first quarter.

Fall in Domestic Demand

Several factors combined to weaken demand by consumers and enterprises over and above the effect of tight financial and incomes policies.23 In large measure these factors derived from the uncertainty generated by the transition to a market economy. From the point of view of enterprises, large investment plans were almost precluded in the transition phase because of uncertainty and the expectation of privatization. Uncertainty about future rules and regulations concerning a broad spectrum of legal, tax, and environmental issues, and even about the structure of relative prices, makes it difficult to evaluate any investment project. Insofar as the prospective privatization would be likely to entail changes in corporate strategy, the logical decision by management would be that any large commitment of funds should wait for approval by the new ownership.

From the point of view of consumers, uncertainty about the evolution of the real wage and poor job security must have dampened what had been feared would be a spending burst after years of repressed consumption of domestic and imported goods. In addition—although reliable data on inventories are not available—the demand for (voluntary) inventory accumulation must have fallen sharply as the move to market rules eliminated the main motive for enterprises to keep large holdings of inventories, namely, the uncertain availability of inputs, while changes in financial markets curtailed the favorable financing that inventory holding had received in the past. The buildup of inventories that took place in the last few months of 1990, in anticipation of devaluation and price increases, probably accentuated the depletion of input inventories in 1991. On the other hand, as sales fell short of production, there is thought to have been an involuntary accumulation of output inventories, probably presaging a further fall in output.

Relative Importance of Supply and Demand Factors

An examination of the evolution of the different branches in the industrial sector may shed some light on the relative importance of the different determinants of the drop in output (Table 4). The data display the change in production level in the first half of 1991 relative to the same period in 1990. Although the output contraction is fairly generalized, the sharpest fall took place in sectors that are believed to include some of the products with the least comparative advantage, such as clothing and electronics.24 Another of the largest drops was in construction materials, reflecting the low level of investment in structures. That all sectors, with the exception of fuels, experienced a decline in output, however, does suggest that macroeconomic forces also played a role. There is no clear correlation between output and relative price changes—either negative, which would suggest a leading role for supply-side factors, nor positive, which would suggest a predominance of demandside factors.

Table 4.Output and Price Changes in the Industrial Sector
Change inChange in
Industrial SectorChange in Output1Relative Price2Relative Price3
Iron metallurgy-7.720.94.8
Nonferrous metallurgy-30.833.014.9
Chemical and rubber-18.9-14.827.9
Building materials-26.912.5-2.7
Paper and cellulose-4.924.27.0
Glass, ceramics, and porcelain-
Frozen foods, spring water, and tobacco-19.851.030.5
Total industry-17.6
Sources: Czechoslovak authorities; and IMF staff estimates.

January-June 1991 relative to January-June 1990 (in percent).

Relative price increase from January to June 1991 (in percent).

Relative price increase from July 1990 to June 1991 (in percent).

Sources: Czechoslovak authorities; and IMF staff estimates.

January-June 1991 relative to January-June 1990 (in percent).

Relative price increase from January to June 1991 (in percent).

Relative price increase from July 1990 to June 1991 (in percent).

Balance of Payments Developments

Several opposing influences combined to produce, in the aggregate, a better-than-expected balance of payments result during the first half of the year (Table 5). A very weak demand for exports by countries in the former CMEA area generated a drop in export receipts, while exports to other areas were also somewhat disappointing—especially in the first quarter. The fall in exports, however, was more than offset by a very steep drop in imports (Chart 9). The capital account suffered from delays in expected disbursements of official balance of payments support, but foreign investment inflows were substantial—albeit driven mainly by a single large transaction.

Table 5.Balance of Payments(In billions of U.S. dollars)
1990 RevisedFirst Half 1991
CMEA &Convertible
Current account-0.9-0.3-1.2-0.40.3
Trade balance-0.7-0.8-1.4-0.50.2-0.3
Exports, f.o.b.5.95.811.
Imports, c.i.f.-6.5-6.5-13.1-4.1-0.9-5.0
Of which: oil and gas2(-0.2)(-2.9)(-3.1)(-1.0)(-0.6)(-1.6)
Services balance0.
Income balance-0.30.1-0.3-0.1-0.1
Transfers (net)0.20.2
Capital account0.10.40.5-0.5-0.5
Direct investment (net)
Suppliers’ credits-
Net medium-/long-term credit extended-0.2-0.20.3-0.20.1
Net medium-/long-term credit received0.30.3-0.3-0.3
Short-term (net)-
Valuation changes, errors, and omissions-0.6-0.1-
Overall balance-1.4-1.4
Use of gross reserves1.1-0.5
Use of IMF credit1.0
Other official support-0.5
Other bank liabilities0.3
Short-term liabilities-0.3-0.3
Market borrowing0.5
Net other (including valuation changes)0.1-0.2
Memorandum items:
Total balance of payments support1.0
Gross reserves at end of period1.21.7
(In months of followingyear imports)(1.4)
Net reserves at end of period-2.6-2.6
Sources: Czechoslovak authorities; and IMF staff estimates.

Data were converted from transferable rubles to U.S. dollars at cross rates and therefore are not comparable to data for 1991.

Indicative only; data are on a trade basis and are not strictly consistent with the overall import figures shown.

Sources: Czechoslovak authorities; and IMF staff estimates.

Data were converted from transferable rubles to U.S. dollars at cross rates and therefore are not comparable to data for 1991.

Indicative only; data are on a trade basis and are not strictly consistent with the overall import figures shown.

Chart 9.Export and Import Volumes

Sources: Czechoslovak authorities; and IMF staff estimates.

The drop in exports to the CMEA countries, although larger than projected, was to be expected. However, the sluggish expansion of exports to market economies, particularly in the first quarter of the year, was something of a puzzle especially in light of the gain in competitiveness associated with the exchange rate depreciation and the policy of wage restraint (Chart 10). Clearly, the particular structure of the export sector of Czechoslovakia was not conducive to a rapid increase in exports to Western markets.25 Also, several other factors worked to offset some of the effect of improved competitiveness: the policy-induced reduction in exports of armaments; the increase in the cost of key raw materials imported from the former CMEA (Chart 11); the loss of economies of scale as demand from the former CMEA area and from domestic sources fell sharply; and the disruption of previous trading links as enterprises specializing in foreign trade were restructured.

Chart 10.Effective Exchange Rates

Source: IMF staff estimates.

Chart 11.Export and Import Unit Values

Sources: Czechoslovak authorities; and IMF staff estimates.

The low level of non-oil imports is obviously linked to the weakness of domestic demand, both for investment and consumption purposes. Imports may also have been dampened by a slow response of the import sector to bring onto the domestic market imported consumer goods that enjoy a competitive advantage over their local substitutes. An additional factor might have been the imposition of the temporary import surcharge on consumer goods. Although at its original level of 20 percent the surcharge might appear to be only a moderate influence, the fact that it was known to be temporary might have encouraged potential importers to postpone their purchase plans. Despite this relatively sluggish performance of trade with market economies, in 1991 the geographical composition of the international trade of Czechoslovakia shifted quickly toward Western countries (Charts 12 and 13).

Chart 12.Direction of Trade: Export

Sources: Czechoslovak authorities; and IMF staff estimates.

Chart 13.Direction of Trade: Imports

Sources: Czechoslovak authorities; and IMF staff estimates.

Tight financial policies and adequate interest rates—including a moderate premium over those prevailing in international capital markets—helped prevent major pressures on international reserves; the lack of large-scale speculative outflows was also reflected in the fact that the premium in parallel foreign exchange markets never reached significant levels after January 1.

See Blanchard and others (1991) on aggregate demand behavior in the transition phase.

As the sectors thought to have the least comparative advantage are also often those that exported significantly to the rest of the CMEA, it is of course difficult to discern the relative importance of the opening to competition and the loss of CMEA markets.

Prominent among Czechoslovakia’s exports are armaments, heavy machinery with a slow marketing process, and manufactures that may not be competitive outside the CMEA area; also potentially important are agricultural, steel, and textile products that face various trade barriers in Western Europe in particular.

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