Chapter

II. 1990–1993: Initial Stabilization and Reform

Author(s):
James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
Published Date:
October 2014
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Most countries faced extreme difficulties during the first years of transition. Output fell dramatically across the board as trade links and internal economic relationships were broken. Inflation skyrocketed as price and foreign exchange controls were removed. The countries with better initial conditions and more aggressive approaches to reform reached stabilization faster. In several other countries, however, conflict or institutional obstacles to market reforms exacerbated the transition challenges.

GDP growth

Source: WEO; various sources for some countries in early years.

Note: CEE average weighted by GDP, others unweighted.

By the end of the 1980s, imbalances in socialist economies had reached critical levels. Falling world oil prices undercut the Soviet Union’s export revenues and diminished its ability to support other socialist-bloc countries. Budget deficits ranging from about 7 percent of GDP (Poland, 1989) to over 20 percent of GDP (USSR, 1991) were covered mostly by printing money. At the same time, consumer prices remained fixed or heavily regulated, while all basic social services were provided for free. These policies overloaded economies with money that could not be redeemed for goods or services (the “monetary overhang”). In the USSR and other countries, supply deficits that were common for centrally planned economies turned into acute shortages of basic staples like sugar and soap. The contrast between these realities and the perceived wellbeing of Western economies inspired daring reforms that had seemed impossible just a few years before.

“Shock therapy” vs. gradualism

Across Eastern Europe, groups of economists debated blueprints for reforms. Many policymakers and members of the general public believed that sweeping transformation of economies and society could be accomplished within a couple of years, if not months. In Poland, a commission led by Leszek Balcerowicz finalized plans for market reforms in late 1989 (see Box 1). Implemented from early 1990, these reforms became known as “shock therapy”, a term coined by Jeffrey Sachs—an adviser to the Polish reformers—in the mid-1980s for reforms in Latin America.1

Meanwhile in Yugoslavia, the new prime minister Ante Markovic initiated a planned transformation to a market economy over the medium term. The stabilization and disinflation program formally launched in December 1989 involved abandoning socially owned, worker-managed companies and liberalizing exchange and import regimes. The aim was to correct economic, structural and institutional weaknesses of the economy in the context of a fixed exchange rate. The reforms were supported by an IMF arrangement approved in February 1990. The program initially achieved a large decline in inflation, at a relatively low cost in terms of output loss.2 However, it foundered in late 1990, in part because of the diverging interests of the Yugoslav republics.

In the USSR in 1990, a group led by Grigory Yavlinsky and Stanislav Shatalin came up with a plan for urgent reforms named “500 days”. It proposed extensive privatization of state property in the first 100 days, then price liberalization and removal of administrative controls in the next 150 days. The following 150 days would witness market stabilization after the initial price shock, and the last 100 days a renewal of economic growth. The newly elected Russian parliament supported the program. However, the Soviet parliament and government considered it overly ambitions. Fearing social consequences, President Gorbachev opted for a gradual transition instead. But this proved insufficient to address mounting problems or meet people’s desire for change.

Box 1.The “Balcerowicz Plan” in Poland

In late 1989 the new Polish government took advantage of the first window of opportunity to embark on a front-loaded stabilization and reform program. It was a bold approach with many risks, and many observers—including some at the IMF—were not confident of its success. Initial conditions were highly unfavorable:

  • Most prices were administered. Initial liberalization in an environment of cheap credit, open-ended subsidies, and fiscal deficits financed by the central bank had led to near-hyperinflation.

  • Foreign exchange was rationed, with the official rate fixed at a much more appreciated rate than the market rate; the current account deficit widened and Poland defaulted on external debt.

  • The labor market was not functioning, with high levels of over-employment. The capital stock was obsolete. Outside of agriculture, ownership was dominated by state firms.

The reform package was built around three mutually reinforcing pillars:

Tightening financial policies. The zloty was devalued and fixed to the dollar, supported by a stabilization fund and credits from the IMF and other international financial institutions. Interest rates were sharply increased. Tax-based incomes policy applied to all state firms, with penalties on wage increases above the norm. Fiscal tightening involved elimination of income tax exemptions and most subsidies.

Liberalizing the economy. Most price controls were removed, and energy prices were adjusted to reflect cost. Import restrictions and foreign trade monopolies were replaced by tariffs. Foreign exchange became freely available for most current transactions.

Building market infrastructure. Structural changes were launched to set up capital markets to facilitate ownership changes; to modernize and strengthen the banks; to improve regulatory and accounting standards; and to modernize the tax system based on income tax and VAT.

Results were positive, though mixed :

Nominal anchors held and financial conditions improved. The exchange rate peg held for more than a year, much longer than the targeted three months. Real wages declined during 1990–91. Initial inflation targets were exceeded, but disinflation resumed in the face of lower demand and import competition. Monetary aggregates remained under control and real interest rates were mostly positive. External performance was initially robust but real appreciation and the collapse of Comecon subsequently eroded competitiveness. Fiscal accounts over-performed in 1990, on the back of windfall corporate profits.

The output loss was deeper than expected. A sharp contraction in state firms was partly offset by private sector expansion. Employment declined less than assumed, as state firms hoarded labor in the hope of a policy reversal. While open unemployment surfaced, many laid-off workers found jobs in the private sector or took advantage of early retirement and disability provisions. Social safety nets based on product subsidies and employment guarantees were replaced by programs focused on unemployment, pensions, family benefits, and social assistance, but the generosity of some programs—such as unlimited unemployment benefits or liberal disability assessment—invited abuses.

In retrospect, the reforms were successful in stabilizing the economy and setting a sound foundation for a market economy. By end-1991, the corporate and financial sectors were reacting to market incentives and there were early signs of recovery; privatization was gaining grounds; and the credibility of market policies was well established. But as with the experience of many early reform efforts, there was a political cost: the government lost the 1991 elections.

Prepared by Robert Sierhej.

After the Soviet Union collapsed in 1991, worsening economic imbalances emboldened the new Russian President Boris Yeltsin to give a mandate for radical reforms to the government led by Yegor Gaidar. Largely following the “shock therapy” in Poland, the reforms in Russia started with removal of price and exchange rate restrictions in 1992, liberalization of external trade, and lifting of administrative controls at the enterprise level. However, the reforms quickly met with resistance. Vested interests successfully pushed for public financing to loss-making enterprises, and large-scale monetization of public sector deficits continued for several years.

The rapid reforms undertaken in Poland set an example for other countries in the region. They were followed most closely by Czechoslovakia in 1990 and, two years later, by the Baltic countries. Hungary, Croatia and Slovenia trod more cautiously, in part because they had more liberalized economies at the start of the transition and less of a need for rapid change. Albania, Bulgaria and FYR Macedonia tried to implement quick reforms and made some initial progress. But the transition pace in these countries subsequently slowed, because of rising economic and social challenges. Eyeing this experience, Ukraine, Romania and Belarus adopted a gradualist approach, delaying or avoiding reforms.3 Meanwhile, intensification of conflict in the former Yugoslavia hampered economic transformation, despite its initially more market-oriented economy.

Sequencing of reform

Closely related to the question of speed of reform was sequencing, with some suggesting that liberalization, and especially privatization, should have waited until adequate legal and institutional frameworks were in place in which the private sector would operate—and taking China’s transition as a model. Like many of the early reformers, the IMF’s view was clear, with the approach towards Russia’s first program in mid-1992 characterizing most of the early programs: “…[I]t was important to move as quickly as possible with all the key changes, especially macroeconomic stabilization, liberalization, and privatization. The IMF recognized that many [structural] reforms would take years to complete… But this was not seen as a reason for postponing the main stabilization and liberalization measures.”4 The approach reflects the reality that a China-style sequencing and gradualism was neither feasible nor desirable for the European transition countries. Unlike in China, the collapse of industrial and trade structures meant economies were mostly already in sharp decline and the new governments (of new countries, in many cases) were struggling to establish credibility, stability and control. Liberalization, hard budget constraints on state firms, and (inevitably far from perfect) privatization were preferable to allowing private interests to move into the vacuum left by the collapse of central planning and administrative control, by stripping assets of public companies and extracting rents from price and trade distortions. And importantly, where pursued vigorously, the broad-based reform agenda allowed the emergence of brand-new firms, which became the engine of growth as recovery took hold. 5

Early reform outcomes

The full scope of transition challenges and related trade-offs became apparent only when the actual reforms commenced, albeit half-heartedly in many countries. Broadly as expected, the centrally planned systems ground to a halt in nearly all economies. However, the new market-based mechanisms were slow to emerge. Many economic and trade linkages within the former communist bloc collapsed, aggravated by the painful dissolution of the former USSR and Yugoslavia, and individual producers faced a long road towards reintegrating into local and global supply chains. Many plants and factories ceased production, as their output met no demand under the new conditions. In turn, they stopped paying wages, or, in some cases, paid them in kind with their own products. As a result, output collapsed or shifted into the informal “gray” economy.

Timing of macro stabilization

Source: WEO; various sources for some countries in early years.

Note: Colors reflect regional groupings.

Cumulative GDP contractions in the first three years of transition ranged from about 13 percent in Poland and Czechoslovakia to about 25 percent in Bulgaria and Romania, 30–40 percent in the Baltics, Russia and Ukraine, and 50 percent in Moldova.6 Moreover, in a few countries the output contraction extended long beyond the first years of transition. At the same time, there are reasons to believe that the imperfect Soviet-style statistics (focused on “material product”) exaggerated the scale of early output losses. On the production side, much of the decline came from falling output of heavy equipment that was of questionable value outside the communist trade and output system, while emerging goods and services sectors were not fully captured in the statistics. Falls in living standards were overstated from the consumption side too: prices went up (so measured real incomes fell) but little or nothing had been available at the low prices and a lot was available at the new higher prices. In addition, queuing and other costly resource-using, rent-seeking activities from before the reforms had never been counted.7

Budget revenues collapsed as well, as old revenue channels splintered and new taxation systems were not yet established. Delays in restructuring state-owned enterprises (SOEs) implied a need to cover their losses as well. In nearly all countries, the resulting large public sector deficits were financed by printing money. Adding to the inherited “monetary overhang”, this stoked hyperinflation in many countries. In the first year after the controls were removed, prices jumped by about 7 times over in Poland, 26 times in Russia and over 100 times in Ukraine. Hyperinflation and the bankruptcy of government-owned banks, like Sberbank and its branches in Russia and other former Soviet countries, wiped out the life savings of ordinary people. Many workers of defunct state-owned companies lost their jobs and faced extreme difficulties adjusting to the new realities.

For many countries, the economic contraction and accompanying currency devaluation made external debt service unbearable. Over 1990–92, Poland and Bulgaria successfully restructured their external debts under the Paris Club framework, in the context of IMF-supported programs. For the former Soviet republics, the solution came as a deal brokered with Russia and the Paris Club. As a result, Russia assumed responsibility for all debts of the former USSR to official creditors, and negotiated their restructuring with the Paris Club. In exchange, it took all former USSR property abroad, as well as its claims on other countries (mostly hard-to-recover claims on developing countries that had received economic and military assistance from the USSR). Along with its assets, debt of the former Yugoslavia was apportioned to the states resulting from its dissolution, paving the way for the countries to reach debt restructuring agreements with the Paris and London Clubs.

IMF support for early transition

At the outset, the IMF assumed the lead role in channeling international assistance to the former communist countries, with other institutions—including the EBRD, created in 1991 primarily to support the nascent private sector—playing increasing roles as transition advanced.8 During this period, the IMF provided advice and technical assistance in areas such as upgrading taxation systems, establishing modern central banks, and adopting international standards for statistics and for fiscal and monetary data reporting. Progress in implementing recommendations varied considerably, very much depending on the authorities’ program “ownership” and commitment to reforms. In addition, the IMF helped meet the urgent early needs to strengthen institutional capacity and develop understanding of the market economy via a wide range of training courses, provided both at headquarters and at the new Joint Vienna Institute.9

Divergent transition paths

The results of the first years of transition were very uneven. Poland, the Baltics and the other countries that embraced “shock therapy” reforms went through the transition faster. But there were still high initial social costs. In Poland, for example, the unemployment rate reached 16 percent, as over a million people lost their jobs. Bold reforms set these countries firmly on the path to economic restructuring and recovery. By 1992, the Polish economy stabilized, and then began to grow. The other Central European economies and the Baltics followed closely, with reversals of their output declines already in sight.

The situation was different in countries such as Belarus and Ukraine, which had stayed longer in the Soviet system and gone deeper in suppressing private sector initiative. These countries often preferred a gradualist approach to reforms and sought to maintain features of the old system. They could not escape the initial sharp economic contraction but lagged behind in the post-transformation recovery. In these countries, the initial stabilization attempts—including those supported by the IMF—did not produce the intended results, and economic slump extended well beyond the early 1990s. And in the former Yugoslavia and Moldova, policy challenges were aggravated by conflict and civil wars.

See, for example, Stiglitz (1999) and Dąbrowski et al (2000), while Husain and Sahay (1992) discuss the impact of sequencing in privatization.

Estimates refer to cumulative output declines over 1990-92 except for Baltics and CIS, where the comparable transition period is 1992–94.

Lipton and Sachs (1990) model some of these effects (including pre-transition repressed inflation). Blanchard (1997) uses alternative measures such as industrial production. See also Åslund (2007).

“By far the most important actor in providing assistance during the early stages of the transition is the IMF… Apart from macroeconomic significance, its programs provided a strong boost to genuinely-committed reformers in transition economies. Once the goals of economic stabilization are achieved, other actors have the potential to play in institution-developing and sectoral problems.” Dąbrowski (1995), p4.

The JVI was established in 1992 in cooperation with the Austrian authorities and other international partners. Examples of critical areas of support included the creation, from scratch, of monetary authorities in the former Soviet republics and the development of national treasury systems to enable budgetary planning and control.

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