Recent developments in Hungary, Czecho-Slovakia, and Poland justify cautious optimism that the sharp contraction of output of the past few years has ended or is likely to end soon. These countries have made substantial progress toward macroeconomic stabilization, price reform, trade liberalization, and, albeit to a lesser extent, systemic reform. In the rest of Eastern Europe, progress has been slower, the decline of output has been larger, and prospects are less favorable. In the countries of the former Soviet Union, most prices have been liberalized, but macroeconomic stabilization has not yet been firmly established, and systemic economic reform is only just beginning or is still in the planning stages.

Recent developments in Hungary, Czecho-Slovakia, and Poland justify cautious optimism that the sharp contraction of output of the past few years has ended or is likely to end soon. These countries have made substantial progress toward macroeconomic stabilization, price reform, trade liberalization, and, albeit to a lesser extent, systemic reform. In the rest of Eastern Europe, progress has been slower, the decline of output has been larger, and prospects are less favorable. In the countries of the former Soviet Union, most prices have been liberalized, but macroeconomic stabilization has not yet been firmly established, and systemic economic reform is only just beginning or is still in the planning stages.

The magnitude and duration of the contraction of output has been more severe than expected at the start of the reform process. As a result, in some Eastern European countries and in most of the states of the former Soviet Union there is considerable uncertainty about the future, and especially about when standards of living will start to improve on a sustained basis. What has become increasingly clear is that macroeconomic stabilization and systemic reform go hand in hand: macroeconomic stabilization needs to be established as rapidly as possible to prevent an acceleration of inflation that would make systemic reforms impossible; yet without systemic reforms to lay the foundations of a market economy, it may not be possible to persevere with the policies needed to sustain macroeconomic stability. It is thus particularly important that macroeconomic policies be directed to stabilization objectives in countries where these have not yet been achieved. In those Eastern European countries where progress has been made toward stabilization and output has started to increase, it is crucial to accelerate systemic reform in order to sustain and broaden economic growth.

Collapse of Output

A substantial drop in output was to be expected when the former centrally planned economies embarked on the process of political reform and economic transformation (Table 14).32 In many of the countries of the former Soviet Union, the sharp declines in output in 1990-91 were associated with the political upheavals that led to the breakup of the U.S.S.R., well in advance of the adoption of economic reform programs. Natural disasters or civil strife also contributed to the drop in output in Armenia, Georgia, the former Yugoslavia, and some other countries. In most countries there were substantial macroeconomic imbalances, large external debt burdens, or both. In Czechoslovakia, Hungary, and Poland, these macroeconomic imbalances were either not large or were rapidly reduced, and the declines in output have been less severe than in other countries. Throughout the region, the central planning system had created perverse incentives and accumulated a multitude of distortions. These distortions were exposed when central planning was abandoned and economies were liberalized and opened to world competition.

Table 14.

Former Centrally Planned Economies: Recent Output Developments

(Annual percent change)

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Excluding Albania.

The territory of the former Socialist Federal Republic of Yugoslavia.

Reliable, comparable economic data for the states of the former U.S.S.R. are not generally available; the estimates presented above should be interpreted as indicative of broad orders of magnitude.

Staff estimate.

Although there can be no doubt that output has declined dramatically in Eastern Europe, official statistics almost certainly overstate the contraction—and, in some countries, understate the recent expansion—because they do not fully reflect the growth of new private enterprises or of the informal sector.33 This is because Eastern European statistical agencies generally collect data only from large enterprises that were the focus of central plans in the period before reform. In Hungary, for example, the fourfold increase in the number of enterprises from end-1988 to mid-1991 is almost entirely accounted for by new private, limited-liability, and joint-stock companies that typically have less than 20 employees, whereas most state enterprises have more than 300 employees. There has also been an enormous increase in the number of new enterprises and in informal activity in other Eastern European countries. Official statistics may also exaggerate the decline in activity because pre-reform output was often overstated and because of index-number problems in measuring changes in output and inflation during the transition period.

A major factor behind the output collapse in Eastern Europe was unquestionably the dissolution of trading arrangements in the Council for Mutual Economic Assistance (CMEA) in early 1991 and the sharp reduction of imports by the former German Democratic Republic and the former Soviet Union.34 Intra-CMEA trade is estimated to have fallen by more than 50 percent in 1991; this affected not only the former CMEA trading partners, but also other countries for which the former Soviet Union was a major trading partner, such as India and Finland (in the latter case, output declined 6¼ percent in 1991 in part because of reduced demand from the former U.S.S.R.). In Eastern Europe, the exogenous drop in trade was compounded by a large terms of trade deterioration associated with the shift to world market prices, especially for energy imports. In the countries of the former Soviet Union, the decline in output has been exacerbated by disruptions in trade among these countries, by a lack of financing for imports from elsewhere, by a deterioration in the terms of trade of net energy importers, and by large increases in the price of energy imports. In all of the former centrally planned economies—with the recent exception of Czechoslovakia, Hungary, and Poland, which have successfully begun to switch their exports to the West, especially to the EC—the difficulty of finding new export markets has delayed the recovery of output.

Macroeconomic stabilization policies accompanied the introduction of reform measures and probably contributed to the initial drop in output in Eastern Europe. This was not the case, however, in the countries of the former Soviet Union, where the initial drop in output preceded the introduction of reform programs and the adoption of macroeconomic stabilization policies. In some Eastern European countries there were substantial budget and current account surpluses in the early stages of the reform programs, which might, ex post, suggest that macroeconomic policies could have been less restrictive. But the budget surpluses reflected, in part, an artificial increase in enterprise profits stemming from inventory revaluations. Moreover, the persistence of inflationary pressures in Bulgaria, Poland, and Romania suggests that, at least in these countries, there was only limited room for a more relaxed stance of financial policies. In Bulgaria and Romania, shortages of foreign currency reserves required the adoption of very tight financial policies that probably exacerbated the declines in output. In these countries, greater access to external financial resources could have mitigated the fall in output.

It is unclear whether the speed and sequencing of the economic reform process may also have contributed to the collapse of output. Eastern European countries moved rapidly to open their economies to world competition, to remove price controls, to reduce government deficits, and to stabilize inflation. These rapid changes were in sharp contrast to the slow pace of structural reform in financial and labor markets. It can be argued that a more gradual liberalization, timed to tie in more closely with the pace of structural reforms, could have cushioned the output shock. There are, however, important economic arguments against gradualism. Gradual price liberalization, for example, may encourage hoarding and inventory accumulation while postponing the correction of relative prices, thereby providing false signals for investment and employment decisions. Although there are limits to the pace of structural reform, more rapid progress was probably possible in a number of Eastern European countries. This would have attenuated the decline in output by increasing the incentives for enterprises to adapt to the new market environment by improving existing products and by developing new products in response to changes in relative prices.

More generally, it is not clear that gradualism was or is a realistic option. Apart from the lack of administrative ability to regulate the pace of liberalization, it is doubtful whether any government in an unstable political and economic environment would have the credibility to make gradual reform believable to markets or its own citizens. Once reform programs have started, the need to strengthen credibility leaves little room to revert to a more gradual approach. There was probably no feasible political alternative to rapid reform in any Eastern European country. In the countries of the former Soviet Union, attempts to slow the pace of reform would clearly increase the risk of macroeconomic instability.

In summary, the output declines in the former centrally planned economies reflect both standard macroeconomic forces that tend to produce downturns even in well-functioning market economies as well as major structural problems associated with political upheaval, the collapse of central planning, the dissolution of CMEA trading relationships, and exposure to foreign competition.35 Somewhat less restrictive macroeconomic policies, or a slower pace of reform, may have resulted in a smaller contraction of output in the short run, but this would have been at the expense of higher inflation. The persistence of the decline in output is, at least in part, a reflection of the uncertainties inherent in a situation in which the old command economy and its institutions have been abolished or have disintegrated, but the institutions of a market economy are not yet established.

Market Institutions

Sustained increases in standards of living will require comprehensive structural reforms to put in place the institutions of a market economy, including the ability of economic policies to stabilize the macroeconomic environment. It will inevitably take time for market-oriented institutions to develop and for the full benefits of systemic changes and structural reform to become apparent in economic performance. For this reason, it is important to move rapidly to implement needed legislative and regulatory changes and to privatize in order to accelerate systemic change and maintain the momentum of the reform process. To speed up the process of structural reform, Eastern European countries are putting increased emphasis on solutions that can be implemented rapidly. A recent example is the mass privatization program in Czechoslovakia, which may provide a workable model for other former centrally planned economies.

Macroeconomic stabilization will be more costly in terms of forgone output and employment—and hence more difficult to sustain—in the absence of systemic changes to establish the institutions needed to encourage the emergence of a dynamic market economy. Without systemic reform, liberalizing prices and stripping away the old control mechanisms may result in perverse incentives that can prevent price reform from increasing the efficiency of resource allocation and may jeopardize the sustainability of stabilization efforts. Perhaps the most fundamental requirement of a market economy is the clear establishment of property rights and the framework of laws that enable the exchange of those rights, enforce contracts, and set the rules for the entry and—what has proven to be much more difficult—the exit of economic actors into and out of productive activities.36 Only with clearly defined “rules of the game” will an entrepreneurial private sector emerge to absorb workers previously employed in state industries.

Most Eastern European countries have a rich legal tradition from the pre-communist era. In countries such as Hungary, Poland, and Romania, the legal framework was not entirely abrogated during the communist period, although many aspects of the legal system were effectively dormant. The legal system in these countries is similar to that in other continental European countries and is flexible enough to permit a wide range of modern, market-oriented activity. Additional legislation has been required mainly in areas such as antimonopoly, bankruptcy, securities, insurance, foreign exchange, and foreign investment. In countries such as Albania, Bulgaria, and Czechoslovakia, the legal system was largely abrogated during the communist period. Legal reform in these countries started in about 1990 and has been largely based on Western European models, although none of the countries has adopted the legal system of another country “lock, stock, and barrel,” as occurred in the former German Democratic Republic.

Although considerable progress has been made toward establishing the legislative framework of a market economy in most Eastern European countries, progress to put in place the administrative and judicial machinery for implementing and enforcing laws and for resolving disputes has, inevitably, been slower. The judiciary did not play an active role in commercial matters during the communist period; in those countries where it did, it treated state enterprises very differently from private actors. The judiciary is thus ill equipped to cope with the sudden expansion of activity in commercial and related areas—including, in a number of countries, rights to real property and questions of compensation or restitution for earlier expropriations. In much of Eastern Europe, and in eastern Germany, unsettled claims are tying up substantial amounts of property in litigation.

In the Russian Federation and the other countries of the former Soviet Union, there have been a number of decrees allowing, for example, private economic activity or small-scale privatization. In general, however, the establishment of property rights and reform of the legal system to provide an adequate framework for market activity have only just begun, including the removal of the multitude of anticompetitive laws and restrictive practices that have been in place for most of this century. Except in the Baltic states, there is limited knowledge of market-oriented legal systems and no modern legal tradition to draw upon.

In Russia, amendments to existing laws on foreign direct investment and privatization—including a bankruptcy law that would supersede a June 1992 presidential decree on bankruptcy—were submitted to the Supreme Soviet in July. Legislation on contract law and property rights will be incorporated in the revised Civil Code that is expected to be submitted to the Supreme Soviet by the end of 1992. In the Baltic states, where progress has been somewhat greater than in other countries of the former Soviet Union, a substantial amount of new legislation has been prepared or adopted, generally based on EC or Nordic models. Significant progress has been made in Mongolia toward establishing the legal framework for private property (including land ownership), banking, and taxation. However, even in these and other countries of the former Soviet Union where statutes have been drafted and legislation adopted, major problems of implementation and enforcement must be overcome to create an effective legal framework for a modern market economy.


The existence of a legal framework is a necessary but not sufficient condition for a modern market-based economy. It is also essential to reform the incentive system within already existing firms to encourage entrepreneurial activity and to promote an efficient allocation of resources. This is one of the central motivations for privatization: to make managers accountable to owners who have a clear interest in maximizing the value of the enterprise and who have the incentive to harden budget constraints, take entrepreneurial risks, improve organization, and resist excessive wage claims. Budget constraints must also be hardened, and management improved, in those enterprises remaining under state ownership.

There has been considerable progress in Czechoslovakia, Hungary, Poland, and Romania in privatizing (or restituting to previous owners) small enterprises, primarily in the retail and service sectors but also in construction, truck transport, and small industry. As a result, the growth of the private small business sector has been robust in the past few years and has helped to moderate the rise in unemployment in the face of sharp declines in measured output. Considerable progress in the privatization of small enterprises has also been made in Armenia, Estonia, Kazakhstan, and Mongolia. In Eastern European countries and the countries of the former Soviet Union, there has also been a proliferation of less formal private business activity, as epitomized, for example, by the widespread emergence of more or less impromptu sidewalk and roadside markets. The increase in small-scale businesses both reflects and contributes to the re-emergence or creation of an entrepreneurial class, and thereby to the reorientation of attitudes and mind-sets that will be necessary for a successful transition to a market economy.

Privatization of medium and large state enterprises has been less successful throughout Eastern Europe and has not yet started in the countries of the former Soviet Union. This is not surprising given the ambiguities concerning ownership rights, the lack of potential investors and entrepreneurs, and the difficulty of judging which state enterprises are viable in a market economy. Moreover, difficult issues of equity, valuation, the participation of foreigners, and a variety of other considerations make privatization one of the most political aspects of reform.

Some Eastern European countries have recently adopted measures to speed up the privatization of medium and large enterprises. In Czechoslovakia, the privatization process has accelerated in 1992 through sales of vouchers to citizens at a nominal fee (Box 2). In Hungary in late 1991, the direct involvement of the State Property Agency was reduced, and the scope for self- or investor-initiated privatization with the help of private investment advisors was increased. In Bulgaria, the legal framework for privatization was introduced in 1992. In Romania, 30 percent of the shares of state-owned commercial enterprises were transferred to five private ownership funds in mid-1992, and distribution of certificates of ownership of these funds has started. In Poland, the mass privatization program has slowed. Large-scale privatization has not started in the other Eastern European countries, although in some cases the necessary legislation has been drafted.

Even with mass privatization, it is inevitable that some enterprises will remain in the public sector for a number of years, perhaps because they are judged to be economically viable after a period of restructuring or because their closure would have unacceptable local or regional implications. The latter is particularly important in the countries of the former Soviet Union. For enterprises remaining in the public sector, hard budget constraints can, in principle, be established through commercialization by turning them into joint-stock companies responsible to a board of directors, perhaps as a first step toward privatization. The experience in Bulgaria, Hungary, and Poland, however, appears to be that commercialization, unless it is combined with significant incentives for managers and directors and a clear understanding that governments will not automatically provide credit, has little immediate impact on performance.

The privatization plans outlined by the Russian Government in March 1992 were made more concrete in July. The objective is to complete the privatization of small enterprises, primarily trade and distribution outlets, in 1993. A program for the mass privatization of medium and large enterprises through the issuance of privatization vouchers, and with the participation of foreign advisors and investors, will be announced later this year. Until the completion of privatization, managers will be held responsible for the performance of the enterprises. To this end, a presidential decree was issued in July 1992 requiring the conversion of all state enterprises into joint-stock companies by November 1, 1992, except for those enterprises that are joint ventures or are to be privatized by other means. A program for improved corporate management of public sector enterprises, including the introduction of hard budget constraints, will be implemented in early 1993.

The countries of the former Soviet Union have a particular problem in that most state enterprises are very large, and many dominate the economy of an entire city or region. To the extent that these firms are vertically integrated, they can be split up—for example, into retail and service shops and smaller manufacturing enterprises. Even with the privatization or commercialization of enterprises, however, there are likely to be many cases where governments will have to develop regional policies that might involve the support of restructured enterprises to ensure their viability during a transition period. This will increase the scope for privatizing these enterprises at a later stage.

In this respect, an approach not unlike that adopted by the Treuhand in eastern Germany may be appropriate. However, none of the countries of the former Soviet Union—indeed, none of the countries of Eastern Europe—has the administrative or financial resources that the German government has invested in the Treuhand. Technical and financial assistance from the international community will be needed to restructure enterprises before privatization where this is justified by a sufficiently high social rate of return. The limited resources available, and the intensely political nature of such decisions, imply that these cases will have to be carefully selected with the help of foreign investment advisors.

Restitution problems have complicated the implementation of land reform and the privatization of housing in most countries of Eastern Europe. In Romania, more than 40 percent of agricultural land is now in private hands, and the intention is to privatize another 40 percent by the end of 1992. In Albania, collective farms have been split up through a process of spontaneous privatization, resulting in the transfer of about half of total agricultural land to private hands, although restrictions still apply to land transfers. In Bulgaria, the restitution process has been streamlined, and claims have been filed for about 80 percent of agricultural land. In Poland, where most of the land remained in private hands during the communist period, and in Albania and Romania, the uneconomically small size of farms—in the case of Poland, a result of the policy of the old regime—remains a serious impediment to improved productivity in the farm sector. With the notable exception of Armenia, little progress has been made on land reform and the privatization of housing in the states of the former Soviet Union. In some countries, including the Baltic states, laws regulating the privatization of housing and land have been extensively debated and in some cases adopted, but restitution problems and nationality issues have delayed their implementation.

Voucher Privatization in the Czech and Slovak Federal Republic

The Czech and Slovak Federal Republic has recently introduced a comprehensive program of rapid privatization. The privatization program complements the “big-bang” price and trade liberalization implemented in January 1991 and continuing reforms in the fiscal and financial sectors. It has four components that are proceeding simultaneously: restitution of expropriated property (including houses) to former owners, auctions of small businesses, conventional sales of large enterprises to domestic and foreign investors, and the transfer of shares in enterprises to citizens through a voucher scheme. Over half of all small businesses were privatized in 1991; although they were sold without their liabilities, the net proceeds have been substantial.

Privatization of large enterprises, involving the transfer of both their assets and liabilities, occurs under the auspices of the Czech and Slovak Ministries of Privatization. From a total of approximately 5,500 large enterprises, at least 400 were prepared for liquidation, and some 4,000 were selected for rapid privatization. Of these, approximately 2,500 were scheduled for the “first wave” of privatization in 1992, and the remainder for the “second wave” shortly thereafter.

Managers of enterprises in the first wave were required to submit proposals for the method of privatization—by auction, public tender, negotiated sale, distribution through the voucher scheme, or by some combination of these—and outside proposals were also invited. In all, some 11,000 proposals were received. Almost 1,500 enterprises and banks—with a book value net of debt of some Kcs 500 billion (50 percent of GDP) and employing some 1.3 million people (almost 20 percent of the labor force)—were placed wholly or partly into the voucher scheme. About 60 percent of the book value of these enterprises was offered in the voucher scheme; the remainder was earmarked for conventional sales, for transfer to the municipalities, or for transfer to the Restitution Fund for eventual transfer to restituents. The remaining 1,000 or so enterprises in the first wave will be sold by conventional methods.

Citizens were invited to purchase 1,000 “investment points” (vouchers) each, in order to take part in a four- or five-round auction process for the shares of enterprises in the first wave. The purchase fee, which will cover administrative costs, was equivalent to one week’s average wages. For each enterprise, the number of shares created was directly proportional to book value; all shares were priced at 100 investment points for three shares in the first round of the auction, with this price to be adjusted in subsequent rounds. When shares are oversubscribed by more than 25 percent, bids are returned and all the shares are offered again in the next round at higher prices; where oversubscription is less than 25 percent, bids are scaled back and the enterprises are “sold.” Undersubscribed shares are sold at bid price, and the remaining shares are offered in subsequent rounds at lower prices. Prices are adjusted in consecutive rounds until virtually all available shares have been sold. Ownership will be transferred once all the rounds of the auction are completed—probably by year-end—even in the case of enterprises that were fully sold in earlier rounds.

Three quarters of those eligible, 8½ million people, purchased vouchers and participated. About 70 percent of participants avoided the complexities of direct bidding (and of ultimately owning shares directly) by placing their vouchers with private intermediaries—Investment Privatization Funds (IPFs)—about 400 of which emerged spontaneously once regulatory provision was made for them. The IPFs competed for individuals’ vouchers, many offering “guaranteed” returns of ten times the purchase price of the vouchers after one year. In addition to facilitating the bidding process for individuals, the IPFs have also alleviated, in part, concerns that the voucher privatization scheme would result in excessively diffuse ownership and so mitigate against effective corporate governance.

Individuals and IPFs were provided with over 600 “bidding offices” with on-line links to the central computer executing the auctions. Two rounds of bidding were completed by the end of August 1992. Participants were informed of the results of each round in the press, in the bidding offices, and by mail. In all, a little over 55 percent of the shares on offer were sold in the first two rounds, comprising both sales at bid price for undersubscribed shares and full divestment of 122 companies that were oversubscribed by less than 25 percent. After the first round, the prices of most oversubscribed shares were raised in direct proportion to the degree of excess demand, while the prices of most undersubscribed shares were reduced from 3 to 7 shares per 100 investment points. Of the 421 enterprises that had been oversubscribed by more than 25 percent in the first round, only 10 percent were oversubscribed again in the second round, indicating that the price adjustments had eliminated most of the excess demand. The results of the third round are expected in early October. Proposals for the second wave of large enterprises to be privatized are currently being received and processed by the Ministries of Privatization.

A stock exchange and an over-the-counter market, using technology developed for the voucher scheme, are being established to facilitate the emergence of an active secondary market in the shares of enterprises being privatized through the voucher scheme. A substantial reduction in the number of IPFs is likely once ownership is transferred: the largest ten IPFs already account for over 40 percent of the investment points placed with IPFs, and many that are not viable will disappear in the near future either through takeover or closure.

The voucher scheme has surmounted a host of practical problems and is proceeding as planned despite the current constitutional debate. Other transforming countries are now expressing interest in the Czechoslovak experience with voucher privatization as a guide for their own programs.

Macroeconomic Stabilization and Structural Reform

Recent developments in Eastern Europe highlight the close link between macroeconomic stabilization and structural reform. It is important to establish macroeconomic stability early in the reform process if inflation is high or if large increases in the price level resulting from price liberalization threaten to start an ongoing inflation process that would be difficult to correct and might escalate into hyperinflation. As recent and historical experience in Latin America and many other countries shows, hyperinflation distorts the price signals on which market systems depend and brings chaos to all aspects of economic life. In an environment of hyperinflation, systemic economic reform is impossible.

The Eastern European countries have been relatively successful in controlling inflation, which, although still high in some countries, is generally on a declining trend. To sustain macroeconomic stability, however, requires control of public budgets and of credit. This has proven to be difficult in a number of Eastern European countries, in part because of overreliance for government revenue on the shrinking financial base of the state enterprise sector. In these countries, and in the states of the former Soviet Union, major structural reforms of government finances and expenditures will be required in order to reduce public deficits and to achieve macroeconomic stability.37

In Russia and the other countries of the former Soviet Union, widespread price liberalizations at the turn of the year resulted in a large jump in the price level in January 1992 and in substantial, albeit considerably smaller, price increases from February to May, when energy prices were increased and some subsidies were removed. In March 1992, the Russian Government announced a number of measures to further tighten macroeconomic policies and to reduce inflation during the remainder of the year. During the second quarter of 1992, however, there were substantial slippages from the announced policies, including a large increase in the government deficit. In July 1992, additional measures were announced with the objective to reduce the monthly rate of inflation from about 20 percent at mid-year to high single digits by the end of the year. The fiscal measures aim to reduce the general government deficit on a commitments basis to below 10 percent of GDP in the second half of 1992, of which about half would be financed from the domestic banking system, compared with a deficit on a commitments basis of about 20 percent of GDP in 1991 and the first half of 1992. The monetary policy measures include limits on the growth of credit, positive real interest rates, and measures to broaden and unify the foreign exchange market. If these policies are not successfully implemented, there is a danger that inflation will accelerate.

Currency Reform in Estonia

On June 20, 1992, Estonia left the ruble area and introduced its own national currency, the kroon. Estonia not only became the first of the countries of the former Soviet Union to introduce an independent currency but also joined a small number of countries operating some form of a currency board.

The currency board was once a common arrangement to effect monetary stability in the colonial territories of European powers, but it lapsed into disfavor along with colonialism. A currency board, in substantially modified form, has nonetheless been retained by the Singapore monetary authorities and was reintroduced in Hong Kong in 1983 to forestall a general crisis of confidence in that economy and its currency. The Hong Kong system, which is probably the purest example of a currency board in existence today, succeeded in restoring stability to the financial system—in particular, to the Hong Kong dollar—within a week of its reintroduction. More recently, a modified currency board was introduced in Argentina and so far has proved effective.1 A currency board is a relatively simple institution to set up and run—an important consideration in countries where expertise in central banking is limited.

A currency board supplies or redeems local currency bank notes (and reserve deposits with the central bank if applicable) for hard currency at a fixed exchange rate without limitation. To instill confidence that it can honor this pledge, the currency board must have sufficient foreign exchange reserves to back its liabilities (the existing outstanding note issue and other relevant liabilities, normally commercial bank deposits). In this respect, Estonia enjoyed a rare advantage, compared with other states of the former Soviet Union, in that it had secured the return of a significant quantity of pre-war gold from the Bank of England, the Bank for International Settlements, and Sweden in an amount that was more than sufficient to back the currency 100 percent.

Once a currency board has been set up, the required supply of bank notes adjusts automatically to demand, and this is reflected in the assets of the currency board. If the demand for cash goes up, the foreign exchange necessary to acquire cash from the currency board needs to be satisfied through the balance of payments, either on the capital or current account. This occurs through the mechanism of rising domestic interest rates, as banks react to withdrawals of cash, leading to a return of cash by those with surplus holdings and the conversion of foreign exchange into local currency by those seeking to benefit from the more favorable return. The more flexible are interest rates and prices, the more effectively will such a system work. The ease with which a currency board can defend the local currency means that the local currency is extremely robust, almost as robust as the currency to which it is linked, with the additional advantage that seignorage accrues to the currency board and not to a foreign central bank.

If currency boards are more robust than conventional exchange rate pegs, why are the latter so much more common? The reason is that the operation of an independent currency board implies the loss of autonomy for monetary policy. An independent currency board does not act as a central bank: it cannot conduct open market operations or influence interest rates; it cannot intervene in the foreign exchange market; and it cannot act as lender of last resort to the government, banks, or enterprises. By excluding the possibility of inflationary government financing, an independent currency board enhances the credibility of the domestic currency. The government can, however, influence the provision of liquidity through its ability to borrow abroad or to obtain external financial assistance.

The Estonian currency board may, however, differ in a number of respects from more traditional currency boards. For example, the limited convertibility for capital account transactions implies restrictions on the conversion of kroon into foreign currency. The arrangements for the Estonian currency board have only recently been established, and it is not clear how it will work in comparison with more traditional currency boards.

The first stage of Estonia’s currency reform involved the conversion of ruble balances, in the form of both cash and deposits, into kroon. To avoid the conversion of unauthorized quantities of rubles, individuals wishing to convert rubles were required to register, with proof of residency, before the day of the reform. Those that did so were permitted to convert up to 1,500 rubles in cash into kroon at the conversion rate of 10 rubles to 1 kroon. Cash balances in excess of this amount could be converted at the less favorable rate of 50 rubles per kroon. Household deposit accounts with the state Savings Bank were converted at the same rate as for cash, with no upper limit. Cash balances held by enterprises and banks were collected by the Bank of Estonia, and those balances that were below the legal upper limits were converted into kroon at the rate of 10 rubles per kroon. All rubles on account, as well as ruble borrowings, were redenominated in kroon at this rate without limit. Special arrangements were made for correspondent accounts with the other countries of the former Soviet Union.

From the day of the reform, the Bank of Estonia has been committed to exchange kroon bank notes, and deposits of commercial banks with the Bank, for deutsche mark (and vice versa) at the rate of 8 kroon per deutsche mark, which was close to the prevailing market rate. To provide additional protection for the new currency, full convertibility is guaranteed only for valid current account transactions. Capital controls remain, although these may be relaxed in due course. Because any government borrowing requirement can only be met by the commercial banking system, the Estonian currency reform was accompanied by significant fiscal measures that put the government accounts into balance in order to limit the crowding-out of enterprises.

The early performance of the kroon has been auspicious. In the first few days, the street value of the kroon was nearly double the official exchange rate, but market rates quickly settled down. Feared withdrawals from the Savings Bank did not materialize, and instead the Savings Bank proved to be a net recipient of deposits. The currency board meanwhile accrued additional reserves by virtue of further issuance of kroon bank notes, reflecting the demand for cash. The stability of the currency board, however, will depend crucially on the successful implementation of the government’s stabilization program, the basic elements of which went into effect on the day of the reform. The currency board may be a robust arrangement, but no system can long withstand the absence of supporting policies.

1Kent Osband and Delano Villanueva. “Independent Currency Authorities: An Analytic Primer,” IMF Working Paper 92/50 (July 1992).

Most of the other countries of the former Soviet Union are also grappling with major budgetary pressures, with the problems being especially acute where subsidies are large, transfers from the former Union have been lost, and there are no natural resources to provide revenue. Most progress has been achieved in Kazakhstan, Kyrghyzstan, and the Baltic countries; all three Baltic countries have taken measures to balance the budget in the second half of 1992.

The tightening of fiscal policy in Estonia was done in the context of the introduction of a national currency, the kroon, and the establishment of a currency board that will effectively foreclose the possibility of the government financing its deficit through money creation (Box 3). The introduction of the kroon went relatively smoothly because of agreement between Russia and Estonia on a wide range of monetary and payments issues, including that rubles would be retired from circulation when the new currency was introduced. In July, Latvia announced that the Latvian ruble would become the only legal tender from July 20, effectively introducing a separate currency, although the new national currency, the lat, would not be introduced until the autumn.

There has been a serious lack of coordination of monetary policy in the ruble area, as evidenced by continued problems over the delivery of ruble notes and by divergent interest rate and exchange rate policies. Little progress has been made to improve coordination, although Russia has started bilateral negotiations with other ruble area members to arrive at an agreed set of rules for monetary policy. Among the members of the ruble area other than Russia, the commitment to remain within the ruble area has diminished. They have concerns that they will have little if any influence over monetary policy, that problems of cash shortages may continue, and that Russia may not be able to stabilize the ruble or to provide cash. As the commitment to the ruble area has weakened, there has been a large expansion of bank credit in some countries, particularly Ukraine; in others the ruble shortage has sharply constrained credit expansion, and credit conditions have been considerably tighter than in Russia.

In addition to Estonia and Latvia, a number of other countries had already announced the intention to introduce national currencies. Lithuania and Ukraine are expected to introduce national currencies this year; Moldova also intends to introduce a national currency, although the timing is uncertain. Belarus has already introduced a parallel currency alongside the ruble, and Azerbaijan planned to do so in mid-August. Some other countries are actively preparing contingency plans to introduce national currencies if discussions with Russia on monetary arrangements are not successful in the coming months.

So long as the ruble remains the currency of more than one country, it will be difficult to reduce inflation and to stabilize the value of the ruble in foreign exchange markets without extensive monetary cooperation. In addition, there is a need for effective agreements to enhance the ruble as a vehicle for trade within the ruble area, to encourage enterprises to make their own cross-border links, to simplify cumbersome trade and payments arrangements, and to abolish quantitative restrictions on exports. Only if the countries of the former Soviet Union recognize their ongoing economic interdependence and adopt cooperative solutions can they hope to attenuate the shocks from the disruption of interstate trade that played such a large role in the collapse of output in Eastern Europe.

The interdependence between macroeconomic stabilization and structural reform is illustrated by the problem of inter-enterprise arrears. This problem has developed in most of the Eastern European countries and, more recently and to a much greater extent, in Russia and other countries of the former Soviet Union.38 In part because of the absence of hard budget constraints, enterprises have been willing to accept growing levels of receivable claims on other enterprises, even though those enterprises might not themselves be viable in the new environment. The increase in inter-enterprise arrears has also reflected inefficiencies in the payments system; impediments to financial intermediation; the lack of structural change in the enterprise sector as reflected in the persistence of unwanted production and the lack of familiarity with market institutions; and, in Russia, the possible attempt to avoid paying the VAT, which was due only upon payment.

The accumulation of inter-enterprise arrears has greatly complicated privatization and has potentially serious implications for government budgets and, hence, for macroeconomic stability. The effectiveness of credit and monetary policies as anti-inflationary tools has been blunted, and tax collections, especially of the VAT, have been reduced. Moreover, there have been increasing pressures to loosen monetary policy to relieve a “credit crunch” and thereby to solve the problem of arrears. A durable solution to the problem of the continued buildup of inter-enterprise arrears must involve enterprise reform. Managers must be made more closely accountable for the financial performance of their enterprises, and bankruptcy-type procedures are needed to force the restructuring or closing of companies that are not economically viable. Governments must also persevere with tight financial policies, since managers will otherwise expect a bailout and will have no incentive to adjust.

Technical assistance is the key channel by which international agencies and countries outside of the region can contribute to a successful economic transition in the former centrally planned economies. These countries are facing the need to create new market-oriented legal systems and government institutions for formulating and managing economic policy where, in most states, none previously existed. Areas where technical assistance is urgently needed include fiscal and monetary policy management, financial sector reform, bank supervision, commercial law and regulatory reform, enterprise restructuring and management, privatization, statistics, and sectoral and infrastructural development. Since late 1991 a major ongoing effort to provide this technical assistance has been undertaken by the IMF, the World Bank, the Group of 24 industrial countries, and the EC Commission together with the Organization for Economic Cooperation and Development (OECD), the European Bank for Reconstruction and Development, and the Bank for International Settlements.