II. Macroeconomic Effects on Western Europe of the Opening Up of Eastern Europe: Some Simulation Results
Author: Mr. Leonardo Bartolini1 and Mr. Steven A. Symansky
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Language:
English
Keywords:
BOOK; inflation risk; OECD Europe; NAFTA debate; producer-interest specific; investment goods; nominal exchange rate; PCPE model; investment scenario; PCPEs lead; financing effort; investment equation; Exports; Consumption
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Abstract

There is little doubt that the opening up of the previously centrally planned economies (PCPEs) and their transformation into market-oriented structures will ultimately have a profound impact on the economies of Western Europe and the rest of the industrialized world. Large investment opportunities in the East, large flows of world savings into this region, new markets for Western products, the normalization of the flow of primary products (mainly energy) from East to West, and ultimately a west-bound flow of manufactured products and savings are some of the channels through which the transformation of the PCPEs may affect the industrial countries.

1. Introduction

There is little doubt that the opening up of the previously centrally planned economies (PCPEs) and their transformation into market-oriented structures will ultimately have a profound impact on the economies of Western Europe and the rest of the industrialized world. Large investment opportunities in the East, large flows of world savings into this region, new markets for Western products, the normalization of the flow of primary products (mainly energy) from East to West, and ultimately a west-bound flow of manufactured products and savings are some of the channels through which the transformation of the PCPEs may affect the industrial countries.

Despite broadly optimistic views on the long-run effects of the integration of the PCPEs into the industrial world, opinions vary on the potential medium-term impact of developments in these countries on industrial economies. The diversity of opinions largely reflects uncertainty about the immediate direction and strength of reform in PCPEs, and in the former Soviet Union (FSU) in particular. In our view, however, it also reflects the limited efforts that have been made to provide a systematic assessment of the impact of the transformation on the economies of Western Europe.1

One of the main channels through which reform in the PCPEs is likely to affect Western Europe over the medium term—the financing of the transition process—provides a good example of an important issue that has received little systematic treatment. Clearly, the impact of financing the transition is likely to depend not only on the size and the duration of the outflows, but also on whether they take the form of unilateral transfers or of loans and whether they are expected to finance mainly consumption or investment.

In this paper, we take a new look at the macroeconomic implications of the financing of the transition process. Our analysis is based on a multicountry macroeconomic model that is extended to include a very stylized PCPE block and that allows for different assumptions on the sources and uses of capital flows. Most previous studies of the financing of the transition in the PCPEs that assume a possible shortage of capital in Western Europe have been based on static investment and savings regressions and back-of-the-envelope measurements of the interest rate impact of potential capital outflows. These partial equilibrium calculations are likely to miss important transmission mechanisms and intertemporal feedback effects that can be captured only within a unified macroeconomic framework.

Our findings can be summarized as follows: given reasonable (yet necessarily imprecise) assumptions on the likely developments in the PCPEs over the next ten years, West European capital markets are likely to experience only a mild squeeze from their concerted efforts to provide external financing to the East, and most macroeconomic aggregates are likely to suffer shocks significantly smaller than would be expected from a typical business cycle. Alternatively, our results can be viewed from a normative viewpoint as suggesting that industrial countries can well afford a significant (perhaps twentyfold) increase in financial assistance to the PCPEs before the impact on Western capital markets induces effects of business-cycle magnitude on economic activity and consumption.

Several assumptions underlie our conclusions. First, the flow of capital from industrial countries to the economies in transition is likely to be modest compared with industrial countries’ saving and investment, even when the most generous estimates of likely flows are adjusted upward toward estimates of needed flows. Second, projected outflows must be viewed from an intertemporal perspective, an approach more likely to capture other potentially beneficial effects that may be generated by a flow of capital from the West to the East. For example, if capital flows take the form of loans, anticipation of the subsequent loan servicing will tend to mitigate the eventual impact on industrial countries’ capital markets. But if capital flows take the form of grants, the transfer of wealth from West to East can be expected to trigger a strong demand for industrial countries’ output, a development that will also mitigate the contractionary effects on industrial economies, at least in the short and medium term. Similarly, to the extent that the PCPEs use industrial countries’ financing to rebuild their capital stock, these economies are more likely, in time, to repay their loans and possibly become net lenders on world capital markets. The worst possible scenario for industrial countries is one in which a transfer of funds to PCPEs in the form of grants is channelled into these countries and used to finance consumption. Even under these circumstances, however, we show that the likely impact on the performance of industrial countries (specifically, of Western Europe) is well short of dramatic.

2. Financing the Transition of the PCPEs: Estimates of Potential Flows

Plans to assist in the modernizing of the PCPEs by increasing capital flows from the industrial world have become a key policy issue in recent analyses of the transition process. The rationale for policies aimed at channelling capital flows toward the PCPEs is that despite potentially high average rates of return in these economies, credit constraints—presumably due to problems of moral hazard and adverse selection—limit these countries’ access to international capital markets and therefore prevents them from financing the transition themselves.

Our analysis does not aim at providing a new set of projections of likely or needed capital flows beyond the numerous estimates already available. Rather, we take stock of the uncertainty surrounding the ongoing process of reform in the PCPEs and use available estimates to develop scenarios and analyze the consequences of potential shocks, using a multicountry general equilibrium macromodel that focuses on the likely effects on Western Europe. If governments and international organizations in industrial countries can monitor the recipients’ use of capital inflows more efficiently than individual investors, then there is scope for increasing official external financing of the PCPEs without displacing a corresponding amount of private investment.

The investment needs of Eastern Europe have been evaluated in a number of recent studies, using a variety of methodologies. Not surprisingly, the range of estimates varies greatly, not only because of uncertainty about the value of the existing capital stock, the projected pace of reform, and the speed of economic recovery, but also because of differences in the basic approach to projecting capital flows. Two main approaches have been taken in the literature: a need-based approach and a source-based approach.2

Need-based estimates of capital flows to the PCPEs are usually derived in a twostep procedure. First, estimates of the existing capital stock in transition economies are formed, often based on estimates of investment flows in recent years, and corrected by a one-time depreciation charge that reflects the poor quality of capital inherited from prereform regimes. Then, based either on assumed rates of catch-up of these countries’ capital/labor ratios to those prevailing in industrial countries, or on assumed paths for income growth (and on the implied capital requirements), need-based estimates of capital flows to the PCPEs are obtained by subtracting estimates of existing capital stocks and of domestic saving from the target path of the capital stock.3 In general, need-based estimates tend to lie at the high end of the spectrum of projected capital inflows and tend to produce implausibly large forecasts—often as much as 40 percent—of investment rates over GDP. Typically, these forecasts are related to two assumptions: that most of the region’s investment will have to be financed externally, and that the catch-up with the production structure prevailing in the West will be relatively rapid.4

An alternative approach has been based on determining possible sources of financial flows over the short and medium term, including international institutions, governments, and private financial institutions. To a certain extent, these estimates take into account differences in the degree of creditworthiness of various destination countries and sometimes incorporate direct surveys of private investors. In a similar vein, likely flows of capital to the PCPEs have also been estimated using other episodes of international assistance, such as the Marshall Plan of the post-World War II period, as a basis for comparison. Such calculations are based on assumptions of similar absolute flows—such as those recorded after World War II (adjusted for inflation) or similar ratios of grants to the GDPs of donors and recipients (Collins and Rodrik 1991).

Table 1 provides a summary of estimates of annual capital flows to the PCPEs over the next few years; these estimates were obtained using the two methodologies discussed above. Some of the estimates were formulated in the early stages of the transition and probably did not take into account the significant progress made by countries such as Poland and the Czech Republic. But they very likely incorporated an overly optimistic projection of progress in the former Soviet Union (FSU).

Table 1.

Projected Capital Flows to Previously Centrally Planned Economies

(Billions of dollars per year)

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Need-based estimate. Catch-up in 10 years.

Source-based estimate (parametrized by Marshall Plan figures). Average over 4 years.

Source-based estimate.

Source-based estimate.

Need-based estimate. Catch-up in 10 years.

Source-based estimate.

Source-based estimate. Estimates based on Bosworth (1990) and a rule of thumb of foreign investment flows of 5 percent of GDP. Average over 5 years, phased out over the next 5 years.

Source-based estimate. Average over 5 years.

Source-based estimate. Projected net external financing in 1994 and 1995 (yearly average).

Need-based estimate. Average over 10 years.

Need-based estimate. Average over the first 10 years of the projection.

Need-based estimate. Average over 10 years.

Table 1 reveals the significant difference between need-based estimates and source-based estimates of capital flows to the PCPEs. Source-based estimates typically fall between zero and $70 billion a year (for all PCPEs), while need-based estimates typically range from a few hundred billion dollars to more than $1 trillion each year. In our simulations, we consider two alternatives: in one scenario, we project a flow of $70 billion a year for ten years from industrial countries to the PCPEs, beginning in 1994; in another scenario, we project a flow of $250 billion a year for the same period. The first figure corresponds to the highest source-based estimate available in the literature surveyed in Table 1 and is equivalent to about 0.3 percent of the GDP of the countries belonging to the Organization for Economic Development and Cooperation (OECD) in 1993; the second figure ranks in the low range of need-based estimates and is equivalent to about 1 percent of OECD GDP in 1993. We (and most observers) regard the latter figure as an exceedingly high estimate of the forthcoming flow of external (exogenous) financing to PCPEs that is obtained by correcting likely flows upward with a measure of needed flows. To place these figures in perspective, consider that the IMF (1994) estimates that lending, debt relief, and other financial assistance from international financial institutions, OECD governments, and other private sources averaged $10 billion per year to the Central European and Baltic countries in 1991-93 and $30 billion to Russia in 1992-93. Similarly, the publicly financed costs of German unification are estimated to have averaged 4-5 percent of Germany’s GDP (roughly $70-$90 billion) since 1991.

At least at first glance, $250 billion appears to be a rather small sum compared with the share of saving in GDP in OECD countries or with the size of the fiscal correction that would be necessary for European countries to meet the Maastricht targets.5 However, several authors (most notably Collins and Rodrik [1991]) have argued that even a financing effort of less than $70 billion each year will have a dramatic impact on OECD financial markets, raising interest rates by more than 200 basis points. The fear often expressed in policy circles is that a shock of this size may have a strong negative impact on industrial countries in general and on Western Europe in particular. In the next sections, we present a series of scenarios showing that under reasonable circumstances the impact on the performance of Western European economies in the next ten years is likely to be small. While the development of a more satisfactory model of transition economies remains an important task for future research, the conclusion of this paper seems unlikely to be reversed even as better data and knowledge on the workings of these economies become available.

3. Modeling Issues

The framework used for our simulations is provided by the IMF’s macroeconometric model, MULTIMOD.6 MULTIMOD is a dynamic multicountry model with rational expectations that measures cross-country linkages mainly through changes in the prices and volumes of traded goods and exchange and interest rates (all of which are endogenous in the model). The model is estimated using annual data from 1965-91, largely with pooled time series/cross-sectional techniques, and can be used to simulate the effects of exogenous and policy changes around a baseline forecast.7

In the industrial country block of the model, private consumption and investment are derived from intertemporal utility and profit maximization. Exports and imports of manufactured goods depend on relative prices and economic activity at home and abroad, as in a model of imperfectly substitutable goods. Export prices follow domestic output prices in the long run but respond to price movements in export markets in the short run. Import prices are defined as a weighted average of partner countries’ export prices. The production and exporting of oil by industrial countries are treated as exogenous, while the consumption of oil by these countries is endogenous. Net oil exports by the developing countries are treated as residuals to clear the world market of oil. Primary commodities other than oil (treated as a homogeneous composite good) are produced by the developing countries and sold at market-clearing prices. Demand for primary commodities by industrial countries is sluggish in the short run but fully responds to relative price changes in the long run. Real government spending is treated as exogenous. In the short run, tax rates are exogenous and deficits are financed through endogenous changes in public debt. Over the medium to long run, the government’s intertemporal budget constraint is enforced by adjusting taxes and transfers. The target supply of base money is exogenous in free-floating exchange rate countries but endogenous in countries that target their exchange rate (in order to maintain a constant open interest premium). The financial assets of the industrial countries are assumed to be perfect substitutes.

The developing countries are divided into two groups: capital-exporting countries (primarily oil exporters) and capital-importing countries. Both groups are the residual suppliers of oil and face explicit import demand functions. The capital-importing group is also assumed to produce and export manufacturing goods and primary commodities. These countries face a supply schedule for foreign loans based on a forward-looking assessment of their debt-servicing capacity; given the existing stock of debt (which defines a flow of debt service, at the going interest rate) and their exports (determined endogenously as import demand from the rest of the world), imports are residually determined, and are both consumed and invested. This region is constrained by supply in the short run, and output can rise only through an increase in the capital stock. Investment adjusts endogenously, responding one-for-one to changes in domestic and foreign savings.

For the purpose of this study, the PCPE model was based on the basic capital-importing model outlined above. The structure of the capital-importing developing countries was duplicated and then calibrated using aggregate data from PCPEs obtained from the IMF’s World Economic Outlook.8 One important change was made to the PCPE model because of the nature of the scenarios in this paper. As explained above, the prototype capital-importing region is constrained by financial resources and able to import only if it receives new capital inflows or increases its exports. Since all scenarios considered in this paper represent some form of new financing, we augmented this framework by including a debt-repayment equation, according to which this region repays some of its outstanding loans as output rises. This repayment of debt then results in a decline in imports.

The resulting PCPE model should be regarded as a rough approximation of the behavioral characterization of this region. For instance, labor markets may be more flexible and productive bottlenecks less severe in the PCPEs than in developing countries, so that output in these countries responds more strongly to demand shocks than is allowed for in our simulations (where output can increase only in conjunction with a rise in the capital stock). The severe limitations on our data also suggest that the simulations should be viewed as providing only an approximate indication of the potential response of the PCPEs to changes in industrial countries’ macroeconomic variables. However, the main reason to include a stylized model of the PCPEs in our framework is to capture some of the feedback effects from these economies of shocks originating in OECD countries. Since the magnitude of these feedbacks can be expected to be of second-order importance with respect to the original shocks, our approximation in dealing with PCPEs seems acceptable for the purpose of this study.

4. Alternative Reform Scenarios

a. Methodological considerations

A few methodological considerations need to be clarified before we describe the specific scenarios that we simulate with the model. First, we follow other studies in assuming that baseline trade shares remain constant at the most recent year for which data are available (1992, in our case), even with the opening up of trade with the PCPEs.9 (However, trade shares are free to adjust in response to endogenous changes in relative prices.) This assumption is not necessarily realistic, however. Several recent studies of prospective PCPE geographic trade patterns, often based on variants of the so-called gravity model, have suggested that countries such as the United States could benefit disproportionately from the reorientation of PCPE trade and may, in fact, increase their trade shares with PCPEs in the next few years.10 Given the uncertainty that surrounds these estimates, and the difficulty of addressing microeconomic issues of trade direction in a macroeconomic model, we have chosen—for the time being—to make the agnostic assumption of constant trade share and to sidestep the issue of trade restructuring.

Second, our focus is primarily on the effects of the financing effort on the economies of Western Europe that, in our framework, are captured by including specific models for Germany, France, Italy, the United Kingdom, and other European countries as a group.11 Naturally, our multicountry framework implies that the analysis cannot be conducted in isolation from developments in non-European countries, and the model is therefore simulated in its multicountry format. Results are reported, however, only for the PCPEs and European countries as a group. Results for the other countries are available upon request.

Finally, in order to isolate the effect of the financing effort on OECD countries, we have assumed a passive approach on the part of industrial country governments in all respects (for instance, regarding monetary policy), except for their involvement in the financing effort. In our simulations, in particular, the industrial countries’ monetary authorities are assumed to follow a neutral stance by targeting monetary aggregates at their baseline values. Alternative assumptions would have been to assume constant inflation targets or constant interest rate targets. Different assumptions about monetary policy lead to somewhat different short-run results in response to unanticipated shocks. With an inflation target, for instance, the expansionary effect of a demand shock of the type modeled here would be mitigated by contractionary monetary policy, while the opposite would be true with interest rate targets. However, to the extent that our study is concerned with the effects of announced (and hence largely anticipated) shocks, different assumptions on monetary policy would have minimal impact on our results.

b. Macroeconomic scenarios

The capital inflow scenarios considered in this paper are essentially a relaxation of the trade balance/financing constraint on the PCPEs, in the form of a rightward shift in the supply schedule of foreign finance (the financing burden is distributed among industrial countries in proportion to their GDP). The relaxation of the external constraint directly allows for an increase of PCPEs’ imports, which is allocated in the rest of the world in proportion to 1992 trade shares. For reference, Table 2 shows our baseline import and export shares of PCPEs with respect to the other nine blocks of MULTIMOD.

Table 2.

Nonenergy Trade Shares of the Previously Centrally Planned Economies with the Rest of the World, 1992

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Sources: IMF, Direction of Trade Statistics; UN Statistical Office, COMTRADE data base; and authors’ calculations.

Our scenarios are classified along three main dimensions.

(1) Size of the capital flow

As mentioned earlier, we consider two basic scenarios. In one case, we simulate the effects of a constant financing flow of $70 billion a year (in constant 1993 dollars) from OECD countries to the PCPEs for a period of ten years, after which the flow is gradually phased out (also over ten years). In a second case, we simulate the projected flow of $250 billion dollars a year (1 percent of OECD GDP, or about 6 percent of PCPE GDP). For convenience, we shall refer to these two cases as the low-flow and high-flow scenario, respectively, even though we view both scenarios as very optimistic projections of exogenous financing from industrial countries to the PCPEs in the next few years.

(2) Investment versus consumption shocks

To capture the effects of alternative uses of capital flow, we consider three different assumptions. The baseline assumption is that the allocation of the capital inflow between investment and consumption is determined endogenously by the model: as the transfer increases the economy’s disposable income, consumption and investment also increase, consistent with the model’s behavioral equations. Alternatively, we consider both the case in which the whole ex ante capital inflow is constrained to finance an increase in the capital stock of the PCPEs, and the case in which the flow is constrained to finance consumption. Clearly, endogenous changes in such variables as income, output, and prices affect consumption and investment in both scenarios. In the case in which the entire flow of foreign capital is destined to increase the domestic capital stock, we also consider a scenario in which the production capability of the PCPEs is enhanced by allowing for an additional growth in total factor productivity of 1 percent a year for ten years. This scenario is consistent with the frequently expressed view that the initial shortage of capital in PCPEs and the inflow of new Western-style capital in a relatively undeveloped production environment (but with a relatively well-educated and skilled labor force) are likely to lead to stronger productivity growth than could be expected based solely on an increase in the capital/labor ratio (see, for instance, Borensztein and Montiel [1992]). Estimates of the effects of increasing productivity by more than the assumed 1 percent can be obtained by scaling the results presented below.

(3) Loans versus grants

In all the scenarios described above, we assume that the financing takes the form of an outright grant. In practice, the financing of the transition is likely to involve a combination of grants, loans at market terms, and loans at concessional terms. In order to span the set of relevant alternatives, we considered a scenario that differs from the reference scenario (a $250 billion grant to be allocated endogenously between consumption and investment) only in the assumption that the exogenous external financing takes the form of a loan.

c. Results

Figures 1-6 summarize the results of our simulations for the period 1994-2008. The figures present results for five indicators for PCPEs: real GDP, consumption, investment, exports, and imports measured as a fraction of baseline GDP. The figures also include results for seven indicators for the industrial countries: real GDP, real and nominal long-term interest rates, consumption, investment, exports, and imports measured as a fraction of baseline GDP. We present aggregate results for Western Europe, but detailed results for the other industrial countries are available upon request.

Figure 1
Figure 1

High Flow-Grant Scenario

Note: Consumption, investment, exports, and imports are relative to baseline GDP
Figure 2
Figure 2

Low Flow-Grant Scenario

Note: Consumption, investment, exports, and imports are relative to baseline GDP
Figure 3
Figure 3

High Flow-Grant Scenario: Grant Used for Consumption

Note: Consumption, investment, exports, and imports are relative to baseline GDP
Figure 4
Figure 4

High Flow-Grant Scenario: Grant Used for Investment

Note: Consumption, investment, exports, and imports are relative to baseline GDP
Figure 5
Figure 5

High Flow-Grant Scenario: Grant used for Investment plus 1% Growth in Productivity

Note: Consumption, investment, exports, and imports are relative to baseline GDP
Figure 6
Figure 6

High Flow-Loan Scenario

Note: Consumption, investment, exports, and imports are relative to baseline GDP

Figures 1 and 2 present results for two scenarios in which import constraints facing the PCPEs are relaxed by $250 billion (labeled a high-flow grant) and $70 billion (labeled a low-flow grant) each year, respectively, for a period of ten years. The inflow of goods is endogenously allocated by PCPEs between consumption and investment. In both cases, the transfer implicit in the relaxation of the import constraint is assumed to be in the form of a grant.

Two features are immediately apparent from these two scenarios. First, the results from the high-flow scenario are, approximately, a proportional increase (by a factor of about 3.5) of the results from the low-flow scenario. This feature is intuitive, reflecting in part the linearity of most of the model’s behavioral equations and in part the small magnitude of the simulated shocks, particularly with respect to the size of the West European economies. Based on this proportionality feature, the scenario presented in Figure 1 will be used as a reference throughout the rest of the discussion; alternative scenarios can be derived by proportional rescaling.

The second feature apparent from these scenarios is that despite the large impact on the performance of the PCPEs, the simulated shocks have a moderate impact on West European economies. In the high-flow scenario, Western Europe’s real output increases by less than 2 percent in the short run and subsequently declines by about 1.5 percent below its baseline. The low-flow scenario projects a proportionally smaller response that is the result of two factors, particularly in the long term. First, even in the high-flow scenario, the projected capital flow amounts only to 1 percent of OECD GDP—clearly a modest shock. Second, there are feedback effects from the PCPEs to Western Europe (mainly, greater demand for Western Europe’s output, as we discuss later) that mitigate the negative medium-term effect of higher interest rates on output in the region. Broadly speaking, the simulations suggest that only flows on the order of one-half trillion dollars per year (some 10 to 20 times those currently discussed in policy circles) would produce fluctuations of roughly business-cycle magnitude in West European economies.

The qualitative results of our simulations are rather intuitive. The relaxation of the financing constraint facing the PCPEs allows them to increase imports, partly in the form of higher consumption and partly in the form of higher investment. Domestic output is roughly unchanged in the short run, because domestic production is constrained by the existing capital stock. The capital stock increases gradually, and the rate of investment is sufficient to raise output by a maximum of 4.5 percentage points. The trade deficit initially rises with the relaxation of the import constraint but subsequently falls slightly as external liabilities are reduced and output increases. However, in this scenario, the PCPEs are not projected to become net lenders on international capital markets.

In contrast with the uniformly positive response of output in the PCPEs to the assumed shock, the short- and medium-run effects of industrial countries’ output show the opposite signs. The transfers to PCPEs lead to a small expansion of output in the short run but to a broad recession in the long term as increased demand for exports raises interest rates and crowds out investment. The relaxation of import constraints in the PCPEs effectively shifts world demand from investment to consumption in much the same way as a bond-financed increase in government consumption. Thus, world output increases on impact but declines in the long run: the relative shortage of savings in the industrial world, which is manifested in an increase in real long-term interest rates of up to 160 basis points, crowds out investment and reduces the capital stock and consumption below their baseline values. Nevertheless, by the tenth year of the experiment, loss of output and consumption in the industrial countries is projected to remain around 1-2 percent.

Among all industrial countries, the resource shift from investment to consumption is strongest in Europe on account of the larger share of European exports to the PCPEs. Thus, the effects of the transition on Western Europe tend to exceed those on other industrial countries. By the same token, Germany and Italy display a stronger response in both the short and long run than their European partners. Reflecting their greater exposure to the import shock affecting the PCPEs, Italy and Germany also exhibit some real appreciation and a relatively large increase in real interest rates.

Figures 3 and 4 present two scenarios in which the ten-year grants for $250 billion annually that are used to relax the import constraint in the PCPEs are earmarked for consumption or investment, respectively. The high-flow investment scenario is complemented by an additional scenario (Figure 5), which allows for an increase in total factor productivity in the PCPEs of 1 percent a year for ten years (see Section 4.b.2 for a discussion). In all these scenarios, the funds transferred from industrial countries to the PCPEs are assumed to be in the form of grants.

The most noticeable feature of these three scenarios is that while the constraints on the use of resources have important output and welfare implications for the PCPEs, they have negligible differential effects on the West European economies. This feature reflects the marginal extent to which a constraint on the allocation of resources affects the main link between Western Europe and the PCPEs: the trade balance and its national saving/investment relation counterpart.

In the high-flow consumption scenario, output in the PCPEs remains essentially identical to its baseline value throughout the whole period, as the capital inflow is used almost entirely to increase consumption of imported goods. As the external financing flow begins to be phased out after ten years, however, consumption, the trade balance, and other economic aggregates tend to return to their baseline paths. Somewhat surprisingly, GDP in the PCPEs rises over the long term. The increase in investment that contributes to higher output largely reflects the decline in the real value of their (nominal) foreign liabilities resulting from lower world prices. In the investment scenario, on the other hand, the faster growth in output in the PCPEs that results from the increase in capital stock enables these countries to begin to pay off past debt. This repayment reduces import spending below the consumption scenario but correspondingly increases the amount of world savings. Although output increases, loan repayments impose a burden on the PCPEs, so that after ten years imports are 3 percent of GDP below the levels in the consumption scenario. The impact on industrial countries’ external sectors is small, however, and there are only very small differential effects on the industrial countries between these two scenarios. These effects become somewhat more visible in the scenario that allows for an additional increase in productivity growth (illustrated in Figure 5); in this scenario, output increases sufficiently to allow these countries to repay more of their net liabilities in the medium term.

As noted above, constraining credit to the PCPEs has little impact on lenders’ economic performance. In both the consumption and the investment scenarios, the relaxation of the import constraint on PCPEs leads to an initial increase in final demand for industrial countries’ output that is quantitatively similar to the reference case. Differences with respect to the reference scenario emerge over the long term, when the consumption scenario begins to contribute to the growing worldwide reallocation of resources from investment to consumption. The opposite is true in the investment scenario: interest rate increases are marginally lower, investment declines are somewhat smaller, and output rises slightly more than in the reference scenario. In the steady state, the investment scenario leads to a marginal increase in the output of West European and other industrial countries above the baseline, a result that is strengthened when allowance is made for a further increase in productivity in the PCPEs. In fact, the reduction in the current account deficits in the PCPEs, and the corresponding increase in the contribution of these countries to world savings (and thus to growth in Western Europe), would have been even stronger had not a worsening of the terms of trade of the PCPEs been required in order to increase their export shares in world markets.

To assess the effects of different contractual specifications of the financing flow, Figure 6 presents results of a scenario in which the capital flow takes the form of a loan at market terms (instead of a grant, as in the reference case). Broadly speaking, the main effect of channeling funds to the PCPEs in the form of a loan rather than a grant is to reduce somewhat the medium- and long-run quantitative impact of the shock without altering its qualitative implications (except for the profile of factor service payments). In this scenario, the PCPEs experience a somewhat weaker medium-term expansion in imports, consumption, and investment, while their GNP (not shown) is lower than in the grant scenario.

Partly because of the offsetting effects of lower interest rates and lower exports, and partly because the differences between this scenario and the reference scenarios are modest even for the PCPEs, the differences between the loan and the grant scenarios are negligible in Western Europe, particularly in the short run. In the medium and long run, however, the cumulative impact of a slightly higher rate of investment induces a marginal gain in West European output and consumption over the reference case, and West European GNP (not shown) is higher in the loan scenario by 50 to 100 basis points.

Despite the similarity between this case and the reference case, one interesting implication of the loan scenario is that a loan at market terms from industrial countries to the PCPEs does have a real effect on economic activity. In an efficient market with forward-looking consumers, a loan at market terms would not change the wealth of either PCPE or industrial country consumers. However, full Ricardian equivalence is hardly a feature of industrial economies, much less of the PCPEs. As liquid assets flow from industrial countries to the PCPEs, demand falls in industrial countries and rises (proportionally more, because of tighter liquidity constraints) in the PCPEs. In fact, one consequence of the presence of liquidity constraints on consumption is that consumers will behave myopically (relatively more so in the PCPEs), as if in the short term they ignored the different effects on wealth a transfer can have when it is specified as a loan rather than as a grant.

In summary, our simulations suggest that neither significant changes in the size of currently discussed financial assistance to the PCPEs nor changes in the contractual specification or final uses of the flow are likely to have a large impact on the performance of West European economies in the short and medium term, although some differences may emerge in the long run, and different contractual specifications will affect the allocation of welfare between the OECD countries and the PCPEs. As we noted, these conclusions reflect both the limited size of the planned financial flows, market imperfections leading to the prevalence of “liquidity” effects in the short run, and the offsetting nature of some of the feedback effects from the PCPEs to industrial countries.

It is worth observing that some of these conclusions contrast with predictions presented in related studies of the transition process in the PCPEs, most notably in terms of the strong impact of the financing effort on Western Europe’s interest rates. Based on a reduced-form estimation of savings and investment equations from industrial country data, for instance, Collins and Rodrik (1991) have estimated that if resource transfers average $90 billion a year, the impact on real interest rates will be nearly 300 basis points. Model simulations performed by Giustiniani, Papadia, and Porciani (1992) suggest that an average flow of about $200 billion a year (including capital flows to East Germany) will raise real interest rates by up to 300 basis points.

The difference between these results and those presented in our study reflect differences in the projected size of the financing flow, its distribution among countries, and the methodology used to assess its impact. Collins and Rodrik’s (1991) projections, for instance, mainly reflect their unusually low estimate of the interest-rate sensitivity of both saving and investment (in fact, saving is estimated to decline in response to a rise in interest rates, although the estimate is insignificantly different from zero). A sharp rise in interest rates is then required to induce a modest increase in industrial countries’ net saving. In contrast, our econometric model uses a structural approach to interest rate determination, so that investment and consumption respond to current as well as future changes in interest rates. The resulting saving and investment equation predicts little response to temporary interest rate changes but significant response to persistent (or long-term) interest rate changes.

The results of Giustiniani, Papadia, and Porciani (1992) lie between Collins and Rodrik’s and ours. Their study employs an analytical framework similar to ours (INTERMOD, an earlier version of the IMF’s multicountry model MULTIMOD), although it does not include a PCPE model. We are inclined to think that different parameter estimates leading to different elasticities of investment and consumption to changes in interest rates, and—possibly—Giustiniani, Papadia, and Porciani’s greater concentration of the financing efforts on Western Europe, may explain some of the differences in the interest rate response. In any case, their projected impact on industrial countries’ output is very similar to ours.

5. Concluding Remarks

An important ingredient of the recent debate on the transition of Eastern Europe and the FSU countries to a market economy has been the ability of industrial countries—and Europe in particular—to generate an amount of savings sufficient to meet profitable or socially desirable investment opportunities in reforming countries. In particular, the debate has attracted policymakers, largely because of the perceived market failures that prevent reforming countries from gaining access to international capital markets to the same extent, for instance, as Germany in its financing of the reconstruction of the former Democratic Republic. Governments of industrial countries and international organizations have viewed themselves as potential intermediaries (as well as monitors) of the financing of the transition of the PCPEs to market economies, a role that has led to questions about the ability of international capital markets to withstand an unprecedented and a potentially large financial effort. Indeed, case studies and debates in policy circles have often advanced the view that even a marginal increase in the currently planned financial assistance to the PCPEs could play a destabilizing role in international capital markets, leading to a shortage of savings in the Western world and spurring a significant rise in interest rates.

This paper has tried to provide a crude quantitative assessment of some of the issues faced by industrial countries (and European countries in particular) that are engaged in a concerted effort to channel financial support to the PCPEs. Our analysis remains, by all accounts, highly stylized, and its descriptive content is limited. Our focus has been exclusively on the effects on industrial countries—and, again, on Western Europe in particular—of potential efforts to finance the transition process in the PCPEs and has ignored the possible benefits to both regions of increasing specialization, increased trade, and other developments. Despite these limitations, we feel that our analysis provides a few tentative conclusions. In general, our findings indicate that (at least over horizons relevant to current policy considerations) Western Europe is unlikely to suffer more than marginally from the currently projected flow of financial assistance to the PCPEs. This financing effort can be expected to stimulate demand in the short run but to raise interest rates and cause some loss of output over the medium term. However, financial assistance to the PCPEs is unlikely to result in a dramatic shock to the capital markets of industrial countries over the medium term. The long-run impact of this transformation, and its political implications, are, of course, another story.

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This article is based on an earlier version of this paper, “Financing the Transition of Previously Centrally Planned Economies: Macroeconomic Effects on Western Europe,” IMF Working Paper WP/95/157, by the authors (1994).

1

Giustiniani, Papadia, and Porciani (1992); and IMF (1991, Chapter II) are notable exceptions.

2

See Collins and Rodrik (1991) for further discussion.

3

See for instance, CEPR (1990) and U.S. Congressional Budget Office (1990) for examples (and criticism) of this methodology. The estimates are crude because of the lack of reliable information on past investment and its productivity, the arbitrariness of the assumed catch-up process, and the fact that the estimates are not independent of variables (such as output and interest rates) endogenous to the transfer.

4

To be fair, few of the studies that have constructed need-based estimates of projected capital flows to the PCPEs interpret such estimates as projections of likely flows. Rather, these studies are usually aimed at highlighting the dilemma that the exceedingly high capital flow needed to assure rapid convergence of the PCPEs to an industrial production structure cannot possibly be accommodated within industrial countries’ capital markets.

5

Naturally, these figures represent a much larger fraction of the GDP of the PCPEs—approximately 6 percent for the $250 billion figure. Thus, as discussed later in the paper, it is not surprising that the impact on PCPEs may be much stronger than on OECD countries.

6

A complete description of the model, including its theoretical underpinnings and estimation details, can be found in Masson, Symansky, and Meredith (1990).

7

The baseline forecast is drawn from country-specific information provided by country economists at the IMF, aggregated and updated every six months as part of the IMF’s World Economic Outlook exercise. The baseline used in this paper is calculated using historical data through the end of 1993 and projected data thereafter. The long-run data are assumed to converge to a steady state defined by conditions that include the equality of each country’s real growth rate and interest rate, and zero primary fiscal and trade balances.

8

Thus, the parameters of the behavioral equations are kept at the values estimated from developing country data, but the macroeconomic baseline is based on PCPE data. Needless to say, the reliability of the macroeconomic series used to calibrate our PCPE model is limited. The series, however, reflect official estimates, adjusted by IMF country economists’ own estimates and projections.

11

Strictly speaking, the model of the other European countries also includes Australia and New Zealand. European countries, however, account for about 90 percent of this group’s output.

Within Same Series

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Cover Western Europe in Transition
Western Europe in Transition
Impact of Opening Up Eastern Europe
Author: International Monetary Fund
ISBN:
9781451954500
Publication Date:
15 Aug 1997
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781451954500.071
Pages:
190

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