The countries in transition—the former centrally planned economies of central Europe, the former Soviet Union, and Mongolia—have adopted, or are in the process of adopting, economic reforms on an unprecedented scale. These countries are now in different stages of the transition to market economies, with central Europe broadly more advanced, having started earlier. Some of the countries in transition—notably the former Czech and Slovak Federal Republic, Estonia, Hungary, Latvia, and Poland—have made significant progress in macroeconomic stabilization. Most, however, still face difficult fiscal problems stemming from the web of soft budget constraints and state subsidies, increases in outlays for social benefits and structural reform, or reductions in revenues because of output declines and administrative difficulties. Containing inflationary pressures will require tight control of government budgets and of credit creation, while reductions in subsidies, hard budget constraints on enterprises, and further privatization will be required if firms are to respond fully to market forces. Both macroeconomic stability and structural change are crucial to ensuring sustainable increases in living standards in the years ahead.

The countries in transition—the former centrally planned economies of central Europe, the former Soviet Union, and Mongolia—have adopted, or are in the process of adopting, economic reforms on an unprecedented scale. These countries are now in different stages of the transition to market economies, with central Europe broadly more advanced, having started earlier. Some of the countries in transition—notably the former Czech and Slovak Federal Republic, Estonia, Hungary, Latvia, and Poland—have made significant progress in macroeconomic stabilization. Most, however, still face difficult fiscal problems stemming from the web of soft budget constraints and state subsidies, increases in outlays for social benefits and structural reform, or reductions in revenues because of output declines and administrative difficulties. Containing inflationary pressures will require tight control of government budgets and of credit creation, while reductions in subsidies, hard budget constraints on enterprises, and further privatization will be required if firms are to respond fully to market forces. Both macroeconomic stability and structural change are crucial to ensuring sustainable increases in living standards in the years ahead.

Economic Transformation in Central Europe

Among the transforming countries of central Europe, the former Czechoslovakia, Hungary, and Poland have made the greatest progress in macroeconomic stabilization and structural reform. In these countries, output has begun to recover, and inflationary pressures have been relatively contained (Chart 21). As the reforms already in place begin to take hold, and assuming that further reforms are carried out as planned and that inflation is contained, real output growth is expected to rise during the rest of the decade. Bulgaria and Romania have also begun to implement many important structural reforms, although both countries have been less successful in macroeconomic stabilization. Reform is still in its very early stages in Albania. Civil conflict in most of the former Yugoslavia has resulted in hyperinflation and widespread economic disruption, although Slovenia, which has been insulated from the conflict, is an exception, and output declines appear to have come to an end in Croatia.

Chart 21.
Chart 21.

Central European Countries in Transition: Inflation

(Monthly percent change in the consumer price index)

Bulgaria and Romania began their reform efforts from a more difficult starting position and a harsher external environment than other central European countries, and these factors, rather than a weaker initial commitment to reform, explain their relatively weak economic performance. Both countries were dependent on primary goods imported from the former Soviet Union and were disproportionately affected by the collapse of trade among members of the Council for Mutual Economic Assistance (CMEA). Bulgaria inherited a large overhang of debt contracted under the previous regime, and a lack of progress toward an agreement with its commercial creditors on a comprehensive debt- and debt-service reduction package has undermined its trade performance. In Romania, the accelerated repayment of debt under the Ceaucescu regime left the country with an impoverished population and an obsolete capital stock. The flow of foreign official financial assistance to both countries has been considerably less than that to other central European countries. Nevertheless, the sharp declines in output in the past few years appear to be coming to an end, and growth is expected to pick up gradually over the medium term. Inflation has proved difficult to control in both countries, but the implementation of appropriate reforms as planned should lead to a moderation of price pressures in 1993 and beyond.

A disturbing development in most of the central European countries in 1992 has been the emergence or continuation of considerable strains on government budgets. Although fiscal deficits in 1992 were the equivalent of 2 percent of GDP in Romania and 11 percent of GDP in Bulgaria, these figures understate the underlying imbalances because of temporary revenues from unsustainable inflation and, in the case of Bulgaria, debt-service arrears. Deficits were 8½ percent of GDP in Hungary and 7¼ percent of GDP in Poland in 1992 (Table 16). A key feature of these budgetary pressures has been the dramatic decline of tax revenue in most countries (Table 17), in large part because of the steep drop in output, which has cut tax revenue on turnover and business profits. Business tax revenue was also adversely affected by the collapse of institutional arrangements whereby the government had direct access to state enterprises. Some transitory factors have also reduced revenue. The introduction of new taxes, such as VATs, are important reforms, but there have been difficulties in implementation that have led to revenue shortfalls. An important part of the fall in tax revenue has also been a consequence of progress in the structural adjustment process. Profit taxes have fallen as an increasing share of activity has moved to the emerging private sector, which has proved difficult to tax owing to inadequate administrative machinery, while at the same time the profits of state enterprises have collapsed. Bank profitability also fell as banks made provisions for potential losses from the bankruptcy of their debtors, particularly in Hungary. Finally, payroll taxes have fallen as excess labor has been shed by enterprises and, in Hungary and Poland, as substantial payment arrears have built up.51

Table 16.

Countries in Transition: Government Budget Balances

(In percent of GDP)

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General government, excluding special funds.

Includes import subsidies.

Table 17.

Central European Countries in Transition: Tax Revenue During the Transition

(In percent of GDP)

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Source: Vito Tanzi, “Fiscal Policy and the Economic Restructuring of Economies in Transition,” IMF Working Paper 93/22 (March 1993).

The sudden and pronounced fall in government revenue has not been matched by an equal drop in public spending, notwithstanding the substantial cuts in subsidies that have already been implemented in almost all countries. Moreover, as the adjustment process proceeds, new pressures on expenditures will arise. Before economic reform, social benefits were provided not only by the government sector but also, to a large extent, by state enterprises. A successful transformation of these enterprises will shift greater responsibility for these functions onto governments, particularly in the case of unemployment insurance, which was not needed under central planning because there was no overt unemployment.

The close relationship between economic transformation and government budgets has important macroeconomic implications. Large and rising budget deficits will crowd out private investment, may result in a deterioration in current accounts, and could lead to accelerating inflation, thereby threatening macroeconomic stability. Preventing this will require new taxes that are suited to market economies, a broadening of the tax base, improved tax administration, and further reductions in subsidies. It will also be necessary to contain expenditures, even as the composition is shifted from subsidies to social transfers and outlays needed to support structural adjustment. Although the inflation risks are clear, larger deficits might be sustainable in the transition period if they can be financed by private saving, as occurred in Hungary, or by external resources. To the extent that these sources of financing are not available, it is particularly important to prevent deficits from increasing to levels where they ultimately result in higher inflation.

To relieve the growing demands on the budget for financial support of loss-making state enterprises, as well as to complete the transition to a market economy, almost all countries in the region have launched ambitious privatization programs as a key part of their reform strategy, although progress has generally been slower than anticipated. In the former Czechoslovakia, shares of state enterprises privatized in the first wave of vouchers (which employ about one-fifth of the work force) will be distributed by end-March 1993. The dissolution of Czechoslovakia (Box 6), however, has delayed the second wave of vouchers, originally scheduled for early 1993.52 In Hungary, about one-fifth of the enterprises owned by the state at end-1990 have since been privatized. In Poland, about a fourth of all state enterprises have been privatized, and ownership transformation is an integral part of the enterprise restructuring program. The Romanian government began the free distribution of certificates of ownership in 1992, allowing the population to participate in five Private Ownership Funds that have been allocated 30 percent of the shares of state enterprises; the remaining 70 percent, now in the hands of the State Ownership Fund, are to be offered for sale over the next seven years. In Bulgaria, 60 percent of the shares of each state-owned enterprise are to be auctioned to the public, with the remaining 40 percent to be distributed to employees and enterprise social security funds. Large companies have already been broken up in preparation for the auctions, which are scheduled to begin in early 1993. In both Bulgaria and Romania, however, actual sales of enterprises are likely to be delayed.

The experience with privatization has so far been encouraging. The growing private sector is contributing to a pickup in economic activity, although much private sector growth is accounted for by newly created, as opposed to privatized, firms. Moreover, unemployment has risen less than had been earlier feared, although in some countries this may be because enterprise restructuring is still in its early stages. The privatization of large industrial enterprises, while now under way in some countries, is proceeding slowly, in part because governments wish to avoid the rise in unemployment that would probably result.

Stabilization, Inter-Enterprise Arrears, and Structural Change in the Former Soviet Union

Output has declined sharply in the former Soviet Union in the past two years, and it is expected to fall further in 1993; inflation has risen rapidly and is likely to remain quite high in 1993 as well. But if macroeconomic stability can be achieved, and if the economic reform programs are followed through, most of the countries in the former Soviet Union could experience sharply falling inflation during 1993 and an economic turnaround as early as the middle of the decade.

The most pressing challenge now facing almost all of the successor states of the former Soviet Union is to reduce inflation and establish macroeconomic stability. The widespread liberalization of prices in these countries at the beginning of 1992 resulted in a large increase in the price level throughout the former Soviet Union, as had been the case in the wake of the earlier liberalizations in central Europe (Chart 22).53 In most of the former Soviet Union, however, price liberalization was incomplete, and prices of several products—energy, public utilities, and rent—remained directly controlled, while extensive subsidies, trade distortions, and other indirect methods kept other prices well below world levels. The price of natural gas, for example, was only 5–10 percent of the world price in early 1993; although oil prices were raised substantially during 1992, they had reached only about one-fourth of the world price by February 1993. In contrast, prices in the Baltic countries, including energy prices, have virtually all been liberalized.

Chart 22.
Chart 22.

Selected Countries of the Former Soviet Union: Inflation

(Monthly percent change in the consumer price index unless otherwise noted)

1 Retail price index.2 Hybrid consumer price index before January 1993.

The price level in most of the former Soviet Union jumped sharply in January 1992 as a result of price deregulation. In contrast to the experience in central Europe, however, inflation fell only temporarily during mid-1992, and then rose sharply to rates of about 20 percent a month, or in excess of 1,000 percent a year. In Russia, inflation soared in the last quarter of the year to about 25 percent a month (or nearly 1,500 percent at an annual rate), raising fears of hyperinflation. High inflation, and the expectation that it will continue or worsen, has contributed to capital flight and to a sharp decline in the value of the ruble, which fell from 135 to the U.S. dollar in July 1992 to about 740 to the dollar in early April 1993.

A major factor behind the inflationary pressure has been the excessive credit expansion by the central banks—including, since July 1992, the Central Bank of Russia—to state enterprises. In addition, the Central Bank of Russia has expanded credits to other central banks in the ruble area on a large scale, even though such credits were in principle to have been limited after July 1992. Other factors include the explosion of inter-enterprise arrears and chaotic monetary relations in the ruble area (both of which are discussed below). Increases in energy prices have also been reflected in the general price indexes, although this represents only a once-off effect as prices are brought up to world levels.

Another important underlying source of inflation pressure has been the monetization of the large budget deficits that have opened up in many of the states of the former Soviet Union (see Table 16). In Russia, the general government budget deficit for 1992 was over 20 percent of GDP, and in Ukraine the situation appears even worse, with the deficit rising to over 30 percent of GDP in 1992. In contrast, budgets were in surplus, or small deficit, positions in the Baltic countries, and inflation has been contained.54

The budget deficits in most of the former Soviet Union have resulted from both revenue shortfalls and excessive expenditures. As in central Europe, the decline in output associated with economic transformation has reduced revenues from turnover, profit, and wage taxes. Moreover, although new forms of taxation that are more suited to a market economy, such as the VAT, have been introduced, they are not yet fully functioning. On the expenditure side, a major problem is subsidies to moneylosing state enterprises. In Russia, explicit transfers, including large import subsidies, amounted to over 20 percent of GDP in the first nine months of 1992. Implicit credit subsidies have taken the form of soft loans from the Central Bank of Russia and credit that has been allocated at highly negative real interest rates. In addition, the policy of holding domestic energy prices well below world levels amounts to a large subsidy to energy users.

A key symptom of, and contributor to, these macroeconomic imbalances has been the explosive growth of inter-enterprise arrears, particularly in Russia, where they grew from 48 billion rubles at the beginning of 1992 to over 3 trillion rubles—70 percent of GDP and twice the value of domestic credit—by mid-1992. Arrears are a feature of alleconomies, in that enterprises extend limited credit to others by not immediately requiring payment due, thereby facilitating commercial relations by relaxing the need for cash on hand in transactions between firms.55 However, the scale and growth of arrears in the former Soviet Union go well beyond what would be warranted by normal commercial relations. Moreover, in contrast to practice in market economies, enterprises in the former Soviet Union have allowed huge arrears to build up with firms that are almost certainly not creditworthy, at least according to normal commercial criteria.

Perhaps the major reason that firms extend credit through arrears is that a failure to do so would disrupt supplies or shipments of inputs needed for production, resulting in closure. Normally, a creditworthy firm could fill the gap through the banking system. In the former Soviet Union, however, the financial system is still underdeveloped. In any case, it would be difficult for a bank (or another firm) to determine an enterprise’s creditworthiness because of the rudimentary accounting system, the absence of a market to evaluate assets, the presence of soft budget constraints, and the possibility of a government bailout. It would also be difficult to untangle the vast inter-enterprise arrears themselves. Another benefit of arrears to firms arises from the fact that, in a holdover from central planning, enterprise profit taxes are assessed on the basis of financial transactions registered through the banking system. Arrears delay registration and, given the high inflation, greatly reduce the real value of tax payments, contributing to the government’s revenue shortage and further increasing the need for inflationary deficit financing.

The possibility that unpaid arrears could force an enterprise into bankruptcy is mitigated by two factors. First, the pervasiveness of soft budget constraints on firms has led to the expectation that either the debtor or, if necessary, the creditor will be bailed out by the state. The second mitigating factor stems from the use of “noncash” rubles (bank accounts) for inter-enterprise payments and “cash” rubles for wages. For most enterprises, the immediate threat to their continued operation had been the shortage of cash rubles, not a shortage of noncash rubles; because inter-enterprise arrears are settled in noncash rubles, nonpayment may not have much affected the short-term viability of these firms.

The massive buildup of inter-enterprise arrears in the first half of 1992 risked destabilizing the economy as the implied credit expansion and tax avoidance intensified inflationary pressures. At the microeconomic level, arrears also made it difficult to judge the creditworthiness of enterprises, a prerequisite to allocating credit on market principles. In mid-1992, the Central Bank of Russia put in place a mechanism to net out the arrears by establishing special accounts with the central bank reflecting each firm’s arrears. This operation was completed by the end of the year, and net arrears, which were monetized, were only about 10 percent of GDP or 7 percent of bank credit to enterprises outstanding at end-November.56 But the incentives that gave rise to the buildup of inter-enterprise arrears largely remain (except that enterprises are no longer short of cash rubles), and the monetization of the residual net position may have raised expectations of a future subsidy if arrears again expand. The limited information available suggests that arrears may be building up again in early 1993, but at a slower rate than a year earlier.

Economic Arrangements for the Czech-Slovak Breakup

Within weeks of the June 1992 general elections in what was then the Czech and Slovak Federal Republic, it was clear that coexistence of the two emerging governments was impossible, and it was agreed that the country would divide into two independent republics on January 1, 1993. In the economic sphere, preparations for the breakup focused on the division of common assets and liabilities between the Czech Republic and the Slovak Republic and on trade, fiscal, monetary, and exchange relations.

The major common assets and liabilities to be divided were held by the central bank, the foreign trade bank, the federal government (government debt, the army, embassies, and the like), and certain enterprises owned by the federal government. The basic principles governing the division were, in order of priority, the “territorial principle” (an item belongs to the republic in which it is located) and a relatively uncontroversial split of two for one in favor of the Czech Republic (roughly reflecting its larger population). In most cases these two criteria were applied sequentially, with little conceptual difficulty. In the case of the central bank, however, a split of bank reserves and other items according to the two basic principles created a mismatch between the assets and liabilities of the two new central banks. This was resolved by the creation of a claim by one central bank on the other, the terms of which are still subject to negotiation.

Assets and liabilities abroad presented special problems. There was concern that the former Czechoslovakia’s considerable credits outstanding to other countries might become less collectible if there were two creditors rather than one. Accordingly, it was decided to retain the former foreign trade bank as an intermediary to manage these assets. In the case of external debt, most of the former Czechoslovakia’s creditors, who had to be consulted on the division of the debts, accepted the two-for-one rule, although a few are still insisting on joint and several liability. The former Czechoslovakia’s quota in, and liabilities to, the IMF were divided in a ratio of 2.29 to 1, determined in accordance with IMF rules for quota calculation.

The Czech and Slovak economies were closely intertwined, with interrepublic exports estimated to have been equivalent to about one-third of the former Czechoslovakia’s exports to the rest of the world, and with considerable labor migration between the two republics. For these reasons, a customs union was established, under which the two countries would share a common tariff vis-à-vis the rest of the world, undertake not to erect trade barriers against each other, and consult informally about wage policies.1 Capital and labor would be free to move between the two countries. However, disruptions to trade during the initial months following the separation have been greater than envisaged. If this situation continues, it would have highly adverse impacts on both countries.

Fiscal relations during the post-communist federal period were characterized by annual negotiations on the allocation of revenues and expenditures between the federal and republic budgets. Upon division of the country, each republic became responsible for its own revenues and expenditures. As a result, firms are required to register separately as taxpayers in each republic in which they have a presence. The VAT, which replaced the turnover tax on January 1, 1993, is paid to the republic in which an item is consumed. Consideration was given to a clearinghouse system for interrepublic trade, but it was decided that such trade would be treated like other foreign trade. Tax competition is to be avoided by informal understandings that the major tax rates would remain the same in the two republics, an arrangement that should also ease enforcement.

The most difficult issues arose in the context of monetary relations. It was decided that the two new countries would—at least initially—share a single currency, with coordination between the two central banks managed by a committee comprising three members from each republic. In principle, this monetary union was to last at least six months but could be terminated early if international reserves fell to less than one month’s worth of imports, if bank deposits in one republic fell by more than 5 percent, if the fiscal deficit of one republic exceeded 10 percent of revenues, or if there was deadlock in the interrepublic monetary committee. In the event, there was considerable speculation about an early dissolution and a subsequent devaluation of one or both currencies, spurred by the explicitly temporary nature of the monetary union. The drain on foreign reserves that had begun in late 1992 continued, and the monetary union was terminated on February 8, 1993.

The introduction of the new currencies—stamped versions of the old Czechoslovak koruna—proceeded smoothly. Banks ceased transactions with nonresidents on February 3, 1993. In the period February 4–8, resident individuals were able to convert 4,000 koruny in cash (about a month’s average wage) into stamped notes; larger sums were paid with a delay. Firms exchanged their holdings during February 810, although large deposits were subject to checking against receipt records in an attempt to prevent money laundering. All deposits were automatically converted, and all foreign individuals and firms were able to convert cash freely on presentation of proof that they had acquired it legally.

The authorities of both countries saw the quick introduction of a bilateral payments arrangement as the best means of minimizing uncertainty and the consequent disruption of trade in the short term. Accordingly, two basic mechanisms were put in place for settlement of new transactions: individuals may purchase a limited amount of cash and an unlimited amount of traveler’s checks in the other republic’s currency at a floating exchange rate; and commercial transactions—with the exception of re-exports, which must be paid for in convertible currencies—go through clearing accounts at the two central banks, under which balances above ECU 130 million are to be settled monthly. Except for tourist transactions, the official rates for the two currencies are fixed against the same basket and at the same level as the former Czechoslovak koruna, although the exchange rates under the Czech-Slovak clearing arrangement can differ by up to 5 percent from the official rates. In response to an emerging bilateral trade imbalance, in early March the Slovak koruna was devalued by 5 percent against the ECU under the clearing arrangement, and the Czech koruna was revalued by 2 percent. Effective in early May, the Czech Republic announced a reduction in the number of currencies in the basket for the Czech koruna.

1 A catch-all clause allows the imposition of trade barriers if “increased imports damage or threaten to damage the market of [a] contracting party” (from Article 22 of the Treaty Establishing a Customs Union between the Czech Republic and the Slovak Republic).

Despite loose monetary and fiscal policy and the expansion of credit through inter-enterprise arrears, output continues to fall sharply in the former Soviet Union as industry is restructured and CMEA trade has collapsed. To some extent, the measured output drop reflects poor underlying data, which overrepresent the declining industrial sectors and do not fully capture the growth of small, consumeroriented activities, many of which are in the informal sector. Moreover, liberalization has resulted in large changes in relative prices, making comparisons of real output indices over time unreliable. These indices also overstate the fall in living standards because they do not account for the sharp reduction in the physical shortages of consumer goods that had characterized centrally planned economies.

The decline in output has been particularly sharp in the industrial sector. In the small service sector, which is largely private and informal, there is substantial evidence that production has been rising. The shift in the composition of output reflects to a large extent the unwinding of distortions under central planning, which favored heavy industry at the expense of the production and distribution of consumer goods. This reallocation of resources is far from complete in most of the former Soviet Union because large industrial concerns are still being propped up by state subsidies. In Belarus, Russia, and Ukraine, the need to convert huge military industries, which has hardly begun, will make this reallocation even more difficult. In this context, it will be vital for the governments of the former Soviet Union to adopt market-oriented policies conducive to the expansion of those activities that will eventually replace the declining industrial sector.

Comprehensive structural initiatives are now under way to promote a flexible and dynamic market economy, although much remains to be done. Most countries of the former Soviet Union and Mongolia have begun to put commercial legislation in place, including property, bankruptcy, and antimonopoly laws. But the application of this legal framework has been uneven. Property rights are still inadequate and unclear, with the result that investment and production decisions have been delayed. Monopoly laws have not been enforced—no monopolies have been broken up—and the trade regime is still too distorted to provide much of a check on monopoly power.

Privatization has also begun in most countries of the former Soviet Union and in Mongolia. In Russia, this process has been proceeding on several fronts.57 In July 1991, the privatization of small enterprises was placed in the hands of local authorities, although progress has been slow. In July 1992, large and medium-size firms were slated for privatization. They were to be transformed into corporations issuing equities that would be purchased first by workers and managers using vouchers, then by the public using vouchers, and eventually by the public using cash. The distribution of vouchers began on October 1, 1992; by the end of the year almost all vouchers had been distributed, and nearly 700 large enterprises and nearly 900 medium-size enterprises had been turned into corporations. In early December, shares began to be sold to the public for vouchers. At the same time, there has been privatization of residential property (about 8 percent of apartments were privatized in 1992) and existing legislation permits privatization of agricultural land. Privatization in some of the other states is moving more slowly than in Russia. In Ukraine, for example, the privatization law passed in July 1992 set ambitious targets, but very little has yet been accomplished. In Mongolia, however, the transfer of ownership under the 1991 voucher privatization schemes is nearing completion, and almost three-quarters of the herds have been privatized.

Monetary Arrangements and the Adoption of New Currencies

The task of economic transformation in central Europe and the former Soviet Union has been compounded by the disintegration of existing political unions into independent countries. The most spectacular example, of course, is the former Soviet Union, which split into 15 sovereign countries in 1991. The former Czechoslovakia separated into the Czech Republic and the Slovak Republic on January 1, 1993 (see Box 6), and the former Yugoslavia has split into five independent states.

The sudden creation of so many new states has greatly complicated the international aspects of the transition to market economies. Trade, monetary, and exchange arrangements, which used to be internal matters, now have to be restructured. For trade, the possibilities range from a fully integrated single market to segregated markets with tariff and nontariff barriers. The range of possible monetary and exchange arrangements extends from a common currency area at one extreme to a system of independent currencies with mutually floating exchange rates at the other.

The preservation of unified currency areas in the former Soviet Union, the former Czechoslovakia, and the former Yugoslavia might, in principle, have preserved the gains from a single currency, which are well known and significant.58 The costs, from an individual country’s perspective, are that the responsibility for the conduct of monetary policy for the region as a whole rests with a central monetary authority—over which any country may have little, if any, influence—and that the exchange rate is precluded as a policy instrument. Preserving monetary union would also require explicit consideration of the institutions of monetary policy, the decisionmaking mechanisms, and a fair distribution of the seigniorage created at the union level.

Many of the newly independent countries have established their own currencies or plan to do so (Box 7). Thus, a common currency area appears to be only a transitional arrangement. A number of countries, including the Baltic states, Slovenia, and Croatia, started to withdraw from their monetary unions as soon as the required institutions were in place. Even as a transitional solution, monetary union has proven to be difficult among former member countries. In the case of the former Czechoslovakia, monetary union was intended to last at least six months after the dissolution of the federation but broke down in less than two months.

In the former Soviet Union the problem of maintaining a monetary union has been compounded by the fact that the institutions that had existed when the Soviet Union was formally dissolved no longer reflected the characteristics of a monetary union. The Gosbank was replaced at the end of 1991 by a decentralized banking system in which the main branch of Gosbank in each of the former republics was transformed into a more or less independent central bank. The Central Bank of Russia had the sole power to issue ruble currency. Nevertheless, the other central banks could extend credit to their governments and to domestic enterprises by creating bank reserves, drawing on credit lines at the Central Bank of Russia, and in many cases (for example, Ukraine) issuing coupons. They were also able to set interest rates charged on central bank credit independently and to determine reserve requirements imposed on commercial bank deposit liabilities.

In the absence of arrangements to control monetary expansion in the ruble area, the efforts by the central banks of Russia and some of the other countries of the former Soviet Union to pursue a restrained monetary policy after price liberalization in early 1992 were ineffective. Central banks in other countries in the ruble area adopted expansionary credit policies, increasing their share of seigniorage and exporting inflationary pressures to other states in the region. Part of this expansion was financed by borrowing from the Central Bank of Russia, which provided automatic financing of interstate payment imbalances through the correspondent accounts of other central banks in the former Soviet Union. As a result, the net credit balance of the Central Bank of Russia vis-à-vis the other states expanded rapidly. In an attempt to regain control, the Central Bank of Russia centralized the processing of interstate payments in its Moscow branch and introduced restrictions on payment orders, although doing so further disrupted interstate trade. Inflationary pressures in the ruble area were reinforced when the Central Bank of Russia itself, in the second half of 1992, reversed its policy of restrained domestic credit expansion in order to meet the growing financing requirement of the government and to increase lending to Russian commercial banks.

The shortage of currency and the blockage of the interrepublican settlement system have led to a de facto dissolution of the ruble area. Ruble deposits earned in one state cannot be used to make payments in the other states and are now being exchanged at exchange rates differing from parity. A number of countries have issued coupons to relieve shortages of ruble currency and, in some cases, in order to delay price adjustments. Where these coupons have been declared sole legal tender for some transactions, excess ruble balances have flowed into neighboring countries, thereby prompting them to impose export restrictions and to introduce their own coupons.

Currency Arrangements in the Countries in Transition

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For many countries with de facto current account convertibility, there continue to be certain restrictions under the transitional arrangements of Article XIV of the IMF’s Articles of Agreement.

New currencies are being introduced in the former Soviet Union. In mid-1992, Estonia introduced the kroon and pegged it to the deutsche mark in the context of a currency board arrangement. One month later, the Latvian ruble was declared sole legal tender in Latvia and was allowed to float in foreign exchange markets. More recently, Lithuania and Ukraine withdrew from the ruble area and declared their already-circulating coupons to be the sole legal tender. Similar moves have been announced by other countries, including Moldova and Azerbaijan.

An orderly withdrawal from a common currency structure is likely to be less disruptive than remaining in a dysfunctional monetary union. Independent currencies will encourage the development of interstate credit arrangements among commercial banks and enterprises that are separate from official monetary arrangements and settlement mechanism. Independent currencies also will facilitate the conclusion of interrepublican credit arrangements by separating them from monetary arrangements and settlement systems. Perhaps most important in the context of the former Soviet Union, independent currencies should permit greater monetary discipline than has seemed possible to date. A national currency, however, does not in itself guarantee low inflation; macroeconomic reforms and monetary restraint are required.

The Systemic Transformation Facility

The Executive Board of the International Monetary Fund on April 23, 1993 approved the establishment of the systemic transformation facility (STF), to provide financial assistance to members experiencing balance of payments difficulties arising from severe disruptions in their traditional trade and payments arrangements due to a shift from significant reliance on trading at nonmarket prices to multilateral marketbased trade. These disruptions would be manifested by a sharp fall in export receipts, a substantial permanent increase in net import costs—particularly for energy products—or a combination of the two. Eligible members are expected to include countries of the former Soviet Union and most former CMEA members. Substantial additional financial support from other sources over a sustained period would also be needed by members that make use of the new facility.

The use of the new facility is open to members that are willing to cooperate in an effort to find appropriate solutions to their balance of payments problemsincluding countries that are at an early stage of the transition process and are as yet unable to formulate a program that could be supported by the IMF under its other facilities and policies. For these countries, the use of the STF would be on the basis of appropriate prior actions and a written policy statement, laying out the member’s economic objectives, projections, and the macroeconomic and structural policy measures to be implemented over the following twelve months. The statement would also indicate the member’s intention to move as soon as possible to adopt a program that could be supported under an upper credit tranche stand-by, extended, or enhanced structural adjustment facility (ESAF) arrangement.1

Convincing actions to stabilize monetary conditions would be a prior action in cases where inflation has been unacceptably high or is accelerating. Early structural measures, such as the liberalization of trade and prices, would be needed as appropriate. Structural reforms would also focus on putting in place the basic institutions of economic management in a market system, and would generally be more comprehensive than under credit tranche arrangements. The member would be expected to put in place a quarterly financial program as soon as possible, and in any event before a second purchase could be made under the facility (see below). The member country would be expected to agree not to tighten exchange or trade restrictions or to introduce new restrictions or multiple currency practices. It would also agree to cooperate with its trading partners in seeking constructive solutions to common problems.

It is anticipated that countries that have already had IMF arrangements would generally make use of the new facility in parallel with such arrangements. Thus, the approval of a new arrangement or the completion of a review under an existing arrangement would satisfy the requirements of the STF.

Access would be for up to 50 percent of IMF quota, provided in two equal purchases. The first purchase would be available on approval, while the second purchase would follow a review by the IMF (normally about six months after the first purchase) to determine whether there are satisfactory policy performance, continued cooperation, sufficient movement toward an upper credit tranche arrangement, and progress in mobilizing external financing. For members making use of the STF in conjunction with an upper credit tranche stand-by, extended, or ESAF arrangement, the second purchase could become available within two months, upon the approval of such an arrangement or the completion of a review.

The rate of charge is the same as for other uses of the IMF’s general resources (currently just below 6 percent a year), and repayment terms of 4½ to 10 years are the same as IMF financing under the extended Fund facility. The new facility is temporary, and will be in effect through the end of 1994. However, the second disbursement may be completed by the end of 1995, provided that the first disbursement is made by the end of 1994.

There are precedents for the creation of temporary financing facilities in the IMF. In December 1990 the compensatory and contingency financing facility (CCFF) was modified to include a petroleum import financing component in the context of the Middle East crisis. Earlier, in 1974 and 1975, the IMF had created two oil facilities, to deal with temporary financing problems related to sharp oil price increases among oil importing developing countries. Both facilities, as well as the CCFF modification, have been discontinued.

1 See the IMF’s 1992 Annual Report, Box 6, pp. 50–51, for a description of the facilities through which the IMF provides financial support to its members.

Momentum for Reform

In the past three years, the former Czechoslovakia, Hungary, and Poland have implemented fundamental structural reforms while following monetary and fiscal policies that have maintained a relatively stable macroeconomic environment. Bulgaria and Romania have put in place some of the necessary legislative framework and have begun to implement reforms, but there has not yet been sufficient time to judge the course of reform. Although there has been considerable debate about the merits of policies that have often been described as “shock therapy” (versus a more gradual reform process), several of these economies now appear to be on the path of economic recovery. Despite this success, much remains to be done. Further progress is needed in the areas of commercial law, property rights, competition policy, fiscal reform, and financial sector reform. The most important task, however, is to complete the privatization of the vast state sector. Privatizing the large enterprises will require the closure of some of them and the sharp contraction of others, which is likely to lead to substantial dislocations and increased unemployment. There is, however, little alternative. The subsidization of inefficient producers cannot be continued indefinitely, and delaying privatization only retards the emergence of efficient producers. Until privatization is substantially complete, it will be necessary to enforce hard budget constraints on remaining state-owned enterprises in order to ensure that they operate as efficiently as possible, and to reduce budgetary pressures.

The countries of the former Soviet Union have put in place reforms broadly similar to those of central Europe. However, they are well behind the pace set in central Europe because of a more difficult starting position, the need to convert or close down military production, and civil strife in many states. Moreover, most of the countries of the former Soviet Union—with the notable exception of the Baltic states—have followed loose fiscal and monetary policies, which have not succeeded in preventing substantial declines in output but have resulted in widespread macroeconomic instability that is undermining their fragile economies. Indeed, the risk of hyperinflation is now the major threat to continued reform in the former Soviet Union. High and accelerating inflation has already caused massive capital flight and, if unchecked, will eventually destroy the price system and make further economic reform virtually impossible. Controlling inflation will require, above all, an end to central bank financing of the losses of state enterprises and an end to monetization of budget deficits. Both would be promoted by further progress on privatization, financial sector restructuring, and the rationalization of government support to enterprises with the aim of making all subsidies transparent, conditional, smaller over time, and consistent with macroeconomic objectives.

Despite the difficulties faced to date, there is a continued determination in the vast majority of cases to press ahead with needed structural and macroeconomic reforms. All the countries in transition, however, face the risk that this enthusiasm will flag as output declines and unemployment mounts, especially because the reforms to comeparticularly the privatization and possible closure of large industrial enterprises—are likely to be costlier to implement than those already undertaken. The international community can play a vital role in supporting reform efforts through financial and technical assistance—including the IMF’s new systemic transformation facility (Box 8)59—and, as discussed in the next chapter, by fully liberalizing trade with the countries in transition.


In Poland, the wage tax was eliminated in January 1992, when the personal income tax came into effect.


See the box on voucher privatization in the former Czech and Slovak Federal Republic in the October 1992 World Economic Outlook, Box 2, pp. 50–51.


In late 1992, the Russian government announced the reimposition of price controls on a wide range of goods, although these controls were never implemented.


In Estonia, the operation of the currency board precludes the monetization of deficits. See Box 3 in the October 1992 World Economic Outlook, pp. 52–53.


The term “arrears” is sometimes restricted to credit that is extended involuntarily. This distinction is not applied here.


Outstanding tax liabilities were cleared as part of this process. Because the government charged no interest on these liabilities, real revenue was reduced by the delay in payments.


Quasi-privatization has been under way since 1987, when control of firms devolved to enterprise managers and some of them were able to transfer ownership of resources to themselves or to their business partners.


In the former Soviet Union, production is regionally specialized, suggesting that a currency union could reduce transaction costs. Yet specialization also exposes different regions to specialized economic shocks, suggesting that flexible exchange rates could help macroeconomic adjustment. In any case, this pattern of production is to some extent a result of central planning, and it may not survive the transition to a market economy. For a discussion of monetary unions, see Paul R. Masson and Mark Taylor, “Issues in the Operation of Monetary Unions and Common Currency Areas,” in Policy Issues in the Evolving International Monetary System, edited by Morris Goldstein, Peter Isard, Paul R. Masson, and Mark P. Taylor, Occasional Paper 96 (IMF, June 1992), pp. 37–72.


The STF is in addition to other facilities of the IMF and other international organizations and to bilateral assistance to the countries in transition.

  • View in gallery

    Central European Countries in Transition: Inflation

    (Monthly percent change in the consumer price index)

  • View in gallery

    Selected Countries of the Former Soviet Union: Inflation

    (Monthly percent change in the consumer price index unless otherwise noted)