Most of the transition economies started moving decisively toward a market system three to five years ago. Since then, performance has varied across countries, depending on initial conditions and economic policies. Although many countries of the former Soviet Union are still experiencing sizable output declines and high inflation, several countries in central Europe as well as the Baltic states have stabilized inflation at relatively low levels and have seen a turnaround in output. The pace of structural change has also been very uneven, and progress in this area has often gone hand in hand with successful stabilization efforts.

Most of the transition economies started moving decisively toward a market system three to five years ago. Since then, performance has varied across countries, depending on initial conditions and economic policies. Although many countries of the former Soviet Union are still experiencing sizable output declines and high inflation, several countries in central Europe as well as the Baltic states have stabilized inflation at relatively low levels and have seen a turnaround in output. The pace of structural change has also been very uneven, and progress in this area has often gone hand in hand with successful stabilization efforts.

In all countries in transition, however, institutional transformation, and especially fiscal reform, is far from complete. It is increasingly appreciated that the transformation process has profound implications for government revenues and expenditures, and major fiscal pressures persist in all but a handful of countries. Although the Baltic countries and the Czech Republic have avoided fiscal deficits, most of the other transition countries have not. Institutional changes to adapt governments’ tax and expenditure systems to a market economy are urgently needed to contain the fiscal deficits and to prevent a rise of inflation that would endanger the reform process. An important aspect of fiscal reform in transition economies is the restructuring of social safety nets to protect the most vulnerable members of society. An acceleration of institutional change in this area should bolster political support for reform in a number of countries.

Stabilization and Transformation

Sustained financial adjustment coupled with bold liberalization has produced the macroeconomic environment necessary for the resumption of sustained growth in Albania, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Mongolia, Poland, the Slovak Republic, and Slovenia (Table 11). Progress has been slower, and macroeconomic instability persists, in Bulgaria and Romania, where output has not yet unambiguously turned around. The recovery in western Europe is good news for central Europe, because import demand is likely to pick up, and protectionist pressures in western Europe can be expected to recede. In 1994–95, inflation in almost all of the central and eastern European countries and in Mongolia is expected to slow significantly, while output is expected to recover.

Table 11.

Countries in Transition: Real GDP and Consumer Prices1

(Annual percent change)

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Data for 1994 are IMF staff projections.

In Russia and most of the other countries of the former Soviet Union, registered output collapsed further in early 1994, mainly because of developments in industry (Table 12), and inflation slowed markedly in a number of countries although it remains relatively high (Chart 19). Reminiscent of developments in central Europe in 1990–91 and in the Baltic states in 1992, the output slump tended to be larger for net energy importers, as a result of the negative terms of trade shock associated with the shift toward world market prices in trade among the countries of the former Soviet Union. Although trade within the region continued to decline, trade with the West has increased steadily. In Russia, for example, oil exports to the West have risen considerably after the significant decline that occurred in 1991. Overall, however, the stronger external environment in general, and the recovery in western Europe in particular, have contributed only marginally to improved growth prospects. In Russia and most of the countries of the former Soviet Union, monthly inflation is projected to reach and remain at single-digit levels in 1994–95, and output is expected to bottom out.

Table 12.

Selected Countries in Transition: Real Output in the First Half of 1994

(Percent change compared with one year earlier)

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Sources: National authorities and State Statistical Committee of the Commonwealth of Independent States, unless specified otherwise.

GDP is IMF staff estimate.

First quarter of 1994.

GDP is proxied by net material product.

Chart 19.
Chart 19.

Selected Countries in Transition: Consumer Prices

(Monthly percent change)

1Retail prices.

Significant structural shifts have taken place in many of those transition countries in which liberalization and stabilization are advanced. Although many large state-owned enterprises are struggling to survive, small firms have proliferated. Partly through transfers of titles under privatization programs, and partly as a result of the emergence of new firms, the share of the private sector in GDP is now close to or exceeds 50 percent in Albania, Poland, Hungary, the Czech Republic, the Slovak Republic, and Latvia. The sectoral composition of output and employment has also evolved rapidly, with the share of services–particularly trade, banking, insurance, and communications—showing vigorous expansion in a number of countries (Chart 20).39

Chart 20.
Chart 20.

Selected Countries in Transition: Share of Employment in Services

(In percent)

Sources: National authorities.1Data for 1992.

The reallocation process, insofar as it has taken place, has been accompanied by labor shedding and, with few exceptions, a surge in open unemployment rates (Table 13). In some countries such as Poland, Bulgaria, Slovenia, and the former Yugoslav Republic of Macedonia, the number of registered unemployed overstates actual joblessness, in part because of a combination of relatively high benefits and lax eligibility criteria. Notwithstanding the transitional nature of a substantial portion of unemployment, high unemployment rates are likely to persist in the foreseeable future, even if they may come down somewhat from current levels in those countries where unemployment rose most, and the average duration of unemployment is likely to continue to increase.

Table 13.

Selected Countries in Transition: Open Unemployment

(In percent of labor force at end of period)

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Sources: National authorities, European Union, and IMF staff estimates. Definitions vary across countries and over time.

Estimates based on the International Labor Organization (ILO) definition of open unemployment.

Annual averages; 1994 figure is IMF staff estimate.

Excluding refugees. Registered unemployment was only 1 percent of the labor force at the end of 1993.

So far, registered unemployment has remained low where the transformation process is less advanced—particularly in Russia, Belarus, Ukraine, and in many of the Transcaucasian and central Asian countries. This measure vastly understates actual unemployment, however, in part because many of the unemployed lack the incentives to register. In Russia, registered unemployment was only 1½ percent of the labor force in mid-1994, but unemployment measured according to accepted international definitions was 6 percent, and a further 6 percent or so of the labor force was on shortened work hours or forced leave.40 As budget constraints harden, legal restrictions on layoffs are relaxed, unemployment compensation is increased, and structural change proceeds, registered unemployment in these countries is likely to increase substantially.

The transformation process has also witnessed large declines in investment. Since the introduction of reforms, investment as a share of GDP has fallen in almost all transition countries. In part, this decline reflects an adjustment from excessively high levels of investment under central planning. As the transition proceeds, however, recovery in investment is essential to renew an aging and partially obsolete capital stock and thereby to sustain growth. In central Europe and the Baltic countries, where the transition process is more advanced, investment has strengthened—particularly in Albania and Poland. Investment has remained weak in other countries, however, because of depressed levels of activity, the absorption of private saving by government deficits, and modest foreign direct investment. The importance of stimulating investment underscores the need to encourage private saving, limit government dissaving, and remove obstacles to foreign direct investment.

In most transition economies, the transformation has also been accompanied by increasing dollarization, mainly as a result of easier access to foreign exchange and high domestic inflation. The scope for seigniorage has been reduced accordingly, as has the national policymakers’ ability to control broad monetary aggregates. Tight and credible financial policies will reverse currency substitution, as already evidenced by some of the more successful stabilizations (Box 8).

In the group of countries with the most advanced reforms, the Czech Republic stands out as the only country that has pursued tight financial policies and bold liberalization while avoiding a sharp rise in open unemployment. This outcome reflects robust private sector growth, a fairly diversified industrial structure, and a relatively small number of bankruptcies to date. In addition, strict conditions on the receipt of unemployment benefits, relatively high labor mobility and productivity, wage moderation, nearby employment opportunities in Germany, and extensive labor training programs have kept unemployment low. As a result of prudent fiscal management, the Czech Republic is one of the few transition economies with a stable nominal exchange rate since the liberalization of prices (Chart 21). Output and export growth, however, remain modest, and enterprise restructuring has been proceeding slowly, even after privatization. Inflation in the Czech Republic is expected to be reduced to single-digit levels in 1994 and to fall again next year, and growth is likely to pick up this year and to strengthen further in 1995. In the Slovak Republic, inflation has remained close to Czech levels, and activity turned around in early 1994. Open unemployment, however, is substantially higher than in the Czech Republic, although it has started to fall in some regions. Large budget deficits also contrast with the surpluses achieved in the Czech Republic.

Chart 21.
Chart 21.

Selected Countries in Transition: Nominal and Real Exchange Rates1

1Real exchange rates are based on relative consumer prices. For Poland and the Czech Republic, real exchange rates based on relative unit labor costs are also shown.2Vis-à-vis the U.S. dollar.3Real effective exchange rate.

Growth prospects remain particularly encouraging in Poland, where activity is being fueled by a dynamic private sector. Real GDP is projected to increase by 4½ percent in 1994, implying that the level of real output probably now exceeds its pretransition peak,41 but with a more market-oriented composition. Underlying inflation has continued to decline gradually, even though the excess wage tax was temporarily lifted from April through July 1994. Demand pressures, partly reflecting strong investment—including by foreign enterprises—have resulted in a persistent trade deficit. In addition to existing commercialization and privatization schemes, a program of mass privatization is to be launched in 1995, involving the creation of investment funds entrusted with an active role in enterprise restructuring. In Hungary, inflation has slowed, and growth has resumed. In 1993 and early 1994, however, the current account deficit surged to over 9 percent of GDP, reflecting weakening export demand because of the recession in western Europe, supply disruptions, and rising imports fueled by a sharp increase in consumption. Tighter fiscal policy to bolster saving will be necessary to improve the external position.

Macroeconomic performance in the Baltic countries also continues to improve. Growth resumed during 1993, and consumption has begun to pick up. Despite fiscal surpluses, inflation edged up in Latvia and Estonia in late 1993 and early 1994. One of the most important factors in explaining this increase is the real appreciation of the Russian ruble. Other factors include the rise in administered prices and indirect taxes; pressures from larger-than-expected capital inflows, particularly in Latvia, which has increasingly played the role of “safe haven” in the former ruble area; and in the absence of substantial nominal exchange rate appreciation, the convergence of domestic prices toward international price levels. By mid-1994, however, inflation in Latvia and Estonia had come down. Lithuania introduced a currency board in April 1994, almost two years after Estonia successfully adopted one. Major structural reforms are under way in all three Baltic states, including the revamping of social protection arrangements. Bankruptcies, which are an inevitable part of the transformation process, have become more common-place in Estonia, but they remain rare in Latvia and Lithuania.

Growth in Albania is likely to reach 8 percent in 1994, compared with 11 percent in 1993, and is in part supported by large private remittances. With the decontrol of energy prices in April 1994, price liberalization is now virtually complete, but further structural reforms are needed, including the privatization of large state enterprises, the development of a commercial banking system, and the establishment of the legal infrastructure of a market economy. While the recovery of the agricultural sector and the development of private imports have ended Albania’s temporary dependence on food aid, sustained improvement in the external sector will depend on successfully concluding recently resumed discussions to restructure the large external debt, which reached 1,000 percent of exports in 1990–92.

Currency Substitution in Transition Economies

High and variable inflation critically impairs the ability of a currency to function efficiently as a store of value, unit of account, and means of exchange. As a result, in high-inflation countries the domestic currency tends to be gradually abandoned in favor of a stable currency—usually, but not always, the U.S. dollar—a phenomenon referred to as currency substitution or “dollarization.”1 In many high-inflation countries, the store-of-value function of the domestic currency has virtually disappeared because residents find it less risky and often more profitable to keep assets in foreign currency. Prolonged periods of high inflation also lead the public to carry out many transactions, especially those involving big-ticket items such as real estate and automobiles, in foreign currency.

The phenomenon of currency substitution typically occurs in countries with high and variable inflation, and it has been especially pervasive in several Latin American countries. In most of these Latin American countries, foreign currency deposits were not allowed until the mid-1970s. Once such restrictions were lifted, however, a gradual but sustained dollarization process took place. Thus, the dollarization ratio—the ratio of foreign currency deposits to broad money inclusive of foreign currency deposits—is currently about 85 percent in Bolivia, 70 percent in Uruguay, and 65 percent in Peru.2 Furthermore, these economies have remained highly dollarized even when inflation has fallen substantially. Although dollarization has the positive result of providing citizens with a reliable store of value, it has also posed formidable challenges to policymakers by hindering monetary control.

With few exceptions, such as Poland and the former Yugoslavia, foreign currency holdings by domestic residents were strictly prohibited in the former centrally planned economies. However, the pre-reform experience of both Poland and the former Yugoslavia is in many ways reminiscent of that of Latin American countries. Chronic inflation, fueled by accommodative monetary and exchange rate policy and sustained by formal and informal indexation, led to increasing dollarization. In early 1990, both countries embarked on exchange-rate-based stabilization programs, which brought about a dramatic initial reduction in inflation. Poland achieved a lasting reduction in inflation, and, by ensuring relatively high interest rates on domestic currency deposits, was successful in drastically lowering the dollarization of the economy to levels prevailing in the mid-1980s (see chart).


Selected Transition Economies: Dollarization and Inflation1

1Dollarization is measured by the ratio of foreign currency deposits to broad money (including foreign currency deposits). Note that the inflation scales differ for Croatia, Poland, Russia, and Ukraine.2Foreign currency deposits exclude blocked deposits.3Foreign currency deposits are evaluated at the auction exchange rate.

In the former Yugoslavia, in contrast, inflation quickly resumed; in Croatia, quarterly inflation peaked at 120 percent during the last quarter of 1992, with the dollarization ratio—in this case primarily representing foreign currency deposits denominated in deutsche mark rather than dollars—surpassing 80 percent. Slovenia, however, has succeeded in rapidly reducing inflation following the breakup of the former Yugoslavia at end-1991, although the dollarization ratio in Slovenia did not decline and has remained at about 45 percent. Since late 1993, Croatia has also dramatically reduced inflation, but with little immediate effect on the dollarization ratio.

As part of their stabilization and reform programs during 1991–93, virtually all transition economies allowed domestic residents to hold foreign currency deposits, albeit with some restrictions. This, combined with high inflation, led to rapid dollarization in Bulgaria, Romania, and Albania. Given the problems encountered by Bulgaria and Romania in containing inflation, dollarization has remained high—at 37 percent in Bulgaria and 35 percent in Romania in the first quarter of 1994. In Albania, however, the dollarization ratio peaked at about 25 percent, and seems to have leveled off at 20–25 percent, following the rapid fall in inflation since end-1992. In contrast, Hungary, the Czech Republic, and the Slovak Republic, where relatively prudent fiscal and monetary policies have been pursued, experienced only a slight increase in the already low dollarization ratios in the early 1990s.

In the Baltic states, Russia, and other countries of the former Soviet Union, dollarization quickly gained momentous significance as financial reforms allowing foreign currency deposits coincided with the onset of high inflation. Russia and Ukraine have had among the highest inflation rates in transition economies, and dollarization ratios have risen rapidly, fluctuating between 30 and 45 percent in 1992–93. In the Baltic states, currency substitution tended to be widespread before the introduction of new currencies and the reduction of inflation. The dollarization ratio peaked at around 60 percent in Estonia in the second quarter of 1992, at 50 percent in Lithuania in the first quarter of 1993, and at 35 percent in Latvia in the first quarter of 1993. These three countries successfully implemented disinflation programs, which led to a substantial reduction in dollarization ratios in Estonia and Lithuania. In Latvia, however, dollarization has declined only slightly, possibly because very liberal foreign exchange markets have provided a “safe haven” for residents of high-inflation countries such as Russia and Ukraine.

The pattern of dollarization in Mongolia has been similar to that in other countries, such as Poland and the Baltic states, that have successfully stabilized. High inflation at the outset of the transition led to an increase in currency substitution, with the dollarization ratio reaching almost 40 percent in the second quarter of 1993. Since inflation started to fall in early 1993, the dollarization ratio has also declined, albeit with a lag, falling to about 20 percent in the second quarter of 1994.

The experience of economies in transition confirms that currency substitution tends to become important in the presence of high and variable inflation. Depending on institutional constraints and macroeconomic conditions, the dollarization ratio has generally varied from zero to 10 percent at the start of reform programs, to a peak of between 30 and 60 percent during 1992–93. Crosscountry variations in the dollarization ratio may also reflect variations in the ratio of deposits to cash, including foreign exchange. In several countries, the dollarization process was exacerbated by very low (and even negative) real rates of return on domestic assets. Unlike the experience of Latin America, however, dollarization ratios in several transition economies appear to be declining in response to sustained reductions in inflation. This suggests that, provided sound financial and fiscal policies are pursued, the dollarization process may be easier to reverse if the use of foreign currencies is associated with a limited period of high inflation. Even in the presence of low inflation, however, some degree of dollarization should be expected because it may simply reflect portfolio diversification.

Although allowing foreign currency deposits has important benefits for an economy, such as reversing capital flight and building international reserves, it may also complicate macroeconomic policy formulation. To the extent that currency substitution reflects a shift away from domestic money, it will exacerbate the inflationary consequences of a given fiscal deficit. Hence, as the experience of Latin America suggests, fiscal discipline is all the more important in highly dollarized economies. Moreover, the authorities’ ability to conduct monetary policy may be substantially undermined because the foreign currency component of the total money supply cannot be directly controlled. This may have hindered attempts to contain and reduce inflation in countries such as Bulgaria, Romania, Russia, and Ukraine.

Despite these potential problems, the experience of Latin America suggests that combating dollarization with artificial measures, such as issuing indexed domestic financial instruments or forcing the conversion of foreign assets into domestic assets, merely contributes to magnifying the eventual explosion of inflation. The greater use of assets denominated in domestic currency would normally occur—and hence would not have to be mandated—with the implementation of sound financial and fiscal policies.

1 See Ratna Sahay and Carlos A. Vegh, “Dollarization in Economies in Transition: Evidence and Policy Issues,” IMF Working Paper (forthcoming, 1994), and Guillermo A. Calvo and Carlos A. Vegh, “Currency Substitution in Developing Countries: An Introduction,” Revista de Arálisis Economico, Vol. 7 (June 1992), pp. 3–27.2 In the absence of data on foreign cash held by the public and on foreign exchange deposited in banks abroad, estimates of the extent of dollarization are based on domestic foreign currency deposits only; hence, the dollarization ratios presented in the text and shown in the charts underestimate the phenomenon of currency substitution.

Progress on inflation has also been sustained in Mongolia, where output is turning around. Despite some improvement since early 1994, macroeconomic stabilization remains to be achieved in Bulgaria. Timid structural reforms and loose financial policies in Bulgaria and initially in Romania have prolonged the period of output declines, high inflation, and falling living standards. In Bulgaria, Parliament approved amendments to the Privatization Act in June 1994 that enable mass privatization to take place in the future.

In Russia, the tightening of fiscal and monetary policies in late 1993 reduced monthly inflation from over 20 percent to high single-digit levels in early 1994. This tightening was initially accompanied by a rise in inter-enterprise, tax, and especially wage arrears, as well as arrears in government procurement (Box 9). The real exchange rate continued to appreciate steadily in the first half of 1994, bolstered by very high positive real interest rates, but at a much slower pace than in the second half of 1993 (see Chart 21).42 Registered output collapsed further in early 1994, and the cumulative decline since the 1989 pretransition peak approached 50 percent. Household consumption, however, fell much less than output.

Notwithstanding the confusion engendered by a plethora of often contradictory legislative acts issued at various levels of government, structural change is proceeding in Russia. The share of military products in total industrial output fell to 31 percent in 1993 from 52 percent in 1990. By mid-1994, over two-thirds of industrial employment was formally in privately owned firms, and more than half of the total labor force is expected to be employed in the private sector by the end of the year. A number of decrees were issued in May and June 1994 to speed up the implementation of bankruptcies, and in July 1994 privatization for cash started to replace voucher privatization. Nonetheless, enterprise behavior, even after privatization, is changing only slowly. Sectoral lobbies, through channels such as interest rate subsidies and tax concessions, continue to capture vast amounts of financial resources that contribute little to structural adjustment.

In Ukraine, a tightening of monetary policy and greater efforts to control the fiscal deficit, implemented at about the same time as in Russia, reduced inflation substantially following a period of near hyperinflation. The ad hoc nature of the adjustment and the lack of supporting policies from the supply side, however, cast doubt on its sustainability. In Kazakhstan, the decline in inflation in the first quarter of 1994 reflected the tight credit stance following the introduction of the tenge in November 1993 and the postponement of some administered price increases. Inflation, however, rebounded subsequently. Institutional change continued to lag far behind Russia in Belarus, Kazakhstan, and Ukraine. Privatization of medium and large firms is still in its infancy, and bankruptcy remains virtually nonexistent. Mass privatization was, however, launched in Kazakhstan and Belarus in April 1994.

Inflation and output developments in other transition countries have been diverse, owing to a variety of country-specific factors. In Moldova and the Kyrgyz Republic, tightened financial policies in late 1993 produced a steady decline in monthly inflation, to about 3 percent by June 1994.43 As a result, the Kyrgyz som has emerged as one of the most stable currencies among the countries in central Asia and in recent months has appreciated in nominal terms against the U.S. dollar. In contrast, inflation remained extremely high in Armenia and Azerbaijan, in part because of the ongoing war, as well as in Turkmenistan and Uzbekistan, reflecting rapid credit expansion. Real GDP in Turkmenistan, which largely originates in the natural gas sector, declined only moderately through 1993 because gas was shipped on credit to long-standing customers in nearby countries; in early 1994, however, output fell sharply as deliveries to nonpaying customers were cut, and the current account moved from surplus to deficit. In Moldova and Uzbekistan, output declines were mitigated by relatively stable agricultural production, which accounts for a large share of total output. Inflation was very high in Tajikistan in late 1993, owing to the massive inflow of pre-1993 rubles that resulted from the introduction of new currencies in neighboring countries, but prices fell for several months in early 1994 as a result of the acute cash shortage that accompanied the withdrawal of the “old” rubles. In Georgia, loose financial policies and severe disruptions in output and trade led to sharp price increases, which reached hyper-inflationary levels around September 1993. Inflation averaged about 60 percent a month in early 1994, and output collapsed from already dismally low levels.

The countries that made up the former Socialist Federal Republic of Yugoslavia have had varying degrees of success with stabilization policies since their independence in 1991. Slovenia began the process of stabilization almost immediately and maintained tight monetary and sound fiscal policies. After declining for two years, output began to recover in 1993, and inflation has stabilized at moderate rates. The implementation of stabilization programs in Croatia and the former Yugoslav Republic of Macedonia was delayed until late 1993. Since then, and in both cases, the nominal exchange rate stopped depreciating, and the inflation rate declined considerably. For the stabilization effort to be sustained in each of the latter countries, there must be strict adherence to fiscal and quasi-fiscal discipline, and pressures to grant credits to state enterprises must be resisted.

The experience of the countries in transition confirms that higher inflation does not deliver increased output in the medium term (Chart 22). If anything, higher inflation is associated with lower growth.44 In the very short run, there may appear to be a positive relationship to the extent that higher inflation postpones output declines. But higher inflation also jeopardizes the limited reserves of goodwill and credibility existing at the beginning of the transition process,45 creates an even more uncertain investment climate, and ultimately exacerbates a largely inevitable output drop. Even though the size of the cumulative output decline is, in most cases, smaller than what is indicated by the official national accounts data, the recorded output collapse has contributed to large increases in fiscal deficits. If not corrected, the fiscal imbalances are likely to result in heightened inflationary pressures and further delays in the process of transformation and economic recovery.

Chart 22.
Chart 22.

Countries in Transition: Registered Cumulative Output Losses and Price Changes1

(In percent)

1Central European countries and Mongolia, 1989–93; the Baltic states, Russia, and other countries of the former Soviet Union, 1990–94. Output is measured by real net material product (NMP) or GDP, and prices by the consumer or retail price index.

Fiscal Implications of the Transition

Fiscal policy is critical for the success of stabilization efforts, and the transition process itself has important implications for government budgets. The fiscal balance is an important signal about the government’s commitment to stabilization. In the absence of well-established government securities markets, public deficits tend to be financed largely through money creation. A moderate or declining deficit—insofar as it is perceived to be sustainable—contains or reduces inflation expectations, thus helping to create an environment conducive to investment and growth. In the transition economies, the dismantling of internal and external trading arrangements, severe terms of trade shocks, and large-scale industrial restructuring have caused a collapse in output, and hence in tax revenues. At the same time, in addition to unfavorable demographic trends in some countries, the necessary restructuring of state enterprises and the urgent need to strengthen social safety nets have heightened pressures on government spending. Moreover, the tax administration and expenditure-control institutions of most countries in transition are not yet adapted to a market economy. Although the large and persistent deficits that have ensued reflect, to a considerable extent, the unique and temporary turbulences associated with the transition process, they will have to be reduced substantially to avoid the risk of exacerbating inflation.46

Although the size of government as measured by budgetary ratios has shrunk in many countries, and despite efforts on both the revenue and the expenditure side, containing budget deficits has often proved elusive (Chart 23.). With the exception of the Czech Republic, Estonia, Latvia, and Lithuania, all countries have had substantial deficits in most years since the onset of the transition. In central and eastern Europe, Albania and Bulgaria experienced the most pronounced deterioration; among other transition countries, the largest deficits have occurred in Armenia, Georgia, and Tajikistan.

Chart 23.
Chart 23.
Chart 23.

Selected Countries in Transition: General Government Expenditure, Revenue, and Budget Balances1

(In percent of GDP)

1Expenditure equals total expenditure (including extrabudgetary funds) plus net lending; revenue equals total revenue plus grants. Data for 1994 are IMF staff projections.

Maintaining or improving tax revenues in the early years of the transition has been very difficult. Declines in tax revenues have been widespread, albeit of uneven magnitude. Between 1989 and 1993, revenues as a percent of GDP fell by at least 20 percentage points in Albania, Bulgaria, and Romania, but remained fairly stable in Poland and Hungary despite sharp declines in real terms. During 1992–93, countries such as Estonia and Latvia have maintained or increased revenue ratios, while others, including Azerbaijan and Moldova have experienced significant losses. These revenue declines are only partially related to the larger-than-expected drops in output.

Price liberalization and privatization have also contributed to lower tax intakes. Price jumps and subsequent inflation have curtailed real tax revenues because of collection lags. Although profits, and therefore tax revenues, initially increased with price liberalization, which reflected holding gains on inventories and lagged adjustment of depreciation allowances,47 this positive impact later disappeared when inflation came down and then registered profits declined.48 Furthermore, whereas price controls limited the scope for tax evasion under central planning, liberalization facilitated underreporting, thereby eroding revenues. Decentralization of control over state enterprises also decreased tax receipts because the government lost the ability to monitor profits closely, while at the same time newly emerging private enterprises proved difficult to tax.

Interenterprise Arrears

Following the initial stages of structural reform, interenterprise debt rose rapidly in many transition economies, including Romania, Russia, and other countries of the former Soviet Union.1 This increase in debt in part reflected a move away from a system in which trade credit was underdeveloped, but it also resulted from the accumulation of arrears.2 The emergence of large-scale arrears stemmed mainly from the lack of decisiveness and credibility in stabilization attempts, although failures in the payments system, the collapse in output, and other factors also played a role. Expecting some form of future bailout rather than bankruptcy—in line with a long-standing tradition of periodic debt clearing and write-off exercises under central planning—state enterprises extended vast amounts of credit to each other.3

In Poland and the former Czechoslovakia, financial policies were credibly tightened and real interest rates were positive, and consequently the rise in interenterprise debt and arrears was small compared with the surge that occurred in countries such as Romania and Russia. In most countries in central Europe, increases in interenterprise debt as a percent of bank credit reflected the normal adjustment to debt levels associated with a market economy. In contrast, in Romania, Russia, and other countries of the former Soviet Union, interenterprise arrears surged early in the transition—alongside and intertwined with arrears on bank loans, tax payments, budget expenditures, and wages—and the expectation of a bailout was validated when the monetary authorities organized the netting-out of outstanding claims accompanied by fresh bank credit. In Russia, clearing occurred once, in the summer of 1992, and has not been repeated since, despite much public debate on several blueprints for new clearings. In Romania, three such operations took place in May, August, and December 1991; the level of arrears has since stabilized because of a firm commitment by the government to avoid bailouts and to monitor indebted state enterprises.

The volume of interenterprise arrears in Russia started rising again in late 1993 as financial policies were tightened because the stabilization program lacked credibility (see chart).4 This second surge in arrears, however, differs from the arrears crisis that took place following price liberalization in the first half of 1992. The recent increase is much smaller than in 1992, and in a context of much higher real interest rates. Moreover, whereas the 1992 arrears crisis affected enterprises across the board, the more recent rise is concentrated in a few sectors, especially among fuel and electricity producers. Enterprises now appear to behave in one of four ways: some apply stringent prepayment rules, and hence control their receivables; others selectively relax this requirement for traditional or nearby customers; others engage in barter trade; and others—especially those still relying on state orders for the bulk of their output—continue to deliver in the absence of payment on the assumption that they are too big to fail or because they lack storage capacity. During the latest arrears crisis, wage arrears have risen much more than overdue receivables, suggesting, perhaps, the relative hardening of overall budget constraints.

In the current situation in Russia, another round of arrears clearing would reward those firms that did not impose hard budget constraints on their clients, thus creating incentives for the further buildup of arrears. Sectoral lobbies argue that direct government credits are needed to resolve the problem, but such a policy would discriminate against enterprises that are adjusting. Securitizing the arrears in the form of bills of exchange was proposed by the Ministry of Finance of Russia in the fall of 1993; however, owing in part to the reluctance of commercial banks to become involved in the restructuring of the stock of arrears, this scheme was not comprehensively implemented. Another option would be to pass on the stock of net claims to an outside agency that would securitize them, collect debt service, and monitor the debtor firms.


Russia: Receivables and Wage Arrears in Industry

(Index, April 1992 = 100; logarithmic scale)

Source: Goskomstat of the Russian Federation.1The consumer price index is used as a deflator.

Without a determined set of policies, the arrears problem in Russia is unlikely to resolve itself. The strategy adopted, however, will need to minimize the bailout component. Preventing new arrears requires positive real interest rates, further improvements in the payments system, better accounting and dissemination of information on enterprise finances—including on foreign exchange holdings, the size of which sometimes contradicts alleged working capital needs—more accountability of firm managers for the contractual obligations they endorse, and effective implementation of bankruptcy legislation.

1 See Eric V. Clifton and Mohsin S. Khan, “Interenterprise Arrears in Transforming Economies,” Staff Papers (IMF), Vol. 40 (September 1993), pp. 680–96: David Bigman and Sergio Pereira Leite, “Enterprise Arrears in Russia: Causes and Policy Options,” IMF Working Paper 93/61 (August 1993); and Jacek Rostowski, “Interenterprise Arrears in Post-Communist Economies,” IMF Working Paper 94/43 (April 1994).2 See Qimiao Fan and Mark Schaffer, “Government Financial Transfers and Enterprise Adjustments in Russia, with Comparisons to Central and Eastern Europe,” Economics of Transition, Vol. 2 (June 1994), pp. 151–88.3 Knowing that payment would be delayed, state enterprises set prices to incorporate an implicit interest component, thus contributing to measured inflation; see Vincent Koen and Steven Phillips, Price Liberalization in Russia: Behavior of Prices, Household Incomes, and Consumption During the First Year, IMF Occasional Paper 104 (June 1993).4 A similar rebound occurred in Ukraine and Moldova. Although much of the subsequent discussion about Russia applies more generally to other countries of the former Soviet Union, there are also striking differences reflecting, in part, different stages of stabilization and transition. For example, at the end of the first quarter of 1994, interenterprise debts in Russia stood at 96 percent of first-quarter GDP, and equaled about 66 percent of broad money, while in Ukraine they were 160 percent of first-quarter GDP, and over 300 percent of broad money. At the same time, however, 40 percent of interenterprise debts were in arrears in Russia (over 30 days), but only 18 percent in Ukraine.

Revenue declines have also been an unintended consequence of the overhaul of the tax system to make it more consistent with a market economy.49 In central European countries, tax reform has typically been implemented in two stages. The first has focused on changing those features of the tax system that caused the most serious distortions by introducing simple market-oriented taxes. Such measures have included the adoption of an enterprise profit tax with a fixed and lower rate; the introduction of a progressive personal income tax that taxes income from different sources at the same rate; the reduction in the number of turnover taxes; and the introduction of ad valorem import duties to replace nontariff barriers. The second stage of tax reform, currently under way, involves further changes in the system to promote compatibility with market activities, including the introduction of a uniform value-added tax (VAT) and of a limited number of ad valorem excise taxes, the broadening of the personal income tax base, and further improvements in the enterprise profit tax. These reforms will enhance the efficiency of the tax system over the long term, but in the short run some of the reforms may have contributed to the drop in tax revenues. For example, the reduction of the rate of the enterprise profit tax has contributed directly to revenue losses, although this has been offset to a limited degree by increases in other receipts such as social security and wage taxes (Table 14).

Table 14.

Selected Countries in Transition: General Government Revenue

(In percent of GDP)

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Sources: National authorities; and IMF staff estimates.

In the Baltic states, Russia, and the other countries of the former Soviet Union, tax reform has been less methodical than in central Europe. In 1991, the government of the former Soviet Union eliminated turnover taxes and prepared the launching of a VAT, which all of the newly independent countries adopted. This VAT, however, had a high rate that created pressures for exemptions and reduced rates, and it was probably too complex given tax administration capabilities. Limited progress has been made, however, in reforming the VAT. In Russia, for example, the rate has been reduced from 28 to 23 percent, and some exemptions have been eliminated. In other areas of tax policy, many of these countries have introduced complex and distortionary taxes that have contributed little to revenue-raising capacity and are difficult to administer.50 Tax reform in these countries must now focus on implementing more basic aspects of reform concerning personal income taxes, enterprise profit taxes, and import taxes and on further improving the VAT.

For all of the countries in transition, tax administration—which played a limited role under central planning—must be established and developed to ensure the ability to raise revenue.51 For example, administering the enterprise tax was simple under central planning because the tax authorities had complete access to financial records of the limited number of state enterprises, and administering the personal income tax was also simple because of its limited use. To administer efficiently a reformed tax system based on voluntary compliance will require the development of taxpayer registration, systems to process returns, and tax collection methods. Improving the legal, computer, and accounting skills of greater numbers of tax inspectors will also be necessary to execute auditing procedures.

A key aspect of the fiscal adjustment process has been the reduction in government expenditures.52 The transition countries—especially those in central Europe—have been quite successful in decreasing spending as a share of GDP, which was excessively high under central planning. This has been particularly important given the short-run limitations on raising revenues, and it has been achieved notwithstanding the decline in national incomes and the accumulation of spending pressures. In some transition countries, however, reducing expenditure has reflected the practice of determining acceptable spending on the basis of monthly tax revenues collected or has reflected the accumulation of arrears.

In central Europe, with the exception of Poland and Hungary, government expenditure as a share of GDP fell between 1989 and 1993 by about 10 percentage points. The cuts in government spending have mainly reflected reductions in subsidies in Albania, Bulgaria, the former Czechoslovakia, Hungary, and Poland, although purchases of goods and services were reduced in Bulgaria, and unproductive capital expenditures in Romania (Table 15). Success in scaling down expenditures has been more mixed in many other transition countries, partly reflecting the later start of the transition process. Between 1992 and 1993, substantial spending cuts as a percent of GDP have occurred in the Kyrgyz Republic, Moldova, Tajikistan, and Ukraine, but there have also been increases, for example, in Azerbaijan and Georgia. In Russia, subsidies were reduced considerably between 1992 and 1993, and operation and maintenance expenditures were also scaled back.

Table 15.

Selected Countries in Transition: General Government Expenditure1

(In percent of GDP)

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Sources: See Table 14.

Expenditures equal total expenditure (including extrabudgetary funds) plus net lending except for Bulgaria and Poland, where net lending is excluded.

In the longer term, however, pressures to increase spending are likely to intensify. Holding these pressures in check will require the development of expenditure control techniques for formulating and implementing government budgets. To the extent that increases in spending involve the consolidation of quasi-fiscal and off-budget expenditures into the general budget, they represent accounting improvements rather than deteriorations in the overall fiscal balance. There are other forces, by contrast, that risk leading to a more fundamental deterioration of the fiscal position. For instance, as persistent deficits add to the accumulated public debt, interest payments will rise as well, as they already have in Bulgaria, Hungary, and Poland. In addition, many transition countries must face the financial burden of a growing number of pensioners relative to the working population. Increased public expenditure on infrastructure to support the emerging private sector and on environmental cleanup will also be needed, although the ability to undertake such investments may depend on the success in cutting other, less productive expenditures. Meanwhile, structural adjustment will result in considerable numbers of dislocated workers, perhaps for an extended period, implying increased expenditures on unemployment benefits, active labor market policies, and social assistance—a trend that is already visible in Bulgaria, Hungary, and Poland.

Social Safety Nets

Under central planning, open unemployment was essentially nonexistent, and many social services such as housing, health care, and education were provided by state enterprises. As the transformation to a market economy proceeds, there is a need to establish social safety nets to protect the most vulnerable members of society. This is necessary not only to facilitate the restructuring of enterprises on market principles but also to sustain public support for the transformation process.

Average living standards declined at the onset of the transition process in virtually all countries. Wages and other money incomes lagged behind prices when prices were freed, although queues shortened dramatically and the availability of goods increased substantially. Calorie intake declined only marginally, even in Russia where there had been considerable concern about food shortages. Yet the share of food in household consumption increased almost everywhere, reflecting the fall in real incomes and the persistence of price controls on rents, utilities, and other nonfood items (Table 16).53 Opinion polls point to a perceived deterioration of living standards, and to the need for supplemental sources of income besides primary employment (Table 17). Following the initial phase of price liberalization, however, most indicators suggest that living standards did not drop much further, or even started to recover, in many cases despite a continuing decline in measured output.

Table 16.

Selected Countries in Transition: Share of Food in Household Consumption1

(In percent)

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Sources: State Statistical Committee of the Commonwealth of Independent States, Statistical Bulletin, No. 13 (April 1994); and national statistical offices.

Excludes alcoholic drinks unless otherwise noted.

Includes alcoholic drinks.

Blue-collar workers.


Table 17.

Selected Countries in Transition: Involvement in Second Activity

(Percentage of respondents)

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Source: Opinion surveys conducted by the Paul Lazarsfeld Society (Vienna) between November 1993 and March 1994.

Moreover, virtually all measures of inequality show a rise in income dispersion toward levels closer to those prevailing in market economies.54 Precise quantification is difficult owing to changing definitions, misreporting, and other data deficiencies. The trend is nevertheless clear, even if standard indicators tend to overestimate the rise in inequality to the extent that they ignore private interhousehold transfers and the relatively more stable distribution of nonmonetary benefits such as housing subsidies, access to subsidized transportation and medical care, and food production from the cultivation of individual plots. In most countries, poverty rose significantly in the early stage of the transition, even though indicators of deprivation do not suggest that vital needs have been threatened (except in war-torn areas). It is estimated that up to a third of the population was living in poverty in Hungary, Poland, Bulgaria, and Russia in 1992.55 Hardest hit were the unemployed—both those formally out of a job and those on part-time or forced leave with reduced or no pay—single-parent households, families with many children, disabled persons, and refugees.

The failure to protect these groups in part stems from the very nature of the inherited social safety net arrangements: under central planning, access to many benefits was linked to employment, large-scale labor hoarding kept open unemployment extremely low, and staples were heavily subsidized. However, wage setting and employment decisions did not promote an efficient allocation of labor resources, and social protection mechanisms were not geared to poverty relief but rather to poverty prevention at the cost of low productivity. The lack of targeting had perverse effects when the resources available to finance social benefits shrank: in Ukraine, for example, the net impact of the existing system of taxes and transfers turned out to be regressive in 1992.56 Holes in the safety net appeared as those excluded from employment in the state sector were poorly covered. And when food subsidies were cut, the accompanying shift to cash benefits was usually not sufficiently targeted, partly because of the lack of administrative capacity.

Early retirement substituted for unemployment on a sometimes massive scale. In Poland, one-third of expenditure on old-age pensions in 1990 was to individuals below the normal retirement age. In many countries, including Armenia, Belarus, Estonia, Moldova, and Russia, the low level of unemployment benefits relative to pensions, and the stigma and difficulties of registering as unemployed, stimulated such a trend. This, along with demographic factors, contributed to a sharp rise in dependency ratios (Table 18), which were already high because of lax criteria for disability certification and numerous special regimes offering full pensions well before the relatively low official retirement ages, which are typically 60 years for men and 55 years for women. In Bulgaria, for example, the number of pensioners is fast approaching the number of contributors. Existing pay-as-you-go schemes financed by payroll taxes levied on a rapidly shrinking base cannot support this rising burden. Despite increases in already high contribution rates in some cases, policymakers have been obliged to allow the generous average statutory replacement rates to be eroded by inflation, and they have let the structure of pensions be flattened by differential indexation. Even so, in Russia, for example, there has been an accumulation of arrears on pension payments.

Table 18.

Selected Countries in Transition: Dependency Ratios

(Ratio of pensioners to employed: in percent)

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Sources: State Statistical Committee of the Commonwealth of” Independent Slates; and national statistical offices.

Number of pensioners.

Old-age pensioners only.