For the first time since the late 1980s, recorded output is growing in most countries in transition. In some, such as Albania. Poland, and Slovenia, real GDP has already surged far above its trough. In others, including Armenia, the Baltic countries, Bulgaria, Croatia, the former Yugoslav Republic of Macedonia, Moldova, Mongolia, and Romania, economic recovery materialized later but is becoming more broadly based. At the same time, inflation is under better control in most transition countries, including Ukraine, Belarus, and most countries of central Asia and the Transcaucasus. Output performance continues to be bleaker in Russia, Ukraine, Belarus, and most of the countries of central Asia and the Transcaucasus, with further large declines in real GDP expected in 1995.

For the first time since the late 1980s, recorded output is growing in most countries in transition. In some, such as Albania. Poland, and Slovenia, real GDP has already surged far above its trough. In others, including Armenia, the Baltic countries, Bulgaria, Croatia, the former Yugoslav Republic of Macedonia, Moldova, Mongolia, and Romania, economic recovery materialized later but is becoming more broadly based. At the same time, inflation is under better control in most transition countries, including Ukraine, Belarus, and most countries of central Asia and the Transcaucasus. Output performance continues to be bleaker in Russia, Ukraine, Belarus, and most of the countries of central Asia and the Transcaucasus, with further large declines in real GDP expected in 1995.

Correspondingly, the policy challenges now faced by the countries more advanced in the transition differ from the challenges confronting countries that started later or moved more slowly. The priority for the former group is to sustain growth and disinflation and to make further progress with structural reforms, particularly with respect to the deepening of market-oriented principles. For the latter group of countries, consolidating or even achieving macroeconomic stabilization remains paramount, and much is still to be done to set up the institutions of a market economy.

A central feature of successful market economies is a well-functioning financial system. In almost all countries in transition, however, financial systems suffer from deep-seated weaknesses. In several countries, banking crises have erupted into the open. In others, crises have been contained, but contingent fiscal liabilities have been building up at a disquieting pace, Rank failures endanger stabilization gains, and slow progress with financial sector reform is impeding improvements in corporate efficiency in the enterprise sector. At the same time, insufficient restructuring and financial discipline in the enterprise sector continue to burden banks with nonperforming loans, undermining the stability of the financial sector.

Sustaining Disinflation and Growth in Countries More Advanced in the Transition

The countries that started earliest and moved most decisively with stabilization and structural reforms have made considerable progress. Disinflation has generally been fairly swift after the initial price jumps associated with decontrol. Output is expanding at a median rate of 4–5 percent. The main policy challenge now facing these countries is to ensure the sustainability of disinflation and growth.

Annual inflation rates have been brought down significantly from the triple-digit levels prevailing in the early phase of the transition. In Albania. Croatia, the Czech Republic, and the Slovak Republic, annual rates of inflation have approached or reached single-digit levels (Chart 27). Nevertheless, inflation remains stubbornly high in most countries, typically fluctuating in the 20–40 percent range. In Hungary, inflation has even picked up anew. The persistence of high inflation is mainly due to the spread of indexation mechanisms and enduring fiscal imbalances (Table 15).42 But it is also related to continuing relative price adjustments. with prices of nontradables rising faster than prices of tradables (Box 5).43

Chart 27.
Chart 27.

Countries More Advanced in the Transition: Inflation

(Twelve-month percent change in the consumer price index)

Inflation has come down but generally remains high.

Table 15.

Countries More Advanced in the Transition: General Government Budget Balance1

(In percent of GDP)

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Sources: National authorities; and IMF staff estimates.

Defined as total expenditure (including extrabudgetary funds) plus net lending minus total revenue and grants.

Central government balance.

Excludes concessional external financing of development projects on the order of 6-8 percent of GDP.

Unexpectedly large capital inflows have been one of the challenges associated with relatively successful stabilization. These inflows are a welcome sign of the confidence of foreign and domestic investors in the economic prospects of the recipient countries.44 However, the inflows have also added to inflationary pressures, most notably in the Czech Republic and Poland but also in Albania, the Slovak Republic, and Slovenia. In the Czech Republic, where the exchange rate is fixed, external borrowing by enterprises, foreign portfolio and direct investment, and short-term borrowing by banks have all contributed to a surge in official reserves, which were equivalent to nearly six months of imports by the end of August 1995. Similarly, in Poland, in the context of a crawling peg, a rapid accumulation of official reserves took place as a result of buoyant exports and, as in the Czech Republic, of expectations that the exchange rate would be revalued. In both cases, restricted exchange rate flexibility coupled with limited scope for sterilization led to rapid money supply growth.45

The ensuing inflationary pressures cannot be durably contained by administrative measures. Price controls, for example, such as the caps on energy prices introduced in Poland, risk delaying structural adjustment. A reintroduction of restrictions on capital flows would also represent a setback to the liberalization and opening up of the economy and deter foreign direct investment. Rather than imposing new restrictions, measures should be implemented to remove distortions in domestic financial markets that might encourage external borrowing or discourage capital outflows. The Czech Republic has announced tighter regulation of short-term borrowing by banks, effective August 1, 1995, in view of the threat that capital inflows have posed to monetary control, while at the same time a draft foreign exchange law would further liberalize outflows of foreign direct investment. Macroeconomic policies, however, have a key role to play in reducing inflationary pressures stemming from large capital inflows. In particular, it may be appropriate to tighten fiscal policy more than planned to reduce the pressures on inflation and interest rates. In some cases, it may even be appropriate to achieve a fiscal surplus. With due regard for competitiveness considerations, it may also be desirable to allow some exchange rate appreciation or to slow down the predetermined rate of depreciation, as has been done in Poland.46

Most of the countries that achieved a fair measure of financial stability early on in the transition have subsequently enjoyed vigorous growth. In 1995, real GDP is projected to exceed its trough by 29 percent in Albania, 19 percent in Poland, and 11 percent in Slovenia. Strong recoveries have helped arrest and in some cases reverse the sharp increases in open unemployment rates that characterized the early stages of the transition (Chart 28). In accordance with the experience of other countries, the contribution of growth to job creation will depend on the degree of flexibility of new and emerging labor market institutions, particularly with respect to wage setting (Box 6).47 Even under favorable conditions, however, high unemployment will remain a major problem in the years ahead in most of the transition countries.

Chart 28.
Chart 28.

Selected Countries in Transition: Open Unemployment Rates

(In percent of the labor force)

Unemployment rates may have peaked in several countries.

Price Liberalization and Inflation Dynamics in Transition Economies

Price liberalization allows the structure of relative prices in transition economies to adjust and move toward that characterizing market-oriented economies with similar levels of per capita income.1 Accordingly, the variability of relative prices is large in the early phase of the transition but declines as prices are realigned closer to market levels.

In Russia, for example, a relatively comprehensive price liberalization took place at the beginning of 1992, causing major shifts in relative prices. After a few months, however, relative price variability had declined substantially (see chart). Price liberalization was more gradual in the transition countries of central Asia. In Kazakhstan, for example, many prices remained administered until late 1994. Before they were decontrolled, these prices were adjusted infrequently and by large amounts, resulting in many spikes in relative price variability.2 The pace of liberalization varied across types of items: in most transition countries, prices for tradables were freed first, and more or less across the board, although the prices of some staples often remained controlled; prices for services were freed last and more gradually. Relative price variability for services thus remained much higher than for tradable goods. As the relative price structure starts to resemble that in comparable market economies and as agents seek to adjust to chronic open inflation, price setting will tend to become increasingly synchronized.

In addition to the ongoing adjustment of relative prices, high and stubborn inflation in most transition countries also reflects the reliance on the inflation tax whereby money creation is used to finance persistently large fiscal and quasi-fiscal deficits.3 In 1993–94, the ratio of the change in base money to GDP—a measure of seigniorage—averaged 1 percent in Poland and the Slovak Republic, 3½ percent in Hungary, 7 percent in Romania, and 9 percent in Russia. The scope for extracting seigniorage diminishes, however, as the demand for money drops in response to higher inflation. Moreover, the efficiency losses caused by high inflation and the inflationary erosion of tax receipts associated with tax collection lags offset seigniorage as a source of off-budget fiscal revenue. If, for example, tax payments are collected with a one-month lag and tax revenues represent 30 percent of GDP, a monthly inflation rate of 10 percent would imply a loss in real fiscal revenue amounting to 3 percent of GDP (assuming no penalties for late payment). Persistent inflation may also reflect the more widespread use of indexation mechanisms, affecting the formation of wages and pensions, and the design of financial contracts. Indexation may help to reduce some of the costs of high inflation, but it causes inflation to become more entrenched. Disinflation under such circumstances requires decisive fiscal adjustment. The reduction of inflation may be facilitated by measures to reduce the inertia in the inflation process stemming from indexation. Institutional reforms enhancing the credibility of financial policies, such as conferring more independence to the central bank, can also reduce inflationary inertia and speed up disinflation.


Russia and Kazakhstan: Relative Price Variability1

(In percent)

1 Measured as a weighted average of the variance of monthly inflation rates for specific items.

See Paula De Mast and Vincent Koen, “Price Convergence in Transition Economies,” IMF Working Paper (forthcoming).


See Mark De Broeck. Paula De Masi, and Vincent Koen. “Inflation Dynamics in Kazakhstan,” IMF Working Paper (forthcoming).


See Rudiger Dornbusch and Stanley Fischer, “Moderate Inflation,” World Bank Economic Review, Vol. 7 (January 1993), pp. 1-44.

To a large extent, robust output growth has thus far been driven on the demand side by a rapid expansion of exports, especially to western Europe but increasingly also to other transition economies (Chart 29). However, even if the revival of east-east trade continues (Box 7), it may be difficult for these economies to sustain rapid export growth without substantial investment to rebuild largely obsolete capital stocks inherited from the command system. Investment is generally beginning to recover and in many cases is rising rapidly from relatively depressed levels. High rates of domestic saving are essential to sustain the pickup in investment. This is an important reason why steady reductions of fiscal deficits will be needed to prevent the crowding out of needed private investments. Provided their macroeconomic consequences are taken into account in the overall policy stance, as discussed earlier, capital inflows, including the return of flight capital, can also help to finance investment. As suggested by the experience of developing countries, foreign direct investment may be particularly helpful to raise overall investment levels, strengthen productivity, improve management practices, and foster export-oriented activities.

Chart 29.
Chart 29.

Selected Countries in Transition: Growth in GDP and Exports of Goods and Services

(In percent, average for 1994–95)

Exports have contributed substantially to output growth.

1Based on value in U.S. dollars.2Merchandise trade.

The continued process of transformation also requires further progress with enterprise restructuring, financial sector reform, and institution building. Although much of the formal framework of a market economy is now in place in the countries that are relatively advanced in the transition,48 corporate efficiency, management practices, and business ethics still have a long way to go to meet international standards, especially among state-owned enterprises. Moreover, in several countries, including Hungary, Poland, and the Slovak Republic, the pace of privatization has remained too slow. Lastly, some of the institutions of a market economy remain to be established, such as well-functioning housing markets, reliable systems of commercial courts, and efficient financial systems. In the longer run, increases in productivity, output, and living standards will be commensurate with improvements in those areas.

Changing Wage Structures in the Czech Republic

Recent evidence suggests that wage structures in the Czech Republic are moving toward those observed in market economies.1 Under central planning, the goal was to encourage the expansion of the goods-producing sector, and in particular heavy industry, and discourage activities in the service sector and most intellectual activities outside of the hard sciences. In designing national wage structures in the early postwar period, central planners took account of education, experience, the attractiveness of jobs, and other factors. However, relative wages were mainly set to allocate labor in accordance with the production goals of the central plans. Accordingly, vocational education was emphasized over advanced academic training. Average economic returns to schooling in central European countries therefore tended to be lower than in most market economies. Thus, the labor force of central European economies began the transition with overinvestments in vocational training and underinvestments in university education.

With the end of central planning, wages in a large number of occupations were free to adjust to market forces. Data from employment and labor force surveys conducted between June 1988 and November 1993 in the Czech Republic suggest that wage structures appear to be moving toward those typically associated with a market economy. Since 1988, for example, it is estimated that average returns to schooling and wage inequality have increased, suggesting a reversal of some of the wage distortions created under central planning. New private firms seem to be playing a leading role in changing the wage structures. For example, returns to university education have increased, and these gains have been particularly noteworthy in the private sector. The survey data also indicate that workers with a vocational degree are no longer guaranteed higher wages than workers with a primary school degree. Although state enterprises and recently privatized state enterprises have mostly retained the old relative wage structures, there may have been some changes—such as increases in the returns to high school and university education—because of labor market competition from the new private sector.

Adjustments in relative wages and the central role of the private sector in bringing about these changes are not unique to the Czech Republic. Estimates of the returns to schooling and wage inequality have increased in Poland and in Hungary, for example. In Romania, by contrast, which has yet to develop a significant private sector, returns to education appear to have changed very little. In a number of transition countries, workers with vocational training have experienced falling relative wages and disproportionately higher unemployment.


Robert J. Flanagan, “Wage Structures in the Transition of the Czech Economy,” Staff Papers (IMF, forthcoming).

Countries Less Advanced in the Process of Stabilization and Restructuring

The key lesson from the countries more advanced in the transition process is that stabilization of prices and resumption of output growth require sound macroeconomic policies coupled with comprehensive structural reforms. In light of this experience, almost all the countries that initially put off fundamental adjustment policies or moved less boldly have more recently been making headway with reforms. Natural disasters and armed conflicts have hindered or undermined the implementation of stabilization and reform policies in a number of countries, Armenia has suffered from the aftermath of the 1988 earthquake, while Moldova endured a severe drought followed by storms with hurricane-force winds. Other countries were set back by the economic disruption and destruction of war, as in Armenia, Azerbaijan, Bosnia-Herzegovina, Georgia, and Tajikistan. Alongside the deleterious effects of such developments, the relatively poor starting point of some countries has tended to exacerbate the adjustment costs associated with the transition. Longer histories of central planning in many of these countries, and lack of basic understanding of market economy principles, have also inhibited the political support for the reform process. Many of these obstacles have gradually been overcome and reforms are under way. There are now visible signs of genuine progress in all but a few countries.

Despite a slow start, the stabilizing effects of tight financial policies are clearly apparent in Moldova and the Kyrgyz Republic. In Moldova, these policies, initiated in late 1993 and steadfastly adhered to since, reduced monthly inflation to less than 1 percent by March 1995 (Chart 30). Real output is expected to bottom out in 1995, harvests permitting (Chart 31). These achievements are particularly impressive in light of the adverse shocks the Moldovan economy has endured since independence, including the armed conflict following the unilateral secession of the Trans-Dniester region and a series of natural disasters. The Kyrgyz Republic, which initiated similar policy measures in late 1993, has reduced monthly inflation to low single-digits and arrested the depreciation in the nominal exchange rate. Real output is expected to begin to turn around during 1995.

Chart 30.
Chart 30.

Selected Countries in Transition: Inflation

(Monthly percent change in consumer price index)

Inflation has slowed considerably during the first half of 1995.

Chart 31.
Chart 31.

Selected Countries in Transition: Real GDP1

(1991 = 100)

The decline of output appears to have bottomed out in a number of countries.

1 Official national accounts data through 1994 and IMF staff projections (blue shaded areas) for 1995.

Following a relatively early start with reforms, progress with stabilization has lagged in Romania and Bulgaria. Since 1994, Romania has tightened financial policies and significantly slowed inflation, while the recovery of output has continued to strengthen. During the first half of 1995, however, the current account deficit widened considerably, partly due to a surge in imports related to devaluation expectations. In Bulgaria, inflation also slowed considerably during the first half of 1995, but, as in Romania, an ailing banking sector and the failure to enforce hard budget constraints on state-owned firms threaten to reverse disinflation.

Clear signs of stabilization have recently become visible in a number of other countries, although progress is still fragile. Following the implementation of tight financial policies, monthly inflation has reached low single-digit levels in Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, the former Yugoslav Republic of Macedonia, and Uzbekistan. Emerging or existing problems in each of these countries, however, jeopardize the success achieved thus far: in Armenia and Belarus, large capital inflows have complicated monetary policy; in Azerbaijan, output has continued to decline, partly reflecting ongoing disruptions of transportation routes and the conflict in Chechnya; in Georgia, external financing needs remain very high and public finances are particularly weak; in Kazakhstan, where large capital inflows have also made monetary policy more difficult, insufficient financial discipline in the enterprise sector could still derail progress in stabilization; in Uzbekistan, stabilization needs to be solidified and recent efforts to speed up structural reform will need to gain momentum to improve growth prospects; and in the former Yugoslav Republic of Macedonia and in Uzbekistan, the limited scope and slow pace of structural reform continue to dampen growth prospects.

Efforts to bring inflation under control continue in Russia. Notwithstanding the tightening of monetary and fiscal policies since early 1995, inflation barely declined during the second quarter, continuing at a pace exceeding 1½ percent a week, corresponding to annual rates of over 100 percent. Russia’s somewhat disappointing inflation performance through mid-1995 is in part due to a decline in the effective reserve requirement ratio, and to the surge in base money resulting from intervention on the foreign exchange market aimed at containing the nominal appreciation of the ruble. Inertia in the inflation process may also reflect lingering doubts about the stance of financial policies, and the memory of earlier failures to stabilize. Meanwhile, there are some signs that output has begun to recover, although measured real GDP is still expected to show a significant further decline in 1995.49

Tight financial policies implemented in Ukraine since October 1994 and in Belarus since early 1995 brought inflation down below Russian levels by the second quarter of 1995. In both countries, the nominal exchange rate stopped depreciating while inflation was falling. Inflation nevertheless remained high and the real exchange rate appreciated substantially against the U.S. dollar and other western currencies. The exchange rate appears to have remained competitive, however: in May 1995, for example, monthly wages stood at less than $50 in Ukraine and at about $65 in Belarus, compared with $70 in Russia and more than $150 on average in the Baltic countries.

Trade Among Transition Countries

With the collapse of central planning, foreign trade among the transition countries declined sharply during 1989–93. Previous trade patterns determined by central plans became less relevant in an environment of trade based increasingly on comparative advantage. Some of the more rapidly reforming transition economies found new markets for their goods in the west, but many struggled to establish trade links based on market principles with their former partners. Recent evidence suggests that intraregional trade flows have recovered somewhat among a number of transition countries.

Trade with the east picked up in 1994 for some of the central European countries, including the Czech Republic, the Slovak Republic, Hungary, and Poland, albeit from very low levels. The strongest gains were in Poland: in 1994, Polish exports to other transition countries rose by 34 percent, with food and manufactured items accounting for more than half of the total, while Polish imports from transition countries increased 21 percent, mainly in fuels, chemicals, and intermediate manufactured products such as iron and steel (see table). Economic recovery in central Europe and multilateral trade arrangements have contributed to the revival of east-east trade. The Central Europe Free Trade Agreement (CEFTA), enacted in 1994 by the Visegrád countries—the Czech and Slovak Republics, Hungary, and Poland—mandates that all trade barriers on industrial products be removed by the year 2001. Slovenia became a full member of CEFTA in 1995. Recently, Poland became the last of the Visegrád countries to sign a separate agreement with Slovenia abolishing all import duties over the next two years.

For the Baltic countries, Russia, and the other countries of the former Soviet Union, the collapse of central planning has meant a gradual disappearance of bilateral interstate barter clearing and settlements through correspondent accounts in central banks. In many countries, these outmoded practices have been replaced by settlements in national currencies through correspondent accounts in commercial banks, forming the basis for expanded international trade.

Poland: Foreign Trade by Direction

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Sources: National authorities; and IMF staff estimates.

The Baltic countries have successfully established trade links with other transition countries, especially with one another. In 1994, intra-Baltic trade rose about 30 percent, reflecting the impact of the Baltic Free Trade Agreement, which eliminated all trade barriers, and the geographic proximity of these countries. More recently, in an effort to expand trade relations further, Estonia and Ukraine have been negotiating a bilateral free trade agreement that covers all products.

Trade among the Baltic countries, Russia, and the other countries of the former Soviet Union has also started to pick up. After a number of years of sharp declines, Russian exports to the Baltic countries increased strongly in 1994, as did exports of gas and diesel fuel to Ukraine and Belarus in 1995, In the past two years, Russia has signed free trade agreements with many of the countries of the former Soviet Union waiving import duties and, in some countries, export taxes. In particular, Russia and Belarus have agreed to create a customs union with a common system of external tariffs. Trade among most of the central Asian and Transcaucasian countries has yet to recover owing to ongoing payments difficulties (resulting in mounting arrears) and continued declines in domestic demand and production.

Tajikistan—until recently the last country other than Russia still using the ruble as legal tender—introduced its own currency, the Tajik ruble, in May 1995. A temporary freeze on bank credit and other emergency measures initially helped support the new currency, but the scope for exchange rate stabilization is limited by the paucity of foreign exchange reserves and foreign financial assistance. In recent months, inflation in Turkmenistan has been much higher than in the other central Asian countries, fueled by an expansionary monetary policy and general hesitation to pursue decisive adjustment and reform policies.

Although success with economic stabilization has varied substantially across the countries less advanced in the transition process, fiscal performance, despite some improvements, remains a serious source of concern in all of these countries (Chart 32).50 As budget deficits are financed in large part through money creation, failure to achieve fiscal consolidation threatens to undermine progress in reducing inflation. The persistence of deficits stems from chronic problems impeding revenue collection and expenditure restraint. To some extent, revenue collection can be bolstered by strengthening tax administration, expanding tax coverage to include the emerging private sector, eliminating tax exemptions, and broadening tax bases. In a number of countries, however, the inability to collect sufficient revenues is due more to political than to economic considerations. In Russia, for example, there has been substantial political resistance to increases in taxing oil production, and tax revenues from the natural gas sector have remained low by international standards. Another source of revenue loss in Russia and in many other countries is tax arrears of unprofitable enterprises. These arrears are unlikely to be repaid in full and, in effect, represent financial transfers from the budget to) enterprises (Box 8).

Chart 32.
Chart 32.

Selected Countries in Transition: General Government Expenditure, Revenue, and Deficit1

(In percent of GDP)

Deficits are generally narrowing but remain large.

1 Expenditure equals total expenditure (including extrabudgetary funds) plus net lending; revenue equals total revenue plus grants. Blue shaded areas indicate IMF staff projections.2Central government.

Gaining better control over expenditures requires considerable changes in the budget process and in the financial management of government operations. Establishing a treasury system centralizing payment and cash management can markedly improve the allocation of government resources.51 Although such a system is being introduced in some countries, including Belarus, Kazakhstan, the Kyrgyz Republic, Russia, and Turkmenistan, it will take time before new procedures yield more effective control over spending. Other pressing expenditure issues merit immediate attention. For example, many countries still rely on cash rationing as an expedient to contain expenditures. Running up arrears, however, is an unsustainable way to achieve budget balance. Off-budget expenditure categories, and especially subsidies, are also difficult to control and therefore should be more carefully monitored. Downsizing and restructuring of the civil service, and more effective targeting of social benefits, are areas where budget savings could be realized.

Implementation and perseverance with sound macroeconomic policies are necessary, but not sufficient, to bring about sustained growth. Structural reforms and in particular price liberalization and privatization are also critical for a durable recovery of output. The different experiences of transition countries indicate that delaying these reforms, as with delaying macroeconomic stabilization, at best postpones output declines and is likely to make them larger. The process of structural reform is relatively advanced in Armenia, Georgia, the Kyrgyz Republic, Kazakhstan, and Russia, but severely lagging in the former Yugoslav Republic of Macedonia, Turkmenistan, and Tajikistan.

Subsidies and Tax Arrears

The scale of direct budgetary subsidies to enterprises in the transition economies was sharply reduced when prices were liberalized. In the Visegrád countries—the Czech and Slovak Republics. Hungary, and Poland—for example, subsidies dropped from 15-25 percent of GDP before liberalization to 3-5 percent of GDP after liberalization. Large declines in direct subsidies also occurred in most other transition countries.

The curtailment of subsidies paid out of the government budget to firms is one of the ways in which hard budget constraints are established. Progress, however, has been slower than what the contraction of budgetary subsidies may suggest. Other forms of explicit or implicit transfers to enterprises—such as arrears, guarantees for bank credit, interest rate subsidies, licenses, quotas, multiple exchange rate arrangements, and tax exemptions—have not declined to the same extent, or have even increased. In particular, arrears on tax payments (including VAT, excises, profit, and excess wage taxes) and social security payments have risen to levels comparable with those of direct budgetary subsidies.

Because eventual payment of most tax arrears may not be enforced, and because inflation erodes the real value of taxes that are paid late, tax arrears often represent a financial transfer from the budget to the enterprise sector.1 Around 1993, the stock of tax arrears was about 5-10 percent of annual GDP in the Visegrád countries, while the flow of tax arrears typically hovered in the neighborhood of 2 percent of GDP,2 The flow of tax arrears also averaged 2 percent of GDP in Russia in I994.3 These estimates far exceed write-offs of uncollectible taxes in most industrial countries: in the United Kingdom, for example, write-offs are typically about ½ of 1 percent of GDP.

Survey evidence for Hungary and Poland suggests, not surprisingly, that the bulk of the tax arrears are owed by the least profitable firms. Balance sheet data for Polish firms show that the losses of financially distressed enterprises were covered mainly by increases in tax liabilities, and much less by increases in trade or bank credit. Paying suppliers and workers thus appears to be given priority. Because bank credit is scarce, the government ends up absorbing a large portion of the losses. As long as no bankruptcy procedures are initiated by the government or other creditors, enterprises can avoid immediate closure by running up arrears.

The tax authorities may have several reasons not to pursue these firms into bankruptcy. First, their net value may be so low that a lengthy and costly bankruptcy procedure would not yield much revenue for the budget in the short run. Second, local tax authorities may face political pressures to resist layoffs and maintain the status quo; moreover, they may hope or expect that the firms will be rescued by the government, that a debt workout scheme will be implemented by bank creditors, or simply that the firms may become viable in the context of a general economic recovery. Partly reflecting such concerns, a scheme has been introduced in Russia allowing the settlement of tax liabilities by oil companies through deliveries of fuel to the agricultural sector.

A full accounting of government aids to enterprises should thus incorporate tax arrears alongside budgetary subsidies and other quasi-fiscal transfers. Hard budget constraints are increasingly ruling most of the financial relations among banks, enterprises, and households in the transition economies. However, effective budget constraints have proven to be harder to impose on obligations between governments and enterprises. Transfers that have disappeared as subsidies have resurfaced as tax arrears.


Penalties For late payment, insofar as they are paid, mitigate the inflationary erosion of tax receipts.


See Mark E. Schaffer, “Government Subsidies to Enterprises in Central and Eastern Europe: Budgetary Subsidies and Tax Arrears,” in Tax and Benefit Reform in Central and Eastern Europe, ed. by David M. Newbery (London: Centre for Economic Policy Research, 1995).


See Gilles Alfandari and Mark Schaffer, “On ‘Arrears’ in Russia,” paper presented at a Joint Conference of the World Bank and the Ministry of Economy of the Russian Federation, St. Petersburg, Russia, June 12-13, 1995.

Price liberalization is necessary to improve the efficiency of resource allocation. All countries have implemented significant price reforms in the markets for domestic goods and services, even though much remains to be done in a few countries such as Turkmenistan. The prices that remain controlled, typically for selected staples, rents, and other services, are periodically adjusted with the objective of full cost recovery in the longer term. Concomitantly, budgetary subsidies in most countries have declined sharply as a share of total expenditure since 1991.52 Nevertheless, numerous off-budget and indirect subsidies persist. In Russia, for example, these subsidies include foreign trade regulations keeping domestic energy prices excessively low, credits carrying below-market interest rates, and tax exemptions. These hidden subsidies are sources of distortion and will need to be cut further as part of the effort to reduce broadly defined fiscal deficits.

The decontrol of domestic prices and quantities must be accompanied by similar measures on the external side. These measures include exchange rate unification and liberalization, abolition of open and hidden import subsidies, harmonization of import tariffs, and elimination or at least streamlining of quotas, licensing requirements, and export tariffs. Progress in some of these areas has been slow, but reforms are proceeding. The Kyrgyz Republic and Moldova have accepted the obligations of Article VIII of the IMF Articles of Agreement, thus marking their transition to convertibility for current account transactions. Postponing reforms in this area only fosters rent seeking and corruption, generates capital flight, and provides a fertile ground for growth of vested interests strongly opposed to further structural reforms.

Privatizing the bulk of state-owned enterprises and improving enterprise management and corporate efficiency are also essential for these economies to realize their growth potential. In addition, legal structures safeguarding market-based incentives must be established and activated, including legislation governing property rights, contracts, bankruptcy, banking, competition policy, and foreign investment. Russia has made the most headway with privatization. In 1992, the Russian government launched a mass privatization program that in eighteen months shifted ownership of a large proportion of state enterprises to the private sector.53 Restructuring, however, has typically lagged the transfer of title. While many Russian privatized enterprises are still overstaffed, handicapped by obsolete technologies, and poorly managed, survey evidence points to improvements in product lines, marketing capabilities, employment levels, and wage structures.54 However, the leasing of land, dwellings, and industrial premises is still often carried out on an administrative basis, giving local authorities scope for discretion and discrimination.55

In Kazakhstan, privatization has advanced more slowly, but the ongoing mass coupon privatization scheme is expected to transfer the ownership of at least 150 large- and medium-scale enterprises each month in 1995. Although initially off to a slow start, efforts are now under way to accelerate the privatization process in Armenia, Georgia, the Kyrgyz Republic, the former Yugoslav Republic of Macedonia, and Moldova. Other countries are moving very slowly in this area: in Bulgaria, high unemployment, resistance from state-owned enterprise workers and managers, and a myriad of bureaucratic obstacles have severely hindered progress; similar difficulties exist in Belarus, Croatia, Romania, Turkmenistan, and Ukraine.

Agricultural reforms are equally necessary in all transition countries. The share of agriculture in employment and output is typically much larger than in industrial countries, approaching one third in Moldova and one half in Albania. Overall growth performance will be significantly affected by the speed with which this sector is revitalized and modernized. In many cases, however, the pace of structural change has tended to be slower in agriculture than in industry and services.

Financial Fragility and Macroeconomic Stability

A sound banking system is indispensable for resources to be efficiently allocated as well as for the protection and encouragement of domestic saving. A healthy financial sector can also contribute to the improvement of corporate governance in the enterprise sector. Through these various channels, financial sector deepening will contribute to higher growth of output and living standards.

Banking systems in most economies in transition, however, are very fragile, as illustrated most recently by crises in Latvia and Russia. Saddled with a legacy of poor assets, but also with more recently committed nonperforming loans, many banks throughout the transition countries either have been closed or are vulnerable to adverse shocks. The fragility of the financial system poses a major risk for the recovery of activity and may exacerbate fiscal imbalances, and thereby increase inflation pressures.

The main functions of financial institutions under central planning involved payments and accounting rather than risk evaluation, allocation of financial resources, and monitoring of borrowers. In the 1980s, the nonobank system still prevailing in many countries was split up and some commercial incentives were introduced. In the early 1990s, when the transition to a market economy started in earnest, small banks proliferated and other financial institutions emerged, including private insurance companies, pension funds, mutual funds, security firms, and equity and bond markets.56 In Poland, for instance, 60 new commercial banks were started in 1990–91. In Latvia, the number of banks soared from 6 in 1990 to 63 by 1993. Russia had over 2,500 banks by the end of 1994.

The pre-existing establishments inherited several handicaps, including a lack of experience in credit operations and an excessive dependence on a small number of state-owned enterprise borrowers. Bad loans carried over from the old regime were less of a problem in countries like Poland, where high inflation wiped out their real value, than in countries like the Czech Republic and the Slovak Republic, where inflation was better controlled. The new banks were often set up with a minimal capital base.57 A number of them—the so-called pocket banks—were little more than the financial subsidiaries of state-owned enterprises, serving as a conduit for directed credits (and sometimes as a channel for tax evasion and capital flight). Prudential regulations and supervision were almost everywhere insufficient to deal with the rapid development of the financial system.

Many banks accumulated new bad loans during the early years of the transition, sometimes at the behest of the government. State-owned enterprises faced with abrupt cuts in demand turned to banks to obtain credit, allowing them to defer adjustment. In the face of a rapidly increasing portfolio of nonperforming loans, banks often preferred to acquiesce, including through the capitalization of interest or the extension of fresh loans to debtors in arrears, rather than to record a loss. In many countries, the agricultural sector managed to continue to obtain soft loans and debt forgiveness from state banks. Often, banks tried to preserve revenue by augmenting spreads, thus exacerbating moral hazard and adverse selection problems, and crowding out some economically viable projects in the new private sector. Outright fraudulent behavior was also rife: bank shareholders, for example, often took out loans worth substantially more than the value of their shares, sometimes with the collusion of bank managers, with little intention of repaying.

As a result, numerous banks became virtually or openly insolvent. In Poland. 15 out of the 73 private banks were near bankrupt in early 1994. and close to 700 of the 1,660 cooperative banks were in crisis or subject to recovery programs. In Russia, the stock of overdue loans increased from 12 percent of bank credit at the end of 1993 to over a third in early 1995, and the central bank has already revoked the licenses of 160 banks since 1993. In Kazakhstan, a recent asset quality survey showed that 40 percent of all loans were effectively lost and should be fully provisioned. In the Kyrgyz Republic, half of the commercial banks had negative net worth in early 1995. In Turkmenistan, 7 out of the 18 commercial banks closed between February and May 1995. In Georgia, 65 of the 229 banks have had their licenses suspended, and all of the state banks have negative net worth. There have been similar developments in Armenia, Bulgaria, Ukraine, and most other countries in transition.

A large-scale banking crisis erupted in Estonia in late 1992 when three of the major commercial banks, holding deposits accounting for almost 40 percent of broad money, suddenly turned out to be insolvent. The three banks were promptly closed down. Two of them were recapitalized with public funds and merged, and the third was liquidated. Although there was not a run on the healthy banks, the public’s confidence in the banking system was shaken, causing some disintermediation. In the wake of the banking crisis, and as capital requirements were increased, the number of commercial banks in Estonia halved. A second banking crisis occurred in 1994, when a large bank became insolvent. Despite some equivocation on the part of the authorities, the systemic repercussions of this bank failure were contained as well.

A major banking crisis also surfaced in Latvia. The largest commercial bank collapsed, after a few other banks had gone bankrupt or lost their licenses. This bank in particular had been offering extremely high interest rates to attract money to finance ventures with questionable prospects. The bank failed to complete its 1994 audit, and customers started to withdraw deposits. The government stepped in and took over the management of the bank. The economic court has appointed an administrator to determine the fate of the bank, including possible liquidation. The confidence crisis also affected the foreign exchange market, where there were large capital outflows and calls for a devaluation of the lat before monetary policy was tightened and the situation calmed down.

More recently, signs of the underlying weaknesses in Russia’s banking system have become visible. During the last week of August 1995. the inability of a few banks to honor interbank obligations led to a sharp rise in overnight interest rates to as high as 1.000 percent a year and to a virtual standstill in interbank trading. In response, the government stepped in to provide liquidity, but emphasized that this action was a temporary measure and that the government would not directly intervene to support any ailing bank. In the aftermath of the crisis, interbank market activity has gradually resumed, starting with trading among a group of large banks, and interest rates have generally returned to previously prevailing levels. By early September, the payments problem appeared to be confined to a small number of banks. Nevertheless, these events have highlighted the need to improve banking supervision and accelerate the structural reform of the banking system.

Preventing such crises and the associated macroeconomic disruptions requires a number of precautionary measures. Supervision—both on-site examination and off-site monitoring—needs to be considerably strengthened in virtually all transition countries. Accounting standards have to be adapted so that enterprise performance can be assessed on the basis of market criteria. Banks should be allowed to deduct provisions for bad loans for tax purposes. Minimum capital requirements should be raised, which would help to consolidate an often overly fragmented banking sector.58 Deposit insurance is desirable to protect savers but should not be unconditional and unlimited, so as to encourage caution on the part of depositors. Insolvent banks ought to be liquidated rather than kept alive through implicit or explicit subsidization schemes. State guarantees on loans should be avoided because of the potential cost to the budget and to ensure that loans finance economically viable projects. Limits on insider lending need to be tightened, and malfeasance investigated more thoroughly and punished. Finally, the entry of foreign banks should be facilitated to spur the modernization of banking practices in domestic institutions.

Banking crises once they emerge should be dealt with promptly and vigorously, and in a way that will prevent their recurrence. As the experience of Estonia has shown, taking a tough line and proceeding with liquidations need not lead to a broader systemic crisis. Recapitalization in particular should be conducted as a one-time rescue operation and not as a prelude to future bailouts, as turned out to be the case in Hungary where several rounds of capital injections took place at considerable budgetary cost. To the extent possible, recapitalization should be combined with privatization. When government rescue operations involve state banks, recapitalization should be accompanied by commercialization. To safeguard financial stability, the fiscal costs of capital replenishment should lead to added restraint in other public expenditures, as was done in the former Czechoslovakia.59

Successful crisis management also requires that the central bank, or, more generally, the supervisory authorities, be given the legal powers to act decisively. Close coordination between the central bank and the government is also needed. Crisis management will be more effective the better is the authorities” prior knowledge of the dimension and distribution of the bad loans problem, including the quality of collateral, the extent of state guarantees, and the magnitude of the provisioning associated with nonperforming loans.

The soundness of the financial system also has implications for corporate efficiency in the nonfinancial sector. Weak banks are not in a position to act as agents of restructuring and of strengthened management principles in nonfinancial enterprises. Shaky investment funds are also unlikely to impose much discipline on enterprise managers. Conversely, for financial institutions to monitor enterprises effectively, the incentives facing enterprises need to be changed. For example, large state enterprises should no longer be led to expect that they can induce the state to force banks to roll over loans that are not serviced. Indeed, reforms in the banking sector alone are insufficient to ensure financial discipline in the nonfinancial sector. Structural reform efforts must also include improvements in corporate efficiency through comprehensive enterprise reforms and social safety net restructuring. Reforms in these areas will, in turn, help to strengthen banks by increasing the number of economically viable borrowers.

* * *

Half a decade into the transition, the main challenge facing the countries more advanced on the path to a market economy is to safeguard macroeconomic stability while maintaining or, where possible, increasing the momentum of structural reform. While substantial stabilization has been broadly achieved, numerous rigidities remain that could undermine disinflation and growth performance. Particularly worrisome in this regard are signs of backtracking, as observed in the Slovak Republic with respect to privatization. It is also important to streamline social safety nets further, for fiscal as well as for efficiency reasons. The prospect of closer relations with the European Union, and perhaps eventual membership, provides added encouragement for many of these countries to persevere with their reform efforts.

While much progress with stabilization has been accomplished recently by most of the other countries, the risk of setbacks is higher than in the more advanced countries. The main challenge, therefore, is to make stabilization stick, particularly by persevering with fiscal adjustment efforts. The recent quickening of structural change noticeable in a number of these countries is encouraging. Sufficient and timely external financial assistance is also crucial, particularly in countries such as Armenia and Georgia that have undertaken courageous adjustment policies, but where the success of these policies is contingent on external assistance.

In most of the transition countries, structural change in financial systems has been substantial, helped by assistance from international institutions. Nonetheless, financial sector reforms still have a long way to go. Financial fragility poses a major risk in many countries. The way bad debt problems are handled is key: covering up bad debts by rolling over hopeless loans will increase the ultimate costs of addressing this problem. A large-scale banking crisis would spoil the fruits of past adjustment efforts and intensify pressures to soften budget constraints. It is essential to recognize and cope with the issue of nonperforming assets early on, to tackle the distortions contributing to the weakness of bank balance sheets, and possibly to spread out the implied financial burden over time, rather than to let the problems grow into a full-fledged crisis.

Annex Exchange Rate Effects of Fiscal Consolidation

The connection between fiscal policy and exchange rates is not obvious from the experience of a number of industrial countries. In the United Slates, the increase in the fiscal deficit in the early 1980s was associated with a strong appreciation of the dollar. Similarly, the shift in Germany from a balanced fiscal position in 1989 to a large deficit in the early 1990s in the wake of unification was accompanied by a real appreciation of the deutsche mark. In Japan, the shift from a substantial structural surplus to a deficit in the general government budget between 1990 and 1994 coincided with a large appreciation of the yen. However, in other industrial countries such as Finland. Italy. and Sweden, fiscal deficits in the early 1990s have tended to be associated with depreciating real exchange rates. Fiscal expansions in France in the early 1980s and in Canada in the mid-1980s were also accompanied by exchange rate depreciations. And the significant fiscal consolidation undertaken by the German authorities during the past three years has not been associated with a weakening of the deutsche mark.

These different experiences suggest that the impact of changes in fiscal policy on nominal and real exchange rates is ambiguous. With a large number of industrial countries undertaking or planning substantial fiscal consolidation, it is useful to explore the factors that may account for this ambiguity. As discussed in the first section of this Annex, the uncertainty regarding the theoretical direction of the effect of fiscal policy on exchange rates relates mainly to the short-run impact. By contrast, the theoretical direction of the longer-run effects of a sustained change in the fiscal position, which are described in the second section, appears to be more clear cut. The third section summarizes some of the empirical evidence.

The relationship between fiscal policy and exchange rates is mainly addressed from the perspective of industrial countries. Although the framework used in the analysis is applicable to developing and transition countries, they are not discussed because in many cases they share characteristics that are quite different from industrial countries. For example, many developing and transition economies peg their exchange rates to other currencies, enjoy only limited access to international capital markets, and tend to monetize fiscal deficits to a much greater extent than industrial countries.1

Short-Run Effects of Changes in Government Budgets

The experiences of the United States, Japan, and Germany noted above are consistent with the predictions of the standard Mundell-Fleming model: a fiscal expansion combined with an unchanged stance of monetary policy leads to a real appreciation of the domestic currency in a world with high capita) mobility. In this model, domestic prices are assumed to be fixed, interest rates are determined in domestic money markets, and expectations are static in the sense that current economic conditions and policies are not expected to change. This last assumption implies that net capital flows are simply a function of the interest rate differential because exchange rates are not expected to change in the future. Finally, the exchange rate floats freely and reserves are unchanged, so the current account is equal to net capital flows.

A fiscal expansion—either through an increased level of government expenditures or a reduction in taxes—raises domestic demand and, with unchanged money growth, leads to a rise in domestic interest rates. The higher level of demand increases imports, implying a deterioration in the current account, and the higher interest rates generate a capital inflow that finances the change in the current account. The net effect on the exchange rate depends on the degree of capital mobility. In the extreme case of perfect capital mobility, the domestic interest rate cannot differ from that abroad and consequently the fiscal expansion would have no impact on the domestic interest rate. The real exchange rate must therefore appreciate so that the deterioration in net exports matches the demand stimulus from the expansionary fiscal policy, Conversely, with zero capital mobility the exchange rate must depreciate so as to keep net exports unchanged. As capital is highly mobile among the industrial countries and comparable financial instruments (in terms of maturity, tax status, default risk, and so forth) issued in the currencies of these countries appear to be very close substitutes, it is reasonable to assume that the interest rate effect dominates. Consequently the fiscal expansion will tend to produce an appreciation of the nominal exchange rate.2 The real exchange rate will also tend to appreciate if prices respond with a lag to the increase in domestic demand.

This result is based on a number of assumptions. First, monetary and fiscal policies are independent and the possibility of future monetization of government debt is ignored. If this assumption is not valid and the monetary authorities fully accommodate the fiscal expansion, then the standard result may no longer hold. Second, as noted above, expectations are static: the current level of the exchange rate does not depend on expectations of the future spot exchange rate, or, more precisely, the expected evolution of future policies does not affect the future spot rate. Violation of any of these two assumptions could account for the episodes described above in which fiscal expansions were associated with exchange rate depreciations. Third, the standard Mundell-Fleming model does not allow for a government intertemporal budget constraint, which implies that government bonds are perceived as net wealth by the private sector, and takes no account of the implications of a growing stock of liabilities to foreigners. For this reason, and because the model is static, there is no difference between the short- and long-run effects on the exchange rate of a change in fiscal policy. As described below, these effects are likely to be in different directions.

Relaxing the last two assumptions does not necessarily overturn the standard result. This can be seen in the simulation reported in Table 16, which shows the effects of an illustrative fiscal contraction in the United States using the Fund’s multicountry macroeconometric model (MULTIMOD), which incorporates intertemporal budget constraints and forward-looking expectations. In this framework, the nominal exchange rate is approximately determined by the uncovered interest parity condition, whereby the interest rate differential is equal to the expected change in the exchange rate. In the scenario reported in Table 16, the public is assumed to know the future path of fiscal policy. Because the government announcement that there will be a permanent reduction in the ratio of government debt to GDP is assumed to be fully credible, the public immediately adjusts its economic actions and plans to take account of the change in policy. Finally, the effects of changes in saving and investment on the capital stock and domestic and foreign wealth are taken into account in a consistent fashion.

Table 16.

United States: Effects of Fiscal Consolidation on the Exchange Rate

(Percentage deviation from baseline unless otherwise noted)

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The estimates for the long run reflect the permanent effects of the shock measured as the difference between the steady-slate solution of the model with and without the shock.

A negative figure denotes a depreciation of the domestic currency.

In percentage points.

In the illustrative scenario reported in Table 16, fiscal policy is tightened to reduce government debt in the United States by 10 percent of baseline GDR3 This is accomplished by increasing the tax rate on household income by 1 percent for a period of ten years beginning in 1996. Thereafter, the tax rate is reduced to stabilize the debt-to-GDP ratio at a level 10 percent below the baseline. This fiscal action, which results in an improvement in the general government balance of about 1 percent, has a short-term contractionary effect on consumption and total demand.4 As the monetary authorities are assumed to keep the monetary aggregates close to their baseline values, the decline in aggregate demand results in a fall in interest rates. The standard Mundell-Fleming result—a short-run nominal and real depreciation—reflects the uncovered interest parity assumption: as interest rates in the United States fall relative to those in the rest of the world, there must be an initial fall in the dollar so that the expected future appreciation of the currency offsets the lower nominal interest rate. The lower real interest rate “crowds in" real domestic investment. Furthermore, the fiscal-induced reduction in domestic demand, combined with the real exchange rate depreciation, improves the current account balance. These two channels more than offset the decline in consumption (relative to baseline) by 1998, and real output and the stock of capital are permanently higher.

This stylized scenario describes a ceteris paribus result that does not necessarily take account of the initial conditions prevailing at the time of the assumed change in fiscal policy. The depreciation of the U.S. dollar since late 1994, for example, may already reflect the anticipation of fiscal actions in the latter half of 1995 and beyond. In this case, the exchange rate may not depreciate further once these fiscal actions are actually announced or implemented. An alternative way to look at this issue is to note that the recent dollar depreciation is expected to improve the U.S. current account balance substantially from its currently prevailing level. To accommodate this improvement in the current account, there must be a corresponding improvement in the national savings and investment balance. If there were no improvement in public saving (through fiscal consolidation), then either private saving would need to rise (for reasons that are not clear) or investment would need to be curtailed (presumably through a rise in interest rates). Alternatively, excess demand pressures in the U.S. economy, resulting from the combination of continued growth of domestic demand and a highly competitive dollar, might push up U.S. inflation and reverse the recent real depreciation of the U.S. dollar. In other words, the anticipation of further fiscal consolidation (and an improvement in public saving) may already be embodied in the current real exchange rate of the dollar. Thus, despite the theoretical prediction that an anticipated fiscal consolidation will result in an exchange rate depreciation, the ex post link between these two variables may not be apparent.

Moreover, in applying economic theory to the foreign exchange value of the U.S. dollar (or other national currencies), it is important to remember that the world has more than two important currencies. During the past year and a half, the U.S. dollar has depreciated considerably against the Japanese yen and the deutsche mark and European currencies closely linked to the deutsche mark; it has held steady or appreciated against the currencies of most of the United States’ other leading trading partners.

Interest Premiums

The illustrative scenario discussed above also does not allow for the possibility of changes in the perceived riskiness of assets in the country implementing the fiscal consolidation measures. Indeed, countries with large budget deficits and public debts have often experienced an increase in interest rates, downward pressure on exchange rates, and an improvement in the current account. By requiring higher yields on government debt in countries with large deficits and by shifting to investments in other countries, investors have frequently signaled their lack of trust in both fiscal and monetary policies.5 Given that deteriorating actual and prospective fiscal positions and widening interest differentials have at times been associated with depreciating exchange rates, it is possible that the adoption of strong, front-loaded, credible fiscal consolidation measures could narrow interest differentials, appreciate the currency, and—possibly—worsen the current account position.

Standard intertemporal models such as MULTI-MOD do not incorporate links between fiscal policy and exchange rates stemming from changes in risk premiums. The ways in which fiscal stabilization may raise investors’ demand for domestic assets, and hence appreciate the domestic currency, can be summarized with reference to a log-linear version of the standard covered interest parity condition. This condition states that the interest differential between assets denominated in different currencies and issued on the same terms in a common offshore center is approximately equal to the difference between the (log) spot exchange rate (X) and the (log) forward exchange rate (F) for delivery on the date corresponding to the interest rate.


where the subscript E denotes Euro- (i.e., offshore) rates, the asterisk denotes foreign variables, and exchange rates are expressed as units of foreign currency per unit of domestic currency.

The interest parity condition can be rewritten in a form that is useful to discuss a variety of possible determinants of the interest differential, defined as the spread required by international investors to hold domestic assets rather than offshore assets denominated in foreign currency:


where iD is the interest rate paid domestically on assets with the same maturity as those earning iE offshore, and Xe is the spot exchange rate expected by investors over the same term.

This expression decomposes the interest differential between domestic assets (issued in domestic currency in the domestic market) and foreign assets (issued in foreign currency in the Euromarket) into three components. It thereby provides a way of accounting for the large gap between domestic interest rates in currencies such as the Italian lira and interest rates on comparable instruments denominated in deutsche mark. The first component, (XeF), is the difference between the expected future spot exchange rate and the forward rate at the same maturity. This is the properly defined measure of the foreign exchange risk premiums: the compensation required by risk-averse investors to hold an asset whose only risk depends on it being issued in a particular currency. Although empirically satisfactory structural models of exchange risk premiums have proven elusive, ad hoc empirical models and insights gained from theoretical models suggest that risk premiums on the currencies of industrial countries are unlikely to exceed 1 percent in absolute terms.6

The second component of the interest differential, (iD - iE), which has come to be known in the literature as “political risk,” encompasses a variety of factors linked to domestic policies that may drive a wedge between yields on domestic and offshore assets issued in the same currency and with the same maturity and other characteristics. Political risk has traditionally been associated with the possibility of capital controls but may be extended to include “default risk” associated with outright default, debt consolidation, or the possibility of taxation of interest income and financial wealth.

Empirically, this source of risk is likely to be small, at least in the case of industrial countries. A recent study by Lane and Symansky (1993), for example, estimated political risk in Italy at the height of the ERM crisis in 1992 to be less than 80 basis points (on an annualized basis), with noncrisis values ranging from 5 to 30 basis points. These estimates were obtained by comparing bonds issued by the Italian government in foreign currency with those issued by (presumed) default-free agents, such as the World Bank, for assets with maturities of twenty to thirty years. Political risk on shorter maturities is likely to be even smaller. Similar results were found by Alesina and others (1992), who found a strong correlation between the size of public indebtedness and the spread between public and private rates of return, but very small default premiums of less than 40 basis points in most cases.

The last component of the interest differential examined here, (X – Xe), is the expectation of currency depreciation. This can reflect a variety of anticipated sources of nominal and real shocks, including changes in equilibrium real exchange rates resulting from demand and productivity shifts or expected changes in economic policies. Based on the general finding that the first two components of the interest differential appear to be fairly small, this third component of the interest differential would therefore appear to be the largest. Direct survey data for exchange rate expectations, such as reported by Consensus Economics. Inc, for example, often indicate significant expected depreciations. Much of the expected depreciation may, of course, simply reflect anticipation of higher inflation than in other countries.

Based on this taxonomy, one can envisage several channels through which changes in fiscal policy can lead to exchange rate changes, all of them implying that fiscal consolidation may result in a short-run appreciation of the home currency. First, debt reduction may cause a fall in the foreign exchange risk premium by reducing the relative stock of domestically issued liabilities held in the portfolio of both domestic and foreign investors. With assets imperfect substitutes and investors risk averse, the required rate of return on these liabilities declines with a reduction in the relative size of the liabilities issued by the government.

Debt reduction may also reduce the volatility of future exchange rates around their expected values. A lower debt stock may reduce uncertainty about taxation and other policies undertaken to service debt, reduce the likelihood of a financial crisis, and—most fundamentally—reduce the exposure of the domestic economy to world shocks (e.g., interest rate shocks). If a reduction in macroeconomic uncertainty causes a reduction in the systemic component of exchange rate risks, investors’ demand for the home currency may increase, thus allowing both a fall in domestic interest rates and an appreciation of the currency. These effects are only likely to occur if the fiscal measures are implemented on a durable basis and are viewed as such by investors.

The second channel is that a lower outstanding stock of debt may lead investors to reduce the perceived likelihood of default, including the imposition of restrictions on capital mobility to prevent capital outflows, or of taxes on interest income and financial wealth. As “default” and “political” risk premiums fall, the domestic currency may appreciate in response to the increase in demand for domestic instruments.

A lower actual and prospective stock of government debt may also lead investors to lower their expectation of the likelihood of an eventual monetization of debt, thereby mitigating inflation expectations and exchange rate devaluation expectations. In this case, the decline in the interest differential reflects a fall in (X – Xe), that is, a reduction in the expected future spot rate that exceeds the appreciation of the current spot rate. Note that the forward-looking nature of exchange rates does not require monetization to take place over the maturity of the forward contract: an anticipated future change in monetary policy and inflation will affect the whole stream of exchange rates, even spot rates prior to the actual policy change (though with a decreasing intensity that reflects discounting). For there to be a decline in the interest differential and an exchange rate appreciation, the fiscal improvement must be implemented on a sustained basis.

One way to gauge the potential size of these various types of interest premiums is to look at the current configuration of long-term interest rate differentials of various assets. The low level of U.S. long-term interest rates relative to Germany suggests that there is currently little, if any, interest premium for the U.S. dollar vis-à-vis the deutsche mark. A stronger case could be made for an interest premium on the lira, given the current spread of about 500 basis points between Italian long-term interest rates and comparable German rates and the recent experience whereby exchange rates and, to a lesser extent, interest rates have shown a positive response to renewed commitments to greater fiscal discipline. Long-term interest rates in Sweden and Canada also appear to embody interest premiums.

As noted above, changes in interest premiums of this kind are not an integral part of most standard open economy macroeconomic models such as MULTI-MOD, Such changes can, however, be introduced into the model as an exogenous shock to gain a sense of the likely effects. Table 17 presents an illustrative MUL-TIMOD scenario of a fiscal contraction combined with a decline in the interest rate differential. This stylized scenario is discussed with reference to Italy, although the size of the fiscal and interest rate shocks are arbitrary, and the actual change in interest differentials associated with fiscal adjustment could be substantially different from that assumed in the simulation. Nevertheless, this scenario demonstrates how the effects of fiscal policy could be substantially different from the standard dynamic Mundell-Fleming result if there are substantial changes in interest premiums, while maintaining the basic underlying theoretical framework.

Table 17.

Italy: Effects of Fiscal Consolidation and a Reduced Interest Premium on the Exchange Rate

(Percentage deviation from baseline unless otherwise noted)

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A positive figure denotes an appreciation of the domestic currency.

In percentage points.

It is assumed in the scenario that the Italian authorities implement fiscal consolidation measures that gradually reduce the debt stock by 30 percent of GDP.7 This is assumed to reduce the premium on Italian lira assets by 250 basis points. In this case, long-term interest rates in Italy fall by about 240 basis points and the nominal effective exchange rate appreciates by an average of about 7 percent. Although there is a negative fiscal impact on domestic demand, the decline in interest rates tends to increase investment and consumption. Combined with the appreciation of the real exchange rate, the external position worsens. Thus, a fiscal contraction combined with a decline in the interest premium can result in an increase in output, an appreciation of the currency, and, in the short run, a deterioration in the current account.

Thus, in countries where large interest differentials suggest the presence of substantial interest premiums, reductions in the fiscal deficit may, in principle, bring about an immediate appreciation of the domestic currency. This is an exception to the standard theoretical case whereby fiscal consolidation leads, ceteris paribus, to a short-run depreciation of the currency. Comparing the two cases, it is noteworthy that in the standard case, fiscal consolidation and exchange rate depreciation are associated with a short-run improvement in the current account; whereas in the reduced interest premium case, fiscal consolidation and exchange rate appreciation are associated with a short-run deterioration in the current account. Thus, economic theory suggests that, in the short run, it is unlikely that fiscal consolidation would lead, ceteris paribus, to exchange rate appreciation and to improvement in the current account, unless the fiscal consolidation is combined with monetary tightening and with a significant fall in output.

Long-Term Implications of Fiscal Consolidation

The standard Mundell-Fleming model does not provide an adequate framework for examining the long-term implications of fiscal consolidation because this model does not account for the dynamic effects of reductions in the stock of government debt. Indeed, as shown below, models that incorporate the dynamic effects of fiscal policy generally indicate that the real exchange rate will appreciate in the long run in response to fiscal consolidation, which brings a permanent reduction in the stock of government debt and a permanent improvement in a country’s net foreign asset position.

In a long-run steady-state equilibrium, when the ratio of a country’s net foreign assets (or liabilities) to GDP is stable, the country will receive (or pay) net income on its international asset (or liability) position that is a constant fraction of its GDP. The payments received by a net creditor country will finance a steady-state trade deficit with imports exceeding exports. Conversely, payments by net a debtor country to its creditors will require a steady-state trade surplus. This steady-state equilibrium condition can be represented by the following equation.8


where CA is the current account balance, Y is nominal GDP, NFA is the country’s net foreign asset position, and g is the growth rate (divided by 100) of all nominal variables. For example, if all nominal variables in the economy are growing at 5 percent and net foreign assets are equal to 100 percent of GDP, the current account surplus must be equal to about 5 percent of GDP. Conversely, if the country is a debtor country, it would be running a current account deficit in long-run equilibrium. A country can only remain a debtor or a creditor in the long run if its deficit or surplus grows at the same rate as nominal income.

The current account can be expressed as the sum of two main components: the net interest payments received from foreigners, r NFAt-1, and the nominal trade balance, TB. Then the current account equation becomes


because NFA-1 is equal to NFAI/(1 + g). Substituting equation (3) into equation (4) gives


Under the condition that the real interest rate is greater than the real growth rate of the economy, the term in parentheses in equation 5 will be negative, which implies that countries that have positive net claims on the rest of the world (NFA > 0) will be running a trade deficit, while countries that are debtor countries (NFA < 0) will have trade surpluses.9 In other words, net creditor countries will receive a permanent flow of interest payments from the rest of the world and thus will be able to maintain a level of imports that is consistently higher than exports.

The discussion above is helpful in shedding light on the long-run results reported in Table 16. The last column shows that a fiscal contraction that reduces the long-run level of government debt to GDP will increase the country’s net foreign asset-to-GDP ratio, or, equivalently, reduce the ratio of its net foreign liabilities to GDP. The increase in net interest receipts means that a higher trade deficit can be sustained in the long run. In the long run, an appreciation of the real exchange rate is required to generate the adjustment in trade flows. As the United States is a net debtor internationally, the rise in total national saving results in a reduction in the ratio of its net foreign liability to income. As can be seen from equation 5 above, this eventually would imply lower net interest payments to foreigners and a smaller trade surplus with the rest of the world. To induce a smaller trade surplus (higher imports or lower exports, or both) with the rest of the world, the real exchange rate must eventually appreciate.

In the simulation reported in Table 16, the real exchange rate depreciates in the short run, but starts to appreciate by the fifth year. In the long run, the real value of the exchange rate is higher relative to its baseline value by 0.3 percent. As discussed above, this appreciation is necessary to sustain a higher level of net imports; as interest obligations to foreigners are reduced, there will be a larger sustainable net flow of goods to U.S. consumers. And under normal assumptions about demand and supply curves, this can only come about if the relative price of these goods falls.

The different short- and long-run exchange rate effects of fiscal consolidation reflect the same macro-economic adjustment mechanism at work. The short-run real depreciation arises from the fact that aggregate demand for domestic output is initially below capacity output as a result of the fiscal action, and consequently the relative price of domestic output (the real exchange rate) falls. Over time, however, the increased national saving that results from fiscal consolidation in the absence of full Ricardian equivalence leads to a higher stock of domestic and foreign assets held by domestic residents. This increase in domestic wealth results in higher consumption (relative to baseline) and a rise in overall total demand (in real terms) for domestic output that exceeds capacity output. This excess demand is equilibrated by a rise in the relative price, that is, by a real appreciation.

Empirical Evidence on the Exchange Rate Effects of Fiscal Policy

Given the theoretical possibility that changes in fiscal policy could either weaken or strengthen the currency, it is not surprising that empirical studies of the linkages are not uniform in their findings. The empirical results discussed below relate to two major episodes of recent exchange rate changes: the appreciation and subsequent depreciation of the U.S. dollar during the 1980s, and expected changes in the parities of selected ERM currencies. There is also a brief discussion of the experience of developing countries.

Several studies have found a positive link between fiscal expansion and the exchange value of the U.S. dollar. Throop (1989), for example, used a model in which the short-run real value of the U.S. dollar over the period 1973-88 is explained by real long-term interest rate differentials, and the long-run expected real value is determined by domestic and foreign structural fiscal balances relative to full-employment GNP. He finds that the dollar appreciated in response to a fiscal expansion in the United States or a fiscal contraction abroad. Melvin, Schlagenhauf, and Talu (1989) lake an explicitly forward-looking approach in which today’s real exchange rate is a function of the future discounted value of a number of exogenous variables (relative outputs, money stocks, and budget deficits). Using expected fiscal positions obtained from opinion surveys, they found that over the period 1974^87 higher expected budget deficits caused on average a significant real appreciation of the U.S. dollar against the pound, the deutsche mark, and the yen. Beck (1993) examined the effects of both deficit and government spending announcements on spot and forward U.S. dollar exchange rates. Using daily observations in the proximity of official federal budget announcements during the period from 1980 through July 1990, she found that the dollar appreciated in response to targer-than-expected federal deficits but did not respond to unexpected increases in government spending.

Other studies, however, have not found statistically significant evidence of a positive link between fiscal expansions and the exchange value of the U.S. dollar. Kramer (1995), for example, uses cointegration techniques to estimate the long-run effect on the U.S. real effective exchange rate of the U.S. fiscal balance relative to partner countries. Using annual data over the period 1955-90, and taking account of the effects of other variables (net foreign assets, the terms of trade, and the relative price of traded to nontraded goods), he finds that a reduction in the U.S. fiscal deficit tends to appreciate the real exchange rate in the long run. Evans (1986) uses an ad hoc reduced form model explaining bilateral dollar exchange rates from 1973 to 1984 in terms of unanticipated real federal government deficits and other macroeconomic variables. He found no evidence of a U.S. dollar appreciation in response to higher federal budget deficits, but rather some evidence of a depreciation. McMillin and Koray (1990) used a reduced form approach to assess the impact of unanticipated changes in government debt in the United States relative to Canada on the bilateral real U.S.-Canadian dollar exchange rate. They found that over the period 1963-84 an unanticipated fiscal expansion in the United States that raised U.S. debt relative to that in Canada produced a temporary depreciation on the U.S. dollar. Given the symmetry of their model, this result can be interpreted as implying that a decrease in Canadian government debt (relative to that in the United Slates) caused a real appreciation of the Canadian dollar because it reduced the importance of the Canadian interest premium.10 Finally, Koray and Chan (1991) looked at the deutsche mark-U.S. dollar exchange rate over the period 1975-89. They found that although the real and nominal bilateral rate appreciated in response to anticipated and unanticipated increases in German government spending, the effect was not statistically significant.

The literature on the link between fiscal policy and exchange rates in the context of the ERM also does not reach unambiguous conclusions. Caramazza (1993) looks at the impact of fiscal variables on realignment expectations and finds fairly strong effects. For example, lower government deficits in France relative to Germany in the post-1987 period are found to reduce the expected devaluation of the French franc against the deutsche mark. By contrast, focusing on the whole EMS history (from 1979 to 1992). Chen and Giovannini (1993) find that fiscal deficits in Italy and in France relative to Germany do not have explanatory power for realignment expectations in the case of the Italian lira and French franc. Thomas (1994) obtains similar results for the same currencies and time period using government debt instead of deficits. Froot and Rogoff (1991) use pooled data for eight EMS countries to test the prediction of a simple intertemporal neoclassical model, according to which higher domestic or lower foreign government spending as a percentage of GDP causes a real appreciation of the domestic currency. Estimation results for the period 1979 to 1989 indicate that higher domestic (or lower foreign) government expenditure is directly and significantly associated with real appreciations of EMS currencies, while government budget deficits are not found to be significantly related to real exchange rates.

In the developing countries, the many episodes of high inflation and consequent nominal depreciations are generally attributed to a mix of expansionary fiscal and accommodating monetary policies. Rebelo and Végh (1995) document that exchange-rate-based stabilization programs introduced in several developing countries—Chile. Israel, and Mexico in the late 1970s and the 1980s, and Argentina in the 1990s—are characterized by real appreciations and fiscal adjustments. This empirical regularity, however, does not seem to reflect any causal connection since the real appreciation could be the result of inflation inertia in the presence of pegging the nominal exchange rate. Further insights on the causal link between fiscal contractions and movements in real exchange rates can be gauged from the simulation results of the intertemporal general equilibrium model specified and calibrated for the Argentine economy by Rebelo and Végh. The authors show that, in general, a fiscal contraction does not bring about a real appreciation but rather a depreciation. In fact, only in one special case does a contractionary fiscal policy (a reduction of government spending for tradable goods that increases the relative price of tradables) cause an appreciation of the domestic currency. The magnitude of this effect, however, is very small and is not capable of replicating the observed appreciations. These are captured in the simulation experiments only by pegging the nominal exchange rate to anchor the nominal variables.

* * *

The existing theoretical literature suggests that under conditions of high international capital mobility, the short-run effect of fiscal consolidation, ceteris paribus, is to depreciate the exchange rate and improve the current account. This result is found across a fairly wide range of models. II, however, fiscal consolidation has substantial effects on confidence and reduces interest premiums, it is possible that it could lead to an appreciation of the exchange rate in the short run and to a deterioration in the current account. There appear to be some countries, with large existing interest premiums apparent in bond yields, for which this latter outcome seems to be a realistic possibility. For the long run, there is a more general presumption that a sustained reduction in the government budget deficit that raises national saving and reduces the ratio of government debt to GDP will eventually lead to a real exchange rate appreciation. This result is intuitively plausible in that a country that saves more than its trading partners will accumulate more foreign assets and ultimately its currency will strengthen relative to other currencies.


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Statistical Appendix


The statistical tables in this appendix have been compiled on the basis of information available on September 18, 1995. The estimates and projections for 1995 and 1996. as well as the 1997-2000 medium-term scenarios, are based on the following assumptions.

  • For the industrial countries, real effective exchange rates are assumed to remain constant at their average level during August 1-23, 1995, except for the bilateral exchange rates among the ERM currencies, which are assumed to remain constant in nominal terms. For 1995 and 1996, these assumptions imply average U.S. dollar/SDR conversion rates of 1.526 and 1.513, respectively.

  • Established policies of national authorities will be maintained.

  • The price of oil will average $16.67 a barrel in 1995 and $15.51 a barrel in 1996. In the medium term, the oil price is assumed to remain unchanged in real terms.

  • Interest rates, as represented by the London interbank offered rate (LIBOR) on six-month U.S. dollar deposits, will average 6¼ percent in 1995 and 1996: the three-month certificate of deposit rate in Japan will average 1 percent in 1995 and 1996; and the three-month interbank deposit rate in Germany will average 4½ percent in 1995 and slightly less than 5 percent in 1996.

Data and Conventions

Data and projections for more than 180 countries form the statistical basis for the World Economic Outlook (the World Economic Outlook data base). The data are maintained jointly by the IMF’s Research Department and area departments, with the latter regularly updating country projections based on consistent global assumptions.

Although national statistical agencies are the ultimate providers of historical data and definitions, international organizations are also involved in statistical issues, with the objectives of harmonizing differences among national statistical systems, of setting international standards with respect to definitions, and of providing conceptual frameworks for measurement and presentation of economic statistics. The World Economic Outlook data base reflects information from both national source agencies and international organizations.

The completion of the comprehensive revision of the United Nations’ standardized System of National Accounts (SNA) and the IMF’s Balance of Payments Manual is an important improvement in the standards of economic statistics and analysis.1 The IMF was actively involved in both projects, particularly the new Balance of Payments Manual, which is central to the IMF’s interest in countries’ external positions. Key changes introduced with the new Manual were summarized in Box 13 of the May 1994 World Economic Outlook. The process of adapting country balance of payments data to the definitions of the new Balance of Payments Manual began with the May 1995 World Economic Outlook. However, full concordance with the BPM is ultimately dependent on national statistical compilers providing revised country data, and hence the World Economic Outlook estimates are still only partly adapted to the BPM.

The focus on world trade in this World Economic Outlook has been broadened to include estimates for international trade in goods and services in addition to the traditional focus on trade in goods. This is in recognition of the fact that trade in services presently accounts for a substantial share of the total value of world trade and is likely to become increasingly important. Estimates of foreign trade volumes for both goods and services are drawn as far as possible from national accounts data. For the relatively few countries lacking national accounts estimates in constant prices, balance of payments data for goods are deflated by trade unit values, and for services by GDP deflators, to generate constant price estimates.

Composite data for country groups in the World Economic Outlook are either sums or weighted averages of data for individual countries. Arithmetic weighted averages are used for all data except inflation and money growth for nonindustrial country groups, for which geometric averages are used. The following conventions are used.

  • Country group composites for interest rates, exchange rates, and the growth of monetary aggregates are weighted by GDP converted to U.S. dollars at market exchange rates (averaged over the preceding three years) as a shave of world or group GDP.

  • Composites for other data relating to the domestic economy, whether growth rates or ratios, are weighted by GDP valued at purchasing power parities (PPPs) as a share of total world or group GDP2

  • Composite unemployment rates and employment growth are weighted by labor force as a share of group labor force.

  • Composites for data relating to the external economy are sums of individual country data after conversion to U.S. dollars at the average exchange rates in the years indicated for balance of payments, and at end-of-period exchange rates for debt denominated in currencies other than U.S. dollars. Composites of foreign trade volumes and prices, however, are arithmetic averages of percentage changes for individual countries weighted by the U.S. dollar value of exports or imports as a share of total world or group exports or imports (in the preceding year).

For central and eastern European countries in existence before 1991, external transactions in nonconvertible currencies (through 1990) are converted to U.S. dollars at the implicit U.S. dollar/ruble conversion rates obtained from each country’s national currency exchange rate for the U.S. dollar and for the ruble.

Unless otherwise indicated, multiyear averages of growth rates are expressed as compound annual rates of change.

Classification of Countries

Summary of the Country Classification

The country classification in the World Economic Outlook divides the world into three major groups: industrial countries, developing countries, and countries in transition.3 Rather than being based on strict criteria, economic or otherwise, this classification has evolved over time with the objective of facilitating the analysis by providing a reasonably meaningful organization of data. Each of the three main country groups is further divided into a number of subgroups. Tables A and B provide an overview of these standard groups in the World Economic Outlook, showing the number of countries in each group and the average 1994 shares of groups in aggregate PPP-valued GDP, total exports of goods and services, and total debt outstanding.

Table A.

Industrial Countries: Classification by Standard World Economic Outlook Groups, and Their Shares in Aggregate GDP and Exports of Goods and Services, 19941

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The GDP shares are based on the purchasing power parity (PPP) valuation of county GDPs.

Table B.

Developing Countries and Countries in Transition: Classification by Standard World Economic Outlook Groups and Their Shares in Aggregate GDP, Exports of Goods and Services, and Total Debt Outstanding, 19941

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The GDP shares are based on the purchasing power parity (PPP) valuation of county GDPs.

The general features and the compositions of groups in the World Economic Outlook classification are as follows.4

The group of industrial countries (23 countries) comprises

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The seven largest countries in this group in terms of GDP—the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada—are collectively referred to as the major industrial countries.

The current members of the European Union (15 countries) are also distinguished as a subgroup. They are

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Composite data shown in the tables under the heading “European Union” cover the current 15 members of the European Union for ail years, even though the membership has changed over time.

In 1991 and subsequent years, data for Germany refer to west Germany and the new eastern Lander (i.e., the former German Democratic Republic). Before 1991, economic data are not available on a unified basis or in a consistent manner. In general, data on national accounts and domestic economic and financial activity through 1990 cover west Germany only, whereas data for the central government, foreign trade, and balance of payments apply to west Germany through June 1990 and to unified Germany thereafter.

The group of developing countries (132 countries) includes all countries that are not classified as industrial countries or as countries in transition, together with a few dependent territories for which adequate statistics are available.

The regional breakdowns of developing countries in the World Economic Outlook conform to the IMF’s International Financial Statistics (IFS) classification, with one important exception. Because all of the developing countries in Europe except Cyprus, Malta, and Turkey are included in the group of countries in transition, the World Economic Outlook classification places these three countries in a combined Middle East and Europe region. It should also be noted that in both classifications, Egypt and the Libyan Arab Jamahiriya are included in this region, not in Africa. Two additional regional groupings are included in the World Economic Outlook because of their analytical significance. These are sub-Saharan Africa5 and four newly industrializing Asian economies.6

The developing countries are also grouped according to analytical criteria: predominant export, financial, and other groups. The first analytical criterion, by predominant export, distinguishes among five groups: fuel (Standard International Trade Classification—SITC 3): manufactures (SITC 5 to 9, less 68); nonfuel primary products (SITC 0, 1, 2, 4, and 68); services. income, and private transfers (factor and nonfactor service receipts plus workers’ remittances); and diversified export base. A further distinction is made among the exporters of nonfuel primary products on the basis of whether countries’ exports of primary commodities consist primarily of agricultural commodities (SITC 0, 1, 2 except 27, 28, and 4) or minerals (SITC 27, 28, and 68). The export criteria, which have been updated to correspond more closely to the current World Bank classification, are now based on countries’ export composition in 1988-92.

The financial criterion first distinguishes between net creditor and net debtor countries. Countries in the latter, much larger group are then differentiated on the basis of two additional financial criteria: by predominant type of creditor and by experience with debt servicing. The financial criteria reflect net creditor and debtor positions as of 1987, sources of borrowing as of the end of 1989, and experience with debt servicing during 1986-90.

The country groups shown under other groups constitute the small low-income economies and the least developed countries.

The group of countries in transition (28 countries) comprises central and eastern European countries, Russia, non-European states of the former Soviet Union, and Mongolia. A common characteristic of these countries is the transitional state of their economies from a centrally administered system to one based on market principles. The group of countries in transition comprises

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The countries in transition are classified in three subgroups: central and eastern Europe, Russia, and Transcaucasus and central Asia. The Transcaucasian and central Asian countries include Kazakhstan for purposes of the World Economic Outlook. The countries in central and eastern Europe (18 countries) are

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The countries in the Transcaucasian and central Asian group (9 countries) are

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Detailed Description of the Developing Country Classification by Analytical Group

Countries Classified by Predominant Export

Fuel exporters (15 countries) are countries whose average ratio of fuel exports to total exports in 1988-92 exceeded 50 percent. The group comprises

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Nonfuel exporters (117 countries) are countries with total exports of goods and services including a substantial share of (a) manufactures, (b) primary products, or (c) services, factor income, and private transfers. However, those countries whose export structure is so diversified that they do not fall clearly into any one of these three groups are assigned to a fourth group, (d) diversified export base.

(a) Economies whose exports of manufactures accounted for 50 percent or more of their total exports on average in 1988-92 are included in the group of exporters of manufactures (7 countries). This group includes

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(b) The group of exporters of primary products (43 countries) consists of those countries whose exports of agricultural and mineral primary products (SITC 0, 1, 2, 4, and 68) accounted for at least half of their total exports on average in 1988-92. These countries are

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Among exporters of primary products, a further distinction is made between exporters of agricultural products and minerals. The group of mineral exporters (14 countries) comprises

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All other exporters of primary products are classified as agricultural exporters (29 countries).

(c) The exporters of services and recipients of factor income and private transfers (37 countries) are defined as those countries whose average income from services, factor income, and workers’ remittances accounted for half or more of total average export earnings in 1988-92. This group comprises

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(d) Countries with a diversified export base (30 countries) are those whose export earnings in 1988–92 were not dominated by any one of the categories mentioned tinder (a) through (c) above. This group comprises

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Countries Classified by Financial Criteria

Net creditor countries (7 countries) are defined as developing countries that were net external creditors in 1987 or that experienced substantial cumulated current account surpluses (excluding official transfers) between 1967 (the beginning of most balance of payments series in the World Economic Outlook data base) and 1987. The net creditor group consists of the following economies:

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Net debtor countries (125 countries) are disaggregated according to two criteria: (a) predominant type of creditor and (b) experience with debt servicing.

(a) Within the classification by predominant type of creditor (sources of borrowing), three subgroups are identified: market borrowers, official borrowers, and diversified borrowers. Market borrowers (23 countries) are defined as net debtor countries with more than two thirds of their total liabilities outstanding at the end of 1989 owed to commercial creditors. This group comprises

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Official borrowers (69 countries) are defined as net debtor countries with more than two thirds of their total liabilities outstanding at the end of 1989 owed to official creditors. This group comprises

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Diversified borrowers (33 countries) consist of those net debtor developing countries that are classified neither as market nor as official borrowers.

(b) Within the classification by experience with debt servicing, a further distinction is made. Countries with recent debt-servicing difficulties (72 countries) are defined as those countries that incurred external payments arrears or entered into official or commercial bank debt-rescheduling agreements during 1986-90. Information on these developments is taken from relevant issues of the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions.

All other net debtor countries are classified as countries without debt-servicing difficulties (53 countries).

Other Groups

The countries classified by the World Bank as small low-income economies (50 countries) are those whose GNP per capita (as estimated by the World Bank) did not exceed the equivalent of $695 in 1993. This group comprises

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The countries currently classified by the United Nations as the least developed countries (46 countries) are9

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List of Tables



Financial Policies

Foreign Trade

Current Account Transactions

Balance of Payments and External Financing

External Debt and Debt Service

Flow of Funds

Medium-Term Baseline Scenario


Table A1.

Summary of World Output1

(Annual percent change)

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Real GDP. For most countries included in the group “countries in transition,” local output is measured by real net material product (NMP) or by NMP-based estimates of GDP.