V Long-Term Growth Potential in the Countries in Transition
Author: International Monetary Fund. Research Dept.
Language:
English
Keywords:
WEO; transition country; output gap; rising prices; rate of inflation; foreign direct investment; monetary policy; market; a number of country; countries in transition; enterprise restructuring; planned economy; Commercial banks; Total factor productivity; Structural reforms; Baltics; Eastern Europe
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Abstract

Growth has now resumed in most of the 28 countries in transition from central planning to market oriented economies.37 Only Azerbaijan, Belarus, the Russian Federation, Tajikistan, Ukraine, and Uzbekistan are expected to suffer further output declines in 1996, and positive growth is within reach for these countries also during the period ahead provided slippages can be avoided in their structural reform and stabilization efforts.

Growth has now resumed in most of the 28 countries in transition from central planning to market oriented economies.37 Only Azerbaijan, Belarus, the Russian Federation, Tajikistan, Ukraine, and Uzbekistan are expected to suffer further output declines in 1996, and positive growth is within reach for these countries also during the period ahead provided slippages can be avoided in their structural reform and stabilization efforts.

The generally positive outlook for the transition economies in the second half of the 1990s contrasts sharply with the dramatic declines in output that occurred during the first phase of the transformation process. These declines were probably less severe in reality than the almost 50 percent drop that on average is suggested by official statistics, which have continued to underreport private sector activities, especially services.38 Nevertheless, there is no doubt that the initial phase of the transition was extremely costly in terms of living standards and economic well-being, with certain segments of the population, including pensioners, being particularly adversely affected.

It is therefore difficult to exaggerate the importance of the improvements in economic performance that already have occurred or that are expected soon to be visible. While the generally favorable outlook is conditional upon sustained efforts at reform and macroeconomic stability, the resolve of policymakers to persevere with the necessary reforms, and public support for the reform process, can only be enhanced when the benefits are forthcoming. The increasing evidence that the transition is working is particularly important to the extent it should help overcome resistance to enterprise restructuring, which remains essential to the transformation process. Apart from its importance for economic efficiency, enterprise restructuring, supported by adequate and affordable social safely nets, is necessary to achieve and safeguard macroeconomic stability. These issues were examined extensively in the May 1996 World Economic Outlook. A number of other important issues, including the need for a sound legal framework, are discussed in the World Bank’s 1996 World Development Report.

This chapter takes a broader and longer perspective with a view to addressing the following questions: What can the transition countries realistically expect in terms of long-run growth? How long will it take before they catch up with the industrial countries’ current income levels? And how can economic policies help raise their underlying growth rates? Estimating the long-run growth potential for the transition countries is obviously a difficult exercise because the very aim of the structural reform process is to transform the fundamentals of these economies. Since this implies that historical relationships for the transition countries are of little use, the analysis draws extensively on the experience of other countries.

Any quantification of the long-term growth trends that potentially are achievable is contingent on assumptions about economic policies, including the successful mobilization of domestic and foreign saving to replace and expand the capital stock, and structural reforms to ensure that resources are allocated efficiently. Fiscal policy will play a key role in influencing the level of domestic saving and in helping to ensure that social priorities are being met without recourse to persistent deficit spending that would lower future growth. Foreign capital flows have already begun to complement domestic saving and raise overall growth but experience from other countries suggests that heavy reliance on foreign saving may not be sustainable, especially when imports of financial capital substitute for domestic saving. The ability of the banking system to allocate financial resources efficiently among potential borrowers is also essential for the growth process but is threatened by the weakness of many banks in these countries, as evidenced by the high levels of nonperforming loans. Resolving these difficulties is a major challenge for most of the transition countries.

It is particularly important that governments foster an economic environment that is conducive to private saving and investment. Successful transition is contingent on the development of a dynamic private sector that will provide employment opportunities for individuals displaced by restructuring. This outcome is critically dependent on the protection of property rights and on the establishment of a stable, transparent tax regime that ensures that saving, investment, and production decisions are made on the basis of the underlying risk and return associated with each activity. Although many of the transition countries have made considerable progress in these areas, others have only just begun to overcome the many legacies of central planning.

Growth Lessons of the Transition Process

Since the beginning of the reform process, the growth experience of the transition countries has been characterized by substantial divergences between countries that started the reform process early and pursued the boldest and most comprehensive strategies and those that began later and were less consistent in their reform and stabilization efforts (Table 18). The next five years are expected to see a substantial closing of these growth differentials. It needs to be underscored, however, that this medium-term baseline scenario is conditional on the steadfast implementation of reform and stabilization policies in accordance with these countries’ stated policy intentions. Since slippages in adjustment policies cannot be ruled out, the scenario should not be interpreted as an assessment of the most likely outcome. Still, based on current trends and the steadily strengthening commitment to continued reform among the transition countries, a degree of optimism is clearly warranted.

Table 18.

Countries in Transition: Medium-Term Scenario for Output and Inflation

(Annual percentage change)

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Albania, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, former Yugoslav Republic of Macedonia, Mongolia, Poland, Slovak Republic, and Slovenia.

Armenia, Azerbaijan, Belarus, Bulgaria, Georgia, Kazakstan, Kyrgyz Republic, Moldova, Romania, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.

Excluding Belarus, Russia, and Ukraine.

The conditional nature of the medium-term scenario applies to both output growth and inflation, which so far have been closely, and negatively, correlated across the transition countries (Chart 31). The fact that high inflation has been associated with negative growth is partly a reflection of the fact that both have been common features of the initial trauma of the transition: high inflation stemming from price liberalization and monetary overhangs, and collapses of output resulting from structural dislocation. But the association is also consistent with a causal link from inflation to growth, as examined in recent empirical work, in which inflation has an adverse effect on growth irrespective of differences in the pace of structural reforms.39 This effect can be attributed in part to the way in which rapid inflation and the uncertainty associated with it has induced consumers and enterprises to resort to barter and the hoarding of goods, and financial investors to seek refuge in foreign currency holdings, both in cash and through capital flight. Moreover, high inflation reduces the return from productive activity relative to the return from activities to avoid inflation-induced losses. Under these conditions, the incentive to hold domestic financial assets and to provide financing for private investment was seriously eroded. Although widespread dollarization helped to prevent a total collapse of the economic system in some cases, the general shortage of financial resources contributed to sharp declines in economic activity. Other factors were clearly at work, but the negative correlation between inflation and output is consistent with the body of evidence on the costs of inflation discussed in Chapter VI.

Chart 31.
Chart 31.

Economies in Transition: Inflation and Real Output Growth, 1992–95

Very high inflation has been associated with negative output growth.

Experience also shows that macroeconomic stabilization and the moderation of inflation, and comprehensive structural reforms are interdependent requirements of successful growth performance. The need for comprehensiveness in the reform strategy is illustrated in Chart 32, which plots countries’ scores on an Index of Reform Progress (IRP) against growth performance in 1995. The IRP, a composite measure of progress across a wide range of structural reforms, is constructed from various indicators of reform compiled by the European Bank for Reconstruction and Development following an approach in a recent study.40 The clear positive relationship between progress with structural reforms and growth performance illustrates the crucial importance of policy complementarities that can be observed also in industrial and developing countries.

Chart 32.
Chart 32.

Economies in Transition: Index of Reform Progress (IRP) and Real Output Growth

(Average, 1994-96)

Broadly based reforms and growth are inextricably linked.Source: The IRP is based on indicators of structural reform reported in European Bank for Reconstruction and Development, Transition Report 1995: Investment and Corporate Governance (London, 1995).

A particularly important aspect of the structural reform process, as noted earlier, is the restructuring of the enterprise sector through the imposition of hard budget constraints on both state-owned and privatized firms. This requires the enforcement of tax compliance; the reduction of subsidies, directed credits, and interenterprise and wage arrears; and the willingness to impose and uphold bankruptcy rulings for insolvent enterprises. In many of the transition countries, however, social (and political) concerns have made the authorities reluctant to implement fully such reforms, especially since unemployment insurance schemes and other social safety nets have been perceived as not being adequate to cope with large numbers of redundancies and because the lack of budget revenues for these purposes meant that the income support the unemployed would receive would barely meet basic needs.

As a result of the reluctance to restructure enterprises, it is the countries recently suffering the largest output declines that are characterized by the lowest open unemployment rates (Chart 33).41 In contrast, the countries that are more advanced in the transition process, and that have been seeing significant positive growth, have tended to witness much higher rates of open unemployment. This positive correlation between unemployment and growth is clearly unusual, reflecting the large scope for raising productivity as labor moves from the inefficient state sector to the private sector. It also indicates the importance of adequate but affordable social safety nets to lower the social cost implied by the restructuring process.

Chart 33.
Chart 33.

Economies in Transition: Unemployment and Real Output Growth

(Average, 1992–95)

Higher unemployment reflects restructuring that facilitates growth.1 Average for 1993–95, Azerbaijan, Moldova, and Russia.

Taken together, the experience to date leaves no doubt about the importance of inflation control, about the rewards of comprehensive structural reforms, and about the need to release excess labor resources from enterprises that are not viable in the environment of a market economy. The experience of the countries that are relatively advanced in the transition process also provides reason for believing that growth will soon resume in those transition countries that began the reform process later, provided of course that policies stay on track.

Growth Experience in Other Countries

The medium-term scenario shown in Table 18 assumes, in particular, that the stabilization and reform programs of the transition countries will be fully implemented. It is unclear, however, whether these rates of growth can be sustained over several decades. This is partly because the growth performance of these countries for a number of years will reflect the gradual absorption of the economic slack that has been created during the initial phase. The current margins of slack are extremely difficult to estimate since so much of the capital stock is economically obsolete as a result of the shift to market-determined prices and the associated changes in the composition of output.42 Nevertheless, the currently high rates of open or hidden unemployment do imply that growth in the transition countries is likely for a number of years to exceed the underlying long-term growth rate of potential.

While the transformation of centrally planned economies represents, in some respects, a unique challenge, the underlying economic problem it poses—mobilizing labor and resources most effectively to meet the needs of society—is not substantially different from the economic problems of many developing countries, or of the industrial countries at an earlier stage of their development. In constructing a long-term growth scenario for the transition countries, therefore, it is useful to look at long-term growth experiences in other parts of the world (Table 19). The per capita growth rates that have been achieved by industrial and developing countries over the past century as a whole may appear to be relatively modest, but it is important to note that there have been extended periods over which groups of countries have expanded at substantially higher rates. These periods include the “golden age” for the industrial countries from 1950 to 1970, when per capita growth averaged 3.7 percent a year. A more recent example is the general strengthening of growth in the developing world since the debt crisis of the early 1980s subsided. The remarkable growth experience of the most successful emerging market countries during the past decade, when their per capita output expanded at an average annual rate of about 7 percent, is obviously of particular interest for the transition countries.43 The role of the postwar reconstruction in Europe and Japan and the influence of structural reforms, deregulation, and especially trade liberalization in all three examples, arguably bear some resemblance to the circumstances facing the transition countries now.

Table 19.

Industrial and Developing Countries: Long-Run Growth of GDP Per Capita

(In percent a year)

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Sources: Robert J. Barro and Xavier Sala-i-Martin, Economic Growth (New York: McGraw-Hill Inc. 1995: and World Economic Outlook database.

Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, Netherlands, Norway, Sweden, Switzerland, the United Kingdom, and the United States.

Argentina, Bangladesh, Brazil, Chile, China, Colombia, India, Indonesia, Korea, Mexico, Pakistan, the Philippines, Peru, Taiwan Province of China, and Thailand.

World Economic Outlook definition.

Chile, Hong Kong, Korea, Malaysia, Mauritius, Singapore, Taiwan Province of China, and Thailand.

One question therefore is whether some of the other conditions that led to the rapid growth in certain periods in other countries are also present in the transition countries. The answer ultimately depends on the elements that determine economic growth—the growth of the labor force, the accumulation of capital, and productivity growth, or improvements in the way in which labor and capital are employed to produce goods and services. As noted above, given the technical obsolescence of a large share of the capital stock inherited from central planning, there is a considerable need for these countries to sustain high levels of investment for a prolonged period.44 But investment must be financed from current production (i.e., saving).

A major issue therefore is the capacity of the transition countries to raise national saving rates, which at present are quite low, especially compared with the most successful emerging market countries (Table 20). Nevertheless, the average national saving ratio in the transition countries has recovered somewhat from a low level of 16 percent in 1993 and is expected to continue to recover as their economic expansions become more firmly established. Thus, the IMF’s medium-term baseline scenario assumes that the average saving ratio will rise to 23 percent of GDP by the end of the decade. Such an increase in the saving rate would strengthen the foundations for sustained economic expansion. But the very unfavorable demographic trends in most transition countries—with a pronounced aging of populations similar to those projected for western Europe and Japan—makes it unlikely that they will attain, and maintain, saving rates as high as those recorded by the most successful emerging market countries.

Table 20.

Rapidly Growing Economies and Countries in Transition: Factors Influencing Growth1

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As a percent of GDP, unless specified.

Average annual percent change.

Total exports plus total imports divided by two times GDP.

Chile, Hong Kong, Korea, Malaysia, Mauritius, Singapore, Taiwan Province of China, and Thailand.

See Table 18.

The transition countries’ openness to foreign trade, as measured by ratios of foreign trade to output, is also much less than that of the most successful developing countries. Among the most advanced transition countries, however, there have already been large increases in ratios of foreign trade in GDP. Such increases in openness are to be expected in the other transition countries even though their geographic location or (in the case of Russia) size suggest that their interactions with the rest of the world may not develop quite as rapidly as has been the case in the countries of central and eastern Europe. Enhanced integration into the global economy is to be encouraged, as trade can provide a continuing impetus to growth (Box 6).

Given the uncertainties about the transition countries’ saving performance and their relatively stagnant populations, productivity increases will play a crucial role in their long-run growth performance. Growth accounting exercises show that growth in total factor productivity (TFP) accounted for most of the differences in the growth rates of output among the major industrial countries in the 1950s and 1960s (Table 21).45 The differences can be explained partly by the progressive catching up of Europe and Japan to productivity levels in the United States. Reconstruction from the war and the transfer of labor from agriculture to industry and services accounted for a significant proportion of the rapid TFP growth in Germany, France, and Japan. The United Kingdom, with a much smaller proportion of the labor force in agriculture at the beginning of the postwar period, could not benefit from such a movement of labor and experienced similar TFP growth to the United States. As the catching-up process was largely completed by the early 1970s, TFP and GDP growth slowed sharply in Europe and Japan.46

Table 21.

Postwar Recovery: Sources of Growth in GDP, 1950–73

(In percent a year)

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Source: Nicholas Crafts, “Productivity Growth Reconsidered,” Economic Policy: A European Forum, No. 15 (October 1992), pp. 388–426, based on Angus Maddison, Dynamic Forces in Capitalist Development: A Long-Run Comparative View (Oxford; New York: Oxford University Press, 1991).

TFP trends among the developing countries have been quite mixed as shown in Table 22. Growth of TFP in developing countries fell sharply from 2.7 percent a year in 1971–75 to about ½ of 1 percent in 1976–81. And, while it increased significantly—to almost 2 percent a year in 1988–91—TFP growth remains well below the level recorded in the early 1970s. Table 22 also suggests that there are substantial differences in the experiences of developing countries, with countries that have implemented and persevered with structural adjustment recording much higher TFP growth. Developing countries characterized by sustained adjustment recorded TFP growth of almost 3 percent a year—a rate broadly comparable with that achieved by France and Germany in the postwar period.

Table 22.

Developing Countries: Total Factor Productivity Growth

(In percent a year)

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Source: World Economic Outlook, October 1993, pp. 70–71.

Trade and Growth in the Countries in Transition

The countries in transition are in the process of recovery not only from the initial disruptions of the transition itself, but also from the distortions created by decades of central planning, including the closed system of international trade that was associated with it. Just as that trade system impeded the growth and development of these economies prior to the transition, so too is the revival of trade as they become reintegrated into the global economy critical for their future growth.

The volume of both imports and exports fell drastically in these countries following the breakup of the Soviet Union and the collapse of the planned trading system.1 The largest declines were in trade flows among the countries of the former Soviet Union, which reflected the necessary undoing of distorted trade patterns imposed by central planning. Trade with the rest of the world declined much more moderately. Trade has rebounded in 1995 and 1996 in the countries of central and eastern Europe and in a number of countries of the former Soviet Union in the wake of progress with macroeconomic stabilization and structural reform, including the liberalization of trade and payments. Particularly strong have been exports to western Europe and trade among the countries that comprise the Central European Free Trade Association (CEFTA).2 As illustrated in the chart, growth in the volume of trade in goods and services has broadly been positively associated with the growth performance of the transition countries.

Trade flows would be expected to shadow the growth of output, if only because increased domestic output will lead to rising imports, while exports will respond positively to growth in destination markets. Recent empirical evidence for a broad range of industrial and developing countries shows, however, that growth in the volume of trade in itself leads to output growth, even after taking into account the effect of growth on trade.3 This suggests that further liberalization of remaining barriers to trade, both in the transition countries and in their trading partners, can provide a continuing impetus to output growth.

A number of channels through which increased trade contributes to output growth are of particular relevance to the transition countries. The fundamental benefit of free trade is that it allows for the efficient allocation of resources across and within countries. This is in contrast to the often arbitrary specialization imposed by central planning. While output in the transition countries declined with the large-scale restructuring of production that followed the breakdown of central planning, new economic structures and the redirection of trade based on comparative advantage rather than nonmarket considerations should provide long-run benefits in terms of increased efficiency. For these benefits to be reaped, it is clearly important that distortions in domestic product and factor markets, which inhibit the necessary adjustments, be reduced and eliminated, and that international competitiveness be maintained at levels that promote export growth, through the containment of costs.

ch05fig01

Countries in Transition: Trade Volume and Output Growth

(Average of percent change in 1994–96)

Recent theories of growth emphasize that the specialization in production that results from free trade not only leads to a higher level of efficiency in production but can also raise the long-run growth rate.4 Integration with the world economy effectively expands the markets open to firms in the transition countries and allows more efficient use of existing productive capacity. The increased scale of production in industries where a country has comparative advantage provides larger benefits through learning-by-doing and increases the incentives for human capital accumulation and for fixed investment aimed at improving technology. These effects from free trade yield increased production without requiring additional inputs, and thus have the potential to raise the long-run rate of growth.

Empirical evidence shows that trade flows also provide a conduit through which advanced production techniques and technological knowledge spread across countries.5 In addition to the growth of trade in the transition countries, steps taken to liberalize capital inflows have allowed increased foreign direct investment, particularly in central and eastern Europe, including the Baltic countries. This provides another, perhaps more direct, route through which technology and advanced managerial and production techniques flow from industrial to less developed countries. Foreign direct investment is likely to be particularly beneficial in the transition countries, since empirical evidence suggests that the growth effects of technological transfer through foreign direct investment are largest in countries with high levels of education, which exist in the transition countries.6

One cautionary note is that the effects of scale economies and learning-by-doing emphasized in these new theories of growth are most likely to exist in the production of advanced manufactures, such as high-technology goods. Currently, however, the vast majority of transition country exports consists of raw materials including energy and agricultural products, and relatively low-technology manufactures such as textiles. The high level of human capital in these countries suggests that in the medium to long term they are likely to find competitive niches in a range of advanced sectors. One challenge for transition countries is to assimilate technologies and production techniques to enable them to shift toward producing goods and services that are characterized by dynamic gains. A lesson of both theoretical and empirical studies is that openness to trade and capital flows is likely to aid in this ongoing transformation.

The extent of trade and exchange liberalization has varied across transition countries, with a number of them quickly adopting a highly liberal trading system and moving toward current account convertibility, while others have continued to intervene to a considerable degree in both import and export markets and retained exchange restrictions. This appears to reflect a number of factors, including both the attempted use of trade restrictions to cushion declines in output and employment, as well as the spillovers of insufficient reforms in other areas such as labor markets.7 Entrance into regional trading arrangements such as CEFTA and the nascent free trade areas forming within countries of the former Soviet Union can provide a means by which trade is liberalized as long as the common external barriers are not more restrictive than those that previously existed in the individual members. But it is questionable whether the diversion of trade to within such trading groups is in countries’ long-term interests. The best course of action remains trade and exchange liberalization within a multilateral framework.

Prospects for the growth of trade in the transition countries are, of course, also dependent on the trade policies adopted by other countries. Virtually all transition countries have requested observer status or have begun the process of accession to the World Trade Organization. Securing market access in the industrial countries is especially important, not least because it increases the potential returns from foreign direct investment. Most industrial countries granted the transition countries most-favored-nation status early in the transformation process and many transition countries receive preferential market access under the generalized system of preferences. There have also been important bilateral initiatives. The European Union has concluded Association Agreements (“Europe Agreements”) with several countries in central and eastern Europe, which include provisions for political dialogue, trade in goods and services, and trade-related issues, such as competition law. They also provide for the immediate or phased elimination of trade restrictions on industrial products; tariffs on a large number of industrial products were abolished immediately.

More restrictive agreements, however, continue to apply to so-called sensitive goods, principally agricultural products, clothing and textiles, and coal and steel. These are products in which many transition countries may reasonably be expected to be competitive. Restrictions on textiles and steel have been eased somewhat, but market opening in agricultural trade has remained limited. In addition, nontariff barriers can form an important obstacle to trade for these countries, particularly in chemicals and metals, but also in agriculture and textiles. Antidumping actions have specifically been a problem. A number of transition economies inherited actions started against the former Soviet Union and have also been subject to new actions. As these countries (with the exception of the Baltics) are still considered “nonmarket economies,” antidumping investigations use “constructed values” in estimating dumping margins, which can result in positive dumping margins even when domestic and foreign prices are identical. Such trade remedy actions by industrial countries penalize exports at a time of difficult transition for these fledgling market economies.

1

See Constantine Michalopoulos and David Tarr. “Trade Performance and Policy in the Newly Independent States,” World Bank Directions in Development, 1996, for a comprehensive examination of the experience of the states of the former Soviet Union.

2

The member countries of CEFTA are the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia.

3

See Jeffrey A. Frankel and David Romer, “Trade and Growth: An Empirical Investigation” NBER Working Paper No. 5476 (Cambridge, Massachusetts: National Bureau of Economic Research, March 1996).

4

For a recent survey of growth theories in the context of international trade, see Gene M. Grossman and Elhanan Helpman, “Technology and Trade,” in Handbook of International Economies, Vol. 3, ed. by Gene M. Grossman and Kenneth Rogoff (Amsterdam: North-Holland, 1995), pp. 1279–1337.

5

See David Coe and Elhanan Helpman, “International R&D Spillovers,” European Economic Review, Vol. 39 (May 1995), pp. 859–87.

6

Eduardo Borensztein, José De Gregorio, and Jong-Wha Lee, “How Does Foreign Direct Investment Affect Economic Growth?” NBER Working Paper No. 5057 (Cambridge, Massachusetts’, National Bureau of Economic Research, March 1995).

7

See Michalopoulos and Tarr, “Trade Performance”; and Michael Leidy and Ali Ibrahim, “Recent Trade Policies and an Approach to Further Reform in the Baltics, Russia, and Other Countries of the Former Soviet Union,” IMF Working Paper 96/71 (July 1996).

Illustrative Long-Run Growth Scenarios

What then can the transition countries expect in terms of long-run TFP and overall growth? It is apparent from other countries’ experiences that TFP growth is not an exogenously given constant rate but that it can vary substantially across countries and over time, depending on circumstances. Such variation in productivity growth has stimulated interest in models of economic growth that attempt to explain the rate of technical change and therefore TFP growth.47 In these models, the rate of technical change is often assumed to be determined by returns from research and development (R&D) expenditures and the application of new ideas. The diffusion of R&D through trade and investment can also contribute to TFP growth, which may be particularly relevant for the transition countries.48 The role of the public sector can be important in raising the marginal productivity of private capital through public investment, the provision of education, and the enforcement of private property rights in the economy. The public sector is financed through the imposition of taxes, however, which can distort saving-investment decisions and thereby adversely affect the rate of growth.49 These approaches further assume that marginal returns to capital do not diminish with capital accumulation, partly because of the embodiment of new technology in new capital. Under these assumptions, long-run growth rates may be affected by the rates of accumulation of physical and human capital. This approach has led to a growing body of empirical evidence on the effects on growth of education, skills levels, taxes, openness to foreign trade, catch-up potential, and the enforcement of property rights.50

The transition countries’ characteristics in several areas that are considered to be relevant in the new growth models are summarized in Tables 23 and 24. Countries’ catch-up potential should be inversely related to their current income levels. Per capita incomes (in terms of purchasing power parity) vary widely among the transition countries, ranging from $538 in Albania to over $8,173 in the Czech Republic.51 Other things being equal, countries with relatively low initial income levels should be expected to be able to grow relatively rapidly provided they remove obstacles to growth through structural reforms. Initial income differences among transition countries may, however, reflect differences in education and labor market skills that may take some years to overcome.

Table 23.

Countries in Transition: Per Capita Income and Selected Demographic Indicators

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Source: World Development Report, 1996 (Washington: Oxford University Press for the World Bank, 1996).

IMF staff estimates.

Infant mortality and life expectancy vary widely, which is not surprising given the differences in income levels. In many of the transition countries, these indicators have improved significantly over the past twenty years, and the declines in income levels that have occurred during the initial phase of the transition do not seem to have been associated with any widespread deterioration, although Russia has experienced a serious decline in life expectancy.52 These indicators are important for growth prospects since they reflect the general health of the population and may be considered a good proxy for other features that contribute to a well-functioning society with a motivated labor force.

Although subject to considerable uncertainties, indicators of educational attainment (Table 24) and the quality of schooling (Table 25) are quite favorable for virtually all the transition countries and suggest that the quality of human capital may make an important positive contribution to future growth. In these areas, the transition countries compare well with the industrial countries and seem to be considerably ahead of most developing countries.53 (Data are not shown separately for the successful emerging market countries, which are also characterized by high levels and quality of education.) This assessment is supported by other indicators, such as literacy rates, in which transition countries rank very high. It should be recognized, however, that the high level of spending per student in the planned economies is not necessarily related to the quality of school inputs, but may partly reflect inefficiencies in the delivery of education services.

Table 24.

Countries in Transition: Trends in Educational Attainment of the Population Aged 15 and Over1

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Source: Robert J. Barro and Jong Wha Lee, “International Measures of Schooling Years and Schooling Quality,” American Economic Review, Vol. 86 (May 1996), pp. 218–23. Similar results are found in Table 7 of the World Development Report 1996.

Regional averages are weighted by each country’s population aged 15 and over.

In millions of individuals aged 15 and over. The fractions shown for education refer to the population over 15 that has the indicated level of school as its highest achievement. “Some” means that the indicated level is the highest attained. “Full” means that completion of the indicated level is the highest attained. (The total of “None” and the three categories labeled “Some” is 1.0.)

Average years of schooling at all levels.

Table 25.

Countries in Transition: Indicators of the Quality of School Inputs1

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Source: Robert J. Barro and Jong Wha Lee, “International Measures of Schooling Years and Schooling Quality,” American Economic Review, Vol. 86 (May 1996), pp. 218–23.

The figures are unweighted averages of countries with available data in each region. The number of countries included varies over time: primary and secondary spending per pupil and salaries of primary school teachers are expressed as ratios to per capita GDP.

As a ratio to per capita GDP.

At the same time, it remains uncertain whether the quality of human capital in the transition countries can compensate for the relatively unfavorable demographic characteristics. The populations of most transition countries are not only growing very slowly—they are even declining in several cases—but they are also aging rapidly (Table 26). In addition to a declining labor force, the rising share of pensioners will imply a considerable burden on public pension and health systems that will need to be financed partly through higher tax rates. The demographic trends could therefore be a powerful negative influence on national saving rates and prevent saving from rising as much as normally would be expected as the growth process gains momentum.

Table 26.

Countries in Transition: Population Growth

(Annual percent change over five years earlier)

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Source: World Bank Population Projections.

Integrating all of these considerations into a formal production function would be a difficult exercise. Moreover, the short period that has elapsed since the reforms began, the fact that the transformation process is continuing, and the initial decline in output, all imply that data from the transition countries them-selves are unlikely to provide a useful guide to future trends. It is possible, however, to draw on empirical analyses of the relationship between economic growth and key determining variables for other countries in different stages of economic development.54 While such an approach may overlook some aspects that are unique to the transition countries, evidence from other parts of the world is probably the best way to assess their long-term growth potential.

The results of this exercise are reasonably encouraging, although the range of possible estimates serves to underscore both the uncertainties that are associated with this type of analysis and the risk that long-term growth in the transition countries may be quite modest. Two specifications are considered here; both yield broadly similar results. The first scenario is based on an approach that particularly emphasizes the positive role of human capital, as reflected in primary and secondary school enrollment, and the negative roles of large government sectors and high rates of taxation (equation 1 in Table 27). Application of this model implies long-term growth rates of GDP and GDP per capita in the range of 4 to 5 percent, which would allow the transition countries, on average, to reach current (1996) income levels in the industrial countries in 20 to 30 years, or about one generation. An alternative specification (equation 2 in Table 27), which gives greater prominence to investment and population growth, implies a somewhat less favorable scenario for the individual countries featured, though growth is moderately higher for transition countries as a group.

Table 27.

Selected Countries in Transition: Simulated Growth Rates

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Source: Based on approach suggested by Stanley Fischer, Ratna Sahay, Carlos Vegh, “From Transition to Market: Evidence and Growth Prospects,” IMF Working Paper (forthcoming).

Simulated values based on current levels of independent variables.

Simulated values based on high-growth policies discussed in text.

Years to reach current industrial countries’ level of per capita income.

Robert J. Barro, “Economic Growth in a Cross Section of Countries,” Quarterly Journal of Economics, Vol. 106 (May 1991), pp. 407–30.

Albania, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, former Yugoslav Republic of Macedonia, Poland, Romania, Russia, Slovak Republic, and Slovenia.

Ross Levine and David Renelt, “Sensitivity Analysis of Cross-Country Growth Regressions,” American Economic Review, Vol. 82 (September 1992), pp. 942–63.

Government policies can help to raise significantly the long-term growth of potential. This is illustrated in the alternative simulations reported in Table 27, which show the results of lowering the share of public expenditure (other than on education) in GDP and where the policy framework leads to an increase in the share of investment. The simulations show that the adoption of these high-growth policies would raise growth rates and reduce the years required to reach the current level of industrial countries’ per capita income. Reducing government consumption to 15 percent of GDP produces a modest increase in the average growth rate in equation 1, with the result that convergence is achieved, on average, four years sooner.55 Raising investment rates to 30 percent of GDP, however, generates a much greater increase in growth, which roughly doubles under the alternative specification (equation 2), As a result, the time required for convergence falls significantly, from 65 to 33 years. Also implicit in these simulations are assumptions about the legal framework, especially the protection of property rights, the enforcement of contracts, and avoidance of corrupt practices, which are all essential for the efficient allocation of resources.56 With the exception of east Germany, which adopted the legal, institutional, and administrative structures from west Germany virtually overnight, the establishment of such a legal framework will necessarily take some time to complete.

Policy Issues and Challenges to Sustaining Growth

Given the strong beneficial effects of investment on growth, a challenge for policy in the transition countries is to ensure the availability of resources necessary to finance investment. Fiscal policy must strike a balance between eliminating fiscal deficits, which soak up domestic savings, while at the same time preserving spending necessary for social objectives. Reducing barriers to foreign investment is crucial to allow transition countries to draw on foreign savings, but at the same time care must be taken to ensure that external borrowing remains sustainable and that the composition of spending financed by the capital inflows does not skew away from investment activities toward consumption. Finally, further development of the financial industry in transition countries is needed to provide greater efficiency in the mobilization of savings and the direction of these resources into productive endeavors.

Role of Fiscal Policy in Raising Saving and Ensuring Adequate Social Protection

Because of the impact of the adverse demographic trends in the transition countries on the evolution of private saving rates, fiscal policy will need to play a key role in ensuring that levels of saving are sufficient to finance the high levels of investment required for sustained economic growth. Indeed, there seems to be a strong case for eventually attaining surpluses in current budget balance, even though this may seem an elusive goal at present. This objective must, however, be balanced against the demands on the budget to finance social safety nets, bank restructuring, environmental cleanup, enterprise restructuring, and other genuine needs for public intervention.

In addition to sizable, though declining, fiscal deficits measured on a cash basis, most transition countries continue to accumulate large wage and pension arrears and unfunded liabilities in public pension systems.57 These problems are compounded by non-performing loans in the banking system owed by insolvent enterprises, as discussed further below. Sooner or later, difficulties in the banking system may have serious budgetary implications. An accruals-based accounting system for public sector operations would therefore show a considerably more worrying picture than that implied by standard budget practices. While such problems are by no means limited to the transition countries, they do seem to be more serious there than in other countries.

In designing both their short-term stabilization policies and their longer-run fiscal strategies, a key consideration for the transition countries is to ensure the financing of social safety nets without recourse to permanent deficit spending. In many countries, budgetary allocations for health care, pensions, and social assistance have been drastically cut or sequestered—whereby funding is temporarily withheld. While these short-term expedients may have been influenced by revenue shortfalls, such practices cannot be sustained in the longer run without doing serious harm to the social fabric. Indeed, many of the individuals who are most dependent on the various safety nets are likely to be among those who have already been the most adversely affected by the transition process. A further widening of the income distribution could also erode support for the reform process.58

As they reform their social policies, the transition countries will therefore need to strike a better balance between social spending and its financing. There is no blueprint that can be applied equally to all transition countries, but some measures may be applicable to most.59 These include improved targeting of pensions and other benefits, which in most countries is very tax. Moreover, greater care must be taken to ensure that benefits go to the truly needy. This is especially important with respect to unemployment benefits, since many individuals that are officially unemployed may be working in the informal sector. To enhance resources available to meet broad social objectives, it will be necessary to bring the informal sector into the social insurance system, particularly in view of the declining share of the state sector in these economies.

Creating a better balance between outlays and funding in payroll-financed social benefits is a particularly high priority in all transition countries in view of the rapid aging of their populations that is under way and the rise in unemployment associated with the needed restructuring of the enterprise sector. Given the magnitude of the task for many countries, a variety of measures are likely to be needed, including an increase in retirement age, a tightening of eligibility criteria, and increased payroll contributions. Table 28 illustrates that the gap between defined benefits and payroll contributions could be substantially reduced through such reforms. Substantial transfers from the general budget—financed by direct and indirect taxes—will still be needed, however.

Table 28.

Selected Countries in Transition: Reform of Social Protection Systems

(As percent of GDP)

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Source: Ke-young Chu and Sanjeev Gupta, “Social Protection in Transition Countries: Emerging Issues.” IMF Paper on Policy Analysis and Assessment 96/5 (May 1996).

Assuming an effective payroll tax of 13 percent of the wage bill. The base for payroll taxation is typically the wage fund, which is narrower than the wage bill. Furthermore, the wage bill is derived by multiplying the average wage by employment. The latter is an overestimate because many workers are being placed on administrative leave and are not receiving wages. This has been taken into account by lowering the effective payroll tax.

Based on population above the age of 55 and 40 percent of the average wage.

Based on 3 percent of the average wage.

Assuming that the effective payroll tax increases to 14 percent.

Based on population of age 60 and above and 40 percent of the average wage.

Increase in 1 percentage point in unemployment and benefit equal to 30 percent of the average wage.

For 1993 and as percent of gross social product.

Capital Flows and Foreign Direct Investment

In view of the concerns that seem to be justified about the future levels of both private and public saving, the ability of the transition countries to draw on foreign saving could have a significant influence on their investment and growth performance. The medium-term scenario shown in Table 18 already assumes that such inflows will be sufficient to finance current account deficits on the order of about 2 percent of GDP a year over the next five years, but some countries may well be able to attract capital inflows at a significantly higher rate. This is suggested by the recent experience of the Czech Republic and Hungary, which saw net inflows in 1995 of about 15 percent of GDP (Table 29), considerably higher than the inflows experienced by many of the successful emerging market countries in the developing world (see Chapter IV).

Table 29.

Selected Countries in Transition: Indicators of Capital Flows

(In billions of U.S. dollars unless otherwise indicated)

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Sources: National authorities; and IMF staff estimates.

For the countries that are most advanced in transition, the capital inflows reflect the progress that has been made toward financial stabilization and the introduction of structural reforms, especially price liberalization and privatization. Although large inflows associated with the reversal of currency substitution (through residents’ conversion of foreign currency into local currency) have also been recorded in some countries less advanced in transition, for most of these the inflow of foreign capital—particularly in the form of foreign direct investment—is limited by the slow progress they have made in the area of privatization and other structural reforms, by continued government intervention in the economy, by uncertainties about property rights, and by weaknesses in the legal framework.60 However, as the reform process gains momentum and financial stability improves, these countries are also likely to benefit increasingly from capital inflows.

Notwithstanding the potential benefits associated with large capital inflows, the transition countries need to guard against excessive reliance on foreign saving. Experience from other countries clearly shows that large capital inflows often finance domestic consumption rather than investment, implying that foreign saving becomes a substitute for domestic saving. Under these circumstances, there is a heightened risk that the external deficits that are the counterpart of the capital inflows may become unsustainable and require painful economic adjustments—sometimes imposed by financial markets when investors suddenly change their sentiment about a country’s economic and financial prospects. Capital inflows are therefore clearly no panacea and no substitute for domestic policies to foster high and stable levels of national saving.61

With the exception of Bulgaria, Hungary, Poland, and Russia the transition countries generally had quite low levels of foreign debt at the start of the reforms.62 While most countries continue to enjoy relatively modest levels of foreign debt, many have increased their external borrowing significantly, increasing debt payments as a share of GDP (Table 30). To the extent that these resources have been used to augment foreign exchange reserves in support of strengthened financial policies, invested in the economic infrastructures necessary to support a market economy, and used to facilitate social and labor market adjustment, the present level of official borrowing is not worrying. But given the large investment needs of these economies, significant additional foreign borrowing by the private sector must be expected. And, since official debts are serviced through taxes levied on the private sector, it is incumbent on governments to ensure that official foreign borrowing be kept at reasonable levels and used effectively.

Table 30.

Countries in Transition: Indicators of External Viability, 1995

(In percent of GDP unless otherwise noted)

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Generally excluding transactions or assets and liabilities among the Baltic countries, Russia, and the other countries of the former Soviet Union.

In months of imports of goods and services.

As a percent of exports of goods and nonfactor services, and on a cash basis.

Debt and debt-service figures include obligations to commercial creditors that are not being serviced.

In countries’ policies toward capital inflows, it is particularly important to remove obstacles to foreign direct investment, which raises investment without a concomitant increase in the external debt burden. Moreover, such inflows not only embody new technology, but also are often accompanied by managerial expertise. An important step to encourage foreign direct investment is to provide assurance that foreign investors will be able to repatriate their earnings. Partly to this end, 14 of the transition countries have already accepted the obligations of current account convertibility under Article VIII of the IMF’s Articles of Agreement.63

Many other factors also impinge on foreign direct investment. Of most importance is the development of a vibrant private sector, since the return on foreign direct investment will generally be higher if there is a growing private sector that can provide a source of inputs and a market for local production. Economic policies must therefore be conducive to domestic saving and investment. The importance of this stems from the experience from other countries that an economic environment that fosters domestic investment will also attract foreign direct investment. A stable, transparent tax regime that minimizes the distortions to saving, investment, and production decisions is especially important. At the same time, foreign direct investment should be treated neither more nor less favorably than domestic projects. But the attraction of a stable, transparent, and nondiscriminatory tax code is lost if investors are, in effect, “taxed” by organized crime or by corrupt government officials.

More fundamentally, however, governments must also ensure that investors are allowed to reap the returns from entrepreneurship. The legal framework—particularly the protection of property rights—is crucial in this regard, since foreign and domestic investors will be reluctant to invest without adequate legal protection.64 The Baltic countries are most advanced among the countries of the former Soviet Union in establishing secure property rights in land to foreign investors. In many transition countries, however, foreign firms—and in some, domestic residents—are prohibited from owning land, which must be leased from the state. This may limit investment, given the possible risk that the terms of the lease may be abrogated by the state once investment is undertaken. Moreover, in Russia, the legal framework for foreign participation in natural resource sectors remains ill defined pending parliamentary approval of the draft law on “production sharing.” There is no absolute guarantee against the risk of expropriation, and political stability is therefore crucial to potential investors. While most countries have made good progress in terms of democratization and establishing the rule of law, popular support for the reform process remains fragile in some.65

It should also be noted that despite their generally beneficial effects in complementing domestic saving and facilitating technology transfers, capital flows often pose a serious challenge for macroeconomic management. In some of the countries that have persevered with stabilization and structural reforms, for example, sizable capital inflows have tested the authorities’ capacity to sterilize and, by contributing to rapid growth in the monetary aggregates, have impaired efforts to further bring down inflation. In most cases, these problems, which are common to all emerging market countries, can be alleviated by tightening fiscal policy (see Annex IV). Another response to persistent large inflows is to allow some upward flexibility in the exchange rate. In the Czech Republic, for example, heavy inflows led the authorities to widen the exchange rate band in early 1996. An additional complication is the potential risks to the domestic financial system that stem from the intermediation of capital inflows by domestic banks. To the extent that banks assume uncovered foreign exchange positions and lend on a medium-term basis, there is an increased risk of financial fragility, especially for banks already burdened by large portfolios of nonperforming loans.66

Role of the Financial System

A crucial condition for sustained economic growth is the effective mobilization of financial resources to finance investment. The financial system and especially banks perform a particularly important role in screening investment projects and enforcing hard budget constraints on enterprises and other borrowers, which helps to ensure that investment funds are allocated to profitable projects with high returns. The degree of financial depth can affect growth performance as well. Countries with a greater proportion of credits intermediated by commercial banks appear to grow faster, as do those with a greater share of credits extended to the private sector.67

In most transition countries, however, the financial intermediation role of the banking sector is still quite limited as suggested by an international comparison of ratios of broad money (Table 31). On the basis of this particular indicator, it would appear that the level of financial development in the transition countries is generally below that in industrial countries and the rapidly growing developing economies, as would be expected. There are also marked differences between the countries in central and eastern Europe and the countries of the former Soviet Union. The very limited role of the banking system in many of the less advanced transition countries in mobilizing domestic saving can be explained by the low interest rates paid on deposits in a period of very high inflation (i.e., financial repression) and the rapid depreciation of domestic currencies, which contributed to widespread disintermediation. The low quality of services offered and the sheer distrust of the public toward banks are also important factors. Despite the decline in the real value of deposits, banks have engaged in aggressive lending practices, typically financed by central bank credits, without adequate prudential supervision. Much of this lending was extended at favorable terms to enterprises in financial difficulty. And, in many countries, governments pressed banks to make directed loans to inefficient state enterprises, thus creating additional quasi-fiscal liabilities. The adoption of tight financial policies to reduce inflation subsequently revealed underlying weaknesses in bank balance sheets. This has further impaired intermediation since investors are now even more reluctant to deposit funds in banks that are perceived to be at risk of failure.

Table 31.

Countries in Transition: Broad Money

(In percent of GDP)

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The high level of nonperforming loans in the banking system in many countries is of growing concern. Although it is difficult to make cross-country assessments because of differences in definitions and reporting, data on three advanced transition countries suggest that the problem is serious indeed (Table 32).68 The large stock of bad loans as a share of GDP in the Czech Republic can partly be explained in terms of the discussion above on financial disintermediation: because the Czech Republic did not suffer from inflation to the same extent, the stock of bad loans inherited from central planning was not eroded in real terms, while the banking system continued to play an important role in terms of financial intermediation. Although Czech banks have made substantial provisions for nonperforming loans, and may thus be less vulnerable than banks in other countries, two distortions—the treatment of accrued but unpaid interest on bad loans as taxable income and limits on provisioning from before-tax profits—add significantly to costs and weaken the banking system. The problem of bad loans is also a threat in other transition countries. For the Baltic countries, Russia, and the other countries of the former Soviet Union, for example, estimates of the ratio of nonperforming to total loans range between 14 and 65 percent.69 Thus, the potential costs of resolving bad loans in some transition countries are undoubtedly very large and threaten to frustrate the fiscal consolidation needed to raise national savings.

Table 32.

Selected Countries in Transition: Problem Loans

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Source: Ronald W. Anderson, and others. Banking Sector Development in Central and Eastern Europe: Forum Report of the Economic Policy Initiative, No, 1 (London: Centre for Economic Policy Research, 1996).

The growing nonperforming loan problems stem mainly from the fact that inefficient state enterprises continue to receive the bulk of bank financing at the expense of more efficient private firms. In many countries, banks have been reluctant to impose financial discipline on recalcitrant borrowers, and rather than enforce the bankruptcy sanction, have typically rescheduled overdue principal payments and capitalized interest arrears. However, the extent to which this response reflects the concern that enforcing loan agreements would erode their capital, rather than more fundamental problems of unenforceability of private contracts on state enterprises, is unclear.

Although the spread between borrowing and lending rates reflects several factors, including the underlying riskiness of the loan portfolio, it may also provide an indication of the serious economic consequence of the fragile state of the banking system in the transition countries (Table 33). It is apparent that high levels of nonperforming loans have compelled banks in many advanced transition countries to maintain quite wide margins between lending and deposit rates. Interest rate spreads in selected advanced transition countries range from a low of 4 percent (in the Slovak Republic) to 13 percent (in Estonia) in 1994. In contrast, spreads in most industrial countries were about 3 percent, although in some spreads were on the order of 5 percent.70 High spreads have several adverse effects on the allocation of investment funds. Potentially productive projects that cannot generate returns required to cover the cost of borrowing either go unfunded or are delayed, while the loans that are contracted may be the most risky and, over time, become nonperforming. In addition, in combination with the nascent state of capital markets, firms without ownership ties to banks are likely to be forced to rely on internally generated funds to finance their investment payments. The growth of new firms, meanwhile, is likely to be constrained by the limited personal financial resources of the entrepreneur. This may seriously impede growth, since experience from other countries shows that new firms are often more dynamic.

Table 33.

Selected Countries in Transition: Bank Interest Rate Spreads1

(In percent)

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Source: David K.H. Begg, “Monetary Policy in Transition Economies,” IMF Working Paper (forthcoming).

Deposit rates average household and enterprise deposits. and sight and time deposits.

The speedy resolution of the distorted incentives in the banking system is therefore critical. This is increasingly recognized, and several steps have been taken to address the problem of financial fragility in most transition economies, including those less advanced in transition (see Box 7). Prudential regulations have been strengthened, with the adoption of capital adequacy guidelines and restrictions on connected lending, while the supervisory capacity of the authorities has been enhanced. These measures are intended to contain the flow of additional problem loans. Attempts to address the “stock” problem have included programs to ensure an orderly working out of problem loans, the recapitalization of problem banks, and debt swaps—in which banks exchange (a share of) their portfolio of bad loans for government securities. These options have been used in several countries, including Albania, Bulgaria, the Czech Republic, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. Recapitalization can impose a heavy fiscal burden on public finances, however, and, if it is not accompanied by strong measures to enhance the effectiveness of the banks, may not prevent the recurrence of problems, as was the case in Bulgaria. Recapitalization thus involves a risk of a moral hazard. At the same time, measures to resolve problems in the banking system are unlikely to have lasting effects unless they are accompanied by structural reforms designed to foster enterprise restructuring.

In most countries, governments have been reluctant to permit bank failures, and frequently intervene to recapitalize problem banks or provide guarantees to facilitate an orderly merger with a stronger institution. Although government action is typically justified on the grounds of protecting the integrity of the payment system, or the potential for contagion effects, in which the failure of unsound banks generates funding difficulties for sound institutions, political factors often figure prominently in the decision to intervene. This is well known by both industrial and developing countries that have experienced banking problems. The political pressure to protect depositors may be higher, however, in the transition countries given the fact that many depositors suffered large losses in the real value of their deposits as a result of rapid inflation early in the transition process. Notwithstanding the potential resistance to bank closures, however, the experience of Estonia, Latvia, and Lithuania demonstrates that bank failures need not impair growth irrevocably, while the recent exchange market crisis in Bulgaria shows the costs of not acting against unsound banks at an early stage. Confidence in the banking system is more likely to be restored with a minimum of disruption when governments demonstrate a willingness and ability to deal quickly and decisively with problem institutions.

* * *

Many formerly centrally planned economies have made good progress toward the goal of transition—fostering market forces so that resources are allocated efficiently. They have been rewarded with robust growth that has provided employment and raised living standards. For countries less advanced in transition, growth has been slower in coming but is nevertheless expected to resume provided they manage to stabilize their economies and sustain the process of structural reform.

Looking to the longer-term growth prospects, these countries have important strengths, particularly in terms of human capital. There are several factors that could significantly raise growth rates, including the scope for expansion of the service sector, and the potential to catchup to the best available technology. In many respects, however, the longer-term foundations for growth do not look as favorable as they do in many of the dynamic emerging market countries in the developing world. Most transition economies have rapidly aging—and slowly growing—populations that will result in rising dependency rates. The economic burden of rising dependency rates suggests that the transition countries’ saving—and hence investment—performance may not improve as much as normally can be expected when economic development gels under way. Moreover, at least for the foreseeable future, the weakness of the banking systems in many countries may impair the mobilization of domestic saving and hamper the efficiency of resource allocation through the financial system. Much will depend, therefore, on the extent to which governments can cope with the three policy challenges outlined above—striking an appropriate balance of fiscal consolidation and social protection, ensuring prudent use of foreign capital to augment domestic savings, and resolving the bad loans problem in the banking system in a way that does not impair fiscal consolidation efforts and fosters the development of effective and efficient financial intermediation. Transition countries have the potential for sustained growth if the policies they adopt successfully address these challenges.

Bank-Restructuring Strategies in the Baltic States, Russia, and Other Countries of the Former Soviet Union: Main Issues and Challenges

As the Baltic states, Russia, and other countries of the former Soviet Union embarked on market reforms during 1991–92, two-tier banking systems emerged with the creation of central banks and the transformation of specialized banks into notionally autonomous commercial banks.1 Concurrently, in large part owing to tax licensing policies and practices, most of these countries experienced a large increase in the number of commercial banks, as well as in the number of branches of existing banks.2 These institutions typically lacked expertise in credit evaluation, and many engaged in aggressive lending to unprofitable enterprises with ownership relationship or other ties to the banks. Early in the transition process, the consequences of poor credit evaluation were effectively masked by high inflation. The sharp reduction in inflation resulting from the successful implementation of stabilization programs, however, revealed the underlying weakness of the banking systems in most cases.

For most of the countries, the current overall financial situation is fragile.3 The ratio of nonperforming loans to total loans varies from 14 percent to 63 percent—ratios that are high in comparison with other countries that have experienced banking crises.4 It is possible that the situation is worse than these figures indicate, however. The overall health of the banking system is difficult to gauge because many countries are only currently developing asset-classification systems and adequate accounting practices. Although the household deposit base is still small in most of these countries, and the banking sector’s total assets are smaller relative to GDP than in central and eastern European transition economies, a banking crisis would nonetheless jeopardize monetary stability. Moreover, the fragility of the banking system is a major constraint on economic recovery.

Large changes in the economic environment, lack of institutional development, and inadequate banking practices are or have been ongoing causes of banking sector weaknesses in the Baltic states, Russia, and other countries of the former Soviet Union. All three factors will need to be addressed in order to increase the prospects of successful bank restructuring in the long term. A comprehensive program of bank restructuring should therefore include measures that encompass the future structure and performance of the banking system: for example, the policy framework to ensure a competitive and viable system; the use of public funds to recapitalize problem banks and the conditionality attached to such use to avoid a recurrence of poor lending decisions, including the phasing in of measures to ensure compliance with prudential standards and supervisory requirements; the treatment of loss-sharing among the parties involved (depositors and other creditors), borrowers, and shareholders, with particular emphasis on the avoidance of moral hazard; transitional arrangements to ensure that basic financial services can be provided to the economy; institutional arrangements for loan recovery and loan workout; and firm exit policy.

In most of the countries, banking sector problems have been dealt with in an ad hoc manner as and when they have surfaced, and a systemic approach to bank restructuring has not yet emerged. Several countries have implemented packages of short-term stopgap measures. These include measures to curb the activities of problem banks and limit ad hoc injections of funds by the authorities. Currently, in most cases, restructuring measures mainly consist of license withdrawals and liquidation procedures directed at small banks.

Only two countries, Kazakstan and the Kyrgyz Republic, have embarked on a systemic restructuring strategy including extensive measures to deal with the formerly specialized banks.5 Both of these countries have made progress in enterprise sector reform. Most of the other countries appear reluctant to close or rehabilitate large banks. Georgia has adopted a “market-based” approach to the restructuring of its banking system. A key element is the implementation of a bank certification program where failure to gain certification will be accompanied by strict limitations on balance sheet growth.

The development and implementation of comprehensive strategies will require a well-defined institutional setting and the identification of available financial resources. Depending on the circumstances, existing institutions may take the lead, or a special agency or task force for bank rehabilitation may need to be formed. The fiscal costs of different strategies must be identified at an early stage. These range from minimization of budgetary outlays through a strict market-based approach of liquidation with only partial compensation for depositors, to sizable budgetary involvement through long-term loans and the assumption of enterprise debt. The cost of government involvement under these approaches will be determined by the extent of the bad loan problems, which in many cases already constitute quasi-fiscal obligations of the government. This underscores the importance of pursuing enterprise restructuring as a necessary complement to bank-restructuring strategies. Guided by the budgetary resources available for bank rehabilitation and the implementation capacity of the restructuring institution, it will then be critical to reach consensus on the various components of a restructuring strategy. As a first step, most countries are beginning with a diagnostic review to establish the magnitude and nature of the problems in the banking sector. Progress has been made also in improving the legal framework; much work, however, still needs to be done in this area to establish the framework for facilitating effective restructuring.

It would be necessary also to devise institutional arrangements for loan recovery and workout and asset management (this may include arrangements for enterprise restructuring).6 Bad loans can be left in banks’ balance sheets and individual banks can set up workout units to deal with nonperforming loans (decentralized approach) or an asset-management agency can be set up to assume bad assets from the banks (centralized approach). If the latter approach is chosen, the asset-management agency will need to have corporate status and be adequately capitalized to finance the acquisition of the assets. An alternative approach is to force restructuring through an obligation to achieve, within a given time frame, capital and prudential requirements, and to let the market mainly work out the restructuring process while introducing temporary limits on the ability of unsound banks to increase the size of their balance sheets and the risk to depositors. However, as one of the functions of the banking system is to provide a public good—in the form of the payment system—it is not clear whether such an approach can be feasible in the case of an imminent crisis. Evidence from a large group of countries that have experienced banking crises suggests that in all cases public funds are likely to be used at some stage of the bank-restructuring process.

Whichever degree of government involvement is chosen, a firm exit policy should be a key element of any strategy to restructure a banking system. For any bank, a determination to close or to save must be made based, in part, on the outcome of discussions concerning the possible merger, twinning, or other form of restructuring. This determination would typically occur in the conservatorship imposed on a bank as part of a spectrum of enforcement actions.

Finally, the strategy should include concomitant reforms and incentives to promote the efficient working of the financial system, as well as to establish a self-correcting mechanism to minimize the recurrence of banking system distress. First, it is necessary to ensure that banks operate on commercial principles and have strong management and internal control, supported by adequate official oversight. Deposit insurance schemes—formally in existence in fewer than half of the countries, although implicit government guarantees on the deposits of large banks seem more common—have to be supported by adequate prudential regulation and supervision. Privatization can be an important means of achieving improved bank governance; but appropriate conditions—fit-and-proper owners and managers, strong lead investors, and adequate competition and regulation—must also be present. Moreover, appropriately qualified investors, if available, may have limited interest in taking over financially troubled or insolvent banks. Therefore, the restructuring of state-owned problem banks is likely to be an important precondition for successful privatization. Second, to minimize recurrence of distress, banking system restructuring must go hand in hand with enterprise restructuring and measures to strengthen the legal and regulatory framework for banking and loan recovery. Otherwise, as shown by the experience of central and eastern European countries, the success of bank restructuring is likely to be limited. Effective collateral and bankruptcy loans are needed not only to minimize the recurrence of distress, but also to facilitate the rehabilitation process.

1

This discussion is based on Ceyla Pazarbaşjoğlu and Jan Willem van der Vossen, “Design of Bank-Restructuring Strategies” (unpublished, IMF, 1996).

2

In some cases, however, new banks have contributed to the development of an emerging private sector through the provision of credit to firms that would have otherwise gone unfunded.

3

Two exceptions are Estonia and Latvia, both of which have already experienced and made progress in resolving banking sector problems. In the case of Latvia, the problems were concentrated in a large private bank that accounted for about 40 percent of the total assets of the banking system. The bank was closed in May 1995.

4

Prior to the onset of banking crises, the ratio reached 9 percent in Argentina (end-1980), 9 percent in Finland (end-1992). almost 11 percent in Mexico (September 1994), 6 percent in Norway (end-1991), 7 percent in Sweden (end-1992), and 9 percent in Venezuela (end-1993).

5

In Azerbaijan and Kazakstan, programs for financial sector reform, including the large state-owned banks, are being developed with IMF and World Bank assistance.

6

In many cases, the status of government-guaranteed loans will also have to be resolved.

37

These comprise the countries of central and eastern Europe, the former Soviet Union, and Mongolia. Other countries with partially command-based economic systems that are also in the process of introducing market-oriented reforms, including China, Vietnam, Cambodia and Lao People’s Democratic Republic, are included among the developing countries in the classification system used in the World Economic Outlook.

38

See Evgeny Gavrilenkov and Vincent Koen, “How Large Was the Output Collapse in Russia? Alternative Estimates and Welfare Implications,” Staff Studies for the World Economic Outlook (IMF, September 1995), pp. 106–19.

39

See Stanley Fischer, Ratna Sahay, and Carlos A. Végh, “Stabilization and Growth in Transition Economies: The Early Experience,” Journal of Economic Perspectives, Vol. 10 (Spring 1996), pp. 45–66.

40

See Jeffrey D. Sachs, “The Transition at Mid-Decade,” American Economic Review, Vol. 86 (May 1996), pp. 128–33. A similar composite index of economic liberalization that measures progress in three areas (liberalization of domestic transactions, external transitions, and entry of new firms) has also been compiled by the World Bank; see World Development Report 1996.

41

The relationship between unemployment and growth depicted in Chart 33 may be somewhat misleading, since workers who are not registered as unemployed but who are on unpaid furloughs may be engaged in productive activity outside their formal place of employment. This effect is likely to be significant in most transition countries and is an additional reason to consider that official statistics Underreport somewhat the level of activity.

42

For example, it has been estimated that between 50 and 75 percent of the pretransition capital stock in the former Czechoslovakia, Hungary, and Poland may be obsolete. This figure is based on estimates of the capital stock that would be required to generate a given level of output under market conditions, taking into account measures of human capital and labor endowments in the transition economies. See Eduardo Borensztein and Peter Montiel, “Savings, Investment, and Growth in Eastern Europe,” IMF Working Paper 91/61 (June 1991).

43

These economies are Chile, Hong Kong, Korea, Malaysia, Mauritius, Singapore, Taiwan Province of China, and Thailand.

44

Data on gross investment in transition countries may be potentially misleading in the sense that a larger share of these flows represents maintenance to keep outdated machines in operation rather than the acquisition of capital equipment embodying vintage technology. It is thus arguable that investment rates should be much higher in transition countries than in other countries.

45

Total factor productivity is calculated as the residual after taking into account contributions of capital and labor to growth of potential output.

46

Although postwar growth in the centrally planned economies was also initially very high, this was the result of very high investment rates, which were pushed up to around 30 percent and held there for some time. TFP growth was not a significant factor; and growth slowed as diminishing marginal returns on fixed capital set in. In fact, TFP growth in the former U.S.S.R. was about one third that of developing countries and less than one sixth that of industrial countries in this period; see Angus Maddison, The World Economy in the 20th Century (Paris: Organization for Economic Cooperation and Development, 1989).

47

These are referred to as endogenous (or “new”) growth models, to contrast them with neoclassical models, in which the rate of technical change is exogenously determined. The development of the new growth theory was also motivated by the recognition that several stylized facts are inconsistent with the implications of the neoclassical growth model. For example, the data suggest that poorer countries often do not grow faster than wealthier countries, as would be expected from the assumption of diminishing marginal returns to factor inputs embodied in the neoclassical growth model.

48

See David T. Coe, Elhanan Helpman, and Alexander W. Hoffmaister, “North-South R&D Spillovers,” IMF Working Paper 94/144 (December 1944).

49

Paul Cashin, “Government Spending, Taxes, and Economic Growth,” Staff Papers, IMF, Vol. 42 (June 1995), pp. 237–69.

50

A comprehensive survey of this work is found in Roben J. Barro and Xavier Sala-I-Martin, Economic Growth (New York: McGraw Hill, 1995), Chapters 11 and 12.

51

Estimates of per capita GDP are highly sensitive to the exchange rate used. The purchasing power parity rates used in Table 23 adjust actual exchange rate movements for differences in purchasing power between the individual transition countries and the base currency country. Because of the steep initial depreciation at the outset of the transition process and the highly depreciated rates at which many national currencies were introduced, the use of current market exchange rates to calculate per capita GDP would, in most cases, exaggerate the decline in living standards in the transition countries.

52

Nevertheless, there have been severe disruptions to key social services—including health care and public education—associated with the transformation of these societies. See the discussion in European Bank for Reconstruction and Development, Transition Report 1995 (London. 1995), and World Bank, World Development Report 1996 (New York: Oxford University Press for the World Bank, 1996).

53

Evidence suggests, however, that the labor force of former centrally planned economies began the transition with overinvestment in vocational training and underinvestment in university education owing to incentives to encourage the expansion of heavy industry. See Robert Flanagan, “Institutional Structure and Labor Market Outcomes: Western Lessons for European Countries in Transition,” Staff Studies for the World Economic Outlook (IMF, September 1995), pp. 92–105.

54

The approach follows that of Stanley Fischer, Ratna Sahay, and Carlos Vegh, “From Transition to Market: Evidence and Growth Prospects,” IMF Working Paper (forthcoming 1996) and is based on empirical estimates by Robert J. Barro, “Economic Growth in a Cross Section of Countries,” Quarterly Journal of Economies, Vol. 106(May 1991), pp. 407—43; and Ross Levine and David Renelt, “Sensitivity Analysis of Cross-Country Growth Regressions.” American Economic Review, Vol. 82 (September 1992), pp. 942–63.

55

In the case of Hungary, the long-run level of government consumption is assumed to be 8 percent of GDP because of differences in the definition of government consumption.

56

See Andrzej Rapaczynski, “The Roles of the State and the Market in Establishing Property Rights,” Journal of Economic Perspectives, Vol. 10 (Spring 1996), pp. 87–103 and Jonathan R. Hay, Andrei Shleifer, and Robert W. Vishny, “Toward a Theory of Legal Reform,” European Economic Review, Vol. 40 (April 1996), pp. 559–67. In addition, it has been argued that rent-seeking and corruption can seriously impair growth: Kevin M. Murphy, Andrei Shleifer, and Robert V. Vishny. “Why is Rent-Seeking So Costly to Growth?” American Economic Review, Papers and Proceedings, Vol, 83 (May 1993), pp. 409–14; and Paulo Mauro, “Corruption and Growth,” Quarterly Journal of Economies, Vol. 110 (August 1995), pp. 681–712.

57

See May 1996 World Economic Outlook, Chapter V, pp. 77–92.

58

See Peter K. Cornelius and Beatrice S. Weder, “Economic Transformation and Income Distribution: Some Evidence from the Baltic Countries,” IMF Working Paper 96/14 (February 1996).

59

See the discussion in Ke-Young Chu and Sanjeev Gupta, “Social Protection in Transition Countries: Emerging Issues,” IMF Paper on Policy Analysis and Assessment 96/5 (May 1996).

60

Alain Ize, “Capital Inflows in the Baltic Countries, Russia, and Other Countries of the Former Soviet Union: Monetary and Prudential Issues,” IMF Working Paper 96/22 (February 1996).

61

Current account deficits are said to be “unsustainable” when current government policies and expected private sector behavior (i.e., saving and investment) entail the need for a policy shift or, if the required policy correction is not forthcoming, result in a crisis—such as an exchange rate collapse leading to an inability to service external obligations. See the discussion in Gian Milesi-Ferretti and Assaf Razin, “Current Account Sustainability,” IMF Working Paper (forthcoming).

62

Bulgaria concluded a debt-restructuring agreement with its commercial creditors in July 1994. The burden of Poland’s officially contracted debts was reduced significantly under the terms of the Paris Club rescheduling agreement in 1991, while contractual liabilities to banks were nearly halved under the terms of a London Club rescheduling agreement that was finalized in 1994. In the 1980s, Romania implemented a draconian policy of import compression to repay its foreign debts. The debts of most successor states of the former Soviet Union, meanwhile, were extinguished under the terms of the so-called zero option agreement with the Russian Federation signed in 1992, in which they relinquished claims on the foreign assets of the former Soviet Union. The value of officially contracted debts of the Russian Federation was subsequently reduced under a rescheduling agreement with the Paris Club concluded in April of this year. Negotiations with the London Club on the rescheduling of commercial bank debts are continuing.

63

The countries are Croatia, the Czech Republic, Estonia, Hungary, Kazakstan, the Kyrgyz Republic, Latvia, Lithuania, Moldova, Mongolia, Poland, the Russian Federation, the Slovak Republic, and Slovenia.

64

Capital market regulations, particularly those relating to disclosure and investor protection, are important in encouraging portfolio investment in transition countries. In most countries, however, including those more advanced in transition, these regulations, are weak and poorly enforced, or have not yet been implemented.

65

The risks of expropriation and other political risks can be partly insured against. All transition countries are either members of or have applied for membership in the Multilateral Investment Guarantee Agency.

66

See Guillermo A. Calvo, Ratna Sahay, and Carlos A. Végh. “Capital Flows in Central and Eastern Europe: Evidence and Policy Options,” IMF Working Paper 95/57 (May 1995).

67

See Robert G. King and Ross Levine, “Finance, Entrepreneurship, and Growth: Theory and Evidence,” Journal of Monetary Economies, Vol, 32 (December 1993), pp. 513–42.

68

Several caveats apply to these figures. First, increases in non-performing loans may be attributable to improved classification and reporting, as well as deteriorating loan quality. As a result, the figures cited here are not comparable across countries and should be viewed as only indicative of banking sector problems in individual countries. Second, no allowance is made for collateral. And, third, in the case of the Czech Republic, accounting principles prevent banks from writing off or marking down classified loans against loan-loss reserves, provisions, and other reserves that altogether amount to about 25 percent of total loans.

69

See Ceyla Pazarbasioglu and Jan Willem van der Vossen, “Design of Bank-Restructuring Strategies” (unpublished; IMF, 1996).

70

See David K.H. Begg, “Monetary Policy in Transition Economies,” IMF Working Paper (forthcoming).