3 Disinflation in Transition—1993–97
Author: Mr. Carlo Cottarelli and Mr. Peter Doyle
Language:
English
Keywords:
SEM; country; transition country; enterprise; government; economy; inflation stabilization; nominal exchange rate; inflation rate; inflation inertia; moderate inflation; Inflation; Disinflation; Exchange rates; Fiscal stance; Price controls; Baltics; Eastern Europe; Central and Eastern Europe
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Abstract

Almost all transition countries experienced an initial spike in inflation at the outset of the reform process as price controls were removed. The speed of the subsequent disinflations, however, varied markedly, partly reflecting the different times when countries gained monetary and political independence. Some Central and Eastern European (CEE) countries had managed to reduce inflation to the two-digit range already by the end of 1992, while inflation remained close to or above 1,000 percent in the Baltics, Russia, and other countries of the former Soviet Union (BRO). Subsequently, inflation continued to fall gradually in the Central and Eastern European countries, albeit with some notable exceptions. But it fell sharply in the Baltics, Russia, and other countries of the former Soviet Union, where, by the end of 1997, it exceeded 100 percent only in one country. As a result, median 12-month inflation in the whole transition group fell from 950 percent at the end of 1992 to 11 percent at the end of 1997.

Almost all transition countries experienced an initial spike in inflation at the outset of the reform process as price controls were removed. The speed of the subsequent disinflations, however, varied markedly, partly reflecting the different times when countries gained monetary and political independence. Some Central and Eastern European (CEE) countries had managed to reduce inflation to the two-digit range already by the end of 1992, while inflation remained close to or above 1,000 percent in the Baltics, Russia, and other countries of the former Soviet Union (BRO). Subsequently, inflation continued to fall gradually in the Central and Eastern European countries, albeit with some notable exceptions. But it fell sharply in the Baltics, Russia, and other countries of the former Soviet Union, where, by the end of 1997, it exceeded 100 percent only in one country. As a result, median 12-month inflation in the whole transition group fell from 950 percent at the end of 1992 to 11 percent at the end of 1997.

This chapter focuses on the experience during 1993–97 of 10 Central and Eastern European countries and the Baltics, Russia, and other countries of the former Soviet Union. It reviews a range of policies implemented in transition economies through the prism of their contribution to disinflation, and factors that were particular to the transition context.1 The chapter first outlines the recent inflation and output record. It notes that inflation peaked at higher rates, the output collapse was more marked, and disinflation came later in the Baltics, Russia, and other countries of the former Soviet Union than in the Central and Eastern European countries. Nevertheless, output began to recover within two years of successful disinflation in both areas. It then discusses the econometric evidence concerning the links between inflation and output. No general evidence is found that disinflation compounded other factors depressing output, but evidence is found that the moderate and low inflation environment brought about by disinflation stimulated growth. Next, the chapter identifies the factors that facilitated such apparently low-cost disinflation, including the transition context in which disinflation occurred and the role of fiscal policy. It then discusses the experience of countries that, having successfully reduced high inflation, remained in a moderate inflation range for several years. The conclusion summarizes the findings and draws out the implications for the inflation rates that transition countries should target in the years ahead.

Inflation Developments

By the end of 1992, major results in stabilizing inflation had been achieved only in the Central and Eastern European countries: inflation had dropped below 60 percent in the Czech Republic, Poland, and Slovak Republic (Table 1).2 Hungary had always remained well below this threshold.3 Inflation in the ruble zone was high and rising at this time. It surged dramatically in many countries that exited the ruble zone and established independent currencies and new central banks thereafter.

Table 1.

Twelve-Month Inflation Rates in Transition Economies

(End of period)

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Source: IMF staff estimates.

A new wave of stabilization efforts followed during 1993–94 and enjoyed considerable success: during 1993–97, 19 other transition economies managed to break the 60 percent inflation threshold (Table 2)—in most cases without reversals—and by the end of 1997, 16 countries had brought inflation below 15 percent (Table 1). Georgia is a particularly dramatic case, reducing 12-month inflation from 50,000 percent during 1994 to single digits in 1997.

Table 2.

Disinflation Thresholds1

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Sources: National authorities; IMF, International Financial Statistics; and IMF staff calculations.

Periods between thresholds were defined using the annualized three-month inflation rates. When these first fell below a threshold, and remained there for a year, and if the 12-month inflation rate fell below that level during the following year without rising above it again in that year (except for countries in which inflation fell below the threshold during 1997), the country was deemed to have crossed the threshold.

From Fischer, Sahay, and Végh (1996), except for Turkmenistan and Bulgaria.

While many countries delayed inflation stabilization for several years—with a relative cluster of stabilizations in late 1994–early 1995—inflation stabilization, once undertaken, was usually rapid. In many cases, less than six months elapsed between the initiation of a major stabilization effort and quarterly annualized inflation falling below 60 percent on a sustained basis (Table 2).4 Only five countries (Estonia, Kazakhstan, the Kyrgyz Republic, Lithuania, and Ukraine) took about 18–24 months from the beginning of the stabilization to get below 60 percent.5

But after the initial inflation stabilization phase, further disinflation was often slow. After breaking the 60 percent disinflation threshold, inflation persisted at moderately high levels (the 15–60 percent range) for more than two years in a number of countries. This slower disinflation group includes the same countries that reached 60 percent Disinflation in Transition—1993–97 slowly (except Ukraine), though Latvia and Albania, which had quickly reduced inflation to 60 percent, joined the group thereafter. However, the most often-quoted cases of persistently moderate inflation (see Cottarelli and Szapáry, 1998) are given by a number of advanced transition economies where inflation had dropped below the 60 percent threshold before the end of 1992. These include Poland (where it took more than four years to bring inflation down from 60 percent to below 15 percent), Hungary (where inflation was still over 18 percent at the end of 1997), and Slovenia (where inflation remained in the 15–30 percent range for over two years after the initial stabilization). Inflation in the Czech Republic and Slovakia has remained stuck to close to 10 percent for a number of years. The median inflation rate of those Central and Eastern European countries that began stabilization before 1993 fell from 27½ percent in 1993 to 15½ percent in 1997; the median inflation rate in the Baltics, Russia, and other countries of the former Soviet Union meeting the same criteria declined somewhat more rapidly, from 35½ percent to 12 percent over this period. Only Croatia and the former Yugoslav Republic of Macedonia have maintained inflation in low single digits for a number of years.6

Despite this persistent moderate inflation, the relapses into high inflation were relatively rare (Table 1). During 1993–97, there were three major reversals of inflation after initially successful stabilizations: Bulgaria and Romania in 1996, and Albania in 1997 (Table 1). And Albania and Bulgaria have since renewed their stabilization efforts. While outside the period covered by this chapter, the resurgence of inflation in Russia during the summer of 1998 is also notable: the 12-month inflation rate jumped from less than 6 percent in July to 59 percent in October (following a monthly inflation rate of almost 40 percent in September), reflecting the depreciation of the ruble during August 1998. As discussed below, this resurgence of inflation shares many of the features characterizing the relapses into inflation observed during 1993–97.

Disinflation, Output, and the Current Account Balance

Disinflation occurred while output was collapsing, and was often followed by large deteriorations in the external current account balance. This section discusses the links between these developments.

Disinflation and Output Growth

The sharp output drop that accompanied some of the early disinflations led some commentators to voice concerns about the additional output costs that could be associated with fast disinflation (Calvo and Coricelli, 1992; Portes, 1993; Amsden, Kochanowicz, and Taylor, 1994; and Fedorov, 1995). Other commentators, however, have subsequently noted that, as inflation stabilized, growth re sumed, often within two years (Figures 1a and 1b), thus suggesting that disinflation was a condition for sustainable growth (Fischer, Sahay, and Végh, 1996; and de Melo, Denizer, and Gelb, 1997).7 These two views are not, of course, inconsistent—the former focusing on the transitory costs of disinflation, the latter on the long-term relationship between inflation and growth—and they underscore the complications in assessing the relationship between inflation and growth from simple indicators. These complications are particularly apparent in a period of deep structural changes affecting potential output: the drop in output may have been due to the collapse of central planning, rather than to disinflation, while the recovery may have been due to the effect of structural change, rather than to the stabilized inflation environment. Only a few studies conduct formal tests of the relationship between inflation and growth for transition economies and they draw somewhat divergent conclusions. Lougani and Sheets (1997) find that, controlling for progress with transition reform (as well as other variables), output growth is negatively affected by inflation: a country with 500 percent inflation in one year loses about 2 percentage points of GDP the following year and 4 percentage points of GDP in the longer run. This finding is echoed by Berg and others (1998) who find different effects of inflation on the private and public sectors: whereas doubling inflation is associated with a decline of 5–15 percent in private sector output, it is associated with increased state sector output by about half that magnitude.

Figure 1a.
Figure 1a.

The Baltics, Russia, and Other Countries of the Former Soviet Union and Central and Eastern Europe—GDP Growth, Inflation, and Transition Index

(In chronological and disinflation time) 1

Sources: National authorities; IMF, International Financial Statistics; EBRD Transition Report, various issues; and IMF staff estimates.1 Stabilization dates are taken from Fischer and others (1996), and are reported in Table 2.
Figure 1b.
Figure 1b.

The Baltics, Russia, and Other Countries of the Former Soviet Union and Central and Eastern Europe—GDP Growth, Inflation, and Transition Index

(In chronological and disinflation time) 1

Sources: National authorities; IMF, International Financial Statistics; EBRD Transition Report, various issues; and IMF staff estimates.1 Stabilization dates are taken from Fischer and others (1996), and are reported in Table 2.

They suggest that the latter arises because subsidies to state-owned firms boost their output, but also stoke inflation by raising the fiscal deficit. Thus, they conclude that the impact of inflation on output depends on the relative shares of the private and public sectors. Ås-lund, Boone, and Johnson (1996) find no significant role for inflation in determining output once both war-torn and ruble-zone dummies are included.

These studies, however, share two main shortcomings. First, they do not investigate whether the relation between inflation and growth may vary at different inflation levels—though there is increasing evidence of this pattern for nontransition economies. Second, they shed no light on the output costs of disinflation, namely whether the change in inflation, rather than the level of inflation, has implications for output. In background work for this paper, Christoffersen and Doyle (1998) address these issues, using panel data on 22 of the 25 transition countries reviewed here (see Appendix I). They find evidence of an inflation threshold for transition economies at about 13 percent: inflation above that level reduces output growth, while no significant effect on growth is apparent if inflation is below that level. They also find no evidence of generalized output loss owing to disinflation.

It is notable that the inflation threshold appears to be higher than that found in market economies (see Appendix I). This suggests that the threshold may be falling in transition time, implying that the threshold is lower for the advanced reformers than for the panel as a whole. More specifically, Christoffersen and Doyle (Chapter IV, p. 29) note that inflation may have played a role in facilitating the large growth-enhancing relative price changes at the outset of transition, off setting other negative effects of inflation on growth. But with structural reforms and the largest of the initial relative price adjustments completed, these initial benefits from inflation would decline, and the relationship between inflation and output in transition economies would come to resemble that of long-established market economies more closely. Thus, the net benefits from low inflation may increase as transition deepens.

In summary, there is evidence that low inflation boosts growth, even after controlling for structural reform and for an inflation threshold that may fall over time as structural reform proceeds. Such a decline in the threshold would be consistent with findings in Fischer, Sahay, and Végh (1996) and Cottarelli, Griffiths, and Moghadam (1998) that fast reformers have, ceteris paribus, lower inflation rates. No clear evidence of a high output cost of disinflation has been found.

Disinflation and the External Current Account

Cukierman (1992) notes that one of the motives for inflation is the perceived risk that disinflation may pose for the external current account. An exchange rate based disinflation may lead to a real appreciation and, thus, affect competitiveness; and competitiveness may also deteriorate in the context of a floating exchange regime if the nominal exchange rate overshoots (Dornbusch, 1976). Indeed, concerns about the possible impact of tighter monetary policies on the external current account have been mentioned by some country authorities (for example, in Hungary) as one of the reasons why accelerating disinflation through a tighter exchange rate policy or the shift to a float was regarded as excessively risky (Surányi and Vincze, 1998).

External current account deficits relative to GDP have increased significantly during the 1990s in both the Central and Eastern European countries and the Baltics, Russia, and other countries of the former Soviet Union. In the early 1990s, the median balance in both was close to zero, while in 1997, it was a deficit in excess of 5 percent of GDP.

Recasting the current account data in inflation stabilization time highlights possible links between these trends and disinflation. The top panel of Figure 2 shows that inflation stabilization was accompanied by a weakening of the external accounts: the external balance declined sharply after disinflation in the Central and Eastern European countries, recovering somewhat in the third year. The Baltics, Russia, and other countries of the former Soviet Union exhibit a smoother decline, of similar magnitude.

Figure 2.
Figure 2.

The Baltics, Russia, and Other Countries of the Former Soviet Union and Central and Eastern Europe—Current Account Balance, in Percent of GDP, 1990–97

(In disinflation time)

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Evidence of a widening of the external accounts, however, should not necessarily be taken as a proof that stabilization was accompanied by a shift to an unsustainable external position. As noted above, stabilization is a precondition for growth and a recovery of investment. In transition economies, such an acceleration of investment should be expected to be financed partially from abroad, through FDI and other long-term capital inflows. In turn, these inflows are likely to increase in stabilized macro-economic conditions. Thus, the observed weakening of the external account after the stabilization may, at least in part, reflect the recovery of growth and investment, rather than an unsustainable loss of competitiveness. In this respect, it is useful to note that the external current account net of FDI in stabilization time shows stronger trends (bottom panel of Figure 2): the debt-financed external balance weakens markedly in the Central and Eastern European countries in the first two years, while in the Baltics, Russia, and other countries of the former Soviet Union, the initial weakening is less marked. But by the third year, the balance has strengthened considerably due to the strong inflow of FDI.

Inflation Inertia, Credibility, and Disinflation

The speed of disinflation and the apparent resilience of output in that context are remarkable features of transition economies’ disinflation experience, and they are evident in the stabilizations of cases of extreme and more moderate inflation.

This section will suggest that disinflation reflected the implementation of decisive financial policies that curtailed excessive monetary growth, and that the absence of evidence of output costs in this context reflected various combinations of low inflation inertia and policy credibility.8 In the highest inflation cases, inflation uncertainty was reflected in a shortening of the duration of nominal contracts, implying that aggregate price expectations were formed for relatively brief periods. This flexibility reduced output losses during decisive disinflation. In these cases, it was more important that financial policies were adjusted to eliminate the source of inflation than that they were adjusted credibly. But in the cases of less extreme inflation, where the duration of nominal contracts was largely unchanged, inflation inertia remained present. In these cases, policy credibility likely played a greater role in accounting for the low output costs associated with rapid disinflation.

The discussion attempts to identify the factors that facilitated the tightening of monetary policy needed to disinflate the economy, those that account for the evidence of limited output cost during inflation stabilization, and the extent to which these factors also explain the relatively slow disinflation in some countries, particularly during the poststabilization period. It addresses first the context in which disinflation occurred; second, the role played by fiscal policy; third, the role of credibility-enhancing devices; and last, the speed and sequencing of disinflation and structural reform. It concludes that fiscal consolidation and the decision of most authorities to disinflate rapidly were key to the success and the low output cost of these disinflations.

The Context for Disinflation

In many respects, the context for disinflation was more favorable than it might have appeared to be: inflation had not persisted for long; backward indexation was limited; the financial system, though fragile, turned out to be less susceptible to stress from disinflation than feared; and political economy factors favored disinflation in some countries. Furthermore, while price liberalization and relative price adjustment initially boosted the price level, they subsequently facilitated disinflation efforts.

Where these circumstances did not hold, disinflation was slower. For example, widespread indexation was a problem in Poland and Slovenia, two of the slow disinflation cases identified earlier. In Hungary—another slow disinflater—creeping inflation had persisted throughout the 1980s, possibly contributing to the stickiness of inflation expectations lamented by policymakers in that country (Surányi and Vincze, 1998). Unresolved financial sector problems contributed to the inflation reversal in Albania and Bulgaria. And gradual administered price adjustments slowed disinflation significantly in some countries (notably in Moldova and Ukraine).

Indexation

Backward indexation implies a lagged response of nominal wages to prices. This raises the output cost of disinflation, thereby reducing its credibility. Formal indexation, however, was exceptional in transition countries, possibly reflecting that while inflation had been violent, it had also been relatively brief, so that indexation had not had time to take root. As a result, even though wages and prices were frequently adjusted in the higher inflation cases, only six countries out of the sample of 25 transition economies ever used backward-looking indexation.9 And one of these (Croatia) abolished indexation at the start of the disinflation program. Even when indexation was present, it did not always increase inflation inertia. Where goods and factor prices were de facto indexed to the exchange rate, such as in Bulgaria, exchange rate stabilization fed directly into the stabilization of domestic prices.

The only two countries where indexation was pervasive are Poland and Slovenia. Both countries are part of the slow disinflation group, and there is evidence that indexation contributed to keeping these countries in the moderate inflation range for an extensive period (Pujol and Griffiths, 1998; and Ross, 1998).

Financial fragility

The banking sector in all these economies was critically weak in the early stages of transition: two-tier systems and the associated legislative and accounting frameworks were generally in their infancy, and the banks were ill-prepared for a competitive environment, let alone one in which output, relative prices, and the price level were subject to major shocks.

While restructuring to address these problems would have facilitated disinflation by improving the strength, efficiency, and competitiveness of the financial system, it also seemed probable that disinflation would exacerbate financial fragility. This appeared likely to complicate disinflation efforts: the additional call on fiscal resources directly would challenge the fiscal consolidation; the additional calls on central bank refinance could undermine the monetary framework; the commitment to sustain disinflation might be weakened by concerns that increased interest rates could have indiscriminate effects, given poor credit assessment; and higher real interest rates could further undermine credit quality if solvent borrowers who expected to repay disproportionately stopped borrowing. Another potential danger, underscored by Cukierman (1992) with reference to nontransition economies, was that the monetary tightening associated with disinflation might be accompanied by lower bank interest rate spreads—owing to the longer maturity of lending rates than deposit rates.

Despite these difficulties, disinflations were rarely accompanied by up-front bank restructuring. In only two cases—the former Yugoslav Republic of Macedonia and Slovenia—were operations to buttress the banking system initiated at the same time as disinflation, and even in these cases, the measures taken began, rather than completed, the task. Furthermore, despite the manifest weakness of many financial systems, rarely were these concerns uppermost in the authorities’ minds when weighing the risks and modalities of disinflation.

There were several reasons why financial fragility did not undermine monetary control and the credibility of disinflation. In some of the high-inflation cases, the financial system had shrunk in real terms prior to disinflation due to negative real interest rates. For example, in Georgia and Moldova in 1994, M2 was 3 percent of GDP and 12 percent of GDP, respectively, and even now in the Baltics, Russia, and other countries of the former Soviet Union overall, banking system claims on nongovernment agencies are roughly half the level relative to GDP of Organization for Economic Cooperation and Development (OECD) countries. This contained the fiscal and refinancing contingent liabilities posed by financial fragility. Furthermore, while a number of banks had profited from transactions predicated on the high-inflation environment, this source of income was rarely critical to their overall profitability. So the demise of that environment rarely affected the overall health of individual banks, or of the banking system.

Fast disinflation and the maintenance of banking spreads also diminished the risk that financial fragility would deepen. The potential sluggishness of lending rates with respect to deposit rates when monetary policy is tightened turned out to be unimportant. At times, the contractual basis for bank loans was sufficiently unclear that lending rates were rapidly adjustable in practice, though more often, banks had shifted to variable rate or short-term lending prior to disinflation. Furthermore, nominal interest rates started falling rapidly along with inflation. So even to the limited extent that lending rates were stickier than deposit rates, rapidly falling inflation allowed spreads to widen during disinflation.

This is not to say that financial instability played no role, or that it may not become a problem in the future. Banking difficulties occurred during the Baltic and Czech disinflations. And most countries had to recapitalize banks at some point, though these operations were generally financed by issuing bonds, rather than by printing money, softening their impact on inflation. In addition, as illustrated by Estonia in 1993, firm decisions were taken to restructure or close banks, rather than to recapitalize them. But in addition to these direct links between financial fragility and inflation, indirect links also played a role. In the Czech Republic, a combination of banking inefficiencies, reflected in large interest rate spreads, accompanied by confidence in the currency, may have induced both domestic disintermediation and capital inflows in the mid-1990s. In this way, financial fragility may have indirectly stoked inflationary pressures.

While fragility remains, there are risks of further calls on the budget and for central bank refinance, and the financial sector’s contribution to flexibility and performance of the whole economy is diminished. Albania and Bulgaria show that, even though much-abused financial systems can survive a remarkably long time, they eventually collapse with serious implications for macroeconomic stability. Recent difficulties in a medium-sized regional bank in Croatia underline that strong inflation performers are not immune from these difficulties. And the exchange rate crisis in Russia in August 1998 reflected to some extent increases in liquidity to sustain the banking sector. While progress has been made in strengthening financial structures and supervision in most transition countries, significant risks remain (see Appendix II).

Political economy

Social and political characteristics of the preinflation stabilization period may also account for the decisiveness of the disinflation effort and its credibility. In some Central and Eastern European countries and in the Baltic States, the perceived short-term costs of disinflation were seen as the price of national liberation. This muted the political backlash to “shock therapies,” and partly explains why determined reformers were often politically successful (Åslund, Boone, and Johnson, 1996). Moreover, when the old economic interest groups were discredited and disorganized, an opening for “extraordinary politics”—in the words of Poland’s Finance Minister Balcerowicz (Bruno, 1996)—ap-peared, which eased the introduction of tough disinflation and reform programs, albeit sometimes only temporarily.

Such openings were, however, rarely apparent in most BRO countries (outside the Baltics), which partly explains why disinflation was often delayed there. Even in some Central and Eastern European countries, such as Bulgaria and Romania, it proved impossible to gather sufficient political support to implement sustained disinflation. In some cases, coalitions of various political interests may have delayed disinflation. Bruno (1996) notes that a high-inflation equilibrium can be generated when interest groups disagree on who should bear the brunt of the adjustment. In other cases, interest groups may have had an indirect interest in inflation, having privileged access to fiscal subsidies or transfers that generate it. Clearly, political instability and war played a key role in delaying disinflation in Armenia, Croatia, Georgia, and Tajikistan. Disagreement between the central bank and the government on the appropriate policy course or insufficient understanding of the economics of inflation—the view that inflation was caused by “speculators” rather than by financial policies—were also factors in some countries (notably, Belarus, Bulgaria, Tajikistan, Turkmenistan, Uzbekistan, and, initially, Ukraine).

By the mid-1990s, however, even in cases where political impediments to disinflation had been most severe, it had become apparent to most policymakers that inflation was a monetary phenomenon fueled by large fiscal and quasi-fiscal deficits. At the same time, the costs of inflation for vulnerable social groups (such as pensioners) were becoming apparent.10 These factors may have eventually strengthened the resolve to stabilize and the credibility of the disinflation programs subsequently implemented.

Relative price disequilibria

The environment for disinflation was complicated by the need for large relative price changes, given that relative prices were far from competitive equilibrium, combined in some cases with monopolistic pricing that emerged after price liberalization (IMF, 1997, pp. 108–11). A shock in relative prices, from either source, risks inducing inflation if there is downward price stickiness. If this pressure is accommodated to avoid an output loss, inflation will rise, with legal or de facto indexation delaying the disinflation process.

In transition economies, the inflationary pressure arising from relative price changes was exacerbated by the type of price shocks that ac companied the transition. Prior to the transition, some goods were largely underpriced while most were marginally overpriced (Pujol and Griffiths, 1998; and Coorey, Mecagni, and Offerdal, 1998). This pattern imparted an inflationary impulse because, while the few largely under-priced goods were rapidly repriced, the many overpriced goods were not cut (possibly reflecting microeconomic adjustment costs) and so were adjusted in real terms through inflation (Ball and Mankiw, 1994).

The role of relative price adjustments in inflation was particularly strong in the early phases of the transition when most prices were liberalized, but seems to have declined over time (Pujol and Griffiths, 1998; Coorey, Mecagni, and Offerdal, 1998; Cottarelli, Griffiths, and Moghadam, 1998; Krajnyák and Klingen, 1998; and Woźniak, 1998). This is because the relative price adjustment process appears to have been fairly rapid, partly reflecting limited indexation in most countries (Koen and de Masi, 1997). A key remaining inflationary impulse from relative price changes concerns administrative price adjustments.11 However, with price ceilings applied only to a limited number of products (energy, transportation, rents, and utilities), these have also declined in importance (Box 1).

Policy Response: Fiscal Policy

The early phase of the transition was accompanied by large fiscal imbalances in virtually all transition countries, as a result of falling revenues and rigid public expenditure. Government securities markets were virtually nonexistent and access to foreign finance was limited. So the emerging deficits had to be monetized when the potential for direct funding from the banking sector was exhausted. Of the Baltics, Russia, and other countries of the former Soviet Union, 7 of 15 countries recorded seignorage in excess of 10 percent of GDP in 1993, when inflation was at or near its peak (Ghosh, 1997).

Relative Prices and Inflation: A Look Ahead

Several years into the transition, goods price levels and structures re main distinct from industrial countries (Koen and de Masi, 1997). This does not necessarily mean, however, that a rapid convergence should be expected, as price levels and structures are generally correlated with GDP (Nuxoll, 1996). Market-determined prices are likely to converge to industrial country standards only in the long run. Thus, the main contribution of relative price changes to inflation in the near future is likely to come primarily from changes in administered prices.

The remaining inflationary potential from changes in administered prices depends on the share of administered prices in the CPI, how far they are below their market-determined level, and the response of other prices. In most cases, the share of administered prices in the baskets used to calculate the CPI is small, albeit possibly understated to the extent that the weights have not been fully adjusted as administered prices have been raised toward full cost coverage (Table 3). In only a few cases is re moving all remaining price controls thought likely to add more than 10 percentage points to the CPI (Table 3).1 But in some low-inflation countries (such as the Czech Republic and Croatia), as well as in some moderate high-inflation countries (Belarus), administered price increases could put significant pressure on inflation developments.

The reaction of nonadministered prices to changes in administered prices will depend, inter alia, on the degree of indexation, the overall credibility of the authorities, and, of course, the degree of monetary ac commodation. In countries where the authorities’ credibility is in doubt, an increase in administered prices may be regarded as signaling that inflation is accelerating, and lead to parallel increases in all prices. A case in point is Romania where in early 1997, the increase in some energy prices started a wave of general price increases. Conversely, the recent experience in Azerbaijan shows that even fairly large increases in administered prices can be absorbed with only a temporary rise in inflation.

Finally, there is evidence that after the initial impact of relative price changes on inflation, price liberalization is generally found to reduce inflation (Fischer, Sahay, and Végh, 1996; and Cottarelli, Griffiths, and Moghadam, 1998). This may be due to the fact that those countries that adjusted to administered prices more slowly through subsidies or price controls, such as Moldova, experienced larger fiscal or quasi-fiscal deficits, and due to the boost to supply-side flexibility that price liberalization engenders.

1 These estimates neither take into account the reaction of other prices nor the degree of monetary accommodation. Moreover, the figures should be taken cum grano salis as, in many cases, it is difficult to evaluate what the market-determined price of certain products would be. Comparisons with industrial countries may be misleading for products (as services) that involve significant labor input. The case of rents is also complex: Zavoico (1995) argues that rents in transition countries may not need to in corporate amortization costs for a number of years, because currently there is an excess supply of houses.
Table 3.

Administered Price Changes

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Source: IMF staff estimates.

Includes energy and utility prices only. If the prices of basic consumer goods—including flour, sugar, bread, and so on—are also included, the weight of administered prices is at least 40 percent.

The development of a broader range of financing options for government alongside fiscal consolidation were key elements underlying the subsequent disinflations. The former reduced the pressure for monetization, given public deficits,12 and the latter reduced the risk of explosive paths for public debt-GDP ratios (Buiter, 1997). This reduced inflationary pressures arising from the expectation of future monetization (Sargent and Wallace, 1981).

Government securities markets

By 1997, all transition economies (with the exception of Estonia, Tajikistan, and the former Yugoslav Republic of Macedonia) had introduced primary treasury bill markets—mostly based on auctions—with many of the Baltics, Russia, and other countries of the former Soviet Union joining the group in 1995–96 (Table 4). In the most advanced transition economies (such as the Czech Republic, Hungary, and Poland), primary government securities markets are more fully developed, and secondary markets are also active, usually organized around a system of primary dealers. The Baltics, Russia, and other countries of the former Soviet Union are lagging behind. However, “moderate” or “substantial” progress had been achieved by 1997 in most of the Baltics, Russia, and other countries of the former Soviet Union (IMF, 1997).13 As a result, the share of fiscal deficits financed by issuing domestic government securities is now sizable in a number of transition economies (Table 4).

Table 4.

Development of Government Securities Markets

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Source: IMF staff estimates.

Fiscal consolidation

Public finances strengthened significantly during 1993–97. The aver age fiscal deficit-GDP ratio fell from 13Û percent in 1992 to 3Û percent in 1997; the decline was faster in the Baltics, Russia, and other countries of the former Soviet Union, but it was sizable also in Central and Eastern European countries (Table 5). Quasi-fiscal deficits—whose importance for macroeconomic developments has been stressed several times (Mackenzie and Stella, 1996; and Buiter, 1997)—also abated (see below).

Table 5.

Overall and Primary General Government Balances, and Central Bank Financing to the Government1

(In percent of GDP)

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Source: IMF staff estimates.

For the countries that stabilized during 1993–97, shaded areas indicate periods in which inflation dropped below the stabilization threshold (see definition in Table 2).

The primary balance is calculated as the general government balance minus net interest payments. Primary balance calculations exclude interest receipts for Armenia, Azerbaijan, Belarus, Estonia, Kazakhstan, Kyrgyz Republic, Romania, Slovakia, and Ukraine.

The higher overall deficit in 1995, the first stabilization year, is due to the payment of arrears related to government-guaranteed domestic loans.

About one-half of the deficit in Lithuania during 1993–96 was due to net lending.

A simple plot of inflation against the overall and primary fiscal balances of transition economies suggests that fiscal consolidation was closely related to the decline in inflation during 1993–97 (Figure 3).14 A closer look at individual country data (Tables 6 and 7) reveals five key features: (1) a sizable fiscal tightening—with a corresponding tightening of money creation through credit to the government—characterized most inflation stabilization cases, a key finding of earlier reviews of the transition experience (Bruno, 1992); (2) fiscal adjustment focused on expenditure cuts; (3) when fiscal adjustment did not accompany the inflation stabilization, the fiscal position was already strong; (4) inflation stabilization did not require a fiscal position that was solvent ac cording to standard formulas; and (5) the link between fiscal tightening and disinflation was weaker in moderate inflation cases.

Table 6.

Fiscal and Inflation Developments

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Source: IMF staff estimates.

Quarter in which the 60 percent inflation threshold was broken (see Table 2).

Table 7.

General Government Revenue and Primary Expenditures in Transition Economies1

(In percent of GDP)

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Source: IMF staff estimates.

For the countries that stabilized during 1993–97, shaded areas indicate years in which inflation was below the stabilization threshold (as defined in Table 2).

The primary expenditure is calculated as the general government expenditure minus net interest payments. Primary balance calculations exclude interest receipts for Armenia, Azerbaijan, Belarus, Estonia, Kazakhstan, Kyrgyz Republic, Romania, Slovakia, and the Ukraine.

Figure 3.
Figure 3.

Transition Economies: Fiscal Performance Versus Inflation Performance, 1994–97

(In percent)

Source: IMF staff estimates.

Fiscal adjustment (typically up-front fiscal adjustment in the disinflation year or the year before) accompanied the drop in inflation in 13 of the 20 inflation stabilization cases observed during 1993–97 (Table 6). In two additional cases—Bulgaria (second disinflation) and Lithuania—the primary balance changed little, but quasi-fiscal losses were substantially reduced. In Lithuania, losses accruing as a result of arbitrage of interrepublican accounts after withdrawal from the ruble area were curtailed. In Bulgaria, quasi-fiscal losses accruing in both the financial and nonfinancial enterprise sectors as a result of widespread soft budget constraints were reduced under the first stabilization, albeit only to reemerge later, inducing a reversal of the associated disinflation gains. Quasi-fiscal deficits—particularly in the form of directed credit—were reduced also in countries that cut the general government deficits, especially in the Baltics, Russia, and other countries of the former Soviet Union (a case in point is Kazakhstan).

Fiscal consolidation allowed a sharp contraction in central bank credit to the government. In the 20 inflation stabilization cases, the average flow of central bank credit to the government fell from 10.6 percent of GDP in 1992 to 0.7 percent of GDP in 1997 (Table 5), contributing significantly to the decline in the growth rate of money (see below).

In almost all the above cases, the adjustment consisted primarily of expenditure cuts. Only in Croatia, Latvia, and Uzbekistan did the revenue-GDP ratio rise significantly, and only temporarily in the latter case. In the former Yugoslav Republic of Macedonia, after an initial increase in the revenue ratio, both expenditure and revenue ratios started declining. In six countries (Armenia, Azerbaijan, Belarus, the Kyrgyz Republic, Russia, and Ukraine), revenue ratios declined during disinflation. The predominance of expenditure rather than revenue adjustment to close fiscal imbalances may have helped the disinflation directly, given that tax increases often produce a one-off increase in the price level, particularly indirect taxes (Surányi and Vincze, 1998).

There are cases where fiscal strengthening did not accompany inflation stabilization. In Estonia, Latvia, and Turkmenistan, the fiscal position prior to stabilization was already fairly strong, and other factors underlay persistent inflation in that context. In Estonia, inflation was driven by price developments in Russia before June 1992, when an independent currency issued under a currency board was introduced. Thereafter, inflation fell sharply, but as Latvia also experienced later, the exchange rate peg was insufficient to eliminate inflation, despite the firm fiscal stance. In Turkmenistan, the reasons for the persistance of inflation are more difficult to assess, although they may have been related to the increasing scarcity of imported consumer goods until early 1997, when the central bank was allowed to sell foreign exchange on the market, relieving the shortage. In contrast to these cases, inflation in Tajikistan persisted in spite of the significant strengthening of the primary balance during 1996–98 because of political instability and civil war.

The only cases in which inflation stabilization succeeded while fiscal and quasi-fiscal deficits remained high were Romania and the Kyrgyz Republic. In the former case, the progress on inflation was ultimately reversed. In the latter case, there was a sharp temporary fiscal relaxation in 1995 associated with an election. But the inflationary impact of the fiscal position, both before and after this, was considerably less than is implied by the overall and primary fiscal balances. These reflect a large, import-intensive, and externally financed public investment program. Apart from 1995, domestic funding of the deficit remained about or below 2Û percent of GDP throughout the disinflation, and this shifted progressively from central bank to other sources of domestic finance. Thus, as with other cases, the Kyrgyz disinflation was underwritten by a firm fiscal position.

It is notable that inflation stabilization did not require fiscal solvency according to simple standard formulas. Such formulas identify the minimal primary balance necessary to avoid an explosive path for the debt-GDP ratio in terms of the initial debt level, the GDP growth rate, and the interest rate on debt (see formula in Table 8). By these standards, the fiscal position during most of the inflation stabilizations was insolvent, and still remained so in 1997.15 The simple assumptions that underlie the formulas, however, may be particularly inappropriate in transition economies. Transition economies have strong potential productivity growth and this is likely to contribute to future strengthened primary balances. In addition, some of these countries also implemented structural reforms that bolstered long-term fiscal sustainability, even if they had little immediate fiscal impact.16 This, and the fact that the Baltics and other countries of the former Soviet Union (ex cluding Russia) started the transition with negligible public debt and so could derive efficiency gains from added leverage, may explain why strict adherence to the standard formulas has not been necessary to support or sustain disinflation.17

Table 8.

Actual and Sustainable Primary Fiscal Balances

(In percent of GDP)

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Source: IMF staff calculations.

The sustainable primary balance is the primary balance that would allow stabilizing of the public debt-GDP ratio; it can be computed as

p = [(i-g)/(1+g)]d

where p is the primary balance-GDP ratio, i is the nominal interest rate on government debt, g is the nominal GDP growth rate, and d is the initial debt-GDP ratio. The figures in Table 8 have been based on a nominal GDP growth rate of 8 percent, and an interest rate-growth differential of 2 percentage points. Actual figures for end-1996 have been used for the debt-GDP ratio. It should be stressed that for countries with high debt-GDP ratios, stabilizing the debt-GDP ratio is unlikely to be sufficient to ensure long-run sustainability. Reducing vulnerability would require lowering the debt ratio and, therefore, stronger fiscal positions than indicated above.

The link between disinflation and fiscal adjustment is less clear at moderate inflation levels, however. In the Czech Republic, inflation remained moderate despite declining primary surpluses during 1993–96. Conversely, the drop in inflation in Slovenia during 1993–97, in the Slovak Republic during 1994–96, and in Poland during 1993–97 was not accompanied by a fiscal strengthening. Various factors may account for this. Moderate inflation countries are also relatively fast reformers with more developed government securities markets. This alleviates the monetary impact of fiscal deficits as illustrated by the case of Hungary, where large deficits in 1993–94 led to only a limited rise in inflation. In addition, once fiscal sustainability is achieved, disinflation may become a problem of expectation coordination (Blanchard, 1998). In this environment, a fiscal expansion that casts doubts on fiscal sustainability or that leads to overheating should be avoided, but a fiscal tightening may not be necessary. The results of more formal research into the relationship between fiscal balances, government securities markets, and inflation, at different inflation levels, are outlined in Box 2.

These findings have implications for fiscal policy in sustaining the progress toward low inflation. Fiscal consolidation, having been so central to laying the groundwork for inflation stabilization, will re main essential to sustain disinflation. Those countries that already have a strong underlying fiscal position, implying that inflation is an expectational problem, should maintain this strong fiscal stance. Whether a fiscal tightening will be necessary to disinflate further will depend on its contribution to reducing aggregate demand pressures. In many cases, however, the priority will be structural fiscal reform, including second-generation reforms aimed at fostering economic growth and medium-term fiscal credibility. Key issues will be the structure and level of taxation, social spending, and social transfers. Progress in these areas can benefit disinflation not only by strengthening the fiscal balances, but also by spurring productivity growth.

Inflation and Fiscal Deficits: Summary of Econometric Results

The relationship between inflation and fiscal deficits in transition economies has been explored through regression analysis in several papers (Fischer, Sahay, and Végh, 1996; Lougani and Sheets, 1997; and Cottarelli, Griffiths, and Moghadam, 1998). All these papers find a significant statistical relationship between inflation and the fiscal deficit, which is robust to differences in the econometric specification and in the definition of the deficit.1 Moreover, these studies show that fiscal factors remain important even after controlling for other factors (such as the exchange regime, measures of the overall progress in reforming the economy, central bank independence, indexation, and relative price changes).

The estimate of the direct quantitative effect of fiscal deficits on inflation is, however, relatively low. In most of the specifications, a decline in the deficit-GDP ratio of 1 percentage point when inflation is, say, 100 percent involves a decline in inflation of only 5–8 percentage points. The effect is larger at high inflation levels, but smaller when inflation is low.2

This result may be explained in two ways. First, in a number of countries, disinflation did not require a reduction in the deficit either because the fiscal position was already sufficiently strong or because the main problem was related to quasi-fiscal deficits. As the regression results “average out” the experience of all countries during the sample period, the effect of deficit cuts estimated from regressions using changes in the variables (rather than levels) appears to be lower than in reality for those countries that had a fiscal problem. Second, the results indicate that fiscal adjustment should not be seen in isolation but rather as a component of a comprehensive package that enhances the credibility of disinflation through appropriate exchange rate policies, and other institutional devices (such as central bank independence). One element of a comprehensive package may be the development of government securities markets. Cottarelli, Griffiths, and Moghadam (1998) report that the relation between inflation and fiscal deficits is stronger in those countries without a developed government securities market, presumably reflecting the greater reliance of such countries on central bank finance for the government deficit.

1 In particular, Cottarelli, Griffiths, and Moghadam (1998) find that the relationship holds also after removing the effect of inflation on government interest payments, thus suggesting a line of causality that runs from fiscal deficits to inflation, and not vice versa.2 This is due to the semilogarithmic specification of the relation between inflation and fiscal deficits, adopted in all papers. This specification seems to fit the data better than alternative specifications.

Policy Response: Credibility-Enhancing Devices

Various monetary frameworks, external agents, and incomes policies were adopted to bolster credibility. This section describes and discusses these devices and assesses their contribution to disinflation.

Monetary frameworks

A striking feature of the 1993–;97 inflation stabilizations is the limited use of formal exchange rate or monetary targets. Though both monetary aggregates and exchange rates did stabilize during and after inflation stabilization (Table 9), the announcement of targets for these variables played a limited role: no country announced monetary targets (although several IMF-supported programs included indicative targets on base money) and, perhaps surprisingly, few announced exchange rate targets when initiating disinflation.

Table 9.

Broad Money Growth and Depreciation Rates in Transition Economies1

(End of period, in percent)

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Source: IMF staff estimates.

The depreciation rates are computed vis-à-vis the U.S. dollar. For the countries that stabilized during 1993–97, shaded areas indicate years in which inflation was below the stabilization threshold (as defined in Table 2).

The depreciation rates refer to the official exchange rate.

The absence of publicly announced monetary targets, other than rules directly implied by the exchange rate regime as in the case of currency boards, reflects structural change and uncertainty. Reform in the financial sector—particularly the advent of substitutes for bank de posits for household savings and innovations in payment systems—was substantial. This compounded the lack of knowledge of money demand and the prospect that disinflation itself would induce a strong, though unpredictable, recovery in real money demand. In this context, money targets appeared to be unworkable as signals for inflation expectation formation.18

Exchange rate targets—the most obvious substitute for monetary targets—were initially adopted only by a handful of countries (Tables 10 and 11). They subsequently became more common: by 1997, the share of floaters had dropped to little more than one-half, and was thus close to the share of floaters in nontransition developing countries in the mid-1990s (Cottarelli and Giannini, 1997). Note that, in the most recent period (1995–97), the increase in the number of pegs reflects the increased popularity of broad band pegs. Former floaters, such as Russia and the Ukraine, as well as former narrow band pegs, such as Poland and the Slovak Republic, have shifted to this intermediate regime.19 In contrast, only the Czech Republic has crossed the whole spectrum from a peg to a managed float.

Table 10.

Number of Peggers and Floaters1

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Source: IMF staff reports.

In this table, the exchange regime of the countries that had not yet introduced their own currency is the exchange regime of the preexisting currency.