Four years after the fall of the Berlin Wall, most countries in central Europe and the former Soviet Union have made irreversible progress toward transforming their formerly planned economies into market-based economies. In central Europe, the collapse of output that followed the onset of the transition is bottoming out, and in some countries activity has started to expand. Further structural reform and additional stabilization efforts will be required to consolidate gains already made and to sustain advances in the years ahead. Sweeping structural reforms are also being implemented in the countries of the former Soviet Union. With some exceptions, however, inflation and government budget deficits remain far too high, and the outlook is for further significant output declines in the near term. Accumulating evidence suggests that controlling credit creation, fiscal deficits, and inflation yields economic benefits. Output declines have been severe even in those countries that have followed inflationary policies, whereas countries—notably Albania, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovenia—that have pursued appropriate macroeconomic policies appear to be among the first to be experiencing renewed economic growth.

Four years after the fall of the Berlin Wall, most countries in central Europe and the former Soviet Union have made irreversible progress toward transforming their formerly planned economies into market-based economies. In central Europe, the collapse of output that followed the onset of the transition is bottoming out, and in some countries activity has started to expand. Further structural reform and additional stabilization efforts will be required to consolidate gains already made and to sustain advances in the years ahead. Sweeping structural reforms are also being implemented in the countries of the former Soviet Union. With some exceptions, however, inflation and government budget deficits remain far too high, and the outlook is for further significant output declines in the near term. Accumulating evidence suggests that controlling credit creation, fiscal deficits, and inflation yields economic benefits. Output declines have been severe even in those countries that have followed inflationary policies, whereas countries—notably Albania, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovenia—that have pursued appropriate macroeconomic policies appear to be among the first to be experiencing renewed economic growth.

Macroeconomic Stabilization and Renewed Growth in Central Europe

In much of central Europe the liberalization of trade and prices, progress toward enterprise reform, and sound macroeconomic policies are beginning to bear fruit. Most countries have made significant progress in controlling inflationary pressures, typically through a combination of restrictive wage policies and a fixed or crawling-peg exchange rate (Chart 31). In general, however, inflation remains higher than in western Europe, and this has been reflected in nominal depreciations of most central European currencies (Chart 32).

Chart 31.
Chart 31.

Selected Central European Countries in Transition: Consumer Prices

(Monthly percent change)

Chart 32.
Chart 32.

Selected Central European Countries in Transition: Nominal and Real Effective Exchange Rates

(January 1991 = 100; an increase indicates an appreciation of the currency)

In the Czech Republic, Poland, Albania, and Slovenia, output is expected to grow in 1993, and in Hungary it is expected to be unchanged from the 1992 level (Table 19). This turnaround, which began late in 1992 (early in 1992 in the Czech Republic), mainly reflects improving supply conditions in response to the reforms that have been put in place. Patterns of economic activity are changing under the influence of market-determined prices, and changes in the legal and institutional environment have led to an increasing amount of output being produced by privatized and newly established firms. The expansion was supported in 1992 by strong growth of exports to the industrial countries, which had been made possible by trade liberalization and currency convertibility. More recently, exports have softened because of the recession in western Europe. Rising domestic private demand, primarily owing to rising incomes in the new private sectors, has provided a boost to economic activity in many countries.

Table 19.

Countries in Transition: Real GDP

(Annual percent change)

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The recovery in output will reinforce earlier efforts at stabilization by expanding the tax base and moderating strains on public finances. The introduction of a value-added tax (VAT) in 1993 in the Czech Republic, Poland, Slovakia, and Romania, as well as other fiscal reforms, should also strengthen the revenue base. Administrative problems with the implementation of the VAT may, however, initially depress receipts. Budgetary pressures are expected to remain particularly severe in Slovakia because of the cessation of transfers from the Czech Republic, which has revealed fiscal weaknesses. But other central European countries also face challenges in adapting their fiscal regimes to the realities of market economies. Continued tight fiscal policies will be needed to avoid pressures to monetize deficits and to free resources to support economic transformation and the recovery of output. Meeting the demands for social and investment outlays requires further fiscal restructuring and a reduction of other government expenditures, as well as reforms to broaden the tax base and to enhance the efficiency of tax collection, particularly from the newly emerging private sector.

Economic reform in Bulgaria and Romania is still hampered by weak economic activity and high inflation. Both countries are struggling to reconcile the need to jump-start the process of economic transformation with efforts to contain expenditures in the face of deteriorating revenues and, in the case of Bulgaria, a high foreign debt burden. International trade has been depressed by the trade embargo on the Federal Republic of Yugoslavia, and imports have also been limited by the relative lack of success in securing external financial assistance to support the reform process. The overall fiscal deficit in Bulgaria was 7 percent of GDP in 1992 (Table 20), although this is an understatement because it excludes deferred interest payments to official creditors, which would raise the deficit to 14 percent of GDP. The introduction of the VAT, which had been scheduled for mid-1993, has been delayed until 1994 at the earliest. Solid progress toward economic stabilization in both Bulgaria and Romania will require firm policies to strengthen financial discipline in the enterprise sector, to counter the renewed emergence of inter-enterprise arrears, and to limit the ongoing financing of state enterprises through the government budget.

Table 20.

Countries in Transition: General Government Budget Balances

(In percent of GDP)

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Excludesextrabudgetary funds.

Includes unbudgeted import subsidies.

Midpoint of a range of - 15.0 to - 20.0.

Macroeconomic Instability in the Former Soviet Union

In contrast with many countries in central Europe, most of the countries of the former Soviet Union, as well as Mongolia, are expected to experience further declines in output and significant increases in open unemployment as economic restructuring continues. Moreover, with the exceptions of Estonia, Latvia, and, very recently, Lithuania (Box 7), inflation has remained chronically high and, at times, has threatened to develop into hyperinflation (Chart 33). After the huge adjustments stemming from price liberalization in January 1992, consumer prices in Russia rose at an average monthly rate of about 18 percent until January 1993, or by about 700 percent in the full twelvemonth period.47 Inflation was still higher in Belarus, in part because of catching up to the Russian price liberalization, and in Ukraine. High inflation has impeded the ability of the price system to allocate resources efficiently and has contributed to the rapid decline in the value of the ruble and other currencies in the region (Chart 34). It has also led to substantial capital flight and, more generally, threatens to undermine support for needed reforms.

Chart 33.
Chart 33.

Selected Countries of the Former Soviet Union: Consumer Prices

(Monthly percent change)

Chart 34.
Chart 34.

Selected Countries of the Former Soviet Union: Nominal and Real Exchange Rates

(Vis-a-vis U.S. dollar; January 1992 = 100; an increase indicates an appreciation of the currency)

The strong inflationary momentum has been the direct result of excessive credit creation, largely driven by a web of credits and subsidies to stateowned enterprises and by monetization of fiscal deficits. Governments have provided extensive direct subsidies to support state enterprises and to hold down domestic import prices. Because most subsidies have been off-budget, official deficit estimates vastly understate public sector financing requirements.

In Russia, total subsidies excluding directed credits were equivalent to about 24½ percent of GDP in 1992, of which 17½ percent was in import subsidies (Table 21). These and other outlays severely strained government finances, with the result that the Central Bank of Russia lent the equivalent of 6 percent of GDP to help cover the fiscal deficit, effectively monetizing part of it. In addition, price and export controls on energy products held their prices to less than one-fourth of world prices in mid-1993. Although not in the budget, this implicit subsidy represents a substantial loss of tax revenue.

Table 21.

Russian Federation: State Subsidies in 19921

(In percent of GDP)

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Source: Russian Federation, IMF Economic Reviews, No. 8, 1993.

The “lower bound” bases the subsidy component of credits on the difference between the Central Bank of Russia discount rate and the lower rate charged to borrowers. The “upper bound” treats the entire credit as a grant.

Stabilization and Economic Reform in the Baltic Countries

In mid-1992 there were serious macroeconomic imbalances in the Baltic countries that were traceable to two major supply shocks. The collapse of the socialist command economy had caused major disruptions in trade, payments, and monetary arrangements with the countries of the former Soviet Union; and the move by Russia toward world market prices for oil and raw material exports to the Baltic countries implied a permanent loss in real national income of over 20 percent of GDP. The Baltic countries responded to these shocks by rapidly implementing stabilization and reform policies, which were supported by financial arrangements with the IMF that were approved in September and October 1992.1

From mid-1992 to mid-1993, the Baltic countries made significant progress toward the establishment of macroeconomic stability. Inflation decelerated rapidly, particularly in Latvia and Estonia, and real incomes declined to reflect the new relative prices and productivity levels. This process was associated with unavoidable losses in output and employment. Recent information on industrial output and emerging private sector activities suggests, however, that the output decline is bottoming out, although unemployment is still expected to rise with the ongoing restructuring of industry.

The most urgent policy tasks at the beginning of the adjustment process were to realign domestic prices with world prices, to adjust real wages to the terms of trade shock, and to prevent hyperinflation. The reform programs in all three countries incorporated rapid completion of price liberalization and the elimination of subsidies and subsidized loans. Thereafter, the monthly inflation rate was targeted to slow gradually to 2 to 3 percent by mid-1993, and to close to western European levels over the longer run.

To insulate themselves from inflationary impulses from the other states of the former Soviet Union, the Baltic countries reintroduced their own currencies at an early stage of the adjustment process. Estonia established a currency board and pegged its exchange rate to the deutsche mark to provide a strong anchor for the price system. Latvia and Lithuania, in contrast, established a traditional central banking system and allowed their currencies to float, relying on monetary policy restraint to achieve price stability.

In Estonia and Latvia, monetary developments indicate strong commitment toward inflation control. Money supply growth has lagged far behind inflation, and real interest rates have become positive. Estonia's currency board arrangement gained strong confidence from the outset; the exchange rate of the kroon has remained fixed against the deutsche mark, and international reserves of the Bank of Estonia have increased steadily.2 Latvia's central bank has achieved similar results through tight control of the monetary base. The exchange rate strengthened after an initial depreciation, and more recently the Bank of Latvia lowered its refinancing rate to arrest the appreciation of the currency. Monetary policy in Lithuania has been significantly easier than in Latvia, because of large inflows through correspondent accounts with the central banks of the former Soviet Union and because of a lack of confidence caused by the drawn-out process of changing administrations. Monetary policy in Lithuania was tightened sharply in May 1993, however, and the exchange rate, which had depreciated rapidly against convertible currencies, has started to appreciate.

Fiscal stabilization was another integral part of the transformation efforts. For the year that began in mid-1992, Estonia and Lithuania aimed for a balanced general government budget despite a sharp fall in economic activity, whereas Latvia allowed a small deficit. The strong fiscal package introduced in Estonia supported the currency reform: the VAT rate was raised from 10 percent to 18 percent, and the taxation of corporate and personal incomes was increased. These measures resulted in a small general government surplus in 1992 (see Table 20). In Latvia, fiscal measures were delayed until late in the fall of 1992, and the 1992 fiscal deficit was equivalent to 1 percent of GDP; in the first half of 1993, however, there was a surplus equivalent to ½ of 1 percent of GDP. The Lithuanian authorities, also facing shortfalls in revenues, raised the VAT rate and moved to cash rationing to maintain a balanced budget. Consequently, the fiscal accounts recorded a surplus of 2¼ percent of GDP in 1992, and the budget balance is expected to be only slightly negative in 1993.

Financial policies were supported by incomes policies, which were introduced in slightly different variants in all three countries. In Estonia and Lithuania, guidelines were set for average wage increases in the government and state enterprise sectors and, in Latvia, for the growth of the wage bill. In all cases the wage guidelines were based on the governments' inflation targets and involved a penalty tax on excessive wage increases. The wage guidelines were generally met in all three countries. Wage increases actually turned out to be lower than expected because of budgetary stringency and poor profitability in state enterprises.

A key aspect of all the stabilization programs was trade liberalization. Before the reform process started, 95 percent of the foreign trade of the Baltic countries was with the former Soviet Union. To open their economies to free trade and global competition, all three countries abolished most trade restrictions, established current account convertibility, and liberalized most capital account transactions during the course of 1992.

Financial sector reform has helped to improve the efficiency of financial intermediation by creating twotier banking systems, introducing prudential banking supervision practices, strengthening the capital base of banks, and establishing interbank markets. All three governments also committed themselves to put in place legal frameworks appropriate for a market economy.

The Baltic countries have been successful in stabilizing their economies despite onerous initial conditions. By the end of 1992, price liberalization had largely been completed in all three countries. Following initial price adjustments, inflation began to subside in Estonia and Latvia in late 1992, and more recently it has also slowed in Lithuania (see Chart 33). In Estonia, monthly consumer price inflation had declined to 1½ percent by mid-1993. In Latvia, in part because of the appreciating nominal exchange rate, the improvement was even more striking—in the second quarter of 1993, prices increased less than 1 percent a month on average. In Lithuania, the monthly inflation rate was still about 6 percent in June but declined sharply to 1 percent in August 1993.

The speed with which real wages adjusted to the terms of trade shock and falling output varied in the three countries. In Latvia and Lithuania, nominal wages were initially allowed to increase in an attempt to maintain real purchasing power. In Lithuania, a decline in real wages took place in late 1992. Real wages have declined less in Latvia than in the other two countries, and more of the adjustment has taken place through higher unemployment. In Estonia, the resistance to declines in real wages had been much weaker, however, and by mid-1992 real wages had fallen by more than 50 percent compared with 1987 levels. These large declines in real wages, however, must also be seen against the background of previous excessive real wage increases and the marked reduction in shortages.

In response to trade disruptions with the former Soviet Union, the Baltic countries shifted their foreign trade to other markets. They have remained highly competitive vis-à-vis industrial countries and, as a result, in 1992, Latvian and Lithuanian export volumes to industrial countries doubled, and Estonian exports to these markets nearly tripled. In the first quarter of 1993, some 70 percent of Estonia's exports, over 60 percent of Lithuania's exports, and 45 percent of Latvia's exports were directed to markets other than the former Soviet Union.

Despite the shift in the pattern of exports, Baltic industries suffered from an overall shrinkage of markets and weak domestic demand. In 1993, real GDP is expected to decline by no more than 3 percent in Estonia, and by about 10 percent in Latvia and Lithuania, compared with a decline of 13 percent expected in the countries of the former Soviet Union as a group. These growth differentials reflect the relative steepness of the initial fall in output in response to the collapse of the Soviet planning system: real GDP fell sharply in the Baltic countries in 1991 and 1992. Because of the strong real wage adjustment and labor hoarding, open unemployment has remained quite low. However, it is expected to rise further as the restructuring of the enterprise sector, which has been slower than initially hoped, speeds up.

Less progress has been made in the area of structural reforms. Privatization has been slow because of political difficulties associated with restitution. As in other economies in transition, privatization of small enterprises has proceeded more rapidly than privatization of large enterprises; progress in large-scale privatization has been greatest in Lithuania. All three countries have created two-tier banking systems, but bank supervision has remained weak, and the banking crisis in Estonia in late 1992 indicates that further improvement is needed. In other areas of structural policies, progress has been better. New bankruptcy laws have been introduced, and their enforcement has increased the financial discipline of enterprises, particularly in Estonia. Governments have also introduced new competition laws in each country, and new accounting standards are being adopted.

The experiences of the Baltic countries underline the importance of speed, consistency, and determination in the implementation of stabilization and reform policies. Despite several changes in the political environment and government coalitions of each country, the basic stance of policies has closely followed the original strategy. Policy slippages have mostly been corrected swiftly, and the adopted policies have greatly improved macroeconomic stability. The task ahead is to consolidate the gains in stabilization and to expedite and broaden the structural reform process to ensure a revival of growth and employment over the medium term. In view of past policy performance, prospects for such a turnaround are promising.

1For a detailed discussion of recent economic developments in the Baltic countries, see IMF Economic Reviews 4, 6, and 7 (1993).2See Adam G.G. Bennett, “The Operation of the Estonian Currency Board,” Staff Papers (IMF), Vol. 40 (June 1993), pp. 451-70.

The Central Bank of Russia and the government have also granted off-budget directed credits, or loans, to enterprises. These credits were equivalent to about 23 percent of GDP in 1992, and almost half of them were directed to agriculture, mainly to fund state procurement. Most credits were granted at rates far below the central bank discount rate of 80 percent a year—rates of about 10 percent were typical. A lower-bound estimate suggests that the subsidy component, based on the difference between the loan rate and the central bank discount rate, was about 4 percent of GDP in 1992.48 This, however, is an understatement of both the value to the recipients of the credits and—assuming the government could have invested at a nominal rate of return greater than 80 percent—of the true budgetary opportunity cost. An upper-bound estimate would treat credits as outright grants: real interest rates on them were so negative that real repayments have been much smaller than the nominal credit value, and some credits may never be repaid.

Most other countries of the former Soviet Union also experienced revenue shortfalls and budget deficits, with those that remained in the ruble area sharing essentially the same monetary conditions as Russia. Considerable efforts were made to control the fiscal deficit in Belarus and Kazakhstan (although credit was provided to state-owned enterprises at highly negative real interest rates), but their participation in the ruble area made high inflation unavoidable. Several countries had already left the ruble area during 1992 to pursue independent monetary policies.49 Their subsequent experiences illustrate that monetary independence does not guarantee improved inflation performance. Ukraine, in particular, continued to pursue very expansionary credit policies together with large public sector financing requirements, to the point where inflation exceeded that in Russia and the national currency (the karbovanets) weakened substantially against the ruble. In contrast, monetary conditions in Estonia and Latvia tightened sharply after national currencies were introduced in mid-1992, and both countries have controlled their deficits. As a result, inflation fell rapidly by the end of the year in both countries, and the external values of the kroon and the Latvian ruble have remained stable. In early 1993, Lithuania also tightened monetary policy, and inflation has consequently slowed sharply.

More recently, other countries have left, or intend to leave, the ruble area, although it is still too early to judge the impact on monetary policy. The Kyrgyz Republic left the ruble area in May 1993, when the som was introduced as the national currency. Georgia left the ruble area in August 1993, switching to coupons in preparation for the introduction of a permanent currency, the lari, announced for October 1993. Moldova also intends to shift to its own currency, the leu, when circumstances permit, and has begun replacing ruble notes with coupons. Azerbaijan has announced the replacement of rubles with the already widely used parallel currency, the manat. Turkmenistan intends to continue using rubles until the introduction of a national currency, the (Turkmeni) manat, in November 1993. Armenia, Belarus, Kazakhstan, Tajikistan, and Uzbekistan agreed in September 1993 to form a new ruble area with Russia.

By mid-1993, inflation in most of the former Soviet Union was still on the order of 20 percent a month; in the absence of decisive policy action, the macroeconomic situation could deteriorate into hyperinflation. There appears, however, to be a broadening recognition that inflation must be brought under control. The experience of many other countries that have experienced high inflation shows that effective stabilization policies can reduce inflation rapidly and that substantial improvements in economic performance can emerge relatively quickly (Box 8).

Some policy measures to reduce inflationary pressures have been put in place in several countries of the former Soviet Union. The Central Bank of Russia raised its discount rate from 80 percent in early March to 170 percent in mid-July, bringing it much closer to market rates. This increase helped to slow the rate of credit growth and was reflected in higher central bank discount rates in other countries of the ruble area.50 In Belarus, a new banking law passed in early 1993 restricted the government's ability to monetize deficits by limiting its access to central bank overdrafts. Outside the former Soviet Union, monetary policy was tightened significantly in Mongolia at the beginning of 1993, and inflation had fallen to under 2 percent a month by May.

Reducing inflation—the single most pressing macroeconomic challenge facing these countrieswill require sharp curtailment of the growth of central bank credit. This will, in turn, be reflected in higher real interest rates, allowing capital markets to better allocate scarce funds. Credit can be sustainably and credibly controlled, however, only if massive fiscal subsidies are cut back. Fiscal control will require that credits be put on-budget so that their true costs can be accurately assessed, and that interest rates on state credits be linked closely to market rates to reduce the subsidy component of credits. Ultimately, however, governments should withdraw from the business of allocating credit.

The IMF established the structural transformation facility (STF) in April 1993 to support the process of macroeconomic stabilization and the establishment of the basic institutions of economic management.51 In accordance with the conditions for borrowing under this facility, Belarus, Kazakhstan, and Russia are in the process of implementing macroeconomic and structural reforms. The Kyrgyz Republic is making a drawing under the STF simultaneously with a standby arrangement.52 The STF is a temporary IMF facility, and it is hoped that conditions in countries eligible to use it will soon warrant the implementation of programs under normal IMF facilities.

Enterprise Privatization

Most central European countries in transition have made considerable progress in liberalizing the economy by freeing prices, reducing trade barriers, creating the regulatory framework to encourage private-sector activity, and privatizing small enterprises. Nevertheless, the transformation of the huge state-owned enterprise sector, including the financial sector, into privately run and efficiently operated firms has proven to be more difficult than anticipated. Both the expertise and financial capital required to manage the transition properly have been underestimated in most cases, and privatization, including the resolution of property rights, has been politically charged and thus prone to delay.

The relative lack of progress in the restructuring and privatization of larger enterprises is particularly striking in Hungary and Poland, where the transformation process started in 1989 and the difficulties inherent in large privatization were first faced. A common feature in both countries was an initial wave of self-privatization, which led in several cases to asset stripping.53 This generated a political backlash against privatization more generally, which still hampers progress. In Hungary, a caseby-case approach was subsequently adopted, with the State Property Agency putting state enterprises up for sale. This process was accelerated by reducing the role of the agency to reviewing privatizations that have already taken place, and by introducing other measures, such as employee stock-ownership plans. Transformation of the financial system started as early as 1987, although commercial banks are still burdened by nonperforming loans to state enterprises. Less than 10 percent of the state-owned industry had been privatized by mid-1993, and foreign investors bought the majority of these assets. With the growth of new private enterprises, however, some 40 percent of Hungary's GDP is now produced in the private sector.

In Poland, the lack of significant progress with initial privatization plans and the continued deterioration in the condition of state enterprises led the government to make transformation of the state enterprise system its top priority. Under a recently enacted mass privatization law, some 200 enterprises are to be privatized by turning them over to a small number of investment funds, the shares of which will be distributed among part of the population. The shares of another 400 enterprises will be offered for sale to all adult citizens. In addition, a key aim of the recently agreed Pact on State Enterprises is the acceleration of privatization, and ownership transformation is also proceeding through other channels. Privatization and the formation of new firms have raised the private sector share of GDP to about 45 percent.

Hyperinflation and Chronic Inflation

High inflation is a modern phenomenon. Before World War I, episodes of high inflation were rare because of the prevalence of convertible currencies and commodity moneys. The first wave of high inflation came in the aftermath of World War I, when monetary financing of large fiscal deficits caused by the war led to hyperinflation—commonly defined to begin when monthly inflation surpasses 50 percent—in Austria, Germany, Hungary, and Russia. After World War II, hyperinflation re-emerged in Hungary, Greece, and China. It then disappeared for more than three decades, only to return in Bolivia in 1984. The Bolivian hyperinflation was the first episode in the twentieth century that was not related to war or political revolution. More recently, hyperinflation has accompanied civil war in the states of former Yugoslavia (other than Slovenia), and it now menaces Russia and Ukraine (see table).1

Episodes of hyperinflation are characterized by extreme inflation rarely lasting more than eighteen months. The average monthly inflation in the twelve months before stabilization reached levels as high as 19,800 percent in Hungary after World War II, 455 percent in Germany after World War I, and 58 percent in the recent Bolivian hyperinflation. In the late 1940s, a much less spectacular, but equally ominous, type of inflation began to emerge: chronic inflation. Some developing countries, particularly in Latin America, began to endure persistent inflation exceeding 20 percent a year. In many cases—such as in Argentina, Brazil, and Uruguay—chronic inflation has lasted for several decades. Countries cope with chronic inflation by creating various indexation mechanisms. By making inflation more tolerable, however, these mechanisms diminish the political will to eradicate it and high inflation becomes a feature of the economic landscape.

The distinction between hyperinflation and chronic inflation is critical for understanding the effects of stabilization policy. Hyperinflation exhibits three distinguishing features. First, it usually has a clear fiscal origin, since it erupts in traditionally low-inflation countries that face temporary, but extraordinary, needs for fiscal revenues. Second, nominal contracts gradually disappear in the face of extreme rates of inflation because most wages and prices become indexed to a foreign currency (and many transactions are actually conducted in a foreign currency). Third, hyperinflation brings about such a chaotic social and economic environment that the public becomes convinced that the situation is untenable.

Paradoxically, the same characteristics that make hyperinflation such an explosive and devastating process explain why stopping it has proved less difficult in many ways than stopping chronic inflation. Typically, ending hyperinflation has involved setting up an independent central bank that has the power to deny credit to the treasury; implementing major fiscal reforms to eliminate the need for inflationary finance; and establishing currency convertibility, often at a fixed exchange rate. Such a policy package has usually stopped hyperinflation in its tracks with relatively small real costs (see chart). Because most wages and prices are quoted in a foreign currency, fixing the exchange rate is tantamount to stabilizing the price of virtually all goods in the economy. Furthermore, because the fiscal root of the problem is obvious to the public and the situation is viewed as intolerable, programs to stop hyperinflation usually enjoy a high degree of support and credibility. This, together with the fact that nominal rigidities have been wiped out, ensures that the real costs from monetary stabilization in countries experiencing hyperinflation are relatively minor compared with those that arise in stabilization plans in countries with low or chronic inflation.

The distinguishing features of chronic inflation stand in sharp contrast to those of hyperinflation. First, since the fiscal problems underlying chronic inflation—although serious—may be less acute in the short run, it is difficult to mobilize political support for reform. Second, there is a high degree of inflation inertia from widespread indexation. Third, the public is normally skeptical of new attempts to stop inflation, particularly when there is a history of failed stabilization efforts, as is usually the case.


Selected Countries: Inflation and Output Growth Before and After Stabilization1

(In percent)

Source: Carlos A. Vegh, “Stopping High Inflation: An Analytical Overview,” Staff Papers (IMF), Vol. 39 (September 1992), pp. 626-95.1 Inflation refers to the average monthly rate twelve months before and after stabilization. Output refers to annual real GDP growth three years before and after stabilization, except for Austria (two years before stabilization) and Germany (industrial production per capita).

Selected Countries: Inflation

(In percent a year)

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1992 excludes Slovenia.

Countless stabilization attempts suggest that stopping chronic inflation is not an easy task. Fiscal adjustment is a necessary, but not sufficient, condition to ensure success. Programs to stop chronic inflation have usually relied on the exchange rate as the nominal anchor. Typically, however, the lack of credibility and the presence of backward-looking indexation have resulted in a very slow reduction of inflation. As a result, real exchange rate appreciation has normally led to widening current account deficits and to a balance of payments crisis, which have frequently led in turn to the demise of the stabilization program, subsequent large devaluations, and new inflationary impulses.

Getting rid of chronic inflation, however, is by no means impossible. Chile, Israel, and Mexico have all managed to reduce inflation to levels of 15 percent a year or less. In Argentina, the convertibility plan implemented in April 1991 also met with considerable initial success. In all cases, the programs were supported by drastic fiscal and structural reforms. In some instances, such as in Israel and Mexico, temporary price and wage controls were used to combat inflation inertia.

The inflation experience in central Europe and the countries of the former Soviet Union is unique in some respects. A key aspect of inflation in the economies in transition has been the initial monetary overhang, the correction of which required a once-andfor-all “jump” in the price level. In practice, of course, this “jump” was often spread over several months after the initial price liberalization as price adjustments worked themselves out through the system (see Charts 31 and 33). In the absence of indexation mechanisms, however, such adjustments should not generate sustained inflation. In the former Czechoslovakia, for instance, the initial price shock led to an increase in prices of 26 percent in January 1991, followed by much lower and declining rates of inflation in the following five months; by July, the adjustment in the price level was basically over. Of course, when price liberalization is gradual, as in Romania, inflation will be spread over a longer period.

Although the short spurt of inflation induced by monetary overhangs has been unique to the economies in transition, other aspects of the inflationary process are reminiscent of the experiences of market economies. Inflation in the former Yugoslavia and, to some extent, Poland, for example, shared many of the characteristics of chronic inflation in Latin America and Israel, with inflation being fueled by devaluations intended to improve competitiveness and sustained by formal and informal indexation. In early 1990, both the former Yugoslavia and Poland embarked on exchange-rate-based stabilization programs that included wage and price controls. These programs brought about a substantial reduction in inflation but, unlike similar programs in other countries with chronic inflation, were accompanied by a sharp contraction in economic activity, explained to a large extent by supply-side disruptions.

Other countries in central Europe, such as Bulgaria and Romania, have inflation rates similar to those in countries with chronic inflation. Because open inflation is a new phenomenon, however, formal indexation schemes have for the most part not been implemented. The Latin American and Israeli experiences underline the importance of doing away with high inflation before mechanisms that tend to perpetuate inflation are put into place.

Inflation in Russia and the other countries of the former Soviet Union that remain in the ruble area resembles typical hyperinflation. Even though monthly inflation in Russia has not surpassed 50 percent (with the exception of January 1992, when prices were liberalized), it has been running at an average rate of 20 percent in the twelve months to June 1993. This is higher than the twelve-month increase in prices that preceded hyperinflation in Germany (17.8 percent) and Hungary (14.2 percent) after World War I, and in Bolivia (15.6 percent) more recently, suggesting that inflation at this level can easily develop into full-blown hyperinflation.

As in past episodes of hyperinflation, the fiscal origin of inflation in Russia is clear. The budget deficit of the general government (including import subsidies) was about 20 percent of GDP in 1992. Revenue from money creation—seigniorage—has been estimated at around 15 percent of GDP for the second semester of 1992. By comparison, the budget deficit in Bolivia was 27.4 percent during 1984 (the hyperinflation started in April), and revenue from money creation was 15.9 percent of GDP. As in other episodes of hyperinflation, nominal rigidities are not likely to be important in Russia, given the absence of institutionalized indexation mechanisms.

The experiences of other countries suggest that a strategy to stop or prevent hyperinflation must be based on a rapid reduction of the budget deficit and a strong nominal anchor. Although the nominal anchor has usually been the exchange rate, the Bolivian experience shows that the money supply can also serve, provided that it succeeds in stabilizing the exchange rate. A strong exchange rate anchor has already borne fruit in Estonia, where inflation has fallen from an annualized rate of over 500 percent during 1992 to 35 percent in the first fivemonths of 1993. In Latvia, where inflation fell from over 600 percent during 1992 to 25 percent in the firstfivemonths of 1993, similar progress was made by using a monetary anchor (see Box 7).

1On the experience of high inflation in market economies, see Carlos A. Vegh, “Stopping High Inflation: An Analytical Overview,” Staff Papers (IMF), Vol. 39 (September 1992), pp. 626-95. On the economies in transition, see Chapter V of the May 1993 World Economic Outlook; Michael Bruno, “Stabilization and Reform in Eastern Europe: A Preliminary Evaluation,” Staff Papers (IMF), Vol. 39 (December 1992), pp. 741-77; and Grant Spencer and Adrienne Cheasty, “The Ruble Area: A Breaking of Old Ties?” Finance & Development, Vol. 30 (June 1993), pp. 2-5.

A fast-track approach toward privatization has been implemented in the Czech Republic, beginning with a wave of mass privatization in early 1993.54 Some 1,300 enterprises have been sold through five successive rounds of bidding—65 percent for vouchers, and the rest for cash and other assets. A second round, scheduled for late 1993, is expected to privatize another 2,100 enterprises, one-third for vouchers. With the completion of this round, 80 percent of state property will have been privatized. Proceeds from privatization have been used to assist the financial system in writing down bad debts and to recapitalize banks.

The sizable macroeconomic imbalances that have emerged in Slovakia have forced the authorities to focus on stabilizing a deteriorating economic environment and have complicated structural reform efforts. The Slovakian economy is characterized by a large number of enterprises in relatively weak sectors—such as military production—that will be difficult to privatize without prior conversion. As in the Czech Republic, the first wave of mass privatization has been completed, and preparations for a second wave were under way in mid-1993. The authorities are, however, moving away from the voucher system toward auctions or direct sales to investors, in order to increase sales revenues.

Progress in ownership reform has been slow in Romania and Bulgaria because of political uncertainties and the difficult economic environment. In Bulgaria, privatization of a number of small-scale companies has already taken place, but only 34 large-scale firms are scheduled for privatization in 1993, and there is some doubt that even this will be achieved. Further progress on the issue of restitution of agricultural lands is needed, together with a complete transformation and recapitalization of the banking system. The pace of privatization has also been slow in Romania, where about half of some 4,400 small commercial units such as shops, restaurants and hotels, and only a few small and medium-sized enterprises have been privatized. Almost all of the assets of the large enterprises remain under state ownership.

The starting position of Slovenia was in many respects more favorable than that of other central European countries. Apart from having the highest level of per capita GDP in central Europe, Slovenia benefited from the absence of a strong centrally managed production and pricing system. Macroeconomic stability was enhanced after monetary independence in 1991. A new central banking law gives the Bank of Slovenia responsibility for managing the exchange rate and prohibits it from lending to the government. Nevertheless, inflationary pressures persist, in part owing to lack of progress in transforming self-managed enterprises. The lack of financial responsibility of enterprises and the moratorium on initiation of bankruptcy procedures in the socialized sector have required direct intervention in the wage-setting process to prevent an acceleration of inflation.

In most of the former Soviet Union, in contrast with the lack of progress in macroeconomic stabilization, privatization has been gathering momentum, although it has tended to be concentrated in smaller enterprises and in the trade and service sectors. There are no comprehensive plans to privatize the largest enterprises—those with more than 10,000 employees—although some progress is being made. Privatization of the largest enterprises has proved especially difficult for several reasons. These enterprises sometimes dominate a region, and the social and economic consequences of failure would therefore be particularly serious. They are also often associated with military production, especially in Belarus, Russia, and Ukraine. Moreover, in Russia the largest firms typically have plants in several regions, and it has only recently become possible to hold country-wide auctions. Despite general progress toward privatization, including legislation that would foster new private sector enterprises, most goods and services are still produced by state enterprises.

In Russia, the process of privatization accelerated sharply in late 1992. About one-fourth of the 250,000 small and medium-sized enterprises that had been owned by municipalities and local authorities were privatized by the first quarter of 1993. Many of the larger enterprises owned by the central government have been corporatized—turned into state-owned joint-stock companies—in preparation for eventual privatization through vouchers. All the vouchers had been distributed by early 1993, and voucher privatization has occurred at a pace of 350 to 600 firms a month. In all, some 5,000 corporations are set to be privatized through voucher sales in 1993. Nonetheless, the program continues to come under attack from conservative institutions.

Significant progress has also been achieved in the Baltic countries. More that 60 percent of small municipal enterprises have been privatized in Latvia, and several hundred proposals for privatization of larger enterprises are being evaluated. The pace of privatization has been slowed by complex regulations, however, and some investors have been deterred by possible restitution claims. The establishment of a voucher system in late 1992 holds the promise of significantly simplifying, and thereby accelerating, the privatization process. In Lithuania more than 80 percent of small enterprises were auctioned in December 1992, and over 1,000 mediumsized and large enterprises have been privatized by public share subscription. In Estonia, the progress in privatizing larger enterprises stalled in late 1992, but the passage of new, more flexible legislation is expected to result in about one-third of such enterprises being privatized by the end of 1993. Outside the former Soviet Union, firms accounting for about half of industrial production have been privatized in Mongolia, as has virtually the entire agricultural sector.

Progress in Ukraine has been limited. There has been little privatization of small enterprises, and little progress in implementing recently adopted legislation on corporatization of medium-sized and large state-owned enterprises. The pace of privatization has also been slow in Kazakhstan; although about one-fifth of all enterprises had been formally privatized by the end of 1992, it appears that in many cases the state has retained majority ownership. Majority state ownership also remains the norm in the Kyrgyz Republic, where 35 percent of enterprises are expected to be converted to jointstock companies by end-1993. In Belarus, the transformation process began in 1990, but subsequent progress has been limited. Legislation passed in early 1993 envisages privatization of two-thirds of the economy (the other third, largely defense industries and natural monopolies, is not eligible), and the legislation for voucher privatization was adopted in July 1993.

The Treuhandanstalt

Privatization in east Germany has been fundamentally different from that in any other economy making the transition to a market system. With west German legal and political institutions providing a welldefined and stable reference point and the west German economy able to provide financial support on a vast scale, it was possible to embark on a far swifter and more radical transformation program than elsewhere.

The mandate of the Treuhandanstalt—“trust fund agency”—is to restructure and privatize most of the state-owned assets of the former German Democratic Republic by the end of 1994. The progress already made in the last three years has been considerable. Privatization of the services sector—which comprised close to 20,000 retail outlets, restaurants, and hotels—was concluded two years after unification. In addition, about 90 percent of the more than 12,000 industrial enterprises have thus far been transferred to the private sector or closed, and industrial privatization is expected to be all but completed by the middle of 1994. Already, employment in Treuhandcontrolled enterprises, which amounted to VI2 to 4 million in mid-1990, some 40 percent of the east German labor force, has declined to about 0.3 million, less than one-tenth of its initial level.

Although the Treuhand's overriding concern has been a rapid transfer of assets to the private sector, it has also given considerable weight to ensuring that enterprises are restructured into viable businesses by potential purchasers rather than simply being stripped of their salable assets. Thus, the Treuhand has generally insisted that purchasers maintain employment and investment at contractually specified levels. In exchange for these contractual commitments, the purchase price was often reduced, resulting in lower privatization revenues. Indeed, when the assumption of environmental liabilities and old enterprise debts by the Treuhand is included, some purchasers in effect received a subsidy for acquiring an enterprise from the Treuhand.

The achievements of the Treuhand have been supported by large public financial transfers. The Treuhand was given annual borrowing authority amounting to about 1 percent of GNP; in addition, it has taken on much of the old debt of the enterprises under its control and has assumed large liabilities for environmental cleanup. In total, the debt of the Treuhand is expected to amount to at least DM 275 billion (8¾ percent of unified Germany's GNP) by the time it formally ceases operations at the beginning of 1995. This debt will be serviced by the federal government beginning in 1995 and is projected to raise the budget deficit by V2 of 1 percent of GDP.

It is expected that some enterprises will not be salable by the time the Treuhand ceases active operations. Some larger enterprises are considered to be vital for maintaining regional “industrial cores” and are likely to come under the direct supervision of the federal government. Most of the others will be placed in so-called management companies that, after receiving additional funds for restructuring, are expected to operate without further subsidies.

Although the Treuhand's success in transferring nationalized assets to the private sector is without historical parallel, the ultimate success of economic transformation in east Germany is not yet assured. The large gap between wages and productivity that currently exists is likely to discourage much-needed private investment and to hamper a self-sustaining economic upswing. The high level of real wages relative to productivity also threatens the viability of many privatized companies, despite the favorable terms at which they were transferred to private owners. Without greater labor market flexibility and wage setting that takes account of labor productivity in the new Lander, the newly recreated east German private sector may be dependent on public assistance fora long time.

Transformation of the Enterprise Sector

Experience in the countries in transition suggests that the choice of strategy for privatization has important implications for budgetary costs and, most important, for subsequent stages of reform. At one end of the spectrum is a strategy of extensive reorganization before privatization, which has been followed most extensively in east Germany. The Treuhandanstalt has effectively assumed management of firms, evaluated their potential, extended initial credit guarantees to prevent immediate collapse, and recapitalized balance sheets (Box 9). The advantage of transforming enterprises before privatization is that subsequent costs of adjustment may be reduced.

This strategy of prior reform has, however, proven very expensive, and it is beyond the financial resources of the countries in transition, at least on the scale seen in east Germany. Moreover, unlike Germany, the countries in transition have a very limited pool of management expertise to manage the restructured enterprises. Some central European countries have attempted to combine restructuring with privatization, but this approach has tended to result in very slow progress. In some cases, restructuring enterprises before privatization will nevertheless prove appropriate, but, given the resources available, such a strategy will be feasible only for a limited number of enterprises.

In an effort to reinvigorate the process, several countries have turned to mass privatization, as described in the previous section. Under this strategy, there is minimal prior restructuring of enterprises. In the Czech Republic, for example, restructuring has been limited to breaking up enterprises on the basis of proposals submitted by potential buyers. As a result, mass privatization is proving to be quick and, from a budgetary point of view, relatively inexpensive, although the vouchers bring in less sales revenue. Moreover, rapid privatization has helped to defuse the political sensitivity of the process.

In the absence of significant restructuring of enterprises, however, privatization alone will not solve the underlying problems facing previously state-owned enterprises. Instead, mass privatization effectively leaves it up to the new owners and managers to implement the reforms and investments needed to make their enterprises competitive and viable. It will therefore be particularly important to ensure that the incentives facing privatized enterprises are appropriate. Liberalized trade, marketdetermined prices, and further reductions in subsidies will help to speed the transition and to promote economic expansion. The scale of subsidies in countries such as Russia and Ukraine not only far exceeds the requirements of economic transformation, it also undermines the incentive of managers of state-owned, privatized, and newly established enterprises to restructure. Export restrictions and remaining price controls in many countries of the former Soviet Union are additional obstacles.

Full transition to market-based economies will require the development of commercial law and corporate governance. Market mechanisms of enterprise governance by shareholder and creditor oversight must be more firmly established. In some countries, key legal aspects of property rights have not been fully tested, and, although most of the countries in transition now have bankruptcy laws, there has generally been little practical experience with them, and the rights and responsibilities of shareholders and creditors remain unclear. Experience is being developed in Hungary, however, on the basis of a law introduced in January 1992. Through April 1993 nearly 3,000 firms, accounting for 5 percent of GDP, had been involved in bankruptcy proceedings.

In all the countries in transition, rapid development of the banking system will be necessary to improve the allocation of scarce credit to the growing private sector, and to deepen the resources available to enterprises that are solvent but cash constrained. In most countries, banking systems are currently weak and undercapitalized, a situation that threatens to result in banking crises, as occurred in Estonia in late 1992. Such crises would be disruptive, could require costly government rescue efforts, and would make it more difficult to establish the public confidence in the financial system that will be required to mobilize financial assets for investment. Many countries in transition have recognized the importance of the development of financial intermediation and have moved to strengthen the balance sheets of commercial banks.

Another aspect of enterprise reform that requires increased attention is demonopolization. The relatively high level of industrial concentration inherited from the system of central planning has led to fears of abuse of monopoly power.55 Large monopolies may also be difficult to privatize if they are not first broken up; and if they are privatized, they may be powerful enough to insulate themselves from the effects of reforms. Apart from breaking up large enterprises in highly concentrated industries, greater competition can be encouraged by liberalizing trade and by promoting the entry of new firms, which may be especially beneficial in industries where the capital stock is largely obsolete.

Even if market incentives are appropriate, mass privatization may give rise to weaknesses in enterprise management. Many firms have been purchased by their current employees—particularly in Russia, where voucher privatization was designed to promote worker participation. But current employees may not have the will to make needed structural changes, such as reducing overstaffing. Another concern is that the voucher method of privatization will result in ownership that is too diffuse to control management effectively. This is an especially pertinent issue because management has often remained in place during the process of mass privatization. It is not clear how well the old managers will be able to adapt to the new market conditions, but if incentives are changed and market discipline is imposed, their performance may improve. In the former Czechoslovakia, ownership control has been enhanced by the establishment of private, but state-regulated, investment funds in which individuals participate in exchange for their vouchers. These funds now control the majority of shares in privatized companies and are already active in securing positions on the supervisory bodies of individual enterprises. Similar funds have appeared in Russia, although they are not yet as influential as those in the former Czechoslovakia and have only recently been subject to effective government supervision.

The transformation of enterprises will have a counterpart in sweeping changes in the role of the state. Governments' direct role in resource allocation and pricing has already significantly diminished, and this trend will continue. As the economic consequences of the reforms discussed above work through the economy, however, pressures will inevitably arise to provide funds to restructure enterprises in danger of failing, although it will be difficult to determine ahead of time if a loss-making enterprise will be viable in the longer run. Such support should be granted conservatively on a caseby-case basis, should be explicitly temporary, and should be conditional on implementation of an enterprise reform program.

Although governments' role in resource allocation will diminish, their responsibility for social expenditures will increase. Under central planning, enterprises had been responsible for a wide range of social expenditures, and unemployment insurance had been unnecessary because there was no open unemployment. To develop a strong private sector and to maintain support for continued economic reform, however, the social safety net will require strengthening. Social outlays are therefore likely to be an increasing drain on budgetary resources, which already face severe pressures. In many countries, especially in the former Soviet Union, these pressures could be relieved by reducing subsidies, particularly those that implicitly or explicitly compensate enterprises for social outlays for which the state, in any case, should assume responsibility. Moreover, in most economies in transition the social safety net has been poorly focused, and in some it has been more extensive than these economies can afford.

Full economic transition to market-based economies will require—in addition to privatizationenterprise reform, the development of commercial law and corporate governance, implementation of workable bankruptcy procedures, and a substantial shift in the role of the state. Soft budget constraints associated with government bailouts, subsidies, and easy credit have undermined the incentives of the managers of state-owned enterprises to produce efficiently. As these supports are withdrawn and as privatization proceeds, market-based incentives will take on increasing importance, and market mechanisms relying on enterprise governance by shareholder and creditor oversight will have to be developed.


See “Declaration on Cooperation for Sustained Global Expansion,” adopted at the conclusion of the fortieth meeting of the Interim Committee of the Board of Governors of the IMF, April 30, 1993 (reprinted in the May 1993 World Economic Outlook, p. x).


Reflecting a bilateral agreement between the German and Dutch monetary authorities, the narrow band of 2¼ percent between the guilder and the deutsche mark was maintained.


Although eligible for the STF, Albania and Mongolia have opted for ESAF arrangements.


Detailed analyses of the causes and consequences of these asset price inflations and deflations may be found in Annex I of past editions of the World Economic Outlook (May 1992, October 1992, and May 1993).


It should be noted, however, that revised national accounts data now suggest that the recession was somewhat less pronounced than previously assumed, and that the recovery was stronger than initially reported. As a result, the estimated output gap for 1993 shown in Chart 4 is now smaller than on the basis of previous estimates.


For an analysis of the effects of a fall in world oil prices, see “An Extended Scenario and Forecast Adjustment Model for Developing Countries,” in Staff Studies for the World Economic Outlook (IMF, 1993, forthcoming).


On a twelve-month basis, consumer price increases were above 4 percent for the first eight months of 1993, but a substantial portion of this is due to increases in indirect taxes—which have added more than½ of 1 percentage point to 1993 consumer price inflation—and to special pressures on the housing and service sectors due to high immigration, which has pushed inflation in these sectors in west Germany to 6 to 7 percent. Goods prices increased by less than 2 percent annually in 1991-92 and have remained broadly stable in 1993.


See Chapter III for a detailed discussion of the background for the decision to widen the fluctuation bands in the ERM.


The emerging stock markets, as defined by the International Finance Corporation (IFC), include those in Argentina, Brazil, Chile, Colombia, Greece, India, Indonesia, Jamaica, Jordan, Korea, Malaysia, Mexico, Nigeria, Pakistan, Philippines, Portugal, Sri Lanka, Taiwan Province of China, Thailand, Turkey, Venezuela, and Zimbabwe. Price changes reported here are changes in the IFC country stock price indices; see IFC, Quarterly Review of Emerging Stock Markets: First Quarter 1993 (Washington, 1993) and Quarterly Review of Emerging Stock Markets: Second Quarter 1993 (Washington, 1993).


Information on 1993 trade may understate trade volumes because of reduced data coverage associated with the opening of the single market in Europe and the abandonment of customs controls on trade within the European Community.


The guilder and the deutsche mark will continue to operate within a2¼ percent band, reflecting a bilateral agreement between the Dutch and German monetary authorities.


Morris Goldstein, David Folkerts-Landau, and others, International Capital Markets: Part I, Exchange Rate Management and International Capital Flows, World Economic Survey (IMF, April 1993).


Foran analysis of the macroeconomic consequences of unification, see Paul R. Masson and Guy Meredith, “Domestic and International Consequences of German Unification,” in German Unification: Economic Issues, edited by Leslie Lipschitz and Donogh McDonald, Occasional Paper 15 (IMF, 1990), pp. 93-114.


Empirical research has shown that foreign exchange markets appear to be affected by risk premia and, accordingly, that short-term interest differentials are not unbiased predictors of future exchange rate changes. Changes in risk premia provide a theoretical mechanism through which shifts in interest rate differentials might induce exchange rate changes larger than what would otherwise be the theoretical norm.


Some countries with floating exchange rates, such as Canada, use a weighted average of movements in short-term interest rates and of the exchange rate as a guide to monetary conditions.


For countries with currently high ratios of government debt to GDP, the Maastricht criterion on the public debt ratio already generally implies more ambitious efforts to reduce fiscal deficits over the next few years. For countries with relatively low ratios of public debt, however, a 3 percent of GDP fiscal deficit would generally be above the level that would stabilize the public debt-GDP ratio, especially if this deficit was achieved only when the economy was performing above its cyclical norm.


These issues were discussed in detail in the May 1993 World Economic Outlook, Chapter III, pp. 35-38. The second stage of EMU will see several institutional developments that should help to strengthen the consistency of policies across the EC and thus promote greater stability in the EMS. The creation of the European Monetary Institute (EMI) should strengthen cooperation among central banks and facilitate coordination of monetary policies. Monetary policy will continue to be the responsibility of national central banks (until the third stage of EMU, when the European Central Bank will assume authority for monetary policy), but the EMI will have the mandate to make recommendations regarding the conduct of monetary policy in individual countries. The Maastricht Treaty also incorporates provisions that prohibit monetary financing of fiscal deficits and privileged access to financial institutions by public entities. At the same time, the Community's surveillance process will begin to tighten rules for fiscal deficits (although sanctions against countries with excessive deficits will not be imposed until the third stage of EMU). The second stage will require governments to initiate the process of granting central banks independence, which should strengthen the credibility of price and exchange rate objectives.


See the discussion on price stability in the May 1993 World Economic Outlook, Box 2, pp. 24-26.


Annex I explains how structural balances are defined and estimated.


See the discussion in the January 1993 Interim Assessment of the World Economic Outlook.


For a description of the April 1993 economic stimulus package in Japan, see Box 3 in the May 1993 World Economic Outlook, p. 34.


In 1965, the dependency ratio ranged from 48 percent in Japan to 70 percent in Canada, and in 1985 it ranged from 43 percent in west Germany to 52 percent in France and the United Kingdom. By the year 2025, this ratio is projected to range from 55 percent in Italy to between 59 and 61 percent in the other major industrial countries. For simulations of the economic effects of aging populations, see “Population Aging: An Attempt to Quantify the Long-TERM Macroeconomic Effects,” Supplementary Note 3 in the May 1990 World Economic Outlook, pp. 100-13.


Although there is rarely full Ricardian equivalence—in which the effect on national saving of a reduction in taxes today is completely offset by an increase in private saving to meet future tax liabilities—there is a relationship between public dissaving and the net flow of foreign capital. An increase in government saving in relation to GDP may not reduce, one-forone, a country's reliance on foreign capital—because the balance of private saving and investment can also change—but it will tend to reduce the need for capital inflows over time.


How much a country must reduce its debt in relation to GDP depends on expected growth, the initial debt-GDP ratio, and the present value of future net liabilities—which itself depends on factors such as the age structure of the population, retirement age, and existing benefit rates.


This estimate, which is for 1991, includes workers who were either discouraged from seeking work by poor job prospects or were part-time workers who wanted to work more hours; see OECD Employment Outlook (Paris, July 1993).


The average unemployment rate in the industrial countries was below 5 percent until 1975. The estimated increase in output is based on 1988-90 average labor productivity levels.


See OECD Economic Outlook 53 (Paris, June 1993), p. 39.


Based on the assumptions that the extra employment income would generate tax revenue, and that unemployment insurance outlays would be reduced, in line with the elasticities described in Annex I.


See Chapter VI in the May 1993 World Economic Outlook.


See OECD Employment Outlook (Paris, July 1993).


The group of “successfully adjusting countries,” identified in the October 1992 World Economic Outlook (Chapter IV), consists of 35 developing countries divided into two categories: sustained adjusters, which initiated stabilization policies and structural reforms five or more years ago; and recent adjusters, which have put in place adjustment and reform policies during the past three to four years.


The importance of domestic saving is indicated by the very high correlation across countries between domestic saving and investment. See, for instance, Michael Dooley, Jeffrey Frankel, and Donald Mathieson, “International Capital Mobility: What Do the Saving-Investment Correlations Tell Us?” Staff Papers (IMF), Vol. 34 (September 1987), pp. 503-30.


Domestic saving is defined in Table A43 of the Statistical Appendix and includes official transfers. The rationale for this is that transfers, because they do not increase external liabilities and necessitate a subsequent outflow, are more akin to domestic rather than foreign saving. If transfers are included in foreign saving, Africa's foreign saving rate increases to 4 ¼ percent of GDP over 1971-93, with the domestic saving rate correspondingly lower. Foreign saving rates for other regions are not affected in any significant way.


See Bijan B. Aghevli, James M. Boughton, and others, The Role of National Saving in the World Economy: Recent Trends and Prospects, Occasional Paper 67 (IMF, March 1990).


Cross-country analysis suggests that, on average, a 1 percent increase in the growth of trend per capita income raises household saving by about 0.30 percent. This elasticity is based on an analysis of 50 developing countries for the period 1985-92 and is somewhat higher than the results obtained for the 1970s by Kanhaya L. Gupta, “Aggregate Savings, Financial Intermediation, and Interest Rates,” Review of Economics and Statistics, Vol. 69 (May 1987), pp. 303-11.


For details of the reforms of domestic capital markets, see IMF, Private Market Financing for Developing Countries, World Economic and Financial Survey (December 1992).


See Chapter III and Annex V in the May 1992 World Economic Outlook.


There is very little evidence to support full “Ricardian Equivalence”—that anticipations of future tax liabilities are fully reflected in current private saving—for developing countries. Although individuals may form expectations about their future tax liabilities, liquidity constraints in general prevent them from acting on these expectations. One implication is that increases in taxation, when not offset by public consumption, increase saving, albeit somewhat less than proportionately. See, for example, Nadeem Ul Haque and Peter Montiel, “Consumption in Developing Countries: Tests for Liquidity Constraints and Finite Horizons,” Review of Economics and Statistics, Vol. 71 (August 1989), pp. 408-15.


See Annex II for a discussion of trends in military expenditure.


Capital adequacy has been enforced by the Basle guidelines, agreed in 1988, and lending to most developing countries has been influenced by national loan-loss provisioning requirements. These requirements have been adjusted by regulators to reflect sustained improvements in creditworthiness by a number of developing countries.


For a detailed analysis of the causes of, policy responses to, and effects of capital inflows in six major countries, see Susan Schadler, Maria Carkovic, Adam Bennett, and Robert Kahn, Recent Experience with Surges in Capital Inflows, Occasional Paper (IMF, 1993, forthcoming). For a broader discussion of these issues for Latin American countries, see Guillermo A. Calvo, Leonardo Leiderman, and Carmen M. Reinhart, “Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors,” Staff Papers (IMF), Vol. 40 (March 1993), pp. 108-51. For a discussion concerning Asian countries, see Kenneth B. Bercuson and Linda M. Koenig, “The Recent Surge in Capital Inflows to Asia: Cause and Macroeconomic Impact,” paper prepared for the SEACEN/IMF Seminar, May 14-16, 1993, Seoul, Korea.


See Eliana Cardoso and Rudiger Dornbusch, “Foreign Capital Flows,” in Handbook of Development Economics, edited by Hollis Chenery and T.N. Srinivasan (Amsterdam and New York: North-Holland, 1989). It should also be noted that, even if domestic output increases due to foreign saving, this may not translate into an increase in national income if the return on capital is less than the cost of servicing the flows.


The correlation between changes in borrowing and changes in the investment rates for 90 developing countries was 0.68, 0.05, and 0.24 for the three periods.


See Bijan B. Aghevli and Jorge Marquez-Ruarte, A Case of Successful Adjustment: Korea's Experience During 1980-84, Occasional Paper 39 (IMF, August 1985).


It is estimated that in Mexico about 40 to 50 percent of the debt accumulated in the early 1980s financed capital flight. To the extent that capital flight occurs through a misinvoicing of imports and exports, recorded current account deficits are larger and domestic saving is correspondingly smaller than would be the case in the absence of capital flight. For a discussion of these issues, see Mohsin S. Khan and Nadeem Ul Haque, “Foreign Borrowing and Capital Flight: A Formal Analysis,” Staff Papers (IMF), Vol. 32 (December 1985), pp. 606-28.


For a discussion of these factors see Mica Panic and Manmohan S. Kumar, “International Interdependence and the Debt Problem,” in Structural Change, Economic Interdependence, and World Development, proceedings of the Seventh World Congress of the International Economic Association, Vol. 2, Natural and Financial Resources for Development, edited by Silvio Borner and Alwyn Taylor (New York: St. Martin's Press, 1987).


See Vincent Koen and Steven Phillips, Price Liberalization in Russia: Behavior of Prices, Household Incomes, and Consumption During the First Year, Occasional Paper 104 (IMF, June 1993), for an examination of the evolution of prices and the effects of inflation on household incomes and consumption in Russia during 1992.


For the interest rates quoted above, the difference would be 70 percentage points. However, the quoted rates are not compound annual rates, and the subsidy estimate is to this extent understated. 70 percentage points. However, the quoted rates are not compound annual rates, and the subsidy estimate is to this extent understated.


See the May 1993 World Economic Outlook, Box 7, pp. 66-67, for details on currency arrangements in the former Soviet Union.


However, on July 24, 1993, the Central Bank of Russia announced that pre-1993 ruble banknotes would no longer be legal tender after July 26, 1993. The initial terms of this demonetization entailed a significant element of confiscation, but these terms were significantly relaxed subsequently.


For a description of the STF, see the May 1993 World Economic Outlook, Box 8, p. 68.


Outside the former Soviet Union, the Slovak Republic has made a drawing under the STF. Albania and Mongolia are eligible to draw under the STF, but have instead requested ESAF arrangements.


Self-privatization refers to the seizure of the assets of stateowned enterprises, often by managers, without formal approval of the authorities.


See “Voucher Privatization in the Czech and Slovak Federal Republic,” Box 2 in the October 1992 World Economic Outlook.


Another factor, however, is that monopolies have frequently, but incorrectly, been blamed for inflation, particularly in the former Soviet Union. It has therefore been common to attempt to control apparent abuses of monopoly power by price and profit controls, but such measures tend to distort incentives and to hinder economic transition.

Annex I Structural Budget Indicators for the Major Industrial Countries

Since the early 1980s, the major industrial countries have increasingly adopted medium-term fiscal strategies to consolidate their public finances. The May 1992 World Economic Outlook reviewed progress in achieving medium-term fiscal objectives, as well as slippages and setbacks, and identified fiscal consolidation as a key policy challenge.1 Since then, the need to reduce fiscal deficits has become even more urgent. On an analytical level, the need to assess and monitor fiscal policies in a medium-term context has led to a thorough reexamination of fiscal indicators.2 In the context of the World Economic Outlook, the fiscal impulse measure has traditionally been used as the main tool to gauge the stance of fiscal policy, although it focuses on the short-term impact of fiscal policy on aggregate demand.3 To assess the medium-term stance of fiscal policies, it is necessary to focus on indicators of structural budget positions—broadly defined as the budget balance adjusted for the effects of the business cycle.

Fiscal Trends and the Concept of the Structural Budget Balance

At the end of the 1970s, significant increases in government expenditures led to a widening of fiscal imbalances as a percent of GDP in all of the major industrial countries (Chart 35). In most of the major industrial countries, revenue and expenditure ratios varied substantially during the 1980s, although there was a clear trend toward fiscal surplus in Japan and, until 1989, in Germany and the United Kingdom. Real interest rates on public debt increased sharply relative to real growth in the early 1980s, raising the prospect of “snowballing” publie debt-GDP ratios (see Box 4). In response to this, many countries undertook to consolidate fiscal positions and to reorient fiscal policies toward mediumterm objectives.

Chart 35.
Chart 35.

Major Industrial Countries: General Government Fiscal Developments1

(In percent of GDP)

1 Blue shaded areas indicate staff projections.

To assess medium-term fiscal strategies, it is necessary to determine the extent to which the changes in budget balances reflect structural factors, in particular discretionary fiscal policy actions, rather than cyclical factors. This distinction is important because movements of the budget balance attributable to the business cycle are essentially selfcorrecting, but increases in deficits owing to structural factors can be offset only through discretionary measures. Removing the self-correcting cyclical component from the observed budget balance, therefore, provides a more accurate indication of medium-term fiscal positions.

Movements in the structural components of revenues and expenditures are often interpreted as broadly indicative of discretionary fiscal policy measures. As conventionally defined, however, these movements also reflect factors not directly related either to discretionary fiscal policy measures or to the business cycle. On the revenue side, these would include changes in natural resource revenues, nonneutralities of the tax system with respect to inflation, and changes in the composition of the economy's tax base induced by growth. On the expenditure side, they include changes in interest rates, changes in the demographic composition of the population, and contingencies that lead to nondiscretionary expenditures. No effort is made here to distinguish the truly discretionary components of the structural deficit from these other factors.

Measures of the structural budget balances have their historical roots in the “full-employment deficit,” which has traditionally been used as a yardstick to judge the adequacy of fiscal policy in supporting aggregate demand. Calculations of structural budget balances are typically based on one of two alternative approaches.4 The first approach yields direct estimates of the level of the structural budget balance (5*), using budget elasticities to adjust revenues (T) and expenditures (G) for movements in the cyclical output gap (GAP):


where eR and eG are the elasticities of revenue and expenditure with respect to output. Expressing the level of the structural balance in percent of potential output gives the structural budget balance. The cyclical budget balance can then be estimated as the difference between the observed and the structural budget balance.5

In the alternative approach used here, the cyclical revenue and expenditure components can be expressed as ratios to GDP and directly estimated using parameters that describe the cyclical response of revenue and expenditure to movements in the cyclical output gap. The budget balance as a percent of GDP (b) is defined as the difference between the observed revenue-GDP ratio (t) and expenditure-GDP ratio (g):


Decomposing the revenue and expenditure ratios into cyclical and structural components yields


where the asterisk (*) indicates structural budget components and the superscript (c) denotes cyclical budget components. The difference between the cyclical revenue and expenditure components is the impact of cyclical effects on the budget balance:


where αR and aG denote the cyclical response of the revenue and expenditure ratios to an increase of 1 percentage point in the cyclical output gap. The overall effect of the business cycle on the budget is given by the difference of the two cyclical response parameters (aRaG). The structural budget balance is the difference between the observed and the cyclical budget balances.

Although the two approaches to calculating structural budget balances are equivalent,6 there are advantages to presenting the estimates as ratios to GDP. The sensitivity of structural budget balance estimates to changes in assumptions about the cyclical output gap and the cyclical responsiveness of the budget is more easily evaluated. Moreover, the cyclical budget response parameters are comparable across countries, whereas the budget elasticities would have to be weighted by the country-specific revenue and expenditure ratios to make them comparable.

Although movements in the structural budget balance are indicative of the orientation of fiscal policy, they should not be used to gauge the effects of fiscal policy on the economy. They do not include the effect of automatic stabilizers on aggregate demand—for example, the potentially different aggregate demand effects (multipliers) of individual expenditure and revenue components are not captured; the effects of fiscal policy on long-term interest rates are neglected; and the distortions of tax and transfer programs on the supply side of the economy are not taken into account.7

Estimates of Structural Budget Balances

A key aspect of the cyclical adjustment is the estimate of potential output, which is defined as the maximum sustainable level of economic activity that is consistent with stable inflation. For each major industrial country, a production-function approach has been used to link output to capital and labor inputs and to total factor productivity. Potential is the level of output that is consistent with normal capital utilization and with the “natural” rate of unemployment—the rate consistent with stable nominal wage growth. These, in turn, are estimated by removing cyclical variations in labor market participation rates, total factor productivity, and unemployment. Recent work has also focused on explaining movements in total factor productivity in terms of underlying economic factors, such as public infrastructure investment, expenditure on research and development, and international trade.8 The growth of potential output is estimated to have slowed in all of the major industrial countries during the 1970s to the mid-1980s, and it is expected to remain broadly stable in the period to 1998 (Table 22). The output gaps (the difference between actual and potential output, in percent of potential) turned sharply negative in all countries as economic activity slowed in the early 1990s, but they are expected to close gradually in the years ahead.

Table 22.

Major Industrial Countries: Potential Output Growth1

(Average annual percent change)

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Staff estimates.

Western Germany before 1990.

In most major industrial countries, the estimates of the cyclical output gaps move with the ratios of the general government balance to GDP, indicating the extent to which the business cycle has influenced public finances in the short term. However, the medium-term movements in budget balances are, by construction, unrelated to the business cycle.

The cyclical adjustment of general government revenues draws in part on revenue elasticities estimated by the OECD, and in part on IMF staff estimates (Table 23).9 The elasticities are available at a disaggregated level for personal income taxes, corporate income taxes, indirect taxes, social security contributions, and other revenues. Aggregate revenue elasticities are formed as a weighted average of the five disaggregated revenue component elasticities by using the average share of the revenue component in total revenue during the 1980s as weights. For corporate income taxes, a partial collection lag of one year is assumed for the United States, France, Italy, the United Kingdom, and Canada. General government expenditures excluding unemployment benefits are assumed to be independent of cyclical output movements. Unemployment benefit payments are adjusted in proportion to the gap between the actual and the structural rate of unemployment, which is estimated in the context of calculations of the output gap as described above.

Table 23.

Major Industrial Countries: Revenue Elasticities and Lags in Corporate Tax Collection1

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OECD figures are from Jean-Claude Chouraqui, Robert P. Hagemann, and Nicola Sartor, “Indicators of Fiscal Policy: A Reexamination,” OECD Economics and Statistics Department Working Paper No. 78 (Paris, April 1990).

A lag of 1.0 indicates that 100 percent of revenues for the tax liabilities in a year are collected in that year. A lag of 0.7 indicates that 70 percent of the revenues are collected in that year and that the remaining 30 percent are collected in the following year.

The cyclical response parameters that have been derived on the basis of these elasticities are shown in Table 24. The cyclical responsiveness of general government budget balances is relatively low in the United States and Japan—a 1 percentage point increase in the output gap raises the balance-GDP ratio by about 0.40 percentage point. The cyclical responsiveness of budget balances in the major European countries and in Canada is higher, ranging from about 0.50 to 0.60 percentage point. Except for the United Kingdom, the partial collection lag for corporate income taxes and, therefore, the lagged cyclical effect are small.

Table 24.

Major Industrial Countries: Cyclical Responsiveness of General Government Budget1

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Percentage point change in the ratio of fiscal balance to GDP for a 1 percentage point change in the output gap.

Estimates of structural budget balances—which incorporate both the effects of the cycle on revenues, as measured by the cyclical responsiveness parameters, and the adjustment for unemployment benefits—show that fiscal consolidation efforts in the major industrial countries over the course of the 1980s met with different degrees of success (Table 25). In Japan, expenditure restraint coupled with a sharp structural increase in the revenue-GDP ratio accounted for an improvement in the structural balance of about 7 percent of GDP between 1978 and 1992. Despite the very different deficit experiences of Japan and Italy, observed and structural general government budget balances moved closely together over the 1980s in both countries, reflecting relatively small cyclical output gaps. In Germany and the United Kingdom, consolidation efforts at the beginning of the 1980s were mainly based on expenditure restraint, with both countries registering significant improvements in their structural positions. These gains, however, were not preserved. Because of the large fiscal costs of German unification, the actual and structural fiscal positions deteriorated sharply in 1990-92. For the United Kingdom, the structural fiscal position began to deteriorate well before the actual budget balance moved sharply into deficit. After significant consolidation gains in the second half of the 1980s, the structural balance in France worsened at the beginning of the 1990s, and a further sharp deterioration is projected for 1993. In the United States, the structural estimates indicate a relatively steady erosion of the fiscal position. In Canada, after a sharp deterioration in the first half of the 1980s, the structural deficit has been reduced substantially since 1985.

Table 25.

Major Industrial Countries: General Government Structural Budget Balances, Actual Budget Balances, and Output Gaps1

(In percent of GDP)

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The structural budget balance is the budgetary position that would be observed if the level of actual output coincided with potential output. Changes in the structural budget balance consequently include effects of temporary fiscal measures, the impact of fluctuations in interest rates and debt-service costs, and other noncyclical fluctuations in the budget balance. The computations of structural budget balances are based on staff estimates of potential GDP and revenue and expenditure elasticities (see the text). Structural balances are expressed as a percent of potential output, and the output gap is defined as actual output minus potential output, as a percent of potential output.

Data for Germany before 1990 refer to west Germany.

Annex II Economic Benefits of Reducing Military Expenditure

Recent changes in the world political situation, particularly with respect to the former Soviet Union, have had profound effects on the global economy. One area where this is particularly true is military expenditure. The World Economic Outlook has recently started to collect data on such expenditure, which indicate that military spending relative to output has fallen by almost one quarter between 1986 and 1992. Furthermore, this fall has been very generalized, involving almost all regions of the world. After a preliminary note about data on military expenditure, the first part of this annex discusses past trends and staff projections.

The second part of the annex uses MULTIMOD, the IMF's world macroeconometric model, to illustrate the economic impact of military expenditure, looking at both the short-term impact on activity and the longer-run economic welfare benefits that accrue from lower military spending. Although the primary impact of military expenditure is on national security rather than on the economy, this annex focuses only on the economic impact.1 A change in the allocation of resources to the military has important indirect economic effects, and identifying the economic consequences provides an important input for overall policy decision making.

There are many factors—such as the impact of changing the composition of government spending—that are not considered in the relatively simple macroeconomic approach adopted here. Nevertheless, the results provide several insights into the economic effects of reductions in military expenditure, as well as an illustration of the potential economic welfare gains. Cutting military spending by 20 percent worldwide could produce a long-run increase in private consumption and in investment of around 1 percent and 2 percent, respectively. These gains, in turn, produce the major share of the rise in economic welfare, which is estimated to have a present value of almost $10 trillion in 1992 dollars (around 45 percent of 1992 world GDP). Those countries that implement the largest cuts have the largest long-term gains in consumption and investment, as well as the largest shortterm losses in output. Relative to the size of the spending cuts, net debtor developing countries gain somewhat more than industrial countries, since the benefits from lower world interest rates and increased demand for their exports are larger. Among the developing country regions analyzed below, Africa has the largest economic welfare gains.

An important implication of this analysis is that military expenditure cuts in any one country produce significant positive externalities for the rest of the world, both through lower interest rates and changes in real exchange rates. As a result, the distribution of the economic benefits is considerably more even than the distribution of the cuts. This implies that there are economic, as well as security, reasons for coordinating military expenditure cutbacks.

Trends and Prospects

Since the mid-1980s, the proportion of output that is estimated to have been devoted to military spending has fallen by almost one-fourth, from nearly 4 percent in 1986 to around 3 percent in 1992.2 As a result, total world military expenditure amounted to $661 billion in 1992, compared with $832 billion if the total had been the same size relative to GDP as it was in 1986. This reduction in military spending has been very general, with almost all regions having significantly decreased their ratio of military expenditure to GDP.3

In the industrial countries, part of this fall in the ratio of military expenditure to GDP reflects a reversal of the buildup of military spending in the early half of the 1980s (Chart 36). This trend is particularly true of the United States, which accounts for over half of all industrial country military expenditure, reflecting both its economic size and that it has the highest ratio of military spending to GDP among the major industrial countries (Table 26). By contrast, the second-largest economy in the world, Japan, has the lowest ratio of military spending to GDP and has shown little change in the ratio of military spending to GDP since 1980. The EC and other industrial country groups, which represent something of a midpoint between these two extremes in terms of percent of output devoted to military spending, had little or no military buildup in the first half of the 1980s but nevertheless show a significant downsizing in the period since 1986.

Chart 36.
Chart 36.

Trends in Military Spending1

(In percent of GDP)

1 Blue shaded area indicates staff projections.
Table 26.

World Military Spending

(In percent of GDP)

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Source: Staff estimates; external estimates in parentheses.

Developing countries and countries in transition show a pattern similar to that of the EC and other industrial countries: little change in military expenditure as a ratio to output in the early 1980s, followed by a significant fall. The World Economic Outlook estimates imply that military expenditure, which is estimated to have amounted to $110 billion in developing countries in 1992, would have been $144 billion if their share in relation to GDP had remained at its 1986 level. Other estimates indicate higher levels of military expenditure for developing countries, although the general trends are similar.4 As mentioned earlier, such differences underline the uncertainties inherent in any empirical analysis of military spending (Box 10).

There are significant differences in the proportion of output devoted to defense among different developing country regions (Chart 37). At 7¼ percent of GDP in 1992, the Middle East and Europe region is estimated to have had by far the highest ratio of military spending to output among developing countries, followed by the countries in transition, where military spending amounted to 3¾ percent of GDP.5 At the opposite end of the spectrum, the Western Hemisphere region had a ratio of military spending to GDP of only 1 percent; Asia and Africa were both below the world average, with ratios of around 274 percent. The spending of small lowincome economies (4 percent of GDP) was significantly higher than the average for developing countries and for the world as a whole.

Chart 37.
Chart 37.

Regional Trends in Military Spending1

(In percent of GDP)

1 Blue shaded areas indicate staff projections.

Military Spending Data

Because military spending is politically sensitive, it is one of the most difficult areas of government expenditure for which to collect reliable data. An important external source, extensively used in several studies, is the Stockholm International Peace Research Institute (SIPRI), although the data do not conform to standard national accounts conventions. SIPRI makes some adjustments to the basic ministry of defense statistics for different countries to take account of factors such as expenditures that are hidden in other ministries' budgets or are off-budget, although the accuracy of these adjustments is unknown.

Recently, the World Economic Outlook data base has been expanded to include data on military expenditure, which are currently available for 84 countries. The estimates may not include all the adjustments in the SIPRI numbers; hence the World Economic Outlook estimates of military spending in developing countries are somewhat lower than other estimates largely based on SIPRI numbers (see Table 26), highlighting the difficulties in obtaining consistent estimates of military spending across countries. However, the SIPRI and World Economic Outlook estimates have very similar trends, which is reassuring given the uncertainties surrounding the absolute values. Data on military spending are also published annually in the IMF's Government Finance Statistics Yearbook. The 1992 issue contains up-to-date data for approximately 70 countries. The World Economic Outlook estimates have two major advantages compared with other sources: they are more current, and they include annual projections of military spending to 1998.

There are also significant differences in the ratio of military spending to output within these regions. These differences are most pronounced in Africa, where countries such as Ghana, Mauritius, and Nigeria have military spending ratios below 1 percent of GDP, but several other countries are estimated to spend more than 4 percent of GDP on the military. Cross-country differences in military spending are also important in Asia, where several countries have military spending ratios of below Vh percent of GDP. There is more uniformity in military spending in the Middle East and Europe region, where only a few countries have ratios much below or above the average. The intraregional differences in military spending are least pronounced in the Western Hemisphere.

Despite the diversity in spending, the fall in the ratio of military spending to output has been relatively general across developing countries, with significant declines in Africa, Asia, and the Middle East and Europe. Several factors may have contributed to the cutback in military spending since 1986.6 Financial factors are found to have a significant impact on military spending, making it likely that the poor growth performance in many developing countries during the 1980s and in industrial countries in the latter part of the decade contributed to the fall in the ratio of military spending to output. The type of government in power was also found to be a major influence on military expenditures, implying that the profound political changes that have occurred in many countries may be another factor in the fall in military spending. Future moves toward more democratic forms of government in developing countries could have a further restraining effect on military spending, since democratic regimes were found to spend the least on the military. Finally, the improved global security environment, and the associated fall in the level of military aid, contributed to the decline in military spending.

The projections indicate that world military expenditure relative to GDP will continue on the downward trend started in the mid-1980s. In the industrial countries, the military spending ratio is projected to fall a further 30 percent between 1992 and 1998. The reduction is particularly large in the United States, where the ratio of military spending to output is expected to fall by 40 percent, but large declines are also projected for the EC and other industrial country groups. The projections for developing countries indicate that the proportion of output devoted to military spending will also fall, although by less than in the industrial countries. As with the decline between 1986 and 1992, it is projected to be very general across geographic regions. The region with the largest decline in military spending relative to GDP is the Middle East and Europe. Small, low-income economies are projected to decrease their military spending ratio by a percentage similar to that of developing countries as a whole.

Economic Impact of Cuts in Military Expenditure

The IMF's multiregional macroeconometric model, MULTIMOD, has been used to simulate the economic impact of worldwide military spending cuts.7 The main links among the industrial and developing countries in MULTIMOD are through trade, exchange rates, and interest rates.8 Three features of the model are particularly important for the results. It is a rational expectations model, which means that expectations about future behavior feed back into exchange rates, interest rates, consumption, and investment. It has a well-defined supply side that is based on a production function, so that changes in investment feed through into future potential output. Finally, the trade equations take account of the geographic distribution of trade across different economies.9

At the same time, the limitations of the highly aggregated MULTIMOD framework should be recognized. It combines all government spending and thus limits the extent to which the model can deal with issues related to the conversion from military to civilian production. The model assumes that prices are sticky in the short run, which implies that reductions in military spending lead to temporary reductions in output and employment. However, any estimate of these adjustment costs is inherently uncertain and depends on many factors (such as the timing of the military spending cuts, the macroeconomic policy response, and the size of the government fiscal multipliers).10 In addition, no analysis is made of the distributional consequences of lower military spending for different sectors or regions of a country, an issue of economic as well as political significance. Finally, the aggregate production functions take no account of the fact that some capital currently used in the production of military output may not be convertible to civilian production.11

Before discussing the simulation results, it is important to consider the nature of the economic costs and benefits from cutting military spending.12 Although real GDP is a useful indicator of the shortrun impact of military spending cuts on activity and unemployment, it is not a good measure of the economic benefits of military spending cuts. The appropriate measure of the economic benefits from curtailing military spending is the rise in nonmilitary consumption over time. The total cost of a cut in military spending includes any decrease in security induced by lower military spending; however, this security loss is difficult—or impossible—to measure, particularly for the type of coordinated military spending cuts considered in these simulations. For this reason the analysis focuses on the economic benefits from military spending cuts, while acknowledging that these benefits should be weighed against any impact on national security.

All countries are assumed to simultaneously carry out a 20 percent reduction in military expenditures in equal increments over five years, a reduction broadly comparable to the decline already incorporated in the medium-term projections. Each nation is also assumed to lower its military aid, military imports, and military exports by the same amount, so that the cut can be thought of as a phased reduction in all types of military spending. To illustrate the benefits of military downsizing for a given fiscal policy, the cuts in government consumption were assumed to be accompanied by tax cuts of a sufficient magnitude so as to leave the government deficit unchanged. The monetary base was assumed to remain the same as in the baseline in most industrial countries. The results from a basic simulation (Table 27) are discussed in detail below. The impact of alternative assumptions—such as implementing the spending cuts immediately rather than gradually, or assuming that part of the spending cuts represents a fall in investment rather than consumption—is also discussed.

Table 27.

Impact of a 20 Percent Cut in Worldwide Military Spending

(In billions of 1992 dollars)

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Source: Tamim Bayoumi, Daniel Hewitt, and Steven Symansky, “The Impact of Worldwide Military Spending Cuts on Developing Countries,” IMF Working Paper (1993, forthcoming).Note: Figures in parentheses represent percent deviations from baseline.

Including four newly industrializing Asian economies (NIEs).

Excluding NIEs.

Like any reduction in government spending, the initial impact of the cut in military spending on the industrial countries13 is to reduce the rate of growth of GDP. The short-term fall in aggregate demand reflects the reduction in government spending, which outweighs the higher demand associated with the tax cuts. Lower government spending, however, leads to lower interest rates and allows governments to decrease taxes. Lower taxes and reduced interest rates raise private sector spending on investment and consumption, which reverses the initial decline in output, and GDP rises significantly above the baseline in the medium term and long run.

First-year military spending cuts of $27 billion reduce GDP by $6 billion in the simulation, reflecting an increase in private consumption and private investment of $4 billion and $17 billion, respectively.14 The relatively small initial output loss reflects the gradual nature of the military spending cuts. Given that agents are forward looking, private sector expenditures are stimulated both by current reductions in government spending and by anticipated future reductions, which lower future taxes and interest rates, thereby raising current wealth. Because the cuts are phased in over several years, the short-run stimulus is relatively large in comparison with the initial expenditure cuts, and the shortterm losses to GDP are correspondingly smaller.15

By the second year of the simulation, the output loss is reversed as private spending continues to grow, and by the sixth year of the simulation, when the decreases in military spending have ceased, the economic performance of the industrial countries is considerably improved. By the end of the eleventh year, GDP, consumption, and investment are $60 billion (0.3 percent), $144 billion (1 percent), and $83 billion (almost 2 percent) above baseline, respectively, and military spending is $170 billion lower. The present value of the gain in economic welfare (using a 4 percent discount rate) is estimated to sum to $8.1 trillion, or 45 percent of 1992 GDP, compared with military spending cuts with a present value of $6.5 trillion, or 36 percent of 1992 GDP (Table 28).16

Table 28.

Present Value of Costs and Benefits of Reducing Military Spending in 19921

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Source: Bayoumi, Hewitt, Symansky, “The Impact of Worldwide Military Spending Cuts on Developing Countries.”

The discount rate used in the present value calculations is 4 percent.

Including NIEs.

Excluding NIEs.

Results are also shown separately for the United States and Japan. During 1987-89 (the baseline period for the simulations), military spending in the United States represented 6 percent of GDP, the largest ratio in the industrial countries.17 As might be expected, the short-term impact of this relatively large cut in military spending—1¼ percent of GDP after five years—is to reduce GDP below the baseline for several years. These losses in output are, however, relatively small; over the first five years the cumulative loss in real GDP is some $7 billion (less than 0.03 percent of GDP) compared with cumulative expenditure cuts of almost $250 billion. After eleven years, private consumption and private investment rise by 1¼ percent and 2 percent respectively—somewhat higher than in the industrial countries as a group.

In Japan, military expenditures represent approximately 1 percent of GDP, the smallest ratio among the major industrial countries. Because of Japan’s relatively low military expenditures in proportion to GDP, two very different results occur. First, the initial fall in output is short lived and mild in comparison with that in the United States; by the second year, real GDP is already above the baseline and continues to increase thereafter. Second, the long-run gains relative to GDP are somewhat smaller in Japan than in the United States. By the eleventh year, real consumption and real investment rise by ½ of 1 percent and 1¼ percent respectively.

Although the gains in Japan are smaller than in the United States, the difference is smaller than might be expected given the difference in military spending. The reason for these relatively favorable effects in Japan is that global cuts in military spending create a positive international economic externality: the economic benefits to all countries are greater in the case of a coordinated reduction in military expenditure than in the case of a unilateral reduction. The externality results from lower world interest rates and from increased volumes of international trade caused by the fact that military spending has a lower trade component than the private sector spending that replaces it. Therefore, cross-country differences in welfare gains are smaller than the differences in the underlying cuts.

The welfare calculations illustrate this point (Table 28). At $3½trillion, the present value of the gain in economic welfare in the United States is 54 percent of 1992 GDP, a significantly higher ratio to output than the 31 percent of GDP ($1¼ trillion) of Japan. However, these differences are considerably smaller than the differential in military spending cuts. The United States experiences military spending cuts with a present value of 60 percent of 1992 GDP, whereas those in Japan total only 10 percent of 1992 GDP.

The impact of this externality can also be seen in the results for net debtor developing countries (excluding the NIEs). For this group, the simulation indicates that the response of private consumption and investment is strong enough to offset the contraction in government consumption, so that GDP does not fall even in the short run. As with industrial countries, however, the short-run effects on output and spending are mostly small. The effects are more strongly felt in the medium term; government consumption shows a sharp decrease over this period, and private consumption and investment, along with GDP, show a sharp increase. The eventual increase in GDP, eleven years after the cut in military expenditures, is $12 billion ¼ of 1 percent), whereas private consumption and investment are higher by $23 billion (¾ of 1 percent) and $18.6 billion (2 percent), respectively.

The present value of the welfare gain is 46 percent of 1992 GDP ($1½ trillion). As a ratio to GDP, these gains are marginally higher than those for the industrial countries, compared with military spending cuts having a present value of 33 percent of 1992 GDP (slightly lower than in the industrial countries). These effects reflect several factors. Lower government spending abroad reduces world interest rates and hence reduces interest payments on foreign debt, whereas the replacement of military spending (which is largely on domestic goods and services) with more import-intensive private consumption and investment boosts world trade and raises commodity prices. These international factors tend to improve the external position of the developing countries, allowing them to invest more.18

The results for individual developing country regions illustrate the effect of the size of the relative cuts and the impact of trade patterns on the level and pattern of benefits from decreasing military expenditure. The Western Hemisphere region experiences the smallest cut in military spending. At the same time, its trade relations are predominantly with the United States, which implements the largest cut in military spending among the major industrial countries, and hence has the largest increase in its demand for imports, many of which are from the developing countries in the Western Hemisphere. As a result, the region experiences welfare gains of 40 percent of 1992 GDP—over twice the present value of the military spending cuts of 19 percent of 1992 GDP. The cuts in military spending in Africa are larger than those in the Western Hemisphere when measured in relation to GDP, although smaller in absolute terms. Because Africa’s trade is heavily oriented toward Europe, where military spending in relation to output is lower than in the United States, the boost to exports from cuts in foreign military spending is smaller than for the Western Hemisphere, although Africa does gain significantly from the rise in commodity prices. At 50 percent of 1992 GDP, the welfare gains are the highest of any developing country region and come from military spending cuts of 33 percent of 1992 GDP. The other developing countries, taken as a region, implement the largest cut in military spending. The gains to consumption and investment are, however, relatively modest. This reflects the regional pattern of trade. Unlike Africa and the Western Hemisphere, which export and import to different areas of the world in roughly equal proportions, other developing countries are net importers from Japan and net exporters to the United States. The military spending cuts in the industrial countries lead to a depreciation of the dollar and to an appreciation of the yen. This loss in the terms of trade for the other developing countries leads to a diversion of domestic output into exports. As a result, the welfare gain is only 49 percent of 1992 GDP, compared with military spending cuts of 41 percent.

Military expenditures in net creditor developing countries, primarily oil exporters, are relatively high: 7 percent of GDP. Because a large portion of military expenditure is imported, costs of conversion would be low, since nonmilitary imports can easily be substituted for military ones. As a result, cuts in military spending are immediately replaced by higher private consumption and investment. For these countries, the reduction in military spending of about 1½ percent of GDP is replaced approximately one-for-one by consumption and investment. The present value of this rise in private sector expenditure is 80 percent of 1992 GDP ($569 billion), reflecting the high level of initial military expenditure.

The sensitivity of the simulation results has been examined by running alternative scenarios involving faster implementation of the military spending cuts; failure of the private sector to anticipate spending cuts in the future; less forward-looking consumption and investment; and the assumption that part of the military spending cuts represents a reduction in productive government investment.19 The first three of these variations, which affect the short-term response of demand, tend to make the short-term reductions in GDP larger than in the base case, but they have little effect on the long-run equilibrium and, hence, on the welfare calculations. In contrast, if part of the cut in military spending is considered to be investment, the welfare gains are reduced appreciably, but the short-run response is essentially unaffected.

Annex III Medium-Term Projections

The medium-term projections in the World Economic Outlook are conditional on several technical assumptions and are therefore not necessarily forecasts of the most likely outcomes. These assumptions include unchanged fiscal policy, except for measures already announced and likely to be implemented; unchanged monetary policy (generally interpreted as nonaccommodating, with shortterm interest rates moving in response to changes in inflationary pressures and cyclical conditions); constant real effective exchange rates, except for bilateral rates in the ERM, which are assumed to be constant in nominal terms; and specific assumptions about commodity and oil prices.1

For the developing countries, two scenarios are considered. The baseline scenario assumes that the economic policies underlying IMF-supported adjustment and reform programs will be fully implemented. This is, of course, an optimistic assumption—although the strong performance of many developing countries in recent years clearly suggests that such an assumption is not unrealistic. Nevertheless, in view of earlier experiences, an alternative scenario has also been included that illustrates the implications of possible policy slippages.

Baseline Scenario for Industrial Countries

Real GDP growth in the industrial countries as a group is projected to recover gradually over the next five years, rising from only1¼ percent in 1993 to an average of 3 percent a year in 1995-98 (Table 29). In general, growth is expected to pick up most in those countries that are now near the trough of the business cycle—Japan, Germany, France, and Italy among the major industrial countries. Although this projected recovery is relatively modest, it would be sufficient to reduce gradually the margins of economic slack that have emerged in the past two years. In some countries growth may be restrained by special factors. In Germany, the strains of unification have contributed to a deterioration in international competitiveness, and in Italy the ongoing need for significant fiscal consolidation and the continuing uncertainty in financial markets are expected to weaken growth of domestic demand.

Table 29.

Industrial Countries: Indicators of Economic Performance1

(Anuual percent change unless otherwise noted)

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See the introduction to the Statistical Appendix for the technical assumptions underlying these projections.

In percent of GDP.