Abstract
This Selected Issues paper on Hungary describes the main factors behind the evolution of output in Hungary since 1990, and examines Hungary’s future growth prospects with specific focus on the role that structural and macroeconomic policies can play in enhancing those prospects. In this paper, the shortfall in growth relative to the other advanced transition economies is attributed to relatively slow progress with macroeconomic stabilization, stalled structural reform between 1993 and mid-1995, and specific features in the design of Hungary’s reform program. The paper also analyzes debt dynamics in Hungary.
I. Hungary’s Growth Performance: Has it lived up to its potential?1
A. Introduction
1. Since 1990, as part of its transition from central planning to a market economy, Hungary implemented a comprehensive liberalization of its economic system, correcting relative prices through subsidy cuts, reducing trade distortions, freeing most food prices, hardening enterprise budget constraints, approving new bankruptcy and banking laws, and privatizing state enterprises. As elsewhere in the region, these reforms were accompanied by a sharp drop in output and a surge in inflation. Although the transition toward a market economy is ongoing, the decline in output has been halted and a recovery has begun. This chapter attempts to describe the main factors behind the evolution of output in Hungary since 1990, and examines Hungary’s future growth prospects with specific focus on the role that structural and macroeconomic policies can play in enhancing those prospects.
B. Growth During 1990–96
2. Following more than two decades of gradual reform, Hungary stepped up the pace of transition in 1990. Output began to decline that year, before falling sharply in 1991. The pace of decline moderated in 1992 and 1993 (the year when output reached its lowest level). Between 1989 and 1993, GDP declined by a cumulative 18½ percent. Consistent with typical cyclical behavior during downturns, the bulk of this decline was due to a sharp drop in fixed investment (Figure 1). In 1993, the output decline reflected a marked deterioration in the external accounts as exports collapsed while import growth remained robust.
Real Output in Advanced Transition Countries
(Index; Year -1 = 100)
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, April 1997.Real Output in Advanced Transition Countries
(Index; Year -1 = 100)
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, April 1997.Real Output in Advanced Transition Countries
(Index; Year -1 = 100)
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, April 1997.3. Thereafter, positive—though modest—output growth was restored, initially on the strength of investment and, following the implementation of the 1995 austerity program (see EBS/96/18, 2/5/96) on the contribution of the external sector, which more than offset a steep decline in private consumption. Activity subsequently accelerated sharply, with growth in the fourth quarter of 1996 rising to 3 percent year-on-year, fueled by a combination of strong investment and continued expansion in the external sector. By end-1996, GDP had increased 6 percent from its trough in 1993, but was still well below its level at the beginning of the transition.2
4. This output growth pattern can be contrasted with those in other countries in the region. Annual GDP indices for Hungary, Poland, the Czech Republic, Slovakia, and Slovenia in “stabilization time” (i.e., with the year in which stabilization was initiated in each country denoted as 0), are depicted in Figure 2. For Hungary, year 0 is 1990, when broad-based price liberalization (including the freeing of food prices and adjustments in energy prices) took place, financial policies were significantly tightened, and decisive structural reform efforts began.3 The figure reveals that, in each of the advanced transition countries, output declined steeply in the first and second year following the initiation of reform, but the process of recovery three years out was well established for most of the countries in the chart. By contrast, Hungary endured four consecutive years of negative output growth during the transition. Moreover, the pace of recovery was also slower in Hungary: Specifically, by 1996, GDP had increased between 12 and 24 percent from its minimum level for the other countries in the chart, while in Hungary, output had recovered by only 6 percent.4 To sum up, Hungary’s depression since 1990 was longer and its subsequent recovery flatter than in other advanced transition economies.
Hungary: Contributions to Growth
(in percent)
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, April 1997.Hungary: Contributions to Growth
(in percent)
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, April 1997.Hungary: Contributions to Growth
(in percent)
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, April 1997.5. Two factors may explain this performance: The postponement of macroeconomic stabilization to the mid-1990s; and the slowing of structural reform during 1993 to mid-1995. The postponement of macroeconomic stabilization is apparent from a few macroeconomic indicators. As shown in Figure 3, Hungary’s progress in reducing inflation has been relatively modest, especially compared with other countries, and this factor itself may reflect a lack of resolve in tightening financial policies (van Elkan (1996)).5 Hungary’s current account deficit stood at 9 percent of GDP in 1993–94, compared to a surplus of 1 percent of GDP in 1990–92. Likewise, the deficit of the consolidated government stood above 7 percent of GDP in 1992–94, compared to a surplus of 1 percent of GDP in 1990 and a deficit of 3½ percent of GDP in 1991.
Inflation in Advanced Transition Countries
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, 1997Inflation in Advanced Transition Countries
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, 1997Inflation in Advanced Transition Countries
Citation: IMF Staff Country Reports 1997, 103; 10.5089/9781451817836.002.A001
Source: WEO, 19976. To what extent did the delay in macroeconomic stabilization hamper growth performance? A tentative answer to this question may be found in the empirical literature linking growth to inflation and fiscal performance. A number of empirical studies conclude that growth is adversely affected by inflation. Bruno and Easterly (1995) find this negative relationship is apparent when inflation exceeds 40 percent. However, Sarel (1996) argues that growth is adversely affected by inflation rates as low as the high single digits, with a doubling of inflation from such levels lowering growth by almost 2 percentage points. This evidence would suggest that Hungary’s failure to achieve a sizable and sustained reduction in inflation since 1990 significantly impeded its growth performance. If one takes the average inflation rate of the advanced central and eastern European countries in 1996 and Sarel’s estimates as a base case, slow progress with inflation stabilization could have reduced Hungary’s current growth rate by nearly 2 percentage points.6
7. As to the effect of fiscal imbalances on growth, according to Fischer et. al. (1996b), transition countries which imposed more restrictive financial policies, in the form of a pegged exchange rate and a tight fiscal stance, grew faster during 1992–95.7 Using their estimates, the relative deterioration in Hungary’s fiscal position could explain about ¾ percentage points of the growth shortfall relative to the other advanced transition countries in 1996.8
8. In addition to the slow progress on the macroeconomic front, Hungary’s growth performance may also have been affected by a slowing of structural reform in the period from 1993 to mid-1995. By 1993 Hungary had already made significant progress in establishing a market-based economy, and was assessed by the EBRD to be among the most advanced of the transition countries in this area.9 Among the notable achievements were: more than 90 percent of prices, weighted by their share in the consumption basket, had been freed of administrative controls; licensing and quota restrictions on trade had been virtually eliminated; small-scale privatization was almost complete; and the private sector already accounted for 50 percent of the economy. However, Hungary’s reform process slowed markedly from 1993 to mid-1995, when little headway was made in ensuring the long-term viability of the social security system, dealing with large, loss-making enterprises, restructuring the financial system, or privatization. Moreover, despite efforts at fiscal retrenchment, the size of the public sector did not decline between 1990 and 1995, with the share of consolidated government expenditure remaining at about 50 percent of GDP in 1995.10 A consequence of the still large size of the government sector is the high level of distortionary taxes required to finance it. In particular, the tax wedge on labor income created by contributions to social security remains among the highest in the world, with negative implications for labor market participation and output growth.
9. The importance of maintaining the momentum of structural reform is borne out by several studies. Sachs (1996), for example, finds that for a group of 25 countries from eastern Europe, the Baltics, and the Commonwealth of Independent States, reform (measured in terms broad-based indices of liberalization) is positively correlated with GDP growth during 1989–95, and, therefore, that greater progress in the structural area leads to a smaller cumulative output loss and/or a faster recovery in activity.11 In addition, de Melo et. al. (1996) find that more than half the variation in growth across transition countries is related to differences in economic liberalization, with the latter’s importance depending on both the duration as well as the intensity of reform. Based on the index and econometric results presented in de Melo, Denizer and Gelb (DDG) (1996), Hungary’s annual growth rate would have been ¼ percentage point higher had it achieved the same degree of liberalization as the Czech Republic in 1993 and 1994.12 The importance of sustaining the pace of reform is supported by Selowsky and Martin (1996), who find that reform requires three years to achieve its full effect on growth. On this basis, Hungary’s slowdown in reform during 1993–94 is likely to have retarded output growth until 1996.
10. Third, Hungary’s growth performance may also be related to specific elements in the design of its program. A case in point relates to the establishment of the Bankruptcy Law in January 1992 which, by automatically activating bankruptcy or liquidation procedures in cases in which obligations were overdue by as little 90 days,13 forced into bankruptcy a number of economically viable firms that were affected solely by temporary liquidity problems.14 Moreover, for those firms impacted by the Law, bankruptcy proceedings were excessively protracted, with resolutions requiring two years on average. It is estimated that about one third of Hungary’s industrial enterprises were affected by the Law in 1992–93, with particularly adverse effects on output in the export sector. This is not to say, however, that Hungary’s output performance would have been stronger had the Law not been in place. On the contrary, the Law was a key instrument in reforming the supply-side of the economy. However, had some elements of the Law been designed more carefully, the resulting output loss would have been more contained.
C. Growth in the Medium Term
11. This section employs an aggregate production function approach to assess the implications for Hungary’s medium-term growth rate—say over the next four years—of recent investments in physical and human capital and improvements in productive efficiency, given initial factor endowments and progress to date with structural reform. It argues that, while slow progress with stabilization and a loss of momentum in structural reform may have held down growth thus far, success in attracting foreign direct investment, together with human capital improvements, augur rather well for Hungary’s future growth prospects, as long as policy shortcomings identified in the previous section (such as the still high inflation rate) are rectified.
Physical capital
12. As in other transition economies, Hungary’s stock of physical capital at the beginning of transition was built up from a series of investments guided by motives other than profit maximization. Since these investments were largely irreversible, the stock of “effective” capital under market conditions was less than the initial stock of capital. An estimate of the effective size of the capital stock—and hence of the degree of inefficiency of past investment—can be made by determining the amount of capital required to generate Hungary’s current level of output under market conditions, controlling for other factors including human capital and labor endowments.15 Assuming that misallocated investments cannot be diverted to productive uses, Borensztein and Montiel (1991) find that three quarters of Hungary’s investment under central planning (equal, on average, to 29 percent of GDP in 1960–85) was unproductive.
13. The initial size of Hungary’s capital stock affects its future growth prospects via the productivity of investment, with the low level of Hungary’s effective capital stock implying a relatively high marginal product. This suggests, paradoxically, that the prospects for growth from new investment are more favorable than if efficiency under planning had been greater, and that a relatively modest investment rate could sustain relatively high rates of growth. Indeed, assuming an investment rate of 22 percent of GDP—well below the average for the period 1960–85 and below the current rate of 25 percent of GDP—Borensztein and Montiel’s cross-country growth regressions suggest that Hungary could achieve growth rates of 5–6 percent in the future (assuming that human capital and population growth rates are the same as in 1960–85), similar to rates achieved at present by the other advanced transition economies. While such regressions are suggestive, it is nevertheless worth examining whether other approaches give similar results.
14. Foreign direct investment is frequently argued to be a good predictor of an economy’s future growth performance, especially given FDI’s role as a vehicle for the international transfer of new technologies and management practices, and the empirical evidence on the complementarities between FDI and human capital and between FDI and domestic investment (Borensztein et. al. (1995)). Hungary has indeed been a leader in the region in attracting a large volume of FDI, with cumulative FDI during 1991–96 of US$12.4 billion, almost three times as much as the next largest recipient (Russia), and accounting for nearly two fifths of all regional FDI.16 17 The magnitude of FDI is even more apparent when scaled against the size of the economy, with the ratio of FDI to GDP averaging 5 percent during 1991–96, compared to an average of less 1¼ percent in the other economies of the region.18
15. Cross-country evidence suggests an economically and statistically significant relationship between the FDI/GDP ratio and growth performance, with Borensztein et. al. (1995) finding that a 1 percentage point increase in the former raises growth by 0.85 percentage points.19 If one assumes (conservatively) that the ratio of FDI to GDP in Hungary stabilizes at 1½ percent of GDP during 1997–99 as the privatization process winds down, Hungary’s FDI ratio during the 1990s would amount to about 3 percent of GDP. Using Borensztein et. al.’s regression results, one would conclude that Hungary’s medium-term growth rate is likely to be boosted by about 2½ percentage points on account of the increase in FDI alone.
Labor
16. The demographic profile of Hungary’s population suggests that the size of the labor force will increase only marginally (0.3 percent per annum) during 1997–2000. However, the effective labor supply will be boosted during this period by improvements in educational attainment. As shown in the text table below, secondary school enrollment increased markedly between 1970 and 1992, while enrollment in tertiary education also rose. Moreover, the illiteracy rate also declined (albeit from a very low level). Increased participation in formal education will serve to improve Hungary’s growth potential by raising the average skill level of workers, since the human capital of workers entering the labor force will exceed that of those they replace through retirement. Based on the regression results of Levine and Renelt (1992), the increase in the labor force and in secondary school enrollment from its 1980-rate should raise Hungary’s medium-term potential growth rate by about ¼ percentage point.
| 1970 | 1980 | 1992 | ||
|---|---|---|---|---|
| Enrollment | ||||
| (percent of age group) | ||||
| Secondary | 63 | 70 | 81 | |
| Tertiary | 13 | … | 15½ | |
| Illiteracy rate | ||||
| (percentage of population age 15 and above) | 2 | 1 | … | |
| 1970 | 1980 | 1992 | ||
|---|---|---|---|---|
| Enrollment | ||||
| (percent of age group) | ||||
| Secondary | 63 | 70 | 81 | |
| Tertiary | 13 | … | 15½ | |
| Illiteracy rate | ||||
| (percentage of population age 15 and above) | 2 | 1 | … | |
Factor productivity
17. A major objective of reforms undertaken during the transition is to improve total factor productivity (TFP). Structural reform can affect TFP through two channels. First, existing resources may be reallocated to more productive uses. Policies which further this objective are those which create incentives for more efficient resource allocation (e.g., subsidy reductions, smaller government), facilitate resource mobility (e.g., greater efficiency in financial intermediation), and enhance competition in the domestic economy (e.g., elimination of trade barriers, establishment of the commercial and legal institutions of a market economy). Second, TFP can be boosted by the upgrading of technologies. Greater openness to trade and investment provides a conduit for the international transfer of advanced production techniques and technical knowledge, thereby enabling transition countries to close the technology gap with industrial countries.
18. Evidence from developing countries suggests that improvements in TFP have been an important factor in sustaining economic growth. Between 1971 and 1993, increases in TFP accounted for nearly half (1½ percentage points) of per capita growth among developing countries. Moreover, among successfully-adjusting developing countries that have sustained reform, TFP’s contribution to per capita growth increased to 2½ percentage points (WEO, October 1993). Individual country studies confirm the importance of reform for growth in total factor productivity. For example, in the case of Chile, Lefort and Solimano (1994) find that the contribution of TFP to output growth increased strongly in the period following the implementation of structural reforms, with the rate of growth of TFP rising from about ½ percent per year before reform to 1¼ percent thereafter.20 In the case of Korea, Lee (1996) finds that distortionary tax/tariff incentives reduce TFP growth.
19. The effects of structural reforms on TFP have been examined in a number of studies. With respect to trade reform, Fischer (1993) finds that tariff protection weighted by the volume of trade reduces the efficiency of resource allocation. During the transition, Hungary undertook a substantial liberalization of its trading environment, reducing average tariffs and import surcharges from 7¾ percent in 1990 to 6 percent in 1996, and to a projected 3 percent in 1998. Partly in response, the degree of openness (measured by the trade ratio) has increased from 38 percent of GDP in 1990 to 70 percent of GDP in 1996. Moreover, the orientation of trade has also shifted, with 65 percent of trade now taking place with EU countries. Based on the econometric results of Fischer (1993), greater openness and reduced protection during 1990–99 is likely to boost future TFP growth by ¼ percentage point.
20. In summary, Hungary’s medium-term growth potential could be boosted by 3 percentage points from the combined effects of capital and labor accumulation and improvements in TFP.
Obstacles to growth
21. Output in Hungary expanded by a modest 1 percent in 1996, largely—as argued in Section B—due to slow progress with macroeconomic stabilization. Nevertheless, as discussed above in this section, several factors suggest that Hungary is now poised to see its growth rate pick up significantly, especially on account of its superior performance in attracting FDI. This said, however, future prospects will continue to be circumscribed if progress is not made in durably reducing inflation towards single digit levels.
22. To get some notion of the benefits to medium-term growth prospects from lower inflation, the empirical results from Section B may be brought to bear. In their medium-term macroeconomic forecast, the authorities target a gradual decline in inflation to 8 percent by 2000. Based on the empirical estimates reported above and this target, the planned disinflation could raise potential growth by 1½ percentage points.21 The analysis in the previous three subsections suggested, meanwhile, that factor accumulation (FDI, effective labor) and improvements in TFP flowing from greater openness could, together, boost Hungary’s growth rate by 3 percentage points. All told, therefore, decisive improvements on the stabilization front in line with the authorities’ targets would be consistent with a medium-term sustainable growth rate of 5½ percent.
D. Conclusions
23. This chapter has analyzed Hungary’s growth performance during 1990–96 and its future prospects. The shortfall in growth relative to the other advanced transition economies was attributed to relatively slow progress with macroeconomic stabilization, stalled structural reform between 1993 and mid-1995, and specific features in the design of Hungary’s reform program. In the next few years, growth prospects will be boosted by factor accumulation (especially FDI) and the effects of structural reform on the efficiency of production. This being said, some impediments to growth remain, notably the persistence of relatively high (by regional standards) inflation. Removal of these obstacles, together with continued inflows of FDI and progress with structural reform, could boost Hungary’s growth rate from 1 percent in 1996 to 5–6 percent in the next few years.
References
Berg, Andrew, 1993, “Measurement and Mismeasurement of Economic Activity During Transition to the Market” in M. Blejer et. al. (eds.), Eastern Europe in Transition: From Recession to Growth? Discussion Papers, No. 196 (Washington: World Bank).
Blanchard, Olivier, 1996, “Theoretical Aspects of Transition,” American Economic Review, Vol. 86, No. 2, pp. 117–22.
Borensztein, Eduardo, Jose De Gregorio, and Jong-Wha Lee, March 1995, “How Does Foreign Direct Investment Affect Economic Growth?” NBER Working Paper Series No. 5057.
Borensztein, Eduardo, and Peter Montiel, 1991, “Savings, Investment, and Growth in Eastern Europe,” IMF Working Paper WP/91/61, (Washington: International Monetary Fund).
Bruno, Michael, and William Easterly, 1995, “Inflation Crises and Long-Run Growth,” NBER Working Paper No. 5209.
De Melo, Martha, Cevdet Denizer, and Alan Gelb, 1996, “Patterns of Transition from Plan to Market,” World Bank Economic Review, Vol. 10, No. 3, pp. 379–424.
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Fischer, Stanley, 1993, “Macroeconomic Factors in Growth,” Journal of Monetary Economics, Vol. 32, pp. 485–512.
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Hernandez-Cata, Ernesto, 1997, “Liberalization and the Behavior of Output During the Transition from Plan to Market,” IMF Working Paper WP/97/53 (Washington: International Monetary Fund).
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Levine, Ross, and David Renelt, 1992, “A Sensitivity Analysis of Cross-Country Growth Regressions,” American Economic Review, Vol. 82, No. 4, pp. 942–63.
Sachs, Jeffrey, 1996, “The Transition at Mid-Decade,” American Economic Review, Vol. 86 No. 2, pp. 128–33.
Sarel, Michael, 1996, “Nonlinear Effects of Inflation on Economic Growth,” Staff Papers, International Monetary Fund, Vol. 43, No. 1, pp. 199-215.
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Prepared by Rachel van Elkan.
As in other transition economies, however, measurement problems confound an attempt to compare output levels in the pre- and post-reform periods (Berg (1993)).
Measured by the annual change in their index of liberalization, de Melo et. al.(1996) find that 1990 was indeed the year of most intense reform in Hungary. For the other economies, time 0 was as follows: Poland (1990); Czech Republic (1991); Slovakia (1991); and Slovenia (1990).
Despite the less severe nature of Hungary’s recession, by 1996 its cumulative output loss was only slightly less than the average of the other advanced transition countries. Moreover, owing to faster growth on average in the other economies, the sign of this difference is expected to be reversed in 1997.
Of course, Hungary was spared very high inflation at the outset of reform as a result of significant progress made with price liberalization over the previous two decades.
This estimate is calculated as the product of Sarel’s coefficient on the logarithm of inflation (-0.0248) and the difference in the logarithm of inflation in Hungary in 1996 (24 percent) and the logarithm of average inflation in 1996 in Poland, the Czech Republic, Slovakia and Slovenia (11 percent).
Looking at the experience of 25 countries from eastern Europe, the Baltics, and the Commonwealth of Independent States, Fischer et. al. (1996a) conclude that growth turns positive two years after the initiation of a stabilization program, and rises to 5 percent within four years.
In 1996, Hungary’s government balance (excluding privatization receipts) was 3½ percent of GDP, compared with an average of 1½ percent of GDP among the other advanced transition countries.
De Melo et. al. (1996) confirm Hungary’s ranking as among the top reformers in 1993.
Total government spending in 1995 remained unchanged from its 1990-GDP share because subsidy reductions were offset by increases in spending on social security and debt servicing.
This is consistent with Hernandez-Cata (1997) who finds that, although the initial contraction of aggregate output is much steeper for a strong reformer than for a slow reformer, the subsequent recovery occurs earlier and is more rapid. On balance, he finds that the cumulative loss is lower for the strong reformer.
According to DDG’s indices of liberalization, the Czech Republic was the most advanced reformer in 1993–94, with a weighted index of 90 in each year, whereas Hungary, Poland, Slovakia, and Slovenia had a weighted average index of 84, 84, 83, and 82, respectively.
The automatic 90-day trigger was repealed at end-1992.
In addition during this period, many large state-owned enterprises were able to evade the Law either because of their close links to state banks which continued to extend credit, or through special debt-resolution channels which entailed a large element of debt forgiveness.
This methodology attributes all the inefficiency to capital investment and assumes that all existing capital is fully employed. Therefore, the resulting estimate may overstate the degree of wasteful investment.
Hungary’s position in attracting regional FDI flows reflects, inter alia, its relatively advanced stage of implementation of market reforms and price stabilization; its geographic proximity to major trading partners; the quality of its labor force; the size and income of its domestic market; and tax incentives to foreign investors. The importance of reform for attracting FDI is supported by a recent EBRD survey of investors (EBRD (1995)) which finds that countries which are comparatively advanced with reform and stabilization have attracted a relatively large share of regional FDI. On the basis of nine indicators, Hungary was rated by the EBRD (EBRD (1995, 1996)) as being the most advanced reformer among the transition economies. Selowsky and Martin (1996) draw similar conclusions about the relationship between reform and FDI, based on the DDG index of liberalization. Also supporting the link between reform and FDI is the fact that FDI to Hungary fell sharply in the mid-1990s, coinciding with the period of stalled reform, and rebounded strongly with the acceleration of reform since mid-1995.
The quality of Hungary’s FDI, as measured by the per capita income level of the source country, was also relatively high, with Germany, the United States and Austria contributing about 60 percent of total FDI during 1993–94.
Albania, Belarus, Croatia, Czech Republic, Estonia, Latvia, Lithuania, Macedonia, Moldova, Poland, Romania, Russia, Slovakia, Slovenia, and Ukraine.
Borensztein et. al.’s estimates are based on time-averaged data over ten year blocks. Given the lags that are likely to be present, it is sensible to assume that Hungary’s future prospects will be influenced not only by future FDI, but also by the relatively high rates of FDI in the past. This is the underlying assumption in the exercise below.
They find that the most important factors in explaining the increase in TFP growth were greater external openness (measured by reductions in import protection) and the increase in financial deepening (proxied by the real level of interest-bearing deposits in the banking system).
Calculated on the basis of the average inflation rate during 1997–2000.
