In the two-year period since the Eastern European countries implemented market-oriented economic reform, measured output in the region has declined sharply. Some have argued that the magnitude of the decline (more than 20 percent for the region as a whole) has been overstated by official statistics, either because their coverage excludes all or part of the growing private sector (Berg and Sachs (1991)) or simply because, beginning from an initial situation in which prices are controlled, standard index numbers will generally overstate the extent of the output decline once prices are freed (Osband (1992)). Such explanations do not claim, however, that the output decline is entirely an artifact of official statistics.
The purpose of this paper is to offer some tentative explanation for this output decline by focusing on the experience of three countries—Bulgaria, the Czech and Slovak Federal Republic (CSFR), and Romania—since they initiated reform. The focus on this particular set of countries (hereafter referred to as BCR) is motivated by the fact that they were perhaps the most rigidly centralized economies in the region. While other countries, notably Hungary and Poland, experimented with enterprise autonomy, limited price liberalization, and private ownership before the beginning of large-scale reform, the three BCR countries remained wedded to rigid central planning more or less until the end. The three countries differed significantly, however, in their degree of adherence to financial discipline during the years of central planning. At one extreme was the CSFR, with low foreign debt and relatively few shortages. At the other was Bulgaria with high foreign debt and significant shortages. In Romania, the economy was able to generate—with considerable hardship—external surpluses sufficient to eliminate its foreign debt, but significant internal imbalances were nonetheless apparent.
Although our analysis of the output declines focuses on the move toward a market economy—defined with reference to the date on which most prices were liberalized—it should be noted that the initiation of market-oriented reforms was not a necessary condition for economic activity to decline, as the experience of the former U.S.S.R. (which began to liberalize much later) clearly shows. Nor is it the case that the cumulative decline in output was largest for countries that started the transition earlier, as the Bulgarian case clearly illustrates. Put differently, output was already falling in much of the region even before reforms were initiated, and it is not obvious what the “counterfactual” to the reforms would look like: that is, how far output would have fallen had markets not been liberalized. To a large extent, the fact that output started to collapse before the reforms was a result of the situation of “neither plan nor market” that emerged after the political changes, a situation in which state enterprises were not tightly controlled but did yet not face appropriate incentives.
The average percentage decline in output in the BCR country group in the two-year period ending in 1991 was a relatively large 23 percent, when compared with an average decline in the entire region of about 19 percent.1 In addition, the BCR group contains the Eastern European country that experienced the largest cumulative drop in output over this period (Bulgaria) and also a country that did relatively well (Czechoslovakia). The cross-country variation in the extent of the output decline should prove instructive in the empirical work that follows.
In Bulgaria and Czechoslovakia, the “big bang” of price liberalization occurred in the first couple of months of 1991, while in Romania, which followed a more phased approach, the first major step toward reform was taken in November 1990. The timing, therefore, makes the reform in the trading arrangements of the Council for Mutual Economic Assistance (CMEA) implemented in 1991, with the subsequent collapse in trade among the CMEA-member countries and the terms of trade deterioration experienced by the BCR countries, strong candidates for factors that could account for the decline in activity. This would appear especially true for Bulgaria given the extent of its prior dependence on CMEA-area trade. To some extent, however, the CMEA shock simply reflected a collapse of activities that were no longer competitive once the system of central planning was abandoned and enterprises began to face world market prices for their inputs and outputs. Enterprises operating in such sectors were bound to experience losses in market share to competing firms from third countries. Viewed in this way, the CMEA reform, in conjunction with price and trade liberalization, helped set in motion a series of changes in the BCR countries that, over time, would be responsible for a radical transformation in the productive structure of these economies. This process of resource reallocation could easily generate an initial decline in aggregate output, especially if an expansion of activities that would be profitable under the new relative price structure were delayed by the presence of significant adjustment costs and uncertainty.
Apart from these longer-term “structural” factors, more conventional macroeconomic forces are also likely to have contributed to the output decline. Price liberalization, in conjunction with the policy stance necessary to harness inflation, led to declines in real wages, money, and credit, which likely depressed domestic absorption and output. On the supply side, reductions in subsidies to energy use could also have been important. In addition, binding credit ceilings imposed on state enterprises may have reduced available working capital to such an extent that firms were unable to pay for their inputs, thereby leading them to contract supply and enter into arrears vis-à-vis their suppliers.2
These arguments suggest that the output decline needs to be interpreted with reference to at least two questions. First, to what extent can “structural change” (or a reallocation of resources across sectors), rather than a macroeconomic recession, account for the output decline? Second, to what extent have demand-side rather than supply-side forces been dominant in generating the output decline? This paper empirically investigates these two questions.
With respect to the first question, one would expect that, in response to a new relative price structure, resources would move toward sectors producing goods and services the relative prices of which (and profitability of which) had risen and away from other sectors, in line with comparative advantage. If the type of economic distortions in these countries was similar before reform (say, because energy prices facing domestic producers were “too low”), and if technologies were also similar, resource reallocation would follow a similar pattern in each economy. Thus, evidence of structural change might imply that sector-specific factors were relatively more important than economywide (aggregate) factors in accounting for the evolution of output. We discuss this issue below with reference to an econometric procedure that separates the effects of aggregate versus industry-specific shocks on output changes. Our findings suggest that the bulk of the variance of output in these countries is accounted for by aggregate (or national) factors, with industry-specific components playing only an insignificant role. Therefore, the data do not support the view that much structural change has taken place in the BCR countries since the initiation of reforms.
Corroborating evidence for this view is obtained by using principal components analysis to investigate the proportion of the variance of price and output movements that can be accounted for by a small number of common macroeconomic factors.3 These results are compared with those obtained for a benchmark country, taken here to be the United States. Our results suggest that the first few principal components account for similar proportions of the variances of the price and output series in the BCR countries and in the benchmark country, again consistent with the view that relatively little of the output decline is attributable to structural change. This conclusion is also supported by regressions of output changes on “comparative advantage”—proxied here by measures of “domestic resource cost” (DRC)4—which do not suggest that resources have been moving toward sectors with relatively low DRCs, as a simple version of comparative advantage theory would predict.
The second issue to be investigated in this paper is the relative importance of supply and demand factors. The simplest way of determining which of these factors has been predominant in the evolution of output is to examine the correlations between price and output changes in particular markets. If shocks to the supply (demand) function predominate, this should be reflected in a preponderance of negative (positive) correlations between price and output changes. The evidence presented below suggests that supply disturbances predominate in the cases of both Bulgaria and Czechoslovakia; in the Romanian case, the relative importance of supply and demand shocks seems to vary over time.
The paper also attacks the “supply shock versus demand shock” problem by estimating a simple “supply-demand” model of output determination.5 Such a model allows us to decompose the source of output fluctuations between supply and demand factors. It also allows us to shed some light on the relative importance of various macroeconomic factors (energy price increases, credit contraction, wage increases) in accounting for the output decline.
In this paper, we first briefly review the economic background to the reforms in the three countries, the main components of the reforms themselves, and the salient features of developments in the real sectors of the economies of Bulgaria, Czechoslovakia, and Romania. A second section discusses the structural change hypothesis and presents evidence on the relative importance of national and industry-specific factors in accounting for the output decline. The third section describes the methodology and presents results on the relative importance of demand and supply factors in the output decline.
Aghevli, Bijan B., Eduardo Borensztein, and Tessa van der Willigen, Stabilization and Structural Reform in the Czech and Slovak Federal Republic: First Stage, IMF Occasional Paper No. 92 (Washington: International Monetary Fund, 1992).
Berg, Andrew, and Olivier Blanchard, “Stabilization and Transition: Poland 1990–1991,” paper presented at the Conference on Transition in Eastern Europe, held by National Bureau for Economic Research in Cambridge, Massachusetts, February 1992.
Berg, Andrew, and Jeffrey D. Sachs, “Structural Adjustment and International Trade in Eastern Europe: The Case of Poland,” paper presented to the Economic Policy Panel in Prague, October 1991.
Borensztein, Eduardo, Dimitri G. Demekas, and Jonathan D. Ostry, “The Output Decline in the Aftermath of Reform: The Cases of Bulgaria, Czechoslovakia, and Romania,” IMF Working Paper 92/59 (Washington: International Monetary Fund, 1992).
Borensztein, Eduardo, and Jonathan D. Ostry, “Structural and Macroeconomic Determinants of the Output Decline in Czechoslovakia and Poland,” IMF Working Paper 92/86 (Washington: International Monetary Fund, 1992).
Bruno, Michael, “Stabilization and Reform in Eastern Europe,” Staff Papers, International Monetary Fund, Vol. 39 (December 1992).
Calvo, Guillermo A., and Fabrizio Coricelli, “Stagflationary Effects of Stabilization Programs in Reforming Socialist Countries: Enterprise-Side and Household-Side Factors,” World Bank Economic Review, Vol. 6 (1992).
Demekas, Dimitri G., and Mohsin S. Khan, The Romanian Economic Reform Program, IMF Occasional Paper No. 89 (Washington: International Monetary Fund, 1991).
Dyba, Karel, and Jan Svejnar, “Czechoslovakia: Recent Economic Developments and Prospects,” American Economic Review, Vol. 81 (May 1991).
Hughes, Gordon, and Paul Hare, “Industrial Policy and Restructuring in Eastern Europe,” Working Paper No. 653 (London: Centre for Economic Policy Research, March 1992).
Hughes, Gordon, and Paul Hare, “The International Competitiveness of Industries in Bulgaria, Czechoslovakia, Hungary and Poland,” paper presented at the European Economic Association Conference, August 1991.
Osband, Kent, “Index Number Biases During Price Liberalization,” Staff Papers, International Monetary Fund, Vol. 39 (June 1992).
Prust, Jim, and IMF Staff Team, The Czech and Slovak Federal Republic: An Economy in Transition, IMF Occasional Paper No. 72 (Washington: International Monetary Fund, 1990).
Stockman, Alan C., “Sectoral and National Aggregate Disturbances to Industrial Output in Seven European Countries,” Journal of Monetary Economics, Vol. 21 (March/May 1988).
Eastern Europe is defined to include Poland and Hungary as well as the BCR countries.
For all three countries in the sample, the output decline was concentrated in the industrial sector, and we use disaggregated data from this sector to estimate the model. The necessary data were available for Czechoslovakia and Romania on a monthly basis, while the data available for Bulgaria permitted only a more qualitative assessment.
Reported diversion of trade with the ex-U.S.S.R. through western countries during 1992 makes this a very approximate estimate.
This section draws heavily on Aghevli, Borensztein, and van der Willigen (1992). Other useful references include Begg (1991), Dyba and Svejnar (1991), European Economy (1991), and Prust and IMF Staff Team (1990).
The national unemployment rate was about 6 percent.
Although Romania imported little of its oil from the CMEA area during the 1980s, it was dependent on the U.S.S.R. for almost all of its natural gas and most of its electricity imports. Total primary-energy imports, in tons of oil equivalent, fell by 15 percent in 1990 and more than 41 percent in 1991.
Data on employment are available on a less disaggregated basis than those on output.
The “CMEA shock” contains both structural and macroeconomic elements. On the structural side, one factor behind the collapse in trade has been increased competition from world markets. On the macroeconomic side, foreign exchange constraints and tightness of policies may have reduced the demand for exports among the CMEA-member countries.
Although an important part of the reallocation of resources is likely to involve an expansion in nonindustrial activities (for example, financial and other services), structural change is also likely to involve a substantial reallocation of resources within the industrial sector itself.
Although Stockman (1988) estimates essentially the same regression for a set of industrial countries, he is testing for a different effect, namely evidence of a “real business cycle” in the form of significant industry-specific shocks. There is a small literature on the decomposition of output changes into industry-specific, regional, and national components. Stockman’s methodology was applied here mainly because it imposes fewer structural assumptions on the data than some of the other papers in this literature.
The estimation of equation (1) was carried out by pooling data from 14 industrial sectors for the BCR countries and Poland (data from the other previously centrally planned economies were not available) on samples that begin on the dates of each country’s big bang.
Again, this factor is defined relative to the shock to the energy industry in the four countries, which it is hoped is neutral.
For example, if industries that utilize underpriced inputs intensively are doing so because they have a high elasticity of substitution, the DRC criterion would nevertheless reveal these industries to be among the most uncompetitive, even though in fact they would be hurt relatively less by raising the price of the relevant inputs.
The transformation is necessary because DRCs are not a monotonic measure. The transformation is such that the higher the measure, the more competitive is the sector.
The increase in energy and other input prices would have a large impact on output if enterprises were liquidity constrained or if they faced limited substitution possibilities because of adjustment costs, for example.
Disaggregated price and output data from the industrial sectors in the three countries were collected for this purpose. The number of sectors varied slightly across countries: 16 for Bulgaria; 19 for the CSFR; and 13 for Romania. Data were available for the whole of 1991 for the CSFR and Romania, but only through the third quarter of 1991 in the case of Bulgaria.
Which specific supply and demand shocks have played a role is investigated in the next section.
The necessary data were unavailable in the Bulgarian case.
All input prices, as well as the stock of credit, are deflated by the aggregate industrial price index.
Lack of disaggregated real wage data prevented us from incorporating real wages directly into the supply function. Also, lagged (rather than contemporaneous) employment was used in the specification, in order to avoid problems of simultaneity bias and also to allow for the fact that production takes time.
Although this specification only crudely reflects the Calvo-Coricelli hypothesis, it could represent a model in which the real stock of credit simply represents another input (like labor and capital) into the firm’s production function.
The apparent reason was multicollinearity arising from the correlation between the fixed-effect coefficients and the employment variable.