Disinflation in Transition Economies 9789633865620

Table of contents :
TABLE OF CONTENTS
LIST OF FIGURES
LIST OF TABLES AND APPENDICES
ABOUT THE AUTHORS
FOREWORD
INTRODUCTION
NOTE
1. Disinflation Strategies and Their Effectiveness in Transition Economies
2. Monetary Expansion and Its Influence on Inflation Performance in Transition Economies
3. Money Demand and Monetization in Transition Economies
4. The Influence of Exchange-Rate Stability on Inflation
5. The Inflationary Consequences of the Devaluation Crises in Russia and the Ukraine: First Observations
6. Disinflation Policy, Capital Inflow, and the Current-Account Balance
7 . Modeling the Real Exchange Rate in Transition: The Cases of Poland and Romania
8 . Fiscal Policy and Disinflation in Transition Economies
9. Central-Bank Independence and Its Impact on Inflation in Transition Economies
10. Relative Price Adjustment in the Czech Republic, Hungary, and Poland: A Comparison of the Size and Impact of Inflation
11. The Wage-Price Spiral in Transition Economies
12. Monetary-Policy Targeting in the Central European Transition Economies
13. Prospects for a Future Disinflation Policy in Poland
Index

Citation preview

DISINFLATION IN TRANSITION ECONOMIES

DISINFLATION IN TRANSITION ECONOMIES

Edited by

Marek Dabrowski

..�',,

► CEUPRESS '1 �

Central European University Press Budapest New York

©2003 by Marek Dabrowski English edition published in 2003 by Central European University Press An imprint of the Central European University Share Company Nador utca 11, H-1051 Budapest, Hungary Tel: +36-1-327-3138 or 327-3000 Fax: +36-1-327-3183 E-mail: [email protected] Website: www.ceupress.com 400 West 59th Street, New York NY 10019, USA Tel: +1-212-547-6932 Fax: +1-212-548-4607 E-mail: [email protected]

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any fom1 or by any means, without the permission of the Publisher. ISBN 963 9241 29 6 Cloth ISBN 978-963-386-562-0 ebook Library of Congress Cataloging-in-Publication Data Disinflation in transition economies I edited by Marek Dabrowski. -­ English ed. p. cm. Includes bibliographical references and index. ISBN -- ISBN 1. Deflation (Finance) -- Europe, Eastern 2. Deflation (Finance)--Former Soviet Republics. I. Dabwroski, Marek, l 95 l­ HG930.7 .D575 2002 332.4' l '0947--dc21 2002003867 Printed in Hungary by Akademiai Nyomda, Martonvasar

TABLE OF CONTENTS

List of Figures List of Tables and Appendices About the Authors Foreword (Simon Johnson) Introduction (Marek Dabrowski) Note 1. 1.1. 1.1.1. 1.1.2. 1.1.3. 1.2. 1.2.1. 1.2.2. 1.2.3. 1.2.4. 1.2.5. 1.3. 1.3.1. 1.3.2.

XIII XVII XXIII XXVII XXXIII XL

Disinflation Strategies and Their Effectiveness in Transition Economies (Marek Dabrowski) The Economic Rationale for Disinflation The Damaging Effects of High and Very High Inflation Moderate and Low Inflation: The Danger of Inflation Inertia Results of the Empirical Research The Varying Speeds of Disinflation The Size of the Initial Destabilization The Timing of Disinflation Programs The Speed of Disinflation (until 1997) Inflation Developments, 1998-1999 Reversal of the Disinflation Trend Looking for an Effective Disinflation Strategy Stabilization Strategies in the First Stage of Transition Controversies Surrounding Exchange-Rate Targeting in Moderate- and Low-Inflation Environments

1 1 2 3 6 9 9 9 10 12 14 15 15 17

VI

1.3.3. 1.4. 1.4.1. 1.4.2. 1.4.3. 1.4.4. 1.5.

References Notes 2.

2.1. 2.2. 2.3. 2.4.

References Notes

3.

3.1. 3.2. 3.2.1. 3.2.2. 3.2.3. 3.3. 3.3.1. 3.3.2. 3.3.3. 3.3.4. 3.4. 3.5.

Exchange-Rate Arrangements That Stimulate Inflation Inertia The Role of Fiscal Policy in Supporting the Disinflation Process Monetary Financing of Fiscal Deficits Nonmonetary Financing of Fiscal Deficits Debt-Trap Episodes and Financial Crises The Role of Fiscal Policy and Central-Bank Independence Conclusions

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies (Rafa/ Antczak) Stabilization and Inflation Simple Monetary Accounting Inflation and the Rate of Growth of Broad Money Final Remarks

Money Demand and Monetization in Transition Economies (Marek Jarocinski) "Unfreeezing" the Monetary Overhang Monetization in the Transition Economies Compared Broad-Money Monetization and Per Capita GDP Inflation and Monetization The Banking Sector and Broad-Money Monetization Factors Determining Monetization in the Transition Economies Real GDP and Inflation Dynamics The Shadow Economy The Banking Sector's Circumstances Currency-Board Arrangements High-Monetization Transition Economies Medium-Monetization Transition Economies

21 23 23 25 27 28 30 31 35

37

38 40 46 50 53 54 55

56

57 57 60 62 62 62 63 63 64 65 67

VII Low-Monetization Countries General Characteristics Additional Factors in Low-Monetization Countries How Demonetized Economies Function? Money-Demand Dynamics during Stabilization, Following Hyperinflation Conclusions 3.7. Appendix. Data Sources References Notes

3.6. 3.6.1. 3.6.2. 3.6.3. 3.6.4.

4. 4.1. 4.2. 4.2.1. 4.2.2. 4.2.3. 4.2.4. 4.2.5. 4.2.6. 4.3. References Notes 5.

5.1. 5.2. 5.2.1. 5.2.2. 5.3. 5.3.1.

The Influence of Exchange-Rate Stability on Inflation (Malgorzata Antczak and Urban Gorski) The Transmission Channels of a Currency Depreciation on Prices Inflation and Currency-Depreciation Rates in a Simple Analytical Framework Exchange-Rate Stability The Partial-Adjustment Model Hypothesis Data Results of the Estimates Some Additional Comments When is an Exchange-Rate Anchor Sustainable?

The Inflationary Consequences of the Devaluation Crises in Russia and the Ukraine: First Observations (Marek Dabrowski, Urban Gorski, and Marek Jarocinski) The Crises: Similarities and Differences The Crisis Spiral Develops Dynamics of the Russian Crisis Ukrainian Follow-up Explaining Jhe Initial Inflation Surge The Influence of the Exchange-Rate Depreciation on Prices in Russia

71 71 74 74 76 80 81 81 83

85 85 87 87 89 89 90 91 93 94 100 101

103 103 107 107 109 110 110

VIII 5.3.2.

Expectations and Speculative Demand during the Initial Price Spike 5.3.3. The Influence of the Exchange-Rate Depreciation on Prices in the Ukraine 5.3.4. The Role of Administrative Price Controls 5.4. Channels of Money Supply and Money Velocity 5.4.1. Money Supply in Russia Monetary Aggregates in the Ukraine 5.4.2. 5.5. Comparing the Inflationary Consequences of the Financial Crises Final Remarks 5.6. Appendix. Data Sources References Notes 6.

6.1. 6.2. 6.2.1. 6.2.2. 6.2.3. 6.2.4. 6.2.5. 6.3. 6.4. 6.5. 6.5.1. 6.5.2. 6.6. References Notes

Disinflation Policy, Capital Inflow, and the Current-Account Balance (Krzysztof Rybinski and Mateusz Szczurek) The Determinants of Foreign Borrowing Policymakers' Responses to Capital Inflows: Theoretical Models The Absorption Approach Responding to Capital Inflows: The Proper Policy Mix Meade's Internal-External Balance Synthesis Mundell's Assignment Problem Intertemporal Current-Account Models What Determines the Current Account's Improvement? The Current Account-Inflation Trade-off: The Causality Issue Capital Inflows, Exchange Rates, and Inflation: The Czech Republic, Hungary, and Poland Panel Analysis PPP Model Analysis Summary and Conclusions

114 116 118 119 119 122 125 128 129 129 130

13 1 131 133 133 138 142 143 144 149 151 152 152 159 167 169 172

IX 7.

Modeling the Real Exchange Rate in Transition: The Cases of Poland and Romania 173 (Mary/a Maliszewska) 7.1. Theoretical Considerations 174 Modeling Real Exchange Rates in 7. 1. 1. 174 Developed Economies Modeling Real Exchange Rates in 7. 1.2. the Transition Economies 176 7.2. Empirical Research: Characteristics of the Model 178 180 7.3. The Real Exchange Rate in Romania General Characteristics 7.3.1. 180 183 7.3.2. Data Description 7.3.3. Methodology and Results 183 7.4. The Real Exchange Rate in Poland 186 General Characteristics 7.4. 1. 186 189 7.4.2. Data Description 189 7.4.3. Methodology and Results 192 7.5. Conclusions References 192 Notes 193 8. 8.1. 8.2. 8.3. 8.4. 8.4.1. 8.4.2. 8.4.3. 8.4.4. 8.4.5. 8.5. References Notes

Fiscal Policy and Disinflation in Transition Economies (Malgorzata Markiewicz) The Interrelationship between Fiscal Deficits and Inflation Budget Deficits in the Early Stage of Transition Quasi-Fiscal Arrangements The Consequences of Nonmonetary Deficit Financing The Hungarian Crisis: 1994 The Bulgarian Crisis: 1994 and 1996-1997 The Russian Crises: 1997-1998 The Ukrainian Crisis: 1997- 1998 The Crises in Kyrgyzstan: 1996 and 1998 Conclusions

195 195 200 201 204 205 208 211 213 214 2 15 217 2 18

X Central-Bank Independence and Its Impact on Inflation in Transition Economies (Wojciech Maliszewski) Central-Bank Independence: 9. 1. Economic Theory and Empirical Evidence Economic Theory and Transition Realities 9.2. 9.3. Indices of Legal Independence Revisions in Central-Bank Laws 9.4. Central-Bank Independence and 9.5. Inflation Performance 9.6. Conclusions Appendix. Central-Bank Laws in the Transition Economies References Notes

9.

219 220 22 1 223 227 230 234 235 24 1 244

Relative Price Adjustment in the Czech Republic, Hungary, and Poland: A Comparison of the Size and Impact of Inflation (Przemyslaw Wozniak) 245 10. 1. Inflationary Pressures Derived from Relative Price Variability 246 10.1.1. 246 Theoretical Framework Relative Price Variability: Visual Inspection 10.1.2. 249 and the Model 25 1 10.1.3. Description of the Data 10.2. 256 Sources of Relative Price Variability 10.2.1. 257 Outlier Price Changes 263 10.2.2. Seasonality 265 Relative Prices of CPI Aggregates 10.2.3. 270 10.2.4. The Evolution of Price Structures 277 Summary and Conclusions 10.3. 278 Appendix. Data Sources 280 References 28 1 Notes 11. 11. 1. 11. 1. 1. 11. 1.2.

The Wage-Price Spiral in Transition Economies (Mateusz Walewski) 285 286 The Wage-Price-Relationship Theory The Wage-Price Spiral 286 Wage-Price-Equation Theory 287

XI 290 Empirical Research on the Wage-Price Spiral Graphical and Statistical Analysis of 29 1 Wage-Price Relations 29 1 The Data Source 11.3. 1. The Price-Wage Relationship 11.3.2. 292 during High-Inflation Periods 11.3.3. Graphical Analysis of the Data from a Moderate-Inflation Period 294 Statistical Analysis of the Relationship between 11.3.4. Wages and Unemployment and Productivity 294 Econometric Analysis of the Relationship 11.4. 296 between Prices and Wages 11.4. 1. Econometric Results from High-Inflation Periods 297 11.4.2. Econometric Results from High-Inflation Periods without the Unemployment Variable 299 11.4.3. Results of Analysis of a Moderate-Inflation Period 30 1 with the Unemployment Variable Included 11.4.4. Results of Estimated Equations for 303 Moderate-Inflation Periods 11.5. 3 10 Summary and Conclusions Appendix 3 12 References 326 Notes 327 11.2. 11.3.

12.

12. 1. 12.2. 12.3. 12.4. 12.5. 12.6. References Notes

Monetary-Policy Targeting in the Central European Transition Economies (Lucjan T. Orlowski) A Review of Monetary-Targeting Practices before 1998 Forward-Looking versus Backward-Looking Monetary Policies The Advantages of Direct Inflation Targeting (DIT) A Model of Direct Inflation Targeting for Central Europe Core-Inflation Targeting in the Czech Republic A Synthesis

329

329 334 337 339 343 345 346 348

XII 13.

13. 1. 13.2.

13.3. 13.4. References Notes Index

Prospects for a Future Disinflation Policy in Poland (Witold M. Orlowski) Future Inflation: The Structural Factors The Exchange Rate, Inflationary Expectations, and the Current-Account Deficit The Experiences of EU Countries Poland's Macroeconomic Policy and Inflation

349 349

352 354 355 360 361 363

LIST OF FIGURES

Figure 1.1.

Annual Inflation and Per Capita Growth Rates, 1960-1992

Figure 3.1. Figure 3.2.

Broad-Money Monetization Compared, 1995 Broad-Money Multiplier and Monetization in Nontransition Economies and Transition Economies, 1996

Figure 5.1. Figure 5.2. Figure 5.3. Figure 5.4. Figure 5.5. Figure 5.6. Figure 5.7. Figure 5.8.

Official Exchange Rates, RUR/USD and UAH/USD CPI and the Official Ruble-Dollar Exchange Rate (July 31 = 100) CPI and the Official Ruble-Dollar Exchange Rate (Percent Change) The Ukraine: Major CPI Components and the Official UAH/USD Exchange Rate (Weekly Percent Change) Russia: Monthly Nominal GDP, M2, and Velocity, 1997-1998 The Ukraine: Monthly Nominal GDP, M2, and Velocity, 1998 Monthly CPI Changes in Russia and the Ukraine, August 1998-January 1999 (in Percent) Monthly IPI Changes in Russia and WPI Changes in the Ukraine, August-December 1998 (in Percent)

7 57 62 108 111 111 117 122 124 125 126

XIV Figure 5.9. Figure 5.10. Figure 6.1. Figure 6.2. Figure 6.3. Figure 6.4. Figure 6.5. Figure 6.6. Figure 6.7. Figure 6.8. Figure 6.9. Figure 6.10. Figure 6.11. Figure 6.12. Figure 6.13. Figure 7.1. Figure 7.2. Figure 7.3. Figure 7.4. Figure 7.5. Figure 7.6.

Fiscal Balance in Russia and the Ukraine (Percent of GDP) Changes in Domestic-Money Supply in Russia and the Ukraine (in Percent)

127 128

Actual Fiscal Balance Swan Diagram Internal and External Balances and the Fiscal-Monetary Mix Real Effective Exchange Rates (Higher Values Reflect Appreciation) Percentage Appreciation of REER and Percentage Change in Annual Inflation (CPI) Percentage Appreciation of the NEER and Percentage Change in Annual Inflation (CPI) Percentage Appreciation of the REER and the Current Account Percentage Appreciation of the NEER and the Current Account Percentage Appreciation of the REER (One-Year Lagged) and the Current Account Percentage Appreciation of the REER and the Capital Account Percentage Appreciation of the NEER and the Capital Account Percentage Appreciation of the REER and the Change in Official Reserves Percentage Appreciation of the NEER and the Change in Official Reserves

139 143

Romania: The Real Exchange Rate Consumer and Producer Price Indexes and the Ratio of the CPI to the PPI The Real Producer Wage and Industrial-Labor Productivity Poland: The Real Exchange Rate Consumer and Producer Price Indexes and the Ratio of the CPI to the PPI The Real Producer Wage and Industrial-Labor Productivity

180

144 153 154 154 155 156 156 157 157 158 159

181 182 187 188 188

xv Figure 9.1. Figure 9.2. Figure 9.3.

Political Independence and CPI Inflation, 1996 (Dec.-to-Dec.) Economic Independence and CPI Inflation, 1996 (Dec.-to-Dec.) Legal Independence and CPI Inflation, 1996 (Dec.-to-Dec.)

230 231 231

Inflation and Relative Price Variability Cumulative Relative Price Changes I USD Nominal and Real Exchange Rates (Falling Indexes Indicate Real Exchange-Rate Appreciation)

250 266

Figure 11.1.

Wage Setting, Price Setting, and NAIRU

289

Figure 12.1.

A Model of DIT in the Transition Economies at Different Stages in the EU-Accession Period

341

Figure 13.1.

Corrective and Inertia-Based Inflation: The Standard Deviation of Monthly Inflation in 31 Groups of Goods and Services Nominal Convergence in the Mediterranean Countries Nominal Anchors: Exchange Rate (XR) (Annual Devaluation Rate and Annual CPI Inflation) Nominal Anchors: Wages (Annual Increase in Nominal Wages and Annual CPI Inflation) Nominal Anchors: Money Supply (Annual Increase in M2 and Annual CPI Inflation)

Figure 10.1. Figure 10.2. Figure 10.3.

Figure 13.2. Figure 13.3. Figure 13.4. Figure 13.5.

267

350 356 358 358 359

LIST OF TABLES AND APPENDICES

Table I.I. Table 1. 2. Table 1.3. Table 1.4. Table 1. 5.

Table 2.1. Table 2. 2. Table 2.3. Table 2. 4. Table 2.5. Table 3. 1. Table 3. 2.

Inflation and GDP Growth in Upper- and Upper-Middle-Income Countries, 1960-1996 Inflation and GDP Growth in Lower- and Lower-Middle-Income Countries, 1990-1996 The Speed of the Disinflation Process (until 1997) Year-End Inflation, 199 1- 1999 Overall Government Balances and Central-Bank Financing of Governments, 1992- 1997 (as a Percent of GDP) Inflation and Monetary Aggregates (Annual Percent Change) Components of Reserve-Money Creation, Broad Money, and the Multiplier Monetization and Velocity Inflation and Broad-Money Correlation Coefficients Fiscal and External Balances Broad-Money Monetization and Its Relationship with PPP Per Capita GDP, 1995 Transition Economies Sorted by the Error of the Broad-Money Monetization Forecast Based on the Relation Estimated for the Rest of the World

7 8 11 13 24 38 42 47 49 51 58

59

XVIII Table 3. 3. Table 3. 4. Table 3. 5. Table 3.6.

Table 4. 1. Table 4.2. Table 4.3. Table 4.4.

Table 5.1. Table 5.2.

Table 5.3. Table 5. 4. Table 5. 5. Table 5.6. Table 5. 7. Table 5.8. Table 5.9.

Broad-Money Monetization in 1 995: Estimation the Relationship of PPP Per Capita GDP and Average Inflation, 1 985- 1 995 High-Monetization Transition Economies, Basic Indicators Medium-Monetization Transition Economies, Basic Indicators Low-Monetization Transition Economies: Monetization (Excluding Foreign-Currency Deposits), Inflation, and Real GDP Dynamics Exchange-Rate Stability and Inflation Results of Hypothesis Testing Macroeconomic Indicators: Poland, Hungary, the Czech Republic, Slovakia, and Russia, 1993- 1 997 Macroeconomic Indicators: Estonia, Latvia, Lithuania, Slovenia, and the Ukraine, 1 993- 1 997, and Russia, 1 993- 1997 Macroeconomic Indicators, 1994-1997 CPI, of which Food, Nonfood, and Services; Industrial Production Price Index (IPPI), and the USD Official Exchange Rate (Percent Change) Russia: Price Changes of Selected Food Products, September 1 988 Russia: Price Changes of Selected Nonfood Items, September 1988 Russia: Price Changes of Selected Services, September 1998 Price and Exchange-Rate Changes, August-December 1998 (Percent Change) Russia: Monetary Supply, July-November 1998 (Billion Rubles) Russia: Changes in the Domestic Broad-Money Supply, Following the August Crisis The Ukraine: Selected Monetary Aggregates, August-December 1 998

60 65 69 71 91 92 96 98 106

1 12 1 12 1 13 114 116 119 121 1 23

XIX Table 6. 1. Table Table Table Table

6.2. 6.3. 6. 4. 6. 5.

Table 6. 6. Table 6. 7. Table 6. 8. Table 6. 9. Table 6. 10. Table 6. 11. Table 6. 1 2. Table 6. 13. Table 7. 1. Table 7.2. Table 7.3.

Table 7. 4.

Table 8. 1. Table 8.2. Table 8.3.

Macroeconomic Indicators of Countries Affected by Currency Crises ADF Test Results for the Polish Zloty ADF Test Results for the Czech Korona ADF Test Results for the Hungarian Forint The Zloty Market Rate and the PPP Rate, December 1997 Zloty Overvaluation(+) and Undervaluation(-), December 1997 The Korona Market Rate and the PPP Rate, December 1997 Korona Overvaluation(+) and Undervaluation(-), December 1997 The Forint Market Rate and the PPP Rate, December 1997 Forint Overvaluation(+) and Undervaluation(-), December 1977 PLN Valuation-Sensitivity Analysis CZK Valuation-Sensitivity Analysis HUF Valuation-Sensitivity Analysis Co-Integration Statistics for REER_US and RPROD, R_PRICES and R_WAGE, April 1992-December 1997 Co-Integration Statistics for the Extended Model of the REER_US, April 1993-December 1997 Co-Integration Statistics for the Real Exchange Rate (RER_US), Relative Productivity, and Relative PPI to CPI, January 1992-December 1997 Co-Integration Statistics for the Extended Model of the REER_US in Poland, January 1992-December 1997 Quasi-Fiscal Operations (as Percent of GDP) Hungary: Selected Economic Indicators, 199 1-1997 Bulgaria: Selected Economic Indicators, 1993-1997

15 1 162 162 162 164 164 164 164 165 165 166 166 167

184 185

190 19 1 203 208 2 10

xx Table 9. 1. Table 9.2. Table 9. 3. Table 9. 4. Table 9. 5. Table 9.A l . Table 9.A2. Table 9.A3. Table 9.A4. Table 10. 1 Table Table Table Table Table Table

10. 2. 10. 3 10. 4. 10. 5. 10. 6. 10. 7.

Table 10. 8. Table 10. 9. Table 10. 10. Table 10. 11. Table 11. 1. Table 11. 2. Table 11. 3.

Index of Political Independence (Pl), 1996 Indices of Economic Independence (El) and Legal Independence (Pl + EI), 1996 Inflation, Stabilization Programs, and Revisions in Central-Bank Laws, 1989-1997 Inflation, Transition-Progress Indicators, and Fiscal Balances, 1996 Relationship between 1996 Inflation and Central-Bank Independence (OLS) Constraints on Central-Bank Credit to Government Central-Bank Governors Central-Bank Boards Monetary Policy Mean and Standard Deviation of the Theil Statistics Modeling Inflation with OLS (Money Model) Modeling Inflation with OLS (Wage Model) Regression Results: Pooled Coefficients Outlier Price Increases Inflation and Seasonality Comparison of Price Levels, 1993 (Austrian Indexes = 100) Evolution of the Price Structure in the Czech Republic Evolution of the Price Structure in Hungary Evolution of the Price Structure in Poland The Price Structure in 1997 Relative to 1993 (Simulation) Main Characteristics of the Price-Wage Relationship during Periods of Very High Inflation Correlation Coefficients between Wages, Productivity, and Unemployment during Moderate Inflation Econometric Results of Estimated Wage Equations for Russia and Romania during High Inflation (with Unemployment)

225 226 228 232 233 235 237 238 240 252 252 253 255 257 264 271 272 273 274 277

293 295 298

XXI Results of the Econometric Analysis of the Data on Romania during a Very-High-Inflation Period (January 1992-April 1994) 300 Table 11. 5 Results of the Econometric Analysis of the Data on Russia during a Very-High-Inflation Period (February 1993-April 1995) 301 Table 11. 6. Results of Econometric Analysis of the Wage Equation with the Unemployment Variable Included for Moderate-Inflation Periods 302 Table 11. 7. Results of Econometric Analysis of Data for the Czech Republic during a Moderate-Inflation Period (February 1994-January 1997) 304 Table 11. 8. Results of the Econometric Analysis of the Data for Kazakhstan during a Moderate-Inflation 305 Period (January 1996-February 1997) Table 11. 9. Results of the Econometric Analysis of the Data for Lithuania during a Moderate-Inflation Period (March 1994-February 1997) 305 Table 11. 10. Results of the Econometric Analysis of the Data for Latvia during a Moderate-Inflation Period 306 (April 1993-February 1997) Table 11. 11. Results of the Econometric Analysis of the Data for Poland during a Moderate-Inflation Period (February 1991-February 1997) 307 Table 11. 12. Results of the Econometric Analysis of the Data for Romania during a Moderate-Inflation 308 Period (January 1995-February 1997) Table 11. 13. Results of the Econometric Analysis of the Data for Slovenia during a Moderate-Inflation Period (February 1993-April 1996) 310 Appendix 11.1. Price- and Wage-Inflation in a Moderate-Inflation 312 Period Appendix 11.2. Price- and Wage-Inflation Crossplots in a Moderate-Inflation Period 315 Appendix 11.3. Price- and Wage-Inflation and Priceand Wage-Acceleration in a High-Inflation 318 Period in Russia and Romania Appendix 11. 4. Real Wage Changes and Unemployment 320 in a Moderate-Inflation Period Table 11. 4.

XXII Appendix 11.5. Price- and Wage-Inflation Accelerations in a Moderate-Inflation Period

323

Table 12.1.

Selected Monetary Indicators in the Czech Republic, Hungary, and Poland

333

Table 13. 1.

Price Levels of Various GDP Components in Poland and in Selected EU Countries, 1994 (Average OECD prices == 100)

351

ABOUT THE AUTHORS

Marek Dabrowski is a professor of economics, a founder of the Center for Social and Economic Research (CASE), Warsaw, and chairman of the CASE Foundation Council. Since 1991 he has been a policy advisor to governments and central banks in Bulgaria, Georgia, Kyrgyzstan, Kazakhstan, Macedonia, Moldova, Mongolia, Romania, Russia, Ukraine, Uzbekistan, and Yugoslavia. In 1989-1990 he was first deputy minister of finance of Poland. From 1991 to 1993 he was a deputy of the Sejm (the lower house of the Polish Parliament). From 1991 to 1996 he was the chairman of the Council of Ownership Changes, an advisory body to the prime minister of Poland. In 1994-1995, he was a visiting consultant to the World Bank's Policy Research Department. Since 1998 he has been a member of the Monetary Policy Council of the National Bank of Poland. His recent research interests concentrate on macroeconomic-policy prob­ lems and the political economy of transition. Malgorzata Antczak earned an M.A. in economics at Warsaw University, in 1994. Since 1995 she has been a researcher at the Center for Social and Economic Research (CASE). She was a co-author of the UN Human Development Report for Poland in 1997-1998. Her research interests include stabilization programs in transition economies, exchange-rate pol­ icy, fiscal policy, and privatization. Rafal Antczak earned an M.A. in economics at Warsaw University, in 1994. He has been a researcher at the Center for Social and Economic Research (CASE) since 1993. Since April 1994 he has participated in policy advising and policy research in Belarus, Kazakhstan, Kyrgyzstan, Poland, Russia, and the Ukraine. His research interests include macro-

XXIV

Disiriflation in Transition Economies

economic policy of transition economies, monetary policy, and foreign trade.

Urban Gorski earned an M.A. in economics at the University of Sussex, UK, in 1 996. From 1 997 to 1 999 he was a researcher at the Center for Social and Economic Research (CASE), where he participated in CASE 's advisory proj ects to the government and national bank of Ukraine. Since 1 999 he has worked as an economist at Commerzbank, in Prague. His research concentrates on the macroeconomic policies of transition economies. Marek Jarocinski graduated with a MSc. degree in economics, in 1 99 7 , from the Catholic University i n Leuven, Belgium. I n 1 998, h e graduat­ ed from Warsaw University's Department of Economics, Program Columbia. He has been a researcher at the Center for Social and Economic Research (CASE) since 1 997. In 1 997-98 he participated in the CASE advisory proj ect to the government and national bank of Georgia, and in 1 999-2000, he participated in a similar proj ect in Moldova. He is present­ ly a postgraduate student at the University of Barcelona. His research focuses on the macroeconomic policies of transition economies. Maryla Maliszewska obtained an M.A. in international economics from the University of Sussex, UK, in 1 996, and an M.A. in economics from Warsaw University, in 1 997. Since 1 996 she has been a researcher at the Center for Social and Economic Research (CASE) . From 1 997 through 1 999 she worked in Romania as a member of the Pro Democratia-CASE International Macroeconomic Advisory Group. She is presently a Ph.D. candidate at the University of Sussex, UK. Her research interests include foreign trade and balance-of-payments and exchange-rate issues. Wojciech Maliszewski obtained an M.A. in international economics from the University of Sussex, UK, in 1 996, and an M.A. in economics from Warsaw University, in 1 997. He has been a researcher at the Center for Social and Economic Research (CASE) since 1 996. In 1 997-2000, he worked in Romania as a member of the Pro Democratia-CASE International Macroeconomic Advisory Group. He is presently a Ph.D. candidate at the London School of Economics. His research interests include monetary and fiscal policies and the political economy of transi­ tion.

About the Authors

XXV

Malgorzata Markiewicz earned an M.A. in economics from Warsaw University, in 1994. Since 1995 she has been a researcher at the Center for Social and Economic Research (CASE), where she participates in pol­ icy advising and research on Georgia, Kyrgyzstan, and the Ukraine. In 2000, she was a visiting fellow at the Bank of Finland. Her areas of research include macroeconomic policy of transition economies, fiscal policy, and public-debt issues. Lucj an T. Orlowski is a professor of economics and international finance and the chairman of the Department of Economics and Finance at Sacred Heart University, Fairfield, Connecticut. He is a member of the Macroeconomic Policy Council of the minister of finance of Poland and a member of the Center for Social and Economic Research (CASE) Advisory Council. He has been a consultant to various research, finan­ cial, and government institutions in the US and Europe and is a region­ al editor of the Journal of Emerging Markets. His research focuses on sta­ bilization policies in transition economies and emerging international financial markets. Witold M. Orlowski obtained a Ph.D. from Lodz University and a habil­ itation degree from Warsaw University, where he is a professor. He is the director of the Center for Economic and Statistical Research of the Central Statistical Office and Polish Academy of Sciences. He is also the presi­ dent of the Independent Center for Economic Research (NOBE). From December 200 1 he is the Economic Advisor to the President of Poland. He was previously with the World Bank and is presently affiliated with the Center for Social and Economic Research (CASE). His current research interests include the problems of macroeconomic policy in tran­ sition economies and the macroeconomics of EU accession. Krzysztof Rybinski obtained an M.A. in mathematics and computer sci­ ences, an M.A. in economics, and a Ph.D. in economics, all from Warsaw University, where he has taught economics and econometrics of financial markets. He was a consultant with the World Bank, a research fellow at Central European University, and the administrative director of the Central European Economic Research Center of Warsaw University. Presently he is the chief economist of BZWBK Bank and is affiliated with the Center for Social and Economic Research (CASE). He is the author of numerous scholarly articles on economic policy, financial markets, and econometric theory.

XXVI

Disiriflation in Transition Economies

Mateusz Szczurek earned a B .A., with honors, from Columbia University and Warsaw University as well as an M.A. in international eco­ nomics from the University of Sussex, UK, and an M.A. in economics from Warsaw University. At present he is with the Warsaw Branch of the ING Barings, where he analyzes macroeconomic developments in Poland and fixed-income instruments, and is affiliated with the Center for Social and Economic Research (CASE). Mateusz Walewski obtained an M.A. in international economics from the University of Sussex, UK, in 1998, and an M.A. in economics at Warsaw University, in 1998. Since 1997 he has been a researcher at the Center for Social and Economic Research (CASE). Since 2000 he has been involved in the USAID-sponsored policy-advising project, in Georgia. His research interests focus on labor-market and inflation issues. Przemyslaw Wozniak earned an M.A. in economics, with distinction, from Warsaw University, in 1997. Since 1996 he has been a researcher at the Center for Social and Economic Research (CASE). He has won research and scholarship grants from the University of Arizona ( 1995-1996), the World Bank ( 1997, Summer Internship), Georgetown University ( 1998--1999), and the IMF (200 1). His research interests include the macroeconomics of transition, particularly, relative prices and inflation issues.

FOREWORD by Simon Johnson, Sloan School ofManagement, MIT

Ideas matter. Economists tend to treat ideas, whether about social orga­ nization or about technology, as exogenous-----something "outside the model." But this is clearly not historically correct. All the important eco­ nomic and political ideas of the past 500 years, whether the joint-stock company or effective constraints on the executive, came from somewhere. In most cases, the ideas can be traced back to a few individuals thinking in isolation; but the real impetus usually comes when a relatively cohe­ sive group of people focus intensively on an idea and determine how to make it work in practice. A good example is the development of the idea of economic reform for countries with Soviet-type communist regimes. It is hard to know pre­ cisely where the original notion originated, but elements of the idea can be traced back to the early 1 950s (Yugoslavia), 1 956 (Hungary and Poland), and 1 965- 1 968 (Hungary and Czechoslovakia). We can also find important precursors in writings from the 1 920s and 1 930s. Self-man­ agement in Yugoslavia may also have had an impact, particularly as man­ ifested in its 1 966-1972 phase, although ultimately the Yugoslav eco­ nomic experience has become more of a lesson about what not to do. But the most important steps toward what became the most important model of reform definitely occurred in Poland, during the 1 980s. A relatively small number of Polish economists-----working closely with, and often named after, Leszek Balcerowicz-thought long and hard about the problems of communism and socialism. The origins of their work can be traced back at least to the fall of 1 978; and by the summer of 1 980 they already had a radical project for "socialist-market reform." During the 1 980s this group looked at alternative models and paid careful attention to the known facts about how they worked. Gradually and carefully they

XXVIII

Disinflation in Transition Economies

developed the idea that only a relatively dramatic change in the economy could induce real improvement in living standards. This was a new idea, building on previous notions of reform, but really quite an innovation. By 1 988 or early 1 989 this idea was fairly well developed and considerable effort had gone into thinking about the details. Yet while appealing in terms of economic analysis, it seemed quite unrealistic politically. Unexpectedly, in mid- 1 989, the Balcerowicz group found the oppor­ tunity to apply these new ideas about reform. In fact, faced with severe macroeconomic imbalance, including pervasive shortages, they were handed what seemed to many to be the poisoned chalice of an opportu­ nity to implement their policies. We will never know what the commu­ nist rulers of Poland and the Soviet Union were really thinking, but most likely their hope and expectation was that Solidarity-backed reform would either fail or, at best, achieve small changes in the existing social and eco­ nomic structure of Poland. Poland 's severe macroeconomic problems-­ particularly inflation-would surely prevent any effective attempt to deal with deeper structural issues. It is now frequently forgotten that the so-called Roundtable Agreements of early 1 989, while opening the door to political change, also lit the fuse on a hyperinflationary time bomb. Wages were supposed to rise by 80 per­ cent of the increase in consumer prices, and the procommunist All-Poland Alliance of Trade Unions pressed hard for 1 00 percent indexation. Wages in the budget sphere, including education, health services, and general administration of the state, were to rise in line with increases in industrial wages. Pensions were to be indexed, with the indexation payments made directly from the government budget. At the same time, many agricultural prices were freed from controls and therefore began rapidly to increase. As the events of 1 989 unfolded, workers also seized effective control over many state enterprises, creating the possibility that wages would rise even more. The final action of the communist government, in August 1 989, was to free all food prices. With indexation in place, there was a surge in inflation and, naturally, a fall in the real value of tax revenues (taxes were not fully indexed). Poland was on the edge of runaway hyperinflation. The communi sts had quit power but left behind a seemingly intractable situ­ ation. Surely it seemed reform could not for long survive. Hyperinflation would in all likelihood sweep away all attempts at coherent change. Confounding all expectations, the Polish government, in September 1 989, was able to act effectively. The government survived those difficult few months and created a set of irreversible (in hindsight) changes. It also initiated what became (again, we see with hindsight) a new wave of eco-

Foreword

XXIX

nomic reform across Central and Eastern Europe and, amazingly, through­ out much of the former Soviet Union. In a very real sense, Soviet com­ munism was broken once and for all on the initial economic success of the Polish reform team. How was this possible? The answer is now obvious: Polish economists possessed the right idea at the right time. They understood that what seemed to be their greatest weakness, inflation, actually offered the oppor­ tunity to make rapid and impressive progress. Initial measures broke the inflationary-shortage spiral that had bedeviled previous reforms. Now reforms would be bolstered by public support and would induce positive microeconomic changes, such as the creation of new businesses. The idea was simple: inflation could be beaten. But this was a new and untried idea for this kind of economy at this kind of moment in the attempt to create economic and political reform. After less than two weeks in power, Deputy Prime Minister and Finance Minister Leszek Balcerowicz and his team (including Marek Dabrowski as first deputy finance minister) circulated a key memo establishing the pri­ orities of economic reform. The agenda was clear: "We see monetary and price stabilization as an immediate task and a precondition for structural adjustment." The crucial features of the Balcerowicz Plan were publicly unveiled on October 12, 1989, less than a month after the creation of the Solidarity-backed government. By the close of December the Sejm had adopted all the plan's key legislative components. Control of inflation was the foremost priority. Without this, nothing else would be possible. The measures were intended to be decisive. The exchange rate for cur­ rent-account payments was unified at 9,500 zloties per dollar. There was approximately a 40 percent real depreciation, with a commitment to sta­ bilizing the exchange rate for at least three months, before adjusting it to remain competitive. Many prices were liberalized, and the notion of a price freeze was rejected. Nominal interest rates were raised sharply (up to 36 percent per month, on January 1, 1990). Trade was substantially lib­ eralized, creating a large number of new entrepreneurial opportunities. A tough policy toward incomes was also introduced. At the time these measures seemed bold and even risky. In retrospect, it is clear that with a stroke, Poland was freed from the threat of hyper­ inflation. Important problems remained, for example, with the budget deficit and with various inflationary pressures. But now for the first time, state firms could begin to focus on restructuring and, probably more importantly, entrepreneurs could come forward to take advantage of new opportunities.

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Disinflation in Transition Economies

This is not to say that all of the reform was or could have been achieved overnight. Rather, Poland moved decisively and, it proved, irreversibly toward macroeconomic stability and microeconomic transformation. There were many trying days still to come, as people questioned the necessity for this kind of reform, and as lingering problemr-particularly inflation-­ had to be fought on a continuing basis. Sustaining reform has proved to be at least as difficult as taking the first few dramatic steps. This volume represents both an assessment of a decade of reform and the latest thinking by this influential group of Polish economists. It also rep­ resents the views of a younger generation that is now seeking to determine where Poland and other postcommunist countries should go next. This is an important volume for intellectual history as well as for economics. There are two main schools of thought about the last ten years of reform in Central and Eastern Europe. The pessimistic view holds that reform has not succeeded. Inflation may have been brought under con­ trol, but this was not central to reform. The only way forward, according to this view, is to discard the ideas of 1 989 and to establish a much greater role for the state. In complete contrast, there is also an optimistic view. In this view, reform is largely complete or even finished. Also in this view, inflation has been defeated permanently and the state should now mere­ ly stay out the way of business. Marek Dabrowski and his colleagues at the Center for Social and Economic Research (CASE) have for more than ten years worked dili­ gently to disprove the pessimists and to caution those who are excessively optimistic. Through careful empirical work they have demonstrated that inflation is central to the process of economic reform and that inflation in this environment is extremely difficult to defeat completely. The emphasis is on inflation because this group grew up battling inflation. The great victory of 1 98 9-90 was against inflation. The specter that haunted reform throughout the 1 990s was inflation. The maj or risk to prosperity in former communist countries even today is inflation. The chapters in this book present various perspectives on the contin­ uing problem of inflation after communism. Here for the first time we have a comprehensive assessment of inflation and disinflation in the post­ communist transition countries of Eastern Europe and the former Soviet Union. Based on extensive first-hand experience, a detailed knowledge of events, and an impressive command of the literature, the authors have produced what should become a classic. Read in combination with statistics from the European Bank for Reconstruction and Development's Transition Report and the IMF 's

Foreword

XXXI

International Financial Statistics database, this volume provides every­ thing you need to know about what happened and why in the fight against inflation during the first decade after the collapse of Soviet communism. The story, while seemingly dry and technical, is actually a compelling account of how inflation has been tamed but not yet conquered. The first chapter provides a broad overview of the costs of inflation and disinflation. It is clear, reasoned, and persuasive. Inflation is not only a major issue after communism, it is the central problem that needs to be defeated first and that continually threatens to derail all other economic policies. Marek Dabrowski 's essay is a tour de force that should be required reading for anyone interested in transition or concerned with inflation anywhere in the world. The following chapters fill out key details of precisely what drives inflation after communism and how this fits with what we know about macroeconomics more broadly. All these chapters have heavy facts and detailed analysis. Chapter 2 (by Rafal Antczak) offers a nice discussion of the link between money creation and inflation in transition countries. Chapter 3 (by Marek Jarocinski) deals with money demand, providing a good discussion of money-GDP ratios in comparative perspective. Jarocinski then usefully reviews what has happened to the demand for money in several groups of countries. The chapter ends with a sensible discussion of hyperinflation-a phenomenon that might seem to be of aca­ demic interest only but actually a real threat that lurks around almost every corner in the fragile financial world of reforming countries. Chapter 4 (by Malgorzata Antczak and Urban Gorski) looks at the importance of exchange-rate stability, a point emphasized in Chapter 1 . It begins with some of the general literature and then estimates some sim­ ple relationships for Eastern Europe. Chapter 5 (by Marek Dabrowski, Urban Gorski, and Marek Jarocinski) provides a nice blow-by-blow account of devaluation and the consequent inflation in both Russia and the Ukraine after August 1 998. The comparison particularly adds to our knowledge on the Ukraine. The rest of the book focuses on particular important issues. Chapter 6 (by KrzysztofRybinski and Mateusz Szczurek) carefully examines how capital inflows have affected Eastern Europe. Any thoughtful policymaker would benefit from reading about the pros and cons of capital inflows, for example for inflation. Also valuable is the detailed empirical analy­ sis of the experience in Poland, the Czech Republic, and Hungary. Chapter 7 (by Maryla Maliszewska) looks at real exchange rates, with particular focus on Poland and Romania. Eastern Europe seems to fit with

XXXII

Disi,ifiation in Transition Economies

our standard models of what determines the real exchange rate. Chapter 8 (by Malgorzata Markiewicz) focuses on fiscal policy. Again the empha­ sis is on the link between fiscal policy and inflation. It then explains how budget deficits developed early in transition, with particular mention of quasi-fiscal deficits. Again, the real added value is the detailed assessment of countries' experiences, in this case, Hungary, Bulgaria, Russia, the Ukraine, and Kyrgyzstan. Chapter 9 (by Wojciech Maliszewski) discusses the importance of cen­ tral-bank independence. Maliszewski provides original data on central­ bank independence in transition countries. He then links this indepen­ dence to inflation performance, showing a strong correlation (although it is not completely clear which direction causation takes). Chapter l O (by Przemyslaw Wozniak) is concerned with relative prices in the Czech Republic, Hungary, and Poland. It begins with the literature on the link between relative price movements and inflation. There is a good discussion of seasonality. The policy recommendations are sensi­ ble, and, again, policymakers should pay attention. Chapter 11 (by Mateusz Walewski) deals with wage-price spirals. It briefly reviews the theoretical literature and then provides a detailed empirical analysis. The author finds that there is a significant spiral when inflation is high but not otherwise. This seems quite reasonable and an important finding for these countries. Chapters 12 (by Lucjan T. Orlowski) and 13 (by Witold M . Orlowski) think through some key issues related to policy credibility. Lucjan Orlowski makes the case for direct inflation targeting, while Witold M. Orlowski shows that Poland can use its developing relationship with the European Union as a way to strengthen confidence in anti-inflation measures. Despite the lingering problems of inflation, Poland has performed rel­ atively well over the past decade. Compared with other countries in Central and Eastern Europe, Poland stands out as having made and main­ tained the most progress. What accounts for this impressive performance? In large part, Poland's steady progress is due to clear thinking and hard work by Polish economists during the 1980s and 1990s. The group rep­ resented in this volume has had the right ideas at the right time. At the same time, compared with Western Europe, a great deal remains to be done. It would be a serious mistake to think that reform is in any sense complete or inflation really vanquished. Again, Poland's leading economists have thought deeply about this. This volume is evidence of their hard work and clear thinking. I recommend it to anyone who wants to change the world in a positive direction. It shows most clearly the power of good ideas.

INTRODUCTION Marek Dabrowski

In the transition economies, driving inflation to low single-digit levels-­ typical in most developed countries-was a long and uneasy process. Ten years after implementing economic and political reforms, only a few post­ communist states enjoy low inflation free of the danger of its return. Still others have problems entering and remaining in the low-inflation zone or even achieving moderate inflation levels (below 40 percent annually). Several factors might explain why this goal has proved so elusive to poli­ cymakers: the high inflation and hyperinflation experienced at the begin­ ning of transition, the low level of monetization, delayed liberalization, huge fiscal and quasi-fiscal deficits, external shocks, monetary policies sub­ ordinated to goals other than disinflation, conflicting monetary and fiscal policies, and many others. To be sure, the effectiveness of strategies aimed at lowering inflation must be analyzed in the broad context of monetary, exchange-rate, and fiscal policies, as well as the balance-of-payments sit­ uation, and other institutional factors, such as central-bank independence. Analyzing the speed and effectiveness of the disinflation process in only one country involves the risk that its results may be influenced by that country's specifics and thus not necessarily reflective of the situa­ tion in the others. Additionally, such an analysis lacks objective criteria, which means that an assessment of any one particular policy may have a relative character. Macroeconomic theory does not provide us with any absolute numerical criteria related to the soundness of monetary or fiscal policies. Short-duration data series from a transition period and the fre­ quent incomparability of data due to methodological changes limit the possibility of historical analysis in one country. In addition, restricting research to one national economy inhibits assessing the potential of alter­ native policy strategies.

XXXIV

Disinflation in Transition Economies

The research project "The Disinflation Process in Poland: Comparing the Experiences of Other Eastern European and FSU Countries," 1 carried out by the Center for Social and Economic Research (CASE), an inter­ national, Warsaw-based research and policy-advising institute, aimed to give a comparative picture of the postcommunist transition countries' disinflation strategies and their results, which related mainly to the speed and sustainability of disinflation. A comparative analysis across countries allowed us to skirt some of the above-mentioned barriers, but new methodological problems emerged. First, the countries selected for this comparative analysis all began their transitions in different economic, institutional, and political conditions, which, at least hypothetically, determined the rationale of their different strategy choices. Thus a strategy that produced a certain result in one country did not necessarily yield the same results in others. To the extent possible this factor was taken into consideration in the research presented in this volume. Yet several countries that began their transitions in much less favorable circumstances than the leading reformers, like Poland or Hungary, achieved faster disinflation in comparison with the leaders. This would seem to mean, at least indirectly, that difficult initial conditions were not a defining obstacle in the successful implementation of an anti-inflationary program. Second, the availability of comparative statistical data from the tran­ sition economies has been limited, despite considerable efforts on the part of the IMF, World Bank, EBRD, OECD, and the Institute of lnternational Finance (IIF). This seriously constrained our research agenda, both with respect to the list of analyzed variables and its geographical coverage. The International Financial Statistics database, a regular IMF publication of the IMF, was used as our primary source of data. When necessary and relevant we also used other IMF publications and data sources from the OECD, World Bank, and IIF. The volume is a compilation of 1 3 papers. Eleven were prepared for the above-mentioned disinflation project. Chapter 7 was written under anoth­ er CASE research project, "The Role of the Exchange Rate and Exchange­ Rate Policy in the Period of Economic Transformation," coordinated by Jaroslaw Bauc and financed by the Polish Scientific Research Committee. Chapter 5 was the result of analytical research performed under the USAID­ funded Ukraine Macroeconomic Policy Project, overseen by CASE. Most of this volume's chapters have an empirical and a comparative character and bring fresh arguments to the ongoing policy discussion on the importance of low inflation in developing and transition countries and

Introduction

XXXV

the role of the proper mix of monetary and fiscal policies and exchange­ rate policy in achieving sustainable disinflation. The authors analyze the dynamics of the disinflation process itself and the factors that determine these dynamics: changes in the money supply and money demand, exchange-rate policy, fiscal policy, the legal status of central banks, mon­ etary-policy strategy, changes in relative prices, changes in nominal and real wages, and others. The various chapters cover different sets of tran­ sition countries, depending on their relevance to the analyzed topic and the availability of data. The research period of this book is limited to the 1 990s (until 1 997), with special attention given to the subperiod 1993-1997. We arrived at this period both because of the availability of comparative data and by our willingness to concentrate our efforts on the disinflation process and not on the high inflation and hyperinflation episodes themselves. Additionally, most of the FSU countries began fully independent mone­ tary policies only at the end of 1993. All the papers were completed in the present form in 1999-2000. In Chapter 1 , "Disinflation Strategies and Their Effectiveness in Transition Economies," I present a broad overview of the problems dis­ cussed in the other chapters, concentrating on four topics: the economic costs and benefits of the disinflation process, a comparison of the speed of disinflation in individual countries and its sustainability, disinflation strategies, including the controversial role of an exchange-rate anchor, and the role of fiscal policy in determining the medium and long-term prospects of the disinflation process. The second problem, i.e., the speed of disinflation, is analyzed by Rafal Antczak in Chapter 2, "Monetary Expansion and Its Influence on Inflation Performance in Transition Economies," with special emphasis on the dynamics of money supply as the factor that explains the differences in inflation performance. The goal of this chapter is to verify, in the transi­ tion economies, Milton Friedman's famous claim that "inflation is always and everywhere a monetary phenomenon." This chapter analyzes inflation performance, changes in various monetary aggregates, the money multi­ plier, money velocity, fiscal balances, and the current-account deficits in 1 2 transition economies. The analysis reveals that the dependence between changes in the money supply and inflation is more straightforward in the high- and very-high-inflation cases when monetary expansion is deter­ mined mainly by central-bank monetization of fiscal deficits. W hen the CPI approaches the moderate- and low-inflation zone, this link becomes weaker, indicating the role of the remonetization process.

XXXVI

Disinflation in Transition Economies

In Chapter 3, "Money Demand and Monetization in Transition Economies," Marek Jarocinski analyzes the other side of the money equa­ tion, i.e., the demand for money in transition economies. He briefly sketches the initial "unfreezing of the monetary overhang" phase. The resulting monetization levels are compared with those of other countries and discussed in relation to cumulative inflation and per capita income. The influence of additional factors is then examined for each country­ real GDP dynamics, the condition of the banking sector, the size of the shadow economy, and currency-board arrangements. A wide variety of patterns in money-demand behavior are detected. Special circumstances contributing to low monetization in most of the FSU economies are dis­ cussed separately as well as the functioning of the demonetized economies. Finally, a model stressing the importance of the credibility of stabilization policy is discussed. In Chapter 4, "The Influence of Exchange-Rate Stability on Inflation," Malgorzata Antczak and Urban Gorski focus on the role of the exchange­ rate anchor in anti-inflationary policy. The main objective of the analy­ sis is to find what kind of empirical relationship exists between curren­ cy devaluation and inflation. In an effort to give quantitative insights to the analysis, a partial-adjustment model has been estimated. The model evaluates the relationship between the annual rate of currency devalua­ tion and the rate of inflation in 1 2 CEE and FSU transition countries. A slow convergence of the inflation rate to the rate of currency deprecia­ tion can be observed in countries that experience the persistence of inflation and where exchange-rate indexation and other indexation mech­ anisms are in place (inflationary inertia in Hungary and Poland). Alternatively, a stable exchange rate lowers inflation at a relatively faster rate. As a result, the authors assert that no matter what the official exchange-rate regime, a stable exchange rate performs much better as a disinflation tool than any other arrangement (such as a crawling peg or crawling band) that seeks to accommodate an exchange rate to the rate of inflation. But the critical question is this: Under what conditions is the exchange-rate anchor-which can safeguard rapid stabilization of the price level-sustainable? The authors ' statistical analysis leads to the con­ clusion that fiscal equilibrium is of critical importance for keeping the current-account balance in a safe position and avoiding an excessive real appreciation of the exchange rate. Continuing on the same topic, in Chapter 5, "The Inflationary Consequences of the Devaluation Crises in Russia and the Ukraine: First Observations," Marek Dabrowski, Urban Gorski, and Marek Jarocinski

Introduction

XXXVII

deal with the special cases of the 1998 currency crises in Russia and the Ukraine. Experiences in both countries give an excellent empirical illus­ tration of the role of the exchange rate and fiscal equilibrium in deter­ mining price stability. Relative-exchange-rate stability helped both to achieve substantial disinflation in 1 996-1997. But fiscal accounts remained in deep disequilibrium. As result, in August 1998 Russia expe­ rienced a full-scale financial crisis, involving a sharp devaluation of the ruble and a systemic banking crisis. Shortly after, the Ukrainian curren­ cy, the hryvna, was also forced to devalue. In both countries, financial crises halted the disinflation trend and ushered in a new wave of inflation. The initial price leap, however, was smaller in the Ukraine than in Russia. This can be explained by the two countries' different import structures and crisis-management techniques as well as by the further complication of political and banking crises in Russia. Apart from adhering to their constitutional mission (fighting inflation), central banks often feel themselves obliged to control current-account deficits. Krzysztof Rybinski and Mateusz Szczurek seek to establish in Chapter 6, "Disinflation Policy, Capital Inflow, and the Current-Account Balance," a transmission mechanism between the current-account deficit and inflation. Several models (an absorption approach to the balance of payments, the Mundell-Fleming flow approach, and intertemporal cur­ rent-account models) are then analyzed. This survey does not provide the authors with a definitive conclusion on whether the inflation-current­ account trade-off must be faced by policymakers in transition economies. It depends on the policy mix used to control the internal or external bal­ ance. Tight fiscal policy remains the prime example of a method of reduc­ ing both inflation and the current-account deficit. The chapter also includes statistical analysis of real exchange-rate appreciation in the Czech Republic, Hungary, and Poland and the factors determining this process. One of the common economic features of the transition period is the continuously appreciating real exchange rate (RER). Many politicians argue that a real appreciation leads to a loss of competitiveness of domes­ tic industry. But such assertions assume that purchasing power parity holds, which should not be expected in transition economies. Further, the rapid process of restructuring results in a stable increase in productivity, thus leading to an appreciation of the equilibrium RER. In Chapter 7, "Modeling the Real Exchange Rate in Transitions: The Cases of Poland and Romania," Maryla Maliszewska examines the determinants of the RER in the long-run setting, using the equilibrium RER model, which fea-

XXXVIII

Disinflation in Transition Economies

tures productivity gains, real producer wages, and differences in the growth of producer and consumer prices as the main determinants. In the extended version of the basic model, other fundamental variables, such as the levels of employment and unemployment and the measure of exter­ nal performance, were added. This model proved to be an appropriate tool for modeling the RER in two transition economies: Romania and Poland. The long-run relationships produced by the model occurred to be both significant and in line with predictions of economic theory. The results of this study give strong support to the Balassa-Samuelson effect expla­ nation of the appreciation of the equilibrium RER. In Chapter 8, "Fiscal Policy and Disinflation in Transition Economies," Malgorzata Markiewicz analyzes the interrelations between fiscal policy and the effectiveness of the disinflation process. The inflationary impact produced by a fiscal deficit depends on how it is financed. Governments can finance deficits either by increasing foreign or domestic debt or by monetizing it. But each of the above options may involve macroeconomic disequilibrium. Additional money creation immediately stimulates inflation. Growth in public debt may lead to prob­ lems with its servicing and to the narrowing of access to credit resources on domestic and foreign financial markets, bringing a country to a debt trap and financial crisis. The author analyzes five financial crises caused by a fiscal disequilibrium: Hungary ( 1 994--1 995), Bulgaria ( 1 996-1 997), Kyrgyzstan ( 1 996), Russia ( 1998), and the Ukraine ( 1 998). The final con­ clusion is that the so-called unpleasant monetarist arithmetic, described by Sargent and Wallace, does exist in transition economies. Continuing the analysis on the interrelation between monetary and fiscal policies, in Chapter 9, "Central-Bank Independence and Its Impact on Inflation in Transition Economies," Wojciech Maliszewski discusses changes in central-bank laws in 16 transition countries and the relation­ ship between inflation and central-bank independence in them. Two indexes of legal independence are constructed, capturing its political and economic dimensions. Revisions to the laws strengthened the position of the central bank in most of the investigated countries. They were intro­ duced after high-inflation episodes, suggesting that the collective mem­ ories of past inflation resulted in greater central-bank independence. With further analysis, an inverse relationship emerges between inflation and the central bank's political independence. In Chapter 1 0, "Relative Price Adjustment in the Czech Republic, Hungary, and Poland: A Comparison of the Size and Impact of lnflation," Przemyslaw Wozniak evaluates the strength of the inflationary impact

Introduction

XXXIX

coming from changes in relative prices. Based on L. Ball and G. Mankiw's theoretical model, he confirms the existence of a positive rela­ tionship between inflation and relative price variability, with transmission processes being the most substantial in Poland. In all countries, relative price adjustments should be considered an important source of inflation­ ary pressures contributing to the worsening of the output-inflation trade­ off. The author also examines the sources of relative price variability and relative price shifts on a cumulative basis, identifying "agricultural" and "administrative" seasonality as the leading factors that regularly con­ tribute to radical shifts in prices. A cumulative examination of relative price changes reveals a significant evolution of price structures, albeit not equally significant for all countries. Disaggregated analysis has shown that the impact coming from administrative adjustments has been great­ est in Poland, during the initial transition years. In the second half of the 1 990s, with the relative prices of "controlled" items more stable in Poland, adjustments contributed relatively more to Hungarian and Czech inflation. Adding to the analysis of the importance of changes in relative prices, in Chapter 11, "The wage-price Spiral in Transition Economies," Mateusz Walewski tries to determine whether a relationship exists between wage and price changes in ten transition economies. The results suggest that wages and prices seem to be driven by the same forces, but there is no gen­ eral interdependence between these two variables. It seems that from the point of view of inflation-sensitive policymakers, an increase in the price of labor should be treated just as any other price increase in an economy. Chapter 12, "Monetary-Policy Targeting in the Central European Transition Economies," returns to the problem of effective disinflation strategies discussed in Chapter l . Lucjan T. Orlowski analyzes monetary­ policy strategies carried out by the central banks of the Czech Republic, Hungary, and Poland, in the 1990s, highlighting their numerous weak­ nesses. By and large, they maintained a backward-looking character, which undermined the credibility of monetary authorities. Orlowski pro­ poses a strategy of direct inflation targeting (DIT) as the solution, which will help the countries prepare for EU and EMU accession. This approach will help to overcome the deficiencies of current monetary policies in the region, namely, the excessive discretion, the short time horizons of inter­ mediate targets, and the focus on interest rates as operating targets. Cooperation among central banks, finance ministries, and other govern­ ment agencies is critical for the overall success of the anti-inflationary policies.

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Disinflation in Transition Economies

In Chapter 13 , "Prospects for a Further Disinflation Policy in Poland," Witold M. Orlowski discusses possible disinflation strategies for Poland during its EU-accession process, based on the experiences of three Mediterranean members of the EU: Greece, Portugal, and Spain. The accession process should allow Poland's macroeconomic policy to import from the EU needed credibility, which would contribute to a lowering of the economic and social costs of further disinflation. On the other hand, accession to the EU and the EMU will make fiscal policy an external dis­ ciplining factor. Apart from conducting academic research, most of the authors have been directly involved in making policy recommendations in a number of transition countries, such as Georgia, Kazakhstan, Kyrgyzstan, Poland, Romania, Russia, and the Ukraine. This afforded us additional and more-practical insight into the dynamics of the transition process, the relative effectiveness of various transition and disinflation strategies, the political economy of transition, the shortcomings of transition statistics, and the like. Our hope is that this comparative advantage has helped us to present competent diagnoses and adequate policy recommendations. The authors want to express their deep gratitude to all those who reviewed and commented both on the individual chapters and on this entire volume. Participants at two policy seminars of the Center for Social and Economic Research, held in June and December 1 99 8 , in Warsaw, also brought important intellectual input to this book's methodology and substance. Special acknowledgement is due Elena Kozarzewska, who was charged with administering this research project and who provided significant support during the post-project period of preparing this pub­ lication. This book reflects only the authors' opinions and not those of the institutions where they are affiliated. The authors also accept sole responsibility for the quality of each chapter and the entire book. NOTE l Grant no. l H02C 0 1 9 1 2 o f the Polish Scientific Research Committee (KBN), the research-sponsoring agency of the Polish government; decision no. 88 l /H02/97/12. This research project was conducted from January 1, 1 977 to December 3 1 , 1 998.

1.

DISINFLATION STRATEGIES AND THEIR EFFECTIVENESS IN TRANSITION ECONOMIES Marek Dabrowski

At the outset of the transition process most of the economies of Central and Eastern Europe (CEE) and the former Soviet Union (FSU) experi­ enced very high inflation or even hyperinflation. Two major factors explain this: ( 1 ) price and exchange-rate liberalizations unleashed the accumulated stock of money (the so-called monetary overhang) that had amassed because of extensive price controls under communism and increased, at least temporarily, the velocity of money in circulation; and (2) weak monetary and fiscal controls. The feebleness of controls was par­ ticularly acute in the last years of the communist regimes and the first years of the democratic governments, when most state institutions were significantly weakened and political elites desperately sought popular support, often at the expense of macroeconomic stability. Additionally, a pronounced output decline, resulting from deep structural distortions inherited from the command economy, complicated fiscal and monetary adjustments and provoked the irresistible temptation to use demand-type antirecession instruments such as fiscal and monetary expansions. Early in the transition process it became apparent that a rapid disinflation was an essential precondition to the success of structural reforms' and macroeconomic stabilization-one of the three major pil­ lars of an effective transition and growth strategy. 2 1 . 1 . THE E C ONOMIC RATIONALE FOR DISINFLATION Before analyzing the speed of the disinflation process and the factors that determined its speed, we should consider why disinflation is so impor-

2

Disinflation in Transition Economies

tant for any economy, particularly for an economy in transition, and why a rapid disinflation process is better than a slow one. Separate cost-benefit analysis is performed on the disinflation process in the case of high and very high inflation and in the case of moderate and low inflation. No single definition exists for high inflation and very high inflation. Here, high inflation is defined as exceeding 40 percent annually and very high inflation as reaching triple-digit levels annually. Hyperinflation is a special case of a very high inflation when monthly inflation exceeds 50 percent during at least three consecutive months (Cagan 1956) . Moderate and low inflation can be defined in various ways. Dornbusch and Fischer ( 1993) suggest, for example, that annual price increases between 15 and 30 percent constitute moderate inflation. In this chapter, 10 to 40 percent annual inflation is defined as moderate, while an annual rate of less than l O percent is considered low. 1.1.1.

THE DAMAGING E F F E C T S OF H I G H AND VERY H I G H INFLAT I O N

The economic and social consequences of high and very high inflation are widely known. In general it destroys the basic functions of money: as a means of transaction, savings, and calculation. High or very high inflation discourages both savings and demand for domestic money. All things being equal, in high-inflation economies the savings rate is gen­ erally lower than in low-inflation ones. One must remember that the tran­ sition economies, for various historical and structural reasons, are rather short on domestic savings. In a high-inflation environment economic agents move from their domestic currency to foreign currencies or to money substitutes, seriously limiting the use of seigniorage or an inflation tax3 for financing public expenditures, which is the original reason for the high or very high inflation. Numerous empirical studies confirm that there is an optimal level of inflation for seigniorage and inflation-tax maximization (Budina 1997), which is usually found in the high-inflation or very-high-inflation zone. This is the source of the initial temptation to resort to such forms of deficit financing, especially when other sources are unavailable (as was the case in most of the postcommunist countries at the outset of the tran­ sition process). But the seigniorage-inflation-tax-maximizing level of inflation is unstable. As economic agents come to realize that they are sub­ jected to an inflation taxation, their demand for domestic-money balances declines, narrowing the base for the inflation tax. If policymakers respond

Disinflation Strategies and Their Effectiveness in Transition Economies

3

with a higher inflation-tax rate, the economy faces the danger of a dra­ matic acceleration of inflation, leading very often to hyperinflation. Additionally, high or very high inflation can erode the conventional tax base. The so-called Olivera-Tanzi effect occurs; that is, a real depre­ ciation of tax obligations fixed in nominal domestic-currency terms (for a certain period of time) unfolds because of the time lag between the date of the tax accrual and its effective payment. Gaidar ( 1 997) also under­ lines the negative effect of the demonetization process on a government's capacity to collect taxes. Demonetization is the unavoidable result of every episode of high or very high inflation. Hence in terms of the fiscal and monetary balances, high inflation is a self-fulfilling and self-accel­ erating process. High inflation also destroys the information function of prices, frus­ trating the efficient allocation of resources (Dabrowski and Rostowski 1 992). Economic agents are left pondering whether a specific price increase reflects an average price increase only or a change in relative prices. Very high inflation or hyperinflation distorts the relative price structure in accidental ways because of the various frequencies and sched­ ulings of indexing prices of individual goods according to inflation (the so-called Taylor rule). Any credit in a high-inflation environment must have a short-term character only and form an up-front barrier of high nominal interest rates (even if they are negative in real terms) to debtor. Such are the addition­ al negative influences-apart from the destruction of savings---0f high inflation on economic growth. We must also mention the negative social consequences of high and very high inflation. In most cases high inflation harms mainly the poor. It widens income and wealth differentiation and stimulates numerous social pathologies. 1.1 . 2 .

M O D ERATE AND INERTIA

Low

INFLAT I O N : THE DANGER OF INFLATION

Given the various negative consequences of high and very high inflation, few could argue against a robust disinflation policy when annual inflation exceeds the level of 40 or 50 percent. But the balance of arguments may change when a country enters the zone of moderate or low inflation, where the destructive characteristics of high or very high inflation evaporate or play a significantly weaker role. In the lower-inflation zones various argu-

4

Disinflation in Transition Economies

ments come to the fore; for example, the relative-price-changes argument, the danger of a self-fulfilling demonetization, the destruction of the tax base, the concomitant social pathologies, and the like. Yet several inflationary impediments to growth are still in place. They relate mainly to the negative incentives to save and the high nominal cost of credit. There are additional negative implications. Inflation differences com­ paring to low-inflation countries coupled with a low savings ratio, and the remaining inflationary and devaluation expectations lead to even greater differences in nominal interest rates. When an economy becomes at least partly open to international financial flows (seemingly unavoid­ able at some stage in the transition process), it is highly vulnerable to short-term capital flows and capricious investor sentiment. A narrowing of inflation differences and closer convergence of macroeconomic fun­ damentals with those of developed countries lower the level of macro­ economic risk. On the other hand, arguments concerning the economic and social costs of disinflation become more important when a country approaches a low level of inflation. The main argument against disinflation, or at least against rapid disinflation, is connected with the downward nominal price and wage rigidities. In a low-inflation environment the room for any decrease in real prices or wages is much more limited than in a high­ inflation one. Thus any necessary adjustment requires more time and costs more, in terms of the output decline and unemployment (Calvo and Coricelli 1 992; and Nuti and Portes 1 993). According to this argument, a slow-disinflation process is less painful for the economy than a rapid one. This argument can be challenged on the same grounds, however. Downward price and wage rigidities are to a significant extent a product of past inflation experiences (Leidy and Tockarick 1 998). Moreover, if inflation has a persistent character, economic agents seek to protect them­ selves against declines in real income through various forms of anti­ inflationary indexation. But this leads to a phenomenon of inflationary inertia whereby nominal rigidities become even more serious than before. An attempt to carry out a negative real price or wage adjustment requires, in such a situation, the additional unexpected inflation impulse, which increases the bias toward an ex ante indexation of the nominal variables. Moreover, if economic agents distrust macroeconomic policy and fear they will be cheated by additional unexpected inflation, they will seek to protect themselves with additional indexation margins.4 If this is the path taken, one can only expect inflation acceleration without any substantial

Disinflation Strategies and Their Effectiveness in Transition Economies

5

output and employment gains. But nominal rigidities can be significant­ ly limited with a credible and sustainable anti-inflationary program; though implementation of such a program requires breaking up the exist­ ing rigidities and inertia, which will result in employment and output loses. Liberalizing foreign trade and the labor market as well as market­ oriented structural reforms can blunt these losses. The same concerns, also, the so-called money illusion in the original Keynesian model. Additional nominal-demand injections can lead to increased output only if they are unexpected and if profit-maximizing eco­ nomic agents have free and complementary production capacity. This is certainly not the case in the transition economies, with their strong inflation inertia, lack of complementary free-production capacity, low savings rates, and seriously flawed microlevel incentive systems. Again, stopping the use of the money-illusion-stimulating mechanism has costs, though it is beneficial to an economy's microeconomic flexibility. In discussing the costs and benefits of a disinflation policy, the real dilemma concerns the time mismatch: the costs must be paid immediately (in the short term), while the benefits come later (in the medium and long term). To be sure, this has political ramifications (see Alesina and Perotti 1994) as a government may face an election schedule and thus lack the time to wait for the economic and social gains coming from the disinflation policy to develop. 5 A slow disinflation strategy does not seem to be a remedy here, how­ ever. Slow disinflation still involves some costs, especially when the benefits are very limited and diluted in time. To achieve a final low­ inflation target,6 painful disinflation measures will have to be repeated several times, and the positive effects will come much later. Additionally, slow disinflation will further support the existing nominal rigidities and the inflationary inertia. It will delay the transition economy's possible macroeconomic convergence with developed countries, which involves, all things being equal, a higher risk premium for investment and high­ er real interest rates for both public- and private-sector debts (Maliszewski 1998). Thus the cumulative economic, social, and politi­ cal costs of slow disinflation may not prove to be lower (than in the case of fast disinflation), while the benefits are certainly delayed and some­ what diluted.

6 1.1.3.

Disinflation in Transition Economies RE SULT S OF THE EMPIRICAL RESEARCH

Numerous empirical studies conducted in 1990s support the above claims. Usually these studies covered large groups of countries (more than one hundred) over long periods of time (more than thirty years). Most ana­ lyzed the relationship between average rates ofannual inflation and GDP growth. Some also attempted to shed light on the dynamic relationship; that is, how the pace of disinflation influenced rates of economic growth. Bruno and Easterly's (1995) comparative analysis of 127 countries, during the period 1960-1992, found that an annual inflation rate higher than 40 percent damages economic growth. The highest per capita GDP growth rates were recorded in countries averaging annual inflation between 5 and 10 percent, followed by those with rates between 10 and 15 percent (see Figure 1.1). Subsequent analyses (Sarel 1 996; and Gosh and Phillips 1998) reached the conclusion that the optimal level of inflation was lower than what Bruno and Easterly found. This seems to reflect the general disinflation trend of the world economy in the last decade. Ten years ago, the fre­ quency of low-inflation cases was much lower than now, particularly among developing countries. Sarel (1996) found evidence that annual inflation higher than 8 percent damages economic growth, while inflation below this threshold is neutral to the rate of growth. Gosh and Phillips (1998) undertook a similar exercise, using data based on most of the members of the IMF for the period 1960-1996. Their estimates for upper- and upper-middle-income countries found that the highest rate of GDP growth was recorded in countries with annual inflation between 0 and 3 percent, followed by those between 3 and 5 percent. With increasingly higher inflation intervals, the rate of growth systematically declined (see Table 1.1.). A similar picture emerges in the group of lower- and lower-middle-income countries (Table 1.2.). But the highest rates of growth were recorded in countries with annual inflation between 3 and 5 percent, followed by those between 5 and 10 percent.

7

Disinflation Strategies and Their Effectiveness in Transition Economies

Annual inflation and per capita growth rates, 1 960--92 average of 127 countries 3 2 l 0 -1 -2 -3 -4

-5 --6

-7 i.n

an

i.n

a:

�

�

�

;;

.Q

.Q

�

.Q _

�

.Q

lli

�� .Q

Annual inflation (in ranges, percent)

Source: Bruno and Easterly 1 995. Figure 1. 1. Annual Inflation and Per Capita Growth Rates, 1 960--1 992

Christoffersen and Doyle (1998) analyzed 22 transition economies for the period 1990--1997.7 They found that GDP loses were directly associated with an annual inflation rate in excess of 13 percent. This is slightly high­ er than Sarel's (1996) result from a wider sample of market economies. But Christoffersen and Doyle's results may be explained by the fact that few low-inflation cases exist among the transition economies. As more countries achieve single-digit rates for longer periods of time, empirical research may unearth an inflation-growth threshold at a lower level. Table 1 . 1 . Inflation and GDP Growth in Upper- and Upper-Middle-Income Countries, 1 960--1 996

Inflation range (in percent)

Number of observations

0 < 7t < 3 3 < 7t < 5 5 < rr < 10 10 < rr < 20 20 < rr < 40 40 < rr < 80 rr > 80

1 80 1 83 244 1 77 66 37 50

Source: Gosh and Phillips 1 998.

Inflation (in percent) Average Mean 2.0 3.9 7.2 1 4.0 26.0 56.6 497 . 1

2. 1 3.9 7. 1 13.5 25.0 56.6 1 68.2

GDP growth (in percent) Average Mean 3.6 3.5 2.8 2.0 2. 1 2.5 --0.7

3 .2 3.5 2.9 2.0 2.2 2.4 0. 1

8

Disinflation in Transition Economies

Gosh and Phillips ( 1998) also investigated the dynamic relationship between the speed of disinflation and its cost to the growth rate. They found that when the initial annual inflation rate is above 6.3 percent, only the most severe anti-inflationary programs-cutting the inflation rate by more than 63 percent-were associated with lower growth. An increase in the rate of inflation was also associated with lower GDP growth. When the initial annual inflation rate was less than 6 percent, only the most severe anti-inflationary programs-reducing the inflation rate by more than half--were associated with lower GDP growth. The same was true when the inflation rate increased by more than 70 per­ cent. Moreover, disinflation costs were usually short lived and were quickly compensated for as a result of the benefits that lower inflation produced. What concerns the transition economies, however, is that Christoffersen and Doyle ( 1998) did not find any evidence that even the most drastic anti­ inflationary programs could diminish the rate of economic growth. Table 1 .2. Inflation and GDP Growth in Lower- and Lower-Middle-Income Countries, 1 960-1 996 Inflation range (in percent) O < it < 3 3 < it < 5 5 < 1t < l O 1 0 < it < 20 20 < 1t < 40 40 < 1t < 80 1t > 80

Number of observations 141 1 20 326 39 1 206 67 43

Inflation (in percent) Mean Average 1 .5 4.0 7.6 1 3.8 27.7 56.5 969.9

1 .7 4. 1 7.8 1 3 .0 26.6 54.5 1 6 1 .0

GDP growth (in percent) Average Mean 1 .4 1 .8 2.4 1 .5 0. 1 0.2 -3 .5

1.8 2.3 2.5 1 .4 0.7 0.5 -3 .5

Source: Gosh and Phillips 1 998.

In general the lower the level of inflation, the better the conditions for sustainable economic growth. The modem economic theory, by and large, rejects the thinking that a possible long-run trade-off exists between inflation and GDP growth. The modem growth paradigm, known as the "Washington consensus," points to low inflation as a fac­ tor in promoting growth (see Barro and Lee 1993). But many empirical studies find a nonlinear relationship between inflation and growth. Marginal-output gains decrease with lower inflation. Short-term disinflation costs are connected with the most severe anti-inflationary programs only in economies that are initially at low-inflation levels; even

Disinflation Strategies and Their Effectiveness in Transition Economies

9

in these case they are quickly compensated for because of the benefits that spring from lower inflation. 1 .2 . THE VARYING SPEEDS OF D I SINFLATION 1.2 .1.

THE S I Z E OF T H E INITIAL D E S TA B I LIZATION

The initial macroeconomic destabilization varied in the postcommunist economies, at the beginning of the transition process. Serbia and Montenegro's hyperinflation of 1992-1994, the second-fastest rate in world history, amounted to 310,000,000 percent a month, in January 1994 (Rostowski 1998). Three other hyperinflation cases are telling: Georgia witnessed 50,654 percent inflation for the 12-month period ending in September 1994; Armenia's was 29,600.9 percent in May 1994; and the Ukraine's was 1 0,155 percent in December 1993. At the other extreme, Hungary, the Czech Republic, Slovakia, and Slovenia never experienced triple-digit inflation for any 12-month peri­ od. Hungary remained in the moderate-inflation zone but failed to drive its CPI below 18 percent until year-end 1997. The Czech Republic and Slovakia experienced relatively limited and short-lived inflation spikes because of price liberalizations (year-end inflation of 52 percent in the Czech Republic and 58.3 percent in Slovakia, in 1991). From 1994, the 12-month inflation rate stabilized in the 8 to 10 percent range in the Czech Republic and in the 6 to 7 percent range in Slovakia (IMF 1998: Table 1). 1 .2 . 2 .

THE TIMING OF D I SINFLATION PROGRAM S

The timing of the disinflation programs and their effectiveness differed in the transition countries. Poland and the former Yugoslavia set out to whip their hyperinflation at the end of 1989. Poland's IMF-supported pro­ gram began officially on January 1, 1990; but several preparatory steps were taken earlier, in the last quarter of 1 989. In a matter of months the positive results of its efforts were already visible. The Yugoslav program started officially in December 1989 and was also quite successful. But the political disintegration of Yugoslavia brought with it a serious macro­ economic crisis at the end of 1990 and in 199 1 . Both Bulgaria and Czechoslovakia implemented stabilization cum lib­ eralization programs at the beginning of 1991, but only the latter suc­ ceeded. Slovenia, having declared its independence from Yugoslavia,

Disinflation in Transition Economies

implemented a stabilization program at the close of 1 99 1 . Albania, Estonia, Latvia, and Lithuania introduced stabilization policies in 1 992, while Croatia, Moldova, and Kyrgyzstan made the effort at the close of 1 993. The Caucasus states--Armenia, Azerbaijan, and Georgia-turned their attention to fighting very high inflation and hyperinflation in 1 994-1995, only after arresting their various military conflicts. Romania, Bulgaria, and many countries of the CIS repeatedly attempted stabilization programs. Russia managed to check a very high inflation only after four attempts, in 1995, and the Ukraine a year later. In both, unfortunately, the hard-fought stability proved fragile, short­ lived, and came undone as a result of the 1 998 financial crisis (see below). Bulgaria suffered two serious financial crises-at the close of 1 993 and the beginning of 1994, and in 1996-1997. The second crisis was extreme­ ly severe, involving a near collapse of the banking industry, default on the public debt, and a deep devaluation of the leva. Bulgaria joined the club of low-inflation economies only after the introduction of a currency board, in mid- 1997, the implementation of a radical fiscal adjustment, and the accel­ eration of structural reforms. Romania, in fact, never reached the moderate­ inflation zone and is a typical case of a chronic high-inflation country. Belarus, Turkmenistan, and Uzbekistan never sought to implement substantial anti-inflationary policies and resisted any genuine liberaliza­ tion and structural-reform efforts, seeking instead to find the ever-elusive "third way," something between a command economy and a free market. Tajikistan enjoyed only short episodes of lower inflation (for example, in 1 998), but the economy was to a significant extent forever at the mercy of internal political instability and continuing civil war. 1 . 2 . 3.

THE S P E E D OF D I S INFLATION (UNTIL

1 9 97)

The successor states of the former Soviet Union and Yugoslavia began stabilization policies later than did the Central Europeans, as a conse­ quence of delayed transition processes and political instability, including military conflicts in some cases. But once begun, in 1 994, some of them intensified their disinflation processes, at times outperforming such tran­ sition leaders as Poland, Hungary, the Czech Republic, and Slovenia. This was illustrated in the IMF's comparative analysis (IMF 1 998). In its analysis, disinflation thresholds were set at the following lev­ els: 60, 30, 1 5, and 7.5 percent (see Table 1.3). Thresholds were defined as annualized three-month inflation rates. A country was recognized as having crossed a designated threshold when it first fell below the thresh-

11

Disinflation Strategies and Their Effectiveness in Transition Economies

old and remained in the new zone for a year, and if the 12-month inflation rate fell below that level during the following year without rising above it again in that year. This final qualification did not relate to countries that crossed the threshold during 1997. Table 1 .3 . The Speed of the Disinflation Process (until 1 997) Country Albania Armenia Azerbaijan Croatia Czech Republic Estonia Georgia Kazakhstan Kyrgyzstan Latvia Lithuania Macedonia Moldova Poland Russia Slovakia Slovenia Ukraine

Number of months required to cross the threshold of 7.5 percent 1 5 percent 30 percent 60 percent 5

6 5

4 3 18 3 17 23 9 21 6 9 18 9 3 18

3 10 1 I I

8 17 13 24 27 26 8 9 33 3 I

3 I

23

2

7 2 2 23

7 0

I

11

12 2 5

14 21 2 27 11

11

5

46

Source: IMF 1 998.

Crossing the highest threshold (60 percent) required 23 months for Kyrgyzstan; 2 1 months for Lithuania; 1 8 months for Poland, the Ukraine, and Estonia; 17 months for Kazakhstan; 9 months for Russia, Moldova, and Latvia; 6 months for Armenia and Macedonia; 5 months for Albania and Azerbaijan; 4 months for Croatia; and 3 months for Georgia, the Czech Republic, and Slovakia. 8 The countries ' stabilization programs were designated as having begun when their IMF-supported programs (usually via a stand-by arrangement or a systemic-transformation facili­ ty} were implemented. Reaching the next threshold (30 percent) consumed 33 months for Poland; 27 months for Latvia; 26 months for Lithuania; 24 months for Kyrgyzstan; 17 months for Georgia; 13 months for Kazakhstan; 10 months for Armenia; 9 months for Moldova; 8 months for Estonia and Macedonia; 5 months for Russia; 3 months for Slovenia and Albania; and 1 month for the Czech Republic, Slovakia, Azerbaijan, Croatia, and the Ukraine (all dated from the point at which the 60 percent threshold had been reached).

12

Disinflation in Transition Economies

The threshold of 1 5 percent was reached in 27 months by Slovenia; 23 months by Albania and Estonia; 21 months by Poland; 1 4 months by Moldova; 12 months by Latvia; 1 1 months by Kazakhstan and Ukraine; 7 months by Azerbaijan; 5 months by Macedonia; 2 months by the Czech Republic, Slovakia, Croatia, and Lithuania; and 1 month by Georgia. Finally, only six countries managed to reach the 7.5 percent thresh­ old, requiring 46 months in Slovakia; 1 1 months in Lithuania; 7 months in Azerbaijan; 5 months in Macedonia; 2 months in Albania; and O months in Croatia. 9 Koen and De Masi ( 1 997) present another approach to measuring the intensity of inflation processes and the speed of disinflation, calculating the cumulative CPI increase during the first five years of transition in each country. The following start dates were taken from their analysis: December 1 989 for Croatia, Hungary, Macedonia, Poland, Slovakia, and Slovenia; October 1 990 for Romania; December 1 990 for Bulgaria, the Czech Republic, Estonia, and Latvia; January 1 99 1 for Albania and Lithuania; and December 1 99 1 for Russia and the other FSU countries. The smallest cumulative increase was recorded in the Czech Republic ( 1 38 percent), followed by Slovakia, Hungary, Albania, and Poland ( 1 ,34 1 per­ cent). The highest figures were recorded by Turkmenistan (more than l 00,000 times), Georgia (in excess of 86,000 times), Armenia, the Ukraine, and Tajikistan. But the absolute "winners" were Serbia and Montenegro, where prices increased a staggering 78,000,000,000,000,000,000,000 times, from January 1 992 to February 1 994 (25 months). l .2.4.

INFLAT I ON DEVELOPMEN T S ,

1 99 8-1 999

In 1 998-1 999, the transition economies experienced strong fluctuations in their disinflation processes (partly illustrated in Table 1 .4). In the first half of 1 998, inflation declined in most of the countries, particularly those of the former Soviet Union. Some even recorded negative 1 2-month inflation (the Caucasus states). This was largely the result of declining oil and commodity prices on world markets. In the second half of 1 998, the anti-inflationary supply shock continued. But Russia, the Ukraine, Belarus, Moldova, Kyrgyzstan, and Georgia (followed by Kazakhstan, in 1 999) suffered currency crises, which unbridled a new round of serious inflation and destroyed the previous disinflation gains (see below). A reversal of economic trends ushered in the inflationary developments of 1 999. While some countries of the CIS began to return to their previ­ ous disinflation performances, after the devaluation crises at year-end

13

Disinflation Strategies and Their Effectiveness in Transition Economies

1998, other countries (mainly the Central European ones) fell victim to a reversal of commodity and energy prices. Additionally, the countries oper­ ating euro-denominated currency boards (Bosnia, Bulgaria, and Estonia) and those with currency pegged to the euro (Croatia and Macedonia) suf­ fered from increased inflation in the eurozone and the gradual weakening of the euro to the US dollar. Also, domestic economic-policy problems and imbalances in some countries (Romania, Hungary, Poland, Slovakia, Kyrgyzstan, Uzbekistan, and Moldova) played a significant role. Despite generally unfavorable inflation developments in 1 999, seven of the ten CEE countries and five of the 1 5 FSU countries listed in Table 1 .4. remained in the zone of low inflation. Georgia and Hungary turned in results that were close to this range, and Slovakia seemed to fall out of the single-digit inflation zone only temporarily. All three achieved the single-digit inflation target in 2000 (Hungary for the first time). Nine states-Albania, Armenia, Azerbaijan, Croatia, the Czech Republic, Estonia, Latvia, Lithuania, and Macedonia-were at the lower end of the low-inflation zone, i.e., below the 5 percent threshold, in 1999. But only six--the three Baits, Croatia, Macedonia, and the Czech Republic-seem to have achieved this result in a sustainable way. All of them but the Czech Republic have stuck to their exchange-rate targets. The Czech Republic has followed direct inflation targeting since the beginning of 1998. It is worth noticing that only the three Balts and the Czech Republic, among the ten EU-accession candidates, seem close to the eurozone level of inflation. Bulgaria, with its euro-dominated currency board, also has a chance to join this group, although it still faces a formidable agenda of changes to its domestic price structure that may bring an additional CPI increase. All the other countries still have a long row to hoe to satisfy eurozone inflation requirements and meet Maastricht inflation criterion, i.e., inflation not exceeding the average of the three-best EMU perform­ ers plus 1 .5 percent. 1 0 Table 1 .4. Year-End Inflation, 1 99 1-1 999 Country

1 99 1

1 992

1 993

1 994

1 995

1 996

1 997

1 998

1 999

42. 1 578.6 3.8

8.7 0.9 5.6 6.8 1 0.3 -3. 1

-1.0 6.3 3.8 2.6 1 1 .2 2.4

Central and Eastern Europe Albania 1 04.0 236.6 30.9 Bulgaria 338.7 79.4 63.8 Croatia ... 937.0 1 1 20.5 Czech Republic 52.0 1 2.6 1 8.8 Hungary 32.0 24.7 21.1 Macedonia 1 1 5.0 1 935.0 24 1 . 8

1 5.8 1 2 1 .9 2.4 9.7 2 1 .2 55.0

6.0 32.9 4.6 7.9 28.3 9.0

1 7.4 3 1 0.8 3.7 8.6 1 9. 8 -0.6

JO. I

1 8.4 3.2

14

Disinflation in Transition Economies

(Table 1 . 4. cont 'd) Country

1 99 1

1 992

1 993

1 994

1 995

1 996

1 997

1 998

1 999

1 3 .2 1 5 1 .6 6.4 9.4

8.6 43.8 5.6 5.7

9.8 54.8 1 4.2 8.8

Central and Eastern Europe Poland Romania Slovakia Slovenia

Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgyzstan Latvia Lithuania Moldova Russia Taj ikistan Turkmenistan Ukraine Uzbekistan

60.3 223.0 58.3 247.0

... ... ... ... ... ...

... ... ... ... ...

...

44.5 1 99.2 9. 1 88.2

37.7 295.5 25.0 22.9

29.5 6 1 .7 1 1 .7 1 8.3

2 1 .6 27.8 7.2 8.6

1 8 .5 56.9 5.4 8.8

Former Soviet Union 1 884.5 32. 1 1 788.0 84.5 1 957.0 244.2 28.8 4 1 .6 57.4 6473.0 1 1 60.3 60.4 32.0 95.7 26.2 23.3 45.0 35.5 1 1 6.0 23.8 202.7 1 3 1 .4 I . I 2 1 33.3 ... 1 328.5 1 26 1 .5 200 1 .0 1 0 1 55.0 40 1 . 1 1 8 1 .4 9 1 0.0 884.8 1 28 1 .4 1 1 6.9

1 24 1 .2 1 0896. 1 ... 1 293.8 1 557.8 1 994.0 942.2 35.7 1 1 78.5 7484. 1 2962.8 2 1 69. 1 1 257.0 766.9 34.8 958.2 1 1 62.5 1 88 . 8 2 1 98.4 836.0 232 1 .6 84 1 .6 ... 7343 .7

5.8 6.7 39. 1 1 5 .0 1 3 .7 28.6 34.9 1 3 .2 13.1 15.1 2 1 .8 40.5 445.9 39.7 64.4

22.0 0.4 63.4 1 2.5 7.2 1 1 .3 1 4.7 7.0 8.5 II.I 1 1 .0 1 63.6 2 1 .8 J O. I

50.0

2. 1 -I . I -7. 6 5.0 1 8 1 .7 25 1 .2 4.5 3.8 1 0.6 1 0. 8 1 .9 1 7. 8 1 8.3 39.8 3.2 2.8 0.3 2.4 1 8 .4 82.7 84.5 36.5 2.7 3 1 .3 1 9.8 20.0 1 9.2 26.0

Sources: IMF; EBRO; and PlanEcon data.

1 .2.5.

REVERSAL OF T H E D I S I N F L ATION TREND

To have a complete picture of the speed of the disinflation processes in the various countries, it is also essential to consider the cases when the process was reversed. Among the countries that achieved low or moder­ ate levels of inflation, major reversals occurred in Albania (1996-1997), Armenia (1997), and Russia, the Ukraine, Georgia, Moldova, and Kazakhstan (in the second half of 1998 and first half of 1999). Hungary (1995), the Czech Republic (1997), Slovakia (1997 and 1999), Kyrgyzstan (1996 and at the end of 1998 and 1999), Slovenia (1997 and 1998), and Poland (1999 and 2000) recorded some more-modest inflation reversals or fluctuations. 1 1 Reversals were caused by serious political crises (Albania and Armenia), fiscal-policy problems and fiscal-policy inconsistency with monetary and exchange-rate policies (Russia, the Ukraine, Moldova, Georgia, Kazakhstan, Kyrgyzstan, Slovakia, and Hungary), a balance-of-payments crisis driven by enterprise-sector weak­ ness (the Czech Republic), and accommodating monetary policies (Slovenia and Poland).

Disinflation Strategies and Their Effectiveness in Transition Economies

15

There have been many more reversals and serious fluctuations caused by weak fiscal and monetary policies and the slow pace of structural reforms in chronically high-inflation countries, which only occasionally reached the moderate-inflation zone during the investigated period. This relates to Romania, Belarus, Uzbekistan, Turkmenistan, and Tajikistan. 1 2 Observing year-end inflation figures, one can see that only Lithuania recorded a continuous, uninterrupted disinflation trend until the end of 1999. 1 3 Estonia experienced one minor reversal in 1993 , while Azerbaijan, Latvia, and Poland experienced the same in 1999. Croatia's and Macedonia's inflation rates fluctuated a bit but remained at very low levels (less than 5 percent) for several years. 1 .3 . LOOKING FOR AN EFFECTIVE DISINFLATION STRATEGY 1 .3 . 1 .

S TABILIZATION S TRATEGIES IN THE F I R S T S TAGE OF TRAN SITION

At the outset of the transitions, in most of the postcommunist states, macroeconomic policy had to focus on checking high or very high inflation. This was both an absolute priority and a precondition for progress on other economic fronts. Looking at the historical experience of fighting high inflation and hyperinflation, particularly in developing countries, one can distinguish three stabilization strategies consisting of various policy mixes (see Kiguel and Liviatan 1992; Ades, Kiguel, and Liviatan 1 995; and Tomczynska 1 998): • the money-based orthodox program (MBOP); • the exchange-rate-based orthodox program (ERBOP); and • the heterodox programs (HP). Orthodox programs, by and large, consist of monetary- and fiscal-pol­ icy measures only, while heterodox programs use, in addition, income­ policy measures (wage controls) and sometimes price controls. The dif­ ference between the two orthodox programs relates to the nominal anchor: money aggregates in the case of a MBOP and an exchange-rate peg in the case of a ERBOP. Most of the transition countries used de facto an exchange-rate anchor even if only a few declared as much formally (Fisher, Sahay, and Vegh 1996; and IMF 1998). An informal pegging of the exchange rate has the advantage of not risking the central bank's reputation and may actually afford the central bank more real autonomy (formal pegging usually requires a joint decision with the government). But the informal peg has

16

Disinflation in Transition Economies

its limits as it restricts one's options in fighting ex ante inflationary expec­ tations, which are connected with a formal and credible peg. Only Poland, Hungary, Czechoslovakia, and several of the states of the former Yugoslavia resorted in the first years of their transitions to income­ policy instruments as an additional anti-inflationary measure. But consid­ ering the slow pace of disinflation and the strong inflationary inertia in countries such as Hungary, the Czech Republic (until 1997), Poland, and Slovenia, the effectiveness of the heterodox approach can be seriously chal­ lenged. Price controls proved completely irrelevant to transition realities. Price liberalization and removing price distortions were preconditions for initial fiscal adjustments (and thus the success of the stabilization pro­ grams) and beginning any structural and microeconomic reforms (Dabrowski 1996). Hence those that delayed price liberalization or revert­ ed back to price controls (for example, Belarus, Uzbekistan, Turkmenistan, the Ukraine, and Bulgaria) saw their stabilization programs fail or seri­ ously delayed. In fact, a successful orthodox program demands a broad liberalization of all markets (Rostowski 1998). That exchange-rate anchors were popular should come as no surprise. In the twentieth-century history of fighting high inflation and hyper­ inflation, most of the successful episodes involved such anchors. Yet the actual advantages of an ERBOP for most of postcommunist economies, in the initial transition stage, were different from those of other devel­ oping economies. Classical arguments in favor of an ERBOP are con­ nected with the lower output costs of stabilization, fighting high inflation­ ary expectations, currency substitution, and the like. Currency substitu­ tion was not a serious problem in most of the transition countries at the beginning of the 1 990s. Apart from Poland, Hungary, and the former Yugoslavia, the people and enterprises in the other former-communist states were unfamiliar with open inflation and thus were unprepared to protect themselves against an inflation tax. Additionally, dollarization was not widespread. Only after a few years of transition economics did agents learn how to respond to high inflation. Thus the countries that either delayed stabilization or failed in their first attempts had to resort to an exchange-rate anchor in order to gain at least minimal credibility. On the other hand, MBOPs were technically very difficult to imple­ ment. Radical price and financial liberalizations, the unfreezing of the monetary overhang, and the high-inflation environment dramatically altered the money-demand function, which was exceedingly difficult to estimate. Central banks possessed scant monetary-policy instruments as money and foreign-exchange markets had only just begun to work and

Disinflation Strategies and Their Effectiveness in Transition Economies

17

two-tier banking systems were still in their infancy. Most economic agents knew next to nothing about basic macroeconomic categories, including monetary aggregates. But practically everyone understood exchange-rate targets, and monetary authorities could operate them with ease. They were also expected to discipline both their monetary and fiscal policies, which was not always the case, particularly in relation to fiscal policy (see below). The transition experience confirmed the ERBOP's advantages. Even superficial analysis shows that the countries that brought their inflation down quickly to single-digit levels (for example, Croatia, Macedonia, the three Baits, Slovakia, Moldova, Georgia, and Azerbaijan) all used either a formal or an informal anti-inflationary exchange-rate anchor. On the other hand, those that subordinated their exchange-rate policy (and indirectly their monetary policy) to their balance-of-payments or export-promotion targets (Hungary and Poland) recorded slow disinflation progress. Most of the empirical research (Fischer, Sahay, and Vegh 1 996; Cottarelli, Grifiths, and Moghadam 1 998; and Chapter 4 of this volume) confirms the impor­ tance of the exchange-rate policy in any speedy disinflation process. 1 . 3 . 2 . C ONTROVE R S I E S S URROUNDING EXCHANGE-RATE TARGETING IN M O D ERAT E - AND Low-INFLATION ENVIRONMENTS While many authors (Sachs 1 996; Rostowski 1 998; and Rosati 1 996) sup­ port the use of an exchange-rate anchor for stopping high inflation or hyperinflation in the initial transition stage, continuing this regime in the face of moderate or low inflation meets much more resistance. Stable exchange-rate arrangements were more frequently criticized after a series of financial crises in various emerging markets, in 1 995-1 998 : Mexico, Thailand, Malaysia, South Korea, Philippines, Indonesia, Russia, the Ukraine, and Brazil. 1 4 This led to a more fundamental debate about mon­ etary and exchange-rate regimes in a world of freely moving capital. Referring to the Mundell-Fleming model and the "impossible-trinity" principle (Frankel 1 999), one can argue that a country cannot have all three policy goals-exchange-rate stability, monetary independence, and financial-market integration-simultaneously. One must be sacrificed. Assuming an increase in capital mobility is irreversible, a choice must be made between monetary independence and exchange-rate stability. In practice this means either preserving monetary independence under a free­ floating exchange rate or giving up monetary independence by adopting an extreme version of a fixed exchange rate--a currency board, mone­ tary union, or the unilateral adoption of a foreign currency.

18

Disinflation in Transition Economies

Adopting one of the "corner" solutions means phasing out intermedi­ ate regimes, including the so-called fixed but adjustable peg, crawling peg, crawling band, targeted band, or managed float. This view has recent­ ly gained ground in the economic literature (Mundell 1 999; Krugman 1 999; and Eichengreen 1 999). Why, in the future, will intermediate regimes prove difficult to oper­ ate and probably disappear? The first and most fundamental reason is that compromised solutions are unlikely to provide the advantages of both extremes, i.e., an exchange-rate anchor and sufficient discretion in man­ aging domestic liquidity. On the contrary, they may bring both substan­ tial exchange-rate variability (actual or expected when the peg is not viewed as credible) and make money supply exogenous (beyond the con­ trol of monetary authorities). Second, compromised regimes are techni­ cally very difficult because of fluctuating demand for money and chang­ ing market expectations. Moreover, economic and political pressures may bring the temptation to go beyond the compromise. Third, the trans­ parency and thus the credibility of intermediate regimes are lower than what is experienced in extreme solutions. To be sure, insufficient trans­ parency and credibility in intermediate regimes were strongly manifest­ ed during the financial crises of the 1 990s (Obstfeld and Rogoff 1 995; Mccallum 1 999; Eichengreen and Hausmann 1 999; and the Institute for International Economics 1 999). Considering the above arguments, one could make the case that man­ aging exchange-rate stability does not invite the danger of a currency cri­ sis (and a reversal of the disinflation trend). Instead it is the attempt to manage both the exchange rate and the domestic-money supply simulta­ neously that can result in a depletion of foreign reserves or undermine the credibility of a concrete exchange-rate t.arget and trigger a specula­ tive attack. In deciding on a "comer," a country is best served with a careful assessment of the advantages and disadvantages of both, given the coun­ try's specifics. For example, opting for monetary independence and a floating exchange-rate regime can look attractive for a number of reasons. First, the country retains its formal monetary sovereignty, which can be an important political and legal argument in many cases. Second, the exchange rate remains as the ultimate shock absorber. Although neither the government nor the central bank can use it as a direct policy tool (intentional devaluation or re-valuation), under a floating exchange-rate regime it can expect that the market exchange rate will follow changes in trade flows unless they are counterbalanced by changes in financial

Disinflation Strategies and Their Effectiveness in Transition Economies

19

flows. Third, if a country possesses a geographically diversified foreign­ trade structure, its anchor currency (dollar or euro in most cases) will still provide only partial external-price stability and only partly eliminate the exchange-rate risk in trade transactions. The currency basket reflecting the country's foreign-transactions structure, which is the standard solu­ tion in intermediate regimes, is rather technically unrealistic with a cur­ rency board, not to mention the adoption of another country's currency. Fourth, there is also at least a theoretical risk that the foreign anchor cur­ rency will tum out to be less stable than the domestic currency. But this danger is hardly the most serious concern for the transition economies. On the other hand, the economic costs of managing an independent monetary policy in the form of interest-rate spreads and exchange-rate risks (the former to a significant extent is a consequence of the latter) must be taken into account. This is strictly connected not only with the credi­ bility of the domestic monetary (and overall macroeconomic) policy but also with the phenomenon of currency substitution. Increasing financial integration provides economic agents in most countries (also those applying partial capital controls) with an effective currency arbitrage opportunity (see Dabrowski 2000), regardless of whether it is conducted between countries or between currencies in one country. As a result, the monopoly power of the monetary authority to issue the national currency and collect seigniorage is undermined. Hence it seems that an independent monetary policy and a free-float­ ing exchange rate are very difficult and costly options for countries that suffer from high or chronic moderate inflation, possess inflationary mem­ ory, enjoy only low levels of monetization, and lack sufficient political and institutional credibility, which is the case in the great majority of the transition countries. This implies that a free float coupled with an inde­ pendent monetary policy is a viable option only for certain large economies and economic blocs (the US, Japan, and the eurozone) and a few other countries that have managed to establish internationally rep­ utable currencies and monetary authorities (Canada, Australia, New Zealand, Switzerland, and the UK). Empirical research on a number of Latin American states confirms the above hypothesis: there are low-credibility and high-macroeconomic costs in floating and in using intermediate currency regimes. The oppo­ site is true in Panama's experience because it uses the US dollar as its national currency (Eichengreen and Hausmann 1 999). Arguments in favor of the ultimate-fix comer solution are similar to those discussed in the context of the ERBOPs: an exchange-rate anchor

20

Disinflation in Transition Economies

allows for importing low inflation, and lower interest rates. Exchange-rate stability also provides economic agents with lower transaction costs. In addition, contrary to a pegged exchange rate in intermediate regimes, it eliminates the devaluation risk and the danger of using monetary policy for purposes other than achieving price stability. But completely closing all windows of a central bank's domestic credit, and thus its lender-of-last­ resort function, may create some problems for banking-sector stability. This fundamental discussion has influenced, to a certain extent, the evolution of monetary exchange-rate regimes in the transition countries, particularly in Central Europe and the Balkans, where some shift from intermediate regimes toward the so-called corner solutions can be observed. This was determined both by the unsatisfactory results of the previous hybrid regimes and, in some cases, by political developments. Responding to serious currency and banking crises in 1996 and early 1997, Bulgaria introduced a D-mark-denominated currency board on July 1, 1997. The same kind of monetary regime was introduced in Bosnia and Herzegovina in 1997-1998 as a consequence of the Dayton Peace Accord. After the Kosovo crisis, the province, under UN admin­ istration, introduced the D-mark as its legal tender, in 1999. Montenegro also introduced the D-Mark, in 1999, as a parallel currency (apart from the Yugoslav dinar), and in October 2000, the D-mark (euro) became its sole legal tender. Much earlier, two Baltic states adopted currency-board regimes: Estonia, in June 1992 (D-mark denominated); and Lithuania, in April 1994 (US-dollar denominated). On the other hand, the Czech Republic introduced direct-inflation-tar­ geting with a floating exchange-rate arrangement at the outset of 1998. Poland followed suit at the end of the year. In the case of Poland (from April 2000) this is a genuine pure float, free of central-bank interven­ tion. In 1998, Slovakia also moved toward a floating exchange-rate regime, although without a clear nominal anchor guiding its monetary­ policy operations. In 1998-2000, the disinflation results of direct inflation targeting seemed satisfactory in the Czech Republic, where inflation has been driven to very low levels, but less so in Poland, where maintaining the disinflation trend in the single-digit zone has proved problematic. Summing up, an exchange-rate anchor can be a feasible monetary strategy in the condition of medium and low inflation, particularly when a country suffers from inflationary inertia. But a fixed exchange rate must be sufficiently credible and cannot be combined with simultaneous liq-

Disinflation Strategies and Their Effectiveness in Transition Economies

21

uidity management. In addition, the exchange-rate target must be sup­ ported by a prudent fiscal policy (see section 1 .4). 1.3 . 3 .

E X C H A N G E - RATE ARRAN GEMENTS THAT S T I MULATE INFLAT I O N

I N E RT I A

As noted in the previous section, an exchange-rate mechanism can serve as a viable anti-inflationary device, anchoring domestic prices to inter­ national levels while dampening inflationary expectations. But exchange­ rate arrangements can also work contrariwise and induce inflationary iner­ tia if they are subordinated to targets other than disinflation. This is par­ ticularly true of a crawling-peg devaluation. Originally invented in devel­ oping countries with chronically high inflation as a mechanism to smooth unavoidable currency depreciations and calm inflationary and devalua­ tion expectations, the crawling peg became all too often an autonomous factor that actually fed inflationary inertia. Additionally, similar to other indexing mechanisms, political pressures come to the fore, making it politically difficult to abandon the crawling peg even when economic circumstances have changed (for example, much lower inflation). More often than not, exporters lobby to defend the crawling-peg mechanism with arguments about competitiveness, the importance of export-led growth, the danger of balance-of-payment crises, and the like. Continuing a crawling peg in a moderate-inflation environment means that monetary policy is left perpetually subordinated to balance-of-pay­ ments or growth targets at the expense of disinflation aims. In fact, most defenders of the crawling-peg (or band) arrangement (Sachs 1 996; and Gomulka 1 998) explicitly or implicitly accept the priority ofbalance-of­ payment targets over disinflation targets. This can mean in practice, how­ ever, that monetary policy should accommodate fiscal-policy and struc­ tural-reform weaknesses, which, in turn, will not generate progress in either. Hence the crawling-peg (or band) regime is rather inconsistent with the consequent anti-inflationary orientation of the central bank. Apart from inducing inflationary expectations, it can provoke a host of prob­ lems controlling the money supply. Converting a crawling peg into a crawling band (which occurred in Poland, in May 1 995) affords a stand­ ing monetary management room to maneuver, but it does not eliminate inflationary inertia on the micro level.

22

Disinflation in Transition Economies

Rybinski ( 1998) stresses that an exchange-rate depreciation's expect­ ed impact on inflation is clearly observable on the micro level in coun­ tries that maintain crawling-peg mechanisms. Resident companies undertake their budgeting projections one to three years into the future, planning price increases and wage and workforce expansions. For that purpose, they often must seek to forecast the future exchange-rate path. If the central bank is pursuing a preannounced crawling peg/band regime, the expected crawling-peg scenario often proves to be the best available forecast of the future exchange rate. Thus central parity's expected depre­ ciation enters the inflation equation. The effectiveness of the crawling peg, or any other type of controlled­ devaluation regime, on export promotion and its inflationary conse­ quences remains an open question. In industrialized countries, a curren­ cy depreciation can sometimes improve competitiveness in the short and medium term without any strong negative impact on domestic inflation. But in developing and transition economies, lacking in credibility and highly indexed, the outcome may be quite different: a return to inflation without any sustainable competitiveness gains. Such was decidedly the case both in Latin America, where the crawling peg (tablita) was a pop­ ular mechanism in the 1970s and 1980s, and in the transition countries, notably in Poland and Hungary. Preannounced crawling-peg/band arrangements have been formally adopted in Poland ( 199 1-2000), Hungary (from 1995), and Russia ( 1995-1998), but they also existed less formally in some other countries, such as in Slovenia and Kazakhstan. Poland and Hungary, having the longest experience with this mechanism, give the best evidence of its neg­ ative inflationary consequences. Poland and Hungary have often been considered as belonging to the group of the most advanced transition countries. They have succeeded in implementing many market-oriented institutional reforms, and they have returned to economic growth. But their disinflation records have proved less than impressive (see section 1.2). Until very recently, both remained within the so-called moderate-inflation range (between 10 and 40 per­ cent). The sources of persistent moderate inflation in Poland and Hungary appear similar: monetary policies have tended to be accommodative, entrenched inflationary expectations persist, the indexation of labor and debt contracts and social-security benefits is widespread, and the exchange-rate regimes have incorporated automatic-devaluation mecha­ nisms to compensate exporters for inflation differentials (Antczak and

Disinflation Strategies and Their Effectiveness in Transition Economies

23

Gorski 1998). To be sure, policymakers have favored the interests of domestic exporters over disinflation concerns. Yet the current-account balances of both countries have been determined by their savings-invest­ ment imbalances and the size of their fiscal deficits rather than by the pace of their nominal exchange-rate depreciations (see Chapter 6 of this vol­ ume). 1 .4. THE ROLE OF FISCAL POLICY IN SUPPORTING THE D I S INFLATION PRO C E S S Fiscal policy i s the second pillar (apart from monetary policy) o f an effective disinflation strategy. The more a fiscal policy is prudent-{)ther things being equal-the greater and more sustainable the progress on lowering inflation and the smaller the output and employment costs. On the other hand, a tight fiscal policy, though necessary and desirable, will not guarantee low inflation. The experiences of Slovenia and Poland are telling. In Slovenia, the fiscal deficit was close to zero; in Poland, it was rather low and stable. Yet neither experienced fast disinflation because of the accommodating character of their monetary and exchange-rate policies. 1 .4 . 1 .

M O NETARY F INANCING O F F I S CAL D E F I C I T S

How a fiscal deficit is financed will determine its inflationary impact. Governments finance deficits either by increasing their foreign or domes­ tic debt or by increasing the liabilities due their central banks (deficit mon­ etization). Both methods may involve macroeconomic disequilibrium. Additional money creation immediately stimulates inflation. Growth in foreign debt may lead to servicing problems and narrowing access to cred­ it resources on foreign financial markets. Excessive domestic debt may result in a rise in real interest rates, which may leave one falling into the proverbial debt-servicing trap, an expanding deficit, rising in interest rates, and the like. W hen a fiscal deficit is financed by central-bank credit, it results in an increasing monetary base (reserve money) and, assuming an unchanged money multiplier, in a proportional increase in the broad-money supply. The eventual inflationary effect depends on the size of the deficit financ­ ing, the money multiplier, and the demand for money (the monetization level). The higher the deficit financed from monetary emission and the

24

Disinflation in Transition Economies

lower the monetization level, the more profound the inflationary conse­ quences of the fiscal disequilibrium (other things being equal). In most postcommunist states, central-bank financing of govern­ ments predominated during the first years of the transition, when other sources of deficit financing, particularly a T-bills market, were not yet available. Even Hungary, considered a reform leader, could not avoid substantial central-bank financing of its fiscal deficit in the first half of the 1990s. In fact, central-bank participation in deficit financing was the most important factor behind the initial high-inflation/hyperinflation episodes in most of the transition countries, apart from the unleashing of the accumulated monetary overhang (see Chapter 2 of this volume). Table 1 . 5 . Overall Government Balances and Central-Bank Financing of Governments, 1 992-1 997 (as a Percent of GDP) Country

Overall Government Balances Central-Bank Financing 1 992 1 993 1 994 1 995 1 996 1 997 1 992 1 993 1 994 1 995 1 996 1 997 CEE countries -1 3 . 1 20.0 9. 1 . 6.6 2.0 1 .0 6.0 -2.6 6.0 1 1 .0 5.5 4.9 1 4. 5 --0. 1 -1.3 ... --0.7 0.5 --0. 1 0.0 -2. 1 ... -2. 1 -2.4 -1 .0 --0.8 0.7 --4.6 1 6.5 1 3 .2 1 1 .2 7.5 7.3 1 .7 0.4 ... 1 .3 0. 1 0. 1 0.4 1 .5 1 .5 0. 1 0. 1 0.5 -2.3 5.2 -3 .5 ... 1 .5 -5 . 1 -1 .5 0.0 0.0 0.0 0.0 0.0 0.0

-2 1 . 8 -1 5.4 -1 3.0 -1 0.4 -12.6 Albania Bulgaria -5 .2 -1 0.9 -5. 8 -6.3. - 1 3 .3 Croatia -3 .8 --0.8 1 .5 -1 .0 --0.4 ... -1 .2 -1 .8 -1 .2 Czech Rep. -6.9 -8.5 -8 .3 -7 . 1 -3 . 1 Hungary . . . -1 3 . 8 -2.9 -1 .2 --0.4 Macedonia Poland -7.5 --4.0 -2.0 -2.7 -2.5 --4.6 --0.4 - 1 . 9 -2.6 --4.0 Romania 0.2 -1 .3 -1 1 .9 -7.0 -1 .3 Slovakia 0.0 0.3 0.2 0.3 --0.2 Slovenia

FSU countries -37.3 Armenia Azerbaijan -27.9 0.0 Belarus --0.3 Estonia -62.3 Georgia Kazakhstan -7.3 Kyrgyzstan -14.8 --0.8 Latvia 0.0 Lithuania Moldova -23.9 -1 8.2 Russia Taj ikistan -30.5 Turkmenistan 1 3 .3 -23.2 Ukraine Uzbekistan -1 8.4

-54.3 -10. 1 ... -1 1 .4 - 1 . 9 -2.5 --0.6 1 .3 -26. 1 -1 6.5 -1 .2 -7.2 -1 4.4 -1 1 .6 0.6 --4.0 -5 .5 --4.8 -7.4 -9. 1 -7.3 -1 0.4 -23.4 -5. 1 --0.5 -1 .4 -9.7 -8 .2 -1 0.4 -6. 1

Source: I M F 1 998: Table 5 .

-1 1 . 1 --4.3 -1 .9 -1 .2 --4.5 -2.0 -1 7.3 -3 .3 --4.5 -5 .8 -5. 8 -1 1 .2 -1 .6 -5 .0 --4. 1

-9.3 -2.6 -1.6 -1 .5 --4.4 -2.5 -9.5 -1 .3 --4.6 -6.6 -8 . 1 -5 .8 --0.8 -3 .2 -7.3

-6.7 ... - 1 . 3 0.0 1 1 .4 ... -1 .2 ... 0.0 2.0 -3 .7 ... ... -3 .6 -9.4 ... 0.7 1 .3 0.0 0.0 -1 .4 0.0 0.0 -6.8 26. 1 5.0 -7.5 9.2 5.9 -3 .3 30.6 24.8 --0.4 9.9 6.0 -5. 1 23.8 14. l -2.3 ...

3.5 0.4 1 .4 -1 .4 8.2 -2.7 1 .4 --0.6 0 . 8 2.6 1 .4 0.4 0.0 0.0 0.0 0.0 2.0 1 .8 2.7 2.2 3.2 1 .7 --0. 1 --0.3 1 .3 7.8 1 .9 0.4 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1 .9 1 .5 --0.7 1 .4 1 .6 2. 1 8. 1 9.6 1 3 . 1 2.3 1 .5 1 .6 1 .8 --0.2 0.4 8.9 5.6 2. 1 1 .4 4.8 1 .4 6.8 1 . 3

Disinflation Strategies and Their Effectiveness in Transition Economies

25

Officially recorded fiscal deficits, on a cash basis, do not necessarily cover all the cases of fiscal disequilibrium. Apart from officially record­ ed fiscal operations, there can also be other activities of the government, public agencies, the central bank, and commercial banks, involving expenditures of a quasi-fiscal character, in the present or in the future. This was a particularly frequent phenomenon at the beginning of the tran­ sitions, when central banks were still heavily dependent on their gov­ ernments and parliaments, most banks were publicly owned, and fiscal accounting standards did not meet international standards (see Chapter 8 of this volume). As I-bill markets developed, the extent of monetary financing of fiscal deficits declined in most of the transition countries, sometimes spectacu­ larly (see Table 1.5 and Chapter 8 of this volume). For example, in Moldova such financing declined from 26.1 percent of GDP in 1992, to -0.7 percent in 1996; in the Ukraine, from 23.8 percent of GDP in 1992, to 1.4 percent in 1997; in Tajikistan, from 30.6 percent of GDP in 1992, to 1.5 percent in 1997; and in Albania, from 20 percent of GDP in 1992, to 1 percent in 1996. However, when various governments found themselves in debt traps, facing problems with continued financing of their fiscal deficits and the need to roll over their existing debts, central-bank financing suddenly and dramatically increased; thus creating an additional inflationary pressure. In 1998, central-bank funding of fiscal deficits occurred in Russia, the Ukraine, and Moldova because the demand for government I-bills col­ lapsed, owing to credibility crises (see below). Bulgaria, in 1996, wit­ nessed the most spectacular reversal. National-bank credits to the gov­ ernment rose from 4.9 percent of GDP in 1995, to a sobering 14.5 per­ cent in 1 996. 1 .4.2.

N ONMONETARY FINANCING O F F I S C A L D E F I C I T S

As macroeconomic stabilization took hold and institutional reforms pro­ gressed, sources of deficit financing (besides central banks) became avail­ able. Domestic I-bill markets, 1 5 external borrowing from official credi­ tors, and private sources of funding all emerged. In theory, access to these sources will halt or at least dissipate any inflationary pressures coming from fiscal deficits. But here we reach the fundamental problem of the role of fiscal equilibrium in guaranteeing the sustainability of the disinflation process. First, the theoretical arguments. In 1994--1995, an interesting polemic between Jeffrey Sachs and the IMF unfolded over the proper primary

26

Disinflation in Transition Economies

macroeconomic-stabilization strategy in the postcommunist states (Sachs 1 994a; Sachs 1 994b; Hernandez-Cata 1 994). Sachs held that the IMF's position on fiscal matters was excessively harsh (from a political point of view) in Russia in 1 992-1 993 . 1 6 His position was that a stabilization pack­ age could rely more on the fixed exchange rate as the main anti-inflation­ ary anchor and on noninflationary sources of financing for the remaining fiscal deficit (through the T-bills market and external financial assistance). A fixed exchange rate would bring inflationary expectations down rela­ tively quickly and increase demand for the domestic currency, which would increase the room for maneuver on the monetary-policy front. To be sure, this kind of stabilization strategy needs substantial external finan­ cial aid: both for partially financing the deficit and for building up the cen­ tral bank's international reserves to back the fixed exchange rate. The countries of the CIS that actually achieved progress on disinflation, in 1 995-1 997, did indeed follow Sachs's recommendations. In almost all the analyzed cases, stable exchange rates ( de facto, since de jure they have often continued to float) and significant reductions in deficit financing via money emission (and quasi-fiscal operations of central banks) have been the main factors behind price stabilization. But fiscal deficits have remained at least at the 5 percent of GDP level and have been financed either from external sources or through T-bills. International assistance, in the form of grants from the developed countries and special credit windows of the IMF (the Enhanced Structural Adjustment Facility [ESAF]) and the World Bank ( cheap cred­ its offered by the IDA), has played an important role in the low-income countries, such as Albania, Armenia, Georgia, Moldova, Mongolia, and Kyrgyzstan. In some of the countries of the CIS, for example in Kyrgyzstan, the stock of public debt rapidly increased, from essentially no debt immediately after the dissolution of the Soviet Union to more than 1 00 percent of GDP at the end of the decade (Brudzynski, Chokoev, and Markiewicz 1 998; and Siwinska 1 999). Bulgaria, Romania, Russia, and the Ukraine have also used external financing, but it has been granted predominantly according to market con­ ditions. Kazakhstan, Russia, and the Ukraine developed domestic T-bill and government-bond markets, following the earlier experience of Hungary and the other countries of Central Europe. The involvement of foreign portfolio investors in the domestic T-bill market and the issuance of government bonds denominated in foreign currencies and floated on international financial markets was the next stage of easing the fiscal con­ straints of the countries in the CIS. The excess of cheap credit and the

Disinflation Strategies and Their Effectiveness in Transition Economies

27

readiness o f financial investors to engage in emerging markets, which pre­ vailed in international financial markets in 1 996 and in the first half of 1 997, made this form of deficit financing relatively cheap and painless (especially under stable exchange rates). Yet massive domestic and external borrowing can solve fiscal prob­ lems and support macroeconomic stability in the short run only. Increasing the debt overhang (the pace of debt accumulation was notably abrupt because of the continuous decline of GDP) led to an explosion of interest payments and thus a debt trap. 1 .4 . 3 .

D E B T-TRAP E P I S O D E S AND FINANCIAL C R I S E S

A relatively short history of economic transitions already provides us with a number of striking examples of government liquidity problems and devaluation crises as a result of excessive fiscal deficits: Hungary in 1 994-1 995 ; Kyrgyzstan in 1 996 and 1 998-1 999; Romania in 1 996-1 997; Bulgaria at the end of 1 996 and beginning of 1 997; Russia, Ukraine, Moldova, and Georgia in the second half of 1 998; and Kazakhstan in 1 999. Bulgaria's 1 996-1 997 crisis was the result of slow and inconsequen­ tial structural reforms, weak fiscal and monetary policies, and excessively high domestic and foreign debts (exceeding 1 00 percent of GDP). Instead of implementing privatization and restructuring based on hard-budget constraints, the government opted for a massive bailout of its loss-mak­ ing enterprises and banks. The resulting debt burden to the government, in addition to its communist-era debts, drove the economy into a debt trap. The lack of financial discipline also led to a banking crisis at the begin­ ning of 1 996, which unfolded on the back of an overall macroeconomic destabilization. At the end of 1 995, the central bank's premature attempts to lower interest rates (in an effort to ease the interest-payments burden of the state budget) detonated an even more serious crisis and brought results that were completely contrary to expectations. Lowering interest rates provoked a chain reaction: a decline in demand for the leva, capi­ tal outflows, a foreign-exchange crisis, a dramatic collapse in the exchange rate of the leva, an inflation shock, and a further decline in demand for the leva. The central bank's efforts to stop the spiral by increasing interest rates was inadequate and came too late. But its actions did result in a dramatic increase in interest payments: in 1 996 they reached 20 percent of GDP, while total tax revenue amounted to 25.5 per­ cent of GDP. The fiscal deficit amounted to 1 3 .4 percent of GDP, despite a drastic reduction in all expenditures apart from interest payments.

28

Disi,iflation in Transition Economies

Two years later, developments in Russia, the Ukraine, Moldova, and other countries of the CIS looked strikingly similar to those in Bulgaria. The Asian crisis of 1997 spooked international financial markets. In its wake, the availability of relatively cheap external financing for emerg­ ing markets instantly evaporated. Reacting to the changing international atmosphere and signs of political and fiscal instability, nonresident investors rapidly withdrew their T-bill holdings in all of the CIS. Two problems immediately followed: governments faced liquidity crises and official foreign-exchange reserves were instantly pressured. On the heels of these came resident and nonresident exchange-rate speculators (and the exchange rate was the only genuine stabilization anchor). Defending the exchange rate proved very costly in terms of lost foreign reserves and high interest rates, but it did not put an end to the speculation and served only to drastically increase interest payments. Central banks were forced to return to financing fiscal deficits, mainly by rolling over the existing stock of T-bills, which further eroded exchange rates. Devaluation was inevitable, and it came first to Russia, on August 17, 1998, and in most of the CIS in the following weeks. Devaluation led to a new wave of inflation, banking crises (especially serious in Russia and Kyrgyzstan), an additional explosion of interest payments, a shift from domestic currencies to foreign ones, and continuous capital outflows (despite the introduction of forei gn-exchange restrictions). The Russian govern­ ment's default on it treasury bills and its 90-day moratorium on repayment of Russian commercial-bank liabilities destroyed the country's credibility among investors. The crisis in the Ukraine, though slightly less severe than the Russian one, brought similar consequences (Dabrowski et al. 1 999). Owing to the crises in Russia and the Ukraine, the other countries of the CIS with persistent fiscal disequilibrium were subjected to specula­ tive attacks both by domestic and foreign investors at the close of 1 998. Among others, they included Armenia, Belarus, Georgia, Kazakhstan, Kyrgyzstan, and Moldova. The transition states with stronger fiscal and macroeconomic fundamentals-most of the Central Europeans and Balts--managed to avoid the adverse contagion effect of the Asian and Russian-Ukrainian crises. 1.4.4.

THE ROLE OF F I S C A L P O L I C Y AND C ENTRAL - B ANK I N D E P E N D E N C E

The above examples show clearly that nonmonetary financing of fiscal deficits can also be inflationary; though the inflationary consequences usually come with a time lag. This observation led Markiewicz (see

Disinflation Strategies and Their Effectiveness in Transition Economies

29

Chapter 8 of this volume) to the conclusion that the so-called unpleasant monetarist arithmetic does exist in transition economies. The famous con­ cept of Sargent and Wallace ( 198 1 ), that monetary and fiscal policies can­ not be separated (at least not in the long run), holds true. They point out that debt financing may be inflationary in the long run. According to their argument, if a government takes on an excessive debt burden that becomes too large to finance by taxes or more borrowing, the only way for it to satisfy the payments is to print money. Debt financing in this case only postpones money financing. If rational economic agents perceive the debt burden as excessive, they will assume that today's debt implies a large growth of money stock and inflation in the future. The expectations of inflation will fuel present inflation. Paradoxically a restric­ tive monetary policy, but one that allows for the expectations of future higher interest rates and dearer costs of debt servicing, can be more inflationary than a monetary policy that accommodates fiscal policy. The experiences of the countries of the CIS, in 1997-1998, seems to support the thesis that monetary policy alone has limited room for maneu­ ver. Even a relatively conservative and tough central banker must give up at some point when the fiscal authorities prove powerless to prevent default on their treasuries. Both the Sargent-Wallace theory and the above observations lead us to another interesting question. If fiscal policy plays the decisive role in fighting inflation and the maneuver room of monetary policy is limited, what is the rationale for recommending central-bank independence? Among other things, making a central bank independent is intended to protect monetary policy from fiscal-policy pressures. Thus the Sargent-Wallace position, if fully accepted, could have far­ reaching consequences on economic-policy and institutional solutions. However, this concept can be challenged both on theoretical and empiri­ cal grounds. According to Parkin ( 1 987), an independent central bank may discipline fiscal authorities and thus contribute to the lowering of a pri­ mary fiscal deficit. Sachs and Larrain ( 1993) argue that while debt financ­ ing by itself does not allow a government to escape inflation, it does buy it time to adopt the desired fiscal-adjustment measures. Yet in the transi­ tion economies the time frame for adopting adjustments was rather short. Considerable empirical research (Cukierman 1992; Bade and Parkin 1 988; Alesina 1989; Grilli, Masciandaro, and Tabellini 1 99 1 ; and Eijffinger and Schaling 1993) demonstrates a pronounced correlation between central-bank independence and inflation levels. Similar conclu­ sions are provided by Maliszewski in these pages (see Chapter 9).

30

Disinflation in Transition Economies

Thus central-bank independence and prudent monetary policy subor­ dinated to a price-stability target are greatly important to a successful disinflation process. But an improper mix of monetary and fiscal policies (an excessively restrictive monetary policy and an excessively loose fiscal policy) can decelerate or even reverse a disinflation trend. Moreover, it can significantly increase the economic and social costs of fighting inflation, as high public-sector borrowing requirements crowd out the pri­ vate sector 's needs and stimulate inflationary expectations. 1.5. CONCLUSIONS Several conclusions follow from our analysis. First, low inflation is con­ ducive to economic growth. Fast and consequent disinflation produces evident benefits in the medium and long run. Although breaking down accumulated inflationary inertia (which is the problem in several transi­ tion economies) can result in a temporary slowing in the rate of economic growth, overdramatizing these costs seems unjustified as they can be quickly compensated for with the benefits of sustainable low inflation. Second, success in fighting inflation depends in the first instance on monetary policy, which should be sufficiently tight and oriented, conse­ quently, toward price stability. Subordinating monetary policy to targets other than price stability, such as stimulating economic growth through short-term manipulation of global demand or export promotion, results in undermining the monetary authorities' credibility, delaying the disinflation process, and provoking ever-so-costly inflationary inertia. Third, exchange-rate-based stabilization strategies proved the most effective in fighting inflation in the transition economies. Yet such a strat­ egy is unsustainable if not adequately supported by a prudent fiscal pol­ icy (with structural reforms, to a significant extent, determining fiscal bal­ ances). In addition, when an economy begins to integrate itself with glob­ al financial markets, attempting active domestic-liquidity management while maintaining an exchange-rate peg can easy lead to speculative attacks and currency crises. Thus continuing the exchange-rate anchor (which is sensible for small, open economies that lack sufficient macro­ economic-policy credibility) requires giving up monetary-policy inde­ pendence and following very conservative fiscal policies. Fourth, the sustainability of disinflation is determined not only by monetary policy but also by fiscal policy and the proper mix of both. Even the most determined anti-inflationary monetary policy will fail in the face

Disinflation Strategies and Their Effectiveness in Transition Economies

31

of a chronic fiscal crisis, which i s confirmed by the experiences of Bulgaria and the members of the CIS. On the other hand, a tight mone­ tary policy carried out by a genuinely independent central bank can dis­ cipline fiscal policy, at least to a certain extent.

REFERENCES Ades, Alberto F., Miguel A. Kiguel, and Nissan Liviatan. 1995. Disinflation Without Output Decline: Tales of Exchange-Rate-Based Stabilizations. In Robert Holzmann, Janos Gacs, and Georg Winckler (eds.) Output Decline in Eastern Europe. Unavoidable, External Influence or Homemade? Kluwer Academic Publishers. Alesina, Alberto. 1989. Politics and Business Cycles in Industrial Democracies. Economic Policy no. 8. Alesina, Alberto and Roberto Perotti. 1994. The Political Economy of Budget Deficits. IMF Working Paper, WP/94/85. Antczak, Malgorzata and Urban Gorski. 1998. The Influence of Exchange Rate Stability on Inflation: A Comparative Analysis. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 137. Aslund, Anders. 1994. Lessons of the First Four Years of Systemic Change in Eastern Europe. Journal of Comparative Economics 19, no. 1. Aslund, Anders, Peter Boone, and Simon Johnson. 1996. How to Stabilize: Lessons from Post-Communist Countries. Brookings Papers on Economic Activity I, 217-313 . Bade, R. and M. Parkin. 1 988. Central Bank Laws and Monetary Policy. Working Paper, Department of Economics, University of Western Ontario. Balcerowicz, Leszek and Alan Gelb. 1995. Macropolicies in Transition to a Market Economy: A Three-Year Perspective. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 3 3 . Barro, Robert J . and J-W. Lee. 1993. Losers and Winners in Economic Growth. In Proceedings of the World Bank Annual Conference on Development Economics 1993, World Bank, Washington, D.C., 267-298. Brudzynski, Robert, Zair Chokoev, and Malgorzata Markiewicz. 1998. Publichnyi dolg Kyrgyzskoi respubliki (Public debt of the Kyrgyz Republic). Center for Social and Economic Research, Warsaw, Studies and Analyses no. 135. Bruno, Michael and William Easterly. 1995. Could Inflation Stabilization Be Expansionary? Transitions 7 (7-8), 1-3 .

32

Disinflation in Transition Economies

Budina, Nina. 1997. Essays on the Consistency of Fiscal and Monetary Policy in Eastern Europe. University of Amsterdam, Tinbergen Institute Research Series. Cagan, Phillip. 1956. The Monetary Dynamics of Hyperinflation. In Milton Friedman (ed.) Studies in the Quantity Theory of Money. University of Chicago Press, 25-117. Calvo, Guillermo A. and Fabrizio Coricelli. 1992. Stabilizing a Previously Centrally Planned Economy: Poland 1990. Economic Policy 14. Christoffersen, Peter and Peter Doyle. 1998. From Inflation to Growth: Eight Years of Transition. IMF Working Paper, WP/98/100 . Cottarelli, Carlo, Mark Grifiths, and Reza Moghadam. 1998. The Nonmonetary Determinants of Inflation. IMF Working Paper, W P/98/23. Cukierman, Alex. 1992 . Central Bank Strategy, Credibility and Independence: Theory and Evidence. MIT Press. Cukrowski, Jacek and Jaroslaw Janecki. 1998. Financing Budget Deficits by Seigniorage Revenues : the Case of Poland 1990-1997. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 155. Dabrowski, Marek. 1996. Different Strategies of Transition to a Market Economy: How Do They Work in Practice? World Bank Policy Research Working Paper 1579. Dabrowski, Marek. 1998. Western Aid Conditionality and the Post­ Communist Transition. Journal of Policy Reform 2, 169-193. Dabrowski, Marek. 2000. Global Integration of Financial Markets and Its Consequences for Transition Economies. In Lucjan T. Orlowski (ed.) Transition and Growth in Post-communist Countries. Edward Elgar. Dabrowski, Marek and Jacek Rostowski. 1992. Inflacja: Wr6g numer jeden (Inflation: Enemy Number One). Gazeta Bankowa nos. 13 and 14. Dabrowski, Marek et al. 1999. Ukraine: From Fragile Stabilization to Financial Crisis. Center for Social and Economic Research, Warsaw, Studies and A nalyses no. 158. De Melo, Martha, Cevdet Denizer, and Alan Gelb. 1996. From Plan to Market: The Patterns of Transition. World Bank Policy Research Working Paper no. 1564. Dornbusch, Rudiger and Stanley Fischer. 1993. Moderate inflation. World Bank Economic Review. Eichengreen, Barry. 1999. Toward a New International Financial Architecture: A Practical Post-Asia Agenda. Institute for International Economics.

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Eichengreen, Barry and Ricardo Hausmann. 1999. Exchange Rates and Financial Fragility. NBER Working Paper no. 7418 (November). Eijffinger, S. and E. Schaling. 1993. Central Bank Independence in Twelve Industrial Countries. Banca Nationale de/ Lavaro Quarterly Review no. 184. Fischer, Stanley and Alan Gelb. 1991. The Process of Economic Transformation. Journal of Economic Perspectives 5, no. 1. Fischer, Stanley, Ratna Sahay, and Carlos A. Vegh. 1996. Stabilization and Growth in Transition Economies: The Early Experience. Journal of Economic Perspectives 10, no. 2. Frankel, Jeffrey A. 1999. No Single Currency Regime is Right for All Countries or at All Times. NBER Working Paper no. 7338. Gaidar, Egor T. 1997. "Detskie bolezni" postsocializma ("Childrens' ill­ nesses" in postsocialism). Voprosy Ekonomiki no. 4. Ghosh, Atish R. and Steven Phillips. 1998. Warning: Inflation May Be Harmful to Your Growth. IMF Staff Papers 45, no. 4. Gomulka, Stanislaw. 1998. Managing Capital Flows in Poland, 1995-1998. CASE-CEU Working Papers Series no. 7. Grilli, Alberto, Donato Masciandaro, and Guido Tabellini. 1991. Political and Monetary Institutions and Public Financial Policies in the Industrial Countries. Economic Policy no. 13. Hernandez-Cata, Ernesto. 1994. Russia and the IMF: The Political Economy of Macro-Stabilization. IMF Papers on Policy Analysis and Assessment, PPAA/94/20. Institute for International Economics. 1999. Safeguarding Prosperity in a Global Financial System. The Future International Financial Architecture. A Council on Foreign Relations sponsored report, Institute for International Economics. Washington, D.C. International Monetary Fund. 1998. Disinflation in Transition: 1993-1997. International Monetary Fund European Department I in consultation with European Department II (September). Kiguel, Miguel A. and Nissan Liviatan. 1992. When Do Heterodox Stabilization Programs Work? World Bank Research Observer. (January). Koen, Vincent and Paula De Masi. 1997. Prices in Transition: Ten Stylized Facts. IMF Working Paper, WP/97/158. Krugman, Paul. 1999. Depression Economics Returns Foreign Affairs 78, 1. Leidy, Michael and Stephen P. Tokarick. 1 998. Consideration in Reducing Inflation From Low Level to Lower Levels. IMF Working Paper, WP/98/109.

34

Disinflation in Transition Economies

Maliszewski, Wojciech. 1 998. Medium-Term Fiscal Projection for Selected Countries in Transition. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 1 5 1 . McCall um, Bennett T. 1 999. Theoretical Issues Pertaining to Monetary Unions. NEER Working Paper no. 7393. Mundell, Robert. 1999. The Prioritiesfor Completing the Transition and the Model for the Future. Paper prepared for the Fifth Dubrovnik Conference on Transition Economies. Ten Years of Transition: What Have We Learned and What Lies Ahead. Dubrovnik, Croatia, June 23-25. Nuti, Domenico Mario and Richard Portes. 1993 . Central Europe: The Way Forward. In Richard Portes (ed.) Economic Transformation in Central Europe. A Progress Report. CEPR and European Communities. Obstfeld, Maurice and Kenneth Rogoff. 1 995. The Mirage of Fixed Exchange Rates. NEER Working Paper no. 5 1 9 1 . Parkin, M. 1 987. Domestic Monetary Institutions and Deficits. In James M. Buchanan (ed.) Deficits. Blackwell. Rosati, Dariusz. 1 996. Exchange Rate Policies During Transition from Plan to Market. Economics of Transition 4. Rostowski, Jacek. 1 998. Macroeconomic Instability in Post-Communist Countries. Clarendon Press. Rybinski, Krzysztof. 1 998. Capital Inflows in Central and Eastern Europe: Inflation, Balance of Payments and Recommended Policy Responses. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 1 32 . Sachs, Jeffrey D. 1 994a. Russia: IMF gives too little, too late. Financial Times, March 3 1 . Sachs, Jeffrey D. 1 994b. Russia's Struggle with Stabilization: Conceptual Issues and Evidence. Proceedings of the World Bank Annual Conference on Development Economics. 57-80. Sachs, Jeffrey D. 1 996. Economic Transition and Exchange Rate Regime. American Economic Review 86, no. 2. Sachs, Jeffrey D. 1 998. Proposals for Reform of the Global Financial Architecture. Paper prepared for the UNDP meeting on reform of the global financial architecture. New York, December 8. Sachs Jeffrey D. and Felipe Larrain. 1 993. Macroeconomics in the Global Economy. Prentice-Hall, Inc. Sarel, Michael. 1 996. Nonlinear Effects oflnflation on Economic Growth. IMF Staff Papers 43, no. 1 . Sargent, Thomas and N. Wallace. 1 98 1 . Some Unpleasant Monetarist Arithmetic. Federal Reserve Bank of Minneapolis. Quarterly Review.

Disinflation Strategies and Their Effectiveness in Transition Economies

35

Siwinska, Joanna. 1999. The external public debt of Baltic and selected CIS countries in years 1992-1997. Estonia, Latvia, Lithuania, Kazakhstan, Kyrgyz Republic, Moldova, the Russian Federation, and the Ukraine. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 169. Tomczynska, Magdalena. 1998. Exchange Rate Regimes in Transition Economies. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 128. NOTES

2 3 4

5 6 7 8 9 10 11

12

Many studies have stressed the importance o f rapid disinflation: Aslund 1 994; Balcerowicz and Gelb 1 995; de Melo, Denizer, and Gelb 1 996; Dabrowski 1 996; and Aslund, Boone, and Johnson 1 996. Apart from liberalization and privatization (Fischer and Gelb 1 99 1 ). Cukrowski and Janecki ( 1 998) discuss at length the differences between seigniorage and an inflation tax. One of the possible scenarios in such a game can be connected with the fiscal gains in the case of unexpected inflation. Nominal revenues and expenditures, including wages, social transfers, and subsidies, are planned assuming a certain projected inflation level. If inflation is higher than expected, the budget takes in more nominal revenues than were planned, while most of the nominal expenditures remain at their previously planned lev­ els. Of course, budget beneficiaries try to protect themselves against such a maneuver with additional indexation. Such was the case in Poland, in 1 993-1 996. Central-bank independence is widely considered the solution in overcoming the polit­ ical-cycle constraint. See Chapter 9. For those states seeking EU membership, the inflation level in the eurozone is the com­ parable level. For additional research on transition economies, see, among others, Fischer, Sahay, and Vegh ( 1 996), and IMF ( 1 998). As noted earlier, the Czech Republic and Slovakia's highest inflation levels were only a few percentage points above this threshold while Georgia suffered the second-high­ est hyperinflation among the transition countries (after Yugoslavia). In its impressive disinflation process, Croatia passed the threshold of 7.5 percent in the same month (May 1 994) that it passed the 1 5 percent threshold. Croatia actually recorded negative inflation during several months in 1 994. Difficulties with nominal convergence relate even more to long-term interest rates. The lowest inflation countries, such as Croatia and Macedonia, also recorded some fluctuations in their end-of-year CPis, but Croatia remained in the 2 to 5 percent annu­ al-inflation range, while Macedonia was in the -3 . 1 percent ( 1 998) to +3 .2 percent ( 1 997) range. IMF statistics record significant progress in Turkmenistan (2 1 .8 percent in 1 997 and 1 9 .8 percent in 1 998, down from the hyperinflation level in 1 994 and 1 995). The same concerns Taj ikistan, where inflation reached a very low level (2 .7 percent) in 1 998 and a moderate level (3 1 .3 percent) in 1 999. But there is insufficient information to assess the sustainability of the disinflation trend in these two. In addition, their inflation performances could be distorted since both maintain price controls, and Turkmenistan uses a multiple-exchange-rate regime.

36

Disinflation in Transition Economies

1 3 This does not mean that there were no increases in the 1 2-month inflation index in subsequent years. The recorded statistics are end-of-December figures only. 14 Sachs's ( 1 998) paper can serve as one example of the fundamental critique of the pegged exchange-rate regime. Earlier he argued that the peg exchange rate was the best instrument to fight inflation. Later, he modified his view, arguing that the exchange-rate anchor could be useful in fighting very high inflation or hyperinflation for and only a limited period of time. Later the anchor would be replaced by a more­ flexible exchange-rate arrangement in order to avoid any overvaluation of the domes­ tic currency and any balance-of-payment crisis (Sachs 1 996). 15 The broad definition of T-bills, including other kinds of government securities and government borrowing on commercial terms, is used in this chapter. 1 6 This critique was incorrect as most of the ' Systemic Transformation Facilities' (STF) programs implemented at that time in the CIS by the IMF contained very loose fiscal­ deficit targets-even up to 10 percent of GDP when monetization did not exceed 20 percent of GDP. See Dabrowski 1 998.

2.

MONETARY EXPANSION AND ITS INFLUENCE ON INFLATION PERFORMANCE IN TRANSITION ECONOMIES Rafa/ Antczak

A sustained and persistent increase in an economy's overall level of prices is generally termed inflation. An increase in the average price of all goods and services must be distinguished from a change in the relative prices of specific goods and services (see Chapter 1 0). Another distinction must be made between underlying inflation (also known as core inflation), which reflects the basic changes in the overall price level, and unusual one-time increases caused, for example, by increases in administered prices or excise taxes or an exchange-rate devaluation. While the rate of overall inflation can be measured precisely, the underlying rate of inflation is more difficult to estimate and may not better signal policymakers in transition economies. This chapter seeks to verify whether inflation is always and every­ where a monetary phenomenon (Friedman and Schwartz 1 963). Put another way, "Is inflation the result of insufficiently restrictive fiscal poli­ cies and the monetary financing of fiscal deficits?" This chapter analyzes twelve transition economies from 1 990 to 1 997, six in Central and Eastern Europe (Croatia, the Czech Republic, Hungary, Poland, Slovakia, and Slovenia) and six from the former Soviet Union (Estonia, Kazakhstan, Latvia, Lithuania, Russia, and the Ukraine). Section 2. 1 summarizes these countries' various stabilization policies and their results. Section 2.2 is devoted to a detailed analysis of the underlying factors in reserve-money creation and its transmission onto broader monetary aggregates. Section 2.3 seeks to unearth any correlation between inflation and monetary pol­ icy, followed by concluding remarks.

38

Disinflation in Transition Economies

2 . 1 . STABILIZATION AND INFLATION Lowering inflation was the central goal of every stabilization program in the postcommunist states. Reducing it to less than 40 percent annually­ roughly 3 percent a month-can be considered a "first-approach" mea­ sure, when stabilization is first achieved (Bruno and Easterly 1 995). The Central and East European (CEE) countries achieved this threshold, by and large, in 1 992, while the countries of the former Soviet Union (FSU) required more time, reaching the goal in the 1 994 to 1 996 period (see Table 2 . 1 ) . Another measure of successful stabilization is when annual inflation falls within the 1 5 to 30 percent range (Dornbusch and Fischer 1 993). I will call this a "second approach." For the most part the CEE countries reached this range in 1 993 and the FSU countries in 1 995- 1 997. Finally, a "third approach" is when inflation declines significantly below 1 0 percent, or, actually, closer to 5 percent annually. Of 1 2 CEE and FSU countries, 1 1 managed to drive their inflation below 15 percent, but only Croatia, Latvia, and Slovakia maintained levels closer to a 5 per­ cent annual rate by the close of 1 997. Inflation in the CEE countries was brought under control at an earli­ er date than in most of the FSU countries, albeit from less extreme lev­ els and less rapidly. Beginning in 1 993, as a group the FSU countries out­ performed the CEE ones because their disinflation path was much more radical. To be sure, there were significant differences among the indi­ vidual transition economies. In 1997, Croatia, the Czech Republic, Slovakia, and Slovenia registered end-of-period CPI within the third­ approach range (5 to 10 percent annually). Poland and Hungary had inflation close to, or above, 1 5 percent (the second approach). Within the FSU countries, results were less differentiated. Most had inflation close to 1 0 percent by the end of 1 997, very close to the level of the best CEE performers. But lowering inflation to the single-digit range (the third approach) is a persistent problem for most of the transition economies. Table 2 . 1 . Inflation and Monetary Aggregates (Annual Percent Change) Country Croatia

Year Inflation 1 993 1 994 1 995 1 996 1 997

1.121 2.4 4.6 3.7 5.0

M2 72.6 4 1 .3 49.4 37.7

M l Country

... Estonia

1 1 1 .9 24. 6 3 7.9 20.9

Year

1 992 1 993 1 994 1 995 1 996 1 997

Inflation 942. 2 37.9 4 1 .6 26.5 14.8 1 2.5

M2

Ml

7 1 . 1 29 1 .5 54.4 85.3 30.0 20.6 30.0 29. 1 36.4 30.9 37.8 22.6

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies

39

(Table 2. 1. cont 'd) Country

M2

Year Inflation

Czech Rep. 1 993 1 994 1 995 1 996 1 997 Hungary 1 990 1991 1 992 1 993 1 994 1 995 1 996 1 997 1 990 Poland 1 99 1 1 992 1 993 1 994 1 995 1 996 1 997 Slovakia 1 993 1 994 1 995 1 996 1 997 Slovenia 1 992 1 993 1 994 1 995 1 996 1 997

20.8 9.7 7.9 8.6 1 0.0 34.6 3 1 .0 24.7 21.1 2 1 .2 28.3 1 9. 8 1 8.5 225.9 60.3 44.4 37.7 29.4 2 1 .9 1 8.7 14.8 23.0 1 1 .7 7.2 5 .4 6.5 8 1 .2 22.9 1 8.3 8.6 8.8 9.4

-17.0 20.4 29.3 6.4 1 .7 1 2 1 .8 29.4 27.3 1 6.8 1 3 .0 1 8.4 1 60. 1 37.0 57.5 36.0 38.2 35.0 29.3 30.7 24. 1 1 7.4 1 8.4 1 6.2 2.9 1 23.6 62.0 43.9 29.3

2 1 .3

1 1 .7

M l Country

Year

Inflation

M2

Ml

-37.5 50.2 Kazakhstan 1 992 2,96 1 6.7 1 993 2, 1 65 4.7 1 994 1 , 1 58 576.0 -7.3 60.3 1 08.2 1 995 20.9 1 996 28.7 1 8.2 1 997 1 1 .2 1 992 32. 1 Latvia 33 1 . 1 1 993 34.9 1 1 .7 1 994 31.1 50.3 8.0 26.3 -2 1 .4 0.8 1 995 23. 1 5.8 1 996 1 8.6 1 8. 8 1 3 .2 34.7 1 997 71.1 7.0 40 1 . 1 Lithuania 1 992 1 , 1 63 88.8 1 88.6 1 993 1 4.4 4 1 .7 62.9 1 994 45. 1 38.8 40.8 27.9 1 995 35.7 3 1 .3 -3 .0 3.5 1 996 13.1 39.7 4 1 .0 34. 1 1 997 8.4 36.4 783.3 1 992 2,526 3 1 .8 Russia 272.6 1 993 840.0 32.4 1 87.0 1 994 2 1 6.5 2 1 5.0 1 1 2.6 1 20.7 1 3 1 .0 1 995 6.2 27.2 29.6 1 996 2 1 .8 20.9 40.6 29.5 1 997 1 1 .0 1 5. 8 1 992 1 ,2 1 0 1 ,333 ---8. 1 Ukraine 1 ,077 1 ,8 1 0 1 ,552 1 993 1 0 , 1 5 5 1 33.7 1 994 568.0 444.0 4 1 .5 40 1 . 1 1 1 5.0 1 5 1 .7 1 995 1 8 1 .7 35.1 35.4 1 996 39.9 39.9 24.8 49.0 33.9 1 997 1 0. 1 1 8.4 1 8. 1

Note: M 1 consists o f currency i n circulation and demand deposits; M 2 combines M 1 and saving deposits in domestic and foreign currencies. Source: IFS IMF, August 1 998.

Obviously, it is difficult to assess the inflationary performance of the above countries from a short-term perspective. Those facing unsustainable fiscal and quasi-fiscal deficits (Russia, Slovakia, and the Ukraine, for instance) can easily find themselves confronting a second round of high inflation. 1 External factors (like, turmoil in international financial markets) usually make existing domestic problems worse, including the political impotency to undertake comprehensive reform measures; thus they serve only to hasten any inevitable economic downturn. But the problem of coordinating monetary and fiscal policies is beyond the agenda of this chapter (see Chapter 8).

40

Disinflation in Transition Economies

2 . 2 . SIMPLE MONETARY A C C O UNTING

The balance sheet of the monetary authorities 2 provides data on assets and liabilities that, after netted out, can be summarized with the follow­ ing equation. RM = NFA + NCG + CNPE + CDMB + COFI + CPS + OIN

(2.1)

A few features deserve mention. Reserve money (RM) 3 is the monetary authorities' main liability and includes, mainly, currency issued (cash in bank vaults and currency in circulation) plus bank and nonbank deposits with the monetary authorities, excluding the deposits of the government and nonresidents, which are netted against claims on the government and foreign assets, respectively. Net foreign assets (NFA) include the domes­ tic currency value ofnet official international reserves (NIR) and any other foreign assets and liabilities of the monetary authorities. Such a definition of NFA is broader than is commonly used in many countries, where NFAs are equated with NIRs. Net claims on the government (NCG) are direct loans and government securities held by the monetary authorities net of government deposits. Claims on nonfinancial public enterprises (CNPE) are the monetary authorities' claims on public enterprises. Claims on deposit money banks (CDMB) include all direct credits to deposit money banks (DMB)4 as well as all bills of exchange for discount from the DMBs that are accepted by the monetary authorities. CDMBs are not netted out, since deposits of the DMBs make up reserve money. Claims on other financial institutions (COFI) and claims on the private sector (CPS), together with CNPEs, in general, are likely to be insignificant. Typically, it is not the busi­ ness of a central bank to make such loans; yet practice in some countries is different. Other items net (OIN) is a residual category of the physical assets, capital, reserves, and profits or losses of the central bank. In addi­ tion, it includes a valuation adjustment to the net foreign-assets position, resulting from developments such as changes ih the exchange rate and any other items not classified elsewhere. Valuation adjustment is of particular importance in economies with high inflation and volatile (nominal) exchange rates, such as the postcommunist ones. Specifically, changes in stocks over time, in the period of this analysis, should be decomposed into changes due to transactions and changes due to valuation. 5 By dividing both sides of the equation (2. 1 ) by the lagged value of reserve money (RM 1 _ 1 ), the growth rate of RM can be expressed in terms of the (weighted) contribution of the various asset items.

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies 6

6NFA

6NCG

6CNPE

6CD B

6CPS

6COFl

60IN

RM t-1

RMt-1

RMt-1

RM t-1

RM t-1

RMt-1

RM t-1

RMt-1

41

M 1 RM1 1 1 1 + --1 + -+ -+ --1 + --= --1 + --

(2.2) As a simple rule of thumb, one can assume that all credits extended by the monetary authorities to all sectors other than the general government, represent quasi-fiscal grants or subsidies. This assumption may not be justified in developed economies, but in the transition states this sim­ plification holds with high probability (Buiter 1 997). Financing the gen­ eral government via the monetary authorities represents a monetization of the fiscal deficit, irrespective of the technical side of such financing (printing money or acquiring Treasury paper on primary or secondary markets by a central bank). The two main components of RM creation can be identified when combining the financing of government by the cen­ tral bank (NCG) with all other domestic credits extended by the central bank (CNPE, CDMB, CPS, and COFI): changes in net foreign assets and changes in net domestic credit (NDC). 6RM _ 6NFA

6NDC

60IN

RMt-1

RM t-1

--1 - --1 + --1 + --1 RMt-1

RMt-1

(2.3)

Table 2.2 presents the averages and medians of quarterly changes in all the main components of RM in the transition economies until the end of 1 997. The monetary overhang inherited from the command-economy era has been taken into account: we cut one or two quarters from the begin­ ning of the data sample (Q2 1990 for Poland and Q4 1992 for most of the FSU states). In some cases, unreliable central-bank data or prolonged use of the Soviet ruble instead of a new national-currency unit shortened the periods of analysis (and abbreviated the period of the monetary over­ hang as well). But this does not strongly affect the outlook of the RM components, because the monetary expansion was stronger in the earli­ er periods than in the later ones. Hence the averages and medians for countries like Kazakhstan, Russia, and the Ukraine only underestimate the results of Table 2.2, compared with Table 2.3. Based on the equation (2.3), two groups of countries emerge: ( 1 ) states where changes in RM were almost exclusively related to changes in NFAs (Croatia, the Czech Republic, Estonia, Latvia, Lithuania, Slovakia, and Slovenia); and

42

Disinflation in Transition Economies

(2) the remaining analyzed transition economies, where both NFAs and NDCs contributed to RM changes. Table 2.2. Components of Reserve-Money Creation, Broad Money, and the Multiplier Country

dRM

Croatia-Average Croatia-Median Czech R.-Average Czech R.-Median Hungary-Average Hungary-Median Poland-Average Poland-Median Slovakia-Average Slovakia-Median Slovenia-Average Slovenia-Median Estonia-Average Estonia-Median Kazakhstan-Average Kazakhstan-Median Latvia-Average Latvia-Median Lithuania-Average Lithuania-Median Russia-Average Russia-Median Ukraine-Average Ukraine-Median

0.308 0.376 0. 1 0 1 0.054 0.047 --0. I 69 0. 1 5 8 0. 1 48 0.008 0.023 0.00 1 --0.038 0.080 0.079 --0.002 --0.025 0.023 0.003 0.073 0. 1 04 --0.007 --0.0 1 3 0.006 --0.003 0.058 --0.0 1 7 0.02 1 0.0 1 4 0.004 0.057 0.046 --0.006 0.0 1 4 0.0 1 5 0.004 0.053 0.074 0.090 0.030 0.039 --0.009 --0.045 0.072 0.09 1 0.D35 0.040 0.007 --0.040 0.067 0.099 --0.02 1 --0.0 1 5 --0.007 --0.0 1 0 0.047 0.065 --0.007 --0.0 1 3 0.003 0.007 0. 1 05 0.366 --0.220 --0.247 0.D28 --0.042 0.068 0.255 --0. 1 5 1 --0. 1 93 0.027 --0.04 1 0.095 0. 1 1 2 --0.004 --0.004 --0.00 I --0.0 1 3 0.090 0.074 --0.002 0.000 --0.002 --0.008 0. 1 64 0.334 0.076 --0.00 I 0.068 --0.245 0. 1 0 1 0. 1 84 0.027 0.006 0.002 --0.086 0.053 0.043 0.004 0.006 --0.002 0.006 0.042 0.053 0.007 0.033 --0.003 0.008 0. 1 25 0. 1 1 1 --0.0 1 7 --0.0 1 4 --0.003 0.030 0. 1 1 0 0. 1 1 6 0.000 --0.007 --0.004 0.0 1 4 0. 1 56 0.025 0. 1 80 0. 1 65 0.0 1 5 --0.050 0. 1 1 4 0.026 0. 1 5 8 0. 1 1 3 --0.00 1 --0.0 1 8 0.399 0.003 0.409 0.243 0. 1 64 --0.0 1 3 0. 1 70 0.0 1 4 0.280 0. 1 89 0.046 --0.0 1 9

dNFA

dNDC dNCG dCDMB dOIN

dM2 m (M2) 0. 1 00 0.099 0.022 0.036 0.05 1 0.050 0.090 0.087 0.040 0.029 0. 1 04 0.087 0.090 0.080 0.084 0.080 0.066 0.087 0.09 1 0.074 0. 1 70 0. 1 1 9 0.425 0.2 1 5

4. 1 4 4. 1 1 3.55 3.61 1 .62 1 .63 3 .22 3 .40 5 .02 5.06 8.42 8.43 1 .99 1 .97 1 .89 1 .78 2.34 2.46 2.32 2.25 2.09 2. 1 3 1 .7 5 1 .7 8

Note: In multiplying the quarterly changes in the components o f R M b y 1 00, w e obtain weighted percent changes with respect to the previous quarter. Source: IFS IMF, August 1 998.

In the first group, two created currency boards-Estonia in 1992 and Lithuania in 1994. A commitment to peg both the exchange rate and domestic-money creation influenced the structure of the RM components. Only changes in NFAs could change RM levels. A mixed picture emerges of the exchange-rate regimes in the rest of the countries in the first group. Croatia and Latvia opted for the consequent policy of stabilizing their nominal exchange rates over the long term. 6 Slovenia took great pains initially to blunt devaluation rates but failed to skirt the perturbations in exchange-rate developments during the entire period of this analysis. The Czech Republic and Slovakia maintained stable nominal exchange rates, but both faced a single corrective devaluation (Slovakia in July 1993 and the Czech Republic in May 1 997), and both allowed for short-run peri-

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies

43

ods of some nominal devaluation and appreciation of their exchange rates. Countries from the second group (Hungary, Kazakhstan, Poland, Russia, and the Ukraine), with two components of RM creation, are a mixed bag, in terms of their exchange regimes. Hungary and Poland generally expe­ rienced frequent fluctuations in their exchange rates. Kazakhstan, Russia, and the Ukraine, after experimenting with floating rates, sought to stabilize their exchange rates after 1995. Actually, all of the analyzed transition economies either chose an exchange-rate anchor (explicitly or implicitly) at the very beginning of transformation or eventually turned to it (explicitly or implicitly) after a few years of experimenting with the money-based approach. It is misleading, however, to compare the results of the money-based stabilizations with the exchange-rate-based ones without considering the fiscal-policy circumstances.7 Two reasons usually favor the primacy of an exchange-rate peg over a money or credit ceiling: the volatility of money demand during a transition and the possibility of overshooting the exchange rate during a money-based stabilization (Fischer 1986). Even if velocity is forecasted perfectly (a rather wishful assumption), mone­ tary targeting, in practice, may prove very difficult in the event of a significant collapse of real output and erratic changes in prices. All this suggests that it was not solely the exchange-rate regime that influenced the structure of the RM components in the postcommunist states (except in the two currency-board regimes). Pegging or stabilizing the exchange rate stimulates capital inflows when domestic nominal inter­ est rates rise too far above world levels (interest-rate parity, even after taking into account the exchange-rate risk and country risk). Disaggregating the NDC (equation 2.2) of the second group of coun­ tries reveals that the changes in the NCG were the main component of the changes in the NDC (Table 2.2). Analyzing the differences between the averages and medians of the NCG component brings to the fore two distinct subgroups: • countries with significant differences between their averages and medians (Kazakhstan, Russia, and the Ukraine); and • countries with small differences between their averages and medi­ ans (Hungary and Poland). The first subgroup represents countries where the monetary authori­ ties massively monetized fiscal deficits at the outset of reforms, from 1992 to 1995. Later, in 1995-1997, owing to stronger foreign-capital inflows and thus a rise in NFAs (after pegging the exchange rate), the monetary authorities retreated from monetization but only periodically. When NFAs

44

Disinflation in Transition Economies

declined (capital outflow), the monetary authorities reverted to monetiz­ ing the fiscal deficits. Put another way, in Russia and Ukraine, the mon­ etary authorities sterilized foreign-capital outflows not inflows. Regardless of the direction of the capital flight in these countries, the monetary authorities continued to finance their governments. In Kazakhstan, the monetary authorities halted financing of the fiscal deficit in Q4 1996, when significant increases in NFAs occurred and cou­ pled with declines in NDCs and, most of all, in NCG and CNPEs. In the previous quarters (Q4 1995 and Q3 1996), however, Kazakhstan, much like Russia and the Ukraine, sterilized the outflow of foreign capital. Changes in the other domestic components of RM were less significant. But the wide divergence between the averages and medians in the CDMB indicates large shifts in the policy of the monetary author­ ities toward their DMBs. A more careful analysis of quarterly changes reveals periods when the monetary authorities strongly refinanced their DMBs. Assuming that the banks began stabilization programs with bad debts inherited from the previous regimes, the significance of the changes was lowered by the initial spike in price levels to eliminate the monetary overhang. Hence the debt problems that matter now developed during the transition process. The most common reason for CDMB fluctuations was the extension of credits to the regions and "strategic" branches of the economy (for example, the agricultural sector and specific industries) that were directed and refinanced by the monetary authorities, which result­ ed in new bad debts in the DMBs. Frequently the clearing off of inter­ enterprise arrears and the repo or reverse-repo agreements on government paper, between the DMBs and the monetary authorities, also played a significant role. The practice of extending direct credits occurred mostly during the first period of the transition ( 1992-1995). For example, the central bank of Russia directly or indirectly financed most of the former Soviet republics until mid- 1993 8 and the subjects of the Russian Federation thereafter. Enterprises in financial straits had four options to soften con­ straints: fail to pay workers, government, suppliers, or creditors (or a mix­ ture of these). Budget arrears to workers were a common feature in the countries of the FSU, but they have their natural limits. Arrears to tax authorities were serious in many transition economies, but with reliable and comprehensive tax reform, nonpayment has become more difficult (or costly). Some of the nonpayments to suppliers can be considered a normal form of voluntarily extended credit (as OECD economies have a large stock of interenterprise debt).

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies

45

In terms of monetary policy, the most significant problem was the fail­ ure to service bank debts, which undermines the use of interest rates and the solvency of the banking system. The hands-off approach to inter­ enterprise debts (solving debt problems by interested parties without state involvement) was not applied in the first subgroup of countries, and the results were bad debts and interenterprise clearings organized by the gov­ ernments and central banks. Rostowski ( 1 994) shows that even sophisti­ cated multilateral clearings with government involvement are always inflationary. The inflationary impact of money substitutes is also out of the question. The situation in Kazakhstan was similar to that seen in Russia and the Ukraine, with one exception oflittle consequence. The monetary author­ ities in Kazakhstan monetized the debts of public enterprises and inter­ enterprise arrears, issuing credits directly to state-owned enterprises instead of relying on DMBs (as in Russia and the Ukraine). This is indi­ cated by the significant divergence in the average and median of the CNPE as well as the CDMB. At least three periods of debt clearing occurred in Kazakhstan since 1994: in Q3 1994, Q2 1 995, and Q4 1 996. The last reason for CDMB fluctuations gained in importance in those periods when NFAs declined, as residents (DMBs) replaced foreign port­ folio investors on the government-paper market. Such could not have occurred without hidden agreements with the monetary authorities that wished to create the impression that the demand for government paper was stable even in the absence of foreign-investor demand. Besides, the monetary authorities also engaged in a process known as "window dress­ ing." They had to comply with IMF-mandated performance criteria on increases in NDC. These limits, usually set quarterly, allowed for some maneuver room within a quarter. The second subgroup of countries represents examples of the rather steady financing of fiscal deficits by monetary authorities. This may con­ tradict the general opinion concerning the tight monetary policies in Poland or Hungary, but the RM components (see Table 2.2) present a clear pattern of monetary-authority involvement. Such involvement was dif­ ferentiated in Hungary as the strongest monetization of fiscal deficits occurred from Q4 1990 to Q2 1992, from Q4 1 994 to Q2 1995, and dur­ ing the first two quarters of 1996. In Poland, there were two such peri­ ods: from the end of 1990 until Q3 1993 , and from Q2 1994 until Q l 1995. It i s important to notice, both in Hungary and Poland, that these were also the periods with the slightest increases (or even declines) in NFAs. Much as they had in Kazakhstan, Russia, and the Ukraine, the

46

Disinflation in Transition Economies

monetary authorities in Hungary and Poland provided financing to their governments when other resources were inadequate. The difference between the two subgroups was only in the "smooth" deficit financing in the second subgroup, as opposed to the "wild" financing of (quasi-) fiscal deficits in the first subgroup.

2 . 3 . INFLATION AND THE RATE OF GROWTH OF BROAD MONEY The money-supply process begins with monetary authorities generating a supply of RM. The demand for RM comes from the public and banks. In a fractional-reserve system (multiplier effect) commercial banks cre­ ate broad-money aggregates. Hence the broad-money (M2) supply can change either because of a change in the money multiplier or a change in RM. Changes in the multiplier reflect the decisions of three different economic agents: (i) the monetary authorities, which set the rules of the game, e.g., reserve requirements,9 (ii) the DMBs, which decide on the stock of excess reserves, and (iii) the nonbank public, which determines the composition of the money stock (the types of deposits and the share of cash). The policies of monetary authorities aside, most of the transition economies experienced only slight changes in their money multiplier (Table 2.2). Reviewing the range of changes, we can distinguish three groups of countries: those that witnessed a decline in the multiplier, those that saw its growth, and those that experienced no changes. The Czech Republic, Lithuania, and Slovakia were in the first group; Croatia, Estonia, Latvia, Poland, and Russia the second; and Hungary, Kazakhstan, Slovenia, and the Ukraine the third. Only four countries from the first and second groups-the Czech Republic, Estonia, Poland, and Slovakia-­ experienced significant changes in the multiplier (more than 50 percent of its value until year-end 1 997). Thus changes both in the multipliers and in RM remained the source of volatility in the broad-money supply in these four only. In the others, changes in the components of RM con­ tributed to the broad money's fluctuations. The dynamics of money demand also differed among the transition economies. In the CEE countries, the velocity of M l and the velocity of M2 were either declining or remained stable during the transformation, with the exception of Hungary, where M l velocity increased in 1 995. The Baltic states experienced a decline or small changes in M l velocity and

Monetary Expansion and Its I,if{uence on Inflation Performance in Transition Economies

47

M2 velocity, with the exception of Lithuania, which registered an increase in M2 velocity. The overall changes in M l and M2 velocities in these state were insignificant. Only Croatia experienced a strong decline (by more than half) in M l velocity and M2 velocity in a short period of time, 1994-1997. But this may have been the result of exogenous factors, such as the end of its military conflict and hyperinflation. Until 1995, Kazakhstan, Russia, and the Ukraine registered increases in their velocities, especially in M l . Upon reaching the second-approach range of inflation, the velocity in Russia and the Ukraine began to decline (in 1996-1997). This is not surprising as velocity usually declines when inflation subsides, transition proceeds, and (M l and M2) monetization of the economy expands. An exception occurred in Russia, in 1997, when M l velocity increased over the previous year and reached its 1995 level. But this may have been the fault of the ruble's denomination, which triggered fear in the public. Table 2.3. Monetization and Velocity M2/ GDP

Country

Year

Croatia

1 993 23.9 1 994 20.6 1 995 27.3 1 996 37.9 1 99 1 1 992 1 04.6 1 993 69.6 1 994 73 . 1 1 995 80.5 1 996 75.4 1 997 7 1 .2 1 990 43.8 1 99 1 47.5 1 992 5 1 .3 1 993 49.7 1 994 45.7 1 995 42.3 1 990 34.0 1 99 1 32.3 1 992 35.8 1 993 35.9 1 994 36.7 1 995 36.5 1 996 37.2 1 997 39.7 1 993 68.8 1 994 67.7 1 995 68.3 1 996 7 1 .2

Czech Rep.

Hungary

Poland

Slovakia

V Country M l/ V GDP (M2) (M l )

Year M2/ GDP

Estonia

30.2 27.8 26.4 25.5 27.0 30.0 26.0 1 2.3 1 1 .2 9.7 3 1 .6 34.2 23.4 23.0 34.7 23. 1 25.8 23 . 1 17.1 1 8.9 57.9 23.9 2 1 .2 1 7.4 1 6.2 1 7.8 SO. I 32.5 26.7

7.5 1 6.7 7.9 7 . 1 9.2 4.2 1 1 . 8 3. 1 ... 1 .2 53.6 1 .0 26.8 1 . 6 35.2 1 .5 32.0 1 .4 29.5 1 .4 25.4 1 .5 24.8 2.6 24.5 2.4 27.5 2.2 25.5 2.2 22.4 2.3 1 8.5 2.6 1 6.8 3 . 7 1 3 .3 3.3 1 3 .0 3.3 12.6 3.2 1 3 .0 3 . 1 1 3. 1 3. 1 1 3 .6 3.0 14.7 2.8 3 1 .6 1 .6 28. 1 1 .7 29.0 1 .6 30. 1 1 .5

1 3 .3 1 8 .5 1 1 .5 9.7 2.3 2. 1 4.6 3.2 3.4 3.6 4. 1 4.8 4.6 4.3 4.3 4.8 5.9 8. 1 7.7 9.0 9.3 9. 1 9. 1 8.4 7.6 3.6 3.9 4.0 3.7

1 992 1 993 1 994 1 995 1 996 1 997 Kazakhstan I 993 1 994 1 995 1 996 Latvia 1 993 1 994 1 995 1 996 1 997 Lithuania 1 993 1 994 1 995 1 996 1 997 Russia 1 992 1 993 1 994 1 995 1 996 1 997 Ukraine 1 992 1 993 1 994

Ml/ V V GDP (M2) (M I ) 2 1 .7 24.0 21.1 20.2 20.6 20.3

3.6 3.9 3.5 3.6 3.4 3.1

6.8 6.0 4.3 4.5 4.5 4.2

4.2 6.9 7.2 6.7 6.1 4.3 6.2 7.0

7.2 1 2.6 1 4.2 1 2.5 1 4.2 4.7 8.8 1 0.8

... 9.1 ... 1 1 .6 ... ... 1 1 .7 ... 1 8.3 1 7.2 3 .4 6.7 I S . I 3.7 6.4 14.9 4.8 7.5 1 7.6 3.3 6.5 I S . I 5.9 9.8 14.6 4.7 8 . 1 1 4.4 4.8 8.3 I 1 .4 6.2 9.3 1 3 . 3 6.0 9.0 ...

1 3.9 1 1 .2 9.5 8.7 1 0.4 4 1 .2 23 . 1 1 5. 5

48

Disinflation in Transition Economies

(Table 2. 3. cont 'd) Country

Year

M2/ GDP

Ml/ V V Country GDP (M2) (M l )

Slovenia

1 993 1 994 1 995 1 996

30.2 33.6 36.3 38.3

6.8 7. 1 7.4 7.6

4.0 3.5 3.0 2.8

1 7 .7 1 7.9 1 5.3 14.9

Year M2/ GDP

Ml/ V V GDP (M2) (M l )

1 995 1 2.7 1 996 1 1 .5 1 997 1 3 .6

8.6 9.7 1 5 . 1 7.7 1 0.2 14.8 9.8 8.1 1 1 .2

Note: M I consists of currency in circulation and demand deposits. M2 combines M 1 and sav­ ing deposits in domestic and foreign currencies. The velocity of M l and M2 is calculated as the GDP divided by the sum of the quarterly averages of the money stock. Monetization indicators are cal­ culated as end-of-year M2 or Ml divided by annual nominal GDP. Source: IFS IMF, August 1 998.

Table 2.3 also captures the monetization of the transition economies. Demonetizations and remonetizations are highly asymmetric processes, and lower inflation does not lead automatically to growth in money demand and remonetization in the transition economies. Higher inflation lowers money demand and provokes monetization ( Gosh 1997). In such conditions the incentive to hold domestic financial assets and to provide financing for private investments or the budget deficit is greatly deterred. By definition, monetization changes must be the opposite of velocity ones. The Central European states and the Balts registered either increas­ es in M l and M2 monetization levels or insignificant changes. The ini­ tial decline in monetization was compensated for after the inflation declined. The composition of the monetary aggregates did not significantly change in the Central European and Baltic states as demon­ etization and monetization followed rather closely both M l and M2 aggregates. Lithuania was an exception, despite its currency-board regime. Its performance was similar to that of Russia and the Ukraine, which experienced strong demonetization and a shift in the structure of their monetary aggregates toward a more liquid one (i.e. , M l ). These economies are based, simply, on cash and time deposits that are excep­ tionally small. Two additional comments are important here. First, the quality of the nominal GDP figures (as a denominator), especially at the outset of the reforms, is rather limited because of the biases that probably result in underestimating GDP (Bloem 1996). But over time and as reforms went forward, these data can be taken more seriously and allow for comparative analysis. Second, monetization levels were measured with the ratio of total broad money to GDP, including the foreign-cur­ rency-deposits component. Thus M2-monetization levels can be mis-

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies

49

leading, assuming that the share of foreign deposits was significant and experienced strong fluctuations. To be sure, it is more important to cap­ ture the level and tendency of changes in the monetization than to depict precise numbers. Table 2.4. Inflation and Broad-Money Correlation Coefficients Countries

Correlation

Fisher test CEE countries

Croatia Czech Republic Hungary Poland Slovakia Slovenia

0. 1 66 0.085 0.364 0.429 0.338 0.826

0. 1 65 0.085 0.348 0.405 0.326 0.678 FSU countries

Estonia Kazakhstan Latvia Lithuania Russia Ukraine

0.46 1 0.597 0.3 1 5 0.8 1 0 0.776 0.9 1 1

0.499 0.688 0.326 1 . 128 1 .036 1 .536

Source: IFS IMF, August 1 998.

Looking at Table 2.1, one notices that the changes in the performance of the inflation index closely tracked the changes in the monetary aggre­ gates. The correlation results of the CPI and the lagged broad-money changes for the transition economies reveal an important dependency (Table 2.4). Allowing for lags in the response of inflation to money growth seems to be a "good fit" in the observed relationship for most of the coun­ tries. In these countries, inflation appears to have closely followed broad­ money growth, with a lag ofroughly one quarter. 1 0 There is a very strong dependency (a correlation in the range of 0.9-0.6) for the high-inflation countries (Kazakhstan, Russia, and the Ukraine) that resorted to inflation­ ary financing of their fiscal deficits in the first years of transition. But this also holds for Lithuania and Slovenia, which registered low inflation and implemented restrictive monetary policies. There is, too, a "medium" group of countries, in which the correlation (0.5-0.4) is lower: Estonia, Hungary, Latvia, Poland, and Slovakia. The correlations (0.3-0.1) in Croatia and the Czech Republic were negligible.

50

Disi,iflation in Transition Economies

2 . 4 . FINAL REMARKS Table 2.5 summarizes the fiscal and external accounts of the transition economies. High- and medium-level inflation occurred during the years when monetary authorities opted for the monetary financing of fiscal deficits, and increases in NCG closely followed budget gaps. When this ceased, inflation begun to decline, as has been seen in Russia and Ukraine since 1995. Quarterly and yearly data show (see Tables 2.2 and 2.5) that the monetary authorities in Hungary and Poland actively financed fiscal deficits during the entire analyzed period. The low-inflation states regis­ tered either small fiscal deficits or surpluses, and they never relied on monetary-authority financing (Croatia, the Czech Republic, Estonia, Lithuania, Slovakia, and Slovenia). The last group of countries reveals another important characteristic-the negative financing in NCG (and NDC), which reflects sterilization efforts. When capital inflows (ceteris paribus) exceed domestic money demand or equal the domestic reserve-money components, they by no means spill over into inflation. In practice, most countries try to steril­ ize capital inflows. Sterilization can be experienced in a narrow or broad sense. The former comes from offsetting foreign-capital inflows with decreases in the net domestic assets of the monetary authorities. The latter includes changes in the monetary authorities ' established rules (altering the reserve requirements or other regulations, increasing the operational costs of the DMBs, restricting or increasing the costs of cap­ ital inflows, or removing the prohibition on residents ' export of capi­ tal). But the fragility and systemic risk in the domestic banking sector in the transition economies limits the maneuver room for sterilization in the broader sense. In fact, fiscal adjustment is the only reliable pol­ icy that can neutralize additional money supply coming from capital inflows without damaging the comp �titiveness of the transition economies (Begg 1996). Sterilization always involves a ( quasi-) fiscal cost because the central bank must usually offer a higher interest rate than what it can capture on its foreign-exchange reserves on interna­ tional financial markets. The transition economies responded differently to capital flows. Countries that registered small fiscal deficits (or surpluses) sterilized their capital inflows, slashing money creation by reducing the NDC (mostly NCG) counterpart of the subsequent RM. Sterilization via the broad­ money multiplier in these countries, except for the Czech Republic and Slovakia (their multipliers declined from 5 and 6, in 1993, to 2.5 and 4.1,

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies

51

at year-end 1997, respectively), was ineffective or absent. Estonia and Lithuania, having currency boards, could do little in terms of sterilizing any capital flows. Poland registered an increase in the money multiplier, which made sterilization all the more difficult. But the sterilization of capital inflows was most pronounced in Poland and Slovenia, which is reflected in the data in Table 2.2 (nearly all the domestic-credit components are negative). Such a policy had to meet obvious fiscal constraints (declining centralbank profits). Table 2.5. Fiscal and External Balances Country /Year

Deficit/Surplus Percent of GDP

Croatia

1 993 - 1 . 5 1 994 0.6 1 995 -0. 8 1 996 -0. 1 1 997 ...

Czech Rep.

1 993 2.7 1 994 0.8 1 995 0.4 1 996 0.2 1 997 - 1 . 0

Hungary

1 99 1 1 992 1 993 1 994 1 995 1 996

0.7 -3 .2 --6.8 -8 .2 --6.5 -3 .5

1 990 1991 1 992 1 993 1 994 1 995 1 996 1 997

3.7 --6.7 --6.7 -2.8 -3 .4 -2.8 -3 .6 -3 . 1

Poland

Slovakia

--6 1 8 544 -7 1 5 -1 34 -1 , 1 60 1 2.6

I.I

1 0.4 7.2 -1.8 1 6.7 -95.2 -2 1 4.6 -202 .9 -3 1 0. 8 -3 55.5 2,080 -5 ,392 -7,660 -3 ,588 --4,8 1 2 -5 ,762 -7,84 1

dNCG n.c. units Million

482 -1 ,078 538 -333 --694

Billion

dNFA

3,379 3,7 1 1 1 ,480 2,624 2,963

-1 8.0 -27. 1 -1 2.4 -14.6 -25.4

47.6 90.5 1 95.8 -23.9 -26.9

43.3 1 28.9 304.7 2 1 5.0 -240.7 442.7

-92.9 1 1 1 .9 -295.3 --420.2 1 08.6 1 40.0

Billion

Million

-1 ,2 1 7 4,024 7,629 2,572 3,300 -8,663 -1 ,460 5,873

Million

1 993 --6.3 -23,304 4, 1 89 1 994 --4. 1 - 1 8 ,093 -5 ,288 1 995 0.8 4, 1 44 -25 , 1 39 1 996 - 1 . 9 -1 1 ,058 2,4 1 7 1 997 ... 1 4,2 1 0

Country /Year

Deficit/Surplus Percent of GDP

Estonia

1 992 1 993 1 994 1 995 1 996 1 997

-0.7

1 .3

-1 .2 -1.5

Kazakhstan 1 994 1 995 1 996 1 997

Latvia

1 993 1 994 1 995 1 996 1 997

0.6 --4 . 1 -3 .5 -1 .4

1 993 1 994 1 995 1 996 1 997

-3. 1 --4.2 -3 .3 -3 .6

Lithuania

1 63.3 --458.5 42 1 . 1 1 8.2 -96.6

-30.382 -25 . 1 8 1 -59.564

dNCG n.c. units Million

-2.3 40.4 --40.3 3.2 0.0 -3 54.6

Million

1 2 ,2 1 9 1 2 ,927 53 1 --44,84 1

Million

--44. 1 23.3 -943 -857 -1 .275 -1 . 1 37

2.054 414 1 ,433 1 ,993 3,582 Russia 1 992 - 1 8 . 9 25,501 -3 ,592 1 4,3 74 1 993 -7. 6 - 1 3 ,035 1 994 -9.7 -5 9,242 1 9,680 1 995 --6.0 --69,508 118 1 996 -8 .8 -147,607 29.966 1 997 -8.2 -1 50,4 1 5 53.553 Ukraine 9.290 1 992 -12.2 582 1 993 --6.5 -96

dNFA

2,656 1 ,433 561 844 1 ,332 3.520 4 1 ,838 25 ,244 46,774 44,989

-0.4 40.6 --48.5 6 1 .7

6.3 -26.4 1 1 0.8 63 . 1

47.4 --46.9 26.6 -203.3

303.6 5 1 0. 5 9.2 928.7

Million

Billion

57,603 46,279 58,622 32,43 1

Million 95

958 34, 1 3 6 - 1 8 ,278 1 1 ,886

2.4

52

Disinflation in Transition Economies

(Table 2.5. cont 'd) Country /Year

Deficit/Surplus Percent of GDP

Slovenia 1 992 0.3 1 993 0.3 1 994 ---0.2 1 995 ---0. 1 1 996 0.3 1 997 - 1 .0

2.6 5.4 -5 . 1 ---0 . 5 1 .6 -43.2

dNCG n.c. units

Bil lion -44.7 0. 1 -73 . 9 -47.4 -26.3 - 1 87.2

dNFA

52.5 30.9 97. 1 48.2 82.9 227.6

Country /Year

Deficit/Surplus Percent of GDP

1 994 - 1 0 . 5 1 995 -7 .9 1 996 -4.6 1 997 -7. 1

- l ,264 -4,307 -3,704 ---0,566

dNCG n.c. units

1,131 3,05 1 1 ,700 1,101

dNFA

1 59.6 -8 74.6 1 89.2 322.6

Note: dNCG - changes in c laims on the general government. net; dNFA - changes in net for­ eign assets; n.c. units - national-currency units expressed in millions or billions. Source: IFS IMF, August 1 99 8 .

Only since mid-1996 have Russia and the Ukraine experienced increases in their NFAs, to the extent that it became significantly impor­ tant for RM creation. Earlier there were periods of highly weighted NFA components, but this might be more related to multinational-donor aid (from the IMF and World Bank) . Besides, any sterilization in Russia and the Ukraine was related to capital outflows. As in the other countries with fiscal deficits, the reason was the same. Changes in velocity and in the money multiplier indicate no common characteristic for the postcommunist states with the lowest inflation. For the high-inflation states (or periods), obviously the picture is clearer. The only common characteristics of the transition economies analyzed here are the size of their fiscal deficits and the sources of financing of those deficits. The countries that registered higher inflation either financed their deficits from domestic sources (mostly via the monetary authorities) or attracted foreign investors. The additional money flow was added to the existing money stock, enhancing inflationary pressures, as money demand (Ml and/or M2 monetization) was not increasing significantly in most of the transition economies. The character of the unexpected inflows made their sterilization very difficult, in any sense; and when unexpected outflows occurred, monetary authorities returned to financ­ ing their fiscal deficits. Coordination of fiscal and monetary policies is crucial if a sustainable path of disinflation is to be found. To be sure, monetary authorities can­ not serve, in the long run, as the lender to government in both the first and last resort.

Monetary Expansion and Its Influence on Inflation Performance in Transition Economies

53

REFERENCES Begg, David. 1996. Monetary Policy in Central and Eastern Europe: Lessons After Half a Decade of Transition. IMF Working Paper, WP/96/ 1 08 (September). Bloem, A. M., P. Cotterell, and T. Gigantes. 1996. National Accounts in Transition Countries: Distortions and Biases. IMF Working Paper, WP/96/130 (November). Bruno, Michael. 1996. Stabilization in Eastern Europe. Oxford University Press. Bruno, Michael and William Easterly. 1995. Inflation Crises and Long­ run Growth. NBER Working Paper no. 5209. Buiter, W. H. 1997. Aspects of Fiscal Performance in some Transition Economies Under Fund-Supported Programs. IMF Working Paper, WP/97/31. Dabrowski, Marek. 1995. The Reasons for the Collapse of the Ruble Zone. Center for Social and Economic Research, Warsaw, Studies and Analyses no. 58. Dornbusch, Rudiger and Stanley Fischer. 1993. Moderate Inflation. World Bank Economic Review. Fischer, Stanley. 1986. Exchange Rates versus Monetary Targets in Disinflation. MIT Press. Fischer, Stanley, Ratna Sahay, and Carlos A. Vegh. 1996. From Transition to Market, Evidence and Growth Prospects. IMF Working Paper, WP/96/3 1 (April). Friedman, Milton and Ann Schwartz. 1963. A Monetary History of the United States, 1867-1 960. Princeton University Press. Gosh, Attish. 1 997. Inflation in Transition Economies: How Much? and Why? IMF Working Paper, WP/97/80. IMF. 1984. A Guide to Money and Banking Statistics in International Financial Statistics. International Financial Statistics (IFS) on CD-ROM. IMF (August 1 997). Koen, Vincent and M. Marrese. 1995. Stabilization and Structural Change in Russia, 1992-94. IMF Working Paper, WP/95/13. Orlowski, Lucjan T. 1 993. Indirect Transfers in Trade Among Former Soviet Union Republics: Sources, Patterns and Policy Responses in the Post-Soviet Period. Europe-Asia Studies 45, no. 6.

54

Disinflation in Transition Economies

NOTE S

2

3 4 5

6 7 8 9 lO

This indeed occurred at the end of 1 998 in Georgia, Kyrgyzstan, Moldova, Russia, and the Ukraine. The central bank represents the monetary authority in most countries, but the term monetary authorities can include the agencies of the government (such as the Treasury) that perform some of the functions of a central bank. According to the IMF accounting procedures followed in this paper, the monetary functions of the govern­ ment are grouped with the accounts of the central bank and presented as one account­ ing unit. Reserve money is also called high-powered money or base money. DMBs are often commercial banks but may also be financial institutions, such as sav­ ings banks, whose liabilities include appreciable deposits, against which checks can be written to settle obligations (IMF 1 984). Monetary accounts are expressed in the local currencies, and all items in foreign cur­ rencies (foreign assets and liabilities) are converted into the domestic currencies at the end-of-period exchange rate because the balance-sheet aggregates are stocks. This is in sharp contrast to the conversion of flow aggregates, which are converted at an average exchange rate for a period. Adjusting for the effects of exchange-rate changes in NFA implies changes in OIN, to ensure that the balance sheet of the monetary authorities remains in balance. This was the policy in Croatia only after October 1 993, once the military conflict with Serbia had ended and a stabilization program was introduced. Bruno ( 1 996) presents a five-point plan for stabilization and structural reform. First on the agenda are the fiscal and external balances. The Baltic states introduced national currencies in 1 992, but most of the countries of the FSU delayed it until 1 993 (see Dabrowski 1 995; and Orlowski 1 993). Reserve-requirements regulations apply not only to the size of the obligatory reserves held by the DMBs but also to the accounting standards, the frequency of reporting to the monetary authorities, and the like. For Russia, regressions of monthly inflation against current and lagged values of ruble broad money indicate that the bulk of the impact of the money growth on prices was felt within a two-month to four-month lag (Koen and Marrese 1 995).

3.

MONEY DEMAND AND MONETIZATION IN TRANSITION ECONOMIES Marek Jarocinski

As can be learned from any economic textbook, money is demanded for transactions and as a store of value. Money, broadly defined, consists of cash in circulation and bank deposits in domestic and foreign currencies. Additionally, the needs of an economy can be further satisfied with the use of foreign-exchange cash, which substitutes for domestic money. The monetization of an economy is defined as the ratio of the (broad or narrow) measure of money to annualized GDP in current prices. The reverse ratio is the velocity of money. In general, both the magnitude and the duration of inflation are the crucial factors influencing moneti­ zation in the medium term. In the longer run, monetization is correlat­ ed with per capita income; richer, more-developed economies tend to have higher rates of monetization than poorer ones. But money demand and monetization in the postcommunist transition economies are influenced, additionally, by many specific phenomena that are analyzed in this chapter. This analysis focuses on broad-money monetization in the transition economies. Additional consideration is given to domestic-money mone­ tization and the size of the money multiplier (the ratio of broad money to narrow money), which exposes the participation of the banking sys­ tem in money creation. Section 1 briefly summarizes the initial transition phase---the "unfreezing" of the monetary overhang. Section 2 concen­ trates on the picture that emerged after stabilization had been achieved. A comparison of monetization (and money multipliers) in the transition economies and in the rest of the world is presented in this section. The patterns that emerge are discussed with reference to per capita income lev­ els and rates of inflation. Section 3 lists additional factors that can

56

Disinflation in Transition Economies

influence monetization in transition countries----real GDP dynamics, the condition of the banking sector, the size of the shadow economy, and cur­ rency-board arrangements-and explains their possible influence. Section 4 discusses money-demand dynamics in high-monetization countries, while section 5 considers middle-monetization examples. The most demonetized economies are discussed separately, in section 6, which describes the factors that worked, in conjunction with hyperinflation, to destroy money demand. The final subsection discusses the phenomenon of falling monetization during the implementation of a stabilization pro­ gram, using the model of De Broeck et al. ( 1997) and its modification applied to countries that use nominal exchange-rate anchors. Section 7 offers concluding remarks. 3 . 1 . "UNFREEZING" T H E MONETARY OVERHANG The "unfreezing" of the existing monetary overhang, at the outset of the transition, was the most important factor that sharply reduced moneti­ zation. Before, in the late 1980s, most of the socialist economies had maintained huge fiscal deficits accompanied by monetary expansion, cre­ ating great pent up inflation that was held in check with price controls. As goods were unavailable at existing prices, forced savings increased. Additionally, state-owned enterprises were prevented by law from spend­ ing their liquid assets (Dabrowski 1995). Thus the pretransition level of monetization was artificially high. Price liberalization and deregulation unleashed an immediate inflation spike (a corrective inflation) that instantly decreased the stock of real money. The monetary overhang kept currency holdings at artificially high lev­ els, but its influence on the level of deposits was even stronger. Much of the stock of forced savings was in the form ofbank deposits. 1 The greatest mon­ etary overhangs existed in the new states of the former Soviet Union, but they were also serious in Albania, Bulgaria, Poland, and Romania. In Czechoslovakia and Hungary, the problem is thought to have been smaller. For the new states that broke from Yugoslavia (socialist Yugoslavia had always been more liberal than the other socialist economies), the monetary overhang was less of a problem (Dabrowski 1995). The unfreezing of the monetary overhang in the transition economies reduced the stock of deposits and thus the money multipliers. In most cases the initial inflation leaps did not return monetization to new equi­ librium levels. Several factors explain why the corrective inflation was

57

Money Demand and Monetization in Transition Economies

not a one-time phenomenon but instead a sustained inflation that contin­ ually reduced the stock of real money. Liberalization was a process not a single act, and it unfolded at different speeds in different countries. Furthermore, Dabrowski ( 1995) points to the buildup of inflation expec­ tations. Patrick Conway ( 1994b) has developed a model that explains sus­ tained inflation after a price liberalization. Also, under certain assump­ tions relative price adjustments can contribute to the persistence of inflation (Coorey 1 996; and Wozniak 1 998). Finally, and perhaps most importantly, many of the postcommunist countries implemented expan­ sionary monetary policies early in their transitions. 3 . 2 . MONETIZATION I N THE TRANSITION E CONOMIES COMPARED 3.2 . 1

B RO A D - M ON E Y MONETIZAT I O N AND P E R CAPITA G D P

Data from 1 995 were selected (owing to availability) to compare broad­ money monetization with per capita GDP in the transition economies and in the rest of the world. Additionally, by 1 995 most of the transition economies had been significantly liberalized and the macroeconomic sit­ uation stabilized. Monetization levels can thus be regarded as reasonably representative in the medium term. Monetization vs. per capita GDP--excl. transition economies

140---------­ ....... 120t----t--t--t----t--.--t·--1 C lOO t---r1---i--1----t---t----1 § 80+----+-:-'+-_........�...+---I ; 60+---'-l"'---1-,,.....F:,,"'"Nir--+---I ; 40�r,1,��-l---+-+---I � 20A"T"F�-+--l---+-+---I

I

o---------0

5000

15000 PPP GDP

25000

Monetization vs. per capita GDP­ transition economies

140 ,..._ 120 100 § 80 �!:! 60

c .

j

=

:;:

�.�

•

• •

40 � 20 0

5000

......

__,..,,. ....

15000 PPP GDP

i.--

25000

• The straight line is fitted for the sample excluding the transition economies.

Sources: M onetization in transition countries (De Broeck 1 997 [Table 2]); per capita GDP at PPP exchange rates in the transition economies (TR); monetization and per capita GDP at PPP exchange rates in the remaining countries (WDR). Figure 3 . 1 . Broad-Money Monetization Compared, 1 995*

58

Disinflation in Transition Economies

Money and credit tend to play a greater role in more-developed coun­ tries than in less-developed ones. As is often the case with factors relat­ ed to economic growth, to some extent causal relationships exist in both. The existence of a reliable and widely used currency and an efficient and active banking sector diminish transaction costs and improve resource allocation in an economy and thus contribute to its growth. Also, rich countries tend to possess ( or can afford) more­ efficient tax administrations and usually have less-pressing budget needs, diminishing the incentive to resort to an inflation tax to gener­ ate budget revenues. They also have ( or can afford) higher levels of human capital and better financial institutions, which implicate a more efficient, safer, and wider use of credit. Of course, there are more argu­ ments of this kind. Table 3 . 1 . Broad-Money Monetization and Its Relationship with PPP Per Capita GDP, 1 995 2 1 995 Money/GDP (percent) Median Mean Std. dev.

Rest of the World

Transition states

35 43 26

18 26 21

Regression: M/GDP = a + bPPPGDP + e No. of observations

96

24

a. Coefficients Constant

Std. Error

Coeff. PPP GDP

Std. Error

25.91

2. 64

0.0024

0. 0003

3.70

6. 48

0.0056

0. 0014

b. Regression statistics Adj . R2 S.E. of regression

0.48 19

0.40 17

Source: Author's calculations based o n data from the WDR.

Figure 3 . 1 and the regressions in Table 3 . 1 illustrate the positive rela­ tionship between per capita GDP and monetization. All the transition economies belong to the low- and middle-income groups. The absence of high-income countries in this sample is the main reason for the steep­ er slope of the regression line. Yet monetization changes more with

59

Money Demand and Monetization in Transition Economies

income in the transition economies than in the rest of the world sample. Estimates of the relationship between broad-money monetization and per capita GDP of the nontransition states can be used to forecast the mon­ etization of the transition economies.3 Figure 3.1 (right panel), support­ ed by an analysis of forecast errors (see Table 3.2), allows for a demar­ cation of the transition economies into three groups: countries with mon­ etization higher than the average for their income level, countries with average monetization, and countries with low and exceptionally low mon­ etization. The standard error of the estimated regression was selected as the cut-off point in Figure 3.3. Table 3 .2. Transition Economies Sorted by the Error of the Broad-Money Monetization Forecast Based on the Relation Estimated for the Rest of the World Country Czech Republic Bulgaria Slovak Republic Albania Hungary Poland Latvia Tajikistan* Croatia Romania Estonia Slovenia Kyrgyz Republic Uzbekistan Moldova Ukraine Azerbaijan Lithuania Belarus* Armenia Russian Federation Kazakhstan Turkmenistan* Georgia

PPP GNP

MQM

Forecast* *

Error

9,770 4,588 7,320 1 ,305 6,4 1 0 5,400 3,29 1 920 3,828 4,3 1 2 4, 1 3 8 1 0,594 1 ,62 1 2,370 2,096 2,400 1 ,665 4,47 1 4,220 2,260 4,480 3,664 2,345 1,813

83.3 66.7 66.7 47.6 43.5 37.0 26.3 1 9.6 26.3 25.0 22.2 35.7 14.1 13.5 1 2.7 1 2.7 1 0.6 1 6.4 1 1 .9 6.4

49 37 43 29 41 39 34 28 35 36 36 51 30 31 31 32 30 36 36 31 36 35 31 30

34 30 24 19 2 -2 -7 -8 -9

II.I

8.8 5.7 2. 1

-I I

-13 -1 5 -1 6 -1 8 -18 -1 9 -1 9 -20 -24 -25 -25 -26 -26 -28

INF9095 3 66 3

II

4 17 88 77,673 7972 1 09 130 14 1 ,389 8,268 1 ,505 l l l ,5 1 1 1 7,734 345 48,035 57,243 4,6 1 8 68,540 3 80, 1 77 242,540

* The country still had an annual rate of inflation of several hundred per cent in 1 995; thus it is far from achieving stability and significant changes in monetization are to be expected. ** The forecast is based on the relation estimated for the rest of the world. Sources: Author's calculations, PPP GDP (TR); MQM, broad-money monetization (De Broeck et al. 1 997 [Table 2]); INF9095, cumulative inflation since the beginning of 1 990, CPI index (TR), and author's calculations.

Based on world levels, there is nothing in the structural characteris­ tics of the transition economies that prevents them from having very high

60

Disinflation in Transition Economies

monetization. Such is the case in the Czech Republic and to a lesser extent in Albania, Bulgaria, and Slovakia. These four represent a wide range of characteristics, with income levels of almost $10,000 per capita in the Czech Republic, to $1,305 in Albania. The monetization of the remaining Central and South European coun­ tries and two of the Baltic states from the examined sample is close to the average levels for their per capita GDP. These economies tum in aver­ age and high-income levels (among the transition countries)--from $3,290 to $6,410 per capita (and $10,594 per capita in Slovenia). The remaining states (all former Soviet republics) have exceptional­ ly low monetization, compared with the 1995 world sample. Kyrgyzstan, Moldova, and Uzbekistan are in this group, although in their cases fore­ cast errors are smaller than the standard deviation of the regression (and they are higher than the rest of the average-monetization group). This is explained by the fact that there is less room for negative deviations in low-income countries because their monetization is already close to nil. 3 . 2.2 INFLATION AND MONETIZATION Including inflation in the regression {Table 3.3) sheds additional light on our analysis. The estimated relationship between monetization and per capita GDP begins to appear similar to our sample of the rest of the world. But it looses its significance as inflation proves to be the crucial determinant (and inflation tended to be higher in the lower­ income transition countries). This confirms the observation of De Broeck and others that monetization reflects the "length of the peri­ od [of high inflation] and the cumulative inflation during it" (De Broeck 1997: 14). Table 3 . 3 . Broad-Money Monetization in 1 995: Estimation of the Relationship of PPP Per Capita GDP and Average Inflation, 1 985---1 995 1 995

Rest of the World

Transition states

Regression: M/GDP = a + bPPPGDP + c ln(INF) + e* Constant

Std. Error

Coeff. PPP GDP

Std. Error

Coeff. inf. (INF)

Std. Error

a. Coefficients 34.39

5. 1 6

0.0022

0. 0003

-3.34

1 . 52

1 03.14

2 7. 22

0.0019

0. 0021 -18.75 4. 77

61

Money Demand and Monetization in Transition Economies

(Table 3. 3. cont 'd) 1 995

Adj . R2 S.E. of regression

Rest of the World

Transition states

Regression: M/GDP = a + bPPPGDP + c ln(INF) + e* b. Regression statistics 0.54 17

0.78 12

* Only 1 2 transition economies are included i n this regression because of the availability of data. This should be kept in mind when comparing the results from Tables 6 and 3 .

Sources: Author's calculations o n the basis o f data i n Figure 2; and average decade inflation

(WDR).

Data for the three groups of countries defined earlier (Table 3.2) confirm inflation's importance in determining monetization levels. In the group of high-monetization countries, inflation indicators are among the lowest and vary from three-fold price increases (in the Czech Republic and Slovakia) to an 1 1-fold increase (in Albania). The case of Bulgaria ( with a 66-fold cumulative price increase) is somewhat different because the persistently high inflation in 1995 (62 percent) suggests that high mon­ etization might not be sustainable. The cumulative inflation varies widely in the second group, from a four-fold price increase in Hungary to a 1 30-fold increase in Estonia. Despite a very high inflation, Croatia lies somewhere between the sec­ ond and third group, with an average monetization level. All the countries from the third group witnessed a period of extreme­ ly high inflation, ranging from an average annual rate of 44 1 percent in Russia to more than 1,000 percent in Turkmenistan. But in the rest of the world sample there are also countries with hyperinflation episodes-Argentina, Brazil, Nicaragua, and Peru. Among them, only Argentina, with 19 percent monetization at a rela­ tively high-income level ($8,3 1 0), is far from the average value for its income level. This is also true of Peru but to a much lesser extent. With its 1 7 percent monetization and $3,770 income, it differs from its fitted value by 1 8 percentage points. The absolute level of monetization of the last group of countries-with the exception of Lithuania-is com­ parable only with a few very poor and typically high-inflation African states.

62

Disinflation in Transition Economies THE B A N K I N G S E C T O R AND B R O A D - M O N E Y M O N E T I Z AT I O N

3 .2.3

Figure 3.2 presents a plot of the broad-money multiplier against mone­ tization for various nontransition and transition economies. ,_ 1 0 .!:! ]. 8

.::= E

=

e

6

4

•

= .. e

� 2

•• if

•

• • • •• • �- • ◄ • • • ◄ '• •• ◄

.

0 0.00 0.20 0.40 0.60 0.80 1.00 1 .20 Broad money / GDP

,_ 1 0 .!:!

� 8

..=� e

E 6

•

.... '· • • ..... = e

4

� 2

0

0.00 0.20 0.40 0.60 0.80 1 .00 1.20 Broad money / GDP

Sources: The money mu\ tiplier is calculated as the ratio of money and quasi money to money (IFS); monetization, Broad Money/nominal GDP (IFS); and for the transition economies (De Broeck et al. 1 997 [Table 2]).

Figure 3.2. Broad-Money Multiplier and Monetization in Nontransition Economies (Left Panel) and Transition Economies (Right Panel), 1 996

Data presented in Figure 3.2 illustrate the fairly obvious fact that money creation performed by a banking sector contributes to higher broad-money monetization. In the transition economies, money multi­ pliers tend to be relatively low. This effect is especially pronounced in the low-monetization countries. 3 . 3 . FA CTORS DETERMINING MONETIZATION IN THE TRANSITION ECONOMIES This section introduces a detailed country-by-country analysis of mone­ tization developments. It lists the factors to be considered and explains the manner in which each factor can influence money demand. 3 . 3 . 1.

R E A L G D P AND I N F L AT I O N D Y N AM I C S

The influence of inflation and the level of real income on monetization have been discussed above. The relationships of these have been confirmed in the cross-sectional analysis and certainly hold as long-run tendencies. But the performance of these relationships in a dynamic con-

Money Demand and Monetization in Transition Economies

63

text, in explaining year-to-year monetization changes, is a different mat­ ter. The results obtained by De Broeck et al. (1997) suggest that the adjustment speed of real money to its equilibrium value differs among countries. Inflation can be expected to have a unanimously detrimental effect on money demand. Real GDP dynamics can influence monetization to the extent that money-demand elasticity, with respect to real output, differs from unity. This effect can complicate the isolation of other influences. 3 . 3 .2.

THE S HADOW ECONOMY

The share of the shadow economy in a country's GDP can have a nega­ tive influence on the demand for its domestic currency. The size of the shadow economy matters. First, shadow-economy transactions are fre­ quently made in cash, with dollars or D-marks. Much of the illegal activ­ ity is connected with smuggling, and profits are often transferred abroad; so cash transactions are preferred. If the shadow sector is large, the use of foreign-currency cash tends to bleed into other sectors. Second, ille­ gal money rarely enters the banking system; thus it does not increase the sum of broad money. On the other hand, shadow-economy growth has a positive influence on measured monetization, to the extent that it is not captured by the sta­ tistics, because it lowers the official GDP figure, which is in the denom­ inator. GDP statistics include official estimates of some unregistered activities, but complete data were unavailable. The data from Kaufmann and Kaliberda's study (hereafter, EBRD 1997) are applied instead. Where official estimates are much lower than these, an opposite effect can be expected. Thus the validity of this portion of the examination is condi­ tional on the similarity of the data used here to those applied in GDP cal­ culations. 3.3.3.

THE B ANKING S E C TOR ' S CIRCUMSTANC E S

For a host of reasons banks in the transition countries were hamstrung with problems (EBRD 1997 : Box 8.1). Former state-owned banks inher­ ited portfolios of bad loans to state enterprises. Bank staffs were under­ qualified and lacked experience assessing clients' creditworthiness. The entry policies for new banks tended initially to be very liberal, which resulted in a proliferation of small banks that were unable to sufficient­ ly diversify their loan portfolios. Supervision and regulation were too fee-

64

Disinflation in Transition Economies

ble to prevent banks from engaging in risky operations, and corruption further eroded the quality of banking operations. Problems with individual banks and bank runs were widespread in the transition countries; some have argued that these were the result of the transition process itself (EBRD 1 997). To a certain extent the weakness of the banking system explains the public 's loss of trust and why it pre­ ferred to hold savings in cash dollars or in some other hard currency. Such behavior contributed to the lowering of the money multipliers. How policymakers responded to their banks ' problems varied from country to country. Often the problem banks were bailed out, which gen­ erated moral hazard for the rest of the sector and contributed to fiscal imbalances. In cases such as these, monetization can be influenced in an indirect and gradual way. In cases when open bank crises emerge, the impact on monetization can be immediate-through an outflow of deposits and possibly a long-term loss of confidence in banks and a switch by the population to saving in foreign-currency cash. Effective banking-sector reform can be an important factor for money­ demand growth. A healthy banking system increases portfolio demand for (broad) money holdings. It should also provide an efficient payment sys­ tem, which will stimulate a switch from foreign currencies to the domes­ tic one; thus decreasing the dollarization of the economy when it is inher­ ited from a high-inflation period. On the other hand, remonetization con­ tributes to the banking sector 's expansion. 3 . 3 . 4 . CURRENCY- B OARD ARRANGEMENTS

How the exchange rate behaves can be expected to have an important influence on money demand. But exchange-rate policy is closely con­ nected with other aspects of monetary policy (and the same concerns interest-rate levels). Inflation developments are assumed to reflect all those aspects quite efficiently, and other indicators related to the broad­ ly understood monetary stance are ignored in order to avoid redundancy. The introduction of a currency board, however, can have a stronger impact on people's confidence in their domestic currency than merely maintain­ ing a constant exchange rate absent a firm commitment. Thus the exis­ tence of any currency-board arrangement is noted (below) whenever rel­ evant, in an effort to distinguish the possible qualitative differences that this factor might introduce.

65

Money Demand and Monetization in Transition Economies

3.4. HIGH-MONETIZATION TRANSITION ECONOMIES This section analyzes the evolution of demand for broad money in high­ monetization transition economies. These can be divided into two sub­ groups: (i) the Czech Republic and Slovakia, and (ii) Bulgaria and Albania (see Table 3.4). In the first two countries, monetization has been high and growing in a stable fashion, in an environment of moderate and mostly declining inflation. Their experience proves the following. (a) An increase in monetization is possible during a real decline in growth. This occurred in the Czech Republic in 1992 and in Slovakia in 1993. The insensitivity of monetization to real GDP dynamics suggests that money demand has a unitary elasticity. (b) A rise of inflation does not necessarily prevent a persistent growth in monetization, accompanied by a stable (or even falling) share of for­ eign-currency deposits. This was seen in both countries in 1993. A sur­ prise increase in the money supply often leads to a short-term increase in monetization, followed by a rise in inflation, which subsequently reduces the monetization. But in the discussed cases the monetization growth was persistent not short-term. In both of these countries, it must be noted that monetization levels significantly exceed world averages for this income level; hence from this point of view, no potential for monetization growth exists. A question arises when comparing these two countries: How is it that money demand grew faster in the Czech Republic than in Slovakia after the breakup of Czechoslovakia? Both were plainly similar with respect to a wide range of social and economic indicators. Even their shadow economies were roughly equal. Table 3 .4. High-Monetization Transition Economies, Basic Indicators Indicators

1 990

1 99 1

1 992

1 993 1 994 1 995

1 996

1 997

83 77 9

9

The Czech Republic Monetization (percent) •• 67 - excl. foreign-currency deposits .. 63 Year-end CPI inflation (percent) 1 8 52 GDP i n constant prices (percent change) -1 .2 -1 1 .5

77 67 13 -3 .3

77 71 18 0.6

83 77 10 2.7

83 77 8 5.9

4. 1

1 .0

Disinflation in Transition Economies

66 (Table 3. 4. cont 'd) Indicators

1 990

..

1 99 1

1 992

1 993 1 994 1 995

63 59

67 63

-6.5

-3 . 7

77 50

77 59

77 63

1 1 .7

-7.3

-2.4

Slovakia

Monetization (percent) 63 - excl. foreign-currency deposits .. 63 Year-end CPI inflation (percent) 1 8 58 GDP in constant prices (percent change) -2. 5 - 1 4.6 Monetization (percent) - excl. foreign-currency deposits .. Year-end CPI inflation (percent) 73 GDP in const. prices -9. 1 (percent change)

9

Bulgaria

339

79

A lbania

53 71 Monetization (percent) 42 - excl. foreign-currency deposits •. 67 1 04 23 7 Year-end CPI inflation (percent) 0 GDP in const. prices -1 0.0 -27 . 7 -7.2 (percent change) Data fo r 1 997 are EBRO proj ections.

25

67 59 12

4.9

77 53

64

1 22

40 32

45 38

31

9.6

1.8

16

9.4

67 63

1 996

71

7

63

67 50

77 38

6.8

5

6.9

33

311

48 38

56 45

2. 1 - 1 0 . 9

6

8.9

17

1 997

7

4.5

592

-7.0

42

8.2 - 1 5 . 0

Sources: Monetization: author 's calculations from De Broeck et al. ( 1 997: Tabl e 1 and 2); Yearend CPI inflation and change of GDP in constant prices: (TR).

The composition of broad money differs in the two countries. Reserve money had a much greater share in the Czech Republic than in Slovakia. In both, money multipliers were falling, which Antczak ( 1 998) ascribes to the sterilization policy of foreign-capital inflows via the money multiplier. The Czech banking sector was beset with more problems than its Slovak coun­ terpart; yet the EBRD's Transition Report ( 1997) ranks the Slovak's bank­ ing-sector reform and interest-rate liberalization lower than the Czech's. Bulgaria presents an example of a medium-term seigniorage-maxi­ mizing inflation policy: inflation rates between 70 and 1 30 percent yield maximum seigniorage, according to the estimates of Ghosh ( 1 997: 8). Regardless of the volatile inflation and poor real sector performance, mon­ etization was remarkably high and stable. This may be partly artificial because Bulgaria was the only country, among the high- and medium-mon­ etization economies, where elements of the command system, including price controls, remained significant until early 1 997. (By 1 996, price con­ trols affected more than half of the standard basket of consumer goods [EBRD 1 997: 1 59].) Also, a closer look at the domestic currency's mon-

Money Demand and Monetization in Transition Economies

67

etization reveals a gloomier picture. The steady downward trend in the domestic-money monetization suggests that Bulgaria's economic policies were unsustainable. In 1996, an acute banking crisis drastically reduced deposits (by 75 percent), but later, in the first half of 1997, stabilization and the introduction of a currency board stimulated a rebound in real money demand (EBRO 1997: 1 60). The medium-term picture remains unclear. Albania, although its monetization is average by world standards, can be treated as a high-monetization country, considering its very low income. Broad money amounted to 56 percent of GDP in 1 996, despite a very low level of financial intermediation (the money multiplier, cal­ culated as the ratio of money and quasi money to money, equaled only 1 .7, in 1996). Albania's experience shows that even a low-income tran­ sition economy can have relatively high money demand, and with a falling inflation rate (and real GDP growth), its monetization can still increase. It is worth noting that--unlike in Bulgaria-both prices and the exchange-rate system were greatly liberalized in Albania (EBRO 1997: 148). The fallout surrounding the 1997 collapse ofthe various investment­ pyramid schemes and the region 's political instability will likely adversely affect the surprisingly high monetization in Albania. 3 . 5 . M E D IUM-MON E T I ZATION TRANSITION E C O N O M I E S

The group of medium-monetization transition economies consists of Hungary, Poland, Romania, Slovenia, and the three Baltic states (see Table 3 .5) . Interesting asymmetries exists between Poland and Hungary. While Poland's relatively high inflation rates did not conflict with its early mon­ etization growth (although it later ended), Hungary, from 1 990 to 1994, saw much lower rates of inflation and the beginnings of a demonetization process. As a result, the levels of monetization in the two seem to converge (their domestic-money monetizations have actually converged). In Poland, monetization growth coincided with a rebound in output, while in Hungary, monetization initially increased only slightly, along with a fall in output. These asymmetries are somewhat difficult to explain. According to the EBRD's ( 1997) transition indicators, Hungary is equal to, or more advanced than, Poland in every transition indicator. Notably, its banking-sector reform and interest-rate liberalization are the most highly rated in the postcom­ munist world. The unofficial economy is estimated to be much larger in

68

Disinflation in Transition Economies

Hungary than in Poland, where its share is steadily falling. Perhaps this fac­ tor accounts for the differences in their monetization tendencies. Slovenia's history of inflation coupled with an inflation surge at the beginning of the 1990s drove money demand toward much lower levels than the average for its income level. Subsequently, after a successful sta­ bilization, monetization growth was significant. Similar remarks can be made of Croatia, except that it suffered a war, accompanied by hyper­ inflation and a much steeper output decline. Surprisingly, with a consid­ erably lower per capita income level and the much tougher experiences of a war behind it, Croatia's level of broad-money monetization was sim­ ilar to Slovenia's only five years after the breakup of Yugoslavia. Dollarized deposits are greater in Croatia, but they are significant in both countries, despite the noticeably low inflation in recent years. Both the high reliance on foreign currencies and low domestic-money monetiza­ tion can probably be connected with the two's common Yugoslav heritage. The level of intermediation is high in both. In 1996, the money multi­ plier equaled 3.2 in Croatia and 5.6 in Slovenia. In Romania, the increase in money demand, which followed on the heels of the initial decline, was accompanied by relatively high and unsta­ ble inflation. The atmosphere was one of unfinished reforms and partial price controls, until February 1997. A further decline in the monetization level is possible, after the inflation surge in 1997. The Baltic states offer exceptional possibilities for analyzing the deter­ minants of money demand because of the similarity of their inflation experiences and macroeconomic policymakers ' unnecessary attempts to control for these. In 1995, per capita GDP at PPP exchange rates ranged from $3,291 in Latvia, to $4,138 in Estonia, to $4,471 in Lithuania. Considering the regression analysis reported in Figure 3.1, this implies a difference in monetization between Latvia and Lithuania of only about 3 percent of GDP. Inflation peaked in the Baits in 1992 and left a significant demonetization in its wake. Stabilization was successful and was followed by an immediate rebound in monetization. It can be argued that Estonia's currency board, in operation since 1992, contributed to the early and significant increase in the domestic-money demand, despite the decline in overall monetization (including foreign­ currency deposits). On the other hand, Fleming (1996) links the curren­ cy board to the banking crisis of late 1992 not as its main cause but as an aggravating factor.

69

Money Demand and Monetization in Transition Economies

Table 3 . 5 . Medium-Monetization Transition Economies, Basic Indicators Indicators

1 990* 1 99 1 1 992 1 993 1 994 1 995 1 996 1 997 Hungary

48 Monetization (percent) - excl. foreign-currency deposits 40 Year-end C P I inflation (percent) 32 33 GDP i n const. prices (percent change) -4 -12 28.0 32.9 Shadow economy (percent of GDP)

22 -3 30.6

50 40

21 -1 28.5

45 36

43 31

43 32

36 27

36 26

37 26

37 29

37 31

26 14

30 16

33

36 22

38 24

50 43

21 28 20 1 3 2 27.7 29.0 ..

17 3

Poland Monetization (percent) - excl. foreign-currency deposits 249 Year-end CPI inflation (percent) GDP i n const. prices (percent change) - 1 2 Shadow economy (percent of GDP) 1 96.0

32 24

60 -7 23.5

44 3 1 9.7

22 1 9 29 38 5 7 6 4 1 8.5 1 5.2 1 2 . 6 ..

15 6

Slovenia Monetization (percent) - excl. foreign-currency deposits 1 05 Year-end C P I inflation (percent) GDP in const. prices (percent change) -5

34 18 247 -9

46 -6

15 3

21 14 5

24 10

20 10

6 4

6 3

4

Croatia Monetization (percent) - excl. foreign-currency deposits 136 Year-end C P I inflation (percent) GDP in const. prices (percent change) -7

37 23

38 25

204 I J ,449 -1 1 -20

1 ,398 -1

3 1

26 11 5 2

36 14

4 4

5

Romania Monetization (percent) - excl. foreign-currency deposits Year-end CPI inflation (percent) 38 GDP in const. prices (percent change) -6

48 45

223 -13

1 99 -9

22 16

296 2

21 17

25 19

27 21

26 15

21 20

23 21

22 20

32 29

26 19

26 14

30 25

62 4

28 7

57 4

1 16 -2

Estonia Monetization (percent) - excl. foreign-currency deposits 23 Year-end CPI inflation (percent) GDP in const. prices (percent change) -8 Shadow economy (percent of GDP)

100 42

304 -8 26.2

954 -14 25.4

36 -9 24. 1

42 29 1 5 4 4 -2 25. 1 1 1 .8 . .

18 13

24 17

29

Latvia Monetization (percent) - excl. foreign-currency deposits JI Year-end C P I inflation (percent) GDP in const. prices (percent change) 3 Shadow economy (percent of GDP)

262

-10

1 9.0

959 -3 5 34.3

21 35 26 -1 5 1 3 1 .0 34.2

23 1 3 -1 3 35.3 ..

12 7

8 3

70

Disinflation in Transition Economies

(Table 3 . 5. cont 'd) Indicators

1 990* 1 99 1 1 992 1 993 1 994 1 995 1 996 1 997 Lithuania

Monetization (percent) - excl. foreign-currency deposits Year-end C P I inflation (percent) 8 GDP in canst. prices (percent change) -5 Shadow economy (percent of GDP)

15

1 161 -3 8 2 1 .8 39.2

345

-13

9

16 12

16 12

27 20

1 89 36 1 3 45 -24 I 3 4 3 1 . 7 28.7 2 1 .6 ..

10 5

* Figures in italics are average inflation. Year-end inflation data were unavailable. Data for 1 997 are EBRO projections.

Sources: Monetization: author's calculations from De Broeck et al. ( 1 997: Tables I and 2); Year­ end CPI inflation and change of GDP in constant prices: (TR), (IFS [Slovenia and Croatia]), shad­ ow economy: Kaufmann and Kaliberda's estimates, after EBRO ( I 997).

The banking crisis resulted in a persistent decline in the money mul­ tiplier, falling from 2.47 in Q3 1 992, to 1 .44 in Q l 1 993 (IFS*). (In 1996, the multiplier had yet to return to its 1 992 size.) Fleming ( 1 996) stress­ es, however, that relatively few depositors were concerned and that the overall effect, thanks to the proper handling of the crisis, was in fact a strengthening of the banking sector. Lithuania introduced a currency board at the beginning of 1 994, while Latvia fixed its exchange rate, without an explicit arrangement. Again, according to Fleming ( 1 996), the tight monetary policies in both coun­ tries played a part in exposing the unhealthy condition of some banks (whose ills would have otherwise gone unnoticed for a longer time) and in the emergence of the banking crises. The decline in monetization (or its stagnation), in 1995, should be attrib­ uted to their banking crises, which struck all the Baltic states. Although some banks were perceived as more stable and gained deposits as a result, the overall impact on the deposit base was negative. Fleming ( 1996) con­ cludes that the withdrawal of deposits and the holding of cash, in Latvia, was the result of the public's loss of confidence. Lithuania, although crit­ icized for the way it handled its problem banks, noted smaller and briefer deposit outflows. Latvia experienced a decline in domestic-currency­ denominated deposits (matched by an expansion in foreign-currency deposits) that was not observed in Lithuania because Latvia had no cur­ rency board. The data in Table 3.5 indicate some connection between the share of the shadow economy and domestic-money demand. Estonia, with the lowest level of illegal activities, had the highest monetization, even

71

Money Demand and Monetization in Transition Economies

though it had slightly higher inflation than Latvia. In spite of the high inflation in Lithuania, its level of monetization caught up with Latvia's, whose shadow economy was the largest. 3 . 6. L OW-MONETIZATION COUNTRI E S 3 . 6 . 1 . GENERAL C HARACTERI S T I C S

The first eight countries presented in Table 3.6 have managed consistent progress (at different speeds) in implementing market reforms, and they have all attained some measure of macroeconomic stabilization. Such achievements allow us to view and interpret these countries' monetiza­ tion as representative in the medium term. Our analysis may also be partly relevant to the last four countries presented in Table 3.6: Uzbekistan, Tajikistan, Turkmenistan, and Belarus. But market reforms have stagnated or even reversed in these, and their economies remain troubled by macroeconomic instability. Thus the data on them are less credible and future developments less predictable. All of the low-monetization examples are former Soviet republics. Since 199 1, all have endured a period of a very high inflation accom­ panied by a rapid decline in output, possess troubled banking sectors, and have witnessed a rise in shadow-economy activity. Their extreme circumstances limit the applicability of the approach used for the high­ and medium-monetization economies. As a result, the discussion here will concentrate on several specific issues, particularly at the moment of stabilization: the additional factors that contributed to demonetization, the problems of measuring demonetization, how a demonetized econo­ my functions, and the higher volatility of money-demand dynamics. Table 3 .6. Low-Monetization Transition Economies: Monetization (Excluding ForeignCurrency Deposits), Inflation, and Real GDP Dynamics Indicator

1 990*

Monetization (percent) Year-end CPI inflation (percent change) -2

..

1 99 1 50 -1 8

1 992

1 993

1 994

1 995

24

II

10

13

20

-29

-1

-3 1

-3

-8

Moldova

1 996 1 997

-2

72

Disinflation in Transition Economies

(Table 3. 6. cont 'd) Indicator

Monetization (percent) Year-end C P I inflation (percent) GDP in cons!. prices (percent change) Monetization (percent) Year-end CPI inflation (percent) GDP i n cons!. prices (percent change)

1 990*

3

6

Monetization (percent) Year-end CPI inflation 4 (percent) GDP in const. prices -3 (percent change) Monetization (percent) Year-end CPI inflation 8 (percent) GDP in const. prices -12 (percent change) Monetization (percent) Year-end CPI inflation 1 05 (percent) GDP i n const. prices (percent change) 0 Monetization (percent) Year-end CPI inflation (percent) 10 GDP i n const. prices (percent change) -7

1991

1 992

1 993

1 994

1 995

18

II

10

14

14

32

35

24

6

6

Kyrgyzstan

1 996 1 997

1 70

1 ,259

1 ,363

96

-5

-19

-16

-20

1 .3

77

23

20

14

1 44

2,50 1

837

217

II

-5

-1 5

-9

-13

--4

-5

67

19

20

18

13

10

161

2,730

1 0, 1 5 5

40 1

1 82

40

15

-12

-14

-14

-23

-1 2

-1 0

-3

22

27

18

9

1 ,395

1 ,294

1 ,788

II

-23

-23

-1 8

-I I

20

20

11

9

9

1 37

2,984

2, 1 69

1 , 1 60

60

29

-1 3

-3

-10

-1 8

-9

33

23

6

7

25

1 ,3 4 1

1 0,896

II

1 ,885

32

6

19

-1 7

-53

-15

5

7

6

6

1 26 -I

Russia

Ukraine

Azerbaijan

Kazakhstan

Armenia

1 32

85

IO

22

7

14

7 5

12 2

73

Money Demand and Monetization in Transition Economies

(Table 3 . 6. cont 'd) Indicator

1 990*

1 99 1

1 992

1 993

1 994

1 995

1 996 1 997

Georgia Monetization (percent) Year-end CPI inflation (percent) 5 GDP in const. prices (percent change) -12

111

34

7

4

2

4

131

1 , 1 77

7,488

6,473

57

14

7

-14

--45

-25

-1 1

2

11

11

29

20

14

14

Uzbekistan Monetization (percent) Year-end CPI inflation (percent) GDP in const. prices (percent change)

3

1 69

910

885

1 ,2 8 1

117

64

2

-1

-1 1

-2

4

-1

2

29

42

32

20

7

204

1 ,364

7,344

2, 1 32

41

1 05

-7

-29

-1 1

-22

-13

-7

-3

40

Taj ikistan Monetization (percent) Year-end CPI infl a tion (percent) 4 GDP in const. prices (percent change) -2

Turkmenistan Monetization (percent) Year-end CPI inflation (percent) 4.6 GDP in const. prices (percent change) 2

18

13

5

6

6

155

644

9,750

1 ,328

1 ,262

446

-5

-5

-10

-1 9

-8

-3 - 1 5

44

Belarus Monetization (percent) Year-end CPI inflation (percent) GDP in const. prices (percent change) -3

59

20

20

16

12

13

93

1 ,558

1 ,994

1 ,990

243

40

99

-1

-1 0

-8

-13

-10

3

3

* Figures in italics are average inflation. Year-end inflation data were unavailable. Data for 1 997 are EBRO projections. Sources: Monetization: author's calculations from De Broeck et al. ( 1 997: Table 2); Year-end CPI inflation and change of GDP in constant prices: (TR).

74 3 .6.2.

Disinflation in Transition Economies A D D I T I O N A L FAC T O R S IN Low-MONETIZAT I O N C OUNTR I E S

Extremely high inflation was accompanied ( and preceded) by government decisions that discouraged money demand in the countries of the former Soviet Union. The first serious blow to the public's confidence in fiat money occurred in January 199 1 , when the Soviet government withdrew 1 00- and 50-ruble banknotes from circulation (Conway 1994a; and Dabrowski 1995) and limited their exchange. A number of other decisions by authorities also undermined the cred­ ibility of the various banking systems. Along with the exchange of ban­ knotes, restrictions on withdrawals from banks were also introduced (and later relaxed). Subsequently, a series of similar decisions was taken in the FSU countries because of cash-ruble shortages in the ruble zone (Conway 1994a). Even in a low-inflation environment, acts such as these would be tantamount to an acute banking crisis, as far as the public is concerned. In fact, because the banking crises coincided with very high inflation, the loss of savings of ordinary people was considerable and irreversible. The poor quality of GDP statistics in the low-monetization countries adds even more uncertainty to any assessment of their monetization. For example, in 1995 the official nominal GDP figure in Kyrgyzstan was cor­ rected downward, which immediately improved the monetization picture. GDP figures in Georgia are also rendered unreliable (IMF 1 997) because of the numerous arbitrary adjustments that were required to account for the informal economy and for production in the breakaway regions: Abkhasia and South Ossetia. 3.6.3.

How D E M ON E T I Z E D E C O N O M I E S F U N C T I O N ?

Monetary issues aside, people still seek to save, and transactions occur in an economy at any level of real GDP. Hard-currency cash, money sur­ rogates, and barter allow an economy to function when domestic mone­ tization is depressed. Absent a reliable banking system, cash dollars or D-marks become the most attractive savings asset during unstable times because they are liquid. As a result, they are also used for larger transactions between households. Additionally, corruption is very widespread in the FSU, and the dollar is the cash currency of choice when paying bribes. To be sure, the dollar is widely used in the shadow economies that flourish in the FSU.

Money Demand and Monetization in Transition Economies

75

Moreover, the economic environment in the demonetized economies sustains various incentives that promote the use of dollars.4 Law enforce­ ment is weak in the CIS, so regulations forbidding the acceptance of other currencies have no effect. But the supply of dollars is limited, which cre­ ates a natural barrier to the endless spread of this substitute of the nation­ al currency. Barter has become an increasingly widespread method of exchange in the FSU. In Russia, the share of barter in total industrial sales has grown from around 5 percent in 1992, to at least 40 percent (according to the highest estimates, 70 percent) in 1997 (EBRD 1997: Box 2.2). The EBRD's Transition Report (EBRD 1997) names three motives for using this method of exchange. First, barter allows firms to conceal flows from tax authorities and from creditors. Second, it helps managers who cling to Soviet management habits to maintain high levels of production while concealing its true value.5 A third reason is connected with the weakness of the financial systems and the high cost of credit in the analyzed group of countries. Enterprises use trade credits collateralized with goods (claims on goods are the easiest to enforce) to obtain working capital. Barter is connected with a more general phenomenon referred to as a "nonpayment crisis." In the absence of cash, goods are used to regulate payments to public utilities. In public procurement, goods are acquired in return for cancellation of tax arrears (see EBRD 1997: Box 2.2). Barter is often supplemented with the use of such money substitutes as securi­ tized nonfulfilled state obligations, which are used to pay taxes and even transactions between enterprises. In rural areas, small-scale barter is the result of declining living stan­ dards and a return to subsistence agriculture. This tendency is believed to be widespread in Georgia, the most demonetized country. But since subsistence agriculture contributes little to GDP, its impact on moneti­ zation is low. The countries with low levels of monetization suffered from a host of related problems: weak legal frameworks (weak payment enforcement, inefficient bankruptcy procedures), the persistence of old-style management in privatized enterprises taken over by insiders, structural problems with tax systems, and the spread of poverty among agricultural populations. All of these played a part in the low monetization levels. Furthermore, avoid­ ing the use of the domestic money (especially in the form of bank deposits) and relying on cash dollars and on barter became features of an economic culture and mentality that emerged in the low-monetization countries, all of which strengthened the persistence of low monetization.

76

Disinflation in Transition Economies

3 .6.4.

M O N E Y- DEMAND DYNAM I C S DURING S TAB ILIZ AT I O N , F O L L O W IN G

HYPERINFLAT I O N

De Broeck, Krajnyak, and Lorie (1997) conclude that the volatility of monetization is much higher in hyperinflation economies than in moder­ ate-inflation ones. A phenomenon that especially caught their attention was observed during the period of stabilization. They noticed that mon­ etization decreased sharply not only during high inflation but also at the outset of a stabilization program's implementation. In several countries (Armenia, Azerbaijan, Kazakhstan, Kyrgyzstan, Moldova, and Russia), a sharp decline in monetization occurred, in fact, only after inflation came down. There are two approaches to this issue: one consistent with the standard framework of the open-economy money-demand theory and another one that stresses temporary money-market imbalances. 3 . 6 . 4 . 1 . Money-D e m a n d Dynamics in the Standard Mon ey-D emand Framework De Broeck et al. ( 1997) developed a simple model that reproduces the sharp drop in monetization in the early phase of a stabilization program and an overshooting exchange-rate appreciation (which is also observed). The assumptions of the model are these: • stabilization is attained by a reduction in the rate of money growth (denoted by u); and • the money market clears in accordance with the money-demand rela­ tionship lnM - lnP = k lny - n (r + E {de/e})

(3. 1 )

The equation states that demand for (the log of) real money (lnM lnP) increases with real output (y) and decreases with the opportunity cost of holding money, calculated as the interest rate under uncovered inter­ est-rate parity (equal to the nominal foreign interest rate r plus the expect­ ed depreciation E{de/e}). • inflation behavior is described as follows: dP/P = a.

Disinflation Policy, Capital Inflow, and the Current-Account Balance

149

One can modify the model by introducing durable goods into the con­ sumption basket. Such modification increases the volatility of the current account's response to unexpected income changes. Another modification allows for the introduction of the terms of trade. It can be shown that if the terms of trade fall, the relative price of exports in terms of imports also falls in relation to the broad CPL In particular, a temporary fall in the terms of trade will thus result in a temporary current­ account deficit, while a permanent fall in the terms of trade causes a shift to a new, lower level of consumption consistent with the external balance.

6.3. WHAT DETERMINES THE CURRENT ACCOUN T ' S IMPROVEME NT? Identity 6.1 states that the current account can improve only i f the gap between national investments and national savings contracts. In other words, the government must reduce its deficit and the private sector must cut investment spending, or the propensity to save has to increase. Such improvement may occur in two ways. ( 1 ) A gradual adjustment in the macroeconomic aggregates is possi­ ble. For example, a high interest-rate policy may boost households' sav­ ings, while a fiscal contraction may reduce public dissavings, which will lead to the current account's improvement. (2) Foreign investors may perceive the current-account deficit as unsustainable and withdraw their capital. In such a situation the current account improves because of a rapid decline in domestic absorption, which is usually associated with a recession (for example, South-East Asia in 1 997) or at least with sluggish growth. Milesi-Ferretti and Razin ( 1997) have analyzed the factors behind reversals of current accounts in developing countries. Two major ques­ tions were addressed: What triggers sharp reductions in current-account deficits? And what factors explain how costly such reductions are? The authors analyzed 86 low- and middle-income countries, from 1 97 1 to 1 992. They studied 72 episodes, in which the current-account deficit was reduced by 3 percent, and 48, in which the current account improved by 5 percent. Their major findings were these. • Current-account reversals (improvements in deficits) were more likely in countries with large current-account deficits. This suggests

150

Disinflation in Transition Economies

that a country with a large deficit may be unable to borrow abroad and is more exposed to changes in investor sentiment. • Reversals were less likely in economies that were more open. • Countries with lower ratios of reserves to imports were more like­ ly to experience sharp reductions in their current-account deficits. Apparently if reserves are too low and imports are growing rapid­ ly, the situation will be perceived as unsustainable in the long run, portfolio capital will flow out, and low reserves will limit the cen­ tral bank's ability to defend the exchange rate, which would lead to an improvement in the trade deficit. • For a given size of the current-account deficit, high investment and savings increase the likelihood of a reversal. It seems that high investments increase future exports and output growth, resulting in a narrowing current-account deficit. • Countries with higher GDP per capita are more likely to experience reversals, which is consistent with the theory that there are stages in the balance of payments. • The probability of an improvement in the current-account deficit is higher in countries with lower public-sector deficits, which may sug­ gest that fiscal austerity actually begins before a reversal in the exter­ nal balance. • The current-account deficit is more likely to improve during the years in which the terms of trade improve. • Reversals in the current account are more likely in developing coun­ tries in those periods when the industrial economies enjoy high rates of growth. High growth implies high demand for exports from devel­ oping countries, which helps to improve the external balance. • The probability of a reversal increases after periods of high interest rates in the industrial countries. In assessing the consequences of current-account reversals, Milesi­ Ferretti and Razin found that countries which had less-appreciated exchange rates, high investment, and more trade openness are likely to grow faster after a reversal. Export growth tended to accelerate after a reversal and was more pronounced in countries that had high investments and larger current-account deficits before the event. Debelle and Faruqee (1996), in a cross-section study of industrial and developing countries, found that specific stages in development and demographic factors significantly influenced the position of the current account. In particular, countries with high dependency ratios 6 tended to run high current-account deficits. The authors also found evidence sup-

151

Disinflation Policy, Capital Inflow, and the Current-Account Balance

porting the theory that the stages in balance-of-payments development were important. In countries with low income per capita relative to that in the United States, larger current-account deficits tended to be asso­ ciated with higher relative income. But after the threshold of 66 per­ cent of US GDP per capita, larger relative incomes were associated with lower current-account deficits. These findings suggest that countries depend on external financing during their initial development. As they grow richer, increasingly they become capital exporters. The authors found, also, that very poor countries have very low current-account deficits, which simply reflects the liquidity constraints they face. Dabelle and Faruqee also found-contrary to Milesi-Ferretti and Razin ( 1 997)-that changes in fiscal policy had no impact on the position of the current account. This may suggest that an increase in government sav­ ings can be (partially) offset by a decrease in private savings. 7 This con­ clusion dramatically changes, however, when a dynamic approach is implemented. A 1 percent of GDP increase in government deficit significantly worsens the external position by 0.5--0.6 percent.

6.4. THE C URRE NT AC COUNT-INFLATION TRADE-OFF : THE CAU SALITY I S S UE The impact of the current account on inflation can come through unsus­ tainable financing and currency crises. If a country runs a large current­ account deficit financed with short-term portfolio or speculative inflows (Mexico and Thailand) or with short-term private borrowing (the Czech Republic), a sudden loss of confidence and rapid capital outflow erode foreign-exchange reserves and force a currency devaluation. This, in tum, through the large share of imported consumption goods, usually leads to a rise in inflation. Table 6. 1 provides the most recent evidence of this process. Table 6. 1 . Macroeconomic Indicators o f Countries Affected b y Currency Crises

Country Mexico

Czech Republic

Year

1 993 1 994 1 995 1 996 1 997 1 998

Real GDP

0.6 4.5 -6.2 3.9 l

-1.5

Current account

CPI

-5 .8 -7 -0.6 -7.6 -6. 1 -2.5

US$/loc.cur.

9.8 7 35 8.8 8.4 11.1

3. 1 5.3 7.6 27.3 34.6 3 1 .7

152 (Table 6. 1 . cont 'd) Country

Thailand Russia Brazil

Disinflation in Transition Economies

Year

1 996 1 997 1 998 1 996 1 997 1 998 1 997 1 998 1 999

Real GDP 6.6 --0.4 -8. 5 -6 0.8 -5 3.2 0.7 -3

Note: Figures for 1 998 and 1 999 are forecasts.

Current account -7. 8 -1 .9 1 0.5 1 .7 0 -4 -4.2 -4 -2 . 7

CPI

5.8 5.6 8.7 22 11 1 30 6.4 1 .9 2.3

US$/loc.cur. 25.6 47.3 4 1 .8 5.6 6 24

I.I

1 .2 1 .4

Source: ING Barings ( 1 998).

The impact of the local currency's depreciation on inflation depends on the inflation history in the particular country. If a country has a long tradition of high inflation, a devaluation may lead to a confidence crisis and provoke the development of hyperinflation. Russia is an excellent example of a crisis of confidence. In countries with histories of low and stable inflation, a depreciation may generate only moderate inflation hikes, as was the case in the Czech Republic and Thailand during the 1997 Asian crisis. The causality of the current account to inflation may also work in the opposite direction. High domestic inflation in a fixed-exchange-rate regime may lead to a currency overvaluation. This makes foreign goods cheaper relative to domestic ones; thus imports accelerate while exports often fall if domestic producers are unable to reduce costs. Enlarging the trade deficit then translates into a larger current-account deficit. 6 . 5 . CAPITAL INFLOWS, EXCHANGE RATES, AND INFLATION: THE CZECH REPUBLIC, HUNGARY, AND POLAND 6 . 5 . l . PANEL ANALY S I S

Figure 6.4 shows how real effective exchange rates appreciated in the Czech Republic, Hungary, and Poland at the end of 1997, in comparison with their January 1992 levels.8 Appreciation was most severe in the Czech Republic, which practically followed a fixed nominal-exchange-

Disinflation Policy, Capital Inflow, and the Current-Account Balance

1 53

rate path. In the Hungarian and Polish cases, the selection of the starting point (January 1992) seems to strongly affect the outcome. If the start­ ing point was set at mid- 1 992, the Hungarian forint would seem to have appreciated much less than the Polish zloty because of a 1 2 percent zloty devaluation in February 1 992. REER (Jan. 1 992 = 1 00) 1 60 1 50 140

- PLN-CPI - PLN-PPI - CZK-CPI - CZK-PPI

130

120 110 1 00 90 80

- HUF-CPI - HUF-PPI

= =°'... °'...="' ...=°' ....°'...="' ....=°'... ...°'"'= =°'... °'...="' =°'...

°' "'

M

M

f'l

f'l

ti)

ti)

�

�

Source: ING Barings.

Figure 6.4. Real Effective Exchange Rates (Higher Values Reflect Appreciation)

As already stressed, expected exchange-rate developments have a strong impact on inflation performance. Exchange rates, in tum, are deter­ mined to some extent by international capital flows. Below we investi­ gate the relationship between inflation, real and nominal effective exchange rates (for both rates, higher values reflect appreciation), and capital flows. 9 As shown in Figures 6.5 and 6.6, most markers lie below the Y = 0 line, which reflects the period of the consequent disinflation in the ana­ lyzed countries. It seems that faster disinflation is associated with depre­ ciation or slower appreciation of both the real and nominal effective exchange rates. The relationship is very weak, however, especially for the nominal exchange rates. This outcome would be consistent with the exchange-rate policy of central banks to engage in sterilized interventions. The sterilizations were not very successful, 1 0 and part of the capital inflows fueled domestic consumption and investment rather than a rise in demand for money. The excess in aggregate demand contributed to slower disinflation, which translated into an appreciation of real exchange rates (as shown on Figure 6.5).

154

Disinflation in Transition Economies REER and CPI

•

• "'ell

-5

•

•

10

•

5

15

0

• •

20

· · · · · · · · · · · · · · · · · · · · · · · · · · · · · · · .,20

•

y • 0.244 1 - 8.1 773 R 2 • 0.0 1 1 2

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .-41

• REER %change

Source: ING Barings.

Figure 6 . 5 . Percentage Appreciation of REER and Percentage Change in Annual Inflation (CPI) NEER and CPI 20

• -35

-40

..JO

•

-25

♦

-28 ♦

•

•

-1 5

-1

•

0

-5

•

•

• 5

·20

y • 0.0484 · 0.0 1 87 R 1 • 0.00 1 7

······························································································� .......... .

•

Source: ING Barings.

NEER % change

-60

Figure 6.6. Percentage Appreciation of the NEER and Percentage Change in Annual Inflation (CPI)

Disinflation Policy, Capital Inflow, and the Current-A ccount Balance

1 55

The link between the exchange rates and inflation seems very weak. This calls for an investigation about what types of capital flows are asso­ ciated with the real/nominal appreciation of the domestic currencies. REER and Current Account

♦

y • 0.) 749 - J .729 R2 • 0.1 7 1 5

Source: ING Barings.

REER %change

Figure 6 . 7 . Percentage Appreciation o f the REER and the Current Account

Figure 6.7 shows that a deterioration in the current-account position tends to be associated with a slower appreciation or depreciation of the real exchange rate, which contradicts the theoretical claim that a stronger currency worsens the external balance. 1 1 There is no relationship between nominal exchange rates and the current-account position (Figure 6.8). The correlation between the REER and the current account disappears, however, if we lag by one year the real exchange-rate appreciation (Figure 6.9). The slope becomes negative (as expected) but not significantly. There are three possible explanations behind these results. First, the REERs we used are improper because monetary authorities seem to fol­ low very different rules. Second, the real exchange-rate appreciation affects the current account with some lag (more than six months); thus the correlation found for the current values is purely spurious. Third, mon­ etary authorities react asymmetrically to different kinds of capital flows. They allow for currency appreciations when foreign-exchange inflows are related to foreign trade, while they resist appreciations when the inflows are from short-term portfolio investors.

156

Disinflation in Transition Economies NEER and Current Account

20

c,:, c,:,

=

CJ CJ