Chapter

Chapter VI.1 Assessment of Medium-Term Economic Prospects

Author(s):
International Monetary Fund
Published Date:
December 1991
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1. INTRODUCTION

This chapter addresses medium-term issues in the management of structural change and the prospects for the Soviet economy over this decade—especially the first five years. The main economic considerations that enter into an assessment of a Soviet reform program for transition to a market economy are identified; some ways in which the economy could evolve are explored; and the contributions that external finance and other means of enlarging access to foreign exchange could make to the transition under various circumstances are assessed, drawing on the analysis and recommendations outlined elsewhere in the report.

At present, the medium-term outlook for the Soviet economy is clouded by uncertainty about the course of economic policies. There is a broad consensus at all levels of government and among the public in favor of a transition to a market economy. However, this consensus appears to rest largely on dissatisfaction with the existing system and on the manifestly better results that market systems have delivered elsewhere. It is not clear that there is wide public understanding of what is involved in the transition. Furthermore, there are two strongly opposing views on how this transition should be carried out. One view is radical—free prices, privatize, and otherwise remake the economy as quickly as possible. The other view is conservative—proceed step-by-step, holding on to the core of the old central planning apparatus (notably administered prices and state orders) through the transition period. Visions of what the ultimate “market economy” might look like clearly differ too, but in the debate over what program to adopt, these differences count for less than issues of the pace and sequencing of reforms. A clear choice between radical and conservative approaches was not made in the presidential guidelines approved by the Supreme Soviet in October 1990. These guidelines contain a mixture of radical and conservative elements, and specific measures that would make intentions in this respect clear have not yet been fully spelled out.

The two alternative views of reform are intermingled with different visions of the future political structure of the union. The resolution of constitutional issues concerning the powers of government at union, republic and regional levels may largely determine which view of the economic transition prevails, or what compromise is struck between them. At least one important feature of the ultimate market economy is also at stake in the political debate—is there to be one market with one money, or disparate markets divided by internal restrictions on trade and a multiplicity of currencies? This choice can be separated from essential aspects of political sovereignty but is often wrapped up with them. In what follows, it is assumed that the republics of the USSR will maintain an all-union market, including an absence of trade barriers between republics; a common currency and exchange rate, and therefore a common monetary policy; a common external tariff; and an agreed division of responsibilities for taxation and expenditures at different levels of government. With fragmented markets, medium-term economic prospects would be poorer than suggested below. Economic arrangements that would preserve a unified market could be agreed among republics exercising full sovereign powers, since movement toward greater political decentralization and independence is consistent with continuing economic interdependence. Indeed, economic integration among sovereign states in other parts of the world has been increasing, as the benefits of wider markets for goods and factors of production are sought.

However the constitutional issues are resolved, the problems facing Soviet society in making the transition to a market economy will be essentially the same: fundamental changes must be made to economic institutions, adaptations in attitudes and behavior are required, adjustments will be necessary through the reallocation of people and physical resources to new types of activity. The main problems involved in managing structural change over the medium term, to ensure a successful transition, will be the same for the individual republics as for the union.

a. Scenarios of radical and conservative reform

It is impossible to produce forecasts of how the Soviet economy will evolve beyond the immediate future. This is partly because the implementation of specific measures under the presidential guidelines is an ongoing process, with the broad character of a reform program not fully defined. In addition, the speed with which economic behavior will adapt to a new environment is uncertain. The approach followed in section 2, therefore, is to explore the main lines of alternative approaches to reform—one essentially radical and the other essentially conservative—each involving policies that are coherent and feasible. Scenarios illustrating how the economy might plausibly evolve over the medium term under each program are then considered. While having no value as forecasts, the scenarios nevertheless serve to highlight the interaction of economic forces that will be at work, provide perspective on relative orders of magnitude, and offer a basis for assessing the risks that the authorities will face under whichever approach they adopt. The scenarios have not been designed to correspond to specific proposals for reform that have been put forward; the intention has been to focus on the broad policy choices facing the USSR rather than to compare proposals that have appeared at different times and have been worked out in more or less detail.

Both scenarios assume the implementation of coherent programs involving extensive stabilization measures. Any feasible path to a market economy would require that government finances be set on a sustainable course from the outset—that is, that deficits not be an engine of excessive money creation. At the same time, stabilization requires subjecting enterprises to harder budget constraints. Both scenarios assume, as well, that the legal and institutional infrastructure for a market economy is put in place promptly. The major difference between the two scenarios is in the pace at which prices are liberalized and instruments of direct economic control, such as state orders, are dismantled.

In the radical scenario, prices are decontrolled rapidly. Starting from initial conditions of widespread shortages and a monetary overhang, prices increase and output falls sharply. Consumption levels are maintained, however, as investment is curtailed, inventories are run down and households draw on their savings balances. A recovery gets under way within two years. By then, inflation has receded and the conditions for a much more efficient allocation of resources guided by market prices has been put in place. A process of catch-up with Western levels of productivity begins, during which output growth averages something like 7 percent per year.

In the conservative scenario, the policy approach seeks to contain inflation by decontrolling prices only gradually, so that only after four or five years have most prices reached levels that balance supply and demand. With prices not yet providing meaningful signals for resource allocation, state orders are retained to a substantial extent for the interim. Output declines, but less in the first year than in the radical scenario. As in that scenario, it is possible to maintain real consumption levels as investment drops and inventories are run down. Unlike the radical scenario, widespread shortages and disruption of normal distribution channels continue.

The positive features of the conservative scenario fade quickly, while the problems arising from a regime of controlled prices persist. So long as a functioning system of market prices is not in place and the planning apparatus continues to direct a significant share of the economy, productivity does not move onto a fast growth track. The unavoidable process of shedding excess labor is stretched out, eventually bringing unemployment to nearly the peak levels reached in the radical scenario. Output would still be well below current levels in the middle of the decade. Nevertheless, assuming economic and political structures do not crumble under the pressures arising from contradictions between the promise of a market economy and continued central regulation on a wide scale, most administered prices might have reached market clearing levels by then. Economic growth might finally pick up with the conditions for functioning markets fully in place.

b. Major risks

The major risk for a radical program is that initial inflation could prove to be much higher than suggested in this scenario. If the government budget deficit was not contained and credit to enterprises checked, this would indeed be the result. The moment of greatest risk would come quickly as declining output and rising unemployment put pressure on the budget. If financial stability is nevertheless maintained, prices and wages would not rise significantly beyond the point at which the initial monetary overhang would be absorbed, even though the economy is heavily monopolized.

The likelihood of very high inflation leading to a collapse of the reform program is not lower under the conservative scenario, indeed it would be greater over the medium term. In this scenario, pressures on the budget would build over time as output sagged and unemployment rose. Moreover, so long as price controls were maintained, the need for stabilization would not be signalled by price increases, and subsidies to cover losses at controlled prices would continue to strain budgets. Fiscal control would very likely slip. If this happened, growing macro-economic imbalances would be reflected in even more widespread shortages. Getting back on track would then involve a still larger price adjustment than is in store now, and it would also require undertaking the budgetary stabilization that was not done earlier.

Credibility that policies will stay on course is essential for enterprises and foreign investors to make plans and to undertake projects in response to expected opportunities. A conservative program would be more vulnerable to a loss of credibility than a radical program. So long as actions are promised but are not taken, and commitment to them appears shakeable, the restructuring of the economy through market forces would remain very slow. Lack of confidence could become self-fulfilling as disappointing results over a period of years discredited the goal of a market economy and resulted in a loss of policy direction. Ever deepening macroeconomic imbalances would result if the authorities sought to mask the costs of their failure to take decisive measures by continuing to subsidize consumption. Such a strategy would become unsustainable and could collapse at a fairly early stage. Indeed, recent developments in the Soviet economy make clear the risks involved with a conservative approach. The combination of controlled prices, rising subsidies and growing budget deficits has added to liquidity in the economy and led to rising black market prices and shortages. As this process goes on, inflation prospects tend to worsen for any reform program.

c. Sensitivity to external trade and finance

Both scenarios assume that the USSR will be debt-constrained over the coming decade. Additional capital inflows could make a difference in both scenarios. The questions of external financing and other measures to boost foreign exchange availability are addressed in section 3, which highlights the importance of domestic conditions and the form of financial flows in determining their effects on the course of the Soviet economy. Sensitivity simulations are used to illustrate some of these effects. The most important results are:

  • (1) If a flow of additional foreign credits were used for consumption, the amount of possible additional consumption would decline year by year as the interest burden built up. Once new credits were no longer being extended, consumption possibilities would be reduced to below baseline since the additional debt would have to be serviced.
  • (2) If additional foreign credits were used for capital investment, there might not be any increase in output available to the USSR in the conservative scenario, after allowing for interest payments and capital depreciation.
  • (3) By contrast, given the background of rapid transformation and high productivity growth of the radical scenario, a flow of foreign credits could add to net income in the USSR, as well as to gross output. Foreign investment inflows could have still more positive effects, if they brought with them technology and know-how that led to higher productivity. Sustained flows of investment on a significant scale are not likely to be forthcoming, however, until the infrastructure of a market economy is securely in place, including adequate investor protection and a market system of prices.
  • (4) The medium-term prospects of the Soviet economy depend significantly on halting the decline in oil production and on energy conservation. The energy sector provides greater possibilities than other parts of the economy for foreign investment in the near term to boost overall economic growth and foreign exchange earnings—provided issues of ownership and control of energy resources are resolved. The scope for increasing foreign exchange receipts through energy conservation is also large.

2. MEDIUM-TERM SCENARIOS FOR THE SOVIET ECONOMY

The Supreme Soviet of the USSR has, at least in principle, committed the country to embarking on a transition to a market economy. What course this implies over the medium term is not at all clear, however, even in qualitative terms. The difficulties in assessing future prospects go beyond those inherent in forward-looking economic policy analysis in four respects. First, the policies for the transition have been given by the authorities in only general terms; a policy program is unfolding piece-by-piece as measures are put in place. Second, in the best of circumstances, adjustment costs will be high for at least some members of society, and consequently there will be resistance to many of the measures that are required for the transition to be successful. A risk exists that support for doing what is required to complete the transition will not be sustained, and that even once a program is elaborated, implementation could falter. Third, it is far from clear that the USSR will continue to have a common economic policy, whether formulated by an all-union government or as the outcome of a consensus joined by governments of republics and perhaps other governmental levels. The country could well become economically fragmented, despite apparently widespread support for recasting the economic system along market lines, because of ethnic and nationality tensions combined with general disillusionment with the policies of the central government. Fourth, even if policies were known with precision, the past would be a poor guide as to the macroeconomic relationships that could be expected during a complete transformation of the economy.

There are nonetheless a number of issues about the medium term which can be explored in terms of alternative scenarios based on particular assumptions about policies. In this section, narrative scenarios and variants on them are used to assess issues concerning the pace and sequencing of Soviet reforms and their implications for the development of the economy. Uncertainty about behavioral relations poses limits to the detail and precision that can be introduced into such an exercise, although careful attention to the budget constraints on the behavior of governments, enterprises and households can narrow the possibilities considerably. Nevertheless, judgment is still required about key behavioral relationships.

The narrative scenarios draw on simulations of a quantitative framework, described in detail in Appendix 1. This framework is mainly a system of accounts which ensures that assumed behavior respects budget constraints and that a scenario is internally consistent. Budget constraints for government, enterprises, households and the foreign sector ensure that differences between income and expenditure are reflected in net financial asset accumulation. Consistency is assured with respect to net financial asset positions across these groups: an increase in the net financial asset position of, say, households implies a decline for the others taken together. Thus, assumptions about tax and expenditure policies must have implications for the government budget deficit and also for the financial surpluses or deficits of other sectors. Over time, these financial balances, together with net investment, determine the net worth and net financial stock positions of each sector. These are, in turn, an important influence on behavior over the medium term. Consistency is also imposed in other respects, for example, between total output and the sum of its industry, energy, agriculture and services components. This output is allocated to household consumption, enterprise investment, government spending on goods and services, and the external sector. These and other accounting relationships make it possible to consider behavior judgmentally from several perspectives. For example, assumptions about sectoral output growth rates can be checked for their implications concerning aggregate productivity growth.

The framework allows almost unlimited flexibility to impose behavior judgmentally, subject to accounting constraints, but the broad features of the resulting medium-term picture are not excessively sensitive to many aspects of behavior over a range of plausible assumptions. Two facets of the framework stand out as particularly important. One is productivity. A conventional aggregate production function is used to impute output effects from purely quantitative changes in capital and labor inputs, with a variable (total factor productivity) capturing residual changes in the relationship between inputs and outputs.

Judgment about how total factor productivity will respond during a transition largely shapes the medium-term output trend in the scenarios. Changing rates of employment of the potential labor force could dominate output developments for a few years, but in the medium to long run employment growth is unlikely to differ significantly between scenarios. While the rate of growth of investment could differ considerably, either over time within a given scenario or between scenarios, the growth rate of the capital stock will change significantly less rapidly than that of investment. Differences in total factor productivity growth, by contrast, will tend to have cumulative effects on output that account for a substantial portion of the differences in output growth.

The second critical aspect of economic behavior where judgment is required is the sustainability of stock-flow relationships. In the Soviet case, a potential concern is the monetary overhang, which has built up over recent years as a consequence of large budget deficits. With prices controlled and output stagnant or declining, government debt and liquidity have risen relative to GDP. A stable transition would therefore appear to require that the debt to GDP ratio be reduced and kept down. Little would be accomplished, however, if a trend of rising government debt were simply replaced by excessive growth of enterprise debt. Thus, the financial position of the enterprise sector must also be considered in assessing financial stability. This implies a hard budget constraint for enterprises, backed up by sound credit judgments by lending institutions, which would rule out ever-rising debt relative to the cash flow of enterprises. The plausibility of the foreign debt position over time is another perspective from which stock-flow ratios must be considered. Therefore, important additional constraints are imposed on the scenarios by requiring that stock-flow imbalances presently visible in the economy be eliminated over time, and that new ones are not created.

One scenario illustrates how key macroeconomic indicators might evolve and points out some of the tensions that might arise if a program of rapid price decontrol and structural change were pursued. This is referred to as the “radical scenario.” The second scenario considers a more gradual conservative program, one that nonetheless has as its long-run objective a full transition to a market economy—the “conservative scenario.” These scenarios ought not be taken as most likely outcomes. Indeed they are based on somewhat idealized assumptions about policy programs; actual economic performance may well fall short of the outcomes suggested in either scenario. Political compromises required to get a program for transition in place are likely to result in less coherent policies, and there is an ongoing risk that commitment to the ultimate objective could falter.

The presidential guidelines appear broad enough to encompass either scenario, although initial actions to implement them appear tilted towards the conservative end of the spectrum.1 The difference between the scenarios is essentially one of pace in those areas where economic circumstances would seem to allow some discretion—mainly in the areas of price liberalization and, more generally, the shift from central planning to market direction of the economy. Both scenarios assume that the budget deficit is brought down quickly to a sustainable level, as this is considered to be necessary to avoid complete economic disintegration under either scenario, and indeed even for an effort to restore central planning. The pace of deficit reduction is, however, somewhat slower in the conservative, as compared to the radical scenario. The two scenarios embody common assumptions of no major change in economic and financial relations with the West. The question of how external economic conditions and external financing of various kinds might affect medium-term prospects is considered in section 3.

a. Scenario for a radical transition program

(1) Policy assumptions

A radical approach means, above all, moving as swiftly as administratively possible to create a functioning market economy. By doing so, advocates of this approach seek to turn around the current disintegration of the economy, even at the risk of somewhat more disruption in the short run. The most difficult measures from the standpoint of popular support would be taken at the outset. Evidence of rapid progress would then soon sustain public support for the program. The policy would gain credibility, thus establishing favorable conditions for the growth of a dynamic private sector. The shape of such a program would be constrained by two considerations. First, it is simply not possible to do everything overnight. Second, financial stability is a requirement for a functioning system of markets. Without this, inflation would accelerate and prices lose their meaning.

The scenario for a radical transition considered here is based especially on four assumptions about specific policies, which reflect these considerations. First, virtually all prices are assumed to be freed and subsidies greatly reduced at the outset (see Chapter IV. 1). Existing state orders become optional, with new ones established only through negotiation and to meet the needs of the Government. The objectives are to eliminate shortages by allowing prices to balance supply and demand, and to reduce price distortions. Energy prices are assumed to be a significant exception, being increased over three years to world market levels through the use of border taxes.

Second, it is assumed that measures to put in place the full legal and regulatory infrastructure for a competitive market economy with privately-owned firms (as described in Chapter IV.7) are accelerated, but that some of the other institutional restructuring involved in the transition—notably privatization and demonopolization—takes place at a more gradual pace, determined by administrative feasibility. Reform of foreign trade is also assumed to be following a pattern of quickly putting in place a new, more transparent institutional infrastructure for trade (along the lines set out in Chapter IV.3), compatible with a market economy, but not fully exposing the economy to world market competition at the outset.

Third, the government budget deficit is assumed to be sharply reduced immediately, so as to reverse the rising trend of debt to national income, and the deficit is subsequently eliminated over a period of years.2 Reducing the deficit to 3 percent of GDP would require real expenditure cuts of 5 percent of GDP. Even with large cuts in military spending and state investment, this could not be achieved without significant reductions in subsidies on consumer goods. Indeed, the costs of increased social transfers to assist the unemployed and others facing economic hardship seem feasible only if general consumer subsidies are eliminated. Even then, costs would need to be carefully controlled—for example, by stringent means tests.

Fourth, given budgetary stabilization, money and credit policies are assumed to be effective in stabilizing the expansion of liquidity in the economy and creating hard budget constraints for firms. In addition, interest rates are raised to levels that provide the prospect of a positive real rate of return at the outset of price liberalization. Asset sales and the proceeds of privatization are assumed to absorb only a relatively small portion of the existing monetary overhang (see Chapter III.3).

While the details of the assumed radical program are left unspecified, they are taken to be consistent with the basic thrust of the program and with the constraints imposed by it. Thus, the policies could be taken to include most of the elements identified in the other chapters of this study as providing the most rapid feasible transition to a market economy. Some social support policies are assumed to be part of the program, but, as already noted, their scale will be constrained by available resources, especially at the outset.

(2) Impact on the economy

Prices, on average, rise quickly in the radical scenario, but with great differences across markets depending on the extent of underlying imbalances between supply and demand for various goods and services. An increase in the overall price level in the neighborhood of 60 percent might be expected, allowing for some overshooting of what would be required to absorb the existing monetary overhang. Wages increase too, but by somewhat less than the price level. Once these initial adjustments occur, budget and liquidity constraints on households and firms begin to restrain price and wage increases, and the inflation rate begins to recede rapidly. Monopolization in the economy means that some prices could rise above optimal levels, but not that they could go on rising indefinitely. By 1993, inflation recedes to near 10 percent in this scenario.

Output, already on a downward trend, drops sharply following price liberalization and the tightening of financial conditions. This has almost always occurred when economies have been subjected to large shocks of this sort. Enterprises that cannot cover operating costs will have to shut down immediately; some others will face slackening demand at the prices they set; and production more generally will be somewhat affected by uncertainty and confusion as new market relationships are established. Investment goods sectors are likely to be most strongly affected, as investment prospects are put on hold until a new pattern of relative prices, costs and future demand becomes more clear. While many enterprises would experience continued strong demand, few of these are in a position to increase production quickly and thus offset declining output elsewhere in the economy. The impact on output, although substantial, should be less than seen in some other countries undergoing rapid transformation, where immediate exposure to intense foreign competition was a factor (for example, Poland and especially the former German Democratic Republic). In the case of the USSR, industrial output is projected to drop 20 percent in the first year of the radical scenario, with total output (GDP) declining something like 10 percent.

Consumption levels are maintained during this adjustment, and even continue to rise slowly. The shift of resources into consumption goods sectors continues, and inventories are drawn down once prices rise and there are no longer incentives for speculative inventory holding.

The economy turns around in 1993 in this scenario. Short-term adjustments have been made, inflation is coming down rapidly, the transformation of the economy is well underway, with rapid growth of small businesses and some privatization of large enterprises. Conditions are in place for sustained rapid growth of output in the following years. By 1995, GDP is up 10 percent over 1990. With continued growth of 7-8 percent per year, at the end of the decade output is up by two-thirds. Consumption rises a bit more than this over ten years.

In the short run, unemployment rises rapidly, from an estimated 2 percent in 1990 to over 10 percent in 1992, largely as a consequence of factory closures and production cutbacks. Tighter financial constraints and commercial criteria for assessing management performance also induce some shedding of excess labor even in firms where demand is strong and output is pressing against capacity limits. Unemployment begins to recede after 1992. Nevertheless, it is still over 6 percent at the end of the decade, which is high by historical Soviet standards. Partly this is a matter of adjusting definitions, but the frictional level of unemployment is also likely to remain relatively high since structural change should still be quite rapid and the country is large and diverse.

Productivity growth is the critical link in this scenario between establishing markets cleared by prices, the resulting restructuring of the economy, and the evolution of broad economic aggregates. There is a wide gap between total factor productivity in the USSR and the industrial countries, and by most accounts this gap has been widening over the past 15 years, with Soviet total factor productivity declining. In the radical scenario it is assumed that productivity turns around from the first year, despite the drop in output, as 20 percent of the capital stock is scrapped and employment is cut back. Large productivity gains, however, are not seen until 1993. From that point through the end of the decade, total factor productivity is assumed to grow at an average annual rate of nearly 4 percent, corresponding to rates observed in other countries undergoing rapid structural change, and narrowing the gap vis-à-vis the industrial economies (Table VI.1). By comparison with episodes of rapid transformation in some other countries, the productivity assumption for the radical scenario may be on the cautious side. Nevertheless, productivity gains account for roughly half the expansion of output from 1993 through the end of the decade. Reabsorption of the unemployed into newly created jobs, together with an increasing capital stock after the initial scrapping, account for the other half.

Table VI.1.USSR: Total Factor Productivity Assumptions(Compared to Historical Record and Other Countries)
Historical Record of the USSRSelected Comparator Countries
Estimated TFP Growth
PeriodHighLowCountry (Period)TFP Growth
1950-601.61.4Korea (1950-73)2.8
1960-701.50.9Taiwan (1950-73)3.5
1970-751.5France (1950-73)3.7
1975-80-0.4-0.8Germany (1950-73)4.2
1980-85-0.5-1.2Japan (1950-73)5.5
Scenario 1990-2000
Radical Scenario3.3
Gradual Scenario1.1
Sources: Ofer (1987) and Maddison (1989). The high estimates are given by Ofer; the low estimates are based on the same data, but use CIA weights to calculate input growth.
Sources: Ofer (1987) and Maddison (1989). The high estimates are given by Ofer; the low estimates are based on the same data, but use CIA weights to calculate input growth.

(3) Risks

There are two major risks associated with a radical transition program, assuming that it is implemented with sustained vigor. One is that inflation could prove much stronger and slower to recede than suggested in the scenario. The second is that the collapse of output could be much larger, as traditional supply and distribution ties are cut and new ones are slow to be formed.

Although the propensity to raise prices and wages could be stronger than assumed (or weaker for that matter), concern about an open-ended inflationary spiral is only warranted if budgetary and financial stabilization is not achieved. In that case, excessive wage and price increases would tend to be ratified by liquidity creation, and there would be no effective brake on the inflation process. This is why budgetary consolidation and financial stability is an essential element of a radical program for transition; it would fail very quickly otherwise. Given successful financial stabilization, the risk is essentially that inflation could peak at a somewhat higher rate and that consequently output could be moderately lower as a result of demand being squeezed, but the qualitative character of the transition would not be different.

The second risk is more difficult to evaluate. The scenario assumes considerable continuity in supply and distribution links, even though managers are given freedom to change these and to negotiate prices. It seems reasonable and consistent with normally observed behavior to expect some inertia on the part of managers. This would provide the envisaged continuity. In the short run, management attention will be focused on those areas where the pressure of financial constraints are most strongly forcing adjustment. Other activities are likely to be left to continue as usual. It is nonetheless possible that production could be disrupted to a greater extent than projected.

The major question mark about a radical program is whether it is possible to achieve sufficient political consensus to implement it. The financial discipline required at the outset is demanding, and the prospect of an immediate plunge into an unfamiliar environment where prices are at the center of the economic system is daunting. But not long after the first steps are taken, the economic turnaround should begin to strengthen support for staying the course. Economic and political forces would soon become self-reinforcing, and this is a strong advantage of the radical approach.

b. Scenario for a conservative transition program

(1) Policy assumptions

The conservative program considered here is so labelled because prices are freed more gradually and the central planning apparatus is dismantled more slowly than in the radical program. The advocates of such an approach are motivated by the belief that a more radical approach to transition would result in levels of inflation and a collapse in production that would be intolerable—that is, conservatives take the risks identified in the radical scenario to be very large. The ultimate objective, the establishment of a competitive market economy, is assumed here to be the same as for a radical program. Consequently, most aspects of the program would be the same, and they would be introduced as quickly as administratively possible. Thus, the assumed program is not conservative in the sense of seeking to preserve the existing economic order, which would imply a rejection of the objectives set forth in the presidential guidelines.

There are two fundamental differences in policy assumptions. First, price adjustments for most goods are administratively constrained so as to keep down the overall rate of price increase. The specific form of constraint is not so important; what matters is that it bites—that prices for a large share of output are significantly influenced by the price regulatory machinery. Controls are assumed to be dismantled once prices have reached market clearing levels, a process that would take three to four years given the allowed rate of price increases.

Second, administrative mechanisms, including state orders, continue to play a significant role in the allocation of resources for several years. This assumption is consistent with the general conservative orientation, and also would seem necessary in order to provide some guidance to firms in making resource allocation decisions, so long as prices are not freed up to play this role.

The assumed conservative program embodies constraints on the budget deficit from the beginning of the transition almost as tight as those in the radical scenario. Without this, convergence to sustainable wealth-income ratios would not be achieved and gaps between administratively controlled prices and market clearing prices would not be reduced, even with prices rising at an allowable rate of 15 to 20 percent per year. Credit to enterprises would also need to be controlled in the aggregate in order to limit the growth of financial wealth, even if budget constraints could not be enforced too stringently on individual enterprises that were facing losses in meeting state orders.

In some other respects, too, a conservative program could not differ widely from the assumed radical program. Establishing the credibility of the program would call for the full legal and institutional infrastructure of a market economy to be put in place. The development of new private enterprises could not be hindered, and it would be important to undertake privatization of some large enterprises to firmly establish the course of reform.

(2) Impact on the economy

Inflation in this scenario is whatever the controls are assumed to allow. It rises to about 40 percent in 1991 and remains in the 15 to 20 percent range through 1993. By then, the overhang of liquidity is absorbed and prices for many goods have reached market clearing levels. Inflation subsequently subsides slowly through several more years of decontrol. Wage increases at first lag a bit behind inflation; from 1994 wages rise more rapidly than prices. Output declines by 4 to 5 percent in 1991, only half of the decline in the radical scenario. Industrial production drops by about 10 percent instead of 20 percent, and cutbacks in government spending are smaller. For the energy and agricultural sectors, there is little difference between the two scenarios. A turnaround in economic activity, however, comes much more slowly in this scenario. Indeed, GDP continues to decline for two more years, bottoming out in 1994 at as low a level as that reached in the radical scenario. From the middle of the decade, however, the economy is no longer affected by controls, the infrastructure of a market economy is in place, and higher growth rates are achieved, characteristic of a period of catch-up with high productivity market economies. Nevertheless, by the year 2000, output and consumption levels are still 20 percent below those achieved in the radical scenario. Unemployment builds up more slowly in the conservative scenario but continues to increase for a longer period. The unemployment rate turns around in 1995, having reached a peak rate of just below 10 percent—only slightly lower than the peak in the radical scenario.

This profile for key macroeconomic indicators largely reflects the trend of productivity, which is assumed to be lower in an environment of price regulation and with significant elements of central control still in place. Price signals do not reliably point the way to a more efficient allocation of resources in this environment; they could well do the opposite. Shortages, which could be aggravated in this scenario by increased hoarding in anticipation of price increases, continue to adversely affect work incentives and to disrupt production. Somewhat greater financial laxity means less pressure on enterprises to raise productivity. Correspondingly, the downward trend of productivity growth is assumed to continue through 1994. Over several years, this means that the capacity of enterprises to pay higher wages falls behind the rate of real wage increase. An upward drift of unemployment results as financial constraints on firms tighten.

(3) Risks

This scenario is premised on the technical feasibility of a conservative program of the sort suggested. It shows a less adverse economic outcome than the radical scenario in the short term but poorer results in the medium to long term. From this purely technical standpoint, the choice would seem to be a matter of trade-offs over time, and of how much weight to attach to the risks of a price explosion or an output collapse in a radical program. There are also risks, however, in a conservative scenario.

As with the radical scenario, there are substantial uncertainties surrounding all the magnitudes involved. It is entirely possible, for example, that the maintenance of controls could lead to much larger productivity declines than assumed, as the old economic structure built up under central planning continues to disintegrate and there are few incentives for private initiative to create a new one. The Soviet experience also adequately demonstrates that establishing output targets in a plan is not sufficient to ensure that this output will be produced. These are quantitative rather than qualitative matters, however.

The crucial qualitative risk in the conservative scenario is that it perpetuates a situation in which pressures would persist that could break out in a price explosion and an output collapse—just the events it is intended to avoid. The problem is that price controls are not a durable substitute for financial stabilization, and the latter is much less assured in the conservative scenario. Initial stabilization must be in place to embark on a radical program, and it will be progressively easier to keep in place as rapid growth swells tax revenues and reduces burdens on social programs. By contrast, in the conservative scenario, several years of sliding output and rising unemployment mean that additional difficult actions are required in order to keep the budget deficit under control. In the mid-1990s, government spending must be kept 10 to 15 percent lower in the conservative scenario than in the radical scenario in order to achieve adequate financial stabilization. Without this, the permitted price increases will not ultimately clear markets, shortages will become more pervasive, and it will not be possible to remove controls without a surge in prices.

The situation in the enterprise sector will further strain financial stabilization. It will not be possible to enforce credit constraints on enterprises that must meet state orders and cannot negotiate their own prices. One result will be that resources will be diverted from profitable to unprofitable firms through the financial system, thereby contributing to misallocation of resources and slower growth. In addition, it is likely that overall credit restraint will be less tight and hence restraint on wages more lax.

With prices administratively constrained, the consequences of excessive credit expansion and associated money expansion may not be directly evident. They will be reflected in shortages, and also in rising activity and prices on the black market. Blame is likely to fall on profiteers, rather than on defects in policy, and public support for a less regulated economy could consequently be undermined. There is a risk that, in the end, the most serious economic problems in the present situation would not be solved. Indeed, current shortages and price pressures in the Soviet economy are the heritage of earlier cautious approaches to economic transformation; they are the best available evidence of their vulnerability. These risks cast doubt on whether a gradual transition program is still feasible.

c. Critical policy elements for any transition program

The radical and the gradual reform programs described above depict just two possibilities from a wide spectrum of scenarios. As noted above, there are clear dangers of a worse outcome than either of these scenarios suggest. Some risks associated with each scenario have been considered. The need for adequate budgetary and financial stabilization has been stressed in connection with both.3 There are three additional policy areas where slippage would pose clear dangers for any program for transition to a market economy: wage moderation, economic integration and political commitment. The scenarios are based on optimistic views concerning each of these.

(1) Financial and budgetary control

There is pressure on government at all levels in the USSR to insulate the members of society from the risks and adjustment costs of the transition. There is also an inclination to distribute the fruits of a fully-working market economy before the institutions of such an economy have been firmly planted, let alone given time to mature. Any socially-concerned government would seek to alleviate the distress of those in greatest economic difficulty, and well-designed policies to this end are affordable; this is not at issue. However, the scale of subsidies and social transfers built into existing policy is not within the present means of the economy, let alone proposals for further expansion. If the cost of these policies is not curtailed, it will be impossible to stabilize public finances; the country will face accelerating inflation, a deepening crisis of basic consumer good shortages at controlled prices, or both. It would prove impossible to make progress towards a market economy under such conditions.

While it is necessary to bring the budget deficit under control, such action would not, by itself, ensure inflation control following an initial price adjustment. Credit to enterprises must also be contained. Otherwise, a money and credit spiral fed by the enterprise sector could produce the same kind of inflationary process as one fed by government deficits. Therefore, it will be important not just to resist pressures for social transfers and spending through the budget, but also to resist the tempting road of shifting this spending to the enterprise sector either directly, or through greatly increased taxation. It will also require reform of the financial system to provide for control over total money and credit expansion.

(2) Wage behavior

Accelerating wages over the past few years have been a source of pressure contributing to growing financial imbalance and inflationary pressures. This is at least partly attributable to ineffective constraints on managers under pressure to grant higher wages, as well as a lack of incentives for them to resist. Tighter financial constraints on firms and a management stake in the profitability of enterprises are assumed in the scenarios to check the tendency towards wage increases in excess of the economy’s capacity to pay, with higher unemployment exerting additional downward pressure on wages during the transition. There is a risk that wage pressures could be much stronger and make the transition more difficult.

A market economy requires a functioning labor relations system within which wages are set in line with the economy’s capacity to pay. Establishing such a system in the USSR will be a much more complex process than getting a functioning price system in place. A labor relations system in any economy determines not just the average level and structure of wages and salaries, but has also a complex social function in determining the allocation of unique individuals across a varied set of jobs. Every society has evolved a set of institutions that perform these functions in the context of a web of rules reflecting its own history and culture. There is no single model that could simply be copied and be expected to work well in the USSR. Hence the process of developing an effective labor relations system for the economy is likely to take a number of years.

In the past, wages were determined centrally. While this system did not produce an efficient allocation of labor resources, it managed for many years to keep wage increases in line with the capacity to pay. This system has broken down. The crucial issue for economic reform is how wages will be determined when the old system is dismantled, but a new labor relations system is not yet in place. The danger is that labor will demand large wage increases to keep up fully with inflation. Policymakers would then be presented with a dilemma: either they accommodate these wage increases by providing enterprises with access to credit and then have to face the danger of a wage-price spiral, or they enforce hard budget constraints and accept the possibility of larger output losses and increases in unemployment in the short run.

In both scenarios, it is assumed that real wages will fall moderately in 1991, and increase thereafter over time. The increase in the share of labor income in GDP is assumed to be the same in both: from 41.3 percent in 1990 to 48 percent in the year 2000. The question for any reform program is how such an outcome can be achieved in an orderly fashion when a functioning labor relations system is not yet in place. Some form of incomes policy may be needed to regulate aggregate wage outcomes. Clearly, the design of an incomes policy involves tradeoffs between the conflicting needs of regaining monetary stability, of containing the expected rise in unemployment and of creating incentives for better labor allocation and performance. An important consideration is that it should not feed a wage-price spiral. A second important consideration is that an incomes policy should be enforced for only a limited time so as not to impede the transition to more flexible wage-setting procedures. Beyond this, the design of incomes policy instruments must fit the particular social environment of the USSR.4

(3) Economic integration

Issues of the sovereignty of republics and autonomy of nationalities have become intertwined with economic issues. Although many who favor various forms of decentralization would consider an integrated market and single monetary system to be a common interest that should be protected by those who hold political power at any level, some republican and nationalist elements would fragment the economy. Such a course would be costly in economic terms, especially for the smaller units that chose autarky. Short-run costs from disruption of established trading relations would be followed by ongoing losses of potential gains from trade and economies of scale. It might be difficult to achieve effective competition in many markets. A proliferation of monetary authorities would also result in efficiency losses, particularly as they could not function independently and maintain a common currency without controls on flows of funds between monetary regions. A further risk is that republican governments may seek to direct economic activity closely, rather than allow markets to play their role. In doing so, they could recreate the problems of the centrally planned economic system. In terms of economic aggregates for the union as a whole, such developments would be reflected in stagnant or even declining output owing to poor productivity performance and stronger inflationary pressures.

(4) Political commitment

Despite the presidential guidelines, there continues to be considerable uncertainty regarding the course of economic policy and reform. Unresolved issues of property rights and policy responsibility among the union, republics and other levels of government have added further to this uncertainty. The guidelines provide a vision of the transition to a market, but few concrete actions to advance the transition have been spelled out, and the legal force of the guidelines is unclear in the absence of agreement on a new all-union treaty.5

Failure to establish a clear direction for reform and to resolve issues of power and property rights among the various levels of government could have much more damaging consequences than merely delaying the start of one of the scenarios sketched above. The centrally planned economic system has been partially dismantled, and the signals and incentives of that system are now largely inoperative. Without a functioning price system, much of the economy is simply directionless. With no clear signals to guide decentralized decisions and with great uncertainty about the future legal environment, the downward drift of output could steepen. Shortages, production interruptions and bottlenecks could become more endemic. While any reform scenario would, to be realistic, also entail declining output in the short run, this would be followed by a strong recovery. A one- or two-year slump brought on by policy vacillation would be quite different: the difficulties of adjustment would still lie ahead and be greater, since the lost time would leave the economy less prepared to make the transition to a market system.

Even after a coherent program has been elaborated and implementation has begun, there will be a risk that political vacillation could adversely affect the transition. The concern is not only that policies could veer from course. Merely the risk that this could occur, if given significant weight by the public, would undermine the private initiative required to achieve sustained efficiency gains and growth of productivity. As noted earlier, this is a particular concern for a conservative program, which puts off taking some difficult steps. This would leave the degree of commitment to the transition in doubt.

3. EXTERNAL FINANCE AND THE MEDIUM-TERM PROSPECTS OF THE SOVIET ECONOMY

The previous section illustrated possible future developments in the USSR with the help of scenarios of conservative and radical policy programs. The two scenarios described there and the qualitative discussions of other possible outcomes leave aside questions related to external financial flows. They presume no fundamental change in either the scale or the nature of financing and investment flows. These could alter macroeconomic outcomes, depending on the economic and policy environment, and on the composition of the flows.

This section explores what difference increased financial flows from abroad might make to the economy over the medium term, how policies and other internal developments might affect prospects for financing, and how such flows might influence the transition to a market economy. Also addressed is the broader issue of how foreign exchange flows can be expanded or used more efficiently, taking into account the ability of foreign direct investment to bring with it transfers of technology and management know-how. Technical assistance possibilities not linked to investment, of the kinds identified in early chapters, are not considered.

The content of the economic reform program, its consistency and the speed with which it is implemented will determine to a large extent what kind of external finance would be helpful and feasible. Financial and many other kinds of assistance provided by Western governments are unlikely to be independent of the reform effort. Capital inflows from private sources will likewise depend on the progress that is being made in economic restructuring and confidence that it will continue. Foreign direct investment inflows will be especially sensitive to the context and pace of the domestic reform program: foreign companies will make investments in the USSR on a significant scale only if legal and institutional reform has proceeded sufficiently to provide assurances of property rights and contract enforcement, as well as a favorable business climate. Satisfying these conditions will involve, among other things, much greater clarity than exists now about the latitude for governments at the union, republic, and lower levels to take actions that would affect the security or profitability of foreign investments.6

While inflows of both private and official funds will depend on the credible implementation of a determined reform effort, the success of domestic reforms could, in turn, be influenced by the external financing that is available and its form. External finance has been advocated in support of domestic policy reforms in three areas:

  • (a) Absorbing macroeconomic imbalances. Macroeconomic stabilization will involve both absorbing the accumulated imbalance from the past (the monetary overhang) and correcting the flow imbalance arising from a large budget deficit, which would otherwise fuel an inflationary spiral or result in the rapid build-up of a new overhang. Foreign credits could contribute to resolving these problems if they were used to import goods sold to households or enterprises for rubles, thus reducing the supply of domestic money.
  • (b) Building public support. The success of any reform program would be strengthened if the population could see some early benefits. Foreign borrowing could be used to import consumer goods until a significant domestic supply response was forthcoming.
  • (c) Boosting supply potential. Growth prospects could be increased by modernizing the Soviet capital stock. Foreign finance could contribute in three ways. First, it could boost the level of investment above that which could be achieved with a given rate of domestic saving. Second, imports of foreign capital goods would improve the capital stock directly. Third, and most important, foreign direct investment would bring know-how and managerial expertise so that new additions to the capital stock could be used more efficiently. The transfer of know-how could also spill over to domestic enterprises, thereby boosting productivity in the economy more generally.

Each of these suggested benefits would come at some cost in terms of future debt servicing or repatriation of investment income unless assistance was in the form of pure grant aid. The question is the balance between benefits and cost. In the following, the contribution that foreign finance could make in each of these policy areas is evaluated.

For many years, the USSR ran an overall surplus on its current account in convertible currency. This surplus mainly reflected trade surpluses with developing countries. Thus the USSR had become a creditor vis-à-vis nonsocialist developing countries of the order of US$65 billion by 1989, though most of these credits are of doubtful value. By contrast, the USSR had accumulated liabilities to developed Western countries amounting to US$54 billion or US$39 billion net of foreign exchange reserves (see Appendix II-1, Tables 1.1-1.3).

In relation to the size of the economy, the external convertible currency debt is small. In 1990, debt amounted to 9 percent of GDP at the commercial exchange rate—which is low by international standards. In relation to exports, the debt burden is relatively larger. Convertible currency debt at mid-1990 amounted to almost 130 percent of exports of goods and services to the convertible currency area.7 Experience has shown that debt indicators alone are not a very good guide to creditworthiness. Nevertheless, the external debt situation of the USSR appears to leave some room for additional foreign borrowing, provided it is backed with a strong and determined program of economic reform which generates the income, and especially the exports in convertible currency, needed to service it.

a. Absorbing macroeconomic imbalances

The sale of imported consumer goods has been suggested as one of several approaches to absorbing a part of the monetary overhang.8 This would require, however, additional foreign exchange. Foreign credits could be used to import consumer durable goods that sell at premium prices in the USSR. Judging from recent black market rates for the dollar in the range of rub 15-25 but allowing for a substantial decline in the prices people would be willing to pay as imported goods became more widely available, it might be possible to neutralize money balances of up to rub 100 billion through the sale of imported consumer goods worth US$10 billion (Table VI.2). The rub 60 billion that might be absorbed on the basis of the recent tourist exchange rate of about rub 6 = US$1 would appear to be fairly conservative. This would amount to almost one-fourth of the total estimated overhang in 1990.

Table VI.2.USSR: Illustration of the Use of Foreign Credit to Reduce the Monetary Overhang
Case 1Case 2Case 3
Foreign borrowing

(in billions of U.S. dollars)
101010
Ruble/dollar exchange rate1.86.610.0
Rubles neutralized

(in billions of rubles)
1866100
Neutralized rubles as percentage

of estimated monetary overhang
72639
Source: Based on methodology described in Appendix VI-1.
Source: Based on methodology described in Appendix VI-1.

In combination with sales of state assets, an operation of this sort would reduce upward pressure on prices. The devaluation of money holdings by inflation would be kept to a minimum, and with it the possible reaction to an erosion of the real value of savings. The gesture of respecting these savings and enabling them to be freely exchanged for something in demand could generate support for the economic reform program that is being implemented.

Clearly, one would need to judge carefully the feasibility of this policy. State distribution channels, which are highly unreliable, could not be counted on for this purpose. A government operation would therefore be difficult to implement. One feasible option could be to implement this operation as part of more general trade reforms. Whatever the precise modalities and associated difficulties involved in executing such an operation, they must, however, be compared to the difficulties involved in selling state assets and the risks of allowing inflationary pressures to build up if prices are let free. Imports of consumer goods financed by foreign borrowing could make a contribution to reducing the monetary overhang, provided the flow imbalances giving rise to it were also eliminated. Another possibility would be to finance imports of investment goods, which would not only reduce the liquidity of enterprises but also enhance the productive capacity of the economy.

b. Smoothing the transition until there is a supply response

In the process of economic restructuring, productive capacity will be shifted from investment goods and military procurement towards the production of consumer goods and services. Consumer goods production is expected to respond to consumers’ tastes once firms are operating under hard budget constraints, and once prices are allowed to move freely and can transmit information about demand to enterprises. At the same time, however, this supply response will materialize over time, rather than all at once, as illustrated by the scenarios presented in section 2. In order to build support for reforms, it has been argued that the transition could be smoothed through the large-scale import of consumer goods.

Such a sustained program for consumption, in contrast to a one-time infusion of consumer durables, would pose difficulties for both the USSR and the West. Additional borrowing of US$10 billion would allow consumption to rise only 3 percent above baseline. Continued borrowing of this order of magnitude over five years would buy progressively smaller increments to consumption, falling to between 1 and 2 percent in 1995 as a rising share of the flow of credits would need to be devoted to interest payments. At the same time, the stock of debt outstanding would rise (Table VI.3). After five years, the net debt to GDP ratio would increase by 5 percentage points from the baseline gradual reform scenario of section 2; the net debt to export ratio (taking into account only exports to the OECD area) would rise by 44 percentage points; and net interest as a percentage of exports to OECD countries would be 3.1 percentage points higher.

Table VI.3.USSR: Increased Foreign Borrowing Used to Increase Consumption in the Gradual Reform Scenario(Deviations from baseline)
19911992199319941995
(In billions of U.S. dollars)
Current account-10-10-10-10-10
Imports108.98.17.26.6
(In percent)
Consumption level2.92.31.71.30.9
(In percentage points)
Consumption/GDP1.71.41.00.80.6
Net debt/GDP1.83.24.14.85.2
Net debt/exports18.228.335.740.344.1
Interest/GDP0.20.30.30.4
Interest/exports1.52.32.83.1
Source: Based on methodology described in Appendix VI-1.
Source: Based on methodology described in Appendix VI-1.

While the debt burden would not reach alarming levels, the pace of increase would still give cause for concern, especially given the uncertainty as to when domestic supply would respond to market incentives. Perhaps a more serious drawback would arise from the debt service involved. This would eventually constrain consumption as domestic resources went into exportable production in order to pay for past imports. An additional problem could arise as consumers became accustomed to imported consumer goods; phasing out these imports might prove politically difficult.

In sum, borrowing to finance imports of consumer goods on a scale large enough to increase noticeably the overall consumption ratio during the transitional period would come at considerable future cost. And if progress in the transition were to falter, it would leave the USSR and its creditors with serious debt problems.

c. Enhancing growth prospects

External borrowing to import capital goods may bolster domestic growth through two mechanisms. First, it may permit an increase in the investment ratio, which is normally expected to expand output capacity. Second, if foreign capital goods are of more advanced design or higher quality than those produced domestically, they may contribute more to productivity growth. Three simulations are used to analyze the impact of the use of foreign borrowing for domestic investment: (1) use of additional foreign borrowing in the conservative scenario to increase investment; (2) the same additional borrowing in the radical reform scenario; and (3) inflows of the same magnitude in the form of foreign direct investment of companies that bring with them managerial expertise and know-how.

(1) Increased investment in the conservative scenario

In the absence of fundamental reforms that would boost economic efficiency as measured by total factor productivity, higher investment financed by foreign borrowing would do little or nothing to improve prospects for the economy. High rates of investment have been maintained in the past, but this has not been translated into high output growth over recent decades. Output growth has continued to decline steadily, showing clearly the limits of a growth strategy centered on the quantity of investment, and not on its quality and efficient use. Taking the conservative reform program as a baseline, additional foreign lending of US $10 billion per year raises gross domestic output in a simulation by 0.7 percent after five years. After making increased interest payments to foreigners, national income would be up only 0.3 percent, and allowing for higher depreciation there would be little or no additional net output available to raise consumption or further augment investment.

There is little from the past record of the USSR to suggest that substituting imported capital goods for domestically produced ones would result in markedly higher productivity unless there were radical changes in how capital is used and maintained. The productivity problems of the USSR are not, at their core, problems of machines; they are problems of incentives and organization.9 Foreign capital goods may be critical for particular sectors, but their purchase need not be financed by expanded foreign credits, provided exports produce an adequate flow of foreign exchange.

(2) Increased investment in the radical scenario

Perestroika and the more recent presidential guidelines are in part responses to the failure of investment to raise productivity. Once fundamental reforms are undertaken and economic incentives begin to influence both what is produced and how it is produced, the risk of lending to the USSR to boost investment will recede, and the benefits to the recipient country would grow. For example, the same US$10 billion per year in foreign borrowing for capital formation that produces such poor results with stagnant productivity would have more favorable effects if it took place against the background of higher total factor productivity growth in the radical scenario. The simulated additional national income is nearly twice as great by 1995 as with the conservative scenario; additional depreciation would eat up less than one-half of this gain, leaving the Soviet public better off as a result of the capital inflow (Table VI.4).

Table VI.4.USSR: Increased Foreign Borrowing Used to Increase Domestic Investment in the Radical Reform Scenario(Deviations from baseline)
19911992199319941995
(In billions of U.S. dollars)
Current account-10-10-10-10-10
Net imports10.08.98.17.26.6
(In percentage points)
Investment/GDP1.71.20.80.50.3
GDP growth0.30.20.20.1
GDP level (Percent over 1989 level)0.30.30.40.50.5
Memorandum item:
GDP level in the conservative scenario (percent over 1989 level)0.30.20.30.20.3
(In percentage points)
Net debt/GDP1.73.24.14.75.2
Net debt/exports18.730.036.642.546.5
Net interest/GDP0.20.20.30.3
Net interest/exports1.62.42.93.2
Source: Based on methodology described in Appendix VI-1.
Source: Based on methodology described in Appendix VI-1.

These simulations of the same additional borrowing against alternative baselines of high and low productivity growth illustrate the risks and the possibilities of foreign borrowing. The outcome depends critically on how productively additional resources are used. Both simulations assume that all additional resources made available by foreign borrowing are devoted to capital formation. Allowing for fungibility, it is difficult to ensure that this will be the case. To the extent that some of the funds go for increased consumption, the problems discussed earlier in connection with sustained borrowing for consumption would arise.

(3) Foreign direct investment

Financial flows associated with foreign direct investment may affect macro-economic prospects more favorably than domestic investment financed by international borrowing. Foreign investment can bring with it not only financing and foreign capital goods, but also the management, planning and marketing resources of the investing firm. Thus there is the possibility that it could contribute more to productivity than would official or private portfolio lending, even if the productivity is increasing rather rapidly across the entire economy, as in the radical scenario after 1993. For example, if the US$10 billion in additional capital inflows considered earlier took the form of direct investments attaining two-thirds of the productivity level of the G-7 countries, output would be boosted up to three times more than for an equivalent inflow of credits.10 Allowing for possible spillover effects on the productivity of domestic enterprises, the effect on output could be even greater. Sustained flows on a significant scale are not likely to be forthcoming, however, until the infrastructure of a market economy is securely in place, including adequate investor protection and a functioning price system.

Foreign direct investment in the oil and gas sectors could play a particularly important role in the transition. These are critical sectors for the economy because of their size, their potential for bringing in foreign exchange, and the evident scope for raising output and improving distribution by introducing techniques in use elsewhere (see Chapter V.6). How expanded output in the energy sector and greater efficiency in energy use might affect the overall economic situation is explored below.

The increased output that would be expected from foreign investment would accrue partly to the investors, with the risk largely borne by them. They would expect to share in the success of the transition program to a greater extent than lenders would, but the country would not be saddled with fixed debt service obligations in the event of a poor outcome for the investment.

Direct investment could pose more serious problems than credit flows, however, if incentives remain distorted. Foreign investors, accustomed to pursuing profit opportunities where they find them may well undertake projects with a negative return to the economy if prices and the tax system distort incentives so as to make them profitable. Hence, establishing a functioning market price system, in which prices reflect costs and relative scarcities, is an important step toward ensuring that foreign involvement in the economy contributes to overall economic development and to better meeting the needs of the population.

d. Increasing foreign exchange by focusing on key sectors

Capital inflows, either in the form of credits or investments, are only one way of enlarging the foreign exchange resources of the USSR. The flow of foreign exchange available for imports of consumer durables or capital equipment can also be enlarged by increasing exports or by expanding domestic production of goods that are now imported. Investment and consumption possibilities would of course remain constrained by the growth in national income, but access to the variety, quality and technology in foreign products would be increased in the course of realizing more fully the gains from trade. Thus exploiting the scope for shifts in energy and agricultural trade towards a more efficient overall structure of trade is an important element in a transition strategy.

(1) Energy

In the short run, the energy sector is potentially the most important sector in the economy from the standpoint of what continued deterioration could cost, and structural change driven by reform could contribute to overall economic performance. The size of the energy sector reflects the USSR’s standing as the largest producer of crude oil and natural gas in the world. In recent years, oil production has fallen. Although the largest oil fields may be past their peak production, much of this decline has been due to worn out equipment, late shipment of new machinery, and social unrest. Turning this sector around could increase foreign exchange availability substantially (Table VI.5).

Table VI.5.USSR: Illustration of the Potential of the Energy Sector 1(Deviations from baseline)
199119921993199419951996-

2000

Average
Energy production
Growth rate (in percent)0.50.50.50.50.50.5
Additional exports (in billions of U.S. dollars)1.63.14.66.27.812.9
Energy consumption
Domestic real energy prices (in percent)252525252525
Additional exports (in billions of U.S. dollars)1.42.95.66.77.39.3
Source: Based on methodology described in Appendix VI-1.

Figures in this table are calculated on the basis of total energy production and consumption, and assuming that changes in the balance between the two can be translated into additional exports. This means that either transport capacity is increased in line with additional exports, or that, domestically, interfuel substitution away from petroleum allows energy to be exported in the form of easily transportable oil. The oil price is assumed to remain unchanged in real terms at US$26 per barrel. Figures in the table are given in constant 1990 dollars.

Source: Based on methodology described in Appendix VI-1.

Figures in this table are calculated on the basis of total energy production and consumption, and assuming that changes in the balance between the two can be translated into additional exports. This means that either transport capacity is increased in line with additional exports, or that, domestically, interfuel substitution away from petroleum allows energy to be exported in the form of easily transportable oil. The oil price is assumed to remain unchanged in real terms at US$26 per barrel. Figures in the table are given in constant 1990 dollars.

For example, if the current annual rate of decline in total energy production could be slowed by only one-half percentage point from its baseline rate, this would allow expanded energy exports (measured in 1990 dollars) of US$1.6 billion in 1991, rising to US$8 billion in 1995 and an average of US$13 billion during 1996-2000.11 These figures refer to total energy production, and it should be borne in mind that oil production above current projections could be directly exported, whereas other forms of energy may largely translate into increased exports indirectly over time as substitution takes place between fuels in domestic usage. On the other hand, larger improvements in energy production may be feasible. For this, both know-how and capital would be needed on a scale not likely to be realized without a substantial role being played by international oil companies (see Chapter V.6). Depending on the degree of their participation, foreign firms would share to a greater or lesser extent in these export gains.

Conservation in the use of energy domestically also appears to have great potential as a way of increasing foreign exchange earnings. At present, the USSR uses two-and-a-half times as much energy per unit of GDP as the OECD average. Part of this is due to specific features of the USSR—a relatively cold climate, vast distances, and a higher than average share of heavy industry in total output. To a considerable extent, however, energy is used inefficiently, and this has been encouraged by low prices. Significant increases in domestic energy prices—even falling short of current world market prices—could free much energy for export, and would thus enhance the capacity to import. A sizeable increase in the relative price of energy would likely lead to an immediate reduction of energy use as waste was controlled more carefully and some marginal economic activities were curtailed. Over time, energy savings would increase as the economy’s capital stock was adapted to an environment of energy scarcity signalled by higher prices.

The impact of a domestic energy price increase on the availability of foreign exchange depends on the reaction of consumption. With energy prices having been maintained at low levels so long, there is no way of estimating the elasticity of this reaction specifically for the USSR. In the simulation framework, it is assumed that energy consumption would decline over a ten-year period by 10 percent in response to every 100 percent increase in its domestic relative price. This illustrative simulation is conservative in two respects. First, the assumed price increase is far less than would be required to bring the internal price of oil to world market levels at the newly established commercial exchange rate and for other energy prices to adjust accordingly. Second, estimated long-term price elasticities for OECD countries are typically four times as large as assumed here for the USSR. Given the relatively high energy intensity of the economy at present, it is arguable that the elasticity would be higher than elsewhere, not lower. Even on this conservative view, however, an increase in the relative price of energy of 25 percent would allow exports to rise after five years by US$7 billion and to average more than US$9 billion higher for the five years thereafter. Unlike foreign borrowing to finance either consumption or investment, there would be no additional debt service to eat into the foreign exchange earnings.

(2) Agriculture

Another sector in which there would seem to be possibilities for expanding output substantially and thereby freeing-up foreign exchange is agriculture (see Chapter V.5). At present, yields are much below what appears feasible given soil quality and geographical location. In addition, losses in storage and distribution are large and estimated at between 20 and 30 percent of production. At the same time, the USSR imports significant amounts of food, accounting for 17 percent of total imports. Relatively modest increases in production and reduction of losses could substantially bring down import requirements for food. For example, if grain production reaching users were increased by about 15 percent, the necessity for grain imports would disappear. This is not a very large increase, if seen against the potential of the agricultural sector and the experience with agricultural reform elsewhere. Just reducing storage and transport losses could make this difference already. In addition, supporting and encouraging the growth of private farming could make an even greater difference: with only 3 percent of the land, private farms produce 20-30 percent of total output at present.

Although care should be taken not to exaggerate the supply response, improved profit incentives for collective and state farms, combined with the closing and selling off of loss-making farms and incipient privatization, could significantly increase production and raise the percentage of production that reaches the market. Precise estimates are not possible, but one scenario would imply that, at a minimum, grain imports could be reduced to about 5 percent of consumption. Similarly, reduction of losses could make sugar imports unnecessary. These two improvements alone would free US$8 billion for imports of other goods.

NOTES
1.The presidential guidelines are discussed in detail in Chapter II.3.
2.Measures to achieve a substantial reduction of the fiscal deficit are proposed in Chapter II.3. Options for a complete reform of government expenditures and revenues are set out in Chapter III.1.
3.A detailed assessment of pressures on the budget can be found in Chapter III.1. Institutional reforms that would improve control over money and credit are assessed in Chapters III.2 and IV.5.
4.Options, and other countries’ experiences with incomes policy, are reviewed in Chapter IV.6.
5.For an overview of the reform debate, see Chapter II.3.
6.Conditions that would be favorable for direct investment inflows are considered in detail in Chapter IV.4.
7.Most countries that encountered debt problems in the early 1980s had debt to export ratios approaching, or even exceeding, 300 percent.
8.For a discussion of the monetary overhang, see Chapter III.3; its implications are also dealt with in some detail in Chapters II.2 and II.3.
9.See the discussion of the manufacturing sector in Chapter V.8.
10.This estimate is derived from comparisons of productivity using the commercial exchange rate for the U.S. dollar.
11.Assuming an international oil price of US$26 per barrel initially, held constant in real terms. Prices of other fuels are assumed to adjust to restore normal parities with oil.
Appendix VI.1-1 A Macroeconomic Framework for the Soviet Economy

This appendix describes the macroeconomic framework that underlies the scenarios and simulations in this chapter. After introductory remarks, the first section characterizes the broad features of the framework. The behavioral elements of this framework are set out in Section 2. Section 3 discusses how this framework has been used for the simulations. The equations are listed in Lotus format in Table 1.

Table 1.USSR: Equation Listing of the Macroeconomic Framework
Supply Block
223Energy=+ENERGY_VA[-1]*(1+ENERGY_GR)
224Industry=@IF(REAL=1, +GDP-ENERGY_VA-AG_VA-SERVICES, +IND[1]

*(1+IND_GR))
225Agriculture=+AG_VA[-1]*(1+AG_GR)
226Services=@SERVICES[-1]*(1+SERVICES_GR)
227GDP@IF(REAL=1, TFP* (DELTA* (K_OLD*K_OLD_EFF+K_NEW)

^ (-SIGMA) + (1-DELTA) *EMPLOYMENT ^ (-SIGMA))

^ (-1/SIGMA), @SUM(D223‥D226))
228GDP Current (Ruble)=+GDP*P_GDP
229Gross Value of Output=+GDP*INPT_GDP
230Net Material Product=+GDP-SERVICES*0.337((OLD_SCRAP+K_WRITEDOWN)

*K_OLD)-NEW_SCRAP*K_NEW
232Energy Consumption=(1+$B$77*D270+$C$77*C270+$D$77*B270)*ENERGY CONS

WITHOUT PRICE EFFECT
233without price effect(1+ENERGY_ELAS*(GDP/GDP[-1]-1))*C233
234Energy Production=+ENERGY_VA * GVOE_RAT10
235Food Consumption=+AG_ELAS *(GDP/GDP[-1]-1)* FOOD CONS[

-1]+FOOD_CONS[-1]
236Food Production=+AG_VA * GVAO_RAT10
Labor Market
240Population=+POPULATION[-1]*(1+POP_GR)
241Labor Force=+POPULATION*LFPART_RATIO
242Employment
243Energy=+ENERGY_EMPL[-1]*((ENERGY_VA/ENERGY_VA[-1])

/(1+WAGE_GR+ENERGY_WAGE))
244Industry=@IF (REAL=1, +EMPLOYMENT-SERV_EMPL

-AG_EMPL-ENERGY_EMPL,+IND_EMPL[-1]

*((IND/IND[-1]) / (1+WAGE_GR+D61)))
245Agriculture=+AG_EMPL[-1]*((AG_VA/AG_VA[-1]) \

(1+WAGE_GR+AG_WAGE))
246Services=+SERV_EMPL[-1] * ((SERVICES/SERVICES[-1])

/(1+WAGE_GR+SERVICE_WAGE))
247TOTAL=@ IF (REAL=1, EMPLOYMENT[-1] * (1+EMPLOYMENT_GR),

@SUM(D243‥D246))
248Unemployment=+L_FORCE-EMPLOYMENT
249Unemployment Rate=+UNEMP LOYED/L_FORCE
Capital Stock
253Capital Stock OLD=+K_OLD[-1] * (1-OLD_SCRAP-K_WRITEDOWN)
254*Capital Stock NEW=+K_NEW[-1] * (1-NEW_SCRAP)+INV
255Total Capital Stock=+K_OLD+K_NEW
256Productivity Level=@ IF (REAL=1, +TFP[-1] * (1+TFP_GR), +GDP/(DELTA

* (K_OLD*K_OLD_EFF+K_NEW) ^(-SIGMA) + (1-DELTA)

* EMPLOYMENT^ (-SIGMA))^(-1/SIGMA))
Aggregate Demand
260Government=+GDP*GOV_SHARE
261Private Consumption=@ IF (CLOSURE=1, @ IF (DEMAND=1, GDP*PCONS_SHARE,+GDP

-GOV-INV-(X_TOTAL+NFSB+NCTR-M_TOTAL)*EXCHR/1000),

@ IF (NAT_ACCOUNT=1, +GDP-GOV-INV-(X_TOTAL+NFSB

+NCTR-M_TOTAL)*EXCHR/1000, +GDP*PCONS_SHARE))
262Investment=@ IF (CLOSURE=1, @ IF (DEMAND=1, +GDP-GOV-PCONS

-(+X_TOTAL+NFSB+NCTR-M_TOTAL) *EXCHR/1000, +GDP

*INV_RATIO), +GDP*INV_RATIO)
Deflators
266Ruble GDP Deflator=+P_GDP[-1] * (1+INFL_R)
267AG Producer Prices REAL=+C267 * (1+AG_P_PRICE)
268AG Consumer Prices REAL=+C268 * (1+AG_C_PRICE)
269Domestic Energy_P REAL=+C269 * (1+D270)
270Real Energy=+DOM_ENRGY_PRICE
Trade and Balance of Payments
Export Volumes
275*Energy=@ IF (ENERGY_PROD-ENERGY_CONS>0,

(ENERGY_PROD-ENERGY_CONS) / EXCHR_BASE*1000, 0)
276Raw Materials=+X_RAWMAT[-1] * (1+X_RAWMAT_GR)
277Manufactures/Other=+X_MANUF [-1] * (1+X_MANUF_GR)
278*Food=@ IF (AG_PROD-FOOD_CONS>0, (AG_PROD-FOOD_CONS)

/EXCHR_BASE*1000, 0)
279TOTAL=@ SUM (D275 ‥ D278)
Import Volumes
282*Food=@ IF (AG PROD-FOOD_CONS>0, 0, (FOOD_CONS-AG_PROD)

/EXCHR_BASE*1000)
283*Energy=@ IF (ENERGY_PROD-ENERGY_CONS>0, 0,

(ENERGY_CONS-ENERGY_PROD) / EXCHR_BASE*1000)
284Manufactures/Other=@ IF (CLOSURE=1, (IM_TOTAL-M_FOOD

*P_FOOD-M_ENERGY*P_ENERGY) / (M_CMEA_RATIO

*P_MANUF_CMEA+ (1-M_CMEA_RATIO) *P_MANUF),

+M_TOTAL-M_FOOD-M_ENERGY)
285*TOTAL=@ IF (CLOSURE=1, +M_FOOD+M_MANUF+M_ENERGY,

@IF (NAT ACCOUNT=1, +M_TOTAL, (+PCONS+GOV+INV

-GDP) / EXCHR_BASE*1000+X_TOTAL+NFSB+NCTR))
287Non-Factor Service Volume=+NFSB[-1] * (1+NFSB_GR)
288Current Transfer Volume=+NCTR[-1] * (1+NCTR_GR)
Trade Prices
292$ Inflation=+C292* (1+INFL_$)
293Energy=+P_ENERGY[-1] * (1+INFL_$) * (1+P_ENERGY_GR)
294Energy CMEA=+C294 * (+P_ENERGY* (1-P_ENERGY_CMEA_D))

/(P_ENERGY [-1] * (1-C153))
295Raw Materials=+P_RAWMAT[-1] * (1+INFL_$) * (1+P_RAWMAT_GR)
296Manufactures/Other=+P_MANUF [-1] * (1+INFL_$) * (1+P_MANUF_GR)
297CMEA=+P_MANUF * (1-P_MANUF_CMEA_D)
298To OECD=+P_MANUF* (1-P_MANUF_OECD_D)
299Food=+P_FOOD[-1] * (1+INFL_$) * (1+P_FOOD_GR)
Trade Values
Exports
304Energy
305OECD=+X_ENERGY*X_ENERGY_OECD*P_ENERGY
306CMEA=+X_ENERGY*X_ENERGY_CMEA*P_ENERGY_CMEA
307Other=+X_ENERGY*(1-X ENERGY_OECD-X_ENERGY_CMEA)

*P_ENERGY
308Raw Materials
309OECD=+X_RAWMAT*X_RAW_OECD*P_RAWMAT
310CMEA=+X_RAWMAT*X_RAWMAT_CMEA*P_RAWMAT
311Other=+X_RAWMAT* (1-X_RAW_OECD-X_RAWMAT_CMEA)

*P_RAWMAT
312Manufactures/Other
313OECD=+X_MANUF*X_MANUF_OECD*P_MANUF_OECD
314CMEA=+X_MANUF*X_MANUF_CMEA*P_MANUF_CMEA
315Other=+X_MANUF* (1-X_MANUF_OECD-X_MANUF_CMEA)

*P_MANUF
316Food
317OECD=+X_FOOD*X_FOOD_OECD*P_FOOD
318CMEA=+X_FOOD*X_FOOD_CMEA*P_FOOD
319Other=+X_FOOD* (1-X_FOOD_OECD-X_FOOD_CMEA) *P_FOOD
Imports
322Food
323OECD=+M_FOOD*M_OECD_RATIO*P_FOOD
324CMEA=+M_FOOD*M_CMEA_RATI0*P_FOOD
325Other=+M_FOOD* (1-M_OECD_RATIO-M_CMEA_RATIO)*P_FOOD
326Manufactures/Other
327OECD=+M_MANUF*M_OECD_RAT10*P_MANUF
328CMEA=+M_MANUF*M_CMEA_RAT10*P_MANUF_CMEA
329Other=+M_MANUF* (1-M_OECD_RATIO-M_CMEA_RATIO) *P_MANUF
330Energy Other=+M_ENERGY*P_ENERGY
332Export Value=@ SUM (D303‥D319)
333*Import Value=@ IF (CLOSURE=1, EX_TOTAL+NFSB_VAL+NCTR_VAL+NIID-

CURBAL, @ SUM (D323‥D330))
335Non-Factor Services=+NFSB*P_MANUF
336Current Transfers=+NCTR*P_MANUF
338*Current Balance=@ IF (CLOSURED=1, +CURBAL_EXOG, +EX_TOTAL-IM_TOTAL+NFSB_VAL+NCTR_VAL+NIID)
Debt and Foreign Investment
342Reserves=+ IM_TOTAL/12*RESERVE_RATIO
343Reserve Change=+RESERVES-RESERVES[-1]
344NDFI Stock=+NDFI_STOCK [-1] +NDFI
345Gross Borrowing OECD=-(D207+NFSB_VAL+NCTR_VAL+NIID)+RES_CHG-NDFI
346Debt OECD=+DOD[-1] +BORROWING
347Net Debt OECD=+DOD-RESERVES
349Net Investment Income=+RESERVES [-1] * (RES_IN_$* INT_$+ (1-RES_IN_$)

*INT DM) -DOD [-1] * (DOD_IN_$* (INT_$+RISK_PREM)

+ (1-DOD_IN_$) * (INT_DM+RISK_PREM))

-NDFI_STOCK[-1] * INT_$+IID_ADF
Appropriation Accounts
Households
385Income=+H_HOLD_INC [-1]/EMPLOYMENT[-1]

*EMPLOYMENT* (1+WAGE_GR)
386memo: % of GDP=+H_HOLD_INC/GDP
387Interest Income=+H_NET_ASSETS* ((1+INFL R) * (1+REAL INTEREST R)

-1) *0.75
388Transfers Received=+TRANSFER_H
389Food Subsidies=+FOOD_SUBSIDIES
390Direct Taxes=+TAX_H
391Disposable Income=+H_HOLD_INC+INTEREST_INC+TRANSFERS_H-TAX_OF_H
392Consumption=+PCONS
393memo: Savings Rate=(+Y_DISP-CONSUMPTION_H)/Y_DISP
394Change in Net Assets=+Y_DISP-CONSUMPTION_H
Firms
398Profits=+GDP-H_HOLD_INC
399Income TOT Gains=+TOT_GAINS
400Subsidies=+FIRM_SUBSIDIES
401Direct Taxes
402Profits=+PROFIT_TAX
403Social Security=+SOCIAL_SECURITY
404Indirect Taxes
405Turnover Tax=+VAT
406Customs duties=+CUSTOMS_TAX
407Non-Tax duties=+NON_TAX
408Interest Payments=+INTEREST_INC*ENTERPRISE DEBT/(ENTERPRISE

+GOVERNMENT DEBT)
409Investment=+INV-GOVERNMENT INVESTMENT
410Change in Net Assets=+BUSINESS INCOME+TOT_GAINS+FIRM_SUBSIDIES-

@SUM (D401 ‥ D409)
Government Budget
414Indirect Taxes
415Turnover Tax=+VAT[-1] * (1+VAT_GR) * (GDP/GDP[-1])
416Customs duties=+CUSTOM[-1] * (1+CUSTOM_GR) * ((X_TOTAL+M_TOTAL)

/(X_TOTAL[-1] +M_TOTAL [-1]))
417Direct Tax Enterprise
418Profits=+PROFIT_TAX[-1] * (1+P_TAX_GR) * (GDP/GDP[-1])
419Social Security=+SOCIAL_SECURITY [-1] * (1+SOSEC_GR) * (GDP/GDP[-1])
420Direct Tax Households=+TAXD_H[-1] * (1+TAX_H_GR) * (GDP/GDP[-1])
421Non-Tax Revenue=+NON_TAX[-1] * (1+NON_TAX_GR) * (GDP/GDP[-1])
422TOTAL REVENUES=@SUM (D415 ‥ D421)
Transfers
424Households=+FOOD_SUBSIDIES+SOCIAL EXPENDITURES+ (UNEMPLOYED-

BASEYEAR UNEMPLOYED) * (BASEYEAR_WAGE) *0.35
425Food=@ IF ($F$28=1, FOOD_SUBSIDIY_EX, FOOD_CONS

* (PRODUCER_P-CONSUMER_P))
426Firms=+FIRM_SUSIDY [-1] * (1+F_SUB_GR) * (GDP/GDP[-1])
Other Expenditure
427Government Consumption=+GOV
428Government Investment=+G_INV[-1] * (1+G_INV_GR) * (GDP/GDP[-1])
429Interest on Foreign Debt=-NIID*EXCHR/1000/P_GDP
430Domestic Interest Paid=+INTEREST_INC-INTEREST PAYMENTS ENTERPRISES
431TOTAL EXPENDITURES=@SUM (D424 ‥ D430)-FOOD_SUBSIDIES
433Deficit [-]=+TOTAL REVENUES-TOTAL EXPENDITURES
434memo: as % of GDP=+DEF/GDP
Foreign Sector
438Imports=+M_TOTAL/1000*EXCHR_BASE
439Factor Payments=-(NIID*EXCHR/1000)/P_GDP
440Exports=(NFSB+NCTR+X_TOTAL) *EXCHR_BASE/1000
441Calc. Chg. Net Assets=+D438+D439-D440
442Actual Chg. in Net Assets=-CURBAL*EXCHR/1000/(IM TOTAL/M TOTAL)
443Income Terms of Trade
444Gains for USSR=+D441-D442
448Discrepancy TOT Effect=+TOT_GAINS-((+EX_TOTAL-IM_TOTAL+NFSB_VAL

+NCTR_VAL) / (IM_TOTAL/M_TOTAL) - (X_TOTAL

-M_TOTAL+NFSB+NCTR)) / 1000*EXCHR_BASE
Net Asset Position
453Households=+H_NFA [-1] / (1+INFL_R) +H_NFA_CHG
454Firms=+F_NFA [-1] / (1+INFL_R)+F_NFA_CHG
455Government=+G_NFA [-1] / (1+INFL_R) +G_NFA_CHG
456Foreign Sector=+FO_NFA[-1] / (1+INFL_R) +FO_NFA_CHG

The complete restructuring of a centrally planned economy into a market based economy is unprecedented, and there is therefore little experience on which economic analysis can draw for developing a view on the medium-term prospects of an economy undergoing such rapid systemic change. Relationships between variables that have been stable in the past are unlikely to hold in the future during such a process, even if they could be estimated. Historical and cross-country experience and stable relationships between macroeconomic variables are normally the basis for macroeconomic models that are used to analyze medium-term prospects. Since these are not available, the objectives in developing a macro-economic framework for the Soviet economy had to be more modest. The framework presented here is basically an accounting framework, which links the main economic aggregates through identities which are true by definition, enriched by a few behavioral elements. It should therefore be regarded not as a machine for generating projections, but rather as an analytic tool that is useful in illustrating how different sectors and policy areas interact, and to show which issues are of central importance and which are of more peripheral interest.

a. Main elements of the framework

(1) Output

Models for medium-term analysis in centrally planned economies are usually based on an input-output matrix that describes the linkages between different sectors of the economy in some detail. The framework used here is not based on such detailed information about the economy, for two main reasons. First, such models have been developed as an aid to resource allocation through central planning, a function that would increasingly be shifted to markets during the transition. Second, in an economy that shifts to a different regime, it is certain that the relationships embedded in an input-output matrix will change rapidly. While this could be taken care of in principle by changing the matrix, there is not enough information for deciding how this matrix is likely to change over the medium term. In any event, it is questionable whether the fixed-proportions assumption underlying the input-output framework would be at all applicable to a market economy. Consequently, the framework considers only value added and final demand for major sectors and for the total economy.

Value added of the economy, or gross domestic product (GDP), is analyzed from three sides. On the production side, value added in four sectors (energy, industry, agriculture, and services) are distinguished and added to yield GDP. Net material product (NMP) is also calculated. NMP is derived by subtracting depreciation and what is called non-productive services from GDP (the assumption is, as a rough approximation, that nonproductive services are a constant fraction of total services).1 Four end-uses of GDP are distinguished: private consumption (the purchase by households of goods and services), public consumption, investment (equal to “accumulation” plus depreciation) and exports. GDP on the income side is divided into wage income—that is, the average wage times employment—and other income that accrues to the business sector.

(2) State Variables

The more interesting simulation results of the model are the outcome of the interaction between flow variables in the framework and state variables. On the domestic side, the state variables are the capital stock and the net financial asset position of individual sectors. The capital stock increases in every year by the amount of net investment. If depreciation is higher than gross investment, the capital stock declines. The framework keeps track of two capital stocks: pre-reform capital stock, and a capital stock that is slowly built up after the introduction of reforms. The relative efficiency of these two capital stocks can differ, and allowance can also be made for different rates of depreciation to account, for example, for the fact that the old capital stock may be phased out rather faster than the newly accumulated stock. The other domestic state variables are the net financial asset positions of households, the government, and the enterprise sector. In each year, their real values are eroded by domestic inflation, and adjusted by the real savings or dissavings of the sector during the year.

(3) Prices and aggregation problems

In general, aggregate economic variables like GDP, NMP, or consumption are calculated by aggregating the constituent transactions, using as weights the prices for these transactions. The rationale is that these prices are either an indicator of the scarcity value of the goods and services exchanged, or reflect the economic costs incurred in producing them, or both. While this assumption is never totally justified, it comes sufficiently close to reality in market economies to make the aggregation meaningful. It is less clear what an economic aggregate means when it has been calculated on the basis of prices at which there is excess production of some goods, and excess demand for others. The problem is compounded if these prices are likely to change rapidly when liberalized, and with them the weight that is given to different goods in the total product. Ideally, one would like to recalculate the domestic product with a different set of prices, and world market prices could be used as a first approximation. Such an undertaking was beyond the scope of this study, and the official data were therefore taken as the basis for the framework. This procedure is most problematic for linking the national accounts to the balance of payments. For one and the same good, domestic prices are different from world market prices as well as from CMEA trade prices. The framework uses the administratively-determined commercial exchange rate; the problems associated with this procedure are well known.2

(4) Balance of payments and external debt

On the external side, the framework is designed to focus on trade. Exports are distinguished by product category (energy, agricultural products, raw materials, manufacturing and other) and, within each category, by direction of trade (socialist, OECD, and nonsocialist developing countries). On the export side, the framework therefore provides a relatively detailed picture. Imports are divided into food, energy, and other, with the same breakdown for trade partners as for exports. For each category of traded goods there is a separate price, permitting relative prices between goods to change. Moreover, prices can vary with the destination of trade. This is already important for energy exports to socialist countries, and may become a broader consideration in the future if the USSR tries to sell more manufactures to industrial country markets, where they are likely to sell at a discount relative to socialist trade. As discussed above, socialist and other trade has been aggregated by using the commercial exchange rate. Nonfactor services and current transfers do not receive detailed treatment since information on these items is sparse. For both items, only the balance is included, together with assumptions about possible future developments.

External debt and factor income are broken out for the OECD area only. Investment income is derived from net external assets by multiplying these with dollar and deutsche mark interest rates, weighted by the share of reserves and debt assumed to be denominated in these currencies. Reserve levels are adjusted each year so that they cover two months’ worth of imports. The gross stock of debt increases each year by the amount of external borrowing. This is given by the current account deficit plus the increase in reserves.

Net direct foreign investment follows a path that can be judgmentally varied in the light of assumptions about domestic economic policies. It is accumulated in a stock of foreign-owned real assets that is assumed to yield income after three years. Thus, in this framework, foreign investment is no “free lunch”: it generates payment obligations similar to foreign borrowing. The difference between borrowing and foreign investment in the simulations is that foreign investment is assumed to enhance the productive capacity of the economy and strengthen its export potential more than foreign borrowing.

(5) Appropriation accounts

The framework has a set of appropriation accounts for four sectors: households, business, government, and the foreign sector. The financial sector does not enter in its own right because the framework keeps track only of net financial asset positions, and this is zero for the financial sector. The domestic accounts are constructed from data for the household sector and the government budget. The enterprise sector is treated as the residual. GDP is divided between labor and other income, which accrues to enterprises. The labor income share varies over time in line with changes in employment and the real wage. The government taxes both sectors, and redistributes part of this through transfers. The remainder is kept for investment and state purchases. The residual of each account is the flow change of the financial net asset position, which is typically positive for households and negative for firms.

These accounts are of interest for three reasons. First, it is possible to trace the influence of budgetary changes to other sectors. Budgetary line items are treated as discretionary policy instruments, with the exception of interest payments on domestic and foreign debt and unemployment benefits. Unemployment payments are calculated as 35 percent of the average 1990 wage in real terms, times the number of unemployed. Net interest payments on foreign debt are determined separately in the balance of payments sector of the model. Domestic interest payments are calculated by multiplying the share of savings accounts backed with government debt by the interest rate on savings accounts. Food subsidies are discretionary, but can also be linked to food consumption and the wedge between wholesale and retail prices for food. In the latter case, for example, an increase in wholesale prices without a corresponding increase in consumer prices leads to rapidly rising food subsidies, which then necessitates other adjustments in the budget.

The second benefit of including appropriation accounts in the model is that these accounts impose constraints on the behavior of government, households, and firms. This is the more important since the behavioral content of the framework is rather limited otherwise. For example, a reduction of transfer payments to households will show up in a declining net asset position or even in a negative household saving ratio. If these changes are viewed as unlikely or infeasible, household consumption in the simulations is manually adjusted. If transfer payments instead increase rapidly, this will show up in the framework as a higher saving ratio and increasing net assets. If the saving ratio and monetary holdings were already high, such an increase in transfers would raise the question of whether upward adjustments should be made to consumption or to inflation. While the framework does not adjust behavior automatically, the accounts impose some discipline with respect to what is feasible, and signal that behavior for a given set of policies may need to be modified in order to be plausible in the light of these policies.

The third use of the appropriation accounts is to analyze the sustainability of government policies by focusing on the change in the sectoral net asset position as a percentage of GDP. If, for example, the net asset position of the government becomes increasingly negative over the years, this is an indication that the budgetary policies analyzed are not sustainable, and adjustments need be made to either expenditures or revenues. Another use of these ratios is in the analysis of macroeconomic stabilization policies. For example, the model allows calculation of the inflation rate necessary to keep ratios constant, and thus provides indications as to the inflation rate that may be compatible with the monetization of a government deficit of a given size.

b. Behavioral elements of the macroeconomic framework

While the framework is largely based on accounting identities, it has some behavioral content. This section describes the behavioral elements under four headings: aggregate production; employment; consumption of energy and food products; and consumption and investment.

(1) Aggregate production

Aggregate production is assumed to be adequately described by a CES production function. The parameters of this function have, for reasons discussed above, not been estimated with past data. Rather, parameters have been imposed. The functional form is:

Y = Gross domestic product

TFP = Level of total factor productivity

K = Capital stock

L = Employment

a, b = Parameters with a = 0.3 and b = 0.25, and

^ indicates “raised to the power.”

In addition to aggregate production as described by this function, the framework has sectoral growth rates for the main sectors of the economy: energy, agriculture, industry, and services. Assumed growth rates for these sectors are exogenous, and depend on the policy assumptions in the scenario that is being analyzed. Consistency between the sectoral assumptions and the production function is achieved either by letting total factor productivity adjust or by letting the growth rate of industry adjust. The interaction between an aggregate production function and sectoral growth rates is helpful, because either can be used as an indicator of whether assumptions for the other are sensible.

(2) Employment

Employment in this framework is determined by labor demand, which is assumed to follow a rule of thumb that relates sectoral growth of value added and real wage growth. The rule is that sectoral labor demand increases in line with value added minus the increase in real wages. An adjustment factor allows sectors to deviate from a constant share of labor income in GDP. In practice, this adjustment factor is used to make judgmental adjustments for a rapid shedding of labor in industry during the early years of the transition, and a fast absorption of labor in the service sector. The labor demand function is:

L = Sectoral Labor Demand

Y = Sectoral Value Added

w/p = Real Wage

c = Adjustment factor.

Real wage growth is exogenous. In simulations it is set judgmentally so as to keep unemployment within bounds that appear reasonable.

(3) Energy and agriculture

Energy and agriculture are sectors of great importance in the USSR. Energy accounts for about 5 percent of NMP, and agriculture for 23 percent. In external trade, energy accounts for 39 percent of exports, and food accounts for 17 percent of imports. In the framework, energy and agriculture are treated in more detail than other sectors. In particular, the domestic and the external side for these sectors are closely linked, in that the net trade balance is the difference between domestic consumption and domestic production. Value added is given by multiplying value added of the previous year by a sectoral growth rate that takes on different values depending on the domestic economic policies pursued. Total domestic production (in 1989 rubles) is then calculated by multiplying value added by the ratio of gross output to value added in the sector. This ratio is calculated from data for previous years:

VAi, t = Value added in sector i (energy and agriculture) in year t

di = Ratio of gross output to value added in sector i

GRi, t = Growth for sector i in year t.

GOi, t = Gross output of sector i in year t.

Consumption of both energy and food is calculated by a function that relates consumption to real GDP via an assumed income elasticity, and to relative prices by way of assumed price elasticities. For simulations, the price elasticity for food consumption has been set equal to zero. The functional form for consumption is:

Xi = Demand for gross output of sector i

m = Income elasticity of demand with respect to GDP

Y = GDP

n = Price elasticity of consumption

Pi = Consumer price of output of sector i

PY = GDP deflator

%D indicates “percentage change in”.

The income elasticity for food is assumed to be 1.0 at the beginning, dropping over time to below 0.8. The income elasticity for energy is set equal to unity. The size and lag structure of the price elasticity is conservatively set to give a smaller and less immediate reaction than has been observed in OECD countries. Consumption is assumed to respond to changes in the relative price of energy with a short-run elasticity of -0.05, rising to -0.1 after 10 years. The effect of an increase in the relative price of energy is thus spread over time. The rationale for this is that it takes time to adjust the capital stock to changed relative prices.

Exports and imports of energy and agricultural products are given by physical balances:

TBi = Net trade balance for sector i

Xi = Demand for gross output of sector i.

(4) Consumption and investment

The consumption and investment functions are very simple. Both are assumed to be fixed fractions of GDP:

It = ft* Yt, where:

C = Consumption

I = Investment

Y = GDP

e, f = Parameters.

While this formulation may appear overly simplistic, the functions are, in effect, only default options. The ratios (e, f) can change over time, and are adjusted in the simulations, using information from the appropriation accounts. For example, consumption is regularly adjusted to keep the household saving rate out of disposable income on a “reasonable” path. What is reasonable depends on the assumptions about reform and macroeconomic policies. Likewise, investment can be adjusted to take into account changes in the cash flow of the enterprise sector. If the framework is simulated in a finance-constrained mode, either consumption or investment is made endogenous, adjusting to whatever external finance is forthcoming. More behavioral richness for both functions would be desirable so as to reduce the dependence of the simulations on judgmental adjustments of the consumption and investment parameters.

c. Use of the framework for simulations

The main purpose of this macroeconomic framework is to highlight which elements of economic reform and policy are of macroeconomic importance, and to provide a quantitative assessment of their relative significance. Such an assessment must necessarily be tentative, because the framework is largely based on accounting identities.

(1) Macroeconomic stabilization

The framework does not have a financial block in which money demand is modeled explicitly. Despite this, it provides useful indications concerning macro-economic stabilization policies. The keys here are the net financial asset positions of the government, households, and the enterprise sector. Starting from a position of a monetary overhang, macroeconomic stabilization requires a reduction of financial balances held by the private sector. This can be achieved in the framework through asset sales, the erosion of financial assets through inflation, or a combination of both. The framework also sheds light on certain policy dilemmas. For example, introducing positive real interest rates on savings accounts before the initial price adjustment phase of a stabilization program conflicts with the objectives of reducing the real money holdings of households and of reducing the government budget deficit. Another example is unemployment benefits. A radical adjustment leads quickly to higher unemployment and hence higher transfer payments, which makes achieving reductions in the budget deficit more difficult. The framework is also useful for indicating flow imbalances. Too high a budget deficit may show up in increasing financial assets of households as a percentage of GDP. If households are saturated with financial assets initially, this indicates that higher inflation—either open or repressed—is the likely result. Inflation rates can then be adjusted such that financial assets increase more slowly or are stabilized as a ratio to GDP.

(2) Productivity and investment

Productivity growth in the framework is exogenous. It is set taking into account the course of economic policy, and drawing on the historical experience of other countries. For any given path of productivity growth, investment also has a sizable impact on the level and the growth rate of GDP over the medium term. (In the long term, the investment rate does not influence the growth rate of GDP under neo-classical assumptions). The higher the productivity growth, the more will additional investment add to GDP growth and thus expand the capacity for future debt service. It is also possible to simulate a different productivity level for a component of new investment, which is important for an analysis of the impact of direct foreign investment.

(3) Energy

Since energy is treated as an aggregate in this framework, the potential for energy exports calculated by the framework has to be checked by careful analysis. Savings in oil consumption or increases in oil production will free energy for export almost immediately, whereas other forms of energy may translate into increased exports only over time as substitution takes place and pipelines and power grids are adapted.

(4) External finance constraint

The framework is simulated under two alternative assumptions, with the current account either endogenous or exogenous. If the current account is endogenous, domestic policies and parameters and international price changes lead to changes in the current account, and there is no limit on how negative or positive the current account can become. If the current account is set exogenously, imports adapt so that the current account identity is satisfied. For example, increased world energy prices would lead, with an exogenous current account, to increased imports. The model also provides for the choice of allocating these additional imports to investment, thereby boosting future output, or to consumption.

NOTES
1.More precisely, NMP equals GDP less depreciation and that portion of nonmaterial services that are not inputs into so-called material production.
2.A discussion of these and other statistical issues appears in Appendix II-2.

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