2 Macroeconomic Developments in 1995 and Early 1996

International Monetary Fund
Published Date:
May 1997
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Henri Lorie

The key to the broad-based macroeconomic stabilization that has taken hold since early 1995 has been a deeper understanding among the authorities of the role of strict financial policies as a precondition for price stability and economic recovery. This progress has taken place in the context of the implementation of comprehensive reform programs, frequently with Fund support (13 of the 15 transition economies). Increasingly, support from the Fund is being provided through multiyear arrangements, whether through the Extended Fund Facility (for Azerbaijan, Kazakstan, Lithuania, Moldova, and Russia) or the Enhanced Structural Adjustment Facility (for Armenia, the Kyrgyz Republic, and Georgia).6

Inflation and Economic Recovery

Besides the Baltic countries, Moldova, the Kyrgyz Republic, and Armenia have now established a credible track record of more moderate inflation of around 25 percent a year (Table 1). Inflation in Russia has continued to decline since September of last year, to a monthly average of less than 3 percent during February-March 1996. Several other transition countries have had similar success in reducing inflation since early 1995 (Azerbaijan, Georgia, Kazakstan, and Uzbekistan). While inflation trends in Ukraine and Belarus have been less consistent, the performance of these countries too has improved on this front in comparison with the previous year. On the other hand, little or no progress has been made until now with disinflation in Turkmenistan and Tajikistan, with monthly price increases in these countries remaining in double digits.

Table 1.Consumer Prices in the Transition Economies(Percent change in the period)
Kyrgyz Republic1,257.01,365.687.
Source: IMF staff estimates.

For 1993 and 1994, Turkmenistan uses retail price index.

Source: IMF staff estimates.

For 1993 and 1994, Turkmenistan uses retail price index.

Based on the experience in all countries in transition, it is now well established that growth is positively correlated with policies that result in low inflation. The origin of pressures for inflationary finance has often been to pay for explicit or implicit tax expenditures and subsidies for distressed production sectors of the economy. Where these pressures have been resisted, new profitable activities have not seen their working capital taxed away by inflation and have not been excessively crowded out from access to limited financial resources. This, in turn, has encouraged the generation of value added. Even the possible short-term costs of rapid disinflation in terms of output loss appear small. There seem to be little formal or informal price and wage rigidities and indexing, with the result that persisting inflationary expectations, if any, have not induced larger output losses than those that appear to have been inevitable as part of the transformation. The evidence also strongly suggests that what matters most in bringing forward sustained economic recovery is a track record of consistent achievement with lower inflation and of commitment to market reforms and economic restructuring, eschewing stops and starts. The sooner credibility in this regard is achieved, the earlier the establishment of an environment conducive to longer-term productive decisions and to attracting foreign investment, and therefore the earlier the prospects for a return to growth.

The Baltic countries were among the first to experience positive growth in 1994 (Table 2). Economic activity also revived in Armenia that year. While recovery accelerated in Estonia and Lithuania during 1995, it stalled temporarily in Latvia, as the country had to deal with a crippling bank crisis that shrank the monetary system and led to capital outflows. Growth is expected to remain strong in the three Baltic countries in 1996, as the government in Latvia, as well as in Lithuania, has generally responded firmly and responsibly to the insolvency and illiquidity situation of certain banks, and as confidence in the banking system is being restored. Both the Kyrgyz Republic and Moldova have begun to harvest the fruits of several years of determined efforts to maintain relatively low inflation, as a turnaround in economic activity is finally emerging in those countries too. Signs of a similar turnaround are also evident in Russia, where the decline in real GDP during 1995 is estimated at not more than 4 percent. In Georgia, economic activity appears to have picked up since mid-1995. In Kazakstan, the rate of contraction in economic activity has slowed down markedly. Only in countries where there have been no significant stabilization gains so far, Turkmenistan and Tajikistan, or where these gains have not been credible owing to the absence of progress with structural reforms and privatization, mainly in Belarus, are there no clear prospects yet for an early recovery in economic activity.

Table 2.Real GDP Growth of Transition Economies(Percent change from previous period)
Kyrgyz Republic–13.9–15.5–20.11.3–41.12.0
Source: IMF staff estimates.

Cumulative rate from 1993 to 1995.

Source: IMF staff estimates.

Cumulative rate from 1993 to 1995.

Financial Policies

The pursuit of stricter financial policies underpinned the success with sharply lowering inflation in the past year, in comparison with 1994 (Table 3). First, the deficit of the general government was reduced significantly during 1995 to below 6 percent of GDP in most CIS countries (Azerbaijan, Belarus, Georgia, Kazakstan, Moldova, Russia, Ukraine, and Uzbekistan), while the Baltic countries maintained closer to overall fiscal balance. In a number of cases, these outcomes amounted to cutting the deficit by half from the previous year (e.g., Russia, Kazakstan, Georgia, and Azerbaijan). In the Kyrgyz Republic and Armenia, however, the government deficit remained at around 10 percent of GDP, largely reflecting a narrowing enterprise tax base; difficulties in collecting taxes due, particularly from the emerging private sector; as well as outlays related to enterprise restructuring (Kyrgyz Republic) and security (Armenia). The government deficit has also remained very high in Tajikistan.

Table 3.General Government Fiscal Balance in the Transition Economies(In percent of GDP)
Kyrgyz Republic–7.7–12.5–5.8
Source: IMF staff estimates.

Central government only.

Source: IMF staff estimates.

Central government only.

An important challenge is to redefine the role for a smaller government and to improve the provision of essential public services in a fiscally sustainable way. In most cases, the support of government for structural adjustment, including strengthening of the financial sector, will necessitate greater success in mobilizing budget revenue, in addition to reform of the expenditure system. Acceptability and implementation of sounder financial policies are also being facilitated by the emergence of more arms-length financial relations between increasingly independent central banks and governments, on the one hand, and between these authorities and the rest of the economy, on the other. Such financial relations, in turn, have been supported by the development of market-based instruments to implement macroeconomic and financial policies, for example, credit auctions and open market operations.

As a result of these trends, growth in central bank credit to government measured as a percent of beginning of period base money averaged less than 30 percent in 1995 in a subgroup of six countries (Armenia, Kazakstan, Latvia, Moldova, Russia, Uzbekistan) compared with 330 percent in 1994 (Table 4). This group excludes, at one extreme, Turkmenistan and Tajikistan—where financing of government by the central bank remained a very large source of money supply growth—and, at the other extreme, Estonia and Lithuania—where governments are not allowed to borrow from the central bank under the currency board arrangements. In Ukraine, Georgia, and Belarus, financing of government by the central bank contributed significantly to money supply growth, mainly because of very limited or negative net external financing rather than because of the sheer size of the deficit. Hence, net credit to government grew in 1995 by 150–200 percent in these countries. The Kyrgyz Republic too was forced to rely on substantial money creation to finance its large fiscal deficit.

Table 4.Growth of Monetary Aggregates (Monetary Authorities) in the Transition Economies(In percent of reserve money; beginning of period)
Net foreign assets199.776.2
Net domestic assets633.521.7
Of which
Net credit to government41 3.415.6
Credit to banks201.81.0
Reserve money833.297.9
Memorandum item: Broad money (percent change)784.2172.3
Net foreign assets12.6272.5
Net domestic assets630.1–91.5
Of which
Net credit to government485.520.1
Credit to banks184.446.4
Reserve money642.8180.5
Memorandum item: Broad money (percent change)486.1122.2
Net foreign assets101.186.1
Net domestic assets1,540.4167.5
Of which
Net credit to government56.2199.9
Credit to banks1,361.8–0.9
Reserve money1,641.6253.7
Memorandum item: Broad money (percent change)1,321.5325.7
Net foreign assets2.223.3
Net domestic assets9.2–4.2
Of which
Net credit to government–1.00.1
Credit to banks4.3–2.7
Reserve money11.519.1
Memorandum item: Broad money (percent change)29.531.3
Net foreign assets208.675.4
Net domestic assets2,270.2172.7
Of which
Net credit to government1,685.8162.9
Credit to banks191.0–0.2
Reserve money2,480.2248.0
Memorandum item: Broad money (percent change)2,269.9114.2
Net foreign assets1,161.680.6
Net domestic assets–470.010.7
Of which
Net credit to government438.841.6
Credit to banks144.1–12.8
Reserve money691.691.3
Memorandum item: Broad money (percent change)574.5104.6
Kyrgyz Republic
Net foreign assets85.8–19.6
Net domestic assets18.8111.4
Of which
Net credit to government23.4130.7
Credit to banks34.4–7.8
Reserve money104.691.7
Memorandum item: Broad money (percent change)127.475.8
Net foreign assets7.1–10.6
Net domestic assets12.612.2
Of which
Net credit to government2.419.1
Credit to banks3.0–4.1
Reserve money19.81.6
Memorandum item: Broad money (percent change)46.3–23.8
Net foreign assets69.135.3
Net domestic assets7.4–0.2
Of which
Net credit to government3.0–3.9
Credit to banks–12.10.6
Reserve money61.935.0
Memorandum item: Broad money (percent change)63.630.8
Net foreign assets40.57.0
Net domestic assets88.034.4
Of which
Net credit to government71.620.3
Credit to banks72.616.6
Reserve money127.941.3
Memorandum item: Broad money (percent change)115.785.1
Net foreign assets1.058.0
Net domestic assets184.058.0
Of which
Net credit to government1296.054.0
Credit to banks–9.0–8.0
Reserve money186.0117.0
Memorandum item: Broad money (percent change)190.0100.0
Net foreign assets64.961.5
Net domestic assets50.9238.6
Of which
Net credit to government28.8170.7
Credit to banks42.7107.6
Reserve money115.9300.0
Memorandum item: Broad money (percent change)156.3
Net foreign assets5,275.7984.7
Net domestic assets–4,091.8–590.3
Of which
Net credit to government177.6116.3
Credit to banks–30.788.6
Reserve money1,183.8394.4
Memorandum item: Broad money (percent change)984.0449.3
Net foreign assets504.5—68.8
Net domestic assets361.4201.2
Of which
Net credit to government420.4200.3
Credit to banks–3.220.4
Reserve money466.0132.2
Memorandum item: Broad money (percent change)573.0117.4
Net foreign assets1,427.5174.1
Net domestic assets–909.17.3
Of which
Net credit to government109.214.2
Credit to banks283.018.2
Reserve money518.4181.4
Memorandum item: Broad money (percent change)537.2174.1
Source: IMF staff estimates.
Source: IMF staff estimates.

Second, and remarkably, virtually all central banks (except Tajikistan and Turkmenistan) have dramatically curtailed their refinancing of commercial banks in comparison with often very high levels for 1994. In many cases, bank refinancing was essentially eliminated as a source of base money growth. Substantial progress was thus achieved across the transition countries in moving toward “classical” central banking during 1995. These developments amplified the impact of the reduction in direct central bank financing of government deficits in reducing the overall expansion in net domestic assets of the central banks.

The move toward greater reliance on market mechanisms to allocate central bank credit helped not only to increase allocative efficiency but also to reduce the political pressures on the monetary authorities to support “priority” and distress sectors. As explicit and implicit interest subsidies were also substantially reduced, an environment more favorable to controlling the demand for credit emerged, at the same time as did positive real interest rates in most countries. Progress was particularly evident in the case of previously directed bank credit to agriculture, even in countries where financing of this sector remained a highly charged political issue, including Russia, Ukraine, and Belarus.

Capital Inflows

In several transition countries, the decline in the growth in net domestic assets of the monetary authorities was less than fully reflected in lower base money growth because of significant increases in net international reserves. Base money growth averaged 110 percent among the transition countries during 1995, compared with 630 percent in 1994 (excluding Turkmenistan and Tajikistan). Growth rates in broad money in most countries exceeded somewhat those of base money because of higher money multipliers. In some cases (especially Kazakstan, Azerbaijan, and Uzbekistan), the higher net international reserves appear to have reflected capital inflows mainly originating with the response of official and private capital to investment opportunities in the country’s real economy, or an increase in the demand for exports. In others, capital inflows appear to have more directly resulted from portfolio changes and a shift in the demand for money by residents, which would indicate progress with remonetization and financial deepening. Greater confidence in the domestic currencies and banking systems, as well as the incentives created by higher interest rates as part of a tightening of monetary policy, would have been at the source of these developments. Reverse currency substitution in the early part of 1995 was especially apparent in Russia, Belarus, and Ukraine; in Ukraine and Belarus, the situation, however, reversed later in the year as the stabilization program ran into difficulties. More recently, episodes of reverse currency substitution have also been observed in Kazakstan, Moldova, Azerbaijan, and Georgia. In Uzbekistan, greater credibility of the sum under the current stabilization program has also led to higher base money growth associated with foreign exchange inflows. In the Baltic countries, capital inflows have been mostly in the form of foreign direct investment and long-term capital, especially in the case of currency board arrangements of Estonia and Lithuania, and have tended to leak more directly into imports, with only limited impact on monetary aggregates. In Latvia during early 1995, and in Lithuania more recently, short-term capital outflows have occurred in connection with the banking crises, as depositors sought safer assets in banks abroad.

Exchange Rates

The transition countries that are not formally pegging their exchange rate (i.e., all except Estonia and Lithuania) have, for the most part, pursued a managed float.7 A band was, however, introduced in Russia in July 1995, and has continued to operate satisfactorily since then. While during 1993 and most of 1994, the financial policies pursued by the authorities did not manage to achieve a sustained stabilization of the exchange rate (which sharply depreciated in most cases), there has been a dramatic change in this respect since early 1995 (Figure 1). Undoubtedly, reflecting the considerable tightening of financial policies as described earlier, as well as likely greater confidence in the ability and willingness of central banks to defend the value of the national currencies, exchange rates have tended to be remarkably stable during 1995 and early 1996. The main exceptions have been Turkmenistan and Tajikistan, mirroring the lack of progress in reducing inflation; and Ukraine, where the stabilization gains have not been sustained enough so far. Pressure for depreciation has also been building up in Belarus, following a reversal in market reforms.

Figure 1.Real and Nominal Effective Exchange Rate1

1 Real effective exchange rate, January 1992 = 1; based on trade-weighted consumer price indices.

2Real effective exchange rate, January 1993 = 1.

3Real effective exchange rate based on U.S. consumer price index.

Capital inflows and reverse currency substitution have greatly facilitated stabilization of the exchange rates, which in turn has contributed to lower inflation rates. In a number of cases, in fact, for example, Russia, Ukraine, Kazakstan, and Belarus in mid-1995, and more recently in Moldova and Georgia, there have been upward pressures on the exchange rate. The authorities have generally shown reluctance in letting the exchange rate appreciate substantially because of possibly exaggerated concerns with competitiveness; as a result, progress in reducing inflation may not have been as impressive as it could have been. The Russian authorities, however, allowed some appreciation of the ruble (before the introduction of the band in the summer of 1995). Other steps were taken to reduce the risk of inflationary pressures from capital inflows. The authorities in several countries, including Russia, Kazakstan, Uzbekistan, and Belarus, partly sterilized the monetary impact of their interventions on the foreign exchange market to limit nominal appreciation (including through auctions of central bank bills).

Besides Turkmenistan and Tajikistan, there have been downward pressures on the exchange rate since late 1995 in Ukraine and Armenia, in addition to Belarus. The authorities have tended to resist those pressures by selling foreign exchange, seemingly because of fear of reigniting inflation if they let the exchange rate depreciate. At the same time, steps were generally taken to tighten financial policies, although in some cases, in particular Belarus, administrative interventions were relied upon as well (e.g., limit access to the foreign exchange market); this situation has also prevailed for some time in Uzbekistan. Because real exchange rates are likely to be still undervalued in most transition countries from a more medium-term perspective, the Fund’s policy advice in circumstances of downward pressures has mainly focused on tightening financial policies to stabilize the nominal exchange rates—with some success recently in Ukraine.

External Current Account and Growth

Further progress with reducing inflation in the transition countries has been associated with declining external current deficits during 1995 in some countries, in particular, Ukraine, Belarus, and Kazakstan; while in others, in particular, Latvia, the Kyrgyz Republic, Azerbaijan, and Uzbekistan, external current account deficits have been widening (Table 5). This appears to have mirrored, in addition to differing GDP growth developments, a decline in energy uses among the first group of countries, and an early response to market reforms and structural adjustment in the second group, which has begun to pay off by encouraging foreign as well as domestic investment. However, there are at this juncture obvious limits to the generation of domestic savings that would be sufficient to support strong investment and growth. A resumption of growth is critical at this time, to improve living standards and avoid the risk of losing political support for market reforms. This risk places an exceptional responsibility on the international financial community in addition to private foreign investors, to remain actively engaged.

Table 5.Current Account Balances of the Transition Economies(As a percent of GDP)
Kyrgyz Republic–11.2–15.2–18.0
Source: IMF staff estimates.
Source: IMF staff estimates.

Structural Reforms in the Monetary, Exchange, and Banking Areas Included in Adjustment Programs

Financial stabilization and the associated macroeconomic and structural objectives typically require adequate institutional arrangements, operational structures, and strong capabilities and skills to implement agreed financial policies and design adequate instruments. The development of such institutions and structures has been a clear goal of adjustment programs, particularly in the monetary, banking, and exchange areas. The requirements of financial policies have often directly influenced priorities of structural reforms in those areas, for instance, the establishment of credit auctions, foreign exchange auctions, and government securities markets. At the same time, specific structural reforms in central banking—for instance, in payment and accounting systems or banking-system restructuring—have supported the design and implementation of stabilization programs in an indirect way by permitting more effective operation of policy instruments and more efficient transmission of policy signals. Technical linkages among various reform components have also called for coordinated implementation of specific financial sector reforms. These and other interactions between stabilization and structural policies are reflected in the content of structural reforms formally included in Fund-supported adjustment programs.

The overriding focus of reforms in the financial sector—by the central banks, in particular—has been the introduction and consolidation of market-based arrangements for the conduct of monetary and exchange policies. Market-based arrangements typically comprise the monetary policy instruments and operations of the central banks and their coordination with foreign exchange operations, the establishment of interbank money and government securities markets, as well as interbank foreign exchange markets, supporting reforms in the payment and accounting systems, and in policies and procedures to foster sound and competitive banking systems that will underpin effective transmission of monetary policy. For instance, an accurate and timely central bank accounting system is needed for the monitoring of financial policies and for formulating and coordinating liquidity operations through the various markets and instruments used by the central bank for indirect monetary control. Similarly, payments system reforms facilitate monetary management, by ensuring effective transmission of monetary policy intentions, anchoring demand for bank reserves, controlling access to lender-of-last-resort facilities, and exposing solvency problems of bank participants in the system. They also provide the infrastructure for interbank and securities markets in which the central bank and the commercial banks can reliably manage liquidity without undue exposures, thus helping to smooth out the impact of policy tightening or contain financial shocks.

In light of these linkages between structural reforms in the financial sector and effectiveness of stabilization policies, the authorities have sought to complement the financial stabilization with comprehensive structural reforms in the monetary, banking, and exchange areas. More recently, systemic distress in the banking systems, partly revealed through successful stabilization, has introduced new risks to policy formulation and implementation, which the authorities are now also beginning to tackle.

The Fund-supported adjustment programs in the region have reflected this mix of structural reforms in the financial sector with macroeconomic stabilization measures. In the early programs, the emphasis was on introducing new instruments and institutional arrangements to underpin effective and increasingly market-based implementation of monetary policy. For example, the early programs included as core reform elements introduction of central bank credit auctions, a government securities issue program, modern prudential regulation, unification of exchange rates, and new banking laws. Subsequent programs have sought to strengthen the operation of these new instruments and institutions by implementing specific measures to strengthen operational capacity market infrastructure and a strengthened enforcement of regulatory framework. The inclusion of specific structural reforms in Fund-supported adjustment programs also reflected a commitment to reforms, and hence of the effectiveness of technical assistance in support of reform designs and implementation.

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