V Stabilization, Reform, and the Role of External Financing in the Countries in Transition

International Monetary Fund. Research Dept.
Published Date:
February 1995
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Output has stabilized or begun to increase in those countries in transition that have made the most progress in macroeconomic stabilization. In many other countries, however, inflation and budget deficits remain very high, contributing to economic uncertainty and inefficiency, the impoverishment of vulnerable groups, capital flight, and a protracted adjustment period. Meanwhile, most countries in transition have made substantial progress in structural reform. In particular, prices are now largely market-determined, and international trade has been liberalized in many countries. Privatization has proceeded rapidly in many—but not all—countries, but the process needs to be speeded up, particularly in the case of large enterprises, for which progress has so far been very uneven. There is an urgent need in most countries to strengthen the financial sector and to put in place a legal framework of property rights and effective bankruptcy procedures. The apparent widening of the income distribution and the hardship borne by the unemployed, low-skilled workers, pensioners, and other groups has undermined public support for economic reforms in some countries. Social programs must be restructured to better protect the truly needy, while containing over-all outlays to levels that are consistent with fiscal sustainability. To help to bridge the period until economic growth recovers, international financial institutions, industrial countries, and the private sector have been providing financial aid, largely in the form of loans and debt relief. More aid will be required, especially for the countries of the former Soviet Union, but it will be of little benefit unless appropriate macroeconomic and reform policies are implemented.

Macroeconomic Stabilization and Economic Performance

Economic developments among the countries in transition have increasingly diverged in the past year. Those countries that have achieved a reasonable measure of macroeconomic stability have begun to grow again, but those that have not yet implemented appropriate stabilization policies have continued to experience high inflation and substantial output losses. The Baltic states, the Czech Republic, Mongolia, Poland, and, more recently. Albania and Slovenia have pursued successful stabilization programs in conjunction with ongoing structural reforms. In most of these countries, budget deficits and credit growth have been contained. In some cases, nominal exchange rates have been fixed, as in the Czech Republic and Estonia, or put on a crawling peg, as in Poland. These policies have delivered relatively low inflation, which has set the stage for economic recoveries that began in 1993 and are likely to strengthen further in 1994 (Table 12).

Table 12.Countries in Transition: Real GDP(Annual percent change)
Central Europe-8.3-1.41.8
Former Czechoslovakia-8.5
Czech Republic0.52.5
Slovak Republic-3.6
Former Soviet Union and Baltic countries-18.2-11.9-9.8
Kyrgyz Republic-19.1-16.4-5.2

Poland is the first of the countries in transition to have experienced a significant recovery of output (Box 9). Real GDP increased by 4 percent in 1993, and there were signs of demand pressures, as reflected by a sharp deterioration in the trade balance. Subsequently, demand pressures abated some-what, although inflation rose to nearly 5 percent a month by the end of the year (Chart 23). The uptick of inflation was attributable in part to seasonal factors and to the lagged effects of the introduction of the value-added tax (VAT), and the inflation rate fell back significantly in the first quarter of 1994, Nevertheless, the abolition of the former incomes policy—the popiwek—in April 1994 raises the risk of increased wage pressures, although the government is in the process of formulating a replacement.

Chart 23.Selected Countries in Transition: Consumer Price Inflation

(Monthly percent change)
(Monthly percent change)

Appropriate policies were reflected in solid economic performance in the Czech Republic in 1993, despite the separation from Slovakia, as the general government balance was close to zero, the currency remained strong, and inflation was well contained (after the blip at the beginning of the year, attributable to an indirect tax increase). Wage increases have somewhat outstripped productivity gains, however, owing to tight labor market conditions; in response, the government reintroduced tax-based incomes policies in mid-1993. In Albania, real GDP rebounded strongly in 1993, increasing by as much as 11 percent because of the progress on structural reform, especially in the agricultural sector, and because of growth in construction and services. At the same time, inflation has been cut sharply. The government deficit remains too large, however, and could eventually prove to be a source of inflationary pressure if it is not reduced. Output appears to have stabilized in Slovenia; during the course of 1993, annual inflation fell to about 20 percent, and the government budget deficit was only about 1 percent of GDP. Real output began to rise in all three Baltic countries in 1993, following rigorous stabilization programs that had reduced inflation to around 1 percent a month and resulted in stable or appreciating exchange rates. Inflation picked up in all three countries near the end of the year, to about 5 or 6 percent a month, although this was thought to be due mainly to temporary factors. The authorities in Latvia and Lithuania responded by tightening monetary conditions, and Lithuania is actively considering establishing a currency board—similar to the one in Estonia—that could enhance the credibility of a program to fix the exchange rate. In Mongolia, inflation has been contained, and output is expected to increase in 1994.

Significant progress toward macroeconomic stabilization has also been made in Hungary, the Slovak Republic, and, to a lesser degree, Bulgaria and Romania. The decline of output in these countries may be coming to an end, but containing budget deficits and inflation has proved difficult (Table 13). The fiscal deficit was large in Hungary, and a serious current account deficit has also developed, reflecting a collapse in savings; inflation, however, was relatively moderate at about 22 percent a year. Inflation in the Slovak Republic was also moderate in 1993, despite an increase in retail prices owing to the introduction of a VAT, and output is likely to stabilize in 1994. In Bulgaria, inflation fell substantially in 1993 but, at about 60 percent a year, remained high. The government budget deficit expanded to about 15 percent of GDP. In Romania, inflation remained high in 1993, owing largely to a collapse in money demand in the face of highly negative real interest rates. The budget deficit fell in 1993, but it may rise somewhat in 1994.

Table 13.Countries in Transition: General Government Budget Balances(In percent of GDP)
Central Europe
Former Czechoslovakia-3.8
Czech Republic0.3
Slovak Republic-7.9
Former Soviet Union and Baltic countries
Kyrgyz Republic1-14.8-8.2

Excludes extrabudgetary funds.

Includes unbudgeted import subsidies.

Excludes extrabudgetary funds.

Includes unbudgeted import subsidies.

The other countries in transition have been less successful in achieving macroeconomic stability. Real GDP fell by almost 12 percent in Russia in 1993, and a further decline is expected in 1994. Inflation remained excessive, averaging 20 percent a month in 1993, because of loose financial policies that reflected central bank financing of the large government budget deficit as well as directed central bank credits to enterprises extended through the commercial banks. In the last few months of the year, interest rates rose substantially—the central bank discount rate became positive in real terms in December—and money and credit aggregates decelerated, although the latter reflected in part the accumulation of arrears by the government. The tightening of monetary conditions in the latter part of the year contributed to a trend reduction of inflation that continued through the first quarter of 1994. The ruble depreciated by only 18 percent against the dollar in the second half of 1993, implying a sharp real appreciation (Chart 24).

Chart 24.Selected Countries in Transition: Nominal and Real Exchange Rates1

1 Real exchange rates are based on relative consumer prices. For Poland and the Czech Republic, real exchange rates based on relative unit labor costs are also shown.

Several other countries of the former Soviet Union were also characterized by very high inflation in 1993—bordering on hyperinflation in Belarus, Georgia, and Ukraine—steep output declines, and, in many cases, large budget deficits.60 In countries that had remained in the ruble area, inflationary pressures were aggravated by the Russian “demonetization” in July 1993, which led to inflows of old, pre-1993 rubles. This episode triggered the introduction of national currencies in all remaining members of the ruble area except Tajikistan by November 1993 (Box 10).61 Except in Turkmenistan, where gas exports have buoyed the economy, and in the Baltic states, output is expected to fail further in 1994 in most of the countries of the former Soviet Union, although at a slower rate than in 1993.

The reduction and control of inflation has been a key policy challenge facing all countries in transition. An important issue that has arisen in this context is the choice of exchange rate regime. The experiences of several countries, including the former Czechoslovakia, Estonia, and Poland, suggest that an exchange rate pegged against convertible currencies can prove to be an effective nominal anchor (Box 11). However, fixing the exchange rate is not in itself sufficient to achieve lasting disinflation. Moreover, it is clear that a fixed exchange rate is not necessary for a successful program of disinflation. Latvia and Lithuania achieved considerable disinflation under floating exchange rates by eliminating domestic financing of the budget deficit and by maintaining tight credit conditions more generally.

Underlying monetary and fiscal policies are more fundamental to macroeconomic stabilization than the exchange rate regime. An exchange rate peg cannot survive long without fiscal discipline and the containment of credit growth by the central bank; inflationary pressures stemming from these factors would quickly overwhelm the ability of the authorities to draw on foreign exchange reserves to stabilize the currency. Other factors that have also proved helpful in establishing the credibility of an exchange rate peg, and of monetary policy more broadly, are a high degree of central bank independence—which reduces the possibility that the central bank will have to monetize future government deficits—and currency convertibility. Moreover, the financial system as a whole must be robust enough to survive crises without extensive central bank bailouts on a scale that would undermine monetary confidence. This will require further restructuring of the banking sector and, in many countries, a solution to the problem of excessive interenterprise arrears.

For many of the countries in transition, including most of the countries of the former Soviet Union, it is clear that the needed budgetary, credit, and financial policies are not yet in place to allow the exchange rate to be pegged successfully. Once they are, however, a fixed exchange rate could play a role by providing an anchor for the monetary authority and by stabilizing traded-goods prices. This proved to be the case in Poland, which has since adopted a crawling peg vis-à-vis a basket of five currencies, and in Estonia, which established a currency board to ensure monetary independence and to strictly limit credit growth. In both cases, however, exchange rates were fixed in the context of the necessary supporting policies.

Privatization, Corporate Governance, and Fiscal Reform

In most countries, significant progress in privatization has been achieved in a relatively brief period, particularly in the case of smaller, mostly service sector, enterprises. The more difficult task of privatizing medium-sized and large enterprises has, of course, taken longer, but it is proceeding in many countries. In Russia, more than two-thirds of small service enterprises have been privatized, and some 10,000 larger firms were corporatized and sold through vouchers in 1993. The status of land ownership is, however, still unclear pending the full implementation of the October 1993 presidential decree on land reform. The use of mass voucher privatization was pioneered in the former Czechoslovakia. In the Czech Republic, the second round began in March 1994, and the plan calls for 90 percent of the economy to be in private hands by the end of the year. In Slovakia, the second round of voucher privatization is anticipated for late 1994, Mongolia has completed the distribution of vouchers for privatization.

The success and rapid pace of privatization has brought the issue of corporate governance to the fore.62 In Russia, control of many firms has, in effect, been taken by current workers and management, who may have neither the skill nor the incentive to carry out needed, but potentially painful, restructuring. This problem has been compounded by soft budget constraints—owing to easy access to credit from the central bank and growing arrears to other enterprises—and by the absence of liquid stock markets through which the ownership of privatized firms could change hands. In the Czech Republic and Slovakia, the shares of privatized firms are held by large Investment Privatization Funds, but these have not yet made much progress in restructuring the enterprises under their control. Although all three countries have bankruptcy laws, they have been little used, apparently because of the reluctance or inability of creditors to force troubled enterprises out of business, as well as the lack of institutional development (for example, the appointment of bankruptcy judges). The hope appears to be that most companies can be restructured without bankruptcy.

Box 9.Poland’s Economic Rebound

The Polish economy staged a remarkable economic turnaround in 1992-93, with conservative estimates putting growth of real output in 1993 at 4 percent, following IV; percent growth in 1992; because of systematic underreporting, actual growth might well have been substantially higher in both years. The recovery seems to be broadly based, with a turnaround in agriculture and a boom in industrial output, and inflation has been brought down to about 35 percent a year.

The recovery is testimony to the power of macroeconomic policy, supported by significant, if incomplete, structural reform, to induce economic transformation. Sweeping measures, first implemented by the Mazowiecki government in January 1990, aimed specifically at coping with an economy bordering on hyper-inflation and facing pervasive shortages, deteriorating budget balances, and a grave external situation. Tough stabilization measures centered on fiscal and monetary contraction, as well as on reducing inflation by pegging the zloty to the U.S. dollar (see Box 11), In addition, price controls were eliminated; currency convertibility was introduced; and restrictions on foreign trade were removed. The trade reforms, in particular, resulted in a sharp shift in trade toward Europe, and in export-led growth.

Subsequently, the focus shifted to structural measures as the web of enterprise-specific taxes, tax relief, and subsidies was replaced with a value-added tax and with personal and corporate income taxes; and enterprise governance was enhanced, even in the face of relatively little progress on privatization, by imposing positive real interest rates on bank credit and hard budget constraints on state-owned enterprises. The resulting improvement in performance, including in the remaining public sector enterprises, has been a key factor in the expansion of output.

Liberalized trade and current account convertibility were crucial to correct the relative price structure and also exposed state enterprises and large unions to competitive discipline. The liberalization of prices initiated the process of resource reallocation away from large-scale state firms toward small enterprises. Growth of small enterprises was initially concentrated in services but subsequently spread to the industrial sector. By the end of 1992, recorded private employment outside agriculture was 3.8 million, an increase of 81 percent since 1990. In contrast, employment in state-owned industrial firms fell from 4.1 million at the end of 1989 to about 2.9 million at the end of 1992. At the end of 1993, private enterprises accounted for over 35 percent of industrial output, compared with 29 percent a year earlier.

The upsurge in 1992-93 was preceded by a substantial decline in measured output in the previous two years (see chart). This was due to several interrelated factors, including the disintegration of the Council for Mutual Economic Assistance trading system in 1991, a sharp contraction in demand for output from state-owned industry, and declines in inventory demand as liberalization and the imposition of hard budget constraints eliminated incentives to hoard. Moreover, measurement problems probably led to an overstatement of the true drop in output, since most of the conventional statistical apparatus was inadequate to capture the emerging private sector and may now understate the recovery (see Box 12).

The rebound has taken place against a brisk but uneven pace of institutional restructuring since 1990. Although much has been achieved, progress with respect to privatization of state-owned enterprises has been hampered by the political complexity of the problem. Financial sector reform has been relatively slow, in line with the pace of broader enterprise reform, leaving banks, the larger of which are still state-owned, with a heavy burden of bad loans. An innovative program of bank-led debt workouts, involving debt-equity swaps, is under way. Structural transformation is, however, a long-term process. Although bankruptcies of large firms have been limited, privatization and restructuring have proceeded through management and employee buyouts and by an ongoing process of selling off assets to the emerging private sector.

The Polish experience provides grounds for optimism that rapid implementation of stabilization and liberalization measures can create an environment in which structural reform can take hold and can initiate a significant shift of resources away from state production of goods that nobody wants toward private firms and services. At the same time, the process of economic transformation has resulted in considerable hardship, underscoring the need for an appropriately targeted social safety net to protect the most vulnerable members of society.

Poland: Industrial Production

(Index, average 1990 = 100)

Source: Polish authorities.

There has also been progress in privatization in other countries. Privatization of small concerns is proceeding in the Baltic countries, the Kyrgyz Republic, and Poland, but there has been little progress in the case of larger firms, Estonia, Latvia, and Kazakhstan have all begun to issue privatization vouchers, and Belarus and Poland plan to do so. In several other countries—notably Bulgaria, Romania, and many countries of the former Soviet Union—privatization has been very limited, although some important measures needed to proceed with the privatization process have been put in place. Nevertheless, many countries in this group do not yet have in place the needed legal framework, including workable bankruptcy laws.

Progress has also been made in the area of fiscal reform—particularly on the tax side—although it has varied widely among countries. The hundreds of turnover taxes that had been integral to central planning have largely been replaced with a much simpler structure, and many countries have introduced versions of the less distortionary VAT, often with the technical assistance of the IMF. Reform of the corporate and personal income tax systems is generally less advanced, although reforms in this area have been made in the Czech Republic, Poland, and Slovakia. There is a general need to broaden the tax base and to strengthen collection of both direct and indirect taxes by reducing exemptions and by extending coverage to more of the growing private sector.

Rather less has been accomplished on the expenditure side. A serious problem is that social safety nets are not sufficiently focused on the truly needy—such as the old and the unemployed—which has resulted in an unnecessarily large increase in income inequality as economic restructuring takes place. This has in some cases eroded support for economic reform and has even called into question the reform process itself. At the same time, state subsidies remain very high in some countries. These distortionary subsidies command resources that could be better used to bolster social protection.

External Trade Reform

The rapid liberalization of external trade and payments was a crucial part of reform in most central European countries and in the Baltic states. Following the collapse of the Council on Mutual Economic Assistance (CMEA) in 1990-91, virtually all these countries rapidly replaced the centralized and highly administrative trading system with some of the most liberal import regimes in the world, based on a limited number of tariffs and quotas and on the rapid introduction of current account convertibility. Trade and exchange liberalization was perceived as a way to mitigate the impact of the collapse of managed trade, to speed up the correction of highly distorted domestic price systems, and to force domestic monopolistic industries to adjust to market forces. Pursuing this policy was made easier by the highly depreciated exchange rates of the currencies of these countries vis-à-vis those of the industrial countries, which boosted competitiveness and limited protectionist pressures. Subsequent real appreciations, however, have revived these pressures and have led in 1992 and 1993 to increases in tariffs in some countries.

Trade regimes in most of the countries of the former Soviet Union, except the Baltic countries, are significantly less liberal.63 As in central Europe, tariffs have been lowered—to no more than 15 percent in most cases—and quantitative restrictions have largely been eliminated. However, centralized trading and state orders still play an important (though diminishing) role, and selectively available import subsidies remain very substantial. On the export side, many commodities are subject to quotas or are traded through centralized organizations. Moreover, within the former Soviet Union, much of the trade in several key commodities, notably energy, is still subject to bilateral agreements, often involving barter. Although in the absence of a well-developed payments system such arrangements may be needed for interstate trade, the mandatory procurement and restrictive licensing arrangements associated with them are the source of substantial distortions.

The willingness of industrial countries to lower trade barriers vis-à-vis the countries in transition has enhanced the gains from the strategy of trade liberalization. Industrial countries have granted most-favored-nation (MFN) status to most of the countries in transition. The European Union signed association agreements with Czechoslovakia—later replaced by separate agreements with the Czech Republic and the Slovak Republic—Hungary, and Poland in 1991, and with Bulgaria and Romania in 1993. At the Copenhagen Summit in 1993, the European Union agreed to accelerate tariff reductions envisaged by these agreements. The Baltic states have entered into free trade agreements with the Scandinavian countries. Free trade agreements between the European Free Trade Association (EFTA) and several central European countries have entered into force or are being negotiated.

Box 10.Currency Arrangements in the Former Soviet Union and Baltic Countries

ArmeniaDramIntroduced on November 22, 1993. There is a floating exchange rate and effective current account convertibility.
Dram 1 = Rus Rub 12.5
Dram 77 - $1
AzerbaijanManatIntroduced on August 15, 1992 as a parallel currency and made sole legal tender on January 1, 1994. There is a managed float and limited convertibility.
Manat 1 - Rus Rub 17
Manat 393 = $1
BelarusRussian ruble and rubel3The rubel was introduced on May 25, 1992 as a parallel currency. There is a managed float and limited current account convertibility. The authorities are currently negotiating the unification of Belarus’s monetary system with that of Russia.
Rubel 5.9 = Rus Rub 1
Rubel 9.150 = $1
EstoniaKroonIntroduced on June 20, 1992 in a currency board arrangement. The exchange rate is pegged at 8 kroon = DM 1, with current account convertibility.
Kroon 1 = Rus Rub 125
Kroon 13.7 = $1
Kroon 8 = DM 1
GeorgiaCouponIntroduced on April 5, 1993 and became sole legal tender on August 2, 1993. There is a floating rate and current account convertibility. The authorities are considering the introduction of a permanent currency, the lari, or unification of Georgia’s monetary system with that of Russia.
Coupons 135 = Rus Rub 1
Coupons 230,000 = $1
KazakhstanTengeIntroduced on November 15, 1993. Exchange rate is determined at weekly official foreign exchange auctions, and there is current account convertibility.
Tenge 1 = Rus Rub 119
Tenge 15.8 = $1
Kyrgyz RepublicSomIntroduced on May 10, 1993. Exchange rate is determined by official auction, and there is current account convertibility.
Som 1 = Rus Rub 140
Som 11.75 = $1
LatviaLatsIntroduced on June 28, 1993, replacing the Latvian ruble, which had been introduced on May 7, 1992 and had become sole legal tender on July 20, 1992. The exchange rate of the lats is floating, and there is current account convertibility.
Lats 1 = Rus Rub 2,500
Lats 0.6 = $1
LithuaniaLitasIntroduced on June 15, 1993, replacing the talonas, which had been introduced on May 1, 1992 and had become sole legal lender on October 1, 1992. The exchange rate of the litas is floating, and there is current account convertibility.
Litas 1 = Rus Rub 435
Litas 3.9 = $1
MoldovaLeuIntroduced on November 29, 1993, replacing the coupon, which had been introduced on July 27, 1993. The exchange rate of the leu is floating, and there is current account convertibility. The Trans-Dniester region continues to use pre-1993 rubles and rationing coupons. Negotiations on the use of the leu in that region are under way.
Leu 1 = Rus Rub 345
Leu 3.95 = $1
Russian FederationRussian rubleFloating rate and current account convertibility.
Rus Rub 1.691 = $1
TajikistanRussian rubleThe authorities are currently negotiating the unification of Tajikistan’s monetary system with that of Russia.
Rub 1.69 = $1 (central bank accounting rate)
Rub 1,650 = $1 (market rate)
TurkmenistanManatIntroduced on November 1, 1993. The exchange rate is administered, and there is limited convertibility
Manat 1 = Rus Rub 600

(official rate)
Manat 1 = Rus Rub 106

(market rate)
Manat 1.99 = $1 (official rate)
Manat 16.5 = $1 (market rate)
UkraineKarbovanetsIntroduced on November 12, 1993. Foreign exchange auctions were suspended as of the beginning of November 1993. Since then, transactions have taken place at different rates and under various arrangements.
Karb 20.5 = Rus Rub 1
Karb 35.000 = $1
UzbekistanSum-couponThe sum-coupon was introduced on November 16, 1993 and became sole legal lender on January 1, 1994. The government has announced that a permanent currency, the sum, is to be introduced in April-July 1994. The sum-coupon is pegged to the Russian ruble, and there is limited convertibility.
Sum-coupon 1 = Rus Rub 1
Sum-coupon 1.650 = $1

Exchange rate quotations are for the week ending March 4.1994. The exchange rate is the noncash market rate quoted in the home country and reported in Moscow.

For many countries with de facto current account convertibility, there continue to be restrictions under the transitional arrangements of Article XIV of the IMF’s Articles of Agreement.

The rubel is used in cash transactions only. The unit of account in banks is the Belarussian ruble, which equals 0.1 rubel.

Exchange rate quotations are for the week ending March 4.1994. The exchange rate is the noncash market rate quoted in the home country and reported in Moscow.

For many countries with de facto current account convertibility, there continue to be restrictions under the transitional arrangements of Article XIV of the IMF’s Articles of Agreement.

The rubel is used in cash transactions only. The unit of account in banks is the Belarussian ruble, which equals 0.1 rubel.

An important outcome of the policies of both the countries in transition and the industrial countries has been a dramatic shift in trade patterns away from intra-CMEA trade to trade with the rest of the world. This development reflects a shift from patterns of trade determined by central planning to those driven primarily by market considerations. Thus, in less than five years the European Union has replaced the former CMEA as the dominant trading partner for Hungary, Poland, Slovakia, and the Czech Republic, and nominal trade flows between the European Union and these countries roughly doubled in the period 1987-92 (Table 14). In most countries of the former Soviet Union and in the Baltic countries, both exports to and imports from other countries grew sharply as a share of the total in 1992 (Table 15).

Table 14.Selected Countries of Central Europe: Trade with the European Union(In percent of total trade)
Imports from EUExports to EU
Former Czechoslovakia26.531.142.046.324.232.049.546.6
Source: IMF, Direction of Trade Statistics.

Through October 1993. Data for 1993 are preliminary.

Source: IMF, Direction of Trade Statistics.

Through October 1993. Data for 1993 are preliminary.

Table 15.Selected Former Soviet Union and Baltic Countries: Trade with Countries Outside the Region(In percent of total trade)
Imports from Outside RegionExports to Outside Region
Kyrgyz Republic2023127
Sources: National authorities; and IMF staff estimates.Note: Comparability of data between 1991 and 1992 is limited because of data and. especially in 1991, valuation problems.
Sources: National authorities; and IMF staff estimates.Note: Comparability of data between 1991 and 1992 is limited because of data and. especially in 1991, valuation problems.

From the point of view of the industrial countries, of course, trade with the countries in transition remains very small. This fact, however, has not precluded the emergence of calls for protection against imports from the transition countries. Steel exports triggered safeguard clauses contained in the European Union association agreements, resulting in limits, until 1995, on European Union imports of certain steel products from the Czech Republic and Slovakia to well below their 1992 levels. There are also barriers against increased imports of aluminum, and steel exports to the United States from Romania and Poland were subject to antidumping duties in 1993. There have also been numerous restrictive trade measures taken against the former Soviet Union and Russia.64

Further reduction in trade barriers remains a crucial element to spur economic transformation. The trade agreements between the European Union and countries in central Europe are a welcome step, but there are still harriers in sectors where the transition countries could have benefited most, such as agricultural products. The uncertainty generated by the possibility of antidumping and safeguard actions by industrial countries is unnecessarily depressing badly needed, inward direct investment to the countries in transition.

External Financing and Economic Adjustment

In 1990, when the countries in central Europe embarked on the transformation to market-based economies, the effects of the disintegration of the CMEA and the economic collapse of the former Soviet Union were critically underestimated. The move to world prices and hard currencies implied large terms of trade movements, particularly for energy products and primary commodities that had been imported at highly subsidized prices—relative to prevailing world prices—from the Soviet Union. Moreover, the old interstate payments system was disrupted, sharply reducing credit available to finance trade imbalances.

As markets disappeared, the terms of trade deteriorated, and trade patterns disintegrated, the countries of central Europe had no alternative but to adjust. To support adjustment programs and to help maintain the momentum for reform, international financial institutions—primarily the IMF and the World Bank—have been providing financial assistance to the transition countries during this period. In most cases, however, the need for orderly adjustment and an early introduction of currency convertibility required more resources than the international financial institutions could provide. This financing was therefore complemented by lending by industrial countries in the context of the Group of Twenty-Four (G-24) framework, coordinated by the Commission of the European Communities.65 The provision of external financing for the transition process, particularly the balance of payments aid from the G-24 and from multilateral agencies, has been in response to the exceptional conditions in these countries. As stabilization takes hold and the central European economies expand, it is anticipated that the high rates of investment required to complete the economic transformation will progressively be financed from private external sources and from increased domestic saving.

In total, lending from international financial institutions and the G-24 to Albania, Bulgaria, the former Czechoslovakia, Hungary, Romania, and the Baltic states amounted to $11.6 billion in 1991-93, an amount equivalent to about 3 percent of the estimated combined GDP of these countries (at market exchange rates) (Table 16).66 Private sources and debt relief have added another $17.4 billion, for a total of about $29 billion in the three years to 1993. Most of the official financial assistance has been in the form of debt at nonconcessional terms.

Table 16.Central European and Baltic Countries: External Financing, 1991-931(In billions of U.S. dollars)
Original AssumptionsActual FinancingActual as Percent of Original2
Official lending15.811.673
World Bank4.22.969
Other international institutions1.30.754
G-24 countries33.72.978
Private capital14.217.4122
Total financing41.141.4101

Data for 1993 are provisional. Figures are based on program years: calendar years for Bulgaria, former Czechoslovakia, Hungary, Poland, Romania, and the Baltic states; July 1993-June 1994 for Albania, Poland is not included in 1992, when no annual program was agreed.

For official lending, actual outlays were less than originally assumed because of delays in program implementation due to administrative difficulties and slippages in adjustment efforts.

The bulk of the G-24 assistance has been provided by the European Union.

Mainly debt relief by private and official creditors for Bulgaria and Poland.

Data for 1993 are provisional. Figures are based on program years: calendar years for Bulgaria, former Czechoslovakia, Hungary, Poland, Romania, and the Baltic states; July 1993-June 1994 for Albania, Poland is not included in 1992, when no annual program was agreed.

For official lending, actual outlays were less than originally assumed because of delays in program implementation due to administrative difficulties and slippages in adjustment efforts.

The bulk of the G-24 assistance has been provided by the European Union.

Mainly debt relief by private and official creditors for Bulgaria and Poland.

The G-24 assistance has typically been made available in support of IMF-sponsored programs, and conditionality for the disbursements has been linked to successful completion of IMF program reviews.67 Conditionality has provided an important incentive for governments to use official assistance for macroeconomic stabilization, rather than to pursue an ultimately counterproductive course of delaying needed adjustments. Conditionality is likely to continue to play a key role in the provision of international financial aid. This will be particularly important because the pressures to slow the process of transformation—which frequently derive from the mistaken impression that the costs now being experienced can somehow be postponed or avoided by putting off macroeconomic stabilization and reform—remain strong. The need for a successful economic turnaround is all the greater because much of the assistance has been in the form of loans at nonconcessional terms.

The disintegration of the Soviet Union required the newly independent countries also to adjust to the rapidly changing economic environment, as earlier had been the case in central Europe. The resulting economic disruptions—including the large declines in output, high inflation, and the erosion of the financial position of vulnerable groups—have resulted in severe economic and social strains that have already significantly delayed reform in most countries of the former Soviet Union and, in some cases, threaten to derail the process. To alleviate the impact of the transition process, Russia received official external financing in 1992 and 1993 totaling almost $38 billion (Table 17); in addition, Germany provided grants of more than $3 billion, and there was a further $16 billion in commercial debt-service deferral. Official financing was conditional on the implementation of appropriate macroeconomic stabilization policies, and much of the difference between the announced amounts and those actually disbursed—some $17 billion over the two years—is related to the failure to put these policies in place.

Table 17.Russia; Official Financial Assistance(In billions of U.S. dollars)
Bilateral creditors and European Union2111410621203
Conditional IMF financing
IMF facilities3178
IMF stabilization fund4666
World Bank and European
Bank for Reconstruction and Development5½5½
Official debt relief5151561515
Sources: Russian Federation Ministry of Finance; Vneshekonombank; U.S. Administration press release of April 2, 1992; Chairman’s statement of the G-7 Joint Ministerial Meeting and the Following Meeting with the Russian Ministers of April 15.1993; Tokyo Summit Economic Declaration of July 9, 1993; and IMF staff estimates.

Excludes most double counting (that is, amounts announced but not disbursed in 1992 and announced again in 1993). A small amount of double counting in the two-year total may nevertheless persist.

Does not include grants from Germany of more than $3 billion to rehouse Russian troops.

Excludes some items in the announced packages for which reliable data are not available (technical assistance, nuclear facility rehabilitation, and the like).

The $6 billion stabilization fund was potentially available in both 1992 and 1993 to help stabilize the ruble in the context of a comprehensive reform strategy. It was not activated because the appropriate conditions were not in place.

This amount was not formally granted during 1992.

Includes $6½ billion deferred or in arrears in 1992.

Sources: Russian Federation Ministry of Finance; Vneshekonombank; U.S. Administration press release of April 2, 1992; Chairman’s statement of the G-7 Joint Ministerial Meeting and the Following Meeting with the Russian Ministers of April 15.1993; Tokyo Summit Economic Declaration of July 9, 1993; and IMF staff estimates.

Excludes most double counting (that is, amounts announced but not disbursed in 1992 and announced again in 1993). A small amount of double counting in the two-year total may nevertheless persist.

Does not include grants from Germany of more than $3 billion to rehouse Russian troops.

Excludes some items in the announced packages for which reliable data are not available (technical assistance, nuclear facility rehabilitation, and the like).

The $6 billion stabilization fund was potentially available in both 1992 and 1993 to help stabilize the ruble in the context of a comprehensive reform strategy. It was not activated because the appropriate conditions were not in place.

This amount was not formally granted during 1992.

Includes $6½ billion deferred or in arrears in 1992.

Box 11.Exchange-Rate-Based Stabilization

The nominal exchange rate has been frequently used as an anchor in disinflation programs, particularly in high-inflation countries. Experiences with exchange-rate-based stabilization range from the post-World War I European hyperinflations to the recent, currency-board-type arrangements in Argentina and Estonia. Both successful and unsuccessful programs have been extensively analyzed, often with the help of theoretical models, in search of common patterns and lessons for the design of future programs.1 Although there obviously are differences in underlying details relevant to individual countries, this research has identified six broad lessons.

1. Budgetary control is a necessary condition for successful stabilization. Large fiscal and quasi-fiscal deficits are the fundamental driving force behind sustained high inflation. In high-inflation countries, attempts to stabilize prices without attacking the fiscal deficit have enjoyed only temporary success at best. The fiscal adjustment should also be viewed by the public as sustainable over lime. The eventual failure of the Argentine austral plan in the mid-1980s, for instance, is attributable to the temporary and partial nature of the fiscal adjustment. Structural reforms in other areas have also contributed to enhance the sustainability and credibility of the fiscal adjustment, as has been the case in Chile, Mexico, and, more recently, Argentina.

2. Abundant official foreign financing is not essential. Assuming that the fiscal situation is brought under control, experience shows that external financing is not essential, although it may be important as a signal of international support, and in some cases a sizable reserve cushion has proved to be useful by reinforcing the credibility of the exchange rate peg. The League of Nations played a major role in the stabilizations of the 1920s, but official external financing was not such an important factor in the recent stabilizations in Argentina, Bolivia, and Mexico. Moreover, under the currently prevailing conditions in international financial markets, the potential for private capital flows (including the return of flight capital) appears to be considerably larger than the potential for official financing.

3. Using the exchange rate as the nominal anchor has been most successful under hyperinflationary conditions.2 During hyperinflations, nominal rigidities and backward-looking indexation usually disappear. Most nominal prices are quoted in foreign currency. Hence, fixing the exchange rate immediately stabilizes prices, which explains why in most successful stabilizations inflation has come down virtually overnight. Furthermore, the absence of nominal rigidities implies that disinflation may take place with relatively small real costs.

4. Exchange-rate-based stabilizations have also been successful in situations of chronic inflation, but inflation inertia can be a major obstacle. In countries with a history of high but relatively stable inflation, wide-spread indexation in goods and financial markets imparts a high degree of inertia to inflation. Fixing either the level or the rate of change of the exchange rate does not usually have an immediate effect on inflation, thus leading to real appreciation and often unsustainable trade deficits. Therefore, incomes policies have sometimes been used to break the wage-price spiral, as in the successful Mexican and Israeli plans, although structural reforms such as the elimination of indexation in Argentina may make incomes policies unnecessary.

5. The costs of failure are high. Fiscally unsound programs that have relied on a fixed exchange rate—and, in many instances, on incomes policies as well—have achieved only a temporary reduction in inflation. When such programs eventually fail, inflation normally comes back with a vengeance, surpassing its initial level. During the second half of the 1980s, countries such as Argentina and Brazil went through a succession of failed exchange-rate-based programs, with inflation reaching a higher plateau after each failure. Failed programs, whether exchange-rate-based or money-based, erode credibility in future programs, increase the public debt, and may have a high cost in terms of international reserves.

6. Disinflation can have real effects. Given full credibility and the absence of nominal rigidities, fixing the exchange rate may stop inflation in its tracks with little real effects, as has been the case in several hyperinflations. In chronic-inflation countries, however, the real effects tend to result in an initial boom, led by consumption spending (often motivated by imperfect credibility), followed by a recession stemming from the cumulative effects of a real exchange rate appreciation. This contrasts with money-based stabilization, where the recessionary costs of disinflation occur early. In this sense, choosing between the exchange rate and a monetary aggregate as the nominal anchor in a disinflation program may imply choosing not if, but when, the recessionary costs will be paid.

In conclusion, as long as a credible sustainable fiscal adjustment is put in place, an exchange rate anchor can enhance the credibility of stabilization programs, particularly when monetary discipline is supported by institutional arrangements such as an independent central bank or a currency board, and by other structural reforms. An exchange rate anchor appears to have been particularly effective in hyperinflationary situations, where there is little inflation inertia and the gravity and nature of the problem are usually clear to everyone. In the presence of inflation inertia—as is often the case in situations of chronic inflation—an exchange-rate-based disinflation program is likely to result in significant output losses.

1 See, for example, Guillermo Calvo and Carlos A. Veégh, “Inflation Stabilization and Nominal Anchors,” IMF Papers on Policy Analysis and Assessment 92/4 (December 1992); Carlos A. Végn, “Stopping High Inflation: An Analytical Overview,” Staff Papers (IMF), Vol. 39 (September 1992), pp. 626-95; and Julio A. Santaella, “Stabilization Programs and External Enforcement: Experience from the 1920s,” Staff Papers (IMF), Vol. 40 (September 1993), pp. 584-621.2 For a discussion of the characteristics of hyperinflation and chronic inflation, see Box 8 in the October 1993 World Economic Outlook, pp. 92-95.

To an even greater extent than had been the case in central Europe, most countries of the former Soviet Union have experienced a steep decline in the large explicit and implicit transfers that had been received from Russia.68 These included fiscal transfers from the former Union budget, which disappeared in 1992, and the subsidy implicit in the under-pricing of energy and raw material exports (relative to world prices), which was reduced significantly as interstate prices for these goods were raised. The effects of these changes were partially alleviated by new financial transfers extended by Russia, mostly by the Central Bank of Russia through its correspondent accounts during 1992 and early 1993, and by a buildup of unpaid claims by Russian enterprises on companies in other countries of the former Soviet Union. As a result, transfers from Russia to the other countries of the former Soviet Union (except the Baltic states, which received virtually no new transfers from Russia in 1992-93) were still some 10 percent of Russian GDP in 1992, and about 20 percent of the combined GDP of the other countries. Important trade subsidies in 1992 amounted to around 5 percent of Russian GDP, evaluated at the average real ruble exchange rate in 1993. These still-large transfers were reduced in 1993 as the Russian authorities further increased energy and materials prices toward world levels and reduced interstate credits, and they are expected to decline again in 1994.

Between 1992 and 1994 the loss of official transfers from Russia and the rise in the import bill—on the assumption that energy and materials prices rise to world levels—may cost the countries of the former Soviet Union other than Russia $15 billion, or about 15 percent of their estimated 1994 GDP (at market exchange rates). Although adjustment to this shock is inescapable, additional financing would allow it to be more orderly. It is estimated that, broadly speaking, every additional $1 billion of external balance of payments financing could diminish the projected near-term decline in output in these states by about 1½ percentage points, by allowing less compression of imports of intermediate inputs. It seems likely that in the short run this assistance wilt have to come largely from official bilateral and multilateral sources. Such financing could be complemented by sectoral loans linked to efforts to raise productive efficiency, particularly with regard to energy use. Consultative groups have been organized to pledge additional financial support for reform programs backed by the IMF and the World Bank for Moldova, Kazakhstan, and the Kyrgyz Republic. In the case of Kazakhstan, over $1 billion was pledged in early 1994, a substantial part by Japan as financing complementary to a systemic transformation facility (STF) program with the IMF. Because Russia has an interest in the successful transformation of the other countries of the former Soviet Union, it can play an active role in the consultative groups and other initiatives to provide and coordinate international financial assistance for these countries.

It is difficult to assess the future financing needs of the countries of the former Soviet Union, but for Russia it is clear that a further comprehensive debt-relief package will be needed to normalize relations with external creditors. External financing will also be needed to help these countries to consolidate large budget deficits in a noninflationary manner, and to finance social safety nets. As was the case in central Europe, external financing, both official and private, will be forthcoming—and, indeed, will be helpful—to Russia and the other states of the former Soviet Union only in the context of strong and sustained stabilization and reform programs. Otherwise, foreign lending will tend to increase capital flight and external debt, and to further delay the development of an environment in which a strong private sector can emerge. Poland in the 1980s is a striking example of how external flows can slow economic reform and raise the burden of external debt. In contrast, Poland’s more recent experience, and that of other central European and Baltic countries, demonstrates the effectiveness of strong domestic policies assisted by conditional external financial support.

Priorities for Reform

The difficult process of transition from centrally planned to market economies is now well under way in many countries and, in most important respects, is essentially irreversible. Some countries, including most of those in central Europe, and especially Hungary, embarked on this process earlier than the countries of the former Soviet Union. Others, such as the Baltic states, have made rapid progress by pursuing reform consistently and vigorously. The results of the differing transition strategies allow the identification of priorities for ongoing reform.

Perhaps the most fundamental observation is that very expansionary monetary and fiscal policies-such as those followed by Belarus, Russia, and Ukraine—have not significantly mitigated the large declines in output that have been associated with the transition process. Instead, such policies have aggravated already difficult economic and social conditions by fueling high and unstable inflation—bordering on hyperinflation in some countries—that in turn has stimulated capital flight, discouraged needed foreign investment, and slowed adjustment. In contrast, the economies that have been successfully stabilized are now beginning to grow again. These gains need to be consolidated and any inflationary pressures that may arise need to be quickly contained.

In those countries where macroeconomic stability has not been achieved, the transition process is proving unnecessarily protracted and costly. In these countries—especially Russia, because of its size—the first priority should be to eliminate the underlying sources of inflation by sharply reducing budget deficits and reining in credit growth. Progress on this front will require lax reform to enhance revenues and to reduce distortions, and expenditure reform to reduce subsidies and to target social assistance more effectively. Eliminating excessive credit growth will require allowing financial markets, rather than central banks, to allocate credit at market-determined interest rates.

All countries in transition still face a daunting agenda of structural reform, despite the considerable strides that have already been made. By reducing economic distortions and freeing resources for productive activity, these reforms are crucial to the medium-term prospects for economic growth. A priority in the countries of the former Soviet Union, except the Baltic states, is the elimination of the system of state orders, bilateral trading arrangements, barter agreements, and export controls and tariffs. These distortionary measures should be replaced with more uniform tariff structures at low rates, a workable interstate payments system, and an MFN-based trading system.

Box 12.Measurement of Aggregate Output in Countries in Transition

The economies in transition have undergone dramatic changes in recent years. Because of the limitations of available economic statistics, however, it is difficult to assess the extent of the macroeconomic effects of the adjustment process. Indeed, it appears likely that the size of the initial output decline may have been overstated by official statistics and, conversely, that the strength of subsequent recoveries is likely to be understated.

Under central planning, the primary task of official statistical agencies had been to monitor state enterprise behavior, especially compliance with plan targets. As a result, information was, and in most countries still is, based on reports by individual enterprises, rather than on economy-wide surveys. The emphasis was on the “socialist sector”—state enterprises, cooperatives, and the government—and the private sector was, in general, excluded. The statistics also emphasized industrial, physical, and quantitative output measures; the concept of net material product, as opposed to GDP, excludes “non-material” services such as education, health care, administration, and private services. Finally, under central planning enterprises had an incentive to report exaggerated increases in real production, either through outright misreporting or by describing price increases as reflecting quality—and, hence, quantity—increases.

The key problem with measuring real output during the transition is that economies are changing rapidly in just the ways that the traditional statistics were not designed to capture. Relative declines in traditionally favored activities, such as state-owned industry, have been accompanied by growth in areas previously neglected by the statistical system, such as private services. This results in an underreporting of private sector growth and an exaggeration of the weakness of overall economic activity and of the decline in living standards.

These types of measurement problems have been most thoroughly documented for Poland at the outset of its transformation program.1 For example, the traditional measure of supply—sates plus imports minus exports—had been collected from retail establishments in physical quantities for a variety of goods. A comparison of these data with those from household surveys on consumption, a measure that is less likely to understate the role of new private shops and other retail outlets, yields remarkable differences: butter supply in 1990 is reported to have fallen by 16 percent compared with 1989, but consumption increased by 4 percent; there was a reported 22 percent decline in bread supply, but only a 5 percent decline in bread consumption. A further indication of the importance of underreporting of private sector activity is provided by a comparison of reported output growth with employment. In Poland, the private sector component of construction activity fell by 7 percent in 1990 in real terms, but employment rose by 4 percent. Similarly, private sector trade grew a reported 102 percent, but employment grew by 408 percent in that sector.

There also appears to have been substantial under-reporting of international trade as existing statistical systems designed to monitor the activities of a small number of state trading organizations were over-whelmed by the explosion of small-scale private trading activity. In 1990, the volume of European Union exports to Poland, as reported by the exporting countries, was 43 percent higher than that reported by official Polish data; the discrepancies were much smaller before the transition process started in earnest—14 percent in 1988 and 18 percent in 1989. For Polish exports, the rate of underreporting, also measured by comparison with available partner-country data, was 7 percent in 1990 and essentially zero in 1988 and 1989. This problem appears to have been mitigated by the introduction of a customs-based data collection system in 1991, Similar reporting problems, however, remain acute for Russia and some of the other transition countries.

In addition to direct underreporting of activity, the transition raises an intractable index number problem. An index of total real output requires a comparison of the values of different physical outputs. In a market economy, the prices of goods provide the measure of their relative values and are used to construct output indices. In a transition economy, however, prereform prices did not reflect the relative values of different goods. Although prices tended to reflect production costs, these costs themselves did not reflect relative scarcities. Moreover, unlike in a market economy, there were no mechanisms to bring relative costs into line with the value to consumers of the output.

One indication of the importance of relative prices in measuring aggregate real output can be found in estimates of the decline in real GDP in Russia in 1992. The official estimate, computed at 1991 prices, is a decline of 18.5 percent. But at 1992 prices, the measured decline would have been about 16 percent, and at world prices it would have been about 14 percent. These differences are largely attributable to the very low domestic price of energy products in 1991, compared with 1992 prices in Russia and with world energy prices. Since decline in the real output of energy products was relatively mild, the underpricing in 1991 results in an excessively low weight for this sector in the aggregate.2 Moreover, because the analysis behind these estimates was carried out at a relatively aggregate level, it does not capture all the index number bias; nor does it address the underreporting problem. Another example of the problem of mismeasured prices is the apparently large declines in inventory stocks recorded in Poland, which were substantially overestimated in official data owing to inadequate adjustment for inflation.

In addition, it is not clear how to value the large number of new goods and services that had not previously been produced, or those that are no longer produced at all. A closely related problem is adjusting for quality changes; although this is a problem in all countries, it is particularly severe in the countries in transition, where large changes in the quality of goods are pervasive. New goods of higher quality and the end of shortages imply higher standards of living and, in the case of capital goods, more efficient investment. Before liberalization, some production could not be sold but was nevertheless counted as output. After liberalization, production of this sort stopped, and measured production fell. But because these goods had had no true economic value before liberalization, the cessation of their production should not have been counted as a reduction in output.

There is very little direct evidence about the magnitude of these measurement problems, but it is clear that the errors are potentially large, even relative to the substantial declines in real output that have been reported. As regards direct underreporting, attempts have been made to use indicators that are less biased against new activities than the traditional statistics, such as data from household consumption surveys, which do not suffer from undercoverage of sales from private sector retailers. One study has suggested that Polish real GDP fell between 5 percent and 8 percent from 1989 to 1990, with consumption falling substantially less than GDP; this compares with official estimates of a 12 percent decline in GDP.3 Another study examined a variety of statistical problems with Polish data and concluded that the cumulative fall in real output from 1989 to 1992 was about 5 to 10 percent, in contrast to the 18 percent decline recorded officially.4

At a minimum, it is clear that any user of official statistics must be extremely cautious and should keep in mind the sources and coverage of the data. More generally, broad conclusions about the impact of economic reform programs in the countries in transition, and especially conclusions about the effects of reforms on real standards of living, need to take account of the potentially large measurement problems.

1 See Andrew Berg, “Measurement and Mismeasurement of Economic Activity During Transition to the Market,” in Eastern Europe in Transition; From Recession to Growth? edited by Mario Blejer and others, World Bank Discussion Papers, No. 196 (Washington, 1993), pp. 39-63; and Andrzej S. Bratkowski, “The Shock of Transformation or the Transformation of the Shock? The Big Bang in Poland and Official Statistics,” Communist Economies and Economic Transformation, Vol. 5. No. 1 (1993), pp. 5-28.2 See Kent Osband, “Index Number Biases During Price Liberalization,” Staff Papers (IMF), Vol. 39 (June 1992), pp. 287-309; and Vincent Koen, “Measuring the Transition: A User’s View on National Accounts in Russia,” IMF Working Paper WP/94/6 (January 1994).3 Andrew Berg and Jeffrey Sachs, “Structural Adjustment and International Trade in Eastern Europe; The Case of Poland,” Economic Policy, Vol. 14 (April 1992), pp. 117-73.4 Zenon Raweski, “National Income,” in Results of the Polish Economic Transformation, edited by L. Zienkowski (Warsaw; Glowny Urzad Statystyczny/Polish Academy of Sciences, 1993).

Privatization and enterprise reform, which are proceeding more slowly in most countries than had been anticipated, are central to the establishment of market economies. The experiences of the Czech Republic, Slovakia, and Russia have shown that mass privatization through vouchers can be rapid, and several other countries have begun or are considering voucher schemes. The pace and scope of privatization should generally be strengthened, particularly to include the large enterprises. Land reform, including liberalized real estate markets and the privatization of agricultural land, should also be speeded up in most countries.

To reap the benefits of privatization, it will also be necessary to strengthen enterprise governance and market incentives in general. The newly privatized enterprises and the growing number of newly established private firms need an appropriate legal, regulatory, and financial framework that provides market incentives for responsible management behavior. Fundamental aspects of commercial law, such as ownership and bankruptcy, must be clarified. Strengthening the financial sector would improve enterprise governance by subjecting managers to closer scrutiny by stakeholders.69 The asset positions of banks should be bolstered, in many cases through mergers and restructuring, and the financial sector should receive adequate regulatory supervision. The development of regulated and liquid equity markets would improve the allocation of scarce financial resources by providing market-based information on the value of enterprises; it also would subject managers to shareholder discipline.

The decline in output during the transition period has put great strain on social, economic, and public institutions. Although the decline in average living standards has probably been significantly less than the fall in measured output (Box 12), some—such as the old. the unemployed, and the unskilled—have been exposed to severe hardship as inflation has eroded the real value of pensions, unemployment benefits, and minimum wages. In general, the patchwork of enterprise-provided social services that prevailed under central planning has not been replaced by adequate alternatives, and the absence of a social safely net has deterred firms from shedding labor. There is an urgent need to maintain the purchasing power of many benefits in the face of inflation, and to better target benefits by overhauling eligibility criteria and benefit structures, while keeping expenditures at levels consistent with sustainable budgetary positions.

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