United Nations Development Programme
Macroeconomic stabilisation and currency crises in transition economies
Ben Slay March 2009
Overview This paper is intended as a short primer on problems of macroeconomic stabilisation in transition economies in general, and in response to currency crises and the current global economic crisis in particular. Reference is to the policy challenges posed in particular by two sorts of macroeconomic instability: Financial instability of the 1990s, in the form the high inflation rates and sharp declines in GDP, incomes, and exchange rates that afflicted nearly all the transition economies of Europe and Central Asia during the early 1990s, with the collapse of socialist economic planning institutions and dissolution of the integrated Soviet, Yugoslav, Czechoslovak, and COMECON economic spaces; and The global economic crisis of 2008-2009, which has generated sharp exchange rate devaluations/depreciations, and pushed most of the transition economies of Europe and Central Asia into recession.
Currency crises and macroeconomic balance A macroeconomic crisis can be said to occur, and a macroeconomic stabilisation programme is needed, when macroeconomic balance—consistency between aggregate demand and supply—is lost. Internal balance refers to the demand (or spending) by domestic economic actors and the supply of domestically produced goods. When the former exceeds the latter in significant amounts for significant periods of time, inflation results; when the latter exceeds the former in significant amounts for significant periods of time, deflation (falling prices) or disinflation (falling rates of inflation) and recession (declines in production, incomes, consumption, and employment) result. Both outcomes are generally undesirable from a poverty-reduction vantage point. Inflation tends to reduce the real incomes of poor and vulnerable households, who typically don’t have the labourmarket positions or access to the financial instruments needed to protect their nominal incomes from inflation. Declines in production, incomes, and consumption increase income poverty almost by definition. They also reduce the state budget resources needed for the provision of social services to address the non-income dimensions of poverty (e.g., access to quality education and health care). External balance refers to the reality that, in the globalised world, demand for a given economy’s goods and services is determined in part by spending in other countries (exports), while supply is determined in part by imports from other countries. The exchange rate, showing how many units of domestic currency are needed to purchase a unit of foreign exchange (dollars, euros)
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is critically important in terms of external balance. The stronger the exchange rate is (i.e., the fewer units of domestic currency are needed to purchase a dollar or euro), the more easily goods and services can be purchased from other countries. Everything else equal, stronger exchange rates (assuming they are sustainable) are good for human development, as they mean that low-income households can afford imported goods (e.g., food, medicines) and services (e.g., access to foreign education institutions) that would otherwise be unaffordable. Exchange rates are determined by the demand for and supply of foreign exchange. These can be understood as being determined by the imports and exports of goods and services (which are shown in the current account of the balance of payments), as well as by capital flows (which are shown in the financial account of the balance of payments).1 If the rest of the world wants to buy a lot of your exports, or invest a lot of money in your country (or if your migrant workers send home lots of remittances), then the supply of foreign exchange will rise relative to the demand, and the exchange rate will appreciate; your currency will strengthen. The relationship between internal and external balance can be represented by the following national income accounting identity: (1) GDP = C + I + G + X – M, where • • •
• • •
GDP = gross domestic product (the market value of the final goods and services produced in a year); C = consumption (the market value of consumption spending by households for domestically produced goods and services); I = investment (spending by households and businesses on new buildings, factories, and productive equipment produced in your country, as well as changes in inventories of goods already produced); G = government spending on goods and services produced in your country; X = exports (spending by residents of other countries on goods and services produced in your country); and M = imports (spending by households, businesses, and government on consumer and investment goods and services produced in other countries).
If GDP is taken as what the economy supplies and C + I + G + X – M is taken as what is demanded, then expression (1) shows demand and supply balancing, both internally (C + I + G) and externally (X – M). If planned spending exceeds planned GDP, prices will tend to rise (i.e., inflation results or accelerates); higher prices help to increase domestic production and imports (which become less expensive than domestically produced goods), bringing the economy back into balance. Expression (1) can be rewritten as: (2) Supply (GDP) = domestic demand (C + I + G) + external demand (X – M) Expression (2) shows that what the economy produces gets distributed across domestic and foreign demanders. It can also be rewritten as: (3) Domestic demand (C + I + G) = GDP + M – X Expression (3) shows that more domestic spending—which probably means higher welfare and less poverty, at least in the short term—can be supported either by goods and services produced
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Remittances appear in the current account, either as payment for services rendered by migrant labourers or as “transfers”. Official development assistance (ODA) also appears in the transfer balance of the current account.
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domestically (GDP) or in other countries (M – X). If we want to reduce poverty, we want M – X to be as big as possible—but sustainably so. M – X—the difference between the imports and exports of goods and services—can be seen as a proxy for the current account of the balance of payments (BoP). The BoP is also an identity, which can be represented as follows: (4) BoP = Current account – Financial account = 0 where the financial (or capital) account shows the difference between capital/assets acquired in/from other countries by your citizens (including foreign exchange), and capital/assets acquired in your country by citizens of other countries. Whereas the former is a capital outflow, the latter is a capital inflow. Expression (4) can be rewritten as: (5) Current account = Financial account, or (6) M – X = Capital inflows – Capital outflows This shows that a current account deficit (M – X) must be offset by capital inflows of the same magnitude. Conversely, if capital inflows stop, the balance of payments becomes dominated by capital outflows (e.g., debt repayment, investment abroad, capital flight). Substituting expression (6) into expression (3) gives is: (7) Domestic demand (C + I + G) = GDP + Capital inflows – Capital outflows Why is this important? Large net capital outflows force M to be smaller than X; they force a country’s domestic spending to be less than what it produces. This is not good for poverty reduction. Resources that could provide food, medical services, or better education services for poor households are instead devoted to production of export. Capital flows come in two forms: debt, and equity. Net inflows of debt capital (e.g., foreign trade credits, loans, bond purchases) increase the foreign debt; these have to be repaid. By contrast, net inflows of equity (e.g., purchases of stocks, land, real estate, or plant and equipment by foreign investors) do not increase the foreign debt. In most transition economies of Europe and Central Asia, foreign direct investment (FDI)— the acquisition of currently existing land, real estate, or plant and equipment, or the construction of new plant and equipment—is the most common form of foreign equity investment. One of the reasons why attracting FDI is so important is that it finances current account deficits without increasing the foreign debt.2 Expression (7) can therefore be rewritten as: (8) Domestic demand = GDP + Net foreign equity investment + Net foreign debt investment, or (9) C + I + G = GDP + Net foreign equity investment + ∆ Net foreign debt 2
In contrast to foreign equity portfolio investments (e.g., stocks), FDI once completed is immobile; the owners can’t “dump it” at the first sign of trouble.
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(where the symbol ∆ means “change in”). Expression (9) can be taken as the expression for internal and external balance. It shows how developments in the domestic economy affect the balance of payments, and vice versa. This expression can be seen as a formal way of saying: “If you want to spend more than you produce, you have to get someone else to lend to you, or invest in you. If the foreign lending and investments shrink, so will your spending.”
Currency crises: Bad news for poverty reduction Expression (9) underscores the importance of the exchange rate in maintaining external balance. If foreign investors become less interested in investing in your country, this reduces capital inflows and the amount of foreign exchange available will shrink. Since current account deficits often mean the accumulation of foreign debt, and repaying foreign debt means large capital outflows (and large demands for foreign exchange), current account deficits that are judged by investors as “too large” are a common cause of shrinking capital and foreign exchange inflows. Less foreign exchange puts downward pressure on the exchange rate (i.e., more units of domestic currency are needed to purchase a dollar or euro), making imports more expensive and exports more competitive on foreign markets. If the foreign debt that is incurred to finance the current account deficit is denominated in foreign currencies—if banks, companies and households borrow in dollars, euros, or Swiss francs—the costs of servicing and repaying foreign debts rise, putting additional strains on the domestic economy. Reductions in the current account deficit (M – X) reduce domestic demand and living standards, increasing poverty. This happens both directly (by reducing other countries’ willingness to finance domestic spending that is greater than what is produced domestically) and indirectly, by reducing GDP (via the higher costs of purchasing imports and producing goods that have imported components). The associated depreciation/devaluation in the exchange rate also requires that more resources be set aside for servicing and repaying foreign debts; fewer resources are left over for health care, education, and social protection. A sharp decline in the exchange rate may restore external balance, but from a socioeconomic point of view, it is something to be avoided. When this happens, it’s called a “currency crisis”.3 Preventing these, or mitigating their socio-economic effects, are major goals of macroeconomic stabilisation. Currency crises only stop when the exchange rate falls to a level at which the demand for foreign exchange is brought into balance with its (typically much reduced) supply. Stabilisation programmes can be seen as efforts by governments and central banks (supported by international financial institutions and donor countries) to limit the drop in the supply of foreign exchange as much as possible, in order to prevent domestic demand from dropping too far. In order to achieve this goal, a stabilisation programme has to be credible, in order to convince investors not to “dump” their investments in your country (and your currency). Maintaining or attaining this credibility may require the introduction of policies to limit domestic demand, in order to limit the demand for foreign exchange and remove or lighten downward pressures on the exchange rate.
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This is a very brief treatment of more complex phenomena that have spawned a very large literature. For a quick introduction to this literature and its associated issues written in the wake of the 1997-1998 Asian financial crisis, see Paul Krugman at (http://web.mit.edu/krugman/www/crises.html).
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Macroeconomic imbalances in Europe and Central Asia during the 1990s The post-communist transition economies that emerged from the wreckage of the USSR and former Yugoslavia during the first half of the 1990s faced a number of threats to internal and external balance. These included the following: Large inherited internal imbalances. Most of these countries inherited deep imbalances from the pre-transition system. These imbalances were primarily of an internal nature: aggregate demand (incomes and spending) was growing much faster than aggregate supply (output), putting sustained upward pressures on prices. These imbalances often resulted from irresponsible or dysfunctional fiscal and monetary policies pursued during the last months and years of the old system. Supply shocks. These imbalances also reflected strong supply shocks—factors that reduced aggregate supply. For the Soviet and Yugoslav successor states, these included the dissolution of what had been unified economic spaces and the consequent disruption of numerous enterprise supply/production relationships.4 For other post-communist countries, these shocks included the collapse of the CMEA and the end of cheap imports of energy and raw materials from the USSR. Military conflicts in the Yugoslav successor states, Tajikistan, the Caucasus, and Moldova were also supply shocks. Redundant production capacity. The liberalisation of prices and commercial activities in the early and mid-1990s showed that many enterprises and industries destroyed value, rather than creating it.5 The revealing of this redundant production capacity further exacerbated the gap between aggregate demand and supply. Immature economic policy institutions. The dissolution of the USSR, Yugoslavia, and Czechoslovakia meant that the region in the early 1990s was full of new states with weak or nonexistent macroeconomic policy institutions. Many did not have their own currencies, functioning national banks, or state treasuries. They did not (some still do not) fully control their borders, making trade policy and collection of tariffs quite difficult. Many also did not (some still do not) possess the technical/analytical expertise necessary to draft a workable macroeconomic stabilisation programme. Most of these countries began the transition with low external creditworthiness; inflows of private capital (as opposed to capital flight) for most of these countries were very small. In contrast to the situation today, export performance and concessionary finance (from the IMF, World Bank, and large bilateral donors) were the primary determinants of these countries’ ability to finance imports and allow for growth in domestic demand and living standards. The high (or hyper- ) inflation occurring in these countries in the early and mid-1990s essentially precluded economic growth and was a major cause of increases in poverty that occurred during this time. International experience shows that countries with annual inflation rates above 3040% rarely experience sustained economic growth.6 Likewise, economies with triple- and quadruple-digit annual inflation rates frequently experience sharp declines in GDP. High inflation 4
These problems also occurred with dissolution of Czechoslovakia in 1993. That is, when valued at prices reflecting world market forces, the prices at which goods produced by these companies and sectors were sold were less than the costs of purchasing the intermediate products (components, raw materials) needed to produce them. 6 Turkey was something of an exception to this pattern during the 1980s and 1990s. During this time Turkey reported rapid GDP growth, even though annual inflation rates were generally well above 40%. Starting in 1999, however, a growing public debt and the decision to pursue closer European integration led Turkey to abandon this approach. The authorities during this time had to make major efforts to avoid defaulting on the country’s public debt by bringing inflation and interest rates under control. The resulting austerity policies were one of the factors causing GDP to decline sharply during 1999-2001. 5
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rates make it hard for firms and households to recognise the changes in relative prices that drive efficient resource allocation in a market economy. They discourage saving and investment, and encourage asset stripping and other forms of “short-termism” by managers and owners. High inflation rates also generate self-fulfilling expectations of continued inflation. Workers demand higher wages to protect their real incomes; households “buy now before the price goes up again”; banks raise interest rates to protect the value of their loan portfolios—all of which drive prices up further. High inflation rates encourage firms and households to abandon the domestic currency for dollars or euros, thereby reducing the ability of policy makers to affect national macroeconomic trends. This “dollarisation” (or “euroisation”) driven by high inflation and financial instability in the early 1990s were accompanied by sharply depreciating exchange rates. Although these episodes in the region were not usually referred to at the time as “currency crises”, they could have been. The main difference between these episodes and more “classical” currency crises was that the people dumping the rouble and dinar were not foreign investors but domestic actors: households who wanted to hold their savings in dollars or deutsche marks, and needed foreign currency to purchase cars and apartments; and companies, who wanted to get their profits out of the country before they could be confiscated by state authorities or the mafia. The economic recoveries that took hold in the region once the high inflation rates were brought down likewise had their exchange rate dimensions. The appearance/return of (some amount of) confidence in domestic currencies convinced businesses to repatriate some of their flight capital, and households to make less use of dollars and euros for savings and purchases of assets and consumer durables. Foreign investors likewise began to taken increasing interests in the region’s “emerging markets”, so that capital inflows from concessionary lending and repatriated flight capital was increasingly supplemented by foreign direct and portfolio investments. Growing net private capital inflows made possible rapid growth in GDP and domestic demand, helping to reduce poverty and restore living standards. Net capital inflows put upward pressures on exchange rates, causing one of two things to happen. In some countries, nominal exchange rates were allowed to appreciate, helping to put further downward pressures on inflation.7 In other countries, exchange rates were held stable as central banks purchased the foreign exchange inflows with domestic currency. In these cases, upward pressures on the exchange rate took the form of rapid monetary growth that produced greater inflation than would otherwise be the case. This was particularly the case in economies where the exchange rate could not be changed, either because the euro had been adopted as the official currency,8 or because the domestic currency is constitutionally tied to the euro in a way that precludes (or significantly limits) the central bank’s abilities to change the exchange rate (e.g., via a currency board arrangement).9
Macroeconomic imbalances, stabilisation, and austerity Because aggregate demand was growing rapidly while aggregate supply was shrinking and prices were soaring, stabilisation programmes in the 1990s focused on slowing growth in demand, in order to bring it into line with supply. When supply shocks caused aggregate supply to fall, stabilisation meant that (sometimes considerable) reductions in demand were necessary to restore 7
The Slovak koruna (skk) appreciated from a rate of $1 = 50skk in mid-2001 to a rate of $1 = 19skk, prior to Slovakia’s adoption of the Euro in January 2009. 8 At present, the euro is the official currency in Cyprus, Kosovo, Malta, Montenegro, Slovakia, and Slovenia. In principle, all the new EU member states are obligated to adopt the euro, once the Maastricht requirements for euro adoption have been met. 9 At present, currency board regimes are in place in Bosnia and Herzegovina, Bulgaria, Estonia, Lithuania, and (arguably) Latvia.
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internal balance. Significant reductions in demand also signalled a commitment to ending inflation and free-falling exchange rates, thereby breaking self-fulfilling inflationary expectations. Four sets of instruments are used in constructing stabilisation programmes: Monetary tightening. International experience shows that high inflation is almost always caused by rapid growth in the money supply. Slowing inflation therefore means slowing (tightening) the rate of monetary growth. Increases in key interest rates controlled by the central bank to levels above inflation, in order to reduce demand for money and credit, are usually part of a monetary tightening. Slower monetary growth and higher interest rates mean weaker domestic demand, in the form of less consumption and investment spending. Fiscal adjustment. Because the monetisation of government budget deficits (the difference between government revenues and spending) is a primary cause of rapid monetary growth, a fiscal adjustment must usually accompany a monetary tightening. A fiscal adjustment typically takes two forms. First, it reduces government spending or increases taxes, thereby reducing domestic demand. Second, in addition to the government budget, fiscal adjustments typically focus on so-called “quasi-fiscal deficits”. These take the form of deficits on off-budget state funds (e.g., pension funds) and losses made by state-owned enterprises. While such deficits may not transparently appear as shortfalls in state finances, they constitute claims on the state that often lead to additional monetary emissions and higher inflation. In many CIS and some Western Balkan economies, losses by stateowned energy companies are a major source of fiscal imbalance—as well as of unsustainable energy use. Planned devaluation. Stabilisation programmes often seek to “pre-emptively” devalue the exchange rate, particularly if the currency is thought to be “over-valued”. This is intended to prevent the disorder that comes with a currency crisis.10 Incomes policies. Some stabilisation programmes attempt to slow inflation by directly controlling the price of key factors of production. Freezing (or slowing the growth of) tariffs for energy, water, transport, or social services are particularly common forms of incomes policy. Wage growth may also be target for incomes policies: rather than permitting high inflation and growing unemployment to reduce real wages, governments sometimes attempt to slow nominal wage growth by taxing enterprises that grant large wages increases, or setting wages directly in state-owned enterprises. Their advocates believe that incomes policies are made particularly necessary by inflation’s self-fulfilling characteristics. In constructing a stabilisation programme, the following issues must be addressed: Right policy mix? Basic decisions must be made about the mix between these four (fiscal, monetary, exchange rate, incomes) policy elements. So-called “orthodox” stabilisation programmes of the type traditionally supported by the IMF typically emphasise monetary and fiscal adjustment; devaluations are recognised as unpleasant necessities by the time the stabilisation package is being designed. Sometimes a fixed exchange rate (following a devaluation) is emphasised, in order for the exchange rate to serve as a “nominal anchor” that will weaken inflationary expectations. Prior to the 1990s the IMF traditionally opposed the inclusion of incomes policies in stabilisation programmes; 10 Stabilisation programmes sometimes also introduce new administrative restrictions on foreign exchange markets, in order to slow the pace of capital outflows and make it easier for the central bank to set the exchange rate and influence financial markets. Such measures de facto reduce the degree of currency convertibility. The effectiveness and desirability of such controls are a matter of some dispute. However, in contrast to many other aspects of market liberalisation, there is no direct correlation between liberalised foreign exchange markets and successful transition/development experiences. Likewise, despite their extensive economic liberalisations of the past decade(s), China and India have retained more administrative controls over their foreign exchange markets than many transition economies.
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they were seen as distorting market signals and weakening incentives to maintain tight fiscal and monetary policies.11 However, a number of transition economies pursued incomes policies as part of stabilisation efforts in the 1990s, generally with IMF support. Right policy magnitudes? Once the basic decisions concerning the role of these four policy elements in a stabilisation programme are in place, more complex decisions about the magnitudes of the desired policy changes must be taken. These decisions are more technical in nature, and must take into account tensions and feedback loops between the various inter-acting components of a stabilisation programme. Examples of these tensions include the following: •
Magnitude of the devaluation. A devaluation boosts net exports, which improves external balance. But it also adds to inflationary pressures, and raises the costs of foreign debt servicing and repayment. Both of these effects add to government expenditures, thereby necessitating larger cuts in other types of expenditures in order to achieve a given fiscal adjustment.
•
Magnitude of real interest rate increases. Money and credit must be tight, and real interest rates positive, in order to increase the attractiveness of saving in domestic currency (as opposed to dollars or euros), and to encourage enterprises to economise on credit and sell or use goods or resources that would otherwise be kept in inventory. But high real interest rates and tight money also raise the budgetary costs of servicing the domestic debt, and can cause banks to collapse. The former requires a larger fiscal adjustment than would otherwise be the case; the latter can generate a banking crisis.
How much external support? The sharpness of these tensions can be reduced by attracting external financial support. Balance-of-payments financing provided by the IMF reduces the scale of the devaluation necessary to restore external balance. In addition to dealing with the policy “mix” and “magnitude” questions, governments pursuing macroeconomic stabilisation programmes also devote a great deal of time to securing external finance. This is done both by negotiating “bail out” packages from the IMF et al., and by selling off state assets (privatisation) in order to raise additional funds for the state budget and to increase capital inflows that do not increase the foreign debt. This obviously has a very important political dimension. How much domestic support? The logic of external adjustment is pretty merciless. When a country can’t obtain external financing, imports fall, inflation accelerates, and the currency depreciates. Real output, incomes, and spending fall, and unemployment and poverty increase. The social consequences of uncontrolled external adjustment can be very unpleasant, if not catastrophic. The desire to avoid or manage these consequences is precisely what motivates governments to adopt—and the IMF to support—stabilisation programmes in the first place. But even when they succeed in minimising these undesirable socio-economic consequences, stabilisation programmes also make these consequences explicit. Governments and central banks cut expenditures, raise taxes, raise interest rates, and the like. Such policies meet with grudging political acceptance at best, violent opposition at worst. A successful stabilisation programme must therefore have a domestic political component, aimed at minimising or deflecting this opposition. When to reflate? Stabilisation programmes that make progress in restoring internal and external balance face the question of “how much austerity is enough?” Tight fiscal and monetary policies must ultimately be relaxed if economic growth is to resume—as is frequently pointed out the government’s critics. A premature abandonment of austerity can allow inflation to return, however, particularly if expectations of continuing inflation or exchange rate weakness have not yet been extinguished. Moreover, explanations of post-communist recessions that emphasise 11
In contrast to “orthodox” stabilisation programmes emphasising monetary and fiscal adjustment, programmes in which incomes policies play a large role are called “heterodox”.
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insufficient demand often miss the fact that these recessions—and transition as a whole—are supply-side phenomena par excellance. This reflects both the supply shocks mentioned above and the wholesale restructuring of enterprise and financial sectors.
The role of the IMF In light of these problems and many transitions economies’ obvious inability to cope with them alone, the IMF played a key role in designing, implementing, and financing stabilisation programmes during the early and mid-1990s. The IMF is not perfect, but it does possess the world’s best technocratic cadre when it comes to answering difficult technical questions about policy mixes, magnitudes, and when to reflate. The financial resources at the Fund’s disposal can also help soften the trade-offs and tensions inherent in any stabilisation programme. The World Bank and other multilateral lenders and donors often require that an IMF programme be in place before they begin (or continue) lending to a country, allowing the IMF to leverage its lending into larger sums. Also, most transition economies during the first half of the 1990s did not have access to significant amounts of commercial finance (via Eurobonds or commercial bank loans). This further helped the IMF to directly and indirectly control the lion’s share of funds flowing into and out of a given country. The IMF also plays the role of a lightening rod in domestic politics: democratically elected governments can blame unpopular (but ultimately inevitable) austerity measures on the IMF, but still implement them—and (sometimes) get re-elected. The 1998 Russian financial crisis, coming as it did on the heels of the 1997-1998 East Asian financial crises, was widely interpreted as indicating the failure or inapplicability of “Washington consensus”/IMF lending to transition economies. The reality of IMF programmes in Europe and Central Asia has been much more complex; in many respects, a more favourable assessment is in order. Most countries in this region benefitted significantly from IMF programmes in the 1990s; inflation would not have been brought down and economic growth restored without the IMF’s technical and financial assistance. Prior to the developments of 2008-2009, virtually all the new EU member states, Croatia, Russia, Kazakhstan, and other CIS countries had “graduated” from IMF assistance and were able to borrow more cheaply on the international capital markets. At the other end of the spectrum are countries like Turkmenistan, Uzbekistan, and (until recently) Belarus that either did not need external financing (because they traditionally run large current account surpluses and do not have foreign debts to refinance) or were able to get external finance from other sources (e.g., underpriced energy imports and soft loans from Russia). The energy boom of 2004-2008 also allowed Russia and Kazakhstan to amass large holdings of foreign exchange reserves, some of which were in off-shore reserve/stabilisation funds. These reserves allowed Moscow and Astana to pay off their outstanding IMF loans, and have precluded the need to borrow from the IMF since the onset of the global crisis. Moreover, the rapid economic growth and favourable emerging market conditions of the 2000-2007 period allowed many countries that had traditionally been reliant on IMF programmes (e.g., Turkey, West Balkan countries other than Croatia, Armenia, Azerbaijan, Georgia, Kyrgyzstan, Moldova, and Tajikistan) to easily meet programme conditions. Some of these countries chose not renew these programmes when they expired, while continuing to pay down their obligations to the Fund. Furthermore, most of the new foreign borrowing in the region during the last five years has been incurred not by governments, but by companies, banks, and implicitly households (e.g., taking out mortgage loans denominated in foreign currency). These developments do not prove that IMF stabilisation programmes were “wrong”. Many transition economies during the past decade have followed IMF advice and run budget surpluses, in order to reduce inflation and keep public debt dynamics under control. Instead, they indicate that— in the RBEC region (as in many other parts of the world—the IMF was becoming increasingly irrelevant. Governments in effect discovered that, when they followed IMF recipes for fiscal 9
probity, they gained the fiscal space and political leverage needed to ignore the advice of the IMF (and of the World Bank and the international community in general) on governance and regulatory reform, when such proved inconvenient. With a few exceptions, it is fair to say that when the IMF has committed itself to supporting stabilisation programmes in Europe and Central Asia, and when these programmes were actually implemented, they have generally been successful. Still, a successful macroeconomic stabilisation exercise should not be confused with sustainable human development. At best, the former is one of many preconditions for the latter. Moreover, the complexity of the stabilisation challenges facing the IMF and governments the region has grown over time.
Stabilisation during the global economic crisis In contrast to the macroeconomic stabilisation challenges of the early and mid-1990s, the problems posed by the global economic crisis are generally not those of inflation or too much domestic demand. Nor are they problems of overvalued exchange rates or unsustainably large fiscal and current account deficits. They are instead problems of: (a) shrinking external demand, (b) falling prices for exports (“terms-of-trade” shocks), and (c) financial contagion emanating from the world’s leading economies.12 Sharp declines in exchange rates (from $1 = 5.9 hryvnia to $1 = 9 hryvnia in Ukraine during the fall of 2008; or from $1 = 302 dram to $1 = 370 dram in Armenia during March 2009) are the most obvious manifestations of these “new” currency crises. In general terms, the only economies that have not experienced devaluations or depreciations are those that have adopted the euro (Cyprus, Kosovo, Malta, Montenegro, Slovakia, Slovenia) or have currency boards (Bosnia and Herzegovina, Bulgaria, Estonia, Lithuania, and arguably Latvia)—as well as energy-rich Azerbaijan and Turkmenistan. To some extent, these problems were present during East Asian crises of 1997-1998, the Russian financial crisis of 1998, the Turkish currency crises of 1999 and 2001. However, while elements of (b) were present in these earlier episodes, (a) and especially (c) were not. For the European and Central Asia countries, the crisis has meant a “double whammy” of shrinking markets for their exports and shrinking capital inflows. This “double whammy” can be illustrated with the help of expression (9): (9) C + I + G = GDP + Net foreign equity investment + ∆ Net foreign debt For many countries in the region (especially those without strong energy sectors), net foreign equity investment is converging toward 0, while ∆Net foreign debt is negative, as many private sector borrowers are unable to refinance their foreign debt obligations and must repay them instead.13 The declining values of the variables in the right-hand side of expression (9) must necessarily depress the domestic demand variables shown on the left-hand side, reducing private and public consumption and government social services and protection, and increasing poverty. Those governments that have the fiscal space to do have responded trying to increase domestic demand by increasing government spending and consumption spending (via tax cuts). However, variables in the left-hand side of expression (9) can only increase to the extent that variables in the right-hand side of expression increase. Governments (like Russia, Kazakhstan) that 12
In many of the region’s poorer countries, but also in some of the new EU member states, declines in remittance inflows are a fourth manifestation of the global crisis. 13 The foreign exchange reserves amassed by Russia, Kazakhstan, and some other RBEC countries allow them to finance growth in domestic spending by selling these reserves, in order to support the exchange rate and finance budget deficits in a non-inflationary manner. In terms of expression (9), sales of foreign exchange reserves take the form of liquidating claims on other countries, reducing the magnitude of the -∆ Net foreign debt term.
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have stabilisation funds are therefore tapping them. In the new EU member states and other countries where domestic financial institutions are reasonably well developed, banks and other investors are willing to buy the additional public debt needed to finance increases in government spending and tax reductions. But these measures are only cushioning the shock, not reversing it. For many countries—and particularly the region’s poorer ones—running significantly larger fiscal deficits is not an option: lenders (other than the IMF and some bilateral donors) are not willing to supply credits; significant domestic borrowing is precluded by shallow financial systems and high interest rates; and printing money to finance larger fiscal deficits puts downward pressure on the exchange rate and upward pressure on prices—thereby defeating the purpose of the fiscal expansion. Two underlying factors make the problems of external adjustment in the face of the global economic crisis are particularly difficult. There are no good macroeconomic policy solutions. Because the problem is not “too much domestic demand”, austerity is unable by itself to restore internal and external balance. Tighter monetary policies or a weaker currency can make things worse by causing more bank failures and further stressing the financial system. Moreover, if the start of the crisis coincides with high inflation (as is the case in Ukraine, Kyrgyzstan, and Tajikistan), a weaker currency can further boost inflation, aggravating all the other problems. At the same time, reductions in capital inflows are forcing reductions in current account deficits and therefore reductions in domestic demand. Austerity may not help, and may even be dangerous—but it is inevitable. IMF assistance may not be enough. In order to be effective, the IMF’s funds must be used catalytically; they must be leveraged with other monies (e.g., from the World Bank, European Commission, bilateral donors).14 Arranging such “multi-donor bailouts” can be complicated and time-consuming. Moreover, a great deal hinges on the credibility of these programmes, on convincing investors and households that IMF-backed stabilisation programmes have the requisite policy mix and magnitudes. Reductions in this credibility require off-setting increases in the amount of funds at the IMF’s disposal, in order for these programmes to be effective. One unsuccessful IMF programme could dramatically reduce the effectiveness, and increase the costs, of subsequent efforts. In sum, developing and transition economies are at present facing an extremely difficult set of macroeconomic stabilisation challenges. The course and severity of the global economic crisis and its impact on the Europe and Central Asian region are difficult to predict with certainty. It is clear, however, that the scale and complexity of these challenges could easily exceed the technical and financial resources of those global governance institutions (like the IMF) that are charged with responding to them.
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Russia has pledged funds in support of IMF packages for Armenia and Belarus; it has also promised significant financial support for Kyrgyzstan, and offered such for Ukraine.
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