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Taming Inflation in the Transition Economies
Carlo Cottarelli and Peter Doyle
Between 1992 and 1997, most of the transition countries succeeded in getting
inflation under control without evident cost in terms of lost output. An understanding of
the factors behind their success could not only shed light on the transition process but
also yield lessons for other countries seeking to tame inflation.
When the centrally planned economies began to transform themselves into market
economies in the early 1990s, inflation spiked in the context of loose macroeconomic
policies and removal of price controls. In 1992, the median inflation rate was nearly 100
percent in the Central and Eastern European countries, and well over 1,000 percent and
rising in the Baltics, Russia, and other countries of the former Soviet Union. By 1997,
the median inflation rate in both areas had fallen to 11 percent.
Most of the transition countries achieved inflation rates below 60 percent remarkably
quicklywithin six months of taking anti-inflationary measures. In Croatia and
Georgia, inflation rates fell even more rapidly, although in other
countriesincluding Estonia and Ukrainethis initial reduction of inflation took
considerably longer.
Although the drop to 60 percent was rapid in most countries, further declines happened
more slowly in several countries. For example, inflation persisted at moderate to high
levels (between 15 and 60 percent) for more than two years in the advanced
reformersthe Baltic countries and the larger countries of Central Europe. One year
after inflation had fallen below 60 percent, the median inflation rate in these countries
was still roughly 30 percent; five years later, it had fallen to 15 percent. Nonetheless,
with a few exceptionsnotably, Albania, Bulgaria, and Romaniathe transition
countries did not see a resurgence of high inflation during 199297. (At the end of
1995, inflation rates had fallen to 6 percent in Albania and to 35 percent in Bulgaria and
Romania; two years later, they had climbed to 40 percent in Albania, 580 percent in
Bulgaria, and 150 percent in Romania.)
Pros and cons
Initially, the anti-inflationary stance adopted by the transition countries was highly
controversial, for several reasons. First, some observers believed that inflation, though
high, was not unduly costly to output and should therefore not be the main focus of
policy. Second, it was feared that efforts to subdue inflation, even if successful, would
precipitate a collapse of output, which had already contracted more than anticipated.
Third, there was a possibility that attempts to control inflation would weaken already
fragile external balances.
It now appears that these concerns
were unwarranted. There is formal evidence that, controlling for other
factorsparticularly the effects of structural reform and export market growth on
outputinflation above a certain level was associated with output losses in the
transition countries. The data suggest that the threshold for this region is in the low
teens. And the greater the extent to which inflation exceeds that threshold, the greater
the loss of output associated with it. Furthermore, controlling for the underlying
relationship between inflation and output, as well as for the other factors noted above,
the sacrifice ratiothat is, the loss of output associated with disinflationfor
the region as a whole has been zero. Moreover, it is also now clear that there has been no
strong link between disinflation and the external balance. On average, the external
current account balance deteriorated in the years following disinflation efforts, but the
debt-financed external balance did not, because foreign direct investment and other equity
flows filled the gap.
These striking successes call for an explanation. Several factors appear to account
both for the reduction of inflation and for the resilience of output and the external
balance to anti-inflationary measures (see chart).
The context for disinflation
First, the context for disinflation may have been far more propitious than it appeared
at first. Most important, because the transition countries' experience with inflation was
brief, they did not resort to the adaptive measures often seen in countries where
inflation has become a way of lifefor example, backward-looking indexation. The only
countries to rely on backward-looking indexation were Croatia, Poland, and
Sloveniaand Croatia abolished it at the outset of its disinflation efforts. Many
other forms of indexation were present, but they were rarely backward looking and
therefore did not generate inflation inertia. In addition, the fact that the general
public was unaccustomed to high inflation may have reinforced political commitment to
disinflation programs, which were associated in the minds of many with the overthrow of
the old regime. (Support for disinflation was by no means universal in the region,
however, and, in some countries, disinflation still has few supporters.)
Other factors contributing to the unexpectedly favorable climate for disinflation are
related to the small size of the transition countries' financial sectors. At the outset,
financial fragility was a critical concerntwo-tier banking systems were in their
infancy, and banking systems were ill prepared to cope with major relative price changes
and shocks to the price level. And yet this fragility did not impede disinflation. In many
countries, the banking sector was small relative to output, partly as a result of the
inflation that had characterized the early stages of transition. Georgia and Moldova,
where broad money was only about 3 percent and 12 percent, respectively, of GDP in 1994,
present two extreme examples of this. Because many countries had small financial sectors,
there was a limited need for public resources to ensure financial sector resilience in the
midst of disinflation efforts. The financial sector was also not essential to the
transmission of disinflation policy to the real economy. Instead, given that the root of
inflation was fiscal in most countries, fiscal policy was the key transmission mechanism.
And the fact that disinflation was marked by sharply falling nominal interest rates meant
that, to the limited extent that bank lending rates were fixed relative to deposit rates,
bank spreads widened during disinflation, bolstering financial stability.
Finally, relative price shocks also made it easier to reduce inflation. Although
relative price adjustment initially impeded disinflation directly by raising the price
level, it ultimately resulted in greater supply-side flexibility, which was conducive to
reducing inflation rates.
Fiscal factors
Fiscal factors also contributed to the transition countries' success in curbing
inflation. Fiscal consolidation in the transition area has been dramatic. In 1992, the
average ratio of fiscal deficits to GDP was around 13˝ percent; five years later, the
ratio had dropped to 3˝ percent. In addition, almost all the countries had developed, at
the very least, primary treasury bill markets, thereby increasing the diversification of
funding sources available. As a result, central bank credit to the government declined
from about 11 percent of GDP in 1992 to less than 1 percent of GDP in 1997.
The correlation between a strong fiscal position and disinflation is also evident in
each country's experience. Fiscal corrections have been closely associated with
disinflation. What exceptions there are confirm the rule. Although Estonia achieved a
strong fiscal position early in its transition, disinflation did not begin until 1992, but
the lag was due to the delayed establishment of the country's new currency. Two other
countriesRomania and the Kyrgyz Republicwere able to achieve a significant
decline in inflation without a particularly marked fiscal correction or a strong fiscal
stance. However, Romania is one of the few countries in which inflation flared up again
after disinflation had begun, and the Kyrgyz Republic's fiscal position was dominated by a
large, externally funded public investment program, so domestic credit and credit from the
central bank to the government were tight throughout the period during which disinflation
was taking place.
Exchange rate policies
Nominal anchor frameworks were the third element in the successful disinflation.
Although it is not surprising that no countries adopted formal monetary targetsgiven
the shocks to money demand emanating from the transition process itselfit is
striking that so few used formal exchange rate targets. Only four countries used some form
of formal exchange rate commitment during 199297Estonia, Lithuania, the former
Yugoslav Republic of Macedonia, and Bulgaria (during its 1997 disinflation program). The
evidence suggests that even informal targeting of exchange rates was exceptional (although
formal exchange rate targets had figured prominently in earlier attempts to control
inflation in Eastern Europe).
Two factors account for the decision not to rely on formal and informal exchange rate
anchors. First, inflation during this period had relatively little inertia. There was thus
less need for a clear nominal anchor around which expectations could form as part of the
disinflation process. Second, there were practical difficulties with pegging during this
period. At the outset, many of the transition countries' currencies were deeply
undervalued and were backed by limited international reserves, making it difficult to
operate pegs at sensible rates. The weakness and vulnerability of the ruble compounded
these difficulties for countries that had Russia as a major trading partner. Had such
countries adopted pegs to hard currencies, as conventional wisdom dictated, a subsequent
recovery of the ruble would have imparted an inflationary impulse through the peg,
offsetting the intended disinflationary effect of the hard currency peg. And if, in light
of this risk, the ruble had been included in the currency basket, the credibility of the
peg as a nominal anchor might have been compromised. Thus, how to design and operate a peg
as a disinflation anchor in this environment was far from obvious.
But if countries were neither targeting exchange rates nor pursuing monetary targets,
what were they doing? Essentially, they were informally targeting inflation. And this
approach was not simply the best of a bad set of choices. Croatia and Georgia, for
example, used this framework to allow nominal exchange rates to appreciate during the
initial stages of their disinflation efforts. This accelerated the disinflation process
and partly explains the exceptional speed with which these two countries achieved declines
in their inflation rates. Progress with disinflation was much slower in countries that
adopted formal exchange rate pegsnotably, the advanced reformers.
Purposefulness
The final factor behind the transition countries' success in slowing inflation is that
disinflation programs were designed to achieve results quickly. They were not held up
until other desirable pieces of the economic jigsaw puzzlenotably, structural
reformshad been put in place.
Conclusion
The reduction in inflation across the transition countries has been remarkable,
particularly given the chaotic conditions in which most of these countries were operating
in the early 1990s. Inflationary pressures that had long been suppressed through price
controls turned out to be less of a problem than the other challenges confronting these
countries' new and inexperienced policymaking institutions, including the collapse of
output, employment, and fiscal revenues; military conflicts; and redrawn national
boundaries.
Not only has output been resilient to disinflation, but low inflation has been
associated with faster economic growth. The fight against inflation is not over, however.
In addition to those countries that experienced a reignition of severe
inflationAlbania, Bulgaria, and Romaniaseveral others, including Armenia,
Belarus, and Uzbekistan, have experienced relapses of less severity. Policymakers who
become complacent risk losing control over inflation again, even in countries where
inflation has been moderate and manageable but persistent. One lesson that has emerged
from both the successes and the failures of anti-inflationary programs in the transition
countries is that even if comprehensive structural reforms are not preconditions for
achieving low inflation, they appear to be essential to sustaining it.
Carlo Cottarelli is Chief of the
Southern European Division II of the IMF's European I Department. Peter Doyle
is a Senior Economist in the Central European Division II of the IMF's European I
Department. |
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