Chapter

IV Disinflation, Growth, and Foreign Direct Investment in Transition Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
May 1995
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Virtually all countries in transition have now embarked on serious stabilization and reform efforts. Early and bold reformers, such as Albania, the Baltic countries, the Czech Republic, Mongolia, Poland, the Slovak Republic, and Slovenia, have witnessed rapid disinflation and a resumption of growth. These countries are currently expanding at a pace approaching or exceeding average growth in the European Union. Despite a head start, performance has been mixed in Hungary. Those countries that initiated reforms later or more timidly have either only recently begun to recover—Bulgaria, the former Yugoslav Republic of Macedonia, and Romania—or have not yet seen a turnaround in measured output—Kazakhstan, Moldova, the Kyrgyz Republic, and Ukraine. In most of these countries, however, disinflation is proceeding or at least being attempted in earnest. Russia made substantial progress toward stabilization during the first half of 1994, but performance deteriorated later in the year. Several countries, including Croatia and the Federal Republic of Yugoslavia, and, more recently, Armenia and Georgia, experienced armed conflicts and hyperinflation before adopting significant adjustment measures. Azerbaijan, Belarus, Tajikistan, Turkmenistan, and Uzbekistan are still at a very preliminary stage of market reforms.

The reversal of capital flight and inflows of private capital in countries in transition has been associated with macroeconomic stabilization and progress with institutional and structural reforms. Except for a few cases, however, the scale of private capital inflows has been modest thus far. While the external viability of the transition mainly hinges on sustained domestic adjustment and reform efforts, foreign direct investment can enhance the pace and quality of growth in the transition economies. However, the scale of foreign direct investment, which is long term and non-debt-generating, will only become significant once a stable, market friendly macroeconomic and institutional environment is in place.

Financial Stabilization and Growth

In the countries that are the most advanced in the transition process, rates of economic growth have picked up and are projected to approach or exceed 5 percent in 1995 (Table 10). Fiscal performance indicators have improved considerably in some cases, although fiscal imbalances remain relatively large. Inflation is nearing the levels recorded in the high-inflation countries of the EU, despite large ongoing relative price adjustments (Box 7). Open unemployment is dropping or stabilizing below the levels prevailing in several countries of the EU.

Table 10.Selected Countries in Transition: Growth, Inflation, Unemployment, and Fiscal Balance(Annual percent change, unless specified otherwise)
EstimatesProjections
1993199419951996
Real GDP growth
All countries in transition-9.2-9.4-3.83.5
Albania11.07.46.05.5
Czech Republic-0.92.63.84.9
Estonia-6.66.06.05.3
Hungary-2.32.60.21.5
Laivia-14.82.04.65.0
Lithuania-16.51.56.74.0
Poland3.86.05.05.0
Slovak Republic-4.15.34.04.0
Slovenia1.35.05.05.0
Memorandum
European Union-0.42.83.13.1
CPI inflation
All countries in transition67529512719
Albania8523119
Czech Republic211087
Estonia89482621
Hungary22192817
Latvia109361911
Lithuania410723026
Poland35322512
Slovak Republic2313106
Slovenia322053
Memorandum
European Union3.83.13.12.8
Open unemployment (percent, end of year)
Albania3021
Czech Republic3
Estonia198
Hungary12½10½
Latvia6
Lithuania44
Poland16½16
Slovak Republic14½15
Slovenia299
Memorandam
European Union (year average)11.111.6
Fiscal balance (percent of GDP)
Albania-16.2-13.4-12.7-12.0
Czech Republic0.80.8-0.10.7
Estonia3-0.7-2.3-3.5
Hungary-7.5-6.0-6.5-7.5
Latvia30.64.1-2.2-1.0
Lithuania3-5.1-4.4-3.8-3.5
Poland-3.4-3.0-3.3-2.8
Slovak Republic-2.3-2.3-2.7-2.6
Slovenia0.50.5-1.0-0.6
Memorandum
European Union-5.9-5.2-4.2-3.6

Period average, based on household survey.

Based on labor force survey.

Includes net lending.

Period average, based on household survey.

Based on labor force survey.

Includes net lending.

While these are genuine achievements, several caveats are in order. Brisk growth rates may, to some extent, reflect a temporary rebound from the previous collapse of output. In some countries, relatively small fiscal deficits coexist with large quasi-fiscal deficits stemming from the off-budget financing of the losses of public enterprises. And modest public debt ratios may hide substantial contingent liabilities associated with unfunded pension liabilities or insolvent enterprises and banks. If these hidden fiscal problems were to result in excessive credit creation, disinflation might be rapidly reversed. Finally, hidden unemployment remains substantial even in some of the more successful transition countries, and open unemployment may yet rise further or anew as restructuring deepens, particularly in the large enterprise sector.

The Czech Republic is one of the few transition countries where all the main macroeconomic indicators are favorable and improving further. It now confronts the types of policy challenges faced by the industrial countries and the successful developing countries. Large capital inflows have put strong upward pressure on the exchange rate, highlighting the dilemmas associated with real exchange rate appreciation and progress toward full convertibility. While the foundations of a market economy are securely in place in the Czech Republic, further structural adjustments are needed, including by newly privatized enterprises where excess labor, weak balance sheets, and deficient corporate governance mechanisms remain widespread. The Slovak economy has now also registered an impressive turnaround. Inflation was nearly halved to 13 percent in 1994, output rose by over 5 percent, unemployment stopped rising, the current account swung into a surplus exceeding 5 percent of GDP, and the fiscal deficit declined by almost 5 percentage points to under 3 percent of GDR Growth is projected to slow only marginally in 1995, and there is scope for further disinflation provided fiscal consolidation is continued. The dynamism of the recovery would have been even more remarkable had it not been for uncertainty regarding the pace of structural reforms. Privatization virtually came to a halt in late 1994 and decisions to dispose of state property have been reversed on several occasions.

Box 7.Price Convergence in Transition Economies

The liberalization of the price system and the move away from the highly distorted price structure that prevailed under central planning are key steps in moving to a market economy. In virtually all the transition countries, there has been considerable progress toward formal price liberalization. For an overall domestic price measure such as the CPI, however, convergence toward market economy price levels will be a prolonged process for most countries. An important policy implication is that the gradual process of price convergence will continue to exert pressure on inflation or on the nominal exchange rate, and contribute to real exchange rate appreciation.

Following large-scale price liberalization, the prices of many tradables rose fairly rapidly toward international levels.1 This was mostly so for nonfood products, and especially for durables, because geographical arbitrage is more difficult for perishable foods and because many staples continued to be subsidized or subject to trade restrictions. But even for basic foodstuffs, prices generally moved closer to international levels following liberalization.2

For nontradables and particularly for services, price convergence is taking more time.3 Increases in the prices of services typically lagged adjustments in the prices of goods prior to broad-based liberalization, partly reflecting deliberate pricing policies, but also because price controls were easier to enforce for services than for goods (see chart). The initial price jump associated with large-scale price decontrol in many cases entailed a further, sharp drop in the relative price of services, as many of them remained administered and were only partially adjusted. There was a subsequent catch-up as some subsidies were reduced and as structural reforms diminished the role of the public sector in areas such as child and health care and housing. In Russia, for example, the prices of paid services rose seven times more than the overall CPI in the first three years of the transition. A very significant catch-up also occurred in Armenia, Azerbaijan, the Baltic countries, Ukraine, Kazakhstan, the Kyrgyz Republic, and Tajikistan. It was less pronounced in the Czech Republic, Hungary, and Poland, possibly because of a less distorted starting position.

Czech Republic and Russia: Price Levels and Real Exchange Rates

1 Logarithmic scales.

2 Based on consumer price indices.

In most transition economies, the depreciation of the real exchange rate in the wake of price and exchange rate liberalization went far beyond what productivity differentials would imply.4 The initial depreciation, however, was typically followed by a rapid real appreciation, reflecting nominal appreciation in some cases as well as high inflation relative to trading partners. In the process, the large initial gap between domestic and international price levels narrowed significantly, although it has remained considerable three or four years into the transition in many countries.5 As a result, and even in the presence of appropriately tight financial policies, substantial inflationary pressures persist. The implied real appreciation, which so far has not prevented rapid export growth,6 will be sustainable if it is supported by sufficiently large productivity gains in the tradable sector.

1The prices of some commodities, including energy carriers, were often not fully liberalized and hence remained well below international levels.2See Paula De Masi and Vincent Koen, “Relative Price Convergence in Russia,” IMF Working Paper (forthcoming, 1995).3The same phenomenon occurs in developing countries. See Bela Balassa, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political Economy, Vol. 72 (December 1964), pp. 584–96; and Paul Samuelson, “Theoretical Notes on Trade Problems,” Review of Economics and Statistics, Vol. 46 (May 1964), pp. 145–54.4See László Halpern and Charles Wyplosz, “Exchange Rate Policies in Transition Economies: In Search of Equilibrium,” IMF Working Paper (forthcoming, 1995).5See, for example, Anthony Richards and Gunnar Tersman, “Growth, Nontradables, and Price Convergence in the Baltics,” IMF Working Paper 95/47 (April 1995).6The latter also reflects the reorientation of trade once interstate trade agreements no longer constrained exports.

Macroeconomic performance in the Baltic countries has also remained impressive.20 The recovery of output is now well under way, with real GDP projected to grow by 5 percent or more in 1995 in all three countries. Nevertheless, large-scale privatization needs to be completed and financial sector reform accelerated, as evidenced by the failure of two large banks in Estonia. Moreover, as in other transition economies, widespread tax evasion and underground activities undermine fiscal revenues and raise equity issues.

Growth strengthened in Poland in 1994, reaching 6 percent, and is expected to remain robust during the period ahead. Exports expanded rapidly, contributing to a narrowing of the trade deficit. Labor productivity gains were substantial in the rapidly expanding private sector and also in the state sector, as a result of labor shedding in the latter. The unemployment rate, though still high at around 16 percent, has started to decline. Prices increased more than targeted in 1994, but inflation remained on a downward trend. Perseverance with a prudent fiscal and monetary stance is required to ensure further disinflation in 1995, especially in light of the pervasiveness of indexation.21 In Slovenia, as well, growth picked up in 1994, fueled by dynamic private small and medium-sized firms. While privatization is proceeding slowly, enterprise restructuring has been relatively extensive, thus laying the foundations for a durable expansion.

In contrast to most other transition countries of central and eastern Europe, growth is expected to slow in Albania and Hungary in 1995. In Albania, the pace of expansion is likely to remain above 5 percent, notwithstanding delays in the next steps in privatization, banking reform, and the creation of a land market. Hungary stood out among centrally planned economies as a pioneer of market reforms until the late 1980s, but macroeconomic performance has not been as good as in some countries that started later. Inflation remains relatively high, in the neighborhood of 20 percent, and the recovery of output that occurred in 1994 appears to be faltering. The persistence of large fiscal and current account deficits points to the need for decisive measures to bolster domestic saving and alleviate pressure on already high real interest rates. The March 1995 devaluation and the associated fiscal package constitute an important step in that direction. Further measures will nevertheless be needed, including a broadening of the income tax base, a reduction of the burden of the pension system, and an acceleration of privatization.

The costs of partial and inadequate reform efforts are visible in Romania and Bulgaria. In Romania, inflation slowed substantially in 1994 and output continued a gradual recovery. Privatization and structural reforms, however, have continued to lag; monetary control has been threatened by an expansion of subsidized lending to agriculture; and progress generally remains fragile. Output finally bottomed out in 1994 in Bulgaria, but prospects for a recovery of investment are poor owing to the lack of industrial restructuring. The fiscal deficit was reduced from over 17 percent of GDP in 1993 to 7½ percent in 1994, still a highly inflationary level.

In Mongolia, output turned around in 1994, and growth is expected to approach 5 percent by 1996. Inflation is slowing but has remained high. In Croatia, the stabilization program launched in the fall of 1993 has succeeded in arresting inflation, even causing a decline in the overall price level. Real GDP grew by 1¾ percent in 1994, and is projected to rise by 4½ percent in 1995. Maintaining macroeconomic stability will require restricting credit to loss-making enterprises, including by eliminating the control of banks by borrowers. The economic outlook for Croatia is also dependent on the security situation in the region. Substantial progress with stabilization has recently been achieved in the former Yugoslav Republic of Macedonia. Despite externally imposed restrictions on foreign trade, the output decline has bottomed out. However, about one third of the labor force is unemployed or on involuntary leave, and privatization has barely begun. In the Federal Republic of Yugoslavia (Serbia/Montenegro), an exchange rate based stabilization program put a sudden end to extreme hyperinflation in early 1994, but growing fiscal and quasifiscal imbalances spurred renewed high open inflation in late 1994.

Financial instability continued in Russia into the early part of 1995.22 Stabilization seemed within reach in 1994, as the fall in industrial output bottomed out during the year and inflation declined to mid-single-digit levels by the summer. Financial stabilization failed, however, as the fiscal deficit widened and inflation picked up to some 17 percent a month—or over 500 percent at an annualized rate—by the end of the year (Chart 18). The loosening of financial policies that caused the resurgence of inflation stemmed from growing sectoral spending pressures and from the erosion of government revenues associated with tax arrears, numerous exemptions and deferrals, and dwindling taxpayer compliance. It was also due to the unsustainable nature of some of the adjustment measures, including an excessive reliance on expenditure sequestration and arrears. The inflationary impact of the deterioration of the fiscal situation was postponed, however, by a sharp drawdown in foreign exchange reserves during the summer. The October exchange rate crisis partly reflected the market’s realization that the depletion of reserves was not sustainable.23 The breakout of open conflict in Chechnya in December 1994 added further pressures to an already difficult fiscal position. Real GDP is reported to have shrunk by another 15 percent in 1994 and is projected to decline further in 1995, although the official statistics probably exaggerate the degree of contraction (Box 8). The pace of structural change remained disappointingly slow, despite a brief pickup with the initiation of cash auctions of enterprise shares in July. Policy intentions with regard to privatization and the liberalization of external trade have at times been hard to decipher. The authorities’ program for 1995, however, involves an invigoration of privatization and liberalization efforts this year, including the removal of restrictions on oil exports.

Chart 18.Selected Countries in Transition: Consumer Prices

(Annualized monthly percent change)

Inflation rebounded in Ukraine in September 1994, partly for the same reasons as in Russia, but also as the result of large and overdue adjustments in administered prices. From its pre-transition peak to 1994, registered output had dropped as much as in Russia while prices had risen over ten times more, mainly reflecting looser financial policies. Determined fiscal adjustment and resolute liberalization and privatization will be needed to achieve stabilization in 1995. In Belarus, some market-oriented reform measures were implemented in 1994, but several were reversed and, in contrast to neighboring countries, near-hyperinflationary conditions prevailed throughout the year. As in Ukraine and Belarus, recorded output in Kazakhstan is projected to decline further in 1995. Tightened financial policies slowed price increases in the second half of 1994, but underlying monthly inflation remained very high. The pace of structural reform has been slow but started gathering momentum around late 1994, particularly with the liberalization of bread and energy prices.

Financial stabilization was largely successful in Moldova and in the Kyrgyz Republic in 1994, allowing a sharp decrease in nominal interest rates coupled with a stable or appreciating nominal exchange rate. While output continued to decline sharply, it is expected to begin to recover in 1995. In Moldova, the fiscal situation remained difficult owing to the severe contraction in real output and a sharp increase in expenditures to ameliorate the effects of weather-related disasters in the third quarter. After several months of hyperinflation, bold adjustment programs were adopted by Armenia in mid-1994 and by Georgia in the autumn of 1994. Given their weak fiscal and external positions, economic reconstruction will continue to require substantial external financial assistance. In Azerbaijan, the monetization of a fiscal deficit on the order of 13 percent of GDP triggered hyperinflation, with monthly price increases exceeding 50 percent by late 1994. Financial conditions were tightened at the beginning of 1995, however, and in February the bread price subsidy was removed and energy prices were brought closer to international levels.

Box 8.The Output Collapse in Russia

According to the State Statistics Committee (Goskomstat), by 1994 real GDP had shrunk by almost half from its 1989 pre-transition peak. This decline far exceeded any contraction experienced during the previous seventy years in Russia and was much larger than the 31 percent drop in U. S. output during the Great Depression of 1929–33.1

While production indeed collapsed in many sectors of the Russian economy, the official figures probably exaggerate the magnitude of the plunge in aggregate output. The statistical authorities themselves recognize that, as in other transition economies, the tools at their disposal fail to capture a significant component of economic activity, particularly in the service sector and among new enterprises.2 Corroborating evidence includes the relative resilience of household consumption and electricity use compared to officially measured GDP, and various discrepancies between financial and production indicators.3

Official real GDP data in Russia are derived only from the production side. By re-estimating real GDP from the demand side, based partly on new estimates of retail sales that include sales through informal channels, it is possible to capture some of the activities that are missed on the production side. These estimates suggest that real GDP declined by at most one third between 1989 and 1994 (see chart). Because these estimates are based on conservative assumptions, the actual cumulative decline could be significantly smaller.

Notwithstanding uncertainties about the precise magnitude of the output loss, a number of factors suggest that average household living standards have been less seriously affected. First, investment declined much more than consumption, partly as a reflection of the prior overaccumulation of capital. Second, many consumer goods that are no longer produced were not desired by consumers. Third, price liberalization reduced searching and queuing costs, and improved the variety and quality of available goods and services. Lastly, the demise of central planning and the gradual hardening of budget constraints on enterprises cut down on waste and other forms of inefficient resource use.

Russia: Indicators of Real Economic Activity

(1989 = 100)

Sources: Goskomstat of the Russian Federation; and IMF staff estimates.

1No re-estimate for 1990.

At the same time, it is important to recognize that living standards and the welfare of some segments of the population have undoubtedly suffered more than suggested by indicators of per capita output and consumption insofar as income inequality and uncertainty about employment prospects have increased during the transition.

1Cumulative output declines of the same order of magnitude were reported by the statistical authorities in Ukraine and Kazakhstan. Much of the following discussion also applies to these countries.2This has been pointed out by the Chairman of Goskomstat, Yurii Yurkov, in “The Statistical Mirror of the Market,” Ekonomika i Zhizn, No. 35 (August 1994). Efforts are reportedly under way at Goskomstat to re-evaluate estimates of real GDP.3For details, see Evgeny Gavrilenkov and Vincent Koen, “How Large Was the Output Decline in Russia? Alternative Estimates and Welfare Implications,” IMF Working Paper 94/154 (December 1994). Electricity use per unit of output may have increased because of declines in the relative price of electricity.

Except for Uzbekistan, where real GDP fell by only 2½ percent, large output declines were recorded in the central Asian countries of the former Soviet Union in 1994. In Uzbekistan, significant price liberalization measures were taken in 1994, and inflation slowed in the second half of the year as a result of stricter monetary policy. Turkmenistan effectively suffered a large negative terms of trade shock in 1994, owing to arrears on its energy exports. Some progress on exchange rate unification was achieved in Turkmenistan and Uzbekistan. In Tajikistan, most prices were freed in December 1994 and preparations for the launch of a new currency are under way.

As macroeconomic stabilization is achieved and activity turns around in the more advanced transition economies, the question arises of what is a sustainable medium-term path for inflation and output growth. Any projections in this regard are highly tentative, not least owing to the tremendous statistical uncertainty surrounding indicators of performance to date. With this caveat, sound financial policies coupled with continuing structural reforms should allow further disinflation and enable output in most transition economies to expand at a rate of 5 percent a year or more over the medium term, not least because of the considerable scope for productivity gains. Open markets will continue to be important, as exports will need to contribute substantially to overall growth in most transition economies. Growth could be even higher in those countries of central and eastern Europe where a high degree of confidence in prudent financial policies and market-oriented institutions may help to mobilize domestic saving and attract foreign investment. Conversely, medium-term growth prospects may be lower in those countries of central Asia where starting conditions are more difficult. In all cases, delays with structural reform, imprudent financial management, or protectionist measures by trading partners could result in a slower expansion.

External Viability and Capital Flows

In the early stages of the transition, capital flight, debt servicing, and the limited availability of foreign loans resulted in net outflows of capital from the former centrally planned countries.24 In central and eastern Europe, these outflows were reversed in 1992 reflecting external assistance from official creditors, including in the form of debt relief, and rising inflows of foreign direct investment. In Russia and the other transition countries where the transformation process is less advanced, net capital flows were in all likelihood still negative in 1994, and in all but a few cases the scale of foreign direct investment remained small. Overall, the magnitude of capital flows to transition economies has been smaller than generally expected early in the transition.25 Total inflows amounted to $15 billion in 1993 and preliminary estimates suggest a decline to about $10 billion for 1994.

Assistance in the form of lending from the international financial institutions and debt restructuring, however, has been substantial since the onset of the transition.26 Since the last World Economic Outlook, Poland has completed the restructuring of its commercial bank debt, nearly halving Poland’s contractual liabilities to banks and considerably easing the debtservice burden.27 Negotiations between Russia and London and Paris Club creditors have continued.28

In many transition countries, private capital inflows were initially dwarfed by capital flight. Despite the maintenance of restrictions on capital flows, the opening up of the economy enabled residents to diversify their financial portfolios away from often low-yielding or excessively risky domestic assets. Persistent macroeconomic instability created strong incentives for households and enterprises to seek safer investment opportunities. At the same time, potential foreign investors facing sizable output declines, high inflation, inappropriate exchange rate and trade policies, and other obstacles frequently have postponed investment decisions. Foreign bank loans to domestic financial intermediaries were considered risky given the lack of reliable balance sheet information, the weakness of most bank asset portfolios, and limited prudential supervision. Barriers to the entry of foreign banks in Russia and several other countries created difficulties in establishing local subsidiaries. Portfolio investment opportunities were also limited by the thinness of domestic bond and stock markets, and by the absence or weakness of capital market infrastructures. Finally, for reasons discussed below, foreign direct investment projects were slow to materialize.

As stabilization took hold, capital inflows rose substantially in some countries, both through repatriation of domestic funds and through new foreign financing. In the Czech Republic, the Slovak Republic, and the Baltic states, where most fundamental indicators of creditworthiness inspired confidence (Table 11), large net inflows reduced or eliminated the need for exceptional balance of payments financing and exerted strong upward pressures on exchange rates.29 Even in Russia, capital inflows increased significantly around mid-1994 as the likelihood of stabilization seemed to improve, and as the cash privatization process got under way. This upsurge proved short-lived, however, as the stance of financial policies visibly loosened during the autumn of 1994, confidence receded, and the ruble again came under heavy downward pressure.

Table 11.Countries in Transition: Indicators of External Viability, 1994(In percent of GDP, unless otherwise noted)
Fiscal

Balance
Current

Account1
Gross

Stock of

Reserves1,2
External

Debt1
Debt

Service1,3
Cenral and eastern Europe
Albania-13-1335810
Belarus-3-8219
Bulgaria-8-221618
Croatia2222111
Czech Republic1-142814
Estonia-637
Hungary-6-10746534
Latvia-4-35-35
Lithuania-4-4382
Macedonia, former Yugoslav Republic of-2-1013215
Moldova-8-9392
Poland-3-134312
Romania-3-12197
Slovak Republic-252319
Slovenia134265
Ukraine-9-61187
Russia-101325
Transcaucasus and central Asia
Armenia-541
Azerbaijan-13-1721
Georgia-18-40
Kazakhstan-7-94247
Kyrgyz Republic-8-203426
Mongolia-5136514
Tajikistan-29-1211
Turkmenistan-1217172
Uzbekistan-3-952717

Generally excluding transactions or assets and liabilities among the Baltic countries, Russia, and the other countries of the former Soviet Union.

In months of imports of goods and services.

As a percent of exports of goods and nonfactor services, and on a cash basis.

Excluding debt prepayments; including prepayment of amortization, the debt-service ratio is 63 percent.

Generally excluding transactions or assets and liabilities among the Baltic countries, Russia, and the other countries of the former Soviet Union.

In months of imports of goods and services.

As a percent of exports of goods and nonfactor services, and on a cash basis.

Excluding debt prepayments; including prepayment of amortization, the debt-service ratio is 63 percent.

In Hungary, foreign capital has long played a much more important role than in other transition economies. Hungary has an impeccable debt-servicing record and a high level of international reserves, but market concerns about external viability have increased during the past year, reflecting the combination of large current account and fiscal deficits, relatively large debt and debt-service ratios, and policy uncertainties. Under these circumstances, a bold and comprehensive fiscal adjustment effort is urgently required to increase national saving and reduce the dependency on capital inflows. Even if fully implemented, the aforementioned March 1995 policy package is unlikely to prevent a further buildup in net external indebtedness in 1995; further fiscal reforms are called for.

In those countries where stabilization has not yet been achieved and private nonresidents are not yet significant asset holders, the risk is not so much that of a withdrawal of foreign capital, but rather that a confidence crisis could trigger a resumption or acceleration of capital flight, and postpone fresh capital inflows. In a few countries, such as Georgia, net external debt has already reached disquieting levels even though private capital inflows have thus far been negligible. The best way to reduce the risk of such a confidence crisis is through sustained implementation of macroeconomic stabilization policies and structural reforms to establish the institutions of a market economy.

Foreign Direct Investment and Macroeconomic Performance

Access to foreign direct investment marks a turning point for the economies in transition, which were virtually closed off to foreign investors under central planning.30 With reforms came the realization that foreign capital was needed to revitalize obsolete methods of production. It was expected that foreign direct investment would play a critical role, sparking and sustaining economic growth. Although foreign direct investment has increased, flows remain modest compared with earlier predictions, mainly due to the deterring effects of continuing macroeconomic instability and insufficient institutional reforms.31

The economies in transition stand to reap considerable benefits from foreign direct investment, although long-term economic growth primarily requires sustained financial adjustment and efforts to mobilize domestic financial resources. Domestic financial markets lack depth, however, and are plagued by adverse selection and moral hazard problems, and loans are often allocated on the basis of criteria other than creditworthiness. In such a context, foreign direct investment in the form of joint ventures, acquisitions, and new businesses—greenfields—offers access to capital that might otherwise be unavailable. Joint ventures, in particular, have facilitated the privatization process in some countries with foreign companies taking shares in formerly state-owned enterprises. In addition to the inflow of capital, foreign direct investment has beneficial effects that are particularly important during the initial stage of the transition process. These include access to modern technology, worker training, managerial know-how and accounting practices, as well as access to foreign markets. Over time, these influences will improve the productive potential of the economy.32

There are strong incentives for foreign firms to invest in transition countries.33 With a population of over 420 million, these countries offer enormous potential as a consumer goods market, and firms investing early are in a better position to establish a market presence. The backwardness of infrastructure, especially in areas such as telecommunications, provides vast investment opportunities, as does participation in the tapping of natural resources, such as oil in Romania, Russia, Azerbaijan, and Kazakhstan, and natural gas in Turkmenistan. Transition countries also offer considerably lower labor costs, even after adjusting for lower productivity. An additional incentive is that using eastern Europe as a base for production meets EU criteria for content requirements, thereby providing preferential access into the EU.34

Foreign direct investment in all transition countries increased from about $200 million in 1989 to about $6 billion in 1993 and then fell somewhat in 1994.35 The flows have so far been predominantly to the countries of central and eastern Europe, mainly reflecting the earlier start in the transition process. For example, in 1992–94, Hungary, the Czech Republic, and Poland accounted for more that half of the total dollar value of foreign investment (Chart 19). Data on the number of announced investment projects indicate a similar pattern (Chart 20). The Baltic countries, and especially Estonia, have attracted foreign direct investment inflows that are very large compared to the size of those economies (Box 9).36

Chart 19.Selected Countries in Transition: Foreign Direct Investment, 1992–941

(In millions of U.S. dollars, and percent of total)

Sources: National authorities; and IMF staff estimates.

1Based on balance of payments definition.

Chart 20.Countries in Transition: Foreign Investment Projects by Host Country, 1990–931

(Number of announced projects, and in percent of total)

Source: Dixon & Co., East European Investment Magazine data base.

1Projects are dated when they are announced rather than when concluded, with any failed projects excluded. Total includes projects in east Germany, except those originating in west Germany.

In Russia and the Transcaucasian and central Asian countries, foreign direct investment has so far been very small, increasing from about $800 million in 1992 to about 1½ billion in 1994.37 Russia and Kazakhstan have attracted well over three fourths of the total flows to these countries in value terms and about 90 percent in terms of the number of announced projects. While much of this investment has been from industrial countries, Russia has been a significant investor in the Baltic States and the other countries of the former Soviet Union. For example, Russia accounted for one fourth of foreign direct investments in Estonia in 1994. In some cases, it has been envisaged that the clearing of large arrears to Russia, notably on energy deliveries, may involve Russian direct investments in the form of debt-equity swaps.

More than half of the announced foreign direct investment projects during 1990–93 in the transition countries originated from the United States, Germany, or Austria (Chart 21). Almost half of these were joint ventures as opposed to greenfields or acquisitions. However, while many joint ventures undoubtedly represent the initial stage of legitimate foreign investment projects, some may simply be facades for illegal activities, and others may substitute for domestically financed investment—such as when offshore flight capital returns in the guise of foreign direct investment. Most of the announced projects in 1990–93 were in the manufacturing sector, particularly in electronics and transport equipment (Chart 22). In services, the largest number of announced projects was in banking and financial services.

Chart 21.Countries in Transition: Foreign Investment Projects, 1990–931

(As a share of total number of announced projects)

Source: Dixon & Co., East European Investment Magazine data base.

1See footnote of Chart 20.

2Includes food distribution.

Chart 22.Countries in Transition: Foreign Investment Projects by Target Industry, 1990–931

(Number of announced projects)

Source: Dixon & Co., East European Investment Magazine data base.

1See footnote of Chart 20.

Policy Issues Related to Foreign Direct Investment

Several factors have prevented foreign direct investment from reaching the levels anticipated only a few years ago. In many countries, macroeconomic instability, ambiguities with respect to future policies and economic reform, and weak governance have created an uncertain investment environment. The lack of a transparent and stable legal structure in most countries has been a serious impediment to foreign direct investment—not least because of the implied high transaction costs—despite steady progress to improve commercial legislation affecting foreign investors.38 Many countries, for example, have eliminated requirements that foreign investors find domestic partners, thus allowing wholly foreign-owned subsidiaries; adopted legislation that provides compensation for investors in case an industry is renationalized; allowed repatriation of profits; and established tax laws that clearly lay out corporate tax obligations and incentives. Further improvements are still needed, notably with respect to enforcement of legal contracts.39 Inadequate accounting procedures and insufficient marketing and strategic planning capabilities, together with other weak business practices, have also discouraged foreign investors and made them reluctant to take on enterprise restructuring. Finally, privatization programs have often given preferential treatment to the employees of state-owned enterprises over foreign investors, reflecting the fear that domestic companies would be purchased for undervalued prices, and that jobs would be eliminated and wages cut.

To offset some of these impediments, many countries have offered generous tax breaks and other financial incentives to attract foreign direct investment, including reduced corporate tax rates, tax holidays, and sector-specific tax exemptions. Some countries, such as Albania, Bulgaria, and Russia, have also used reductions in, or exemptions from, various customs duties, which may be particularly important if no credit is given for value-added taxes (VAT) paid on capital goods or if VAT refunds are slow. Experience has generally shown, however, that tax incentives are not an effective way to attract foreign direct investment.40 Although lower tax rates may improve short-term profitability, the principal beneficiaries are likely to be enterprises that are already profitable, and hence need no incentives. In the long run, there is no conclusive evidence that tax incentives boost foreign direct investment. And because tax breaks erode revenue collections, many countries that have had a widespread revenue collapse during the transition have had to eliminate these incentives.41 Furthermore, tinkering with the tax system creates loopholes and legislative confusion, requires additional tax administration efforts, and encourages nonproductive rent-seeking behavior. As demonstrated by the Czech Republic, where such investment incentives have been avoided, foreign direct investment flows respond positively and substantially to a favorable overall economic climate.

Box 9.Foreign Direct Investment in Estonia

Foreign direct investment has contributed significantly to a vigorous recovery of output in Estonia.1 By the end of 1994, the total stock of foreign investment was about $471 million, and the number of fully or partially foreign-owned companies grew to over 7,700 (see chart).2 Finland has accounted for the largest number of these foreign-owned companies, followed by Russia and Sweden.3 The bulk of these investments was concentrated in manufacturing (36 percent) and trade (32 percent), but foreign capital was also channeled into transport and communications (15 percent), banks (6 percent), and real estate and business services (5 percent).

Several factors underpin Estonia’s relative success in attracting foreign investment compared with the other Baltic countries. Bold economic reform, currency stabilization, and a liberal trade regime created an appealing business environment. The large-scale and rapid privatization that began in mid-1993 has actively encouraged foreign investor participation, with public tender auctions making no material distinction between foreign and domestic investors. Estonia’s foreign investment legislation, which is relatively more advanced than that of many other transition economies, has been transparent and generally liberal. No restrictions on capital flows or repatriation of profits exist. A foreign investment license is required only for investments in certain sectors such as mining, energy, railways, and telecommunications. In the past, various tax incentives have also attracted foreign capital. These tax incentives, which were recently eliminated, included a three-year tax holiday and a 50 percent tax reduction for the subsequent five years for investments of more than $1 million that provided at least 50 percent of a firm’s capital, and a two-year tax holiday and a 50 percent tax reduction for the subsequent two years when foreign share ownership exceeded $50, 000 and provided 30 percent of the capital.

Estonia: Fully or Partially Owned Foreign Companies

Sources: Estonian Investment Agency; and Liuhto, “Foreign Investment in Estonia.”

Sweden and Finland’s geographic proximity and cultural kinship with Estonia have also facilitated foreign investment from those two countries. With monthly wages in Estonia averaging about 10 percent of levels in Finland and Sweden, subcontracting labor-intensive work to Estonian subsidiaries has become an attractive alternative to outsourcing production in other low-cost countries.

1See Seija Lainela and Pekka Sutela, The Baltic Economies in Transition (Helsinki: Bank of Finland, 1994); and Kari Liuhto, “Foreign Investment in Estonia Since 1987—Statistical Approach,” Turku School of Economics and Business Administration, Business Research and Development Center and Institute for East-West Trade, Series C Discussion 9/94 (Turku, Finland, 1994).2About one third of this total value was in the form of loans and reinvested earnings. Although foreign-owned companies account for about 10 percent of all companies in Estonia, preliminary data suggest that about 20–30 percent of companies with foreign participation are not in operation.3Based on the total value of foreign capital, however, Sweden has accounted for 28 percent followed by Finland (22 percent) and Russia (12 percent).

Provided that heightened macroeconomic uncertainty does not disrupt current investment flows and cause foreign companies to abandon or postpone projects, foreign direct investment in the transition countries is likely to expand. Substantial inflows of foreign direct investment, however, are likely to raise a number of new policy issues for the recipient economies. First, in central and eastern Europe, foreign direct investment has often been concentrated in large dominant companies in oligopolistic industries, such as food processing, telecommunications, and automobiles, where investment returns are likely to be high.42 Antitrust policies need to be strengthened to increase competition and ensure that market entry is possible. Second, foreign direct investment is often accompanied by rising imports and a deteriorating current account as investors import unavailable capital equipment. These trade deficits need not be a cause for concern because they are a reflection of capacity-increasing productive investment, in contrast to deficits associated primarily with consumer goods imports. Finally, rising foreign direct investment has both a temporary and a permanent effect on the real exchange rate.43 Flows of foreign direct investment stimulate demand for nontraded inputs, such as labor and materials, and bid up their relative prices. Until the flows recede and relative input prices revert to their previous levels, there is a temporary real exchange rate appreciation. Such upward pressure on the real exchange rate should not be a cause for concern. Countries with considerable unemployment are less likely to experience these relative price shifts, whereas those with low unemployment, such as the Czech Republic, are more susceptible. At the same time, increases in foreign direct investment add to the domestic capital stock thus improving the marginal productivity of labor, which implies a permanent real appreciation. Attempting to prevent such real exchange rate movements would slow the adjustment process by interfering with and distorting relative prices.

Many transition economies have made significant progress toward the objectives and policy requirements set out in the Interim Committee’s October 1994 Madrid Declaration. Stabilization and reform efforts have been sustained in virtually all of the countries that started early on the road to a market economy. In the others, the costs of delaying the introduction of financial discipline and bold systemic changes have become increasingly apparent in terms of hyperinflation and continued output declines. These countries are now beginning to implement belated, but serious, adjustment measures. Even in the few countries that continue to hesitate to undertake decisive market-oriented reforms, partial progress is being made in areas such as price and exchange rate liberalization.

Notwithstanding the progress to date, continued financial prudence and substantial further institution building will be required in the years ahead, even in the most advanced countries in transition. In most countries, there has been insufficient progress in the areas of enterprise privatization and restructuring and in financial sector reform. The social safety nets necessary to cushion the effects of such changes are often still far from adequate, thus contributing to the postponement of critical reforms. The contribution to growth of spontaneous capital inflows, particularly in the form of foreign direct investment, will be commensurate with the soundness of the macroeconomic fundamentals, the extent of structural transformation, and the success in strengthening and mobilizing domestic saving, which remain the key to economic recovery and the realization of potentially high medium-term growth prospects.

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