- Donal McGettigan
- Published Date:
- February 2000
This appendix provides a brief description of the factors underlying the ongoing situation in Russia and assesses the relevance of the indicators already discussed.
External factors undoubtedly had a role to play in the Russian crisis. Contagion effects arising from the Asian crisis began to be felt in Russia in the latter part of 1997. as manifested by reduced foreign investor confidence in the country’s economy. Declines in commodity prices—especially in the cases of oil and gas, two important Russian products—arose partly from the Asian crisis, and contributed to balance of payments difficulties. Ultimately, however, internal factors are mainly responsible for Russia’s current predicament.
Perhaps the main internal factor contributing to the Russian crisis was the persistent failure to bring fiscal problems under control. Lack of commitment toward fiscal reform at the highest political levels, political opposition to such reform, lack of cooperation by regional governments, and the emergence of influential oligarchs unwilling to share the tax burden all helped stifle the pace of fiscal reform. On the expenditure side, control over spending, particularly in the military area, was also lax.
Such difficulties are clearly reflected in the set of fiscal indicators presented earlier. As Table 3.2 shows, government imbalances have barely fallen since 1993, when the Russian general government deficit stood at 8.6 percent of GDP, the median government imbalance at the time for the Baltics, Russia, and other countries of the former Soviet Union. This deficit remained at 7.9 percent in 1997. the second highest in the group, and far higher than the new, lower median deficit of 3.3 percent. Table 3.3 illustrates that falling government revenues, combined with only modest reductions in government expenditure, were to blame. Of the financial indicators, only two provided some indication that a crisis may have been imminent: the overall debt stock and debt service relative to reserves (Table 3.10) and the high ratio of M2 to gross foreign exchange reserves (3.6 percent), the highest of the countries (Table 3.12).
Other, more long-term, structural factors were also responsible for the Russian crisis. Lack of competition in the banking and enterprise sectors, the persistence of soft budget constraints in the form of arrears tolerance and continued subsidies, and weak property rights are among the main structural problems that have persisted in the absence of fundamental reform. While such lack of reform is not directly reflected in any of the indicators, certain long-run indicators, such as low GDP growth performance (Table 3.9) and lack of openness, reflected by the decline in its export-to-GDP ratio (Table 3.7), showed that Russia’s performance was much worse than that of most of the other countries, thus signifying underlying structural difficulties.
Of the indicators that did not provide accurate signals, Russia’s current account imbalance is the most notable, in that a surplus was recorded in 1996 followed by an almost balanced current account position in 1997 (Table 2.1). As a result, its external debt-to-GDP ratio declined sharply to 27.5 percent in 1997 from 61 percent in 1993 (Table 2.2). Its budgetary debt service had not increased sharply by 1997 (Table 3.5), and its real exchange rate appreciation was not excessive in comparison with the other countries (Table 3.1). Also, its investment rate was not particularly low and stood at almost 27 percent of GDP in 1997 (Table 3.6). Russia’s gross foreign exchange reserves in months of imports increased to 2.3 in 1997 from 1.7 in 1993 (Table 3.11). while none of the banking indicators, except for M2 relative to reserves, provided any idea that a crisis was imminent.
The main implication of this preliminary discussion, and one that is commonly drawn in the indicator literature, is that it is necessary to rely upon a wide variety of indicators when gauging the likelihood of an incipient crisis. Although, invariably, several indicators will convey the signal that all is well, if a number of important indicators are raising danger signals, such as the fiscal and liquidity signals in the Russian case, then it is important to investigate in greater depth the likelihood of a future crisis. This idea has recently been formalized by Kaminsky (1998). who constructs composite crisis-leading indicators based on signals emerging from different sectors of the economy.
Czech Republic, 1997
Unlike Hungary, the Czech Republic achieved early progress in the stabilization of its economy. From the mid-1990s, however, it began to experience increasing macroeconomic imbalances. Large capital inflows under a fixed exchange rate regime led to excessive domestic demand and wage pressures. When the exchange rate band was widened in February 1996, to ±7½ percent, from ±½ percent, the Czech National Bank used its greater independence to increase interest rates and curtail the money supply. Unfortunately, a balanced policy package was not achieved, because supporting fiscal and wage policies were not forthcoming. As corporate governance problems persisted, real wages continued to outstrip productivity growth rates, while fiscal balances, excluding the use of privatization revenues, moved to a deficit of 1.8 percent of GDP in 1995, from a surplus of 0.5 percent in 1993. This deficit declined to 1.2 percent in 1996. Furthermore, while the investment ratio rose because of increased infrastructure and environmental investment, the savings ratio declined as resources moved from the high-savings enterprise sector to the low-savings household sector as a result of excessive wage increases. The combined impact of these policies led to a sharp change in the current account to deficits averaging 7 percent of GDP in 1996 and 1997, from a surplus of 1.5 percent in 1993. These external sector developments, together with internal political uncertainty and the contagion effects from Southeast Asia, weakened confidence in the Czech koruna and, ultimately, led to a foreign exchange crisis in May 1997.
How well would the Czech crisis have been forecast by traditional external sustainability indicators of the types previously outlined? In addition to the worsening of the current account over 1993–96, real GDP growth declined to 4 percent in 1996 from 6 percent in 1995 and, subsequently, to between 1 and 1½ percent in 1997. Poor output performance is symptomatic of underlying problems that may ultimately be reflected in a weakening of confidence in the economy. Furthermore, slower growth makes it more difficult to sustain large current account deficits. Real appreciation, arising from large capital inflows and combined with a pegged exchange rate regime, led to competitiveness problems, as did excessive wage increases. Lack of competitiveness, combined with the diversion of exports to the home market and a slowdown in trading partner markets, led to a sharp slowdown in exports. Merchandise export growth, another indicator previously examined, slowed sharply to zero growth in 1996 from 15½ percent in 1995.
Other signals were not so helpful, however. The Czech Republic had high investment levels and the savings-investment imbalance was driven primarily by private sector, rather than public sector, imbalances, although fiscal imbalances had widened somewhat. The Czech Republic did not have an exceptionally large debt-to-GDP ratio, which stood at 43 percent in 1997, or high debt-service ratios. Also, its share of short-term debt was just above 20 percent in 1997. Broad money growth decelerated sharply in 1996 and even further in 1997, and there was no evidence of diminished public confidence in the banking system, such as widespread deposit withdrawals.
Like other transition countries, Hungary suffered steep output losses at the start of its transition process.83 The effects of the various shocks during this period were, however, exacerbated by policy efforts to shield the household sector from economic turbulence to the greatest extent possible. Fiscal imbalances worsened, to annual deficits greater than 7 percent of GDP in 1992-94 from a consolidated government surplus of 1 percent in 1990, as the tax base shrank and public expenditures did not adjust commensurately. Reflecting continued soft budget constraints, real wages declined less than output, thus lowering savings as resources shifted from the high-savings enterprise sector to the low-savings household sector. Monetary policy was relaxed in 1992. with negative real interest rates remaining until late 1993. Exchange rate policy, which was used to contain consumer price increases, nevertheless led to a sizable appreciation of the real exchange rate.
All these policies harmed the overall savings-investment balances of the Hungarian economy. The consequence was unsustainably large current account deficits, moving to negative balances averaging 10 percent of GDP in 1993 and 1994 from surplus positions in each of the years 1990 to 1992. As a result, net external debt, which already stood at 35 percent of GDP at the end of 1992, increased to 45 percent of GDP by the end of 1994. The authorities’ adjustment program, initiated in March 1995 and including a 9 percent devaluation of the forint on March 13. 1995, succeeded in bringing down the external deficit to a sustainable level, thus avoiding a wide-ranging external crisis.
Thus, many of the indicators examined would have been relevant to the Hungarian situation, especially those relating to the real exchange rate, the fiscal and current account positions, and debt. What of the other indicators considered? On Hungary’s savings-investment balances, these were largely driven by fiscal problems, with the consolidated government position worsening to a deficit of 7½ percent of GDP in 1993 from 3 percent in 1991, before falling back to 6½ percent and 3½ percent in 1994 and 1995, respectively. In contrast to the case of the Czech Republic, real exports increased by more than 13 percent in real terms in both 1994 and 1995, following a real decline of 10 percent in 1993. After a period of decline, real GDP growth of almost 3 percent took place in 1994, although this rate halved in the following year.
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It is not possible to divorce current account sustainability from external sustainability in a broader sense. Accordingly, the terms “current account sustainability” and “external sustainability” are used interchangeably throughout the paper.
Various definitions of “crisis” have been used in the literature. Details of such definitions are provided at the beginning of Section III of the paper.
A HIPC–type analysis has not, however, been undertaken, as this was outside the terms of reference of the study.
References to this crisis are also included in the text, where appropriate.
Current account developments in these countries are also covered by Odling-Smee and Zavoico (1997 and 1998). The experiences of Estonia, Lithuania, and Ukraine are examined by Roubini and Wachtel (1997). alongside the experiences of Bulgaria, Croatia, the Czech Republic. Hungary. Poland. Romania, and the Slovak Republic.
As argued in Havrylyshyn and others (1999). output growth may depend more on the recovery of underused capacity and efficiency gains than on additional investment at the start of the transition process. As transition proceeds, however, heavier emphasis must be placed on investment, as the scope for efficiency gains is reduced.
Throughout the paper average, or mean, values refer to simple unweighted means. Where the distribution of a particular statistic is highly skewed, as is the case of 1997 current account deficits for these countries, the median value is employed.
This reflects the fact that, under the “zero option” agreement. Russia inherited the debt obligations of the Union of Soviet Socialist Republics (USSR), and thus started with a more unfavorable debt position than the Baltics and other countries of the former USSR.
For example, only two of the countries, Tajikistan and Turkmenistan, recorded external-debt-to-GDP ratios in excess of 60 percent of GDP in 1997.
The ratio of total debt (i.e., external plus domestic debt) to GDP was also calculated for all of the countries. With the exception of Russia, domestic debt stocks of Ukraine and the Baltics are small in relation to external debt. Of course, the large buildup of domestic debt in Russia played a significant role in the crisis and, accordingly, total debt stocks and debt service are analyzed in Section III.
Following the zero option agreement in 1992/93. most of the countries, except Russia, were left with little or no external debt.
The median external-debt-to-GDP ratio shows an even sharper upward movement from 1993 to 1994 (to 26.9 percent from 18.9 percent), while having fallen since then. As the distribution of debt-to-GDP ratios is quite skewed, the median values may present a clearer picture of overall developments.
This table is an update of Table 2 from Kapur and van der Mensbrugghe (1997).
The increase in private market financing has been assisted by the fact that a number of the countries have obtained country ratings, although of these only the Baltics have been assessed as investment grade.
While these developments reflect in part the greater willingness of private investors to finance advanced transition economies, such developments also reflect the unwillingness of the World Bank and IMF to sanction potentially unsustainable commercial foreign borrowing by those countries less advanced in the transition process.
In the case of the Baltics, Russia, and other countries of the former Soviet Union, movements in the parallel exchange rate, as well as the official exchange rate, should be considered, because the former may, in certain cases, provide a better picture of underlying pressures or crisis situations.
These authors first discuss the most useful indicators that have emerged from the literature, and subsequently reevaluate their effectiveness in predicting crises over the 1970-95 period.
Flood and Marion (1998) also provide a good review of the theoretical currency crisis literature.
Some indicators of contagion in the Baltics. Russia, and the other countries of the former Soviet Union region are provided in the next section. However, their vulnerability to outside influences, such as world demand and real interest rates changes, is not explicitly analyzed in the paper.
The authors note, however, that many of the indicators listed are simply transformations of the same underlying variables.
As IMF (1998) observes, it is not surprising that the real exchange rate is found to be a useful indicator in the sense that it is often appreciated relative to trends prior to crises, since most crises contain large depreciations. Hence, such real appreciations reflect, to a certain extent, the way in which crises are defined.
Using the plausible assumptions that the tradables sector is capital intensive relative to the nontradables sector, and that the dollar price of tradables is given, the authors demonstrate that a linear relationship between the real exchange rate and dollar wages is implied. Grafe and Wyplosz (1998) also make use of the strong relationship between the real exchange rate and the real wage, and use the finding that there is a 95 percent correlation coefficient between dollar wages and the nontraded/traded goods price ratio to support their approach.
Specifically, the equilibrium real wage is the wage that emerges from a cross-country regression, relating real wages to variables such as purchasing-power-parity-adjusied GDP, school enrollment rates, the share of agriculture in GDP (as a proxy for development), and an index of overall economic freedom. Once these explanatory variables are known, the equilibrium real wage can be calculated for each individual transition country based on the regression coefficients that emerge. The equilibrium real wage is calculated over the 1992-95 period in the case of those countries covered.
The pattern whereby the actual real exchange rate starts from an undervalued position, gradually catches up with the equilibrium as transition proceeds, and finally possibly overshoots equilibrium is outlined by Rosenberg and Saavalainen (1998). In their stylized account, the equilibrium real exchange rate remains flat at the beginning of transition and gradually appreciates thereafter. It is interesting to note that, according to Krajnyàk and Zeltelmeyer’s calculations, the equilibrium dollar wage remained fairly flat for Latvia. Lithuania, and Russia, while increasing somewhat in the case of Estonia. In contrast, the equilibrium wage declines steadily for the remaining countries covered: Belarus. Kazakhstan, the Kyrgyz Republic, Moldova, and Ukraine.
As a further check on the relationship between competitiveness levels and current account positions, in Figure 3.2 the relationship between the percentage increase in dollar wages over the 1993 to 1997 period and the average current account balance over the same period is shown. This time the relationship is positive, although statistically insignificant.
Grafe and Wyplosz (1998) also provide evidence that, in the case of transition economies, there is no apparent link between nominal and real exchange rates.
It may, therefore, be necessary to combine the role of the real exchange rate as a possible indicator with subsidiary indicators, such as export performance, that might indicate whether the real appreciation in question was of the good or bad variety.
Indeed, Grafe and Wyplosz (1998) argue that continuous real appreciation and accompanying increases in the real wage are needed to attract labor away from the unproductive state sector, forcing it to close down inefficient production lines. They do acknowledge, however, that an overly appreciated exchange rate will retard growth in the private traded sector.
David Ricardo is reputed to have first proposed this idea, hence the terminology. The theoretical debate on Ricardian equivalence has been revived since the seminal paper of Barro (1974).
See, for example, Romer (1996), which reports that Ricardo himself is reputed to have ultimately rejected the idea of full substitutability.
IMF (1998) has noted that “in transition countries, sizable fiscal deficits have generally not been offset by higher private saving and have consequently been reflected in large current account deficits” (see p. 103).
These are the public-debt-service-to-government-revenue ratio, considered below, and the public-debt-service-to-government-expenditure ratio. The first indicator is considered later in the section.
Cheasty and Davis (1996) argue that the very high deficits recorded at the beginning of transition reflect a variety of factors, including costly conflicts, the loss of intra-USSR transfers, the liberalization of prices without a corresponding dismantling of subsidies, and a general lack of understanding of financing constraints.
See EBRD (1997), p. 127.
See. for example, Buiter (1997).
See, for example, Hemming. Cheasty, and Lahiri (1995) for details of revenue collection difficulties.
In Moldova, both government revenue and expenditure have risen as a percentage of GDP. In this case, however, both fell sharply from 1992 to 1993.
See IMF (1998), pp. 108-110.
See, for example, de Castello Branco (1998).
According to Fischer, Sahay, and Végh (1996), out of this group of countries, only the Baltics had embarked upon a serious stabilization attempt prior to 1993.
Turkmenistan is the only country that has not yet made some serious attempt to reform. Belarus and Uzbekistan represent cases, however, where earlier reform efforts are unraveling over time.
As Roubini and Wachtel (1997) contend, however, if consumption has been held at an artificially low level for a sustained period, consumption-led current account deficits may be beneficial.
Sachs, Tornell, and Velasco (1996) do not find any econometric support for the hypothesis that current account deficits caused by an increase in investment are less likely to lead to an external crisis than those resulting from higher consumption.
The positive relationship between the pace of structural reforms and economic growth is discussed later in the paper.
EBRD (1997) notes that foreign borrowing was. in certain instances, explicitly for the purpose of reducing budgetary pensions and wage arrears (see p, 129).
To put investment rates in context, according to IMF (1998). the average investment rate in the newly industrialized Asian economies was 32 percent of GDP in 1997—of which almost 7 percent was public— and 28 percent in developing countries.
See Brau (1995) for an elaboration of this viewpoint.
A more pessimistic view of the use of foreign funds for government consumption purposes is that these monies could have been used to postpone necessary structural adjustments. See. for example, Kapur and van der Mensbrugghe (1997), and Odling Smee and Zavoico (1997 and 1998).
This doctrine is named after the former U.K. Chancellor of the Exchequer, Nigel Lawson. who argued that current account deficits reflecting private sector behavior should not be a cause for concern. See also Corden (1977. Chapter 3, and 1994, Chapter 6) for an elaboration of this viewpoint. Corden recognizes, however, that this argument does not hold where private sector behavior is based upon misleading information, where there are divergences between private and social costs and benefits, or where there are explicit or implicit government guarantees for private sector borrowing,
Many of these arguments are outlined by Reisen (1997)
Of course, openness in a broader sense reflects many factors other than the ratio of exports to GDP. A fuller definition would include the presence of formal and informal barriers to trade, the environment for foreign investors, currency convertibility, and so on. An oil-rich exporter may be deemed to be open according to the above table and yet may have a closed trade regime.
Median values are used here because the sharp decline in the share of exports in GDP in Turkmenistan—reflecting the steep drop in its energy exports—distorts the mean values.
EBRD (1997) argues that the law of one price does not necessarily hold in the transition economies. It states that “severe deficiencies in domestic distribution systems in most transition economies effectively led to a segmentation of markets and, given the initial overcapacity in many industrial sectors, to prices for domestically produced tradable goods that could be far lower than world market levels (even adjusted for quality)” (see p. 132). The declining share of exports in GDP will be offset to some extent by any real appreciation that takes place through convergence of traded prices.
Of course, the impact of second-round trade effects are not considered when using such an indicator.
The dependence of growth on a variety of factors covered elsewhere in the paper should be borne in mind. To this extent, the growth rate is similar to the real exchange rate indicator, in that it encapsulates many different aspects of the performance of an economy. For instance, although higher growth in itself leads to lower vulnerability, this generally requires higher investment, which, of course, may have implications for a country’s current account position.
As noted below, the Russian crisis has seen a reversal of positive growth in certain other countries in the group.
See Anderson, Citrin. and Lahiri (1995) for an elaboration of these arguments.
This decline largely reflects the collapse of energy exports during 1997.
The IMF approach follows closely that of Fischer, Sahay, and Vegh (1998).
The variable included is the International Country Risk Guide index, which attempts to encapsulate security of property rights and contract enforcement, and is published by Political Risk Services, a U.S. company.
Once again, however, the Russian crisis demonstrated that domestic-currency-denominated debt (in this case, short-term government treasury bills) can be a real threat, regardless of who the ultimate holders are.
Garibaldi and others (1999) find that FDI flows to transition countries have been highly concentrated, with the vast majority moving to Central European countries and to the Baltics.
Indeed, official capital inflows may increase in times of economic stress. Furthermore, much of the financing from international organizations is also concessional in nature, thereby making such debt easier to service.
Selowsky and Martin (1997) find that the share of FDI in GDP is positively related to economic reform in transition economies.
Most of this external debt is denominated in foreign currency, although this is not necessarily a cause for concern, given that much of the debt is owed to multilateral institutions. Moreover, available information suggests that short-term debt (i.e., of less than a year’s duration) does not account for a very high proportion.
Debt service ratios greater than unity can be explained by the fact that debt service figures represent a flow, whereas gross reserves are measured at the end of the year.
Rojas-Suá rez and Weisbrod (1995) argue, however, that large stocks of foreign exchange reserves can lead to delays in the correction of policy inconsistencies and that when domestic interest rates, adjusted for the exchange rate, are greater than international rates earned on reserves it can be costly for the authorities to hold excessive amounts of reserves. In many of these countries, however, reserves are largely built up using loans from international financial institutions on favorable terms.
Nevertheless, in the empirical section of their paper they adjust the ratio by its first-log-difference standard deviation, also citing the example of Austria as the reason for doing so.
Other countries, however, such as Estonia in 1992, and Latvia and Lithuania in 1995, experienced banking crises without any fundamental external implications.
The argument that transition economies face problems of a distinctive nature is also made by Demirgüć-Kunt and Detragiache (1997).
Some of the external crisis indicators considered above, such as GDP growth rates and inflation, have also been found to be useful in predicting banking crises. See Demirgüć-Kunt and De-tragiache (1997) for details.
Several measures were introduced as of 1997 by the Estonian authorities in response to the rapid increases in credit, including higher banking capital adequacy ratios and reserve requirements.
Data on this and the following capital adequacy indicator are only available for a few of these countries prior to 1997.
The very volatile macroeconomic environment that has characterized most transition economies since independence would also be expected to contribute to the bad loan problem in this group.
This reflects the fact that the Savings Bank, the country’s largest holder of deposits, is forced to hold most of its deposits with the central bank for prudential reasons.
The Lawson doctrine—that private-sector-based current account imbalances are no cause for concern—was found to be subject to too many shortcomings to provide grounds for complacency on this account.
Investment data from these countries are. however, of very poor quality and are subject to considerable uncertainty.
The background to the turbulence experienced by Hungary in its early years of transition is described by Cottarelli (1998), upon which the information in this appendix is based.
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Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMF Publication Services.