Transition countries: current challenges

John Odling-Smee and Gonzalo Pastor
European II Department, International Monetary Fund (IMF)

The Baltic countries, Russia and other countries of the Former Soviet Union (FSU) have made considerable progress towards macroeconomic stabilisation over the last three years, and several are now recording positive economic growth. In virtually all countries in the region, the situation remains fragile, however, because of the pressing need to improve public sector finances, and continued pressures on the authorities by interest groups hurt by the restructuring. Three region-wide issues that have commanded the attention of the authorities and the IMF are:

  • tax revenue collection;
  • the pace of structural reform in countries with IMF-supported structural adjustment programmes;
  • potential banking sector problems.


Monthly inflation rates have fallen to low levels in most of the region.

In the three Baltic countries as well as Russia, Armenia, Azerbaijan, Georgia, Kazakstan, Kyrgyztan and Moldova, inflation is expected to range from 15 to 30 per cent in 1996. Although still high, these rates reflect adjustments in administrative prices and catch-up in domestic prices following the undervalutaion of domestic currencies that prevailed at the outset of economic reforms.

Annual inflation rates above 50 per cent in 1996 are expected for only three countries: Turkmenistan, which does not have an IMF-supported adjustment programme in place; Tajikistan, where an IMF-supported programme started just a few months ago; and Belarus, whose IMF-supported programme is now inoperative.

Declines in output appear to have bottomed out in most of the region, and IMF staff are now projecting postive economic growth in several countries during 1996/97. Actual growth rates may be lower than initially expected, however, owing partly to political uncertainties in Russia and the effect of bad weather on agricultural output. Further output declines are expected mainly in such high-inflation countries as Tajikistan and Belarus.

Exchange rates
Nominal exchange rates are fairly stable in most countries in the region, largely reflecting a reduction in inflation expectations and in line with policy intentions. Currencies continue to appreciate in real terms because of inflation rates that are higher than those of their main trading partners. In the view of the IMF, however, the competitive advantage deriving from the initial undervaluation of the currencies has not yet disappeared in most countries.

External sector
Progress in macroeconomic stabilisation has been associated with rapid export growth and positive trends in official reserves. In most countries, the reserve position is fairly comfortable - equivalent to 2.5 months of imports or more - in marked contrast to the insignificant levels prevailing when these countries first gained independence.

Fiscal position
Budget deficits are now under control in most countries, with monetary financing at very low and declining levels. Tax revenue-to-GDP ratios remain depressed, however. This has resulted in sequestration of government spending and in accumulated payments arrears (including wages and pensions) in many countries.

Economic issues

In addition to these key financial policy issues, the authorities are focusing attention on three structural issues.

Revenue collection
Tax revenue-to-GDP ratios have fallen sharply in most countries of the FSU over the past three to four years. Tax evasion has become another means used by enterprises to avoid the hardening of their budget constraints and delay necessary adjustment. During the initial years of reform, rent-seeking behaviour (that is, the search for financial assistance from the government) and the proliferation of inter-enterprise arrears were the main means firms used to avoid adjustment. Governments increasingly resisted pressure for subsidies and credits, however, and enterprises became stricter about extending credit to each other. As the reform process continued, non-payment of taxes, wages and energy bills became a major means of circumventing budget constraints.

The efficacy of this approach is expected to lessen as governments take firmer corrective measures in the face of the mounting political and social costs of non-payment.

Programme targets
Slippages in meeting structural reform targets, including enterprise privatisation, land reform, trade policy and social safety nets, are probably greater and more frequent than in other areas. These delays largely reflect the complexity of the measures involved, as well as opposition from vested interests and from the slow pace of the legislative decision-making process.

The banking sector
Weaknesses in the banking sector are endemic throughout the region. This fragility stems mainly from activities carried out by inexperienced lenders in a context of systemic changes that further complicate risk assessment; the precarious financial situation of most borrowers; directed lending by governments; and, in some cases, fraud. These underlying problems are now being brought to a head by macroeconomic stabilisation and the strengthened role of central banks in tightening supervision and raising prudential standards. Resolution of banking sector problems should aim to:

  • foster an orderly restructure of the sector;
  • minimise the fiscal impact of restructuring;
  • preserve the financial stability of the economy.
Despite the major restructuring required in the banking sector, the financial costs of recapitalising the banking system and the macroeconomic impact of its problems are likely to be limited because of the relatively small size of the sector in most of the region's economies.

The task ahead

The main task for policy-makers in the FSU is to secure non-inflationary growth over the medium term, while continuing the transformation to market economies.

Economic restructuring has been proceeding forcefully in most countries in the region, but much remains to be done.

First, the old regime has not completely died out: a large share of productive resources, including land, is still in the hands of the public sector and drawing financial resources (taxes and credit) away from productive uses.

Second, the institutional fabric of the market system is still full of gaps. A system of property rights protecting certain basic freedoms (private property, the enforcement of contracts and the right to buy assets such as land, for example) and punishing corruption and uncompetitve behaviour is still missing in many of these countries.

Finally, uncertainty is high and the ability to manage risk is scarce. For an investor in the FSU, macroeconomic uncertainty looms large. Will the next government support reform? Are bank deposits safe, or will they be annihilated by confiscation or a banking collapse? Even financial risk in individual enterprises is difficult to assess given the short history of most enterprises.

Addressing the question of economic growth in the FSU thus requires action to address these three basic problems:

  • bringing to an end the old regime, which includes reducing government intervention in the economy, lessening economic regulation and fostering market competition;
  • consolidating the development of a stable, predictable and fair property rights system;
  • reducing economic uncertainty by preserving price stability, accelerating structural reform and creating a basic institutional framework which would make the move towards the market irreversible and immune to the whims of political leaders.
The achievement of these three tasks would undoubtedly raise the levels of investment and saving in the FSU, accelerate productivity growth, foster the development of healthy financial markets, increase the flow of foreign direct investment and, most importantly, bring about a society in which individuals are free to choose.