Download Macroeconomic Stabilization and Capital Inflows in Transition

Bostjan Jazbec*
Faculty of Economics
Ljubljana
______________________________________________________________________________
Macroeconomic Stabilization and Capital Inflows in Transition Economies
*
Abstract
*
The average rates of inflation in Central and Eastern European countries are still well above the
rates in their Western European counterparts. From that perspective, the transition in Central and
Eastern Europe has not yet been finished. In theory, liberalization and privatization can take
place without price stabilization, however, in practice the lack of latter has proved to be fatal for
many transition economies. Consequently, price stabilization is therefore the necessary, although
not sufficient, condition for an effective transition from centrally planned to market oriented
economy. Moreover, it is argued that the volume of foreign direct investments depends on the
degree of macroeconomic stabilization and the type of inflation stabilization program which was
conducted in the beginning of transition process. In other words, it seems that only economies at
a more advanced stages of transition and macroeconomic stability have experienced the surge of
capital inflows.
Makroekonomska stabilizacija in tokovi kapitala v državah v prehodu
*
Povzetek
*
Inflacija v državah srednje in vzhodne Evrope je še vedno večja od povprečnih inflacijskih
stopenj v zahodni Evropi. S tega vidika tranzicija še ni končana. Liberalizacija trgov in cen ter
privatizacija lahko načeloma potekata v razmerah visoke inflacije, čeprav dejstva zadnjih let
kažejo, da lahko prav neukročena inflacija ogrozi prestrukturiranje držav v prehodu. Trdili bi
lahko, da je stabilizacija cen torej predpogoj za učinkovit prehod iz planskega v tržno
gospodarstvo. Umiritev cen in izvedba stabilizacijskega programa pa hkrati določata tudi obseg
pritoka tujega kapitala – predvsem tujih neposrednih investicij. Podatki kažejo, da so samo
države, ki so uspešno stabilizirale svoja gospodarstva, med večjimi prejemnicami tujega kapitala.
I would like to thank Christof Rűhl from the World Bank for helpful comments and suggestions. All
remaining errors and conclusions are mine.
*
Table of Contents
I. Introduction
1
II. Inflation Stabilization Programs in High Inflation Countries
4
III. Macroeconomic Stabilization and Capital Inflows
10
IV Conclusions
12
References
Appendix
14
I. Introduction
At the time the transition began, there was little or no experience of economic
transformation from centrally planned to market oriented economies at all. Therefore, all advises
and help to design the reforms had to be drawn on general economic principles or - at somehow
lesser extent - lessons from structural reforms in developing countries. Although some of
transition economies1 had undergone economic reforms during an old era of communism (e.g.
Yugoslavia), the transition process at the end of 80’s did not focus solely on the economic
restructuring of the economy, but also and at most on political reform aiming to proliferate the
democratic transformation of the society. However, as it was the case in some transition
economies the macroeconomic stabilization proved to be the background for a political
reorganization and smooth path to a sound democracy. If the initial macroeconomic stabilization
program conducted by reformist party had failed, former communists overtook the governing of
economy. However, not all transition economies have started with a new non-communist
government. Accordingly, the economic policies aimed to stabilize and restructure the economy
have been implemented on different premises. Aslund, Boone and Johnson (1996) look at the
correlation between political regime and economic policies - aimed especially to macroeconomic
stabilization - and conclude that in these terms, transition economies can be divided into five
groups. First group of countries like Poland (1990)2, former Czechoslovakia (1991), Estonia
(1992), Latvia (1992), and Albania (1992), was initially ruled by liberal governments which
enforced radical reforms in order to stabilize and liberalize the economies. Inflation usually
soared in the beginning of the reform, but was then brought rapidly down to less than 50 percent.
A second group of countries has proceeded with less radical reforms enforced, however, also by
non-socialist governments: Hungary, Lithuania, Bulgaria, Russia, and the Kyrgyzstan. With the
exception of Hungary, all these countries had higher inflation after two years of reform than the
countries from the first group, and none had inflation of less than 50 percent by 1994. In third
group there are countries where the former communists stayed in power and delayed the reform.
This was the case of Romania, Moldova, Belarus, Ukraine, Kazakhstan, Uzbekistan, and
Turkmenistan. Significant cuts in inflation rates were gained only in years of 1994 and 1995.
However, in some countries from this group (Belarus and Romania) the macro projections of
increasing inflation have indeed materialized in recent years. The fourth group consists of wartorn countries of the former Soviet Union: Georgia, Armenia, Azerbaijan, and Tajikistan which
entered the transition with high inflation and remained there until 1995 when even in these
countries were able to cut down the inflation from over 1000 percent at the beginning of
transition in 1991. The last group represents countries of former Yugoslavia which began the
macroeconomic stabilization already at the end of 80’s end entered the transition with relatively
1
2
There are 26 transition economies as classified by EBRD.
The take-off of the reform as determined by Aslund, Boone, and Johnson (1996).
1
low rates of inflation in comparison with other transition economies. Data on inflation in
respected groups of countries are presented in Table 1. Aslund, Boone and Johnson (1996) define
the degree of reform on two criteria: how rapidly inflation was brought under control, and the
change in the level of the liberalization index as measured by de Melo, Gelb and Denizer’s index
(1996)3.
Although some countries have tried to undertake early and radical stabilization and
liberalization and others have chosen to delay the implementation of these policies, the central
problem in transition economies is still the one of controlling inflation. The average rates of
inflation in Central and Eastern European countries are still well above the rates in their Western
European counterparts. From that perspective, the transition in Central and Eastern Europe has
not yet been finished. In theory, liberalization and privatization can take place without price
stabilization, however, in practice the lack of latter has proved to be fatal for many transition
economies. Consequently, price stabilization is therefore the necessary, although not sufficient,
condition for an effective transition from centrally planned to market oriented economy. Despite
significant differences in economic structure and institutional frameworks, the inflation and
stabilization experiences of transition and market economies are similar in many respects.
Monetary accommodation and lack of financial discipline are crucial in sustaining inflation.
However, the transition economies have started the process of disinflation with inherited
instabilities in the system. Price liberalization and privatization fueled the inflationary spiral and
almost endangered economic and political reformation of previously centrally planned
economies. The evidence on transition economies confirms the overdetermination of prices and
wages in these economies (Sahay and Vegh, 1995). The source of inflation inertia has been
usually linked to the traditional factors of excessive money and wage growth, but also to an
underlying natural pressure for real exchange rate appreciation and relative price adjustments.
Additional characteristics of the transition economies have been increasing capital inflows to the
region. Although these inflows could be the sign of a growing confidence in transition countries,
they could also bring their own problems which have already been demonstrated particularly in
Czech Republic and Russia.
An attempt to stabilize the inflationary economy requires the choice of nominal anchors
which are a necessary condition for the stabilization in a sense that at least in a long run the
chosen variables will converge to the predetermined rate of growth of the anchors. The history of
the inflation stabilization tells us that either the nominal exchange rate or the money supply are
among the most effective nominal anchors to be used in inflation stabilization throughout the
world. The relevant additional anchors generally fall under money or credit constraints, nominal
interest rates, price and wage controls. Fisher, Sahay and Vegh (1996) emphasize the need for
action in transition economies in six areas: macroeconomic stabilization; price liberalization;
trade liberalization and
3
For the purpose of the paper focus is only on the inflation rates.
2
current account convertibility; enterprise reform (especially privatization); the creation of safety
net; and the development of the institutional and legal framework for a market economy
(including
Table 1: Inflation rates in percents and classification of reforms4 in transition economies
1991
1992
1993
1994
1995
1996
1997
Radical reform
Poland
Czech Republic
Slovak Republic
Estonia
Latvia
Albania
60
52
58
304
262
104
44
13
9
954
959
237
38
18
25
36
35
31
29
10
12
42
26
16
22
8
7
29
23
6
19
9
5
15
13
17
15
9
7
12
8
42
Gradual reform
Hungary
Bulgaria
Lithuania
Russia
Kyrgyzstan
32
339
345
144
170
22
79
1161
2501
1259
21
64
189
837
1363
21
122
45
217
96
28
33
36
132
32
20
311
13
22
35
17
592
10
14
24
Ex-communist
Romania
Moldova
Belarus
Ukraine
Kazakhstan
Uzbekistan
Turkmenistan
223
151
93
161
137
169
155
199
2198
1558
2730
2984
910
644
296
837
1994
10155
2169
885
9750
62
116
1900
401
1160
1281
1328
28
24
243
182
60
117
1262
57
15
40
40
29
64
446
116
11
99
15
12
40
44
War-torn
Georgia
Armenia
Azerbaijan
Tajikistan
131
25
126
204
1177
1341
1395
1364
7488
10896
1294
7344
6473
1885
1788
1
57
32
85
2132
14
6
7
41
9
19
7
105
Former Yugoslavia
FYR Macedonia
Croatia
Slovenia
230
250
247
1925
938
93
230
1149
23
55
-3
18
9
4
9
0
3
9
8
4
9
Source: EBRD Transition Report 1997,
Aslund, Boone and Johnson (1996).
4
As in Aslund, Boone, and Johnson (1996).
3
the creation of a market-based financial system). One cannot separate one area of action from the
others. However, the sound macroeconomic stabilization is necessary for the success of all other
reforms since it forces some state enterprises to contract as a consequence of the implementation
of hard-budget constraints and pushes people into a new private sector.
The structure of the paper is as the following. Section II presents the overview of the
inflation stabilization programs in high inflation countries. Two types of inflation stabilization
programs are presented: exchange rate- and money-based programs. Advantages and
disadvantages of both are sketched. Special attention is paid to the transition economies. Section
III presents some facts on the surge of capital inflows in the region. The evidence on capital
inflows is assessed in the lights of different stabilization programs implemented across the
Central and Eastern Europe. It is argued that the volume of foreign direct investments depends on
the degree of macroeconomic stabilization and the type of inflation stabilization program which
was conducted in the beginning of transition process. In other words, it seems that only
economies at a more advanced stages of transition and macroeconomic stability have experienced
the surge of capital inflows. Section IV provides a general conclusion and indicates the areas of
further research.
II. Inflation Stabilization Programs in High Inflation Countries
In order to start with the stabilization the main causes of inflation have to be eliminated.
If this is not so, even the best stabilization policy is most likely to fail in an attempt to bring the
economy on the path of long-run growth and stability. Generally, two main causes of inflation
can be identified:
1. Fiscal indetermination which initiates money creation. Money supply is then driven by the
financing requirements of the government. However, it is not the budget deficit per se which
is the cause of inflationary money creation, but the reasons of why the government budget is
in deficit. The causes of budget deficits in transition economies can be traced down to:
particular institutional factors as was the case in the former Soviet Union (Johnson, 1994;
Havrylyshyn, Miller, and Perraudin, 1994); liberalization and privatization of enterprises
which caused the lack of tax revenues (McKinnon, 1991); labor market disequilibrium
(Aghion and Blanchard, 1993), soft-budget constraints (Calvo, 1991), and others. The
4
stabilization of fiscal dominated inflation requires the elimination of the main reasons for the
budget deficit and the control over the money supply.
2. Balance of payments difficulties which affect the exchange rate. The adverse balance-ofpayments developments force exchange rate depreciation which in turn deteriorates inflation
and budgetary performance. In a setting of passive money, exchange rate disturbances then
cause inflation (Dornbush, 1987). This phenomenon was particularly important in explaining
recent financial and macroeconomic turmoil in East Asia and, currently, in Russia. The crisis
usually occur as the economy enters a recession5 , following a period of economic recovery
that was fueled by rapid credit creation and heavy capital inflows accompanied by
appreciated domestic currency (Kaminsky and Reinhart, 1996).
The determinants of inflation could also traditionally be identified as various demandpull and cost-push factors that have successfully explained the temporal behavior of inflationary
processes. Classic demand-pull factors include periodic episodes of money or credit growth
expansion as well as the familiar pattern of monetization of fiscal deficits. On the other hand,
cost-push factors of inflation focus on wage growth in excess of productivity and on structural
supply shortages that tend to drive up price levels in the short run. It is established as a stylized
fact that the transition economies rather experience both demand-pull and cost-push
determination of the inflation. Moreover, both groups of factors seem to originate in fiscal
imbalances characteristic to the transition process.
It is a question what to do first: either to bring the inflation rate down by cutting the
money supply or to eliminate the main cause of inflation. The experience from the successful
stabilizations shows that these two issues usually go in step with each other. It is believed that
disinflating can be done quickly, but stabilizing takes longer. The inflation rate may be brought
down very abruptly, but lasting stabilization demands that people both in and out of government
modify patterns of behavior that have become fundamental through prolonged experience with
inflation (Heymann and Leijonhufvud, 1994).
The most important question when inflation stabilization takes place is whether people
will accept and believe in the stabilization program, and therefore change their behavior which is
pertinent to inflationary environment. By choosing the right nominal anchor, policymaker can
command the credibility of the program. It is believed that when the stabilization policy is fully
credible, inflation falls instantaneously without significant output costs. On the other hand, when
5
This is not exactly the case in Russia. However, it is believed that unfavorable movements in Russian
balance of payments (surge in short term capital flows mainly generated to finance the budget deficit)
triggered the crisis.
5
the stabilization program is not credible, the economy experiences relatively high output costs
(Vegh, 1992). The choice of main nominal anchor greatly depends:
Firstly, on the cause of inflation in the economy. If inflation is initiated by imbalanced
budget and constant need of government to finance it by printing money, it is most likely that
money-based stabilization program is introduced. In so doing, the central bank reduces the rate of
money growth and thus eliminates the main cause of inflation. On the other hand, the balance of
payments crisis rather implicitly require exchange-rate-based stabilization. By fixing a nominal
exchange rate, the central bank reduces volatility on the foreign exchange market and soothes the
inflationary pressure in the economy.
And secondly, on the public perception of inflation. People relatively soon realize their
costs of inflation in everyday life. In order to protect their wealth held in money, they figure out
numerous ways to fight inflation. Transactions are processed faster, wages and prices are
indexed, people use foreign currencies to keep the real value of their money balances stable, time
span for bank credits is shortened and so forth. The stabilization program must cut this kind of
behavior by persuading people that stabilization will be successful. In this respect, the use of
nominal exchange rate as a nominal anchor in the stabilization program has great advantage over
the money-based stabilization policy. People can daily check the exchange rate in the news. By
so doing, they value the promise of policymaker regarding the inflation stabilization. After a
while, people either adapt their behavior and expectations about inflation to the new
circumstances or continue to work out their fight with inflation. If latter, the stabilization
program has little chances to succeed ever.
Getting rid of high inflation has proved to be a long process. More often than not,
stabilization attempts have failed and inflation has come back with even more devastating effects
on the economy. With few exceptions, most major stabilization programs in high-inflation
countries (before the transition process in Central and Eastern Europe) have used the exchange
rate as the nominal anchor. In fact, during the past 30 years there have been 13 major exchangerate-based stabilizations in Argentina, Brazil, Chile, Israel, Mexico, and Uruguay. Rebelo and
Vegh (1995) describe the stylized facts on these episodes with the following nine points: slow
convergence of the inflation rate to the devaluation rate; an initial expansion in economic activity
followed by later slowdown; real exchange rate appreciation; an ambiguous response of real
interest rates; a remonetization of the economy; a deterioration of the trade and current account;
a large fiscal adjustment in successful programs; and a boom in the real estate market.
Despite some unfavorable effects of the exchange-rate-based stabilization programs, it is
believed that using the exchange rate as nominal anchor produces a sudden end of high inflation.
Sargent (1982) attributes this sudden end of inflation to the re-establishment of a credible
intertemporal macroeconomic policy, mainly fiscal discipline and central bank independence.
6
This in turn, increases the credibility of the stabilization program. Stopping the exchange rate
depreciation is, therefore, tantamount to ending inflation. On the other hand, the money-based
stabilization programs are mainly characterized by possible lack of credibility which the
exchange-rate-based programs relatively easy achieve by reducing the exchange rate depreciation
and providing visible effects of the stabilization6. Controlling the money supply growth does not
produce an immediate visible progression in slowing down the inflation rate. This is mainly due
to a relatively rigid transmission mechanisms of monetary policy in high inflation economies,
and the fact that the real money supply cannot change on impact when the program is introduced
(Calvo and Vegh, 1992).
Additionally, there is one more distinctive characteristic between the exchange ratebased and money-based stabilization programs. It can be captured by the picturesque expression
“recession now versus recession later” (Calvo and Vegh, 1992). The evidence on different
stabilization programs in Latin America and Israel shows that the choice between using the
money
supply as the nominal anchor or the exchange rate may imply choosing the timing of the
recession. Under the money-based program recession usually takes place in the beginning of the
stabilization, while in the case of the exchange rate-based program, it occurs later (Hoffmaister
and Vegh, 1996). In this respect, the money-based program seems to be better since the economy
struggles with the recession on the beginning of the stabilization. This can be less harmful then
the later recession which may change people’s inflationary expectation. Consequently, this can
affect the success of disinflationary program. Timing of the contractionary costs associated with
reducing inflation, therefore, depends on what nominal anchor is being used.
Although both programs exhibit an output loss, Fisher (1986) shows that the case of
exchange-rate stabilization is in general less costly. For the same drop in inflation rate, the fall in
the quantity of money is smaller under exchange-rate adjustment. The extent of recessions is
therefore smaller than in the case of the money-based program. Sargent (1992) on the other hand
shows that a larger recession with monetary stabilization could, in principle, be avoided if the
reduction in the growth rate of money supply is coupled with one-at-the-time upward adjustment
in the level of the money stock. However, such a monetary expansion would again create a
credibility problem.
Bruno (1991) further provides several quasi-practical advantages of choosing the
exchange rate over the money supply in the process of disinflation. Firstly, in an open economy,
tradable goods present a substantial part of the goods basket and thus of the components of the
price level. Stabilizing the exchange rate therefore provides a more important and clearer signal
6
This is, of course, true only in a very short interval. People can observe the change of policy directly in the
newspapers by looking at current exchange rates. A clear signal of sharp shift in policy, therefore, generates
the credibility needed for the success of the stabilization .
7
to the rest of the economy that the indirect signal embodied in the quantity of money. Secondly,
the exchange rate is also used in setting the wages which again generates the stability of the
economy. And finally, the monetary targets are not stable especially during disinflations.
While inflation dynamics in transition economies can be described by the same basic
factors that are used in market economies, there are critical institutional and historical legacies
from the centrally planned era which have affected the transition process. Calvo and Kumar
(1994) summarize four striking feature of former centrally planned economies in the transition to
a market-based system. First, output in all transition economies has dramatically declined. Some
estimates range between 20 to 40 percent, although it seems that this figure is even higher 7. The
decline in output has been accompanied by sharp increases in unemployment. In some countries
unemployment rate came close to 15 percent of the work force. Second, in the period after price
liberalization inflation sharply increased. It should be noted that some countries entered the
transition with very high inflation rates (e.g. Yugoslavia and consequently all former Yugoslav
republics). Third, in most countries large fiscal deficits have emerged as a result of the dramatic
decline in tax revenues, largely because of the steep drop in output. This fall in government
revenue has not been matched by an equal reduction in public spending. Governments in many
countries have continued subsidizing state-owned firms in order to prevent further output decline
and rise in unemployment. And fourth, there has been a huge initial deterioration of the external
current account and depreciation of the real exchange rate. Nonetheless, the real exchange rate of
most transition countries has appreciated significantly since the onset of the reforms, adversely
affecting the competitiveness of the exporting sectors (Krajnayak and Zettelmeyer, 1998).
Macroeconomic policies in transition economies have primarily focused on containing
the inflationary consequences of price liberalization and what was considered to be a significant
monetary overhang. Supply shortages and deteriorating real monetary balanced have accelerated
the inflation rates across the region. In order to immediately cut down the inflationary
expectations, most transition economies have introduced the exchange-rate-based stabilization
programs. In so doing, the credibility of the stabilization programs across the region was at least
temporarily established. People were able to daily check the progress of the stabilization by
looking at current exchange rates. This effect was reflected in a relatively successful stabilization
of the velocity of money and stable money demand in a very short period of time (Sachs, 1994).
In addition, few other factors were identified that appear to have undermined the use of money as
an anchor especially in transition economies (Sahay and Vegh, 1995):
1. Unpredictability in the velocity of money. In high-inflation countries velocity is likely to be
subject to unpredictable shifts often magnified by a high degree of currency substitution. The
magnitude of the decline in velocity of money is difficult to predict, especially in a transition
economy. With greater demand for money which is fueled by lower inflationary
7
All data referred to the transition economies are from EBRD Transition Reports of various issues.
8
expectations, velocity of money should fall. However, structural changes in the economy
might even increase the velocity despite successful inflation stabilization. In this respect, the
money target can be over- or under-estimated.
2. Lack of instruments of monetary control. Most transition economies enter the stabilization
with inadequately developed financial markets and monetary policy tools. Open policy
operations as one of the most important policy instruments for controlling the money supply
cannot be implemented effectively. Also reserve requirements most often do not provide a
sound monetary policy tool because of the specific structure of the banking system (see
Johnson (1994) for broader analysis).
3. Currency substitution. People use foreign currency in high inflation economies in order to
retain their real value of wealth. Stable foreign currency substitutes inflationary money
which is still in use. As a consequence, the definition of broad money changes and monetary
policy loses its sharpness (see Rodriguez (1993)).
4. Targets on variables such as foreign exchange reserves and real exchange rates may be
inconsistent with monetary targets. In an attempt to smooth out the exchange rate
fluctuations, interventions in the foreign exchange market are unavoidable. Such
interventions are most likely to be inflationary biased when targeting the money supply is
not an immediate goal of the stabilization program (Calvo, Reinhart and Vegh, 1995). When
additional targets on nominal interest rates are set, monetary policy also loses its tightness.
Despite relative favoritism of exchange rate-based stabilization over money-based
programs not all countries with high and persistent inflation were able to implement it. Table 2
provides information on exchange rate regimes in transition economies. According to the
different inflation stabilization programs, flexible exchange rate regime corresponds to the
money-based program and fixed exchange rate regime to the exchange rate-based stabilization
reform.
Although the Central and Eastern European countries have adopted different exchange
rate regimes, they have all experienced real appreciation as well as large inflows of capital in a
relatively short time span (Halpern and Wyplosz, 1997; Krajnyak and Zettelmeyer, 1998).
Capital inflows are important to the process of rebuilding and recovery from the severe economic
problems mostly created by the effects of central planning. However, the surge of capital inflows
- if not landed on solid macroeconomic grounds - may further deteriorate the external position of
the economy as it was the case in Russia in recent months.
9
Table 2: Exchange Rate Regimes in Transition Economies
______________________________________________________________________________
Flexible Exchange Rates
-----------------------------------------------------------------------------------------------------------------------Albania, Armenia, Azerbaijan, Belarus, Bulgaria, Georgia, Kazakhstan, Kyrgyzstan, Moldova,
Romania, Russia, Slovenia, Tajikistan, Ukraine, Uzbekistan
Fixed Exchange Rates
-----------------------------------------------------------------------------------------------------------------------Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Macedonia, Poland, Slovak
Republic
______________________________________________________________________________
Source: EBRD Transition Report 1997 ; Fisher, Sahay and Vegh (1996).
III. Macroeconomic Stabilization and Capital Inflows
Net capital flows into transition economies started already during the 1980’s. There were
largely in the form of commercial bank loans and trade finance to the state-owned banks and
companies. At the outset of transition in the beginning of the 1990’s, there was a large rise in the
official lending, while private flows were still waiting for the signs of recovery and
macroeconomic stabilization in the region. After almost a decade of transition, the magnitude of
these inflows to the transition economies is still small compared to other regions - especially
South Asia. Also their composition has changed dramatically since the time of central planning.
Nowadays, most of those inflows consist of foreign direct investments and equity portfolio
investment. Moreover, the capital inflows tend to be distributed extremely unevenly across the
receiving countries. Figure 1 presents the cumulative capital inflows and foreign direct
investments (FDI) in transition economies during 1991 - 1997. If the movement of total capital
inflows is difficult to explain, because they consist of private and official foreign lending
together and some countries in the region had different agreements with international financial
institutions (e.g., debt forgiveness in Poland in 1995), it is the FDI which reflects the progress in
10
transition and macroeconomic stability. It is widely accepted, that portfolio investment and
commercial bank lending usually follow the FDI flows in developing and emerging markets. This
conclusion is firmly drawn from the fact that FDI is strongly based on a human capital and
natural resources endowments together with the advantages of a geographical position of a
certain country. However, since FDI primarily represents long term investment it must be the
case that the long term investors generate their investment decisions on the grounds of sound
macroeconomic and political environment. Recent developments in Russia support this argument
since Russia did not have large FDI per capita (see Figure 1 in Appendix) in recent years. And
moreover, Russia did not show any positive signs of macroeconomic recovery and progress. It
was primarily a speculative capital which entered the country following the enormous yields on
government bonds (GKO) used to finance budget deficit. Assessing the macroeconomic
performance of Russia, one could conclude that Russia is still far from sound macroeconomic
stability needed to attract FDI. The opposite arguments holds for Hungary, Czech Republic,
Poland, Estonia and Slovenia, just to mention the group of five countries which are about to join
the European Union, where macroeconomic stability and democratic processes were strong
enough to persuade foreign investors to form their long term interest in these countries (see
Figure 2 in Appendix). Not surprisingly, these countries are also the main recipients of the FDI.
Table 3 reproduces the evidence on FDI per capita in selected transition economies.
Table 3: FDI per capita (in USD Millions)
1991
1992
1993
1994
1995
1996
1997
Hungary
140.3
142.8
227.1
106.5
432.4
192.7
194.2
Czech Republic
49.6
95.4
48.4
99.4
264.1
122.7
97.1
Poland
3.1
7.4
15.1
14.1
29.4
71.1
116.6
Estonia
na
36.25
97.5
141.33
132.7
74.0
133.3
Slovenia
20.5
56.0
55.5
65.5
85.0
90.0
170.0
Latvia
na
15.9
19.6
62.0
63.5
92.0
120.0
Bulgaria
6.5
4.9
4.7
12.5
9.8
11.9
51.2
Romania
1.6
3.1
4.2
15.3
17.9
18.4
40.7
Russia
na
4.7
3.3
3.9
13.6
13.8
21.0
Ukraine
na
3.3
3.8
1.9
5.8
9.8
7.8
Source: EBRD Transition Report 1997 and IMF IFS of various editions.
11
It is only Latvia where FDI have a comparable volume to the mentioned group of the
most developed transition economies. All other countries fall below the line of 100 USD
Millions of FDI per capita in 1997. One of the possible explanation for the bad performance in
the light of foreign capital inflows could be found in poor macroeconomic environment and
stabilization programs in those countries. The correlation between the intensity of reforms and
macroeconomic performance in the transition economies was already formally and empirically
established (Aslund, Boone and Johnson (1996); Fisher, Sahay and Vegh (1996)). In the
countries which implemented and conducted radical reforms, output growth was back on positive
track and inflation was cut down to the levels around 10 percents. Not surprisingly, those
countries are also the main recipients of FDI (compare Table 1 and Table 3). Moreover, direct
comparison between the strength of reforms and the volume of FDI also show one important
similarity. All radical-reformed economies with high FDI per capita have introduced the
exchange rate-based stabilization programs (see Table 2). The only exceptions are Hungary and
Slovenia. Hungary is classified by Aslund, Boone and Johnson (1996) as a gradual-reformed
economy. However, some authors (Siklos (1996); Halpern and Wyplosz (1996)) claim that
Hungary has indeed implemented the radical reform in order to stabilize the economy. The
confusion, therefore, originates in different definitions of reform. The case of Slovenia - on the
other hand - is different in the sense that Slovenian stabilization program is a school example of a
money-based stabilization. The choice for the money-based stabilization in 1992 was determined
by the fact that Slovenia did not have enough foreign currency reserves to support the fixed
exchange rate regime. Additionally, Slovenia already performed some macroeconomic and
political reforms before the ‘official transition’ had started. Ignoring the distinguishing
characteristics of Hungary and Slovenia, one can conclude that in addition to the degree of
political determination of governments to reform the economies, it is the choice between the
money- and exchange rate-based stabilization program which helps us understand the dynamics
of capital flows into transition economies.
IV. Conclusions
Rather short exposition of relevant facts in transition economies may disguise some
important macroeconomic developments in certain Central and Eastern European countries.
However, looking only at data on inflation, type of inflation stabilization program, and FDI per
capita one can draw interesting conclusions on the progress of transition in the region. Exchange
rate-based inflation stabilization program, introduced and implemented by determined radicalreformed government, generally implies relatively short period of time needed to cut down the
inflation rates. In all those countries where governments have conducted a radical reforms,
inflation rates in 1997 were cut down to around 10 percents. All these countries have introduced
a fixed exchange rate regime on the premises of exchange rate-based stabilization program. Not
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surprisingly, these countries are also the main recipients of foreign capital inflows. More
specifically, Poland, Czech Republic, Estonia, Hungary and Latvia have the highest ratios of FDI
per capita among all transition economies. Because of rather specific initial conditions at the
beginning of transition, Slovenia also falls in the group of the most developed transition
economies although its transition record is different. It is therefore possible to conclude that the
type of stabilization program matters in a sense that its implementation assures relatively short
inflation stabilization period and attraction of foreign capital. If governments are not determined
to stabilize and restructure their economies, even the best exchange rate-based stabilization
programs may fail. Rather educational example is the case of Czech Republic in the middle of
1997 and recent developments in Hungary and Croatia, for example.
Nonetheless, this short presentation hopefully indicates a research area, namely the
inflation stabilization programs, which may help to understand and analyze the dynamics of
foreign capital flows to transition economies. Since it is only a small group of transition
economies which has shown the macroeconomic progress in recent years, this research area still
requires full attention. Only few countries were able to cut down their inflation rates below 10
percents in 1997. However, even that number is a way above the average of the EU member
countries. A widely accepted fact that the foreigners invest only in stable and solid economies
has to be seriously taken in transition economies since it is only foreign capital that may
accelerate the growth in the region.
13
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