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SHOCK THERAPY VERSUS GRADUALISM RECONSIDERED: LESSONS FROM TRANSITION ECONOMIES AFTER 15 YEARS OF REFORMS Vladimir Popov This paper is the logical continuation of my earlier article: Shock Therapy versus Gradualism: The End of the Debate (Explaining the Magnitude of the Transformational Recession) Comparative Economic Studies, Vol. 42, No. 1, Spring 2000, pp. 1-57. The arguments of this earlier article, however, are reconsidered in light of new research and evidence. GDP change in selected transition economies, 1989 = 100% Poland 125 Slovenia Central Europe 115 Slovak Republic 105 Hungary 95 Czech Republic South Eastern Europe 85 Rom ania 75 Bulgaria 65 FSU (Russia, Ukraine) 55 Russia Ukraine 45 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 35 INITIAL LIBERALIZATION AND OUTPUT CHANGE DURING RECESSION LIBERALISATION AND OUTPUT CHANGE IN CHINA AND RUSSIA Fig. 3. Indices of econom ic freedom and GDP grow th in Russia and China 250 4 GDP as a % of 1994 Index of econom ic freedom , right scale 220 3,5 190 3 160 2,5 CHINA 130 2 GDP, 1993=100%, left scale 100 1,5 RUSSIA 70 1 1993 1994 1995 1996 1997 1998 1999 2000 2001 GDP change in Asian economies, 1989 = 100% Fig. 1b. GDP change in Asian transition econom ies, 1989 = 100% 200 China 180 Vietnam 160 Central Europe 140 Uzbekistan Mongolia 120 Turkm enistan 100 Kazakhstan 80 Russia 60 Kyrgyzstan 40 1989 1991 1993 1995 1997 1999 2001 2003 Tajikistan Source: EBRD, World Bank. GDP change in FSU economies, 1989 = 100% Fig. 2. GDP change in FSU econom ies, 1989 = 100% Central Europe Uzbekistan Belarus 115 Kazakhstan 105 Estonia 95 Turkm enistan Azerbaijan 85 Latvia 75 Lithuania Tajikistan 65 Russia 55 Kyrgyzstan Arm enia 45 Ukraine 35 Georgia 25 Moldova 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Russia was leading in economic liberalization, while Belarus was lagging Private sector share in GDP, % 80 Russian Federation 70 Ukraine 60 Belarus 50 40 30 20 10 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 0 But Belarus and Uzbekistan are doing better (even though they are net importers of fuel), not to mention net exporters like Azerbaijan, Kazakhstan, Turkmenistan GDP in 2006 as a % of 1989 Moldova Georgia Ukraine Tajikistan Kyrgyzstan Russia Bulgaria Croatia Lithuania Latvia Rom ania Azerbaijan Kazakhstan Arm enia Czech Republic Hungary Belarus Uzbekistan Slovakia Slovenia Albania Estonia Poland Turkm enistan 40 60 80 100 120 140 160 180 Russian growth is lagging behind that of oil exporters and some oil importers Average annual GDP grow th rates in CIS countries in 2000-07, EBRD estimates Azerbaijan Turkmenistan Armenia Kazakhstan Tajikistan Belarus Ukraine Georgia Russia Moldova Uzbekistan Kyrgyzstan 16 14 12 10 8 6 4 2 0 INITIAL LIBERALIZATION AND OUTPUT CHANGE DURING RECOVERY Fig. 8. Liberalization index by 1995 and perform ance in 1994-98 1998 GDP as a % of 1994 GDP 155 LITH 145 CHINA 135 125 CIS countries ALB 115 LATV ROM 105 95 EST R2 = 0,3345 POL VIETN SLOVAK CZ CROAT SLOVEN HU MACED MONG BULG 85 75 65 0,5 1 1,5 2 2,5 3 Cum ulative liberalization index, 1995 3,5 4 4,5 LIBERALIZATION STOCK AND OUTPUT CHANGE DURING RECOVERY Fig. 9. Liberalisation and output change in transition econom ies in 1995-2003 2003 GDP as a % of 1995 200 LIBER_94 LIBER2004 180 160 R2 = 0,0229 140 R2 = 0,0618 120 100 80 1 1,5 2 2,5 3 Cum ulative liberalisation index 3,5 4 4,5 LIBERALIZATION STOCK AND OUTPUT CHANGE DURING RECOVERY Fig. 10. Liberalisation increase and output change in transition econom ies in 19952003 2003 GDP as a % of 1995 200 180 160 R2 = 0,0645 140 120 100 80 -1 -0,5 0 0,5 1 1,5 Increase in cum ulative liberalisation index in 1995-2003 2 2,5 Does liberalization matter? • Vietnam and China are similar in initial conditions and in transition results (immediate growth of output without transformational recession) despite different reform strategies: • Chinese reforms are the classical example of gradualism • Vietnamese reformers introduced shock therapy treatment (instant deregulation of most prices and introduction of convertibility of dong) in 1989 • Differing performance of the former Soviet Union (FSU) states: • Baltic states are the champions of liberalization and stabilization in the region. In the Baltics, however, output fell in the early 1990s by 36-60% and even in 2005, 10 years after the bottom of the recession was reached, was still below the pre-recession maximum. • Uzbekistan is commonly perceived to be one of the worst procrastinators. However in Uzbekistan the reduction of output in 1990-95 totaled only 18% and the economy started to grow again in 1996 • By 2005 only two former Soviet republics - Uzbekistan and Turkmenistan - surpassed the pre-recession level of 1989 Reasons for recession: (1) Supply shock - change in relative prices Fig. 4. Change in relative prices and output in 1990-98 in Russian industry January 1998 output as a % of January 1990 output 90 Electric energy Non-ferrous m etals R2 = 0,4062 60 Steel Fuel Chem icals 30 Food Petrochem icals Wood Machinery Constr. m aterials Light 0 40% 60% 80% 100% 120% 140% Ratio of 1998 proices to 1990 prices as a % of industrial average 160% Industrial structure and external trade distortions 1996 GDP as a % of 1998 GDP Fig. 7. Aggregate distortions in industrial structure and external trade before transition and GDP change during transition CHINA 200 VIETN 170 140 SLOVEN 110 HUNG EST 80 MACED 50 CZECH CROAT ARM 20 0 10 20 30 40 50 60 70 Distortions in industrial structure and external trade, % of GDP 80 90 Reasons for recession: (2) Collapse of state institutions - government revenues and expenditure fell in most transition economies Fig. 13. Consolidated government revenues as a % of GDP Central European countries 55 50 45 South East Europe countries 40 Baltic states 35 25 Caucasian states % 30 Central Asian countries 20 -China 15 10 1989 RUSSIA 1990 1991 1992 1993 1994 1995 1996 Three major patterns of change in government expenditures Fig. 10. Gove rnme nt e xpe nditure , % of GDP 60 POLAND 50 USSR/ RUSSIA CHINA 40 Debt service 30 Defence 20 Subsidies 10 Investment "Ordinary government" 0 1985 1989 1995 1978 1985 1994 1989 1996 The decline in government revenues is correlated with performance Impact of initial conditions, institutions, liberalization:1989-96 Table 1. Regression of change in GDP in 1989-96 on initial conditions, policy factors, and rule of law and democracy indices, robust estimates Dependent variable = log (1996 GDP as a % of 1989 GDP) For China - all indicators are for the period of 1979-86 or similar Equations, Number of 1, 2, 3, 4, 5, 6, Observations / Variables N=28 N=28 N=28 N=28 N=28 N=28 Constant 5.3*** 5.4*** 5.2*** 5.4*** 5.4*** 5.5*** -.005** -.005** -.003 -.006** -.007*** -.007*** Distortions, % of GDPa 1987 PPP GDP per capita, % of the US level War dummyb Decline in government revenues as a % of GDP from 1989-91 to 199396 Liberalization index Log (Inflation, % a year, 1990-95, geometric average) Rule of law index, average for 1989-97, % Democracy index, average for 1990-98, % Ratio of the rule of law to democracy index Adjusted R2, % -.009** -.006* -.007** -.007** -.009*** -.19c -.36*** -.011*** -.16*** -.20*** .05 -.18*** -.17*** -.13*** -.008 *** -.37*** -.008*** -.011 *** -.011 *** -.02 -.13*** .03 -.14*** .008 *** -.005 *** 82 7, N=28 5.7*** -.007*** -.45*** -.003** .07*** .07*** .06*** .05*** .05*** 83 83 85 91 91 *, **, *** - Significant at 1, 5 and 10% level respectively. aCumulative measure of distortions as a % of GDP equal to the sum of defense expenditure (minus 3% regarded as the 'normal' level), deviations in industrial structure and trade openness from the 'normal' level, the share of heavily distorted trade (among the FSU republics) and lightly distorted trade (with socialist countries) taken with a 33% weight – see (Popov, 2000) for details. bEquals 1 for Armenia, Azerbaijan, Croatia, Georgia, Macedonia, and Tajikistan and 0 for all other countries. c Significant at 13% level. 90 Evaluating the impact of non-policy and policy factors:1989-98 Dependent variable = log (1998 GDP as a % of 1989 GDP) For China - all indicators are for the period of 1979-88 or similar Equations, Number of 1, 2, observations / Variables N= 2 8 N= 2 8 Constant 5 .3 0 4 .8 8 -.01 -.01 Distortions, % of GDPa 1987 PPP GDP per capita, % of the US -.01 -.02 level -.67 -.58 War dummyb Decline in government revenues as a % of -.02 -.01 GDP from 1989-91 to 1993-96 Liberalization index ( .1 1 ) Log (Inflation, % a year, 1990-95, geometric average) Shadow economy as a % of GDP in 1994 67 69 Adjusted R2, % 3, N= 2 8 5 .6 8 -.01 -.01 4, N= 2 8 5 .7 3 -.01 -.01 -.38 -.01 -.37 -.01 -.15 (-.01) -.15 80 80 5, N= 1 7 5 .7 4 -.01 -.01 6, N= 1 7 5 .4 3 -.01 c -.02 7, N= 1 7 5 .8 6 (-.00) -.01c 8, N= 1 7 6 .0 8 (-.00) (-.01) -.13 (-.06) -.16 -.01 82 -.02 81 ( .1 1 ) -.02 72 -.02 73 aCumulative measure of distortions as a % of GDP equal to the sum of defense expenditure (minus 3% regarded as the 'normal' level), deviations in industrial structure and trade openness from the 'normal' level, the share of heavily distorted trade (among the FSU republics) and lightly distorted trade (with socialist countries) taken with a 33% weight (see Appendix for details). bEquals 1 for Armenia, Azerbaijan, Croatia, Georgia, Macedonia, and Tajikistan and 0 for all other countries. cSignificant at 8% level. Best performance: low distortions, strong institutions Worst performance: high distortions, weak institutions INITIAL CONDITIONS (DISTORTIONS) AND INSTITUTIONS – CLASSIFICATION OF COUNTRIES DISTORTIONS INSTITUTIONAL CAPACITY HIGH LOW LOW HIGH CHINA, EASTERN VIETNAM EUROPE ALBANIA, FSU MONGOLIA Explaining the magnitude of recession: • Differences in performance during transition depend strongly on the initial conditions: • The higher the distortions (militarization, overindustrialization, "under-openness" of the economy and the share of perverted trade flows), the worse is the performance • The higher was GDP per capita before transition, the greater were distortions embodied in fixed capital stock, the more difficult it was to overcome these distortions to achieve growth Explaining the magnitude of recession: • Macroeconomic stability matters a great deal for economic performance • Liberalization index does not appear to be important • Changes in the institutional capabilities of the state have dramatic impact on performance By the end of the 1990s most countries were already recovering from recession Table 6. Regression of change in GDP in 1994-98 on non-policy and policy-related factors (all coefficients are significant at 15% level except those in brackets) Dependent variable = log (1998 GDP as a % of 1994 GDP) For China - all indicators are for the period of 1984-88 or similar 5, 4, 3, 2, 1, Equations, Number of N=28 N=28 N=28 N=28 N=28 Observations / Variables 4.60 4.51 4.25 4.56 4.32 Constant .003 .004 .005 .003 Distortions, % of GDPa 1987 PPP GDP per capita, % of the US level .15 War dummyb Decline in government revenues as a % of -.003 c -.004 GDP from 1989-91 to 1993-96 .07 .10 .09 .12 .07 Liberalization index .04 -.06 Log (Inflation, % a year, 1990-95, Geometric average) 33 29 37 27 21 Adjusted R2, % aCumulative measure of distortions as a % of GDP equal to the sum of defense expenditure (minus 3% regarded as the 'normal' level), deviations in industrial structure and trade openness from the 'normal' level, the share of heavily distorted trade (among the FSU republics) and lightly distorted trade (with socialist countries) taken with a 33% weight (see Appendix for details). bEquals 1 for Armenia, Azerbaijan, Croatia, Georgia, Macedonia, and Tajikistan and 0 for all other countries. c Significant at 21% level. Impact of initial conditions, institutions, liberalization Table 2. Regression of change in GDP in 1995-2003 on initial conditions, institutional capacity, liberalization and rule of law and democracy indices, robust estimates Dependent variable = 2003 GDP as a % of 1995 GDP For China - all indicators are for the period of 1979-86 or similar Equations, Number of 1, 2, 3, 4, 5, Observations / Variables N=28 N=28 N=28 N=28 N=28 Constant 105*** 91*** 99*** 78*** 99*** 1996 GDP as a % of 1989 GDP .33*** .45*** .46*** .24** 1987 PPP GDP per capita, % of the US level 22.9** 42.3*** 32.0*** 19.4* War dummya Liberalization index in 1995 Increase in the liberalization index in 1995-2003 Decline in government revenues as a % of GDP from 1989-91 to 1993-96a Rule of law index, average for 1989-97, % Democracy index, average for 1990-98, % Adjusted R2, % -19.9*** 15.3 *** 16.7 *** 17.6*** 17.6*** -.8*** .8** 25 38 45 1.0*** -.6*** 52 *, **, *** - Significant at 1, 5 and 10% level respectively. aEquals 1 for Armenia, Azerbaijan, Croatia, Georgia, Macedonia, and Tajikistan and 0 for all other countries. 1.2*** -.8*** 55 OBJECTION: Speed and extent of liberalization may be endogenous Cumulative iberalization indices by 1995 Fig. 3. Liberalization indices and distortions in industrial structure and trade patterns 5 4 3 2 1 0 CIS 0 20 40 60 Distortions in the industrial structure and trade patterns (% of GDP) 80 Economic liberalization and democratization go hand in hand Cumulative iberalization index by 1995 Fig. 4. Democracy index (1990-98, average) and economic liberalization index by 1995 5 4 CIS and BALKANS VIETN CROAT, MACED 3 CHINA 2 1 0 0 20 40 60 Democracy index (Freedom House) 80 100 Instrumenting liberalization stock with democracy level variable: 1989-96 Table 3. 2SLS robust estimates – regression of change in GDP in 1989-96 on initial conditions, institutional capacity, liberalization and rule of law and democracy indices (Liberalization index instrumented with the democracy level variable) Dependent variable = Log (1996 GDP as a % of 1989 GDP) For China - all indicators are for the period of 1979-86 or similar Equations, Number of 1, 2, 3, 4, Observations / Variables N=28 N=28 N=17 N=17 Constant 6.4*** 6.3*** 6.0*** 6.0*** Pre-transition distortions, % of GDP -.01*** -.02*** -.004 1987 PPP GDP per capita, % of the US level -.007** -.01*** -.45*** -.29b War dummya Liberalization index in 1995 Decline in government revenues as a % of GDP from 1989-91 to 1993-96 Log (Inflation, % a year, 1990-95, geometric average) Rule of law index, average for 1989-97, % Increase in the share of shadow economy in GDP in 1989-94, p.p. R2, % -.18** -.02*** -.39* -.02*** -.19*** -.19*** -1.7*** -.22*** -.01c -.22*** -.19*** -.02*** 88 -.015*** 90 86 77 *, **, *** - significant at 1, 5 and 10% level respectively. aEquals 1 for Armenia, Azerbaijan, Croatia, Georgia, Macedonia, and Tajikistan and 0 for all other countries. b Significant at 12% level. c Significant at 16% level. Instrumenting liberalization change with liberalization stock and FSU dummy variables:1995-2003 Table 4. 2SLS robust estimates – regression of change in GDP in 1995-2003 on initial conditions, institutional capacity, liberalization and rule of law and democracy indices Dependent variable = 2003 GDP as a % of 1995 GDP For China the indicator is for the period 10 years earlier. Equations, Number of Observations / Variables Instruments for liberalization change in 1995-03 variable 1, N=28 LIBER95 2, N=28 FSU Constant 1996 GDP as a % of 1989 GDP War dummya 97.8*** 95.8*** 3, N=28 LIBER95 and FSU 97.7*** 19.5* 19.8** 19.5* 4, N = 28 LIBER95 and FSU 79.5*** .18* 25.0** Increase in liberalization index in 1995-2003 Decline in government revenues as a % of GDP from 198991 to 1993-96 Rule of law index, average for 1989-97, % Democracy index, average for 1990-98, % R2, % 18.2*** -.76*** 19.2** -.78** 18.3*** -.76*** 22.9*** -.65*** 1.24*** -.76*** 55 1.28*** -.76*** 54 1.25*** -.76*** 55 1.13*** -.62*** 56 *, **, *** - significant at 1, 5 and 10% level respectively. aEquals 1 for Armenia, Azerbaijan, Croatia, Georgia, Macedonia, and Tajikistan and 0 for all other countries. Conclusions • The impact of the speed of liberalization at the initial stage of transition, i.e. during the transformational recession, appears to be negative, if any. • The reason for the negative impact is most probably associated with limited ability of the economy to adjust to new price ratios Conclusions Fig. 5. Hypothetical trajectories of output (Year "0" = 100%) assum ing gradual and instant liberalization Reduction of output in a NC sector at 10% annually Output, Year "0" = 100% 125% 120% 115% 110% Reduction of output in a NC sector at 30% annually 105% 100% 95% 90% 85% 80% 0 1 2 3 4 5 6 7 8 9 10 Years Assum ptions: size of non-com petitive sector (NC) in the initial year = 20% of total output; net investm ent (s) = 10% of total output; m arginal capital productivity, output increase per unit of net investm ent (a) = 1/3. Reduction of output in a NC sector at 100% annually Conclusions • At the recovery stage liberalization starts to affect growth positively, whereas the impact of pretransition distortions disappears. Institutional capacity and macroeconomic policy continue to be important prerequisites for successful performance. • Liberalization at the recovery stage influences performance positively because it creates market stimuli without causing rapid collapse of output of inefficient industries, which cannot be compensated fully by the rise of efficient industries due to investment constraints.