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Fiscal and Monetary Policies in Transition Economies

Fiscal and Monetary Policies in Transition Economies. Fiscal policy relates to how the state collects taxes and spends revenues. Monetary policies are conducted by a central bank, which determines the quantity of money. I. The macro economy in a socialist country:

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Fiscal and Monetary Policies in Transition Economies

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  1. Fiscal and Monetary Policies in Transition Economies Fiscal policy relates to how the state collects taxes and spends revenues. Monetary policies are conducted by a central bank, which determines the quantity of money.

  2. I. The macro economy in a socialist country: The banking system was primitive Single state bank would serve 2 purposes: It would passively allocates credit to enterprises in accordance with the plan It would serves as a system of checking plan performance b/c all movements of material through the economy has trail in the bank (ruble control) From the perspective of influencing passive role of money No financial markets SOE were funded by the state budget State control of the foreign trade with both exports and imports control Currency was not convertible, so the balance of payments was not a function of external mkt forces and commodity and financial flows. II. Financial Sector Reform One of the first stages in developing a new monetary system in transition economies was the development of banking system. At the beginning of the transition period all the post-communist countries faced the similar challenges concerning banking sector reform. They had to create a two-tier banking system: a CB and commerce banks. They also faced similar constraints that made this task quite difficult.

  3. Constraints No managerial and supervisory know-how, inexperience of bank management No market history of potential lenders Greater uncertainty regarding the outcome of entrepreneurial projects Inherited bad loans or debts of SOE No adequate legal framework and regulation, including a general framework for creditor protection, such as bankruptcy laws. Banking reform an the setting-up of capital mkts are generally seen as the most urgent and related problems. One of the first priorities must be the creation of a CB, usually achieved by divesting of its other responsibilities and focusing it on functions traditionally reserved for the CB.

  4. 2. Development of a banking system Central bank—the overall general goal of the CB is to ensure macroeconomic stability Functions of the Central Bank Acting as a clearing bank for the commercial banks. Acting as the promulgator and enforcer of regulation to enhance the stability and efficiency of the financial system Controlling the stock of money in the economy and hence the interest rate Monitoring the foreign exchange value of the currency The main goals of CB are to minimize inflation rate and maximize aggregate output level. The CB tries to find optimal policy, which will create econ situation that will stimulate output but without high inflation After creating the CB priority must be given to developing a commercial and investment banking system that can be effective in mobilizing savings and allocating investment capital among potential borrowers. This process is unlikely to be rapid. Some banks can be created by assuming the deposit and lending functions of the monobank, holding them for a while in the public sector, and then privatizing when conditions are appropriate.

  5. The biggest banking problem for transition economies is controlling the growth and behavior of new financial intermediaries that spring up. In Russia, for example, b/w 1989 and 1992 some 1600 “bank” were created but most did not meet the definition of banks as applied in the west. Many were created by industrialized enterprises and exist largely to finance their parent companies by borrowing on the interbank mkt. As such they perform little in the way of impartially assessing risk or allocating scarce capital resources. Banking crises in the beginning of transition and had been numerous in less advanced transition countries, but even in the Czech. The components of such crises are: Non performing loans (esp. short term) to SOE Too quick financial liberalization allowing too many new banks on the mkt Combination of inexperience of bank management, insufficient regulation, and large opportunities and incentives for fraud, led to dramatic bank failures and deposit withdrawals The banking business was plugged by fraud, bribery and negligence, which had emerged during the financial scandals (Russia—fraud, money laundering linked with mafia control, and by open crime) The remedy for such crises was sought in privatization

  6. The new banking system need: To support the stabilization program (high interest rates and credit tightening, restrict credit) To provide finance to the economy To facilitate privatization and enterprise control 3. Stock markets Stock markets in transition economies are generally underdeveloped, with low market capitalization and turnover. Although most of the transition economies have established formal stock mkts, many of these mkts are undeveloped. Even the most developed mkts in CEE are small—mkt capitalization does not exceed $15 billion in the Czech, Hungary, Poland. Among the FSU with the exception of Russia, mkt capitalization is less then $1 billion. There is little trading activity with value traded as a share of mkt capitalization averaging less than 30%. Poor macro conditions, weak legal protection for minority shareholders and limited development of institutional investors have constrained their development. Stock markets are expected to grow but their scale will remain small relative to world stock markets Large companies are raising funds and listing their shares abroad Through depositary receipt (to place shares in trust and for trustee to issue depository receipts that are traded on major financial mkts. By 1999 there were 12 Russian ADRs (American depository receipts) including 3 with NYSE listings.

  7. III. A Macroeconomic Framework Macroeconomic balance: I=S+ (T-G) + (M-X) I—investments; T—government revenues G—government expenditures S-private savings M-imports X-exports (T-G)—government balance (M-X)—foreign balance Investment The state structure through which the investment process took place began to crumble, and it was not quickly replaced by mkt arrangements Absence of organizational arrangements to facilitate investments. The emergence of financial mkts was slow and uneven, hence there was a fall in investments. The absence of investment was an important reason for initial collapse of output Investment initially collapses in transition, subsequently recovering somewhat, though not generally to levels sustained during the command era.

  8. Private Savings During the early years the PS fell from 30% of hhld income to some 15% or less, and later saving rates increased Russia—initial collapse, Russian hhlds moved away from making deposits toward simply holding rubles in cash. Therefore, there was a sharp movement out of rubles toward as ruble convertibility was introduced. The Government Balance difference between taxes (revenues) T and expenditures G Under socialism T and G were directly under the state control. During the early years of transition two major changes occurred: SOE w/o plan, reduced output and therefore were unable to pay their expenses (wages, other inputs, etc.) In the absence of tax system, gov’t revenues declined; although gov’t expenditures could be shrunk, it was difficult (not to close enterprise since unemployment would increase, safety net in transition, pressures on T and G resulted in a budget deficit = T-G During the early transition there were serious imbalances. Although it improved in mid and late 1990s, there remain persistent deficits that vary with countries.

  9. Inflation and Emerging Markets a) Two sources that affected inflation in transition During the early years of transition state controlled prices were released. This boosted the inflation in the transition economies. Changing fiscal and monetary policy (F&M) for the stabilization in econ; from extremely simulative F&M to F&M contraction policies to bring down the inflation. Necessary part of econ reform was monetary and fiscal contraction to bring down the inflation.

  10. At the beginning of transition, the stabilization policy needed to bring both F&M variables under control; the supply of money increased, devaluation of the currency also expanded money supply. The economies used interest rate policy, direct control of money supply, targeted inflation to bring down the inflation. 2 phases of inflation Initial and expected sudden surge in prices Stabilization phase marked by the decrease in inflation rates, which nevertheless still remain high b) Current inflation-4.3% CEE, 13% Southern Europe, 13.7% CIS. The External Balance When the demand and supply of foreign exchange is equalized or the market for foreign exchange is in equilibrium Imbalance between the export and import of goods and services implies the movement of capital, which along with investment flows (either thru portfolio investment, loans and grants, or FDI) implies that an external mechanism may be available for assisting w/ the budget deficit. For example, during the early years of transition, the devaluation of currencies led to an increase in exports and financial inflows in terms of loans and grants, and FDI. Although capital inflows are attractive, they expand the domestic money supply and thus must be controlled by some sterilization policy A policy used to counteract over-expansion of money is called sterilization (sales of state securities by the CB to shrink the money supply)

  11. IV. The Macroeconomic Agenda and Its Evolution One of the most controversial aspects of transition has been emergence of new market-type banking arrangements Necessary to create a CB, commercial banks, liberalization of interest rates, convertibility of currency To create the appropriate legal structure governing the banks operation. Table 18.1 lists the macroeconomic developments in transition economies. The macroeconomic agenda has been similar in the various transition economies but has had different outcomes.

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