Quotation of the Month: "The IMF's Role in the Transition Has Come under Increasing Scrutiny"

The Economist Intelligence Unit Introduces Aggregate Policy Indicators

Of all the international financial institutions involved in the economies in transition, the International Monetary Fund (IMF) has been the most significant, both because of the amount of financing that has been made available ($15 billion disbursed to the region since 1990) and because of the conditionalities that have shaped policies, especially at the initial stages following the collapse of communism.

The IMF's importance derived from the crucial role of general-purpose funding, again especially at the initial stages of the transition, to absorb the impact of economic liberalization on the external balance and to at least mitigate the deterioration of living standards. The IMF has also been closely involved in debt restructuring undertaken by a number of countries in the region. Finally, the IMF sometimes fulfilled a useful political role familiar from developing country experience_as a convenient scapegoat, or lightning rod, for governments that had to sell the need for harsh policies to restive domestic constituencies.

It would be an exaggeration to attribute to the IMF a decisive causal role in stimulating change. The commitment to the transformation sprang from the internal processes in the transition economies, and above all from the failure of central planning and of models of limited market (socialist) reform. Nonetheless, it could be equally misleading to underestimate the role of the Fund in influencing the policy mix, the intensity of particular policies, and their sequencing.

Because of the economies' acute need for outside support and the catalytic role of an IMF imprimature in generating funding from other institutions and from Western governments, the IMF has had considerable leverage in dealing with most of the region's governments, although the east European regimes' general commitment to change represented a propitious circumstance for cooperative relations between governments and the Fund.

Price liberalization was the cornerstone of the reformist model. The freeing of prices was a sine qua non for the move toward a market economy. Freed-up prices would signal producers on what output to produce and what inputs to purchase. Incentives to enterprises would come from sharply reduced subsidies, tightened financial discipline (and dear credits), and competitive pressures following the liberalization of foreign trade. Access to imports and incentives to export would be enhanced by a liberalized foreign exchange regime.

Price and trade liberalization were complemented by elements of a standard IMF demand management package, designed to deal with inherited macroeconomic imbalances, and to contain the adverse impact of the reform-induced price shocks. This included subsidy cuts, controlling domestic credit expansion, interest rate hikes, and usually, but not always, devaluing the currency.

The increasing involvement of the IMF in the region, with signing of various arrangements occurring almost monthly, has meant that the Fund's role in the transition has come under increasing scrutiny. On the one hand, the IMF has been criticized for straying too far outside of its area of expertise, by focusing on policies such as privatization and institutional change. The opposite, more frequent criticism has been that it has not done so sufficiently_that the specific circumstances of the transition economies would have required an even greater emphasis on the microeconomics of the supply side of the economy (as opposed to the standard demand management package), which determines the effectiveness of available policy instruments. It has now been acknowledged even by IMF staff members that the early period of Fund involvement in the region was accompanied by a series of unexpected developments: output decline was much deeper and more prolonged than had been expected, fiscal balance was much more difficult to achieve than had been thought, and inflation was higher than predicted.

Five years into the transition, there is now a considerable body of evidence available that allows a more rigorous evaluation of the IMF's impact on the performance of the region's economies. The main difficulties in evaluating the impact of IMF policies will be:

• To assess what would have occurred in the absence of an IMF program. It is clearly misconceived to ascribe developments to the IMF if it can be argued or demonstrated that the events in question would have occurred anyway_for example, an upsurge in inflation or an external shock precipitating a contraction in income. (This means that any investigation of IMF policies must allow for something that roughly approaches a controlled environment_usually a comparison with countries affected by similar external variables that did not have IMF programs.)

• To identify to what extent countries comply with IMF conditions. If compliance for one reason or another is low, events cannot be attributed to IMF influence.

There are two ways to measure compliance:

• Directly, by comparing IMF-agreed macroeconomic policy targets with actual policies where such information is available.

• Indirectly, by evaluating the extent to which actual policies conform to an "IMF-type" policy mix. The indirect method relies on the construction of a synthetic or aggregate policy indicator that takes into account exchange rate policy, the real interest rate, monetary expansion relative to consumer price growth, the budget, real wage growth, and the share of general government expenditure in GDP. Policies are simply assigned scores of 1 or 0, according to whether they are in the "orthodox" direction, that is, in accord with IMF precepts. For example, real wage growth is compared with productivity growth; fiscal policy is scored according to whether there is a year-to-year improvement in the fiscal balance by at least 2 percentage points of GDP; government expenditure is evaluated according to whether there is a decline in its share of GDP.

Two findings stand out:

• The aggregate policy indicator (derived by simply summing the components) is not significantly related to whether a country had an IMF program in place or not. Part of the weak correlation could result from our failure to distinguish between higher conditionality facilities, such as standby arrangements, and softer Systemic Transformation Facility (STF) loans.

• Some of the countries that are associated with having virtuous policies do not score consistently well on the indicator (for example, Poland in 1991, 1992, and 1994; the Czech Republic in 1993; Slovenia, Estonia, and Latvia since 1992), while perceived slouches such as Bulgaria, Slovakia, and even Romania, score comparatively high on the orthodoxy scale. (An orthodox policy approach, which in some developing countries has been maintained for years, has rarely been sustained in two successive years in any country in this region).

In countries of Central and Eastern Europe, inflation has been falling, current account deficits are now mostly under control (with notable exceptions such as Hungary), and a fragile recovery is under way. The IMF has become concerned that complacency should not set in after initial successes and has seized on the opportunity provided by economic recovery and favorable external conditions to press hard for ambitious financial and fiscal targets to be met, for faster progress in institutional reform, and for further price liberalization, especially in the energy sector. The IMF has stated that the region's priority now is to "maintain tight macropolicy, possibly supported by wages and exchange rate policies."

Conclusions:

• Countries find it difficult to sustain orthodox policies. Unlike the experience in some developing countries, where virtuous policies have been sustained for long periods (or have even become the norm), in the transition countries pressures for a relaxation arose without exception.

• The relationship between growth and IMF involvement was significantly negative in the early reform years and positive in later years, according to the empirical investigation of performance in Central and Eastern Europe. There was an indeterminate impact on inflation and a positive effect on the current account. Orthodox policy, measured by an aggregate policy indicator and only weakly related to the IMF's presence, is shown to have had a significantly positive effect on inflation.

• The failure rate of early programs at the start of reform was generally high. However, the chances of success pick up significantly in later transition years, as both the IMF and the East European governments move up their learning curves. Furthermore, at least some of the institutional changes creating an environment more conducive to the success of orthodox policies are likely to have taken place after several years of experience with a market economy. In an environment of exogenous shocks such as the breakup of federations and regional trading areas, and the sharp terms of trade losses, the application of the standard medicine may not yield the desired results.

Excerpted from Senior Economist Laza Kekic's study, "The IMF and Eastern Europe," regional overview, 3rd quarter 1995, published by the London-based Economist Intelligence Unit Limited. Information: The Economist Intelligence Unit, 15 Regent Street, London SW1Y 4LR, United Kingdom.