Richard Portes,
Centre for Economic Policy Research,
UK
How quickly and by what route should currency convertibility be approached by the economies in the process of transformation from socialist central planning t o market capitalism? I t is likely t h a t more has been written on this issue than on all others involved in the transition except perhaps for privatization.
There are some obvious reasons. The creditors of the East European debtors see convertibil- ity as a major step towards normalizing the position of these economies in the world economy and thus facilitating debt service. The international financial institutions naturally put the highest priority on one of their own major objectives (Article VIII). Potential investors regard convertibility in general as a touchstone of virtue, though they may not distinguish between its various forms. And for many Eastern economists and policy-makers, convertibility is almost equivalent t o legitimacy, a badge t h a t will entitle them to sit a t the table with Western finance ministers and central bankers on a par-so t o speak-as long as it lasts.
All this may help t o explain why some argue there should be no stages in the transition t o convertibility: t h a t it should come a t the beginning of a. comprehensive reform program, at least in the form of "internal" convertibility (on current account, for residents). This view was not merely implemented in the Polish effort t o exit dramatically from hyperinflation, but is also a feature of the radical version of the Czechoslovakian reforms. Many Hungarian economists too want convertibility first, questions later.
A qualified version of this approa.ch is that there is a minimal initial package of reforms necessary t o establish a credible change of economic regime, and that this package must include resident convertibility on current account. T h e strongest version is the extreme "Big Bang": that i t is necessary t o do almost everything simultaneously, because i t is well known in economics that everything depends on everything else. This is after all what we learn in basic general equilibrium theory. Dynamics is difficult, made even more so by the increasingly popular notion t h a t the outcome actually depends on the path (hysteresis). T h e easiest strategy, it seems, is t o ignore it.
Some would do so by saying that if you want t o go there, you should not start from here-no path will make it. But these economies are indeed here-burdened with the multiple legacies and distortions of decades of central planning and comprehensive state ownership. T h e difficulty is that it is impossible t o test the hypothesis t h a t a purist "Big Bangn is the most effective road from here t o there-an efficient, dynamic market economy with predominantly private ownership.
The hypothesis is not testable simply because it is administratively and institutionally im- possible to implement all the required reforms a t once. Hence the failure of any program can always be blamed on wha.t it left out or implemented inadequa.tely. If, as in Poland, convert- ibility is the keystone of the initial package, and even a.t the ma.cro level that package does
not seen, to be delivering on i t s promises, its architects may claim that this is because a micro level supply-side response was necessary (assumtd"), and this required immediate privatization, whicli the system did not deliver.
There is a weaker version of the assertion that "stages" is just a euphemism for indecision and delay when comprehensive action is required. At recent OECD and IMF seminars, it was concluded that the academic literature on "sequencing" was just that--"academic9' in the sense of being an unhelpful intellectual rationalization of the inability t o prescribe clear, practical programs for action (IMF Survey, August 1990).
I believe, on the contrary, that the notion of "robust sequencingn is not merely relevant but must serve as the organizing framework for any serious, implementable reform program ("Introduction" t o European Economy 43, March 1990). It is hard t o spend more than half an hour analyzing any major component of such a program without asking what must precede it and what other measures it will make possible that would otherwise not work. Indeed, the
*Shatalin Plan" may give insufficient attention t o the interactions among the main component measures; the sequencing is there, but only temporal, not economic.
The chosen sequence of stages must be robust t o external shocks and errors in assessing behavioral responses. It must be credible-preferably announced ex ante as a comprehensive sequence that clearly changes the economic regime and thereby changes expectations radically.
The problem here, as always, is how policy-makers can credibly pre-commit themselves to a time-inconsistent program. Will they really control credit and avoid tax-subsidy concessions if that will cause many bankruptcies? Will they maintain controls on nominal wages regardless of how far real wages fall? Will they stick to their chosen nominal exchange rate if it quickly becomes drastically over-valued and convertibility itself is threatened?
This line of reasoning leads t o the conclusion that convertibility should come towards the end of the sequence because it appears that there are so many preconditions for it t o succeed.
For this very reason, however, a commitment to early convertibility, backed by international institutions and perceived as a key element of the political-economic program, raises the stakes and may itself help to push the "preconditions" through. And the "critical mass" of measures required for credibility may include convertibility, for which the necessary conditions need not be preconditions.
Just as it is impossible to implemeilt all the necessary reforms simultaneously, so I cannot in a brief introduction cover all the relevant issues. We shall discuss exchange-rate policy and debt later in the conference. Maintaining convertibility a t the pegged rate requires a realistic choice of exchange rate, adequate reserves, and a sustainable debt burden; and it helps to choose properly the currency (basket) to which to peg. The alternative of floating must be evaluated: My remarks below on the importance of macroeconomic stabilization should not be taken t o mean that these countries must achieve (for example) the EC inflation rate (adjusted for differential productivity growth) so as t o maintain a fixed parity with the ECU.
I take it as given that commodity convertibility is a prerequisite for current account con- vertibility, and I do not discuss capital account convertibility. It clearly must come after the freeing of current account transactions, not only to avoid capital flight, but also conversely, t o keep control over inward flows. Newly independent domestic firms, households and banks may borrow irresponsibly; excessive capital inflows may not be absorbable and may in the short run lower the price of tradeables and discourage production for export, while in the long run proving unserviceable. It seems unlikely that inconvertibility on capital account will be a significant ob- stacle t o desirable foreign direct investment, as long as current account convertibility guarantees the freedom to remit profits.
Finally, I shall not consider intermediate forms of convertibility. There has been much dis- cussion of proposals for an East European Payments Union analogous t o the postwar EPU, a s a successor to CMEA (ECE, Economic Survey of Europe 1989-90; CEPR Bulletin 40; P. Bofinger, CEPR Discussion Paper No 458; P. Il;e~le~l, IMF). One could envisage a looser, informal pay-
ments union without credit facilities, in which trade surpluses would actually be Utransferablen (Nuti).
The issues here are analytically and empirically interesting, but there are limits to the analogy with postwar "gradualists" approaches to convertibility. The multiple legacies of central planning are different from and deeper than those of a war economy, not merely because the former has lasted so much longer. The Eastern countries undergoing transformation need totally new price systems and a massive injection of competition. It is hard t o see how t o do this quickly except through a radical opening of the economy t o trade, which would include current account convertibility a t a unified exchange rate. That would overcome some (by no means all) of the inherited distortions.
But this open trade policy is not sustainable without domestic macroeconomic stabilization and substantial price responsiveness of import demand and export supply. Restoring macroe- conomic equilibrium is both a stock and a flow problem. The stock dis-equilibrium in most, if not all, of these countries can probably be eliminated without a confiscatory currency reform, through a combination of initially pushing the price level up sharply, providing a reasonable portfolio of assets a t attractive returns, and creating sufficient uncertainty about employment prospects t o encourage precautionary savings. The flow dis-equilibrium is in most countries due t o budget deficits which must be eliminated by quite conventional measures.
It is claimed that imposing financial discipline ( a "hard budget constraint") on enterprises is a necessary and/or sufficient condition for macroeconomic equilibrium and hence for convertibility.
It is clearly not sufficient, since the government budget can remain in deficit for all sorts of other reasons that keep revenues low and expenditures high. Nor is it necessary: the macroeconomic (strictly, monetary) position in most of these countries was sustainable until the mid- 1980s, when it deteriorated sharply in the USSR, Bulgaria and Hungary. Poland has always been more inflationary and had a burst a t the beginning of the 1980s, but the slide into hyperinflation did not begin until late 1988 (or even perhaps early 1989).
There is a strong case for the view that the deterioration was due partly t o external shocks (especially a rising burden of debt service) and policy aberrations (e.g., the Soviet anti-alcohol campaign that reduced excise revenues), but mainly to partial and inconsistent decentralization, which eroded the enterprise "tax" base and weakened central (and bank) control over enter- prise expenditures. If the "soft budget constraint" and all its nefarious consequences had been characteristic of the centrally planned economies from the outset (early postwar), it would be remarkable that the.denouement was so long delayed. Moreover, the "levelling" characteristic of the standard, unreformed CPE system of enterprise finance and "taxation" involves not merely subsidizing loss-makers but also siplloning excess (above-plan) profits away from profit-makers.
Part of the recent problem comes from giving the enterprises control over those excess profits.
It is nevertheless clear that current account convertibility is not sustainable if enterprises can borrow unlimited amounts of domestic currency a t low real interest rates in order t o purchase foreign currency, without a credible medium-run solvency constraint. This is also a compelling objection t o foreign currency auctions until financial discipline is established; but when i t is, there is a strong argument for adopting a single fixed exchange rate that will make i t transparently clear which activities and firms are profitable and which are not.
Most of this is consistent with a fairly conventional sequencing (Nuti):
(1) Monetary restraint with budgetary discipline.
(2) Letting prices vary t o clear markets.
(3) Establishing competition by breaking up monopolies.
(4) Instituting financial discipline and elimina.ting "levelling" across enterprises.
(5) Cutting the hierarchical links between centra.1 authorities and the enterprises.
(6) Opening to international trade at a unified excha.nge rate.
(7) Current a.ccount convertibility.
(8) Capital account convertibility.
But some of the arguments above suggest a rather different program, in which current account convertibilii,~ does indeed come arruch earlier. Is ~ i o t the top priority t o establish a reasonably rational price structure? Wliy free prices only t o establish a closed-economy, monopolistically distorted equilibrium? How long will it take t o break up the monopolies? How much longer thereafter will it take t o move from the closed-economy equilibrium t o something approximating the open-economy eqnilibrium, and how much damage will have been done in t h e meanwhile?
Both views--or a t least my own-reject a wide variety of partial measures. Partial, cen- trally directed price "reform" however much it used "world market prices" as a reference point;
enterprise retention of part of their export earnings; restricted and necessarily distorted foreign exchange markets, in particular auctions in the context of a basically closed economy with ir- rational prices and firms ( a t least some) not subject t o financial discipline; all these would be intermediate steps more likely t o go backward than forward.
I t is clear t h a t convertibility is for these countries not simply a question of international macroeconomics, not a monetary issue. It is central t o the process of transformation and must be situated within that process in a way appropriate t o t h e particular country concerned, which may depend heavily on whether it will be possible t o sustain convertibility once introduced.
Certainly a forced retreat would be devastating t o the credibility which is indispensable for any reform program. But sustainability is not merely a matter of when convertibility is implemented, but also how. There is considerable scope for discussion of this throughout the conference.