Striving For Success: Growth, Globalization and Economic Policy ReformAddress to the Institute for the Economy in Transition
by Anne O. Krueger, First Deputy Managing Director, IMF
Delivered on Ms Krueger's behalf by Mr Poul Thomsen, Senior Advisor, European Department
March 20, 2006
[Good afternoon. I first want to pass on a personal message from Anne Krueger, First Deputy Managing Director of the IMF. As you know, Ms Krueger had intended to be here today, to deliver this speech in person. Unfortunately, she has to be in Australia for a meeting of the G20 Deputies. Ms Krueger has therefore asked me to pass on her best wishes for the success of the conference.
Absent in person, but present in spirit. What follows is the text of the speech Ms Krueger had planned to deliver today.]
This conference comes at an auspicious time. It is now fifteen years since Russia and the other transition economies started the lengthy and challenging transformation from central planning to normally functioning market economies. Challenging, yes, and often very difficult for many of those countries and their citizens.
But none of us who had any involvement in those early days could have imagined that so much progress would be made so quickly. Thanks to the enormous efforts of many of those involved in the reform process‚and Yegor Gaidar's name features on everyone's list‚a great deal has been achieved. Most transition countries have come further, and done so more rapidly, than even the optimists among us had expected.
Today, I want to put this reform process in historical and global context. After all, the most striking feature of the reform process today is how much it has in common with the reform process in the rest of the world.
The world economy
Even the skeptical commentators are obliged to acknowledge that the world economy is in remarkably healthy shape. 2006 is likely to be the fourth successive year in which real world GDP will have grown by 4 percent or more.
And this strong growth performance has been worldwide, with higher growth seen in almost every region. Emerging market Asia experienced growth rates of more than 8 percent in 2004 and close to that in 2005. Africa, Latin America and the Middle East have all experienced growth rates above 4 percent last year‚in some cases, significantly above. And, of course, the transition economies have continued to experience rapid growth.
The global economy appears to be stronger and more resilient than it has for many years. The slowdown of 2001-2002 was unusually modest and recovery from it has been strong, rapid and sustained. The world economy has, so far, shrugged off geopolitical uncertainty, the sharp rise in oil prices and the growing problem of global imbalances‚though, of course, these downside risks remain.
One important contributory factor to this benign economic environment is the significant improvement in macroeconomic management in many countries around the world. The experience of the past ten or fifteen years has taught us a great deal about how economies work and what scope policymakers have for achieving and maintaining macroeconomic stability, accelerating growth and reducing poverty. Putting some of those lessons into practice is already producing results in the form of higher and more stable growth rates. Much progress has been made in many parts of the world as governments have implemented policies aimed at achieving macroeconomic stability, including the reduction of inflation, sound fiscal policies that curb government budget deficits and reduce debt burdens.
And progress towards stability at the national level has, in turn, led to greater international stability and more rapid global growth.
The most striking global phenomenon‚and sometimes underestimated‚is what has happened to inflation rates worldwide‚and what that has shown about the role that low inflation can play both in providing a stable economic framework and in making possible more rapid growth.
In the 1970s and 1980s, inflation came to be seen as a fact of life‚albeit an undesirable one. Between 1980 and 1984, for example, the global inflation rate was close to 15 percent, and nearly 9 percent in the industrial economies. In developing countries it was much higher, of course. Even in the early 1990s, barely a decade ago, the average inflation rate in developing countries was just over 80 percent.
More recently, though, policymakers have made considerable progress in achieving significant and lasting reductions in inflation. The global inflation rate was down to 3.7 percent in 2004. In the industrial economies it had declined to 2 percent in 2004 and an estimated 2.3 percent in 2005.
In developing countries, the decline has been even steeper‚from that 80 percent level in the early 1990s to 5.8 percent in 2004, and as estimated 5.6 percent, in 2005.
In 2004, only three of the IMF's 184 members had inflation rates in excess of 40 percent. That is a remarkable global transformation over a relatively short period.
The transition economies have been part of this success story. Consumer price inflation in the transition countries averaged 61.3 percent a year between 1987 and 1996. In the following decade the average inflation rate declined to just over 18 percent. The Fund's latest World Economic Outlook, published last September, shows the average inflation rate in Central and Eastern Europe is projected to be below 5 per cent this year. In Russia, too, much progress has been made towards achieving price stability. By the end of 2005, year end inflation had declined to 10.9 percent, down from the peak of 85.7 percent as recently as 1999.
High inflation has always penalized the poor more than the rich because the poor are less able to protect themselves against the consequences, and less able to hedge against the risks that high inflation poses. Lowering inflation therefore directly benefits the poorest members in society. As low inflation becomes firmly established, uncertainty among economic actors is reduced and resource allocation becomes more efficient and investment decisions are easier: and this in turn contributes to higher growth rates.
The experience of the past decade has also shown that flexible exchange rates are an important component of macroeconomic stability. The capital account crises of the 1990s in Mexico, in Asia, here in Russia and elsewhere reminded us how important it is for economies to have the flexibility to respond to shocks. With fixed exchange rates, shocks must be absorbed by other variables‚such as wage rates and domestic prices‚that often impose larger costs and require longer adjustment periods.
The Asian crises showed the dangers of mismatches of currency exposures of assets and liabilities. And fixed exchange rates require monetary policy to be subordinated to the exchange rate regime, thus making it more difficult to control and reduce inflation and maintain macroeconomic stability.
As a result of what we learned during the capital account crises of the 1990s, most countries now have flexible exchange rates regimes.
So much has been learned, much has been implemented: and the result has been significantly more rapid growth in many parts of the world. There is, however, every reason to think that‚at some point‚world growth will, once again, slow or even that the world economy will go into recession. Economic cycles have not-yet-been abolished. Looking ahead, then, the challenge is twofold. The first is to build on the progress achieved thus far, to accelerate growth [especially in those countries where living standards are relatively low] and so enable more rapid reductions in poverty.
The second challenge is to continue to work to reduce the disruptions that economic slowdowns cause. When the next downturn comes it will be those economies where policymakers have done most to prepare that will be least affected by it. And the more economies that are prepared for a downturn, the more modest the global impact is likely to be.
In other words, the current favorable conjuncture is an opportunity for action rather than an excuse for inaction. Now is the moment to act, to press on with reforms because they are always easiest to manage at a time of expansion.
Growth and structrual reforms
One important lesson brought home more forcefully than ever by the experience of the past decade or more is the importance of a healthy financial sector. This is a key component of macroeconomic stability. A weak financial sector can undermine efforts to achieve stability through prudent fiscal and monetary policies.
But a strong and well-functioning financial sector is also critical if sustained higher growth rates are to be achieved. Banks and the financial sector in general have a vital role to play in fostering economic growth: by providing credit to those investments that offer the highest risk-adjusted rates of return, banks contribute to a higher growth rate for the economy as a whole. But to be effective, banks, even small ones, must develop the ability to assess creditworthiness, risk and returns. They need to be able to assess the likely returns from competing borrowers and so direct resources to those offering the highest rates of return.
As economies grow, they become more complex and interdependent; and the demands placed on the financial sector grow commensurately. Banks grow bigger: they need to in order to meet the demand for investment capital. They must also grow more sophisticated, and become more diversified in terms of the risks they assume. Continued expansion means that firms need banks able to serve their needs across national boundaries and to provide specialized financing services. And appropriate regulatory and supervisory regimes become assume increasing importance.
But the financial sector has to meet the needs of the range of economic activity and other sources of financial intermediation‚equity, bonds and insurance, for example‚are important to provide the necessary breadth and depth. Healthy and sustained growth of firms and economies requires constant innovation as firms seek the best terms and intermediaries become increasingly refined in making risk assessments.
Experience has repeatedly shown that high growth rates are sustainable only as the financial sector develops in parallel with the economy as a whole. A weak financial sector can undermine growth. Resources are misallocated, and average returns fall. We all knew that a healthy financial sector was an important ingredient of macroeconomic stability. But the role that weak financial sectors played in the crises of the 1990s made us appreciate even more than before quite how central the financial sector's role is.
In a sense, the increased focus on financial sector soundness is one‚albeit very important‚way in which the rapid integration of the global economy has highlighted the importance of structural economic reforms. In many parts of the world we have made considerable progress in maintaining macroeconomic stability. But stability alone can only do so much to raise growth rates and reduce poverty. Other policy reforms are also necessary to raise an economy's growth potential. And our experience in recent years has altered our thinking in significant ways. All of us‚and by all I mean academic economists, national policymakers, and the policy community, including the IMF‚have come to realize that an array of other policy reforms that we used not to think of as macroeconomic are critical.
Key to improved financial sector performance, and key to the improved governance that makes possible improved macroeconomic performance in general, is the issue of transparency. We have learned that at the sectoral, the national and the global level the more openly individuals, firms and institutions go about their business, and the more open to public scrutiny they are, the more effectively they will perform. The IMF has taken a lead in this: we are now one of the most transparent institutions in the world. Some have gone so far as to argue that the importance of transparency will prove to be one of the most significant and durable lessons of the past decade.
More generally, we have come to appreciate that institutional health is an important ingredient of economic progress. Enterprise is stifled and foreign investment discouraged if a country does not have an effective judiciary that makes contract enforcement possible. Businesses simply relocate to somewhere that offers them greater legal protection. Similarly, countries that do not offer legally, and easily enforceable, property rights will find it hard to attract and retain investment. Such shortcomings have always undermined business activity and, in consequence, economic growth: but as the world economy becomes more integrated, business has become more mobile and a climate hostile to business even more damaging. Even some of the advanced economies have business red tape that makes establishing a new business difficult or costly, or that makes the process of enforcing contracts time-consuming and cumbersome.
But institutional shortcomings tend to be far more serious in emerging market and low income countries, and the Fund, in co-operation with our sister institution, the World Bank, now works actively to promote institutional reform among our members as a vital ingredient in promoting sustained and rapid economic growth.
In short, then, we have learned much in the past decade and a half, but we still have much to do to make the most of our experience.
The transition economies
Where do the transition economies fit in to this global picture? If we look back at what has happened in this part of the world in the past fifteen years or so, we can see that the transition economies increasingly face just the same problems and challenges as the rest of the world. That is a clear indication of the extraordinary progress made thus far. It is difficult to overestimate the achievements made in this part of the world in a remarkably short period.
After all, reversing decades of economic mismanagement is no easy task. Adopting a market-based economic system is a difficult and lengthy process. It takes time for activities to spring up and for people to adapt to new incentives, institutions and constraints. Dismantling a command economy meant starting all over again. What economic assets remained had to be valued and transferred into private hands‚and entrepreneurial private hands at that. At every level of activity people had to start thinking for themselves.
Those in charge of economic policymaking had to learn how to function in a market-based economy. The basic structures of a market economy had to be put in place as rapidly as possible. Yet infrastructure was often lacking, or in poor condition. Health and education provision needed overhauling. Pension systems needed radical reform. There was thus an urgent need to establish properly-functioning tax systems that would generate revenues and provide incentives to support the transition to the market system.
At the same time, the financial sector needed effective regulatory structures. The banking system needed wholesale reform to equip it for its new role as a provider of credit. Financial markets needed to be created and fostered‚vital for the efficient allocation of credit and the management of risk.
This would be a challenging reform agenda for any country. For countries with no recent experience of operating in a market-based economy, it was truly formidable.
Yet look at how far we have come. Russia has experienced rapid growth and rising living standards over the past several several years. Eight of the transition economies are about to celebrate the second anniversary of their joining the European Union. Others hope to join in the coming years. And the new members of the EU have experienced more rapid growth than most of their Western European neighbors in recent years. That's as it should be, of course: these countries have quite a bit of catching up to do. But the EU's experience with earlier enlargements suggests that those countries that most rapidly embrace the need for reform will be those that integrate with the EU, and approach average per capita incomes in the EU, most rapidly.
After 15 years the transition economies as a whole are entering a new phase of the reform process, and as they do so, the problems they face have much in common with other emerging market economies. Russia and the other transition economies are increasingly facing the challenges of success because much has already been achieved. Looking ahead it will be important to build on that progress.
Russia, for example, like other oil-producing economies is benefiting from the rise in oil revenues following the oil price increases of the past couple of years. But this brings challenges as well as benefits: high revenues can make it more difficult for governments in oil producing countries to resist pressures for more public spending. It's worth noting what the IMF's Executive Board had to say about this at the time of the last Article IV consultations in [September last year]. The Directors "considered that the policy of gradually escalating the taxation and saving of oil revenues as oil prices have surged has served Russia well".
In Russia's case spending more of the oil windfall at this juncture would add to existing inflationary pressures. Over the medium term, though, there should be scope for relaxing fiscal policy. The key challenge for the government at that time will be to ensure that the oil wealth is spent on reforms, including tax cuts that bolster the economy's growth potential.
Several other transition economies‚Poland, Hungary and the Czech Republic, for example‚are also focused on strengthening fiscal policies and reducing public debt burdens. But continued progress with structural reforms remain crucial if, over the medium term, growth potential is to improve further.
Many transition economies have made considerable headway in the move to become more business-friendly. The World Bank publication, Doing Business in 2006, makes this clear. Latvia, Georgia, Romania and Slovakia were among the twelve countries around the world that did most to reform business regulation in 2004 (the latest year for which figures are available). Lithuania, Estonia and Latvia are in the top 30 economies where it is easiest to do business.
In many transition economies there is relatively little red tape involved in starting a business‚an important source of job creation, of course. Only 6 procedures are involved in Estonia and Hungary, for example, and 8 in Russia; while it needs 10 procedures in Poland and the Czech Republic. That compares with only 3 procedures required in Denmark, and only 2 in New Zealand and Australia.
The time involved in starting new business varies widely across the transition economies: only 18 days in Latvia, 25 in Slovakia, 26 in Lithuania and 33 days in Russia. But it takes 40 days in the Czech Republic and 60 days in Slovenia to complete a process which takes only 2 days in Australia, 5 days in Denmark and 8 days in France. The length of time involved, and the cumbersomeness of the procedures, can be important factors for entrepreneurs deciding where to locate a new business, especially in a world where falling transport and telecommunications costs, and the development of the internet, have reduced the importance of geographical distance for many types of business.
In most transition economies there is still plenty of scope to make labor markets more flexible. Experience has taught us that labor market flexibility both helps raise growth rates and, at the same time, helps ensure that employment rises as growth accelerates. Once again, Doing Business 2006 offers useful comparative data in this area.
The World Bank study shows that compared with many parts of the world, many transition economies have made significant progress, especially given their starting point as centrally-planned economies a relatively short time ago. It costs a firm 188 weeks of a worker's salary to fire someone in Sierra Leone, 174 weeks's salary in Sri Lanka and 165 weeks' salary in Brazil. These are all much higher than in transition economies.
But there are important labor market rigidities, the removal of which would bring considerable benefits. Firms in Slovenia, must pay 43 weeks of salary to fire a worker‚and it costs 33 weeks salary or more in Hungary, Estonia and Lithuania. In Russia the comparable figure is only 17 weeks. But in the US and New Zealand, which have social safety nets for unemployed workers, by contrast, firms incur no costs in firing workers . The evidence shows that the easier it is to fire workers, the more willing employers are to hire them‚because they are taking on less risk when they recruit new staff.
Many transition economies also have strict rules about working hours. The World Bank has an index measuring rigidities in this area, using a scale of 1-100, where 100 is the worst. Slovenia, Hungary and Estonia all score poorly on this, with an index of 80, while Russia, Romania, Poland, Lithuania and Slovakia all score 60: that compares with a score of 20 for the UK, and zero for the US and New Zealand. Yet strict limits on working hours make it difficult for employers to respond to increased demand‚especially if the labor market also discourages recruitment of new workers.
The role of the IMF
Discussions of business regulation and labor market flexibility highlight important challenges for the transition economies‚and indeed for many other countries, including some in Western Europe. But they also underline the extent to which transition countries now confront the challenges shared by many other countries around the world. Indeed, at the end of 2003, the IMF abolished the department set up in 1991 to look after the transition economies. They are now integrated into the rest of the Fund's work.
But we continue to support the reform process in the transition economies as indeed we seek to support all our members. We do this through our surveillance work‚like all Fund member countries, transition economies have what we call Article IV consultations every year. Over the years, the Fund has provided‚and continues to provide‚technical assistance to transition economies on a wide range of issues ranging from monetary policy to public expenditure and tax administration.
And, of course, the Fund has been able to provide financial support to transition economies; though as they have achieved macroeconomic stability and more rapid growth, fewer countries are in need of financial assistance than in the early years of the transition period.
This is an appropriate moment to reflect on what has been achieved in the transition economies in the past fifteen years. Progress has been significant and has arguably surpassed all expectations. The transition economies have rapidly become integrated with the world economy as a whole. In recent years, many of them have achieved macroeconomic stability and experienced rapid growth.
The challenge now is to consolidate the progress made and to build on it. That means ensuring the macroeconomic stability is maintained. And it means raising the long-term growth potential of the transition economies that can only come through the adoption of further structural reforms.
The benign global economic environment provides countries around the world with a valuable opportunity to press on with reforms. But this opportunity is not open-ended: so the phrase "make hay while the sun shines" continues to hold true‚for the transition economies along with everyone else.
[Let me, finally, pass on Ms Krueger's very best wishes for a successful conference.]