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The IMF and Ukraine: What Really Happened
A Commentary by Lorenzo Figliuoli and Bogdan Lissovolik
IMF Resident Representatives in Ukraine
Zerkalo Nedeli (translation of Russian version)
August 31, 2002

Recently the Zerkalo Nedeli newspaper has published a number of articles disparaging of the role of the International Monetary Fund in this country and around the world. The interview given by Yuri Pakhomov in the issue of July 13 is particularly noteworthy. We find many of these criticisms exceedingly biased, poorly argued, or plain wrong. A more truthful assessment of the IMF's role is called for.

One of the major criticisms leveled by Mr. Pakhomov against the IMF is that the core policies supported by the Fund- the so-called "Washington consensus"- are "destructive." Mr. Pakhomov cites as evidence the "actual impact" of those policies on the developing countries of Asia, Africa and Latin America, as well as on transition economies. Even the commonly-held success stories of the Washington consensus-such as Poland and Hungary -are summarily dismissed claiming that "the advice of the IMF was ignored" there. Furthermore, countries such as China, Vietnam, Spain, Turkey, and Egypt that actively cooperate with the Fund (although in different forms) are mentioned as having "rejected the IMF model." Ukraine's difficult transition to the market is also ascribed to the same wrong-headed policy framework, which supposedly neglects the specific conditions of each country and "is imposed" on borrowers against their will.

Mr. Pakhomov does not elaborate on what specific aspects of these policies cause the "damage." In his interview, there are cryptic references to: (i) demonetization of the economy as a result of tight macroeconomic policy, which "primarily destroys expenditures on science;" (ii) over-reliance on "shock-therapy," while ignoring political and social factors and constraints; (iii) disintegration of the state as a result of liberalization and privatization; (iv) widespread corruption and theft, also in the wake of liberalization and privatization; (v) neglect of income distribution problems and social issues in general.

Finally, the interview contains allegations as to why the IMF would be preaching "counterproductive" policies. The causes would range from sheer incompetence of the IMF staff to conspiracy. With respect to the latter, the IMF would be pandering to the interests of global capital and particularly of the United States. According to Mr. Pakhomov, these interests aim to weaken the former Soviet Union by "destroying its industry and technology." The accusations of pandering to the US look naive -considering the virtually universal membership of the world economies in the Fund including the FSU countries. As to the decision making process at the IMF Board, the role of the European states is collectively no smaller than that of the USA. Regarding the level of competence and experience of IMF staff, their high professionalism is recognized by the overwhelming majority of independent economists.

Statements and speculations of this sort demean those that formulate them and we will not discuss them again here. Let us instead examine Mr. Pakhomov's "arguments".

Global-scale "arguments"

The "general" points in the interview are factually wrong or misleading. For instance, it is unclear how Turkey or Vietnam can be regarded as having rejected IMF advice, as both these countries actively cooperate with the Fund and just this summer have received substantial disbursements in the context of IMF programs. As for Spain-like the other industrialized countries-it supports the thrust of IMF policy recommendations. At present, most industrialized countries simply do not need to borrow from the IMF because of their level of development, stable external position, and high quality of economic policies. However, many may be surprised to know that a number of Western European countries were the IMF's most important borrowers in the 60s and 70s, before successfully graduating from Fund financing. Moreover, many developed countries request the Fund's assistance in evaluating their financial systems (e.g. banking system), and analyzing the budgetary policies. China and Egypt also are engaged in constructive dialogue with the IMF. Egypt, in particular, has broadly followed Fund stabilization advice in the 90s, while China's growth record owes much to its openness to foreign direct investment and export orientation, which are central to IMF recommendations.

The supposed "abysmal record" of the "IMF-imposed" policies around the world is also a plain falsehood. First, there are many examples of successful stabilization achieved with IMF support. Indeed, it is regrettable that cases of successful adjustment (e.g. the countries of Western Europe in 1960s and 1970s, Chile, Poland, Mexico, South Korea) do not attract as much attention from the press and the public as countries suffering from protracted crises. In part this is because the more successful countries often "graduate" quickly from IMF financing and do not require further assistance. Second, the "abysmal record" claim cannot be substantiated, even for "unsuccessful cases," in the absence of a realistic assessment of what would have happened without Fund assistance. Third, the IMF often has to deal with very complex situations characterized by major disagreement about the right policies, ways of their implementation and who is to blame for things that have gone wrong. Often the IMF's ability to facilitate implementation of the appropriate economic policies is constrained by domestic political considerations. In any case, it is the government of the country that chooses the economic strategy, while Fund's programs are based on the principle of "reform ownership", i.e. support of the key reform measures under the program by as wide and stable consensus inside the country as possible.

All of this, however, is not to deny that the IMF can also make mistakes (and has to accept responsibility for them) but to stress that some general allegations are absolutely groundless.

Against this background, it may come as a surprise to some in Ukraine that the international press-especially professional publications-has been far less one-sided than Mr. Pakhomov in assessing the role of the IMF. For example, the Fund had to endure perhaps the most formidable wave of criticism in its history at the time of the Asian crisis five years ago. Well, recently, the respected weekly magazine "The Economist," known for its independence, carried an article about the lessons of the 1997 Asia crisis. In brief, it concluded: "The recovery in the region speaks well of the way the crisis was managed. Mistakes were made, no doubt. The Fund itself acknowledges as much-and, to its credit, showed a willingness to correct its errors promptly. To have done better at the time, without the benefit of the hindsight, would have been a tall order."

The real issue is whether there is a way to do better on a consistent basis in a crisis situation, and it does not seem that there are very good alternatives. Strategically, the IMF is an advocate of broadly-defined market economics, and, in this respect, alternative models have little or nothing to offer. The experience of countries that have rejected, largely or entirely, market based economic growth (for instance, North Korea, Cuba, maybe Belarus, or the former communist states, say East Germany), prove that they could have done much better had they pursued market-friendly policies.

The experience of Ukraine

Now let us revisit the critics' arguments with reference to Ukraine. Ukraine's transition to a market economy has been very painful indeed, perhaps more painful than for some other transition economies. But to what extent are the policies ascribed to the IMF to be blamed for these difficulties?

For a start, Ukraine's close cooperation with the IMF began late compared to the early reformers (Poland, Hungary, etc.). Indeed, the first true Fund program-involving Fund conditionality - was agreed with Ukraine only in late 1994. Thus, Ukraine's economic performance in the first three years of independence cannot be associated at all with IMF-supported policies. Were these years good or promising for Ukraine? It does not seem so from any reasonable point of view. In this period, Ukraine suffered from hyperinflation that peaked at 10,000 percent in 1993, a dramatic output collapse, and huge declines in the population's standard of living.

IMF programs are often blamed for output declines, although the latter are often simply the consequence of the economic disorder which has made an IMF program necessary. In any case, the largest output loss for Ukraine occurred before the IMF really stepped in: in 1994 Ukraine's real GDP was already 55 percent of the 1990 level.

In light of the above, several of the "specific" policy criticisms of the IMF's economic policies look wrong or misleading as well. First, the demonetization (i.e. the low circulation of domestic currency) of Ukraine's economy can hardly be attributed to tight macroeconomic policies. Much of the demonetization really occurred during the high inflation of 1992-1993. In 1993 the real money stock contracted almost three times and money demand collapsed, because of the price explosion induced by lax fiscal and monetary policies. Since 1995, the share of money in Ukraine's GDP has been increasing more or less continuously. Second, the bulk of the "disintegration of the state" arguably occurred before late 1994, with "unofficial privatization" of state-owned enterprises by their directors and top managers even before formal privatization started. There is no evidence whatsoever to this day that state-owned enterprises including their contribution to the budget outperformed formally privatized enterprises. If anything, all data point in the other direction.

Arguments like "had Ukraine not pursued cooperation with the Fund, it would have been a more prosperous country" are also completely groundless. This assertion literally means that IMF involvement with Ukraine, and its "shock therapy," resulted in additional economic or social costs for the country. Indeed, the IMF's cooperation with Ukraine did not instantly stop the output decline or produce rapid improvements in the living standards of the population. However, IMF lending softened the short-term cost of adjustment and its impact on the population's well-being. Had the IMF not lent to Ukraine, the balance of payment and the budget would have had to adjust even more, as well as much faster.

The IMF stepped in under conditions of considerable financial disequilibria, which themselves were a big contributing factor to the downward spiral of Ukrainian output and, ultimately, of its living standards. In these circumstances, measures that would correct the most egregious disequilibria fairly quickly were called for, as the continuing depreciation of the national currency and high inflation impeded the establishment of normal economic relations. Thus, the first steps proposed by the IMF in Ukraine were aimed at containing the fiscal deficit to a level consistent with declining inflation and stability in the foreign exchange market. The Fund also insisted on basic liberalizing measures-like unification of the exchange rate-so that price signals could reflect market conditions, creating the foundations of a market economy. In part because of the more stable environment that these steps brought about, Ukraine's output decline moderated substantially in 1996-1997, and was subsequently reversed.

Obviously, while the stabilization measures were necessary, they could not alone resolve the more deep-rooted problems related to poor governance and corruption, as well as ensure the development of essential market institutions. Nonetheless, the benefits of stabilization are under appreciated in this regard. Other things equal, macroeconomic stability greatly helps promote transparency, since all financial flows are then much easier to monitor. For instance, when the inflation rate is low and stable, opportunities for manipulating interest rates are greatly reduced. In the past, these were often used for building financial pyramids or creating and maintaining unjustified privileges in the financial sector.

Also, macroeconomic stability is a powerful tool for stemming rampant inequalities in the distribution of wealth. Rich and well-connected individuals always find ways to protect their assets from inflation and economic depression, while these possibilities are not open to the vast majority of the population. Inequality problems are further aggravated by microeconomic distortions, which may result in, say, accumulation of wage arrears. Due to persistent structural inadequacies, including poor governance, macroeconomic instability in Ukraine would surely have engendered even greater distributional inequalities.

The IMF actively sought to strengthen social protection of the population by including targets for reducing government arrears on social payments under its programs. More generally, it advocated the introduction of a targeted, efficient social safety net. Certainly, the IMF did emphasize the primacy of financial stabilization, as its statutes require it to do. However, it is difficult to imagine how a safety net could have operated with rampant inflation and collapsing output.

The IMF was in favor of maintaining adequate level of expenditures on education, science, and technology. The collapse of public spending in these areas was the result of erosion of the revenue base of the government, mainly associated with the proliferation of tax privileges; persistent economic disorder (because of the lack of rule of law) and inconsistent incentives for different economic agents often at the expense of productive sectors of the economy. These problems were too pervasive and structural in nature to be addressed by macroeconomic policy, which is the main area of IMF's expertise.

In fact, the "overly fiscal" approach of the IMF often lamented by its critics is nothing but recognition of the basic fact that "two plus two equals four," that is, you need to pay for your expenditures. It is not possible to get around this elementary rule in the long run. Countries that pursued the "alternative" of recourse to inflationary financing -e.g., Belarus-have as a result suffered from lack of foreign and domestic investment, with the result that growth has been lower. Belarus, with the highest inflation in the CIS last year, also had the slowest real GDP growth in the CIS, and has enjoyed very little foreign direct investment since independence. Low productivity, lack of competitiveness on international markets, and high wage and budgetary arrears have arisen in Belarus due to relatively slow and inconsistent reforms.

Conclusion

Could Ukraine have done much better during its transformation? Even taking into account the complexities of transitioning to market after seventy years of communism, which were may be underestimated at the inception of the process, the answer is probably affirmative. But, again, many issues that Ukraine could not resolve throughout the 1990s have their roots in history, or originated at the beginning of the transition and were worsened by the high inflation environment of 1992-1994, before Fund involvement with Ukraine.

Of course, in hindsight, the Fund perhaps should have addressed more vigorously in its conditionality some of these deep-rooted structural problems, for example by being more prudent in disbursing because of the ingrained nature of governance problems. Nonetheless, it is difficult to envision how this approach would have materially affected Ukraine's economy and the well-being of its people. At the same time the domestic political support for reforms - including those required for basic stabilization of the economy - could have been further weakened. We hope that advantages of macroeconomic stability have become evident in Ukraine.

As to the Fund-supported specific structural reform agenda for Ukraine, it was prepared in close cooperation with the World Bank and sparked very little controversy among independent economists from market-oriented countries, including from the EU. Many of these structural reforms are not completed and need further progress, which, in addition to cooperation with international financial organizations, will be facilitated by Ukraine's movement toward the European Union and WTO. We hope that Ukraine will increasingly take advantage of the commonly accepted macroeconomic and structural policies, which would permit an increase in the population's living standards on a sustained basis.




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