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How did structural reform influence inflation in transition economies?
Economic Systems 34 (2010) 198–210
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How did structural reform influence inflation in transition economies? David Barlow * Business School, Ridley Building, Newcastle University, Newcastle-upon-Tyne NE1 7RU, UK
A R T I C L E I N F O
A B S T R A C T
Article history: Received 1 April 2009 Received in revised form 28 October 2009 Accepted 30 October 2009
This paper empirically examines the contribution of structural reforms to reducing inflation using a panel data-set of 25 transition economies. Two econometric methodologies are applied. First, the Blundell and Bond (1998) estimator for panel data incorporating lags of the dependent variable. Second, a panel logit estimator is employed to consider the likelihood of achieving low inflation. Results highlight the importance of price and trade liberalization and the reform of credit allocation for reducing inflation, the latter being especially important for bringing inflation below 10%. ß 2009 Elsevier B.V. All rights reserved.
JEL classification: E31 P24 C23
Keywords: Structural reform Inflation Transition Panel data
1. Introduction In the early 1990s all of the countries of Central and Eastern Europe and the former Soviet Union experienced high inflation following the demise of the command economies. Consumer price inflation exceeded 100% for at least 1 year in all but Hungary and the Czech and Slovak Republics. By 2003 many, but not all, had brought inflation down to less than 10%. For some, single digit inflation was achieved relatively rapidly, but even so inflation generally remains above the levels of advanced economies. The varying success in restricting inflation occurred despite stabilization being a cornerstone of the advice given at the start of transition. To some extent the variation in experience is a consequence of
* Tel.: +44 191 222 8585; fax: +44 191 222 6548. E-mail address: [email protected]. 0939-3625/$ – see front matter ß 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.ecosys.2009.10.001
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the initial conditions at the start of transition. For example, the extent of the monetary overhang (excessive money holdings accumulated in the later years of the communist era) varied greatly. One way to conceptualize economic reform is to think in terms of policies undertaken to diminish the influence of all but immutable initial conditions. de Melo et al. (1996) find inflation to be negatively correlated with economic reform. Typically such studies use an aggregate or overall reform index. While such an index makes some sense when there are complementarities in the effects of reform, it does leave unresolved the issue of how exactly reform influences inflation and whether some reforms are more important for stabilization. A standard view of the causes of inflation is well summarized by Friedman and Schwartz (1963) ‘inflation is always and everywhere a monetary phenomenon’. This suggests that explanations for inflation should focus on why monetary growth occurs. The success of stabilization depends not only upon monetary policy but also the institutional and legal framework in which monetary policy operates. Though a consensus has emerged favouring indirect monetary instruments, including reserve requirements and rediscount facilities, it is not clear to what extent this is true of the transition economies. A number of authors argue that the success of indirect instruments depends upon the quality of the transmission channels. Early in the transition such channels were compromised by the scale of non-performing loans, ineffective reserve requirements and the absence of debt markets making open market operations impossible (Sahay and Vegh, 1996). Reform of banking and finance should raise the efficacy of monetary policy. More generally reform may also reduce the policy makers’ gains from monetary expansion. There could also be beneficial influences upon expectations if stabilization becomes more credible. A major source of instability in the communist era would have been the widespread ‘soft budget constraint’ (SBC). Soft credit either from the central bank or through involuntary trade credit creates excessive demand for credit. If credit supply passively increases to meet demand the consequence is frequently inflationary (Kornai, 2001; Calvo and Coricelli, 1996). Soft taxation, such as allowing tax arrears, by increasing the fiscal deficit creates an inflation bias as government may be tempted to monetize the deficit (Maliszewski, 2000). If reform hardens budget constraints, stabilization should be enhanced as a commitment not to monetize deficits becomes more credible. Stabilization over the transition has incorporated institutional change, most notably central bank independence; experiments with intermediate targets such as exchange rate anchors and monetary targeting; and more recently inflation targeting.1 The success of such measures always depends upon their credibility, which should be enhanced by structural reform. Given the economic distortions inherited from the communist era, the capacity to implement stabilization is likely to have been a consequence of such reforms. The purpose of this paper is to examine the effects of price liberalization, trade reform, enterprise reform, privatization, and bank and financial reform on inflation. The reform of credit allocation and the liberalization of trade and prices are both found to reduce inflation. Surprisingly, privatization is found to raise inflation. These findings support the view that the inclusion of inflation as an explanatory variable in regressions to explain GDP growth may reduce the estimated effect of reform (see, for example, Radulescu and Barlow, 2002). Section 2 considers how reform would have been expected to influence inflation in the transition economies. Section 3 discusses the data and estimation strategy. Section 4 presents the results and Section 5 concludes. 2. Inflation and economic reform Economic reform in the transition was inspired by the ‘Washington Consensus’ of stabilization, liberalization and privatization. Thus the transition may be characterised as involving the removal of price controls, subsidies, quantitative trade barriers and state directed credit; in conjunction with tight monetary and fiscal policies; and the establishment/extension of private production. How are the 1 Recent empirical literature has considered such factors of the inflation process as the output gap, interest rate rules and the exchange rate. The studies usually focus on single countries or a small set of countries, which greatly limits the ability to consider the influence of institutional change (for example Golinelli and Rovelli, 2005, apply a small macromodel to Hungary, Poland and the Czech Republic).
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various elements of the reform packages likely to have influenced inflation? As shown below the expectation would have been that each element would reduce inflation, though the initial impact may be to raise inflation for a short time until the imbalances inherited from the communist era are eroded. 2.1. Liberalization A considerable literature argues that liberal trade regimes are associated with lower inflation. A leading explanation given for this effect is that foreign competition applies downward pressure on inflation by limiting domestic firms’ ability to raise prices, while the presence of imports improves the supply response. In addition, when the prices of many items are determined by foreign supply and demand the link between inflation and domestic economic conditions is weakened. Romer (1993) and Rogoff (2003) argue that globalization may reduce the policy makers’ return from accommodative monetary policy. Also, as liberal trade regimes are often associated with liberal capital markets monetary policy is also likely to be constrained by the discipline imposed by international financial markets. The evidence is somewhat mixed. Romer (1993) finds open economies have lower inflation. However, Terra (1998) argues that the relationship is not robust, being evident only for severely indebted countries during the 1980s debt crisis. Gruben and Mcleod (2004) shows a negative relationship between inflation and trade openness for a set of OECD and developing economies, which strengthened over the 1990s as global inflation declined. Distorted prices could be associated with higher inflation due to resource misallocation. This is likely to even apply to widespread price controls so long as the price index also measures black market prices. The removal of the subsidies that support below cost prices should reduce pressure to monetize the fiscal deficit. For example, Bogetic´ and Mladenovic´ (2006) points out that Belarus has had persistently high inflation since independence despite widespread price controls. Even if liberalized prices are associated with lower inflation, the process of liberalizing prices was associated with a burst of inflation. However, price liberalization per se did not cause inflation which was a one off adjustment to the monetary overhang and repressed inflation. In addition, the start of liberalization coincided with large currency devaluations. The increased domestic price of imports exacerbated the initial burst of inflation (Wyplosz, 2000). Furthermore, the inflationary surge was often amplified and sustained by indexation and monetary laxity. 2.2. Reform of credit allocation Bank and financial reform, by raising the efficiency and effectiveness of credit allocation, should improve the transmission of monetary policy. de Melo and Denizer (1997) contrasts the passive nature of credit under central planning, that credit was directed to fulfil the plan, with the active role of monetary policy to influence aggregate demand in market economies. The paper also contrasts direct with indirect instruments of monetary control. The former includes directed credit and interest rate controls; the latter involves reserve requirements and discount facilities, and relies upon market signals. Alexander et al. (1996) argues that direct controls often generate such destabilizing phenomena as liquidity overhang and disintermediation, over which the authorities have little control. However, a number of authors argue that the success of indirect instruments in stabilization depends upon the quality of the transmission channels. Early in the transition such channels were compromised by the scale of nonperforming loans and the lack of a framework for prudential regulation. de Melo and Denizer (1997) also argues that though there is a negative correlation between inflation and indirect instruments, the direction of causation is ambiguous; and they claim that inflation is more clearly related to the policy stance. For example, direct instruments were often used to give credit to un-restructured enterprises to maintain employment. Early in the transition large quasi-fiscal deficits are believed to have largely accounted for high inflation in slow reformers (de Melo et al., 1996). Such central bank losses put the consolidated deficit in the order of three times the fiscal deficit in the mid 1990s. These losses included debt write-offs, subsidized foreign exchange guarantees and credit to banks and firms at highly negative real interest rates. In the absence of debt markets and bank lending these deficits were financed by money growth.
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More important than bank reform for controlling inflation could be the hardening of budget constraints by tightening subsidies and credit to industry. Enterprise restructuring, driven by improved corporate governance as budget constraints harden, reduces the demand for subsidies. A key element in hardening budget constraints would be effective bankruptcy procedures to eliminate the struggling enterprises that soften the budget constraint by not paying workers, suppliers, government and creditors. The latter, according to Begg (1997) weakens monetary policy and leads to perverse reactions in monetary transmission. Often enterprises avoided restructuring by resorting to non-monetary trade. Non-monetary trade such as barter, offsets and trade credit, enables enterprises to circumvent the restriction on credit. Central to the nexus of non-monetary trade has been the willingness of some states to accept payment in kind. 2.3. Privatization Privatization, by severing the direct link between state and firm, was believed to be essential for the hardening of budget constraints. For example, according to Sahay and Vegh (1996), in expectation of soft budget constraints, state owned enterprises (SOE) often gave in to wage demands. The budget deficit then widened as SOE performance worsened and tax revenues declined. However, Li (1998) shows how insider control by weakening corporate governance can cause soft budget constraints. ‘Insiders’ obtained corporate control not only via management buyouts. Voucher privatizations frequently lead to shares being held on behalf of the general public by investment trusts, run by the state. In addition lags in the privatization of banks weakened the withdrawal of the state from the provision of credit. Privatization also influences the fiscal balance. The sale of an enterprise generates a one off increase in revenue, while the associated hardening of budget constraints reduces future expenditure. However, the outlay on privatization, such as the evaluation of enterprises, could increase current expenditure. The effect on future expenditure depends upon how well privatization breaks the link between state and industry. If the state remains willing to subsidize then it may become committed to expenditure which it cannot finance through further privatization. In such circumstances privatization could undermine the credibility of stabilization. 3. Data and estimation Annual data for consumer price inflation and economic reform are taken from the EBRD’s Transition Report (see Appendix A for a fuller description of the data used). To reduce the number of parameters to be estimated, the indices are simplified into three: indices of credit reform (the mean of the index of bank reform and enterprise restructuring)2; privatization (the mean of the indices of large and small scale privatization); and liberalization (the mean of price and trade liberalization).3 Figs. 1– 4, respectively, plot inflation, and the indices of liberalization (lib), credit reform (cred) and privatization (priv). The analysis must also control for a number of other factors. First, the budget surplus would be expected to have a significant effect on inflation.4 Cottarelli and Doyle (1999) presents evidence that large fiscal deficits undermined stabilization early in the transition. Cottarelli et al. (1998) finds 2 The bank reform index measures the extent of directed credit, progress on bank supervision and regulation, and interest liberalization. Higher scores are indicative of moves towards indirect instruments. For example, de Melo and Denizer (1997) require the following for indirect instruments to be in operation: maximum reserve ratio <12%; refinance with auction or nonpreferential rates or rediscount facilities. The index of (corporate governance and) restructuring measures the hardness of budget constraints. 3 An alternative procedure, which could also lessen the problems due to collinearity between the indices, would be to use principal components analysis to create reform indices. Such analysis reveals the first component explains 82% of the variation, the loadings are almost equal for each of the six reform indices, this can easily be interpreted as an index of overall reform. The second component explains 7%, but is difficult to interpret in an economically meaningful way. The same applies to the other components. 4 Part of the influence of reform on inflation is likely to come through reduced budget deficits, particularly if the deficit is monetized. However, there are other causes of fiscal deficits. The budget deficit is included for this reason, even though there might then be a problem of collinearity with the reform indices.
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Fig. 1. Log(inflation), inf.
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Fig. 2. Index of liberalization, Lib.
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Fig. 3. Index of credit reform, cred.
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Fig. 4. Index of privatization, Priv.
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significant effects for fiscal deficits on inflation for a sample of industrial and transition economies, particularly where the government securities market is poorly developed. Second, external inflation is likely to have had an influence. The benign global inflationary environment of recent years may have made a significant contribution to the improved inflation performance of transition economies. To account for this the estimating equation includes a measure of advanced economy inflation. Third, a quadratic time trend is included to model the general decline in inflation following the initial inflationary surges at the start of transition, caused by the disintegration of states; the disintegration of monetary authority; conflict; excessive currency devaluations; the initial price liberalization; the money overhang and other unspecified factors. The paper is therefore examining if reforms have reduced inflation faster than the trend.5 Fourth, as there is likely to be inertia in inflation the model incorporates a lagged dependent variable. Finally, as periods of conflict are likely to raise inflation, such periods are accounted for by a binary dummy variable. The model determining inflation can be written as Eq. (1) inf i;t ¼ a0 þ a1 inf i;t1 þ a2 inf i;t2 þ a3 bsurplusi;t1 þ a4 T t þ a5 T sq;t þ a6 advinf t þ a7 wari;t þ b1 libi;t1 þ b2 credi;t1 þ b3 privi;t1 þ et þ ei þ ei;t
(1)
where lib is the index of economic liberalization; cred is the index of credit reform; priv is the index of privatization6; inf is consumer price inflation, measured as natural logarithms owing to some extremely high values; bsurplus is the budget surplus as a percentage of GDP; T is a linear time trend; Tsq is T squared; advinf is inflation in advanced economies; war equals 1 for country j in period t if in that period the country was subject to armed conflict. i indicates country, t indicates year, ei;t is an idiosyncratic error, ei a time invariant error and et is a country invariant error. The expected signs are bj < 0, where j = 1, 2 or 3; a1, a6 and a7 > 0; a3 and a4 < 0; a2 and a5 have no a priori values. Owing to the inclusion of the lagged dependent variable estimation is by the Blundell and Bond (1998) estimator; this is preferred to the Arellano and Bond (1991) estimator due to the small number of time periods in the data-set. Inferences are valid in the presence of first order serial correlation. The second lag of inflation was found necessary to remove second order serial correlation to obtain valid inferences. The estimator removes country fixed effects by first differencing the data. The reform indices and budget surplus are lagged one period both to reduce the problems of endogeneity and co-determination and to allow for lagged responses of inflation to these variables. The estimating equation is (2)
Dinf i;t ¼ l0 þ a1 Dinf i;t1 þ a2 Dinf i;t2 þ a3 Dbsurplusi;t1 þ l1 T t þ l2 T sq;t þ a6 Dadvinf t þ a7 Dwari;t þ b1 Dlibi;t1 þ b2 Dcredi;t1 þ b3 Dprivi;t1 þ ht þ hi;t
(2)
where D is the first difference operator,7 ht ¼ et et1 , and hi; ¼ ei; ei; . 5 There is likely to be collinearity between the trend and advanced economy inflation as the latter moderated. However, as these variables are used as controls, rather than being of primary interest, the preference is to maintain both the quadratic trend and advanced economy inflation. 6 Implicitly this formulation regards each of priv, lib and cred as being continuous. While there is no reason to believe that the indices are linear, such an assumption is a convenient way to gain parsimony as opposed to using dummy variables for each interval of an index (such as dum=1 if 2
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Table 1 Results of Blundell–Bond estimation. Dependent variable log of inflation. Dependent variable infi,t
1. Full
2. Full with year dummies
3. West
4. East
libi,t1 credi,t1 privi,t1 wari,t bsurplusi,t1 Tt Tsq,t advinft infi,t1 infi,t2 Cons Year dummies N Wald Serial corr. Reform = 0 Sample
0.82*** (0.14) 0.42***(0.13) 0.49***(0.16) 1.0*** (0.28) 0.04***(0.01) 0.42*** (0.08) 0.02*** (0.004) 0.16 (0.17) 0.44***(0.06) 0.15*** (0.03) 6.16*** (0.93) No 359 2245.66 0.05 0.00 1993–2007
0.79*** (0.14) 0.52*** (0.15) 0.44*** (0.17) 0.96*** (0.27) 0.04*** (0.01)
0.58 (0.53) 0.32 (0.21) 0.43** (0.20) 0.70* (0.40) 0.04* (0.03) 0.15 (0.13) 0.004 (0.005) 0.53** (0.21) 0.52*** (0.09) 0.13* (0.08) 2.87 (2.51) No 186 18072.12 0.04 0.08 1993–2007
0.59*** (0.11) 0.58 (0.36) 0.27 (0.19) 0.96** (0.40) 0.02** (0.01) 0.70*** (0.08) 0.03*** (0.004) 0.24 (0.21) 0.41*** (0.10) 0.15*** (0.04) 8.57*** (0.68) No 173 83017.94 0.70 0.00 1993–2007
0.45*** (0.07) 0.20*** (0.04) 4.19*** (0.77) Yes 359 14531.24 0.10 0.00 1993–2007
Notes: Serial corr. reports the probability value for the test of no second order serial correlation. N is the number of observations. Wald tests the null that the explanatory variables do not jointly explain the dependent variable. Reform = 0 reports the probability that the joint contribution of the reform indices is zero. Numbers in parenthesis are robust standard errors. *** Statistically different to zero at 1% level. ** Statistically different to zero at 5% level. * Statistically different to zero at 10% level.
To test robustness Eq. (2) is re-estimated with the trend, its square and advanced country inflation replaced by year dummies. As a further test of robustness and to aid the interpretation of the results the model is re-estimated for two sub-samples: the East (CIS members) and the West. Figs. 2–4 show that in general the reform effort has been deeper and more consistent in the West group (top panels of the figures), partly as a consequence of greater integration with the EU. It is possible that the reforms have a less precise ‘qualitative’ effect on inflation, tending to make low inflation more likely. The next part of the analysis uses a panel logit model to examine this issue.8 Low inflation is alternately defined as inflation <40% and inflation <10%.9 lowi;t ¼ d0 þ d3 bsurplusi;t1 þ d4 T t þ d5 T sq;t þ d6 advinf t þ d7 wari;t þ f1 libi;t1 þ f2 credi;t1 þ f3 privi;t1 þ mt þ mi þ mi;t
(3)
where lowi,t = 1 if inflation < threshold (alternately 10% or 40%) and 0 otherwise, bsurplus, T, Tsq, advinf, war, lib, cred and priv are as previously defined, mt , mi and mi;t are time invariant, country invariant and idiosyncratic error terms. The expected parameter values are d3 and d4 > 0, d6 and d7 < 0, fj > 0 for j = 1–3. 4. Results Eq. (1) is first estimated without the reform indices and then with each reform index included singly inf i;t ¼ 0:55 inf i;t1 0:19 inf i;t2 0:05 bsurplusi;t 0:39T t þ 0:01T Sq;t þ 0:18 advinf t þ 1:29 wari;t
(4)
The parameters on all variables except advinf are statistically significant at 1% or better. When added singly all of the reform indices have negative effects, and are statistically significant at 5% or 8 It is not possible to achieve estimate (3) if year dummies are incorporated. Estimation, also, is not possible for the subsamples. 9 The definitions of ‘low’ inflation follow from the growth literature. Fischer et al. (1996) argue that only when inflation is below 50% is GDP growth positive, Christofferson and Doyle (1998) puts this threshold at around 13%.
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Table 2 Marginal effects for results of logit estimation. Dependent variable lowi,t
1. lowi,t = 1 if inflation < 40%
2. lowi,t inflation < 10%
libi,t1 credi,t1 privi,t1 bsurplusi,t1 Advinft wari,t Tt Tsq,t N LR(8) Reform = 0 Sample
0.02 (0.02) 0.03 (0.02) 0.004 (0.008) 0.0004 (0.001) 0.002 (0.02) 0.12 (0.14) 0.002 (0.01) 0.0006 (0.0005) 391 292.21 0.0 1992–2007
0.24** (0.10) 0.51*** (0.13) 0.24** (0.10) 0.014 (0.11) 0.07 (0.56) 0.02 (0.33) 0.37*** (0.08) 0.01*** (0.004) 391 265.72 0.0 1992–2007
Notes: see Table 1. LR(8) is a likelihood ratio test that only the intercept is required to predict the dependent variable.
better. The point estimates are: priv 0.29, cred 0.52 and lib 0.67, the other parameters are little changed. For the full model (column 1 of Table 1) the results show that both credit reform and liberalization reduce inflation.10 However, privatization is found to raise inflation. The null hypothesis that the reform indices jointly make no contribution to inflation is strongly rejected.11 The other variables all take the expected signs; though for the full sample the effect of advanced economy inflation is not significant. The results are robust to the inclusion of the year dummies (column 2, Table 1). The sub-samples reveal some variation (columns 3 and 4 of Table 1). Surprisingly credit reform is not significant in either region, though the point estimates are not greatly different to those of the full sample. This could be due to the variation in this index being much smaller within the regions than in the whole sample (see Fig. 3). The liberalization only has a significant effect in the East, though the point estimate is almost identical to that for the West; this likely reflects the lower variation in lib in the western subsample. Privatization raises inflation in both regions, but the effect is only statistically significant in the west. The hypothesis that the effect of the reform indices are jointly zero is strongly rejected in the East group, for the west rejection is only possible at 8%. Advanced economy inflation has a statistically significant positive effect in the west; in the east the effect is negative but indistinguishable from zero. The logit estimations (Table 2), reported as marginal effects, show that credit reform and liberalization are important for reducing inflation below 10% (column 2). Individually the reforms do not appear to significantly influence the likelihood of reducing inflation below 40%. Jointly, however, the reforms do make inflation below 40% more likely.12 10 Cukierman et al. (2002) develops indices of central bank independence for transition economies over the 1990s. They find, on average, reformers in transition economies created Central Banks with substantially more independence than those of developing countries in the 1980s. However, they report that lower inflation is associated with greater independence only when the economy is sufficiently liberalized. Campillo and Miron (1996) finds a lesser role for central bank independence once variables such as trade openness are taken into account. This latter finding is supported for transition economies by Cottarelli et al. (1998). The legal central bank independence index (LVAW) from Cukierman et al. on inflation was incorporated into Eq. (1). This index was chosen due to having the greatest coverage of all those used by Cukierman et al. In the absence of the reform indices the effect is negative and statistically significant, but one the reform indices are incorporated the effect is statistically indistinguishable from zero. The reform indices, however, have effects statistically different to zero. 11 An anonymous referee questioned the robustness of the results, suggesting that the findings may be due to a shift to a low inflation coinciding with reform. To test the model is estimated with the addition of a dummy variable that takes the value of 1 in the low inflation era and 0 otherwise. The low inflation era has three possible starting years: 1995, 1999 and 2002. This dummy is not significant in any case and makes no qualitative difference to the results reported in column 1 of Table 1. If the model is estimated over a sample curtailed to start in 1997 cred and lib remain significantly negative, priv is also negative but indistinguishable from zero. This result also holds if the estimation period runs from 1996 to 2004. 12 The regressions were also estimated with the inclusion of country dummies. The only changes of note occur for the 10% threshold. In this case the budget surplus significantly raises the probability of low inflation and the effect of liberalization becomes statistically indistinguishable from zero. Given the limited variation in lib over time, the latter result most likely reflects collinearity between the country fixed effects and lib.
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5. Conclusion The results suggest that liberalization and improved credit allocation reduce inflation, but that privatization of large firms increases inflation. When the sample is divided into eastern and western sub-samples some interesting differences emerge. Most strikingly, the adverse effect of privatization is not statistically significant in the east. This result is surprising given the greater reform progress in the west. Furthermore, once the estimation excludes the early/mid 1990s period the effect of privatization on inflation is no longer positive. This result could be a consequence of attempts to moderate the rise in unemployment during the initial phase of privatization. Appendix A. Data definitions and sources Inf is the log of consumer price inflation. Lib = (PL + TRA)/2 Cred = (BK + RES)/2 Priv = (LSP + SSP)/2 PL is an index of price liberalization. TRA is an index of trade regime liberalization. BK is an index of the liberalization of banking and interest rates. RES is an index of governance and enterprise restructuring. LSP is an index of the privatization of large enterprises. SSP is an index of the privatization of small enterprises. The indices range from 1 for unreformed to 4.3 for standards of a market economy. Bsurplus is the ratio of the fiscal surplus to GDP. Advinf is the average inflation rate in industrial economies. Consumer price inflation, PL, TRA, BK, RES, LSP, SSP, gdp growth and Bsurplus are sourced from the EBRD transition report, http://www.ebrd.com/country/sector/econo/stats/index.htm. Advinf is sourced from the IMF, world economic outlook. References Alexander, W.E., Balino, T.J.T., Enoch, C., 1996. Adopting indirect instruments of monetary control. Finance and Development 33, 14–17. Arellano, M., Bond, S., 1991. Some tests of specification for panel data: Monte Carlo evidence and an application to employment equations. Review of Economic Studies 58, 277–297. Begg, D., 1997. Monetary policy during transition: progress and pitfalls in central and eastern Europe. Oxford Review of Economic Policy 13, 33–46. Blundell, R., Bond, S., 1998. Initial conditions and moment restrictions in dynamic panel-data models. Journal of Econometrics 87, 115–143. Bogetic´, Zˇ., Mladenovic´, Z., 2006. Inflation and the monetary transmission mechanism in Belarus, 1996–2001. International Research Journal of Finance and Economics 1, 1–20. Calvo, G.A., Coricelli, F., 1996. Monetary policy and inter-enterprise arrears in post-communist economies: theory and evidence. Policy Reform 1, 3–24. Campillo, M., Miron, J.A., 1996. Why Does Inflation Differ Across Countries. Working Paper No. 5540. National Bureau of Economic Research. Christofferson, P., Doyle, P., 1998. From inflation to growth: eight years of transition. Working Paper No. 98/100. International Monetary Fund. Cottarelli, C., Griffiths, M., Moghadam, R., 1998. The non-monetary determinants of inflation: a panel study. Working Paper No. 98/23. International Monetary Fund. Cottarelli, C., Doyle, P., 1999. Disinflation in transition, 1993-97. Occasional Paper No. 179. International Monetary Fund. Cukierman, A., Miller, G.P., Neyapti, B., 2002. Central bank reform, liberalization and inflation in transition economies—an international perspective. Journal of Monetary Economics 49, 237–264. de Melo, M., Denizer, C., 1997. Monetary policy during transition: an overview. Policy Research Working Paper no. 1706. World Bank. de Melo, M., Denizer, C., Gelb, A., 1996. Patterns of transition from plan to market. World Bank Economic Review 10, 397–424. Fischer, S., Sahay, R., Vegh, C., 1996. Stabilization and growth in transition economies: the early experience. Journal of Economic Perspectives 10, 45–66. Friedman, M., Schwartz, A., 1963. Monetary History of the United States 1867–1960. Princeton University Press.
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Golinelli, R., Rovelli, R., 2005. Monetary policy transmission, interest rates and infllation targeting in three transition countries. Journal of Banking and Finance 29, 183–201. Gruben, W.C., Mcleod, D., 2004. The openness-inflation puzzle revisited. Applied Economics Letters 11, 465–468. Kornai, J., 2001. Hardening the budget constraint: the experience of the post-socialist countries. European Economic Review 45, 1573–1599. Li, D.D., 1998. Insider control and the soft budget constraint: a simple theory. Economics Letters 61, 301–311. Maliszewski, W.S., 2000. Central bank independence in transition economies. Economics of Transition 8, 749–789. Radulescu, R., Barlow, D., 2002. The relationship between policies and growth in transition countries. Economics of Transition 10, 719–745. Rogoff, K., 2003. Globalization and global disinflation. Federal Reserve Bank of Kansas City Economic Review 88, 45–78. Romer, D., 1993. Openness and inflation: theory and evidence. Quarterly Journal of Economics 107, 869–903. Sahay, R., Vegh, C.A., 1996. Inflation and stabilization in transition economies: an analytical interpretation of the evidence. Policy Reform 1, 75–108. Terra, C.T., 1998. Openess and trade: a reassessment. Quarterly Journal of Economics 113, 641–648. Wyplosz, C., 2000. Ten years of transformation: Macroeconomic lessons. Policy Research Working Paper No. 2288. World Bank.
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Economic Systems jo urnal homepage: www.elsevier.com/loc ate/ecos ys
How did structural reform influence inflation in transition economies? David Barlow * Business School, Ridley Building, Newcastle University, Newcastle-upon-Tyne NE1 7RU, UK
A R T I C L E I N F O
A B S T R A C T
Article history: Received 1 April 2009 Received in revised form 28 October 2009 Accepted 30 October 2009
This paper empirically examines the contribution of structural reforms to reducing inflation using a panel data-set of 25 transition economies. Two econometric methodologies are applied. First, the Blundell and Bond (1998) estimator for panel data incorporating lags of the dependent variable. Second, a panel logit estimator is employed to consider the likelihood of achieving low inflation. Results highlight the importance of price and trade liberalization and the reform of credit allocation for reducing inflation, the latter being especially important for bringing inflation below 10%. ß 2009 Elsevier B.V. All rights reserved.
JEL classification: E31 P24 C23
Keywords: Structural reform Inflation Transition Panel data
1. Introduction In the early 1990s all of the countries of Central and Eastern Europe and the former Soviet Union experienced high inflation following the demise of the command economies. Consumer price inflation exceeded 100% for at least 1 year in all but Hungary and the Czech and Slovak Republics. By 2003 many, but not all, had brought inflation down to less than 10%. For some, single digit inflation was achieved relatively rapidly, but even so inflation generally remains above the levels of advanced economies. The varying success in restricting inflation occurred despite stabilization being a cornerstone of the advice given at the start of transition. To some extent the variation in experience is a consequence of
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the initial conditions at the start of transition. For example, the extent of the monetary overhang (excessive money holdings accumulated in the later years of the communist era) varied greatly. One way to conceptualize economic reform is to think in terms of policies undertaken to diminish the influence of all but immutable initial conditions. de Melo et al. (1996) find inflation to be negatively correlated with economic reform. Typically such studies use an aggregate or overall reform index. While such an index makes some sense when there are complementarities in the effects of reform, it does leave unresolved the issue of how exactly reform influences inflation and whether some reforms are more important for stabilization. A standard view of the causes of inflation is well summarized by Friedman and Schwartz (1963) ‘inflation is always and everywhere a monetary phenomenon’. This suggests that explanations for inflation should focus on why monetary growth occurs. The success of stabilization depends not only upon monetary policy but also the institutional and legal framework in which monetary policy operates. Though a consensus has emerged favouring indirect monetary instruments, including reserve requirements and rediscount facilities, it is not clear to what extent this is true of the transition economies. A number of authors argue that the success of indirect instruments depends upon the quality of the transmission channels. Early in the transition such channels were compromised by the scale of non-performing loans, ineffective reserve requirements and the absence of debt markets making open market operations impossible (Sahay and Vegh, 1996). Reform of banking and finance should raise the efficacy of monetary policy. More generally reform may also reduce the policy makers’ gains from monetary expansion. There could also be beneficial influences upon expectations if stabilization becomes more credible. A major source of instability in the communist era would have been the widespread ‘soft budget constraint’ (SBC). Soft credit either from the central bank or through involuntary trade credit creates excessive demand for credit. If credit supply passively increases to meet demand the consequence is frequently inflationary (Kornai, 2001; Calvo and Coricelli, 1996). Soft taxation, such as allowing tax arrears, by increasing the fiscal deficit creates an inflation bias as government may be tempted to monetize the deficit (Maliszewski, 2000). If reform hardens budget constraints, stabilization should be enhanced as a commitment not to monetize deficits becomes more credible. Stabilization over the transition has incorporated institutional change, most notably central bank independence; experiments with intermediate targets such as exchange rate anchors and monetary targeting; and more recently inflation targeting.1 The success of such measures always depends upon their credibility, which should be enhanced by structural reform. Given the economic distortions inherited from the communist era, the capacity to implement stabilization is likely to have been a consequence of such reforms. The purpose of this paper is to examine the effects of price liberalization, trade reform, enterprise reform, privatization, and bank and financial reform on inflation. The reform of credit allocation and the liberalization of trade and prices are both found to reduce inflation. Surprisingly, privatization is found to raise inflation. These findings support the view that the inclusion of inflation as an explanatory variable in regressions to explain GDP growth may reduce the estimated effect of reform (see, for example, Radulescu and Barlow, 2002). Section 2 considers how reform would have been expected to influence inflation in the transition economies. Section 3 discusses the data and estimation strategy. Section 4 presents the results and Section 5 concludes. 2. Inflation and economic reform Economic reform in the transition was inspired by the ‘Washington Consensus’ of stabilization, liberalization and privatization. Thus the transition may be characterised as involving the removal of price controls, subsidies, quantitative trade barriers and state directed credit; in conjunction with tight monetary and fiscal policies; and the establishment/extension of private production. How are the 1 Recent empirical literature has considered such factors of the inflation process as the output gap, interest rate rules and the exchange rate. The studies usually focus on single countries or a small set of countries, which greatly limits the ability to consider the influence of institutional change (for example Golinelli and Rovelli, 2005, apply a small macromodel to Hungary, Poland and the Czech Republic).
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various elements of the reform packages likely to have influenced inflation? As shown below the expectation would have been that each element would reduce inflation, though the initial impact may be to raise inflation for a short time until the imbalances inherited from the communist era are eroded. 2.1. Liberalization A considerable literature argues that liberal trade regimes are associated with lower inflation. A leading explanation given for this effect is that foreign competition applies downward pressure on inflation by limiting domestic firms’ ability to raise prices, while the presence of imports improves the supply response. In addition, when the prices of many items are determined by foreign supply and demand the link between inflation and domestic economic conditions is weakened. Romer (1993) and Rogoff (2003) argue that globalization may reduce the policy makers’ return from accommodative monetary policy. Also, as liberal trade regimes are often associated with liberal capital markets monetary policy is also likely to be constrained by the discipline imposed by international financial markets. The evidence is somewhat mixed. Romer (1993) finds open economies have lower inflation. However, Terra (1998) argues that the relationship is not robust, being evident only for severely indebted countries during the 1980s debt crisis. Gruben and Mcleod (2004) shows a negative relationship between inflation and trade openness for a set of OECD and developing economies, which strengthened over the 1990s as global inflation declined. Distorted prices could be associated with higher inflation due to resource misallocation. This is likely to even apply to widespread price controls so long as the price index also measures black market prices. The removal of the subsidies that support below cost prices should reduce pressure to monetize the fiscal deficit. For example, Bogetic´ and Mladenovic´ (2006) points out that Belarus has had persistently high inflation since independence despite widespread price controls. Even if liberalized prices are associated with lower inflation, the process of liberalizing prices was associated with a burst of inflation. However, price liberalization per se did not cause inflation which was a one off adjustment to the monetary overhang and repressed inflation. In addition, the start of liberalization coincided with large currency devaluations. The increased domestic price of imports exacerbated the initial burst of inflation (Wyplosz, 2000). Furthermore, the inflationary surge was often amplified and sustained by indexation and monetary laxity. 2.2. Reform of credit allocation Bank and financial reform, by raising the efficiency and effectiveness of credit allocation, should improve the transmission of monetary policy. de Melo and Denizer (1997) contrasts the passive nature of credit under central planning, that credit was directed to fulfil the plan, with the active role of monetary policy to influence aggregate demand in market economies. The paper also contrasts direct with indirect instruments of monetary control. The former includes directed credit and interest rate controls; the latter involves reserve requirements and discount facilities, and relies upon market signals. Alexander et al. (1996) argues that direct controls often generate such destabilizing phenomena as liquidity overhang and disintermediation, over which the authorities have little control. However, a number of authors argue that the success of indirect instruments in stabilization depends upon the quality of the transmission channels. Early in the transition such channels were compromised by the scale of nonperforming loans and the lack of a framework for prudential regulation. de Melo and Denizer (1997) also argues that though there is a negative correlation between inflation and indirect instruments, the direction of causation is ambiguous; and they claim that inflation is more clearly related to the policy stance. For example, direct instruments were often used to give credit to un-restructured enterprises to maintain employment. Early in the transition large quasi-fiscal deficits are believed to have largely accounted for high inflation in slow reformers (de Melo et al., 1996). Such central bank losses put the consolidated deficit in the order of three times the fiscal deficit in the mid 1990s. These losses included debt write-offs, subsidized foreign exchange guarantees and credit to banks and firms at highly negative real interest rates. In the absence of debt markets and bank lending these deficits were financed by money growth.
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More important than bank reform for controlling inflation could be the hardening of budget constraints by tightening subsidies and credit to industry. Enterprise restructuring, driven by improved corporate governance as budget constraints harden, reduces the demand for subsidies. A key element in hardening budget constraints would be effective bankruptcy procedures to eliminate the struggling enterprises that soften the budget constraint by not paying workers, suppliers, government and creditors. The latter, according to Begg (1997) weakens monetary policy and leads to perverse reactions in monetary transmission. Often enterprises avoided restructuring by resorting to non-monetary trade. Non-monetary trade such as barter, offsets and trade credit, enables enterprises to circumvent the restriction on credit. Central to the nexus of non-monetary trade has been the willingness of some states to accept payment in kind. 2.3. Privatization Privatization, by severing the direct link between state and firm, was believed to be essential for the hardening of budget constraints. For example, according to Sahay and Vegh (1996), in expectation of soft budget constraints, state owned enterprises (SOE) often gave in to wage demands. The budget deficit then widened as SOE performance worsened and tax revenues declined. However, Li (1998) shows how insider control by weakening corporate governance can cause soft budget constraints. ‘Insiders’ obtained corporate control not only via management buyouts. Voucher privatizations frequently lead to shares being held on behalf of the general public by investment trusts, run by the state. In addition lags in the privatization of banks weakened the withdrawal of the state from the provision of credit. Privatization also influences the fiscal balance. The sale of an enterprise generates a one off increase in revenue, while the associated hardening of budget constraints reduces future expenditure. However, the outlay on privatization, such as the evaluation of enterprises, could increase current expenditure. The effect on future expenditure depends upon how well privatization breaks the link between state and industry. If the state remains willing to subsidize then it may become committed to expenditure which it cannot finance through further privatization. In such circumstances privatization could undermine the credibility of stabilization. 3. Data and estimation Annual data for consumer price inflation and economic reform are taken from the EBRD’s Transition Report (see Appendix A for a fuller description of the data used). To reduce the number of parameters to be estimated, the indices are simplified into three: indices of credit reform (the mean of the index of bank reform and enterprise restructuring)2; privatization (the mean of the indices of large and small scale privatization); and liberalization (the mean of price and trade liberalization).3 Figs. 1– 4, respectively, plot inflation, and the indices of liberalization (lib), credit reform (cred) and privatization (priv). The analysis must also control for a number of other factors. First, the budget surplus would be expected to have a significant effect on inflation.4 Cottarelli and Doyle (1999) presents evidence that large fiscal deficits undermined stabilization early in the transition. Cottarelli et al. (1998) finds 2 The bank reform index measures the extent of directed credit, progress on bank supervision and regulation, and interest liberalization. Higher scores are indicative of moves towards indirect instruments. For example, de Melo and Denizer (1997) require the following for indirect instruments to be in operation: maximum reserve ratio <12%; refinance with auction or nonpreferential rates or rediscount facilities. The index of (corporate governance and) restructuring measures the hardness of budget constraints. 3 An alternative procedure, which could also lessen the problems due to collinearity between the indices, would be to use principal components analysis to create reform indices. Such analysis reveals the first component explains 82% of the variation, the loadings are almost equal for each of the six reform indices, this can easily be interpreted as an index of overall reform. The second component explains 7%, but is difficult to interpret in an economically meaningful way. The same applies to the other components. 4 Part of the influence of reform on inflation is likely to come through reduced budget deficits, particularly if the deficit is monetized. However, there are other causes of fiscal deficits. The budget deficit is included for this reason, even though there might then be a problem of collinearity with the reform indices.
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Fig. 1. Log(inflation), inf.
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Fig. 2. Index of liberalization, Lib.
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Fig. 3. Index of credit reform, cred.
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Fig. 4. Index of privatization, Priv.
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significant effects for fiscal deficits on inflation for a sample of industrial and transition economies, particularly where the government securities market is poorly developed. Second, external inflation is likely to have had an influence. The benign global inflationary environment of recent years may have made a significant contribution to the improved inflation performance of transition economies. To account for this the estimating equation includes a measure of advanced economy inflation. Third, a quadratic time trend is included to model the general decline in inflation following the initial inflationary surges at the start of transition, caused by the disintegration of states; the disintegration of monetary authority; conflict; excessive currency devaluations; the initial price liberalization; the money overhang and other unspecified factors. The paper is therefore examining if reforms have reduced inflation faster than the trend.5 Fourth, as there is likely to be inertia in inflation the model incorporates a lagged dependent variable. Finally, as periods of conflict are likely to raise inflation, such periods are accounted for by a binary dummy variable. The model determining inflation can be written as Eq. (1) inf i;t ¼ a0 þ a1 inf i;t1 þ a2 inf i;t2 þ a3 bsurplusi;t1 þ a4 T t þ a5 T sq;t þ a6 advinf t þ a7 wari;t þ b1 libi;t1 þ b2 credi;t1 þ b3 privi;t1 þ et þ ei þ ei;t
(1)
where lib is the index of economic liberalization; cred is the index of credit reform; priv is the index of privatization6; inf is consumer price inflation, measured as natural logarithms owing to some extremely high values; bsurplus is the budget surplus as a percentage of GDP; T is a linear time trend; Tsq is T squared; advinf is inflation in advanced economies; war equals 1 for country j in period t if in that period the country was subject to armed conflict. i indicates country, t indicates year, ei;t is an idiosyncratic error, ei a time invariant error and et is a country invariant error. The expected signs are bj < 0, where j = 1, 2 or 3; a1, a6 and a7 > 0; a3 and a4 < 0; a2 and a5 have no a priori values. Owing to the inclusion of the lagged dependent variable estimation is by the Blundell and Bond (1998) estimator; this is preferred to the Arellano and Bond (1991) estimator due to the small number of time periods in the data-set. Inferences are valid in the presence of first order serial correlation. The second lag of inflation was found necessary to remove second order serial correlation to obtain valid inferences. The estimator removes country fixed effects by first differencing the data. The reform indices and budget surplus are lagged one period both to reduce the problems of endogeneity and co-determination and to allow for lagged responses of inflation to these variables. The estimating equation is (2)
Dinf i;t ¼ l0 þ a1 Dinf i;t1 þ a2 Dinf i;t2 þ a3 Dbsurplusi;t1 þ l1 T t þ l2 T sq;t þ a6 Dadvinf t þ a7 Dwari;t þ b1 Dlibi;t1 þ b2 Dcredi;t1 þ b3 Dprivi;t1 þ ht þ hi;t
(2)
where D is the first difference operator,7 ht ¼ et et1 , and hi; ¼ ei; ei; . 5 There is likely to be collinearity between the trend and advanced economy inflation as the latter moderated. However, as these variables are used as controls, rather than being of primary interest, the preference is to maintain both the quadratic trend and advanced economy inflation. 6 Implicitly this formulation regards each of priv, lib and cred as being continuous. While there is no reason to believe that the indices are linear, such an assumption is a convenient way to gain parsimony as opposed to using dummy variables for each interval of an index (such as dum=1 if 2
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Table 1 Results of Blundell–Bond estimation. Dependent variable log of inflation. Dependent variable infi,t
1. Full
2. Full with year dummies
3. West
4. East
libi,t1 credi,t1 privi,t1 wari,t bsurplusi,t1 Tt Tsq,t advinft infi,t1 infi,t2 Cons Year dummies N Wald Serial corr. Reform = 0 Sample
0.82*** (0.14) 0.42***(0.13) 0.49***(0.16) 1.0*** (0.28) 0.04***(0.01) 0.42*** (0.08) 0.02*** (0.004) 0.16 (0.17) 0.44***(0.06) 0.15*** (0.03) 6.16*** (0.93) No 359 2245.66 0.05 0.00 1993–2007
0.79*** (0.14) 0.52*** (0.15) 0.44*** (0.17) 0.96*** (0.27) 0.04*** (0.01)
0.58 (0.53) 0.32 (0.21) 0.43** (0.20) 0.70* (0.40) 0.04* (0.03) 0.15 (0.13) 0.004 (0.005) 0.53** (0.21) 0.52*** (0.09) 0.13* (0.08) 2.87 (2.51) No 186 18072.12 0.04 0.08 1993–2007
0.59*** (0.11) 0.58 (0.36) 0.27 (0.19) 0.96** (0.40) 0.02** (0.01) 0.70*** (0.08) 0.03*** (0.004) 0.24 (0.21) 0.41*** (0.10) 0.15*** (0.04) 8.57*** (0.68) No 173 83017.94 0.70 0.00 1993–2007
0.45*** (0.07) 0.20*** (0.04) 4.19*** (0.77) Yes 359 14531.24 0.10 0.00 1993–2007
Notes: Serial corr. reports the probability value for the test of no second order serial correlation. N is the number of observations. Wald tests the null that the explanatory variables do not jointly explain the dependent variable. Reform = 0 reports the probability that the joint contribution of the reform indices is zero. Numbers in parenthesis are robust standard errors. *** Statistically different to zero at 1% level. ** Statistically different to zero at 5% level. * Statistically different to zero at 10% level.
To test robustness Eq. (2) is re-estimated with the trend, its square and advanced country inflation replaced by year dummies. As a further test of robustness and to aid the interpretation of the results the model is re-estimated for two sub-samples: the East (CIS members) and the West. Figs. 2–4 show that in general the reform effort has been deeper and more consistent in the West group (top panels of the figures), partly as a consequence of greater integration with the EU. It is possible that the reforms have a less precise ‘qualitative’ effect on inflation, tending to make low inflation more likely. The next part of the analysis uses a panel logit model to examine this issue.8 Low inflation is alternately defined as inflation <40% and inflation <10%.9 lowi;t ¼ d0 þ d3 bsurplusi;t1 þ d4 T t þ d5 T sq;t þ d6 advinf t þ d7 wari;t þ f1 libi;t1 þ f2 credi;t1 þ f3 privi;t1 þ mt þ mi þ mi;t
(3)
where lowi,t = 1 if inflation < threshold (alternately 10% or 40%) and 0 otherwise, bsurplus, T, Tsq, advinf, war, lib, cred and priv are as previously defined, mt , mi and mi;t are time invariant, country invariant and idiosyncratic error terms. The expected parameter values are d3 and d4 > 0, d6 and d7 < 0, fj > 0 for j = 1–3. 4. Results Eq. (1) is first estimated without the reform indices and then with each reform index included singly inf i;t ¼ 0:55 inf i;t1 0:19 inf i;t2 0:05 bsurplusi;t 0:39T t þ 0:01T Sq;t þ 0:18 advinf t þ 1:29 wari;t
(4)
The parameters on all variables except advinf are statistically significant at 1% or better. When added singly all of the reform indices have negative effects, and are statistically significant at 5% or 8 It is not possible to achieve estimate (3) if year dummies are incorporated. Estimation, also, is not possible for the subsamples. 9 The definitions of ‘low’ inflation follow from the growth literature. Fischer et al. (1996) argue that only when inflation is below 50% is GDP growth positive, Christofferson and Doyle (1998) puts this threshold at around 13%.
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Table 2 Marginal effects for results of logit estimation. Dependent variable lowi,t
1. lowi,t = 1 if inflation < 40%
2. lowi,t inflation < 10%
libi,t1 credi,t1 privi,t1 bsurplusi,t1 Advinft wari,t Tt Tsq,t N LR(8) Reform = 0 Sample
0.02 (0.02) 0.03 (0.02) 0.004 (0.008) 0.0004 (0.001) 0.002 (0.02) 0.12 (0.14) 0.002 (0.01) 0.0006 (0.0005) 391 292.21 0.0 1992–2007
0.24** (0.10) 0.51*** (0.13) 0.24** (0.10) 0.014 (0.11) 0.07 (0.56) 0.02 (0.33) 0.37*** (0.08) 0.01*** (0.004) 391 265.72 0.0 1992–2007
Notes: see Table 1. LR(8) is a likelihood ratio test that only the intercept is required to predict the dependent variable.
better. The point estimates are: priv 0.29, cred 0.52 and lib 0.67, the other parameters are little changed. For the full model (column 1 of Table 1) the results show that both credit reform and liberalization reduce inflation.10 However, privatization is found to raise inflation. The null hypothesis that the reform indices jointly make no contribution to inflation is strongly rejected.11 The other variables all take the expected signs; though for the full sample the effect of advanced economy inflation is not significant. The results are robust to the inclusion of the year dummies (column 2, Table 1). The sub-samples reveal some variation (columns 3 and 4 of Table 1). Surprisingly credit reform is not significant in either region, though the point estimates are not greatly different to those of the full sample. This could be due to the variation in this index being much smaller within the regions than in the whole sample (see Fig. 3). The liberalization only has a significant effect in the East, though the point estimate is almost identical to that for the West; this likely reflects the lower variation in lib in the western subsample. Privatization raises inflation in both regions, but the effect is only statistically significant in the west. The hypothesis that the effect of the reform indices are jointly zero is strongly rejected in the East group, for the west rejection is only possible at 8%. Advanced economy inflation has a statistically significant positive effect in the west; in the east the effect is negative but indistinguishable from zero. The logit estimations (Table 2), reported as marginal effects, show that credit reform and liberalization are important for reducing inflation below 10% (column 2). Individually the reforms do not appear to significantly influence the likelihood of reducing inflation below 40%. Jointly, however, the reforms do make inflation below 40% more likely.12 10 Cukierman et al. (2002) develops indices of central bank independence for transition economies over the 1990s. They find, on average, reformers in transition economies created Central Banks with substantially more independence than those of developing countries in the 1980s. However, they report that lower inflation is associated with greater independence only when the economy is sufficiently liberalized. Campillo and Miron (1996) finds a lesser role for central bank independence once variables such as trade openness are taken into account. This latter finding is supported for transition economies by Cottarelli et al. (1998). The legal central bank independence index (LVAW) from Cukierman et al. on inflation was incorporated into Eq. (1). This index was chosen due to having the greatest coverage of all those used by Cukierman et al. In the absence of the reform indices the effect is negative and statistically significant, but one the reform indices are incorporated the effect is statistically indistinguishable from zero. The reform indices, however, have effects statistically different to zero. 11 An anonymous referee questioned the robustness of the results, suggesting that the findings may be due to a shift to a low inflation coinciding with reform. To test the model is estimated with the addition of a dummy variable that takes the value of 1 in the low inflation era and 0 otherwise. The low inflation era has three possible starting years: 1995, 1999 and 2002. This dummy is not significant in any case and makes no qualitative difference to the results reported in column 1 of Table 1. If the model is estimated over a sample curtailed to start in 1997 cred and lib remain significantly negative, priv is also negative but indistinguishable from zero. This result also holds if the estimation period runs from 1996 to 2004. 12 The regressions were also estimated with the inclusion of country dummies. The only changes of note occur for the 10% threshold. In this case the budget surplus significantly raises the probability of low inflation and the effect of liberalization becomes statistically indistinguishable from zero. Given the limited variation in lib over time, the latter result most likely reflects collinearity between the country fixed effects and lib.
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5. Conclusion The results suggest that liberalization and improved credit allocation reduce inflation, but that privatization of large firms increases inflation. When the sample is divided into eastern and western sub-samples some interesting differences emerge. Most strikingly, the adverse effect of privatization is not statistically significant in the east. This result is surprising given the greater reform progress in the west. Furthermore, once the estimation excludes the early/mid 1990s period the effect of privatization on inflation is no longer positive. This result could be a consequence of attempts to moderate the rise in unemployment during the initial phase of privatization. Appendix A. Data definitions and sources Inf is the log of consumer price inflation. Lib = (PL + TRA)/2 Cred = (BK + RES)/2 Priv = (LSP + SSP)/2 PL is an index of price liberalization. TRA is an index of trade regime liberalization. BK is an index of the liberalization of banking and interest rates. RES is an index of governance and enterprise restructuring. LSP is an index of the privatization of large enterprises. SSP is an index of the privatization of small enterprises. The indices range from 1 for unreformed to 4.3 for standards of a market economy. Bsurplus is the ratio of the fiscal surplus to GDP. Advinf is the average inflation rate in industrial economies. Consumer price inflation, PL, TRA, BK, RES, LSP, SSP, gdp growth and Bsurplus are sourced from the EBRD transition report, http://www.ebrd.com/country/sector/econo/stats/index.htm. Advinf is sourced from the IMF, world economic outlook. References Alexander, W.E., Balino, T.J.T., Enoch, C., 1996. Adopting indirect instruments of monetary control. Finance and Development 33, 14–17. Arellano, M., Bond, S., 1991. Some tests of specification for panel data: Monte Carlo evidence and an application to employment equations. Review of Economic Studies 58, 277–297. Begg, D., 1997. Monetary policy during transition: progress and pitfalls in central and eastern Europe. Oxford Review of Economic Policy 13, 33–46. Blundell, R., Bond, S., 1998. Initial conditions and moment restrictions in dynamic panel-data models. Journal of Econometrics 87, 115–143. Bogetic´, Zˇ., Mladenovic´, Z., 2006. Inflation and the monetary transmission mechanism in Belarus, 1996–2001. International Research Journal of Finance and Economics 1, 1–20. Calvo, G.A., Coricelli, F., 1996. Monetary policy and inter-enterprise arrears in post-communist economies: theory and evidence. Policy Reform 1, 3–24. Campillo, M., Miron, J.A., 1996. Why Does Inflation Differ Across Countries. Working Paper No. 5540. National Bureau of Economic Research. Christofferson, P., Doyle, P., 1998. From inflation to growth: eight years of transition. Working Paper No. 98/100. International Monetary Fund. Cottarelli, C., Griffiths, M., Moghadam, R., 1998. The non-monetary determinants of inflation: a panel study. Working Paper No. 98/23. International Monetary Fund. Cottarelli, C., Doyle, P., 1999. Disinflation in transition, 1993-97. Occasional Paper No. 179. International Monetary Fund. Cukierman, A., Miller, G.P., Neyapti, B., 2002. Central bank reform, liberalization and inflation in transition economies—an international perspective. Journal of Monetary Economics 49, 237–264. de Melo, M., Denizer, C., 1997. Monetary policy during transition: an overview. Policy Research Working Paper no. 1706. World Bank. de Melo, M., Denizer, C., Gelb, A., 1996. Patterns of transition from plan to market. World Bank Economic Review 10, 397–424. Fischer, S., Sahay, R., Vegh, C., 1996. Stabilization and growth in transition economies: the early experience. Journal of Economic Perspectives 10, 45–66. Friedman, M., Schwartz, A., 1963. Monetary History of the United States 1867–1960. Princeton University Press.
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