Monetary overhang is often cited as the cause of excess aggregate demand in Poland and the former Soviet Union. Czechoslovakia and Hungary, in contrast, are widely viewed as suffering primarily from microeconomic structural problems. All the transforming countries have underdeveloped financial markets and their fiscal deficits are significantly exacerbating inflationary pressures. Debt service not pervasive shortages or the monetary overhang may be the key determinant of their stability during transformation.

In Discussion Paper No. 625, Research Affiliate István bel and John Bonin develop a simple one-sector open macroeconomic model with restrictions on capital account transactions, in which the investment/savings imbalance reflects excess demand in the product market, to analyse the transformation's medium-term aggregate macroeconomic effects. These include the impact of foreign direct investment on the real exchange rate and the possible incompatibility of trade liberalization with macroeconomic stabilization.

They find that a prototype Polish stabilization policy, based on tight fiscal policy and a tariff-induced reduction in the marginal propensity to import, reduces nominal GDP and raises the equilibrium value of the zloty, which increasingly diverges from its already undervalued actual exchange rate. For Hungary, where the forint was initially overvalued, the CMEA's dissolution leads to a significant increase in the fiscal deficit. Combined with a deterioration of the trade balance as the effective price of oil rises, this raises nominal GDP and reduces the equilibrium exchange rate. Again, the gap between the equilibrium and actual exchange rates widens. In the Hungarian case, bel and Bonin find that an increase in foreigners' marginal propensity to invest reduces nominal GDP and appreciates the currency, increasing dollar-valued GDP. This both reduces the gap between the actual and equilibrium exchange rates and further stimulates foreign direct investment. This effect will not apply to the Polish-type stabilization, however, unless and until its exchange rate is undervalued.

In Discussion Paper No. 626, bel and Bonin compare the effects of the two approaches on real wages, inflation and the effective exchange rate: Poland used an undervalued fixed exchange rate as the nominal anchor, while Hungary operated a `crawling peg' to maintain a stable real effective exchange rate in the approach to convertibility. The authors maintain that if inflation is not kept under control, removing exchange controls from the business sector may require more frequent and more severe devaluations to maintain a real exchange rate anchor. They compare Polish and Hungarian inflation in the 1980s to show that Poland was suffering hyperinflation by mid-1989, while inflation in Hungary accelerated during 1988-90 but was characterized by first-quarter spikes in each year and much smaller changes in the subsequent three quarters. They attribute much of Hungary's inflation to a series of one-shot price adjustments which coincided with price liberalization but did not develop into hyperinflation. Hungary's tax-based incomes policy controlled the growth of nominal wages, kept real wages stable and slightly declining, and helped to restrain inflation. Polish real wages have been more volatile, however, reaching a peak in the first quarter of 1989 some 40% above their sustainable level.

Throughout Eastern Europe, inflationary pressures from price liberalization are exacerbated by excess aggregate demand. Monetary overhang was the major problem in the first phase of Poland's stabilization, but the fiscal budget deficit lay at the root of inflationary pressure in Hungary. bel and Bonin maintain that differences in the deficiency of financial intermediation in Hungary and Poland explain the variation in policy options and call for different approaches to stabilization. Hungary's gradualist policies, which were designed to dampen fluctuations in the real exchange rate and real wages, produced less volatility than Poland's `big bang'. Significant institutional and legal changes accompanied the gradualist policies in Hungary, while Poland's `shock therapy' may have suffered from a lack of institutional development and legislative lags.

Debt Service, Foreign Direct Investment and Transformation to Market: A Simple Model
The `Big Bang' Versus `Slow but Steady': A Comparison of the Hungarian and the Polish Transformations
István bel and John P Bonin

Discussion Papers Nos. 625-6, January 1992 (IM)