Speech

The Next Ten Years of Transition: The Challenges Ahead, Address by John Odling-Smee, International Monetary Fund

November 23, 2003

Introduction

I am very pleased to have been invited to participate in this conference celebrating the 110^th anniversary of the State Bank and the tenth anniversary of the Dram. It provides an excellent opportunity to acknowledge the substantial achievements of Armenia in moving from a planned to a market economy. Moreover, an anniversary like this is an encouragement to reflect more broadly on what has been accomplished, and to take stock of what remains to be done.

One sense in which I would like to broaden out my reflections is by looking at the CIS countries more generally. Many have shared with Armenia similar challenges and successes in transforming their economies into vibrant market economies offering to their citizens better prospects for sustained increases in standards of living. Secondly, I will go beyond purely monetary and central bank issues which are naturally my starting point on this occasion and in this location. Specifically, I shall argue that, despite significant progress, much remains to be done to transform the government sector as a whole. It is still too often the case, in my view, that the government sector has hindered rather than supported the development of the private sector, which holds the key to sustained long-term growth.

The remainder of my speech will be structured as follows: First, I shall make a few brief remarks about what has been accomplished so far in Armenia and the CIS. Second, I shall offer some backward and forward reflections on the role of monetary and exchange rate policy. Third, I shall elaborate on the need to complete the transformation of the government sector in the CIS.

Achievements so far

There have been many achievements in the past ten years: in most countries market-oriented government institutions such as an independent central bank and adequately functioning treasury and tax administration have been built, basically from scratch; key basic market legislation covering contract, bankruptcy, private ownership, budget and tax laws has been passed; prices and trade have been liberalized; and much progress has been made in making it possible for individuals to engage in market activities of their own choosing.

Although the process was a difficult one at first, macroeconomic stabilization has now been broadly achieved. During 1999-2002 average annual (end-of-period) inflation in Armenia was only 2 percent (13 percent in all CIS countries); and there has been strong economic growth in the period, averaging 8 percent per year in Armenia (6 percent in all CIS countries).² At the same time, the external balance of payments position in Armenia and the CIS as a whole has strengthened.

With its very strong economic growth, Armenia is reaping the benefits from early structural reforms in addition to prudent macroeconomic management. While remittances and foreign grants have in part fueled domestic demand, exports of new goods such as processed diamonds, textiles, and food products, as well as market driven import substitution have in fact led the growth in real GDP over the last four years, auguring especially well for the future.

While the strong economic growth in the CIS appears to have mainly reflected improvements in productivity and the redeployment of existing capacities, growth in the future will increasingly depend on new investment and a sound financial sector. How to encourage significant new investment and enable the financial sector to fulfill its role of intermediating savings efficiently remains a key challenge in Armenia and other CIS countries.

The role of monetary and exchange rate policy

There is no doubt that the introduction of national currencies in all CIS countries was a major factor in focusing attention on macroeconomic stabilization as a key priority early in the transition. Although it took a while in most cases, two major decisions underpinned the eventual success of stabilization policies: the abandonment of directed central bank credit, to ailing state enterprises in particular; and the abandonment of direct (and even indirect) financing of the government by the central bank. These steps were rooted in the newly gained independence of the central bank. The second one also required a supportively tight fiscal policy stance to be effective and credible.

With price stability broadly established, a new challenge has been facing central banks in many CIS countries. This is how to manage monetary and exchange rate policy during the years of rapid and difficult-to-predict remonetization of the economy and strong foreign exchange inflows. In many countries, real money demand has been recovering faster than expected. This has made it possible to combine rapid monetary and credit expansion with low inflation and stable exchange rates. But this situation will not last indefinitely. At some stage there is a serious risk that monetary expansion will pose an inflation threat. Furthermore, the rapid growth in domestic credit could present risks for the stability of the banking system given still relatively weak capacities to assess loans and creditworthiness.

I would like to suggest that the main instrument for dealing with this situation is greater (in this case upward) exchange rate flexibility. This would help to restrict the monetary and credit growth and the associated foreign exchange inflows to levels compatible with the low inflation target, and to limit risks to banks arising from rapid credit growth. A second instrument is more active sterilization of inflows, which require a deepening of the domestic money market and appropriate monetary policy instruments.

I recognize the concerns in many CIS countries that exchange rate appreciation might damage competitiveness and growth. However, we have to recognize that real appreciation of the exchange rate is a natural part of the process through which incomes will gradually catch up with incomes in more advanced countries as a result of favorable differentials in productivity growth in the traded goods sector. This expected relatively higher real productivity growth will inevitably push up the foreign currency prices of non-traded goods in the CIS countries relative to the foreign currency prices of tradables—in other words, the real exchange rate will appreciate. There are two ways this real appreciation can come about: one is through higher inflation at home than abroad; and the second is through nominal appreciation of the exchange rate. I hope that we will all agree that higher inflation is an unnecessary cost to pay for the process, and that greater (upward) nominal exchange rate flexibility has indeed to be the preferred option. This argument depends critically on there being rapid productivity growth which is certainly the case in Armenia, where labor productivity grew at 9 percent per year during 1999-2002. Growth rates like this are certainly quite enough to allow for a considerable nominal appreciation without any deterioration in competitiveness.

More active use of sterilization policies to mop up the possible excess liquidity associated with foreign exchange inflows might also be part of monetary and exchange rate policy for the short term, especially if there are doubts about the pace of gains in competitiveness. In a number of CIS countries, the central banks have successfully reduced liquidity by issuing their own bills, thereby reducing possible inflationary pressures. Beyond the short term, however, this is not only an expensive policy for the central bank (or the government), but possibly a counter-productive one if the higher domestic interest rates in turn encourage further capital inflows.

Fiscal policy also has a role to play in facilitating monetary and exchange rate policy in the circumstances that I have just described. Budget surpluses, provided that they are deposited at the central bank and their counterparts are invested in foreign assets, could effectively contribute to the sterilization effort and help to reduce inflationary pressures and the need for nominal exchange rate appreciation. This has been a main reason why we have advised the authorities of oil producing countries in the CIS, including Russia, to run larger overall budget surpluses. But other countries might do well to do the same.

The transformation of the government sector

At the very heart of the transition process is the transformation of the government itself. The government has had to stop directing every detail of economic life and limit itself instead to providing the legal and institutional framework within which private economic agents can act. Unfortunately, this transformation still has some way to go. In the meantime, the government's activities in many countries too often hinder beneficial private activity and discourage economic growth.

Let me begin with some remarks about what governments should be doing

· Governments should provide for a strong and independent judiciary. In many cases bankruptcy courts are still not functioning effectively; the judicial system remains ill-equipped to enforce contracts and protect property rights; and there is some way to go in ensuring that it is fully independent and not corrupt.

· Governments should provide independent regulatory agencies with highly qualified and independent staff, and all the necessary legal authority. I am referring to bank and financial market supervisors, commissions to set tariffs of natural monopolies, especially in the energy sector, and independent state audit agencies, as important examples. I am encouraged, in particular, that Armenia is actively enhancing the legal framework governing the financial sector.

· Governments should provide a more competitive environment by reducing the exit and restructuring costs, on the one hand, and reducing the barriers to entry, on the other hand. More transparent and less onerous business registration procedures, easier access to commercial real estate, less pervasive corruption and organized crime, and a more predictable regulatory environment are some of the key conditions to facilitate entry and competition. The same fiscal and regulatory level playing field should apply to all existing and potential domestic and foreign investors.

· Governments should provide Tax Codes that aim at mobilizing a reasonable amount of tax revenue (judged against the international experience, and taking into account the level of incomes) through the application of relatively low and uniform rates on as broad a tax base as possible. And they should set up a Tax Administration which is market-friendly and honest, stressing self-assessment and taxpayers services, in addition to enforcement. Let me say in this context that we welcome the intention of the Armenian authorities to correct the apparent lack of equality of treatment among taxpayers in Armenia, where for instance VAT exemptions appear to have been used as a tool of industrial policy.

· Governments should provide public services (such as health and education), public investments, and social safety nets which deliver better value for money in terms of "enabling" the population, encouraging restructuring, and supporting private sector development and its productivity. They should select only those projects with the highest rate of return, given the need to keep the overall level of government expenditure under control.

· Governments should ensure that public servants adhere to the highest standards of transparency and honesty, and are fully accountable. Here, I am encouraged by the authorities' intention in Armenia to finalize soon an anti-corruption strategy to combat corruption and enhance governance and transparency, with a time-bound action plan of measures to deal with the problem.

Let there be no doubt about the extent of reforms still necessary to meet the above requirements for the role of government, notwithstanding the significant progress in some areas. Among such progress I could mention, in particular, recent promising tax reforms in a number of CIS countries, although there is a need to guard against unexpected reductions in revenues.

Clearly, one prerequisite for the transformation in the role of government which I have sketched here is a reform of the civil service sector itself. This should be aimed at strengthening its professional competence, including its capacities to formulate good policies and high value-for-money programs, and its professional skills; depoliticizing appointments and promotions; and increasing efficiency. Attitudes and modi operandi should be changed: civil servants are working for the population, rather than the other way around-as was too often the case under the Soviet system. Pay incentives for skilled civil servants will have to be better than they are now. They should be financed by reducing numbers because most experts agree that in many countries there is overstaffing in segments of the civil service (such as in the police and military, education, and health).

Let me now say a few words about what governments should not be doing.

· First, governments should not intervene in the decisions of private sector entities nor the commercial decisions of the remaining state enterprises. For example, local governors should not be allowed to interfere with farmers' decisions on planting or exporting; and ministers should not be allowed to force utility companies to maintain services to enterprises with long accumulating payment arrears or tariffs that do not cover costs. All such interventions usually result in inefficiencies, frustrate entrepreneurs, and frighten potential investors, in addition to creating burdensome quasi-fiscal deficits (in the energy sector, for instance).

· Second, governments should not interfere with the judiciary or regulators for political purposes or personal financial gain. Government officials should be prohibited from influencing the outcome of court proceedings in bankruptcy and other cases; they should not be allowed to interfere with privatization tenders on behalf of bids which they favor, nor with the work of the banking supervision or external audit agencies, among other examples.

· Third, governments should refrain from planning the country's economic development in detail. Even in advanced industrial countries, the past experience with government-led industrial policies has not generally been a happy one. Especially given the more limited human resources available in the CIS countries, including Armenia, I very much doubt that the outcome could be different in this region. I observe that the sources of economic growth in the world have increasingly been found in the genius of a multitude of start-up entrepreneurs in often complex knowledge-based areas that could not possibly be covered by some grand industrial policy plan. Especially in such cases, winners can only be picked up by the market: will the products/services sell? will the prices at which the products/services sell cover the costs and generate some profit? Government bureaucrats cannot answer ex ante such questions.

· Fourth, governments should not alter tax systems, expenditure plans, or regulatory regimes to favor specific enterprises or sectors of the economy. Such changes cause distortions and thus lead to a misallocation of resources, in addition to unfairly discriminating against competing enterprises or sectors. They create uncertainty, and encourage enterprises to spend their energies on lobbying for privileges rather than developing new products and markets.

· Finally, governments should not tolerate corruption, whether high level (capture of the state by vested interests, theft from state enterprises, connivance in smuggling and other tax evasion) or petty corruption. Not long ago, in the USA a politician was sent to prison for accepting and not reporting a corporate sponsor's free private jet flight and admission ticket to a baseball game in his home state of Illinois. But in many cities of CIS countries, mayors routinely demand and receive kickbacks for local contracts or granting of various permissions, without fear of legal pursuit. Although blatantly corrupt senior government officials are sometimes fired, they are often re-appointed to similarly senior positions. And generals and tax officials on modest salaries have built themselves mansions and fleets of imported cars without anybody apparently raising questions. In many CIS countries, government officials, including ministers, have financial interests in businesses that are affected by decisions they make as officials—a major conflict of interest. Tolerance for corruption and its adverse effects on business and investment is the single most important factor holding back the more rapid economic growth that many CIS countries could achieve.

Until a critical mass of the needs and problems that I have listed has been addressed, resources will continue to be misallocated, income inequalities will worsen, investment and financial intermediation will remain weak, and growth prospects will remain below potential. I recognize that it will take some time for the full transformation of the government sector to be completed. This is not only because the necessary reforms involve going beyond the broad architecture of a market economy to deal with its more intricate operations, but also because they touch on basic attitudes and quasi-philosophical changes about the nature and role of government. It took generations, in some cases revolutions, in advanced market economies to achieve the standards of transparency and accountability now expected from their governments. The next ten years of transition seem like a reasonable timeframe to reach the same position in the CIS, recognizing that there are likely to be large differences between countries. With its Western orientation and strong ties with Western Europe and the Americas, I would expect Armenia to be among the leaders in this process.

Finally, let me suggest that the role of government in the economy is closely related to the nature of the political system or structure, which indeed often tends to define that role. Entrenched regimes that are not exposed to free and fair elections are more likely than regimes that depend on the popular vote to develop cozy relations with key business groups—sometimes called cronyism, interfere with the independence of the judiciary, tolerate corruption, and avoid transparency and accountability. Progress with democratic reforms can thus be viewed as an important complement to the process of transforming the government sector. Here, I am afraid, more needs to be done within the CIS, where the political systems have too often allowed a few to capture the state and its resources for their own benefit. I believe that democratic reforms would not only benefit society in a broad sense, but would strengthen the process of transforming the government and thereby enhance the prospects for increasing living standards and reducing poverty.

Conclusion

By way of conclusion, let me link these remarks about the transformation of the government sector with the reason for our being here today. The introduction of the dram ten years ago was not simply a matter of establishing a national currency, which itself has wide social, political and economic implications. It was also an essential basis for constructing an independent monetary policy designed and implemented by a new government institution, the Central Bank of Armenia. As we know, the dram has been a successful currency, and the Central Bank has also been successful in ensuring its stability, and in its other tasks. So we can say that this part of the transformation of the government sector has been completed. Given the achievements of the last ten years, I am confident that Armenia can look forward to ten and many more years of successful performance by the Central Bank.

¹ I would like to thank Henri Lorie for the major contribution he made to the preparation of this paper.

² The numbers for the CIS exclude the slow reformers: Belarus, Uzbekistan, and Turkmenistan.