Information about Asia and the Pacific Asia y el Pacífico
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Chapter 4 Growth and Inflation in Asia’s Transition Economies

Editor(s):
Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Information about Asia and the Pacific Asia y el Pacífico
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Author(s)
Emil-Maria Claassen

One of the first countries “in transition” to a market economy was China, even though it would not like this epithet. The success of the emerging economies in Asia, in particular, of Taiwan Province of China, may have been one impetus for China’s early liberalization efforts in 1978. China’s success, in turn, could have been one among various motivations for Gorbachev’s initiation of perestroika in 1985. One year later, in 1986, Vietnam embarked on the Chinese path followed by the Lao People’s Democratic Republic and later by Myanmar and Cambodia. It was only in 1990–91 that Eastern Europe, Russia, and Central Asia reached their definite turning point. (See Table 1 for a breakdown of the countries in Indochina and Central Asia.)

Table 1.Macroeconomic Indicators for Countries in Transition, 1993
CountryPopulation (millions)GNP per Capita (U.S. dollars)GNP per Capita (intl. dollars: PPP)Openness
China and Indochina
China (t1 = 1978)1,175.44902,12016.8
Vietnam (t1 = 1986)70.91701,04026.1
Lao P.D.R. (t1 = 1986)4.529018.0
Myanmar (t1 = 1988)44.7
Cambodia (t1 = 1989)9.6
Central Asia and selected European countries
Armenia (t1 = 1991)3.76602,0802.3
Azerbaijan (t1 = 1991)7.47302,2305.4
Kazakstan (t1 = 1991)17.21,5403,7703.1
Kyrgyz Republic (t1 = 1991)4.58302,4203.0
Tajikistan (t1 = 1991)5.76001,43011.8
Turkmenistan (t1 = 1991)3.91,38014.4
Uzbekistan (t1 = 1991)22.09602,5803.9
Mongolia (t1 = 1991)2.440039.4
Russia (t1 = 1991)148.52,3505,24010.2
Poland (t1 = 1990)38.42,2705,01016.0
Czech Republic (t1 = 1991)10.32,3707,70090.0
Slovak Republic (t1 = 1991)5.31,9006,45058.0
Sources: World Bank (1995a); United Nations (1995a); and Organization for Economic Cooperation and Development (1995).Notes: t1 refers to the first year of price liberalization and macroeconomic stabilization. Strictly speaking, Myanmar does not belong to the Indochinese countries. With respect to Central Asia, the International Monetary Fund (1995) differentiates between the Transcaucasus (Armenia, Azerbaijan, Georgia) and Central Asia. GNP per capita of Turkmenistan is for 1992. Openness is total trade (sum of imports and exports divided by 2) as a percentage of GNP. For Central Asia and Russia, trade does not include trade with other members of the Commonwealth of Independent States.
Sources: World Bank (1995a); United Nations (1995a); and Organization for Economic Cooperation and Development (1995).Notes: t1 refers to the first year of price liberalization and macroeconomic stabilization. Strictly speaking, Myanmar does not belong to the Indochinese countries. With respect to Central Asia, the International Monetary Fund (1995) differentiates between the Transcaucasus (Armenia, Azerbaijan, Georgia) and Central Asia. GNP per capita of Turkmenistan is for 1992. Openness is total trade (sum of imports and exports divided by 2) as a percentage of GNP. For Central Asia and Russia, trade does not include trade with other members of the Commonwealth of Independent States.

Focusing on Asian countries in transition, one should look not only at their growth and inflation performance, but also at their income level (Table 1). In 1993, China’s GNP per capita was nearly one-fifth that of Russia’s, although, measured in terms of purchasing power, it was only one-half of Russia’s.1 Again, in terms of purchasing power parity (PPP), China’s GNP per capita was rather similar to that of the Central Asian economies and twice as high as that of Vietnam.

A second important indicator of how far a country has progressed toward a market system concerns the openness of the economy. Of the classic small open economies like the Lao People’s Democratic Republic and the Kyrgyz Republic, both have the same population, but the former has a far greater degree of openness than the latter. At the other extreme, for the semi-open economies, China and Russia, we observe the same phenomenon. The former is more open than the latter. In both cases, the explanation may be that the two more open economies, the Lao People’s Democratic Republic and China, experienced not only a longer but, above all, a more successful transition.

In what follows, we shall show that the most successful countries in transition were China and those of Indochina. Explanations for their higher growth rates and lower inflation rates are presented.

Success Stories and Failures

On the basis of their growth and inflation performance during the first transition years (Table 2), China and the socialist Indochinese countries seem to have followed the right economic policies compared with Russia and its monetary satellites in Central Asia (Table 3), which suffered tremendous output declines and chronic inflation. Among the Central European countries, we have added the strongest performers, Poland and the former Czechoslovakia, which succeeded rather well in pushing down inflation and the decline in output. We have excluded the former German Democratic Republic, for obvious reasons, and the Baltic countries.2

Table 2.Growth and Inflation: China and Indochina
Countryt1t2t3t4t5t6t7t8t9
China (yuan; t1 = 1978)
Growth7.67.94.58.510.214.512.98.5
Inflation0.72.06.02.41.91.52.88.86.0
Exchange rate1.581.501.531.741.921.982.753.20
Vietnam (dong; t1 = 1986)
Growth4.05.07.84.96.08.68.18.8
Inflation301.0310.995.836.483.137.88.59.9
Exchange rate182259004,3005,00012,50010,53010,51011,000
Lao P.D.R. (kip; t1 =1986)
Growth4.8−1.1−1.813.06.74.07.05.98.0
Inflation14.814.859.535.713.49.86.36.7
Exchange rate95367452587708702716717726
Myanmar (kyat; t1 = 1988)
Growth−11.43.72.8−0.69.36.06.4
Inflation16.127.217.632.321.931.835.0
Exchange rate6.76.76.36.36.16.26.0
Cambodia (riel; t1 =1989)
Growth3.51.27.67.04.34.9
Inflation63.6145.787.9176.731.026.1
Exchange rate1674187031,2532,4702,585
Sources: Asian Development Bank (1995); and World Bank (1995b).Notes: t1 refers to the first year of price liberalization and macroeconomic stabilization. The exchange rate for the U.S. dollar (annual average) is in many cases the official one, which is rather evident for Myanmar. With respect to China, at least from 1987 (t10), there are two rates, the official exchange rate and the swap market exchange rate. From these results a weighted exchange rate for exporters, who are allowed to retain a percentage (r) of their export revenues. The weighted exchange rate for exports is r swap rate plus (1−r) official rate. In 1987–90, r was 0.44 and 0.80 from 1991 onward. The exchange rates were unified in 1994. A similar pattern existed for Vietnam and Lao P.D.R. before 1989 (i.e., before t4), the year the exchange rates were unified. However, this unified exchange rate (as well as in China) can still be below the parallel market rate.
Sources: Asian Development Bank (1995); and World Bank (1995b).Notes: t1 refers to the first year of price liberalization and macroeconomic stabilization. The exchange rate for the U.S. dollar (annual average) is in many cases the official one, which is rather evident for Myanmar. With respect to China, at least from 1987 (t10), there are two rates, the official exchange rate and the swap market exchange rate. From these results a weighted exchange rate for exporters, who are allowed to retain a percentage (r) of their export revenues. The weighted exchange rate for exports is r swap rate plus (1−r) official rate. In 1987–90, r was 0.44 and 0.80 from 1991 onward. The exchange rates were unified in 1994. A similar pattern existed for Vietnam and Lao P.D.R. before 1989 (i.e., before t4), the year the exchange rates were unified. However, this unified exchange rate (as well as in China) can still be below the parallel market rate.
Table 3.Growth and Inflation: Central Asia and Selected Eastern European Countries
19911992199319941995
t1t2t3t4t5
Central Asia (t1 = 1991)
Growth−7.7−17.6−11.9−14.9
Inflation969151,2411,338
Armenia
(dram: 11/22/93)
Growth−11.8−52.4−14.8
Inflation1408001,8204,960
Exchange raten.a.n.a.77400
Azerbaijan
(manat: 8/15/92)
Growth−0.7−22.1−23.3−21.9
Inflation1129391,1131,780
Exchange raten.a.3934,500
Kazakstan
(tenge: 8/15/93)
Growth−13.0−14.0−12.0−25.0
Inflation1151,5101,6631,880
Exchange raten.a.n.a.6.315.859
Kyrgyz Republic
(som: 5/10/93)
Growth−5.0−19.1−16.0−26.5
Inflation1131,0891,194280
Exchange raten.a.n.a.8.0311.7510.50
Tajikistan
(Tajik ruble: 5/95)
Growth−8.7−30.0−27.6−16.3
Inflation1139072,136240
Exchange rate
(45 = $1 in 5/95)n.a.n.a.n.a.n.a.320
Turkmenistan
(manat: 11/1/93)
Growth−4.7−5.3−10.0−19.5
Inflation1127701,6312,710
Exchange raten.a.n.a.16.5230
Uzbekistan
(sum: 7/1/94)
Growth−0.9−11.1−2.4−2.6
Inflation974151,2321,550
Exchange raten.a.n.a.n.a.730
Mongolia (tugrik)
Growth−9.9−7.6−1.22.5
Inflation2020326888
Exchange rate39105397414460
Central and Eastern Europe
Growth−11.1−11.4−6.2−3.8
Inflation96368457203
Russia (ruble; t1 = 1991)
Growth−13.0−19.0−12.0−15.0
Inflation931,353896302
Exchange rate1674151,2474,500
Czech Rep. (korony; t1=1991)
Growth(−15.9)(−8.5)−0.92.6
Inflation59112110
Exchange rate(27.8)(28.9)29.928.026.4
Poland (zloty; t1 = 1990)
Growth (1990 = −11.6)−7.02.63.86.0
Inflation (1990 = 586)70433532
Exchange rate
(1990 = 9,500)10,95715,76721,34424,33022,450
Sources: International Monetary Fund (1994, 1995); and United Nations (1995b).Notes: t1 means the first year of price liberalization and macroeconomic stabilization. Inflation rates concern consumer prices; the foreign exchange rate is for the U.S. dollar (end of period). The dates following currency names represent date of introduction of the currency. The figures for the Czech Republic of 1991 and 1992 are those for Czechoslovakia. Exchange rate figures are for February 1994 for Armenia, Azerbaijan, Kazakstan, the Kyrgyz Republic, Turkmenistan, and Uzbekistan; 1995 exchange rate dates are for the following months: Armenia and Azerbaijan, October; Kazakstan and Mongolia, August; Kyrgyz Republic and Turkmenistan, June; Tajikistan and Russia, November; Uzbekistan, July; and the Czech Republic and Poland, September.
Sources: International Monetary Fund (1994, 1995); and United Nations (1995b).Notes: t1 means the first year of price liberalization and macroeconomic stabilization. Inflation rates concern consumer prices; the foreign exchange rate is for the U.S. dollar (end of period). The dates following currency names represent date of introduction of the currency. The figures for the Czech Republic of 1991 and 1992 are those for Czechoslovakia. Exchange rate figures are for February 1994 for Armenia, Azerbaijan, Kazakstan, the Kyrgyz Republic, Turkmenistan, and Uzbekistan; 1995 exchange rate dates are for the following months: Armenia and Azerbaijan, October; Kazakstan and Mongolia, August; Kyrgyz Republic and Turkmenistan, June; Tajikistan and Russia, November; Uzbekistan, July; and the Czech Republic and Poland, September.

In the first six years of transition, the best scores in macroeconomic performance go to the largest and smallest countries, China and the Lao People’s Democratic Republic. Other countries, like Vietnam and Cambodia, also had continuously positive growth rates, but their inflation performance was considerably less satisfactory. We shall briefly review the special circumstances under which each of the Indochinese countries implemented its transition scheme toward a market economy.3 We shall not describe the Chinese economy because it is already the main subject of the conference.

Following Vietnam’s reunification in 1975, economic integration with the south was only partially successful. After it invaded Cambodia in December 1978, assistance from China and major Western donors ceased. The Sixth Vietnamese Party Congress in 1986 endorsed an economic reform program. Price liberalization similar to the Chinese two-track system was introduced, and, until the end of 1989, nearly all prices were deregulated. In that year, the Vietnamese army left Cambodia, and Western aid was resumed although the United States ended the economic embargo only in February 1994. Because the economy was predominantly agricultural, the agricultural supply response to the price liberalization was rather quick. Furthermore, the agricultural sector consisted basically of household agriculture at the end of the 1980s. Although the first years of transition were highly inflationary, they were accompanied by considerable growth.

The experience of the Lao People’s Democratic Republic with reform was similar to that of Vietnam, despite registering lower inflation rates and two years of negative growth. Agriculture was gradually decollectivized and, although price reforms began with dual prices, they were abolished more rapidly than in Vietnam. The inflation differential beween the two countries in 1987–88 can probably be ascribed to higher budget deficits in Vietnam, which the Lao People’s Democratic Republic avoided.4

The other two Southeast Asian countries in transition, Myanmar and Cambodia, are special cases. In Myanmar, agriculture was never collectivized, and 1988, the first year of reform, was characterized by price adjustments, in particular, for agricultural products. By contrast, Cambodia, shaken by the Khmer Rouge regime in the late 1970s, began to re-collectivize agriculture in the early 1980s. In 1989, the first year of reform, the Government restored private ownership of land for family plots and traditional usufruct rights on public land. Prices for rice procured by the state had been raised almost to free market levels.

In contrast to the success stories of China, Vietnam, the Lao People’s Democratic Republic, and Cambodia (Myanmar’s figures are still not reliable), the Central Asian experiment looks like a disaster (Table 3). During 1991–93, Central Asia experienced a decline in output and a rise in the price level similar to those that befell Russia. The main reason for these countries’ experience was that they remained in the ruble zone after the dissolution of the Soviet Union and that the monetary center did not succeed in implementing a solid macroeconomic stabilization program. One country that had already disposed of its own currency, namely Mongolia, performed better than Russia. All countries except Tajikistan left the ruble zone at the end of 1993 and became even more inflationary than Russia (with the exception of the Kyrgyz Republic). In comparison, China and the Indochinese countries looked like “islands of monetary stability and economic growth.”

Common Features of Growth Performance

In the literature, the difference in macroeconomic performance between Russia and Central Asia on the one hand, and China and Indochina on the other hand, is often attributed to “gradual” versus “radical” stabilization policies. Gradualism is found to be less disruptive than shock therapy. However, neither group of countries conducted a radical macroeconomic stabilization policy, so that it is misleading to characterize the approaches in terms of their speeds. As far as growth is concerned, the growth differential between the two regions must be explained mainly by the labor surplus in the Chinese and Indochinese agricultural sectors.5

Even though we are not able to give precise data for the composition of agricultural employment in the total labor force, some figures already indicate the relative weight of agriculture in the various economies in transition. Toward the end of the 1980s, agricultural employment over total employment was 13.1 percent in Russia and 27.8 percent in Poland. In Vietnam, it was 72.3 percent in 1986. China’s relative share of agricultural employment was 70.8 percent in 1978 and declined to 58.6 percent in 1992.6 The other Indochinese countries are likely to have a similar if not higher share of agriculture than Vietnam. Central Asia’s labor reservoir may be by far less important: in 1987, the distribution of employment in agriculture was 23 percent in Kazakstan, 34 percent in the Kyrgyz Republic, 38 percent in Uzbekistan, 41 percent in Turkmenistan, and 42 percent in Tajikistan.7

During the early years of transition in China, the high growth rates resulted mainly from the production boom in agriculture, which was the outcome of decollectivization and price adjustments within the dual-price system. A similar hypothesis may be advanced for the Indochinese countries in transition. However, the massive labor movement from the agricultural sector to new activities, which was observable for China in the later years of transition, has not yet occurred in the Indochinese countries.8

Comparing the Chinese and Indochinese economies with those of Central Asia and Eastern Europe, many observers emphasize the successful gradual transition of China and the Indochinese countries, and the disastrous radical transition of Russia and the Central Asian countries. Of the two largest economies, China and Russia, China is both an economy in transition and a developing country.9 For developing countries with a labor surplus in the agricultural sector, early development theory explains that the economic takeoff results from the shift of labor from the agricultural sector to the new industrial sector, in which the amount of capital is also increasing.10 This movement of factors of production is, by nature, gradual. Furthermore, if there are restrictions on labor mobility, as in China, the new activities will be located mainly in rural areas.

But China is also a country in transition as far as central planning and the state-owned industry are concerned. In this respect, the two countries, China and Russia, followed a similar approach by maintaining this industry under the authority of the government or the old managers. One feature of China’s state enterprises was the dual-pricing system, under which preferential prices were set for a proportion of their inputs and outputs. In Russia, the restructuring of the state-owned industry (even if privatized) was also gradual because the ailing industry was heavily subsidized. Under this aspect of transition, neither Russia nor China followed a “big bang” approach.

Inflation and the Exchange Rate Regime

Inflation in any economy, whether industrial, developing, or in transition, is linked to an “excessive” growth rate of its money supply. Equally, for most inflationary economies, this excessive growth rate results from budget deficits that are financed by credits from the central bank. A successful anti-inflation policy must settle, among various other policy measures, the budget deficit issue so that the excessive growth rate of the money supply can be stopped.

The two largest economies in transition, China and Russia, embarked on price liberalization with a substantial budget deficit. However, one was highly inflationary and the other not. One possible explanation for the Chinese success is the increasing demand for real money holdings, which absorbed the currency creation resulting from the money-financed budget deficit. The steady rise in the ratio of M2 to GDP could be explained by the low degree of monetization (in particular, in the agricultural sector); by the limited access of individuals, farmers, and small enterprises to credit markets; and by the still rudimentary menu of financial assets.11

The transition to a market economy can be viewed from three angles, namely, macroeconomic stabilization, privatization, and the restructuring of the economy. Privatization also implies liquidating state-owned enterprises whose market value is zero. If the liquidation is postponed, the government has to step in to grant wage subsidies to the ailing industry. Such a policy—one could call it “industrial policy” or a surrogate for a nonexistent social safety net—could be in conflict with the macroeconomic stabilization program if it implies money-financed budget deficits. The main cause of the budget deficits in many economies in transition was the wage subsidies granted to that part of the state-owned industry that would have been closed down in the environment of a market economy.12

It is important to know what group of people ultimately “finances” the wage subsidies. Transfers have to come from somewhere, even in the case of money-financed budget deficits. In the case of Russia or Central Asia, it is the inflation tax on real currency holdings that was “paid” by the whole population, including the recipients of wage subsidies (“forced savings”). In the case of China, it is the seigniorage gain from growth in currency holdings that was supported by the whole population equally (“voluntary savings”). Both types of savings represent the “real counterpart” of the money-financed budget deficits.13

In addition, most countries have still not yet fully established a two-tier banking system. The central bank, through its various branches, can still grant direct credits to the industry through which state-owned enterprises are subsidized (soft budget constraint). These credits have to be considered “hidden” government expenditures and must be added to the “visible” part of the official budget deficit. In this sense and in the presence of inflation (in the case of Russia and Central Asia), not only currency but the whole money stock of M2 can be considered the base for the inflation tax. Low nominal interest rates redistribute wealth from lenders to borrowers. The decline in the real value of loans is due to negative real interest rates, which is the inflation tax received by borrowers, and this tax is paid by the holders of deposits.14

Another important element of a successful stabilization policy is the choice of the exchange rate regime. The stabilization of the exchange rate could be one possible element of an overall anti-inflation stabilization program. The ultimate target of an exchange rate peg is price stability. The currency of the selected “anchor” country must have a high score for price stability, while the monetary “satellite” country should have strong commercial links to the anchor country. Thus, for countries like the Lao People’s Democratic Republic or Vietnam, the anchor currency could be the Singapore dollar, the Thai baht, or the yen because the two countries have important trade relationships with Singapore, Thailand, and Japan. An alternative to stabilizing the exchange rate would be to stabilize the growth rate of the money supply.15

The superiority of a fixed exchange rate depends on two conditions. On the one hand, the stabilization of the exchange rate must constitute a better guarantee for price stability. On the other hand, this policy should be able to limit more successfully any reduction in output when the anti-inflation policy is implemented. Both conditions could depend crucially on the level of the initial inflation and on the openness of the economy.

As far as past “hyperinflations” that took place after the two world wars are concerned, only those countries that used a fixed exchange rate succeeded in reducing their inflation rate to a one- or two-digit level (shock therapy).16 One of the main reasons for this success lies in the dominant use of a foreign currency as the unit of account, means of payment, and store of value (dollarization). If the exchange rate peg becomes credible, and credibility also depends on sound underlying monetary and fiscal policies, and if inflationary expectations are revised toward a modest, or even zero, inflation rate, the domestic currency will again be used increasingly as the unit of account, means of payment, and store of value.

With respect to “chronic” inflation rates, the policy of reducing the growth rate of the money supply (floating exchange rate) would not succeed in revising inflationary expectations downward. Because inflationary expectations are the most important elements in labor and credit contracts, only a credible fixed exchange rate peg would give rise to a fundamental break in inflationary expectations, avoiding higher ex post real wages and real interest rates and, thus, an important fall in output. The three countries in transition that fought successfully against inflation—Vietnam, the Lao People’s Democratic Republic, and the Kyrgyz Republic—all used an exchange rate peg or maintained a stable exchange rate.

In a small open economy, the exchange rate plays a greater signaling role than in a large economy, where it is ignored by the public at large. Thus, a fixed peg and the expectation that the exchange rate will remain fixed may have a decisive impact on the formation of inflationary expectations in small open economies. In this respect, an anti-inflation policy that uses the fixed peg will be more successful in avoiding a sharp output decline for these economies.17

Concluding Remarks

All Asian countries in transition share for the moment one common feature—maintenance of the state-owned industry, which is heavily subsidized. An important part of the industry would have been closed if it had been denationalized. This subsidized industry deteriorates the public budget situation in all countries.

From the point of view of macroeconomic performance, China and the Indochinese countries are showcases of great success, while Central Asia represents total failure. One reason for this discrepancy is that the successful countries also belong to the group of “classic” developing countries, with a large part of their labor force located in the rural sector. Decollectivization and price adjustment for agricultural products led to an output boom, and, subsequently, labor migration from agriculture to new activities caused the expansion in industrial production.

All countries suffered from high budget deficits, which they have financed partly with the seigniorage gain from money creation. However, the same cause—money creation—does not necessarily produce the same effect, namely, inflation. The Central Asian countries relied on the inflation tax levied on the real money holdings of their new currencies (forced savings). China, and to a lesser degree the Indochinese countries, could profit from the growth in real currency holdings (voluntary savings) without any demonstrable impact on inflation. In both cases, it was the whole population that supported the subsidies paid to the wage earners in the state-owned industry.

All countries must still address the problem of their state-owned industry being the main cause of the budget deficits. Those countries that are effectively at a high level of inflation must implement a disciplined monetary-fiscal policy mix. The choice of the exchange rate regime is of equal importance. A fixed peg is desirable for the correct downward revision of the inflationary expectations to avoid additional output reduction. In particular, this exchange rate policy could be most effective in small open economies and in those that are dollarized.

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1This lower income differential is due to the lower price level of nontradable goods in China; the same price level is assumed for tradable goods in both countries.
2However, these latter successfully stabilized countries also performed poorly in terms of growth and inflation during the first three years of transition:
1991199219931994
Estonia
Growth−7.9−21.6−6.66.0
Inflation2831,0738948
Latvia
Growth−11.1−35.2−14.82.0
Inflation17295010936
Lithuania
Growth−13.1−56.6−16.51.5
Inflation2161,02041172
4Since 1989, Vietnam’s budget deficit should have improved because of the first oil revenues, which have grown quickly in recent years.
5See, for instance, Sachs and Woo (1994a and 1994b).
8Other common features that are often advanced for explaining the positive and high growth rates in China and the other Indochinese countries in transition are the relative importance of light industry, the role of central planning, former trade relationships, and the political regime; see Rana and Paz (1994). First, heavy industries were more limited, even in China, than in Russia and Central Asia. Second, central planning in the Soviet style, which covered millions of commodities in the former Soviet Union, was never implemented in China because it concerned only a few thousand commodities. Third, the importance of trade with the former Council for Mutual Economic Assistance (CMEA) was marginal and its breakdown of little importance, except for Vietnam. Fourth, the political regime did not change fundamentally as it did in Eastern Europe and Russia.
9See Pomfret (1995), chap. 10.
12Another cause was food subsidies, which were provided to the whole population.
15In the industrial world, countries like the United States, Japan, and Germany have chosen to fix money growth, which implies a floating exchange rate. Others, like Austria, the Netherlands, and France, have opted for a fixed peg with respect to the deutsche mark. The criteria for the choice of appropriate exchange rate regime are more complicated for industrial countries than for countries in transition, because the former have integrated financial markets, while the latter have only a limited convertibility of their capital account transactions.
17The principal argument against a fixed rate concerns the difficulty of maintaining it in the future. Thus, for one reason or another, the country may be exposed to an “unsustainable” current account deficit that cannot be financed by capital inflows, so that a new stabilization policy that would also imply a devaluation or a floating rate must be introduced. However, the need for a change in the parity will be less urgent for small open economies than for large ones, that is, for semi-open economies. Such a program of external stabilization involves a mix of policies, including an expenditure-reducing policy (e.g., lower public expenditures) and an expenditure-switching policy (e.g., a devaluation). In an open economy—that is, a small economy—the share of imported goods in total tradable goods (i.e., domestic plus imported tradables) is far higher. Consequently, a restrictive fiscal policy aimed at improving the current account balance will be more successful, because the reduction in public expenditures will be more likely to affect imported goods than in a relatively closed (i.e., large) economy.

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