Annual Report 1995. International Economic and Financial Environment

Major Industrial Countries

The developed industrial countries were characterised in 1995 by a higher than forecasted slowdown of economic growth. This was mainly due to the relatively sharp interest rate increases in 1994 and the atypically large inventories by the beginning of 1995. Relatively high unemployment and the resulting low level of consumption kept the inflation level low. Thus, the majority of industrial countries lowered interest rates in 1995. However, it is not yet clear whether this was sufficient to initiate new economic growth.

Budgetary policies of nearly all industrial countries were directed towards decreasing deficits and retrenching. As a result, bond issue volume decreased over another year, supporting, in its turn, the decrease of inflation. An exception was Japan where the economic growth was near zero and the economic activity as well as export decreased.

Due to the decreasing inflation rate, 1995 was the most successful year of the decade in the securities market. The development of equity market was very different even in the G-7 countries (see Table 1. Profitability of shares and bonds of the G-7 countries in 1995). The most important economic indicators for 1995 are given in Table 2 (Economic indicators of some leading industrial countries in 1995).

In 1995 the European economies were also characterised by the development of new structures of the European Union and, in some countries, by the adoption of internal policies in line with the provisions of the Maastricht treaty. Bearing in mind the economic slowdown in many European countries, the notable interest rate decreases in peripheral European countries may have been very timely.

In Germany the main problem concerned the increase of unemployment caused by the low competitiveness and low efficiency as well as a decrease in production in the new federal republics. A low inflation rate and the slowdown of economic and money supply growth enabled the Deutsche Bundesbank to lower its discount rate three times, all together by 1.5%.

Inflation in Finland and Sweden was low. The general slowdown of economic growth in developed countries in the second half of 1995 badly effected Finland, where, encouraged by the trends over last years, big investments were made. Export decreased and plants were working below capacity. Due to the enormous level of unemployment it is doubtful whether a budget economy programme will be realised. The trade balance surplus reflects, most of all, a favourable movement of prices and not an increase of export volume. Imports increased slowly but continuously.

The situation in Sweden was relatively better, regarding, first of all, unemployment. The passing off of internal scandals has created prerequisites for stable development and a greater decrease of interest rates.

The most remarkable occasion in the first half of 1995 in foreign currency markets was the steep decline of the US dollar against the Japanese yen and the German mark and the rapid increase against the yen that occurred in the second half of 1995. Despite of the abrupt strengthening of the German mark at the beginning of the year, the Finnish markka also strengthened against the German mark over the year. Starting from the second half of 1995, the Swedish krona also strengthened. The British pound sterling continued its slow and stable decrease.

These processes in Finland and Sweden were first and foremost signs of an improving economic background. In France and Italy abrupt exchange rate changes were mostly caused by internal policies.

Transition Economies of Central and Eastern Europe

The rapid economic growth that began in 1994 continued in Poland, Slovakia and the Czech Republic. The real GDP of Poland, the first to initiate reforms, increased a fourth year running and with increasing pace. The development of the Czech Republic and Slovakia is comparable to that of Poland. The Hungarian economy was still influenced by the financial crisis of 1993-1994 and the GDP growth was lower than in other countries (see Table 3. Economic indicators of some Central and Eastern European countries). Nevertheless, the stabilisation programme adopted in March 1995 improved the international competitiveness of Hungary in the second half of 1995.

The financial position of the public sector remained satisfactory in the transition economies of Central Europe. The budget deficit did not exceed 2.6% of GDP in any of these countries; the Czech Republic ended the year with a budget surplus.

Due to restrictive monetary and moderate fiscal policies the inflation rate decreased in 1995 in three of these four countries. In the Czech Republic and Slovakia the inflation rate fell to the level comparable with that of industrial countries, although it was higher than that of their major trading partners. In Poland consumer prices increased by up to 21% and in Hungary (due to excise taxes and import tariffs imposed to improve the budget) by up to 28%. The latter exceeded the inflation level of 1994. The lower price increases in the Czech Republic and Slovakia were achieved by avoiding the extremely high inflation during the initial phases of economic reform as well as strict budgetary policy.

In the foreign sector the economic development of the four countries was supported by the increase (in terms of value and volume) of export based on the association agreements concluded with the EU and increasing intra-regional trade. The value of exports increased the most in Poland -35% - and the least in the Czech Republic - 20%. In spite of the increase in exports, the demand for imports related to the increase in investments and real income has caused a foreign trade deficit in most of the Central and Eastern European countries. Although the deficit was partly compensated for by the surplus on services balance, the overall current account showed a deficit. An exception was Slovakia where both the foreign trade balance and current account balance were in surplus in 1995.

The amount of official debt varies from country to country. It amounts to nearly half of annual exports value in the Czech Republic and Slovakia and exceeds the annual exports value by more than 1.5 times in Poland and Hungary. The ratio of foreign debt to GDP was the highest in Hungary (approximately 50%) and the smallest in Slovakia (approximately 20%).

Supported by a relatively favourable external financial position, Poland, Slovakia, the Czech Republic and Hungary took big steps in the international capital market where the government and private sector, using share and bond issues, were able to attract more than USD 5.5 billion. The biggest borrower was still Hungary. The Czech Republic, Slovakia and Poland participated in international financial markets mainly through banks and large businesses. After the decrease in direct investments into these countries in 1994, direct investments increased, amounting to a total of more than USD 1.2 billion in the first half of 1995. The majority of the direct investments during the reform period went into Hungary, where they amounted to USD 717 per capita (increase USD 106 in 1994 and USD 45 in the first half of 1995).

The inflow of short-term capital continued especially intensely to the Czech Republic and Poland. The high country ratings reflected stable macroeconomic situations. Fixed exchange rates and high interest rates created favourable conditions for attracting foreign funds in banking, thus causing the Czech Republic serious problems in implementing the monetary policy. The foreign currency reserves of all four countries increased, to a level exceeding 6 months import value in each country. Purchases made by the Czech Republic for stabilising the exchange rate have increased the country's reserves to the equal of 8 months import value.

The continuation of investments necessary for stable economic growth depends, in the long term, more on the domestic savings rate. In the first years this tendency in Central European countries has exceeded the respective figures in developing countries. Although it is lower than that of the rapidly developing East Asian countries. Domestic savings in the four Central European countries amounted to 22% of GDP in 1994.

The stabilisation of the economy in Latvia and Lithuania which began in 1994 continued in 1995. Though, the crises in the banking sector of both countries had negative impacts on the development of the real sector of economy. As a whole, the growth of the real GDP of Lithuania remained below the prognosis, reaching 2.5% according to the preliminary estimations. The real GDP of Latvia decreased by 1.6%.

The real exchange rate of the Latvian lat and the Lithuanian litas increased also in 1995: the real exchange rate of the lat increased by approximately 15% and that of litas by more than 20%. As both countries proceeded with a fixed exchange rate policy the increase in the real interest rate was mostly reflected in the difference between domestic and foreign price-level changes: the annual growth of consumer prices reached 23% in Latvia and 35% in Lithuania. As in Estonia the main reason for inflation in both countries was the price increase in the sheltered sector, particularly administratively regulated prices.

The budget deficit was mainly covered by a short-term bond issue. The low volume domestic financial markets and liquidity problems caused by the banking crisis, made the borrowing conditions for the Government temporarily very unfavourable. It also led to the interest rate level being very sensitive to the changes in the expectations of domestic and foreign investors.

The increase in the real exchange rates reflected the continuing levelling of the domestic and international price level and did not essentially influence the state's export abilities. In Latvia exports increased 31% in 1995 and in Lithuania 14% (calculated in USD). Although a large proportion of exports from both countries (approximately 50% in Latvia and 40% in Lithuania) was directed to the EU, their biggest trading partner was still Russia. The proportion of other Baltic countries in each others foreign trade is approximately stable 10% for both Latvia and Lithuania.

As in other transition economies, stabilisation has brought about an increase in the demand for imported goods in Latvia and Lithuania and as a result the foreign trade balance in both countries is in deficit. With a relatively low level of foreign debt, the positive net export of services balanced the current account the surplus of which in the first half of 1995 reached 1.1% of GDP both in Latvia and Lithuania.

A relatively small current account deficit shows the smaller share of foreign savings in financing investments. Direct foreign investments continued to increase in Latvia in the first half of 1995. Lithuania has so far been the most modest of the Baltic states in attracting direct foreign investments. This is partly due to the more closed nature of the economy and partly to the privatisation strategy which was originally based on vouchers. Cumulatively, direct foreign investments made between 1993 and the first half of 1995 amounted to USD 349 million in Latvia and USD 84 million in Lithuania. Loans obtained from international financial organisations and guaranteed by the Government were the major source of financing in Lithuania in 1995. Direct investments prevailed in Latvia. In 1995 both Latvia and Lithuania brought their first international bond issue to market, totalling USD 45 million for Latvia and USD 60 million for Lithuania.

Of the three Baltic countries only Estonia had survived a serious crisis in commercial banking by 1995. In 1995 large banks in Lithuania and Latvia were in trouble. In Latvia the crisis culminated in May-June when a moratorium was declared on five large banks. Difficulties in the Lithuanian banking system started to appear in the second half of 1995 and by the end of the year, a moratorium had been declared on four big private banks.

The main reason for the banking crises in Latvia and Lithuania was the stabilisation of the macroeconomic environment that reflected in the decrease in inflation, the external stability of the domestic currency and the lowering of interest rate levels. At the same time, a large amount of bank lending was invested in short-term and high risk projects. While supervision over the commercial banks started to improve at the end of 1994 and the beginning of 1995, the amount of loan loss provision and the end of quick profits resulted in a catastrophe for the banks which had taken excessive risks.

In 1995 signs of initial stabilisation appeared in the Russian economy for the first time since the disintegration of the Soviet Union. The economic decline slowed down remarkably compared to previous years: the real GDP decreased 4%, the real industrial production 3%.

The economic developments of 1995 were based on the agreement signed by the Government of the Russian Federation and the IMF in March, limiting the deficit in the public sector to 6.5% of GDP. Contrary to the earlier similar programmes that were not fulfilled in 1993 and 1994, the Russian Government was able to stick to the limits agreed with the IMF: in 1995 the deficit of the general budget (federal government, local authorities and extra-budgetary funds) formed 4.8% of GDP.

A principal change occurred in the monetary policy implemented by the Central Bank of Russia which up to 1995 was de facto subjected to the Government budget policy. In the second quarter the Central Bank ceased to refinance the credits given to individual industries. The Law on the Russian Bank adopted in May stipulated the stable ruble as the main monetary policy aim of the Bank and prohibited the Bank from directly crediting the Government. In order to increase the money supply, the Russian Bank increased the reserve requirement for commercial banks several times and raised its refinancing rate to 200% per month in the first half of 1995. As a result of these steps the money supply growth rate decreased in the second half of the year and inflation started to fall quickly. In December 1995 consumer prices increased by only 3.2%, the lowest monthly inflation after the 1992 reforms. The total CPI increase in 1995 was 131%.

Restriction of the money supply growth and the increased credibility of financial policy allowed the Government and the Central Bank to change the exchange rate regime in 1995. On 6 July the so-called exchange rate corridor was established by which the Central Bank determined the upper and lower rate of the ruble external value. The change in the exchange rate policy was a means of avoiding the rapid nominal strengthening of the ruble brought about by stabilisation and was used by the Central Bank to increase medium-term credibility of monetary policy.

The Russian foreign trade balance was constantly in a surplus in 1995. The total export and import comprised USD 77.3 billion and USD 46.4 billion, respectively. Exports into non-CIS countries increased by 25%, reflecting partly the further liberalisation of the export regime. Nearly 40% of Russia's exports comprised of oil, gas and products thereof. One of the reasons for the rather modest volume of imports (11% of GDP) was the slow pace of industrial re-structuring.

The foreign trade surplus first of all reflects the capital outflow caused by the so far unstable economic environment. The stabilisation of the ruble exchange rate in the first half of 1995 and the interest rates of government bonds which reached 200%, partly changed this movement. Over 1995 part of the funds invested abroad were repatriated to the Russian money market in the form of short-term capital. This allowed the Central Bank to increase foreign reserves to USD 17.3 billion by the end of year (from USD 6.5 billion at the beginning of year). At the same time, the share of long-term foreign capital remained modest. Direct investments of approximately USD 1 billion were made into the Russian economy over the first three quarters of 1995.