Financial Repression in Transition Output Reduction and Hyperinflation in the Formerly Soviet Economies UNC-MGIMO Seminar, 27 April 2001

Thesis Financial Repression contributed to the output reduction and hyperinflation observed in the former Soviet economies in the 1990s. Sustainable recovery from this depression requires governments in these economies to follow policies that eliminate financial repression.

Definition: Financial Repression In financial repression, artificially low quantities of saving are channeled into the formal banking system. This is the outcome of policies that artificially limit the interest rate offered to depositors in that system or threaten the security of deposits there.

Definition: Sustainable Recovery A sustainable recovery is characterized by non-inflationary economic growth not reliant upon foreign saving for its continuation. Foreign saving is the purchase of domestic debt and equity by foreign nationals: it is the counterpart of a current-account deficit.

Testing the thesis First: demonstrate the logical consistency of the argument in a theoretical model. Second: test the predictions of the model econometrically for Ukraine.

Theoretical building blocks Output depends upon the cost and availability of credit. The saving (non-consumption) choice depends upon the real interest rate on saving instruments and the real value of accumulated wealth. Financial repression reduces desired saving and credit availability: output falls as firms are rationed, hyperinflation follows as saving is induced.

Equilibrium without Financial Repression

Inflationary Consequences of Financial Repression With excess demand for saving, the real interest rate will rise. The government has another tool to raise saving. It can induce saving by lowering the value of accumulated wealth. Inflation does this.

Financial Equilibrium for Earmarked Instruments

Inflation/Output Dynamics

Financial Fragmentation: the Foreign Exchange Market

Ukraine: fall in GDP

Ukraine: Hyperinflation

Real interest rates in Ukraine

Output depends on credit availability GDP Function Regression Results (Quarterly data, 1993/1 to 1998/3) Dependent variable: ln(y t ) Intercept (0.88)(0.72) ln(W t-1 /P t-1 ) (0.10)(0.14) ln(Ry t ) (0.12)(0.14) ln(CR t ) * 0.24 (0.10) ln(CR t-1 /PB t-1 )0.11 (0.03) R F(.) N1919 * – Treated as simultaneously determined variable. Instruments include lagged endogenous variables, budget deficit, and exogenous regressors in these equations.

Inflation to induce saving Dependent variable: B t Intercept (50.17)(49.93) ( t (3.27)(3.21) a t (1.04)(1.13) µ t (0.36) R F(x,23-x) N2323 For the F statistic, x=2 for the first equation and x=3 in the second equation. Standard errors in parentheses.

Saving Allocation Responded to Real- interest-rate movements Household portfolio decisions show significant support for theory. (Table 4) Enterprise portfolio decisions follow quite different incentives. The role of foreign-currency denominated instruments is also in line with theory. (Table 5)

Sustainable Growth?

Conclusions to paper Financial repression is demonstrated as a logically consistent cause of both output reduction and hyperinflation. Evidence from Ukraine supports this thesis.

Financial Repression and the Financial Crisis of 1998 Was the non-inflationary growth in Russia and Ukraine prior to August 1998 sustainable?

Real Interest Rates in Russia

Sustainable Growth in Russia?

Russian Borrowing at the IMF