toPS A/4 r P)OLICY RESEARCH WORKING PAPER 3145 Alternative Paths to Structural Adjustment in Uzbekistan in a Three-Gap Framework Thilak Ranaweera The World Bank Development Economics Senior Vice Presidency L Development Data Group October 2003 POLICY RESEARCH WORKING PAPER 3145 Abstract Ranaweera presents an internally consistent policy implementation strategy. He finds that an macroeconomic framework that could be used as a first aggressive adjustment policy would indeed improve most step toward a more comprehensive quantitative and performance and welfare indicators. Two major qualitative assessment of the adjustment alternatives ingredients of such an aggressive adjustment strategy are facing Uzbekistan. The three-gap framework focuses on the unification of the exchange rate and implementation the major imbalances of the economy for evaluating of current account convertibility in the balance of policy choices facing Uzbekistan. It emphasizes the payments. The author also draws attention to the relative domestic and external factors that determine economic importance of external financing and the sustainability of outcomes and welfare. The author attempts to quantify the balance of payments under alternative structural two policy scenarios-gradual as against an accelerated adjustment paths facing Uzbekistan. This paper-a product of the Development Data Group, Development Economics Senior Vice Presidency-is part of an ongoing effort in the group to improve quantitative analytical tools for country assistance strategies. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Premi Rathan Raj, room MC2-742, telephone 202-473-3705, fax 202-522-3645, email address prathanraj@worldbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at tranaweera@worldbank.org. October 2003. (29 pages) The Policy Research Working Paper Sies disseminates the fedings of ea ork in progress to encourage the exchange of ideas about development issues. An objective of theseries is to get tbefindings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and shomld be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the autbors. They do not necessarily represent the viewJ of the World Bank, its Executive Directors, or the countries they represent. Produced by the Research Support Team Alternative Paths to Structural Adjustment in Uzbekistan in a Three-gap Framework Thilak Ranaweeral DECDG 1 Thanks are due to Asad Alam, Michael Lewin, Sayyora Umarova, and Afsaneh Farzin for helpful comments. The unstinted help of Samuel Otoo and Ritu Anand was instrumental in bringing this study into print. 3 1.0. Introduction Since its independence in 1991, Uzbekistan, a successor state of the former Soviet Union (FSU) in Central Asia, has followed a unique path to economic transition. At the time of independence, the country's relatively rich resource endowment, low degree of over- industrialization and trade dependence, large share of agriculture in aggregate output, and the predominance of cotton and other raw materials in exports, pointed to a relatively better transition path (in comparison with other FSU countries) to a market-based system. Rather than embracing the "shock" therapy favored by the "Washington consensus" that has been tried in other Eastern European countries such as Poland, Uzbekistan has adopted a unique transition strategy of promoting stability and equality through a state-controlled gradual transition strategy. This goal is pursued by subsidizing employment, controlling prices on essential items, privatizing large enterprises gradually, and attempting to attain self- sufficiency in energy and food supplies. Although no clear characterization of this strategy exists, it could be broadly considered as some form of "gradualism" to economic transition.2 Following this path in recent times, Uzbekistan was able to achieve modest growth and a modicum of macroeconomic stability by 1999 with inflation down to about 45 percent per year, the budget deficit reduced to about -2.5 percent of GDP, and the current account deficit under -2 percent of GDP. In the year 2000, Uzbekistan started to address its fundamental imbalance in the foreign exchange market by devaluing its currency by 50 percent in May and by announcing a series of other measures to ease the supply and demand for foreign exchange. Having made this turnaround, the policymakers faced a choice between (i) accelerating the pace of foreign exchange liberalization with the intention of unifying the 2 For example, in comparison with China and Hungary, this strategy is perceived to be relatively less orthodox gradualism. 4 exchange market and introducing current account converdbility as soon as possible or (ii) continuing with a slower and more deliberate pace of foreign exchange liberalization, deferring convertibility to some future year. The policy makers seem to have chosen the latter path as evidenced by piecemeal changes that have been made to the existing foreign exchange system periodically. It turns out that this decision is central to the choice of macroeconomic, social, and structural policies, which would need to be implemented to complement foreign exchange liberalization. The path that Uzbekistan chooses would determine the extent to which it is able to capitalize on many of its inherent economic strengths, accelerate growth, and improve living standards of its people. This study provides an intemally consistent macroeconomic framework that focuses on the major imbalances of the economy for evaluating some of the policy choices facing Uzbekistan. It lays emphasis on both the domestic and the external factors that determine economic performance. The study also attempts to quantify the relative importance of external financing and the sustainability of the balance of payments under alternative structural adjustment paths facing Uzbekistan. The three-gap framework presented here is intended as a first step toward a more comprehensive qualitative and quantitative assessment of the adjustment altematives facing Uzbekistan. The study is organized as follows: In section 2, the major developments in Uzbelcistan are described with particular emphasis on developments since the breakdown of the USSR. Section 3 is devoted to the discussion of the three-gap model used in the study. In section 4, two main adjustment scenarios are analyzed. Section 5 draws together some conclusions of the study. 5 2.0 Major Macroeconomic Developments Since Independence The transition process in Uzbekistan has so far been rather uneven (see, EBRD (1998), Fischer, Sahay, and Vegh (1997), De Melo, Denizer, Gelb, and Tenev (1997), Spechler (2000), World Bank (1999)). Beginning in early 1992, Uzbekistan has evolved through three different transition phases, which are very different from each other in terms of macroeconomic policies followed by the government, progress made in the implementation of market-oriented reforms, and stability of the macroeconomic situation. During the first phase, covering the period 1992-93, the government seemed to have followed rather loose macroeconomic policies, the implementation of market-oriented reforms was limited in scope and slow, and the macroeconomic imbalances inherited from the FSU deteriorated markedly. During the second phase, which covered the period from early 1994 to the 3d quarter of 1996, macroeconomic performance improved considerably perhaps as a result of the tightening of financial policies and the acceleration of many market-oriented reforms. The third phase covers the period from the 4t quarter of 1996 to the present, and is characterized by occasional loosening of macroeconomic policies, a reversal of some key reforms while maintaining sustained progress in others, and the worsening of the external imbalances (see table 1 for some key macroeconomic indicators for Uzbekistan during the period 1997-2002). The macroeconomic situation continued to be difficult during the early years of 2000. Low gold prices, large debt service payments, the restrictive foreign exchange and trade regime, and the overvalued exchange rate continued to put pressure on the balance of payments. The rebound of gold prices in the year 2002 somewhat helped to ease the 6 country's balance of payments. On the other hand, the decline in cotton prices resulted in the balance of payments remaining tight. Nevertheless, preliminary estimates show that in 2002, the balance of payments current account deficit was marginally lower than in 2001. Government's consolidated budget deficit is estimated to have increased to about -2.1 percent of GDP due largely to an increase in current expenditures (see table 1). The most significant policy changes so far were in the area of exchange rates. On May 1, 2000, the official and commercial bank exchange rates against the US dollar were unified at the level of the comnmercial bank rate. As a result, the spread between the new official rate and the curb market rate was reduced by almost 20 percent. In the first half of 2002, access for individuals to the cash foreign exchange market and to the over-the-counter (OTC) market was somewhat liberalized. However, the multiple rate system continues to exist, and the long-awaited full unification of the exchange rate has not been carried out so far (see chart I on page 28). 3.0 Chairmeteirstiics nmd Structure oT the UzlbeMastnm Model3 The three-gap model is considered to be particularly useful for analyzing the policy problems faced by the Uzbekistan economy. The three-gap approach emphasizes domestic savings and investment constraints, foreign savings and capital inflows, and fiscal constraints to growth and structural adjustment (see, Bacha (1990), Taylor (1990), Sepheri, Moshiri, and Doudongee (2000), Iqbal (1995, 1997, 2000) for a variety of three-gap models) The particular version of the three-gap model applied to Uzbekistan belongs to the family of models used by many international organizations and govermnent agencies for macroeconomic work on developing countries. This framework, which is based on a 3 For a brief description of the model, see the appendix. 7 consistent flow-of-funds among multiple economic agents in an economy, facilitates the exploration of different policy options open to a country. The original "gap" models were designed to calculate the need for additional foreign savings to close the so-called savings/investment gap and/or were used to calculate the additional foreign exchange requirements for purchasing the imports that were critically needed in the growth process. 4. 0. Simulations with the model4 We use the model to examine two alternative scenarios for the economy of Uzbekistan. In the "base case" scenario, we focus on the continuation of the present policy stance with no significant gains in growth and inflation fronts. In the recent past, this "gradualist" approach to adjustment has been characterized by a "stop-go" cycle of reforms and backtracking to deal with emerging economic problems. This has been the case particularly with the exchange rate system. In the "high case" scenario, it is assumed that indeed the country would resort to a more aggressive adjustment approach of implementing appropriate policies that would encourage investment and growth in the medium term. In particular, the high case assumes the abolition of the multiple exchange rate system currently in place and the unification of the exchange rate in the second half of the year 2003 and early part of 2004, and the achievement of current account convertibility during the same period. 4.1. Base Case Scenario: Gradual Liberalization The base case is a scenario of low productivity growth, low GDP growth, increasing pressure on the balance of payments, higher levels of external debt, and moderate to high and variable inflation (see, table 2). 8 The base case scenario assumes that the policy makers will not implement immediately a broad-based adjustment policy package, but will continue with the "gradualist" strategy followed so far. Under the circumstances, it is likely that macroeconomic and structural policies would not be fully synchronized, which would limit growth and the possibilities to bring down inflation. In the base case scenario, GDP growth not exceeding 2.5 percent per annum and inflation of not less than 25 percent on average during the period 2003-2007 are the most likely outcomes. A key feature of the "gradualist" approach is the maintenance of the multiple foreign exchange system currently in force. Nevertheless, it is reasonable to expect that given the pressure from international institutions and other donors, the policy makers would build upon recent foreign exchange liberalization measures and continue along a slow and gradual path of further reforms. Because of limited pass-through effects of higher Sum border prices into higher farm gate prices for cotton and wheat, the short-run supply response associated with the "gradual" approach to further foreign exchange liberalization could be limited. Thus, export volume growth is not expected to dramatically pick up during the period in question. Gold and cotton production and exports volumes, where external factors have a dominant influence, are assumed to remain at their current levels. Taking into consideration the developments in trading partner economies and the disincentive effects of the prevailing exchange rate regime, manufacturing and related other exports are likely to remain less buoyant, especially toward the latter part of the period 2003-2007. Given the trends in cotton and gold prices, nominal export growth is projected to stabilize around 4.0 percent per annum after 2005. Several factors affect the level and composition of merchandise imports under the "gradualist" strategy. On the one hand, relatively lower GDP growth under the base case 4The scenarios and the simulation results are purely exploratory and are intended for illustrative purposes only. 9 scenario is likely to dampen import demand. On the other, the continuation of the present exchange rate system is likely to somewhat encourage imports. Under these conditions, following recent practice, the policy makers are most likely to resort to administrative measures to contain the level and type of imports. Consequently, import volume growth is assumed to be lower than GDP growth and imports are expected to rise somewhat only towards the latter part of the period. Given the anticipated changes in import prices, nominal imports are projected to increase by about 4 percent per annum after 2005. Thus, the trade balance under the base case scenario is unlikely to improve and will remain around -1.4 percent of GDP during the period. If account is taken of the interest payments on external debt arising from the need to borrow externally to cover the resource gap, the current account of the balance of payments would gradually decline to over -4.0 percent of GDP by 2007. It is also noteworthy that there is no significant reduction in debt service payments until the end of the period in question. The "gradualist" path is unlikely to attract a great deal of foreign direct investments or significantly abate the current capital flight. Apparently, in the recent past, "gradualism" does not seem to have persuaded bilateral and multilateral donors to commit more resources to Uzbekistan. Relatively lower levels of multilateral and bilateral flows are likely to induce the policy makers to continue to undertake external commercial borrowing at high cost. Even if the multilateral and bilateral flows remain more or less at current levels, there still would remain a need for further external financing, which can come from only commercial sources. Under the "base case" scenario, the need to provide fiscal relief to fixed income groups, among other things, is likely to result in higher budget deficits. The overall budget deficit is projected to reach a level of -3.5 of GDP in 2005 from a level of-2.1 percent in 2002. It is likely that this deficit will worsen in years after 2005 if the current fiscal stance is 10 continued. Monetization of this deficit is likely as foreign financing is unlikely to be forthcoming on a large scale, as mentioned before. As a result, monetary growth is expected to be high (about 30 percent on average during the period) and inflation (about 25 percent on average) would be moderate to high and variable as efforts to establish tighter discipline is likely to be undermined by the lack of adequate structural adjustment in the real sectors. 4.2. Eigm (Cse $cenErcio: AcceReraited Refoirmns The High Case scenario is one of accelerated reforms. In particular, it is assumed that the foreign exchange liberalization begun in the year 2000 would be followed at long last by the unification of the exchange rate and implementation of current account convertibility by the end of 2003 and beginning of 2004 (see, chart 1). It is also expected that fiscal and monetary policies would be tight enough in order to rapidly bring inflation under control. The fiscal stance would need to be focused on prudent public sector deficits and borrowing with a view to achieving lasting improvements in debt and debt service ratios. Furthermore, other consistent and complementary accompanying social and structural policies (including, among others, policies related to directed credits, excessive state participation in production and marketing, improving private sector development, etc) are expected to be an integral part of an aggressive policy reform package. If the a broad-based policy program is implemented, GDP growth rates of 5 percent per arnum towards the latter part of the period 2003-2007 are well within the capacity of the Uzbek economy. Improved incentives are expected to raise investments and productivity in agriculture, thus leading to higher incomes for the rural sector. Complementary reforms in the business environment-accelerated privatization, and improvements in the competitive environment-would lead to rapid growth of small enterprises and job growth. 11 In this scenario, gross domestic investment is assumed to rise gradually from a level of 19 percent of GDP in 2002 to about 23 percent by 2007. Government investment is expected to decline gradually to make room for private sector investment. While the overall investment will be financed by foreign savings in the initial years, national savings will have a relatively larger contribution in the later years of the period. Exchange market and other structural reforms are bound to unleash "repressed" inflationary pressures. Thus, the Uzbek policy makers would need to tighten fiscal and monetary policies not only to contain but also rapidly reduce inflation. The high case scenario assumes that such fiscal and monetary tightening at the outset (and prudent policy adjustments thereafter) would enable to bring down inflation gradually to a level of 15 percent by 2005 and to about 8 percent per annum by 2007. Inflation control, among other things, has also an important implication to welfare, which is reflected in this framework in consumption. Under the "gradualist" approach, some improvements in consumption are possible, but these are bound to be erratic and uneven over the years, depending on a variety of considerations, including the policy makers ability to adjust the economy to "smooth" consumption. Under the "high" case, however, a more comprehensive and broad-based coordinated policy stance is likely to result in more consistent and durable gains in consumption, especially after the year 2005. Accelerated exchange market reforms are expected to provide a big boost to export- oriented sectors and consequently the medium term balance of payments prospects are bound to improve substantially. These prospects are largely determined by cotton, gold, and other exports and interest payments on external debt. Given the cropping cycle in the cotton sector, the supply response to the increased incentives and ensuing increases in exports are likely to 12 take 1-2 years. Thus, only a moderate increase in cotton exports may be possible during the initial years of accelerated reforns. However, as a result of the improved policy environment, the share of manufacturing and other non-traditional exports in total exports should increase substantially. In sum, export volume growth is projected to increase gradually to nearly 4 percent by the year 2005. Throughout the period 2003-2007, imports are assumed to grow somewhat faster than GDP largely because of the rise in aggregate investment and the increasing need for intermediate and capital goods imports to sustain higher economic growth. The only probable exception could be the year 2004 when the full impact of the exchange rate unification (at a substantially devalued rate) is likely to constrain import volume growth. With the slower pick up in exports in the initial years of this period largely because of structural constraints, the resource balance and the current account deficit are expected to somewhat deteriorate. However, towards the end of the period, the current account balance would improve relatively to a level of about -2.5 percent of GDP by 2007. In addition, if progress is made in the area of implementing regional integration, the enhancement of the government's credibility through an accelerated adjustment program is likely to attract a great deal of investor enthusiasm. Higher levels of foreign direct investment would lead to job and productivity growth in new industries. While the higher import competition would lead to some rationalization of the industrial structure with the elimination of non-competitive industries, the net gains from growing sectors of the economy would far outweigh the losses. The full benefits of these reforms would be seen in the medium- to long- run, but noticeable gains would be visible in the short-run as well. 13 With an improvement in the policy environment, short-term capital outflows (including capital flight) are assumed to stabilize around US$150 million by 2005. Taking into account the net resource flows from long term borrowing and the need for reserve build- up (the reserve requirements are specified as approximately 2.8 months of imports of goods, services and income), the external financing gap is estimated to be relatively higher in the "high" case than in the "base" case scenario for the years 2003 and 2004 when exchange rate reforms are expected to be implemented. However, in the years after 2005, improvements in exports earnings, direct foreign investment and capital outflows are likely to significantly reduce the external financing gap in the "high case" scenario. The government budgetary outcomes in the medium-term hinge, among other things, on two crucial considerations: the path and success of the disinflation program and the path and level of the exchange rate adjustment that goes with the latter. Higher than anticipated inflation (for example, arising from a devaluation of the currency) is likely to put pressure on the budget. Even if some revenues go up, higher inflation coupled with increased demands for social protection are likely to increase government expenditures. Furthermore, monetary tightening to control inflation could also work through to higher interest rates, thus pushing up government's interest payments. In the light of these conflicting factors, the achievement of fiscal targets in the "high" case scenario are contingent on the policy makers ability to maintain a revenue level of roughly over 28 percent of GDP throughout the period and to gradually reduce expenditures from a level of nearly 30 percent of GDP in 2003 (if not maintain that level up to about the year 2005). Fiscal fine tuning on these lines should enable to reduce the budget deficit from a peak of nearly -3.0 percent of GDP in 2004 to about -2.2 percent in 2007. One important implication of this fiscal stance would be relatively higher private borrowing to offset substantial external debt repayments falling due, especially towards the latter part of the period. 14 The improvements in the budget are expected to come from both revenue and expenditure related sources. On the revenue side, higher growth and expansion of the tax base with the incorporation of the informnal sector are two contributing factors. The sustenance of the revenue effort is likely to help defraying expenditures towards transitional social costs of foreign exchange liberalization, which would partly be supported by external aid. The budgetary consolidation on these lines would reduce the need for financing to a level compatible with available non-inflationary financing. The tight fiscal stance would also greatly help monetary management aimed at bringing inflation down to around 15 percent by 2005. In the medium-term, full macroeconomic stability could be attained with low and stable rates of inflation with relatively low monetary growth. 43. MIeasurirtng IEmzermal SurtainnAbnaiy of Alkeir%nodve Seeorfiio The three-gap model can address external sustainability issues of a country as it links domestic output, export, and import growth, the path of the exchange rate, and external debt dynamics in a consistent framework. Furthernore, the model has the capability to handle detailed extemal debt transactions of different borrowing sectors of the domestic economy from different external lenders. The model can also be used for analyzing the sensitivity of different borrowing strategies available to a country. For example, it can be used to explore the balance of payments implications of borrowing on different concessional and non- concessional terms, from different types of creditors. 15 Tables 2 and 3 show the non-interest extemal current account balances for both the "base" and "high" case scenarios in US dollar terms and as a ratio to GDP. The non-interest current account balance in the "base" case is expected to be on average around -95 million US dollars, which is only slightly higher than that for the "high" case. In relative terms, there is a marginal improvement in the non-interest current account balance towards the latter part of the period (2003-2007) due mainly to the relatively higher export growth under the "high" case scenario. The net outcome in the "high" case is a noteworthy improvement in both the non-interest and overall current account balances, especially in the latter part of the period. Some standard indicators for measuring the sustainability of Uzbekistan's external debt are given in table 4 and the charts on page 29. Countries with high GDP growth relative to the real interest rate that they face on their external debt can support initial higher extemal debt relative to GDP and exports. From this perspective, the ratio of extemal debt to GDP is a critical measure for assessing the solvency and creditworthiness of a country.5 This ratio can increase for three reasons: increased resource transfers from the rest of the world to the borrowing country, interest payments on past debt at a real interest rate higher than the real growth rate of the economy, or capital losses incurred on outstanding debt as a result of depreciation of the real exchange rate. The chart 2 (page 29)shows that the extemal debt to GDP ratio is relatively higher in the "base" case than in the "high" case. The reason for this is that the extemal financing requirements in the "high" case are relatively lower than in the "base" case, at least in the later years following accelerated reforms. In the "base" case the extemal debt/GDP ratio rises from 68 percent to 78 during the period 2003-2007. In contrast, in the "high" case, this ratio nThe debt-GDP ratio measures the debt in terms of home goods. If the relative value of home goods falls (increases), as in the case after a real depreciation (appreciation), the debt-GDP ratio will rise (fall). Against that must be set offthe favorable (unfavorable) impact of the real devaluation (appreciation) on exports, an important determinant of creditworthiness. 16 rises to 74 percent at the end of the same period. Compared with ratios for other countries, these figures for both scenarios may not be "alarming". In the absence of any concrete benchmarks, we compare these ratios with an "internationally" used guideline (around 60 percent). The debt service to GDP (or exports) indicator helps to identify bunching of repayments and/or liquidity problems that a country faces in repaying its external obligations. The charts given on page 29 show that under both scenarios the debt service to exports ratio is relatively lower than an "internationally" accepted "threshold" (approximately, 25 percent). However, the ratio is relatively higher for the "base" case towards the latter part of the period 2003-2007. Apparently, an accelerated reform program with substantial external financing need not necessarily be accompanied by a significant escalation of external debt service payments. This depends crucially on the mix of such financing as well as its conditionality. The graph on the ratio of debt service to government revenue shows some adverse implications to the government budget of a rise in external debt service payments. In the case of Uzbekistan, the extent of debt service payments would be a significant element that needs to be given consideration in the design of an appropriate economic adjustment program. While these debt and debt service ratios are not alarming in comparison with other countries in the FSU, they suggest that Uzbekistan's external debt position will have to be closely monitored, even under a fairly "high" case policy setting. 17 5.0 Some Conclusions This study reports on an internally consistent macroeconomic framework that focuses on the major imbalances of the economy for evaluating some of the policy choices facing Uzbekistan. It lays emphasis on both the domestic and the external factors that determine economic performance. The study also attempts to quantify the relative importance of external financing and the sustainability of the balance of payments under alternative structural adjustment paths facing Uzbekistan. Two somewhat "polar" policy alternatives are analyzed using the model. The "base" case of "gradual" reforms is associated with low growth, low investment, high and variable inflation, lower inflows of direct foreign investment, and rather low per capita consumption growth. The basic assumption underlying the "high" case is that the country will carry out a comprehensive set of structural adjustment policies to eliminate the distortions in the economy. In particular, under this scenario, exchange market reforms are expected to be a major element of public policy. The "high" case entails a persistence of inflation especially after the exchange market reforms (but a rapid disinflation thereafter) and higher external borrowing in the initial years of the period in question. Nevertheless, the external exposure indicators under the "high" case turn out to be relatively better than those related to the "base" case, especially towards the latter part of the period. The three-gap framework presented here is rather rudimentary and is intended as a first step toward a more comprehensive qualitative and quantitative assessment of the adjustment alternatives facing Uzbekistan. Even this rudimentary framework is capable of highlighting the policy choices that are critical in the determination of the creditworthiness and external sustainability. It appears that liberalization of the foreign exchange system is a key element of a broad-based reform package to promote growth and development of the Uzbek economy. 18 llne Accounting IFrarnewoirK of the "Thiree-Gap" modlel The Uzbekistan model consists of two modules: the flow of funds module (FOF), and a external debt module (DM). The basic version contains four economic agents or "sectors": Central Governnent, the Monetary System (Central Bank and Deposit Money Banks), the "Private" Sector? (or more appropriately, the"Rest of the Economy," including households and private firms, non-central government agencies, public enterprises, and non-monetary financial institutions) and the Foreign Sector. Equations of the model The savings-investment gap: Y - (Cg + Cp) - ( Ig + Ip) = X - IM (1) The foreign exchange gap: X - IM + NFY + NCT + KTfg + DFI + POR + NLT + NST + dRES = GAPF (2) The fiscal gap: NTXpg + Td + (Ti - Sub) + NCTfg + NFfg + NFgp + Krev - Ig - NKTRgp = = Lmg + Lpg + KTfg + NLTfg + NSTfg (3) The monetary sector flows are summarized by equation (4) below: L,p + Lmg + dRES = dM + dNOL (4) The model consists of 4 equations and 33 variables.7 To obtain a numerical solution (33-4) variables should be assigned values. In order to prepare for a numerical solution, we endogenize a number of important variables by specifying several appropriate behavioral equations. Some of these are discussed below in the section on behavioral structure of the 6 In this framework, the so-called 'Private Sector' should be interpreted as a residual sector consisting households, corporate sector, and public sector institutions not included in the "government" sector defined within the framework. 7The 5a equation of the system, i.e. that for the private sector is redundant according to Walras' law. 19 model. For the remainder, we adopt a number of different methods of exogenously specifying the expected values for the variables. Some behavioral equations of the model The money demand function: M = P y t v (5) The investment/output relation: I(t) = ICOR(t+1) * [y(t+l) - y(t)] (6) Private consumption function: Cp =c *(Y-T + NCTR + NFY) (7) Import functions: IMi = f(ye, RERi) (8) Manufacturing exports function: Xm = f(yf, RERm) (9) Other exports: Xi = (1+gxi) * Xi(t-1) (10) The model can be solved using one of two approaches. First, all resource flows could be specified exogenously and the model could then be solved for the implied growth and inflation rates.8 Second, resource requirements (including the additional foreign exchange needs) could be estimated for given growth and inflation assumptions. We have adopted the latter approach for computational convenience. Either approach could be considered as a first step in an process that converges to a feasible solution to the model.9 This is also referred to as the "availabilities" approach to solution of this type of model. 9 Since no explicit objective function is used, the solution is best described as a feasible one. The importance of iteration in this process cannot be overemphasized. 20 To evaluate the external sustainability of the country, a module that incorporates external debt information supplements the flow-of-funds framework. This enables the calculation of the debt servicing capacity of a country taking into account the existing stock of external debt and changes in that stock as a result of new extemal borrowing. AppDeimdit 2. SyMnblls used. Y - Gross domestic product at market prices C - Total consumption I - Gross domestic fixed capital formation (investnent) X - Export of goods and services im - Imports of goods and services. NFY - Net factor income NCT - Net current transfers KT1f Capital transfers to government from abroad DFI - Direct foreign investment POR - Portfolio investment NLT - Net long-term borrowing NST - Net short-term borrowing dRES - Change in extemal reserves GAPF - Financing requirements for closing the balance of payments gap.'I Td - Direct taxes Ti - Indirect taxes Sub - Subsidies NCTfg - Net foreign current transfers to govemment For simplicity, government and private sector flows have been aggregated to show NFY,NCT,NLT,NST on a net basis. Note also that the flow-of-funds matrix in table 2 contain more details than shown in the equations in the text. 21 NTXpg - Non-tax revenue of government NFfg - Net foreign factor payments by government NCTgp - Net current transfers from government to private sector NFgp - Net factor payments by government to private sector NFgm - Net factor payments by government to monetary sector Cg - Government consumption Krev - Capital revenue Ig - Government investment NKTRgp- Net private capital transfers of government Lmg - Government sector borrowing from the monetary sector NLTfg - Net long-term borrowing from abroad NSTfg - Net short-term borrowing from abroad KTfg - Net foreign capital transfers Lpg - Net government borrowing from the private sector Lmp - Private sector borrowing from the monetary sector: i.e. change in the stock of domestic credit to the private sector (DCp) Lmg - Government sector borrowing from the monetary sector: i.e. change in the stock of domestic credit to the government sector (DCg) dNOL - Change in net other liabilities of the monetary system (NOL) M - Broad money (M2) dM - Change in broad money stock P - Price level y - Real GDP at market prices v - Velocity of circulation of broad money. ICOR - Incremental capital-output ratio c - Propensity to consume 22 NCTR - Net current transfers in real terms received by the rest of the economy from the other sectors Imi - Demand for ith import category;l RERi - Real exchange rate for the ith import category Xm - Exports of manufacturing goods Yf - Proxy for trading partners income level RERm - Real exchange rate for manufactures. gxi - exogenously given growth rate of export category i. Refeirence5 Alam, Asad, and Arup Baneiji, "Uzbekistan and Kazakhstan, A Tale of Two Transition Paths," The World Bank, Europe and Central Asia Region, Poverty Reduction and Economic Management Sector Unit, November 2000. Bacha, Edmar L., "A Three-Gap Model of Foreign Transfers and the GDP Growth Rate in Developing Countries," Journal of Development Economics, Vol. 32, 1990, pp.279-296 Bacha, Edmar L., "Growth with Limited Supplies of Foreign Exchange: A Reappraisal of the Two-Gap Model," in M. Syrquin, L. Taylor and L. Westhphal (eds), Economic Structure and Perfornance: Essays in honor of Hollis Chenery, Academic Press, New York, 1984 Blitzer, Charles, Peter B. Clark, and Lance Taylor, Economy-Wide Models and Development Planning, Oxford University Press, 1975 Chadha, Bankim, Paul R. Masson, and Guy Meredith, "Models of Inflation and the Costs of Disinflation," Staff Papers, Intemational Monetary Fund, Vol. 39, June 1992, pp. 395-431. De Melo, Denizer, Gelb, and Tenev, "Circumstances and Choice: The Role of Initial Conditions and Policies in Transition Economies," World Bank Policy Research Working Paper No. 1866, The World Bank, Washington DC, 1997 European Bank for Reconstruction and Development, Transition Report 1998z; Financial Sector in Transition, London, EBRD, 1998. The Economic Intelligence Unit. Uzbekistan. Country Risk Service. Various Issues, 2000 Fischer, Sahay, and Vegh, "Stabilization and Growth in Transition Economies: The Early Experience," The Journal of Economic Perspectives, vol. 10, 1996. Iqbal, Zafar, "Foreign Aid and Public Sector: A Model of Fiscal Behavior in Pakistan," The Pakistan Development Review, Vol. 36: 2 (Summer), 1997, pp.1 15-129 " The import components identified in the model are: food, consumer goods, intermediate raw materials, intermediate manufactures, capital goods and fuel and other petroleum based products. 23 Iqbal, Zafar, Constraints to the Economic Growth of Pakistan: A Three-Gap Approach," Pakistan Development Review, Vol. 34, 1995, pp.1 119-1133 Iqbal, Zafar, Jeffrey James, and Graham Pyatt, "Three-Gap Analysis of Structural Adjustment in Pakistan," Journal of Policy Modeling, 2000, 22(1), pp. 117-138 Nickell, Stephen ,"The Supply Side and Macroeconomic Modeling," in Empirical Macroeconomics for Interdependent Economies, ed. by Ralph C. Bryant and others, Brookings Institution, Washington, 1988, pp. 202-21 Khan, Mohsin, Peter J. Montiel, and Nadeem U. Haque (ed), Macroeconomic Models for Adjustment in Developing Countries, International Monetary Fund, 1991 Masson, Paul R., Steven A. Symansky, and Guy Meredith, MULTIMOD Mark II: A Revised and Extended Model, IMF Occasional Paper, No. 71, 1990, International Monetary Fund, Washington. Rosenberg, Christoph B.,and Maarten de Zeeuw, "Welfare Effects of Uzbekistan's Foreign Exchange Regime," IMF Working Paper No. 00/61, March 2000 Spechler, Martin C., "Uzbekistan: Silk Road to Nowhere?," Contemporary Economic Policy, Vol. 18, July 2000, pp. 295-303 Sepehri, A., S. Moshiri, and M. Doudongee, "The Foreign Exchange Constraints to Economic Adjustment: The Case of Iran," International Review of Applied Economics, Vol. 14, No.2, 2000pp.235.251 Taylor, L., "A Three-Gap Model," in F.D. McCarthy (ed), Problems of Developing Countries in the 1990s, World Bank, Washington DC, 1990, pp. 55-90 World Bank, "Uzbekistan Social and Structural Policy Review", Grey Cover Report No. 19626, August 1999 Zettelmeyer, Jeromin, "The Uzbek Growth Puzzle,"iIMF Staff Papers, Vol. 46, No.2, June 1999 Zettelmeyer, Jeromin, Gunther Taube, "Output Decline and Recovery in Uzbekistan - Past Performance and Future Prospects," IMF Working Paper WP/98/132, September, 1998 24 Table 1: Uzbekistan - Selected Indicators 1997 1998 1999Y 2UUU SUUil - Zuul Main macroeconomic aggregates Atnuualgrowth rates (from constantprice data) I GDP (mp) per capita 3.2 2.6 2.8 2.7 3.2 1.6 Total consumption per capita 5.5 i}6 i13.1 18,. u 5.3 GDP at market prices 5.2 4.3 4.3 3.8 4.5 3.0 Total consumption 7.5 tS.5 15.3 19.2 16.8 3.8 Gross domestic investmet (DD) .. 15.0 2.0 1.0 3.7 3.0 Exports (GNFS) 3.2 -15.4 -8.1 9.2 -5.4 -u.] of w4ich Goods 3.1 -17.4 -10.9 1.6 -6.9 u-l-pO s (GNFSJ -7.2 -22.8 -8.0 -5.8 6.4 0.5 of wich Goods -10.5 -26.3 -12.4 -3.4 3.7 Savings-investment haanLe-, -- --ertn-u-c .If C--P Gross Domestic investmnent 22.8 16.9 17.8 14.0 19.3 19.4 of which Government investment 7.4 6.7 6.6 5.9 5.0 4.8 Foreign savings 5.5 1.0 1.5 -2.7 1.5 0.8 Gross national savings 17.3 15.9 16.3 16.8 17.8 18 6 Goverranem savings 5.2 4.5 4.7 5.7 5.1 5 5.5 | Nongovernmentnsavings 12.2 11.4 11.6 11.1 12.6 13.1 Gross domestic savings 18.7 16.5 17.3 19.4 19.9 19.8 Otf,er GDOP inflation 66.1 39.0 4-4.1 47.3 43.1 39.1 Annual average exchange rate (LCU/US$) 91.2 132.2 245.6 416.7 652.0 800.0 Terms oftrade index (YR97 -100) 113.2 111.7 110.6 116.5 116.2 116.6 Money growth 45.6 28.1 32.1 37.1 54.3 44.6 Government finance imdicators Percentage of GP Total revenues, ofwhich 30.8 31.3 29.4 28.3 26.5 27.1 Tax rrvenues 27.7 29.4 27.9 26.4 24.0 25.6 Total expenditures, of which 32.5 34.5 32.0 30.4 27.8 29.21 Consutnption 20.5 20.5 20.6 18.7 18.4 18.4 Deficit(-y/Surplus(+) -i.1 -2 42.6 -2. I -I.4 -.1 Total Goverment Debt I 8.5 22.0 24.8 37.2 53.9 60.2 External debt & liquidity indicators Total DOD and TDS DOD (US$ millions) 2781.4 3213.2 4773.6 4372.8 4626.3 470S. DOD/GDPmpratio 26.0 30.0 55.1 56.0 62.0 53.9 tD u3S milliore) 511.9 348.8 553.6 853.6 833.5 914. TDS/exports(XGS)ratio 12.8 10.2 17.5 25.2 25.9 27.7 Total gross reserves (months' imDorts G&S) 3.0 3.9 4.5 4.8 4.3 4.0 External financing (USS, miiGons) Official capital grants 0.0 -50.0 -14.0 -50.0 -8.0 -65.0 Priate invecsnent (nel) 167.0 140.0 121.0 75.0 83.0 85.0 Net Long term borrowingexcl IMF 166.7 617.8 1112.3 161.3 237.4 69.0 Adjustments to scheduled debt service 0.0 7.0 1 5.0 -2.0 0.0 0.0 { All other capital flows -230.2 -610.8 -1009.3 -300.8 -161.4 -146.6 Notes: I .The indicators given here were assembled from a varety of sources, both official and nonofficial. This may have caused consistency problerms of figures over the period convered. 2. Figures for 2002 are based on early estimates that are available in April, 2003. 25 Table 2: Uzbekistan - Macroecononiic Scenarios Scenario Indicators. - Etimate r Base Case - ,,,,_,,; .i.,;,i,,-, !.t ', '> " ' " '. /'- 1-'';-% io2002 21_031 20041 20051' :200617 2007 GDP Growth(%) 3.0 2.2 2.3 2.4 2.5 2.5 Consumption (per capita) Growth (%) 0.0 0.1 0.7 0.8 0.9 0.9 Gross Domestic Investment (% ofGDP) 19.4 19.2 19.2 19.2 19.2 19.2 Inflation (annual GDP deflator change:%) 39.1 30.0 28.0 25.0 25.0 25.0 Broad Money Growth(%) 44.6 48.1 30.9 28.0 28.1 28.1 FISCAL OPERATIONS Overall Fiscal Balance (% of GDP) -2.1 -2.6 -2.8 -3.5 -4.4 -4.9 Primary Fiscal Balance (% of GDP) -1.6 -2.0 -2.1 -2.8 -3.4 -3.3 Total govt. expenditures (% of GDP) 29.2 29.8 30.3 31.5 32.5 33.0 Current govt. expenditures (% of GDP) 21.5 22.8 23.4 24.5 25.6 26.0 Govt. interest payments (% of GDP) 0.5 0.6 0.7 0.7 1.1 1.5 Govt. total revenues (% of GDP) 27.1 27.2 27.5 28.0 28.1 28.1 Total debt service (BOP)/Gov. Revenue (%) 38.7 42.5 34.7 30.6 33.1 30.2 EXTERNAL SECTOR Current Ac Balance (Mln US$) -71.0 -202.8 -302.3 -382.9 431.2 -492.1 Current Ac Balance (% GDP) -0.8 -2.4 -3.2 -3.6 -3.9 -4.3 Non-interest Current Ac Bal (% GDP) 1.0 -0.4 -1.0 -1.2 -1.0 -1.7 Trade Balance (Mln US$) -103.7 -105.1 -102.1 -131.1 -139.1 -147.4 Trade Balance (% GDP) -1.2 -1.4 -1.2 -1.4 -1.4 -1.4 Gapfill financing requirements (Mln US$) 0.0 178.0 287.9 342.0 354.5 411.6 Debt Service/Exports GNFS+IR+WR (%) a) 27.7 25.8 23.1 22.5 24.5 22.4 Debt Service/GDP (%) 10.5 11.5 9.5 8.6 9.3 8.5 Interest payments/Exports GNFS+IR+WR (%) 4.9 5.0 6.0 7.3 8.5 7.9 Interest payments/GDP (%) 1.9 2.2 2.5 2.8 3.2 3.0 Total DOD/GDP(%) 53.9 68.0 69.2 71.6 78.6 86.1 Export Volume Growth (%, annual) - GNFS 0.0 2.0 2.1 2.1 2.3 2.3 Imnport Volume Growth (%, annual) -GNFS 0.0 0.2 2.2 2.3 2.5 2.5 Nominal Export Growth (%, annual) --GNFS 0.0 4.9 3.9 3.3 4.0 4.0 Nominal Import Growth (%, annual) --GNFS 0.0 4.8 3.6 4.1 4.1 4.0 Some key Assumptions Direct foreign investment (Min US$) 85 80 80 82 85 85 Capital outflow (Min US$) -155 -192 -154 -200 -200 -200 Foreign res. (months of imp.of GNFS & income) 2.8 2.8 2.8 2.8 2.8 2.8 Cotton price (cts/lb) b) 46.2 58.0 62.0 65.0 66.0 67.0 Goldprice($/troyoz)_b) 310.0 320.0 300.0 280.0 283.9 287.8 Notes: a) Exports GNFS+IR+WR include goods, services, income receipts and workers rernittances b) Source of information on cotton and gold price projections: The World Bank 26 Table 3: Uzbekistan - Macroeconomic Scenarios Scenario Indicators Estimate High Case 2002 20031 20041 20051 2006 2007 GDP Growth(%) 3.0 2.5 3.5 4.5 5.0 5.0 Consurmption (per capita) Growth (%) 0.0 -0.3 0.3 0.2 3.2 3.0 Gross Domestic Investment (% of GDP) 19.4 20.0 21.0 23.0 23.0 23.0 Inflation (annual GDP deflator change:%) 39.1 30.0 30.0 15.0 10.0 8.0 Broad Money Growth(%) 44.6 48.5 34.5 20.2 15.5 13.4 FISCAL OPERATIONS Overall Fiscal Balance (% of GDP) -2.1 -2.6 -2.9 -2.7 -2.5 -2.2 Primnary Fiscal Balance (% of GDP) -1.6 -2.1 -2.2 -1.8 -1.6 -1.4 Total govt. expenditures (% of GDP) 29.2 29.8 30.4 30.7 30.6 30.3 Current govt. expenditures (% of GDP) 21.5 22.8 23.5 23.7 23.4 23.1 Govt. interest payments (% of GDP) 0.5 0.6 0.7 0.9 0.8 0.8 Govt. total revenues (% ofGDP) 27.1 27.2 27.5 28.0 28.1 28.1 Total debt service (BOP)/Gov. Revenue (%) 38.7 42.3 33.6 29.2 30.1 ,25.4 EXTERNAL SECTOR Current Ac Balance (Min US$) -71.0 -228.1 -298.3 -324.1 -313.2 -315.7 Current Ac Balance (% GDP) -0.8 -2.8 -3.1 -3.1 -2.7 -2.5 Non-interest Current Ac Bal (% GDP) 1.0 -0.7 -1.0 -1.1 -0.8 -1.2 Trade Balance (Min US$) -103.7 -129.3 -89.8 -127.9 -108.7 -75.0 Trade Balance (% GDP) -1.2 -1.7 -1.0 -1.3 -1.1 -0.7 Gapfill financing requirements (MIn US$) 0.0 209.1 277.8 215.7 160.5 154.0 Debt Service/Exports GNFS+IR+WR (%) a) 27.7 25.8 23.0 20.7 21.6 18.3 Debt Service/GDP (%) 10.5 11.5 9.2 8.2 8.5 7.2 Interest paymnents/Exports GNFS+IR+WR (%) 4.9 5.0 5.9 5.8 5.8 4.4 Interest payments/GDP (%) 1.9 2.2 2.4 2.3 2.3 1.7 Total DOD/GDP(%) 53.9 68.6 67.7 70.7 72A4 73.6 Export Volume Growth (%, annual) - GNFS 0.0 2.0 2.2 3.9 4.2 4.5 Irnport Volumne Growth (%, annual) --GNFS 0.0 1.0 1.5 4.0 4.0 4.0 Nominal Export Growth (%, annual) --GNFS 0.0 4.9 4.0 5.5 6.3 6.6 Norninal Imnport Growth (%, annual) --GNFS 0.0 5.7 2.5 6.5 5.5 5.5 Some key Assumptions Direct foreign investment (Mn US$) 85 80 80 102 115 125 Capital outflow (Mln US$) -155 -192 -154 -150 -150 -150 Foreign res. (months of imp.of GNFS & income) 2.8 2.8 2.8 2.8 2.8 2.8 Cotton price (cts/lb)_b) 46.2 58.0 62.0 65.0 66.0 67.0 Gold price ($/troy oz) b) 310.0 320.0 300.0 280.0 283.9 287.8 Notes: a) Exports GNFS+IR+WR include goods, services, income receipts and workers remittances b) Source of informnation on cotton and gold price projections: The World Bank 27 Table 4: Uzbekistan - Debt Exposure Indicators (%), 2003-2006 ln-dkitors 2003- - 2004 - 2005%s-; ;>0g6 TDS/XGNFS Base Case 25.8 23.1 22.5 24.5 Empirical crisis threshold 25.0 25.0 25.0 25.0 High Case 25.8 23.0 20.7 21.6 TDS/REV Base Case 42.5 34.7 30.6 33.1 Empirical crisis threshold 30.0 30.0 30.0 30.0 High Case 42.3 33.6 29.2 30.1 DOD/GDP Base Case 68.0 69.2 71.6 78.6 Maastficht criterion 60.0 60.0 60.0 60.0 High Case 68.6 67.7 70.7 72.4 Notes: TDS - total debt service payments XGNFS - exports of goods, services, income and workers rernittances DOD - debt outstanding and disbursed 28 C1kn i: UJkAstgD - ~13Zcmie L2nX tJgo 2000.0 1800.0 1600.0 - 140.0 - 1200.0 - 1000.0 800.0 6000 - 400.0 200 0.0 1998 1999 2000 2001 2002 2003 2004 2005 200 207 YensT -o- OFFI -o-CURB -a-COMM - EBBY ---EBSL -o- AALL OFFI - Official exchange rate CURB - Curb market exchange rate COMM - Commercial exchange rate EBBY - Exchange Bureau buying rate EBSL - Exchange Bureau selling rate AALL - Aggregate Average exchange rate 29 Chart 2: Uzbekistan - Debt Exposure Indicators, 2003-2006 (Base & High Case Scenarios) TDS/XGNFS Enrpincal crisis threshcld -.- High Case a 0 TDS/REV iBase Case - E ffriric h crisis threshold 63i + High Case | 20- 2003200420520 | ~~~~~~DOD/GDP so- 40 -. Biase Case -Maastricht criterion +High Case 20 - 2003 2004 2005 2006 Policy Research Working Paper Series Contact Title Author Date for paper WPS3116 Dollarization of the Banking System: Gianni De Nicol6 August 2003 A. Yaptenco Good or Bad? Patrick Honohan 38526 Alain Ize WPS3117 Policy Research on Migration and David Ellerman August 2003 B. Mekuria Development 82756 WPS3118 To Share or Not to Share: Does Local Beata Smarzynska August 2003 P. Flewitt Participation Matter for Spillovers from Javorcik 32724 Foreign Direct Investment? Mariana Spatareanu WPS3119 Evaluating the Impact of Conditional Laura B. Rawlings August 2003 M. Colchao Cash Transfer Programs: Lessons Gloria M. Rubio 38048 from Latin America WNPS3120 Land Rights and Economic Quy-Toan Do August 2003 P. Sader Development: Evidence from Vietnam Lakshmi Iyer 33902 WPS3121 Do Bilateral Investment Treaties Mary Hallward-Driemeier August 2003 A. 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