Relative sensitivities of the Hungarian economy to internal and external shocks.

• Author: Silver, J. Lew

1. Introduction

   Short term economic stability in any relatively small, trade dependent country is sensitive both to domestic policy and the vagaries of world economic activity. This is particularly true when such a country is undergoing transformation from a system of central planning with a limited number of trading partners to a market oriented economy with increasing participation in world markets. Shortly after the second world war the countries of Eastern Europe adopted the Soviet planning system and all are now attempting some degree of economic reform. Hungary took its first steps away from the Soviet model in 1957 with proposals designed to free some agricultural markets, and with more comprehensive programs since then it has been at the forefront of the reform process within Eastern Europe. One such program, and perhaps the most important in terms of setting guidelines for future reform, was the New Economic Mechanism (NEM), first introduced in 1968.(1) However, movement toward a market economy has been gradual and often slowed by limited political commitment, reversions to centralization and adverse conditions in world markets for goods and funds.

   The purpose of this paper is to measure the relative importance of domestic versus external shocks on the Hungarian economy since the beginning of its reform process. We model domestic and external economic activity as a system of autoregressions and then introduce a sequence of standardized shocks to this model. Statistics summarizing the domestic responses to these shocks, such as sums of squared responses and mean-squared forecast errors (in-sample), give us the desired relative effects. Throughout the analysis we maintain the assumption that Hungary is too small to have any impact on external economic activity. In this way we can isolate effects on domestic indicators of both external and internal shocks without being concerned with spurious feedback. An internal innovation to the model is defined as an unanticipated change in any of five domestic macroeconomic indicators: three components of GNP, inflation and real wages. External shocks to the system are innovations to such exogenous factors as world oil prices and an indicator of conditions in world financial markets. The analysis covers the period 1957 through 1989 and uses annual data. The complete specification of the model is given in the next section of the paper.

   Despite its progress toward reform, Hungary's economy was largely centrally planned throughout the 1957-89 period. It is reasonable to believe, therefore, that many static and dynamic structural relationships given by neo-classical economic theory may not be entirely relevant to the Hungarian situation during this time. An autoregressive modelling approach is thus a defensible one: it allows us to examine complicated processes without having to completely specify a multivariate system of structural relationships with possibly ad hoc restrictions. This is not to say, however, that knowledge of institutions or economic structure cannot be used in formulating the model. Knowledge of contemporaneous relationships is incorporated by imposing restrictions on correlations among system innovations |9~.

   Most previous analyses of the Hungarian economy have concentrated on a single sector or on a particular set of innovations (mostly external; e.g., terms of trade and oil price shocks) during the 1970s.(2) A notable piece by Szakolczai, Bagdy and Vindics |29~ examines Hungary's dependence on the world economy for the years 1961-1981 but makes no comparisons between the effects of external and internal influences. Here we examine economy-wide effects of external and internal shocks throughout the entire 1957-89 period.

   The paper is organized as follows. Section II discusses the model, details the data set used in the analysis and describes the estimation procedures. Some preliminary results are also given in section II. Section III discusses historical decompositions, variance decompositions and impulse response functions of the domestic time series. This is the heart of the paper: each of these empirical tools is based on predictions of the systematic components in the autoregressions and provides a measure of relative effects. Section IV concludes the study and offers some summary remarks.

2. The Model, Data and Some Preliminary Results

   Let X(t) denote a vector of exogenous influences, Y(t) a vector of domestic macroeconomic indicators and describe the link between them with:

   X(t) = A(L)X(t - 1) + ||epsilon~.sub.x~(t), (1a)

   Y(t) = B(L)Y(t - 1) + C(L)X(t - 1) + ||epsilon~.sub.y~(t); t = 1,..., T. (1b)

   A(L), B(L) and C(L) are matrix polynomials in the lag operator, L. The (random) innovation vectors, ||epsilon~.sub.x~(t) and ||epsilon~.sub.y~(t), are assumed to be jointly distributed with zero means and finite variances. Errors of individual equations within and across the X and Y groups of equations may be contemporaneously correlated. T denotes the number of observations on each element of X and Y. This system is a special case of the transfer-function-noise model often used in time series analysis |17~ and of a vector-autoregression |37; 30~.

   The Y vector we consider has the following five elements: inflation of consumer prices (INFL), the real trade balance (TBH; total exports less total imports, both measured in millions of real foreign exchange units per year), the (natural) log of a real consumer plus real government material expenditures index (CG), the log of an index of real net capital formation (KFORM) and the log of a real wage index (RWAGE). These data are available in various issues of the Hunganan Statistical Yearbook |22~.(3) The reported wage index series is an index of average nominal wage per wage earner among workers and employees. The domestic consumer price index was used to deflate this and the trade balance series. Figure 1, part A, graphs the standardized values (mean zero, unit variance) of these five series, showing their relative movements for the 1957-89 period. The variable ordering in the estimated model coincides with the above listing, although other orderings were tried as a check on the robustness of the results presented below.(4)

   The elements of the X(t) vector are, in the order in which they enter the estimated system: the prime rate of interest in the U.S., the log of the world price of oil (WOILPR; real dollars per barrel); the world-wide inflation rate (WINFL; annual percentage change in the world-wide index of consumer prices as reported by the IMF) and the real trade balance of the Soviet Union (TBSU; millions of real rubies per year).(5) Hungary has traded actively with the Soviet Union since the 1940s, relying particularly on the Soviets for raw materials for manufacturing and for oil. Typically, contracts with the Soviets have been long term and with prices tied to (but lagging) world prices. After the mid-1970s Hungary began purchasing increasing amounts of oil on world markets. The world inflation variable captures, among other things, effects of Hungary's increased trade with non-CMEA countries since the early 1960s. The U.S. prime rate (USPRM) is used to proxy conditions in world credit markets.(6) Figure 1, Part B graphs standardized observations of the X variables. WOILPR and TBSU were deflated by the IMF's world consumer price index.

   Ignoring the error terms, system (1) models dynamic relationships, relating current Hungman economic activity to its past behavior and to past conditions in the world-wide economy. More specifically, equations (1a) describe the dynamics of the adjustments in the X's to an innovation in one of its own elements. An innovation to world oil prices causes continuing adjustment in various input markets throughout the world, for example. Such adjustments will be reflected not only in future oil prices but in such quantities as world inflation and interest rates. If the system is stable, all responses eventually damp out.

   Equations (1b) trace domestic responses to external and internal shocks. An OPEC oil price shock, for example, will effect the Hungarian trade balance by (eventually) changing the terms of trade for oil. Continuing effects of this shock will be felt as both internal and external markets for energy and related goods adjust to the shock over time. Similarly, an internal shock, such TABULAR DATA OMITTED as an unanticipated change in CG, causes adjustments in domestic markets and are measured by the B(L)Y(t - 1) terms in equations (1b). However, domestic adjustments--regardless of the source of the shock--are not permitted to systematically effect external variables. It is doubtful, for example, that the domestic inflation rate has any effect on world inflation or that changes in Hungary's expenditures on imported oil have any effect on the world price. We maintain throughout the analysis, therefore, that past external adjustments influence future Y(t) values, but not vice versa, and for this reason no Hungarian indicators appear in the X(t) equations.

   The only contemporaneous relationships permitted in the model are among innovations. Viewing system (1) as one of reduced forms, errors of individual equations are (potentially) related to all structural errors. The reduced form innovations should, therefore, reflect prior knowledge of structural relationships |9~. Table I shows the estimated relationships amongst innovations given the structure we imposed.(7) This particular specification permits oil price changes and world inflation rate changes to contemporaneously influence USPRM (by 0.428 and 0.299, respectively), WOILPR to affect world inflation changes and TBSU to be related to all external variations. The units of measure are percentages of conditional standard deviations; all error relationships have been standardized so as to make own effects unity. The real oil price is regarded as the only exogenous quantity in the system in the sense...