Download Official PDF , 45 pages

Public Disclosure Authorized
THEWORLD
BANK
ERS6
DiscussionPaper
Public Disclosure Authorized
Public Disclosure Authorized
Public Disclosure Authorized
DEVELOPMENT POLICY ISSUES SERIES
Report No. VPERS6
Macroeconomic
Adjustment in
DevelopingCountries:
A PolicyPerspective
Mohsin S. Khan
August 1986
Office of the Vice President
Economics and Research
The views presented here are those of the author,and they should not be interpretedas reflectingthose of the World Bank.
MACROECONOMIC
ADJUSTMENTIN DEVELOPINGCOUNTRIES:
A POLICY PERSPECTIVE
by
Mohsin S. Khan
August
1986
The author is Chief, MacroeconomicsDivision, DevelopmentResearch Department,
World Bank, on leave from the InternationalMonetary Fund.
The author is grateful to Willem Buiter, Mansoor Dailami, Indermit Gill,
Nadeem U. Haque, Malcolm Knight, Anne Krueger, Ricardo Martin, Costas
Michalopoulos,and Peter Montiel for helpful comments and suggestions.
for the viewsexpressedherein
The WorldBank does not acceptresponsibility
whichare thoseof the author(s)and shouldnot be attributedto the World
Bank or to its affiliatedorganizations.The findings,interpretations,
and
conclusions
are the resultsof researchsupportedby the Bank; theydo not
necessarily
representofficialpolicyof the Bank. The designations
employed,
the presentation
of material,and any maps used in this documentare solely
for the convenience
of the readerand do not implythe expressionof any
opinionwhatsoeveron the part of the WorldBank or its affiliatesconcerning
the legalstatusof any country,territory,
city,area, or of its authorities,
or concerningthe delimitations
of its boundariesor nationalaffiliation.
Abstract
Broadly speaking, a comprehensivemacroeconomicadjustmentprogram is
expected to have the following objectives: a sustainablecurrent account
position, a stable and high rate of economic growth that would allow for a
steady rise in per capita consumption,a reduced rate of inflation,and a
manageable level of foreign debt. Given these multiple objectives,the
package that is designed would typically include a variety of policy measures
that simultaneouslyrestrain aggregate demand and increase the availabilityof
resources. These policies may be grouped as follows: demand-management
policies; structuralpolicies; exchange rate policies;and external financing
policies. The purpose of this paper is to describe how these policies can be
expected to achieve the goal of macroeconomicadjustment. The focus is
primarily on the theoreticaland empirical links between policy instruments
and the ultimate objectives. An examinationof these links is necessary
before issues of the appropriatemix of demand-management,structural,
exchange rate, and external policies, and the sequencingof these policies in
a program, can be properly addressed.
Table of Contents
Page No.
I.
II.
III.
Introduction ............................
I
Demand-Management Policies ......
5
............................
A.
Monetary Policy ........................................
6
B.
Fiscal Policy
9
Structural Policies
A.
........................................
Policies to Improve Efficiency and
Resource Allocation
B.
11
........................................
.........
...
*.... ...
*... ...
...
.
Policies to Increase the Rate of
Growthof Capacity Output .........................
IV.
Exchange Rate Policies
A.
B.
V.
VI.
12
15
20
......................................
Determiningthe Extent of Exchange
Rate Adjustment ...................
Policies to Achieve a Target Real
Exchange Rate .......................
C.
Effects of Exchange Rate Changes ....
D.
ExchangeRate Systems and Regimes ....
22
...............
.......
...................
..................
.....
.
23
25
26
External Financing Policies .................................
28
Conclusions ................
34
Macroeconomic
Adjustmentin DevelopingCountries:
A PolicyPerspective
MohsinS. Khan
I. Introduction
In recentyears developingcountrieshave foundthemselvesin serious
includingworseningbalanceof paymentspositions,
economicdifficulties,
risingratesof inflation,and decliningratesof growth. The predicament
of
thesecountrieshas led to a heightenedinterestin the subjectof
on how to eliminatethe
and particularly
adjustment,
macroeconomic
in the economiesthat gave rise to theseproblemswithout
disequilibrium
growthin the process. The basicquestionthat is currentlybeing
sacrificing
in the developingworld,and the
askedby academics,policymakers
international
economiccommunityat large,is what policiescan be employed,
and in what combination,
to achievethe goal of macroeconomic
adjustment.
The need for macroeconomic
adjustmentariseswhen a countryhas a
fundamental
imbalancebetweenaggregatedomesticdemandand aggregate
supply. This demand-supply
imbalancecan be a resultboth of external
factors,suchas a deterioration
in the termsof tradeand an increasein
domesticpoliciesthat expand
foreigninterestrates,as well as inappropriate
aggregatedemandtoo rapidlyand reducethe rate of growthof productive
capacityof the economy. In principle,a countrycan avoidadjustmentby
borrowingabroador imposingcontrolson tradeand payments,or a combination
in the economycan persistfor an extended
of the two,and the disequilibrium
period. Thereare, however,costsassociatedwith this type of strategythat
are well known. These includea wideningcurrentaccountdeficit,increasing
-2-
inflation,overvaluationof the domestic currency and loss of international
competitiveness,an inefficientallocationof resources because of distortions
in relative prices, reduced economic growth, and a heavier foreign debt
burden.
This type of disequilibriumcannot continue indefinitely,and in the
absence of appropriatepolicy actions to correct the underlying imbalances,
living standards in the country would be adversely affected. Moreover, the
steady loss of internationalcompetitivenessand an increasinglevel of
foreign debt would affect the country's creditworthinessand thus its ability
to obtain additionalforeign financing. Naturally, a cessation of foreign
financing would impose adjustmenton the country, and as recent experience in
a number of countries has shown, this forced adjustment is likely to be very
disruptive. The fundamentalobjective of an adjustment program is to provide
for an orderly eliminationof the imbalancebetween aggregate domestic demand
and resource availabilitybefore the point at which the economy becomes
seriouslydistorted and external resources are exhausted. To achieve this
objective the adjustmentprogram necessarilyhas to include a variety of
policies that simultaneouslyreduce aggregate demand and increase the
availabilityof total resources. Following Khan and Knight (1982), (1985),
these policies can be broadly grouped according to whether their primary
impact is on the level of absorption-level of current and potential output --
demand-managementpolicies -- on the
structuralpolicies--
on the
compositionof absorptionand productionas between tradableand nontradable
goods -
exchangerate policies -- and finally, on the level of capital flows
-- external financing policies.
-3-
Demand-managementpolicies typically include monetary and fiscal
measures designed to affect the aggregate level or rate of growth of demand
relative to production. On the other hand, structuralpolicies are intended
to increase the supply of goods and services in the economy at any given level
of domestic demand. Included in structuralpolicies would be, among others,
measures to increase the level and efficiencyof investment,reductionsin
tariffs and eliminationof other trade distortions,removal of subsidies,
raising the efficiencyand profitabilityof public sector enterprises,
measures to raise public and private savings,and increases in producer
prices. Policies to improve internationalcompetitivenessand expand the
supply of tradablegoods through both reduced consumptionand increased
production principallyinvolve changes in the real exchange rate. Exchange
rate policies, therefore,have both demand-sideand structural
characteristics,and thus are treated separately. Changes in the net flow of
foreign financing, includingthe financingdirectly provided by international
institutions,also affect absorption,and if they assist domestic capital
formation,raise potential output as well. External financing polic:ies
generally include measures to ensure that the supply of funds, both from
official as well as private external sources,are at a sustainablelevel,
changing the maturity and compositionof foreign debt, and reducing capital
flight from developingcountries.
Generally speaking,comprehensiveand long-term macroeconomic
adjustmentwould involve elements of all four of the policies listed above.
Programs aimed at adjustmentwith growth cannot rely exclusivelyon demandmanagement policies, nor for that matter solely on structuralpolicies. In
fact, these policies are closely interrelated. For example, the achievement
-4-
of a higher growth rate in the medium term generally requires an increase in
productiveinvestment,while stabilizationrequires a reduction in the
savings-investment
gap. The policy package, therefore,must be designed to
reduce the level of aggregatedomestic demand and simultaneouslyto cause a
shift in the compositionof demand away from current consumptionand toward
fixed capital formation. Exchange rate policieswill assist in the adjustment
process by dampening demand and creating incentivesfor investmentin the
tradables sector. External financing policieswould set limits to the current
and future availabilityof foreign resources,and this in turn would define
both the degree and speed of the necessary adjustment.
The crucial question that arises in the design of adjustmentprograms
is how should these policies be combined in the overall package? The relative
emphasis placed on various policieswill depend primarily on two sets of
criteria. First, the objectivesof the authoritiesand the constraints
(institutional,timing, and structural)that they face. The choice in this
case would inherentlybe country-specificand there is limited scope for
generalizations. Second, the nature, magnitude, and timing of the effect of
various policies on the key macroeconomicvariables,which would determine not
only the mix of policies but also the sequence in which these policies are
enacted. This is a more general issue that would have relevance for
developing countriesat large.
The purpose of this paper is to describe how demand-management,
structural,exchangerate, and external financing policies can be expected to
affect the targets to which they are directed and thereby achieve the goal of
macroeconomicadjustment,characterizedby a sustainablecurrent account
position,a low rate of inflation,a stable and high rate of economic growth,
-5-
and a manageable level of external debt. While an attempt is made to cover
the main links between policy instrumentsand the ultimate objectives, the
survey does not deal with all of the possible effects of macroeconomicpolicy
measures. For example,no attempt is made to discuss the distributional
effects of adjustmentpolicies, even though it is recognizedthat the pattern
of income distributionis often a key objective for policymakers. Such
exclusions were considerednecessary in order to limit the scope of the
paper. Nevertheless,the paper will highlight a number of the important
theoretical and empirical questions that need to be addressed in the course of
designing macroeconomicadjustmentprograms.
The remainder of the paper proceeds as follows: Section II discusses
the role of demand-managementpolicies. Structuralpolicies to increase the
efficiencywith which resources are utilized, and the overall supply of
resources, are described in Section III. Section IV takes up questions of how
to determine the size of the exchange rate change and the effects of a
devaluation on the economy. This section also discusses briefly questions
relating to the exchange rate systems and rules a country might adopt.
Section V on externalfinancing policies describes the methods for judging the
sustainabilityof foreign borrowing and the issue of capital flight from
developing countries. The concludingsection brings together the main points
of the paper and discusses the issues that arise in combining the various
policy measures into a comprehensiveadjustmentpackage.
II. Demand-ManagementPolicies
Macroeconomicadjustment is often viewed as synonymouswith policies
to restrain aggregatedemand and absorption,and has accordingly received
-6-
considerableattention in the literature. 1/ The two main instrumentsfor
controllingabsorptionare monetary policy and fiscal policy. 2/
A. Monetary Policy
The standardview of the transmissionmechanism between monetary
policy and aggregate demand emphasizes the role of interest rates. In the
closed-economycase an increase in the supply of money causes individualsto
purchase real and financial assets in an attempt to restore portfolio
balance. This lowers market interestrates and stimulatesaggregate demand.
A basic descriptionof the way monetary policy works in a small open economy,
on the other hand, is that which appears in versions of the monetary approach
to the balance of payments. 3/ In such simple models, under fixed exchange
rates, the public disposes of surplus cash balances produced by an expansion
of domestic credit through purchasingforeign goods and securities,leaving
domestic output and prices unaffected. Under flexible exchange rates, a
similar expansion in domestic credit results in an increase in the money
supply, a rise in the domestic price level, and a depreciationof the exchange
rate.
Most developing countries,however, possess neither the range of
financialassets nor the degree of integrationwith internationalgoods and
1/ IMF adjustmentprograms, for example,are described by some observers as
being primarily demand-oriented. See Dell (1982) and Diaz-Alejandro
(1984). While demand-sidepolicieswere stressed in earlier Fund work on
financial programs,namely by Polak (1957) and Robichek (1967), (1971),
this is not necessarily a valid descriptionof present-dayprograms.
2/ The demand-sideeffects of exchange rate policies are treated separately
in Section IV.
3/ See Frenkel and Johnson (1976) and IMF (1977).
-7-
financial markets that would make these descriptionsof the effects of
monetary policy directly relevant. How then does monetary policy work, and
what are its effects on aggregate demand in situationswhere financialmarkets
are underdeveloped,interestrates are set below market-clearingrates by the
government, a relativelyfree curb market operates, 4/ and there are foreign
exchange controls? Since such featureswould tend to be present in many
developingcountries,these questions would appear to be the more appropriate
ones to consider for such countries.
If exchange controls are effective then the authoritiescan control
the monetary base via their control over the availabilityof foreign exchange
and over credit extended by the central bank. Starting from portfolio
equilibrium,a fall in the supply of bank credit to the private sector will
cause borrowers to shift towards the curb market, thus leading to an increase
in the curb market interestrate. Since this rate would represent the
marginal cost of funds in the economy, the interest-sensitive
componentsof
aggregate demand will decline. In particular,the implicitvalue of real
assets will fall relative to their productioncosts and demand for such assets
would be reduced. 5/ With the decline in aggregate demand there would be
downward pressure on inflation. Similarly,a decrease in the money supply
leaves the private sector with too little money in its portfolio relative to
loans and real assets. The resulting decrease in the supply of curb market
loans leads to a rise in the curb market interestrate. Aggregate demand is
4/ The assumptionof the curb market allows one to analyze interestrate
effects on aggregatedemand. In the absence of such a market, monetary
policy would only have wealth effects.
5/ This is basically the well-knownTobin's Q mechanism.
-8-
again reduced as a result of the reduced demand for real assets. If, on the
other hand, exchange controlsare ineffective,then the power of monetary
policy to affect aggregate demand would be diminished. Some of the effects of
a reduction in the money supply would be offset by changes in foreign exchange
claims or liabilities. Therefore, the effects on the curb market interest
rate and on the demand for real assets are weakened. In the limit, the
propositionsassociatedwith the monetary approach to the balance of payments
would become operative.
While it is possible to argue that even in a world of credit and
foreign exchange rationing changes in the growth of money would be neutral in
the long run, it is clear that during the adjustment process a restrictive
monetary policy would be associatedwith a reduction in capacity utilization
and a rise in unemployment,since prices would normally tend to be sticky
downwards.6/ The estimated size and duration of the deflationaryeffect
would naturally depend on the responses of aggregate demand and aggregate
supply to a tighter monetary policy. More specificallyin this context, as
argued by Khan and Knight (1982), the relevant factors would include: (i) the
speed with which the initial monetary disequilibriumis offset by
internationalreserve movements (an effect that depends on the presence and
effectivenessof exchange controls); (ii) the stickinessof domestic prices,
which in turn will be conditionalon wage-settingbehavior and the degree of
excess capacity in the economy; (iii) the effect on investmentof a rise in
6/ The consequencesof macroeconomicpolicies on the labor market in
developingcountries is certainly not well establishedat the theoretical
level, and consequentlythere is also very little empirical evidence
available on this relationship.
-9-
the cost, or a reduction in the availability,of credit; and (iv) the extent
to which the policy measures were anticipated at the time that currently
prevailingwage contracts were negotiated. 7/ To determine the aggregate
demand effects of monetary policy requires investigatingboth theoreticaland
empirical validity of these factors.
B. Fiscal Policy
The effects of fiscal policy, whether through reductionsin
governmentexpendituresor increases in taxes, on aggregate demand and
absorptionare much debated. Public sector spending on currently-produced
goods and services is itself a component of total domestic spendingand this,
of course, representsits direct contributionto absorption. If government
purchases are limited to nontradablegoods, they also representan addition to
aggregate demand for domestic goods. Public sector spending on traded goods
will, however, only contributeto a worsening of the trade balance while
having no effect on real aggregate demand, or on output and inflation.
It is the indirect effects of public sector purchases that have
generated some controversy. At issue is the extent to which an increase in
public expenditurereduces or increases private spending, thus resulting in an
increase in total spending. There are a variety of mechanisms through which
private spendingwould fall as a result of increased public spending. For
example, increased public spending could raise domestic economic activity and
thereby the private sector's demand for money. If interest rates adjust to
7/ It has been argued by Lucas (1972), among others, that the greater the
extent to which changes in monetary policy are anticipatedby the private
sector, the smaller would be the effect on output. For a discussionof
the applicabilityof rational expectationsmodels to developing countries,
see Corden (1985).
-
10
-
maintain portfolio equilibrium,the higher interest rates associatedwith the
increased demand for money would, other things equal, tend to reduce the
aggregate demand. This is, of course, the familiar "financial crowding-out"
proposition. Even if interest rates do not adjust immediately,and portfolio
imbalancespersist, the excess demand for money may cause households to
curtail spending in order to accumulatecash balances. 8/
Private spending can also be reduced if the increased public spending
gives rise to an equal tax liability for the private sector, either in the
present through tax financing or in the future due to the need to retire
public debt. This is the well-known "Ricardianequivalence"proposition
developed by Barro (1974). 9/ Finally, if nominal wages are flexible, or if
the increase in public spendingwas foreseen at the time wage contracts were
entered into, the domestic price level could rise sufficientlyto reduce
private spending by an amount equal to the increase in public spending,
thereby leaving total real aggregate demand unchanged. 10/ The validity of
rational-expectations
models relating public sector and private sector
expenditureshas yet to be tested for developingcountries,and the debate has
remained essentially on a theoreticalplane. 11/
8/ See Khan and Knight (1981) for a model utilizing this type of effect.
9/ For a discussionof this effect in the context of developingcountries,
see Corden (1985).
10/ This "policy neutrality"result has come to be known as the Lucas-SargentWallace (LSW) proposition;see Lucas (1972) and Sargent and Wallace
(1975).
11/ Even the empirical evidence for developed industrialcountries does not
suggest that changes in public sector saving are entirely offset by
private saving.
-
11 -
Tax receipts from the private sector have no direct effect on
absorption. They do, however, affect private disposable income and may
thereby have an indirect effect on private spending. The effect of a given
tax on private spending is likely to depend on whether the tax is viewed as
permanent or temporary (temporarytaxes are expected to reduce saving), the
characteristicsof the recipient which affect the marginal propensity to
consume out of current income (includingdemographic factors such as age and
household size), and the nature of the financial system (which will affect the
extent to which the taxpayers are liquidity-constrained).Transfers are
essentially the negative of taxes. Their effects on domesticabsorption can
be expected to be the opposite of the effects of taxes described above.
Although domestic absorption is not directly affected, a transfer should
increaseprivate absorption, though not necessarily total absorption. The
effect on the latter will depend on how the governmentfinances the payments
of transfers.
In summary,the effects of fiscal policy on aggregate demand would
appear to be more complex than standard Keynesian macroeconomictheory would
suggest. At this stage it is debatable whether on balance a restrictionary
fiscal policy would reduce aggregate domestic demand and growth or not.
Ultimately, the issue is an empirical one and will accordinglyrequire more
testing.
III. StructuralPolicies
Structuralpolicies differ from demand-managementpolicies in two
respects. First, they place more emphasis on growth rather than the control
of domestic demand and immediate improvementin the current account. In
-
12 -
developingcountries the goal of achievingmore efficient resource allocation
and increasedgrowth may sometimes conflict with that of reducing the current
account deficit in the short run. Since these countries import a large
proportionof capital goods, programs that place a greater emphasis on
structuralmeasures frequently take a different view about the objectives
regarding the current account in the early years of the adjustment program
than do programs that aim primarilyat reducing excess aggregate domestic
demand. In particular, to the extent that major adjustmentsin aggregate
domestic supply require an initial rise in the level of domestic investment,
reductions in current account deficitswould not necessarilybe sought in the
early years of the program.
Second, substantialtime may be needed for structuralpolicies to
show results.
Major
shifts in resource allocation may entail a significant
rise in fixed capital formation in expanding sectors,combined with the
release of capital and labor from contracting sectors. Such major adjustments
tend to occur slowly, so that the time frame for a program involving
structuralmeasures has to be longer than one that focuses on reducing
aggregate demand.
Structuralpolicies can take a wide variety of specific forms
dependingon the economy in question and the types of problems faced by the
domestic productivesector. They can, however, be categorizedunder two broad
headings: policies to improve efficiencyand resource allocation;and
policies to increase the level or rate of growth of capacity output.
A. Policies to Improve Efficiencyand Resource Allocation
This category basically includesall types of measures to reduce
distortionsthat drive a wedge between prices and marginal costs. In a number
-
13 -
of developing countries distortionsare fairly pervasive in factor markets,
credit markets, and goods markets. The distortionscan arise, for example,
from price, wage, and interestrate controls; imperfectcompetition;taxes and
subsidies;and trade and payments restrictions. The attractivenessof
policies designed to improve the efficiencywith which scarce resources are
utilized lies in the fact that such measures can potentially increase the
output that can be produced from a given stock of resources without
necessarily lowering the level of current consumption. Nevertheless,attempts
to eliminatemajor distortionspresent certain practicaldifficulties. First,
if capital and labor are not mobile among different sectors of the economy,
changes in the patterns of relative prices and incentivesmay necessitate an
extended period of adjustmentduring which some factors, in particuLar labor,
may be unemployed. Second, many government policiesthat create distortions
may have been designed to achieve objectivesother than economic efficiency.
These policies typically would include among others, employmentprograms,
consumer subsidies,price controls on essential commodities,and restrictions
on imports of luxury goods. Thus, political realitieshave to be recognized
when advocating changes based purely on efficiencygrounds. Finally, the
theory underlyingmicro-orientedpolicy measures is not sufficientlydeveloped
to be able to yield precise answers on the effects of such policies. For
example, well-known considerationsassociatedwith the theory of second best
suggest that if a country has a number of significantdistortions,the
elimination of only some of them will not necessarilyresult in an overall
gain in efficiencyand welfare.
By their nature, distortions tend to be both microeconomicand
country-specific. Nevertheless,two sources of inefficiencythat have
-
14 -
macroeconomicsignificancehave gained importancein recent years, and
accordinglyreceivedconsiderableattention from researchers. First, there
are the inefficienciesthat result from imposing artificialbarriers to
foreign trade. Tariffs, quotas, and other restrictionson trade and payments
reduce the levels of trade and specialization,and tend to foster the
developmentof import substitute industriesthat often fail to attain the
degree of efficiencyand flexibility shown by firms that are continuously
exposed to internationalcompetition. A number of studies (i.e., Balassa
(1982) and Krueger, et al (1981)),have shown that at the broadest level, the
countries adopting outward-lookingdevelopment strategieshave fared better in
terms of growth, employment,economic efficiency,and adjustment to external
shocks than those that have taken a more inward-lookingapproach to
development. The outward-orientedstrategieshave been typically
characterized,inter alia, by the provisionof incentivesfor export
productionand the encouragementof import competition for most domestically
produced goods. The relative success of outward-lookingpolicies has led to
considerableefforts to encourage developingcountries to liberalizetheir
trade systems. 12/
A second source of inefficiencyin a number of developingcountries
arises from controls on producer prices. For example, agriculturalpricing
policies often cause the prices of agriculturalcommoditiesto deviate from
prices that would be established in competitivemarkets or prices in the
internationalmarkets. Such policies have a strong impact on the level and
12/ See Edwards (1984) and Krueger (1985) for a discussion of trade
liberalizationin developingeconomies.
-
15
-
allocation of agriculturalproduction,and on consumption. In many developing
countries governmentmarketing boards control the purchase of a major portion
of domestically-produced
agriculturalcommodities. If the marketing board
attempts to increase its revenues (or reduce its losses) by holding the prices
it pays below world levels, this policy can act as a tax on output. This type
of tax creates disincentivesboth to domestic supply and exports, and can
result in an increase in imports and a drain on the governmentbudget. In an
adjustment program, therefore,an initial upward adjustment in the prices
offered to domestic producers by the marketing board is frequentlyneeded.
Indeed, there is now empirical evidence that suggests that pricing policies to
increase the return to producerswould tend to stimulatethe output of major
agriculturalcommodities,particularlyin the longer term. 13/ Another
example in this area is pricing policies for energy and energy products.
Again if these prices are held below world market prices, the governmenthas
to absorb the cost of subsidies in its budget. Aside from the budgetary
effects, a policy of subsidizingenergy tends to slow down the shift to less
energy-intensiveproductiontechniquesand patterns of consumptionby not
providing the right incentivesfor efficient use of energy.
B. Policies to Increasethe Rate of Growth of Capacity Output
The rate at which the aggregate potential supply of output can be
expanded depends, among other things, on decisions about the proportionof
current output to be invested in productivecapital rather than consumed, as
13/ See Bond (1983).
-
16 -
well as on the nature and quality of the capital stock being added. 14/ The
appropriate structuralpolicies for this objectiveare those that tend to
favor investmentand savings. As there is now general consensus that
investment in developingcountries is largely constrainedby the availability
of resources,policies that encourage public and private savings have to be
given a special importancein adjustmentprograms that emphasize growth. On
the public sector side this involves steps to improve the fiscal position,
while in the case of private savings the focus has to be primarily on interest
rate policies.
Interest rate policy is consideredto have a significantinfluenceon
the supply of (domestic and foreign) savings as well as the level and
composition of investment. 15/ In many developingcountries the financial
systems are tightly controlledby the governments,with ceilings placed on
nominal interest rates. Under inflationaryconditionssuch controlshave
resulted in highly negative real rates of intereston domestic financial
instruments for extended periods. 16/ Consequently,real financial savings
have grown less rapidly than the real economy and disintermediation,
particularlyin the form of development of parallelor curb markets in credit,
has been a serious problem. When such developmentsoccur, they can severely
restrict the availabilityof real credit through the financial system and
14/ See Krueger (1986) for a discussion of the role of capital formation in
the growth and developmentprocess. See also Sen (1983).
15/ This view is generally referred to as the McKinnon-Shawhypothesis; see
McKinnon (1973).
16/ The real interest rate is defined as the nominal interest rate adjusted
for anticipated inflation.
- 17 -
thereby inhibit the level and efficiencyof investment. Since available
credits are often first allocated to large firms and state enterprises,
credits for small- and medium-sizedfirms and householderscan be especially
limited and severelyrationed, with the consequencethat uneconomicprojects
are undertakenat the expense of more efficient ones. To increase the
availabilityof real credit, interestrate policy could be used to encourage
the accumulationof domestic financial assets by offeringholders of these
assets a sufficientlyattractivereturn. At the same time, other structural
and institutionalreforms could be undertakento increase the general
efficiencyof the financial system.
The above considerationsindicatewhy raising real interest rates on
domestic financial instrumentshas to be a key element in adjustmentprograms.
In setting the level of nominal interestrates, considerablejudgment must
thereforebe exercised regarding the future course of inflationduring the
program. Nonetheless,establishingthe perception that holders of domestic
financial instrumentswill earn positivereal returns that are to some degree
competitivewith the real yields that can be obtained on comparableforeign
instrumentsis necessary in promoting balance of payments adjustment,
increasingforeign direct investment,and preventingcapital flight.
Any changes in interest rates and other financial reforms,
however,
must also be coordinatedwith the other policy actions that are a part of the
stabilizationprogram. The experiencesof a number of developingcountries
with financialreforms suggeststhat this coordinationis especially important
during the early phases of the stabilizationprogram. In particular,certain
combinationsof policies can potentiallybe a source of instabilityfor a
financial system undergoingmajor structuralchange. Two examples appear
-
18 -
particularlyrelevant in this context. First, it is crucial that the fiscal
accounts be brought under control to avoid the sharp changes in the flow of
funds in and out of the financial system. Second, interest rate policy has to
be coordinatedwith exchange rate policy to ensure that capital movements do
not destabilizethe financial reform.
While most of the attentionhas been on the relationshipbetween
savings (financialand real) and rates of return, there are other aspects of
savings behavior that have to be considered. One important issue is the
relationshipbetween public and private savings,which was referred to earlier
in connectionwith the concept of Ricardian equivalence. If in fact public
and private savings are substitutes,then clearly an adjustmentprogram that
called for increasedpublic savings, as typically programs do, would cause a
reduction in private savings. In the limit, if the offset is complete, total
domestic savings may remain unchanged with the private sector reducing its
savings as the public sector improved its fiscal position. A second issue
relates to the the effects of capital inflows on domestic savings, both public
and private. If an increase in foreign savings, i.e., a rise in the current
account deficit, results in lower domestic savings then total resources
available to the country would be unchanged. 17/ In general, if the supply
curve for foreign financing is upward sloping, the level of domestic savings
(and investment)will depend directly on the amount of foreign savings the
country can generate. Even though such offsets are unlikely to be complete in
reality, care has to be taken to ensure that other policies, such as increases
17/ The net effect on national savings would obviously depend on the extent to
which foreign and domestic savings are substitutes.
-
19
-
in real rates of return and improvementsin the availabilityof savings
instruments,are able to compensatefor the possible negative effects of
public and foreign savings on domestic private savings.
Despite the importanceattached to private investmentin the
adjustment process, there is a serious lack of understandingof the factors
that influence investmentdecisions in developingcountries. Although in
recent years a broad consensus has emerged on the forms of several key
macroeconomicrelations in developingcountries --
such as the aggregate
consumptionfunction, money demand, imports,and exports -- no such
convergenceof views is apparent in the case of private investment. The
theoretical literatureon investmentis quite rich and has yielded a welldefined class of models, generally of the flexible acceleratortype. There
is, however, quite a large gap between the modern investmenttheory and the
models that have been specified for developingcountries. Because of
institutionaland structuralfactors present in most developingcountries,
such as the absence of well-functioningfinancialmarkets, the relatively
large role of the governmentin the capital formation process,distortions
created by foreign exchange constraints,wage rigidities,and other market
imperfections,the assumptionsunderlyingthe standard optimizinginvestment
models typically are not satisfied in those countries. As such, the standard
models have to be adapted to allow for the structuralfeatures of developing
countries,but this has not been an easy task in general. 18/ What is needed
in particular is a clearer idea of the theoreticaland empirical links between
18/ See Blejer and Khan (1984) for a discussionof the issues and an attempt
to specify a model that takes such factors explicitlyinto account.
- 20 -
policy variables and private capital formationso as to evaluate the influence
that government can exercise over private investmentdecisions that change the
current and future growth rate of the economy.
Assuming that measures are implementedthat are successfulin raising
investment,what would be their impact on growth? This question can be
addressed by formulatinga growth model that relates the rate of growth of
output to increases in various factors of production,such as the capital
stock (of both domestic and foreign origin) and the labor force, as well as
technical progress and the use of importedinputs. Attempts at this type of
analysis have only been partially successful. One of the problems is that the
identifiablefactors listed above are only able to account for a relatively
small proportionof the variation in growth rates over time or across
countries. There is a large unexplained source of growth remaining,which
could reflect efficiency changes in investment,changes in human capital
(education,skills, and health), or exogenous events. What precisely these
factors are, and whether they can be influencedby governmentpolicies, is a
task that will undoubtedly occupy macroeconomicresearchers.
IV. Exchange Rate Policies
Exchange rate action to improve internationalcompetitivenessand
increase the incentive to produce tradablegoods is often the centerpieceof
any adjustment effort. Since devaluation,in the terminologyof Johnson
(1958), is simultaneouslyan expenditure-reducing
and expenditure-switching
policy, it affects both domestic absorptionand domestic supply, and thus
containselements of both demand-sideand structuralpolicies.
- 21 -
The basic demand-sideand supply-sideaspects of devaluationhave
been discussedextensively in the literature. 19/ Consider, for example, a
situationwhere excess real domestic demand shows up in a current account
deficit. A devaluationincreases the level of foreign prices measured in
domestic currency terms and thus the price of tradablegoods relative to
nontraded goods in the domestic economy. On the demand side, the effect of a
devaluationon domestic absorptionis unambiguouslynegative: the main
demand-sideeffects are a reduction in private sector real wealth and
expenditure,owing to the impact of the rise in the overall price level on the
real value of private sector financial assets, and on real wages and other
factor incomes,of which nominal values do not rise proportionallywith the
devaluation. For these reasons, devaluationdecreases domestic demand and
reduces current absorption.
On the supply side, however, the effects of the devaluationtend to
move output in the opposite direction. If the prices of (variable)domestic
factors of productionrise less than proportionatelyto the domestic currency
price of final output in the short run, devaluationwill have a stimulative
impact on aggregate supply. 20/ Thus both the aggregate demand and aggregate
supply effects of a devaluationwork toward reducing the excess demand in the
economy and the current account deficit. Whether total output rises or falls
during this process obviously depends on whether the contractionaryeffects on
aggregate domestic demand are outweighedby the supply-stimulating
aspects of
this policy. This depends, among other things, on the relative sizes of the
19/ See, for example, Cuitian (1976) and Dornbusch (1981).
20/ For a discussionof the supply-sideaspects of devaluation,see Khan and
Knight (1982), (1985).
-
22 -
price elasticitiesof imports and exports, on the relative shares of tradable
and nontradablegoods in total production,and on the other policies that are
adopted at the same time.
The above analysis is, of course, very standard,but it does
highlight the importanceof getting the "right" real exchange rate in the
adjustment process. However, althoughexchange rate action may be the obvious
way to correct a misalignmentof relative prices and thereby improve
internationalcompetitiveness,there are still a number of difficult
theoreticaland empirical issues involved. Here we consider four such issues,
namely: (a) determinationof the degree of overvaluation,and thereforethe
size of the real depreciationrequired; (b) achieving the target value of the
real exchange rate; (c) determinationof the effects of a change in the real
exchange rate; and (d) the exchangerate regime or exchange rate rules that
the country should adopt.
A. Determining the Extent of Exchange Rate Adjustment
Ascertainingthe "equilibrium"exchange rate against which the
current rate is compared, and thus the extent of the required devaluation,has
proved to be a fairly intractableproblem, even for developed countrieswith
sophisticatedfinancial systems,well-developedforward markets for
currencies,and few distortionsin foreign trade and payments. Consequently,
in the case of developingcountries it has become common practice to base
judgments on the appropriatenessof the exchange rate at least in part on
Purchasing Power Parity (PPP) calculations,such as indices of real exchange
rates based on some combinationof export and import weights. However, these
indices are only suggestiveand can be useful when domesticrates of inflation
have been considerablyhigher than-thoseabroad. One should generally be
careful in attaching an excessive degree of importanceto small changes in
-
23 -
such indices. The use of a PPP-based index to judge the appropriate level of
exchange rate requiresan assumptionthat some past level of the rate was
correct and then setting up that past level as a target. The size of the
required devaluationis then determinedby the differencebetween the target
and actual values of the real exchange rate. However, it should be remembered
that the choice of the target rate can be quite arbitrary,and thus subject to
error.
The question of the appropriate real exchangerate is made more
difficult once it is recognizedthat it is an endogenousvariable that
responds to a variety of factors. For example, as shown by Khan (1986),
exogenous foreign shocks such as worsening of the terms of trade, an increase
in foreign real interestrates, or a slowdown in the growth rates of partner
countries,will all tend to depreciatethe long-run real exchange rate.
Similarly,domestic supply shocks will alter the equilibriumreal exchange
rate. Consequently,the "right" real exchange rate is conditionalon the
state of the world, and in any realistic setting,changes in the latter are
likely to occur. In judging the appropriatenessof the level of the real
exchange rate these factors affecting its long-runbehavior have to be taken
into account.
B. Policies to Achieve a Target Real ExchangeRate
Having determinedthe appropriatelevel of the real exchange rate,
either through PPP calculationsor through some more sophisticatedmodel-based
approach, it is then necessary to choose a set of policies that would achieve
this target. Clearly a nominal devaluationby itself would not be
sufficient. It is well known that in the absence of supportingpolicies that
limit the increase in domestic prices, a nominal devaluationwill only have a
transitoryeffect on the real exchange rate. In the long run, domestic prices
- 24 -
will rise by the full amount of the devaluationand the real exchange rate
will return to its original level. Broadly speaking, therefore,any
sustainablereal exchange rate change requires policies to restrain aggregate
demand and factor costs. The extent to which a devaluationwill affect the
real exchange rate, as well as the length of time over which the effects
persist,are a direct function of the supportingpolicies -- fiscal, monetary,
trade, and wage policies -- that are put in place.
To calculatethe effects of a devaluationon the real exchange rate
requires in the first instance informationon substitutionelasticities
between tradable and nontradablegoods in consumptionand productionand the
share of tradable goods in total expenditure.21/ This, however, is only the
first-roundeffect which will only be sustained if supportingpoliciesare
implemented. To determine the long-runvalue of the real exchange rate
requires detailed specificationof these other policies. Without such
information the level of the real exchangerate, for a given nominal
devaluation,could not be predictedwith any certainty.
If it is establishedthat the alignmentof relative prices is
inappropriate,say because the existence of an unsustainablecurrent account
balance, it is possible to correct this situation,in principle,through
policies other than exchange rate adjustment. In general, however, the latter
is likely to be a much simpler way of achieving the correct alignment than are
deflationarypoliciesdesigned to force down domestic prices and wages, which
21/ A limiting case is when prices of nontradable goods are constant. The
impact of a devaluationon domestic prices is then simply the product of
the exchange rate change and the share of tradable goods in expenditure.
The depreciationof the real exchange rate would, therefore,be equal to
the nominal devaluationadjusted for the resulting increase in domestic
prices.
- 25 -
in most countries tend to be resistant to downward changes without substantial
falls in output and employment.
C. Effects of ExchangeRate Changes
One of the standardcriticismsagainst devaluationas a policy of
adjustment is that it tends to induce stagflationand increases
unemployment.22/ As mentioned previously,whether a devaluationexerts a net
contractionaryor expansionaryeffect on domestic output and employment
depends on the relative strengthson the effects it has on aggregate demand
and aggregate supply, and the time period in question. As long as devaluation
succeeds in altering the real exchange rate by raising product prices in
domestic currency relative to factor incomes, it should exert a stimulative
effect to the extent that the short-runmarginal cost curves of the relevant
(tradable goods) industriesare upward sloping. Naturally,the longer a real
exchange rate change persists, the larger are the gains to be achieved.
Furthermore,if the wealth and distributionaleffects of devaluationstimulate
savings and investment,a long-run gain of increasedpotential output will
likely be realized.
Despite the controversysurroundingthe output and employmenteffects
of exchange rate policy, there is surprisinglylittle empirical evidence
available on the subject.23/ Furthermore,the relativelyfew studies
examining this question yield mixed results. Basically,the direction and
magnitude of the growth effects depend on such issues as the extent and
duration of the real exchange rate change, the structure of production,and
22/ See, for example,Diaz-Alejandro(1965), Cooper (1971), Krugman and Taylor
(1978), and Hanson (1983).
23/ See, for example, the studies described in Khan and Knight (1985).
-
26 -
the responses of trade flows to relative price changes. If devaluationdoes
alter the sectoraldistributionof income, as it is designed to do, it will
not be completely costlessto some sectors. On the other hand, no strong
empirical evidence can be brought forward to support the propositionthat
devaluationnecessarilyreduces the overall growth rate and increases
unemployment. Given the state of empiricalknowledge it would be dangerous to
draw strong conclusionsone way or the other. Of more relevance are the
short-termand long-termeffects that devaluationhas on trade flows, and here
the empirical evidence points to the existence of relative price elasticities
that satisfy the Marshall-Lernerconditions. What needs exploring is whether
the result carries over to the case where importedinputs are important in the
export productionprocess and where imports are constrainedby foreign
exchange availability.
D. Exchange Rate Systems and Regimes
Unlike the developed industrialcountries there are very few
developing countriesthat operate a freely-floatingexchange rate system.
Most either maintain fixed parities or follow some type of crawling-peg
rule. 24/ While there may be advantages to maintaininga fixed peg, such a
system also has a number of disadvantageswhich have been dealt with at length
in the literature. One of these drawbacks is that the policy leaves a country
vulnerable to speculativeattacks and may result in exchange rate crises if
the authoritiesare unwilling to alter the peg. 25/
24/ The 1985 Annual Report of the IMF lists 50 developingcountries as having
fixed pegs to a single currency, 38 as pegged to a currency composite,29
that follow an exchange rate rule, and only 7 countriesare classifiedas
floating.
25/ See, for example, Blanco and Garber (1986).
-
27 -
At the otherextremefrom countrieswith fixedexchangeratesare
high-inflation
countrieswherecontinualexchangerate adjustmentis built
into the economicsystem. Indeed,exchangerate changescan be regardedin
some casesas merelya particulartypeof indexation.For thesecountries,
the key decisionis at what rate the domesticcurrencyshouldbe depreciated;
this dependson a numberof considerations,
especiallythe policiesbeing
simultaneously
carriedout with respectto the interestrate,fiscalpolicy,
and domesticcreditexpansion.Recentlysomewritershave questionedthe use
of exchangerate rules,arguingthat they increasefluctuations
in outputor
increasedomesticinflation,
and thus are inconsistent
with macroeconomic
stability.
26/ Also at issueis how and when rulesthat are designedto keep
the realexchangerate constant,or slowlydepreciateover time,shouldbe
changedwhen circumstances
dictate.
Confrontedwith persistentbalanceof paymentsproblems,some
countrieshave resortedto a dual exchangesystemas an alternative
to a
uniformexchangerateadjustment.Under the dual system,certainselected
transactions
takeplaceat an officialexchangerate,which is maintainedby
officialintervention,
while the remainingtransactions
take placeat a
generallymore depreciated
("free"or "parallel")
exchangerate,which is
usuallydeterminedby marketforces. Dual exchangemarketshave not always
been successfulin achievingthe objectivesthatmotivatedtheiradoption. In
particular,
they have been largelyineffective
in preventingspeculative
capitalflowsfrom affectinginternational
reserves,as uncertainties
concerningthe viabilityof the officialexchangerate have generallyproduced
leadsand lags in importsand exportsin the officialmarket. Similarly,the
26/ See, for example,Dornbusch(1982)and Adams and Gros (1986).
- 28 -
large differentialsthat often arise between the free and the official
exchange rate have motivated the over-invoicingof imports and the underinvoicing of exports in the officialmarket, thus contributingto a further
erosion of internationalreserves. In addition, dual exchange rates are
equivalent to a series of implicit subsidiesand taxes that may work against
some of the objectivesof the country. For example, commodities that receive
export promotion incentivesare sometimesassigned to the official market,
thus implicitlytaxing their export and defeating the initial purpose of
export promotion. In summary, there is a need to study the workings of dual
exchange rate systems in more detail to determine the reasons why they have
not survived, and what lessons can be learned from the experienceswith such
systems.
V.
External Financing Policies
It is generally thought that as developing countries face a scarcity
of capital they should be net foreign borrowers during the development
process. This idea has been formalizedin a number of studies showing that
countries can attain a desirable growth path by supplementingdomestic savings
with foreign savings. The rate at which they borrow abroad, or in other words
the "sustainable"level of foreign borrowing,depends on the relationships
among foreign and domestic savings, capital formation and growth. The main
lesson of the "growth with debt" literatureis that country can and should
acquire foreign savings (in the form of net imports of goods and services) as
long as this provides the basis for paying the required rate of return to the
supplying country over the time period during which the resources are made
available.27/ The justificationfor paying this rate of return is usually
27/ See the useful survey by McDonald (1982).
-
29 -
thought of as the increased output made possibleby the additionalreal
capital that can be accumulatedwith the aid of net foreign savings. 28/
Theoreticallyit is possible to calculate the sustainablelevel of
net resource transfers,based, for example, on informationon the nature of
the constraintson the supply of foreign loans and the availabilityover time
of new loans that vary both in terms and maturity, but in practice this is a
nearly impossible task since such informationis not often available.29/
Consequentlyit is thus necessary to make approximationsto the relationship
between debt and the capacity to service debt through calculatingratios of
debt to exports or debt to GNP. However, it is very difficult to determine
the "sustainable"level of such ratios. If a country can profitablyemploy a
stock of foreign savings that is large relative to domestic savings, it
follows that its debt to exports ratio will be high relative to a country that
has a lesser capacity to profitablyutilize foreign savings. The equilibrium
level of such ratios will thus vary from country to country and for a given
country over time.
The main practical value of the existing empirical measures is that
they can provide signals to the danger of situationsin which debt can grow
28/ It might also be optimal for countries to utilize external debt to smooth
consumptionover time in the face of various internal and external shocks.
A more general criterion would be that the pattern of distributionof
world savings should be welfare enhancing. See Williamson (1973).
29/ Furthermore,any such calculation is by definitionconditionalon the
assumptions of the future path of the interestrate on existing and new
debt. What might be considered sustainableat a given interestrate may
prove to be unsustainableif the interestrate should rise above the
assumed value. Since most commercialdebt carries a floating interest
rate, calculationsbased on some fixed rate are bound to be only
conjecturalat best.
-
30 -
explosively. If additionalexternal debt increases investmentincome payments
by more than it increasesthe capacity to make such payments, this must be
reversed through net exports of goods and services. If it is not, additional
debt will be incurred in order to make payments, and the stock of foreign debt
will grow faster than debt service capacity. A convenientway of stating this
condition is that the real interestrate paid on additional debt must be less
than or equal to the expected growth in the volume of exports. 30/
While it may be difficult to see the relationshipbetween empirical
indicatorsfor debt capacity and the criteria for foreign borrowing that
emerge from the theoreticalliterature,there are neverthelesscircumstances
in which the proxies are useful. For example, an unexpected rise in the
external real interest rate can make the payments associatedwith existing
debt excessive relative to the outlook for a country's debt service
capacity. Moreover, a country's debt service capacity could deteriorate
because of unwise domestic policies that reduce the expected return of foreign
borrowing in terms of export capacity. Finally, less favorable external
factors such as slow growth in trading partners or adverse changes in the
terms of trade could introduce the possibilityof explosive growth of debt.
Therefore,the theory of real resource transfers is probablymost useful as a
warning in circumstanceswhere concepts such as debt to GNP, debt to exports,
or debt-serviceratios are changing or are expected to change rapidly. Such
possibilitieswould call into question the sustainabilityof the country's
external position.
30/ Strictly speaking, this result assumes that the rate of growth of imports
is less than or equal to the rate of growth of exports.
-
31 -
In recent years the sharp decline in the availabilityof foreign
financinghas created difficult adjustmentproblems for a large number of
developingcountries. When private creditorshave already determinedthat the
sustainabilityof the country's position is doubtful, the short-termoutlook
for the current account is constrained since only official financing may be
available. In this case, to the extent that the country cannot influence
official capital flows, the short-runadjustmentpath for the current account
is largely determinedby forces outside the control of the adjustment program.
The issue remains,however, as to what policies (perhaps involving debt
reduction relative to domestic output for some interval)will allow a quick
and relativelycostless eventual return to a normal growth path for debt.
The theory of "growth with debt" is not well-suitedto guide policy
during such transitionperiods. 31/ The obvious solution is that the
necessary adjustment should be accomplishedat the minimum cost in terms of
loss of output, but this is obviously not an easy task. One practical
considerationis that imports should not be compressedbelow the level which
causes an unnecessaryreduction in the rate of economic growth and, to the
extent that exports require imported inputs, the growth of exports. It should
be recognized,however, that there may be little room to maneuver where
credits from private sources are no longer available. Official financial
assistance obviously plays an important role in these circumstances,and an
adjustmentprogram can also advance the time in which the country's access to
the internationalcapital markets and thus to foreign savings is restored.
31/ For a discussion of some of the issues that arise, and the policies that
may be implemented,see Selowsky and van der Tak (1986).
-
32 -
In discussionsof capital flows in the context of developing
countriesattention has focused almost exclusivelyon foreign borrowing by
these countries. Recently some advances have been made to analyze the other
side of these flows, namely the acquisitionof external claims by residents of
developingcountries.32/ The interesthas been triggered because of what has
been termed the phenomenon of "capital flight." It has been argued by some
studies that the outflow of capital has caused serious economic difficulties
for developing countries. For example, Cuddington (1985) and Dornbusch (1985)
contend that capital flight in a number of countrieshas caused the build-up
of gross foreign debt, an erosion of the tax base, and to the extent that
there was a net real transferof resources from the countries,a reduction in
investmentand growth.
Since the availableestimates of capital outflows from debtor
countriesare surprisinglylarge, it stands to reason that capital flight is
of concern to policymakersin these countriesas well as to international
institutions. If increases in foreign debt in the past merely financed
capital flight rather than productiveinvestment,then what is to prevent
future lending from leaking out in the same way? Furthermore,following from
the first question, what policies if any, can be enacted to prevent a
repetitionof large scale private capital outflows from debtor countries
facing acute financing needs?
While there is some theoreticalsupport for the notion that expected
devaluationsand interest rate differentialsdrive capital abroad, in general,
the effects of changes in the macroeconomicenvironmenton preferences for
32/ See, for example, Cuddington (1985), Dooley (1985), Dornbusch (1985), and
Khan and Haque (1985).
-
33 -
where wealth is held are not that straightforward. A change in the
macroeconomicenvironmentwill generallybe recognizedby both residents and
nonresidentsat the same time, limiting the incentivesfor trade between these
groups of investors. Some market imperfectionis usually needed in order to
predict changes in the location of investments. For example, in the case
where a government is supportingan unrealisticexchange rate and where there
are no opportunitiesfor the private sector to acquire domestic securities
denominated in foreign currencies,private capital outflows would be
expected. In this case the "differenceof opinion" between the government and
the private sector (both residentand nonresident)will lead to a change in
the preferred location of investments.
In addition to the macroeconomiccauses behind capital flight, there
are a whole host of incentivesthat may affect the decisions of investors on
where and in what form to hold their wealth. The key to these "micro"
incentivesis the actual and expected taxes, subsidies,and controls that
various governmentsimpose on holdings of wealth within their jurisdiction.
For example, countries that have taken over large debts have a clear need to
generate revenue. To the extent this is likely to fall on investment income,
residents will attempt to find a tax haven outside the country. The effort to
impose a differentialtax on investmentincome will be very counterproductive
since revenue can very rapidly fall to zero as the tax base shrinks.
Of course, it should be recognizedthat it is highly unlikely that
the governmentwill be able to prevent all private capital outflows even in
the best of circumstances,since many of the causes are well beyond its
control. What the authoritiescan do is to try and change existing
incentives,both macro and micro, in the economy to minimize the amount of
capital flight, and thus direct more resources,both domestic and foreign,
-
34 -
towards expanding the productivebase of the economy, and increasing its
current and future debt-servicingcapacity.
VI. Conclusions
This paper has had a twofold purpose: first, to identify the
policies that would be called for to achieve macroeconomicadjustment,and
second, to describe the links between these policies and the ultimate
objectivesof an improvementin the balance of payments, a reduction in
inflation,and an increasedrate of economic growth. The resulting package
would be a fairly complex mix of policies designed to simultaneouslyreduce
aggregate demand and increaseaggregate supply and the production of tradable
goods. As has been shown in this paper, the links between policies and the
ultimate objectivesare equally complex and there are large gaps in knowledge
on both the theoreticaland empirical fronts.
The set of policiesconsideredhere would be broadly acceptableto
most economistsconcerned with the issue of macroeconomicadjustment in
developingcountries. For example, in one of the few concrete expositionsof
an adjustmentstrategy,Diaz-Alejandro(1984) describes a policy package that
containsmany of the same elementsas described in this paper. Considering
the case of a country that has an unsustainablebalance of payments deficit
and high inflation,Diaz-Alejandro(1984) proposes that the policy package
should contain the following: fiscal and monetary restraint to reduce
aggregate demand; eliminationof distortions;incomes and wage guidelines; a
gradual liberalizationof imports;provision of incentivesfor exports; a
crawling-pegexchange rate regime, with emphasis on undervaluationof the real
exchange rate to support export promotion and import liberalization;and
positivereal interest rates to encourage savings. The "real economy"
-
35 -
approach advocated by Killick and others (1984) is yet another example of a
specific set of proposals for adjustmentthat is quite consistentwith the
package described here. This real economy approach basically emphasizes
structuralpolicies at the sectoral level, in addition to demand-oriented
policies.
While there may be agreement on the policy measures to be
implemented,there is certainlya lack of consensus on how these policies work
to achieve the principal goals. This is specially true in the case of policy
measures that are essentiallymicroeconomicin nature but have macroeconomic
implications. It has to be recognizedthat the analyticalbasis for a number
of micro-orientedpolicies typically includedin an adjustmentprogram is
relativelyweak. The theory underlyingthe effects of eliminatingdistortions
(real and financial)is not well-suitedto policymakingas it very quickly
gets into welfare-relatedissues. For example,whether the removal of
consumer subsidies or a devaluationraise overall efficiencyand production,
when there are significantdistortionsin the economy, or not, are still very
much open questions.
Even on the macroeconomicfront there are serious theoreticaland
empirical issues that are still up in the air. For example,as pointed out in
this paper, both the direction and size of the effects of fiscal policy on
aggregate demand are ambiguous. The subject of devaluation in a developing
economy is yet another importantexample of which existing analysis does not
yield definitive conclusions. The available literaturegives only a limited
amount of informationon the important policy questions of precisely how a
devaluationis expected to work, how to determine the size of the required
depreciation,and whether a nominal depreciationcan alter the real exchange
rate sufficientlyto generate a shift in resources between sectors. A third
- 36 -
example is the issue of savings and resource mobilization. Since raising
private savings is a key element in programs emphasizinglong-term growth, it
is crucial to establish the theoreticaland empirical links between private
and public savings,interest rates, and exchange rate policies. Finally, and
perhaps most importantly,there is still much to be learned about the factors
.hat drive growth in developingcountries,and in particularof the
relationship,or trade-off,between short-run stabilizationand long-run
growth.
Many of these questions will clearly have to be answered through
concerted empiricalanalysis. Even when the theoreticalunderpinningsof the
relevant relationshipsare clear-cut, it has to be stressed that economic
theory providesa guide only to the basic equilibriumrelationships,and does
not provide informationon how long it takes for a change in an exogenous
variable or policy instrumentto have an impact on the endogenousvariable.
Such questions concerningdynamicsand lags in adjustmentobviously have to be
approachedfrom an empirical standpoint,and thus empirical analysiswill be
crucial in the design of an adjustmentpackage. Furthermore,in many
instancescomparisonsof alternativemodels may prove necessary to decide
which are the more appropriateto form the basis of the policy package.
This paper has provided only very general guidelineson the type of
measures that should be includedin an adjustmentpackage. The issues of the
appropriatemix of demand-management,structural,exchange rate, and external
financing policies,and the sequencingof these policies,which are basic from
an operationalpoint of view, were not directly addressed. An analysis of
these issues would require in the first instancedetailed theoreticaland
empirical knowledge of the relationshipbetween policies and the ultimate
objectives. However, this would not in itself be sufficientsince the ways in
which policies are combined depends on a number of other factors. These
-
37 -
include,among others, the relativeweights assigned to objectivesof the
program. If, for example, an improvementof the current account is considered
a higher priority, more stress would be given to demand-managementand
exchangerate policies. On the other hand, the achievementof higher mediumterm growth would call for more emphasis on structuralpolicies. Equally
important in the decision about the mix of policies would be the initial
conditions,such as the external payments situation,the outstandingstock of
foreign debt, the rate of inflation,and the level and growth of per capita
income, when the program is implemented. The time period over which
adjustment is to be achieved also has an obvious bearing on the choice of
policies to be undertaken. Since structuralpolicies generally act with a
lag, the longer the time horizon of the adjustment the easier it would be to
utilize such policies. Finally, the choice would be dictated by the
structuraland institutionalcharacteristicsof the country in question. For
example, in countries where indexationis importantand inflationhas become
ingrained in the system, policies directed towards restrainingaggregate
demand may be very costly in terms of output and employment. All these
factors argue strongly for the tailoring of adjustment programs to the
circumstancesof the individualcountry.
Nevertheless,it is crucial to have an analytical frameworkwhich can
be adapted to the particularcountry undergoingadjustment. Only then would
it be possible to predict the effects of alternativecombinationsof policies
on the importantmacroeconomicvariables in the system. The advances in
macroeconomictheory for developingcountrieshave been significantin recent
years, but as this paper has tried tolshow, there are large number of issues
in the area of macroeconomicadjustment,and the policies to be applied to
this end, that are as yet unresolved.
References
(1)
Adams, Charles and Daniel Gros, "Some IllustrativeExamples of the
Consequencesof Real ExchangeRate Rules for Inflation",
InternationalMonetary Fund, Washington,D.C., mimeo, January 1986.
(2)
Balassa, Bela, "StructuralAdjustment Policies in Developing
Economies",World Development,January 1982, pp. 23-38.
(3)
Barro, Robert J., "Are Government Bonds Net Wealth?", Journal of
Political Economy, December 1974, pp. 1095-17.
(4)
Blanco, Herminio and Peter M. Garber, "RecurrentDevaluationand
SpeculativeAttacks on the Mexican Peso", Journal of Political
Economy, February 1986, pp. 148-66.
(5)
Blejer, Mario I. and Mohsin S. Khan, "GovernmentPolicy and Private
Investmentin DevelopingCountries",InternationalMonetary Fund
Staff Papers, Washington,D.C., June 1984, pp. 379-403.
(6)
Bond, Marian E., "AgriculturalResponses to Prices in Sub-Saharan
African Countries",InternationalMonetary Fund Staff Papers,
Washington,D.C., December 1983, pp. 703-26.
(7)
Cooper, Richard N., Currency Devaluation in DevelopingCountries,
Essays in InternationalFinance No. 86, Princeton University, 1971.
(8)
Corden, Max, "The Relevance for DevelopingCountries of Recent
Developmentsin MacroeconomicTheory", DevelopmentPolicy Issues
Series, No. 5, World Bank, Washington, D.C., June 1986.
(9)
Cuddington,John T., "Capital Flight: Issues, Estimationand
Explanations",,
World Bank, Washington, D.C., mimeo, March 1985.
(10)
Dell, Sydney, "Stabilization: The Political Economy of Overkill",
World Development,August 1982, pp. 597-612.
(11)
Diaz-Alejandro,Carlos, Exchange Rate Devaluationin a SemiIndustrializedEconomy: The Experienceof Argentina 1955-1961,
Cambridge, 1965.
(12)
Diaz-Alejandro,Carlos, "IMF Conditionality: What Kind?", PIDE
Tidings, January/February1984, pp. 7-9.
(13)
Dooley, Michael P., "An Analysis of the Role of Country-SpecificRisk
Premiums in DeterminingNet InvestmentIncome Payments in Selected
DevelopingCountries",InternationalMonetary Fund, Washington,D.C.,
mimeo, October 1985.
(14)
Dornbusch,Rudiger,Open Economy Macroeconomics,New York, 1981.
(15)
Dornbusch,Rudiger, "PPP ExchangeRate Rules and Macroeconomic
Stability",Journal of Political Economy,February 1982, pp. 158-65.
(16)
Dornbusch,Rudiger, "External Debt, Budget Deficits and
DisequilibriumExchange Rates", in J. Cuddingtonand G. Smith eds.,
InternationalDebt and DevelopingCountries,World Bank, Washington,
D.C., 1985, pp. 213-35.
(17)
Edwards, Sebastian,"The Order of Liberalizationof the Balance of
Payments: Should the Current Account be Opened Up First?", World
Bank Staff Working Paper No. 710, Washington, D.C., December 1984.
(18)
Frenkel, Jacob A. and Harry G. Johnson (eds.), The Monetary Approach
to the Balance of Payments, London, 1976.
(19)
Guitian, Manuel, "The Effects of Changes in the Exchange Rate on
Output, Prices and the Balance of Payments",Journal of International
Economics,February 1976, pp. 65-74.
(20)
Hanson, James A., "ContractionaryDevaluation,Substitutionin
Productionand Consumption,and the Role of the Labor Market",
Journal of InternationalEconomics,February 1983, pp. 179-89.
(21)
InternationalMonetary Fund, The Monetary Approach to the Balance of
Payments,Washington, D.C., 1977.
(22)
InternationalMonetary Fund, Annual Report 1985, Washington, D.C.,
1985.
(23)
Johnson, Harry G., "Towards a General Theory of the Balance of
Payments",in InternationalTrade and Economic Growth, London, 1958,
pp. 153-68.
(24)
Khan, Mohsin S. and Malcolm D. Knight, "StabilizationPrograms in
DevelopingCountries: A Formal Framework,"InternationalMonetary
Fund Staff Papers, Washington,D.C., March 1981, pp. 1-53.
(25)
Khan, Mohsin S., "Some Theoreticaland Empirical Issues Relating to
Economic Stabilizationin Developing Countries",World Development,
September 1982, pp. 709-30.
(26)
Khan, Mohsin S., Fund-SupportedAdjustment Programs and Economic
Growth, InternationalMonetary Fund Occasional Papers No. 41,
Washington, D.C., November 1985.
(27)
Khan, Mohsin S. and Nadeem U. Haque, "Foreign Borrowing and Capital
Flight: A Formal Analysis",InternationalMonetary Fund Staff
Papers, Washington,D.C., December 1985, pp. 606-28.
(28)
Khan, Mohsin S., "DevelopingCountry Exchange Rate Policy Responses
to Exogenous Shocks", American Economic Review, May 1986, pp. 84-87.
(29)
Killick, Tony (ed.), The Quest for EconomicStabilization: The IMF
and the Third World, London, 1984.
(30)
Krueger, Anne O., "How to Liberalizea Small, Open Economy", in M.
Connolly and J. McDermott (eds.),The Economics of the Caribbean
Basin, New York 1985, pp. 12-23.
(31)
Krueger,Anne O., "Aid in the DevelopmentProcess", The World Bank
Research Observer,World Bank, Washington,D.C., January 1986, pp.
57-78.
(32)
Krueger, Anne O., et al (eds.), Trade and Employmentin Developing
Countries: Vol. 1 - IndividualStudies, Chicago, 1981.
(33)
Krugman, Paul and Lance Taylor, "ContractionaryEffects of
Devaluation",Journal of InternationalEconomics,August 1978,
pp. 445-56.
(34)
Lucas, Robert E., Jr., "Expectationsand the Neutralityof Money",
Journal of Economic Theory, April 1972, pp. 103-24.
(35)
McDonald, Donogh C., "Debt Capacity and DevelopingCountry
Borrowing: A Survey of the Literature",InternationalMonetary Fund
Staff Papers, Washington,D.C., December 1982, pp. 603-46.
(36)
McKinnon, Ronald I., Money and Capital in Economic Development,
Washington,D.C., 1973.
(37)
Polak, Jacques J., "MonetaryAnalysis of Income Formation and Payments
Problems",InternationalMonetary Fund Staff Papers, November 1957,
pp. 1-50; reprinted in InternationalMonetary Fund, 1977.
(38)
Robichek, E. Walter, "FinancialProgrammingExercises of the
InternationalMonetary Fund in Latin America", address to a seminar
of Brazilianprofessorsof economics,Rio de Janeiro, mimeo,
September 1967.
(39)
Robichek, E. Walter, "FinancialProgramming: Stand-ByArrangements
and StabilizationPrograms", InternationalMonetary Fund, Washington,
D.C., mimeo, January 1971.
(40)
Sargent,Thomas J. and Neil Wallace, "Rational Expectations,the
Optimum Monetary Instrument,and the Optimal Money Supply Rule",
Journal of Political Economy,April 1975, pp. 241-54.
(41)
Selowsky,Marcelo, and Herman van der Tak, "The Debt Problem and
Growth", World Bank, Washington, D.C., mimeo, 1986.
(42)
Sen, Amartya K., "Development: Which Way Now?", Economic Journal,
December 1983, pp. 745-62.
(43)
Williamson,John H., "Payments Objectivesand Economic Welfare",
InternationalMonetary Fund Staff Papers, November 1973, pp. 573-50.