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Structural Adjustment
CHAPTER 23
Reinert/Windows on the World Economy, 2005
Introduction

In a fixed exchange rate regime, an overvalued domestic
currency (Mexican peso or Ghanaian cedi) is associated
with an excess demand for foreign currency (US dollar or
EU euro)
 This excess demand for foreign currency is often met by the central
bank drawing down its foreign reserves
• However, the drawing down process is not sustainable



Can result in a balance of payments crisis
In most circumstances, the International Monetary Fund
(IMF) stands ready to assist member countries in dealing
with such balance of payments crises
If this assistance involves the member country’s moving into
its upper credit trances (which it almost always does), the
IMF imposes policy conditionality on its loans
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Introduction


Beginning in the 1980s, the World Bank began structural
adjustment lending to countries facing balance of payments
difficulties
 Also imposing policy conditionality in the process
Developing countries with balance of payments crises
caused by fixed exchange rates or changes in global
economic conditions face structural adjustment under the
supervision of IMF and World Bank
 Effectiveness of these structural adjustment programs has been
source of a significant amount of disagreement among international
economists

Chapter develops your understanding of structural
adjustment
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Traded and Non-Traded Goods

Imagine that you are an international economist advising the
Ghanaian government on their approach to structural
adjustment.
 Need to simplify the complexities of the adjustment processes to
clarify your own thinking and to communicate with government
representatives
 Useful first step is to distinguish between traded goods and nontraded goods
 In the Ghanaian context, you might imagine the following
Traded Goods
• Petroleum
• Gold
• Cocoa
• Food
Non-Traded Goods
• Tailoring
• Auto repair
• Education
• Health Services
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Differences Between Traded
Goods and Non-Traded Goods

Prices of traded (non-traded) goods are determined in world (domestic)
markets
 For Ghana the price of petroleum is a world price denominated in US dollars
 The price of tailoring, on the other hand, is a domestic price, denominated in
cedis



For traded goods, domestic consumption and domestic production can
differ in value, causing a trade surplus or deficit
However, domestic consumption and domestic production of non-traded
goods must be exactly the same in value
Can represent the supply side of this economy with a production
possibilities frontier (PPF)
 Depicts the combinations of output of traded goods and non-traded goods
that the economy can produce given its available resources and technology

Given the available resources and technology, Ghana can produce
anywhere on or inside the PPF
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Table 23.1. Traded Goods vs.
Non-Traded Goods
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Figure 23.1. Ghana’s PPF
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Internal and External Balance
Internal balance
 All resources are efficiently employed
 External balance
 Consumption and production of tradable goods

are equal
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Figure 23.2. Internal and
External Balance
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Figure 23.3. External Imbalances
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External Imbalances
If consumption is at CTD, consumption of
traded goods exceeds production of traded
goods along vertical axis
 Implies Ghana has a trade deficit
 If consumption is at CTS, production of traded
goods exceeds consumption of traded goods
along vertical axis
 Implies Ghana has a trade surplus

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Figure 23.4. A Current Account
Deficit
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A Current Account Deficit
If inflows on capital account begin to
disappear, difficulties arise
 Suppose direct and portfolio investment
decline (foreign savings falls)
 Still possible for Ghana to maintain its current

account deficit by drawing down its foreign
reserves
• However, this situation is not sustainable

Can last only as long as the central bank has foreign
reserves to sell
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A Current Account Deficit

What could you advise Ghana to do?
 Recognize that external imbalance problem comes from
the demand for tradable goods being too high
• Suggest that Ghana engage in demand reduction to reduce the
demand for tradable goods
• Significant limitation--demand reductions typically cannot be
confined to traded goods alone


In most instances, demand falls for both traded and non-traded
goods
External balance adjustment via demand reduction
has been achieved at the expense of internal
balance
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Figure 23.5. Adjustment via
Demand Reduction
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Implementation of Demand
Reduction Policies

Economist Francis Stewart (1995) studied
the ways in which demand reduction policies
have been implemented in many countries of
the world and their impacts on the poor in
those countries
 Her conclusions
• Demand restraint has unambiguously negative effects
on the poor

Demand-reducing policies include
 Cuts in government expenditure
 Rises in taxation
 Reductions in real wages and credit restraint
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Implementation of Demand
Reduction Policies

What else could you suggest to the
Ghanaian government?
 In principle at least, a country can achieve
external balance and maintain internal balance
• The key according to economist Max Corden (1986) is
To have two instruments as the demand reduction instrument
is not enough
 Also need a switching policy
 Implemented by a change in the nominal exchange rate

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A Current Account Deficit

Devaluation or depreciation of the domestic currency
causes an increase in the domestic (cedi) prices of both
imports and exports
 If Ghana were to devalue the cedi, there would be an increase in the
relative price of tradable goods or a decrease in the relative price of
non-tradable goods resulting in
• Increased incentive to produce traded goods
• Decreased incentive to consume traded goods




Both effects tend to reduce the trade deficit
Ghanaian firms switch their production towards traded
goods
Ghanaian consumers switch their consumption away from
traded goods
A successful adjustment program must combine both
demand reduction and switching elements
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Figure 23.6. Adjustment via Demand
Reduction and Switching
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The Structuralist Critique

Structural economists argue that we must account
for structural diversity of developing economies
undergoing balance of payments crises and
adjustment programs
 Productive resources may not be mobile between sectors
• For instance, certain barriers can prevent productive resources in
Ghana from moving freely to the traded sector from the nontraded sector

Urban workers in the non-traded sector might face a number of
barriers (e.g. culture and family ties) to relocating to rural areas to
increase the supply of agricultural products
 Domestic production may be highly dependent on
imported intermediate and capital goods
• Devaluation of the cedi raises domestic prices of these traded
goods
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The Structuralist Critique

Demand reduction can include lost productive
investments
 Often achieved by reducing government expenditures
• However some government expenditures may be necessary to
support private investment and production
• In the structuralist view, public and private investments are
complementary

Adjustment often takes place under negative
foreign savings (capital outflows or capital flight)
 Not simply a matter of regaining external balance but of
generating a trade or current account surplus to
accommodate a capital account deficit
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Figure 23.7. Adjustment Under
Resource Immobility
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Structuralists’
Recommendations

Depends on the country in question—however,
generally structuralists would call for
 Measures to ensure that key productive investments are



not sacrificed in demand reduction
Import quotas and export subsidies to reduce trade
deficits in order to require lower nominal exchange
rates—preventing inflation and poverty problems
Government involvement in allocating scarce foreign
exchange
Foreign debt forgiveness to prevent the necessity of
generating large trade surpluses
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The Order of Economic
Liberalization

Typically, adjustment programs designed by IMF and World
Bank include a number of kinds of market liberalization
 Exchange rate depreciation or devaluation
 Reductions in government expenditures
• Including reduction in public sector workforces, elimination of agricultural
and industrial subsidies, and elimination of food and medical subsidies

 Wage controls to reduce demand and to prevent inflation
 Elimination of import quotas and export taxes
 Reduction of ad valorem tariffs to “moderate” levels of 10-15%
 Privatization of state-owned enterprises
 Liberalization of domestic financial markets
Has been a tendency for the IMF and World Bank to call for
the implementation of the above components all at once
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The Order of Economic
Liberalization—Ghana

Suppose that Ghana faces a balance of payments crisis
such as that described in the previous sections
 Financing the current account deficit by selling foreign exchange
reserves
 Central government is running a deficit

Additionally, suppose
 Government owns some enterprises on which it depends for some
revenue
 Government restricts imports using a set of quotas
 Exchange rate is fixed

How should the steps Ghana will take in alleviating the
balance of payments crisis and securing sustainable
adjustment be ordered?
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The Order of Economic
Liberalization—Ghana

First: Seek a means of securing central government
revenue through a broad-based tax
 Government accounts are in deficit
 Government may be called upon to lower trade taxes and sell its
enterprises
• Will involve a loss of revenue sources—alternative revenue sources
must be found



Possible sources are sales taxes, producer taxes, or value-added taxes
 Should be broad-based and set at low rates
Increase in tax revenues will lower the government deficit and
 Tend to narrow the gap between domestic investment and domestic
savings
 Position the government for further reforms without precipitating a fiscal
crisis
Second: Depreciate or devalue the exchange rate
 Begins a switching process
• Imports are reduced and exports can expand

Tend to reduce the current account deficit
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The Order of Economic
Liberalization—Ghana

Third: Tariffy quotas on imports of consumer goods and
remove quotas on imports of intermediate and capital goods
 Causes a quota premium equal to amount by which domestic price
of the good increases above world price as a result of quota
 Converts quota rents into government revenue
• Helps alleviate the government’s budget deficit
 Removal of quotas on intermediate and capital goods will ensure that
these goods are available to domestic producers
• Tend to lower the domestic prices of the goods, offsetting the effect of
•

exchange rate depreciation and addressing structuralist concerns about
declining production
Any tariffs on these goods should be set very low
Fourth: Selectively begin to privatize government-owned
enterprises
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The Order of Economic
Liberalization—Ghana

Fifth: Liberalize the foreign direct investment
component of the capital account
 Edwards (1984) concludes capital account should be
liberalized only after current account is liberalized
• Capital account can be divided into


Direct investment
 Ownership and control of physical capital
Portfolio investment
 Ownership alone of government bonds, corporate equities,
corporate bonds, and bank deposits
 Long-term
 Short-term
 Tends to be highly volatile
 Makes sense for a country to begin liberalization of the
capital account with direct foreign investment
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The Order of Economic
Liberalization—Ghana

Sixth: In preparation for an eventual
liberalization of the domestic financial
industry and the capital account, develop an
effective system of bank regulation
 Banks in developing countries
• Predominate the provision of financial services
• Pose the most serious threat to financial stability due
•
to their inherent instability
The prevention of financial crises requires a welldeveloped system of banking supervision

Pay attention to capital adequacy requirements, auditing,
loan policies, and degree of foreign borrowing
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The Order of Economic
Liberalization—Ghana

Rodrik (1990) argues that, where a conflict between
idealized adjustment policies and the economic and
political sustainability of these policies exists
 Idealized policies must be compromised
• Welfare benefits of liberalization policies such as privatization
and the removal of trade restrictions must be weighed against
potential costs in terms of sustainability
 Introduced a distinction between the range and the
magnitude of policy reform programs
• Range relates to the number of areas in which reforms are to
take place
• Magnitude refers to the degree of change in any particular policy
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Figure 23.8. Range and Magnitude in
Adjustment/Liberalization
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Adjustment and Development

Ghana has been participating in a structural
adjustment process since 1983
 However, Ghana’s health and education statistics and

human development overall are disappointing
What do you, as an advisor to the Ghanaian government
make of this?
• Adjustment involves restructuring domestic production away from
non-traded goods and towards traded goods


For non-traded goods such as tailoring and auto repair, this is
perhaps no great loss
For non-traded goods such as education and health services,
however, the future human capital of the country is compromised
 In turn, compromises long-run growth
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Adjustment and Development


The challenge is to help the government achieve
adjustment without sacrificing productive human
investments that are essential for long-run growth
and development
Additionally, productive government investments
that are complementary to private investment must
also be maintained where possible
 Otherwise, adjustment will be achieved at the expense of
development
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