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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 Reinert/Windows on the World Economy, 2005 2 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 Reinert/Windows on the World Economy, 2005 3 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 Reinert/Windows on the World Economy, 2005 4 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 Reinert/Windows on the World Economy, 2005 5 Table 23.1. Traded Goods vs. Non-Traded Goods Reinert/Windows on the World Economy, 2005 6 Figure 23.1. Ghana’s PPF Reinert/Windows on the World Economy, 2005 7 Internal and External Balance Internal balance All resources are efficiently employed External balance Consumption and production of tradable goods are equal Reinert/Windows on the World Economy, 2005 8 Figure 23.2. Internal and External Balance Reinert/Windows on the World Economy, 2005 9 Figure 23.3. External Imbalances Reinert/Windows on the World Economy, 2005 10 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 Reinert/Windows on the World Economy, 2005 11 Figure 23.4. A Current Account Deficit Reinert/Windows on the World Economy, 2005 12 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 Reinert/Windows on the World Economy, 2005 13 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 Reinert/Windows on the World Economy, 2005 14 Figure 23.5. Adjustment via Demand Reduction Reinert/Windows on the World Economy, 2005 15 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 Reinert/Windows on the World Economy, 2005 16 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 Reinert/Windows on the World Economy, 2005 17 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 Reinert/Windows on the World Economy, 2005 18 Figure 23.6. Adjustment via Demand Reduction and Switching Reinert/Windows on the World Economy, 2005 19 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 Reinert/Windows on the World Economy, 2005 20 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 Reinert/Windows on the World Economy, 2005 21 Figure 23.7. Adjustment Under Resource Immobility Reinert/Windows on the World Economy, 2005 22 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 Reinert/Windows on the World Economy, 2005 23 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 Reinert/Windows on the World Economy, 2005 24 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? Reinert/Windows on the World Economy, 2005 25 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 Reinert/Windows on the World Economy, 2005 26 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 Reinert/Windows on the World Economy, 2005 27 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 Reinert/Windows on the World Economy, 2005 28 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 Reinert/Windows on the World Economy, 2005 29 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 Reinert/Windows on the World Economy, 2005 30 Figure 23.8. Range and Magnitude in Adjustment/Liberalization Reinert/Windows on the World Economy, 2005 31 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 Reinert/Windows on the World Economy, 2005 32 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 Reinert/Windows on the World Economy, 2005 33