Measures to Improve Resource Allocation

In recent years, countries undertaking Fund-supported adjustment programs have faced multiple supply-side problems, many of which have required detailed attention at the microeconomic level. As a result, Fund-supported programs have given increased emphasis to supply enhancement. While the problems that give rise to an inefficient allocation of resources tend to be both microeconomic in character and country-specific, the evidence surveyed suggests that in the case of developing countries misallocation of resources typically stems from one or more of the broad problem areas discussed below.⁸⁵ It will be evident that a number of the policies mentioned influence both the efficiency with which existing resources are utilized and the rate of return to new investments. Indeed, these outcomes are interrelated, as the rate of return on new investment may improve with better utilization of the existing capital utilization.

Policies to Increase the Rate of Economic Growth

Fund-supported adjustment programs place considerable emphasis on achieving external adjustment through policies that will ensure a satisfactory rate of economic growth over the longer term. Although a considerable increase in output can be achieved in the short term through more efficient and fuller utilization of existing resources, economic growth over the long term also requires an increase in productive capacity. This can come about through both a higher rate of investment and the choice of investments that yield a higher rate of return.

Increasing the Rate of Investment

In general, the goal of stimulating higher levels of investment, and thus higher output growth, has been implemented via measures to increase domestic saving.⁹⁰ Investment in developing countries is frequently constrained by the availability of savings, thereby giving policies that favor public and private saving a special importance in adjustment programs. For the public sector, this involves steps to improve the fiscal position, while the focus in fostering private saving has been on interest rate policy. Other factors strongly influencing investment are the state of confidence in the economy and the state of development of financial institutions.

In Fund-supported programs, interest rate policy is regarded as having a major influence not only on short-run adjustments of spending, inflation, and external payments but also on the longer-term accumulation of financial wealth and the level and composition of investment.⁹¹ The basic theory underlying interest rate policy as a means of increasing saving and investment can be illustrated using a simple diagrammatic analysis. In Chart 2, where the horizontal axis measures real private saving and investment and the vertical axis measures the real return on savings and the real cost of capital, the volume of investment (I) is assumed to be negatively related to the cost of capital (r). The total supply of funds available to finance domestic investment consists of domestic saving, S_D, plus available foreign savings, S_F (= ΔFIp). The horizontal sum of savings from the two sources, (S_D + S_F), is assumed to be an upward-sloping function of the real return.⁹² Both the investment and saving curves are drawn for a constant level of real income.

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Effects of Interest-Rate Policy on Private Saving and Investment

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Suppose that, as a result of a combination of domestic inflation and ceilings on interest rates, the real return on savings is initially equal to r₀. At this interest rate, the supply of savings that is available to domestic private investors from both domestic and foreign sources is equal to OD, while the desired demand for funds by private investors is equal to OC. Since the amount of private capital formation that can actually be undertaken is constrained by the supply of savings, the interest rate ceilings imply that the economy will be continuously at point A, where the actual level of fixed capital formation is equal to the amount of savings that is available at that interest rate, and there is a continuous excess demand for investment funds equal to DC. Domestic saving is equal to OF, and the private sector’s current account deficit is equal to FD. If interest rate ceilings were eliminated, the equilibrium in the domestic market for savings would occur at some real interest rate r_e above r₀ and, to the extent that the supply of either domestic or foreign savings is interest-elastic, ex ante saving would increase. The new equilibrium at E would involve both a higher real domestic interest rate, r_e, and a higher equilibrium level of both saving and private sector investment, OH. The private sector’s current account deficit would rise from FD to GH, but this larger deficit is now a reflection of a higher level of private domestic investment, financed by foreign capital inflows, rather than a low rate of saving. This analysis suggests that elimination of distortions in the market for financial savings would be expected to yield significant gains in terms of a higher rate of domestic private fixed capital formation, and therefore a more rapid rate of growth of capacity output.

Fund members have adopted a broad spectrum of policies relating to the control of interest rates and the regulation and supervision of their financial systems. While some members have recently been reducing regulations in the financial system and have begun to rely on market-determined interest rates to clear financial markets, others have established extensive controls on interest rates and other aspects of financial market behavior. These restrictions have been motivated by a variety of factors including the desire to influence the flow of credit among sectors of the economy and the concern that market-determined interest rates would produce serious imperfections. For example, it has been argued that such imperfections would arise because domestic financial markets are “thin” in the sense that they have an oligopolistic or monopolistic structure. In this situation, freeing interest rates from controls would lead to sharply higher loan rates that would increase the cost of capital and thereby discourage investment. Moreover, high nominal interest rates would also increase the cost of servicing government debt. There could also be adverse effects on the distribution of income, especially if holdings of financial instruments are narrowly distributed.

In many cases, such controls have resulted in high negative real rates of interest—defined as the nominal interest rate adjusted for anticipated inflation—on domestic financial instruments for extended periods, at least in regulated financial markets.⁹³ In such instances, the real holdings of domestic financial assets have often grown less rapidly than the real economy, and capital flight has tended to be a serious problem.⁹⁴ When such developments occur, they can severely restrict the availability of real credit and thereby inhibit investment. Since available credits are often first allocated to large enterprises, credits for small and medium-sized firms may be severely rationed, even though their investments may yield a higher rate of return. To increase the availability of real credit, interest rate policy could be used to encourage the accumulation of domestic financial assets by offering holders of these assets a sufficiently attractive return. At the same time, other structural reforms could be undertaken to increase the efficiency of the financial system.⁹⁵ Among such steps might be the liberalization of regulations impinging on existing financial institutions and, where appropriate, support for broadening the range of financial instruments and institutions available to the public. A well-developed financial sector is crucial both for mobilizing financial saving and for efficiently channeling such saving into productive investment.

The above considerations indicate why raising real interest rates on domestic financial instruments is a key element in Fund-supported adjustment programs. In setting the level of nominal interest rates, considerable judgment must be exercised regarding the future course of inflation during the program. Establishing the perception that holders of domestic financial instruments will earn positive real returns that are to some degree competitive with the real yields that can be obtained on comparable foreign instruments appears to be a vital element in promoting balance of payments adjustment, preventing capital flight, and strengthening domestic saving. If such a return is paid to holders of domestic deposits, however, then loan rates must also be set at a level sufficient to ensure that efficient financial institutions, both private and state-owned, at least cover their operating costs. The spreads between lending and deposit rates tend to be relatively large in most developing countries for a variety of reasons, including high required reserve ratios, a limited degree of competition in the financial system, low productive efficiency of financial institutions, and selective credit and interest controls that require these institutions to undertake a substantial amount of concessionary lending. Financial reforms that reduce reserve ratios or lead to greater efficiency in the financial system can help reduce these spreads.

Any changes in interest rates and other financial reforms must be coordinated with the other policy actions that are a part of the stabilization program. The experiences of a number of developing countries with financial reforms suggest that this coordination is especially important during the early phases of the stabilization program. In particular, certain combinations of policies can potentially be a source of instability for a financial system undergoing major structural change. For example, if a large fiscal deficit is being financed through extensive issuance of central bank credit to the government, then there is likely to be little scope for interest rate policy or a financial reform program.⁹⁶ The rapid monetary growth and inflation that would be associated with such a fiscal deficit could potentially lead to sharp changes in the flows of funds in and out of the financial system as well as between different types of financial institutions. Until the fiscal accounts can be brought under control, major financial reforms may best be deferred.⁹⁷

Perhaps even more fundamental is the need for sound financial policies to create an atmosphere of confidence in the future of an economy and its management. Without such confidence, savings will tend to be transferred abroad and private investors will postpone or cancel domestic capital investments. One of the unfortunate consequences of weak confidence is that domestic interest rates must be raised to extremely high real levels to avoid capital flight; but at such levels, borrowing for productive purposes is discouraged and economic activity is dampened.

Interest rate policy must also be coordinated with exchange rate policy to avoid problems with capital flows. Although many member countries have restrictions on external capital movements, holdings of foreign assets and liabilities have nonetheless become important components of resident portfolios in a number of these countries since the 1970s. Moreover, while the linkages between domestic and international financial markets are often imperfect, significant differences in the perceived yields on domestic and foreign instruments have at times stimulated periods of capital inflows or capital flight. In this context, the relevant yield on foreign instruments would equal the foreign interest rate adjusted for anticipated changes in the exchange rate between the domestic currency and the currency in which the foreign instrument is denominated. Interest rate and exchange rate policies therefore have the potential to sharply alter the relative yields on domestic and foreign financial instruments. For example, the initial phase of a stabilization program could involve an increase in domestic interest rates (e.g., to stimulate savings) and a significant depreciation of the exchange rate (e.g., to improve the current account balance). If the initial exchange rate depreciation is viewed as reducing or eliminating the need for further exchange rate adjustments, then these interest rate and exchange rate changes may make domestic assets quite attractive relative to foreign assets and make foreign credits appear relatively less expensive. The resulting capital inflows (which could involve repatriation of holdings of foreign assets by domestic residents) could result in a significant expansion of reserve money as the central bank intervenes to maintain the exchange rate. Such monetary growth could create strong inflationary pressure, which could seriously destabilize any financial reform.

While these potential problems make specifying the initial increase in interest rates a difficult issue, they should not be viewed as justification for maintaining high negative real yields on domestic financial instruments and an inefficient financial system. Although circumstances at the beginning of a Fund-supported program may warrant a sharp increase in administered interest rates, an excessive increase in rates could affect investment and create problems with capital flows. In such a situation, it may be useful to adjust interest rates to the rate of inflation that is anticipated to prevail as the new stabilization and financial reform policies take hold, rather than to the current rate of inflation. For this to be successful, however, the public would have to believe that the authorities were committed to carrying out a program based on realistic objectives. If such a perception were established, then the maintenance of positive real yields on domestic financial instruments would strengthen domestic savings and the financial system.⁹⁸

Supply-Side Policies and the Period of Adjustment

Whatever the supply-oriented measures that are being implemented in the context of a Fund-supported adjustment program, substantial time may be needed for such policies 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. It is difficult for such major adjustments to occur smoothly without a short-term impact on the level of output and employment. In addition, in developing countries the goal of achieving more efficient resource allocation may often conflict with that of reducing the current account deficit in the short run. Since developing countries import a large proportion of capital goods, programs that place a greater emphasis on supply-oriented measures frequently take a different view of the objectives regarding the current account in the early years of the adjustment program than do programs that aim primarily at controlling excess aggregate domestic demand. In particular, to the extent that major adjustments in aggregate domestic supply require an initial rise in the level of domestic investment, reductions in current account deficits are not necessarily sought in the early years of programs. In these cases, adjustment programs have on occasion allowed for an initial increase in the current account deficit to reflect higher imports of essential inputs and investment goods. This would be necessary, for example, where a rise in export processing activity is being planned and an initial increase in imports must be financed before the corresponding export earnings are realized.

These considerations also influence, and are influenced by, the relative importance in the program of improving the growth rate of output over the medium term. Although measures to improve output from currently available resources may also take time to achieve results, those to generate growth in usable productive capacity may take even longer. While the results of the first type of measures to some extent provide breathing space until the second type takes hold (see pages 10-11), it is nevertheless true that a program with a strong growth orientation may also involve larger amounts of financing over a longer period than a program in which a shorter time horizon is appropriate.

Availability of Exchange Rate Adjustment as a Policy Instrument

A long-standing debate in the economic literature concerns the proposition that the easiest and most logical means for dealing with an external imbalance that can (or should) no longer be financed is to allow the exchange rate for the domestic currency to be determined in the market, that is, to float.⁹⁹ Against this proposition it has been argued that foreign exchange markets for the currencies of many developing countries are too thin to prevent excessive volatility of exchange rates and that for small open economies a reasonable degree of exchange rate stability is a necessary condition for financial stability generally.¹⁰⁰ Ever since the onset of widespread floating of major currencies in 1973, the Fund has not taken a rigid view as to the exchange arrangement adopted by a member, so long as timely measures of a nonrestrictive nature are taken to maintain the needed degree of international competitiveness of the traded goods sector.

In determining the proper role for exchange rate adjustment in a particular adjustment or stabilization program, the special characteristics of the member country need to be taken into account. Countries that are members of a currency union or have a strong tradition of maintaining a fixed link with another currency will generally choose to use policy instruments other than the exchange rate to carry out necessary adjustments, often with negative effects both on the speed of adjustment and the cost of adjustment in terms of lost output. It may nevertheless be felt that the long-term advantages of the currency union or fixed currency peg outweigh these costs of adjustment, especially when the currency is linked to that of a country with stable financial conditions. Another type of country where exchange rate adjustments may be regarded as running counter to the established policy framework is that with a centrally planned economy, where the tendency is to deal with internal or external imbalances through revisions in the plan, rather than through changes in price incentives to producers and consumers. In this instance, the emphasis finally laid upon exchange rate policy reflects the willingness of the authorities to modify the system of economic management in favor of one relying more on decentralized decision making and price incentives.

At the other extreme from countries with an established tradition of fixed exchange rates are high-inflation countries where continual exchange rate adjustment is built into the economic system. Indeed, exchange rate changes can be regarded in some cases as merely a particular type of indexation. For these countries, the key decision is at what rate the domestic currency should be depreciated; this depends on a number of considerations, especially the policies being simultaneously carried out with respect to the interest rate, fiscal policy, and domestic credit expansion.

Between these extremes are countries with varying degrees of exchange rate flexibility. Closely related to the degree of exchange rate flexibility are varying degrees of willingness on the part of the monetary authorities to permit prices and trade flows to be determined by market processes; to foster financial institutions that are both free and competent to adjust interest rates in line with market conditions; and to allow market participants to engage in a wide range of both spot and forward exchange transactions. Such a system has the advantage that it avoids large swings in international reserves and domestic liquidity—provided, of course, that inflationary financial policies are avoided.

When the authorities are reluctant to use exchange rate adjustments as an expenditure-switching device they have at their disposal only two types of options to influence the relative prices of domestic and foreign goods: government intervention in the exchange and trade system and demand-management policy. Both alternatives are in most circumstances inferior to exchange rate adjustments: the first, because unless very carefully administered it leads to distorted prices among traded goods, and the second, because bringing down the price level, or lowering the rate of inflation, can be slow and difficult and may entail reduced output and employment. Yet in a number of countries fixed exchange rates, whether inside or outside a currency union, are seen as yielding large benefits in terms of such factors as investment confidence, avoidance of capital flight, encouragement of foreign trade, and provision of a stabilizing influence on domestic demand-management policies. In a related case, where an effort is being made to bring a high rate of inflation to a halt through currency reform and related measures, fixing the exchange rate for a specified period may be necessary to support temporary general freezes on prices and wages.

For countries that are members of currency unions, the use of exchange rate adjustment as a policy instrument is literally not considered as an option, except on the rare occasion when membership in the currency union is itself being reconsidered. In certain other countries, however, exchange rate adjustments may be complicated by what might be described as involuntary de facto membership in a currency union, namely through “currency substitution,” or the widespread use of foreign currency (or other forms of money) as a payments and accounting medium for domestic transactions. Currency substitution can create serious problems of monetary control and in other ways also complicate the formulation of adjustment policies.¹⁰¹

Analytical Aspects of Exchange Rate Policies

The main theoretical aspects of devaluation have been discussed at considerable length in the literature,¹⁰² and for the case of a small country that cannot alter its terms of trade, a graphical analysis adapted from Khan and Knight (1982) can be used to illustrate both the demand-side and supply-side effects of exchange rate adjustments.

In Chart 3 the vertical axis measures the domestic currency price of output, P, and the horizontal axis measures the quantity of real output demanded and supplied by domestic residents, Y. The S_L curve represents the amount of real output that domestic producers would be willing to supply in the long run at each price level, given their existing stock of capital, labor and other factors of production.₁₀₃ Real domestic demand, D, is a downward-sloping function, reflecting the fact that an increase in the price of output reduces the real values of both factor incomes and financial assets.₁₀₄ With the world price level (in domestic currency) equal to P_o(= e_oP_F), the country produces S_o and aggregate domestic demand is D₀, so that there is excess real aggregate domestic demand equal to D₀-S₀ and a current account deficit equal to P₀(D₀ — So) in terms of domestic currency and (P_o/e_o)(D_o — S₀) in terms of foreign currency. The devaluation increases the world price level, in domestic currency terms, to P₁. The main demand-side effects are a reduction in real wealth and expenditure owing to the fall in the real value of financial assets, an increase in the domestic price of tradable goods, and a reduction in real wages. For these reasons, devaluation decreases domestic demand in Chart 3 to a point like C. This move to C thus represents the expenditure-reducing effect of devaluation.

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Effects of a Devaluation

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On the supply side, however, the effects of the devaluation tend to be expansionary. To the extent that the prices of domestic labor, land, and capital rise less than proportionately to the domestic currency price of final output in the short run, devaluation has a temporary stimulative impact on aggregate supply, and real output initially rises along the short-run supply curve, S_o. In this case, both the aggregate demand and aggregate supply effects of the devaluation tend to reduce excess domestic absorption and the payments deficit. Since foreign demand for domestic output is infinitely elastic at the price level P₁, the short-run effect of the devaluation in the example of Chart 3 is to turn the current account (in real terms) from an initial deficit of D_o — S_o to a surplus of S₁ — D₁. Over time, as nominal factor prices gradually rise, output will tend to move back toward its equilibrium level on the long-run supply curve, S_L. At the same time, the gradual rise in real factor incomes, together with the increase in financial assets resulting from the payments surplus, will cause aggregate real domestic demand to shift gradually outward toward the long-run curve D′, reducing the excess supply of domestic goods and the current account surplus. As a result of these changes in demand and supply, the effects of devaluation on the current account will gradually diminish, until the two curves intersect at point F, where demand-supply balance exists in the domestic economy and the current account is in equilibrium, albeit at a higher price level.

The above analysis is, of course, standard, and it is perhaps useful to describe in some detail the role of price incentives, as they are such a crucial part of the adjustment process. It is often argued with respect to developing countries that, for certain kinds of exports or import-substituting production, relative prices are not important, at least not in the short run. For example, it is sometimes maintained that where the prices of agricultural exports are controlled by the government and where the quantities produced are either invariant in the short run or, in the longer run, are limited by factors of production that are in fixed supply, a change in the exchange rate has no effect on exports.¹⁰⁵ While it is true that increased production of certain commodities may require additional inputs (e.g., water through irrigation) that cannot be provided by the producers themselves, this in no way changes the conclusion that decisions (by either government or private individuals) regarding the desirable level of production cannot be made without the relevant decision makers being faced by a set of relative prices that reflect the true economic costs and returns to the society. As for the issue of government price controls, the government itself cannot be indifferent to a misalignment of prices of tradables and nontradables that requires a growing subsidy to (or declining revenue from) producers; a fall in the relative domestic price of exports (owing, for instance, to domestic inflation and a fixed exchange rate) will eventually force the government to pass on a part of the price change to producers, who may then decide to shift their effort into subsistence food production or even leisure. As for the analogous argument made on the import side, namely, that when imports are controlled directly, exchange rate changes do not control the volume imported, recent experience in a number of countries has shown that controls and misaligned prices breed black market operations, and, moreover, that economies formerly self-sufficient in food production can, when imported food becomes progressively cheaper, become increasingly dependent on imported foodstuffs.

If it is established that the alignment of relative prices is inappropriate, say, because of the existence of an unsustainable current account balance, it is possible to correct the 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 deflationary policies designed to force down domestic prices and wages, which in most countries are resistant to downward changes without substantial falls in output. In some cases, where price misalignment has occurred through exogenous exchange rate movements—for instance, an effective appreciation of the major currency to which the domestic currency is pegged—exchange rate action is again the obvious means of restoring a correct alignment. Indeed, a number of countries now maintain exchange rate regimes that are designed to make such corrections more or less automatically, either by pegging to a trade-weighted basket of other currencies or by frequently adjusting the exchange rate for the domestic currency according to a formula that takes into account foreign and domestic inflation.

While it is generally accepted that exchange rate adjustment is the simplest way of restoring a previously existing alignment of domestic and foreign prices that had changed because of domestic inflation or exchange rate movements among other currencies, it is more difficult to decide to what extent exchange rate policy should bear the burden of external adjustment that has become necessary for other reasons, such as long-run changes in the terms of trade, a change in net capital inflow, or a permanent decline in domestic resources associated with traditional export commodities. There are long-standing concerns that a devaluation has avoidable contractionary effects on output, as well as inflationary effects on prices—the latter tending to occur especially in situations where either a large initial exchange rate adjustment appears to be called for, or where a continual fall in the value of the domestic currency contributes to inflationary expectations. In considering the role of exchange rate policies in these contexts, one must in general compare the impact of alternative policy packages, which may or may not include an exchange rate adjustment.¹⁰⁶

The fact that exchange rate adjustments may have both desirable and undesirable short-term effects has led some countries to establish a dual exchange rate system, under which selected transactions take place at an “official” exchange rate maintained by intervention of the monetary authorities; remaining transactions take place at a “free” or “parallel” exchange rate, which is usually determined by market forces and is in most cases more depreciated than the official rate. A dual exchange market may also enable the authorities to increase revenues from the foreign exchange profits of the central bank. Nevertheless, such a system creates additional complications in the design of adjustment programs, and because of the administrative problems and price distortions arising from a dual exchange system, Fund-supported adjustment programs generally specify the eventual unification of exchange markets.¹⁰⁷

Determining the Desirable Extent of Exchange Rate Adjustment

The task of determining the degree of exchange rate change required, in conjunction with other policies, to achieve a given amount of adjustment in the balance of payments, is extremely complicated. In the first place, it is not just merchandise imports and exports that are affected by a change in exchange rates; in many countries, large changes in flows of private capital, workers’ remittances and other invisible transactions may result. Moreover, it may be difficult to predict the impact of an exchange rate adjustment on all types of external transactions if the previous misalignment was so large as to encourage a sizable parallel market. Finally, the results may be yet more uncertain if the policy package includes liberalization of the foreign trade and payments system. In view of these problems, it is not surprising that the move to an appropriate exchange rate is often accomplished gradually and by utilizing to some degree market forces. Where a parallel market existed before the exchange rate adjustment, it may be maintained for a certain period or at least the rates previously prevailing in that market will be relied upon as an indicator of an appropriate “market-related” or “equilibrium” rate.

In many instances, however, there is reluctance to depend upon the market to determine an appropriate rate, and in any event one may wish to arrive at an independent judgment of what such a rate should be. It has become common practice in the Fund to base such judgments at least in part on indices of real effective exchange rates, based on some combination of export and import weights. These indices are especially useful when domestic rates of inflation have been considerably higher than those abroad; in such instances, broad judgments as to the range of necessary exchange rate correction can be reasonably sound. Two caveats are in order, however. First, one should beware of attaching an excessive degree of importance to relatively small changes in such indices. For example, there are instances when the temporary appreciation of the real effective exchange rate may be necessary to dampen inflationary pressures arising from a once-for-all inflow of foreign exchange.¹⁰⁸ Second, it should be realized that this index may be inferior to certain other indices as measurement, for example, of the “competitiveness” of the export sector of the country concerned. For countries whose chief exports are manufactures, an index of unit labor costs, relative to those of competitors and corrected by relevant exchange rates, would be a more accurate indicator. The real effective exchange rate is the principal index used for exchange rate analysis for most developing member countries chiefly because of data availability and comprehensiveness of coverage, not because of its superiority as an indicator of export competitiveness. In any event, the usefulness of any index is limited when it comes to judging what would be an appropriate level of the exchange rate, without additional information; usually, such judgments are based on determining that some past level of the rate was correct and setting up that past level as a target, but such reasoning is in danger of falsely estimating the influences of economic events that have occurred in the meantime.

A more sophisticated approach to exchange rate analysis is to estimate import demand and export supply equations for the country in question, and to use the resulting elasticities to arrive at that exchange rate which will produce the desired changes in foreign trade flows. Where the data availability makes such an approach possible—and it is not possible for a large number of developing countries—it does provide a more accurate idea of the appropriateness of a particular change in exchange rates than does use of the real effective exchange rate index. Nevertheless, this technique is open to the criticism that it takes a partial equilibrium view of the economy and that ultimately the correct level of the exchange rate cannot be determined without taking a general equilibrium view, that is, examining the interaction between the exchange rate and the other principal macroeconomic variables, all of which are being simultaneously affected not only by the exchange rate itself but also by the other policy actions that are part of the stabilization program. The impact of exchange rate adjustments on domestic inflationary pressures is an important example of these interrelationships.

In attempting to estimate the correct size of an exchange rate adjustment, the time element must also be taken into account. There is no presumption that imports and exports will respond instantaneously to changes in relative prices, income, or other relevant variables. The lags in trade relationships could arise as a result of lags in recognition, decision making, delivery, replacement, and production. Gauging the pattern and length of such time lags is important not only for obtaining forecasts of imports and exports but also for evaluating many policy issues related, for example, to changes in tariffs, exchange rates, and so on.¹⁰⁹

One approach to incorporating lags in trade equations is to employ the error-learning or partial-adjustment model that was discussed in the context of the demand for money. However, in contrast to the modeling of money demand, such models may not be realistic when used to estimate the dynamic behavior of imports and exports for a variety of reasons. First, the error-learning models assume that the largest effect of any change in the explanatory variables occurs in the first period. It could be argued, however, that the true lag effect in foreign trade relationships builds up gradually over time and declines after that. In other words, the appropriate lag pattern could have an inverted “v” shape rather than the steadily declining pattern emerging from the error-learning model. This becomes particularly important in the case of export supply functions. If, for example, a country is a primary producer, then a change in relative prices, brought about through, say, an exchange rate change, may only affect supply after a considerable lag.

Second, the error-learning model assumes that the lag in response of the dependent variable is the same irrespective of whether the change in imports or exports is due to variations in prices or in the scale variable. A number of writers have argued that the delayed response of imports and exports is likely to be quite different depending on the explanatory variable that initiates the response. While there appears to be some agreement that the effect of real income on imports and capacity on exports is largest in the initial period and declines rapidly thereafter, there is much less of a consensus on the proper distributed-lag pattern for price changes.

These two problems have led researchers to experiment with alternative lag structures;¹¹⁰ the timing issue in trade relationships is far from settled. The types of lags will depend, among other things, on the commodity composition of imports and exports, the capacity of the country’s productive sectors, port facilities, and so on. In other words, the lags will be country specific and generally have to be determined case by case, whether through econometric estimation or by use of other information.

Estimating the Impact of Exchange Rate Changes

For countries where a reliable macroeconomic model exists, with all the caveats with which such models are used for either forecasts or simulations, it would in principle be possible to simulate different combinations of exchange rate and other policy actions, in order to determine which combination would produce the best possible result in terms of external and internal balance. In practice, for Fund member countries such a procedure is hardly ever used, because the requisite model simply does not exist. The financial programming exercise described earlier in Section III provides a workable way of determining some of the principal results of policy actions being considered, and the consequences of possible exchange rate adjustments can be grafted, as it were, onto this framework.¹¹¹

To do so, it is necessary, first, to examine the interaction among the exchange rate, prices, and wages in the economy, in order to determine what are likely to be the repercussions of a change in the exchange rate for domestic prices and costs. This can be done by estimating the share of the prices of imported goods and services in whatever domestic price index (typically, the consumer price index) is being examined; by assuming that wages adjust by a particular percentage of the resulting change in the price index (the extent of such an adjustment may itself be a policy variable); and by using these initial estimates of changes in prices and wages to estimate the overall change in the price index resulting from the initial exchange rate adjustment. One will thus have a basis to determine what real effective exchange rate is likely to result from a given change in the nominal exchange rate.¹¹²

The proposed exchange rate adjustment and resulting price changes are then available for estimating the impact on the balance of payments. As mentioned above, such an estimate must employ whatever data and econometric analysis is available on price elasticities of import demand and supply of exports and import substitutes, and must also take into account the impact of previously existing parallel markets (in goods as well as foreign exchange) and of any planned liberalization of the trade and payments system. Furthermore, as already mentioned, the impact of an exchange rate adjustment (as well as the expectation of a continued active exchange rate policy) on private capital flows may be quite important in some countries but is extremely difficult to forecast. Finally, if a change in the official exchange rate is considered sufficient to rechannel through the official market transactions that were formerly conducted through illegal parallel markets and therefore not recorded, it will be necessary to modify the estimates by the expected amount of the previously unrecorded exports and imports moving through the official market.

The next step in integrating exchange rate projections with the financial programming model is to estimate the impact of the changes in exchange rate, prices, wages, and foreign trade (as described above) on government expenditures and revenue. In particular, close attention will have to be paid to the implications for expenditures of the price and wage adjustments (as regards the domestic component of expenditure) and of the exchange rate adjustments (for the foreign component). On the revenue side, as import and export taxes are typically an important—often, the most important—source of revenue, one can normally expect substantial movement arising both from the exchange rate adjustment and from the resulting changes in the volumes of imports and exports.

The last step in programming a simultaneous change in the exchange rate and in financial policies is to substitute the predicted changes in the balance of payments into the equation relating the change in domestic credit to the change in net foreign assets (equation (8)), thereby yielding, for a projected change in the demand for money, a particular value for the change in domestic credit. The desired change in money demand should, of course, itself be consistent with the changes in price level that are being targeted, given the size of exchange rate adjustment being attempted, and the predicted change in real output. If the resulting value for domestic credit does not seem reasonable, that is, if there is insufficient credit available for the private sector once the amount of credit going to the public sector has been determined, the assumptions with regard to other policy variables—especially exchange rate policy, fiscal policy, and wage policy—need to be examined and readjusted to come to a more consistent solution.

The type of programming exercise just described is complicated by the need to look at medium-term as well as short-term consequences: for example, the inflationary process linking exchange rate, prices, and wages is likely to take place over a period of months, if not years. Furthermore, as noted earlier, the combined impact of price and exchange rate changes on the trade balance is also subject to various lags. Associated with the programming problem is a policy issue, namely, whether it is better to make the required exchange rate adjustment in one step or to permit a certain portion of this adjustment to be made gradually over time in a series of small steps, after a large initial step. It is sometimes felt that a more gradual adjustment tends to soften the inflationary consequences; against this, there is the consideration that a front-loaded adjustment brings about a quicker change in the foreign trade balance. The choice of speed of adjustment is essentially a variant of the “gradualism versus shock” issue discussed in Section II. However, since there are ample reasons, already spelled out above, for considerable uncertainty as to the proper amount of exchange rate movement, it may be best at the start to make only the minimum amount of adjustment that is certain to be needed. Following that, further moves can be made in small stages, observing the results at each step, until the desired balance of payments adjustment has been obtained. Against this, however, it is sometimes argued that if a country is not willing to adjust the exchange rate frequently, one might wish to devalue by more than initially necessary to avoid the capital flight arising from the expectation of a further imminent devaluation.

Real Aspects of Debt Problems

At the most basic level the problem of determining the sustainable level of foreign borrowing is one of allocation of real resources over time and across countries. In terms of the monetary framework developed in Section III, the difference between domestic income (Y) and absorption (A) must be matched by an equivalent change in net foreign assets (ΔR) and changes in net external indebtedness (ΔFI), that is,

This subsection focuses primarily on the relationship between a country’s use of the net goods and services provided by nonresidents and the net external debt associated with these flows. For the present analysis the monetary authorities are combined with the rest of the economy so that the change in total foreign debt is defined as:

For developing countries there is a strong presumption that foreign savings can and should be utilized to augment the stock of domestic capital over and above what could be provided by domestic savings; in addition, short-term and medium-term borrowing (such as the use of Fund resources) may also be used to smooth the consumption path over time. This presumption in turn implies that the “normal” external position for a developing country would involve net inflows of goods and services from abroad, conventionally measured by the current account balance. Roughly speaking, the addition to the stock of net financial debt over time must contribute to the country’s ability to make payments to nonresidents; this is the fundamental relationship underlying the notion of sustainability. In the aggregate this means that the value of net exports of goods and services must increase sufficiently to pay nonresidents for the use of their savings without impairing the flow of imports required for supporting the full utilization of productive capacity.¹¹⁴

The analytical framework relevant to this question deals with the relationships among foreign and domestic savings, capital formation, and growth and has been extensively reviewed in publications by Fund staff.¹¹⁵ This framework, which is based on the “growth-with-debt” literature, focuses on the net exchanges of goods and services among countries, and its main lesson is that a country 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. The basis for paying the required rate of return is usually thought of as the increased output made possible by the additional real capital that can be accumulated with the aid of net foreign savings.¹¹⁶ To be sure, however, the ability to acquire foreign savings is limited by their availability, a circumstance partly exogenous and partly dependent on foreign perceptions of domestic economic developments.

While in theory it may be possible to calculate the sustainable level of net resource transfers, many of the theoretical determinants of these transfers, such as the rates of return on capital in different countries, are very difficult to quantify.¹¹⁷ Nevertheless, it is necessary to make approximations, and one useful way to summarize the relationship between debt and the capacity to service debt is to calculate ratios of debt to exports or debt to gross national product over time. There are, however, conceptual problems in defining the “sustainable” level of such ratios. If a country can profitably employ 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 profitably utilize foreign savings. The equilibrium level of such ratios will vary from country to country and for a given country over time. It has not proven possible, even after the fact, to measure the factors that would allow an accurate prediction as to what levels of the ratios would be sustainable.¹¹⁸

Perhaps the chief practical value of this framework is that it provides signals to the danger of situations in which debt can grow explosively. If an increment to external debt adds more to investment income payments than to the capacity to make such payments, the “error” implicit in obtaining these resources must be reversed through net exports of goods and services.¹¹⁹ If it is not, and conditions do not change, additional debt will be incurred to make payments, and debt will grow faster than debt service capacity. A shorthand way of stating this condition is that the “real,” that is, inflation-adjusted, interest rate paid on additional debt must be less than or equal to the expected “real” rate of growth in exports.

These relationships are illustrated in Chart 4. In this example, inflation is assumed to be zero; hence, real and nominal magnitudes are equal. At time t⁰ real exports are growing at a constant rate (g). Real debt (FD), shown in the second panel, is growing at a constant rate (d). Since real investment income payments (IY), shown in the third panel, are equal to FD times the real interest rate (r), which is constant, IY also grows at rate d. As long as g = d the ratio of investment income payments to exports, (IY/X), will remain at its initial value. A convenient way to ensure that g = d is to assume:

1. that trade in goods is balanced so that the real value of debt cannot change over time because of trade in goods;¹²⁰

2. that the real rate of interest on external debt, r, is equal to the growth rate of exports, g; and

3. that under these conditions the real current account deficit will be equal to IY = r FD and will grow at rate d. (This is shown in the bottom panel of Chart 4.)

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Growth Paths for Exports, Debt, Investment Income Payments, and the Current Account Balance

¹ All vertical axes are in log scale.

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In this special case, the growth in debt is matched by the growth in exports, and as long as r is constant, the ratios (IY/X) and (FD/X) will remain unchanged.

It follows that in cases where a country’s exports are expected to grow at the same rate as, or more rapidly than, the real rate of interest on its external debt, the outlook for a current account deficit is not a cause for concern. Nevertheless, a number of factors can change this outlook. For example, a change in the real rate of interest on external debt immediately alters these relationships. In Chart 4, the real rate of interest increases at time t₁. There is no immediate effect on FD or X, but IY jumps to IY’ and the ratio (IY/X) also increases proportionately.¹²¹ If the trade balance does not change, the current account deficit widens to CA’ and the increased real interest payments are added to the debt so that FD grows at a higher rate along FD’, which further increases (IY/X) and (FD/X). In fact, if the real rate of interest exceeds the growth rate of exports, the trade balance will have to move into surplus to avoid an ever-increasing ratio of debt and investment income payments to exports.

Although it is perhaps difficult to see how such a situation could develop in the world of certainty assumed in a simple analytic framework, such situations can easily arise when conditions change in an unexpected manner. As in the example above, an unexpected rise in the external real interest rate can make the payments associated with existing debt excessive relative to the perhaps unchanged 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 on foreign capital in terms of export capacity. Finally, unfavorable external factors, such as slow economic growth of trading partners or adverse changes in the terms of trade, could introduce the possibility of explosive growth of debt. In practice, therefore, the “theory” of real resource transfers is probably most useful in warning against circumstances where concepts such as debt-to-GNP or debt-to-export ratios are changing or are expected to change rapidly. Such an outlook would call into question the sustainability of the country’s external position.

A crucial judgment in designing a Fund-supported program, therefore, concerns the current viability of a country’s debt position and whether it may become unviable in the foreseeable future. To provide a quantitative view of these possibilities, staff analyses include medium-term outlooks for key debt relationships under alternative assumptions about the country’s own policies and the external environment, including the projected behavior of interest rates on external debt. In this context the exercises connected with the World Economic Outlook provide a coherent outlook for the external environment likely to be faced by individual program countries.¹²²

Where a country’s external debt is deemed to be excessive, the short-term current account target of the authorities is constrained by their self-imposed objective of reducing the rate of increase of external debt (or in some instances, even reducing outstanding debt). In cases where private creditors have already determined that the sustainability of the country’s position is doubtful, the short-term outlook for the current account is also constrained, since only official financing may be available. In this case, to the extent that the Fund cannot influence official capital flows, other than the resources it itself provides, the short-run adjustment path for the current account is largely determined by forces outside the control of a Fund-supported adjustment program. The issue remains, however, as to what path of policies (perhaps involving debt reduction relative to domestic output for some interval) will allow a quick and relatively costless eventual return to a normal growth path for debt.

The theory of growth with debt is not well suited to guide policy during such transition periods. The obvious, but not very helpful, condition is that the necessary adjustment should be accomplished at the minimum cost in terms of loss of output. One practical consideration is that imports should not be compressed below a level that causes an unnecessary reduction in the rate of economic growth. It should be recognized, however, that there may be little room to maneuver where credits from private sources are no longer available. Financial assistance by the Fund obviously plays an important role in these circumstances, and furthermore, by making the medium-term implications of the adjustment effort clear, the program can advance the time in which the country’s access to foreign savings is restored.

Financial Aspects of Debt Problems

There is a growing recognition both within the Fund and elsewhere that the basic theory of resource allocation over time discussed above needs to be augmented by a more complete analysis of the financial transactions of program countries. A given net transfer of goods and services to a country—that is, the current account balance—is consistent with a virtually unlimited exchange of financial assets and liabilities between residents and nonresidents. As conditions within the program and in the world economy change, the currency composition, maturity, yield formula, and a host of other factors also have important implications for the country’s position. Gains and losses on financial positions are typically not recorded in the balance of payments; nevertheless, they may be an important short-run determinant of both the debtor countries’ and their creditors’ financial strength. A Fund-supported adjustment program can provide a framework for modifying the terms of financial contracts to facilitate planning for an orderly adjustment effort. In this context, rescheduling amortization payments to creditors in ways that sustain the adjustment process and facilitate the return of normal creditor-debtor relations can be important.

Another important aspect of financial arrangements is that in some cases a rise in gross external debt is accompanied by an increase in gross external claims on nonresidents.¹²³ In such cases of private capital outflows the net resource transfer to the country in the past has not been equal to the stock of gross debt but instead to the stock of debt less accumulated official and private financial claims on nonresidents. In principle, the income from such financial claims should provide the basis for servicing gross external debt—just as would productive physical capital. In cases, however, where the financial incentives are such as to keep earnings outside the country, these incentives must be altered as a part of an adjustment effort to persuade residents to repatriate their foreign earnings and assets, and thus recapture this element of debt-servicing capacity.

Implementing Adjustment Policies with a Large External Debt

Recent experience of countries with debt-servicing problems in implementing adjustment policies suggests that the presence of a large external debt creates special problems that are not normally emphasized in modeling such policies.¹²⁴ Suppose that in such a country it becomes necessary to carry out a large adjustment in the current account of the balance of payments, and that the principal expenditure-changing policy is a reduction in the fiscal deficit, while the principal expenditure-switching policy is a devaluation of the domestic currency. The devaluation increases the proportion of income going toward meeting interest payments on external debt (of both the public and the private sector), thereby reducing aggregate demand and contracting domestic output.¹²⁵ Another result of the devaluation may be to increase the fiscal deficit; this would be the case when interest payments have become such a large proportion of government expenditures that their rise following a devaluation, together with the increase in the domestic-currency equivalent of other foreign-exchange components of government expenditures, outweighs the normally dominant increase in revenues resulting from the rise in domestic-currency equivalents of foreign grants and foreign trade taxes. This worsening of the fiscal situation, at a time when an adjustment in the opposite direction is called for, could, of course, be offset by a reduction in government noninterest expenditures, but such a reduction is difficult to achieve in the short run. In the meantime, there is often resort to emergency tax increases or expanded inflationary financing. The result of these developments may be increased capital flight, which puts pressure both on the domestic currency (to depreciate further) and on domestic interest rates (to be pushed higher to combat capital flight). Higher inflation also tends to raise nominal interest rates. These secondary effects on the exchange rate and interest rates tend to lead to a further deterioration of the fiscal situation.¹²⁶

The conclusion to be drawn from this analysis is not that devaluation is an incorrect response to pressures on the balance of payments. An overvalued exchange rate would produce other problems, such as intense capital flight. There is nonetheless evidence that the tendencies described above render policymaking in an environment of high external debt especially difficult, all the more so when there is significant inflation to begin with. Further study is required of these relationships, which need to be taken into account in deciding on the proper mix of policies and on the desirable balance between financing and adjustment.