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Price distortions and growth: A Bank study shows a negative association

International Monetary Fund. External Relations Dept.
Published Date:
March 1984
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A study of the association in developing countries

Ramgopal Agarwala

During the past decades, discussions on development policy have been heavily influenced by the vision of what has been called the “structuralist school” in development economics. This vision underplays the role of markets and prices as tools of resource allocation for economic development. It assumes a benevolent government machinery that can, in principle, ascertain the optimum allocation of resources for “maximizing the national welfare” and has instruments to achieve such an allocation. In determining the optimum allocation, this view emphasizes sectoral balances and self-sufficiency in production rather than prices and costs; for achieving the optimum, it would manage quantities rather than prices, implying either that the latter are not adequately effective tools of allocation or that they have perverse welfare implications. According to this view, distortions that may occur in prices while quantities are manipulated are therefore either innocuous or necessary for achieving social objectives.

During the 1940s and 1950s when the structuralist school flourished, its popularity was understandable. The theory of “market failures” had been developed in the 1930s and 1940s. The newly independent countries, often led by political leaders of considerable stature, were anxious to bring about rapid economic and social modernization, and government activism seemed necessary. The faith in the ability of government to plan and guide the economy was further strengthened in the latter part of the 1950s by the development of econometric models and programming techniques that suggested a rich potential for scientific social engineering. Without the benefit of actual planning experience in a mixed economy, these leaders could only contrast the reality of markets (along with their failures) with the ideal of a planned “golden path,” and naturally the ideal seemed more attractive than the reality.

During the 1960s and 1970s, however, the ideal was severely tested and the structuralist vision can no longer be accepted as a tenet of faith. It is necessary to review the reality of the structuralist approach and see how its performance compares with the alternative neoclassical approach, which puts emphasis on the importance of the “right” prices for an efficient allocation of resources.

The results of such an empirical study concentrating on the role of prices in development are reported in this article. The period selected for review was the 1970s and the approach was cross-sectional. The study assessed the variation in price distortions among developing countries during the 1970s to identify any significant relationship between the degree of price distortion and country performance in terms of growth and equity. A review of the experience in the 1970s is particularly useful in learning about the role of prices in managing development; during this period there were several examples of the practical implementation of the competing approaches (following from structuralist and neoclassical visions about prices and markets) that were sustained over a long enough period to provide a basis for some comparative judgment. During this period, too, developing countries experienced several external shocks, and the responsiveness of economies following the alternative systems was tested.

Price distortions

Price distortions exist when the prices of goods and services, as well as capital and labor, depart from “equilibrium” prices.

The more comprehensive study on which this article is based is published by the World Bank, under the same title, as Staff Working Paper Number 575. Copies are $3 and can be ordered from World Bank Publications, P.O. Box 37525, Washington, DC 20013, USA.

Since in practice these are difficult to define, some approximations are commonly used. For example, as a measure of distortions in the pricing of foreign exchange, changes in real effective exchange rates from a base period are generally used, together with the “effective protection” or taxation of traded goods. Similarly, distortions in interest rates are judged by how far they have been negative in real terms rather than by deviation from market clearing prices. Moreover, since the data in many cases pertain to different years and different methodologies are followed for different countries, the quantification of even these approximations is not exact. Therefore, in this study countries were classified into three broad categories of distortion—high, medium, and low—and an attempt was made to obtain average indicators for the decade for growth performance as well as for price distortions. These broad categorizations are considered useful for improving the robustness of the estimates.

Protection of manufacturing. In the 1940s and 1950s, the strategy of industrialization through import substitution was widespread among developing countries. It was supported by various currents of economic and political thought—the basic structuralist vision, an equation of development with industrialization and free trade with economic dependence, and pessimism about exports and fluctuations in export earnings. The then popular two-gap model of development also seemed to assume that import requirements were rigid and it thus provided a rationale not only for trade and exchange controls (to keep imports at their minimum level) but also for inflows of foreign capital, which were considered essential for development.

By the early 1960s, several costs of the import substitution strategy were becoming evident: high capital intensity, excess capacity, low value-added at international prices, underutilization of economies of scale, lack of competitiveness, and the encouragement of “luxury” production behind trade barriers. Several trade studies in the 1970s underlined the importance of these adverse effects and emphasized the “bureaucratic failures” inherent in import substitution. Quantitative restrictions gave industries protection that was far more extreme and discriminatory than the governments imposing them knew or intended. When protection is provided through quantitative restrictions, it creates strong temptations for corruption. Efforts to prevent this lead to a mechanical allocation on the basis of “past shares,” which tend to shelter the existing inefficient firms and reduce the speed of adjustment in the economy. On the other hand, an exportoriented strategy limits the use of quantitative restrictions, and the distortions of economic incentives that accompany them, and forces the early recognition and rectification of mistakes that are hidden by an import substitution strategy.

Discussions of trade strategy then led to the theory of effective protection, which has been called “one of the most profound and important recent advances in economics.” Despite several conceptual and measurement problems, there has been a spate of estimates of effective protection rates for various countries. As noted by Balassa, protection introduces three forms of distortions to an economy: (1) discrimination among domestic products, (2) discrimination between domestic and foreign products, and (3) discrimination between the domestic and foreign sales of a particular product. Fortunately, Balassa’s estimates indicated that not only do these three forms of discrimination go hand in hand, but also that on the whole the extent of discrimination and its dispersion among industries in the individual economies are positively correlated.

On the basis of Balassa’s findings, this study concentrated on the measures of the gross effective protection rate (EPR) as indicators of trade-related distortion in the pricing of value-added in manufacturing. The figures available for different years in the 1970s for 31 countries were considered and countries classified into three categories of distortion: high (with EPR of 80 percent or more), low (with EPR of 40 percent or less), and medium (with EPR between 40 percent and 80 percent). The countries with high protection were particularly concentrated in South Asia and East Africa (see chart).

Underpricing of agriculture. The counterpart of protection of industry is taxation of agriculture. This may occur through various instruments, such as direct taxes on output and on exports, compulsory procurement at low prices, or the subsidization of the sale of agricultural products through government channels of marketing and distribution. The rationale for underpricing agriculture is based on four main assumptions: (1) that agricultural production is not very responsive to price changes; (2) that the chief beneficiaries of higher prices would be the larger farmers; (3) that higher prices for food and other wage goods would have adverse effects on low-income consumers; and (4) that rapid growth requires rapid industrialization, which in turn requires a transfer of income from agriculture to industry.

Underpricing agriculture was common in the developing countries in the 1950s. By the 1960s, it was recognized that such underpricing slowed agricultural growth, and that this slowdown, in turn, adversely affected overall growth and equity. On a project level, it was found that inadequate pricing of agricultural products led to poor execution and utilization of agricultural projects, particularly those involving irrigation, extension work, and input distribution. Many countries, including India and Pakistan, switched to policies aimed at reducing discrimination against agriculture, but many developing countries, especially in sub-Saharan Africa, were still under-pricing agriculture in the 1970s. In some exceptional cases (for example, the Republic of Korea), there was also distortion in the opposite direction of high protection.

Effective taxation or protection in agriculture has not been studied as thoroughly as it has been in industry, and effective protection coefficients are generally not available. Nominal protection coefficients are more widely available, however; and since, in agriculture, purchased inputs are generally a small proportion of total value added, these are, by and large, satisfactory indicators of the degree of distortion.

On the basis of available information on agriculture, countries were classified into three categories of distortion: high (with absolute value of EPR 30 percent or more), low (with absolute value of EPR 10 percent or less), and medium (with absolute value of EPR 10–30 percent).

Exchange rate. This is, of course, the key variable affecting the relation between domestic and foreign prices. It could be the most effective instrument for simultaneously promoting exports and saving imports in an efficient manner without burdening the administrative system. Unfortunately, the developmental role of the exchange rate has not been adequately emphasized, but rather its suitability for tackling balance of payments problems and sometimes (by and large with disastrous consequences) for controlling inflation. In general, the distortions in exchange rates were the result less of active policy decisions and more of rigid exchange rates in the face of changing underlying conditions.

The problem of distortions due to inflexible effective exchange rates became particularly serious in the 1970s following the breakdown in the Bretton Woods system and the growing inflation in the world economy. In this study, the years before the oil crisis of 1972–73 (when the instability in exchange rate and prices had not yet become endemic) were taken as the base period (with some exceptions, such as Chile), and calculations were made as to the extent that the annual average of real effective exchange rates during 1974–80 deviated from that base. Distortion was regarded as high when the average appreciation was more than 15 percent, low when it was less than 7.5 percent, and medium otherwise.

Price distortions and growth in the 1970s

Source: World Bank, World Development Report 1983.

Note: In this figure, countries are listed in order of increasing degree of distortion in prices. In the first section, the color of the squares indicates the degree of distortion in the principal categories of prices. The middle section is a composite index of price distortion for each country: as a country’s distortion index increases, the color of the circle changes from gray to red. In the right hand section, the small circles show the actual annual rate of growth of GDP; the large circles are estimates of GDP growth obtained by a regression relating growth to the distortion index.

1Price distortions for the decade were heavily influenced by the policies of the Allende Regime, which ended in late 1973.

Cost of credit. Governments in nearly all developing countries in the 1950s believed firmly in low and controlled interest rates and credit rationing. The reasons for the policy ranged from a desire to keep down the costs of servicing public sector debts to one to encourage smaller borrowers and investment.

The policy of low (and relatively stable) nominal interest rates became Increasingly untenable as inflation accelerated, particularly in the 1970s. In many countries, nominal interest rates became significantly lower than inflation, and not just temporarily, but on a sustained basis for a decade or more. Negative interest rates penalize and can be expected to discourage savings. Even more clearly, they encourage the public to hold a larger proportion of their savings outside the domestic financial system, and thus reduce financial savings as well as foreign exchange available for domestic investment—thereby encouraging rationing of credit with all its attendant administrative problems. By lowering the real cost of capital to those that have access to it, they permit investments to take place where marginal rates of return are low or even negative. This leads to excessive inventories and excessively high capital intensity, along with overcapacity and slow-moving project implementation; all these serve to lower the average efficiency of investment. The latter also suffers because of the adverse effect of negative real interest rates on the development of financial intermediaries, which can help in allocating savings according to productivity.

During the 1970s, financial savings in several countries were being eroded at an average rate of over 10 percent a year in real terms. In some cases, particularly in Latin America, the real interest rate was lower than –20 percent a year for a decade. Very few countries managed to have positive (small) real interest rates during the 1970s. In this study, countries were classified as belonging to the high distortion category when the decade average of real interest rate was below –5 percent a year, low distortion when it was nonnegative (there was no case of an excessively high positive real interest rate for the ten-year average), and medium otherwise.

Cost of labor. While the cost of credit was distorted primarily because of inflexible interest rate policies, the cost of labor was distorted mainly because of the misplaced interventions of government and pressures from trade unions. Most developing country governments in the 1950s favored the Fabian socialist principles of encouraging trade union activities and promoting minimum wage legislation on the basis of “adequate” income for workers. The fact that organized labor formed a small part of the total labor force in developing countries and the fact that underdevelopment did not permit “adequate” income for all were not heeded by the urban-oriented governments that often mandated the minimum wages. The concern with high wage costs was further muted by the structuralist view that factor proportions were not sensitive to the costs of labor and capital.

In many developing countries real wages increased far beyond the rate of increase in productivity. By the late 1960s, studies and anecdotal evidence showed that capital-labor ratios were, in fact, sensitive to the relative cost of labor and capital. Distortions in labor markets tended to hurt both growth and labor intensity, impeded the growth of employment, and, in particular, contributed to urban unemployment.

Facts on the degree of this distortion are especially hard to collect, since very few developing countries have systematic data on wages and productivity. As a result, the classification of countries by degree of distortion in this case was based more on qualitative information than on other prices. The basic indicator used was whether real wages in manufacturing rose significantly faster than per capita real income adjusted for changes in external terms of trade. However, any significant evidence of intervention in labor markets by government and/or trade unions was taken into account. Similarly, the longer-term effects of rapid increases in wages in the 1960s were also taken into account.

Pricing of infrastructural services. The pricing of nontradables, particularly infra-structural services, presents difficult problems since they have no border price to serve as a benchmark for pricing. Moreover, since externalities and increasing returns to scale are often important for infrastructure services, markets cannot determine the right prices. The generally accepted criterion is to make the price equal to marginal cost, with the investment level being at the optimum. Here, again, it is difficult to determine whether short-run or long-run cost is a more appropriate basis for pricing and how to measure that cost in practice. Most developing countries tend to underprice infrastructural services, given the externalities. Since these services are generally both capital and energy intensive, however, such a policy leads to an excessive demand for both capital and energy. In many cases, pricing does not cover the average costs of production, and the agencies supplying these services are financially strained and unable to make adequate investments. The usual result is excess demand and rationing, with their attendant problems.

Although the general picture of under-pricing of infrastructure services was evident, exact figures on the pricing of individual sectors were not available for the sample countries. The distortions in pricing power utilities were taken as a proxy for distortion in other infrastructure services as well. In this study, countries with an average rate of return in public utilities below 4 percent were regarded as cases of high distortion, those with above 8 percent as low distortion, and others as medium distortion.

Inflation. Particularly when it is high and accelerating, inflation strongly affects the efficiency of resource allocation by creating uncertainty about future prices—both absolute and relative.

It is, however, by no means easy to define high and accelerating inflation. The approach used here was purely statistical. Acceleration was defined as the ratio of the average inflation rate in the 1970s to that in the 1960s, and the cutoff points in terms of level and acceleration of inflation were defined so as to distinguish the top 25 percent and the bottom 25 percent by the degree of distortion. On that basis, distortion was considered high when the inflation rate was greater than 15 percent a year and acceleration greater than four times; low when the inflation rate was less than 15 percent a year and acceleration less than four times; and medium in other cases.

Country classification

Analysis showed that for each of the price distortions noted above, there was a negative association between the degree of price distortion and growth performance. However, many of these price distortions were interconnected: some counteracted each other, others were reinforcing. Some composite measure of price distortions was therefore desirable. Because of the complex interaction between distortions in different prices, however, there are major conceptual problems in identifying analytically their relative importance. Three statistical approaches were therefore followed. First, the effects of all seven distortions on growth were analyzed individually through a multiple regression. Second, a composite distortion index was constructed by giving weights to individual distortions in proportion to their correlation coefficient with growth. Third, on the basis of the argument that the initial regression was insufficient basis for determining weights, equal weights were assigned to each of the distortions.

The three approaches led to some differences in ranking of countries by degree of distortion, but the basic conclusion regarding a clear and significant negative association between growth and composite price distortion index was common to all three. As expected, the explanatory power of the first approach was the highest, followed by that of the second and the third. For further analysis and tabular presentation, the composite index was constructed on the basis of simple averages, so as to avoid the risk of exaggerating the association between price distortions and growth. The 31 countries are presented in order of increasing price distortions in the chart.

A high degree of government intervention in a country may be expected to lead to high price distortions. This was certainly the case for many countries. However, in theory, as well as in practice, it seems useful to distinguish between intervention and distortions. It is interesting, for instance, that countries such as Korea, where the government has been activist in national economic management, nevertheless managed to avoid high price distortions.

Distortions; growth; equity

The relationship between price distortions and growth seemed to operate through both resource mobilization and the efficiency of resource use (Table 1). The average savings rate and returns on investment in the high distortion countries were lower than average, and these two effects added up to 2 percentage points of their GDP growth. Both the savings rate and returns on investment in the low distortion countries seemed to be higher; and these again added up to almost 2 percentage points of their GDP.

Table 1Distortion indices and various components of growth during the 1970s(In percent)
Distortion indexAnnual GDP growth rateAverage domestic saving income ratioAverage return on investmentAnnual growth rate of agricultureAnnual growth rate of industryAnnual growth rate of export volumePercent of income going to bottom 40 percent
Simple group average1.566.821.427.
Sri Lanka1.864.11322.22.84.0-2.419.2
Ivory Coast2.146.72425.53.410.54.620.0
Simple group average1.955.717.826.
Simple group average2.443.113.816.
Overall average2.015.017.423.
Sources: World Bank, World Development Report 1983, and World Bank Data Bank.

Indicates data not available.

Price distortions for the decade were heavily influenced by the policies of the Allende regime, which ended in late 1973.

Sources: World Bank, World Development Report 1983, and World Bank Data Bank.

Indicates data not available.

Price distortions for the decade were heavily influenced by the policies of the Allende regime, which ended in late 1973.

Price distortions also seemed to have adverse effects on both agriculture and industry. Compared with the overall average, the high distortion countries had a lower average growth rate in agriculture and in industry, while the low distortion countries had, on average, higher growth rates in these sectors by about the same magnitude.

Finally, Table 1 shows that, compared to the overall average, the high distortion countries had, on the average, lower growth rates of exports and the low distortion countries had higher export growth.

When growth and price distortions were cross-classified by rate of growth and degree of distortions, it is interesting to note that none of the countries with low distortion had a low GDP growth rate; in fact, none had growth rates below 5.5 percent a year. Neither the lack of natural resources (for example, in Korea), nor the early stage of development (for example, in Malawi), nor the socialist system (for example, in Yugoslavia) seemed to be insuperable barriers to policies of right prices (low distortions) and high growth. With one exception, which had obviously special circumstances (namely, Nigeria), none of the countries with high growth rates had high distortions; 60 percent of them had low distortions.

At the opposite end is the experience of the low growth countries: none of them had low distortions, while 80 percent had high distortions. Here, again, neither the availability of resources (for example, in Peru or Chile), nor the stage of development (for example, in Argentina) was adequate to prevent low growth when price distortions were high.

The group averages discussed are convenient summaries, but they do not give any idea of the variation within each group, nor do they identify the major deviations from the averages. A simple regression of growth rates on a distortion index showed the latter to have been a statistically highly significant variable for explaining growth in the 31 countries considered, although it accounted for only 34 percent of the variance in growth. For cross-sectional analysis this degree of explanatory power is respectably high, but it does suggest that, as is to be expected, other factors also affect growth. The nature of these other factors is suggested by an examination of the outliers in the chart showing actual growth rates compared with those estimated by the regression equation. Among the countries that had significantly higher growth than estimated are: Nigeria, Korea, Brazil, Egypt, the Ivory Coast, and Indonesia. For Indonesia, Egypt, and Nigeria, oil resources played an important part in explaining this deviation; for Korea and Brazil, political and institutional factors probably contributed to their spectacular success. For the Ivory Coast, it was probably the external assistance—both technical and financial—that contributed to success. Countries that had significantly negative deviation from regression estimates were: Ethiopia, Jamaica, Ghana, and India. For the first three, political factors probably played a key role; for India, bureaucratic rigidities relating to licensing and the control system probably accentuated the losses resulting from the distortions in the pricing system.

In many countries, price distorting policies are justified on the basis of their income distributional impact. For example, it is often argued that low interest rates, high wages, low infrastructure prices, and import restrictions are designed to help the low-income groups. However, studies by Krueger (1978 and 1982) and others have found no evidence of any positive association between protectionist policies and income distribution. Studies of Pakistan have even argued that credit and exchange rate distortions in the 1960s might have increased inequality in income distribution.

Our analysis confirmed these earlier findings. For 27 countries for which figures are available on income distribution, regression analysis showed that the distortion index explained barely 3 percent of the variation in equity, when the latter was measured by the proportion of income going to the poorest 40 percent of the population. And even this low association goes in the opposite direction to that claimed to justify distortions. If anything, high distortion seemed to be associated with lower, not higher, equity.

The analysis of the experience in the 1970s—a period observationally rich for testing the hypothesis about the role of prices in growth—confirms the view that price distortions hurt growth, particularly when they assume high proportions. Countries with low distortions were found to have relatively high growth. There is no evidence that price distortions helped equity. In fact, they may have hurt equity in addition to creating serious administrative problems and corruption.

Needless to say, no statistical analysis by itself can be conclusive in such matters. However, when it is supported by theoretical analysis and earlier detailed country studies, it does constitute a powerful argument—in this case, in favor of avoiding high distortions in prices, trade, and factor markets, as well as in nontraded products.

The findings reported here are a case for “getting the prices right” and should not necessarily be interpreted as an argument for laissez-faire. What they mean is that the general case for avoiding price distortions is strong; in particular cases, if price distortion is advocated, the burden of proof lies on those advocating it, either for growth or for equity.

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