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Adjustment and Growth: The Fund’s Role in Adjustment - Adjustment and growth must go hand-in-hand

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International Monetary Fund. External Relations Dept.
Published Date:
June 1987
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Growth-Oriented Adjustment Programs: a Fund-Bank Symposium

Intensified collaboration between the World Bank and the IMF in helping developing countries design growth-oriented adjustment programs and mobilize resources for carrying out such programs is an important element in the reinforced debt strategy. The lessons emerging out of the experience of both institutions were the focus of a three-day symposium organized by them in Washington DC in February 1987.

The symposium received special impetus from the rededication of efforts by both the Bank and the Fund to assist the highly indebted countries. It preceded the April 1987 meetings in Washington DC of the Interim Committee and the Development Committee, at which the debt strategy and growth prospects of the developing world were major topics.

How can the Bank and the Fund help developing member countries achieve balance of payments viability and return to a normal debtor-creditor relationship in a manner that would promote sustainable economic growth, open and growing trade, and international monetary cooperation? With a view to obtaining answers to this multilayered question, the symposium provided senior staff of both institutions an opportunity to join with ministers, other senior officials, bankers, consultants, and leading academics from both the developed and developing world in a frank exchange of views.

Several important issues were discussed in the symposium, including: (1) the combination of macroeconomic and structural policies that offers the best approach to achieving adjustment with growth; (2) the broad lessons of growth and adjustment that can be drawn from alternative strategies followed by different developing countries; and (3) the role of, and prospects for, equity financing, commercial bank lending, and official capital flows in growth-oriented adjustment programs. The Managing Director of the Fund and the President of the Bank made opening statements. A roundtable discussion concluded the symposium.

The first two articles in the following special section on adjustment are based on papers presented at the symposium. A volume based on all the papers presented at the symposium is in preparation and will be published in due course.

The Fund’s Role in Adjustment

Fund-supportedprogramsstressthefundamentalcomplementaritybetweenadjustmentandgrowth

Manuel Guitián

The complementarity between adjustment and economic growth is a basic principle underlying the approach of the Fund in assisting its members. In describing the Fund’s role in support of economic adjustment efforts, this article seeks to explain the opportunities that this complementarity opens as well as the limitations it imposes for economic policy formulation. After reviewing the principles the Fund must follow in its support of members’ policies, the article outlines a conceptual framework for the design of adjustment and the attainment of growth. This framework is used to examine the issues, choices, and constraints posed for the Fund and member countries by the pursuit of these goals.

Scope of Fund assistance

Economic policies in general, and adjustment policies in particular, seek a broad range of generally interrelated objectives, whose pursuit is based on a combination of economic, social, and political considerations. Besides the achievement of a sound growth rate and the maintenance of an appropriate level of employment, a measure of domestic price and exchange rate stability, and a viable balance of payments position, governments often pursue equity-oriented goals, in areas such as income distribution, education, and nutrition. The scope available for full attainment of policy aims depends on the relationship between required and available resources, and therefore the setting of priorities involves choices about the mix of objectives as well as the speed of their attainment, and constitutes an integral part of the process of economic policy formulation and decision making.

The aims of the Fund’s support for adjustment programs are prescribed by its Articles of Agreement. These call for the expansion and balanced growth of world trade as a means toward the promotion and maintenance of high employment and real income levels as well as toward the development of the productive resources of all members. The Fund seeks to fulfill its purposes by fostering economic and financial cooperation among member countries in a setting of exchange stability and orderly exchange arrangements, and in the context of a liberal system of multilateral payments. To this end, it stands ready to make resources available to members in support of their efforts to correct maladjustments in their balance of payments. The basic aim is to shorten the duration and lessen the degree of the imbalance in the payments positions of members through the adoption of policy measures compatible with individual members’ interests as well as with those of the membership as a whole.

The Articles call upon the Fund to support members in balance of payments need that are willing to adopt corrective policies that conform to the code of conduct embodied in its charter and that give assurances that the specific objective of balance of payments recovery will be achieved over a foreseeable period. In this manner, adequate safeguards are established to ensure that the use of resources will be temporary.

The Fund’s mandate focuses mainly on external objectives, and in particular on balance of payments viability. In its financial relationships with individual members, the Fund stresses the attainment of balance of payments objectives as a domain where the interest of each member and those of the membership as a whole coincide. Out of respect for sovereignty in national policy decision making, the Fund observes a principle of political neutrality with regard to other domestic economic objectives, such as growth and price stability, and even more so as regards domestic policy objectives pursued for equity, social, or political reasons.

Observance of this broad principle has kept the Fund from entering areas that require judgement of social or political priorities. To the extent that other economic objectives (e.g., price stability, growth) contribute to balance of payments viability, however, the Fund argues forcefully for the adoption of policies to promote their achievement. Moreover, the principle of noninterference does not preclude the Fund from assessing the claims that domestic priorities put on available resources and from pointing out their economic implications and, in particular, any resulting balance of payments pressures. Moreover, while its mandate does not extend to policies and objectives that reflect mainly social or political considerations, the Articles enjoin the Fund to pay due regard to these policies and objectives in connection with its exercise of surveillance over exchange rate arrangements. The Fund has striven to abide by this prescription in its relationship with members.

An essential consideration behind the Fund’s principle of political neutrality in domestic decision making has been the need to maintain an acceptable balance between protecting the interest of an individual member and safeguarding the interest of the membership as a whole. Its emphasis on the external objectives and consequences of members’ economic policies helps to protect the membership’s collective interest and is based on a broad consensus among members that these policies are subjects of legitimate international concern. Were the Fund to widen its focus beyond the external area, to include areas of policy with respect to which the grounds for international concern are less firm, the general acceptance of the priority the Fund accords to external objectives would be less assured, if not contested.

Conceptual framework

Major goals of adjustment efforts, as noted earlier, include balance of payments strengthening, price stability, and sound growth performance. Growth and adjustment depend on two critical factors: the amount of available resources and the efficiency with which they are used. Consequently, policy programs are aimed at mobilizing resources and enhancing their productivity.

A typical task of adjustment programs is to keep aggregate demand in an economy in line with productive capacity or, for a given level of demand in the economy, to bring productive capacity up to its potential level. Among the variety of factors behind the emergence of an economic imbalance, there is frequently an unsustainable expansion of aggregate demand and expenditure, whose elimination will entail a reduction in the level or growth rate of aggregate demand. Early on, it is not always easy to see whether such an expansion in demand indicates that an imbalance is developing that requires correction. This is particularly the case when the effects of the expansion give grounds for diverse, if not conflicting, assessments. Incipient increases in aggregate demand and expenditure can give rise to developments in, say, employment and output that are generally seen as favorable, and receive more notice than concurrent unfavorable developments in, say, prices and the balance of payments.

Why do the favorable effects of demand expansion often receive more notice than the unfavorable ones? Pressures on domestic prices and the balance of payments may not show themselves immediately, as some of the effects of the expansion of demand can be masked by borrowing abroad or by using international reserves. Even where the resulting increases in external debt and declines in foreign assets are viewed with concern, they may be considered a reasonable price to pay for the positive events elsewhere in the economy. However, the scope for increases in external debt and declines in international reserves is limited. The adverse price and balance of payments performance often becomes evident at a time when the improvements in employment and output begin to falter or have already disappeared.

Amountofresources, macroeconomicbalance. A key function of economic management is to keep the level and the rate of growth of aggregate demand in a sound relationship with the level and growth prospects of the economy’s productive capacity. For a given level of productive capacity and a given structure of relative prices and costs (including exchange and interest rates), this will require domestic financial policies that are consistent with macroeconomic balance in the economy. This is a first broad area of interest in the context of the relationship between the Fund and its members.

Expansions in aggregate demand are often associated with imbalances in the fiscal accounts or more broadly in public sector finances. Such imbalances are typically the outcome of the pursuit of policies and programs that require public expenditures in excess of the sector’s revenues. To correct imbalances originating in the public sector requires actions to curtail fiscal spending or to raise additional fiscal revenues. Actions of this type may be labeled the fiscal aspect of macroeconomic management.

The implications for the private sector of the economy will depend on the particular mix of measures chosen. For example, an approach based on the reduction of public sector spending seeks to restore balance in the economy by directly lowering the participation or weight of the public sector in aggregate demand, while an approach based on raising domestic fiscal revenues would tend to be accompanied, other things being equal, by a reduction in private demand. The consequences of different fiscal policy mixes also vary in the certainty and speed with which they yield results—partly because the government’s scope to control its spending generally exceeds its ability to ensure that its receipts will rise.

Fiscal policies are closely related to the broader sphere of financial policies—those affecting developments in credit, money, and borrowing flows in an economy. It is often difficult to distinguish clearly between the roles of fiscal and monetary policies in macroeconomic management; public sector spending or revenue measures—fiscal policy—strongly influence the public sector borrowing requirement and its need for domestic bank financing—monetary policy.

These considerations emphasize that to keep demand on a sustainable path requires a measure of control over the flows of domestic financing and specifically over the rates of monetary and credit expansion. These variables constitute what might be called the monetary aspect of macroeconomic management.

An important relationship exists between the rate of domestic credit expansion and increases in the money supply, on the one hand, and the levels of aggregate demand and expenditure, on the other. Another important relationship exists between the demand for money balances and the level of income in the economy. Thus under most circumstances a discrepancy between the supply and demand for money (an imbalance in the money market) has as a counterpart an imbalance between expenditure and income (an imbalance in the market for goods and services).

A sound relationship between expenditure and income will also require that domestic credit expansion be kept in an appropriate balance with the prospective path of desired money holdings in the economy. Generally the behavior of these holdings is largely determined by the public. Thus policy formulation in this area focuses mainly on the rate of domestic credit expansion to ensure that sustained balance prevails or is brought to the money market, in the sense that it is not bought at the expense of the balance of payments (e.g. through international reserve losses or excessive foreign borrowing) or of price and exchange rate stability.

These general considerations provide the rationale for the importance the Fund attaches to domestic credit expansion as a policy instrument. The close relationship between this policy variable and the balance of payments is a more direct one than that between monetary expansion and the external accounts. To correct imbalances and thus protect the temporariness of the use of Fund resources, policy needs to be formulated so as to avoid—even over the limited periods in which they occur—trade-offs among economic policy objectives that endanger balance of payments prospects and weaken international reserve positions.

Consistency in macroeconomic management requires that its fiscal and monetary aspects be complemented by supportive foreign borrowing policies—the external debt aspect of macroeconomic management. External debt policies directly influence the expenditure-income flow, since foreign and domestic credit can substitute for each other. In general, monitoring of the global (domestic and foreign) flow of financial resources is required to keep the pattern of aggregate demand and expenditure in line with the economy’s productive and absorptive capacities.

Efficiencyinresourceuse, economicincentives. The productive potential of the economy, and its capacity to service debt, are influenced directly by macroeconomic policy actions as well as indirectly via the effects these actions have on relative prices and costs. In general, the borrowing process transfers command over resources from surplus to deficit sectors or economies. In an open economy, foreign borrowing, aside from its macroeconomic impact already discussed, adds directly to the resources available. If used efficiently, such borrowing can allow the economy both to reach higher expenditure levels and to grow at higher sustained rates than otherwise.

These considerations highlight the link that exists, via the current account of the balance of payments, between domestic macroeconomic management, external debt policies, the saving-investment process, and the long-run evolution of the economy. They also make clear that a medium-term horizon is required for the formulation and assessment of policies, and this is also the appropriate time frame for the achievement of objectives such as growth and external payments viability.

A sustained adjustment effort requires that macroeconomic balance be attained in a setting of appropriate incentives and signals to guide decisions to allocate and use resources in the economy. Relative costs and prices are critical in this regard. Imbalances can result in relative price-cost misalignments both among sectors in the economy and between the economy as a whole and the rest of the world. In these circumstances, changes may need to be made in key prices and costs if progress in the attainment of macroeconomic balance is to be durable.

This is an area of economic policy where macroeconomic management blends with structural adjustment and supply aspects. In the realm of fiscal policy, particularly expenditure management, a key issue is the efficiency and composition of spending. The durability of an effort to control demand and public sector expenditure will depend, inter alia, on the curtailment of unproductive spending and in particular on the protection of productive investment outlays.

Improvements in the structure of tax rates can also help to enhance productivity in the economy. Other important supporting actions encompass public sector enterprise pricing policy, including sectoral producer and consumer prices and the related issue of subsidies. More generally, the maintenance of an appropriate structure of relative prices is needed to promote efficiency in the allocation and use of resources among sectors in the economy.

Monetary and credit policies must lead to appropriate domestic interest rates, which are critical to efficiency in the allocation and use of financial resources in the economy and thus of primary importance for growth and balance of payments viability. On a general level, these objectives call for domestic interest rates that help to mobilize domestic savings—that is, appropriate real interest rates. They also call for interest rates to be competitive internationally so as to retain savings internally and encourage foreign capital inflows. This is yet another perspective from which the policies required for purposes of growth and the balance of payments coincide.

Exchange rates and competitiveness are of crucial importance for growth and external payments viability. With persistent imbalances in an economy, domestic prices and costs typically diverge significantly from those abroad; resource allocation is distorted; competitiveness is impaired, and so are the growth and balance of payments performance of the economy. In these circumstances, exchange rate adjustments or flexibility in exchange rate management, or both, supported by appropriate macroeconomic policies, can be essential to restore competitiveness and balance to the economy by helping to bring factor prices, including wages, and absorption, particularly consumption, to realistic levels. When competitiveness has been eroded and balance of payments pressures prevail, exchange rate action helps to shift demand from international goods to domestic goods. Exchange rate action also changes the real value of nominal assets and thus it has an influence on demand and expenditure throughout the economy. Properly conceived, exchange rate action thus helps to balance the external accounts directly by containing domestic absorption and indirectly by improving resource allocation between the internal and external sectors.

To ensure that economic incentives and pricing signals fulfill their functions, another important and desirable component of an adjustment strategy is the liberalization of exchange and trade regimes. The efficiency of pricing signals in imparting information among sectors and among economies, concerning their relative resource scarcities and demand patterns, can be seriously impaired by restrictions and controls.

Specificsectoralmeasures. The attainment and maintenance of an economy’s growth potential often call for other types of action to eliminate inefficiencies in the economy as a whole or in specific sectors. Through its regular consultation as well as its technical assistance to member countries, the Fund actively contributes to the reform of specific sectors. Examples of this work include the development of central banking and money market institutions; the improvement of exchange market arrangements; and the establishment of adequate institutional machinery for coordinating policy decisions, as well as for monitoring economic performance, particularly in the fiscal and debt management areas. In a number of these activities, the Fund collaborates closely with the World Bank. The issues that arise in connection with such institutional reforms are not generally perceived as an integral part of aggregate economic management, but they can be critical for the efficient operation of the economy, and therefore they are important in the context of a growth-oriented adjustment strategy.

Current issues

The policies and conditions associated with the assistance provided by the Fund have helped members to mobilize financial resources from other sources. From this standpoint, it can be said that the Fund helps to oversee the distribution of capital flows among member countries, so that it contributes to the effectiveness of adjustment and thus proves beneficial to the individual member and the membership as a whole.

In recent years, capital flows to developing countries have been severely curtailed. Procedures built around members’ financial arrangements with the Fund have been developed in an attempt to ensure that external assistance in support of adjustment efforts actually flows on the required scale. Besides being the main vehicles for the provision of Fund resources, these arrangements have become a pivot for the Fund’s efforts to elicit support for adjustment from major creditor countries and from the main sources of private capital, particularly the commercial banks. In this manner, the Fund has played an increasingly important role as a catalyst for capital flows to strengthen adjustment. An important factor for adjustment and growth will be its continued ability to muster external resources, as well as to elicit responsible actions on the part of creditors and capital exporting countries, so as to allow capital to flow efficiently.

The general characteristics of the main policies that are necessary to achieve growth with a viable balance of payments have already been discussed, but the scope and variety of possible policy packages give rise to a number of issues. The first issue concerns the availability of resources: the longer an imbalance has been allowed to prevail, and therefore the larger it is, the tighter is the constraint on the resources available and the more limited become the possible courses of action. Given the resource constraint, emphasis in the selection of policies must be placed on efficiency in resource use. Resource availability can pose a constraint on policy choices, but the quality of policies can also influence the availability of resources and thus ease the constraint.

The second issue applies to the relationship of growth, price, and balance of payments objectives to other aims sought on account of a combination of economic, social, and political factors. In a relatively open environment, social and political aims can rarely be pursued, on a sustained basis, at the expense of efficiency. Permanent conflicts between the criterion of economic efficiency and equity are unlikely because inefficiency and waste run counter to equity. However, these considerations do not mean that economic objectives can be pursued without regard to social and political aims. In general, the pursuit of social and political goals may help economic performance but it also places a claim on available resources. In this sense, trade-offs exist between policy objectives, but as long as efficiency in resource use is not impaired and as long as choices conform to the economy’s preferences, conflicts between policy goals need not arise.

The third issue is that when imbalances develop, financing and adjustment can either substitute for or complement one another. Reliance on foreign borrowing or on use of international reserves (financing) rather than on policy action (adjustment) is a course of action that can be pursued only temporarily. Such a strategy essentially transfers and adds the imbalances from one period to the next until the cumulative need for adjustment surfaces abruptly, often when no more financing is available and there is no more scope for incurring payments arrears. At that moment, the burden of adjustment is to correct the existing flow imbalance that remains, together with the accumulated previous imbalances.

Alternatively, financing can be used in conjunction with adjustment policies to tide the economy over the period required for the policies to yield their results. Other things being equal, the stronger the policy measures are and the faster they are implemented, the smaller will be the associated need for financing. The larger the amount of financing being used during the adjustment process and the harder its terms, the higher will be the claims placed on future resources, and thus the stronger the balance of payments results that will need to be sought by policy action.

Manuel Guitián

Spanish, has a PhD from the University of Chicago. He is a Deputy Director of the Fund’s Exchange and Trade Relations Department, and has published articles on international monetary economics.

Normally the attainment of growth goes hand in hand with balance of payments viability. But it is important to stress that when the imbalances to be corrected have led to or have been associated with unsustainable growth rates in the economy, the restoration of growth to a sustained—even though lower—path represents not a problem but an element of the solution.

With a given level of resources, concentration on achieving growth may set a constraint on the range of policy mixes that are compatible with a viable balance of payments. To some extent, such constraints may also arise on account of choices made between growth and other domestic policy objectives, particularly those of a redistributional character.

When a balance of payments imbalance is to be corrected, it is often argued that a bias in favor of financing is appropriate whenever growth objectives are part of the strategy. However, the more foreign financing is resorted to, the more resources will have to be devoted in the future to its servicing. Unless the growth associated with such financing reflects its efficient use, it will not be sustained. Indeed, growth in the future may have been mortgaged with financing undertaken in excess of the economy’s absorptive and productive capacities.

These relationships between policy objectives and the criteria for their selection are but aspects of the broader interdependence and interaction between the political environment and economic policy implementation. In general, a stable political environment is essential for the effective and sustained implementation of economic policies that is required in most circumstances to bring an adjustment effort to fruition.

In conclusion…

This article has stressed the essential complementarity that exists between adjustment and growth. Indeed, by removing distortions and impediments to efficiency, adjustment is necessary for the attainment of sound growth. The notion that adjustment is inimical to growth only serves to conceal the fact that without adjustment, growth today is at the expense of often significantly slower growth tomorrow.

The Fund’s support of policies to restore viability to the balance of payments thus also represents support for growth on two counts: first, because those policies typically promote efficiency in resource use; and second, because the financial support from the Fund, as well as the other finance that the institution helps members to attract, adds to the resources at the disposal of countries undertaking adjustment.

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