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Adjustment in the 1980s: An Overview of Issues: The policy choices before governments

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1987
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Planning and implementing policies to restore external balance and create the conditions for sustained growth

Marcelo Selowsky

In the early 1980s most developing countries suffered three types of external shocks: prices of their major export commodities fell; world real interest rates increased; and international capital flows, particularly from commercial sources, all but dried up. The effects were threefold: lower commodity prices and higher interest rates (particularly the latter, in countries with high external debt) reduced disposable incomes in both the private and the public sector; the cost of borrowing increased; and the scarcity of foreign exchange rose in the domestic economy. Some countries were already experiencing high rates of inflation resulting from the inflationary financing of public deficits. Other countries, largely as a result of their heavy external borrowing during the late 1970s, entered the 1980s with a large external debt; they need to reach a new, sustainable, external asset equilibrium that will allow them to recover their credit-worthiness.

Adjustment can be broadly defined as the adaptation of consumption patterns, the reallocation of resources, and the changes in factor accumulation necessary to recover sustained growth in the face of a more adverse external environment. This article examines the types of government policies needed to effect this adjustment.

Restoring external balance

The most immediate task of adjustment is to restore a viable current account position and level of expenditure in a way that minimizes short-term output losses and safeguards the capacity of the economy for further growth. The current account position can be improved through general expenditure reduction, which works by lowering the domestic consumption of goods that can be internationally traded, and expenditure-switching policies, which change the prices of these goods relative to nontraded goods. Both of these policies improve the trade balance by reducing imports and expanding exports. The key switching policy is the real devaluation of the exchange rate, though this needs to be accompanied by supportive fiscal and monetary policies.

Timing is crucial. If adjustment is delayed, in the extreme case until external credit is completely exhausted, the current account deficit has to be reduced very abruptly. In this case, a large part of the adjustment will have to be sought through expenditure-reduction policies, since expenditure-switching policies take longer to have effect, particularly on the supply side. Expenditure-reducing policies do not affect the output level of goods that are traded internationally, but they do affect the export and import levels of these goods and hence the trade balance. For goods that are not traded, by contrast, use of these policies can cause quite heavy losses in output in the short term. If prices and wages in the nontraded goods sector are rigid in the short term, capital and labor become unemployed, instead of being transferred to the traded sector. Thus an improvement in the balance of payments position can be associated with significant unemployment and output losses in the nontraded goods sector.

These losses will be particularly serious in economies where the traded goods sector uses very specific factors of production and where it takes considerable time to transfer labor, land, and capital from the nontraded sector. Such is the case in countries, including many in Sub-Saharan Africa, whose important export sectors are mining or tree crop production—activities in which investments take a long time to produce output. At the other extreme are countries such as Brazil, the Republic of Korea, or Thailand, where large parts of both the traded and nontraded goods sectors are within the urban economy, factor markets are relatively well integrated and more homogeneous, and it is relatively easy to retrain and transfer labor originally working in, say, construction or commerce for employment in the export or import substitution of, say, radios or garments.

Because of the costs associated with a drastic reduction in expenditures, countries have much to gain by emphasizing expenditure-switching instruments. Because these measures take more time for their resource allocation effects to be felt on the supply side, their implementation must start early and be orderly. This allows the country some minimal access to external credit during the transition. An early implementation of switching policies thus allows the country to choose a smoother pace of adjustment with a smaller loss of output. (See article by Tanzi in this issue.)

An early and gradual introduction of switching policies, rather than a delayed but sharp introduction of expenditure-contraction policies, also has implications for long-run growth because it requires a smaller contraction of investment—one of the components of expenditure. This is an important additional reason for countries to avoid delaying adjustment.

Structural adjustment

As time passes, adjustment becomes increasingly a process of resource reallocation and then factor accumulation, influenced by the structural reforms that must be undertaken as a response to the new external conditions. First, because foreign exchange is scarcer than before (and may become even more so), countries have to expand the output of their export and import-competing sectors. But this expansion should not be pursued regardless of costs—the objective of trade policy reforms is to encourage the expansion of the most efficient export and import-substitution sectors. Second, because borrowing abroad is more expensive than before, domestic savings are now of greater value, and need to be increased, but again in ways that are cost-effective. Third, and most important, the recovery of growth depends heavily on increasing the efficiency of resource use and on the productivity of new investment throughout the economy.

The objective of structural adjustment is to create the conditions for sustained growth, including an improved flexibility to adjust to changes in the economic environment. Two broad areas of structural reform are discussed in what follows: rationalizing the scope and operations of the public sector, and improving the structure of incentives faced by the private sector.

Rationalizing the public sector

The size of the public sector is of course partly a result of political forces and the pursuit of noneconomic objectives. But in many countries there is now a wide awareness of the need to reevaluate the scope and operations of this sector using economic criteria, and to make a choice as to how cutbacks are to be shared between the private and the public sector. Noneconomic objectives that were affordable under more favorable external conditions are not affordable today. This recognition should lead the public sector to concentrate on activities with high benefits that complement instead of compete with private sector activities.

Two areas are of particular importance today. The first is the provision of public infrastructure to support the expansion of the most efficient sectors producing internationally traded goods. Examples are the introduction of better technology, extension services, and irrigation in agriculture, and improvements in transport infrastructure to increase the mobility of goods.

The second area is investments in human capital formation (i.e., in health and education). These should concentrate particularly on programs where externalities are high—so that they directly benefit other people as well as those whose health and education they improve—and on beneficiaries whose incomes are low and who cannot borrow for health services or education. Preventive health measures in rural areas, targeted nutrition programs for infants and mothers, epidemiological and vaccination campaigns, and primary education should receive most of the government subsidies and administrative resources. These investments in human capital not only have proven high rates of return; they are also vehicles for governments to protect the living standards of the poor in periods of generally declining incomes. The wider introduction of cost recovery and user charges for services that consumers are willing to pay for, such as curative health care, and secondary and higher education, will release resources to be used in these other areas (see articles by Huang and Nicholas, Akin and Birdsall, and Pfeffermann in this issue).

Publicenterprises. In many countries public enterprise deficits have become the most important component of the overall public deficit. A key aspect of structural adjustment is to reassess whether the magnitude of these deficits can be justified today. When public enterprise deficits are the result of pricing policies aimed at subsidizing consumer goods, several questions should be raised. Why should these specific consumers be subsidized? Are these the poorest individuals in society? Are there more efficient ways of transferring income to the poorest groups of the population, if that is the objective? (See article by Michalopoulos in this issue.)

In other cases, public enterprise deficits are not the result of pricing policies but of inefficiency in the use of resources. Inefficiency may be caused by managers’ lack of accountability and the expectation that any deficit will automatically be financed by the central government. It also commonly arises when public enterprises are charged with such noneconomic objectives as maximizing employment, irrespective of worker productivity.

The public ownership of enterprises to avoid monopoly practices may be justified in the case of public utilities. It cannot be justified in the case of traded goods, because domestic producers can always be exposed to external competition. In summary, in most developing countries, the need both to increase public savings and to raise the overall efficiency of resource use requires a reevaluation of the scope and operations of public enterprises (see article by Park in this issue).

Smoothingpublicexpenditurelevels. In many countries the current need for stabilization is a result of unsustainable bursts of government expenditure that took place in reaction to external events in the 1970s. Some governments, faced with a decline in their terms of trade, behaved as if the deterioration were only temporary, and maintained expenditure levels until it became clear that it was not. Others, in countries where the terms of trade improved, behaved as if the gains were permanent or would increase even further; public expenditure accelerated, financed by heavy external borrowing. To assume that when external conditions improve, they will continue to do so, and that when they deteriorate, they will soon improve again, makes for very risky public expenditure behavior. What we have certainly learned is that the costs of stabilization are high if optimistic predictions turn out to be wrong. Smoothing public expenditure behavior in the face of changing external conditions is an important institutional change required in most developing countries.

Incentives for the private sector

Production and investment decisions in the private sector depend not only on the level of incentives but on whether people can predict incentives on the basis of a rational evaluation of future economic events. Incentives need to be “transparent” and automatic: even if future economic events are uncertain, the knowledge that incentives will respond to them in predictable ways is helpful. For example, a domestic exporter of oranges knows that the world price of oranges is volatile, but he will expect an increase in that price to benefit him. It is hard for him to forecast future incentives if the government, with the purpose of protecting domestic consumers, uses export prohibitions each time the world price of oranges increases. The same government objective could be achieved through a transparent export tax, even if the tax rate varied as a function of the world price. Using the tax instead of the prohibition would make the incentives much more predictable.

Incentives become almost impossible to predict if different producers in the same activity receive different treatment, according to discretionary interpretations of the law. Moreover, if producers feel that their treatment can be influenced by lobbying or bribery, they will invest real resources and time in these activities. This is the second cost of incentives that are not automatic and transparent.

The worst offenders against these principles of transparency and automaticity are all incentives and instruments based on quantitative restrictions and quantitative allocations. Investment licenses and prohibitions, quantitative allocations of import licenses and foreign exchange, export permits, and quantitative allocations of fertilizers and other inputs are typical examples. Because they are subject to discretionary implementation, they can be expected to vary strongly over time and across productive units in the same activity. The most important first stage in a reform of the incentive structure is to replace quantitative rules and allocations by rules based on prices, taxes, tariffs, and subsidies.

Reforms to realign the level and structure of incentives have two broad aspects: realigning the incentives for the traded goods sectors of the economy and improving the functioning of capital markets.

Tradepolicyreforms. In most countries, present trade policies give very different treatment to different internationally traded goods. Activities that save foreign exchange commonly receive very different incentives from those that earn foreign exchange, while activities that save foreign exchange receive different incentives according to the sector of which they are a part.

In most countries both agriculture and manufacturing produce goods that are exported and goods that substitute for imports. This defines four major sectors producing internationally traded goods. Trade policy has, however, heavily discriminated in favor of one of them—the manufacturing of import substitutes—through the use of import prohibitions and import tariffs on manufactured goods. Thus, for example, an import tariff of 50 percent on manufactured goods allows the import-competing manufacturing sector to use 50 percent more real resources per dollar saved, than all export activities are allowed to use per dollar generated, or import-competing agriculture is allowed to use per dollar saved. The objective of reforms in the trade regime is to equalize, or make more neutral, the system of incentives across all producers of traded goods. This will encourage the expansion of those activities which can save or earn foreign exchange at the lower cost—in the case of the example, export and import-substituting agriculture and manufactured exports.

The above example emphasizes that the objective of an improved trade policy should not be cast solely in terms of expanding exports. In some countries, most of the benefits of a more neutral incentive structure may come from an expansion of the most efficient import-substitution activities (agriculture, in the example) rather from than an expansion of exports.

Neutrality in trade policy has some crucial implications for the choice of expenditure-switching instruments in adjusting to an external shock. Proper switching is achieved when the external adjustment is obtained by expanding the most efficient internationally traded sectors. The best mix of exports and expansion of import substitutes is achieved when the switching is done through the use of changes in the real exchange rate (see article by Guitián in this issue). Extra tariffs or extra quantitative restrictions on imports are inefficient to the extent that they use more resources than necessary to achieve the same amount of external adjustment. If during the shock there is a case for redistributing its cost through taxation on luxury goods, the proper vehicle is a consumption tax on those goods, irrespective of whether they are imported or produced internally.

Reformsinthecapitalmarket. As a result of increases in world interest rates and the decline in the availability of foreign credit, countries must also adjust their policies in the capital market. Incentives are needed to increase domestic savings and to allocate credit more efficiently among alternative investment uses.

Ceilings on domestic interest rates inhibit the generation of domestic savings. They also distort the allocation of credit, since credit from banks tends to flow to large established enterprises with low risk and secure collateral. Smaller and less-known enterprises with high rates of return but without access to bank credit have to borrow at higher interest rates in the informal market than they would face under more unified markets. Special allocations of credit through government-sponsored programs to preferred sectors rarely have the intended effect. Because of “fungibility” they are easily diverted, and because they are provided in limited amounts (the rest of the credit has to be procured in the informal market) they do not lower the cost of credit at the margin but simply transfer income to selected recipients. When credit programs are used to compensate for discrimination against these sectors in another market (e.g., on the product market), new distortions are introduced. It is usually more efficient to correct the distortion in the original market directly.

The first reform is to let domestic real interest rates truly reflect the new scarcity of savings that results from the higher cost of borrowing abroad. Second, domestic markets should be liberalized by allowing lenders to charge different rates to different users. The net effect of this will be to help allocate credit to the activities with the highest rates of return. Reforms in the credit market should not be planned and judged solely in terms of their effects on savings, for the effects on the allocation of credit across investment uses may be equally or even more important. For example, improvements in the allocation of new investment that increase its productivity by 20 percent have the same effect on long-run growth as a 20 percent increase in the savings rate.

Highly indebted countries

Several countries entered the 1980s with a particularly large external debt. Because much of the debt had been contracted at variable interest rates, the increase in real interest rates in the 1980s hit them hard. Commercial lending stopped as these countries lost their creditworthiness. Today they not only need to improve their current account position, as do most developing countries, but they need to generate a trade surplus to the extent that their new borrowing falls significantly short of interest payments. Moreover, to recover creditworthiness, these countries will have to create trade surpluses that are large enough to allow their debt position—measured for example by the ratio of debt to GDP—to improve over the long run. What is distinctive about this group of countries is that the recovery of creditworthiness calls for a sharp adjustment of their external asset position. This cannot be achieved through regular stabilization or in a short time; it requires a substantially longer period.

Lengtheningtimehorizons. To restore their creditworthiness, high debtor countries need to lower the ratio of their external debt to GDP. To achieve this would normally require a significant surplus of domestic savings over investment and a corresponding surplus of exports over imports. If the improvement has to be achieved quickly, the surpluses can only be generated by sharply contracting investment and imports, and thus constricting output and future growth. This has been the recent course of events.

A better alternative is to improve creditworthiness by generating these surpluses through expanding savings and exports while increasing output and consumption. This calls not only for additional time in which to reach creditworthiness but also for additional flows of external finance in the short run, to facilitate the transition. If consumption levels are to be maintained in the short run, it will take time to increase domestic savings rates significantly. Exports take time to respond to improved incentives. It also takes time for policy reforms to affect the productivity of capital and overall resource allocation, improvements in which will ultimately help to sustain growth with lower resource requirements. Although savings will be increasing during the adjustment period, in the short run they will not be large enough simultaneously to finance interest payments on external debt and the investment required to sustain the critical growth of output. Additional external inflows are needed during the transition.

A successful resolution of the debt problem thus requires an effort on the part of both creditors and debtors. Creditor countries will have to resume lending and keep an open trading system, resisting protectionist pressures. Debtor countries will have to restrain their growth of consumption and undertake reforms to improve the efficiency of resource use. Many of the reforms outlined above are desirable irrespective of the debt problem. But in the high debtor countries their urgency is now much greater.

Fiscalaspects. In most debtor countries a large part of the debt is the responsibility of the public sector, but most of the foreign exchange earnings arise in the private economy. Solving the debt problem thus requires solving an important fiscal problem: how to run a significant surplus in domestic currency—equivalent to several percent of GDP—without jeopardizing other goals of the adjustment program. In many countries the public sector’s servicing of its debt has relied on inflationary finance and domestic borrowing, rather than on public savings. This has accelerated the rate of inflation and increased domestic real interest rates, crowding out private investment. Higher nominal interest rates augment the difficulties of servicing the domestic debt if the private sector becomes increasingly unwilling to hold a constant real public debt.

A successful internal adjustment to the debt crisis will require significant increases in public savings through a mix of government expenditure reduction and increased taxation. The proper combination will obviously depend on the specific country; however, priority should normally be given to cuts in those elements of government consumption that cannot be justified on efficiency or distributive grounds, and to the introduction of taxes that do not affect the incentive to save and invest (e.g., consumption taxes). All the adjustments in the scope and operations of the public sector discussed earlier become even more urgent for highly indebted countries.

Some implementation issues

Structural reforms that improve economic efficiency should be welcomed independently of external shocks, but the presence of shocks makes these reforms more urgent and more valuable. To implement structural reforms in the midst of an external shock, which necessarily calls for a reduction in aggregate expenditures, presents some additional problems of sequencing and policy coordination. In order to prevent an increase in the inflationary financing of public deficits, early decisions must be made about how the necessary reduction in aggregate expenditure should be distributed between the private and the public sector. The external shock may trigger an inflationary process, unless all the steps discussed earlier regarding a reasssessment of the scope and operations of the public sector are quickly undertaken. Without these steps, reforms to realign relative prices for the private sector will be swamped by the inflationary instability created by the public sector deficit.

Reforms in the incentive system for the private sector should start only if specific steps are already being taken to correct the fiscal imbalance. The first objective is to improve competition within the domestic economy by eliminating restrictions on the movement of productive factors and investment. Competition is also encouraged by replacing quantitative allocations by equivalent price signals, taxes, tariffs, and subsidies. The benefits of these reforms become even larger as lower inflation improves the information content of prices.

The process of opening the economy, to expose it to more foreign competition, should start when inflation has been lowered and a more sustainable current account deficit has been achieved; when substantial progress has been made in addressing the major structural determinants of fiscal deficits; and when a minimum level of domestic competition and transparency of incentives has been reestablished. These conditions make it easier to sustain the process of opening the economy to world markets.

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