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Growth and Adjustment in South Asia: Lessons from four countries

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1987
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Bijan B. Aghevli, In-Su Kim, and Hubert Neiss

During the late 1970s and early 1980s, the international economy experienced the re-emergence of serious payments imbalances, primarily reflecting the sharp increases in oil prices and the precipitous decline in commodity prices. These imbalances were particularly pronounced in the non-oil developing countries, which suffered not only from the marked deterioration in their terms of trade, but also from the ensuing recession in the industrial countries and the sharp rise in international interest rates. The severe external payments difficulties facing these countries led to a substantial increase in the number of adjustment programs supported by Fund resources under stand-by and extended arrangements, from 54 (with a total commitment of SDR 8 billion) during 1976-78, to 88 (committing SDR 24 billion) during 1979-81.

This increase in Fund-supported programs was accompanied by a growing emphasis on structural adjustment to strengthen productive capacity and foster growth. In view of the substantial payments imbalances and the apparent persistence of the shift in the terms of trade, the adjustment strategy generally attempted to supplement traditional demand-oriented policies with more comprehensive structural polices. These policies were designed to improve resource allocation, promote domestic investment and savings, and strengthen external competitiveness. This shift in the adjustment strategy was reflected in a marked increase in member countries’ recourse to extended arrangements with the Fund, which were designed to provide medium-term assistance to cope with structural imbalances. Among the members that entered into such arrangements were four South Asian countries-Bangladesh, India, Pakistan, and Sri Lanka-which together accounted for more than half of the total commitment of Fund resources under the extended facility during 1979-81 (Table 1).

Table 1Arrangements of South Asian countries under the extended Fund facility
Amounts
Original

expiration

date
Date of

cancellation
In millions of SDRs
Date of

agreement
CommittedAs percent

of quota1
Drawn
BangladeshDec. 1980Dec. 1983June 1982800(351)220
IndiaNov. 1981Nov. 1984May 19845,000(291)3,900
PakistanNov. 1980Nov. 19831,268(445)1,079
Sri LankaJan. 1979Dec. 1981260(219)260
Source: IMF

Based on the size of quota at the time of the inception of the programs.

Source: IMF

Based on the size of quota at the time of the inception of the programs.

This article reviews the design and implementation of the growth-oriented adjustment programs adopted by the four South Asian countries, and attempts to analyze the impact of both policy and exogenous variables on actual developments during the program periods.

Background

The four countries initiated adjustment efforts in the late 1970s before the introduction of the extended arrangements with the Fund. Except in India, these efforts to counter a deteriorating external position were supported by regular stand-by arrangements with the Fund. However, despite the progress made in achieving economic adjustment, the four countries continued to face a number of deep-rooted structural problems that required sustained reform efforts over the medium term. While the extent of these problems varied across the countries, a number of common factors are identifiable.

At the time the adjustment efforts were launched economic growth in most South Asian countries was hampered by inefficiencies in key economic sectors, industrial and infrastructure bottlenecks, and cost-price distortions arising from infrequent adjustments of both administered prices and the exchange rate in the face of domestic inflation. Further, adverse weather disrupted agricultural production and, in the case of India, also interfered with power generation. Fiscal conditions remained weak because of low and inelastic revenue and rapidly rising government expenditure propelled by increasing social and development needs. The fiscal imbalance was a primary reason for excessive monetary expansion, and consequent inflationary pressures.

Meanwhile, weak production bases, together with inadequate producer incentives, continued to constrain the countries’ export capacities. At the same time, rising domestic demand led to strong import demand, which was suppressed through tight exchange and import controls at the expense of economic efficiency. These strains on the domestic economies and the balance of payments positions were intensified by the marked deterioration in the terms of trade and the subsequent slowdown in export markets.

Design of extended programs

The adjustment strategy adopted by the countries under review was to strengthen productive capacity and promote economic expansion in a climate of financial and external stability. Higher economic growth rates were to be realized by supply-side measures designed to raise both domestic investment and savings and to improve the efficiency of production and resource allocation. The latter goals were to be achieved primarily by correcting cost-price distortions, relaxing restrictive industrial regulations, and liberalizing trade policies. All these policies were to be accompanied by restrained financial management aimed at maintaining price stability in order to facilitate structural adjustment. In view of the relatively long gestation period of structural programs, the external current account position was expected to improve only gradually.

Underlying the supply-oriented adjustment strategy was the recognition that there was substantial scope for export growth and import substitution in these economies through the removal of structural imbalances and bottlenecks. The strategy was also consonant with the urgent developmental need to provide employment for the growing labor forces and to alleviate poverty. The adjustment programs were, to varying degrees, incorporated into national development plans.

The adjustment programs of all four countries envisaged a substantial increase in domestic investment. In view of the major role of the public sector in these countries, the government was expected to take the lead in expanding investment. In general, public sector investment programs were to be reviewed and reoriented in close consultation with the World Bank to improve infrastructure, exploit comparative advantage, and avoid projects with excessively long gestation periods. Most programs foresaw a broadened role for private investment, encouraged by the adoption of policies conducive to liberal industrial and import licensing arrangements and to foreign collaboration.

The increase in domestic investment was to be financed by greater domestic resource mobilization, mainly through the public sector. The government budget was expected to generate larger savings through tax reforms, reductions in subsidies, and restraint in wage outlays. Substantial savings were also to be generated by nonfinancial public enterprises primarily through flexible pricing policies and the rationalization of their operations. The programs also generally stressed the need for encouraging private savings through flexible interest rate policies, introduction of new financial instruments, and strengthening of financial intermediation.

The alleviation of cost-price distortions was seen to be essential for improving resource allocation and stimulating production. Procurement prices were to be increased substantially, particularly for those agricultural commodities that were either exportable or import substitutes. Administered prices for industrial outputs were also to be adjusted more flexibly to reduce distortions. Furthermore, increased financial incentives were designed to improve the profitability and external competitiveness of the export sector, which had been adversely affected by heavy indirect taxes and inflationary pressures. A flexible exchange rate policy responding to developments in domestic and external prices would support these measures.

A crucial element of the adjustment programs was the liberalization of restrictive industrial and import regulations which had been pervasive. In order to encourage private sector production and facilitate modernization, the programs called for the simplification of licensing approval procedures and for the easing of regulatory restraints on capacity utilization and expansion, particularly in India. The liberalization of imports was aimed primarily at ensuring increased access to raw materials and intermediate goods so as to alleviate supply bottlenecks and improve international competitiveness. Imports of capital goods were also to be liberalized in order to improve the efficiency of domestic production and investment. The program in Pakistan envisaged a shift from quantitative restrictions to tariffs for regulating imports and protecting domestic industry.

Notwithstanding the emphasis on structural measures, prudent demand management remained a principal element of the adjustment programs, as financial and price stability was viewed as a fundamental prerequisite for successful economic adjustment. A major policy objective was the strengthening of the budgetary position through measures to increase revenue and restrain expenditure. The programs sought to reduce substantially the overall budget deficit and thus government recourse to bank borrowing. At the same time, they envisaged restraints on the growth of liquidity and domestic credit to moderate inflationary pressures while supporting economic growth and private sector activity.

Performance under programs

The performance of the four economies with respect to growth, inflation, and external adjustment was uneven: India and Pakistan broadly achieved the original objectives of the programs, while Sri Lanka and Bangladesh were less successful in meeting all their targets. Generally, the average economic growth during the program period was broadly in line with program targets (Table 2). In the case of India and Pakistan, a favorable growth outcome was accompanied by relative financial and price stability and a larger-than-anticipated improvement in the external current account deficit. In contrast, Sri Lanka suffered from both intensified inflation and a marked deterioration in its current account balance. In the case of Bangladesh, program objectives in terms of both growth and inflation were not met and the reduction in the current account deficit was made possible only through a drastic cut in the issuance of import licenses. The Fund’s extended arrangement with Bangladesh became inoperative during its first year.

Table 2Selected economic indicators of four South Asian countries(In percent)
Program annual

average
Post-program

annual average 1
Pre-programTargetsOutcome
Bangladesh
Real GDP growth3.57.23.73.1
Inflation (Consumer Price Index)18.511.514.410.2
External current account as
proportion of GDP-11.5-12.09-10.6-8.1
Exports (In billions of dollars)2.40.90.70.8
Imports (In billions of dollars)2.42.82.52.4
India
Real GDP growth7.84.85.34.0
Inflation (Wholesale Price Index)18.29.36.16.4
External current account as
proportion of GDP-1.6-2.1-1.6-1.4
Exports (In billions of SDRs)6.69.57.68.6
Imports (In billions of SDRs)12.315.413.213.3
Pakistan
Real GDP growth7.35.76.55.3
Inflation (Consumer Price Index)10.710.08.48.0
External current account as
proportion of GDP-4.5-4.6-3.3-4.2
Exports (In billions of dollars)2.43.22.62.5
Imports (In billions of dollars)4.96.25.66.0
Sri Lanka
Real GDP growth5.86.06.05.1
Inflation (GDP deflator)7.811.718.115.1
External current account as
proportion of GDP-5.5-10.8-14.9-10.4
Exports (In billions of SDRs)0.70.90.81.1
Imports (In billions of SDRs)0.81.21.41.8
Source: IMF

Note: dates for pre-program, program, and post-program periods are defined as follows:

Pre-Program

period
Program

period
Post-program

period
India1980/811981/82–1983/841984/85–1985/86
Pakistan1979/801980/81–1982/831983/84–1984/85
Sri Lanka19781979–19811982–1984
Bangladesh1979/801980/81–1981/821982/83–1984/85

Partly preliminary.

Source: IMF

Note: dates for pre-program, program, and post-program periods are defined as follows:

Pre-Program

period
Program

period
Post-program

period
India1980/811981/82–1983/841984/85–1985/86
Pakistan1979/801980/81–1982/831983/84–1984/85
Sri Lanka19781979–19811982–1984
Bangladesh1979/801980/81–1981/821982/83–1984/85

Partly preliminary.

The path and pace of adjustment in these economies were influenced significantly by unanticipated developments in exogenous factors and policies. Droughts during the programs adversely affected growth in Bangladesh, India, and Sri Lanka. The task of adjustment was further complicated by the prolonged international recession and by a precipitous decline in export prices that reinforced emerging fiscal difficulties, especially in Bangladesh and Sri Lanka. On the other hand, all four countries benefited from higher-than-expected remittances particularly from oil exporting countries, and from only moderate increases in oil prices (which were especially important for India).

The extent of policy implementation also varied across the four programs. On the whole, significant progress was made in the area of pricing policy: incentives to agricultural producers were raised, subsidies were reduced, and the financial position of public enterprises was improved. The price adjustments, however, did not eliminate certain costly subsidies or mobilize sufficient resources for investment in some cases. However, implementation of structural measures, especially those aimed at increasing tax revenue, mobilizing private savings, and relaxing industrial and import controls, was weaker than envisaged. Measures taken to promote exports were also modest. Financial policies were generally restrained in India and Pakistan, but they turned out to be expansionary in Bangladesh and Sri Lanka.

Production, investment, and prices. The favorable growth performance achieved by India, Pakistan, and Sri Lanka was generally associated with higher agricultural production. This reflected the effects of policies to increase the area under irrigation and to stimulate the spread of modern production techniques and inputs, particularly fertilizer; the use of fertilizer was encouraged by reducing its price and by strengthening support services to farmers (India and Pakistan). Notwithstanding recurrent adverse weather, substantial progress was made in Bangladesh, India, and Pakistan toward self-sufficiency in foodgrain production.

Industrial developments were also generally encouraging. Manufacturing registered a strong expansion in Pakistan, as a result of new capacity for import substitution, fuller capacity utilization, and improved availability of imported inputs. The growth of India’s manufacturing sector remained well below program targets, reflecting the impact of the world recession and continued domestic controls. However, performance in basic industries and infrastructure generally improved, and bottlenecks were reduced substantially. The production of oil increased robustly in both India and Pakistan, leading to a substantial reduction in oil imports in the former.

Domestic investment relative to GDP was below target in both India and Pakistan. Public investment in these countries was lower than expected because of limited resource mobilization by the public sector. In India, private investment was constrained by weak domestic and external demand in the aftermath of the oil price increases and by uncertainties over the relaxation of industrial regulations and import controls. Sri Lanka was successful in achieving the program growth target, but at the expense of excessive expansion of public sector investment; private investment in the country also remained buoyant, aided by monetary and fiscal concessions and low prices for imported capital goods.

Despite the importance attached to domestic resource mobilization, savings fell short of program targets in all four countries. Shortfalls were registered by both the public and private sectors in the case of India. In India and Sri Lanka, private savings were adversely affected by drought-induced declines in agricultural income, a sharp fall in the terms of trade, higher energy prices, and weak policy initiatives. Weaker than expected domestic resource mobilization, however, was partly offset by buoyant workers’ remittances in most South Asian countries.

Inflation subsided broadly in line with program targets in India and Pakistan, as restrained financial policies and improved supplies more than offset the increases in administered prices. In Sri Lanka, however, the rapid expansion in domestic credit, combined with a sharp increase in international oil prices, gave rise to strong inflationary pressures, and the program targets were exceeded by a wide margin. Inflationary pressures were also strong in Bangladesh.

External developments. The cumulative current account deficit in India and Pakistan over the program period was substantially smaller than targeted. Bangladesh also kept its current account deficit below target, primarily through a substantial tightening of import licensing. In contrast, the current account deficit in Sri Lanka exceeded the program target because of higher imports and poor export performance.

Stronger net exports of services (workers) and private transfers (remittances) helped limit the deficits in India and Pakistan. In the former, a significant decline in imports, mainly because of reduced oil imports, also contributed to the lower deficit. The growth of non-oil imports was generally slower than expected in these countries, largely because of the improved domestic availability of key agricultural commodities and industrial inputs.

Exports were considerably below expectations in all four countries. The cumulative shortfall in export earnings largely offset the gains achieved in lowering imports in India and Pakistan. In most countries, the average growth rate of export volume was below that achieved by non-oil developing countries during the corresponding period. The disappointing export growth performance reflected the severe international recession, lingering domestic impediments to export development, and generally weak external competitiveness.

Post-program developments

During the program period, the South Asian countries stepped up their efforts at structural adjustment. The progress made in this area, however, was relatively limited, partly because of the intensity of structural imbalances before the programs, but also because of delays in policy implementation and the lags before policies become effective. In order to sustain the structural adjustment efforts, most countries introduced follow-up measures after the Fund-supported structural adjustment program came to an end.

In India, significant liberalization measures were taken during 1985 in the areas of industrial licensing, import policy, and tax and financial reforms. The coverage of anti-monopoly legislation was reduced considerably through a substantial increase in the asset limit and the exemption of a large number of industrial groups from restrictions on capacity expansion. In addition, most of the exempted industries were no longer required to operate under licenses and large companies were permitted to diversify their operations. Regulations applying to foreign collaboration and investment were liberalized with a view to facilitating import of technology. Substantial progress was made toward a more liberal import regime through the removal of licensing requirements, simplification of procedures, and the termination of monopoly imports by public corporations for a wide range of materials and components. In the area of tax policy, the structure of direct tax was rationalized, with a substantial reduction in tax rates and an increase in the exemption limit for personal income tax, in order to foster private sector growth and reduce tax evasion. Steps were also taken to alleviate rigidities in the interest rate structure through an increase in interest rates on government securities. Complementary action is now under consideration for further financial sector reform.

In Bangladesh, an adjustment program was reinstated in 1982/83 and supported by a new stand-by arrangement. Under the new program, the fiscal position was improved by increasing taxes, reducing subsidies, and adjusting key administered prices. At the same time, exchange rate policy was conducted more flexibly and a more liberal import policy was pursued with a view to improving the efficiency of the economy, especially that of the export sector. Adjustment efforts were stepped up in 1985/86 supported by another stand-by arrangement, in order to deal with a re-emerging deterioration in the balance of payments and weakening in growth performance.

The authorities in Pakistan continued to pursue flexible pricing policies for petroleum and gas, leading to a significant increase in petroleum production and to the containment of petroleum subsidies. However, further progress toward structural adjustment was needed in key areas, including tax reform, liberalization of import controls, and promotion of manufactured exports.

The pace of structural adjustment in Sri Lanka was slowed by the deterioration in national security, while the need for urgent action was softened by a marked boom in export prices of key primary commodities in 1983/84. The authorities, however, have been cognizant of the need to overcome the long-standing structural weaknesses in the economy, especially the diminishing growth potential of the narrowly based export sector, a weak budgetary process, and the poor performance of public enterprises. The first step in a phased program of tariff reform was undertaken in late 1984.

Notwithstanding the further steps some of them have taken, continued adjustment efforts remain essential in the South Asian countries, particularly in the areas of export development, economic efficiency, and public finance. During the post-program period, export volume growth has remained generally low, partly reflecting slow improvement in economic efficiency. With the exception of Sri Lanka, the fiscal deficit has widened, as expenditure has risen rapidly in the face of stagnant revenues; in the case of Sri Lanka, a large cutback in current expenditure resulted in a substantial decline in the fiscal deficit. The weak management of public enterprises has remained a source of low productivity and financial instability in most countries.

Conclusions

The adjustment strategy of Fund-supported programs underwent a major shift in the late 1970s in response to the change in economic environment arising from the sharp rise in oil prices and the associated imbalances in members’ payments positions. Adjustment programs placed greater emphasis on structural measures to promote domestic resource mobilization, alleviate price distortions, ensure increased access to imports, and reorder investment priorities in countries that sought Fund assistance.

The adjustment programs adopted by the four South Asian countries, which have much in common in the way of economic legacy and structures, were framed against this emerging shift in the Fund’s adjustment strategy. Under the programs, these countries were generally successful in achieving their growth objectives, despite a deepening of the international recession and adverse weather conditions. Notwithstanding this growth performance, the extent of structural adjustment achieved in key areas was below expectations. Public sector resource mobilization was constrained by inadequate returns from improvements in the tax systems and by rising current expenditure.

The most disappointing development for all four countries was the continued weakness in export performance. Export growth was below that achieved by other developing countries, mainly because of low productivity growth and inadequate financial incentives. Despite some progress in liberalizing trade regimes, the continuing tight control on imports constrained improvements in economic efficiency and export growth. Although there appears to be further scope for external adjustment through efficient import substitution in these countries, the strong development of the export sector is crucial for achieving external viability over the medium term. In these circumstances, continued progress in liberalizing industrial and import controls and in improving the profitability and external competitiveness of the export sector remains essential.

The experience of the South Asian countries during the program periods confirms that restrained financial management plays a major role not only in improving the balance of payments but also in facilitating structural adjustment. The cases of Bangladesh and Sri Lanka demonstrate that, in the absence of financial stability, it is difficult for the authorities to focus their attention on structural adjustment. In addition, financial instability tends to exacerbate existing cost-price distortions, resulting in inappropriate investment patterns and inadequate savings. In view of the dominant role of fiscal operations, success in demand management will inevitably require bold actions to reform the tax systems and limit the excessive expansion in current expenditure.

The slower-than-expected progress in undertaking structural adjustment was primarily attributable to delays in policy implementation. These delays were associated both with long and careful preparations required for most of the structural measures and with weaknesses in administrative capacity for effective policy implementation. These technical and administrative constraints were compounded by social and political resistance to structural reforms. In view of the lengthy process of forming a political consensus for reform, the required measures were implemented only gradually in these countries.

In conclusion, our review of the structural adjustment experiences of Bangladesh, India, Pakistan, and Sri Lanka suggests that successful reforms require considerable preparation so that they can be implemented swiftly when the conditions are ripe. Further structural adjustment can only be successful if the momentum of economic reforms that are initiated under a Fund-supported program is sustained beyond the period of the program. Ultimately, it is the commitment of governments to reforms that determines the pace and intensity of structural adjustment. It is, therefore, encouraging that in all four countries structural efforts have been continued and, in some areas, intensified following the Fund-supported adjustment programs.

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