The term “financial program” is commonly used to describe adjustment programs that qualify for financial support from the IMF, although the term may also be applied in the absence of an IMF arrangement. In essence, a financial program is a comprehensive set of policy measures designed to achieve a given set of macroeconomic goals. These goals could simply be to maintain the current level of economic performance or, more often, they may aim to restore equilibrium between aggregate domestic demand and supply, (Disequilibrium between demand and supply typically manifests itself in balance of payments problems, rising inflation, and low output growth.)
The measures most often employed in a program include monetary, fiscal, and exchange rate policies. As a practical consideration, financial data to monitor the implementation of such policies are available on a more timely basis than other economic data. But financial programs also incorporate other policy instruments, especially those aimed at increasing aggregate supply.
The distinguishing feature of a financial program is that it seeks to achieve an orderly adjustment, preferably through the early adoption of corrective policy measures and the provision of appropriate amounts of external financing. This should minimize losses in output and employment during the adjustment period, while eventually leading to a balance of payments position that is sustainable (a current account position that can be financed on a lasting basis with the expected capital inflows). Such a program should also be consistent with adequate growth, price stability, and the country’s ability to meet fully its external debt-servicing obligations.
A financial program must, therefore, be set in a forward looking time framework. Typically, a government works out a program in considerable detail for a period of about one year. The treatment of prospects and policies in more distant periods is complicated by the lack of reliable information and inevitable uncertainties. In order to assess sustainability, how ever, a government must develop a medium-term scenario, which generally considers a time horizon of at least five years. These scenarios are by their nature less certain and often focus only on the broad features of the required external adjustment.
A proper framework is essential
An integrated system of macroeconomic accounts underlies the construction of a financial program. Data from national income and product accounts, the balance of payments, government finance statistics, and the monetary accounts all provide basic information needed to assess the performance of the economy and the extent of policy adjustment required. These data also provide a framework for policy analysis and help ensure consistency of policies. The accounting relationships highlight the fact that any sector that spends beyond its income must be financed by the savings of other sectors, and that excess spending by an entire economy is possible only when external financing is available. For policymaking, however, the accounting framework must be complemented by behavioral relationships, which indicate the typical reaction or response of some of the variables included in the accounting framework to changes in other variables—for example, the impact of different levels of income and taxation on private sector spending.
These behavioral relationships, together with the accounting identities, form a schematic quantitative representation of the relevant economic processes. This framework can be used to assess the changes needed in policy instruments that are under the government’s control to achieve given objectives for variables—such as inflation and the balance of payments—that are not directly under the government’s control.
The design of a program is subject to many uncertainties and difficulties. Behavioral relationships may be difficult to identify and estimate with any precision. Analysis may be further complicated by difficulties in assessing the timing of the effects of policy changes, the impact of expectations on behavioral responses, and the interrelationships among measures in complex policy packages.
From framework to policy options
Within the framework outlined above, governments designing a financial program can explore various policy options. These options can, in turn, be framed around two basic accounting identities:
gross national disposable income less domestic absorption (residents’ expenditure on domestic and foreign goods and services) equals the external current account balance; and
the external current account balance plus net capital inflows equals the change in net official international reserves.
The first identity indicates that an improvement in the external current account balance requires either an increase in a country’s output or a reduction in its expenditure. Accordingly, adjustment policies may aim to increase output and reduce domestic expenditure to allow a greater proportion of output to be devoted to exports and a lower proportion of expenditure to imports.
The second identity, from the balance of payments, shows that any excess of expenditure over income, as reflected in a current account deficit, must be financed either by capital inflows or a drawdown of reserves.
From these basic accounting identities emerge various policy options, which can be grouped according to type: demand management, expenditure switching, structural, and those designed to attract capital inflows. To be effective, these policies must be constructed and implemented in a mutually supportive manner.
Demand management. These policies primarily aim to reduce domestic demand (or absorption) in order to narrow an external current account deficit and to lower inflationary pressures. Most prominent are monetary, fiscal, and incomes policies, but other measures—such as an exchange rate devaluation—may also help reduce expenditures.
In many instances, the source of excess domestic demand is the fiscal sector, in which case a combination of a reduction in public sector outlays and an increase in revenues may be called for. Domestic absorption can also be dampened by restraining monetary aggregates—for example, by introducing measures to change the volume of credit extended to the private and public sectors. Because monetary and fiscal policies are linked—the banking system often provides net financing to the public sector—fiscal restraint may be a key condition for limiting the growth of monetary aggregates.
Expenditure switching. Many programs seek to complement reductions in absorption by expenditure-switching measures such as exchange rate policy. By changing the relative price of foreign and domestic goods (from a resident’s perspective, increasing the price of acountry’s exports and imports relative to the price of domestic goods), a devaluation aims to increase the global demand for domestic goods and services while discouraging imports. From the supply side, an exchange rate devaluation increases incentives to produce goods for export or that compete with imports. Redirecting output from domestic absorption to the external sector minimizes the negative effects of demand restraint on output—that is, any fall in domestic sales resulting from a decline in domestic consumption can be offset by increased export sales.
Structural. These policies aim to enhance supply to close the gap between domestic expenditure and output. In this area, a country designing a financial program will work closely with both the IMF and the World Bank. Policies can be divided between those designed to raise output by allocating existing resources more efficiently and those that seek to expand the productive capacity of the economy. In practice, it is difficult to distinguish between policies serving these two purposes. But conceptually, the former category includes all measures that bring prices back in line with marginal costs by reducing distortions arising from, for example, price controls, imperfect competition, taxes and subsidies, and trade and exchange restrictions.
To increase capacity, governments must implement policies that encourage investment and savings. For example, they must maintain realistic interest rates, reduce fiscal deficits, reallocate fiscal expenditures toward activity with the strongest benefits for growth and economic development, and generally implement policies that tend to guide new resources to investments with the highest rates of return. Such structural policies may take substantial time to show results.
Financing. The ability to attract capital inflows to sustain a current account deficit without running into debt service problems depends, among other things, on the judgement of potential lenders about the creditworthiness of the country and how efficiently the borrowed funds are being used. If foreign borrowing is being used to finance investments that generate sufficient returns to finance the repayment of such funds, then debt servicing problems should not arise. When resources are used inefficiently, or to support domestic consumption only, then debt servicing problems are likely to occur. Changes in world economic conditions may also significantly affect the availability and cost of funds.
Considerations relating to external debt management have become an increasingly important part of program design. Key debt relationships must be monitored on a medium-term basis, under alternative assumptions about the country’s own policies and the behavior of the external environment, including interest rates. The development of such medium-term scenarios has represented an important aspect of the IMF’s work in helping countries design stabilization programs.
Financing may also take the form of a reduction in international reserves, although such possibilities are limited by the size of the initial stock of reserves. In extreme circumstances, some countries may finance external deficits by accumulating arrears. But arrears undermine creditor confidence, thereby complicating relations with external creditors. They also constitute payments restrictions and are thus contrary to IMF policies.
Putting it all together
Finally, the major sector accounts must be completed to provide an internally consistent—and feasible—scenario of developments that could result from adopting a given package of policy measures. More than one scenario may be considered; these might include a “baseline” scenario that reflects the impact of continuing existing policies, and a normative “program” scenario based on an explicit policy package designed to achieve a desired set of objectives.
Given the linkages among the accounts, an iterative procedure is likely to be required to ensure a consistent program. The following steps demonstrate how a financial program might be prepared:
Evaluate economic problems. An understanding of the economic, institutional, and sociopolitical structure of the economy and recent economic developments is essential for forecasting and policy analysis. The government must identify the type of policy instruments available, and diagnose the nature, source, and seriousness of the economic imbalance. For example, the appropriate policy response might be different for self-correcting imbalances than for more permanent ones, as well as for those originating from fiscal excesses as opposed to those resulting from terms of trade deterioration. The dimensions of the problem and availability of financing will also have an impact on program options.
Identify exogenous factors. External sector forecasts, for example, must take account of developments in the world economy, including prospects for commodity and other foreign trade prices, world interest rates, and output and demand growth in partner and competitor countries. Forecasts of these variables can be obtained from private, government, and international trade organizations (from the IMF’s World Economic Outlook, for example). Nevertheless, a considerable degree of uncertainty must underlie these forecasts. It is thus useful to undertake sensitivity analyses of the effects of deviations from projected levels of some of the more important external variables.
Set preliminary targets and develop a policy package. The outcome of a baseline scenario, reflecting existing policies, can provide a basis for establishing appropriate targets for the program. A program scenario would include specific targets and policy measures for their achievement.
A government typically sets targets for the balance of payments (in terms of the current account balance or the level of international reserves), prices, and output. These targets should be consistent with a viable balance of payments position in the medium term.
Prepare sectoral forecasts. There are many possible approaches and starting points in developing a scenario. And the need to adjust the sectoral forecasts to ensure accounting and behavioral consistency may involve difficult policy choices.
For example, assume that a government has made preliminary projections or set targets for prices, real output, and the change in net international reserves. The implications of these projections for the external sector can be verified by forecasting values for exports and capital flows and deriving imports residually from the balance of payments identity. But in a second round, the derived import figure must be made consistent with the demand for imports at the projected levels of output and prices (a behavioral relationship). If, for instance, the demand for imports is greater than the value of imports derived residually, some adjustment must be made. The government has a number of choices:
increase the foreign exchange available to support a higher level of imports, either by adopting policies to raise export receipts or by seeking additional financing;
lower the initial projection or target for net international reserves to allow for a higher level of imports;
reduce the initial projections or targets for prices and output to lower the demand for imports; and
do some combination of the above.
Review desirability of use of IMF resources. Programs that are supported by IMF resources include performance criteria to ensure that these resources are disbursed only when programs are being implemented satisfactorily. Quantitative performance criteria commonly relate to such macroeconomic variables as overall domestic bank credit, net domestic bank credit to the government (or public sector), nonconcessional external borrowing, and net international reserves. Values for these variables should be based on the results of the government’s program scenario.
Other kinds of policies may also be subject to performance criteria. In this context, additional understandings affecting the exchange and trade system, including measures relating to exchange rate policy and the reduction or elimination of external payments arrears, are important. Disbursements of IMF resources can also be subject to completion of a review, which typically monitors structural and other policies that may not be amenable to quantitative performance criteria.
Where macroeconomic imbalances exist, some form of correction must ultimately be taken to bring claims on resources in line with those available. If deliberate policy actions are not taken, the adjustment is likely to be disorderly and inefficient. For example, reserves may be depleted and creditors may become unwilling to lend further to a country. The adoption of a financial program, particularly when supported by the use of IMF resources, offers a country the possibility of an orderly adjustment that minimizes losses in output and employment and ultimately restores the balance of payments to a sustainable basis.
This article was prepared by current and former staff of the English Division of the IMF Institute, with contributions from Jeffrey M. Davis, Leylá U. Ecevit, and Karen A. Swiderski. A more detailed review of the framework for financial programming can be found in “Theoretical Aspects of the Design of Fund-Supported Programs,” IMF Occasional Paper No. 55, $7.50. Practical aspects of financial programming are reviewed in more detail in “Financial Programming and Policy: The Case of Hungary,” IMF Institute, August 1992, $17.50. Both are available from IMF Publication Services, Washington, DC 20431, USA.