The longer the delay in adjusting to economic shocks, the more volatile the movement of macroeconomic indicators, and the larger the eventual adjustment
It has become fairly common these days for international institutions and other advisors to urge small developing nations to adjust quickly when the domestic economy enters a state of disequilibrium. Otherwise, it is suggested, the costs of adjustment will be greater. But little effort has been spent to date on trying to spell out the exact nature of these costs, a matter that has concerned policymakers in these nations for some time. Perhaps not surprisingly, countries have tended to postpone adjustment as long as they possibly could, often waiting until a point where the costs have become painfully high.
The rationale for not detailing the costs of postponed adjustment has always been that the reasoning is intuitively obvious. After all, if you want a car going 80 miles per hour to stop, you start slowing down reasonably quickly, or risk being thrown through the window when you are finally forced to slam on the brakes. We decided to see if this intuitive argument could stand up to rigorous scrutiny by investigating whether the postponement of adjustment could be linked to any identifiable macroeconomic costs in a model of a “representative” developing economy beset by realistic domestic or external shocks that implied the need for adjustment. The first step was to review the experiences of a selected group of small developing countries that had gone through major devaluations, as a form of adjustment. We then constructed a model that permitted us to reproduce the salient macroeconomic characteristics of these episodes. Finally, we investigated the role of postponement per se in determining these characteristics.
This article is based on a more detailed study by the authors, “Devaluation Crises and the Macro- economic Consequences of Postponed Adjustment in Developing Countries,” to be published in a forthcoming issue of the IMF Staff Papers. Available from Publication Services, IMF, Washington, DC 20431 USA.
We found that the effects of postponing adjustment depended on the source of the original shock, and as fiscal expansion was the most frequent trigger of a devaluation episode, it became the main focus of our attention. The study showed that these episodes were accompanied by substantial macroeconomic instability—in the form of unstable current account balances, accelerating inflation, erratic real exchange rate movements, depletion of foreign reserves, and a continuously increasing black market premium. All of these manifestations of instability are likely to entail substantial economic costs, because they create uncertainty and diminish the information content of relative prices, thereby leading to distortions and wasteful resource reallocations. Most important, the substantial macro- economic fluctuations that give rise to these costs in the period surrounding adjustment can be shown to result from delaying the necessary adjustment measures. This clearly implies that there is a stiff price for countries to pay if they choose to postpone adjustment.
The choice of countries for our sample was essentially determined by data availability; only those major devaluation episodes for which we could gather figures on most of the key variables were incorporated into our analysis. The episodes totaled 20 in all, and the stylized facts that we derived covered the periods both preceding and following the implementations of the adjustment programs. What follows are the major characteristics we observed in various small, open developing economies.
Devaluation episodes were stepwise or followed by a crawling peg; in none of the cases was the exchange rate allowed to float after the devaluation.
All of these countries (see Table 1) devalued their currencies by at least 15 percent after having maintained a fixed official exchange rate against the US dollar for two or more years. Thirteen of them implemented a stepwise devaluation, attempting to once again fix the parity following the nominal exchange rate adjustment; many of them did not succeed and experienced recurrent devaluations. Seven countries adopted a crawling exchange rate after the nominal devaluation. Without exception these devaluations were followed by some kind of predetermined regime—either fixed or passive (exchange rate adjusts to the differential between domestic and foreign inflation rates) crawl—and not by a freely floating nominal rate, as most theoretical models of exchange rate collapse have assumed.
|One year after|
|(Percentage of devaluation)1|
|Devaluations followed by crawling peg|
Historically, the vast majority of devaluation crises have been preceded by loose and inconsistent macroeconomic policies. In particular, the evidence shows that fiscal policy in the devaluing countries as a group was significantly more expansive than in countries with fixed exchange rates that did not devalue (our control group).
Macroeconomic, particularly fiscal, policies became increasingly expansive in the devaluing countries immediately preceding the year of the devaluation, as can be seen in Table 2. While the top entry deals with monetary (domestic credit) policy, the rest of the categories take us beyond the monetary realm and into the fiscal side of the economy, providing four different ways of looking at fiscal pressures. In addition, data for a control group of countries that maintained a fixed rate for 10 or more years are presented. Clearly, the devaluing countries as a group behaved quite differently than the group that did not devalue. This is particularly so for the fiscal policy indicators. For example, during the year prior to the crisis, half of the devaluing countries allocated one quarter or more of total domestic credit to the public sector; the median for the control group was only slightly more than 10 percent.
|Annual rate of growth of domestic credit||22.1||16.8||17.8||22.9||17.4|
|Annual rate of growth of domestic credit to public sector||24.4||14.8||10.2||31.0||22.7|
|Share of public sector in total domestic credit||26.0||24.7||24.7||25.5||11.4|
|Fiscal deficit as percentage of GDP||3.3||0.8||1.3||3.7||1.6|
|Growth of credit to public sector as proportion of GNP||1.7||1.1||1.1||2.7||0.8|
In a significant number of episodes there was a marked worsening in the international terms of trade immediately before the crisis. This suggests that historically some collapses may have been triggered by exogenous external shocks.
Of course, balance of payments difficulties are not always the result of inconsistent domestic macroeconomic policies. Historically, exogenous shocks have sometimes been the sources of serious external imbalances. In our sample, a wide variety of experiences emerge. While in some episodes the terms of trade did not change in the period preceding the exchange rate collapse, in others there was a substantial change. In six of the 16 episodes for which there are data, there was a significant worsening in the terms of trade before the devaluation.
In the period preceding the devaluations, we observed a significant real exchange rate appreciation, the depletion of the stock of international reserves, a deterioration of the current account deficit, and a decline in the ratio of net foreign assets to money.
In the vast majority of our devaluation episodes, the external sector experienced a serious deterioration in the period leading to the crisis. In 16 out of the 20 episodes, the ratio of net foreign assets to money experienced a steep decline during this two-year period. Moreover, in 14 cases, the current account ratio worsened. In fact, in some of these episodes the current account to GDP ratio grew to remarkable levels. In Kenya and Israel, for example, the 1971 deficit swelled to approximately one-fourth of GDP. An important characteristic of these devaluation episodes is the tendency, present in most countries, for the ratio of net foreign assets to return to its pre-crisis level following the devaluation. This suggests that countries have a relatively stable level of reserves to which they seek to return.
Regarding real exchange rates, in 15 out of the 19 countries with relevant data, the bilateral rate experienced a real appreciation in the three years prior to the devaluation. In 13 out of the 19 cases, there also was a real appreciation of the multilateral rate. The average real appreciation during this time period was almost 9.2 percent, while the real multilateral appreciation was 9 percent. These movements were the result of domestic rates of inflation that increasingly exceeded the world rate of inflation.
What these data suggest is that devaluation decisions are based on the behavior of at least two indicators: foreign reserves and the real exchange rate. It is possible to think of some devaluations as undertaken in order to improve a country’s competitive position rather than because reserves have disappeared—Indonesia in 1978 comes to mind. In many episodes, the authorities postponed the implementation of the adjustment measures, even after it had become evident that the economy was facing a severe macro- economic disequilibrium. Moreover, in a number of cases, in its effort to postpone the adjustment, the government resorted to exchange and capital controls.
Devaluation crises have been preceded by very steep increases in the black market premium. Moreover, the evidence shows that immediately following the devaluation the premium experienced a significant decline.
We could obtain information on the black market rate for foreign exchange for most of the countries in our sample. These data are, in fact, extremely suggestive, showing a marked increase in the premium in the period leading to the exchange rate collapse. In all but one of the episodes, the black market premium was higher one month before the devaluation than three years prior to the devaluation. It is interesting to note that in every country immediately following the devaluation, the parallel market premium experienced a sudden drop, closing the gap between the parallel and the official rate. This type of behavior is, in fact, consistent with perfect foresight models of dual exchange rates, which imply that the black market exchange rate should not change appreciably when the official rate is devalued. This is so because such changes would be quickly arbitraged away as soon as the official devaluation was foreseen.
Although there are indications that in some countries real wages increased in the years preceding the crisis and dropped in the years that followed, the evidence is not conclusive on this point.
Critics of orthodox stabilization programs have argued that devaluations result in important reductions in real wages. In order to analyze this issue we collected data on the evolution of real wages in the manufacturing sector in the period surrounding our devaluation crises. These figures, however, show no clear-cut behavior. In only eight out of 18 episodes for which there are data, real wages increased in the period preceding the crisis and then dropped after the devaluation. In the other 10 episodes, real wages did not decline after the crisis. Thus the popular belief that all devaluations are followed by a wage reduction is not sustained by our data.
Dynamics of postponed adjustment
Armed with these six stylized facts, we next developed a model of a typical developing country, designing the model in such a way that it could trace the dynamic response of certain key macroeconomic variables to a variety of shocks that would eventually culminate in a devaluation episode. As it turned out, the effects of the shocks were very similar to those which we observed in the real world, that is, in the characteristics of countries that had to devalue as described above. For a given shock that eventually results in adjustment-cum-devaluation, the primary determinants of the path followed by domestic macroeconomic variables—both before and after adjustment—are the nature of the eventual macroeconomic adjustment to the shock and the magnitude of the associated devaluation.
In our model, the introduction of a fiscal shock triggers a state of macroeconomic disequilibrium. For a fixed official exchange rate to be sustainable in the absence of inflation in a country’s trading partners, the government’s budget has to be balanced. Unless the budget is balanced, excessive growth of the domestic money supply eventually drives up the free exchange rate, and the capital gains reaped by holders of foreign exchange boosts domestic spending, resulting in a current account deficit that gradually depletes the central bank’s reserves.
The critical question thus becomes: although the removal of the deficit is necessary, is its eventual removal sufficient to restore a feasible equilibrium? We find the answer to be no, as long as the central bank has a well-defined target for international reserves. The timing of the removal is essential. This is so, because even if the government’s budget is eventually balanced, the economy may already have been placed on an unsustainable path by the temporary deficit, which may have led to a depletion of the stock of foreign exchange reserves beyond the point considered acceptable by the authorities. In cases where the deficit itself cannot be erased quickly, its eventual removal may have to be accompanied by a devaluation of the official exchange rate in order to attain the acceptable level of foreign exchange reserves. The longer a nation waits to make this adjustment, the greater the devaluation will have to be.
The key to the dynamics of postponed adjustment is the private sector’s intense awareness of the developments taking place. When an unsustainable fiscal deficit emerges, private agents know that remedial steps must in the end be taken to remove it. Moreover, they are well aware that if such steps are delayed, the degree of reserve depletion will be such that an official devaluation is likely to accompany the eventual fiscal retrenchment. The longer the fiscal adjustment is postponed, the greater the size of the devaluation that will be necessary, as the depletion of official exchange reserves becomes more pronounced over time in the absence of adjustment.
The private sector, therefore, acts to modify its own actions in ways that tend to aggravate the fluctuations in macroeconomic variables, upon observance of the emergence of an unsustainable fiscal policy and the perception that adjustment is likely to prove delayed. Specifically, anticipating the eventual devaluation, private individuals seek to purchase foreign exchange. The free exchange rate, therefore, immediately depreciates following the implementation of the unsustainable policy. And as the value of the foreign exchange held by the private sector increases, a more rapid depreciation of the free exchange rate is implied, since individuals will only be willing to hold a larger proportion of their portfolios in the form of foreign exchange if they expect the value of the foreign exchange to rise more quickly than before. At the same time, this increase in private wealth increases private spending, inducing both higher domestic inflation and a trade balance deficit. As the domestic price level rises, the real exchange rate becomes progressively more overvalued relative to an equilibrium value that remains unchanged. The overvalued real exchange rate itself promotes more private spending on foreign goods, aggravating the trade deficit. This increase in the external deficit stemming from the reactions of the private sector in turn hastens the pace at which the country’s foreign exchange reserves are depleted, over and above the effects of the fiscal deficit itself.
All this culminates with the previously foreseen fiscal adjustment and official devaluation, rendering the private sector’s behavior rational after the fact. If reserves are heavily depleted, the devaluation will prove to be large. The real exchange rate will experience a substantial depreciation, and since the domestic price level will increase, the real value of private wealth will fall. This decrease in wealth reduces private absorption and, combined with the depreciation of the real exchange rate and the fiscal adjustment, results in a reversal of the trade balance, from a deficit to a surplus. Foreign exchange reserves begin to be accumulated, and the domestic money supply gradually recovers its original real value. Over time, the original real equilibrium is restored, but only after the economy has gone through a period of trade deficits, inflation, and rising premiums for the black market exchange rate—followed by devaluation, trade surpluses, and yet more inflation. In the end, the economy remains saddled with a permanently higher price level, but in other respects the original real equilibrium has been restored.
For a small developing country in which the central bank has a well-defined target for international reserves, an unsustainable fiscal expansion cannot be ignored. Postponing the eventual fiscal adjustment will only necessitate a larger official devaluation and trigger a period of macroeconomic instability. That is, the longer adjustment is postponed, the larger the deviations of the critical macro- economic variables from their equilibrium values, partly because of the reactions of the private sector, which will foresee the eventual need for adjustment-cum-devaluation and react in ways that magnify the movements of these variables. When adjustment finally does occur, the macroeconomic variables will then tend to overshoot their equilibrium values, the extent of which will depend on the postponement period. A delayed adjustment will only serve to exacerbate the extent of the overshooting and thus the extent of macro- economic instability associated with a given shock.
An important finding of our analysis on the effects of the timing of adjustment is that the observed pattern of continuously rising black market premia, inflation, and current account deficits can only be explained by the postponement, for a sufficiently long time, of adjustment. The suggestion, therefore, is that “devaluation crisis” episodes in developing nations have resulted not so much from the occurrence of domestic or external shocks, but from a failure to adjust promptly in response to such shocks.
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