Adjustment, Indebtedness, and Economic Growth: Recent Experience
- Ana María Martirena-Mantel
- Published Date:
- January 1987
More than tour years have passed since the outbreak of the debt crisis. During this time, considerable experience has been gained with regard both to the ability of the world economy and the international financial system to respond and to the nature and effectiveness of the adjustment programs implemented by the indebted countries. An initial phase, in which there was a dramatic improvement in the external imbalances of the indebted countries, was followed by a short period during which it was thought that the strategy adopted in 1982 might effectively restore the economic growth and creditworthiness of these countries and ensure the resumption of voluntary credit flows from the international banking community. However, it soon became evident that the position of the indebted countries was still deteriorating, and in late 1985 the U.S. Secretary of the Treasury made an important statement on the debt problem in which he acknowledged that only economic growth could overcome these difficulties.
Since then, it has become fashionable to talk about “growth-oriented adjustment programs.” The factor supposedly distinguishing these from the more traditional programs—that is, the growth-stimulating component—is their emphasis on the implementation of policies promoting “structural change.” The logic of this approach is that measures to curb demand have in most cases failed to revive the indebted countries’ economies, and on the other hand have been extremely costly in terms of production and consumption. As a result, priority must now be given to stimulating aggregate supply. Much has been said and written about the best policies for improving the allocation of resources (essential components of the structural change strategies), about policies on exchange rates, interest rates, and flexible and appropriate prices and tariffs (avoiding overvaluation and paying higher rates), about trade liberalization, and about the privatization of public enterprises, the reduction of fiscal deficits (and, in general, of public sector participation in economic activity), and so forth.1 But what has yet to be defined is how and under what conditions the growth is to occur—before, after, or at the same time as stabilization. Nor has the problem of financing been resolved, or that of the institutional framework in which this growth is to take place, or whether it is feasible given the existing amounts of and burden posed by debt.
This work does not presume to help resolve these issues, but is rather a collection of observations on some relevant aspects of recent experience that could be useful in formulating a “new strategy,” which pinpoints some conceptual and operational problems that have been encountered at different levels. The paper is organized as follows. Section two provides a brief review of how the debt strategy has developed, with emphasis on the problem of financing (section three). The adjustment process is then examined in general in section four, with attention to how the existence of high indebtedness levels has caused problems and raised obstacles specific to the adjustment process. Finally, the last section raises a number of questions on the possible significance of a new stage of adjustment with growth.
Implementation and Results of Debt Strategy
In evaluating the status of and outlook for the debt problem, the Managing Director of the Fund took note of some of the major achievements made through early 1986. First, there had been a sharp turnaround in the external imbalances of the developing countries, the magnitude of which “few could have imagined.” The current account deficit of the indebted countries had dropped from the equivalent of 30 percent of their exports in 1982 to 3 percent in 1985; second, the developing countries had taken firm adjustment measures, reflected primarily in large cuts in their fiscal deficits and a notable improvement in the competitiveness of their exports; third, debt servicing had continued, and principal had been restructured in an orderly fashion (de Larosière, 1986).
Along with these achievements, it should be added that the pragmatic and cooperative approach adopted at the onset of the crisis—and which the Fund played a central role in formulating—not only successfully prevented a destabilization of the international financial system but also helped to establish mechanisms enabling the indebted countries to cope with the initial stages of adjustment. A cornerstone of this strategy was the adoption of a “case-by-case” approach; although there were aspects common to all the countries affected, the circumstances of each in terms of debt level and structure and of payment capacity were sufficiently dissimilar to merit individual treatment. Another essential aspect of this strategy was the negotiation of “concerted” financing packages, involving a mix of resources from official and multilateral institutions and from commercial banks. The latter were frequently obtained under considerable pressure from the governments of industrial countries and from multilateral institutions.
Thanks to the balance of payments progress mentioned above and the fact that some of the heavily indebted countries, helped by a favorable external environment, appeared to be recovering from the sharp recession of 1983, the debt problem appeared to be on the road to recovery toward the end of 1984.2 Indeed, as shown in Table 1 the Latin American and Caribbean countries as a whole achieved a slight increase in per capita gross domestic product (GDP), while the indicators that measure these countries’ payment capacity (debt/export and debt/GDP ratios) developed favorably. However, the factors on which this optimism was based were of short duration. The slowdown in the pace of world economic activity, the continuing decline in commodity prices, and the decrease in the growth of international trade in 1985 and in 1986 to date have meant considerably less bright prospects.
|Annual growth in percent|
|GDP per capita||–3.3||–5.3||0.8||1.5||0.5|
|Volume of exports||–2.5||8.5||8.6||–1.7||0.6|
|Volume of imports||–1.8||–3.2||–1.2||–0.7||1.3|
|Terms of trade||–5.4||–3.0||3.5||–2.6||–17.5|
|Billions of U.S. dollars|
|Current account balance||–41.9||–10.7||–3.1||–4.6||–17.1|
|Net resource flow2||–5.5||–19.2||–24.8||–33.4||–31.4|
Difference between debt service payments and new borrowing.
Difference between debt service payments and new borrowing.
Four years after introduction of the adjustment strategy, we must ask ourselves what have been the costs of adjustment and the distribution, what is the present situation of the indebted countries in terms of their capacity to continue servicing their external debt and to return to a path of sustained economic growth after four years of adjustment, and whether the restoration of normal debtor-creditor relationships is yet in sight. Although the adjustment process is far from complete and the problems associated with excessive indebtedness will probably continue into the foreseeable future, there have already been many studies that try to evaluate both the results and the feasibility of continuing with the strategy followed so far.3 As regards the first question, the magnitude and distribution of the costs of adjustment, suffice it to say that the 1980s are being referred to as the “lost decade” in most countries with debt problems—particularly in Latin America—in view of the highly likely prospect that per capita incomes in 1990 will be less than in 1980.4 Up to 1985, per capita GDP in Latin America and the Caribbean had fallen by more than 6 percent (Table 1), and wages and per capita consumption declined even more sharply.5
Two aspects of recent experience are of particular relevance to this document. First, the fiscal adjustment implemented by the countries with debt problems has resulted in severe contraction of public investment. According to the UN Economic Commission for Latin America and the Caribbean—ECLAC—(1986), gross capital formation for the Latin American countries declined in real terms by about 23 percent on average. Except for Colombia, all countries in the region experienced a sharp contraction, in excess of 30 percent in the case of the Southern Cone countries. The drop in investment is due to the type of fiscal adjustment the indebted countries have been forced to implement, and certainly raises serious doubts as to the possibility of returning to a satisfactory rate of growth in the future. It would be no exaggeration to say that, in some countries, the severe contraction of investment in basic infrastructure has already seriously impaired their potential for economic growth.
The second noteworthy aspect is the great vulnerability of the indebted countries to adverse changes in the international environment. One development widely discussed in 1984 was the indebted countries’ seeming emergence from the stage of import compression and their prospects of entering a new phase of economic growth stimulated by increased exports, leading to an easing of the debt burden. These predictions were based on more favorable performance of the world economy and trade than had been anticipated (Table 2). However, a drop in the rate of growth of the world economy was enough to significantly alter the growth prospects and payment capacity of the indebted countries.6 This point may be illustrated with some figures. In April 1985, the Fund projected in its World Economic Outlook that the combined debt/export ratio of the countries experiencing debt problems would be approximately 246 percent in 1986 and 186 percent in 1987. In the financial year ended April 1986, these figures were revised to 275 percent for 1986 and 261 percent for 1987. The latest projections (October 1986) contain yet another revision for 1986 and 1987: to 292 percent and 285 percent, respectively. The projected debt/export ratio has been increased by 46 percentage points in the course of 18 months.
|Values Projected in World Economic Outlook|
|GDP of industrial countries|
The impact of the slowdown in world economic activity on the indebted countries’ growth prospects and creditworthiness was compounded by the development of the terms of trade. Apart from the “normal” effect on revenues implied by a deterioration in the terms of trade, for the indebted countries it entails an additional burden, in that the real interest rate that effectively applies to them is the rate found by deflating the nominal interest rate by export unit values. Accordingly, despite the drop in the nominal interest rate, most Latin American and Caribbean countries have experienced a considerable increase in the real rate; the terms of trade for this group of countries have declined by more than 20 percent since 1982 (see Table 1). Concerning Mexico, for example, recent estimates indicate that the transfer of resources abroad attributable to shifts in the terms of trade, even after taking into account the favorable impact of the lower nominal interest rate, has amounted to approximately US$30 billion since 1982 (Table 3).
|Exports of goods and services|
|At current prices||26.1||27.2||30.1||27.7||10.6|
|At 1980 prices||29.2||33.7||35.0||34.2||16.5|
|Imports of goods and services|
|At current prices||20.3||12.8||16.2||18.8||8.6|
|At 1980 prices||18.0||11.1||13.7||15.8||7.3|
|At 1980 rates||11.6||12.3||12.5||12.5||6.4|
|Effect of interest rates||0.6||–2.2||–0.8||–2.6||–2.0|
|Total net transfer||6.0||5.0||6.6||6.9||5.2|
Clearly, the negative correlation between internal adjustment and external environment has meant far higher costs in terms of products and wages, and has introduced considerable uncertainty as to whether some countries will be able to continue servicing their debt.
Regarding the third question raised in the previous section, the prospects for restoring normal debtor-creditor relationships now seem considerably diminished in comparison to what was projected in 1984 when the first multiyear rescheduling agreements were reached. This is hardly surprising in view of the deterioration of the economic situation and creditworthiness of a large number of indebted countries and the policy being pursued by the international banking community of proportionately reducing their exposure in the developing countries and of voluntarily extending new loans to only a select group of countries with no debt-servicing problems, principally in Asia. Total new credit to the developing countries from the international banks has declined from US$82 billion in 1981 to US$34.7 billion in 1983, US$16 billion in 1984, and only US$9 billion in 1985. The total portfolio involving this group of countries increased by only 1.6 percent in 1985. The regional distribution pattern (Table 4) illustrates this process clearly. Asian countries received 25 percent of total loans in 1983, but 56 percent in 1985. In the latter year, the increase in the portfolio corresponding to the countries of Latin America and the Caribbean was less than 1 percent. From another perspective, new bank lending accounted for about 10 percent of the interest paid by the countries of the region.
|Increase as a percentage of portfolio||7.0||2.9||7.6|
|Latin America and the Caribbean||14.8||6.2||1.9|
It has become increasingly difficult to work out concerted financing packages with the commercial banks. Disbursements of such financing to all developing countries during 1985 amounted to only US$5 billion, half the amount granted the year before. New financing commitments assumed by banks during 1985 and the first half of 1986 amounted to only US$2.5 billion against US$16.5 billion in 1984. Even when the amounts in the financing package recently arranged for Mexico are included, total estimated flows for 1987 are substantially lower than for this year. One explanation for the increasing difficulties experienced in arranging new financing packages is that the banks are now a far less cohesive group than when the debt problem arose in 1982. Because the banks have different regional interests, have pursued different capitalization and funding practices, and must deal with banking regulations specific to each country, the problem of spreading risks and possible losses has become far more complex. Advisory committees appear to be playing a less effective role, in that the banks comprising the committees represent increasingly diversified groups.
An ostensibly positive aspect of decreased cohesiveness of the banking community is that it would allow for a wider range of financing arrangements, such as the automatic capitalization of interest. However, one problem met with in trying to broaden the range of financing is that the banks not only encounter difficulties in reaching agreements with their own customers on the terms and conditions of new financing, but increasingly have problems reaching agreement among themselves as well. This phenomenon—which is typical of the decision-making process in cartel-type organizations—has to some extent been fostered by the approach adopted by the governments of creditor countries and by multilateral organizations. Allegedly in order to preserve the stability of the international Financial system and be able to respond “systematically,” a system of “rewards and penalties” has been set up whereby the indebted countries must individually negotiate with groups of creditors, thus institutionalizing the banking cartel.
The system of rewards and penalties, however, has become increasingly lopsided. Clearly the “reward” to be received by the indebted countries that have pursued intensive adjustment programs would be the restoration of economic growth and normal relationships with creditors, factors which in turn should lead to recovery of their debt-servicing capacity. However, the anticipated growth did not materialize, and the chance of restoring “normal” relationships with creditors—a return to spontaneous or voluntary leading—is still very remote for most of the indebted countries. Indeed, some of the contradictions inherent in the strategy pursued have become more obvious, particularly following negotiation of the financing package recently concluded with Mexico:
On the one hand, banks that have already withdrawn from voluntary financing are more and more reluctant to participate in concerted financing schemes. When they do so, they use various means to minimize their participation as much as possible. The economic subcommittees seek to reduce the financing requirements derived from balance of payments projections agreed with the multilateral organizations. Similarly, the banks try to obtain guarantees from the latter for at least part of the financing to be committed. On the other hand, they warn against initiatives on the part of the debtors and against interest capitalization schemes, arguing that these imply a departure from normal commercial practices.
On the whole, the banks are inflexible in granting general concessions, such as the elimination of surcharges, partial debt cancellations, or the granting of interest rates below the prevailing market rates. Such proposals are felt to be premature, among other reasons, because the establishment of criteria on which to base the granting of concessions and the scale of such concessions pose considerable problems. Similarly, the banks argue that once such practices have been introduced, it would be difficult to prevent their extension to cases where they are not fully justified. The banks maintain, however, that each case is considered separately and on its own merits.
Perhaps the most obvious paradox is that, although creditor governments, banks, and multilateral institutions have defended the implementation of a case-by-case strategy from the outset, the fear of setting a precedent seems to be a decisive factor in the course of negotiations. This was more than evident throughout the recent negotiations with the commercial banks on the Mexican financial package.
The banks’ reluctance to provide an increased flow of financing to the indebted countries and their inflexibility in granting concessions raise serious doubts as to the viability of the current strategy. First of all, it is clear that no genuine system has actually been adopted for considering each case individually, adjusting the amount and terms of the financing to individual requirements. In fact, the strategy has been one of uniform treatment, in which a series of ritual steps or stages must be adhered to by the indebted countries (beginning with a Fund-supported adjustment program and followed by agreements with the World Bank, etc.) if they wish to obtain from the banks any arrangement on a rescheduling of debt principal or—perhaps—a reduction in surcharges. Similarly, through the official creditor members of the Paris Club, the indebted countries can aspire to negotiate restructurings—possibly under more favorable terms than those obtained from the banks, provided they have agreed upon a Fund-supported program—but risk losing additional import credits guaranteed by official agencies.7
The other aspect of the debt strategy is the adjustment process being pursued by indebted countries on the basis of programs supported by Fund resources. Historically, the developing countries have adopted this type of program in situations characterized by “unsustainable disequilibria” (of a temporary nature) in their balances of payments. Although the Fund staff has frequently stressed that it is advisable for members to approach the Fund before imbalances become more severe, adjustment programs are frequently introduced when the situation has reached at least a certain degree of seriousness. This was surely the case before the debt crisis became manifest, and has unquestionably been the norm since 1982, even though the notion of temporariness has obviously changed.
In general, the term unsustainable disequilibria is understood to mean current account deficits that cannot be financed by a voluntary contraction of external credit or the use of international assets. Given the sharp cutbacks in external financing in recent years and the virtual disappearance of the voluntary financing referred to earlier, the margins of what could previously be considered a sustainable disequilibrium have contracted considerably. Traditionally, distinctions have been drawn for program design purposes on the basis of whether the causes of imbalances were domestic or external. The origins of the debt problem have been widely discussed and documented, and while discussion continues as to whether the principal factors responsible for the crisis were inadequate financial policies or events outside the control of governments, it is clear that both came into play.
Although, in designing programs, an effort has been made to adapt them to the nature of the disequilibria, to the availability of resources, and to the macroeconomic objectives sought, the general lines of these programs have changed only slightly over the years. Given that the fundamental objective of the programs is to restore a balance of payments position that is viable in the medium term, the type of measures normally included consists of a mix of policies aimed at reducing domestic “absorption” and redirecting the spending required by various sectors (Guitián, 1981). Although the programs applied to indebted countries in recent years have placed more emphasis than in the past on measures designed to improve resource allocation and promote “structural change,” it is clear that demand-management policies have remained the backbone of these programs.
It is widely known that the theoretical underpinning of the programs supported by the Fund is based on the works by Polak (1957) and Robichek (1967, e.g.). Even at the risk of oversimplification, it is worth reviewing briefly the analytical basis of program design, which may be summarized in two equations:8
The first equation results from combining the identity of the national product with the definition of the balance of payments, while the second is obtained from the balance sheet of the banking system and from the equilibrium condition of the money market. The first equation shows that for a given level of external financing, and considering the difficulty of increasing the product in the short term, improving the balance of payments (reflected in an increase in international reserves) requires a reduction in domestic absorption. This may be achieved by reducing government spending, raising taxes, or both measures combined. In turn, to achieve domestic and external equilibrium simultaneously, it is normally necessary to apply measures to redirect spending, this because, if we assume an initial position of disequilibrium, reducing domestic demand alone provides no guarantee of equilibrium in both sectors in the absence of perfect price flexibility. Among such measures, for theoretical and other reasons it is normally advisable to opt for exchange rate adjustments. The second equation, on the other hand, provides us with the working tool for correcting the external imbalance (provided that the demand for money is a stable and predictable function), namely the reduction of domestic credit. In fact, this equation represents the rudiments of financial programming and usually serves as the basis for establishing the criteria or quantitative targets for financing of the public deficit.
In practice, exercises in financial programming normally start from a predetermined amount of external financing, making certain assumptions about the trends of the fundamental macroeconomic variables (nominal GDP, inflation, exchange rate and interest rate developments, exports, etc.) and about the functional behavior of certain others (the demand for money and other financial assets, and imports), and use these to derive the size of the public sector deficit that is consistent with a particular target for rebuilding international reserves and financing the private sector. This is an iterative exercise that should converge on reasonably consistent macroeconomic scenarios; these in turn are used as the basis for negotiating the program. In fact, if the demand for money is a relatively stable function throughout the length of the program (or if the velocity of circulation is more or less constant), controlling the monetary aggregates through the use of targets for credit expansion, the public deficit and international reserves may make it possible to roughly approximate the projected development of nominal GDP, except that the extent to which the contraction has an impact on inflation and the growth of real GDP is indeterminate and the latter normally constitutes the adjustment variable. It is specifically because of this that Fund programs are frequently criticized for having a pronounced contractionary bias that works against economic growth.
The debate on whether Fund programs are or are not contractionary in nature dates back at least to the celebrated structuralist/monetarist controversy of the 1950s, a debate revitalized of late in light of the results obtained so far in the application of adjustment programs—especially in Latin America—since 1982 (Taylor, 1986). White this topic is of the utmost importance, and without seeking to join this debate, it should be noted that a substantial proportion of the discussion on the possible recessionary effects of adjustment programs supported by the Fund appears not to have been focused on the most relevant aspects of the current problem. On the one hand, the policies designed to reduce aggregate demand do, by definition, have some contractionary effect, at least in the short term. In addition, depreciating the exchange rate frequently has an initial impact that is recessionary.9 On the other hand, the positive effects on economic activity of eliminating distortions or of changing relative prices are normally not immediately of sufficient magnitude to offset the recessionary impact of measures to contain aggregate demand. As a consequence, it is extremely difficult to conceptualize a program aimed at correcting macroeconomic disequilibria that grow out of excess demand which does not have a negative impact on economic activity in the short term. However, this does not necessarily justify the conclusion that the program in question is biased against economic growth. It may be argued, and indeed has been argued by persons defending the design and implementation of the programs, that a return to a viable balance of payments position is a necessary precondition for renewed economic growth. It might also be asked whether there is any alternative to the application of adjustment measures in that, in the absence of a program, there will be an adjustment to a balance of payments crisis anyway, but in a disorderly manner and at a social cost that would ultimately be far greater (Khan and Knight, 1985).
It could almost be argued that some degree of initial deterioration in economic activity (and, of course, a reduction in consumption) is an unavoidable cost of restoring domestic and external equilibrium. In turn, such a deterioration will be a function of the financing available, the magnitude of the disequilibria that were to be corrected, the rigidities and distortions brought about by them or by institutional factors and, to a significant degree, by the initial holdings of assets and liabilities of the transactors in the economy. However, this does not invalidate observations to the effect that some programs make no effort to minimize the social cost of adjustment, or that their design entails some bias toward overshooting balance of payments targets and underestimating the effective degree of adjustment (e.g., Dell, 1982). Another type of concern that has frequently been voiced is the operational workings of the programs. In particular, the logic of establishing performance criteria with respect to given variables presumes that these variables can be controlled by the authorities and that their behavior has a direct impact on the macroeconomic targets and objectives. In some cases, however, the variables supposedly under the control of the authorities in fact are quite endogenous.10
One relevant point is that orthodox or traditional types of programs, while they may have a contractionary bias, may be extremely effective in helping to restore external equilibrium, providing a sound basis for future growth, when they are applied in countries where the disequilibria are moderate. In the worst of cases, the additional social cost of overshooting external targets at the cost of a greater downturn in economic activity would not be politically intolerable so long as this is an effort to correct imbalances that are not disproportionate. However, in cases involving the type of disequilibria affecting the highly indebted countries, the problems associated with designing and implementing adjustment programs take on a new dimension.
While the Fund has accumulated vast experience with adjustment programs, their implementation in countries where the public and private sectors are heavily indebted, both domestically and abroad, is relatively recent. It should be recalled that the last episodes of generalized external debt moratoria in Latin America occurred in the 1920s and 1930s, well before Bretton Woods. A high level of indebtedness has significant consequences in the process of adjusting to external disequilibria that are not always recognized and incorporated into the design of programs. One important point is that, in addition to the “flow” imbalance represented by the current account deficit, the disequilibrium represented by high indebtedness entails problems more directly related to a “wealth” imbalance. Correction of the external deficit (or economic stabilization) does not resolve the problem of long-term dynamics complicated by the existence of high debt levels. In this regard, if countries have borrowed “excessively”—judging from a current cross section of relative prices and the perception of creditors—the adjustment may be conceived as a process of “debt elimination” or amortization.11 This process applies, of course, both to the external and the domestic debt, although the economic implications of actual amortization of the two types of debt, of course, have quite distinct effects. Their most obvious difference is that amortization of the external debt entails a net transfer of resources from abroad, while payment of the domestic debt has redistributive effects only domestically.
The experience of Latin America in recent years illustrates this process clearly. Indeed, an assessment to the effect that the current strategy is viable in terms of the extent to which the above objectives are achievable is effectively a contention that the transfer of resources involved may occur at the same time as the indebted countries recover some measure of economic stability and begin to grow. It should thus come as no surprise that the efforts made to judge the viability of this strategy quantitatively as regards long-term dynamics consist in simulation models designed to identify which conditions must be fulfilled for a transfer of resources and economic growth to occur simultaneously.12
Impact of Indebtedness on Adjustment Program
We now turn to specific illustrations of the manner in which the existence of a high level of domestic and external indebtedness complicates adjustment processes and affects the impact of the measures normally included in stabilization programs. The examples set forth below do not, of course, constitute an exhaustive list.
The quite sizable adjustments in the real exchange rate carried out by various Latin American countries in recent years have had significant contractionary and inflationary effects simultaneously.
In accordance with traditional approaches, depreciation of the exchange rate should be reflected in an increase in the production of marketable goods stimulated by increased external demand for exports and domestic demand for import substitutes. However, various authors have noted that in practice—especially in the developing countries—many devaluations have been followed by some type of economic recession. Worse still, it is not always clear to what extent the lower level of economic activity can be attributed to the exchange rate change. Díaz-Alejandro (1965) observed that the redistributive effects associated with exchange rate depreciation could have a negative impact on economic activity to the extent that they result in a transfer of income toward sectors with a lower propensity to spend.13 In addition, other authors have indicated that there are supply-side mechanisms whereby a devaluation may have a recessionary impact (Van Wijnbergen, 1986; and Gylfason and Risager, 1983). Furthermore, when the public and private sectors are indebted in foreign exchange, the possible negative effects of a reduction in the exchange rate may be amplified considerably. Tanzi and Blejer (1986) note that one initial and obvious outgrowth of the existence of public debt is that it must be serviced, and there is therefore an increase in the associated payments (either in the form of higher interest rates or through the effect of an exchange rate reduction on debt service expressed in terms of domestic currency) which increases the public deficit. It is clear that measures taken to reduce the deficit will have some impact on economic activity, with the added difficulty, as the authors observe, that on many occasions the type of adjustment that occurs is inefficient and tends in the long run to affect the potential for economic growth. For example, as noted earlier, it has been seen that the drastic fiscal correction brought about in Latin America in the past four years has had an impact in particular on cutbacks in public investment. On occasion there has also been recourse to tax measures that introduce distortions and run counter to the medium-term and long-term objectives of deregulating trade and promoting exports, such as the increases in tariffs or export taxes.
Regarding private debt, exchange rate depreciation may have a significant recessionary impact by affecting the investment decisions of enterprises. A devaluation has the immediate effect of revaluing upward those assets of an enterprise that are denominated in foreign exchange, while the revaluation of its other assets (to the extent they include marketable goods) may not be immediate or in the same proportion. This negative “risk effect” may directly affect the cost and amount of Financing available to the enterprise, giving rise to liquidity problems that obligate the firm to rebuild its working capital before undertaking new investment projects. Likewise, the uncertainties about future exchange rates that may be induced by a devaluation may prompt enterprises to restructure their obligations by paying off their credits in foreign exchange ahead of schedule. These effects were significant in the 1976 devaluation of the Mexican peso and explain the substantial decline in private investment that was noted in the following year (Córdoba and Ortiz, 1980). More recently, the potentially devastating impact on economic activity represented by the exchange losses incurred by enterprises following the 1982 devaluations prompted Mexico’s financial authorities to establish mechanisms to spread such losses over time. A further effect of exchange rate devaluation on the Financial position of enterprises is that they endeavor to make up for foreign exchange losses and restore their liquidity position by increasing prices beyond the level justified by just the impact of the exchange rate on imported inputs. To the extent that effective protection allows for such a shifting of prices to the consumer, it will increase price inertia and make it extremely difficult and costly to reduce inflationary pressures.
Inflation and Fiscal Deficit
A high level of external indebtedness is not the only factor complicating the stabilization process. The existence of a significant amount of domestic debt may also pose important problems for the implementation of adjustment programs, especially in countries with a high rate of inflation. If the domestic debt is in the form of bonds whose yield is adjusted in order to compensate the holders of such bonds for the erosion of capital caused by inflation, an increase in inflation will have a disproportionately large impact on the interest bill paid by the government. If we assume, therefore, that the nominal value of the gross domestic product increases pari passu with the rate of inflation, as the latter increases the financial requirements of the public sector will increase in relation to GDP, creating the impression that public finances are deteriorating even though this is not necessarily the case.14 These effects significantly complicate the management of public finances within the adjustment process by giving equivocal domestic and external signals as to the fiscal effort being made by the authorities.
While the inflation may be fully predictable, for economic policy purposes the implications of the distortions it causes in measurement of the fiscal imbalance are less important. In this case, for a given financial structure of the public sector, it is possible to make a target for the real debtor position of the government compatible with a particular level of financing requirements. However, given that inflation is not a sure thing, it may happen that, even when the nominal targets for the public deficit are not met, the real adjustment in public finances that is sought under the program is in fact taking place. In an inflationary environment, an increase in the financing requirements of the public sector does not necessarily lead to increased pressures on aggregate demand or the balance of payments, in that these increased requirements may simply reflect accelerated amortization of debt principal which should not be expected to have an impact on aggregate demand. For this reason, a more appropriate yardstick for the fiscal position of the government is the operating deficit, a concept which encompasses only the real portion of the interest paid on the public debt. A further argument in favor of incorporating this measurement of the fiscal deficit in adjustment programs is that it is more directly controllable by the authorities.
Indebtedness and Capital Flight
Capital flight is a topic that has received considerable attention of late. It has frequently been said that a country unable to keep its residents’ savings from being sent abroad has little hope of attracting capital flows from abroad. In particular, in negotiations with creditor countries, the international banking community has used such arguments in asserting that capital flight occurs because countries are applying incorrect policies.15
Unquestionably, capital flight originally arose from a perception on the part of savers that the policies implemented lacked coherence. A classic example of this is the outcome of an exchange rate policy that results in undervaluation of the exchange rate (such as the “tablita” in Argentina or the “managed floating” of the Mexican peso in 1980–81), with the resulting pressure on the exchange market being financed by borrowing abroad. Under current circumstances, however, indebted countries may experience both capital flight and exchange rate instability, even though they are pursuing coherent macroeconomic policies (on exchange rates, interest rates, etc.).
The debt problem involves more than just the external debt. When it also includes the domestic debt, and the financial position of the public sector is precarious and vulnerable, the sudden emergence of an additional fiscal imbalance (caused, for example, by a disruption on the supply side or a deterioration in the terms of trade affecting tax revenues) may cause concern on the part of savers, who may fear that the government will be compelled to impose some kind of tax on the holding of Financial assets, either in the form of higher inflation or via some other confiscatory mechanism. In these circumstances, the natural reaction of the public will be to try to unload this type of asset. Paradoxically, if the public perceives that the government is firmly resolved to fulfill its external commitments, it may have even greater doubts about the government’s capacity to continue servicing the domestic debt. The notion that overall indebtedness has reached limits that exhaust the capacity to borrow additional amounts abroad, and that there is thus a problem with the basic solvency of the public sector, may go a long way toward explaining capital flight under present circumstances.16
Adjustment and Growth?
A fundamental issue to be resolved in the design of “growth-oriented” adjustment programs is the temporary nature of the measures they include. It has been said that the orthodox or traditional measures for curbing demand that are applied in the heavily indebted countries under Fund-supported stabilization programs, while succeeding in producing sharp turnarounds in external positions, have not been successful in either reducing inflation or restoring the conditions needed for growth. The hypothesis is that the debt problem raises problems of “access” whose dynamics work at cross-purposes with efforts to stabilize the economy in a dimension of “flows.” The dynamics of inflation and its inertial forces—which are reflected in both the amount of debt and the impact of stabilization policies—have meant that the trade-off between output and short-term inflation has proven more costly than past experience with stabilization (in countries without debt problems) would have indicated. For these and other reasons, the anti-inflationary programs implemented in Argentina, Brazil, and Israel have been focused on directly controlling the pricing process.
By definition, structural adjustment processes require a relatively long-term outlook in order to obtain results. To ensure their continuity, adequate Financing must be available and they must not be jeopardized by exogenous shocks. In turn, this Financing will require an updated institutional framework. However, the banks appear reluctant to participate. The Fund, which has played a preponderant role, is an institution whose resources are revolving in nature and are intended to support programs for correcting temporary balance of payments imbalances, not problems of a more structural type. The final question is whether the financing will have to come from additional indebtedness or whether the amounts and burden of debt must be reduced as a prerequisite to the resumption of growth (Dornbusch, 1986).
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I basically agree with the author’s assessment and description of the existing external debt situation. I will make an alternative submission, illustrating the viewpoint of creditors and of most of the international organizations and their belief that the strategy is working and has been strengthened. It is not a view to which I would subscribe, but it is the prevailing view on the other side of the negotiating table vis-à-vis the debtor countries.
I will therefore describe the strategy and its recent development.
First of all I should like to run through some known facts about the strategy, such as the diagnosis, the objectives, and the tactics for achieving them. To put the diagnosis in simple terms, the problem of external debt is a liquidity problem.
At one time or another there have been interest rate rises that have aggravated the existing situation, problems with repayment dates being concentrated within a short period as a result of the way in which external indebtedness has been tackled, and the very important phenomenon known as contagion.
The aim is a return to normality, which is seen as the re-establishment of the flow of funds from the commercial banks to the debtor countries. The tactics are based on two fundamental rules, namely, case-by-case treatment and a combined effort versus unilateralism. Here, the advisory committee of commercial banks plays a fundamental role. So long as ideas are kept within the confines of those rules, there is no problem. If someone breaks the rules, the full weight of the sanctions of the commercial banks and public institutions descends on his head. The reason for the case-by-case approach is that, in the early days, the international Financial system could not have withstood a generalized bankruptcy of the debtor countries, but with the passage of time the commercial banks would find themselves better placed to absorb losses (and if one looks at the banks’ balance sheets since 1982, that is precisely what they have been doing), and it would also be possible to confine the problem to a much smaller number of countries, isolating the most problematical cases, to which radical measures could be applied. These circumstances explain the approach adopted by the banks since 1982.
The statistics show that matters improved substantially in the great majority of debtor countries during 1984–85, to the point where their situation was becoming manageable. And then what happens? A drastic deterioration in their terms of trade, particularly in those countries affected by the steep decline in oil prices, such as Mexico and to a lesser extent Venezuela and Ecuador. These countries were seen as shining examples of the success of the strategy, and were being groomed by the international economic community for a return to the “voluntary” financial market, in other words, access to normal commercial bank credit.
What is the flaw in this strategy? Are the creditor banks possibly too cautious? And where do the designers and overseers of this strategy direct their efforts?—toward dealing with the aftereffects, which means renegotiating the agreement in the cases of Mexico and Venezuela and some special measures in the case of Ecuador. This means offering new alternatives, and we start to hear talk about stand-by loans, as in the case of Mexico, and about growth, albeit more rhetorical than real. The Baker proposal shows how politically convenient it can be to change tack, but even before that, of course, people had already been thinking about growth. The hardest part is putting pressure on the banks to participate in a scheme where they will have to put in more money.
The picture as I have described it makes it fairly unlikely that the banks will make any concessions on accepting losses of any kind. The preferred strategy is to move toward a normalization of financial flows. When general proposals such as those of Senator Bradley of the United States Congress are put forward, the reply will be that it is undesirable to set precedents. For this reason, I do not think that solutions of the kind which offer generic concessions are likely to win the day. The problem may in fact transcend the question of the indebted countries of Latin America. The Bradley proposal on reducing interest rates could generate calls within the United States for similar solutions to the problems of credit for energy costs, mortgages, and so forth, in that country. Once the senators have done their sums, I wonder if they will still look so favorably on this kind of proposal. This, then, is the view which is now tending to prevail, and it will have to be considered in the debate on external debt.
I think that Guillermo Ortiz’s paper, with which I agree, is extraordinary, particularly in the clarity of its ideas. The only thing I might question is that the title given to the subject, by connecting adjustment policy problems with those derived from indebtedness and growth, could be understood as meaning that each process is conditioned by the other and that they are interdependent. Indebtedness and growth certainly are, while adjustment is necessary only when practices occur that are not appropriate for the proper management of economic policy. To bind these three ideas together could lead us to distort the true nature of the problem, and we might consequently create situations that are not appropriate for the political, social, and economic stability of our countries.
I would very particularly stress that in Guillermo Ortiz’s paper, as in those of the other exponents, although expressed in different terms, there is one common denominator: their analyses conclude by emphasizing that the external indebtedness problem took shape and its consequences started being felt many years ago, and since that time, both creditors and debtors have accumulated considerable experience in handling negotiations and in designing and enforcing the economic policies that such circumstances require. It is striking that in this commentary, as in others of its kind on this subject, the intellectual effort of the distinguished minds at work continues to focus on analyzing the contributing factors, the magnitudes and the effects, and the future that we might expect in our societies as a result of external debt under the present rules of the game. On the other hand, very little of this intellectual effort is directed to the creative work of seeking pragmatic solutions.
It is stated again and again that there are many solutions to the problem of external debt; it is emphasized that the success of any one of them will be just as much characterized by and dependent on the political determination in the minds of those who will have to choose and then impose it as it will on the resolution required to enforce it. Although the point made is genuine and of quite valid significance, I think that it is not very pragmatic simply to state it, without completing it with the corresponding contribution of a solution.
Naturally, thinking more as a lawyer than as an economist, I would say that what is missing is the determination by somebody to work on a viable solution from the political, legal, financial, and social viewpoints, both in the creditor and in the debtor countries, so that the incentive or coercive forces of the state for this very reason push for its rapid implementation.
By way of support for some concrete thinking along these lines, I am wondering this afternoon why the International Monetary Fund cannot make one of its basic purposes to demand that creditor and debtor countries adopt political and economic measures that would offer a final solution to the debt problem?
For this course not to be adopted by an institution such as the Fund, whose purpose, among others, is to seek equilibrium in the economies of its member countries, is to reject the use of its basic function and to turn all its other efforts into acts of only temporary worth that are mere palliatives for the serious problems of the world that it oversees; and what is more serious, to make the economies of our countries pay a price that will erode their social bases, which will never recover, thus endangering the international economic system, and the sociopolitical structures of the world and particularly those of the Latin American region.
One of the recommendations or measures the International Monetary Fund might adopt along the lines of what I am thinking could be to redefine the objectives of the World Bank, the Inter-American Development Bank, or of any other similar institution or, perhaps, to create a new financial institution that could be given, as its specific purpose, the restructuring of the indebtedness of our countries in terms of cost and maturity. They would be adapted to the internal realities of each individual country so that our people would not be subjected to adjustment pressures caused by external indebtedness or sacrifice the requirements of growth, on which any ambitions for political, economic, and social development are predicated.
Such an institution would be given resources to carry out its commitments by means of capitalization, or rather, by the contributions that international banking institutions would make to its capital—from the accounts receivable or obligations vis-à-vis the developing countries, or those of Latin America. In due course, these could be reinforced by contributions in kind of uncommitted exportable surplus products provided by the debtor countries to pay any shareholdings they may wish to subscribe to, as a means of obtaining greater influence in the new organization.
The new contributions in kind would be a major source of resources to be channeled to Latin America, as well as a means of linking the commercial future of Latin America with the destiny of its debt, as the new institution would, because of the interest there would be in converting the contribution in kind into cash, be its best ally in opening new markets for their products.
In exchange for its contribution from the accounts receivable of the developing countries, or those of Latin America, international banks would become owners of shares in the institution. These shares could be bought and sold on the capital market or be used by them to support the issue of any kind of securities they might wish to issue. Failing this, they might be used as an instrument to guarantee extraordinary credits that might be obtained from the central banks of their respective countries.
This difficult situation can be faced only with a positive attitude, with a free rein being given to the imagination, and with iron determination.
I think that only by creating a financial institution to tackle the serious problem of debt can we overcome the great conceptual abyss that stands between the debtors’ and the creditors’ intentions; the first are rooted in the political responsibility and vision of those who govern, and the second only in the responsible opinions of the administrators who work toward strictly Financial and economic goals.
The prescription that my thoughts lead to after Guillermo Ortiz’s presentation by no means claims to be anything other than an exercise intended to stimulate in you the overriding need to redirect this kind of effort toward other channels and toward the obvious possibility of obtaining pragmatic results from such intellectual and physical efforts as this, which are very frequently made in this Continent.
See, for example, Balassa (1986).
This viewpoint was widespread in the private financial and governmental circles of the creditor countries and in international organizations. It is reflected, for example, in the positive tone of the conclusions drawn in September 1984 by the Interim Committee on the outlook for the world economy and the debt problem. Cline’s noted study appeared at about the same time (1984); it, too, took an optimistic view and supported implementation of the strategy in the form in which it had evolved.
An interesting study by Sachs (1986) summarizes the academic debate on the debt problem and also contributes new ideas. The study under Taylor’s direction (1986) is an effort to compare the recent adjustment experience of the indebted countries and to evaluate the policies recommended by the Fund.
Excluding Brazil and Cuba, the ECLAC estimates that per capita output in Latin America fell by 8.8 percent between 1981 and 1985 (United Nations, 1986).
See ECLAC’s 1986 Annual Report, according to which the urban minimum wage had declined in real terms, since 1980, by 13 percent in Brazil, 24 percent in Chile, 40 percent in Ecuador, 28 percent in Mexico, and 47 percent in Peru.
Although there has been a considerable slowdown in economic activity in the industrial countries since 1984, particularly in light of the favorable effects that it was assumed would follow from the drop in oil prices, these countries still cannot be said to have entered the recessionary stage of the economic cycle.
Brazil is facing many problems in its relations with the Paris Club because it has not negotiated a program with the Fund.
Edwards (1985) provides a recent empirical analysis of this point.
As indicated in the next section, for example, the public sector deficit is extremely sensitive to the behavior of the exchange rate and inflation rate (see Córdoba, 1986).
One process resembling the “real amortization” of the external debt, in terms of the transfer of reserves it entails, is the increase in its balance resulting from the impact on the balance of payments of changes in the terms of trade and interest rates. As noted earlier, in Mexico, the increase in the nominal balance of the debt attributable to adverse terms of trade has amounted to almost US$30 billion since 1982.
Krugman and Taylor (1978) have formalized these and other possible contractionary effects of a devaluation on aggregate demand.
It should be borne in mind that the types of fiscal measures (such as price and rate increases for goods produced by the public sector) and exchange rate measures normally included in programs frequently have a significant inflationary impact at the outset.
It is to some degree ironic that the banking community has been so insistent on this topic, in that more than a few banks have directly promoted capital flight through their branches in the capitals of Latin America. Intense debate has also arisen with respect to the amount of such flight; the various estimates available show quite a wide range of results (see Zedillo, 1986).
Ize and Ortiz (1986) developed a model that reflects these concepts and includes the endogenous determination of the maximum amounts of domestic and external indebtedness that may be incurred by the government.