Chapter

Adjustment in Latin America, 1981–86

Editor(s):
Mohsin Khan, Morris Goldstein, and Vittorio Corbo
Published Date:
September 1987
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Author(s)
Andreés Bianchi

Latin America is entering the sixth year of an adjustment process, whose end is not yet in sight notwithstanding the fact that the process has entailed the costliest recession since the Great Depression and strong efforts in most countries to restructure policy. Although 1986 showed some improvement in domestic economic activity and control over inflation, their sustainability is unfortunately in doubt because of a simultaneous deterioration in external accounts. Given the duration and severity of the crisis, adjustment is no longer feasible except when accompanied by growth. Nonetheless, with the rebound in the current account deficit in 1986 and the reluctance of private creditors to renew voluntary lending, the financing of an expansive growth-oriented adjustment would not seem forthcoming. Therefore, new, bolder, and more comprehensive initiatives may have to be introduced in order to achieve adjustment with growth.

The Adjustment Process

Origins of the Crisis and Need for Adjustment

Latin America’s debt crisis exploded in August 1982 when, as a result of Mexico’s debt moratorium, banks cut back lending abruptly and forced the region virtually to close its current account deficit of $40 billion (equivalent to about 35 percent of its exports of goods and services and some 6 percent of gross domestic product (GDP)) in but two years.

Nevertheless, at least in the oil importing countries of the region, the need to adjust originated earlier. It was set off by the oil price hike of 1979 and subsequent reaction by the OECD. The simultaneous pursuit of anti-inflationary policies in the industrial countries, coupled with the decision to target money growth rather than interest rates in most OECD economies, induced a prolonged recession in the North, together with unusually high real interest rates.

Oil importing developing countries were thus faced with huge and simultaneous increases in both their oil import bills and interest payments, just when the contraction in international trade lowered the prices and the demand for their primary commodity exports. Judging the crisis to be cyclical and consequently temporary, nearly all these countries borrowed heavily to finance their rising current account deficits, most, largely to maintain consumption. A few, Brazil for example, invested to increase export capacity and to substitute imports. Others, especially in the Southern Cone, also borrowed to acquire imports in an attempt to reduce inflation, but this led to ever more overvalued exchange rates.

Oil exporters, buttressed by independent forecasts of continuously rising energy prices, also borrowed heavily to expand production and to raise public and private consumption to a level consonant with their higher expected permanent income.

Since banks were once again awash in liquidity, they attempted to recycle petrodollars as quickly and easily as they had done after 1973. In merely two years, 1980-81, the region’s external debt rose some $100 billion to nearly $290 billion, most financed by commercial banks. Banks sharply increased lending, apparently unconcerned that by 1979 debt/export ratios were much higher than in 1973 (2.1 vs. 1.4). Moreover, banks overlent to borrowers with conflicting interpretations of the shocks (losers considering them transitory; gainers, permanent) and hence with mutually incompatible rationales for borrowing. Thus the debt crisis grew out of imprudent lending as well as imprudent spending.

Difficult though it was in 1979 to foresee the magnitude and duration of the OECD recession, the exceptional rise in international interest rates, or the length and depth of the depression in the prices of basic commodities (except oil), it was even more difficult to predict the coincidence of these three events. Had real interest rates remained at, or soon returned to, their historic levels (2 percent), and had prices of basic commodity exports (exclusive of oil) maintained their long-term (1950-70) values in real terms, the external crisis would have been relatively mild and the region would have been in current account surplus (in theory able to reduce debt) from 1983 onwards (Table 1). Unfortunately the protracted crisis rendered permanent the damage caused by presumably cyclical factors.

This unstable state of affairs came to a close in 1982, when the prolonged recession in the OECD and the Mexican debt moratorium made banks fearful of their exposure in Latin America and led them to curtail their lending. Because of this abrupt fall in net capital inflow, Latin America could no longer finance current account deficits of the colossal magnitude it had run in 1981-82, or even of the modest extent recorded in 1977-79. Adjustment became mandatory in nearly every country.

Table 1.Effect of Deterioration of Unit Prices of Non-Petroleum Exports and of Rise in International Interest Rates on Latin America’s Current Account Balance(In billions of U.S. dollars)
Deficit in Current Account Arising fromCounterfactual Current Account
Export pricesBalance Without
(excluding oil)LIBOR aboveDeterioration in
below 1950-70historicExport Prices
averagerate (2 percent) inActual Currentor Rise in
in real termsreal termsAccount BalanceInterest Rates
(1)(2)(3)(4) = (3)-(1)-(2)
19814.75.4-40.5-30.4
19829.87.5-40.6-23.3
198312.86.8-7.412.2
198410.88.6-0.219.2
198511.75.0-4.012.7
19868.57.0-14.21.3
Source: Calculated on the basis of ECLAC’s balance of payments series.
Source: Calculated on the basis of ECLAC’s balance of payments series.
Phases of the Adjustment Process

From the beginning the adjustment process had to be carried out under unfavorable external conditions. International interest rates reached an all-time maximum in 1981 and in real terms remained until 1985 at the highest level for half a century. The prolonged recession in the OECD countries slowed international trade and contributed to the sharp decline in the prices of primary products, setting off a continuous deterioration in Latin America’s terms of trade.

Moreover, since mid-1982, voluntary lending by the international commercial banks disappeared altogether, thus reversing the steep and sustained upward trend of 1970–81. Because of this shift and despite Fund-led efforts to organize rescue packages, net capital inflow to Latin America plunged from $37.5 billion in 1981 to $3.2 billion in 1983 and fluctuated around $6.5 billion in the three following years.

Such a radical drop in external financing would have been difficult to handle in the best of circumstances. In this instance, however, its negative effects were compounded by a sizeable increase in factor payments and in some countries by large capital flight. In fact, after rising by 40 percent to a record level of nearly $39 billion in 1982, net payments of interest and profits hovered around $35 billion thereafter, double their average level in the four years preceding the crisis.

The increase in factor payments and the near cessation of net capital inflow led in turn to a dramatic reversal in the external transfer of resources. In effect, after receiving net resources from abroad amounting to an annual average of $13 billion in 1978–81, Latin America was forced to transfer to the rest of the world more than $26 billion a year during 1982–86. Hence, while in 1978–81 capital flows covered amortization and interest payments and added to the region’s import capacity the equivalent of 18 percent of the value of exports, in 1982–86 the net transfer of resources subtracted from the import capacity an amount equivalent to 25 percent of the region’s exports. This shift was equivalent to the effect of a 36 percent fall in the terms of trade. Thus, since 1982, rather than serving to cope with external disequilibrium, procyclical private capital flows aggravated the crisis and constituted an additional factor to which the region had to adjust.

Phase I: Recessionary Adjustment (1982–83)

Because of this unfavorable external environment, Latin American countries were forced to adjust quickly. Notwithstanding higher interest payments, the region’s current account deficit was cut from over $40 billion in 1981–82 to less than $0.2 billion in 1984. The current account disequilibrium was virtually eliminated by a turnaround in the trade balance, which, after recording a deficit of nearly $2 billion in 1981, marked up a surplus of over $39 billion in 1984 (Table 2).

Nevertheless, because of the way in which it was achieved, the closing of the current account deficit entailed large costs in terms of output, investment, employment, and living standards. Owing to Latin America’s heavy dependence on primary products for its export earnings and the fall in the international prices of most commodities, the value of the region’s merchandise exports, after declining in 1982 and 1983, barely recovered in 1984 the level obtained before the crisis, in spite of a 20 percent expansion of their volume between 1981 and 1984. Hence, the burden of correcting the external imbalance had to be shouldered by imports, which plunged from $98 billion in 1981 to $56 billion in 1983 and stabilized at less than $60 billion in 1984–86.

Of course, this cutback in the value of imports reflected in part the excessive level that these had reached in 1981, at the height of the period of easy, overabundant, external financing. Nevertheless, the contraction in the volume of imports (35 percent in 1982–83) went well beyond the “fat” in the pre-crisis import bills (luxury consumer goods, military hardware, and less urgent capital goods), so requiring sharp cutbacks in the imports of indispensable intermediate inputs, as well.

Consequently, despite the rapid pace of import substitution—which manifested itself partly in the plummeting of the import coefficient to its lowest level in 40 years—the reduction in the availability of imports had strong recessionary effects. In 1982 and again in 1983, the region’s GDP fell for the first time in the postwar period while fixed investment, contracting by 30 percent, failed to meet even replacement needs in several countries. By 1983, output per capita was fully 10 percent lower than in 1980 and had fallen back to the 1976 level. Moreover, because of the deterioration in the terms of trade and the increase in factor payments, the reduction in national income per head—by far a better indicator of economic well-being than GDP per capita—was even larger (14 percent).

Table 2.Latin America: Main Economic Indicators, 1980-86
1980198119821983198419851986
Indices (1980=100)
Gross domestic product100.0100.599.096.699.8102.4105.9
Per capita gross domestic product100.098.194.590.190.991.392.4
Per capita national income100.096.589.885.686.786.7
Terms of trade100.094.085.285.690.185.678.1
Exports of goods
Value100.0107.698.198.2109.6103.187.8
Volume100.0108.5110.2119.8130.6130.6127.3
Purchasing power of exports of goods100.0101.994.2104.6118.5112.8101.9
Imports of goods
Value100.0108.186.661.964.464.666.2
Volume100.0102.683.465.570.771.776.7
Growth Rates
Gross domestic product5.30.5-1.4-2.43.22.73.4
Per capita gross domestic product2.8-1.9-3.7-4.70.90.41.2
Per capita national income3.6-3.5-6.9-5.11.40.0
Consumer prices56.157.684.8131.1185.2275.369.1
Current value of exports of goods32.27.6-8.80.111.7-5.9-14.8
Current value of imports of goods34.98.1-19.8-28.54.00.32.4
Terms of trade4.3-5.8-9.01.16.5-5.0-8.7
Purchasing power of exports of goods10.31.9-7.610.113.3-4.8-9.7
Billions of Dollars
Current account balance-28.3-40.3-41.0-7.6-0.2-4.0-14.2
Merchandise trade balance-1.3-1.99.131.539.433.518.4
Exports89.195.987.487.597.792.078.3
Imports90.497.678.355.058.358.559.9
Factor payments17.927.238.734.336.235.330.7
Capital account balance29.437.520.03.29.22.48.6
Global balance1.4-2.8-21.0-4.49.0-1.6-5.6
Net transfer of resources11.510.4-18.7-31.2-27.0-32.9-22.1
Gross external debt230.4287.8330.7350.8366.9373.2382.1
Percentages
Current account deficit/total exports26.034.739.87.40.23.715.7
Net transfer of resources/total exports10.79.0-18.1-30.5-23.7-30.2-23.2
Interest payments/total exports20.228.041.036.035.635.235.1
External debt/total exports214248321343322342401
Source: ECLAC, on the basis of official data.
Source: ECLAC, on the basis of official data.
Phase II: Adjustment with Partial Recovery (1984—85)

The recessionary nature of the adjustment process seemed to change in 1984, however, as the downward trend of economic activity was interrupted. In effect, favored by the acceleration of world trade, and in particular by the increase in U.S. imports, and stimulated by higher real effective exchange rates, exports rose almost 12 percent. This and a partial recovery of net capital inflows made it possible for imports to increase moderately, thus facilitating the first rise in GDP per capita since 1980. At the same time, the region’s current account deficit virtually disappeared, primarily as a result of improvements in the external accounts of Brazil (which eliminated the current account deficit of $16 billion it had recorded in 1982), Mexico (where a current account surplus of over $4 billion replaced the $14 billion deficit registered in 1981), and Venezuela (which, after incurring a $4.2 billion deficit in 1982, ran a $5.4 billion surplus in 1984), and the sharp reductions of external imbalance in Argentina, Chile, Ecuador, Peru, and Uruguay, all of which had by 1984 cut their 1981–82 current account deficits by at least 50 percent.

That in 1984 Mexico and Brazil—the most indebted countries in the region—and Venezuela—the fourth largest debtor—covered their interest payments with their respective trade surpluses and that Argentina, Ecuador, and Peru generated trade surpluses that financed nearly 60 percent of interest payments, together with improvements in the debt renegotiation mechanisms, prompted optimistic assessments in some circles about the prospects for adjustment. In this view, that the huge external imbalance had been closed in the brief span of two years, seemed to open the way in several countries for the resumption of growth, external equilibrium, and, in some cases, renewed access to voluntary lending by the banks.

Phase III: Frustration of Expansive Adjustment (1986–?)

These expectations were, however, short lived. By mid-1985, Mexico—the “model adjuster”—was facing severe balance of payments difficulties primarily because of having let its currency again become dangerously overvalued, with the consequent need to devalue. At the same time, Latin America’s terms of trade fell once more, thus continuing the downward trend only briefly interrupted in 1984. Moreover, in December oil prices began their precipitous dive.

Because of this massive external shock, and despite the relief brought about by the decline in international interest rates, the balance of payments position of the oil-exporters changed markedly. By the end of 1986, their combined current account surplus of $8.6 billion in 1984 had been replaced by a deficit of about $7.5 billion, and their trade surpluses financed only one fourth of their interest payments instead of all of them as in 1983–85 (Table 3).

Table 3.Latin America: Relationship Between the Trade Balance and Total Interest Payments, 1980–861(In percent)
19801981198219831984198519862
Latin America-46.9-39.0-3.074.888.780.046.2
Latin America without Brazil
-28.9-50.15.588.884.572.827.4
Oil exporting countries3
39.6-14.519.4139.3126.899.625.6
Non-oil exporting countries4
-106.8-56.5-21.223.658.064.960.4
Argentina-146.7-19.754. 163.958.084.848.8
Brazil-79.6-16.3-22.339.799.197.088.0
Colombia-20.0-184.2-197.8-194.9-16.2-26.676.6
Costa Rica-212.5-38.618.1-4.3-5.0-28.56.5
Chile-91.6-167.0-16.535.0-6.526.231.2
Ecuador-11.1-29.6-25.0101.769.198.220.0
Mexico-40.6-55.650.940.9118.889.843.0
Peru102.7-89.6-72.53.562.186.4-19.5
Uruguay-367.9-180.5-14.062.049.754.7100.0
Venezuela300.0144.3-56.2196.9205.0136.7-0.9
Source: ECLAC, on the basis of official figures.

Trade balance in goods and services.

Preliminary figures.

Includes Bolivia, Ecuador, Mexico, Peru, and Venezuela.

Includes Argentina, Brazil, Colombia, Costa Rica, Chile, El Salvador, Guatemala, Haiti, Honduras, Nicaragua, Paraguay, Dominican Republic, and Uruguay.

Source: ECLAC, on the basis of official figures.

Trade balance in goods and services.

Preliminary figures.

Includes Bolivia, Ecuador, Mexico, Peru, and Venezuela.

Includes Argentina, Brazil, Colombia, Costa Rica, Chile, El Salvador, Guatemala, Haiti, Honduras, Nicaragua, Paraguay, Dominican Republic, and Uruguay.

The trend toward a sounder external position was also reversed in 1986 in Argentina—both because of a fall in the terms of trade and a large increase in imports—and, surprisingly, in Brazil. In this latter country—which in the two previous years had succeeded in combining rapid economic growth with near equilibrium in its current account, thanks to the expansion and diversification of exports and substitution of imports—the trade surplus virtually vanished in the last quarter of 1986 as a result of the large increase of domestic demand unleashed by the Plan Cruzado. Hence, in spite of positive external shocks in the form of lower oil prices and lower interest rates, both the current account and the overall balance of payments closed with deficits in 1986.

Among the highly indebted countries of the region, only Chile, because of the fast expansion of non-copper exports and import substitution in agriculture and manufacturing, Uruguay, thanks to the recovery of exports, which benefited from the huge increase of Brazilian imports, and Colombia, whose exports rose nearly 50 percent as a result of high coffee prices, the growth of exports of coal and petroleum (made possible by the coming on stream of investments undertaken in previous years) and expansion of manufactured exports (under the stimulus of a high real effective exchange rate), were able in 1986 to record advances along the path of adjustment with growth that seemed to be open in 1984.

Nevertheless, because of the worsened external situation, in 1986 debt indicators in most countries deteriorated. Debt-to-export ratios shot up 17 percent, rising, on the average, even in oil importing countries, so that they reached a new historic maximum of 4 to 1 for the region as a whole. Hence, after five years of adjustment, debt-to-export ratios were 60 percent higher than in 1981—when they had already surpassed critical thresholds—and interest-payments-to-export ratios were 20 percent higher, notwithstanding the fact that the London Interbank Offered Rate (LIBOR) fell by over 50 percent between these years.

Domestic Policy Response

Adjustment requires expenditure reduction, expenditure switching, and structural transformation. No longer having financing to support transformation, adjustment necessarily fell on the first two, usually under the aegis of Fund agreements. Generally speaking, demand was restrained through the reduction of both fiscal expenditure and real wages. Interest rates were raised to discourage consumption and promote savings. Exchange rates were increased to promote exports and discourage imports. Commercial policy (tariffs and export incentives) tended to be modified in this same direction.

Real effective exchange rates have been raised throughout the region, with increases reaching over 50 percent relative to the trough of the crisis in Argentina, Chile, Colombia, Ecuador, Mexico, and Uruguay, though these higher rates were not maintained consistently (especially in Mexico). Indeed the crisis often gave rise to multiple exchange rates: one for traditional exports and preferential imports, another (sometimes free) for other trade flows, and yet a third for debt-service payments, in addition to a free market or parallel rate. Such a phenomenon ocurred even in countries characterized in the past by single, often times fixed, rates (e.g., Ecuador, Mexico, and Venezuela) and indeed for a time also affected countries with a neo-conservative bent (e.g., Argentina in 1981 and Chile in 1982).

Commercial policy was widely used as well to discourage imports and encourage exports, especially during 1982-84. Tariffs and import surcharges were raised or foreign exchange for travel reduced, in Brazil, Costa Rica, and Peru, among others, while tighter quotas (or bans) were placed on imports at least for a time in most countries of the region. Even in Chile, tariffs were raised from 10 percent to 35 percent before they were finally left at 20 percent; in addition, surcharges were imposed on some manufactured imports and large implicit tariffs were established on imports of wheat, sugar beet, and oil seeds, through the policy of agricultural support prices. Nevertheless, to the extent that the exchange rate has been raised, the pressure to increase tariffs has abated in most countries. Thus, since 1985 many of the restrictive measures placed on imports after 1982 have been relaxed.

Export incentives, especially for nontraditional products, be they in the form of tax rebates, tax credits, subsidized interest rates for export financing, or duty-free zone arrangements have been implemented in Brazil, Colombia, Mexico, Chile, Peru, and Uruguay. Yet, except for Brazil, these have not been as important in trade policy as increased import restrictions. Nevertheless, most export incentives established during the crisis remain in place.

As for policies to restrain demand, fiscal expenditures tended to fall in real terms throughout the region, especially between 1982 and 1984. Real expenditures were cut 20 percent or more in Argentina (1982–85), Ecuador (1982–83), Mexico (1983–84), Uruguay (1982–84), and Venezuela (1982–83); smaller but sizeable cuts were also registered in Brazil, Chile, and Peru. Only Colombia, which really did not face a debt crisis and had accumulated large international reserves during the coffee bonanza of the mid-1970s, continued to increase real fiscal outlays until 1984.

As could be expected, the heaviest reductions were made in capital expenditures, closely followed by declines in public sector wages. Other current expenditures proved difficult to cut; indeed interest payments rose throughout the period. Though emphasis was placed on reducing investment in machinery (to save scarce foreign exchange), public investment in construction also fell, thus reducing domestic output (and in this case with a low, direct, import component). In fact, construction has been the activity most seriously affected (falling almost 20 percent between 1981 and 1984). Moreover, in the three countries (Argentina, Uruguay, and Venezuela) where construction has been most depressed (operating in 1986 at some 50–60 percent of 1980 levels), total GDP in 1986 was still well below 1980 levels, whereas in the rest of the region it had surpassed that level by 1985–86.

Cuts in fiscal expenditures were not matched by like reductions in fiscal deficits. For fiscal revenues are sensitive to the economic cycle, and, as already noted, until 1983 adjustment tended to be recessive. For example, Peru’s deficit rose from 4 to 5 percent of GDP between 1982 and 1984, despite a 9 percent cut in real expenditures, because revenues fell 14 percent as total output declined 7 percent. Much the same occurred in Argentina and Chile in 1982 and in Uruguay in 1984. In such circumstances, larger deficits were a sign not of increased excess demand, as is normally presumed, but of a demand-deficient recession.

Conversely, success in lowering fiscal deficits during adjustment was associated not only with cuts in expenditures but with the ability to maintain or even raise fiscal revenues. The most dramatic reductions in the weight of public deficits in GDP were achieved in Argentina (8½ points in 1985), Bolivia (10 points in 1986), Ecuador (6 points in 1982–85), and Mexico (9 points in 1983), countries that in those periods succeeded in raising government revenues. In particular, fiscal revenues rose in countries which dramatically reduced inflation (Argentina and Bolivia) because, as inflation declined, the loss in real revenues owing to the lag in collecting taxes fell. Elsewhere revenues rose because efforts were made to increase general tax rates (e.g., Mexico raised the value-added tax in 1983 from 10 to 15 percent for all but necessities), to reduce tax evasion, and to adjust public sector prices. In this latter regard, the rise of public utility rates and of the prices of goods produced by state enterprises in Mexico in 1983 and in Argentina just before the start of the Austral Plan made important contributions to the reduction of the government deficit. Even more noteworthy were energy prices in Bolivia: as part of the 1985–86 stabilization program, special taxes were placed on these products, so that revenues arising from them came to constitute over half of fiscal income and over 5 percent of GDP.

Wage policy too was an important component of expenditure-reducing adjustment packages in most of the region. Except for Argentina’s short-lived effort to raise real wages in 1983–84, which finally gave way to runaway inflation in 1985, Brazil’s policy of increasing real wages in 1985–1986, and Colombia, where wages went on increasing until 1984, in the rest of the heavily indebted countries of the region real wages fell during the crisis (Table 4). Worse yet, in Ecuador, Mexico, Peru, and Uruguay through 1985, this decline far exceeded the fall both in per capita national income and output, suggesting that up to that year adjustment in these cases was unnecessarily regressive as well as costly. Finally, credit tended to be tightened, and interest rates were raised during the adjustment program. While negative real interest rates characterized much of the region before the crisis, real interest rates are now positive, and oftentimes excessively so. For example, real rates of over 5 percent a month have been observed in Argentina, Bolivia, and Brazil, and for considerable periods of time.

The objective of all of these policies was to shift output to tradables, and expenditures to nontradables, as well as to contain capital flight. While, as already noted, these policies succeeded in virtually eliminating the region’s current account deficit by 1984, they did so, not so much because output shifted, but because expenditure fell, compressing imports and stunting growth. It is not that switching policies failed to increase exports. In fact, export volumes increased 27 percent in the region since 1980 (and 34 percent for non-oil exporters) despite the world recession and the difficulties of increasing exports for countries so heavily dependent on basic commodities. Yet the fall in the unit value of exports in that period (20 percent for non-oil exporters, 45 percent for oil exporters) wiped out for the latter and virtually wiped out for the former the effects of the increased volume of exports achieved in this period.

Table 4.Latin America: Evolution of Real Wages, 1981–851(Percentage variation)
Cumulative Variation
During
PresentFormer
19811982198319841985crisis2decade
Argentina-10.6-10.425.526.4-15.27.8-6.9
Brazil8.512.1-7.3-6.77.112.655.5
Colombia1.43.45.27.4-2.913.4-0.6
Costa Rica- 11.7-19.810.97.88.9-7.831.6
Chile9.1-0.4-10.60.3-4.5-14.8-0.8
Ecuador-13.8-11.9-16.2-1.3-3.2-39.215.2
Mexico3.60.8-22.7-6.21.2-26.115.4
Peru-1.72.3-16.8-15.2-15.3-38.9-13.9
Uruguay7.5-0.3-20.7-9.214.1-18.1-50.2
Source: ECLAC, on the basis of official information.

Average real wages in urban activities (Costa Rica, Chile, and Uruguay) or in industry (Argentina, Brazil, Colombia, Mexico, and Peru), Real minimum wages in urban area for Ecuador.

Since the crisis did not begin simultaneously in all the countries included, cumulative variations have been calculated over different periods in order to reflect the impact of adjustment on real wages more accurately. Figures in this column thus show the variation registered between 1980 and 1985 for Argentina, Brazil, Costa Rica, and Ecuador; and between 1981 and 1985 for Colombia, Chile, Mexico, Peru, and Uruguay.

Source: ECLAC, on the basis of official information.

Average real wages in urban activities (Costa Rica, Chile, and Uruguay) or in industry (Argentina, Brazil, Colombia, Mexico, and Peru), Real minimum wages in urban area for Ecuador.

Since the crisis did not begin simultaneously in all the countries included, cumulative variations have been calculated over different periods in order to reflect the impact of adjustment on real wages more accurately. Figures in this column thus show the variation registered between 1980 and 1985 for Argentina, Brazil, Costa Rica, and Ecuador; and between 1981 and 1985 for Colombia, Chile, Mexico, Peru, and Uruguay.

The speed with which switching policies in fact succeeds in reallocating resources to tradables depends not only on correct price signals but on the volume of investment. While the proportion of investment allocated to tradables probably rose, the amount of investment in tradables may in fact have grown not much, for overall investment fell by almost one-third in 1983–85 compared with 1980. This decline in investment took place although domestic savings held up and indeed rose as a percentage of gross domestic income, notwithstanding the simultaneous fall in per capita income. Higher savings failed to materialize in greater investment because of increased interest payments and the reversal in the net transfer of resources. While the share of savings in gross domestic income rose from 22 percent in 1980 to 23 percent in 1985, the investment coefficient in the same period fell from 24 percent to 16 percent.

Significant structural transformation of output was largely limited to Brazil and Colombia. Colombia was able to maintain, indeed raise, the investment coefficient until 1983 and by 1985–86 was deriving foreign exchange from the coming on line of investments in oil, coal, and nickel. Brazil for its part invested heavily in the second half of the 1970s, while financing was available, in petroleum, energy substitution (cane alcohol), chemicals, heavy metals, and fertilizers, which allowed it to substitute energy imports and increase exports after 1981. Thus structural transformation in the case of Brazil began to take place with the investment program designed after the oil crisis of 1973.

Once outside financing dried up and interest payments rose, however, investment was called on to bear the brunt of adjustment in most countries, thus slowing structural transformation. Nevertheless, most countries did not shirk from checking consumption in order to try to raise savings. In fact, consumption per capita in the region fell almost 10 percent on the average during the crisis, often cutting into critical expenditures on health, education, and nutrition.

In short, despite the efforts to increase exports (not simply to compress imports), to check consumption and raise savings (not simply to cut investment), and to reduce expenditures (but not output), adjustment was largely achieved at the expense of growth. This outcome resulted not from the absence of switching policies, but because, given the magnitude of the needed turnaround in the trade balance, the brief time span available to effect it, and the unfavorable evolution of the world economy, the principal short-run effect of switching policies centered on demand, for the contractive income effect of switching policies swamped the expansionary substitution effect, thus accentuating rather than mitigating the recessive impact of expenditure-reducing policies.

Consequently, adjustment, which necessarily entails lowering the level or the rate of growth of domestic absorption, unnecessarily cut economic growth as well, with per capita output in 1986 for the region as a whole still 8 percent below 1980 levels, likely making this a lost decade for most of the countries. What is worse, given the deterioration in the region’s external position in 1986 and its heavy debt burden, adjustment has proven to be not only costly and inefficient, but indeed is far from complete.

Why Has Adjustment Been so Costly and Protracted?

The costs of adjustment depend on the structure of the economy and its capacity to respond, on the effectiveness of policy, and on the international context in which adjustment is effected. These factors, together with the exceptional size of the initial external imbalance, contributed to the severity and duration of the adjustment process.

Weak Initial Position

Four features characterized the bulk of the region’s economies at the onset of the crisis, which both magnified the shock and limited the speed and effectiveness of response (Table 5).

The first was a high level of debt. In fact, the debt-led growth strategy pursued in the region between 1970 and 1981 raised the debt-to-export ratio from 1.4 in 1973 to 2.5 in 1981 (as opposed to 1.0 in the Republic of Korea); moreover interest payments in 1981 amounted to 27 percent of exports (tripling their percentage in 1973). Hence, in 1981 the region was far more vulnerable to interest rate hikes than were other countries or than it was itself at the beginning of the 1970s. Moreover, precisely because indebtedness was reaching precarious limits, countries were unable to draw on capital inflows to compensate deteriorations in trade flows as they did after the 1973 oil crisis.

The second feature was the high proportion of debt at floating interest rates. In 1970–81, commercial banks lent heavily to Latin America, so that by 1981 not only was the region’s level of debt dangerously high, but some two thirds of it was at floating interest rates. This again contrasts with Asia in general (12 percent) and the Republic of Korea in particular (33 percent) as well as to the region itself in 1970 (less than 25 percent).

A third feature in most countries was the low levels of exports relative to GDP. Despite a fairly strong export push in the 1970s, when the value of exports grew 20 percent a year and the quantum of manufactures grew 15 percent a year, exports averaged 13 percent of GDP in 1979, and in few countries did they exceed 20 percent (as opposed to the Republic of Korea’s 38 percent or the Taiwan Province of China’s 52 percent). To be sure, this was a reflection not of a God-given fact, but of the policy option to pursue a largely inward oriented, import substituting development strategy during most of the post-World War II period. For this reason, exports made up a low proportion of tradables in Latin America, accounting for just one fourth of all tradables. So, at the beginning of the 1980s the region in fact possessed a very low export (and import) base from which to adjust trade flows (either by further import substitution or by export expansion) to external shocks.

Table 5.Indices of Financial Vulnerability and Trade Flexibility at the Onset of the Crisis (1980–81): Selected Latin American and Asian Countries(In Percent)
Financial VulnerabilityTrade Flexibility
Basic
commodity
Percent of debt atInterestExports2
floatingpaymentsExportsExportsto total
ratesto exportsto GDPto tradables1exports
Latin America64.528.0132776
Argentina58.315.171579
Brazil64.328.391960
Colombia39.2316.3152676
Costa Rica49.312.6357167
Chile58.2328.2204785
Ecuador50.5321.3234597
Mexico73.019.0143061
Peru28.0319.8214084
Uruguay33.5312.0122966
Venezuela81.4310.4326298
Asia
Republic of
Korea33.36.2386710
Taiwan, Province
of China5.05214
Source: ECLAC, Preliminary Balance of the Latin American Economy 1986 (December 1986); World Bank, World Development Report, various years; and G. Ranis, “East Asia and Latin America: Contrasts in the Political Economy of Development Policy Change” (unpublished. May 1986): and J. Fei, G. Ranis, and S. Kuo, Growth with Equity: the Taiwan Case (World Bank, 1979).

Agriculture, mining, and manufacturing.

Fuels, minerals, metals, and other agricultural commodities.

1980-82.

Source: ECLAC, Preliminary Balance of the Latin American Economy 1986 (December 1986); World Bank, World Development Report, various years; and G. Ranis, “East Asia and Latin America: Contrasts in the Political Economy of Development Policy Change” (unpublished. May 1986): and J. Fei, G. Ranis, and S. Kuo, Growth with Equity: the Taiwan Case (World Bank, 1979).

Agriculture, mining, and manufacturing.

Fuels, minerals, metals, and other agricultural commodities.

1980-82.

Finally, a fourth crucial characteristic was the high dependence (over 75 percent) on the export of relatively few primary commodities. On the one hand, this led to fluctuations in the terms of trade; on the other, because such goods are relatively inelastic both in supply and demand, it provided a restricted margin for adjustment through export expansion. This contrasts with the Republic of Korea and the Taiwan Province of China, where 80 to 90 percent of their exports was represented by manufactures with far higher price and income elasticities.

The first three problems were largely determined by policy, whereas the latter also reflected Latin America’s rich natural endowment of resources. Yet, whatever the cause, these four factors heavily conditioned the region’s adjustment process. Thus, unlike what happened after the 1973 crisis, when the region was able to compensate this export structure by drawing on capital inflows until the OECD’s recession was over and the quantum and value of its exports picked up, at the beginning of the 1980s this latter route would be severely limited because of the region’s already heavy debt and exposure in the banking system. Indeed since real interest rates shot up and bank lending eventually collapsed, capital inflows soon ceased to be a variable that could ease trade adjustment, and became a variable to which the region had to adjust further.

Nor was the region able to pursue on its export base an expansive adjustment as did the Republic of Korea. Since export expansion must come largely from manufactured exports, and since these accounted for only one fourth of exports and less than 5 percent of GDP (as opposed to 85 percent of exports and 45 percent of GDP in both the Republic of Korea and the Taiwan Province of China), no reasonable short-run growth of nontraditional exports could correct the external imbalance that the region was forced to eliminate. Thus, in the brief time frame available, adjustment could hardly be expansive, but had to be based largely on recession-inducing import compression.

Policy Shortcomings

However limited the freedom of policy response, once the crisis set in, there was still room for maneuver. Obviously, then, some of the variations in the costs of the crisis can be attributed to the differing policy responses. While, in general, domestic policies moved in the right direction, in many instances response has been sluggish, shortsighted, incoherent, or lacking in continuity.

The single most serious error in policy in most oil importing countries of the region (with the important exception of Brazil) was the decision to use the strong capital inflows of 1979–81 to postpone rather than to facilitate adjustment. Rather than augmenting investment, the bulk of such inflows went to maintain, or even raise, consumption, and, in some countries, facilitate capital flight. Unfortunately much of the investment was, in fact, poorly allocated, at least in part because relative prices were distorted owing to exchange rate policies aimed at combating inflation rather than maintaining external equilibrium.

In the same vein, Chile’s persistence in maintaining its fixed exchange rate well into 1982, in hope of achieving a real exchange depreciation through a reduction in absolute prices and wages, is a prime example of policy sluggishness or obstinacy in the face of facts. This policy, which was followed closely by Uruguay, no doubt helps explain the severity of the ensuing recession in both these countries in 1982 (–13 percent and –10 percent growth rates, respectively). So too, if to a lesser extent, was the failure of most oil exporters to set domestic energy prices at international levels. Venezuela was by far the most laggard in this regard, with gasoline retailing for less than 5 cents a liter as late as 1985 when the international price was five times that. Not only did this policy foment excessive domestic consumption, but it also reduced fiscal income.

Policy instability has also prolonged, if not accentuated, the crisis. National currencies have been devalued to raise real effective exchange rates throughout most of the region. Yet movements have often been extremely erratic, with cycles of overshooting and undershooting, making it difficult for would-be exporters to determine whether in fact there is any but a momentary advantage in exporting, and consequently effectively discouraging them from incurring the costs of penetrating and developing markets. Mexico’s exchange policy probably is the most notable example of such policy discontinuity: the real effective exchange rate doubled between the end of 1981 and the end of 1982; then it was allowed to fall steadily through mid 1985, almost reaching its 1981 trough once again, before it was pushed up 30 percent. Such a roller coaster exchange policy could hardly serve as a useful signal to exporters. While Venezuela’s exchange rate has fluctuated less extremely, it has unfortunately allowed the real effective exchange rate to continue to fall in the face of the fall in energy prices in 1986.

Another variant of policy instability is given by the frequency of changes in exchange rate regimes in Chile in 1982. The year began with a fixed exchange rate; adjustment was to take place through price declines. In mid-year, however, this policy was reversed. The exchange rate was raised 18 percent and a further monthly devaluation of 0.8 percent was pre-announced. Two months later, a third regime was enacted—a free float (to save reserves). Within a month, this became a dirty float (scarce reserves again being used to control the exchange rate), while a preferential rate was set for service of the foreign debt. One month later, a formally controlled, crawling peg was reestablished (after a further devaluation). Thus five exchange regimes were experimented within less than six months.

Wages and interest rates have been subject to fluctuations of almost equal severity. For example, real wages fell 20 percent in Argentina between 1980 and 1982, grew 59 percent in the next two years, and then fell again 15 percent in 1985. Given such behavior, employers are simply apt to hire in accordance with expected labor costs, rendering employment inelastic to any but the sharpest variations in ongoing wages. These thus cease to serve their allocative role in the economy, which simply confirms the acute zero-sum conflict mentality prevailing in many countries and renders efficiency considerations marginal in the face of distributive concerns. As for interest rates, although negative real rates tend to misallocate investment, unduly high real rates (which in Argentina and Bolivia have reached 5 percent a month) simply choke it off.

Adjustment policy has not only been sluggish, shortsighted, and unstable; at times it has been inconsistent. An example of this is Brazil’s policy during 1986. Though the Cruzado Plan was conceptually well designed in its insistence on the feasibility of ridding the economy of the inertial component of inflation without recession, it was mistaken in two issues: (1) as a matter of empirical fact, the government’s operational deficit was not zero (as the Plan’s authors apparently thought to be the case); hence there was a disequilibrium component of inflation to be attacked along with the inertial one; and (2) in its assessment that to avoid the risk of recession, an 8 percent real wage increase should also be decreed at the onset of the Plan. The result is well known: an extraordinary boom, which led to scarcities and repressed inflation on the domestic front at the expense of external disequilibria and the resurgence of inflation at the end of the year. In fact, the trade surplus fell from an enormous $1 billion a month in the first nine months of 1986 (sufficient to cover interest payments) to about $180 million a month in the last quarter, while consumer prices rose over 7 percent in December and were expected to increase at an even faster pace in January and February. Thus Brazil will need to adjust and fight accelerating inflation in 1987 as well as seek out new money from the banks.

Important components of adjustment policy have at times been in error as well. In Mexico, the growth in nominal wages was curtailed between 1982 and 1985 in an attempt to bring down inflation, and yet to little avail. Inflation rebounded to 100 percent in 1986 (never having gone below 60 percent), whereas real wages have, in fact, been cut 26 percent. Since this is double the fall in per capita national income, it implies that the failed attempt to lower inflation led to an unnecessary, not to mention regressive, sacrifice of wages, which was only partially offset by the apparent rise in modern sector employment.

Finally, inflationary escalation occurred with the crisis. The region has long been characterized by high inflation. Yet with the crisis, average inflation quintupled from 55 percent a year in 1979-81 to 275 percent in 1985 (before stabilization programs again lowered it to 70 percent in 1986). Indeed, in the course of the crisis seven countries experienced triple digit inflation (and Bolivia over 20,000 percent in August 1985). Moreover, this inflationary escalation beset several countries heretofore characterized by relatively low inflation (e.g., Costa Rica, in which it exceeded 100 percent in mid-1983; Ecuador, in which it exceeded 50 percent in 1983; Mexico, in which it reached 100 percent in early 1983 and again in 1986; Nicaragua, in which it exceeded 750 percent in 1986; and Peru, in which it exceeded 150 percent in 1985). It is not easy to control domestic inflation in the face of a sharp hike in oil prices, and certainly the magnitude of the adjustment required placed a demand on fiscal resources well beyond its proven capacity to satisfy in the short run (since fiscal deficits were already of the same order of magnitude). It is even less easy if adjustment has to be effected in the face of already high and persistent inflation, in economies characterized by widespread indexing. Hence, it is understandable that inflation has accelerated. That the magnitude of that acceleration often bore little relation to the size of the external (and fiscal) shock denotes serious failings in policy design and implementation.

Unfavorable External Environment

Nevertheless, the high costs of adjustment have been not so much the consequence of ill-designed or badly applied domestic economic policies, but, in most cases reflect the exceptionally adverse external environment under which the adjustment process had to be carried out. In fact, during the 1980s the region has faced a uniquely grave external crisis in both trade and external finance, involving not only cyclical but also structural elements. Moreover, the negative consequences of the crisis have been compounded by the acute instability and unpredictability of world economic trends.

Managing adjustment has undoubtedly been rendered more difficult because of these erratic features in the world economy. The first rise in Organization of Petroleum Exporting Countries (OPEC) prices was generally viewed as temporary but proved to be more permanent than originally thought, while the second price hike, which was generally viewed as permanent, turned out to be a temporary change. Similarly, over the last six years the dollar has soared and tumbled. So too, nominal international interest rates, after skyrocketing at the turn of the decade, began their downward course in 1982, but not before an unexpected and worrisome rise in 1984. In addition, they remained persistently high in real terms even after an extended period of world price stability. Meanwhile, recovery from the world recession in 1981–82 has been slow and uncertain. The forecasts announcing the beginning of a strong recovery in the OECD in 1983–84 did not materialize. Moreover, in subsequent years industrial countries’ annual performance has disappointed and frequently required downward revisions of world growth projections. And, of course, still looming large is the question of how quickly the United States, Germany, and Japan will adjust to their respective trade deficits and surpluses.

In any event, the effects of adjustment policies have been limited and their costs have been increased by the insufficiency and burdensome terms of external finance as well as by the adverse trading conditions that most Latin American countries have had to face since 1981.

The Pro-Cyclical Retreat of Creditors

As already noted, since mid-1982 net capital inflow to Latin America has declined, largely as a result of the withdrawal of private banks, the region’s principal creditors. Because of its size and suddenness, this pro-cyclical retreat of the banks was scarcely offset by the rise of net loans extended by the international and national public financial agencies. In fact, during 1982–85 total external finance fell far short of even the transitory components of the current account deficits. Far from acting as a countercyclical force facilitating a gradual and efficient correction of external imbalances, external financing (or rather underfinancing) forced Latin America to “overadjust.” Moreover, in some countries, and especially in Argentina, Mexico, and Venezuela, what financing became available was sometimes negated by the flight of private domestic capital to northern financial centers.

The adjustment process was handicapped not only by the scarcity of external financing but also by its high costs. When Latin America began to adjust, international interest rates were at record levels and acted simultaneously as a factor in the need to adjust as well as in the costliness of the process. LIBOR peaked at 16.5 percent in 1981, averaged 10.7 percent in 1982–85, and declined to an average of 6.7 percent in 1986, hovering around 6 percent at year-end—its lowest level since 1977. In spite of this downward trend in nominal rates, real rates remained persistently high. The real LIBOR measured by the industrial countries’ rate of inflation averaged 5 percent in 1982–86, which compares unfavorably with a real rate of zero in the 1970s and a long term historical rate of around 2 percent.

But this tells only part of the story. The burden of interest payments depends too on the dollar value of the debtors’ exports. Since Latin America’s exports suffered generally declining prices during the adjustment period, the annual average real interest rate from their perspective was an extraordinarily high 17 percent for the period 1982–86. This compares with an average of -4 percent during 1971–80, when most of the region’s foreign debt was contracted (Table 6). That the real weight of interest payments remained burdensome throughout the adjustment process is seen in Table 7.

Table 6.International Rates of Interest, Nominal and Real, 1970—86(In Percent)
Percentage Variation in
ConsumerUnit price
pricesof exportsRealReal
Nominalindustrialof LatinLIBORLIBOR
LIBOR1countriesAmerica(1) / (2)(1) / (3)
(1)(2)(3)(4)(5)
19708.475.68.12.70.3
19716.795.21.91.54.8
19725.414.79.20.7-3.5
19739.317.733.01.5-17.8
197411.2013.357.5-1.9-29.4
19757.6111.1-5.7-3.114.1
19766.128.38.1-2.0-1.8
19776.428.410.6-1.8-3.8
19788.337.2-3.71.112.5
197911.999.221.02.6-7.4
198014.1511.221.22.0-5.8
198116.529.9-2.86.019.9
198213.257.5-11.25.327.5
19839.795.0-6.54.617.4
198411.204.82.66.18.4
19858.644.20.64.39.3
19866.711.8-12.74.822.2
Source: ECLAC, on the basis of data in Morgan Guaranty Trust, World Financial Markets, and International Monetary Fund, International Financial Statistics, various issues.

180 days.

Source: ECLAC, on the basis of data in Morgan Guaranty Trust, World Financial Markets, and International Monetary Fund, International Financial Statistics, various issues.

180 days.

Table 7.Latin America: Ratio of Total Interest Payments to Exports of Goods and Services, 1978–861(In Percent)
Country1978197919801981198219831984198519862
Latin America15.717.620.228.041.036.035.635.235.1
Oil exporting countries3
16.115.716.622.635.631.432.532.336.5
Non-oil exporting countries.4
15.519.323.733.646.740.738.737.934.2
Argentina9.612.822.035.553.658.457.651.151.8
Brazil24.531.534.140.457.143.539.740.037.7
Colombia7.59.911.821.925.926.722.826.318.6
Costa Rica9.912.818.028.036.133.026.627.322.7
Chile16.916.519.338.849.538.948.043.539.2
Ecuador10.413.618.324.330.027.430.727.032.2
Mexico24.024.523.329.047.337.539.036.040.0
Peru21.215.516.024.125.129.833.230.027.3
Uruguay10.49.011.012.922.424.834.834.223.8
Venezuela7.26.98.112.721.021.620.126.333.3
Source: 1978–1986: ECLAC, on the basis of official data.

Interest payments include those on the short-term debt.

Preliminary estimates subject to revision.

Includes Bolivia, Ecuador, Mexico, Peru, and Venezuela.

Includes Argentina, Brazil, Colombia, Costa Rica, Chile, El Salvador, Guatemala, Haiti, Honduras, Nicaragua, Paraguay, Dominican Republic, and Uruguay.

Source: 1978–1986: ECLAC, on the basis of official data.

Interest payments include those on the short-term debt.

Preliminary estimates subject to revision.

Includes Bolivia, Ecuador, Mexico, Peru, and Venezuela.

Includes Argentina, Brazil, Colombia, Costa Rica, Chile, El Salvador, Guatemala, Haiti, Honduras, Nicaragua, Paraguay, Dominican Republic, and Uruguay.

Notwithstanding lower nominal interest rates, since 1983 there has not been much change in the coefficient of interest payments to exports in the region, which has been stuck at around 35 percent and is, of course, higher in the most heavily indebted countries.

Private banks aggravated the problem of the cost of credit by jacking up their spreads and commissions and shortening amortization periods on rescheduled debt and fresh credit during the first round of the rescheduling exercises. It has been estimated that the negotiated cost of credit (based on spreads, amortization period, and commissions) rose in most debtor countries by between 100 and 250 percent.1

It is true that in subsequent rounds of rescheduling the private creditors have reduced the negotiated cost of credit in response to criticism at home and to the stiffer bargaining positions of the debtors. Concessions have included multi-year reschedulings, lower spreads, longer amortization periods, and the foregoing of commissions. By the third round in 1984–85, the negotiated terms were almost the same as those that countries were contracting before the crisis. Nevertheless, while these concessions have been welcome and helpful, they arrived late in the adjustment process and in general still lag behind the reality confronting borrowers. While the banks made important concessions, they kept the negotiated terms at commercial levels even though a number of problem borrowers were in need of noncommercial repayment terms.

Because of the abrupt fall in net capital inflow and the simultaneous rise in interest payments, Latin America has since 1982 been experiencing a protracted transfer of resources to its creditors that is nonvoluntary, premature with respect to its stage of development, and large by any measure. In fact, in the last five years this transfer is estimated to be equivalent on average to roughly 4 percent of the region’s GDP and 25 percent of its export earnings. Moreover, the cumulative outward transfer in this period ($132 billion) nearly doubled the cumulative inward transfer during the previous six years (Table 8).

Table 8.Latin America: Net Inflow of Capital and Transfer of Resources, 1973-86(In billions of U.S. dollars and percent)
YearNet Inflow of Capital

(1)
Net Payments of Profits and Interests

(2)
Transfers of Resources

(3) = (1) - (2) (3)
Exports of Goods and Services

(4)
Transfers of Resources/ Exports of Goods and Services1 (5) = (3)/(4)

(5)
19737.94.23.728.912.8
197411.45.06.443.614.7
197514.35.68.741.121.2
197617.96.811.147.323.5
197717.28.29.055.916.1
197826.210.216.061.326.1
197929.113.615.582.018.9
198029.417.911.5107.610.7
198137.527.110.4116.19.0
198220.038.7-18.7103.2-18.1
19833.234.3-31.2102.4-30.5
19849.236.2-27.0114.1-23.7
19852.435.3-32.9109.0-30.2
198628.630.7-22.195.2-23.2
Source: 1973–85: ECLAC, on the basis of data supplied by the International Monetary Fund. 1986: ECLAC, on the basis of official figures.

Percentages.

Preliminary estimates subject to revision.

Source: 1973–85: ECLAC, on the basis of data supplied by the International Monetary Fund. 1986: ECLAC, on the basis of official figures.

Percentages.

Preliminary estimates subject to revision.

Latin America’s outward transfer also compares unfavorably with historically famous transfer cases, such as the war reparations effected by France in the 1870s after the Franco-Prussian War and Germany’s payments to the victorious nations after World War I. In fact, the weight of Latin America’s financial transfers to its creditors in terms of the debtor nations’ income and exports is almost twice that of Germany’s and is roughly comparable to that of France (Table 9). More pertinent are the still more adverse results that emerge from comparing the real effective burden represented by the transfer of resources currently being effected by Latin America and those canceled out by Germany and France in the past. To gain an idea of this burden, it is necessary to consider to what extent a transfer is facilitated by financial resources coming from other sources. For instance, Germany received loans and other foreign capital in excess of its war reparations through most of 1925–28; hence, its reparations exceeded those capital flows only during 1929–32. Consequently, in order to facilitate the transfer, Germany did not have to generate a trade surplus until 1929. France, on the other hand, ran a surplus throughout 1872–75, while Latin America has had a trade surplus since the outbreak of the crisis in 1982. The trade surplus in Latin America, however, has been roughly double the magnitude of that registered in France and Germany, whether measured as a percentage of income or of exports (Table 10).

Table 9.Latin America’s Registered Net Outward Transfer of Financial Resources Compared with War Reparations of France and Germany1(In percent)
Transfer/Transfer/Transfer/
GDP2Exports3Domestic Savings
France, 1872–7545.630.0
Germany, 1925-3252.513.4
Latin America, 1982–8564.225.718.7
Argentina6.041.431.0
Brazil2.924.213.7
Colombia-0.3-2.8-1.8
Costa Rica-0.3-1.2-1.7
Chile3.314.218.6
Ecuador4.519.616.9
Mexico7.942.128.5
Peru0.84.63.2
Uruguay5.320.830.6
Venezuela9.333.634.2
Sources: Germany and France: calculated from data in Fritz Machlup, International Payments, Debt and Gold (New York: New York University Press, 1976); and Helmut Reisen, “The Latin American Transfer Problem in Historical Perspective,” in OECD,Latin America and the Caribbean and the OECD (Paris: OECD, 1986). Latin America: Estimated on the basis of ECLAC“s balance of payments and national income data series.

In view of the dates of the German and French cases, data should be viewed with appropriate caution and taken as estimates of rough orders of magnitude.

The denominator is national income in the case of Germany and France and GDP in the case of Latin America. Note that GDP is larger than national income for debtor nations.

Presumably goods for France and Germany. Goods and services for Latin America.

War reparations of F5,000 million as part of the 1871 peace treaty of Frankfurt, which ended the Franco-Prussian War.

War reparations to victorious nations of RM10,720 million in currency and payments in kind as formulated in the 1919 Treaty of Versailles.

Net inflow of capital less net payments of profits and interests.

Sources: Germany and France: calculated from data in Fritz Machlup, International Payments, Debt and Gold (New York: New York University Press, 1976); and Helmut Reisen, “The Latin American Transfer Problem in Historical Perspective,” in OECD,Latin America and the Caribbean and the OECD (Paris: OECD, 1986). Latin America: Estimated on the basis of ECLAC“s balance of payments and national income data series.

In view of the dates of the German and French cases, data should be viewed with appropriate caution and taken as estimates of rough orders of magnitude.

The denominator is national income in the case of Germany and France and GDP in the case of Latin America. Note that GDP is larger than national income for debtor nations.

Presumably goods for France and Germany. Goods and services for Latin America.

War reparations of F5,000 million as part of the 1871 peace treaty of Frankfurt, which ended the Franco-Prussian War.

War reparations to victorious nations of RM10,720 million in currency and payments in kind as formulated in the 1919 Treaty of Versailles.

Net inflow of capital less net payments of profits and interests.

Because of both its size and protracted nature, the outward transfer of resources has inhibited growth-oriented structural adjustment. In the first place, except in Colombia, Costa Rica, and Peru, the transfer has siphoned off large proportions of domestic saving needed to stimulate the growth and transformation of the economy. Indeed, as already mentioned, the reversal in the direction of the transfer of resources largely explains the growing gap that has emerged in recent years in most countries of the region between a stable or rising domestic savings effort and a falling investment coefficient. Second, this transfer of resources has restricted the capacity to import, which fell abruptly in 1982 and has represented since then the most binding constraint on economic growth in virtually all Latin American countries. Third, in some countries the transfer of resources has contributed to accelerate inflation. This is because most debt is by now guaranteed by the state, either because it was originally contracted by public agencies or because in the successive negotiation rounds governments were pressured by the banks to provide ex-post guarantees of private debts that the banks had originally not requested but for which they had charged appropriately higher premiums. Most of the transfer has consequently had to come directly or indirectly out of government budgets. As Helmut Reisen has shown, this “budgetary phase” of the transfer process was generally not resolved during the 1982-85 adjustment. In his view, because of the budgetary burden involved, governments found it impossible to enforce fully the required restrictive fiscal and credit policy.2 Deficits resulting from the transfer burden and other factors had hence to be financed by borrowing from the domestic banking system, which led to inflationary consequences.

Table 10.Accumulated Trade Surplus of Germany, France, and Latin America During Periods of Nonvoluntary Transfers1(In percent)
As Percent of Income2As Percent of Exports3
TradeTrade
surplus insurplus in
Trade surplusgoods andTrade surplusgoods and
in goodsservicesin goodsservices
France, 1872–752.312.3
Germany, 1925–28
1929–322.513.8
Latin America, 1982–854.33.531.121.4
Argentina5.95.648.038.1
Brazil3.72.734.622.9
Colombia-2.8-3.6-25.0-25.7
Costa Rica-0.4-0.3-1.50.7
Chile2.60.814.33.7
Ecuador6.64.532.219.7
Mexico7.07.346.839.3
Peru2.31.215.86.8
Uruguay4.62.923.711.4
Venezuela11.27.243.326.0
Sources: Germany and France: Calculated from data in Fritz Machlup, International Payments, Debt and Gold (New York: New York University Press, 1976); and Helmut Reisen, “The Latin American Transfer Problem in Historical Perspective,” in OECD, Latin America and the Caribbean and the OECD (Paris: OECD, 1986), pp. 148–154 Latin America: Estimated on the basis of ECLAC“s balance of payments and national income data series.

In view of the dates of the German and French cases, data should be viewed with appropriate caution and taken as estimates of rough orders of magnitude.

In the case of Germany and France the denominator is national income and in the case of Latin America it is GDP. For a debtor nation GDP is normally higher than national income.

In the first column exports are measured in goods and in the second column in goods and services.

Sources: Germany and France: Calculated from data in Fritz Machlup, International Payments, Debt and Gold (New York: New York University Press, 1976); and Helmut Reisen, “The Latin American Transfer Problem in Historical Perspective,” in OECD, Latin America and the Caribbean and the OECD (Paris: OECD, 1986), pp. 148–154 Latin America: Estimated on the basis of ECLAC“s balance of payments and national income data series.

In view of the dates of the German and French cases, data should be viewed with appropriate caution and taken as estimates of rough orders of magnitude.

In the case of Germany and France the denominator is national income and in the case of Latin America it is GDP. For a debtor nation GDP is normally higher than national income.

In the first column exports are measured in goods and in the second column in goods and services.

Adverse Trading Conditions

The costs of adjustment have also been high because the process had to be carried out during a period of sluggish growth in the industrial economies and in world trade. With the exception of 1984, economic growth in the industrial countries during 1982–86 was well below the average annual rate of 3.5 percent registered in 1968–77. The same was true for the volume of world trade, whose growth was considerably below the 8 percent annual average mark registered over 1968–77. Moreover, the strong growth of world trade volume (8.6 percent) recorded in 1984 was disproportionally reliant on the robust expansion of the U.S. economy, which, after its 1982 slump, was the only major industrial country to grow at a rate equal to, or greater than, its 1966–78 average.

Under these circumstances, a significant part of the benefits that could be expected from the expansion of the volume of Latin America’s exports were in fact offset by the fall in export prices. The figures in the first column of Table 11 confirm this for nearly all the countries of the region, as the increase in the value of exports over 1982–86 was but a fraction of the rise in export volume. As might be expected, the most severe cases occurred among the oil exporting countries, but non-oil exporters, such as Argentina, Chile, and Uruguay, also had part of their export effort frustrated by declining world prices for their goods. Brazil, which is less dependent on exports of primary products, suffered somewhat less. Only Costa Rica and Colombia escaped running the treadmill of falling prices, mostly because of high prices for coffee in 1986.

The second column of Table 11 shows that for the majority of non-oil exporting countries real devaluations during 1982-86 were associated with a more than proportional movement in export volume. Nevertheless, the corresponding relation for export value was positive only in Colombia and Costa Rica.

Over the period 1982–85 the loss of income because of the deterioration in the terms of trade was equivalent to nearly three quarters of the region’s bill for net interest payments. Indeed for Costa Rica and Chile the loss of income stemming from the fall in the terms of trade was equal roughly to the value of net interest payments, and for Uruguay it was substantially greater.

Finally, the negative effects of the evolution of world trade over this period can be seen by analyzing what would have happened if export prices had held their ground while the countries increased the volume of their exports in order to carry out an expansive adjustment. The figures in the last two columns of Table 11 are instructive. Valuing 1986 exports with 1980 export prices shows the fall in the net interest payments/export coefficient in comparison with its actual 1986 level. Indeed, had export prices remained stable, the region’s coefficient would be 24 percent instead of 35 percent. All countries except Colombia and Costa Rica show important declines in their respective coefficients. Moreover, some countries, such as Ecuador, Peru, and Uruguay, would have recorded what might be termed acceptable coefficients and Venezuela’s would have turned out to be a remarkably low 9 percent.

Adjustment With Growth: Prospects and Requirements

While the region as a whole is in difficult straits, the situation differs significantly among countries. By 1986 Colombia no longer had a debt problem, if it ever had one; its ratios of debt to exports (2.0) and interest to GDP (3.0 percent) were below regional averages for 1980, before the crisis emerged, and its trade surplus allowed it to meet almost 80 percent of its interest payments (Table 12). While Brazil’s current account deficit increased at the end of 1986, it did so because of excessively expansive domestic policies. Thus correction of this imbalance “merely” requires redressing previous policy errors, which, needless to say, will be no easy task.

Table 11.Latin America: Selected Trade Indicators(Coefficients)
Variations in 1982–86 in1982–85 Effect of change in the terms1986
Net interestNet interest
X ValueX VolumeX Valueof tradepaymentspayments
Real effectiveReal effectiveNet interestX in currentX in 1980
X Volumeexchange rateexchange ratepaymentspricesprices
Latin America70.4-72.635.124.2
Oil exporting countries53.9-63.636.119.9
Non-oil exporting countries85.5-78.934.527.6
Argentina68.577.954.1-78.058.637.2
Brazil86.7111.797.4-69.036.729.8
Colombia118.1111.5131.9-37.119.320.2
Costa Rica106.7113.6134.5-99.425.024.0
Chile74.288.166.6-93.639.425.2
Ecuador55.193.051.2-65.536.019.4
Mexico61.674.341.8-74.947.526.6
Peru67.2116.477.9-69.731.321.0
Uruguay78.077.860.5-122.127.420.3
Venezuela47.694.545.0-4.118.49.2
Source: Calculated from data in the balance of payments series prepared by ECLAC.
Source: Calculated from data in the balance of payments series prepared by ECLAC.

More complex, however, is the situation of Costa Rica, Chile, Uruguay, and Argentina, whose debt burdens—as measured by interest payments to GDP—are among the highest in the region (9.1 percent, 8.4 percent, 6.5 percent, and 6.5 percent, respectively). Though the first three reduced their external disequilibrium in 1986, their high level of debt nevertheless implies the need for long-enduring, and, except for Uruguay, even further adjustment. While Peru’s debt burden is lower than average for the region (its interest payments are just under 4 percent of GDP), its trade surplus disappeared in 1986, in part because of a deterioration in the prices of its exports, in part because of its domestic demand-driven expansion. Finally, the major oil exporters (Mexico, Ecuador, and Venezuela), face the stark prospects of adjustment on top of adjustment. Given their high debt burden, this process would seem to be manageable only if oil prices stabilize in the medium run at levels well above those prevailing in 1986.

Table 12.Debt Burden, Domestic Effort, and Effort or Financing Still Required as of 19861(In Percent)
(1)(2)(3)Effort to Be Made
Debt BurdenDomestic Effortand/or Further
i/GDP2TS/GDP3Financing Needed
(1)(2)(3) = (1) - (2)
Latin America5.32.33.0
Argentina6.53.23.3
Brazil4.03.20.8
Colombia3.02.30.7
Costa Rica9.12.46.7
Chile8.42.65.8
Ecuador5.81.24.6
Mexico5.72.53.2
Peru3.9-0.64.5
Uruguay6.56.50.0
Venezuela5.3-0.15.4
Sources: Estimated on the basis of ECLAC’s balance of payments and national accounts

Preliminary estimates.

i/GDP = net interest payments on foreign debt as a percentage of gross domestic product.

TS/GDP = trade surplus in goods and services as a percentage of gross domestic product.

Sources: Estimated on the basis of ECLAC’s balance of payments and national accounts

Preliminary estimates.

i/GDP = net interest payments on foreign debt as a percentage of gross domestic product.

TS/GDP = trade surplus in goods and services as a percentage of gross domestic product.

Nevertheless, despite these differences, the basic problem is similar. Put in a nutshell, interest payments on debt amount to 5.3 percent of GDP, notwithstanding the fall in interest rates in 1986, whereas the trade surplus amounts to 2.3 percent of GDP despite the efforts of recent years. This implies that, were the terms of trade not to improve and were the region unable to attract fresh money, the meeting of interest payments would require an additional effort to improve the trade balance larger than that which has already taken place in the past five years in all countries except Brazil, Colombia, and Uruguay (Table 12) . Since this effort has driven per capita income below 1980 levels in all countries except Brazil, Colombia, and Panama, small wonder that adjustment weariness has set in.

Recessionary adjustment is therefore no longer feasible, politically or socially. In fact, adjustment is acceptable only if it is subject to a minimum growth in output and consumption. This means that while, under recessionary adjustment, debt service was the prime recipient of foreign exchange and growth a residual, in expansive adjustment, the first priority for scarce foreign exchange is to meet the import requirements for minimum acceptable growth and debt service is the residual. In other words, while recessionary adjustment placed the onus of costs on debtors, expansive adjustment shifts part of the costs to creditors. Not only does expansive adjustment redress the heretofore exclusively one-sided nature of adjustment costs between creditors and debtors, but it also redresses the skewed absorption of these costs in creditor nations between its productive and financial sectors, that is to say, between OECD exporters and bankers, for the reduced sales to the region by the former largely account for the trade surpluses needed to meet interest payments to the latter.

At first sight, this reordering of priorities may not seem pleasing to banks or developed countries. Yet a moment’s reflection should suffice to show that this more symmetrical approach is the only nonconfrontational way to solve the debt crisis and to carry on the adjustment process.

Ultimately there are only two ways of servicing the debt of the developing countries: either through fewer OECD exports or through more developing country exports. The first is the approach that has prevailed so far: the banks gain, developed countries’ growth and exports suffer, and development is hamstrung. Moreover, the international financial system is jeopardized because, the longer debtors are forced to stagnate, the stronger the temptation to adopt unilateral solutions. Only in the second approach in which banks are paid from the growth of developing country exports and not from further import compression (at the expense of OECD exports) can all gain.

This second approach requires the concurrence of the key participants—private creditor banks, debtors, international financial institutions, and the governments of developing countries and of the OECD—in recognizing that the debt problem is systemic, and not merely one specific to, or brought on by, individual creditors or debtors. This is what the region means by a “political” solution to the debt problem.

To be sure, the strategy of growing out of the debt problem requires structural adjustment. Domestic policies need be pursued both to mobilize currently idle resources as well as to restructure production from nontradables to exports and imports substitutes. Yet expansive adjustment also requires adequate financing to provide the needed time for such transformation to take effect. Thus structural adjustment is the counterpart to adequate financing.

Domestic Requirements

In the long run, to grow out of the debt problem requires a structural transformation of the economy in at least two senses: the growth strategy needs to be outward oriented and largely based on domestic efforts to raise savings and productivity. Hence, foreign exchange, the savings/investment process and efficiency-raising innovations will be the key bottlenecks to growth and the central focus of policy attention.

Outward-oriented growth means that investment in the production of tradables must increase to expand and diversify exports and to augment the region’s capacity to substitute imports. This involves not only raising and maintaining the incentives for saving or generating additional foreign exchange (i.e., a high and stable real effective exchange rate), but also equalizing on the margin and over time the incentives or costs of saving additional foreign exchange through import substitution or generating it through export expansion. Given the bias of the past strategy of import substitution in favor of production for home markets, presumably such an equalization of incentives will give rise to the expansion and diversification of exports far more than to further import substitution. Thus growth is likely to be not only outward oriented but also more export led and based especially on the expansion of manufactures and other nontraditional exports.

Given the debt burden and the likely insufficiency of voluntary capital inflows in the immediate future, this upsurge of investment in tradables will have to be based largely, if not exclusively, on domestic savings. Still, given the need to recover consumption levels, savings cannot be expected to do the job alone. Rather the productivity of investment and the overall efficiency of the economy will have to rise. Fortunately, the high incremental capital output ratios of investments in the 1970s suggest that there would be ample room for improvement in this regard.

In much the same vein, austerity implies not that distributive concerns be sacrificed, but that what efforts are made be focused on the needy lower 25 percent of the population. For not only are these groups living in abject poverty, but they receive only 4 percent of GDP. Hence, even modest redistributive efforts (say 2 percent of GDP), which spread over the bulk of the population (say the lower 80 percent which receive 50 percent of GDP) amount to very little, if focused on the lowest 25 percent, could eliminate extreme poverty, raising the income of this group 50 percent.

Finally, the experience of the past 15 years suggests that it would be imprudent to organize economic structures in the expectation of a smooth and steady evolution of the international economy. Rather, strong fluctuations in the terms of trade, in real interest rates, in the value of the U.S. dollar, and in the relative prices of basic commodities may be the rule rather than the exception. This not only heightens the importance of macroeconomic policy in establishing and maintaining basic internal, external, and distributive equilibria, but it implies the further need to bias policy planning and economic structures in favor of flexibility.

It is likely that there will be agreement on the importance of a less inward-oriented, more export-led growth, of greater domestic savings, of a more focused distributive effort, of improved productivity and efficiency, and of the need for a firmer, more coherent, and stable macroeconomic policy. Disagreements, however, are likely to emerge as to the means.

Thus, most will agree on the critical importance of a high and stable real exchange rate in promoting exports and efficient import substitution. But commercial policy? To be sure, tariff “policy” in the region has been more the result of the principle “to each activity the protection it needs,” that is, protection at any social cost, rather than the attempt to redress divergences between social and private costs associated with, say, infant industries, technological externalities, or labor market distortions. Yet more than their elimination, this implies that tariffs should be lowered to levels proportionate to social (and not private) need and, where justified, should be rationalized among sectors so as to tend to equalize effective protection.

Moreover, to the extent that the arguments to protect a sector are socially valid, they justify equivalent incentives for production to all markets, external as well as domestic—all the more so if there are economies of scale. Put differently, unlike as was done in the past when incentives were provided only for production for domestic markets (at the resulting expense of exports, especially nontraditional ones), in the future these ought to be extended to production for international markets as well.

Nor does it suffice to do away with all tariffs and export incentives and replace these with a higher exchange rate. This would, in fact, be correct were all sectors deserving of equal amounts of protection and export incentives. Yet this would be an extreme case. More likely, important divergences between social and private benefits.3 will occur in only some sectors and are likely to vary in degree and over time. At one and the same time new activities may be receiving tariff protection, import substituting activities that are coming of age will be increasingly receiving only export incentives, and fully mature activities will be receiving no special incentives at all.

A second critical bottleneck is the savings-investment process. Experience has clearly demonstrated the drawbacks of negative real interest rates, if not as to the amount of savings, certainly as regards the poor quality of investment: oversized plants, excessively capital-intensive technologies, investment determined by easy access to capital rather than by rate of return, and so forth. Yet excessively high real interest rates have proven to be equally disastrous, leading more to the pursuit of ephemeral quasi-rents (through financial speculation) than to investment in productive activities. The former are normally the result of long-term intervention in capital markets, the latter of financial market liberalization in the throes of disequilibrium often arising out of adjustment or stabilization programs. Hence, a case can be made to move towards liberalization through transitorily controlled rates, keeping these positive, but not much above real international rates.4

In fact, liberalization would seem to be but one, and certainly not the most critical, aspect of improved capital markets. More important is the need: (1) to correct capital-market segmentation between size of firms and types of credits. That large firms enjoy easy access to capital, while small and medium-size firms have little or no such access, biases lending “backwards” to firms with guarantees rather than “forward” to firms with high prospective rates of return. Segmentation between types of credit biases lending towards new equipment, which normally enjoys ample supplier credits at relatively low international interest rates, and away from used equipment and working capital, where financing, when available, is at high interest rates; and (2) to compensate for the absence of critical sections of capital markets, the most obvious being the lack of fluid, long-term capital markets.

Increased savings would seem to be more sensitive to appropriate fiscal policy than to higher (though certainly positive) real interest rates. Given the squeeze on consumption of the past five years, efforts should especially focus on channeling to savings far higher proportions of the new income generated in the recovery phase, be it that deriving from greater exports, improved terms of trade, or lower international interest rates. This implies a “carrot and stick” policy: increases in marginal tax rates, especially on increased consumption, and special incentives for savings.

Finally, the restoration and preservation of basic macroeconomic equilibria implies not only the reduction in the current account deficit (external equilibrium) but the reduction in the unemployment of labor and in the generally widespread levels of underutilized capacity (internal and distributive equilibria). Though the simultaneous achievement of the three is a difficult task, it is the only way open to maintain any of those equilibria in the long run. For the achievement of the one at the expense of another is but transitory and hence ultimately self-defeating.

Since adjustment in the region has been largely recessive, this establishes a prima facie case for short-run policy to be biased in favor of utilizing currently underutilized productive capacity, while the longer run effects of policy on investment take hold. Ordinary aggregate demand policies will not do, however, for these will soon run up against the dearth of foreign exchange to purchase needed intermediate inputs. It is essential for expansive adjustment that a significant part of the output obtained from this increased capacity utilization be for export, not necessarily 100 percent, but enough to generate the foreign exchange required to direct the rest of unused capacity for domestic use, in both import substitution and the production of socially needed nontradables (e.g., housing).

To do this, an appropriate rule of thumb is to equalize the short-run marginal costs of generating or saving foreign exchange through expenditure-switching or expenditure-reduction policies. Since it can be foreseen that expenditure-reduction policies will operate far more quickly than switching policies, heavy and selective switching policies would be called for in the short run. These incentives should, however, be transitory, set in accordance with the degree of currently unused capacity and limited only to those products with the highest short-term output elasticity to price and those with the best chances of achieving long-term international competitiveness.5

In brief, the experience of recent years suggests two types of pitfalls: those deriving from pervasive intervention and a virtual disregard of the market and those deriving from overly rapid liberalization and an excessive reliance on the market. At the risk of oversimplification, our analysis suggests the merits of intervention in the short run (while macroeconomic relations are in disequilibrium) and increased reliance on the price system and a few, simple rules of intervention for the long run (once the economy is closer to basic equilibrium). Intervention in the latter case should be largely limited to attacking the two critical bottlenecks (foreign exchange and the savings-investment process) and to achieving distributive objectives.

More generally, we would emphasize the need for sectoral, not just across-the-board, policy and for selective, and not just general, policy instruments. We would also insist, however, on the need for an outward-oriented development strategy, export promotion being the natural follow-up to the industrial base created by import substitution. Thus, while industrialization based on import substitution was at the heart of regional policy in the past, the reorientation of this established industrial base toward an export-oriented industrialization would seem to be the direction of the future for many countries. This would suggest the virtues of combining orthodox goals and instruments (export orientation and devaluation) with their structural counterparts (industrialization and carefully chosen selective incentives).

For those who see the essential policy issue as between more intervention or more markets, such an “unholy alliance” would appear to be a contradiction in terms. For those who see the challenge as to how to achieve better intervention and better markets, this proposal may ring true, as the essence of balance and common sense.

External Requirements

However effective the design and implementation of domestic adjustment policies may be their efficacy is in fact today heavily conditioned by external events. For one, growth-oriented adjustment relies critically on the expansion and diversification of exports. While this certainly depends on domestic economic decisions, especially exchange and commercial policy, it will be easier or more difficult as the expansion of international trade becomes brisk or sluggish and the currently depressed basic commodity prices rebound or continue to fall. Not much can be done to reverse depressed demand resulting from structural or technological changes. Yet, much of the sluggish demand for Latin America’s exports is a result of weak OECD growth, policy-induced artificial surpluses in agricultural commodities, and increased protection generally.

There are sectoral interests which OECD authorities must take into account in formulating policies. Nevertheless, these policies must clearly be reconciled with the basic accounting identity that interest payments from debtor countries require equivalent trade deficits in creditor countries or corresponding capital inflows to debtors. If creditors want interest repayment and low capital flows, they must run high trade deficits (hopefully through increased imports from debtors, rather than through reduced exports to them). Alternatively, if creditors want protection and trade surpluses they need to promote capital flows to debtors or else to assume the consequences of debt moratoria. In short, creditor countries can have trade surpluses, or receive full interest repayment or extend no new net loans. What is impossible for them is to have all three simultaneously. Hence, the improvement and harmonization of their macroeconomic, sectoral, trade, and financial policies is not simply a matter of international “do goodism” but a basic condition for economic equilibria in the center’s own external accounts.

Expansionary adjustment also requires time and resources. For the speed with which exports expand and efficient import substitution takes place depends not only on correct relative prices but on the amount of resources actually available for investment. So long as the region must transfer the equivalent of 25 percent of its savings for these purposes, such investment can hardly be forthcoming in the appropriate amounts to permit significant trade surpluses and a rapid and sustained rate of economic growth. Hence, if expansionary structural adjustment is to take place, the region’s net outward transfer of resources need be sharply reduced.

This can be achieved through lower international interest rates and the return of flight capital, or increased net lending, or debt forgiveness. Given the severity and duration of the crisis, it is likely that in many cases solutions will require most of the above.

Lowering Interest Rates

During the past four years net interest remittances have absorbed around 35 percent of the total value of the region’s exports, which is double the percentage they represented before the crisis. Hence, ceteris paribus, if these payments are reduced, it would be possible to raise imports without producing any increase in the deficit on current account. Furthermore, if the decline in interest payments was the result of a drop in international interest rates, the reduction in the transfer of resources could be achieved with less pressure on bank profits, and the ensuing recovery of the economy could be achieved without expanding the external debt. It would therefore have the additional advantage of not jeopardizing future import capacity. In other words, the reduction of international base rates constitutes the less conflictive solution to the debt problem.

Hence, it is important that the recent fall in international interest rates be maintained and strenghthened. Yet such a decline, welcome as it is, should not be overrated, for the decline that took place in 1985–86 was in nominal interest rates while real rates fell much less. What is required is that real interest rates decline; only if nominal interest rates fall more than inflation will total interest payments decline in relation to the region’s capacity to pay them (which depends on exports, whose value tends to rise and fall with world inflation). In contrast, as long as real interest rates persistently remain higher than the growth rate of output, and nominal interest rates remain higher than the growth rate of export earnings, there is a progressive risk that debtor countries will drift into insolvency.

The reduction of interest rates depends ultimately on neither debtors nor creditors but on the policies of the principal industrial countries. This is an example—possibly the example par excellence—of why a satisfactory resolution of the debt crisis cannot be found within the limited confines of debtors and creditors but depends strongly on the public policy of industrial countries as well. Thus industrial countries must more decisively tackle their own internal adjustment problems, because without it the world-wide adjustment process is asymmetric and places an unnecessary burden on the developing country debtors.

Reversing Capital Flight

As mentioned earlier, the region, and especially some countries, have experienced a large amount of capital flight. This is reflected in the fact that toward the end of 1985, Latin American residents had $83 billion deposited in the international banking system, more than 2.5 times the level of the region’s official gross international reserves. The reduction of the outward transfer of resources and a growth-oriented adjustment process would clearly be facilitated if most of this capital began to return to the region. This, of course, would be another nonconflictive way of reducing the debt problem and easing the adjustment process.

Both the outflow of this capital and its return depend heavily on the macroeconomic policy and political conditions in the debtor countries. For a return to be effected, good macropolicy must be sustained and rates of return must rise on productive investments. There also must be political stability and guarantees for the security of private capital. That this is a possible and not just a theoretical option is demonstrated by the fact that some countries, such as Mexico, Chile, and Uruguay, were able to stop the capital outflow and even partially reverse it in 1986. It is unlikely, however, that in most countries the amounts will be very large, at least until this critical juncture of the debt crisis be over, given flight capital’s tendency to be first out, last in.

Increasing Net Lending

An alternative and complement to lower interest rates and the return of flight capital is more lending. The less interest rates fall for the debtor countries, the more new lending is required from the creditors to reduce the outward financial transfer and support dynamic and socially efficient adjustment.

At the outset of 1986 there was a surprising consensus about what constituted a conservative estimate of Latin America’s financing needs to support a growth-oriented adjustment process: roughly $20 billion a year for annual growth rates of 4–5 percent a year.6 This compares with actual net capital inflows of $2 billion in 1985 and $9 billion in 1986.

As already mentioned, private banks have demonstrated in recent years a great reluctance to lend to Latin America. More concerted nonvoluntary lending to Latin America is unattractive for many banks since they want to further reduce their asset/capital ratios in the region. Moreover the banks’ ability to resist new lending has been enhanced by loan writeoffs and growth of loan-loss reserves. That resistance can be especially strong in European institutions which are often obliged to set aside new reserves for any additional dollar lent. This situation will put increased pressure on public lenders, which so far do not have adequate resources to fill the perspective gap.

Nevertheless, to the degree that the debtor country has the necessary underlying economic conditions to support its commercial debt—or merits the benefit of the doubt—a violent pull-back of new lending by the banks constitutes a certain degree of myopia on the part of private markets. This is where public policy in the OECD can legitimately employ strong moral suasion to “encourage” private lenders to stay in the game and support the financing of a dynamic adjustment process with new loans. The required financing can come about directly by the authorization of new credits or indirectly through the semi-automatic capping of interest rates (which, of course, should be commercial) and the rescheduling of amortization. The amount of financing required from the banks will vary in individual cases, but creditors would have to commit themselves to an annual financial transfer that subordinates itself to the requirements of a growth-oriented adjustment program, as banks themselves have in fact accepted in the recent Mexican package, for which new finance adjusts itself to the need to support a 3–4 percent rate of economic growth in that country.

Debt Forgiveness

While new lending to the borrowers in whatever form is perhaps better than no finance at all, commercial reschedulings and new loan packages are not technically appropriate for all of them. There are countries where the debt overhang is large either because of the past willingness of lenders and borrowers to create debt largely for purposes which had little prospect of generating a commercial return or because of possibly permanent adverse shifts in the debtors’ terms of trade. In either case the country’s economic structure needs a thorough and time-consuming overhaul before internal rates of return will be high enough to support a commercial interest rate. Consequently, for these countries, adjustment promises to be unusually protracted and the prospects of regaining autonomous access to private credit markets in the foreseeable future are remote. They are analogous to an insolvent commercial borrower and some form of noncommercial debt relief, with hidden or explicit debt forgiveness, is appropriate.

The market already admits to the problem because as soon as Latin American paper is subject to competitive trade, an automatic discount materializes. Although the secondary trading market is thin, and its valuation of paper may not be entirely reliable, any discount above a third of face value is suggestive of a problem loan. For these countries, continuing insistence on commercial returns for loans of noncommercial value only burdens the adjustment process and leaves open the prospects of permanently high and rising debt/export and debt/GDP coefficients in the debtor country. It also involves wishful accounting in the banks and undermines the strength of the home country banking system.

The form debt forgiveness takes—noncommercial interest rates or partial cancellation of principal—would vary from country to country and ideally should be done as painlessly as possible for banks. Yet it is clear at this stage, after five years of adjustment, that countries with very severe and protracted additional adjustment problems will need some form of debt forgiveness.

Of course, debt forgiveness represents a cost for the creditors. Nevertheless, this organized and predictable financial cost must be weighed against other costs, such as loss of export markets and jobs in the creditor countries, as well as the potential and unpredictable financial costs deriving from the risk of disorderly defaults by the debtor countries.

While banks do write down loans (as many have done to date) or even write them fully off, there is no incentive for them to forgive debt. Hence, the menace of the debt crisis continues. The problem then is how to translate the costs of debt writeoffs to banks into equivalent benefits for debtors. Since the debt problem is by now systemic, and the object of OECD governments should be, at least, to minimize the disruption to the international financial systems of spasmodic moratoria on the part of problem debtor nations, creditor governments should now act to minimize this eventuality and push for concerted debt forgiveness. Certainly there are precedents for this. Debt forgiveness by banks, often with their governments’ help and cost sharing, is frequently practiced in the domestic markets of the creditors. Recently there have been a number of measures introduced providing debt forgiveness on problem farm loans, with the appropriate accounting flexibility for the lenders. Why not practice internationally principles that already are considered appropriate for systemic debt problems at home?

Conclusions

By and large, most countries of the region reacted to the post-1979 crisis initially by putting off domestic adjustment and then overad-justing. The first was ineffective; the latter inefficient. The former, because domestic policies failed to adjust while financing was available, achieved short-term growth at the expense of worsened external disequilibria; the latter, because financing collapsed. Thus, though domestic policies were adjusted, the improvement in external accounts was obtained at the expense of economic growth.

Efficient adjustment requires better domestic policies together with adequate financing. The first assures its permanence, the latter wins valuable time for the needed structural transformations to take hold. Efficient adjustment requires not only expenditure reduction and import compression—which can be as sharp as desired—but also a reallocation of real resources from nontradables to exports and import substitution—which is necessarily a slower process. In short, there is no such thing as an efficient shock adjustment program.

In any case, the dramatic improvement in external accounts achieved by 1984 at the expense of costly reductions in output, employment, and wages was seriously set back in 1986, in large part because of the fall in the prices of oil and other basic commodities. Hence, debt indicators deteriorated in most countries of the region, implying the need for more prolonged, if not more pronounced, adjustment. In addition, because of the length and severity of the crisis, adjustment weariness has set in among debtors and debt fatigue among creditors. The former are unable to postpone growth any longer; the latter want to supply little, if any, new money.

In the face of such an impasse, a scenario which could ultimately lead to spasmodic moratoria, which would jeopardize not just particular creditors and debtors but the international financial and open trading system as well, cannot be discounted. To break this impasse and reconcile growth and creditworthiness, concerted action by all parties involved is now essential. Debtor countries—which up to the present have shouldered a disproportionate amount of the burden of adjustment—must persist in their efforts to restructure their economies. In return, and to make this process both economically efficient and politically viable, private creditors, their governments, and official lenders must provide finance far above present levels, thus restoring symmetry to the adjustment process.

In some ways this resembles the Baker Initiative, but with important differences. On the one hand, the content of adjustment that we have outlined is more selective in the use of policy instruments, more pragmatic with regard to the role of state intervention, and more directly concerned about social questions of equity. On the other, we stress that while commercial solutions are acceptable for some problem borrowers, some degree of debt forgiveness is unavoidable for others.

Note: Robert Devlin and Joseph Ramos of the Economic Commission for Latin America and the Caribbean (ECLAC) are, with Andrés Bianchi, co-authors of this address, which was delivered at the symposium by Mr. Bianchi.

See ECLAC, External Debt in latin America (Boulder, Colorado: Lynne Rienner Publishers, 1985), Table 15

Helmut Reisen, “The Latin American Transfer Problem in Historical Perspective,” Latin America and the Caribbean and the OECD (Paris: OECD Development Centre, 1986), p. 151-52.

We say important divergences for it would be an administrative nightmare to try to compensate all theoretically conceivable divergences; much as it would be a gross oversimplification to disregard all such divergences, as do neoconservative policymakers for the sake of administrative simplicity, and put policy on “automatic pilot,” as if all such divergences were trivial or nonexistent.

For a few months high real interest rates may be needed to help stem capital flight in the midst of an adjustment or stabilisation program, while expectations adjust. Yet, if real interest rates need be very high for long, it is a signal that the exchange rate in particular and macroeconomic policy in general, are in doubt. High interest rates are simply no substitute for credible macroeconomic policy.

Once again, the temporary and selective use of such instruments permits incentives to be tailored to those export- and import-substituting activities with the fastest response in the short run, as opposed to an across-the-board instrument such as an even greater devaluation. Selective instruments have the further advantage of having a lesser impact on costs and expectations, and hence on inflation, than a devaluation. Finally, precisely because these selective instruments should be temporary, the exchange rate can be set for long-run equilibrium, thus rendering a clearer and stabler signal to producers as to the objective of policy. Obviously, once the effect of regular switching policies (devaluation) on investment takes hold, these transitory super-switching incentives should be phased out.

The $20 billion figure was cited in early 1986 in separate reports of the World Bank, ECLAC, and the Inter-American Dialogue, The ECLAC report, however, did not take into account the net effect of the sharp fall in petroleum prices in early 1986. The timing of the two other reports suggests that they could not incorporate this effect either. Since Latin America is a net petroleum exporter, annual financing requirement may in fact be higher than $20 billion. See ECLAC, The Problem of External Debt: Gestation, Development, Crisis, and Prospects (Santiago, Chile: January 1986); Inter-American Dialogue. Rebuilding Cooperation in the Americas (Washington: April 1986) and David Knox, “Address at the Bankers Club,” Tokyo, February 20, 1986.

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