Mohsin Khan, Morris Goldstein, and Vittorio Corbo
Published Date:
September 1987
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Jacob A. Frenkel

Director, Research Department International Monetary Fund

Mr. Fischer has provided us with a comprehensive and illuminating paper on economic growth and economic policy. With characteristic clarity and economy he presents a balanced summary of the literature on the determinants of long-run growth in developing countries, discusses the pros and cons of alternative growth strategies, identifies key problems of adjustment and growth facing indebted countries, and draws together the main lessons for economic policy.

To set the stage for my discussion it is worth recalling some of the implications of Mr. Fischer’s analysis. First, our concrete knowledge of the fundamental sources of growth is still meager. Indeed, using the traditional framework of growth accounting, Mr. Fischer shows that about 50 percent of per capita growth cannot be attributed to conventional sources like changes in the quantities of factors of production (labor and capital), education, economies of scale, and improved resource allocation. The unknown residual is typically referred to as “technological progress” or “advance in knowledge.” In view of our limited understanding of the factors governing the growth process, a certain amount of humility is clearly warranted. It follows that programs that aim at growth should be designed with sufficient flexibility so as to correspond to our limited knowledge.

Second, while investment in capital formation contributes to the growth process, its quantitative contribution is rather limited.

Third, while small changes in growth rates have little effect in the short run, their cumulative effect may be very significant for the long run. Mr. Fischer characterizes this fact as “the great power of compounding.” The implications of this observation are profound. Programs, even those aimed at short-term crisis management, must be designed with a long-term perspective. Indeed, there are no short cuts. A runner planning for a successful long-distance race must follow a steady, feasible, and sustainable pace; unsustainable accelerations in mid-course may yield illusory short-term gains but at the cost of jeopardizing the successful completion of the race.

Fourth, and on a bit more pessimistic note, even the long-run effects of a steady rise in the growth rate are somewhat limited: the low-income countries would have to grow (in per capita terms) 3.9 percent a year faster than the industrial market economies to catch up within a century. Such a growth rate is clearly unlikely, and therefore a complete convergence of the economic positions of developing and industrial countries is unlikely to take place. The fifth fact to which Mr. Fischer draws our attention is that most success stories involve outward orientation of policies, although the role of government varies in implementing these policies.

The main theme emerging from Mr. Fischer’s analysis is that the analysis of economic growth and economic policies is highly complex, that economic growth involves hard policy decisions, and that one should not expect immediate results. Simply stated, there is no quick fix.

In discussing the implementation of policies, Mr. Fischer recommends a balanced approach to the design of programs; I certainly agree with his general line of reasoning. Perhaps I can best contribute by expanding on some of the issues that emerge from Mr. Fischer’s analysis. The first concerns the question of gradualism versus drastic measures. The advantages and disadvantages of each one of the two extremes are well known. It seems, however, that the desirable solution to the problem of the choice between gradualism and drastic measures should be a plan that incorporates the best elements of each option. Such a balanced solution could be obtained through a pre-announcement of a feasible path for the policy instruments. Thus, if stabilization involves a cut in government spending, a reduction in the rate of monetary growth, and the like, a gradual reduction coupled with pre-announcement of the entire path is likely to avoid the undesirable consequences of immediate drastic cuts, while, at the same time, the feasibility and the consistency of the plan is likely to indicate the government’s long-term commitment, and thereby enhance the plan’s credibility and promote stabilizing expectations.

A second area where a balanced view is called for involves the choice between an analysis that is based entirely on formal models and an analysis that is based entirely on informal judgment. Since structural parameters are unlikely to remain constant in the face of large policy changes, it is clearly unwise to follow mechanically the predictions of rigid models. On the other hand, models may be very useful in disciplining what might otherwise be an unstructured analysis by providing consistency checks. Informal judgment can aid and can be aided by formal models.

A third area involves the relation between adjustment and growth. In this context several points are noteworthy. The first concerns timing: should adjustment policies precede growth policies, or vice versa? I believe that the correct answer is neither of the above. Growth policies cannot be effective if implemented in a highly distorted economy that needs adjustment. By the same token, adjustment policies will not be sustainable unless implemented in an environment of growth. The two sets of policies should not be viewed as alternatives, but rather as complements to each other. They must be implemented in a balanced fashion; they must be implemented simultaneously. The second point involves the quality of adjustment and growth. There is a “good adjustment” and there is a “bad adjustment”; there is a “good growth” and there is a “bad growth.” An analysis that distinguishes the good patterns of adjustment and growth from their bad counterparts must focus on the commodity composition of aggregate demand and aggregate output. Aggregate measures of demand and output levels are not “sufficient statistics” for this purpose.

The third point relates to the composition of government revenue and outlays. One of Mr. Fischer’s policy lessons is: “Keep budget deficits under adequate control. Absolute balance may be impossible; but there is not much room for deficits.” Very sensible advice. But I think that if we are to embed sound fiscal policy within a program that has growth, current account, inflation, and perhaps even income distribution objectives, it makes a big difference not only if the country reduces its fiscal deficit but also how it does so. Let me elaborate.

If a country wants to improve its current account or to effect a change in its exchange rate, it matters a lot whether it reduces the deficit by cutting expenditures or by raising taxes, or by cutting expenditure on tradable goods versus nontradables. Similarly, the growth implications of fiscal consolidation will be different depending on whether higher taxes fall mainly on consumption or on investment, or on whether these taxes promote or impede work effort. Likewise, the success of efforts to protect the most vulnerable groups in an economy will not be indifferent to whether cuts in expenditure take the form of decreases in defense spending or reductions in health and nutrition expenditures. In short, one cannot draw useful predictions about the impact of fiscal policy without being quite specific about the structure of expenditure and revenue measures.

A fourth area involves the balance between short-run and long-run considerations. To begin with, it is important to emphasize that a sharp dichotomy between the two is unhelpful and may result in fundamental errors. A sensible model of economic behavior must recognize that the short-run effects of policies depend on the degree to which the policies are perceived as being sustainable in the longer run. Furthermore, decisions on whether to implement short-run policies must hinge on their longer-run consequences. This interdependence between the short and the long runs implies that it makes little economic sense to argue that the International Monetary Fund should be concerned only with short-run considerations involving short-run balance of payments adjustments, whereas the World Bank should be concerned only with long-run considerations involving long-run growth. A proper analysis of the short run must recognize the long-run consequences, and a proper analysis of the long run must recognize that the path involves a succession of short-run policies. This logical overlap of interest provides the intellectual rationale for enhanced Bank-Fund cooperation.

A fifth area involves the balance and interaction between growth and external finance. In general, the specification of programs and the length of the time horizon that is incorporated into the program design depend on the amount of available external finance. There is, however, the difficulty of circular reasoning since the amount of available external finance depends itself, in some measure, on the particular elements in the program and on the length of the time horizon assumed in the program design. A proper balance must allow for these two interacting factors.

A sixth area in which a delicate balance must be found is between the case-by-case approach and the general approach. The virtues of the former approach are well known. It recognizes that countries differ from each other in customs and conventions, in political systems, in socioeconomic structures, in economic organization, in circumstances, and the like. On the other hand, one must recognize that a strong case can be made in favor of consistency and of a general application of common basic principles. Accordingly, a midway course between the two extremes would acknowledge that a properly functioning system needs some general rules, but at the same time these rules must allow for the prevailing large diversities among member countries. The recognition of such diversity would facilitate the adoption of policy measures tailored to the circumstances and needs of a given country without the paralyzing concern that such necessary measures create dangerous precedents that must be generalized and applied in all other cases and under all other circumstances.

A seventh area of prime importance relates to the policy lessons drawn from the inflationary experience. I agree with Mr. Fischer’s dictum that in promoting growth policy one needs to make sure that inflationary pressures do not get out of line. The key question is how to bring inflation down without significantly damaging growth. The issue is perhaps of particular interest when the inflation rate is high and long-lived and when labor, goods, and financial markets have adapted to “living with inflation” via various indexation mechanisms.

One option is to rely more heavily on wage and price controls to deal with the “inertial” nature of inflation, while simultaneously de-indexing. The worry, of course, is that the longer these controls stay in force, the more they distort market signals and lead to serious misallocation of resources. On the other hand, high and variable inflation rates also cloud the information content of the price system so that, at least initially, the resource-misallocation cost of controls may be limited. The other danger is that the initial success of the controls in reducing inflation may lead to a weakening of monetary and fiscal discipline, the results of which can become readily apparent during the “re-entry period” when the authorities move to gradually relax the price and wage controls. Yet another concern is to see that increases in the demand for money induced by greatly reduced inflationary expectations do not lead to dramatic rises in real interest rates—a consideration that argues against excessively restrictive monetary policy. In the end, I fully support Mr. Fischer’s conclusion: “Use price and wage controls sparingly if at all.”

A second general option is to stick closer to orthodox stabilization measures to combat inflation but to adopt a gradualist approach that produces a smooth adjustment path so as to minimize any employment losses. While, as indicated earlier, the choice of shock treatment versus gradualism has many dimensions, the political one will often be decisive. It may not be possible to sustain gradualist policies over a long period. In this sense, a sharp cut in real wages followed by a gradual rise may be more manageable than a steady decline over several years. Equally, the temptation to put off painful measures until the future carries the risk that politicians will not do what they pledged when the time comes. Concerning the lessons from the recent experience with heterodox stabilization programs (Argentina, Brazil, and Israel), my impression is that there is no substitute for orthodox measures. Heterodox programs that do not include significant orthodox components—budgetary consolidation and real wage restraint—do not seem to succeed owing to lack of credibility. Once the key orthodox measures are implemented, the heterodox aspects of the programs may provide some of the tranquil environment necessary for the breaking of vicious circles. I should note that these impressions are tentative since (at least for some of the programs) the jury is still out.

Another issue for inflation control concerns the role of exchange rate policy. Here, one has to guard against the danger that real exchange rate rules—put in place to avoid slippages in competitiveness and to underpin improvements in the current account—do not destabilize the price level. If inflation is to be controlled over the long term, experience shows that it is helpful to have some nominal anchor for monetary policy. I couldn’t agree more with what Mr. Fischer regards as the most important lesson: don’t allow the exchange rate to result in an overvalued currency—but we also should recognize that fixation with the current account can play havoc with other objectives of programs if exchange rate management is too mechanical. In this context, I should note that the real exchange rate is one out of three critical indicators that should not be allowed to get out of line. The other two are the real rate of interest and the real wage. An economy for which any one of these three indicators is out of line is likely to be heading for difficulties.

The final issue on which I wish to comment concerns Mr. Fischer’s question of the proper order of economic liberalization measures. What markets should be liberalized first and what should be the proper sequencing? To begin with, it is worth noting that the question of the optimal process of economic liberalization involves one of the most difficult aspects of the theory of economic policy, namely, the transition toward equilibrium. The prescription of economic theory is very clear when applied to “first-best” situations. Economic theory, however, is much more reserved when it comes to evaluation and comparison of distorted situations. The evaluation of alternative strategies for economic liberalization involves making comparisons among various distorted situations that characterize alternative paths an economy may adopt in its approach to undistorted, first-best equilibrium. Consequently, views about the “proper” sequencing of liberalization measures should be put forward with great care and modesty; economic theory does not provide an unambiguous answer to that important question. With these reservations in mind, some general principles may still be stated.

Consider an economy that suffers from numerous distortions in goods and capital markets and suppose that in the past many barriers to international trade in goods and capital were imposed. Suppose that the government wishes to remove the distortions and to liberalize trade in goods and capital. Under these circumstances, the general rule is that the first step in the liberalization process should be removal of domestic distortions in goods and capital markets and attainment of fiscal order, so as to reduce the heavy reliance on inflationary finance. The second step should be the liberalization of the economy’s links with the rest of the world. The external liberalization should also proceed in two phases. The first phase should reduce distortions to the free flow of goods by liberalizing the balance of trade. The capital account of the balance of payments should be opened up and liberalized only in the final phase. In what follows, some arguments are offered in support of the proposed order of liberalization of the trade and the capital accounts of the balance of payments.

The key distinction between the effects of opening up the trade account and those of opening up the capital account of the balance of payments stems from the fundamental difference between goods and asset markets. As is known, the speed of adjustment in asset markets is much faster than in goods markets. Asset markets are more sensitive to expectations concerning the distant future, and new information that alters expectations is reflected in asset prices much faster than in the prices of goods and services. This intrinsic difference in the basic characteristics of goods and assets has several implications. First, since the economy under consideration has been distorted for a significant period, nobody (including economists) can be certain about the precise paths that its various sectors will follow after liberalization. Under such uncertain circumstances, prudence is called for. A program of liberalization that opens up the trade account first has the virtue of providing policymakers with an opportunity to examine the market’s reaction and to correct any errors found. A program that opens up the capital account first is not likely to provide such an opportunity, since once the capital account is opened up, the initial reaction is likely to take place very quickly and the resulting capital flows are likely to be huge. Thus, although it is eventually desirable to have an open capital account, prudence calls for a gradual transition to openness so as to facilitate the required change in institutions and the economic structure. An analogy can be made between an economy recovering from a long history of distortions and an individual recovering from a heart condition and a by-pass operation. While the latter’s complete recovery may well be anticipated, nobody would recommend that he start his rehabilitation program by running a marathon race.

The implications of the different speeds of adjustment of the trade and capital accounts can be illustrated picturesquely by a carriage pulled by two horses. Suppose that one of the horses is a fast runner while the other is a slow runner. As is obvious, if the two horses run at different speeds, the carriage would turn over. To avoid a disaster, the speeds of the two horses must be equalized. This can be achieved by speeding up the slow horse or by slowing down the fast one. It stands to reason that the former solution is not sustainable while the latter can be achieved with little effort. Analogously, the overall balance of payments constraint requires that the trade and the capital accounts be brought into line with each other, and thus, even though the two accounts tend to respond at different speeds, the overall constraint implies that the two speeds of adjustment must be harmonized. It seems that such consistency could be achieved with less effort by slowing down capital flows than it could by speeding up trade flows.

Second, it is easier (and less costly to society) to reverse wrong portfolio decisions than to reverse wrong real investment decisions. This potential difference in social costs also supports the thesis that the proposed sequence of liberalization measures is the correct one. Once the authorities remove distortions in the commodity markets and open up the trade account, real investment in the economy will take place in a less distorted environment—and thus will be more consistent with long-run patterns of real investment. Portfolio investments will continue to be based on a distorted capital market as long as the capital account is not opened up. Once the capital account is liberalized, some portfolio decisions will have to be reversed, but such a reversal is not likely to be very costly. On the other hand, if the capital account is opened up first, portfolio decisions are likely to reflect more accurately the undistorted long-run conditions, but real investment decisions will still reflect a distorted environment as long as the trade account is not opened up. Owing to the distortions, the social costs of investments are likely to exceed the private costs. Such real investment decisions will have to be reversed once the trade account is liberalized. Therefore, the trade account should be liberalized before the capital account. In this context, it should be noted that distortions in the flow of goods affect both the trade account and the capital account and, by the same token, distortions in the flow of capital also affect both accounts. However, it is likely that the relative effects of each distortion on the two accounts differ; distortions in the flow of goods are likely to have a stronger effect on the trade account than on the capital account, while distortions in the flow of capital are likely to have a stronger effect on the capital account than on the trade account. This difference in the relative sensitivities of the two balance of payments accounts to the two distortions underlies the recommended order of liberalization.

Third, the cost of a distortion depends on the distortion itself and on the volume of transactions that take place in the presence of the distortion. Thus, when the trade account is opened up first, the cost of the remaining distortion (i.e., the closed capital account) is proportional to the volume of trade, which, owing to the slow adjustment of the market for goods, is likely to be relatively small. On the other hand, when the capital account is opened up first, the cost of the remaining distortion (i.e., the closed trade account) is proportional to the volume of capital flows, which, owing to the high speed of adjustment in asset markets, is likely to be very large. Thus, a comparison of the costs of distortions also supports the proposition that the trade account should be opened up first.

The removal of various distortions in the market for goods—including various taxes, subsidies, and tariffs,—will yield a new equilibrium price level, a new nominal exchange rate, and a new real exchange rate. It is pertinent to note that prior to setting out on such a path, the initial conditions have to be set correctly, so as to reflect the new equilibrium exchange rate and the prices that will prevail following the removal of the distortions. In this context, it is useful to recall that several attempted liberalizations have resulted in uncontrolled inflation. These outcomes can be explained, in part, by the nature of indexation clauses. In order to avoid such failures, it is critical that the initial (once-and-for-all) changes in prices that result from the removal of subsidies and other distortions be excluded from the indices that are used for wage indexation.

As was emphasized earlier, it is essential that the liberalization program be preceded by restoration of a fiscal order that reduces the government’s dependence on inflationary finance. This restoration is an especially important prerequisite to opening up the capital account. The liberalization of the capital account is likely to encourage the process of “currency substitution.” This phenomenon results in an effective reduction of the “tax base” for inflationary finance. Unless the need for inflationary finance is reduced, the opening up of the capital account and the resultant shrinkage of the inflationary tax base may result in an accelerated rate of inflation as the government attempts to collect the needed revenue from a smaller tax base.

The success of the liberalization program depends crucially on expectations concerning the feasibility and credibility of the program. It is important that the various measures that are undertaken hang together in a consistent way. Trust and confidence that has been built up with great difficulty can be destroyed very easily. Therefore, it is important not to start the program until all loose ends are tied up. The economic system, through the mechanism of memory that builds itself into expectations, shows little tolerance of errors. Therefore, while a slight delay in the introduction of a program will not be fatal, the premature introduction of an inconsistent plan might be.

Mr. Fischer concludes his paper with a perceptive list of key lessons and commandments for policymakers. I would amend that list with the additional obvious but, in view of past experience, very important principle: avoid correcting a mistake by overreacting. Stated differently, do not attempt to undo a mistake by making another mistake in the opposite direction. As noted by the Austrian economist, Ludwig Von Mises, if somebody has been run over by an automobile, you do not put him back on his feet by letting the car run over him in the other direction.

S. Shahid Husain

Vice President, Operations Policy Staff

World Bank

I will be very selective and mention three basic issues about the role of governments.

First, regarding the whole question of controls and rent creation in developing countries, one of the most common causes of frustrated growth is large-scale rent creation and rent receiving that may follow from specific control and allocation decisions. While for a short period transfers implicit in subsidized exchange rates and subsidized interest rates may be justifiable in terms of creation of capital and the establishment of a technological base, there is evidence that before too long they start frustrating the whole process of growth.

Let me mention the extreme case of Nigeria, where, during ten years of the oil boom when the investment rates were 20 or 30 percent, there was no increase in GNP at all, none. Basically what happened is that the so-called investment was nothing but a way of getting hold of scarce resources to create monopolies. Clearly any process which is going to lead to adjustment and viable growth has to tackle this issue in developing countries.

The second point I want to make is that there is an inherent contradiction in any development approach that discriminates against exports and yet relies heavily on external borrowing. The sheer arithmetic of the debt cycle is such that if the mutually supportive process of borrowing, growth, and debt servicing is not to come to an abrupt end, then sooner rather than later exports and GNP have to increase faster than debt.

The only ways this eventuality can be postponed is through substantial flows of concessional assistance, which has been the case in such countries as India that have avoided this crisis, or a substantial improvement in terms of trade. That is the second issue.

The third point I want to make is that in many developing countries there has been a large expansion of government ownership and control of the directly productive sectors. This creates an inherent conflict of interest in the formulation of policies. There is evidence in Africa, Asia, and Latin America that stretching government management and finance has caused an internal impediment because of the conflict between the policy setting and the management of government enterprises in exposing particular industries to competition and to financial discipline.

A word about stabilization and adjustment. It is true that in an environment of high inflation and high expectation of inflation there has to be some priority in bringing to balance the fiscal and monetary factors. And yet if we examine what has happened in developing countries we find that most of these apparent stabilization issues have a base in institutional questions.

For example, how do you bring government expenditures into control and to balance without going deeply in the issues of the management of public enterprises or of the agricultural support-price mechanism? At this stage in the process of stabilization and development it is very difficult to distinguish between the issues of stabilization and the longer-term issues of viability of growth. In my view, they go hand in hand and have to be tackled as integral parts of a coherent and cohesive program.

A. David Knox

Vice President, Latin America and the Caribbean Regional Office

World Bank

Let me say that I found Mr. Bianchi’s paper an excellent one. I thought it was lucid and balanced. And indeed I would be quite happy to stop there, but I fear that the organizers of this conference might withdraw my invitation to lunch tomorrow. So I will continue for a little bit longer.

I think in the paper and in his presentation Dr. Bianchi has made a number of excellent points, bringing out the nature of an extraordinarily prolonged and severe crisis that has beset the Latin American countries for the last five years now. And as he says, it is the result of an extraordinary combination of events, both external factors that have been extremely unfavorable for the countries, in terms of the countercyclical behavior of most of the sources of capital, and the very sharp deterioration in the terms of trade.

In addition to those external factors that have been so adverse, I think he very rightly points to the fact that the Latin American countries began this long period of crisis in an extraordinarily weak position. They began it indeed with economies weakened as a result of policies that have been followed in most of them for many years. They began it with policies that were ill-adapted to insuring sustained growth under almost any conditions.

I would just like to emphasize that because I think it is important to keep in mind that while much of our attention is devoted to how to overcome the problem of debt and the crisis produced by the problem of debt, even if there were no debt problem there would still be a need for some basic changes in the economic policies of most Latin American countries.

I think that point is brought out very clearly in Mr. Bianchi’s paper.

Now what need one to do about this? Well again, I think that he emphasizes, briefly but correctly, the key elements of change, the key areas where change has to be made.

Without trying to elaborate on them, because you wouldn’t allow me to even if I wanted to or even if I could, these areas are first the need to redirect those economies to make them much more outward-oriented than they have been in the past. It is, as the paper points out, an extraordinary feature of Latin America that external trade contributes a very small proportion to gross domestic product. And it is an even more extraordinary feature that within their exports something like 75 percent (I think this is the figure quoted in the paper) consists of primary products.

If I were to have one small point of disagreement with the paper, I was a little bit surprised to see this fact attributed simply to the rich resource endowment of the countries. It is true that they are richly endowed, and therefore it is easy for them to have substantial exports of primary products. But it is also paradoxical that in the countries that also have a substantial industrial base, countries in which manufacturing industry contributes a very high proportion to total domestic product, that such an industrial base is so little reflected in their external trade. And I think one of the things that clearly needs to be done, as is brought out in the paper, is to move away from this extreme dependence on primary products and to develop the manufactured exports that are certainly possible in the Latin American countries.

Mr. Bianchi went on, of course, to tell us in addition to that, the countries need to do more to promote their domestic savings. I would subscribe very much to that. And also to increase the efficiency of their investments. No one can look at the capital output ratios in Latin America over the years without being struck by the fact that these countries have unfortunately in the past made ineffective use of the capital resources at their disposal. It also means, of course, that they therefore have the capacity to get much more out of available capital.

I would subscribe also to what Mr. Bianchi had to say about the need to redirect investment to try to address some of the problems of unemployment and poverty that are so endemic to Latin America.

Again, I think he is correct in saying that one of the problems of Latin American investment has been its extremely capital intensive nature, another way of saying its higher capital output ratios. Putting it in terms of capital intensity draws attention to the fact that the investments have been so predominantly those that have contributed little to employment and have therefore contributed much to unemployment which is so severe throughout the continent today.

These are certain areas where I think change is needed and where change is possible. How to bring that about? Well, he tells us to avoid the extremes, and not to be laissez-faire on one side. I would subscribe to that. I might be a little more on the laissez-faire side than he might be. I don’t know.

I was struck at one point where he argues in his paper in favor of the use of selective policies. I am never quite sure what selective policies mean but I suspect they mean that governments know which industries to promote and which commodities to push. That would be very nice, I am sure. I am a little skeptical as to whether experience shows that most governments really know how to do this. But if we can find one that can, I for one would certainly be prepared to support it. I am a little skeptical as to whether I ever will find one. But never mind.

One point, however, on which I think I would differ from him a bit is that he put, particularly in his oral presentation, a great deal of emphasis on the adverse developments of 1986. I would certainly agree, they were very adverse. Whether this really means that the clock has been rolled back, I am less certain. If you look at Mr. Bianchi’s Table 3. at the end of his paper, you will see this very interestingly. I think the worsening of the external situation in 1986 had very much to do with three things: one, oil; two, the problems, particularly of Argentina, with terms of trade; and third, Brazil.

I say that with due respect, but I would also say that just as Brazil got into serious trouble in 1986 with a catastrophic decline in its trade surplus, Brazil could almost as easily get back to a substantial trade surplus.

I would also say that oil prices are not quite as catastrophically low as they were. And that there is some reason to hope that the oil countries are improving their situation.

In addition to that, I would draw attention to the fact that in the oil countries themselves (Mexico is a good illustration of this), it is encouraging to see the extraordinary development of non-petroleum exports. Mexican non-petroleum exports rose last year by something like 32 percent. And this is, I think, an indication of the kinds of changes, the kinds of potential, that exist in Latin America.

But, again, let me just conclude that I thought the paper that we were given was an excellent one and one I certainly could subscribe to in very great measure.

Arjun Sengupta

Executive Director

International Monetary Fund

Messrs. Bianchi, Devlin, and Ramos have given in their stimulating paper a graphic description of the adjustment process in Latin America during the five years ending 1986. The paper is, however, not just a historical review of the recent Latin American experience, as it also provides an assessment of the prospects for growth-oriented adjustment in that region. That assessment, which is quite detailed, forming almost one third of the paper, is most illuminating and original. It is good that this paper has been presented at this symposium, particularly because of the unconventional way it has dealt with some of the conventional questions.

The Debt Crisis and Resource Transfer

The debt crisis was precipitated, according to the authors, by an abrupt cutback in the commercial bank lending since the second half of 1982, reversing its sustained upward trend between 1970 and 1981. This forced the Latin American countries to engage in a sharp recessionary adjustment to bring down the region’s current account deficit of over $40 billion in 1981-82 to less than $0.2 billion in just two years. This was done despite a high level of factor payments of interest and profit of around $35 billion a year, double their average level in the four years preceding the crisis. Closing this deficit through severe import compression was costly to output, investment, employment, and living standards. The volume of exports expanded by 20 percent between 1981 and 1984, but because of a drastic fall in the prices of primary products, the value of exports remained virtually unchanged. The Latin American GDP actually fell in 1982–83, and fixed investment contracted by 30 percent, unable to meet even the replacement needs in several countries. There was a partial recovery of GDP in 1984–85 because of the acceleration of world trade and increase in U.S. imports, and a partial recovery of capital inflows. Mexico, Brazil, and Venezuela covered their interest payments with trade surpluses, and Argentina, Ecuador, and Peru covered nearly 60 percent of such payments. But the hope that this would lead to expansionary adjustment in the region was frustrated by mid-1985 by the slackening of international activity and a fall in the terms of trade despite the decline in international interest rates. This is the scenario of crises portrayed by the authors, who also point out that after receiving net resources from abroad of $13 billion a year on the average in 1978–81, Latin America transferred to the rest of the world $26 billion a year during 1982–86. The net transfer of resources to the rest of the world totaled over $130 billion in 1982–86.

The paper shows that scarcity of external financing and high interest costs, in the context of large outward transfer of resources, have severely limited the possibilities of launching a growth-oriented, structural adjustment process in these countries. The outward resource transfer from Latin America 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 victorious nations after World War I. The real weight of Latin American interest payments was high. If the London Interbank Offered Rate (LIBOR) is deflated by the dollar value of the debtors’ exports, the annual average real rate of interest was as high as 17 percent during 1982–86.

The authors note that so long as the ratio of interest payments on debt to GDP is higher than the ratio of trade surplus to GDP, the problem cannot be resolved by “recessionary” adjustment. They advocate “expansive adjustment” in which the scarce foreign exchange is used to meet the import requirements necessary for minimum acceptable growth. Such an expansive adjustment would require adequate financing to provide the needed time for structural transformation to take full effect. It is not a question of trade-off between adjustment and external financing. The two are complementary—appropriate adjustment requires adequate financing. They emphasize the need to combine orthodox approach (export orientation and devaluation) with structural policies (industrialization and carefully chosen selective incentives) together with a more focused distributive effort. Clearly there will be agreement on the policy orientations that they advocate, but disagreements would likely emerge on the details, especially regarding the details of specific incentives and discriminating interventions.

Global Implications of Adjustment

I would like to concentrate on a few issues raised here which have global implications beyond Latin America. First, the authors rightly emphasize the accounting identity that interest payments from debtor countries require equivalent trade deficits in creditor countries or corresponding capital flows to debtors. This brings out the interdependence of the countries very clearly. If the banks extend no new lending and other capital flows are reduced, creditor countries can receive full interest repayments only if they give up protectionism, generate trade deficits, and increase imports from debtors. The alternative route of generating trade deficits in the OECD countries through a reduction of exports from these countries and a corresponding reduction of imports in the debtor countries harms everybody. Even the banks, which seem to gain immediately, suffer in the long run, because of general stagnation and the likelihood of debtors falling in default.

Management of their interdependence, I am afraid, does not admit any Adam Smithian solution. Policy coordination has to be organized, as uncoordinated policies harm everybody. International institutions have a clear role to play, particularly the Fund with its mandate for international surveillance. We in developing countries have repeatedly pointed out that this surveillance function is conducted highly asymmetrically—developing deficit countries that borrow are subjected to all the rigors of policy prescriptions, but the surplus industrial creditor countries have little compulsion to adjust. This was surely not the intention of the founding fathers of the Bretton Woods institutions, and today the need for the surplus countries to adjust has become even more important in view of the debt crisis.

Policy coordination to manage the adjustment of the surplus countries depends not just on technical issues, such as the choice of indicators and appropriate policy rules, which the Fund with its technical expertise can help to resolve. It basically depends on the political will to cooperate among the major industrial countries, which also to some extent, and only to some extent, the Fund can help to generate by working out the trade-offs, the costs and benefits of different options, and their implications for the sharing of the burden of adjustment among countries.

Role of the Fund

If the Fund can perform this role, it is not difficult to imagine that the Fund can also play an effective role in mobilizing the finance that is necessary to help the debtor countries to implement policies for adjustment with growth. The Fund has in the past played the role of a catalyst, but this, as the recent experience of the Mexican package shows, has not yielded satisfactory results. Perhaps the Fund has to have a role in debt consolidation, and even in debt forgiveness, apart from encouraging new net financial flows. The Fund could provide bridge finance by itself or in collaboration with other multilateral institutions. The main problem in discharging this task would be constraints on the Fund’s own resources and the policy of access limits, which the Fund has imposed upon itself, even when it has no immediate problem of liquidity.

I was very much encouraged by the statement of the Managing Director indicating his determination to have the Fund play a major role in the international process of adjustment with growth. Nevertheless, as the international community settles down to cope with the problems of balance of payments adjustment with growth, it becomes increasingly clear that a number of conceptual cobwebs have to be cleared, some very complex issues have to be resolved, and a number of basic institutional reforms have to be introduced. I want to touch upon some of these problems.

Balance of Payments Adjustment with Growth

First is the concept of adjustment with growth—and the problems of reconciliation of the conventional Fund approach to balance of payments adjustment with the new paradigm—not so new to many of us—that such adjustment has to take place with growth.

Take the assertion about the “fundamental complementarity between adjustment and growth,” which is the title of Mr. Guitián’s paper in this symposium. According to the orthodox approach to the Fund programs, it means that adjustment is necessary for growth. Sometimes it also implies that adjustment is sufficient for growth. Contrast this to the argument that for many countries, and particularly developing countries, growth is necessary for adjustment. This argument is behind all the emphasis on supply-oriented policies. If adjustment means a sustained balance of payments viability, the supply of tradable goods must increase, and that cannot happen without an increase in productive capacity and a removal of the bottlenecks stemming from specific shortages that prevent the full use of the existing capacity. Both require growth. Even the distortions caused by policies, preventing the fuller utilization of capacity can be removed effectively only if their causes are removed. One must appreciate that the causes of these policy distortions are not always the stupidity of the policymakers but are most often introduced by the need for rationing scarce resources, for reconciling multiple objectives. Such policy distortions cannot be removed without creating the conditions that would allow policymakers to correct their policies. This would essentially require expanding the availability of such resources, so that they can be more rationally allocated among compiling claims, and growth is a necessary condition for that.

The argument that growth is necessary for adjustment should not be caricatured by saying that it means that the higher the growth, the better the adjustment. Everybody recognizes the constraints on optimal growth. Appropriate adjustment cannot take place without appropriate growth, and adjustment policies that detract from growth and contract output cannot produce viable adjustment.

Demand-Management and Supply-Augmenting Policies

An implication of this is that demand-management policies alone cannot produce such adjustment in developing countries, because the balance of payments problems in these countries are rarely the result only of excess demand. Maybe in a full employment economy or in a mythical economy where all prices are fully flexible, all resources are fully mobile, and all markets are instantaneously cleared, this would work, but not in a developing country as we know. It does not mean there should be no control over demand, but it means that policies should be emphasized that stimulate the growth of supplies.

Such supply-augmenting policies take time to fructify. Even the exchange rate policy, which the Fund makes often, and sometimes rightly, the centerpiece of policy advice, takes time to yield its “switching” effects through which supply-side adjustments take place. There is a J-curve effect of exchange rate changes in developing countries, though not for the same reason as in industrial countries. There would normally be a period of time during which the deficits actually increase and would have to be financed. This is true for most supply-oriented policies. Deficits during the period these policies take to produce their effect have to be financed. The longer the period of such adjustment, the longer the period for which finance should be provided and the larger would be the amount of finance needed.

Two conclusions derive from this perception of the balance of payments problems of developing countries. First is that finance and adjustment are not substitutes, but are complements. It is no longer a question of more adjustment and less finance; it is more adjustment and more finance. Second, and for the Fund particularly important, appropriate adjustment requires longer period of finance.

Let me dwell on both points. If excess demand were the cause of payments deficit, only adjustment with demand-management policies would have been sufficient, requiring not much finance except for meeting specific shortages to remove frictions, as the demand policies usually take a short period to fructify. Since the deficits are supposed to equilibrate with the normal level of autonomous capital flows, external finance is basically needed to supplement these flows if they temporarily fall short of their normal or “trend” level. In a purely excess-demand situation, more finances would arguably tend to sustain such excess demand and so would hamper adjustment. This would not be the case, however, if the situation is not purely of excess demand. A current account imbalance, ex post, always shows up as domestic absorption exceeding domestic output; but if the corrective policy leans more toward increasing output and not so much toward decreasing absorption—at best maintaining a constraint on absorption—it would require more finances to support that policy. The normal level of capital flows would also be difficult to estimate. The level cannot be based on the projection of the past trend, because if the program succeeds in producing adjustment with growth, autonomous capital flows should also increase in the future. So the current shortfall of resources that have to be compensated by external finance to help payments equilibrium to work itself out would have to be calculated not from a normal level of capital flows based on past trends but from higher level consistent with sustained growth. We cannot avoid this problem by saying that the market would have foreseen this development and therefore would have supplied the additional capital. The market does not work this way for developing countries whose exposure to the capital market is low for a variety of factors (and not just information). More important, improved growth prospects would not materialize if appropriate growth-oriented adjustment policies are not adopted, and they cannot be adopted if adequate finance is not available. If the required finance is made available by the Fund or some other international institution, the appropriate policies can be followed in turn which would increase the inflow of external finance.

The second problem is more tricky. If the policies are basically supply oriented, they will take time to work out—the more underdeveloped the economy, the longer the time they usually take—and during that period the deficits have to be financed. So the financing available from the Fund cannot be for a very short period, and may have to be stretched over a number of years. The Fund seems reluctant to extend its lending period beyond 1–2 years to be repaid between 3–5 years—the normal stand-by arrangements. The Extended Financing Facility introduced in mid-70s involving disbursements over 3 years, and repayment between maximum 4–10 years has fallen into disuse, with only one such program being allowed between 1984 and 1986.

Monetary Character of the Fund and Repayment of Fund Loans

The reluctance to use this facility is based on an interpretation of “the monetary and revolving character of the institution,” whose Articles provide for adopting adequate “safeguards” to allow “temporary use” of its resources by the members. It is necessary to look into this question carefully, and more academic work needs to be done to define the appropriate role of a monetary institution and the nature of a revolving fund, and differentiate it properly from a developmental institution. Peter Kenen’s latest Brookings Institution volume is a major contribution in this direction. I may also refer to the paper by Sidney Dell in World Development to show that at the time of the Bretton Woods conference there was a strong American position, supported by Keynes, that stabilization often needed long-term finance and the international institution concerned with problems of stabilization should be prepared to offer such finance.

One would have thought that the revolving nature of a monetary institution depends on the prospect that the loans made by it are repaid with interest and that the interest should reflect the opportunity cost of its funds. If repayments are assured, and the monies actually revolve, this institution can only face temporary liquidity problems, which may arise mainly from a mismatch of flows of funds, and not from the period of repayment.

The problem really boils down to the prospects of repayment. If the adjustment programs are successful and produce a viable balance of payments outcome, there should be no problem of repayment. So the first “safeguard” for the “temporary” use should be designing the adjustment program appropriately so that the borrowers are able to repay at the right time. Even if the balance of payments adjustment results in a payments surplus but is accompanied by a contraction of output, the surplus position may not be viable and the sustained ability to repay by the country may be in question, especially if the Fund loan is only one part of a larger liability of the country. So it is possible to argue that an adequate amount of finance is not only more likely to produce appropriate balance of payments adjustment consistent with growth, it is also more likely to ensure its repayment, and thus better protect the revolving character of the Fund than would a smaller or inadequate amount of finance.

In fact, in the original design of the Fund, its lending was not subjected to a fixed repayment schedule. It may be worthwhile to revive that flexibility in the repayment obligation to the Fund, which would normally be a fraction of a borrowing country’s total external payments. Indeed, such repayment obligations may be linked to a country’s ability to repay, and it may be agreed between the Fund and the borrowing member that its repayment schedule is linked with, say, a proportion of the country’s export earnings, according to a projection of exports based on the past trends or used in the baseline scenario of the Fund program. If actual exports exceeded the projected exports, then this repayment could be accelerated. If exports turned out to be less than this projected level, then obligations should be automatically rescheduled or capitalized according to a predetermined formula. This would be in the spirit of helping the country to plan its policies of adjustment. If the policies are right, there is no reason why money lent would not revolve.

There is one problem in this scheme. If the adjusting country meets with an exogenous shock because of factors beyond its control, causing a fall in exports despite all its adjustment efforts, its repayments will have to be postponed. If this happens to a large number of Fund borrowers, at the same time, the Fund may suddenly encounter a liquidity problem. A provision has to be made so that the Fund can overcome this liquidity shortage.

A financial institution can of course face temporary liquidity problems. If it does, it normally borrows from other financial institutions to tide over the situation. A similar approach may be adopted for the Fund also, especially because when some of its members face deficits, some other members must be facing surpluses. This means that in a liquidity squeeze, the Fund should be automatically entitled to borrow from these surplus countries. In practice, this would mean activating the General Arrangements to Borrow (GAB) at the discretion of the Fund and not as at present dependent upon the agreement of the GAB lender.

The Fund is not a commercial bank; it is an international cooperative institution to facilitate an orderly development of the international monetary system. The benefit of this orderly development accrues to all membership, including the creditor countries, which should lend to the Fund not in the expectation of normal commercial returns but because of the value they attach to such benefit of orderly international development. If this principle is accepted, the operation of the Fund should focus on the appropriate management of the world economy to the benefit of all the participants and not on protecting the narrow commercial interest of the Fund as a financial institution.

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