IV Increasing Openness of Developing Countries—Opportunities and Risks
- International Monetary Fund. Research Dept.
- Published Date:
- October 1995
Robust growth in developing countries in recent years has been associated with increasing openness and greater integration into the global economy (Chart 18). Traditional trade linkages have been deepened and new linkages developed by more open trade and exchange regimes, increased diversification of developing country exports, and closer financial linkages. Increasing financial integration has both contributed to and reflected the successful performance of the developing countries. The industrial countries have clearly benefited from this process, especially during the recent slowdown when rapid growth in developing countries helped to sustain world trade and industrial country growth.
Chart 18.Developing and Industrial Countries: Openness1
(In percent of GDP)
Openness in developing countries has increased sharply.
1 Average of exports and imports of goods and services as a percent of GDP.
2Belgium, Denmark, the Netherlands, and Sweden.
3Excludes oil exporting countries.
Closer integration in both goods and financial markets promises unprecedented opportunities, but it also poses new risks. With increased openness to both trade and financial flows, the external environment for all countries will be more competitive and more demanding. Many countries continue to be challenged by large capital inflows, and the Mexican financial crisis has highlighted the risk of economic disruptions from sudden reversals of capital flows, especially in countries where macroeconomic fundamentals are not sufficiently strong. For some countries, it will be essential to strengthen domestic financial markets and address macroeconomic policy imbalances both to fully benefit from the opportunities that present themselves in a closely integrated world economy and to reduce their vulnerability to shifts in financial market sentiment and in economic conditions in industrial countries.
Changing Relationships Between Developing and Industrial Countries
The close correlation that used to exist between growth in industrial countries and growth in developing countries appears to have broken down in the late 1980s (Chart 19). For most of the postwar period, growth in industrial and developing countries was relatively synchronized, with business cycles in industrial countries typically leading those in developing countries. During 1990–93, however, growth in the developing countries increased sharply in spite of the marked slowdown in the industrial countries, and it has remained robust as industrial country growth has subsequently recovered.25
Chart 19.Developing and Industrial Countries: Output Growth1
Developing countries have become more resilient to output fluctuations in industrial countries.
1 Prior to 1970. growth in industrial and developing countries is based on a subset of countries for which data are available from International Financial Statistics. Blue shaded area indicates IMF staff projections.
This apparent increased resilience to cyclical downturns in the industrial countries masks considerable regional disparities in the developing world. It primarily reflects a strengthening of growth in Asia and the Western Hemisphere since the late 1980s. Economic conditions in Africa and the Middle East have continued to be closely influenced by developments in the industrial countries. Many countries in these regions have made less progress with reforms and adjustment efforts and continue to be heavily dependent on exports of primary commodities. The lack of diversification is also reflected in relatively low growth of intraregional trade in Africa and the Middle East compared with Asia and Latin America.
Economic growth in the developing countries has exceeded industrial country growth throughout the past twenty-five years, and the importance of developing countries in the global economy can be expected to continue to increase in the years ahead. Developing countries as a group continue to grow at about 6½ percent a year in the staff’s medium-term baseline projections. These projections assume that policy reform efforts are sustained, that industrial country interest rates remain close to current levels, and that there are no major disturbances that might provoke a sharp reversal of capital flows.26 If industrial countries continue to grow at around 2½ percent a year, broadly in line with past trends and current estimates of potential output growth, and countries in transition expand at a rate of 6 percent a year, the share of global output produced by the developing countries could surpass that produced by the industrial countries by the middle of the next decade (Chart 20).27 Their share of world trade may exceed 33 percent in 2004, compared with about 27 percent in 1994.
Chart 20.Shares of World Output1
By the year 2004, output in developing countries is expected to exceed that of industrial countries.
1 Based on real PPP weights in 1987 dollars.
2Assuming annual growth rates of 2.5 percent in the industrial countries, 6.5 percent in the developing countries, and 6 percent in the transition countries.
The increased openness of developing countries and their greater integration into the world economy do not necessarily mean greater vulnerability to external conditions. Paradoxically, increased openness and greater integration may reduce vulnerability because of stronger growth momentum in individual developing countries and in the developing countries as a group, and because of increasing export diversification. In addition, the impact on developing countries of changes in the demand for their exports may be partially offset by countercyclical changes in capital flows, as has been the case recently, implying a dampening of overall cyclical impulses from the industrial countries. The ability of developing countries to benefit from stronger trade and financial linkages, however, will depend critically on their own domestic policies.
Growth and Diversification of Trade
The adoption of more liberal exchange and trade regimes and the abandonment of the protectionist, import-substitution policies of the 1960s and 1970s have enabled many developing countries to substantially expand both intraregional trade and, more recently, trade with industrial countries (Chart 21). The remarkable performance of many east Asian countries and some Latin American countries that have pursued outward-oriented policies over the past two decades clearly illustrates the benefits of more open trade policies. In most Latin American countries, both tariff levels and the incidence of nontariff barriers have been lowered significantly. For example, average tariff levels in Colombia and Peru have fallen from over 60 percent in the early 1980s to under 20 percent, and the dispersion of import tariffs has been drastically reduced. And Chile now has one of the most liberal trading systems in the world. A few Latin American countries, however, have imposed trade restrictions in the wake of the Mexican crisis, partially reversing previous liberalizations. Trade liberalization in Africa and in the Middle East and Europe region has been more gradual and limited, although several countries, notably Ghana, Mauritius, and Turkey, have significantly reduced restrictions on trade recently. The increasing trend toward more open trade regimes has been accompanied by liberalization of exchange arrangements, as suggested by the number of countries that have liberalized payments for current international transactions (Chart 22).
Chart 21.Developing Countries: Export Shares
(In percent of total world exports)
The share of world exports going to developing countries has been rising rapidly in recent years.
Chart 22.Developing and Industrial Countries: Current Account Convertibility1
The pace of liberalization of exchange regimes in developing countries has quickened in recent years.
1 Percent of developing and industrial countries that have accepted Article VIII of the IMF’s Articles of Agreement: countries are weighted by their share of aggregate exports of cither all developing or all industrial countries.
Diversification of the export base, especially an expanded manufacturing sector, has reduced vulnerability to external shocks for many developing countries. Compared with manufactures, the demand for primary commodities is more cyclical and has risen less rapidly. This is reflected in marked differences in the evolution of prices of manufactures and primary commodities: primary commodities have been subject to particularly large price swings and a secular decline in real prices, with resulting terms of trade losses for exporters of commodities (Chart 23). Exporters of manufactures and countries with diversified export bases have experienced higher export growth and smaller terms of trade losses, which have contributed to increased resilience, higher investment, and more rapid growth during the recent period (Table 10). In Asia, the share of manufacturing exports relative to primary commodities has increased substantially since 1970 and was 74 percent of total exports of goods in 1990 (Table 11). Although the share of manufactures has also increased markedly in the Western Hemisphere and the Middle East, it remains relatively low at 34 percent and 21 percent, respectively. In Africa, by contrast, the export share of manufactured goods has declined from 27 percent in 1980 to 22 percent in 1990.
Chart 23.Trends and Cycles in Prices of Commodities and Manufactured Goods
(1970 = 100)
Commodity prices have declined relative to manufactures prices and are more volatile.
|Real GDP||Terms of Trade||Terms of Trade Volatility1||Export Volumes||Investment2|
|Exporters of no nonfuel primary products||2.8||-1.5||9.1||5.8||18.3|
|Exporters of fuels (mainly oil)||2.5||-3.1||9.1||6.5||22.7|
|Exporters of services||2.4||—||6.5||8.9||20.4|
|Exporters of manufactures||8.7||0.3||0.6||8.6||35.6|
|Africa||Asia||Middle East and Europe||Western Hemisphere|
|Nonfuel primary products||62.8||17.0||31.2||49.4||30.7||16.0||10.7||1.8||5.7||64.5||42.1||39.9|
The changing composition of developing country exports has been aided by the removal of distortions in domestic markets and reductions in trade barriers, but it also reflects an underlying shift in the comparative advantage of many developing countries toward manufacturing. Relatively low wage costs coupled with rising investment have made some developing countries highly competitive in the production of many manufactured goods. This is particularly so in some of the Asian countries where high-domestic saving has been reflected in sharp increases in the stock of capital. The composition of manufactured exports in a number of Asian countries now includes a significant proportion of advanced, high-technology manufactured goods. At the same time, the comparative advantage of many industrial countries has shifted toward services, many of which are now tradable owing to changes in technology, especially improvements in communications and information technology.
Diversification of export markets and a marked rise in intraregional trade have also contributed to the increased resilience. This is particularly true in Asia where almost 40 percent of the region’s exports are now destined for other Asian countries (Table 12). The expansion of markets in Asia has benefited other regions—all industrial and developing country regions have increased the share of their exports going to Asia. Intraregional trade has also risen markedly among Latin American countries, although export diversification has been limited with almost 50 percent of the region’s exports being shipped to North America. Export markets have also remained relatively undiversified among African countries, with almost 50 percent of the region’s exports destined for Europe, and the level of intraregional trade, while increasing, remains modest. The level of intraregional trade among the countries of the Middle East and Europe region is also relatively small, and in contrast to the other developing country regions, the importance of intraregional trade actually diminished from 1984 to 1994.
|Exports to Developing Countries|
|Africa||Asia||Middle East and Europe||Western Hemisphere||Total1|
|Middle East and Europe||1.9||2.0||13.8||19.9||10.9||8.9||3.9||2.1||30.4||32.9|
|Exports to Industrial Countries|
|Middle East and Europe||7.9||11.2||20.8||16.6||30.6||28.0||59.3||55.8|
For many developing countries, the growth of the manufacturing sector has been associated with greater efficiency in agricultural production, which has released resources for industrialization. With the benefits of the green revolution, increased productivity of both labor and land in agriculture has allowed the developing countries of Asia and the Western Hemisphere to devote a declining share of the labor force to agriculture (Table 13). Sub-Saharan African countries have been less successful in diversifying their economies, and labor productivity in agriculture has been virtually unchanged over the past two decades. This is partly due to excessive government regulation of agriculture and inadequate price incentives to producers, although a number of countries have also been adversely affected by frequent and severe droughts. The slow pace with which new technologies have been adopted in Africa, and some countries in other regions, is symptomatic in many cases of such fundamental problems as systems of land tenure that reduce the incentives for long-term investments.28 Increases in agricultural productivity will require sustained efforts to reduce regulations and distortionary taxes on agriculture in many countries.
|Share of agriculture in GDP1||35||33||31|
|Share of labor force in agriculture||78||73||68|
|Share of irrigated land2||3||4||4|
|Fertilizer usage (kilograms per hectare)||7||14||14|
|Labor (output per employee)||434||407||432|
|Land (output per hectare)||232||233||283|
|Share of agriculture in GDP1||33||28||24|
|Share of labor force in agriculture||71||67||61|
|Share of irrigated land2||26||31||35|
|Fertilizer usage (kilograms per hectare)|
|Labor (output per employee)||1,971||2,514||3,167|
|Land (output per hectare)||477||589||827|
|Middle East and Europe4|
|Share of agriculture in GDP1||14||13||16|
|Share of labor force in agriculture||55||44||35|
|Share of irrigated land2||21||21||25|
|Fertilizer usage (kilograms per hectare)||18||52||85|
|Labor (output per employee)||1,020||1,371||1,754|
|Land (output per hectare)||278||396||534|
|Share of agriculture in GDP1||10||9||9|
|Share of labor force in agriculture||41||32||26|
|Share of irrigated land2||9||10||10|
|Fertilizer usage (kilograms per hectare)||25||54||52|
|Labor (output per employee)||2,160||2,666||3,203|
|Land (output per hectare)||433||477||549|
Increased openness has allowed many countries to narrow the technological gap with industrial countries. International trade enables developing countries to employ a larger variety of intermediate products and capital equipment that embodies foreign know-how, production methods, and product design. The potential benefits from such technological spillovers will be larger the more a country trades with technologically advanced countries.29 Many countries have also benefited from technological spillovers through foreign direct investment, which is closely related to trade.30 With foreign direct investment comes direct access to state of the art technology, production techniques, and management practices.
Changing Nature of Financial Linkages
Following almost a decade of limited access to international capital markets in the wake of the debt crisis, the recent surge in capital flows to developing countries has helped to alleviate the relative scarcity of capital in these countries. The 1990s have also been characterized by radical changes in the composition of capital flows to many developing countries. In contrast to earlier episodes that were dominated by official flows and commercial bank lending to public sector borrowers, recent capital flows have been largely private direct investment and portfolio flows to private sector borrowers, often motivated by higher returns on developing country investments and their low correlation with the returns on investments in the industrial countries. Moreover, the substantial rise in both gross and net flows indicates that investments have become more diversified in both the capital-exporting and the recipient countries.
Most of the recipient countries appear to have employed foreign capital more efficiently than in the 1970s, when the recycling of oil revenues sometimes led to large capital inflows into countries with serious policy weaknesses. The recent flows, by contrast, have been attracted by improvements in economic policies and performance in many of the recipient countries. In addition, a significant proportion of the capital flows in 1990–94 occurred during recessions and periods of declining interest rates in the industrial countries. Such cyclically driven flows started to moderate as industrial country activity strengthened and interest rates rose, suggesting an inverse relation between economic conditions in the industrial countries and capital flows to developing countries.
The substantial increase in gross capital flows in recent years and the narrowing of interest differentials between industrial countries and some of the emerging market economies are indicative of increasing financial integration. At the same time, domestic investment in most countries has continued to be financed largely by domestic saving.31 Indeed, with integrated financial markets there may be even tighter limits on how much countries can rely on foreign saving on a sustained basis. As suggested by Mexico’s experience, the risks of sudden reversals of capital inflows are particularly important in countries where increased use of foreign saving is accompanied by lower domestic saving rather than by higher domestic investment.
Net capital flows to developing countries averaged over $130 billion a year during 1990–94, almost a fourfold increase over the 1983–89 period. In contrast to the experience of the 1970s and early 1980s, when the bulk of private capital inflows to developing countries was bank lending, often to public entities, recent flows have been dominated by portfolio investment in bond and equity markets and by foreign direct investment (Chart 24). In part, this reflects the ongoing process of securitization and the international diversification of investment portfolios of institutional investors. It also reflects a number of structural changes in developing countries. In particular, the deregulation of financial sectors, including the liberalization of domestic interest rates and the removal of restrictions on the activities of nonbank financial institutions, paved the way for an expansion of domestic bond and equity markets.
Chart 24.Developing Countries: Capital Flows
(In buttons of U.S. dollars)
Recent capital flows have been dominated by direct investment and portfolio flows.
In some of the most successful countries, the depth of equity markets now matches that of many industrial countries, at least by some measures. In Chile. Korea, Malaysia, Mexico, and Singapore, for example, stock market capitalization as a proportion of GDP exceeds that of industrial countries such as Germany, France, and Italy. The development of domestic equity and bond markets has helped to strengthen financial systems by enabling underlying investment risks to be spread across a broader investor base, and by allowing a more efficient pricing of financial assets in active secondary markets.
The surge in foreign direct investment flows to developing countries since the late 1980s stands out as a particularly promising trend. As noted above, the liberalization of trade and investment regimes in many developing countries has been a key factor, but foreign direct investment has also been spurred by the growth of intraregional trade and by the attraction of some countries as low-cost locations for production by multinational enterprises. In a number of developing countries, privatization programs have also attracted foreign direct investment. In some of the larger developing countries, especially in Asia, rising per capita incomes and more hospitable environments for foreign investors in recent years have been instrumental. The importance of such medium-term considerations is underscored by the fact that direct investment flows, although marginally lower, have remained at relatively high levels following the Mexican crisis.
Among the developing country regions, there are marked differences in the composition of recent capital flows (Chart 25). In the Asian countries, over 40 percent of net capital flows during 1989–94 has been in the form of foreign direct investment, while portfolio flows account for the bulk of capital flows to Latin America. The greater export orientation of the Asian countries compared with most Latin American countries and the recent appreciation of the Japanese yen have been key factors attracting foreign direct investment. Although Latin America and Asia account for most of the recent surge in capital flows, some countries in the Middle East and Europe, such as Egypt and Turkey, have also received relatively large inflows since the late 1980s.
Chart 25.Developing Countries: Net Capital Flows by Region, 1989–94
(Annual average: in billions of U.S. dollars)
Most capital flows to Asia have been direct investment flows, while portfolio flows have accounted for the bulk of capital flows to the Western Hemisphere.
In Africa, aggregate net capital inflows are still largely official flows, which remained substantial throughout the 1980s and early 1990s. However, some African countries—the CFA franc zone countries, Kenya, and Uganda, for example—have recently attracted private capital flows, as policy reform efforts have strengthened and structural adjustment measures have helped to maintain gains in competitiveness resulting from more appropriate exchange rate policies. For many other countries in Africa, debt burdens incurred during the first half of the 1980s continue to hamper adjustment efforts and the high debt burdens can deter foreign investors, although debt indicators have improved somewhat since the late 1980s (see Chapter II). The high debt burdens of many low-income countries point to the continuing importance of concessional financial assistance, both from multilateral institutions like the IMF and from bilateral donors.
Reaping the Opportunities of Increased Integration
A key requirement for maximizing the benefits from greater integration is to maintain a stable macroeconomic environment that promotes high rates of saving and investment. By reducing uncertainty, macroeconomic stability creates an environment where future profitability is more predictable and resources are allocated more efficiently. Macroeconomic stability also tends to be associated with strong external performance and large inflows of foreign direct investment. Among the developing country regions, the benefits of macroeconomic stability in terms of rising investment and growth are most evident in Asia, where most countries have maintained low and stable inflation rates and moderate fiscal deficits. Inflation has been higher in other regions, and investment and output growth have been lower (Table 14). In many African countries, unfavorable external conditions and high indebtedness, as well as domestic political instability, have hampered the attainment of macroeconomic stability. However, the experience of countries such as Uganda illustrates that such difficulties can be overcome through sustained adjustment and stabilization policies (Box 3).
|Fiscal balance (in percent of GDP)||-3.9||-4.9||-5.5|
|Investment (in percent of GDP)||29.3||21.3||19.6|
|Saving (in percent of GDP)||25.3||19.1||17.7|
|Current account balance (in percent of GDP)||-4.0||-2.2||-1.9|
|Openness (average of exports and imports as percent of GDP)||25.3||22.9||25.5|
|Fiscal balance (in percent of GDP)||-3.8||-3.7||-2.6|
|Investment (in percent of GDP)||26.5||27.3||30.4|
|Saving (in percent of GDP)||24.8||27.3||30.5|
|Current account balance (in percent of GDP)||-1.7||—||0.1|
|Openness (average of exports and imports as percent of GDP)||22.0||25.5||33.9|
|Middle East and Europe|
|Fiscal balance (in percent of GDP)||-4.8||-12.6||-8.1|
|Investment (in percent of GDP)||24.6||22.4||22.0|
|Saving (in percent of GDP)||32.7||19.7||18.8|
|Current account balance (in percent of GDP)||8.0||-2.7||-3.2|
|Openness (average of exports and imports as percent of GDP)||39.4||30.1||29.2|
|Fiscal balance (in percent of GDP)||-2.5||-4.4||-0.9|
|Investment (in percent of GDP)||24.1||19.3||20.6|
|Saving (in percent of GDP)||20.3||18.3||18.7|
|Current account balance (in percent or GDP)||-3.8||-1.0||-1.9|
|Openness (average of exports and imports as percent of GDP)||13.7||13.9||13.9|
In some developing countries, the combination of fixed exchange rates and high inflation has reduced competitiveness and limited the expansion of trade. In such cases, nominal exchange rate depreciations are necessary to restore competitiveness, especially in the face of terms of trade shocks. However, as the experience of the CFA countries illustrates, the success of devaluations depends critically on the implementation of macroeconomic policies strong enough to prevent increases in domestic inflation that would quickly erode the gains in competitiveness. In some countries, fixed exchange rates have helped to restrain inflation pressures and, in the context of low inflation, have led to improved competitiveness.
In many instances, persistent fiscal imbalances are the underlying cause of low saving and investment rates. Although countries may be able to resort to foreign saving in the short term, the correction of fiscal deficits is often a critical requirement for increasing overall saving.32 Fiscal policies can also affect private saving through microeconomic channels, such as taxes and subsidies, that raise the rate of return to saving and through public pension schemes. A mandatory fully funded pension system may lead to higher saving by making people more aware of the need to save for the future and by increasing forced saving.33
Structural reform and trade liberalization are also essential for a country to benefit fully from greater integration. The removal of distortions created by price controls, subsidies, and licensing requirements enables domestic industries to benefit from increased access to industrial country markets and greater opportunities for diversification. Previous issues of the World Economic Outlook have extensively addressed many of these policy requirements. In the context of stronger trade linkages, the critical requirement is to remove distortions that can mask the comparative advantage of domestic producers. The removal of quantitative restrictions on imports is a key aspect of trade liberalization as such restrictions prevent the price system from operating effectively: if domestic industries are not able to compete successfully with imports in their home market, it is unlikely that they will be able to compete in international markets.
Despite widespread consensus on the benefits of open trade regimes, significant barriers to trade are prevalent in a number of developing countries. In some African countries, such as Malawi, Mozambique, and Tanzania, concerns about the availability of foreign exchange have limited progress in the areas of payments and trade liberalization. In addition, exports are frequently discouraged by controls that hold prices significantly below international levels, further exacerbating foreign exchange constraints.34 Governments are also often concerned with the fiscal implications of reductions in tariffs, and this has hindered trade liberalization in some countries. It is clear that shortfalls in government revenues from lower tariffs can be a very serious problem in the short term. Over the longer term, however, these losses will tend to be offset through higher volumes of trade, reduced incentives for illegal trade, and higher allocational efficiency.35
A number of developing countries have attempted to liberalize trade within the framework of regional trading arrangements such as the North American Free Trade Agreement and Mercosur in Latin America, the ASEAN Free Trade Area in Asia, and the Gulf Cooperation Council in the Middle East, In Africa, where regional arrangements have in the past had limited success, there have been renewed efforts to strengthen regional integration, including the Cross-Border Initiative in east and southern Africa. Regional trading arrangements can, in principle, promote trade, industrialization, and growth, especially in developing countries where domestic markets are small and fragmented. However, they are unlikely to boost trade where they involve relatively undiversified economies with limited scope for intraregional trade. Moreover, regional trading arrangements may result in trade diversion, creating potential friction for the multilateral trading system.
Developing countries will potentially benefit more from multilateral trade liberalization under the Uruguay Round than from regional trading arrangements. The realization of benefits, however, depends critically on the extent of unilateral liberalization measures and the implementation of appropriate domestic policies to make economies more responsive to the new trading opportunities. Although a number of developing countries have made commitments to reduce tariffs within the context of the Uruguay Round, many will need to increase the pace of liberalization by binding specific tariff reduction measures to the international framework offered by the Round. Countries that have as yet made no commitment to reduce tariffs will need to liberalize their trade regimes unilaterally.
With the exception of the members of the Southern African Union, most sub-Saharan African countries have made few significant liberalization commitments on border protection in agriculture, manufacturing, or services.36 This reflects concerns that the immediate effects of the Round on low-income net importers of food, many of which are in Africa, might be a decline of the terms of trade because of higher world agricultural prices resulting from lower agricultural subsidies, principally in the industrial countries.37 The resulting declines in income will occur gradually as Uruguay Round commitments are phased in. Provided these countries successfully diversify exports, declines in income will tend to be reversed over time through gains in efficiency and increases in trade and global activity.
For exporters of primary commodities, the volatility of commodity prices has posed considerable difficulties for macroeconomic management as fiscal revenues and external positions fluctuate with export earnings. These difficulties have been exacerbated by poorly designed stabilization funds and, in some cases, by state-owned agricultural boards. Windfall gains associated with temporary price rises are often transferred to the government, which may find it difficult to resist political pressures to raise expenditures on a permanent basis. In Nigeria, for example, the temporary boom in oil prices in 1990 was used to finance higher government expenditures, which led to a serious fiscal crisis when oil prices declined in 1991.38
Box 3.Uganda: Successful Adjustment Under Difficult Circumstances
Since the end of the civil war in 1986, Uganda has made significant and impressive strides to improve economic performance under the government’s Economic Recovery Program. The adjustment policies aimed at economic stabilization, the restoration of balanced growth, and the normalization of relations with external creditors. In pursuit of these policy objectives, important structural reforms were required in price and trade arrangements, the financial sector, public and quasi-public enterprises, the civil service, and the size of the military.1
Uganda faced a difficult situation in the mid-1980s and throughout much of the adjustment period. The civil war had devastated transportation, power, and water facilities. In 1986, per capita GDP was 60 percent below its level of 1970, inflation had risen to 240 percent, and external debt service was more than 50 percent of exports.2 A fixed exchange rate had eroded the country’s competitiveness leading to an acute shortage of foreign exchange, the development of parallel exchange markets, and increasing external payment arrears. By 1987, exports other than coffee had virtually ceased. Coffee prices declined steadily from 1985 to 1993 and Uganda suffered annual declines in its terms of trade every year from 1986 through 1992. Largely as a result of these declines in the terms of trade, Uganda’s ratio of scheduled debt service to exports increased sharply, peaking at almost 130 percent of exports in 1992.
Despite the difficult preconditions, Uganda has staged a remarkable economic recovery (see chart). Economic-growth has averaged about 6 percent a year since 1987, and is estimated to have been at least 7 percent in 1994. Inflation has fallen consistently, to an average of 6 percent in 1994, and the overall fiscal deficit has been contained. As a result, bank credit to the government is now negative and is no longer contributing to inflationary pressures. Total government revenues, which had shrunk to less than 5 percent of GDP recovered to 8 percent by 1993 and are estimated to have been over 10 percent of GDP in 1994. Despite unfavorable terms of trade movements, the external current account deficit (excluding grants) declined markedly, from a peak of 17 percent of GDP in 1988 to an estimated 5 percent of GDP in 1994.
Uganda and Other Sub-Saharan Africa: Growth and Inflation
Exports have become more diversified, with noncoffee exports now representing about 26 percent of total exports—despite the surge in coffee prices in 1994. The domestic economy has also become more market oriented, with the liberalized pricing and interest rate environment providing positive incentives for saving and investment. Uganda’s saving rate has risen from negative 12½ percent in 1986 to an estimated 13 percent in 1994, while over the same period investment has risen from 9¼ percent of GDP to 17¾ percent of GDP. Although still below the average for sub-Saharan Africa, saving and investment have responded positively to the adjustment policies.
The consistent implementation of strong fiscal policies was the cornerstone of these adjustments. Although the achievement of financial stabilization called for the pursuit of restrictive fiscal policies, the need to strengthen economic performance required increased outlays to restore and rehabilitate devastated infrastructure. The authorities reconciled these objectives by implementing tax reforms, including discretionary measures and the Strengthening of tax administration to augment revenues, and by raising donor disbursements. To complement this, monetary and credit policies were kept tight while increasingly shifting the composition of domestic credit in favor of the productive private sector. A number of financial sector reforms, including the development of an active government securities market, a strengthening of central bank operations, and restructuring of weak banks, increased monetary control. Many of these reforms are ongoing and require deepening to improve further the efficiency of the financial sector.
In recognition of Uganda’s heavy debt burden, Paris Club creditors reached agreement in June 1992 on concessional rescheduling (London terms) of Uganda’s debt, In February 1995, Uganda became the first country to receive a stock-of-debt operation under the new Naples terms—the rescheduling agreement provided for a 67 percent net present value reduction of eligible debt. That eligible debt, however, represented less than 4 percent of Uganda’s total outstanding debt. This reduction, together with comparable action by non-Paris Club creditors and a significant improvement in the terms of trade, helped reduce the debt-service ratio to an estimated 25 percent of exports in 1994; this ratio is expected to stabilize at about 20 percent in the next decade. Nevertheless. Uganda’s debt burden remains high, with a sizable level of multilateral debt, and its debt-servicing capacity is sensitive to external developments and other circumstances that can change quickly over time.
The liberalization of the foreign exchange market coupled with supporting foreign and domestic trade reforms improved incentives and enhanced growth prospects. To improve competitiveness, the official exchange rate was devalued in several discrete steps between 1987 and 1989. In 1990, foreign exchange bureaus were established and in November 1993 the exchange market was unified with the introduction of an interbank market. Important trade and payments reforms complemented the reforms in the foreign exchange market. As foreign exchange bureaus began operations, increasingly more transactions were shifted to this market. On the supply side, foreign exchange surrender requirements for noncoffee exports and private transfers were abolished, and all restrictions on current international transactions were eliminated with the introduction of the interbank market.
Price liberalization began in 1987 with a 182 percent increase in producer prices paid to coffee farmers. By 1992, virtually all domestic price controls had been abolished, removing significant distortions and providing needed incentives for domestic producers and exporters. The liberalization of agricultural prices was accompanied by the abolition of various marketing boards, thus raising revenues to farmers and lowering marketing costs. As a result, agricultural production expanded substantially and smuggling was eliminated.
Significant progress has also been made in other structural areas. The size of the civil service has been reduced from over 300,000 to about 150,000, and ministries continue to be restructured and rationalized. The size of the military has also been reduced by about 33,000 in two phases of army demobilization. With the expected completion of the third and final stage during the coming year, the size of the army will have been reduced to about 45,000, half its former size. To speed up privatization of public enterprises, the organizational structure of the government’s Privatization Unit has been revised to overcome operational and jurisdictional problems. Enterprises to be retained in the public sector are being put on a commercial footing.
The successful implementation of reforms was made possible by the political stability of recent years. The credibility of the adjustment programs was enhanced by the commitment of policymakers, the consistency of policy implementation, the appropriate sequencing of reforms, and improved governance through the institutionalization of administrative procedures and practices. Nevertheless, several challenges remain. These include accelerating many of the structural reforms, particularly in the financial system and the privatization of public enterprises, to raise productivity, saving, and investment and thereby improve prospects for long-term sustainable growth.
For a detailed discussion of Uganda’s adjustment efforts, see Robert L. Sharer, Hema R. De Zoysa, and Calvin A. McDonald. Uganda: Adjustment with Growth, 1987–94. IMF Occasional Paper 121 (March 1995).
Most figures refer to fiscal years starting in July of the year noted and ending in June of the following year.
Many developing countries also have found it difficult to hedge commodity price risks beyond the short term owing to relatively high transactions costs and the absence of futures and forward markets beyond a year or two. While financial markets may offer limited insurance against large declines in export prices, there is some evidence that private agents have been better able to increase precautionary savings when faced with temporary price movements. Rice farmers in Thailand, for example, have been able to smooth consumption patterns quite successfully, both within and between harvest years.39 And coffee producers in Kenya saved about 70 percent of the windfall profits from the coffee price boom associated with the frost in Brazil during 1976–79.
Box 4.Financial Liberalization in Africa and Asia
In many developing countries, macroeconomic stabilization and structural reform policies, especially the liberalization of financial markets, have been implemented simultaneously. The experiences of a number of developing countries, including many of the early liberalizers in Asia and Latin America, suggest that financial liberalization has been more successful in countries with a stable macroeconomic environment. For developing countries in Africa that are only now beginning to deregulate their financial sectors, the experience of the Asian countries, where deregulation has been most widespread, is particularly instructive.
A number of Asian countries liberalized their domestic financial systems during the 1980s through a combination of deregulation of interest rates and abolition of administrative controls on credit expansion and allocation. Further liberalizations in some Asian countries permitted the establishment and expansion of securities and equity markets and other nonbank sources of credit. In many African countries. The liberalization of domestic financial systems only began in earnest in the late 1980s and early 1990s. Despite the abolition of formal controls, however, continued government intervention in the allocation of credit and ongoing problems of insolvent banks, often stemming from subsidized credit extended to public sector entities, have limited the development of financial sectors in Africa. In large part reflecting the lack of progress in these areas, financial sector liberalization in Africa has generally been associated with only modest increases in the amount of financial intermediation.1
Following the liberalization of domestic interest rates, real interest rates rose to positive levels in Indonesia, Malaysia, and Thailand, and financial intermediation increased substantially. In Indonesia, the ratio of broad money to GDP rose dramatically from about 9 percent in 1983 to over 40 percent in 1991, while the ratio of private sector bank borrowing to GDP increased markedly from under 15 percent in 1983 to well over 45 percent in 1991. Interest rates were liberalized earlier in Malaysia, and financial deepening was over 60 percent by 1982 compared with about 40 percent in the mid-1970s. In Korea and Thailand, real interest rates were maintained at positive levels even before nominal rates were liberalized, resulting in substantial financial deepening prior to the reforms. In the Philippines, by contrast, real interest rates were both less stable and, during brief periods of high inflation, substantially negative; financial deepening was, accordingly, considerably lower, at about 20 percent, in the early 1980s, although it did increase to over 30 percent in the early 1990s following the implementation of reforms.
The Gambia and Ghana were among the first countries in Africa to liberalize financial markets in the mid-1980s. Interest rate deregulation resulted in a dramatic move to positive real rates in The Gambia, whereas in Ghana the liberalization process has been considerably slower, although real interest rates have been modestly positive recently. In both countries, the ratio of private credit to GDP has remained virtually unchanged since interest rate deregulation; the ratio of broad money to GDP has increased, however, mainly reflecting government borrowing from the banking system to finance continuing fiscal imbalances. In Kenya, Madagascar, and Malawi, liberalization prompted a fall in real interest rates on deposits as banks widened margins, and there has been little financial deepening. As in The Gambia and Ghana, progress since financial liberalization in these countries has been concentrated on the deposit rather than the lending side of bank balance sheets. Recent reforms undertaken in Uganda have led to a rise in real interest rates to modestly positive levels, although the liberalization process is too recent to assess the extent of any concurrent or subsequent financial deepening.
On the basis of conventional measures of financial deepening, such as the ratio of broad money (M2) to GDP, financial liberalization has clearly been less successful in Africa than in Asia. Although financial deepening in Asia has been supported by the higher levels of income and saving than in Africa, financial liberalization and market-oriented economic policies in Asia have also boosted growth of the financial sector. Among African countries, much of the increase in the ratio of broad money to GDP that has occurred since financial liberalization reflects lending to the public sector, with the ratio of private sector credit to GDP rising only marginally, which is in sharp contrast to the experience of the Asian countries (see chart). Key factors that appear to have retarded the development of financial systems in Africa include unstable macroeconomic environments, widespread public ownership of financial institutions and their principal clients, and the lack of viable institutions to mobilize saving, particularly in rural areas. In the absence of well-developed domestic capital markets, fiscal deficits have been financed largely by the banking system, much of which is publicly owned and often compelled to finance government deficits at below-market interest rates. This has effectively crowded out credit to the private sector. A number of African countries implemented financial liberalization in an environment of large fiscal deficits and relatively high inflation. Inflation was more than 20 percent in Ghana when interest rates were deregulated, With the exception of the Philippines and Sri Lanka, the Asian countries were characterized by moderate macro-economic imbalances and inflation rates well below those in the African countries.
While a stable macroeconomic environment is essential for successful financial liberalization, a sound banking system is also important. In many African countries, and also in some Asian countries such as Indonesia, public ownership of banks has resulted in financial institutions that face “soft budget constraints,” and rely on the provision of subsidized credit by the central bank to remain solvent. The activities of such banks more closely resemble the provision of government subsidies financed by borrowing from the central bank, rather than commercial lending. In these cases, the deregulation of interest rates and the removal of controls on credit allocation may be insufficient to spur financial deepening or to improve the allocation of saving. Where nonperforming assets are inherited from the prereform era, interest rate liberalization should be accompanied by a number of structural measures, including restructuring of bank balance sheets, privatization of publicly owned banks, and improvements in prudential supervision of financial sector institutions. Strengthening the management and risk assessment capabilities of bank managers should also be an integral part of the restructuring process.
Selected African and Asian Countries: Indicators of Financial Deepening
1Indonesia, Korea, Malaysia. Philippines, Sri Lanka, and Thailand. Data for 1993 exclude Indonesia.
2The Gambia, Ghana, Kenya, Madagascar, and Malawi.
See Huw Pill and Mahmood Pradhan, “Financial indicators and Financial Change in Africa and Asia,” IMF Working Paper (forthcoming).
External Financial Liberalization
As part of the integration process, many developing countries need to address the issue of domestic and external financial liberalization to improve the allocation of saving. The benefits from external financial liberalization include improved access to foreign capital, which can supplement domestic saving; greater scope for domestic investors to diversify internationally; strengthening of the financial system; and greater discipline on governments that can promote sustainable macroeconomic policies. There are, however, valid concerns about the necessary prerequisites to ensure that liberalization of the external capital account is viable, and in particular that it does not result in destabilizing capital flows.
In most of the countries that have witnessed large capital inflows in recent years, the positive sentiment of foreign investors has reflected improvements in un derlying economic fundamentals and market-oriented policies that have increased efficiency and raised the rate of return on investments. The capital inflows attracted in response to these developments have helped to ease balance of payments constraints, allowed domestic enterprises to reduce the cost of capital by borrowing from international capital markets, and enhanced longer-term growth prospects.
In some countries, however, capital inflows have also been attracted by relatively high short-term interest rates resulting from macroeconomic imbalances, including excessive fiscal deficits and inadequate levels of national saving. In such circumstances, capital inflows may exacerbate problems of overheating. Moreover, financial markets in most developing countries lack sufficient depth to intermediate large inflows. Together with ineffective prudential supervision, this may increase the vulnerability of financial systems to reversals of foreign capital inflows. The Mexican financial crisis underscores the risks of such reversals and the potential costs from the abruptness of the required adjustment process. While the prerequisites for capital account liberalization are desirable in their own right, countries that have made little progress toward macroeconomic stability and strengthening domestic financial markets need to be cautious about removing barriers to capital flows. Caution is particularly warranted with regard to short-term capital flows intermediated through the domestic banking system.
Sustainable macro economic policies are clearly an important prerequisite for successful capital account liberalization. Weak fiscal positions place an excessive burden on monetary policy to contain increases in aggregate demand and to prevent rises in inflation, which is often reflected in high interest rates. Removing restrictions on short-term capital flows under these circumstances attracts portfolio flows that add to inflation pressures—especially under fixed exchange rates—and pose further difficulties for monetary control. The experience of countries such as Argentina, Chile, and Uruguay that liberalized their capital accounts during the late 1970s and early 1980s illustrates the risks of capital account liberalization before macroeconomic stability has been established.
In many developing countries, administrative controls on interest rates have been liberalized relatively recently. The experience of some countries in Africa and Asia suggests that successful liberalization requires a well-capitalized and profitable domestic banking system (Box 4, on previous page). When direct controls on credit allocation are removed, a common feature in most countries is a rapid expansion of bank credit, often fueling booms in consumption expenditure. Under these circumstances, the liberalization of the capital account may expose domestic banks to new types of risks. Prudential and supervisory regulations are often inadequate to guard against these new risks. Rising domestic interest rates may induce banks to finance local currency lending with foreign currency deposits without adequate cover for foreign exchange risk. In the event of capital outflows, banks may face large deposit withdrawals that would force balance sheet contractions, with potentially strong repercussions for their domestic borrowers. Moreover, with poor internal monitoring systems, banks may not identify problem assets, making it difficult for regulators to assess the quality of their portfolios.
Liberalization of the capital account also has strong implications for the conduct of macroeconomic policy. A number of countries have found it difficult to reconcile monetary policy and exchange rate objectives in a regime of free capital mobility. In countries such as Chile and Colombia, large capital inflows have necessitated greater exchange rate flexibility. In some emerging market countries, attempts to sterilize capital inflows while limiting upward flexibility of the exchange rate have only led to even larger inflows, and the eventual reimposition of controls. Malaysia, for example, imposed extensive administrative controls in early 1994 to deter further inflows, while Venezuela imposed relatively stringent controls on inflows in mid-1994. A number of emerging market countries continue to maintain some restrictions on portfolio inflows, and in some cases these appear to have been a deterrent to excessively volatile short-term inflows that are driven more by changes in Financial market sentiment than by the underlying fundamentals.
For developing countries that are less advanced in their reform programs, it is important to strengthen financial market regulation and supervision and address policy imbalances. Although freedom of capital movements will promote growth and improve the allocation of resources over the longer term, liberalization of capital movements can be undertaken gradually. The transition to a regime of full convertibility for capital account transactions can start with the liberalization of trade-related investment flows and foreign direct investment that allows countries to reap many of the benefits of foreign capital flows while avoiding some of the pitfalls. The risk of capital flow reversals, especially when capital flows are intermediated largely through the domestic banking system, does appear to be higher in countries that institute a liberal regime for capital movements before all of the complementary policies are in place. However, restrictions on capital movements should not be viewed as a substitute for stronger adjustment efforts. It is also important to recognize that although they may help to dampen capital inflows, restrictions on capital flows have limited effectiveness in preventing capital outflows in the face of unsustainable macroeconomic and exchange rate policies.
Implications of a Reversal of Capital Inflows
The new environment of greater openness and integration may well penalize countries with macroeconomic imbalances and inadequate structural reforms to a greater extent than in earlier periods. Recent crises in some emerging market countries have highlighted the potential for large and sudden reversals of capital flows and the consequent sharp contractions in domestic demand. An alternative scenario has been constructed using the IMF’s developing country model to illustrate the potential consequences of a partial reversal of capital flows as a result of an external financial shock.40 The scenario builds on the policy slippage scenario for the industrial countries discussed in Chapter III and assumes a sharp reversal of capital inflows in 1996 in response to higher long-term interest rates in the industrial countries. This negative external shock leads to policy slippages in the developing countries.41 The lower capital inflows reduce investment and imports relative to the baseline, including imports of capital goods. This, in turn, is assumed to reduce the beneficial effects of trade on productivity growth. The net effect would be to lower the level of output in the developing countries in the year 2000 by almost 4 percent relative to the baseline projection (Chart 26). Economies with low domestic saving rates and large external deficits would be hardest hit by the decline in capital flows while higher world interest rates would have the largest impact on growth in the heavily indebted countries.