Chapter

IV The Experience of Successfully Adjusting Developing Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1992
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Economic activity in the developing countries has been relatively resilient in the face of the recent slowdown in the industrial countries. This resilience reflects, in part, the fall in world interest rates and external debt reduction; but it is also due to the economic policies pursued in many countries. These policies have reduced macroeconomic imbalances, improved efficiency, helped to attract capital inflows, and led to an increase in productive capacity. As a growing number of countries implement similar policies, the developing countries should see significant improvements in economic growth in the 1990s. In reviewing the experience of the successfully adjusting countries it is impossible to do justice to the diversity of situations and problems in individual cases. The following discussion attempts to highlight some of the more salient features common to most of these countries.15

Medium-Term Trends in Developing Countries

The economic performance of developing countries has been generally disappointing during the past decade. The growth of real GDP fell from an annual average of 4¼ percent during 1974-82 to 3¾ percent during 1983-91 (Table 8). Average inflation increased from 24½ percent to 46 percent, investment ratios declined, and external debt increased sharply. This overall performance, however, conceals a wide range of different trends across countries and regions. While Asia saw an increase in annual growth of nearly 1½ percentage points, and only a small increase in inflation, other regions experienced a marked slowdown in growth (Chart 22); and in the Western Hemisphere there was a sharp increase in inflation.

Table 8.Developing Countries: Growth and Related Indicators(In annual percent change unless otherwise noted)
1974-821983-911992-931
All developing countries
Real GDP4.23.76.2
Real per capita GDP1.51.43.6
Consumer prices24.546.134.9
Export volume−0.86.58.7
Investment (percent of GDP)26.723.824.4
External debt (percent of exports)2121.1126.5113.4
Africa
Real GDP2.81.82.6
Real per capita GDP0.1−1.1−0.1
Consumer prices16.118.323.5
Export volume−1.73.33.9
Investment (percent of GDP)31.521.720.0
External debt (percent of exports)2151.2230.5227.2
Asia
Real GDP5.77.16.7
Real per capita GDP3.45.35.1
Consumer prices7.910.58.2
Export volume6.911.411.0
Investment (percent of GDP)27.929.231.7
External debt (percent of exports)290.968.462.2
Middle East and Europe
Real GDP3.61.69.3
Real per capita GDP−0.3−1.64.9
Consumer prices18.518.216.4
Export volume−6.10.85.3
Investment (percent of GDP)26.221.017.9
External debt (percent of exports)259.3134.2121.6
Western Hemisphere
Real GDP3.71.63.3
Real per capita GDP1.2−0.41.3
Consumer prices53.9191.7128.7
Export volume1.44.66.2
Investment (percent of GDP)23.419.122.0
External debt (percent of exports)2269.4268.2247.9

Chart 22.Developing Countries: Real GDP1

(1970 = 100; logarithmic scale)

1 Composites are indices based on arithmetic averages of real GDP weighted by the average U.S. dollar value of respective GDPs over the preceding three years. The shaded area indicates staff projections.

The deterioration in economic performance in the 1980s was the result of both external and domestic factors. A general problem was the excessive accumulation of debt in the second half of the 1970s (Chart 23). For oil importing countries, the drying up of commercial credit and higher real interest rates on commercial borrowing compounded the effects of the second oil price shock in the early 1980s (Table 9). Within this group of countries, exporters of primary commodities were also adversely affected by declining world market prices for their exports. For oil exporters, the deterioration in the terms of trade came after 1985.

Chart 23.Developing Countries: Total External Debt1

(In percent of exports)

1 The shaded area indicates staff projections.

Table 9.Developing Countries: External Environment1
1974-821983-861987-911992-932
Terms of trade
(in percent, annual changes)
Fuel exporters19.8−13.10.2−1.7
Nonfuel exporters−1.71.4−0.8−0.7
Africa6.8−4.8−1.4−4.2
Asia−0.4−0.40.2−0.4
Middle East and Europe17.4−8.80.10.2
Western Hemisphere2.2−3.8−1.6−1.4
Real interest rate
(percent per annum)
LIBOR31.74.84.00.9
Non-debt-creating flows, net
(average, in billions of dollars)
Fuel exporters−2.20.22.98.0
Nonfuel exporters15.522.633.342.2
Africa3.45.29.310.2
Asia4.46.912.217.7
Middle East and Europe0.77.85.85.7
Western Hemisphere4.74.79.016.6
Net external borrowing
(average, in billions of dollars)
Fuel exporters14.38.314.017.1
Nonfuel exporters47.336.834.062.1
Africa10.58.97.39.4
Asia14.817.918.341.3
Middle East and Europe7.05.98.56.8
Western Hemisphere29.212.414.021.7

In both groups of countries, structural rigidities and inappropriate macroeconomic policies added to the problems created by the difficult external environment. Several countries tightened import restrictions, which exacerbated the inefficient allocation of resources that was already apparent in the 1970s. Similarly, in an attempt to stimulate domestic demand, many countries increased government expenditures despite stagnant or falling revenues. As a result, fiscal imbalances widened, inflation accelerated, and external balances deteriorated further.

There were some exceptions to the generally unsatisfactory picture, mainly in Asia, where the economies of newly industrializing countries and China expanded at rates ranging from 7 percent to 9 percent during the past decade, as the ratio of investment to GDP remained high (Chart 24). In addition, many countries in other regions have experienced a gradual improvement in performance during the past three to four years, reflecting substantial progress toward stabilization and economic reform. Some of these countries have benefited from debt reduction, but the decisive factor in their improved performance has been their domestic policies. At present, some 35 developing countries, accounting for over 50 percent of developing world output, can be characterized as successful reformers on the basis of the persistence of their policies and improvements in economic performance. Of course, many other countries have implemented economic reforms in recent years, but significant improvements in performance may not yet have emerged, or there may have been slippages in the implementation of reforms and stabilization policies.

Chart 24.Developing Countries: Investment1

(In percent of GDP)

1The shaded area indicates staff projections.

A summary of the performance of the adjusting countries is provided in Table 10, which compares their growth, inflation, external debt, and fiscal balances with the averages for their regions. The adjusting countries are divided into two groups: those that initiated stabilization policies and structural reforms five or more years ago, and those that started adjustment and reform during the past three to four years. There were two main criteria for classifying countries as “adjusting.” First, they had to have undertaken significant stabilization, defined as a decline in fiscal deficits as well as an improvement in the current account; for countries with IMF-supported adjustment programs (a large majority of cases) the criterion used was fiscal deficit reduction as targeted in the programs. Second, if there were pronounced rigidities in their economies, countries had to have introduced structural reforms to remove these rigidities, or to reduce them significantly. Five main areas of reforms were considered—financial, fiscal, trade, labor markets, and privatization of public sector enterprises; to be included in the adjusting group a country needed to have a persistent record of reform in several of these areas.

Table 10.Developing Countries: Growth, Inflation, Fiscal Balance, and External Debt in Countries Undertaking Adjustment1(In percent a year)
GrowthInflationExternal Debt

(In percent of export

of goods and services)
Fiscal Balance

(In percent of GDP)
1987-891990-91199221987-891990-91199221987-891990-91199221987-891990-9119922
Africa2.51.61.917.920.126.5242.7225.9237.0−6.3−4.4−4.8
Of which:
Adjusting4.84.64.125.815.319.4176.8178.7193.9−2.5−2.4−2.2
Sustained6.04.13.020.418.99.094.595.1120.3−0.3−0.1−0.7
Recent4.14.94.829.013.49.7260.7261.1256.0−3.8−3.2−3.0
Others32.31.31.717.220.528.3252.5233.0243.7−6.7−4.6−5.1
Asia7.55.46.816.410.810.776.366.063.7−3.2−2.9−2.5
Of which:
Adjusting8.25.67.48.66.66.856.147.647.2−2.9−3.0−2.5
Sustained9.16.68.78.94.66.139.832.533.4−0.7−0.8−1.2
Recent6.23.34.47.911.48.7314.7311.7311.8−8.1−8.0−5.5
Others34.14.44.159.231.729.5276.1249.0238.0−4.3−2.8−2.5
Middle East1.57.64.520.116.613.8135.6103.4104.6−9.1−6.5−4.1
Of which:
Adjusting0.37.85.621.414.98.9227.5154.9156.3−8.6−5.4−2.8
Sustained5.55.56.84.99.46.5214.4192.2172.3−8.2−8.3−7.6
Recent−0.38.15.523.615.69.2233.0141.8149.9−8.6−5.0−2.2
Others32.87.43.218.518.820.0112.390.190.6−9.8−7.9−5.8
Western Hemisphere1.31.82.9253.6337.1149.8299.5260.5267.1−6.3−0.6−1.2
Of which:
Adjusting1.03.54.4131.8105.417.1311.9247.1243.4−7.8−0.50.7
Sustained2.13.83.966.325.715.5269.9211.7214.6−7.41.1
Recent−2.22.86.0981.11.039.821.7510.5418.1385.9−9.0−1.9−0.5
Others31.50.51.8402.1698.5346.5288.2274.4292.8−5.1−0.7−2.6

The results show a clear pattern. The adjusting countries as a group exhibit, in general, higher growth rates, lower inflation rates, and lower external debt. The results with regard to output growth are particularly noticeable, especially in Africa and the Western Hemisphere, given the adverse initial impact that is often associated with adjustment.16 The reform process in the adjusting countries in these two regions illustrates the impact of the significant changes in economic philosophy that have occurred. In the early 1980s, only a few countries in these two regions were seriously engaged in adjustment and restructuring, but the number of countries rose sharply in the second half of the decade. In the case of Africa, the reform process was supported by the IMF’s structural adjustment facilities (SAF and ESAF) and by the launching by donors and creditors of the “Special Program of Assistance” for low-income, debt-distressed African countries undertaking reform programs.17 In the case of Latin America, there has been a new focus on fostering competition and efficient resource allocation, while reducing the intervention of the state.

Credibility of Stabilization Efforts

The stabilization policies undertaken in the adjusting countries have sought to reduce inflation and to restore external viability. A central objective of these policies, together with that of structural reforms to improve incentives and remove rigidities, has been to provide a sound environment for growth. One main policy prescription that emerges from the experience of these countries is the need for comprehensive and consistent financial policies. For instance, the implementation of a stable, non-inflationary monetary policy depends crucially on inflationary expectations, which in turn hinge on fiscal discipline.18 Similarly, consistency between monetary policy and exchange rate policy is essential to prevent losses of foreign exchange reserves.

The successes over the past few years also emphasize the crucial importance of credibility for sustaining the momentum of any adjustment program. For instance, the improvement of profitability in the traded-goods sector, a cornerstone of many adjustment programs, has to be accompanied by the building of confidence that the authorities will not change course and reverse policies. Only then will domestic investment be revived and encouragement be provided for the return of flight capital, as well as fresh capital inflows.

Credibility cannot, of course, be achieved overnight. In countries that have a history of failed stabilization attempts, the success of any new program may initially be in doubt. Credibility can be helped by providing clear signals, especially on the fiscal side, so that the adjustment that is part of the stabilization plan is viewed as permanent. If the fiscal deficit is reduced by means of measures that are perceived as temporary, the anticipation of the reversal of such measures can lead to failure.

Credibility may be enhanced even before the implementation of the stabilization plan. For example, it may be fostered by an announced change in policy or by underlining the independence of the central bank if the bank is committed to pursuing a suitable policy objective, such as price stability. In addition, credibility is gained or lost as the program evolves, depending on implementation of the policies. For instance, in the program to deal with hyperinflation in Bolivia during the mid-1980s, credibility in the adjustment process was acquired only as stabilization was achieved.

Similarly—and of particular interest because of its marked success—in the case of Mexico, the policy changes introduced by the administration that took office in late 1988 gained credibility as the implementation of the program proceeded. The reinforced economic program put special emphasis on fiscal consolidation and structural reforms and included a “social pact” on price and wage increases. At the same time, the exchange rate was depreciated daily by a preannounced small amount starting in January 1989. In addition, an accord was signed consolidating outstanding debt with commercial banks; the program was supported by fresh funds from commercial and official creditors, including an extended arrangement with the IMF, approved in May 1989. Finally, the commitment to privatize public sector enterprises, as well as substantial unilateral trade reforms undertaken earlier that paved the way for an agreement on a free-trade area with the United States, further raised confidence in the program.

The strengthening of policies had the desired effect. The growth of real GDP accelerated, inflation declined, and the differential between the spread in the domestic interest rates on U.S. dollar-and peso-denominated treasury bills (adjusted for the preannounced depreciation of the exchange rate) declined sharply during 1989-90. In addition, real interest rates began to fall in 1990. This had a further beneficial impact on the budget deficit, which in time reinforced the reduction in interest rates. There was a significant reversal of capital shaded area indicates staff projections, flight, and net international reserves rose by over $3 billion in 1990.

Even if it appears credible, a stabilization program may not succeed if there is widespread indexation (implicit or explicit) that causes the inflation rate to be sticky. The use of price and wage controls has been advocated in the belief that it would help to fight inflation inertia. This was a key motivation in four major “heterodox” stabilization programs: the Mexican plan noted above, the austral plan in Argentina (June 1985), the cruzado plan in Brazil (February 1986), and the stabilization program in Israel (July 1985).

Of the four programs, only the Israeli and the Mexican plans were successful in reducing inflation on a long-term basis. The major reason was that while monetary and fiscal policies remained tight in Israel and Mexico, this was not the case in Argentina and Brazil. An important lesson that emerges from these programs is that the short-run benefits of controls may be more than offset by the resulting price distortions and by subsequent pressures on prices if the necessary fiscal and monetary adjustments are delayed.

It might appear that, rather than wage controls, stabilization programs envisaging a decline in inflation could allow for forward-looking rather than backward-looking indexation; but this has difficulties of its own. If wages are set in line with government price projections, lower-than-expected inflation will result in higher real wages, whereas higher-than-expected inflation will reduce real wages, encouraging demands for retroactive salary adjustments. Given these uncertainties, the way to reduce inflation inertia may well be to attempt to eliminate, or at least to reduce, indexation schemes.

Dealing with Capital Inflows

During the past two years, some developing countries—particularly but not exclusively the successful reformers—have experienced large capital inflows. The inflows, consisting of borrowing, equity flows, foreign direct investment, and capital repatriation, have been marked in Latin America, Asia, and the Middle East. In Latin America, the total inflows increased from $12½ billion in 1989 to about $25¼ billion in 1990 and to $40½ billion in 1991 (Table 11). The bulk of this increase was accounted for by portfolio flows to Argentina, Mexico, and Venezuela. This follows a period of over six years during which private external financing was limited essentially to concerted bank financing, primarily in the form of principal rescheduling.19 In Asia, total capital inflows increased from $11 billion in 1989 to $41½ billion in 1991, with net borrowing by Korea and Thailand accounting for a large part of the increase. In the Middle East, the sharp increase in capital flows in 1991 reflects largely the portfolio inflows to Kuwait and Saudi Arabia following the normalization of activity after the Middle East conflict.

Table 11.Developing Countries: Capital Inflows(In billions of U. S. dollars)
1986198719881989199019911
Africa
Deficit on current account215.711.017.314.610.212.1
Capital flows14.913.316.817.215.815.2
Non-debt-creating flows, net36.86.88.411.49.810.1
Net external borrowing10.87.88.95.97.57.4
Asset transactions, net4−2.7−1.3−0.5−0.1−1.5−2.3
Reserve accumulation1.9−1.10.6−2.7−5.0−3.7
Asia
Deficit on current account2−1.6−18.9−6.91.84.77.4
Capital flows22.924.16.611.030.041.6
Nondebt creating flows, net38.710.711.610.814.017.9
Net external borrowing21.119.29.210.228.635.2
Asset transactions, net4−6.9−5.8−14.2−10.0−12.6−11.5
Reserve accumulation23.640.711.18.123.136.3
Middle East and Europe
Deficit on current account228.717.116.45.81.433.2
Capital flows21.124.19.315.610.031.1
Non-debt-creating flows, net34.26.72.84.5−0.9−14.1
Net external borrowing13.07.34.24.86.612.9
Asset transactions. net43.910.12.36.34.332.3
Reserve accumulation−8.06.7−7.69.58.5−2.0
Western Hemisphere
Deficit on current account219.112.112.310.28.821.9
Capital flows11.115.55.412.525.240.6
Non-debt-creating flows, net34.75.88.67.88.713.8
Net external borrowing9.410.24.610.829.318.0
Asset transactions, net4−3.0−0.5−7.8−6.1−12.88.8
Reserve accumulation−6.43.4−7.42.715.117.2

The causes of the inflows to Latin America and Asia are largely domestic and reflect developments in the economies of these regions. In Latin America, the implementation of adjustment and structural policies has led to an increase in the credibility of the reform process and to renewed confidence in their economies. But the timing of the inflows suggests that external factors may also have been important. Countries such as Chile—and to some extent Mexico, which had implemented reform policies earlier—did not experience any appreciable increase in inflows before 1989. It was only when activity slowed and interest rates fell in the United States that there was an increase in capital inflows.20

In the southeast Asian countries, the inflows were largely in response to significant increases in the rates of return on capital investments arising from the structural reforms undertaken by these countries. Interest rates, in turn, were pushed up. More recently, rates have increased further as authorities have moved to restrain domestic demand in the face of mounting inflationary pressures.

The capital flows, in particular to Latin America, have increased access to foreign exchange and have led to a pickup in domestic investment. Although highly welcome, the magnitude of the inflows can create a dilemma for policymakers by increasing inflationary pressures. The inflows have been an important factor behind a sharp increase in private consumption and in asset prices, particularly of real estate and equities, in nearly all of these countries. In some cases, there has been a marked appreciation of the real exchange rate, which has contributed to increases in current account deficits. There is also a risk that the capital flows could be reversed, although this concern varies greatly from country to country.

Several of the affected countries are resorting to sterilized intervention via open market operations, with the central bank removing liquidity in return for government paper. This intervention means that the inflows of capital do not lead to an equal increase in the domestic monetary base, which helps to dampen the effects on inflation and some of the other adverse effects noted above. But this policy response has led to other problems. Because domestic real interest rates are already high, the burden on the budget has been quite substantial. Moreover, large placements of government bonds have led to even higher real interest rates, which now exceed 25 percent in several Latin American countries.

A different response, and one that has been recently adopted by Chile and Colombia, is to raise the reserve requirement on the domestic banking sector for short-term deposits. This could lead to a reduction of the rates commercial banks pay on these deposits, which in turn may provide incentives for asset holders to shift to longer-term deposits, although it may also simply divert the flows altogether. Further, this policy implies increased spreads between lending and deposit rates, which could be harmful to investment. A number of other countries—including Brazil, Indonesia, and Mexico—have taken a series of administrative actions such as introducing queuing systems, minimum maturities, and withholding taxes. These measures could, however, lead to distortions in the newly liberalized financial markets and thus prove counterproductive.

A more appropriate response would be to strengthen fiscal consolidation, so that domestic interest rates are moderated or at least do not continue to increase. Further steps to remove restrictions on both current and capital account outflows—as is being done in the Philippines, among other affected countries—and to step up the privatization of state enterprises could also play a role. Finally, some exchange rate appreciation may be appropriate, given the relatively strong competitive position of some of these countries and the large real depreciations of the 1980s.

Structural Reforms

Two broad types of complementary reforms have been undertaken by the successful developing countries. First are reforms to permanently eliminate existing inefficiencies of resource use, such as reforms of the financial system and labor markets, and to privatize state enterprises. These reforms can raise potential output directly. Second are measures that add to existing productive resources by increasing total factor productivity or by fostering capital accumulation through incentives to save and invest. Examples include fiscal measures, especially tax reform, and measures that remove obstacles to direct investment inflows. Trade and financial sector reforms, of course, may also have a positive effect on incentives and on productivity. As in the case of macroeconomic policies, credibility in structural reforms is also crucial, both for reviving domestic investment and for attracting foreign investment.

Financial Sector Reforms

Major reforms of financial markets, institutions, and the regulatory framework have been undertaken during the past five years in many countries, including Argentina, Bolivia, Botswana, Chile, the Dominican Republic, The Gambia, Ghana, India, Indonesia, Kenya, Malawi, Malaysia, Mexico, Pakistan, Thailand, and Tunisia.21 These reforms have aimed to enhance the mobilization and allocation of domestic savings as well as to improve the monetary control system. With the objective of stimulating private saving and improving its allocation, many IMF programs have featured an active interest rate policy, either in the form of interest rate liberalization (Chile, The Gambia, and Mexico), or a more flexible management of administered rates (Rwanda, Tanzania, and Uganda). The experience of these countries suggests several key lessons.

  • A full-scale liberalization of interest rates requires prior implementation of policies to eliminate selective credit policies based on below-market interest rates; to modify rules on new entry, mergers, and branching in the banking sector; and to improve the soundness of the banking system and the adequacy of bank supervision.

  • Liberalization can help to avoid problems of an inappropriate term structure of interest rates in regulated systems. A term structure that offers insufficient returns to longer-maturity deposits can increase the risks for financial intermediation, which in turn may reduce the availability of funds for investment.22

  • Policies to improve the provision of long-term investment funds should include measures to reduce interest subsidies; to improve the operating efficiency of financial institutions by allowing them to provide deposit instruments of varying maturities; and to minimize the incidence of bad debt through legal, regulatory, and institutional changes.

  • Removing interest rate or credit controls cannot, by itself, ensure that financial systems will develop as intended. It is crucial to remove barriers to entry to encourage competition and ensure that funds are intermediated at least cost. At the same time, the legal and accounting systems should be updated, laws concerning collateral and foreclosure have to be enforced, and prudential regulations and supervision need to be strengthened.23

  • The techniques of monetary control have to change radically when credit controls are removed and interest rates are liberalized. Thus, modernization of the central bank and the development of indirect methods of monetary control have to be an integral element of the reform process.

  • Financial liberalization needs to be undertaken together with macroeconomic reform. Countries that attempted such liberalization before undertaking other reforms suffered destabilizing capital flows and high interest rates.

  • Internal and external financial liberalization are complementary. If the domestic banking sector has overly restrictive regulations, significant government participation, and a noncompetitive structure, external financial liberalization should be implemented only after internal financial reform is well under way.

The effectiveness of capital controls, however, has been limited. To have much of an impact, such controls involve highly distortionary exchange and trade restriction on both current and capital account transactions. The introduction of current account convertibility—itself a crucial element of an effective reform strategy—may create a variety of channels whereby capital controls are weakened. Conversely, if domestic financial market distortions are not too significant, an early opening of the capital account can serve as a catalyst to force the pace of internal financial liberalization. This suggests that, in general, comprehensive and rapid progress on all fronts would be appropriate.

The level of financial intermediation is often considered to be related to the level of real interest rates. Positive real interest rates are likely to stimulate financial intermediation and, to some extent, to encourage saving; these effects would increase the supply of credit channeled to the private sector.24 Moreover, positive real interest rates make the allocation of financial resources more efficient. Real interest rates may, however, increase to levels where they begin to hamper growth. This may be the case because of a lack of credibility in the adjustment policies, expectations of inflation, or repudiation of government obligations; high real interest rates also may reflect high risk premiums attributable to a fragile financial structure. Perhaps most important, high real interest rates may reflect excessive public sector borrowing and a crowding out of the private sector, with adverse effects on growth. These factors suggest a nonlinear relationship between real interest rates and growth. This is borne out to some extent by the data provided in Table 12. In those countries where interest rates are strongly negative, growth has been low or negative. However, moderately positive real interest rates—between zero and 5 percent a year—have been a feature of the highest proportion of countries with annual growth rates above 2 percent.

Table 12.Developing Countries: Growth and Real Interest Rates1
Proportion of Countries with Average Annual

Real Interest rates During 1984-91
Average Annual Growth Rate (percent)−5% or less−5% to 0%0% to 5%Above 5%
Less than zero29.015.06.56.7
0-225.830.023.926.7
2-429.020.035.026.7
4-612.915.023.933.3
Greater than 63.220.010.96.7
Total number of countries31204615

Fiscal Reforms

Changes in tax policy, expenditure policy, and public enterprise policy have had a significant impact on resource allocation and growth in a large number of countries (Argentina, Chile, China, Colombia, Jamaica, Korea, Malawi, Mexico, Pakistan, Tanzania, Thailand, Tunisia, and Uganda). A major issue in fiscal reform relates to the appropriate combination of revenue and expenditure policies to obtain the desired adjustment in the short run while ensuring a sustainable fiscal position in the long run. The experience of the successfully adjusting countries suggests a need to combine immediate adjustment efforts with longer-term measures that improve the fiscal structure.25

The most important aspect of recent tax reforms in the developing countries has been a shift from steeply progressive income and property taxes to simplified, broadly based, and more neutral taxes on domestic consumption, such as the VAT (Argentina, Bolivia, Costa Rica, Senegal, Morocco, Thailand, and Tunisia).26 The pursuance of simplicity and neutrality in the tax structure has been a result of the recognition that complicated tax systems, designed to achieve multiple economic and social objectives, tend to generate costly distortions in resource allocation, provide scope for tax evasion that leads to loss of revenue, and increase the administrative burden of their enforcement.

In several countries, the objective of maintaining a simple tax structure led to the introduction of a uniform VAT rate (Argentina, Chile, Costa Rica, and the Dominican Republic). Countries that had other objectives in addition to raising revenue–such as regional development or redistribution–chose a multiple-rate VAT (Brazil, Colombia, Mexico, Morocco, and Tunisia). To enhance the revenue raising feature of the VAT, countries have often sought to expand the VAT revenue base. In addition, almost all countries imposed excise taxes at higher rates. Indirect tax reforms have also involved radical changes in trade taxes: rationalization and consolidation of import duties; elimination of ad hoc exemptions; establishment of a uniform minimum duty rate on all imports; and abolition of export duties, or at least a reduction of rates if revenue needs required export duties to be maintained in the short run.

By simplifying the tax system, enhancing its neutrality, and broadening the tax base, these reforms have reduced tax-induced distortions and have fostered productivity and growth as well as, in several cases, increasing tax revenues. This process has been enormously complex, often taking several years, with the scope and direction of the reforms frequently being circumscribed by a multitude of political and economic factors. Countries’ own determination, often with technical assistance from the IMF, was a key factor in the implementation of these reforms. Although additional work will be needed to reform property taxation further and to address growing environmental issues, tax reforms have been a key element in the improved performance of many countries.

In the short run, however, improvements in fiscal performance in several of the successful countries occurred through cuts in public expenditures; in this context, reductions in unproductive outlays have been crucial. At the same time, several countries have increased the priority attached to investments in physical infrastructure and human capital formation as a means of encouraging growth.27 Since capital expenditure is usually highly import-intensive, many countries have endeavored to increase the efficiency of their investment programs. In addition, in some cases essential expenditures on operations and maintenance have been increased to raise the productivity and longevity of the existing capital stock. Experience also suggests that it is important to ensure that public wage levels are adequate to attract and retain the quality of manpower the public sector needs. Since the overall public wage bill has to be kept within limits, however, this may require adjustments in the number of public sector employees.

The operations of public enterprises have been a major source of weakness in the public finances of many countries. The experience of the reform process suggests that hard budget constraints should be placed on public enterprises while providing them greater autonomy for their management of pricing and investment. Moreover, in many cases, major efficiency gains can be expected from exposing enterprises to domestic and international competition and by privatizing enterprises (see below).

As regards other components of expenditures, military expenditures in general account for a large proportion of unproductive expenditures. They should be assessed very carefully in any adjustment program because of the trade-off between these expenditures and social programs as well as growth. Generalized consumer subsidies are not only expensive in budgetary terms but also tend to be regressive; experience suggests that both fiscal performance and equity can be improved by reducing such subsidies or by replacing them with transfers targeted for low-income groups.

In many adjustment programs there has been increasing emphasis on the need to provide protection from the short-term adverse effects of adjustment policies. Different approaches to the provision of social safety nets have been adopted. In Sri Lanka, for instance, the elimination of subsidies was phased in through a gradual adjustment of administered prices. This was accompanied by raising excise duties and turnover taxes on tobacco, alcohol, and luxury items. A temporary food-rationing system, subsidized through the budget, was set up in Jordan to protect the population in rural and urban areas from the effects of the removal of generalized subsidies following a major devaluation. The Venezuelan program included an extensive system of food subsidies for some of the main products purchased by the poorest groups.28

Trade Liberalization

A major component of recent trade reforms has been the elimination of quantitative restrictions (China, Colombia, The Gambia, Ghana, Indonesia, and Mexico). Several countries simultaneously increased their reliance on the price system by replacing quantitative restrictions with tariffs and by eliminating exemptions to existing tariffs. This has the effect of increasing the transparency of the trade regime with a favorable side-effect of increasing the tax base. Another major component of trade reform has been the reduction of domestic market protection, consisting of a reduction in both the average level and the dispersion of tariff rates. In several instances (Chile, Ghana, and The Gambia), the so-called concertina method—cutting the highest rates in successive rounds—has been favored as a way to reduce protection. This, however, has been a relatively slow process.

Trade liberalization reforms can be “locked in” by binding tariffs in the General Agreement on Tariffs and Trade (GATT)—that is, accepting obligations not to raise them above agreed levels and by disinvoking special exemptions in the GATT that permit developing countries to impose import restrictions for balance of payments purposes. In both of these areas, the reform record in Latin America during the past few years has been impressive. Bolivia, Chile, Costa Rica, El Salvador, Mexico, and Venezuela have bound all their tariff rates in the GATT, and since 1989 Argentina, Brazil, Colombia, and Peru have disinvoked the exemptions, as did Ghana and Korea during the same period.

Recent efforts at trade and payments liberalization underline the crucial importance of macroeconomic stability. By implementing stabilization policies, the successfully adjusting countries controlled inflation and avoided generating an environment of uncertainty (Argentina, Chile, The Gambia, Ghana, Indonesia, and Mexico). This in turn was beneficial in encouraging both domestic and foreign direct investment. Further, in some cases exchange rate changes have played a key role during the liberalization process and the elimination of quantity restrictions; a depreciation of the exchange rate—at times substantial—has been implemented at the beginning of the trade reform process in several countries. (This was the case, for example, in Chile, Colombia, Ghana, and Sri Lanka.)29

Trade reform can be expected to increase efficiency by increasing competition in domestic markets and by reducing distortions in the prices of traded versus nontraded goods. Trade orientation can be measured in several different ways—for instance, directly by using information on changes in trade restrictions, or indirectly by comparing the deviations of actual trade flows from flows predicted using conventional trade models. The degree of openness (defined as the ratio of average exports and imports to GDP) is also sometimes adopted as a measure of the degree of outward orientation. This measure, although highly correlated with the available direct measures of trade orientation, should be used with caution because large countries tend to have a low degree of openness, regardless of their policy orientation.30 Nevertheless, analysis of 74 developing countries reported in Table 13 shows that the rate of growth tends to increase with the degree of openness.

Table 13.Developing Countries: The Degree of Openness and Economic Performance(Average annual percent change, 1986-91)
Number of

Countries
Growth

(In percent a

year)
Inflation

(In percent a

year)
Investment

(In percent of

GDP)
Terms of

Trade
Average degree of openness1
Less than 25283.5244.624.8−1.9
25 to 40235.250.724.30.5
More than 40235.75.020.9−1.7
Openness by exports2
Less than 25383.5247.624.7−1.9
25 to 40165.314.423.4−0.2
More than 40206.23.122.0−1.0

Even when the size of the economy and other determinants of growth are taken into account—investment rate, terms of trade and domestic inflation—there is a statistically significant relationship between the degree of openness and growth. In Asia, for example, an increase in the degree of openness of 10 percentage points is associated with an increase of nearly 1 percentage point in the growth rate. In the Middle Eastern and Western Hemisphere countries, however, the effect is less than half of that, and in Africa it is even smaller. This may be due in part to the relatively greater flexibility of the Asian economies, which allows resources to flow rapidly into expanding sectors. This flexibility is due, in turn, to significant human capital formation and major complementary reforms in the financial and fiscal sectors implemented during the past few years.

Labor Markets and Privatization

Before the implementation of reforms, labor markets in many of the successfully adjusting developing countries were subject to severe institutional rigidities constraining labor mobility and reallocation, and wages were often determined according to past inflation, on the basis of formal or informal indexation rules. Moreover, inter-industry wage differentials were strongly influenced by the relative degree of unionization. Against this background, labor market deregulation has been essential, both to improve the allocation of labor and to reduce the impact on unemployment during the transition process.

The main labor deregulation policies implemented in the successfully adjusting countries over the past six years include major reforms of the social security system (Argentina and Chile); changes in legislation governing minimum wages and labor conditions (Mexico, Sri Lanka, Thailand, and Uruguay); reduced government intervention in labor market negotiations (Chile and Mexico); the institution of flexible labor employment systems aimed at increasing labor productivity; and the elimination of payments to inactive civil workers (Mali, Niger, Thailand, and Uruguay). An important consequence of these developments has been a move toward more decentralized wage-bargaining procedures, which has helped to reduce the costs associated with the process of transition.

Privatization and the introduction of commercial accountability for state-owned firms is part of a broader trend of disengagement from state involvement in the economy. This trend includes not only the sale of public enterprises, but also the liquidation of some state operations and the transfer of others to local governments. Privatization has also been undertaken because of tight budget constraints, which have limited new investments, and to reduce public debt.

In combination with other policies to create a more competitive environment, the benefits from properly executed privatization have proved to be considerable.31 In the past six years, Chile and Mexico have privatized a large number of government enterprises; more recently Argentina, Korea, Laos, Niger, and Vietnam have privatized telecommunications, airlines, and transport companies. Improved scope for expansion and diversification following privatization has contributed to higher labor productivity, increased profits, and faster growth in many of these countries.

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