Policy Issues in a Medium-Term Context: Developing Countries
- International Monetary Fund. Research Dept.
- Published Date:
- January 1987
The debt strategy that has been pursued since 1982–83 has aimed at the gradual resolution of debt difficulties in the context of growth. Growth in turn has been viewed as flowing from three policy requirements; growth-oriented adjustment in the developing countries; sustained noninflationary expansion and liberal trading policies in the industrial world: and continued flows of financing from both private and official creditors.
This approach has elicited fairly widespread support among national authorities, in part because of its flexibility and adaptability to changes in circumstances. Recently, however, views on the strategy have become more divided. Some see the strategy as beginning to bear fruit. They point, for instance, to the strengthening of growth in developing countries; to an apparent “bottoming out” of the decline of bank lending to these countries; to the fall in debt ratios that is in prospect this year after a period of rises; to the recent firming of prices of a number of primary commodities; and to the welcome given to the “menu” approach to refinancing operations, which has eased somewhat the process of achieving agreement among creditor banks.
Others, however, take a less sanguine view. They note that debt ratios reached record highs in 1986; spontaneous new financing is still at a record low; commercial banks are openly advocating a sharp reduction in their involvement in developing countries; growth prospects in industrial countries are both uncertain and relatively weak: protectionist pressures and actions have intensified: and some debtor countries have become reluctant to make debt service a high priority. Moreover, questions have been raised as to whether the debt strategy takes adequate account of the impact of existing levels of indebtedness on future flows.
The Fund staff’s scenario of medium-term prospects in the developing countries contains a number of encouraging elements (Table 6). Output growth in the capital importing countries is projected at 4½–5 percent annually, and current account deficits are seen as stabilizing at levels that permit a decline in the ratio of debt to exports. The average debt ratio, which reached 187 percent in 1986, is projected to come down to 166 percent by the end of 1988, and to fall further to 140 percent by 1991.
|Growth of real GDP1||5.4||3.9||2.9||4.2||4.5||4.1||4.7||4.8|
|Current account balance3||–15.5||–18.8||–4.3||–4.5||–4.8||–2.2||–2.6||–17|
|Growth of private lending4||25.5||21.5||6.0||3.0||1.7||1.9||0.9||1.5|
|Countries with recent debt-servicing problems|
|Growth of real GDP1||4.7||3.2||0.3||2.7||3.5||3.2||4.3||4.6|
|Current account balance3||–23.0||–29.1||–4.6||–2.9||–11.7||–8.5||–8.3||–5.1|
|Growth of private lending1, 4||25.6||20.3||4.4||–1.0||–0.5||1.6||0.3||0.9|
|Countries without recent debt-servicing problems|
|Growth of real GDP1||6.1||4.6||5.8||5.8||5.5||5.1||5.0||5.0|
|Current account balance3||–8.8||–10.2||–4.0||–5.5||–1.1||1.1||0.4||—|
|Growth of private lending1, 4||25.0||24.0||10.1||11.4||5.9||2.4||1.9||3.2|
Although the overall picture conveyed by this scenario is one of gradual consolidation of domestic performance and external positions, there are several aspects of the outlook that give grounds for concern. In the first place, the envisaged strengthening of growth is unevenly distributed. Asian countries are seen as continuing to outperform the rest of the developing world, with a rate of increase in GDP of almost 6 percent in the medium term. In Africa, by contrast, the projected growth rate is some 3¼ percent, barely above the rate of population increase. While this would constitute an improvement over the record of the past decade, it must be regarded as an unacceptably slow rate of increase in living standards in a continent where income levels are already very low. A second cause for concern in the scenarios is the fact that flows of finance to developing countries are envisaged to remain at meager levels. Given the high costs of servicing existing debt, many countries will thus be forced to run sizable surpluses on trade in goods and nonfactor services. The need to devote such a large share of domestic resources to generating payments surpluses will inevitably act as a drag on the development process.
A third source of concern about the staff’s medium-term scenario is that it might turn out to be too optimistic. For several years now. the staff’s analysis has pointed to the feasibility of growth in the 4½–5 percent range being combined with a steady reduction in debt ratios. While growth rates have been more or less in line with the staff’s projections, debt ratios have risen sharply. The question therefore arises whether there is an inherent bias toward optimism in the staff’s medium-term outlook.
A number of observations may be pertinent in this regard. First, the staff does endeavor to be “realistic.” As regards industrial countries, growth of 2¾-3 percent per annum may appear “optimistic” in the present conjuncture, but such an estimate seems reasonable for growth over a five-year period, unless one is willing to assume a major and protracted recession, as occurred in 1980–82. As regards financing, interest rates, and the terms of trade, the staff has endeavored to reflect prevailing expectations with a prejudice for assuming little change from current developments unless there are strong grounds to do so. While these assumptions have often turned out to be wrong, they are intended to be neutral in the sense of not assuming, without good reason, developments that are either favorable or unfavorable to the debt strategy.
Nonetheless, it remains true that these procedures did point to a significantly faster easing of the debt situation than has in fact materialized. The current debt ratio estimate for non-oil developing countries in 1987 is 30 percent higher than it was three and a half years ago. It is germane to note, however, that this error is grounded not in generalized optimism about the real economic situation, but rather in a large misjudgment as to the evolution of (I) developing countries’ export prices and (2) the pattern of exchange rates among industrial countries. This is apparent from Table 7. which shows a decomposition of the forecast “error” attaching to the first scenario estimate for 1987 of the debt ratio. Real output has actually been as strong or stronger than originally envisaged in both industrial and developing countries, with the recent weakening of growth in industrial countries having only now offset the higher-than-anticipated growth in 1983–84. The rise in the debt ratio has instead been largely due to two factors: first, the depreciation of the dollar has raised the dollar value of debt denominated in non-dollar currencies; second, the unit value of exports, far from rising in dollar terms as one would expect when the dollar depreciates, has actually fallen. These two factors have combined to both increase the numerator of the debt ratio and reduce the denominator. Looking ahead, the staff’s projections assume little further change in real exchange rates or real commodity prices. Undoubtedly, these assumptions will be confounded by actual developments, but the staff does not believe they can be viewed as seriously biased, ex ante.
|“Error” in projection||38|
|Of which, due to:|
|Underlying forecast error||24|
|Of which, due to:|
|Valuation of debt3||13|
|Price of exports||19|
|Volume of exports||–3|
|Change in projected level of real GNP or GDP in 1987|
|In industrial countries||—|
|In non-oil developing countries||2|
As noted above, the medium-term debt strategy contains three main elements: effective growth-oriented adjustment policies; a supportive international environment; and an adequate flow of financing. The following paragraphs provide an assessment of the respective roles of these three elements, as a background for drawing policy conclusions later in the section.
Role of Growth-Oriented Domestic Adjustment
The fundamental basis of the debt strategy is the pursuit of effective adjustment policies in the developing countries themselves. The importance of policies is apparent from the sharply contrasting performance of those non-fuel exporting countries that have encountered debt-servicing problems and those that have not (excluding China, which is an unusual case and for which some historical data are not available). While these two groups comprise quite heterogeneous countries, notably as regards per capita incomes and the commodity composition of trade, they are relatively large—about sixty countries each. Moreover, both faced similar external environments as regards oil prices, interest rates, industrial country growth, and prices of manufactured imports. Finally, the two groups had comparable debt ratios in the late 1960s and comparable growth records over the ten to fifteen years prior to the debt crisis.
In other respects, however, the performance of these two groups has differed sharply, reflecting in large part basic differences in policy attitudes. These differences include the following:
Contrasting attitudes toward the use of foreign savings, on the one hand, and the generation of the export earnings necessary to service the increased indebtedness, on the other. During the 1970s, the problem countries incurred increases in external indebtedness one and a half times that of the non-problem countries, but increased export earnings by only half as much. As a result, the debt ratios of the two groups, which had been comparable in the late 1960s, diverged widely over the 1970s.
Differences in the speed of response to external shocks. The non-problem countries adjusted to deteriorations in external circumstances well ahead of the countries that experienced debt-servicing difficulties. These countries’ adjustment “lead” amounted to one year in 1974–75 and about two years in 1979–80 (Chart 9. top panel). This difference in speed of response is confirmed by the behavior of absorption, with the non-problem countries being evidently prepared to adjust more or less contemporaneously with external shocks (indeed, ahead of industrial countries). Moreover, the willingness of the non-problem countries to adjust early is matched by their willingness to shift resources on a large scale into the tradable goods sector, in part through use of the exchange rate.
Differing priorities placed on financial stability. Inflation is much lower and the stability of inflation is much greater among the non-problem than the problem countries. As regards central government fiscal deficits, the magnitude of the deficits in percent of GDP is roughly comparable between the two groups, but the deficits have been more variable among the problem countries. Real interest rates have tended to be substantially negative in the problem countries and centered about zero among the non-problem countries.
Differing priorities as regards consumption and investment. As the global environment soured in the late 1970s and early 1980s and countries experienced sharp losses in the net flow of real resources from abroad (see below), the problem countries effected a much larger part of the adjustment through cuts in investment than did the non-problem countries. In the former, investment spending was cut roughly in step with the loss of foreign savings, whereas in the non-problem countries the loss was shared between consumption and investment more or less in line with their respective shares of expenditures.
Contrasting attitudes toward exports. The countries without debt-servicing problems have been far more successful in exploiting export opportunities. Over the course of the current upswing (1982–86), debt-problem countries increased their real exports by some 12 percent while the non-problem countries increased theirs by over 50 percent. These differences are due to many factors, with the commodity composition of exports being particularly important. Nonetheless, even such factors partly reflect past policy choices, notably as regards trade policy. The importance of such choices is illustrated in the World Bank’s most recent World Development Report. Countries which are classified in the report as having pursued strongly or moderately outward-oriented policies in 1973–85 had GDP growth rates of over 6 percent in 1984–86, as against only about 2 percent for those classified as having pursued strongly or moderately inward-oriented policies.
Chart 9.Non-Fuel Exporting Developing Countries: Real GDP Growth and Real Resource Balances, 1972–88
2Balance, with sign reversed, on goods and nonfactor services in constant 1980 prices, in percent of GDP.
Role of External Environment
The second component of the growth-oriented debt strategy is the maintenance of a favorable external environment. In general terms, this has been perceived as requiring sustained noninflationary growth in the industrial countries, more liberal trading arrangements, and, if not improved, at least stable terms of trade and international interest rates. The importance of these conditions to growth in developing countries is evident from the highly pro-cyclical relationships between output and exports in these countries (Chart 10).
Chart 10.Non-Fuel Exporting Developing Countries: GDP Growth, Investment, and Foreign Trade, 1972–88
1 In percent of GDP and in deviations from 1972–88 averages—of 3.2 percent for the real resource balance in 1980 prices and 24.1 percent for investment.
2 Centered three-year moving averages of the deficit on the merchandise and nonfactor service account in constant prices.
In present circumstances, concerns about the external environment loom large because of the uncertainties regarding industrial country growth prospects, commodity prices, the course of international interest rates, and the threat of increased protection. What would be the implications for developing countries of reduced export earnings? During the 1970s, cyclical dependence was often viewed as being relatively low. Indeed, in 1973–76, growth in developing countries did not appear to be much affected even though output swings in industrial countries were quite pronounced. In the 1980s, on the other hand, growth rates in the two groups of countries moved in tandem. That experience suggests that a significant slowing of output growth in industrial countries could have more serious implications for developing countries and the debt strategy.
There are a number of reasons for thinking that an intermediate position is the most likely for the period ahead. During the 1970s, many developing countries were able to at least partially shelter their economies from the deterioration in the external environment by increasing their recourse to external financing. During the first half of the 1980s, on the other hand, this shelter was no longer available, and countries were required to adjust both to the deterioration in their external environment and to the sharp curtailment in the availability of external financing. Now, however, developing countries are much less dependent on private financial flows than they were at the beginning of the decade. There thus seems a reasonable prospect that the consequences for developing countries of output fluctuations in the industrial countries will be less marked in the period ahead than they were in the first half of the 1980s.
Nonetheless, the adverse consequences of an industrial country slowdown should not be minimized. Past experience suggests that each percentage point shortfall in industrial country growth is associated with a decline in the growth of developing countries’ export earnings of about 3 percentage points. Moreover, on past experience, such a loss might well end up being concentrated among the debt-problem countries, so that the projected improvements in these countries’ debt ratios could be largely eliminated. Quite apart from the strains such an outcome might place on the debt strategy, it would seriously undermine the growth of output in developing countries. The impact would probably be especially marked among the low-income primary product exporters which have few alternative uses in the short run for the resources employed in the export sector.
An even more worrisome development would be a resurgence of protectionism in industrial countries. As discussed earlier, the intractability of external imbalances raises significant risks that solutions will be sought through increases in protectionism. While such measures are motivated by concerns about the allocation of world output, their result could well be to reduce world output, by potentially quite large amounts. Moreover, the effects on developing countries would be likely to be especially acute since they are typically the marginal suppliers of those products that are most likely to be protected, so that the export earnings prospects of countries would be dimmed yet further. An even more corrosive influence would be the impact protectionist measures would have on countries’ attitudes toward the outward-oriented development policies favored by the debt strategy. Such policies bear their full fruit only over the long term and are unlikely to be seriously considered in circumstances where market access is being increasingly hampered.
Role of Financing
Financing has been an important feature of the debt strategy from the outset. It has been viewed as essential for facilitating macroeconomic adjustment, for supplementing the domestic resources available for productive investment, and for making market-oriented structural measures more attractive. The adequacy of finance has usually been assessed with reference to calculated flows of net new money. While useful, especially for short-run analyses, such measures are less well suited to medium-term analyses of the role of external resources in a growth-oriented debt strategy. By itself, a measure of net new money does not provide information on changes in the availability of resources to an economy unless it is accompanied by measures of changes in the terms of trade and other relevant developments in the external accounts. In the present context of assessing the role of financing in the medium term, it is more relevant to measure the volume of real resources that a given amount of financing, together with developments in the terms of trade, permits a country to obtain. The measure used here is the deficit on merchandise and nonfactor service transactions in constant prices; it will be referred to as the real resource balance.5
On this basis, most developing countries experienced a major drop in real resources from abroad between the early 1970s and the mid-1980s. For the non-fuel exporters, for instance, the shift in this balance from 1976 to 1986 was equivalent to about 8 percent of their GDP (at 1980 prices). Although the size of this shift varied across countries, virtually all outside the fuel exporting group experienced large declines in net real resource availability over the period (Chart 9, bottom panel). The reasons for the decline were, of course, the large losses on the terms of trade, the rise in interest rates, and the drying up of private financing in the early 1980s.
The immediate and principal casualty of this net loss of external resources has been investment spending. For the non-fuel exporters as a group, the decline in investment as a share of GDP has been nearly in step with the decline in the availability of net real resources from abroad (Chart 10). This association reflects a variety of factors, the most important of which include the policy choices made by national authorities, the relatively high import content of investment, and the loss of foreign financing, which is particularly important in investment projects.
At first sight, Chart 10 does not suggest a very close association between the loss of external savings and growth. A major reason is presumably the increases in efficiency that resulted from adjustment policies and the increased opportunity costs of funds. Another may be the depressed state of demand in the first half of the 1980s, which postponed the emergence of supply bottlenecks. On another plane, however, it may be that the overall buoyancy of trade—the growth of exports and imports—is more important to the developing countries than the net availability of foreign saving.
Nonetheless, looking forward, it is hard to dispute that, given appropriate policies in borrowing countries and taking account of future debt service capabilities, increased financing would have beneficial effects. Moreover, financing, unlike world trade growth, can be focused on those countries best able to use external resources productively. The direct effect of financing arrangements that permitted an increase of developing countries’ net imports would be on absorption rather than output. However, supposing that increased imports were matched by a corresponding increase in investment, in a context of debtor reforms that ensured efficiency of resource use, one could expect an additional $10 billion a year in financing to result in an increase in output growth over the medium term of about ¼ of 1 percent per annum for heavily indebted countries. To the extent that the additional foreign resources were associated with greater domestic saving, the impact on growth would be correspondingly greater.
In practice, of course, the outlook for flows of finance to developing countries remains subdued, and the question arises of why this should be so. In this context, attention has sometimes focused on the large discounts that prevail in the (admittedly thin) secondary market for the claims of banks on heavily indebted countries. These discounts are large—for several countries on the order of one third or more in 1986. Their significance for the debt strategy stems from the fact that they are thought to carry over to new lending as well, since there are no generally accepted mechanisms for subordinating sovereign debt in the hands of private holders. As a result, potential creditors face large and immediate capital losses on any new lending they might consider undertaking. In addition, the misgivings of external creditors are thought to extend to domestic investors as well, partly out of concern that the return on their investments will be taxed away, either directly or indirectly, to pay for the servicing of the external debt.
A more fundamental question concerns the factors underlying these discounts on existing debt. In part, they probably stem from perceptions by debt holders of policy inadequacies in the indebted countries. Private lenders are understandably reluctant to acquire claims on countries where fiscal deficits remain high, domestic savings are low, and the necessary steps to sustain stronger growth while maintaining a viable balance of payments performance are perceived to have not yet been taken. In part, however, current discounts on debt may represent a legacy of past decisions. That is to say, even where appropriate policies are being pursued, the sheer size of existing indebtedness, together with fears on the part of investors that earlier policy mistakes might be repeated, makes it difficult to bring about a resumption of spontaneous lending.
A key implication of this review of the debt strategy is that the three elements of the strategy—better policies, favorable external environment, and external financing—are fundamentally interdependent. Indeed, effective growth-oriented policies are a prerequisite if developing countries are to benefit from possible improvements in the external environment or increases in the availability of financing. Increased flows of global savings to developing countries can contribute effectively to growth only if policies are in place that can make the best use of the resources thus provided. Similarly, a better global environment can strengthen medium-term performance in developing countries if it promotes, rather than retards, needed improvements in the domestic allocation of resources.
As noted earlier, it is not an easy matter to distill exactly which policies have met with success in the past. Especially as regards short-run adjustments, experiences have varied widely across countries and are difficult to generalize. Nonetheless, policy requirements over the medium term seem fairly clear. First, the establishment and maintenance of a reasonable degree of financial stability and continuity of policy are necessary. Financial instability in the form of large and fluctuating inflation rates distorts the allocation of resources both contemporaneously and intertemporally and can only undermine productive potential over the medium term. More generally, there is a need for continuity in policy so as to provide agents with consistent signals, especially as regards relative prices. Second, policies in the heavily indebted countries need to place greater emphasis on raising the level of savings and thereby investment. Because of the effects of capital depreciation and low investment rates, the capital stock in many developing countries may well be more fully utilized than is realized. Policies therefore need to begin to look forward and induce a rise in the propensity to save so as to generate the savings needed to finance increased investment. Third, for the sake of these countries’ own long-term growth performance, macroeconomic policies need to become better attuned to the exigencies of the external position. As noted earlier, countries which have tended to delay adjustments so as to safeguard domestic spending have been the countries where performance has deteriorated most. Fourth, structural policies, while aiming to improve the overall efficiency of the economy, should pay particular attention to the need to give the tradable goods sector price signals that insure its long-term growth and thereby enhance the authorities’ ability to adapt to changing external circumstances.
While better economic policies are at the heart of the debt strategy, it is also true that a favorable external environment is vital if such policies are to bear fruit. Foreign trade is one of the major engines of growth in developing countries, and growth in those countries hinges in large part on a good performance of the global economy. Thus, if the terms of trade losses which were such a prominent feature of 1984–86 were to continue into 1988 and beyond, it would be difficult to envisage a satisfactory growth performance. A similar outcome would result from increased protectionism, which would not only undermine developing countries’ exports but also their long-term incentive to move toward outward-oriented trade policies. Moreover, as noted in the scenario analysis for industrial countries, a monetary tightening in the United States in response to exchange rate turbulence could prompt increases in interest rates, declines in export volumes, and losses on the terms of trade that would seriously threaten the fabric of the debt strategy. The brunt of such an outcome would, even under the best of circumstances, fall most heavily on indebted countries. Looking forward, therefore, it is central to the debt strategy that a favorable external environment be sustained.
While a favorable environment is obviously supportive to the debt strategy, it will not be sufficient to remove the debt-servicing constraints that still face a broad range of developing countries. It is against this background that financing in its various forms (including actions to reduce the interest cost of external debt) acquires its importance. It permits a much more pointed channeling of foreign exchange to countries undergoing growth-oriented adjustment than is possible solely through growth in industrial countries. The fundamental question, however, is how much financing there should be and on what terms.
As regards the amount of financing, a case can be made for a significant rise from the levels that have prevailed recently. Given the requisite financial policies and structural reforms, there are good grounds for supposing that increases in investment would be the best and most reliable channel for increasing output. Indeed, the signs of bottlenecks that have emerged in several countries in the recent past suggest that a strengthening of investment will be needed if supply considerations are not to become an additional source of constraints on developing economies in the years ahead. While these increases in investment will of course need to be financed primarily from domestic saving, foreign savings could also be instrumental, especially during the transition period while policies are applied to the task of increasing domestic saving. With suitable policies, these investments would be expected to enhance output growth over the medium term and, assuming judicious choices of projects, to generate the foreign exchange necessary to service the increased indebtedness.
A basic issue here, however, is whether countries can afford the additional external saving. Given the drag on their economies exerted by existing levels of indebtedness, will these countries be able to repay the additional debts and will their economies be able to move onto a higher growth plane? Fundamentally, financing is a means of increasing countries’ access to real resources from abroad. That access can be increased either by increasing countries’ foreign exchange receipts, through new lending and interest capitalization, or through reductions in payments, such as debt forgiveness or concessional debt-servicing terms. The most appropriate manner to provide such financing will vary widely from case to case, depending in particular on the policies being pursued, the debt-servicing burden and the extent to which particular financing solutions might be thought to affect future financing.
For low-income countries where debt burdens are extremely high, there is agreement on the need to reduce the debt-servicing load and to increase the volume of concessional flows. The degree of agreement on these solutions in this case stems in part from their being coupled with programs of structural reform, but also from the nearly exclusive reliance of these countries on financing from official creditors.
The issue is more complicated in the case of countries whose financing is primarily from private creditors. For these countries, attitudes toward arrangements that are perceived to be equivalent to debt forgiveness are likely to be heavily conditioned by perceptions of the basic causes of the countries’ debt-servicing difficulties. To the extent that these stem from developments perceived to be beyond the authorities’ control, such as a change in the terms of trade, investors may, in effect, write off any losses to misfortune and let bygones be bygones when making future investment decisions. If, on the other hand, countries’ difficulties are perceived to stem from their own mismanagement, then resolution of the difficulties via schemes that lower the contractual value of debt rather than via increases in its market value, such as through improved domestic policies, is likely to affect future financing flows and growth prospects adversely. In either case, perceptions are likely to be heavily conditioned by assessments of the policies pursued by national authorities—assessments that can only be made on a case-by-case basis.