Chapter

Chapter IV. Medium-Term Prospects and Policy Issues in Developing Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1990
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Since the early 1980s, external payments problems, and in particular the burden of debt, have been the main policy issue in many developing countries. Despite the progress achieved since 1982 and some recent successes, the need for action on external debt remains pressing. This concern was reflected in the recent strengthening of the debt strategy, in particular in the recognition that a reduction of the debt overhang may be necessary in some cases as part of a broader strategy to improve the economic performance of debtor countries.30 At the same time it was recognized that debt reduction is no panacea and that the success of the strategy also requires an adequate flow of new financing, the maintenance of a favorable external environment and an open trading system, and, most important, substantial further adjustment efforts by the debtor countries.

In many developing countries, the debt crisis has been associated with a considerable weakening of growth and investment and a deterioration in relative inflation performance (see Table 10). While the average rate of inflation fell substantially in industrial countries during the 1980s, it declined only slightly in developing countries without debt-servicing difficulties and it rose sharply in developing countries with debt-servicing difficulties. As the decade drew to a close, inflation stabilized or declined in a number of countries, but in large parts of the developing world, inflation remained considerably higher than in the industrial countries. Moreover, inflation accelerated further in many countries with chronically high inflation, and several of these countries are now verging on hyperinflation. If debt-reduction operations are to make an effective contribution to the restoration of growth in developing countries, they must take place in a macroeconomic environment conducive to a recovery in investment. At present, this is by no means assured, given current inflation trends. In reviewing the medium-term outlook for developing countries, this chapter therefore gives particular emphasis to the problem of inflation, its consequences, causes, and possible remedies.

Table 10.Growth and Inflation in the World Economy, 1969–89(Annual rates, in percent)
1969–731974–821983–89
Growth1
Industrial countries4.32.13.6
Developing countries7.24.33.6
Africa7.52.81.8
Asia5.25.97.4
Europe5.93.92.6
Middle East11.93.51.0
Western Hemisphere6.93.81.7
Countries with recent debt-servicing difficulties6.63.51.9
Countries without debt-servicing difficulties5.75.46.7
Inflation2
Industrial countries5.59.73.9
Developing countries10.024.249.5
Africa7.516.917.2
Asia7.59.89.4
Europe6.119.047.0
Middle East6.515.516.0
Western Hemisphere17.052.0177.3
Countries with recent debt-servicing difficulties11.934.8107.8
Countries without debt-servicing difficulties7.813.611.3

Weighted average of growth rates of real GDP, where weights are average U.S. dollar value of GDPs over the preceding three years.

Weighted average change in consumer prices, where weights are average U.S. dollar value of GDPs over the preceding three years.

Weighted average of growth rates of real GDP, where weights are average U.S. dollar value of GDPs over the preceding three years.

Weighted average change in consumer prices, where weights are average U.S. dollar value of GDPs over the preceding three years.

Policy Background

The stance of policies in countries with and without debt-servicing difficulties has differed considerably in recent years. In the period 1983–89, fiscal deficits were considerably larger, and monetary aggregates expanded at a much faster rate, in the group of countries with recent debt-servicing problems than in the countries that have avoided such difficulties. In the first group of countries, central government fiscal deficits averaged 7 percent of GDP, and broad money increased at an average annual rate of 106 percent in 1983–89. This compares with an average fiscal deficit of 4 percent of GDP and an average annual rate of monetary expansion of 22 percent in the countries without debt-servicing difficulties.

A significant number of countries with debt problems have intensified their adjustment efforts in the past three years. In 1987, Mexico launched a comprehensive anti-inflation plan which entailed significant cuts in the fiscal deficit and strict monetary control. In 1989, Côte d’Ivoire, Nigeria, and Venezuela began to strengthen adjustment policies after repeated slippages in earlier years. Among the low-income problem debtors in Africa, Uganda and Zambia have recently tightened financial policies; and Ghana and Madagascar continue to pursue a strategy of fiscal consolidation and monetary restraint. In most high-inflation countries, however, policy slippages continued in 1989, highlighting the difficulties of stabilizing rapidly accelerating inflation. Fiscal conditions worsened markedly and monetary expansion accelerated last year in Brazil, and, after a temporary improvement, in Argentina. In Poland and Yugoslavia, unrestrained credit expansion accommodated rapid wage and price increases. At the beginning of this year, however, Poland implemented a strong stabilization program and, more recently, Argentina, Brazil, and Yugoslavia have substantially tightened policies.

Financial policies have generally been more cautious in countries that have avoided debt-servicing difficulties. Central government budgets in recent years were in balance or in surplus in Korea and Thailand. In Indonesia, timely adjustment after the decline in oil prices in 1986 prevented a lasting deterioration in the fiscal position. Credit expansion was strong in the latter countries but it accommodated mainly private sector investment and generally did not lead to a significant rise in inflation. In China, inflation accelerated sharply in 1988 but credit conditions were quickly tightened.

Recognizing the negative implications for growth and macroeconomic stability of widespread structural rigidities in their economies, many developing countries, notably Mexico, Ghana, Indonesia, Madagascar, and Viet Nam have implemented far-reaching structural reforms in recent years. These reforms generally included trade liberalization to enhance efficiency and competitiveness; decontrol of price systems to increase the responsiveness of both supply and demand to price signals; restructuring of government finances to free resources for private sector investment, to permit a reduction in credit expansion, and to lessen the dependence of revenues on external developments; reorganization of public sector enterprises to enhance efficiency; and deregulation of the financial sector to stimulate private sector saving and improve the allocation of saving. Such reforms have raised potential output and enhanced the flexibility with which the economy adjusts to changes in the external environment.

Medium-Term Outlook

The staff’s projections are generally based on the assumption of broadly unchanged policies. However, in certain cases where significant policy changes are considered likely—for example, in the context of Fund- or Bank-supported adjustment programs—policies are projected to improve in line with program objectives. In view of the slippages that have repeatedly occurred in a number of countries, this assumption could entail considerable downside risk for some of the projections.

The medium-term outlook for developing countries also depends critically on the global economic environment. The baseline projections for developing countries envisage the continuation of recent trends in the world economy. Output growth in industrial countries is assumed to be sustained at a rate of about 3 percent over the medium term. Short-term interest rates (six-month LIBOR on U.S. dollar deposits) are assumed to average 8¼ percent over the forecast period, somewhat below the average for the period 1983–89. The terms of trade for net debtor developing countries would remain relatively weak in the medium term, following a decline in 1990.

Total financing flows to the net debtor countries are assumed to change little in 1990–95 compared with 1983–89. The prospect of a major resumption of spontaneous commercial bank lending to developing countries with recent debt-servicing problems appears unlikely at present. Debt-reduction operations should help to alleviate the burden of debt service for some debtors; and this has been taken into account in the projections in those—relatively few—cases where debt-reduction packages have already been agreed or where negotiations are at an advanced stage. In other cases, because of the continued low level of spontaneous nonofficial lending, some further need for concerted financing by private creditors appears likely. Borrowing from official sources is expected to rise slightly, leading inevitably to a further rise in the share of debt held by official creditors.

Against this background, the staff’s medium-term baseline scenario (details of which are given in Tables A5153 of the Statistical Appendix) shows GDP growth in net debtor developing countries increasing to 5 percent in 1992–95, significantly faster than in 1989–91. Compared with 1983–89 (see Table 11), there would be a considerable improvement in the first half of the 1990s in the performance of countries that have recently experienced debt-servicing difficulties. The increase in growth projected for these countries rests heavily on the assumption that adjustment policies are successful in bringing down inflation and improving the climate for domestic savings and investment. Inflation is projected to fall to 12 percent in these countries in the 1992–95 period, and investment ratios would rise by 4–5 percentage points from recent levels, largely on the basis of higher domestic savings. The assumption of improved adjustment is particularly critical for the projected increase in growth in Western Hemisphere developing countries. A marked improvement in growth rates from current levels is also projected for Eastern European countries. The projections for Africa, based on a fairly weak outlook for the region’s terms of trade, would allow little scope for recouping the real income losses of the last decade. The strongest growth rates are projected for Asia, despite downward revisions to the staff’s forecast for China.

The combined current account deficit of net debtor countries is projected to narrow significantly in the medium term to 1.4 percent of exports by 1995. In Africa and the Western Hemisphere, substantial reductions in deficits are projected, reflecting relatively strong export volume growth, falling interest payments (as a percentage of exports) and the limited availability of external financing. A significant reduction in current account deficits relative to exports is also projected for net debtor countries in Asia and the Middle East. In Europe, the current account balance is projected to return to surplus after deficits in 1990 and 1991.

External debt and debt-service ratios for developing countries are projected to decline considerably in the medium term, as a result of a continued expansion of exports, reduced borrowing, and the impact of debt and debt-service reduction operations. For countries with recent debt-servicing difficulties, total external debt would decline from 249 percent of exports of goods and services in 1989 to 189 percent in 1995. Among geographic regions, the sharpest reductions are projected for the Western Hemisphere and the Middle East. However, debt-service ratios of developing countries with recent debt-servicing difficulties, although declining from 27 percent in 1989 to 24 percent in 1995, are expected to remain high, in particular in some countries in sub-Saharan Africa and the Western Hemisphere. The debt situation in these countries is likely to remain difficult for a number of years.

The decline in debt ratios is projected to be accompanied by a shift toward lending by official creditors (see Chart 24). In contrast to the period prior to 1983, official creditors are expected to provide nearly all of the total net (nominal) external credit extended during 1990–95 to countries with recent debt-servicing difficulties. The rise in the relative importance of official lending largely reflects the projected modest level of new financing flows from the commercial banks.

The baseline scenario is of course sensitive to any policy slippage in developing countries and to changes in the global environment. The improvement in growth prospects in countries with recent debt-servicing difficulties depends on a recovery of investment ratios and an increase in the efficiency of investment, both of which would be threatened if the projected improvement in policies does not materialize. Given the past record in some countries, there is a risk that the projections may be too optimistic.

As regards the external environment, previous issues of the World Economic Outlook have examined the impact on the developing countries of higher world interest rates or lower growth in the industrial world. Another important question that arises in this context is how developing countries might be affected by policies aimed at eliminating inflation in the industrial countries. The simulations reported in Chapter II (Table 6) suggest that a program designed to achieve price stability in the industrial countries would result in a decline in nominal interest rates and a temporary slowdown in industrial country growth. The implications of this alternative scenario for net debtor developing countries are summarized in Table 12.31

Table 11.Net Debtor Developing Countries: Indicators of Economic Performance, 1969–95
1969–731, 21974–8211983–891990–95
Net debtor countries, total
(Annual changes in percent or percent of GDP)
Real GDP6.34.14.04.6
Investment ratio21.925.823.526.4
Export volume6.21.98.16.8
Import volume7.75.54.26.5
Terms of trade2.32.2−1.7−0.2
Consumer prices10.527.857.420.2
(Annual averages, in billions of U.S. dollars)
Trade balance−5.7−27.83.0
Current account balance−8.5−50.0−34.1−31.0
Net official credit34.820.728.130.4
Net bank credit45.42.7
(As percent of exports of goods and services, period averages)
Trade balance−7.5−8.30.4−0.1
Current account balance−11.1−14.1−6.3−3.1
Total external debt5110.8165.7149.3110.0
Debt-service payments17.218.623.416.9
Of which: interest payments7.68.112.58.8
1969–7321974–821983–891990–95
Countries with recent debt-servicing difficulties
(Annual changes in percent or percent of GDP)
Real GDP6.63.51.94.1
Investment ratio22.826.019.323.8
Export volume4.4−0.54.65.0
Import volume6.84.2−1.85.2
Terms of trade2.53.2−3.1−0.6
Consumer prices11.934.8107.832.7
(Annual averages, in billions of U.S. dollars)
Trade balance0.2−6.926.425.3
Current account balance−4.8−34.9−21.0−24.8
Net official credit31.713.120.721.3
Net bank credit4−2.1
(As percent of exports of goods and services, period averages)
Trade balance−3.910.56.7
Current account balance−10.1−17.4−8.7−6.8
Total external debt5111.5222.2248.7188.7
Debt-service payments18.824.231.625.9
Of which: interest payments7.410.219.315.6
1969–731, 21974–8211983–891990–95
Countries without debt-servicing difficulties
(Annual changes in percent or percent of GDP)
Real GDP5.75.16.75.1
Investment ratio20.625.428.629.0
Export volume9.35.610.87.8
Import volume8.97.08.57.2
Terms of trade1.80.7−0.6
Consumer prices7.815.811.37.6
(Annual averages, in billions of U.S. dollars)
Trade balance−6.0−21.0−23.3−25.2
Current account balance−3.6−14.9−13.2−6.2
Net official credit33.17.47.49.1
Net bank credit45.34.8
(As percent of exports of goods and services, period averages)
Trade balance−19.8−14.5−7.63.8
Current account balance−12.7−10.2−4.6−1.0
Total external debt5110.4105.490.067.8
Debt-service payments15.011.517.111.8
Of which: interest payments8.05.57.35.0

Excluding China.

Net official credit, debt service, and interest payments shown are 1971–73 averages.

Estimate of long-term borrowing from official creditors. See footnotes to Table A40 in (he Statistical Appendix for further explanation.

Estimate of net lending from commercial banks, including impact of debt reductions. See footnotes to Table A40 in the Statistical Appendix for further explanation.

End of period.

Excluding China.

Net official credit, debt service, and interest payments shown are 1971–73 averages.

Estimate of long-term borrowing from official creditors. See footnotes to Table A40 in (he Statistical Appendix for further explanation.

Estimate of net lending from commercial banks, including impact of debt reductions. See footnotes to Table A40 in the Statistical Appendix for further explanation.

End of period.

Chart 24.Net External Credit to Developing Countries

(Annual averages, in billions of U.S. dollars)

1Excluding reserve-related liabilities.

2Estimate of long-term borrowing from official creditors. See footnotes to Table A40 in the Statistical Appendix for further explanation.

3 Estimate of net lending from commercial banks, including impact of debt reductions. See footnotes to Table A40 in the Statistical Appendix for further explanation.

As a result of the slowdown in industrial countries, output growth in developing countries would be slightly lower than in the baseline and the level of national income in the period 1992–95 would be on average 1 percent lower. However, the impact would vary widely across countries. The decline in income would be most pronounced for the exporters of manufactures, although terms-of-trade gains would offset some of their export volume losses. Heavily indebted countries and small, low-income countries would suffer relatively small output losses and many of them would experience a slight increase in national income because of the reduction in interest payments. Lower nominal interest rates would lead to a substantial reduction in the debt-service burden (equivalent to about 2 percent of exports for heavily indebted countries) despite a sharp rise in debt-export ratios resulting mainly from the decline in dollar export prices. The group of countries with recent debt-servicing problems would therefore gain slightly from a move toward price stability in industrial countries. Moreover, as indicated in Chapter III, the elimination of inflation would yield large and lasting efficiency gains in the industrial countries that would indirectly benefit the developing countries, particularly the exporters of manufactured goods.

Debtor countries would also benefit through a reduction in their own inflation rates in relation to the baseline. In addition to a 16 percent decline in import prices, some net debtors could benefit from reductions in domestically generated inflation of up to 2 percent a year on the basis of unchanged policies. However, for many developing countries, the reductions would be insignificant and the solution to their inflation difficulties would need to be sought elsewhere.

Recent Experience in Developing Countries

The end of the 1980s witnessed an upsurge in inflationary pressures in many parts of the developing world. The increase in inflation occurred mainly in the Western Hemisphere and among the developing countries of Europe, and affected mainly countries with recent debt-servicing difficulties. In these groups, inflation reached record levels in 1988 and again in 1989 (see Chart 12 in Chapter I). Countries as diverse as Argentina, Brazil, China, Nigeria, Poland, Turkey, and Yugoslavia have experienced sharp increases in inflation in the last few years.

Episodes of high inflation in developing countries are not new, but they have become much more frequent in recent years. Over the last 25 years, 16 countries have experienced acute inflation—defined as inflation rates in excess of 80 percent for two years or more (Table 13).32 In all but three cases, inflation peaked in the second half of the 1980s, and in most cases prices were increasing at an annual rate of at least 200 percent in the peak year. Another 13 developing countries suffered “chronic” inflation in the 1980s—experiencing inflation rates in excess of 20 percent for five or more years—although, as discussed in Chapter I, some have subsequently succeeded in reducing their inflation rate.

Table 12.Medium-Term Implications for Developing Countries of Eliminating Inflation in Industrial Countries, 1990–95(Difference from the baseline scenario in percentage points)
199019911992–95
Net debtor countries
Current account balance1−0.6−0.6−1.2
Debt ratio4.36.615.9
Debt-service ratio−0.2−0.5−0.6
Real GNP−0.4−0.4−1.1
Export volume−1.5−2.0−4.6
Import volume−0.5−0.4−0.2
Terms of trade0.30.72.5
By region
Africa
Current account balance1−0.4−0.5−0.8
Debt ratio5.48.420.2
Debt-service ratio−0.2−0.6−1.0
Real GNP0.10.40.9
Export volume−0.8−1.0−1.6
Import volume0.10.71.6
Terms of trade0.30.9
Asia
Current account balance1−0.5−0.6−1.3
Debt ratio2.13.58.9
Debt-service ratio−0.1−0.1
Real GNP−0.8−1.0−2.5
Export volume−2.2−3.1−7.6
Import volume−1.0−1.3−2.0
Terms of trade0.61.13.5
Europe
Current account balance1−0.2−0.2−0.8
Debt ratio2.84.412.2
Debt-service ratio−0.5−1.0−1.4
Real GNP−0.2−0.2−0.4
Export volume−0.8−1.0−2.2
Import volume−0.20.31.6
Terms of trade0.30.83.0
Non-oil Middle East
Current account balance1−1.1−1.3−1.8
Debt ratio9.015.135.4
Debt-service ratio0.40.51.8
Real GNP−0.6−0.9−1.8
Export volume−1.4−1.8−3.2
Import volume1.3
Terms of trade1.11.44.3
Western Hemisphere
Current account balance1−0.9−0.9−1.4
Debt ratio9.613.128.3
Debt-service ratio−0.7−1.6−2.7
Real GNP0.1
Export volume−1.2−1.5−2.8
Import volume0.20.91.6
Terms of trade−0.4−0.10.3
By financial criteria
Countries with recent debt-servicing difficulties
Current account balance1−0.5−0.7−1.1
Debt ratio6.39.923.1
Debt-service ratio−0.7−1.3−2.0
Real GNP0.10.20.3
Export volume−0.8−1.1−1.9
Import volume0.40.92.5
Terms of trade0.10.41.5
Countries without debt-servicing difficulties
Current account balance1−0.60.6−1.2
Debt ratio2.64.010.1
Debt-service ratio0.1−0.1−0.1
Real GNP−0.8−0.9−2.3
Export volume−2.1−2.9−6.9
Import volume−1.0−1.1−1.9
Terms of trade0.41.03.3
By miscellaneous criteria
Primary products exporters
Current account balance1−2.0−2.1−4.2
Debt ratio15.220.346.3
Debt-serviee ratio0.2−0.5−1.3
Real GNP−0.4−0.3−0.6
Export volume−1.7−2.3−4.8
Import volume−0.9−0.5−0.4
Terms of trade−1.2−0.7−0.1
Exporters of manufactures
Current account balance1−0.5−0.5−1.0
Debt ratio2.53.89.1
Debt-service ratio−0.1−0.3−0.4
Real GNP−0.7−0.9−1.9
Export volume−2.2−3.0−6.6
Import volume−1.0−1.2−1.4
Terms of trade0.41.03.3
Fifteen heavily indebted countries
Current account balance1−0.7−0.8−0.9
Debt ratio8.111.825.5
Debt-service ratio−0.7−1.4−2.2
Real GNP0.20.3
Export volume−1.0−1.3−2.3
Import volume0.31.01.7
Terms of trade−0.30.3
Small low-income countries
Current account balance1−1.7−1.8−4.1
Debt ratio13.417.744.4
Debt-service ratio−0.7−1.8
Real GNP−0.20.10.5
Export volume−1.1−1.5−2.9
Import volume−0.5−0.11.1
Terms of trade−1.0−0.20.9

Ratio to exports of goods and services.

Ratio to exports of goods and services.

Table 13.High-Inflation Episodes in Developing Countries, 1964–89
Chronic Inflation1Acute Inflation2Runaway Inflation3
Annual RateAnnual RateAnnual Rate
CountryYears(In percent)Years(In percent)Years(In percent)
Argentina1975–89280.81976443.2
1983–85529.2
1988–891,087.1
Bolivia1982–86776.51983–861,133.4
Brazil1967–7123.41980–89233.51984–85223.0
1974–7938.71987–89605.6
Chile1973–77265.41973–76329.2
Colombia1973–7724.2
1985–8923.8
Ecuador1983–8940.9
Ghana1975–8464.5
Guinea1980–8432.1
Guinea-Bissau1983–8952.8
Indonesia1964–68221.3
Israel1974–7944.91980–8518.3.51984–85337.9
Lao, P.D.R.1980–8669.0
Mexico1980–8554.41986–88109.9
Mozambique1983–8948.0
Nicaragua1964–7326.91985–891,515.8
1979–8432.8
Paraguay1984–8924.4
Peru1975–8251.51983–85127.01988–891,827.9
Poland1989252.0
Sierra Leone1981–8550.71986–87124.5
Somalia1979–8740.91988–8994.0
Sudan1978–8934.6
Tanzania1980–8929.8
Turkey1977–8947.6
Uganda1979–81100.81987256.0
1985–88166.4
Uruguay1964–6964.51967–68106.5
1971–8159.8
1983–8964.6
Viet Nam1980–8459.21985–89236.41986–88364.0
Yemen Arab Republic1969–7532.6
Yugoslavia1979–8541.91986–89257.619891,233.7
Zaire1974–8650.21987–8984.1
Zambia1984–8946.0
Source: Official and Fund staff estimates.

Chronic Inflation: Annual rates of 20–80 percent for five or more consecutive years.

Acute Inflation: Annual rates over 80 percent for two or more consecutive years.

Runaway Inflation: Annual rates over 200 percent for one year or more.

Source: Official and Fund staff estimates.

Chronic Inflation: Annual rates of 20–80 percent for five or more consecutive years.

Acute Inflation: Annual rates over 80 percent for two or more consecutive years.

Runaway Inflation: Annual rates over 200 percent for one year or more.

Table 14.World Economic Outlook Forecasts of Developing Country Inflation, 1984–89(In percent)
All Developing

Countries
AfricaAsiaEuropeMiddle EastWestern

Hemisphere
Forecast DateForecastOutturnForecastOutturnForecastOutturnForecastOutturnForecastOutturnForecastOutturn
April 198428.337.715.717.84.96.923.028.047.216.591.6119.8
April 198534.839.316.113.65.56.722.427.917.313.8113.7144.0
April 198625.928.613.114.85.45.925.227.411.911.176.086.5
April 198730.140.312.616.25.48.722.730.311.116.397.7130.8
April 198846.767.112.718.87.614.631.349.314.118.8177.5277.6
April 198945.5104.115.120.210.011.950.3169.814.613.9154.9531.0
Sources: World Economic Outlook, various years. April forecasts are for the current year. “Outturns” are the figures reported in the World Economic Outlook published in April of the following year (i.e., they do not reflect later data revisions).
Sources: World Economic Outlook, various years. April forecasts are for the current year. “Outturns” are the figures reported in the World Economic Outlook published in April of the following year (i.e., they do not reflect later data revisions).

In an environment of accelerating inflation, it is perhaps not surprising that the forecasts published in recent editions of the World Economic Outlook have tended to underestimate inflation. Table 14 shows that the under-prediction applies to all regional groupings apart from the Middle East. Under-prediction of inflation was also a feature of earlier forecasts,33 but the extent of under-prediction has tended to increase in recent years, largely as a result of policy slippage and delayed implementation of stabilization programs.

Consequences of High Inflation in Developing Countries

It is sometimes argued that a moderately high rate of inflation is a necessary by-product or even a spur to development.34 Proponents of this argument point to structural rigidities in developing countries as the main source of inflation. These rigidities include downward inflexibility in nominal prices, susceptibility to supply shocks, bottlenecks in production and distribution, a narrow tax base, and underdeveloped financial markets. There is no question that these distortions and rigidities exist and that they seriously hinder growth. But the solution must be to tackle the root cause of the problem through structural measures. Attempts to smooth out the development process by accepting inflation are bound to be counterproductive and risk leading to runaway inflation.

As discussed in Chapter III, inflation involves serious costs, many of which apply with particular force to the high-inflation developing countries. High inflation and inflation variability create uncertainty and undermine the confidence of domestic investors and foreign lenders. At very high levels of inflation, the economic horizon is shortened and financial instability disrupts economic decisions. High inflation is usually also a symptom of fundamental problems in macroeconomic management. While inflation persists, private sector investors will expect the government to be driven eventually to take corrective measures. The longer these are delayed, the more disruptive the effect on the economy.

Inflation also distorts the functioning of the price mechanism. The evidence from studies of developing countries35 suggests that relative prices tend to become more variable as inflation rises even where indexation is prevalent, partly because many governments attempt to protect certain segments of the population from inflation through the expedient of selective price controls. In addition, high inflation tends to be more variable over time. Chart 25 shows a clear tendency for the variability of inflation to be greater in high-inflation developing countries. The variability of inflation—both between sectors and over time—makes it difficult to plan ahead and diverts resources away from productive uses.

Inflation can also have adverse effects on the financial sector. As a result of controls on nominal interest rates in many developing countries, high inflation tends to be accompanied by highly volatile (and often negative) real interest rates. There is evidence that negative real interest rates and high inflation have a significant adverse impact on financial savings and that low savings rates are generally associated with poor growth performance in developing countries.36 Attempts at financial sector reform will be seriously complicated unless inflation is first brought under control.37 Finally, the costs of. high inflation will be exacerbated if the exchange rate is not allowed to depreciate in line with relative inflation performance, as competitiveness will deteriorate and capital flight will be encouraged.

Chart 25.Developing Countries: Inflation Rates and Inflation Variability

(In percent)

1 Inflation variability is measured by the standard deviation of changes in the inflation rate over the period 1968–89.

2 Developing countries with populations of less than 2.5 million and high-inflation countries have been excluded for presentational purposes.

3 The estimated regression line includes the smaller developing countries, but excludes high-inflation countries. Inclusion of the latter group would give a steeper line.

Thus, for a number of reasons, high inflation in developing countries may be expected to be associated with weak economic performance. This relationship is examined in Table 15, which divides developing countries into three groups according to their average inflation rates in the seven-year period 1983–89.38 It can be seen that low-inflation and moderate-inflation countries tend to have higher investment ratios and higher rates of growth of GDP per head than the high-inflation countries. Cross-section statistical analysis confirms the existence of a significant negative relationship over the whole sample between inflation and growth, and between inflation and investment ratios.39 It is possible, of course, that causation may run from low growth and investment to inflation through, for example, effects on tax revenues or on production bottlenecks; or the relationship may reflect the influence of third factors such as the pattern of supply shocks across countries. But the data is at least consistent with the view that high inflation has a negative impact on economic performance in the medium term.

There is also some evidence of a negative correlation between inflation and export performance but it is less well determined. The effect of inflation on exports will be stronger if it is accompanied by an appreciating real exchange rate. This was true during the 1970s,40 but, during the 1980s, the relationship between inflation and real exchange rates was reversed (see Chart 26). Whereas high inflation contributed to real exchange rate appreciation in the earlier period, it appears that the large devaluations experienced in many developing countries in the 1980s may have been a factor contributing to inflationary pressures.

Sources of Inflation

Inflation is a complex process and it is difficult to find a single empirical model that fits the circumstances of all developing countries. It is possible, however, to identify key elements of the inflation process that can help to explain why inflation experience has varied so widely across countries.

Table 15.Inflation and Economic Performance: Net Debtor Developing countries, 1983–891(Average annual rates, in percent, except where indicated)
LowModerateHighAll
InflationInflationInflation2countries3
Number of countries28312988
Inflation rate
Unweighted average3.29.684.8**32.4
Weighted average2.89.2183.193.8
Growth rate4
Unweighted average1.41.0−0.3**0.7*
Weighted average4.34.00.12.1
Investment ratio5
Unweighted average22.822.217.2**20.7*
Weighted average27.524.718.221.9
Growth rate of exports
Unweighted average5.25.63.4*4.8*
weighted average610.99.26.18.7

The 88 countries included here are those net debtor countries for which a full data set was available. Countries with annual average rates of consumer price inflation below 6 percent are characterized as “low inflation” while countries with rates in excess of 15 percent are characterized as “high inflation.” The thresholds were chosen to give roughly equal numbers of countries in each group. Weighted averages are calculated using GDP weights except where indicated.

Statistical significance tests were carried out for differences between the group averages for each variable (using unweighted averages only). An asterisk in the “high inflation” column indicates that the unweighted average of the variable for high-inflation countries was significantly different, at the 90 percent level, from the average for one of the lower inflation groups; two asterisks indicate that it was significantly different from both other groups. The statistical test used was a nonparametric, rank-sum test.

Where the variable was found to be approximately normally distributed, an F-test for differences in means was carried out. An asterisk in the final column indicates statistically significant differences in the means of the three groups when this test was used. The F-test was not carried out for the inflation variable in this table.

Growth of real per capita GDP.

Gross fixed capital formation as a percentage of GDP.

Weighted by merchandise exports.

The 88 countries included here are those net debtor countries for which a full data set was available. Countries with annual average rates of consumer price inflation below 6 percent are characterized as “low inflation” while countries with rates in excess of 15 percent are characterized as “high inflation.” The thresholds were chosen to give roughly equal numbers of countries in each group. Weighted averages are calculated using GDP weights except where indicated.

Statistical significance tests were carried out for differences between the group averages for each variable (using unweighted averages only). An asterisk in the “high inflation” column indicates that the unweighted average of the variable for high-inflation countries was significantly different, at the 90 percent level, from the average for one of the lower inflation groups; two asterisks indicate that it was significantly different from both other groups. The statistical test used was a nonparametric, rank-sum test.

Where the variable was found to be approximately normally distributed, an F-test for differences in means was carried out. An asterisk in the final column indicates statistically significant differences in the means of the three groups when this test was used. The F-test was not carried out for the inflation variable in this table.

Growth of real per capita GDP.

Gross fixed capital formation as a percentage of GDP.

Weighted by merchandise exports.

There is little disagreement that in the long run inflation is primarily a monetary phenomenon; high rates of price increases cannot be sustained for extended periods without corresponding increases in the money supply. Table 16 illustrates this point. The average annual rate of money growth during 1983–89 was significantly greater in higher-inflation countries than in countries with lower inflation. In time-series analyses, the link between money growth and inflation is empirically well established for high-inflation countries, but adjustment lags and shifts in money demand functions tend to weaken the short-run correlation in countries with more moderate rates of inflation. Nonetheless, in the longer run, a sustained increase in the rate of monetary expansion in excess of the desired increase in real balances eventually will result in a higher rate of inflation.

Monetization of fiscal deficits is frequently the major source of excessive monetary expansion in developing countries with high inflation.41 Data on seigniorage suggest that developing countries resort to money financing of fiscal deficits to a greater extent than industrial countries.42 This is perhaps not surprising considering the structural weaknesses of public sector finances in developing countries, which are typically characterized by narrow tax bases, low elasticities of tax revenue, and high collection costs, as well as underdeveloped capital markets and low private saving. Indeed, it has been argued that in these circumstances some monetization of the fiscal deficit can, in theory, be an optimal strategy. In practice, of course, the inflation tax is a hazardous way of financing fiscal deficits because of the harmful effects of inflation on economic performance. Moreover, since the demand for real balances declines as expected inflation rises, the revenue that can be raised from the inflation tax is limited. The scope for inflationary financing is further constrained by the negative effect of inflation on revenue from other taxes because of long collection lags and other rigidities in the tax system. Attempts to extract resources from the private sector through the inflation tax at a faster rate are likely to lead to ever-accelerating inflation accompanied by a rapid weakening of public sector finances, as suggested by the experience of Bolivia in 1984—85 and that of Argentina more recently.

Chart 26.Developing Countries: Average Annual Inflation Rates and Changes in Real Effective Exchange Rates

(In percent)

1 Includes all developing countries for which estimates of real effective exchange rates are available, except some high-inflation countries that have been excluded because of limitations of scale.

The role of money-financed fiscal deficits in the inflation process is theoretically well established and empirically documented by numerous country examples. It is usually difficult, however, to find a significant relationship between inflation rates and fiscal deficits in cross-country comparisons. Table 16 indicates that the (unweighted) average fiscal deficit as a percentage of GDP was larger in countries with high inflation than in countries with low or moderate rates of inflation, but the difference is not statistically significant. This probably reflects the definition of the fiscal deficit that was available for comparison, which may be excessively narrow for many countries.43 Moreover, the impact of the fiscal deficit on inflation will depend on the proportion that is financed through money creation and on the underlying growth rate of the economy. Weak cross-sectional evidence on the relationship between fiscal deficits and inflation in developing countries thus does not necessarily invalidate the argument that fiscal policy—in particular monetization of fiscal deficits—plays a crucial role in the inflation process and that fiscal correction is likely to be a prerequisite for successful inflation stabilization.

Although a sustained rise in inflation is only possible if it is accommodated by inappropriate financial policies, episodes of high inflation can be triggered by other developments. Large depreciations of the nominal exchange rate are widely regarded as a cause of inflation and frequently resisted for that reason. There is indeed some evidence that episodes of accelerating inflation in countries like Argentina, Brazil, and Israel have been initiated by devaluations.44 The adjustment in the relative price of tradables and nontradables implied by a devaluation often involves an increase in the overall price level, although this will lead to higher inflation only if monetary policy accommodates continuing wage and price increases. Further monetary expansion may then result from the monetization of a widening fiscal deficit brought about by the rise in inflation. Eventually, accelerating inflation tends to lead to another balance of payments crisis, which necessitates a further devaluation. The combination of accommodating financial and exchange rate policies can result in a highly unstable vicious circle, as illustrated by the experience of a number of high-inflation countries, such as Yugoslavia.

Another potential source of an inflationary impulse is a supply shock such as a crop failure or an increase in import prices. Adverse shocks to agricultural output can have a pervasive, albeit temporary, impact on price developments because of the large share of agriculture in most developing economies. However, cautious financial policies (as, for example, in India after the drought of 1987) can prevent a permanent acceleration of inflation. Import prices as a source of inflation were more important in the 1970s when inflation in the industrial world was higher and more volatile, and many developing countries had fixed exchange rates. In contrast, the phenomenon of imported inflation appears to have been unimportant in the 1980s (see Table 16). Indeed, a negative relationship between inflation and the degree of openness suggests that exposure to international competition may well have constrained domestic price increases in many countries.

Table 16.Factors Affecting Inflation: Net Debtor Developing Countries. 1983–891(Average annual rates, in percent, except where indicated)
LowModerateHighAll
InflationInflationInflation2Countries3
Number of countries28312988
Inflation
Unweighted average3.29.684.8**32.4
Weighted average2.89.2183.193.8
Money growth4
Unweighted average9.815.481.9**35.5
Weighted average12.018.9187.8101.0
Fiscal deficit5
Unweighted average4.85.56.95.7
Weighted average1.34.57.55.6
Change in import prices
Unweighted average1.91.62.52.0
Weighted average60.71.20.50.8
Degree of openness7
Unweighted average50.837.922.7*37.0*
Weighted average50.820.715.622.0

See footnote 1 to Table 15.

See footnote 2 to Table 15.

See footnote 3 to Table 15. An F-test was only carried out for the degree of openness variable in this table.

Broad money aggregates (see Table A18 in the Statistical Appendix).

Central government fiscal deficit as a percentage of GDP (see Table A19 in the Statistical Appendix).

Weighted by merchandise imports.

Measured by exports of goods and services as a percentage of GDP.

See footnote 1 to Table 15.

See footnote 2 to Table 15.

See footnote 3 to Table 15. An F-test was only carried out for the degree of openness variable in this table.

Broad money aggregates (see Table A18 in the Statistical Appendix).

Central government fiscal deficit as a percentage of GDP (see Table A19 in the Statistical Appendix).

Weighted by merchandise imports.

Measured by exports of goods and services as a percentage of GDP.

Structural transformation is another kind of supply shock that may have inflationary repercussions if financial policies are accommodating. For example, steps to liberalize centrally planned economies typically involve significant relative price changes which may initiate an inflationary process, particularly where there is a liquidity overhang or where the tools of demand management are inadequate.45 Similarly, structural reforms in developing market economies may create some temporary inflationary pressures, for example where prices are being decontrolled or subsidies cut. However, in such cases the fiscal effects of reduced subsidies and the supply-side benefits of structural reform should exercise a restraining influence on domestic inflation.

Short-term inflationary pressures can be more difficult to contain if inflation inertia is a feature of the economy. Inflation inertia can occur for a variety of reasons such as backward-looking expectations and staggered wage contracts, but indexation of nominal incomes and interest rates to past changes in the overall price level is generally the most important source. With indexation, a temporary acceleration in the rate of price increases arising from exogenous shocks triggers a series of wage and price adjustments leading eventually to persistently higher inflation. If adjustment intervals are shortened, indexation itself becomes a factor that accelerates inflation. Also, by reducing (but by no means eliminating) the costs of inflation, indexation lessens the pressure for, and the determination to implement, stabilization measures.46

Once again, however, inertia alone cannot perpetuate inflation if financial policies do not accommodate ever-accelerating price increases. Whether devaluations, agricultural supply shocks, import price increases, or structural change translate into higher inflation rather than a one-off price rise depends ultimately on the stance of policies. Brazil and Korea are instructive examples of the differential impact of adverse supply shocks depending on policy responses. In Brazil, the oil price increase in 1979–80 permanently raised the level of inflation because ensuing price and wage adjustments, partly resulting from indexation mechanisms, were accommodated by monetary policy. In Korea, inflation increased temporarily in 1979 and 1980, but declined again significantly from 1981 to 1983 following the implementation of a comprehensive stabilization program.

Inflation and External Debt

At the beginning of the 1980s, net debtor developing countries faced a number of external shocks. Interest rates rose sharply, the terms of trade deteriorated for most countries and there was a cutback in the flow of external finance. Debtor countries faced both an external adjustment problem and a budgetary problem. The amount of adjustment required was related to the magnitude of the internal and external imbalance and the level of external debt. In order to achieve external adjustment, countries cut imports and allowed their exchange rates to depreciate. The degree of success varied from country to country, but, on the whole, there was a substantial increase in net exports of goods and non-factor services (see Chart 20 in Chapter I). However, in some cases, adjustment was insufficient and countries sought temporary relief through debt rescheduling and by accumulating arrears.

In addition to the external adjustment, countries had to confront the “internal transfer” problem, that is, the need to transfer resources from the domestic private sector to finance interest payments on the large proportion of external debt owed by the public sector. This process had two aspects. In the first place, expenditures which had previously been financed through external borrowing now had to be either cut or financed domestically. According to one estimate, external financing contributed 44 percent of the funding of the central government deficit in a group of developing countries in 1975–82 but only 26 percent in 1983–85.47 In addition, the fiscal burden of debt service rose as a result of higher interest rates and the real devaluations re-quired in order to effect the external transfer. To the extent that the additional fiscal burden was financed through money creation, inflation was the result.48

Nevertheless, the empirical evidence on the relationship between inflation and debt is mixed. Countries which have encountered debt-servicing difficulties recently have experienced much higher inflation rates than other developing countries (see Table 10), but the weighted aggregates are dominated by the experience of a small number of countries. Table 17 suggests that the relationship between external debt and inflation is not straightforward. Although the vast majority of countries in the high-inflation group experienced debt-servicing difficulties, the debt burden they faced—measured by total debt, debt service paid or net resource transfer (all expressed as a percentage of GDP)—was not particularly large compared with low- and moderate-inflation countries.49

The experience across countries appears to have been quite diverse. There are countries with relatively high debt and below-average inflation (Chile, Congo, Côte d’Ivoire. Jordan, Philippines): while, at the other extreme, a number of countries (Argentina, Brazil, Viet Nam, Yugoslavia) experienced disproportionately high rates of inflation relative to their levels of debt or resource transfer. Country-specific factors, such as differences in underlying growth rates and exposure to other shocks, may partly explain the diversity of country experience, but the impact of the debt problem appears to have been particularly severe in countries that were already prone to inflation or had difficulty in cutting non-interest government spending. In those cases, attempts to resort to domestic borrowing simply drove up inflationary expectations and domestic interest rates. On the other hand, countries that promptly tackled the underlying fiscal imbalance and implemented strong adjustment programs—which also enabled them to tap alternative sources of finance—were able to avoid a sharp upsurge in inflation.

A number of other factors relevant to the debt crisis played a role in weakening fiscal positions and generating inflationary pressures. In some developing countries, budgetary problems were aggravated when the public sector took over responsibility for private-sector debt. More recently, debt-equity swaps appear to have had inflationary effects in a number of countries. Where such swaps involved an exchange of public debt for private equity, there was an expansion of domestic liquidity—and hence higher inflation—unless public-sector revenues were raised to effect the transfer or government expenditures were cut. Finally, those countries where external adjustment required large nominal devaluations, either because of structural rigidities or because of indexation mechanisms, were vulnerable to inflationary pressures from higher import prices. In all these cases, however, inflation could only take hold if the initial impulse was accommodated by lax fiscal and monetary policy.

Table 17.Inflation and External Debt: Net Debtor Developing Countries, 1983–891
LowModerateHighAll
InflationInflationInflation2Countries3
Number of countries28312988
Inflation (percent)
Unweighted average3.29.684.8**32.4
Weighted average2.99.2183.193.8
Proportion of countries with
debt-servicing difficulties
Unweighted average50.032.389.7**56.8
Weighted average26.815.389.452.2
Debt/GDP ratio (percent)
Unweighted average59.748.781.6*63.0
Weighted average39.527.045.937.6
Debt service payments4
Unweighted average6.55.76.96.3
Weighted average7.33.75.85.2
Net resource balance5
Unweighted average−3.3−4.0−1.6*−3.0
Weighted average4.12.61.7

See footnote 1 to Table 15.

See footnote 2 to Table 15. The statistical test applied to the proportion of countries in each group with debt-servicing difficulties was a binomial test.

See footnote 3 to Table 15. An F-test was only carried out for the debt-service variable in this table.

Expressed as a percentage of GDP. Debt-service payments refer to actual payments of interest on total debt plus actual amortization payments on long-term debt.

Expressed as a percentage of GDP. The net resource balance is defined as the balance on goods and non-factor services; a surplus represents a transfer from developing countries to their creditors.

See footnote 1 to Table 15.

See footnote 2 to Table 15. The statistical test applied to the proportion of countries in each group with debt-servicing difficulties was a binomial test.

See footnote 3 to Table 15. An F-test was only carried out for the debt-service variable in this table.

Expressed as a percentage of GDP. Debt-service payments refer to actual payments of interest on total debt plus actual amortization payments on long-term debt.

Expressed as a percentage of GDP. The net resource balance is defined as the balance on goods and non-factor services; a surplus represents a transfer from developing countries to their creditors.

Thus, although external debt may have increased the vulnerability of certain countries to inflationary pressures, inflation was by no means a necessary consequence of the debt crisis. It seems more likely that where inflation difficulties emerged, these were symptoms of more fundamental problems in the domestic economy and in macroeconomic management rather than a direct result of the debt problem itself.

Lessons from Stabilization Experiences

In recent years, a number of developing countries have implemented stabilization programs to bring down inflation. Some of these programs, as, for example, in Bolivia, Chile, and Ghana, have focused on relatively orthodox measures of aggregate demand restraint through restrictive financial policies. Others, as in Argentina, Brazil, Israel, and Mexico, have sought to combine heterodox measures, such as incomes policies, with varying degrees of financial restraint. The orthodox programs succeeded in bringing down inflation, albeit not without short-run cost. Of the four other stabilization attempts, two, Israel and Mexico, were successful in reducing inflation while in Argentina and Brazil inflation accelerated again after a temporary respite.

One rationale often given for the heterodox approach is that high inflation is mainly due to inertia. Fiscal imbalances, it is argued, are the result rather than the cause of inflation. If inflation inertia can be broken, for example, through temporary wage and prize freezes, the resulting decline in the rate of inflation would significantly improve public finances, in particular through lower nominal interest payments; consequently, the need for fiscal adjustment would be limited. A reduced fiscal deficit would in turn obviate the need for rapid monetary expansion.

Experience suggests, however, that relying on endogenous reductions in the fiscal deficit is unlikely to be sufficient for a credible program of inflation reduction. Where inflation has taken hold to the extent that the authorities have resorted to indexation, excessively accommodating financial policies are typically part of the underlying problem and not just a consequence of inflation. In such cases, strong fiscal adjustment is an essential precondition for a credible stabilization program because it eliminates expectations of a future relapse into inflationary financing of fiscal deficits.

The stabilization programs implemented in Israel and Mexico both had strong orthodox components of fiscal adjustment which strengthened their credibility. By contrast, in the Argentine and Brazilian stabilization programs of 1985, fiscal adjustment was insufficient and only temporary. In the event, both programs failed to convince the public that the sources of inflation had been addressed and prices began to rise sharply when the price freezes were lifted. The main lesson from these stabilization attempts is that heterodox measures can only be successful if the stabilization program has a strong orthodox core. Provided this is the case, however, heterodox measures may, in the right circumstances, help to speed up the transition to a lower level of inflation and hence reduce the cost of adjustment in the presence of inertia. The relatively rapid success of orthodox stabilization in Bolivia is frequently considered a special case because the process of hyperinflation had practically eliminated inertia.

A number of stabilization programs implemented in recent years have included nominal exchange rate pegging aimed at reducing price pressures from the external sector and providing a nominal anchor. This policy can have considerable merits, but it also entails risks. Although large upfront devaluations generally preceded the pegging of the official exchange rate, the real exchange rate tended to appreciate significantly during the stabilization period with ensuing negative consequences for the tradable goods sector and the balance of payments. Availability of sufficient foreign financing thus became a precondition for successful stabilization. Eventually, nominal exchange rates had to be adjusted to avoid jeopardizing the stabilization process through a balance of payments crisis. However, in countries with a credible stabilization program these exchange rate adjustments did not have a permanent inflationary impact.

Policy Considerations

An improvement in the economic performance of indebted developing countries remains one of the foremost international economic priorities for the 1990s. The industrial countries can make an important contribution through policies designed to sustain steady growth and efforts to contain inflation and reduce nominal and real interest rates. At the same time, progress in the GATT negotiations is essential to preserve an open international trading environment and increase developing countries’ access to markets in the industrial world.

The recent strengthening of the debt strategy has enlarged the range of debt-restructuring instruments available to developing countries in support of their adjustment programs. It is still too early to assess its impact. The recent conclusion of a debt-reduction arrangement between Mexico and its creditors and the progress of reforms in that country are clearly encouraging. But the generally slow progress of debt-reduction negotiations has been disappointing. Among the low-income countries, several are now benefiting from concessional rescheduling terms agreed by Paris Club official creditors following the Toronto Summit in June 1988, but the overall cash flow saving for these countries is relatively small. Moreover, many of the beneficiaries have been hit by further declines in their terms of trade and the outlook for real income growth in these countries remains bleak.

Although debt reduction can make an important contribution, it will not in itself be sufficient to restore growth in developing countries. Alternative medium-term scenarios in previous issues of the World Economic Outlook have shown that the impact of debt reduction per se will be limited unless it is accompanied by measures to improve the efficiency of resource use and policies conducive to a recovery of investment. The adoption of strong adjustment policies to reverse current inflationary trends in many developing countries is essential if the opportunities afforded by debt reduction are not to be wasted.

The evidence reviewed in this chapter suggests that, in the medium term, countries with higher inflation rates tend to suffer from lower growth. Consideration of the effects of high inflation on uncertainty, on confidence, on the financial sector, and on sectors exposed to international competition suggests several mechanisms through which high inflation could adversely affect growth. Moreover, almost always the revealed preference of the authorities in inflationary countries is ultimately for stabilization, suggesting that they themselves recognize that high inflation is costly and unsustainable.

While imported inflation and adverse supply shocks were important factors in the inflation of the 1970s, they have played a much reduced role in more recent inflation episodes. In some countries, structural reforms may have contributed to price rises in the short run, particularly where the degree of adjustment was large, where inflation had previously been suppressed, or where institutional weaknesses limited the authorities’ ability to prevent inflation from taking hold. In the longer run, however, structural reforms should improve the flexibility of the economy, reduce bottlenecks, increase competition, and thus help reduce inflationary pressures.

The higher burden of external debt service may also have added to the pressures on countries to resort to inflationary financing, but the empirical evidence for such an effect is mixed. Inflation seems to have been associated with external indebtedness mainly in countries which were already prone to inflation and in countries where weaknesses in the tax base or in the control of government expenditure were particularly acute. In those cases, a reduction in the burden of debt will not, on its own, provide a lasting solution to the problem of inflation. It seems clear that the main reason for the re-emergence of inflationary pressures in certain developing countries in the second half of the 1980s was the pursuit of inappropriate domestic financial policies.

Stabilization of inflation is neither costless nor easy. In most cases where stabilization programs have brought down high inflation, success has only come after several previous attempts had failed and drastic rather than gradual measures have usually been required. The two key requirements are to establish credibility and to establish a social consensus in favor of stabilization. The former may require measures, such as the suspension of wage indexation, the temporary pegging of the exchange rate and, most important, correction of the underlying fiscal deficit through cuts in government consumption and appropriate adjustments in public-sector prices. Achievement of social consensus may be more difficult, but it is likely to be facilitated if the authorities act decisively and if action is taken at an early stage in the electoral cycle. The impact of stabilization on income distribution will depend on the structure of poverty and the nature of the measures taken, but the evidence from a number of developing countries suggests that the main beneficiaries of government spending are not necessarily the poorest members of society and that bringing down inflation may reduce the inequality of income distribution.50

Stabilization of inflation and the restoration of growth in the indebted developing world is in the interests of both debtors and creditors, and the international community must be ready to recognize and show its support for those countries willing to undertake the necessary reforms. The appropriate strategy to be pursued needs to take account of the specific problems facing individual countries. For the low-income countries eligible for Toronto terms, this will mean the continuation of the process of debt cancellation and Paris Club reschedulings at favorable terms. For the middle-income debtors, the onus is more on the commercial banks to reach agreement with heavily indebted countries on debt-reduction schemes. In the case of some middle-income countries that are indebted mainly to bilateral official creditors, debt-restructuring agreements may need to encompass debt owed to both official agencies and commercial banks. In all cases, however, external finance must be used to facilitate rather than postpone adjustment. Action to control inflation is essential in order to permit a return to creditworthiness and sustained growth, and the most substantial contribution must come from debtor countries themselves.

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