Chapter

II Initial Conditions and the Setting for Adjustment

Author(s):
International Monetary Fund
Published Date:
February 1998
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Before turning to the record of adjustment and reform undertaken in ESAF countries, it is useful to recall why countries embarked on this process, and what they hoped to achieve. This section looks first, in broad terms, at the nature of the economic difficulties that countries faced prior to their first SAF/ESAF-supported program, since these naturally determined much of what followed. The objectives and key components of the strategies designed to address those problems are then summarized. The final element considered is the background—both domestic and global—against which policies were implemented.

Initial Conditions

Countries seeking support under the SAF and ESAF had typically accumulated deep-seated economic problems over an extended period. Most came to the IMF in circumstances not of sudden macroeconomic or financial instability but rather of persistently weak growth, often chronically high inflation, and fragile external positions. Development strategies, based commonly on pervasive state intervention in the economy, public ownership, and protectionism, had left a dismal legacy. Distortions and rigidities were stifling entrepreneurship and promoting waste and corruption. They also aggravated the vulnerability of economies that were unusually prone to adverse economic shocks. In many countries, especially in Africa, these profound weaknesses had been masked during much of the 1970s by heavy foreign borrowing on the back of improving terms of trade. When commodity prices turned down sharply and interest rates rose in the early 1980s, both the debts and the policies they had financed became manifestly unsustainable.7

The immediate need in most cases was to bring some order to countries’ external cash flow positions, through a combination of debt relief or rescheduling and new resource flows. Even though many countries had already begun to adjust in the context of programs supported by stand-by arrangements, their external situations prior to SAF/ESAF-supported programs remained precarious: current account deficits (excluding official transfers) averaged 12–14 percent of GDP, scheduled debt service was typically 35–40 percent of exports, and official reserves were uncomfortably low, given the volatility of these countries’ foreign exchange earnings. External imbalances were particularly severe among future ESAF users in Central America and parts of Africa, much less so in Asia.

Net resource transfers did pick up sharply in the context of SAF/ESAF-supported programs. By this time, however, it was widely recognized that the debt crisis of the early 1980s was not a temporary problem of liquidity shortage—a matter of tiding over until the next upturn in commodity prices—but a true watershed. Countries had become locked in a cycle of low saving, weak external positions, and low growth, with each element constraining the others. In the years leading up to their first SAF/ESAF arrangement (by and large, the early to mid-1980s), most were experiencing stagnant exports and declining living standards, with saving rates averaging only about 8 percent of GDP.

Certainly, the early 1980s were lean years for the developing world as a whole. But future SAF/ESAF users were on average falling further behind other developing countries in terms of per capita income during this period (Table 1): their saving rates were half the average of other developing countries, and they had larger budget deficits, higher inflation, higher levels of external debt, more distorted exchange systems, faster population growth, and more adverse social indicators (such as education, health, and life expectancy). It was apparent that fundamental economic reform was required to reverse these trends and deliver a lasting improvement in growth and the external finances.

Table 1.Economic and Social Indicators in ESAF and Other Developing Countries(In percent a year, unless otherwise indicated)
 ESAF CountriesNon-ESAF Developing Countries1
 1981–851991–9521981–851991–952
Real per capita GDP growth–1.10.00.31.0
Inflation3    
    Mean94.444.923.5139.9
    Median11.71 1.69.110.3
Gross national saving (in percent of GDP)8.09.918.617.4
Budget balance4 (In percent of GDP)–9.1–5.6–6.8–4.8
Export volume growth1.77.94.45.7
Debt-service ratio (actual) (in percent of exports of goods and nonfactor services)27.925.718.815.7
External debt (face value, in percent of GNP)81.9154.255.775.6
Gross reserves (in months of imports)2.03.54.75.6
Premium in parallel market exchange rate    
    Mean230.518.349.0201.2
    Median28.68.253.2211.0
Population growth2.82.52.42.2
Life expectancy (years at birth)51.555.059.763.6
Infant mortality (per thousand live births)111.987.571.852.7
Illiteracy (In percent of population age 15 or above)54.847.332.223.0

Sources: Bredenkamp and Schadler (forthcoming); International Monetary Fund, World Economic Outlook and International Financial Statistics; and World Bank, World DebtTables and Social Indicators of Development.

Developing countries as defined in World Economic Outlook, excluding countries classified as “high income” by the World Bank and SAF/ESAF users.

1991–94 for some variables.

End of period when available, period average otherwise.

Overall balance, including grants as revenue.

Sources: Bredenkamp and Schadler (forthcoming); International Monetary Fund, World Economic Outlook and International Financial Statistics; and World Bank, World DebtTables and Social Indicators of Development.

Developing countries as defined in World Economic Outlook, excluding countries classified as “high income” by the World Bank and SAF/ESAF users.

1991–94 for some variables.

End of period when available, period average otherwise.

Overall balance, including grants as revenue.

The Adjustment Strategy

SAF/ESAF-supported adjustment programs varied widely in their emphasis and detail, in keeping with the differing circumstances of individual countries. But countries’ common problems—and the universal underlying aim of achieving higher sustainable economic growth—resulted in reform strategies that shared certain core objectives.

First, to raise saving rates. The very low saving rates in ESAF countries were reflected in a combination of low investment ratios and high current account deficits. Since public dissaving was seen both as a root of this problem and as the most likely source of an early improvement in national saving rates, fiscal adjustment was at the heart of almost all SAF/ESAF-supported programs. Supporting policies, to bolster private saving, included financial sector reform and a shift from negative to positive real interest rates. The basic aim was to shift the macroeconomic balances underlying current account deficits in favor of greater investment.

Second, to secure macroeconomic stability. Although only 9 of the 67 three-year SAF/ESAF arrangements covered by this review began with initial inflation rates in excess of 40 percent, most ESAF countries—with the exception of those in the CFA franc zone and some in Asia—had experienced volatile inflation for some years, with rates seldom falling into the single-digit range. This instability was viewed as disruptive, and a deterrent to investment. Programs aimed to reduce it by bringing inflation to low (single-digit) levels and by putting the government budget (a chronic source of financial instability) on a surer footing. Low inflation was also considered an important factor in improving conditions for the poorest sectors of the population.

Third, to liberalize and open economies to foreign trade. ESAF economies were generally inward-oriented with distorted internal relative prices. Producers faced substantial protection from external competition and disincentives against export activity. Programs sought to eliminate systemic anti-export bias through removal of exchange and trade restrictions (particularly quantitative import restrictions), exchange rate unification, tariff reform, liberalization of export price and marketing regimes, and public enterprise reform. In addition, in many cases, real devaluations of the domestic currency—secured by fiscal adjustment—aimed at enhancing the outward orientation of the economy.

Fourth, to reduce government intervention and promote well-functioning markets. The state needed to cease controlling prices, foreign exchange, and product marketing and by and large to withdraw from ownership and control of the means of production. Instead, its challenge was to establish a legal and institutional framework conducive to private business, where contracts could be enforced and property protected. The development of the financial sector was encouraged through a combination of financial and operational restructuring, privatization, and more effective supervision. Deregulation of pricing and marketing, public enterprise and banking system reform, and privatization were thus important structural components of SAF/ESAF-supported programs. The sequencing of reforms in these areas posed particularly difficult issues.

Fifth, to reorient government spending and restructure revenues. “Government,” if represented by the share of its expenditure in GDP, was not unusually large in ESAF countries, but it was doing many of the wrong things. An excessive portion of government spending was devoted to subsidies for consumers and state-owned firms, wages for inefficient (or, in some cases, nonexistent) civil servants, ill-chosen capital projects, and the military. Programs aimed increasingly to reorient spending from areas with relatively low social and economic rates of return—unproductive spending—to activities with high rates of return, such as primary education and basic health care. Revenue systems to finance these expenditures also needed to be rendered more efficient, through the simplification of tax and tariff structures, a move toward modern tax instruments such as the value-added tax (VAT), and more effective tax and customs administration.

Sixth, to mobilize external resources. A key part of the strategy under the ESAF was to support countries’ reform efforts by temporarily easing the external financing constraint and to move them toward viability in part through reducing reliance on debt-creating inflows and, in some cases, debt burdens. Policies to this end included the clearance of payments arrears, agreements on debt reschedulings and debt relief, a shift to more concessional financing, and a rebuilding of official reserves.

The Setting for Adjustment

Reforms of this scope and magnitude would be challenging in the best of circumstances, and the environment within which policymakers had to implement ESAF-supported programs often complicated their task.

During the late 1980s and early 1990s, most countries had to contend with a sizable deterioration in their terms of trade as they embarked on their first SAF/ESAF-supported programs. The many countries for which tea, coffee, or cocoa was the principal export—almost one-third of all ESAF users—suffered from a 60 percent drop in world beverage prices between 1986 and 1992 (Figure 1). Other nonfuel commodity prices—and, more generally, the growth of demand in ESAF users’ export markets—weakened from 1988 through the industrial country recession of 1991–93.

Figure 1.The External Environment

Sources: International Monetary Fund, International Financial Statistics and World Economic Outlook; and IMF staff estimates.

Roughly one in four ESAF users also experienced severe civil strife or war during the late 1980s and early 1990s, in some cases associated with transition to more pluralistic political systems. In such circumstances, it was difficult to formulate policies, still less to sustain their implementation, and this was a factor contributing to the interruption or breakdown of a number of programs. In addition, many countries suffered from natural disasters during this time, including recurrent drought in sub-Saharan Africa and cyclones and flooding in Bangladesh and Nepal.

On the whole, market conditions improved for ESAF users after 1993. Nonfuel commodity prices (especially beverage prices) and the growth of global demand picked up markedly during 1994–95. At the same time, world energy prices remained subdued, at levels 20–30 percent below their peak in 1990. The prevalence of civil conflict also appeared to diminish in the mid-1990s, albeit with some striking exceptions (Burundi, Pakistan, Sierra Leone, and Sri Lanka). This generally more favorable climate seems to have continued in 1996, and is likely to have contributed to the widespread improvement in growth in ESAF countries during 1994–96.

ESAF countries suffered throughout the adjustment period, however, from restricted access to industrial country markets for key export products—particularly in agriculture, textiles, and clothing. Various international agreements defining market access, and granting preferences in some cases, contributed to segmenting markets and discouraging export diversification. Whether trade barriers were eased or intensified over time for ESAF users is difficult to determine: some preferential trading schemes have been broadened, with liberalizing effects; by contrast, some ESAF countries were adversely affected by increased protection in textiles and agriculture.

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