In the context of Fund-supported adjustment programs, there is now much discussion of growth-oriented adjustment. This involves the integration of traditional short-term adjustment—essentially the correction of external and internal imbalances through aggregate demand management—with longer-term structural measures aimed at stimulating the supply side of the economy. The Fund has been criticized for not paying enough attention to growth; the most common claim is that the fiscal and monetary policy prescriptions that characterize short-term adjustment programs are inimical to growth, and that this reflects inadequate concern. A similar line of reasoning is used by those who argue that the Fund has lacked concern about the social implications of adjustment, and in particular its impact on poverty and inequality.

In the context of Fund-supported adjustment programs, there is now much discussion of growth-oriented adjustment. This involves the integration of traditional short-term adjustment—essentially the correction of external and internal imbalances through aggregate demand management—with longer-term structural measures aimed at stimulating the supply side of the economy. The Fund has been criticized for not paying enough attention to growth; the most common claim is that the fiscal and monetary policy prescriptions that characterize short-term adjustment programs are inimical to growth, and that this reflects inadequate concern. A similar line of reasoning is used by those who argue that the Fund has lacked concern about the social implications of adjustment, and in particular its impact on poverty and inequality.

While the basis for these claims is not entirely unfounded—it is difficult to argue against the proposition that Fund-supported programs have, in several cases, been associated with lower growth and increased poverty and inequality in the short term—it is misleading to attribute this to the pursuit of stabilization at the expense of all other considerations. Rather, it reflects the seriousness of the initial imbalances, the urgency with which balance of payments viability and price stability must be restored, and the mechanisms used to achieve these objectives. Fund-supported programs, even in the most extreme cases, have called for measures that should improve the efficiency of resource allocation. Most notably, an exchange rate depreciation is intended to increase international competitiveness, thus enhancing the prospects for growth. The same is true for many fiscal and monetary policy measures. The problem is that the supply-side effects are slower to emerge than those on the demand side. A short-term Fund-supported program is then associated with demand restraint and any immediate adverse effects this has on growth; it is not linked with the beneficial longer-term impact that supply-side measures have on growth.

It would be less than honest to claim that the current emphasis on growth (and poverty) issues in the Fund is not a response to criticism. There are, however, other relevant considerations. The most important is the impact of the debt crisis. In many of the poorer developing countries, where domestic resources are insufficient to offset the impact of sharply reduced access to external resources and heavy external debt service obligations, the adjustment process would inevitably be slow. It is also clear that fundamental structural adjustments and exceptional assistance are necessary to expand productive capacity, and that the recovery in growth takes time. It is in recognition of this that the Fund has introduced concessional longer-term borrowing facilities for the poorest countries, with programs that emphasize the growth objective and attach considerable importance to structural policies. A longer horizon for these programs provides time for responses to supply-side initiatives, and the resulting growth should allow for a steady reduction in debt burdens.

While a discussion of the link between structural policies and growth does not have to be placed in the context of Fund-supported adjustment programs, it is in this connection that some of the more interesting issues arise. This is especially true where fiscal and monetary policy are concerned, since these are central to traditional adjustment programs. The principal aims of this paper are therefore (i) to describe the characteristics of fiscal and monetary policies directed at influencing domestic demand; (ii) to highlight the channels through which these policies have an impact on growth; and (iii) to examine the nature of fiscal and monetary reforms that would enhance efficiency and growth.


In their most basic form Fund-supported adjustment programs can be viewed as an application of the simple monetary approach to the balance of payments. The objective is to achieve a desired outcome for the balance of payments through controlling the rate of domestic credit expansion. Monetary policy clearly plays the central role in this approach; fiscal policy is only supportive, ensuring that the ceiling on domestic credit expansion is not exceeded because of the need to finance a larger-than-anticipated fiscal deficit.1 In the simple monetary model, nominal income is exogenous. In Fund-supported programs, however, the domestic inflation rate is also a target, and the exchange rate is the additional instrument used to facilitate independent determination of the balance of payments and inflation. Real income is now exogenous; fiscal policy remains supportive.

While the fiscal and monetary policy rules arising out of the monetary model are straightforward, as indicated above, policy prescriptions in Fund-supported programs have tended to be more complex. They are the subject of detailed discussion between country authorities and the Fund, and extend well beyond the domestic credit restraint, fiscal deficit reduction, and exchange rate depreciation that dominate most summary descriptions of the programs. As regards fiscal and monetary policy, typical programs contain agreements with respect to the restructuring of taxation, changing public expenditure priorities, public enterprise reform, reform of the financial system, and interest rate and credit policies. In these areas the focus of attention is not the degree of adjustment embodied in a program but the quality of adjustment, and the most important aspect of quality relates to the growth implications of alternative policy packages.


In terms of the underlying analytical framework, the more recent stress on growth-oriented adjustment attaches greater significance to fiscal policy than the monetary model. Relaxing the assumption of exogenous real output that characterizes the monetary approach has been reflected in efforts to integrate a simple open-economy growth model with the monetary model. A principal implication of this integration is that as a counterpart to the inclusion of growth as an additional target, fiscal policy is assigned the role of ensuring that there is sufficient domestic saving, in general, and public saving, in particular, to guarantee that the investment requirements associated with the growth target are met without threatening the balance of payments and inflation objectives.

While the integrated analytical framework introduces an explicit growth objective, it continues to emphasize in policy terms the role of the fiscal deficit, since this is the difference between public saving and public investment. Public saving and public investment are not, however, the only channels through which fiscal policy affects growth; the structural aspects of public sector activities also have to be considered. A more fully articulated growth-oriented model would allow fiscal (and monetary) policy a more direct role in the output determination process, taking into account the impact of structural reforms. There are, however, problems with pursuing this too far. The behavioral relationships underlying supply-side responses are complex, and the introduction of supply-side considerations would result in considerably more detailed models, which would necessarily be more country-specific and lack general applicability. The relationship between structural policies and growth tends therefore to be focused on separately.

Fiscal Policy and Growth

Before exploring the relationship between fiscal policies and growth in more detail, a few methodological issues need to be addressed. First, the concept of the public sector used in this paper refers to the government (at all levels) and public enterprises. If public enterprises were distinguishable from private enterprises only by their ownership, they could be excluded from the public sector and operations on their behalf omitted from the government accounts. In most meaningful respects, however, public enterprise operations have little in common with practice in the private sector; rather, their activities are inextricably linked to those of the government. Second, the public sector deficit is defined as the difference between public sector revenue (including the investable surplus of public enterprises) and total public expenditure and corresponds to the gap between public saving and public investment. This number, however, captures only one aspect of the public sector's impact on the economy, namely, the extent to which its activities require net borrowing and therefore repayment obligations in the future. This in turn has an impact on monetary conditions, domestic demand, and the balance of payments, both now and in the future. Tracing the implications of the deficit more precisely and, as other circumstances demand, focusing on the separate components of the overall deficit, such as bank financing or private sector borrowing, or alternative deficit concepts, such as the inflation-adjusted deficit and the cyclically corrected deficit, can be more helpful. For this paper, the overall deficit provides an appropriate summary of public sector activities.

A reduction in the public sector deficit—either through an expenditure cut or a tax increase—is consistent with both the balance of payments and inflation targets but could lead to a fall in output, reflecting the reduced fiscal stimulus to the economy. If public sector borrowing has previously crowded out the private sector from financial markets and restricted investment, the reduced public sector claim on available credit and domestic saving will instead crowd in private sector investment. If the reduction in the deficit was not achieved by cuts in productive public investment, the resulting increase in private investment, if it too is productive, will lead to higher growth in the longer term. If private investment is substituted for public investment and the rate of return on private investment exceeds that on public investment, only higher growth will result.

The idea that fiscal policy can be used to release resources to finance additional investment is appealing only insofar as private saving does not adjust to offset changes in public saving. There is a view that money creation and borrowing to finance a deficit are equivalent to taxation. Money creation imposes an inflation tax on holders of money balances, while servicing the debt created by borrowing requires higher taxation or additional money creation at some time in the future. According to the debt neutrality hypothesis, sophisticated taxpayers recognize the equivalence of taxes and debt, and adjust their private savings to offset anticipated future tax changes (including use of the inflation tax). While there may be an element of truth in this argument, the degree of rationality that is necessary for it to hold in its strictest form is unlikely to exist in practice. Evidence suggests at most only a modest degree of substitution.

While reducing the public sector deficit in pursuit of demand-management objectives can lead to an initial reduction in output growth, growth can increase without threatening macroeconomic stability, to the extent that private investment is crowded in by the lower deficit. There are, however, other important channels through which fiscal policy can influence growth. As indicated above, these relate to the structural features of the public sector. Without affecting the public sector deficit, changes in tax policy, expenditure policy, and public enterprise policy can have a potentially significant impact on resource allocation and growth.

Tax Policy

Considerable attention has been focused on the relationship between the structure of taxation and its impact on resource allocation and growth. In particular, the combination of a heavy dependence on a few tax instruments applied at high rates to narrow bases has severely distorted relative prices and economic behavior. For example, many developing countries collect a large share of total revenue from import taxes; but in so doing, protective barriers are raised that promote inefficient import-substituting activities and discourage exports. All taxes for which revenue varies at the margin with the extent of the activity being taxed give rise to similar distortions; moreover, the magnitude of the distortion increases more than proportionately with the tax rate. A significant part of the problem stems from inadequate administrative capabilities, which limit the range of feasible tax instruments. Administrative weaknesses also admit widespread avoidance and evasion, which usually have adverse distributional consequences. The challenge for tax policy is to design tax structures that are administratively feasible, raise sufficient revenue, are equitable, and minimize distortions.

The scope for tax reform varies from country to country, depending on the nature of the initial tax system, administrative constraints, and the government's social and economic priorities. Some general conclusions about the appropriate direction of tax reform in developing countries can nevertheless be drawn, based on accumulated experience. To reduce tax rates and so minimize distortions, the tax base should be as broad as possible. As much economic activity as possible should be brought into the tax net, and tax exemptions should be given in only the most compelling cases. A special effort should be made to ensure that relatively fast-growing sectors are effectively taxed, since this, in combination with administrative reforms that reduce collection lags, will provide for an elastic tax system. A high tax elasticity minimizes the need for frequent discretionary tax measures to prevent tax revenue growth falling behind that of public expenditure.

Commodity taxation should be a major revenue source. A broad-based tax on final consumption, such as a sales or value-added tax, levied at a single rate to ensure neutrality (i.e., to minimize distortions to consumer prices owing to taxation) is most desirable.2 This tax should apply equally to domestically produced and imported goods, and all inputs should be free of tax. Where raw materials, intermediate goods, and capital are not relieved of tax—as in the case of a turnover tax—final taxation is unrelated to the value of output, but depends more on the structure of production; this can lead to inefficient production decisions. While the consumption tax should ideally apply at the retail stage, a full-fledged consumption tax requires a degree of administrative sophistication that we only begin to find in middle-income developing countries. Administrative considerations might therefore dictate that the consumption tax be restricted to the manufacturing stage. Similar considerations may also preclude the taxation of more atomistic sectors, such as agriculture, small-scale business, and services; consideration could, however, be given to imposing a minimum tax on these activities. A case can be made for levying heavier taxes on certain sumptuary and luxury items, where practical, at ad valorem rates to prevent the erosion of revenue through inflation. The resulting non-neutrality can be justified by reference both to the benefits of discouraging excess consumption of alcohol, tobacco, petroleum, etc. and the equity of taxing purchases of consumer durables, jewelry, and other conspicuous consumption items.

Trade taxes typically call for extensive reform in developing countries. Import taxes should be set only with a view to establishing a desirable level and pattern of effective protection, which will in general imply a significant reduction in the general level of tariff protection and a much reduced dispersion of rates. Since this will lead to large revenue losses in many cases, the appropriate offset is an increase in general consumption taxes. Many countries levy export taxes, especially on major agricultural products. Since these are a disincentive to exports—and given the strong link between exports and growth—they should in general be eliminated. An exception could arise where it is administratively difficult to tax agricultural incomes, and land taxation is impractical. In such circumstances, an export tax may be a reasonable proxy for a tax on farmers’ incomes. It should, however, be accompanied by a presumptive tax on the rest of the agricultural sector to preserve equity.

Personal income taxes present something of a problem in a developing country tax structure. Their primary objective is redistributional. But because they tend to be more difficult to administer than consumption taxes, their base is often dominated by less well-paid public sector employees and the wage bills of larger private sector companies. At the same time, high rates are usually associated with disincentives to work and, in many cases, to save, as well as evasion and avoidance. Equity objectives are therefore not well served. A better structure would feature a large exemption, so that many low-income workers do not pay tax, with low and at most mildly progressive rates. Tax bands should be indexed to ensure that taxpayers are not exposed to higher tax rates simply as a result of inflation. While incentives and compliance should improve, the combination of the large exemption and a fairly flat rate structure would still result in significant redistribution. However, the overall effectiveness of such reforms would critically depend on establishing the administrative capability to ensure that most income is reported to the revenue authorities and that tax is actually collected. In the latter regard, tax withholding has considerable administrative disadvantages.

Since companies are indistinguishable from their owners, an effective personal income tax—where all corporate profit is allocated to shareholders—would appear to eliminate the need for a separate company tax. Such taxes are nevertheless commonplace. One explanation for this concerns the administrative problems involved in taxing the profit of international companies effectively under a personal income tax. Another justification for company taxation—more applicable in developing countries than elsewhere—is that since personal income is difficult to tax, it is better to levy tax at the corporate level. One problem with a company tax, however, is that it tends to fall not only on the returns to investment but also on investment itself. This is because existing systems of depreciation and other investment allowances tend to result in only partial relief of investment from tax. Taxing investment, even in part, probably reduces the amount undertaken, and the method of taxation certainly distorts investment decisions. In principle, the full expensing (or free depreciation) eliminates the tax disincentive to investment and is nondistortionary. But given that it also reduces revenue significantly compared with existing arrangements, a compromise is to raise initial depreciation allowances, apply them uniformly across investments and sectors, and eliminate all other allowances.

Tax systems of developing countries often also comprise taxes levied on land, wealth, and capital transfers. These taxes are often complex to administer and easy to avoid or evade; this is reflected in low revenue yields. As such, these taxes are little more than a nuisance, and their elimination would be appropriate; however, where they can be administered effectively and compliance is not a problem, not only might such taxes perform a useful function in their own right (for example, where wealth is unevenly distributed) but they may also be a reasonable proxy for more difficult to administer income taxes.

Expenditure Policy

Public expenditure can contribute to the growth process through a number of channels. The public sector can undertake large-scale investment, such as infrastructure projects, that are beyond the scope of private investors; it provides social goods like education and health that raise the stock of human capital and its productivity; and it more generally provides or subsidizes the production of a wide range of goods and services that can contribute to economic, political, and social stability and thereby enhance the prospects for investment and growth. The body of knowledge on the desirable direction for expenditure reform has not, however, produced a cohesive package of reforms similar to that described above in the case of tax policy. But, again, experience suggests the desirability of certain structural changes.

Of paramount importance in encouraging growth is a good public investment program. Current expenditure is not necessarily the principal source of inefficiency in expenditure as often claimed, and the frequent call for protection of capital investment in many cases preserves wasteful projects. Since capital expenditure is usually more import-intensive than current expenditure, an inefficient investment program can be especially costly. Effort should therefore be made to ensure that the public investment program comprises high quality projects that are justifiable on economic grounds, taking due account of social objectives. Public investment expenditure should also be supported by sufficient funds for the appropriate operation and maintenance of new investment. Effective operation and maintenance activities also increase the productivity and longevity of the existing capital stock.

As regards other categories of current expenditure, wage levels should be adequate to guarantee that the public sector can retain the quality of manpower it needs and to discourage employees from taking second jobs and engaging in fraudulent activities to increase their incomes. Particular attention should be paid to maintaining performance incentives through appropriate pay differentials. Materials and supplies must also be sufficient to ensure that public employees can function efficiently. Insofar as possible, however, less productive expenditure should continue to be eliminated. Moreover, to the extent that the objectives of a particular expenditure program can be met more efficiently, for example, by targeting expenditure more directly at beneficiaries or substituting one form of expenditure for another, this should be pursued. In this connection, spending on subsidies warrants special attention. Although in many cases subsidies can be easily justified, there are numerous examples of expensive subsidies with no economic and social justification.

Public Enterprise Policy

The operations of nonfinancial public enterprises have been a major source of weakness in the public finances of many countries. A number of factors have contributed to their poor performance. These include complex bureaucratic relations between the government and public enterprises; the need to pursue a wide range of social and other noneconomic objectives; the protected monopoly status of many enterprises; administrative control of public enterprise prices; powerful trade unions; and the ready willingness of the government to cover public enterprise losses. In this environment, public enterprises have emerged as typically inefficient producers relying heavily on budget subsidies. They tend to be overmanned with wage levels significantly out of line with productivity, the quality of management is often poor, investment decisions are not made using economic criteria, capacity utilization is low, and prices are out of line with international prices.

While the problems associated with public enterprises are widely recognized, effective solutions have been slow to emerge. Moreover, the time lag between implementation and response is particularly long. However, the identification of the sources of poor public enterprise performance points to the principal elements of a reform strategy. In particular, emphasis should be placed on freeing public enterprise management from political and ministerial interference, giving them greater autonomy over pricing and investment decisions, and letting them pursue clearly specified objectives. In many cases, major efficiency gains can be expected from exposing enterprises to competition and, where it serves the promotion of competition, privatizing enterprises. Even in those cases where public monopoly is inevitable—for example, in markets where average costs are continuously decreasing—particular activities can still be contracted out to the private sector. It is critical that the government provide financial support for public enterprises on a selective basis only, primarily where compelling noneconomic objectives prevent efficient enterprises from making a profit. Enterprises that are expected to operate commercially but cannot survive in a competitive environment should certainly be liquidated.

The above summary of a public sector reform strategy consistent with more efficient resource allocation and higher growth is highly selective, focusing on the key structural changes. From this brief description, it should be clear that the reforms discussed represent a major dislocation and could create much political difficulty. They also have the potential to frustrate stabilization objectives, especially in the short term. Many of the tax measures may initially reduce revenue—for example, tariff reform, the elimination of export taxes, and higher investment allowances—but offer the prospect of higher growth and additional revenue in the future. Similarly, many expenditure measures may increase spending—for example, wage restructuring, improving operations and maintenance, and severance payments associated with reducing overmanning in public enterprises—but will improve efficiency in the longer term. This should not, however, be taken to imply that the fiscal deficit ought not to be reduced in the short term. Rather, the growth objective should play a larger role than before in determining how fiscal adjustment is achieved. Sound demand management policy is essential both to the creation of investor confidence and the maintenance of credibility on international capital markets that ensures the external resource availability essential to growth.


Monetary policy is primarily concerned with controlling inflation and achieving a sustainable balance of payments; and in this connection, it needs to be closely coordinated with fiscal policy. Without fiscal discipline, the stabilization role of monetary policy is limited. As with fiscal policy, in a stabilization role monetary policy supports growth. Monetary impulses also have a direct effect on output. Thus the credit restraint that characterizes Fund-supported programs is often associated with some reduction in output growth in the short term, although the effect of credit restraint is difficult to disentangle from that of the fiscal contraction, which it usually accompanies. In addition, the structural characteristics of the financial system—like the structure of taxation, expenditure, and the public enterprise sector—have a longer-term influence on resource allocation and growth.

In many developing countries, the financial system is characterized by a highly oligopolistic banking sector and pervasive interest rate and credit controls that are used to promote investment, develop priority sectors, and provide low-cost finance to the public sector. These controls have often resulted in an inefficient allocation of financial resources and low savings, which have impeded investment and growth. Moreover, such controls tend to be undermined over time as unregulated financial markets proliferate, which severely limits the ability of monetary policy to achieve stabilization objectives. Financial reform can play a role in structural adjustment and growth over the medium term by promoting the development of financial markets and by increasing the reliance on market-determined interest rates and credit allocation mechanisms. The effectiveness of monetary policy may also be enhanced as a result.

Financial Reform

A principal objective of financial reform is to foster a more efficient allocation of financial resources and to mobilize savings through increasing financial intermediation and promoting competition in the financial sector. Financial reform is often part of a broader economic liberalization that emphasizes a greater role for market forces. More extensive financial intermediation typically involves increasing both access to money and capital market institutions and the range of financial instruments. While new markets and new instruments can be created in a heavily controlled system, savings mobilization has tended to be more responsive to market-based developments. Nevertheless, the government can be a catalyst in developing financial markets, for example, through primary issues of government and central bank paper and by making greater use of the central bank's rediscount window for monetary management.

A first step in any financial reform should be the removal of regulations that inhibit competition and a lifting of barriers to entry and exit. Total deregulation is not the objective. Government intervention will remain necessary to ensure the smooth functioning of the financial system—for example, government responsibilities for bank supervision cannot be relinquished. Indeed, liberalization will probably require more effective regulation directed toward preventing incumbent institutions from exploiting existing monopoly positions and ensuring that appropriate prudential standards are observed. The objective is to rationalize the extent and form of government intervention. In a competitive financial system, new markets and new instruments will emerge in response to signals given by savers and investors. This assumes, however, that the price mechanism provides appropriate signals.

Interest Rate and Credit Policy

Competitive interest rates would be differentiated to reflect the maturity of loans (or the associated investments), and the associated risk of credit would flow into what are judged to be the most profitable investments. Pervasive interest rate and credit controls prevent this from happening. Financial systems in developing countries are characterized by direct control of interest rates, in the form of entirely administered rates or binding ceilings; bank credit ceilings; selective credit controls and preferential central bank refinance facilities to direct credit to priority sectors; or high reserve and liquid asset requirements designed to absorb liquidity and to finance the fiscal deficit.

Removing interest rate and credit controls is essential to financial reform. It cannot be undertaken independently of more general financial liberalization. For example, raising interest rates in an uncompetitive financial system may result only in wider margins for existing institutions. Similarly, with binding credit ceilings—which cause excess liquidity in the banking system and discourage deposit taking—higher interest rates may have little impact on savings. Market-oriented interest rates, the elimination of credit controls, and the promotion of competition in the financial sector together provide the appropriate incentives for saving, investment, and growth. This does not, however, preclude a phased approach to reform. Rather, it suggests that the elements of a phased reform package need to be mutually supporting.

Monetary Control

As a result of financial reform, monetary control will also become more market oriented. Direct instruments of monetary control will be replaced by indirect instruments. In essence, the monetary authority will control the stock of reserve money, and hence money market interest rates. Deposit and lending rates, together with the allocation of credit, will be determined by the market. At the same time, the relationship between money and credit, interest rates, and output are a reflection of institutional arrangements. Financial reform will change these arrangements, with implications for money demand elasticities, the money multiplier, and other parameters that influence monetary policy and its impact. The shift in the underlying determinants of money demand and money supply will render monetary control less precise in the short run; however, in the longer term—once new relationships have been established—market-based monetary control exercised at the level of the central bank's balance sheet will allow more effective targeting of inflation and balance of payments objectives.


Three countries in Southeast Asia—Korea, Thailand, and the Philippines—have implemented. Fund-supported adjustment programs during the 1980s. Korea has achieved enormous success (Table 1). Following a period of high inflation and very low output growth in the late 1970s, the authorities implemented a comprehensive adjustment program, while maintaining the emphasis on export-led growth. Growth in the 1981–88 period averaged nearly 10 percent annually, and inflation subsided from nearly 30 percent in 1980 to around 7 percent in 1988. The external payments position exhibited significant improvement: the current account moved from a deficit of nearly $5 billion in 1980–81 to a surplus of almost $14 billion in 1988. The fiscal deficit widened relative to gross domestic product (GDP) in the early years of adjustment, reflecting increases in capital expenditure on education, housing, and energy. Between 1983 and 1988, however, the deficit averaged less than ½ of 1 percent of GDP, primarily because of tight control over current expenditure. The evolution of domestic credit reflects the objectives of supporting the growth momentum and containing inflation. Financial sector reforms and the shift to high and positive real interest rates have led to a steady increase in the ratio of financial savings to GDP.

Table 1.

Korea: Adjustment and Growth, 1980–88

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Sources: International Monetary Fund, International Financial Statistics and Government Finance Statistics, various issues: and Fund staff estimates

Percentage change in the period average consumer price index (CPI).

Excludes certificates of deposit.

Financial savings defined as broad money less currency in circulation.

Maximum rate on time deposits of duration one year or more.

Based on actual inflation.

A marked deterioration in public finances, owing in part to an ambitious public investment program, and adverse developments in Thailand's external environment, including the 1979 oil price increase, led to an unsustainable buildup of external imbalances and debt (Table 2). Despite several years of adjustment effort in the early 1980s, which met with some success, Thailand's external situation remained weak. Following the implementation of the adjustment program beginning in 1985, and reflecting favorable external developments, Thailand's situation improved considerably. Although it is difficult to discern clear trends in growth, as in the case of Korea, real growth has been strong in the second half of the 1980s and inflation considerably lower and more stable than in the early 1980s. Fiscal imbalances, however, remained large despite a significant improvement in tax effort, owing largely to the increasing current expenditure. The more recent reduction in the deficit reflects not only measures to increase revenue and contain current expenditure but also the cutting back of capital spending. Interest rate policy and financial sector reforms have been successful in generating a steady and marked increase in the ratio of financial savings to GDP during the 1980s.

Table 2.

Thailand: Adjustment and Growth, 1980–88

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Sources: International Monetary Fund. International Financial Statistics and Government Finance Statistics, various issues: and Fund staff estimates

Percentage change in the period average consumer price index (CPI).

Financial savings are defined as broad money less currency in circulation.

Maximum rate offered by commercial banks on deposits of from three to six months.

Based on actual inflation.

The Philippines has had a series of stand-by arrangements covering almost the entire 1980s. The evidence of balanced and sustained growth has not emerged as clearly, however, as in the case of Korea or even Thailand (Table 3). The performance of growth and inflation has fluctuated considerably during this period. The adjustment efforts in 1984–85 were largely concerned with macroeconomic stabilization—the reduction in explosive inflation rates and the restoration of normal external financial relations. The major recession that followed is, in large part, attributable to the disruptions following the crisis in late 1983, reduced access to external credit, and the collapse of investor confidence. The 1986–88 program focused on stable macroeconomic policies, together with widespread structural reforms, and has been successful in increasing efficient private sector investment, improving the external payments position, lowering inflation, and restoring growth. Fiscal imbalances, measured by both the national government deficit and the consolidated public sector deficit, were reduced in the mid-1980s, mainly through reductions in capital expenditure. Interest rates are market determined in the Philippines, responding to developments in both international and domestic financial markets and changes in the monetary policy stance. Real interest rates have exhibited considerable variation over the period, reflecting movements in the inflation rate and the fact that nominal rates lagged behind inflation. The ratio of financial savings to GDP has changed little, reflecting, in part, the onset of the internal and external financial crises of late 1983 and the subsequent decline in confidence in the financial system, and the implicit tax on financial intermediation resulting from the large increase in reserve requirements in 1984.

Table 3.

Philippines: Adjustment and Growth, 1980–88

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Sources: International Monetary Fund. International Financial Statistics and Government Finance Statistics, various issues: and Fund staff estimates.

Percentage change in the period average consumer price index (CPI).

The consolidated public sector deficit is not available prior to 1983. It includes nonfinancial and financial institutions, including the Central Bank.

Financial savings defined as broad money less currency in circulation.

Rate on 61-to-90-day time deposits.

Based on actual inflation.

The lessons that can be learned from the experiences of Korea, Thailand, and the Philippines are limited. While the adjustment programs in each of these countries contained significant elements of structural reform in the fiscal and monetary spheres, the contribution of this to growth performance is difficult to discern (Table 4). This is especially so in the case of fiscal policy, where sometimes temporary changes necessitated by stabilization objectives—ad hoc tax increases and cuts in current and capital spending—did not help growth. Certainly for Korea and Thailand, it can reasonably be claimed that structural changes in the external sector—and in particular trade liberalization in Korea and devaluation in Thailand—have contributed greatly to growth through the promotion of the export sector. In both cases, it is clear that sound monetary and fiscal policies have contributed to an environment that has facilitated structural change, and that this has encouraged growth. In the Philippines, the most recent adjustment efforts, which have been based on more stable macroeconomic policies and far-reaching structural reforms, have already begun to yield similar benefits.

Table 4.

Fund-Supported Programs in Korea, Thailand, and the Philippines

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This paper has described the contribution structural reforms in the areas of fiscal and monetary policy can make to growth-oriented adjustment. In principle, there appears to be a much-expanded role for fiscal policy compared with less ambitious adjustment strategies. While the focus of monetary policy should continue to be stabilization, there is scope nonetheless for structural change to enhance efficiency, although this is likely to be less influential than fiscal reform.

The set of reforms described in the paper is not intended to be exhaustive. Moreover, while the reforms are derived from principles that are probably of general applicability, it should be emphasized that the precise package of reforms that can most successfully foster improved resource allocation and growth is very much dependent on the circumstances of the country in question.

Lastly, it should be borne in mind that the empirical support for the suggested reforms is not overwhelming. While in many cases such reforms have been successfully implemented, there is a risk that they may not have their intended effect, or at least that any impact will be much less than expected. The economic principles that point to their beneficial consequences are not natural laws; they are simply the best basis for reform that we currently have.



The International Monetary Fund has received widespread criticism over the years concerning policy prescriptions it has made for member countries. Partly as a reaction to these criticisms, and partly through its own experience, the emphasis of its policy recommendations appears to be shifting toward greater attention to growth.

The paper prepared by Messrs. Hemming and Kochhar, it would not be an exaggeration to say, offers a comprehensive and unbiased treatment of the role of fiscal and monetary policy in growth-oriented adjustment.

In general, monetary policy and exchange rate policy are the major players in short-term balance of payments adjustment, with fiscal policy playing a supportive role; whereas when it comes to long-term growth-oriented adjustment, fiscal measures can assume a prominent role, together with other structural adjustment measures. Monetary measures will help to improve the efficiency of resource allocation and expand productive capacity.

I also agree completely with the paper's conclusion that the precise package of reforms that can most successfully foster improved resource allocation and growth is very much dependent on the circumstances of the country in question.

My comments will address three areas: first, some of the specific policy issues raised in the paper; second, the experience of Thailand; and third, other ingredients of successful growth-oriented adjustment.


In the discussion of tax policy, one of the recommendations made is that commodity taxation should be the major source of revenue. In principle this is desirable. Whether and to what extent it is feasible, however, is another matter, particularly for poorer countries. As these countries usually produce only a few commodities, and the majority of the population relies on these few commodities for income, it may not be possible to prevent the tax incidence from falling on the poor farmer, notwithstanding the fact that the tax may be collected at the final consumption stage or at the wholesale stage. When this happens, the principle of equity may not be achieved.

In countries where it is not practicable to impose a value-added tax, direct taxation may be the next best choice insofar as revenue raising is concerned. This is because in poor countries, it may not be so undesirable for the tax burden to fall on persons with fixed incomes, since these people will generally be in a higher revenue bracket than the large majority, who are farmers. Taxes on property should also not be completely overlooked, though this is usually not politically feasible in poor countries.

On the question of government expenditure, the paper correctly encourages strict control of capital expenditure in order to limit investments to efficient activities that truly contribute to economic growth. Here, there seems to be some scope for increased cooperation between the Fund and the World Bank. Besides financial assistance, the latter could provide technical assistance in order to help ensure that government capital expenditure is used efficiently and leads to balanced growth.

Current expenditure may merit somewhat more attention. One of the reasons for overspending by the government may be the attempt by bureaucrats to extend their “domain,” for example, by increasing their agency's staff. This leads to overstaffing and inefficiency and makes it difficult to control current expenditures.

Spending on subsidies, the paper correctly asserts, warrants special attention. It would be interesting to see a discussion on the pros and cons of transparency—subsidies provided in budget allocations are more easily amenable to evaluation of costs and benefits—as opposed to hidden subsidies, for example, those indirectly implemented through the financial system, such as in the form of regulatory provisions. In the latter case, it is difficult to ascertain whether or not the benefit falls on the target group, and who is bearing the brunt of the burden. Where the central bank is the provider of a subsidy, economic stability may suffer; that is, in effect, an inflation tax is imposed. In discussions of adjustment programs, the relevant authorities should be alerted to these issues.

It is a standard prescription that interest rate policy should be implemented in a flexible manner. How effective positive real interest rates can be in promoting adjustment, however, depends greatly on the structure of financial markets. Thailand's experience is that when interest rate flexibility was increased, the downward rigidity of interest rates inherent in the financial system gave rise to a sustained period of high real interest rates. Despite an ensuing economic downturn, businesses continued to have to put up with high interest rates, to the detriment of both the debtor businesses and their financial institution creditors. In some cases, some intervention may therefore be necessary, for example, in the form of timely adjustments of ceiling interest rates. The lesson here is that liberalization of interest rate policy may need to be implemented step by step.

On the subject of deposit insurance, attractiveness is at present much diluted by the problems currently being faced by the often-quoted model, the deposit insurance scheme in the United States.


Thailand's long-term policy objective has always been sustained economic growth, that is, growth with stability and an appropriate income distribution. The authorities have used both stabilization and structural adjustment policies to help the country cope with continually changing world economic conditions. This does not mean that the policy measures used by Thailand are universally applicable. The policy mix and timing of implementation must be adjusted to the circumstances of each country.


A combination of adverse economic factors and serious weakness in domestic policies began threatening the stable growth of the Thai economy in the late 1970s. The former comprised the second oil shock in 1979, weakening demand for traditional Thai exports, and high international interest rates. The rising U.S. dollar, to which the baht was pegged, made Thai exports less and less competitive during 1983–84. Agricultural production stagnated owing to land shortage, low production efficiency, and inadequate incentives. The industrial sector was distorted owing to a strategy which, since the mid-1970s, encouraged import substitution under a heavy shield of protection and discouraged nontraditional exports. Government revenues were low, with 80 percent consisting of indirect taxes; state enterprises had large deficits; and price distortions led to excessive use of imported oil when international prices were soaring. Domestic inflation reached almost 20 percent in 1979, and the current account was almost 7 percent of GDP in 1979–81. International reserves fell and external debt climbed.

Various measures were subsequently introduced underpinned by financial assistance from abroad, particularly the IMF's Trust Fund, various stand-by programs, and two structural adjustment loans from the World Bank.

Policy Implementation

A wide range of measures were simultaneously adopted. To stabilize the economy, improvement in the Government's fiscal position was accomplished by improving public sector expenditure management, increasing tax revenue, improving the tax structure,1 and strengthening the planning and implementation stages of tax administration. New initiatives were launched in state enterprise finances: public utility rates were raised, investment programs were scaled down, and monitoring systems were set up.

Restrictive monetary policy was adopted in 1980–82 and again in 1984–85. The Thai baht was devalued by 8.7 percent in 1981 and again by 14.8 percent in 1984 when it was also floated with a basket of currencies. A committee was set up to oversee official external debt policy, and restrictive annual ceilings were placed on new borrowing commitments.

Structural measures were also taken. To reduce demand for energy, domestic oil prices were adjusted upward to reflect costs. Conservation measures and domestic and alternative energy sources were introduced. Through fiscal measures, the trade system was liberalized to strengthen export development. Price controls on various commodities were lifted, in order to eliminate distortions that impeded the efficient working of market forces. Financial assistance was given by the central bank to promote exports. Various privileges were given by the Board of Investment to promote manufacturing activities. In agriculture, modern technology was gradually adopted and crop diversification promoted. Concessional agricultural credit and cheap fertilizer were made available. Commercial banks were encouraged to pay more attention to rural lending. The financial sector was completely overhauled through new legislation and guidance by authorities. Interest rates were made more flexible to reflect global trends.


Thailand experienced a slowdown of economic activities during 1985–86 owing partly to domestic stabilization measures and partly to global recession. The degree of setback, however, was not very severe. Even at its slowest, real gross domestic product managed to grow at not less than the 3.5 percent attained in 1985. A decline in oil prices and global interest rates in 1986 helped to start the turnaround of the Thai economy. Recovery began in 1987, led primarily by manufacturing exports, which were in turn supported by exchange rate policy, a more liberal export regime, and increased promotion efforts. Inflation averaged under 2 percent during 1984–87, the current account enjoyed a small surplus in 1986, and the external debt/service ratio fell sharply from the almost 23 percent peak in 1985 to under 13 percent currently.


From the lesson of Thailand, the only thing that can be concluded is that comprehensive policy packages are necessary for growth-oriented adjustment. It cannot, however, be concluded that a comprehensive package is sufficient for growth-oriented adjustment. In Thailand's case, external factors have played a crucial role in its economic woes and achievements. For example, the problems of the early 1980s were partly due to high oil prices, high global interest rates, sluggish demand for commodities by industrial countries, and the unrelenting appreciation of the U.S. dollar. Subsequent improvement, besides being due to stabilization and structural adjustment measures adopted by the authorities, was helped by lower oil prices, lower international interest rates, global economic recovery, and the downturn of the U.S. dollar. Furthermore, Thailand has vast natural resources, an adaptable and inexpensive labor force, and a multitude of entrepreneurs who are responsive to external developments. Last but not least, the Government had the political will to painstakingly follow through the adjustment program that had been mapped out. This firm commitment on the part of the Government is a prerequisite to any such accomplishment.


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The paper has benefited from comments by Vito Tanzi, Alan A. Tait, Peter S. Heller, G. A. Mackenzie, and R. Barry Johnston. The seminar discussant, Tanya Sirivedhin of the Bank of Thailand, also provided valuable comments. David Goldsbrough, Louis D. Dicks-Mireaux, and Juha S. Kahkonen assisted in the preparation of the section on adjustment.


This distinction is blurred when domestic credit is largely a function of the fiscal deficit; in extreme cases (i.e., the West African Monetary Union), fiscal policy is dominant and monetary policy is passive.


Uniform commodity taxation contrasts with the structure that minimizes all distortions—including the choice between consumption and leisure—which implies taxes that reduce demand for all commodities in the same proportion. The administrative arguments against such taxes are formidable, however.


For example, restructuring and reducing personal income taxes (from 65 to 55 percent maximum), reducing corporate income tax (from 40 to 35 percent), and revising taxes on revenues from various financial instruments to promote saving. Introduction of a value-added tax is still in the pipeline as is a restructuring of the import tariff structure.