A financial program is a comprehensive set of policy measures designed to achieve a given set of macroeconomic goals. These goals could simply be to maintain a given level of economic performance. More often, however, the policies are designed to eliminate disequilibrium between aggregate domestic demand and supply, which typically manifests itself in balance of payments problems, rising inflation, and low output growth.

Nature of Financial Programming

A financial program is a comprehensive set of policy measures designed to achieve a given set of macroeconomic goals. These goals could simply be to maintain a given level of economic performance. More often, however, the policies are designed to eliminate disequilibrium between aggregate domestic demand and supply, which typically manifests itself in balance of payments problems, rising inflation, and low output growth.

The term “financial program” is commonly used to describe adjustment programs which support use of Fund resources, but may also be applied in the absence of a Fund arrangement. It emphasizes the importance of monetary, fiscal, and exchange rate policies in controlling domestic demand and correcting balance of payments disequilibria. In addition—as a practical consideration—financial data to monitor the implementation of such policies are typically available on a more timely basis than other economic data. However, it should be underscored that financial programs also incorporate the effects of other policy instruments, most prominently those aimed at increasing aggregate supply.

Where macroeconomic imbalances exist, some form of correction (or adjustment) will ultimately be necessary in order to bring claims on resources in line with those available. If deliberate policy actions are not taken, the adjustment is likely to be disorderly and inefficient. For example, reserves may be depleted and creditors may become unwilling to lend further to a country. A drastic cut in imports could ensue, with consequent negative effects on economic growth and welfare. The distinguishing feature of a financial program is that it seeks to achieve an orderly adjustment, through the early adoption of corrective policy measures, and through the provision of appropriate amounts of external financing. This should minimize losses in output and employment during the adjustment period while eventually leading to a balance of payments position that is sustainable.

Sustainability of the balance of payments may be assessed with reference to the evolution of the external current account balance over the medium term. While circumstances may vary from one country to another, in general terms it may be said that a sustainable current account position is one that can be financed on a lasting basis with the expected capital inflows and which, at the same time, is consistent with adequate growth, price stability, and the country’s ability to service fully its external debt servicing obligations.

A financial program thus needs to be set in a forward looking time framework. The concept of medium-term is not a rigid one; medium-term scenarios have generally considered a time horizon of at least five years. Typically, programs for the forthcoming year are worked out in considerable detail because of the more imminent need to formulate a comprehensive package of policy measures and the more readily available and reliable information. Forecasts of the more distant years are less detailed, often focusing on the broad implications for external adjustment, and are by their nature less certain.

A Basic Financial Programming Framework 1/

An integrated system of macroeconomic accounts, as described in Chapter II, covering national income and expenditure, as well as financial flows and associated stocks, is essential in the construction of financial programs. These accounts provide the information needed to assess the performance of the economy and the need for policy adjustment. They also provide a framework and consistency checks for policy analysis. The accounting relationships in the framework highlight the fact that any sector’s spending beyond its income must be financed by the savings of other sectors, and that such excess spending by an entire economy is possible only when financed from external sources.

To be of interest to policy makers, the accounting framework must be complemented by the specification of a set of behavioral relationships. These relations indicate the typical reaction or response of some of the variables included in the accounting framework to changes in other variables. These behavioral relationships together with the accounting identities form a schematic quantitative representation, or “model”, of the relevant economic processes. This framework can be used to assess the changes in policy variables, i.e., variables that are under the authorities’ control, needed to achieve given policy objectives for such variables as inflation and the balance of payments, which are endogenously determined.

The design of programs is subject to many uncertainties and difficulties. Behavioral relationships may be difficult to identify and estimate with any precision and they may vary across countries and over time depending on institutional, political, and other factors. Moreover, when major policy shifts and structural reforms are being undertaken, behavior in the post-reform period may differ greatly from historical patterns. Analysis may be further complicated by problems of assessing the timing of policy effects, the impact of expectations on behavioral responses, and the interrelations among measures in complex policy packages. Finally, assumed changes in exogenous variables, which are determined independently of the processes illustrated in the model, may prove to be incorrect.

Policy Content of Programs

Discussion of the policy options can be framed around two accounting identities discussed in Chapter II. Specifically:





GDI = gross national disposable income

A = domestic absorption, i.e., residents’ expenditure on domestic and foreign goods and services

CA = external current account balance

ΔFI = net capital inflows

ΔR = the change in net official international reserves

Equation (1) indicates that an improvement in the external current account balance requires either an increase in a country’s output or a reduction in its expenditure. Accordingly, adjustment policies may aim to increase output and reduce domestic expenditure to allow a greater proportion of output to be devoted to exports and a lower proportion of expenditures to imports.

Equation (2) is the balance of payments identity: any excess of absorption over income, as reflected in a current account deficit, must be financed either by capital inflows or a drawdown of reserves.

1. Demand management policies

Demand management policies primarily aim at reducing domestic demand (or absorption) when an external current account deficit and/or inflationary pressures need to be reduced. These primarily comprise monetary, fiscal and incomes policies, but other measures such as an exchange rate devaluation may also include expenditure reducing elements.

In many instances the source of excess domestic demand is the fiscal sector. A combination of a reduction in public sector outlays and an increase in revenues may be called for. However, simple measures of the government’s overall balance may not give adequate indication of the demand effects of fiscal policy. In particular, how the overall balance is financed is important in determining program impact.

Domestic absorption can also be dampened by restraining monetary aggregates—for example, by introducing measures to change the volume of credit extended to the private sector and/or the public sector. Monetary and fiscal policies are linked to the extent that the banking system provides net financing (whether positive or negative) to the public sector. For example, a narrowing of the public sector deficit that reduces the need for bank financing (or increases recourse to nonbank financing of a given deficit) will directly affect the balance sheet of the banking system. Other things being equal, this would result in a decline in monetary aggregates.

2. Expenditure-switching policies

Many programs seek to complement reductions in absorption by expenditure-switching measures and, in particular, exchange rate policy. By changing the relative price of foreign and domestic goods facing both residents and nonresidents—i.e., from a resident’s perspective, increasing the price of a country’s exports and imports relative to the price of domestic goods—an exchange rate devaluation aims to: (1) increase the global demand for domestic goods and services while reducing residents’ domestic absorption by discouraging imports, and (2) from the supply side, raise incentives to produce goods for export or that compete with imports. By redirecting output from domestic absorption to the external sector, the negative effects of demand restraint on output can be minimized.

Other examples of expenditure-switching policies include removal of price controls and quantitative trade restrictions.

3. Structural policies

Structural policies aim at the enhancement of supply to close the absorption-output gap. These may be broadly divided into: (1) policies designed to raise output from existing resources through increased allocative efficiency; and (2) policies to expand the productive capacity of the economy. While in practice it is difficult to distinguish policies serving these two purposes, conceptually one can think of the former category including all measures to reduce the distortions that drive a wedge between prices and marginal cost. Such distortions can arise, for example, from price controls, imperfect competition, taxes and subsidies, and trade and exchange restrictions.

Increases in capacity require policies that encourage investment and savings. Examples include maintaining realistic interest rates, reducing fiscal deficits, reallocating fiscal expenditures toward activity with the strongest benefits for growth and economic development, and policies that tend to guide new resources to investments with the highest rates of return. By their nature, substantial time may be needed for structural policies to show results.

4. Financing options

The ability to attract capital inflows to sustain an external current account deficit without running into debt service problems depends, among other things, on the judgment of creditors as to the creditworthiness of the country and how efficiently the borrowed funds are used. In particular, if foreign borrowing is used to finance investments which generate sufficient returns to finance the repayment of such funds, then debt servicing problems should not arise. Debt servicing problems, however, may be expected when resources are used inefficiently or to support domestic consumption only. In addition, changes in world economic conditions may significantly affect the availability and affordability of funds. For example, rising interest rates in the early 1980s exacerbated the debt servicing difficulties experienced by many developing countries.

Considerations relating to external debt management have become an increasingly important part of program design. Key debt relationships need to be monitored on a medium-term basis, under alternative assumptions about the country’s own policies and the behavior of the external environment, including interest rates. Development of such medium-term scenarios has represented an important aspect of the Fund’s work in stabilization programs.

Financing may also take the form of a reduction in international reserves. However such possibilities are limited by the size of the initial stock of reserves.

In addition to the above sources of voluntary external financing, in extreme circumstances some countries may finance external deficits by accumulating arrears. Arrears, however, constitute payment restrictions and are therefore contrary to Fund policies. In addition, they undermine creditor confidence and, therefore, complicate relations with external creditors.

Policies, to be effective, need to be constructed and implemented in a mutually supportive manner. For example, a depreciation of the exchange rate, if not supported by demand restraint, may fail to redirect resources to the external sector while raising the inflationary pressures in the economy.

In designing the objectives of a policy package, account should be taken of tradeoffs between different objectives and, thus, of the policies needed to achieve them. Listed below are several examples. A depreciation of the exchange rate, aimed at reducing the external current account deficit, will also raise the domestic currency costs of servicing the external debt. In the absence of other measures, this will raise the fiscal deficit. Policies aimed at sharply reducing inflation may not be consistent with strong output growth in the short-run, particularly if prices are not fully flexible downward. Balance of payments surpluses may result in excessive monetary growth and inflationary pressures. Supply side measures to liberalize trade may result in an initial deterioration in the overall balance of payments position as the pent up demand for imports is unleashed; the removal of price controls is likely to raise inflation, at least initially.

Steps in Economic Forecasting

Preparation of a financial program requires an assessment of economic problems and the quantification of a coordinated set of policy instruments to achieve a given outcome. It requires completion of the major sector accounts to provide an internally consistent, and feasible, scenario of developments that could result from adopting a given package of policy measures. Given the linkages among the accounts, an iterative, rather than sequential, procedure is likely to be required to ensure a consistent program.

The workshop series is developed by sector, with the intention of providing participants with an understanding of the issues and methods needed for forecasting individual sectors. However, while the focus at any point in time will be on a particular sector, the overall aim is to develop a consistent macroeconomic projection of the Hungarian economy in 1990, and its implications for the medium-term balance of payments position. A first step is the development of the so-called the reference scenario, broadly based on the assumption that policies remain unchanged from the recent past. The reference scenario is intended to indicate whether the existing problems are likely to be resolved by themselves, to remain the same, or even worsen.

An assessment of what constitutes an unchanged policy stance involves elements of judgement. For example, if budgeted expenditures have regularly been overrun by wide margins, then continuation of this practice could be considered to constitute one element of an unchanged policy stance. Similarly, if the exchange rate has been adjusted according to the differential between domestic and trading partners’ inflation rates, then adoption of this rule could be another element of unchanged policies. In assessing the policy stance, it is important that the coverage be comprehensive, including fiscal, monetary (including interest rate), exchange rate, and structural issues.

Reference scenarios may differ for a variety of reasons. These may include differences in the relative importance attached to the various economic problems; in interpretation of what constitutes an unchanged policy stance; in assessment of the policy trade-offs; and in the methods used in forecasting. While formulation of these scenarios necessarily involves a considerable element of judgement, it needs to be underscored that repeated cross-checking of sectoral forecasts is required to ensure overall behavioral and accounting consistency.

The reference scenario, serves as a benchmark for elaborating a normative program scenario. This scenario would be based on an explicit policy package designed to achieve a desired set of objectives. Comparison of reference and program scenarios would indicate the expected impact of the policy package.

Below are some suggested general guidelines for preparing a financial program. The more technical details are treated separately in the individual workshops.

1. Evaluate economic problems

An understanding of the economic, institutional and socio/political structure of the economy and recent economic developments is essential for forecasting and policy analysis. The type of policy instruments available should also be identified. A diagnosis should be made regarding:

  • (1) the nature of the economic imbalance. If the problem is expected to be short-lived (cyclical, seasonal, etc.) all that may be required is some bridge financing or a temporary drawdown of reserves. More permanent imbalances will likely need to rely more heavily on a package of adjustment measures.

  • (2) the source of the imbalance. If at root of the problem is a large fiscal deficit, corrective measures will need to be implemented in this area. If the cause is external, for example a terms of trade deterioration, an exchange rate adjustment is more likely to be considered as part of a package to improve current account prospects.

  • (3) the seriousness of the imbalance related to, among other things, the dimensions of the problem and availability of financing. The more urgently the imbalances need to be addressed, the more drastic adjustment measures that will be needed.

2. Identify developments that are outside the authorities’ control

External sector forecasts involve interrelationships with the rest of the world and must, therefore, take account of developments in the world economy, including prospects for commodity and other foreign trade prices, world interest rates, and output and demand growth in partner and competitor countries. Forecasts of these variables can be obtained from various private, government, and international trade organizations. Chapter V on balance of payments forecasting summarizes forecasts in the Fund’s World Economic Outlook that may be of relevance when making projections for the Hungarian economy. Nevertheless, a considerable degree of uncertainty must underlie these forecasts. It is thus useful to undertake sensitivity analyses of the effects of deviations from projected levels of some of the more important external variables.

3. Set preliminary targets and develop policy package

The differences between the reference scenario and the program scenario should be noted. In a reference scenario, the preliminary targets are derived as an outcome of the assumption of a continuation of the existing policies. By contrast, in a program scenario targets are first set and then policy measures are adopted to meet these targets. The outcome of the reference scenario should provide a basis for establishing appropriate targets for the program scenario.

Targets are typically set for the balance of payments—in terms of the current account balance and/or the level of international reserves—prices, and output. They should be consistent with a viable balance of payments position, in the medium term, as well as with growth and inflation objectives.

4. Prepare sectoral forecasts

Given the iterative nature of the exercise, there are many possible approaches and starting points in developing a scenario. The approach taken in the forthcoming workshops is to start with a preliminary price and output projection, followed by forecasts for the balance of payments, fiscal sector and finally the monetary sector. However, at various stages there will be a need to iterate among the sectoral forecasts to ensure accounting and behavioral consistency and the feasibility of achieving the stated targets. This is highlighted by the following examples.

Assume that a preliminary set of projections or targets has been made for prices, real output, and the change in net international reserves. The implications of these projections for the external sector can be verified by forecasting values for exports and capital flows and deriving imports residually. However, in a second round the derived import figure must be made consistent with the demand for imports at the projected level of nominal output (a behavioral relationship). If, for instance, the demand for imports is greater than the value of imports derived residually, some adjustment must be made. The basic choices include:

  • (1) increasing the foreign exchange available to support a higher level of imports, either by adopting policies to raise export receipts or by seeking out additional financing;

  • (2) lowering the initial projection or target for net international reserves to allow for a higher level of imports;

  • (3) reducing the initial projection or target for nominal output to lower the demand for imports; and

  • (4) a combination of some of the above.

A similar iterative procedure would be carried out for the fiscal and monetary sectors. For instance, projections for prices, output, and net foreign assets underlie any estimate of net banking system domestic credit. If the implied bank credit extended to the government sector is insufficient to cover the estimated fiscal deficit then the following options are available:

  • (1) introduce a package of fiscal measures to reduce the public sector deficit, which may result in lower nominal output growth;

  • (2) redirect credit from the private sector to the government sector, which may also have a dampening effect on nominal output growth;

  • (3) raise additional external financing, which has obvious balance of payments implications;

  • (4) increase nonbank domestic financing, which may have interest rate implications;

  • (5) increase bank credit extended to the government, accepting the likely negative effects on inflation and/or the balance of payments; and

  • (6) a combination of some of the above.

In general, abstracting from some of the peculiarities and discrepancies evident in any data set—some of which were discussed in Chapter II for the case of Hungary—the following accounting relations should hold:

  • output from the expenditure side should be based on fiscal data for government consumption and investment and on external data for net foreign expenditure;

  • government recourse to banking system credit, as shown in the fiscal data, should be consistent with the change in net domestic credit to the government, as reported in the monetary accounts; and

  • government recourse to external financing, as shown in the fiscal data, and changes in the net foreign asset position in the balance sheet of the banking system should have counterpart entries in the capital flows of the balance of payments.

Key behavioral relationships that need to be considered include:

  • the demand for money and its relationship to nominal output and other variables

  • the demand for imports and its relationship to nominal output and other variables

  • the relationship between private sector bank credit and private investment and imports

5. Review desirability of use of Fund resources

This step is relevant for the program scenario. A decision that a program should be supported by use of Fund resources requires that performance criteria be set. Performance criteria provide a direct link between program implementation and the disbursement of the Fund’s resources. Failure to observe the performance criteria results in interruption of the member’s drawings under an arrangement. Depending on the causes and nature of the deviations, either a waiver, or modification, may be granted to permit a resumption of drawings, or a new understanding may need to be reached.

Performance criteria and other monitoring devices are intended to be limited to those necessary to evaluate implementation of the program so as to avoid excessive involvement of the Fund in the details of economic policy making.

The following are the most commonly used types of performance criteria:

  • a ceiling on domestic bank credit expansion;

  • a sub-ceiling on net domestic bank credit to the government, or the nonfinancial public sector;

  • ceilings on nonconsessional external borrowing, including short and medium-and long-term debts;

  • a floor on net international reserves; and

  • understandings that there will not be new, or an intensification of existing, exchange and import restrictions.

Bank credit ceilings may be set at either the level of the monetary survey or the monetary authorities’ accounts. The former provides immediate consistency with targets (through the inflation and growth rate used in predicting the demand for money and the change in net foreign assets), but leaves open the measures the authorities may take to limit monetary aggregates. Placement of the ceilings at the level of the monetary authorities’ accounts has the advantage of dealing with aggregates more subject to the authorities’ control, but means that consistency with targets depends on the stability of the assumed money supply function.

Other kinds of policies may, where appropriate, also be subject to performance criteria. Important in this context have been additional understandings affecting the exchange and trade system, including measures relating to exchange rate policy and to the reduction or elimination of external payments arrears.

Disbursements of Fund monies can also be subject to completion of a review, which typically monitors structural and other policies that may not be amenable to quantitative performance criteria.

Prior actions, i.e., implementation of policy measures seen as critical to the effectiveness of an adjustment program prior to approval of a Fund arrangement, may also be required. Such actions are particularly important where severe imbalances exist, or in cases where the record of policy implementation has been weak.

Issues for Discussion

  • 1. On the basis of Chapters I and II, discuss the main economic problems facing Hungary at end-1989. This review should identify the main macroeconomic and structural weaknesses and provide some initial assessment of the causes, size, and urgency of the economic difficulties.

  • 2. Assess the policy stance of the authorities’ in the recent past. Consider the effectiveness of these policies in achieving major economic objectives. Identify the policy instruments available to the authorities.

  • 3. Review in broad terms the main assumptions that will underlie the reference scenario.

  • 4. What are the major factors affecting economic performance that you consider to be outside of the authorities’ control?


A more detailed review of a framework for financial programming can be found in “Theoretical Aspects of the Design of Fund-Supported Adjustment Programs,” IMF, Occassional Paper No.55, September 1987.