What is a financial program? There is a difference between economic or financial projections and economic or financial programs.20 In preparing a financial projection, the values of economic or financial variables at the end of a given period (month or year) are estimated on the basis of past developments and current present policies. A program means either (a) the estimated value of economic variables by the end of a defined period given certain objectives, parameters, or decisions (a “passive program”) or (b) the policies the authorities should implement to achieve certain objectives (an “active program”). See following examples:


What is a financial program? There is a difference between economic or financial projections and economic or financial programs.20 In preparing a financial projection, the values of economic or financial variables at the end of a given period (month or year) are estimated on the basis of past developments and current present policies. A program means either (a) the estimated value of economic variables by the end of a defined period given certain objectives, parameters, or decisions (a “passive program”) or (b) the policies the authorities should implement to achieve certain objectives (an “active program”). See following examples:

Projection. On the basis of data on central government revenues and expenditures for the first nine months of the year, the end-of-year fiscal situation is projected. No judgment is passed on whether the end-of-year situation is acceptable; there is only a statement that, given recent and expected trends in revenue and expenditure, and in the context of present policies, the central government will record a certain surplus or deficit by the end of the year.

Passive program. The authorities have decided to grant a general salary increase to public sector employees. Its impact on other economic and financial variables such as the budget, bank credit expansion, balance of payments, and domestic inflation, is projected. In other words, an attempt is made to identify the repercussions of that decision. No statement is made on whether or not the impact of the decision is acceptable.

Active program. The authorities would like to reduce the balance of payments deficit from X to Y. The kinds of policies and measures that must be implemented to achieve such an objective are then set out.

In practice, the distinction is not so clear, and programs are a mixture of projections, passive programs, and active programs. Thus, in preparing a stabilization program (active program), it would not be realistic to ignore recent developments such as trends of government revenue, access to foreign borrowing, terms of trade, and demand for exports, or the existing social and political environment (projections, broadly defined). At the same time, the repercussions of decisions taken in the context of the stabilization plan cannot be ignored, since they will affect other economic and/or social variables. For example, if the recommended program includes a sharp increase in taxes, that measure is bound to have an impact on private investment and/or consumption. If the authorities should decide to grant wage increases or subsidies to compensate for a devaluation, that decision will clearly have an impact on the budget and domestic inflation. Similarly, if an active program is prepared, decisions (for instance, salary increases or subsidies) that are likely to be taken by the authorities as a consequence, direct or indirect, of the program itself must be taken into account.

If a stabilization program aimed, for instance, at a certain balance of payments result (active program) were being prepared, the staff would start by reviewing recent and expected trends of different variables, such as production, prices, fiscal operations, and exports (projections). Once the stabilization plan has been drafted, the authorities may conclude that they will have to give certain salary increases or tax exemptions to compensate for measures proposed in the plan. These decisions will have an impact on the various economic variables, which will, therefore, no longer be consistent with the stabilization plan (passive program). If the above decisions on wages and taxes cannot be reversed, the stabilization plan must be modified to accommodate their impact, either through additional compensatory measures or through a revision of the targets.

There is also a difference between (a) a financial program in general, (b) a stabilization or adjustment program, and (c) a development program. Broadly speaking, the objectives of these programs are different.

A financial program in general is prepared, or should be prepared, in every country, regardless of whether or not the country is facing a financial crisis. It consists of an allocation of the country’s resources on the basis of certain priorities or objectives. Its horizon could be short term or long term, depending on the circumstances. A government budget is a form of financial programming, inasmuch as revenues of the government are allocated to finance certain expenditures on the basis of objectives and decisions. A credit program is a form of financial program, inasmuch as the resources of the banking system, or of the central bank, are distributed according to certain priorities. Since the circumstances of a financial program may be somewhat different from those of a stabilization program, attention may be given to measures that are expected to yield medium-term, rather than short-term, results.

A stabilization program has a short-term focus—how to solve an immediate problem. In general, it is in response to a crisis and calls for measures that are expected to yield quick results, even if in some cases these measures are not necessarily the best in the medium and long term. For example, to solve an immediate crisis caused by a sudden large fiscal deficit, the authorities may adopt an emergency tax, which may work in the short term but definitely is not a substitute for a more far-reaching tax reform. But in a crisis period, there is no time to prepare, approve, and implement a thorough tax reform. A stabilization program may have a medium-term horizon, if the crisis cannot be solved within a year. In this case, the program should include both short-term measures to address the immediate problem, and medium- to long-term measures to yield future results.

A development plan is geared to achieving certain long-term objectives, such as economic growth or structural changes of the economy, and it involves policies and measures that will not necessarily achieve results in a short period of time.

There are many points of overlap among these different forms of programs, as well as some duplication. Also, a stabilization program may be needed to set the basis for a development program, which otherwise could not be carried out. By introducing an emergency tax, and so temporarily financing the immediate fiscal gap, the authorities may gain time to study and implement a thorough tax reform that may be required to stimulate the economy.

IMF missions can involve all these different kinds of projections and programs. An Article IV consultation mission would primarily focus on projections and financial programming. In other words, more emphasis is on telling the authorities where they are going (projections) and the likely impact of their present and expected policy decisions (passive program). In use-of-Fund-resources missions, the staff emphasizes measures aimed at achieving a certain objective (active program) in the context of a stabilization program.

The first step is to clearly define the objectives. For example, is it a projection or a program that is being prepared? If a program is being prepared, is it in response to an immediate crisis or not? Depending on the answer to that question, what is the objective: a certain balance of payments result, a certain rate of economic growth, or a certain slowdown of inflation? In the short run, a plan cannot try to achieve too many objectives, which would limit the efficient use of the instruments at the disposal of the authorities. A plan may, however, define the different objectives to be achieved over a given period of time and their order of priority, thus linking short-term plans to medium- and long-term horizons. Once these objectives are defined, all policies to be adopted must be consistent with the achievement of the objectives. This is true for financial, stabilization, or development programs.

This does not mean that other objectives are undesirable or should be disregarded. It only means that, in the given circumstances, some objectives have a higher priority than other—equally commendable—objectives. In many cases, short-term objectives (such as the reduction of a balance of payments deficit, an increase in international reserves, and a slowdown of inflation) must be achieved if other objectives (such as a sustained rate of economic growth or the implementation of a public sector development program) are to be achieved. Without the former, the latter have no chance of being achieved. For example, it would be difficult for a country to receive, and fully exploit, external development assistance, if it could not raise sufficient savings to provide local counterpart funds.

A financial program, as defined in the IMF, is a technique for balancing the availability and uses of resources so as to reduce pressure on the domestic price level and obtain a desired result in the balance of payments. This does not mean that a financial program must rapidly stabilize domestic prices and achieve a balance of payments equilibrium. A program could be aimed at slowing inflation and achieving a balance of payments surplus—or deficit—that can be financed, given other financial flows. Usually, the IMF intervenes when a country is facing financial difficulties that are the result of domestic or external factors and that are manifested in balance of payments difficulties, rapid inflation, sluggish economic growth, or a combination of these.

In preparing a financial program, some constraints, or “rules of the game,” must be recognized:

  1. Objectives must be clearly spelled out, and the entire package of measures included in the program must be geared to achieving those objectives.

  2. Unless the authorities are convinced of the need to take some adjustment measures, no program will be successful.

  3. There is a close relationship among different financial and economic variables, which creates a “ripple effect.” Thus, whenever one variable is affected, there are repercussions somewhere else. For instance, if the government should grant a subsidy to a particular sector, other sectors must pay for it. If the government should increase taxes, there will be an impact on economic activity. If consumption is rising faster than domestic production, there will be an impact on inflation or on the balance of payments, or both.

  4. Measures do not necessarily have an immediate impact; the economy does not necessarily react immediately to stimuli or decisions. For example, if a new investment law is being approved, new investment will be made with a certain delay, and the impact in terms of additional production will not be seen right away. If interest rates are increased on both credit and deposits, banks may delay paying higher interest rates on deposits until the higher interest rates on their loans become effective on a reasonable portion of their portfolio.

  5. Calculations must be revised early on and constantly, as reality may evolve differently than assumed. For example, if to reduce the government deficit to a desired level government revenues must increase by 15 percent, and revenues are increasing by only 10 percent, compensatory action must immediately be taken; otherwise, the objective of reducing the budget deficit will not be achieved.

  6. One cannot substantially modify some elements of the program and expect the planned results to be achieved.

  7. Sufficient information (broadly defined) must be available to whoever prepares a program, if it is to succeed.

A program should be realistic in terms of its objectives. For example, if the terms of trade are expected to deteriorate, or if a hurricane has destroyed the main export-earning crop, it might be unrealistic to project, and try to achieve, a balance of payments surplus. On the other hand, it would also be unrealistic to expect a turnaround in the balance of payments of a country without taking any adjustment measures.

Once the objectives of a program have been clearly defined, the different elements of the program must be consistent with the achievement of those objectives. This may require actions in several different areas, at times simultaneously, and must take into account different factors such as changes in the external situation (terms of trade, access to foreign borrowing, or demand for a country’s exports); internal circumstances; action to stimulate supply; and the impact of demand management policies. In general, a piecemeal approach to implementing measures is likely to result in a waste of policy instruments and a weakening in the credibility of the program.

The time span of the action must also be defined, in other words, whether the program will require a long or short period of adjustment. In general, the “shock approach” means that adjustment measures are being implemented forthwith, but the results will be seen only gradually. With the “gradual approach,” measures are adopted over a longer period of time, and results may often never be seen, unless the authorities have a program of properly sequenced measures and the willpower to implement them. Also, the time span of the adjustment process is a function of the gravity of the situation and of the resources available. The gradual adoption of adjustment measures is not a viable alternative in a crisis situation. Finally, it should be noted that populations tend to get tired of periodic adoptions of measures. Moreover, such a strategy may be misunderstood as a symptom of confusion on the part of the authorities, thus undermining the credibility of the program.

Stabilization programs are often criticized as being insensitive to domestic problems. In reality, any country with serious financial imbalances and without resources is forced to adjust. The stabilization program merely tries to make an orderly adjustment on the basis of certain priorities. A stabilization program should help the authorities to focus on problems and solutions, but the existence of a problem is not a fault of the program. A program, however, should include measures aimed at providing greater protection to the more vulnerable segments of society through a reordering of public expenditures policies.

Conditionality is nothing more, and nothing less, than the set of policies required to achieve certain objectives. Objectives, and therefore conditionality, depend on the degree of imbalance and on the timing of action. The longer a country delays taking certain decisions, the greater the need for action, and the more ambitious the objectives; hence, the higher the conditionality. Can conditionality be avoided? No. If a country has financial or economic problems, it is because something is wrong, whether internally or externally or both, and action (conditionality) is required to redress the situation or to minimize the negative factors. Even the continuation of a country’s deficit is subject to a certain conditionality. Objectives, and action to achieve them, are a function of past policies and of the resources at the disposal of the country.

Because conditionality is a function of the objective, a given objective cannot be maintained while softening the implicit “conditionality” by adopting a more modest set of adjustment measures. A softening of adjustment measures implies aiming at a more modest objective. However, the mix of measures can be changed so that a more modest action in one area is compensated by more aggressive measures in others.

The timing of action is important. If action is taken when the problem is just emerging or, even better, before the problem has fully emerged, the size of the adjustment will be limited, orderly, and less painful. The longer action is delayed, the higher the price, particularly in social and political terms. A delay may also have a spiral effect: since the cost of adjustment (for example, price adjustments or devaluation) is high, political opposition increases, thus delaying the action and increasing the cost of the adjustment even further.

There is always a price to be paid, despite the reluctance of some authorities to recognize this fact. If adjustment measures are delayed, the price is already being paid in the form of inflation, a sluggish rate of economic growth, a drop in investment, and so on. Certain countries have tried to delay adoption of corrective measures by financing their gaps with excessive foreign borrowing. However, events of the past decade have demonstrated that this is not a lasting solution and, in the end, has created serious problems.

What instruments should be used and what kind of policies should be followed? The more instruments used, the less that will be demanded of each of them. A good stabilization program should consider simultaneous action in the areas of fiscal, monetary, and income policies, exchange rate management, and structural changes to dilute the negative impact in any one domain. However, there is always a reluctance to act in some areas. For example, authorities may take a negative attitude to modifying the exchange rate. At the other extreme, some authorities may have unrealistic expectations and believe that exchange rate action alone will solve their problems. This attitude has, in many cases, compounded a country’s problems. The authorities must have a realistic view of what each instrument is able to accomplish.

Scheme of a Stabilization Plan

To summarize, in preparing a stabilization plan, the objectives must be clearly defined, and the time span over which the objectives should be achieved clearly stated (Table 10).

Table 10.

Scheme of Stabilization Plan

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In many countries, financial difficulties and economic sluggishness may be due to structural imbalances. Therefore, before deciding on the strategy and instruments to be used to achieve the objectives of the program, the staff should identify whether vital structural reforms are required. Unless existing structural imbalances are rectified, even the best of stabilization programs would provide only a temporary respite. For example, intractable fiscal deficits may be due to lax tax administration, in which case new tax measures could encourage tax evasion rather than solve the fiscal problem. The existence of far-reaching subsidies and price controls may foster consumption rather than investment. Protectionism may hinder competition and encourage or shield inefficient industries. State-owned monopolies are usually a source of government spending and stifle private initiative. Balance of payments difficulties may be the result of an inadequate exchange system.

At the same time, there may be strong resistance to these structural changes, because they are likely to adversely affect powerful local interests. Moreover, while some of these structural reforms (for example, dismantling of subsidies and price controls, modification of exchange system) may be implemented in a reasonably short period of time, provided that there is the political willpower, other changes (such as improvement in fiscal administration, crackdown on tax evasion) may require lengthy periods of implementation and may also call for cultural changes and adequately trained personnel. As a result, the importance and magnitude, as well as the speed at which these structural changes may be implemented, would define both the time span and the strategy of the proposed stabilization plan.

A stabilization plan should also be put in a medium-term scenario, which would assist in assessing alternative adjustment strategies and in judging whether the policies can be sustained over time. In this context, staff should review with the authorities the actions to be taken beyond the successful implementation of the short-term stabilization plan, to ensure the continuity of policies, consolidation of the gains achieved under the plan, and agreement on a timetable for action on structural changes that are considered necessary.

The main strategy to achieve the objectives may emphasize the supply-side and/or demand-control instruments, depending on the circumstances of the country. The instruments to be used are a function of the overall strategy to be pursued. The instruments can be classified into five broad categories: fiscal, monetary, external policy, income policy, and structural changes. The plan must identify how these instruments will be used, their relative shares in the overall strategy, and a detailed description on how they will be used. For instance, if in order to achieve the objectives of the plan the public sector deficit must be reduced, the plan should indicate whether this outcome is to result from the adoption of revenue measures, control of current and/or capital expenditure, financing of the deficit, etc. The simultaneous use of a wide variety of instruments improves the chances of achieving the desired results, as slippage in one area may be compensated for by over performance in other areas.

The use of the different instruments is also a function of:

  1. Time span. If the desired objectives must be achieved over a very short period of time, the plan must emphasize the use of instruments that will yield quick results. In this case, certain instruments (such as comprehensive structural changes) may not play a key role in the initial stage and may be set aside temporarily, as they would yield results only over a longer period of time.

  2. Current situation. If the adjustment process has been delayed for too long and the financial situation is critical, the plan will call for the use of instruments capable of yielding quick results. By contrast, if the plan is adopted at an early stage and the situation is still manageable, the intensity of the instruments could be somewhat less.

  3. Objectives. The objectives to be achieved dictate the instruments to be used.

  4. Political and social constraints. Certain instruments cannot be used because of political circumstances. For instance, minority governments would need to avoid using instruments that require congressional action. Countries with strong labor unions are not likely to succeed implementing substantial income policies.

  5. Exogenous factors. External circumstances, at times beyond the control of the authorities, should be taken into account in selecting the instruments to be used.

  6. Other constraints. Existing legislation may limit the use of certain instruments. Similarly, widespread tax evasion and contraband would limit the usefulness and expected yield of certain instruments.

  7. Available resources. The instruments to be used depend also on the availability of internal and/or external resources.

It should be noted, however, that at times one of the instruments may become an objective. Thus, for instance, maintenance of a certain exchange rate policy or pursuit of a certain wage policy may limit the action the authorities may take, inasmuch as those instruments (exchange rate and wage policy) would become objectives of the program. In this case, the use of other instruments would be needed to compensate for these additional constraints.

Strategy and Instruments

In reviewing the different instruments that may be used to achieve the objectives of a program, the staff should be aware of the advantages, limitations, and shortcomings of each instrument. It must be emphasized that some of the instruments listed below have serious shortcomings and may increase distortions; nevertheless, they are listed here because the authorities may wish to discuss their possible use with the staff. In any event, the specific circumstances of the country, including its sociopolitical situation, must be taken into account.

As mentioned above, the authorities may operate on the supply side, adopt demand management policies, or implement a combination of the two. The different instruments may be summarized as follows:

Supply-Side Measures

This strategy is appropriate in the longer run and for countries that still have room to maneuver; however, it is not likely to address the immediate problems of countries that are faced with financial crisis. Critics sometimes contend that emphasis should be on supply-side policies, rather than demand management, to overcome the economic difficulties of a country. However, these critics often ignore or underestimate the political implications of supply policies. To be effective, the supply-side strategy requires implementation of far-reaching structural changes, such as revision of exchange rate, pricing, and interest rate policies; elimination of subsidies; enforcement and reform of tax legislation; and overhauling of wage and labor legislation. Often these structural defects reflect the political situation of the country, and the reluctance to implement structural reforms has been the main cause of the problems of the country. In the absence of these structural changes, supply-side policies may yield only marginally positive results, while delaying much-needed action in other areas and aggravating the situation.

Supply-side measures include:

  1. Measures to stimulate production by providing incentives to investment:

    1. Tax concessions and other fiscal legislation to encourage investment in particular and production in general (for example, lower capital gains taxes, favorable depreciation schedules, tax rebates such as reimbursement of value-added tax (VAT) and sales taxes, tax certificates for payment of income taxes, exemption from payment of income taxes for certain periods). However, as these measures may result in (possibly temporary) declines in government revenue and increases in central government budget deficits, they may have to be compensated for by other revenue measures or by cuts in government expenditures;

    2. Measures aimed at limiting the growth of and/or reducing private and/or public consumption. Such a policy would result in higher savings, which may be used to finance investment; and

    3. Measures aimed at increasing producer prices. More remunerative selling prices can be achieved through direct controls on domestic prices, quotas, high tariffs on less expensive imported goods, and exchange rate incentives on exported products. These measures are likely to result in higher domestic consumer prices, and the authorities may expect pressures to extend subsidies to certain sectors of the economy. Also, protectionist measures may encourage the establishment of inefficient enterprises.

    Producer profits may also be raised by reducing production costs through the use of preferential interest rates, subsidies for the consumption of electricity and other utilities, preferential prices for fuel, or lower import tariffs for inputs. This may either reduce government revenues, as in (i) above or require compensatory action elsewhere, for instance, higher interest rates on other forms of credit, and higher fuel and public utility prices for uses not directly related to production. It may be difficult to limit the use of preferential credit lines to strictly production-related operations. Also, the quality of the credit has to be taken into account.

  2. Measures aimed at promoting exports and import substitution, which would assist directly in reducing the resource gap. As the current account deficit is narrowed, the country’s financing needs are also reduced and, in particular, recourse to foreign savings in general and foreign borrowing in particular is scaled down. Moreover, achievement of net international reserve targets is facilitated, while pressure to constrain imports is reduced somewhat.

    The exchange rate is a powerful instrument to achieve the above-mentioned objectives. A devaluation can accomplish two things: it can reestablish the competitiveness of the local currency, hence facilitating increased exports by producers, otherwise, they may require subsidies; and it can promote the development of new exports. However, if domestic prices are allowed to increase in line with the devaluation, little or no benefit will be achieved, as the effective situation will be the same or even worse, while a powerful instrument will have been wasted or discredited. In this context, the staff should make clear to the authorities that exchange rate action may grant some time and respite, but unless it is accompanied by additional, more lasting measures, it is not a solution. Realistic exchange rates encourage exports and also provide for better producer prices, thus increasing output or maintaining current levels of production of certain goods. Exchange rate devaluation may also result in higher fiscal revenue in the form of import duties and, in certain circumstances, windfall profit taxes on exporters. The latter, however, should not be unduly high; otherwise exporters will have no incentive to export or may be encouraged to underreport their sales and sell foreign exchange earnings directly to importers. Such windfall profit taxes should also be phased out over time, as rising domestic prices will eventually erode the gain to exporters from the devaluation.

    On the negative side, a devaluation has an adverse impact on imported inputs that could be compensated by lowering certain import tariffs and on domestic consumer prices, both directly (for goods that are either imported or that contain imported inputs) and indirectly (in general, domestic prices tend to increase even for goods and services that are not affected by the devaluation). Also, the government’s external debt service would rise in terms of local currency, and this could necessitate additional fiscal measures. Similarly, the external debt service of the private sector would be affected, and pressure would rise to pass the higher debt service on to consumers in the form of higher prices, or for the central bank to grant an exchange rate guarantee. In oil-importing countries, there may be strong pressure to minimize the higher cost of imported fuel to the consumers and to subsidize certain activities, such as urban transportation and public utilities.

  3. Measures to encourage private saving through increases in interest rates paid on financial savings. A combination of exchange rate and interest rate action may assist in slowing or stopping capital flight. This action may also necessitate increases in interest rates charged on bank loans; otherwise, the financial position of banks may be jeopardized. Pressure would arise to provide interest rate subsidies on certain credit lines and/or remunerate banks’ legal reserve requirements. The final burden could fall on the central government and on the central bank.

  4. Measures to reduce costs of production. Production and exports may be encouraged either by providing higher prices to producers or by controlling production costs. Following is a review of the main components of production costs and action that would control them, as well as impact of such measures:

    1. Wages and salaries. These are one of the most important components of production costs; controlling wages and salaries by freezing them or limiting future increases would directly assist producers. In the short run, this measure could be effective in reducing production costs but, if prolonged, it might begin to be circumvented by the granting of benefits, bonuses, and promotions. Also, quality and efficiency of staff would tend to deteriorate over time, as better-qualified staff would emigrate to enterprises that offer better remuneration. The authorities must be politically strong and labor unions weak for such a policy to be enforced. Pressure for compensatory subsidies would increase over time;

    2. Utilities. Production costs may be lowered by maintaining low or subsidized prices for public utilities (electricity and transport). However, the providers of these services may incur losses or may not have sufficient financial resources to carry out their own investment programs. Also, this measure may result in a higher consumption of electricity; the increased demand might not be satisfied because of the inability of the electric company to make the required investment;

    3. Other domestic inputs. Prices of other domestic inputs could be controlled through ceilings; however, this would discourage production of these inputs;

    4. Imported inputs. Producer costs could be lowered by reducing import tariffs, but this measure could result in lower fiscal revenues and higher fiscal deficits in the absence of compensatory measures;

    5. Interest on bank credit. This measure should be reviewed in the context of the financial stability of the banking system. It is likely to lead to a call for higher interest rates on other bank credits or for lower interest rates on bank deposits. The former would discourage bank credit, which would not necessarily be an adverse outcome, while the latter may discourage the accrual of private financial savings to the banking system and encourage capital outflow; and

    6. Profits. Producers’ profits may be increased by lowering indirect and income taxes, and by providing fiscal incentives, such as favorable depreciation schedules. In the absence of compensatory action, these measures would have an adverse impact on fiscal revenues and on the central government budget deficit.

Demand Management Policies

In a financial crisis, demand management policies are more effective than supply-side policies; however, the use of the former must be carefully controlled and coordinated. Also, in the longer term, benefits from these policies will dissipate unless they are supported by structural changes. Political resistance to demand management measures is likely to be stronger than in the case of supply-side action partly because demand management policies are expected to have an immediate impact on vested interest groups, whereas supply-side policies may be perceived as long-term measures that might be watered down before or during their implementation; they may, therefore, be perceived as a lesser threat to those vested interests.

Demand management measures include:

  1. Exchange rate, interest rate, and wage controls. These measures act on both supply and demand, by stimulating production and discouraging demand.

  2. Import restrictions in the form of tariffs and/or quantitative limits on imports. Some authorities may support increases in tariffs on the grounds that they yield fiscal revenue, thus facilitating the narrowing of the budget deficit. Local industries, particularly if they are inefficient, may also be in favor of obstacles to foreign imports. These enterprises are likely to raise the specter of unemployment and the outflow of domestic savings to pay for imports. However, these limits are usually imposed on imports of products that are produced domestically at noncompetitive prices, thus shielding inefficient industries. Import restrictions also distort the allocation of resources, which is difficult to correct in the medium to long run, because the price of liquidating inefficient enterprises—which usually have a large labor force—may become a political issue. Advocates of import restrictions are likely to justify their proposals on the grounds that “excessive” foreign exchange reserves are being used to import luxury goods (such as liquors and specialty food), even though such imports usually account for a fraction of total imports. High domestic prices and import tariffs are likely to encourage contraband, as well as pressure for exemptions, and are likely to fuel a growing black market and corruption.

  3. Monetary policy. A tightening of monetary policy would have an immediate impact on demand. The advantages and disadvantages of the different instruments are as follows:

    1. Legal reserve requirements. An increase in reserve requirements raises the cost of resources accruing to the banking system, and is likely to increase interest rates on loans and discourage marginal credit. Banks are likely to press for remuneration on their reserve requirements, thus resulting in central bank losses, or for exceptions (for instance, a discharge of the additional requirement in the form of treasury bills or credit to certain sectors), in which case the objective of cutting credit would not necessarily be achieved and/or pressure to improve central government finances would weaken. The effectiveness of this measure in countries with state banks is rather limited, as those banks normally do not fulfill their legal reserve requirements;

    2. Reduction in central bank rediscount and credit. This measure is very effective, as it curtails credit to the private sector;

    3. Upward revision of interest rates charged on loans and paid on deposits. This action yields positive results in several areas, as it limits demand for credit (although some potential borrowers may be encouraged to borrow abroad), while making possible an increase in resources available to the banking system by encouraging the accrual of private sector financial savings to the banking system;

    4. Increase in interest rate charged by the central bank. This measure is particularly effective in achieving an upward revision of bank interest rates, as banks are forced to pass the higher rates on to customers;

    5. Ceilings on banks’ portfolios. Use of this instrument should be carefully reviewed to avoid that marginal and inefficient credits receive preferential treatment for political reasons. Also, policing of bank portfolios requires strong monitoring of banks and close scrutiny of bank portfolios; and

    6. Open market operations. This instrument is effective in removing from the system (sterilizing) resources that otherwise could be used by banks to expand credit. The cost of these operations can be rather high to compete successfully with other forms of financial savings, and it has to be financed either by the central bank or by additional taxes. In many developing countries such a market does not exist; therefore, operations may be directed at sterilizing resources of commercial banks, thus opening the door for remunerating legal reserve requirements.

  4. Fiscal policy. The use of fiscal instruments should be viewed in a broader context of incentives, controls, and the fiscal situation of the country. Thus, if the financial difficulties of the country are mostly the result of excessive public sector expenditures, increases in taxes may alleviate the fiscal difficulties in the short run but certainly would neither address nor solve the basic problem, which is excessive government spending. Tax increases may result in even higher spending, thus aggravating the problem. The staff should be wary about assurances from government authorities that budgeted expenditures represent the necessary bare minimum. In every budget, there is always some margin for saving. The problem is that often the unnecessary spending is politically untouchable.

    1. Increase in taxes. This measure can provide resources for the financing of government spending; reduce resources at the disposal of the private sector, and thus contract spending; and reduce central bank credit to the central government. Indirect taxes are not an equitable form of taxation, as they hit low-income sectors relatively harder than higher-income sectors, but they are easier to collect and evasion is less likely to occur. Direct taxes are more equitable but easier to evade. Also, they may discourage investment and production. Too much dependence on periodic tax increases or on a high level of taxation may encourage tax evasion; therefore, strong tax administration and collection agencies are required. Yielding to pressure for exemptions may exacerbate inequities of the tax system and alienate support for the stabilization program.

      Often the authorities indicate that similar or even higher results may be obtained by cracking down on tax evasion, and they may quote extravagant estimates of undeclared income and unpaid taxes. The staff should be cautious regarding these claims, because the high estimates are mere guesses based on often inflated perceptions and supported by the desire to not increase taxes on some economic sectors. As in the case of contraband and broadly defined capital flight, no reliable data are available on undeclared income; otherwise, the authorities would have already prosecuted those responsible and collected the taxes. All efforts should be made to reduce tax evasion; however, the difficulty of the task should not be underestimated. If tax evasion in a country is as widespread as the authorities claim, this can only reflect a weak tax administration and/or political inability to address the problem.

      Also, in some countries, tax collection is relatively low because of legal loopholes. Such cases are not necessarily a question of tax evasion, because taxpayers may have correctly declared their income and simply taken advantage of legally available deductions, in which case additional revenue can be collected only by modifying the pertinent legislation, not by strengthening the tax office.

    2. Control of public sector wages and salaries. This measure is rapid and effective, because it is under the direct control of the authorities. Moreover, it can provide a guideline for private sector wage adjustments. The measure is usually unpopular, however, and if carried out for long periods of time, it can result in an inefficient government sector, because trained personnel will transfer to the private sector for higher remuneration as soon as they have acquired sufficient experience with the public sector. In some countries, stringent wage guidelines for public sector wage increases are approved, but their impact is weakened by promotions, bonuses, and other benefits.

    3. Control of interest payments and pensions. There is only limited scope for action in regard to interest payments, which are based on contracts, and any arrears in their payments would jeopardize the possibility of further borrowing. Interest payments to the central bank are usually low or are often paid not in cash but by capitalizing the government obligation; therefore, lower payments would not affect the cash position of the government.

      As for pensions, in many developing countries these obligations are not indexed to inflation, and they do not usually represent a large item in the budget. Similarly, central government contributions to the social security system, both as employer and as state, are often paid only up to the amount needed by the system to meet its cash outlays, with the difference either being capitalized or in arrears. In other countries, retirement benefits were increased sharply in the past, either by lowering the retirement age or by raising pensions. As life expectancy improved, those countries have encountered serious problems in financing their pension schemes. Efforts to modify the systems have met with strong political opposition, in spite of the fact that in many cases the existence of the problem was openly acknowledged by all parties involved.

    4. Other expenses. Usually there is considerable scope for cutting outlays for transfers and for the purchase of goods and services. In the case of transfers to the rest of the public sector, cuts in appropriations may even result in better control by the ministry of finance over the operations of these agencies. However, in some countries, transfers to universities, local governments, and certain other state agencies cannot be reduced for political reasons. Purchases of goods and services are usually inflated, and cuts would not necessarily affect the efficiency of the government.

    5. Investment outlays. In the short run, these outlays could be cut or postponed; however, in the longer run, drastic cuts in capital outlays would jeopardize the production capacity of the country. Priority could be given to foreign-financed investment projects, but there is a limit to projects that can be financed abroad. Moreover, many of these projects call for local counterpart financing. Authorities may claim that their objective is to enhance capital spending, particularly for infrastructure and social projects, such as hospitals and schools, while allowing only for minimum increases in current expenditure. However, an aggressive investment program eventually requires increases in current outlays, as there would be no purpose to building, but not equipping or staffing, new hospitals and schools or to failing to maintain infrastructure. Therefore, any country embarking on an ambitious development program needs to rationalize its government’s current outlays.

    6. Floating debt and arrears. The authorities may suggest that, in order to minimize recourse to central bank financing, the central government should delay payments and make more liberal use of floating debt. Such a policy has many shortcomings, as it ignores the short- and long-term impact on the rest of the economy. Nonpayment for goods and services by the government, which in most countries accounts for a sizable share of economic activity, would have a ripple effect. Affected suppliers would not be able to service their bank loans or to pay their own bills. Banks would be forced not only to refinance the outstanding loans but also to continue to extend credit to producers. Soon, such a practice would spread to borrowers who had not previously been affected by the government’s nonpayment of its bills. Domestic prices would be adjusted upward to cover incurred and expected losses attributable to the government policy. The decision to delay payments would not assist the government in reducing its deficit, as suppliers would tend to overcharge the government for their goods and services as compensation for late payment, thus aggravating fiscal imbalances.

    7. Sale of government bonds and bills. Through these sales, the government may avoid the inflationary impact linked with central bank financing. It should be clearly understood that the central government would be competing with the banking system for private sector savings, as the private sector is not likely to reduce its consumption to purchase government bonds. In this context, this instrument differs somewhat from the use of taxation, which may squeeze private consumption. To compete successfully, the central government must be ready to pay a competitive rate on its bonds, which would increase its financing requirements. This instrument is of limited use in countries with an underdeveloped bond market.

    8. Rest of the public sector. In preparing a program, the staff should analyze not only the central government’s finances but also those of the rest of the general government and state enterprises. Often, government subsidies and transfers have been extended because of inefficiencies in government agencies, which, in turn, are not eager to improve their administration as long as they receive this financial support. The measures considered to address the financial difficulties of the country may, therefore, include a review of the price and tariff policies of state enterprises, which should be realistic and profitable, to ensure that these enterprises have sufficient resources to finance their operating and capital expenses. Costs of enterprises should also be carefully reviewed and controlled, paying special attention to increases in prices and tariffs that are being used to finance additional current outlays or unnecessary investment.


All the instruments described above can be effective in the short run in achieving the objectives of the program. However, if only one or a few of them are to be used, the chances of success are considerably smaller, as the role to be played by each instrument may be too broad. Resistance and pressure to change the direction of policies are likely to mount. Thus, for example, a program that depends exclusively on exchange rate action would require periodic and ever steeper devaluations. Similarly, too much reliance on new taxation would not solve fiscal difficulties in the long run, and may very well encourage tax evasion.

The best strategy is to use as many instruments as possible so that the adverse impact of each one is somewhat diluted, although each instrument also has positive effects. Also, the piecemeal approach is likely to yield results below expectations, while giving the impression that the authorities do not have a clear plan of action. The credibility of a government that is constantly taking or considering measures to deal with the problems of a country is bound to suffer. The correct combination of fiscal, monetary, income, and exchange rate policies may yield the desired results, whereas no one of them would be sufficient by itself to guarantee lasting results.

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