Abstract

An increased availability of external financing during adjustment can facilitate growth by financing higher investment, helping to avoid sharp declines in domestic absorption or imports, and improving confidence by bolstering reserves or resolving arrears problems. Whether these effects occur in practice will depend importantly upon the response of policies. The interaction between policies and financing is complex, and it has typically been difficult to identify a robust association between external financing and growth from cross-country or time-series studies.61 As an illustration, the correlations between changes in net external financing and growth for the eight countries in the present study, and for a broader set of developing countries, were positive but rather small.62 Moreover, the level of financing is itself likely to be an endogenous outcome, heavily influenced by a country’s macroeconomic and structural policies. Causation probably acts in both directions, since faster growth may also attract capital inflows, including foreign direct investment.

An increased availability of external financing during adjustment can facilitate growth by financing higher investment, helping to avoid sharp declines in domestic absorption or imports, and improving confidence by bolstering reserves or resolving arrears problems. Whether these effects occur in practice will depend importantly upon the response of policies. The interaction between policies and financing is complex, and it has typically been difficult to identify a robust association between external financing and growth from cross-country or time-series studies.61 As an illustration, the correlations between changes in net external financing and growth for the eight countries in the present study, and for a broader set of developing countries, were positive but rather small.62 Moreover, the level of financing is itself likely to be an endogenous outcome, heavily influenced by a country’s macroeconomic and structural policies. Causation probably acts in both directions, since faster growth may also attract capital inflows, including foreign direct investment.

Whether an increase in foreign saving is available to finance higher investment will depend upon how much is offset by lower domestic saving. Changes in net external financing appear to be positively associated (although not one-to-one) with changes in investment rates;63 in this respect, the experience of the eight countries appears to be broadly similar to that of developing countries in general (Chart 17).64

Chart 17.
Chart 17.

Selected Developing Countries: Comparison of Changes in Investment and Net External Financing1

(In percent of GDP)

Sources: International Monetary Fund, World Economic Outlook, various issues; and IMF staff estimates.1 In terms of changes from preceding five-year period. BGD = Bangladesh, CHI = Chile, GHA = Ghana, IND = India, MEX = Mexico, MOR = Morocco, SEN = Senegal, and THA = Thailand.

Examining particular episodes where the sharpest swings in net financing occurred in the eight countries highlights a number of further observations (Chart 18 and Table 10). Three types of episodes are considered here: countries that experienced severe debt crises and a cutoff in external financing; countries that benefited at some stage from a substantial pickup in official financing; and countries that have received substantial private capital inflows in recent years.

Chart 18.
Chart 18.

Total Net External Financing1

(In percent of GDP)

Sources: International Monetary Fund, World Economic Outlook, various issues, and International Financial Statistics; and World Bank, World Tables.1 Net external financing equals the current account deficit plus the net increase in assets on portfolio and other investment account (including errors and omissions) plus the change in gross reserves. See Table 10.
Table 10.

Periods of Sharpest Swings in Net External Financing1

(Annual averages in percent of GDP; at current prices)

article image
Sources: IMF staff estimates; and International Monetary Fund, World Economic Outlook, various issues.

Based on three-year periods that show the largest swings in average net external financing as a share of GDP;two-year periods for Mexico (1980-81) and India (1991-92).

Equals current account deficit plus the net increase in assets on portfolio and other investment account (including errors and omissions) plus change in gross official reserves.World Economic Outlook data do not identify separately private and official current transfers. For Bangladesh, Ghana, Senegal, and Thailand total current transfers are largely official and are excluded from the current account deficit for the purposes of calculating net external financing.

Includes net portfolio investment (the data do not allow the separate identification of inward portfolio inflows) plus net external borrowing from banks.

For Bangladesh, Ghana, Senegal, and Thailand includes total current transfers. Includes World Bank disbursements separately identified as exceptional financing.

Equals IMF purchases (excluding reserve tranche) plus disbursements under the IMF’s structural adjustment facility and enhanced structural adjustment facility plus World Bank disbursements under structural adjustment loans.

First, the earlier discussion has already indicated that delaying adjustment until forced by a sharp withdrawal of external financing is likely to be particularly costly, in terms of lower investment and output. The external borrowing constraints were most severe in countries that experienced major debt-servicing difficulties, with Mexico especially hard hit, despite the cushioning effects of exceptional financing from the IMF and World Bank. The estimated investment equations discussed earlier suggest that confidence factors associated with the debt crisis and the authorities’ initial policy response were important factors behind the fall in private investment. Although an independent effect of “debt overhang” indicators on private investment could not be identified for most countries, this should certainly not be interpreted as meaning that the debt crisis—and its resolution—did not have a major impact on investment and growth. Obviously, such factors were of major importance, but they tended to operate indirectly through their impact on other variables—notably interest rates and the availability of credit to the private sector. In fact, other evidence indicates that the resolution of debt and debt-servicing difficulties typically raised investment. For example, the impact of Mexico’s agreement with commercial bank creditors during 1989-90 appears to have been more important for its effects on the private sector’s perceptions of creditworthiness and economic prospects than for its direct cash flow impact (equivalent to a total annual net saving on contractual interest payments of a little over 1/2 of 1 percent of GDP). Although it is difficult to disentangle the effects of the bank deal from policy measures, domestic real interest rates and Mexico’s risk premiums did fall sharply soon after the announcement of the preliminary agreement in 1989 on the bank package (see Chart 14).65

Second, Bangladesh, Ghana, and Senegal experienced sizable increases in official external financing at some point during their adjustment cycle, but with different outcomes for growth. In Ghana, the additional financing following the adoption of the Economic Recovery Program in 1983 appears to have had a major beneficial effect on the growth response to adjustment through several channels: (1) by alleviating a starvation of imported intermediate inputs essential for production, which appears to have been a factor behind the initial improvement in productivity; (2) by supporting a recovery in public investment; and (3) by improving confidence through the elimination of arrears and a modest rebuilding of reserves.66 Increased official financing also helped improve the social and political acceptability of adjustment, including through the Program of Actions to Mitigate the Social Costs of Adjustment (PAM-SCAD).67 Equally important, however, was the fact that increased external financing was accompanied by a marked improvement in public saving.

In contrast, higher official financing to Bangladesh at the outset of the first adjustment period also supported higher public investment, but was accompanied by a deterioration in public saving. This constrained the availability of domestic counterpart funds for investment projects.68 Evidence from Senegal during the early 1980s confirms that even massive inflows of external financing will not have a substantial impact on longer-term growth if the right policies are not put in place; inflows soared to over 20 percent of Senegal’s GDP in the early 1980s and helped cushion consumption and investment against severe adverse terms of trade movements and drought-related supply shocks, but did not support lasting adjustment measures.

Third, several countries experienced substantial surges in private capital inflows at a later stage of the adjustment process: in Chile, Mexico, and Thailand these began in the late 1980s, and in India beginning in 1993. Availability of external financing was obviously not a constraint on growth during these episodes, but the inflows were associated with widely varying developments in saving and investment and hence in growth. Again, policies appear to be an important part of the explanation for the different outcomes. In Chile and Thailand, the inflows helped finance a large increase in private investment while national saving as a share of GDP rose either moderately (Chile) or substantially (Thailand). By contrast, the inflows to Mexico financed mainly higher consumption; investment also rose, but by much less than in the other two countries.

The influence of policies on these outcomes operated through several channels, including the effects of the inflows on bank balance sheets and household liquidity constraints and the effects of fiscal policy on aggregate demand and the real exchange rate.69 In Chile, concerted efforts were made to discourage short-term inflows, including through the creation of some downside risk for the exchange rate and limiting the expansion in bank balance sheets. In Mexico, the capital inflows took place at a time of financial liberalization and contributed to a massive expansion of bank balance sheets. As indicated in Section V, the resulting easing of household liquidity constraints may have contributed to the decline in Mexico’s private saving.

Chile, Mexico, and Thailand—but not India—started the period of capital inflows with strong fiscal positions, but only Thailand achieved a significant fiscal contraction in response to the inflows; in Chile, the fiscal position changed little, while in Mexico and India some fiscal relaxation occurred (although in Mexico the fiscal position remained in surplus). The more restrained fiscal stance in Thailand, by influencing the level and composition of aggregate demand, also affected the real exchange rate path and probably helped to avoid a real appreciation. But other factors, including an overall policy framework that is conducive to foreign direct investment (FDI), have also been important. Such capital flows have been viewed as especially beneficial to growth because, in addition to their direct contributions to financing domestic investment, they are an important vehicle for the transfer of technology. Cross-country estimates by Borensztein and others (1995) suggest that there are significant crowding-in effects (a net inflow of FDI is associated with an increase in total investment at least one and a half times as large) and that there is a strong complementarity between FDI and human capital (FDI is more likely to be productive when human capital endowments exceed a minimum threshold level). Such inflows have been especially important in Chile and Thailand over the last decade (Chart 19); indeed, direct investment into Thailand was probably much larger than suggested by available statistics.70

Chart 19.
Chart 19.

A Comparison of Foreign Direct Investment and Gross Fixed Capital Formation, 1982-931

(Annual averages; in percent of GDP)

Sources: International Monetary Fund, World Economic Outlook, various issues; and IMF staff estimates.1 BGD = Bangladesh, CHI = Chile, GHA = Ghana, IND = India, MEX = Mexico, MOR = Morocco, SEN = Senegal, and THA = Thailand.
Lessons from Adjustment Policies in Eight Economies
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    Selected Developing Countries: Comparison of Changes in Investment and Net External Financing1

    (In percent of GDP)

  • View in gallery

    Total Net External Financing1

    (In percent of GDP)

  • View in gallery

    A Comparison of Foreign Direct Investment and Gross Fixed Capital Formation, 1982-931

    (Annual averages; in percent of GDP)

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