The promotion of sustainable economic growth is one of the principal objectives of ESAF-supported programs. This chapter examines the pattern of growth in ESAF countries over the past 10–15 years, drawing comparisons with other developing countries, and seeking to explain differences in growth outcomes among countries and over time. The chapter begins with a brief outline of the stylized facts. It then presents a general overview of the methodology used to examine the empirical behavior of long-term growth and surveys the extensive literature on this subject to identify the various policy-related and other factors that have been found to influence growth. An equation relating growth to these factors is estimated on data for 84 low- and middle-income countries, and it is used to compare the growth performance of ESAF countries with that of other developing countries (information on the data and results is reported in an appendix). A more detailed analysis focuses on the impact of structural policies on growth in ESAF countries. The chapter concludes with a summary of its findings.

The promotion of sustainable economic growth is one of the principal objectives of ESAF-supported programs. This chapter examines the pattern of growth in ESAF countries over the past 10–15 years, drawing comparisons with other developing countries, and seeking to explain differences in growth outcomes among countries and over time. The chapter begins with a brief outline of the stylized facts. It then presents a general overview of the methodology used to examine the empirical behavior of long-term growth and surveys the extensive literature on this subject to identify the various policy-related and other factors that have been found to influence growth. An equation relating growth to these factors is estimated on data for 84 low- and middle-income countries, and it is used to compare the growth performance of ESAF countries with that of other developing countries (information on the data and results is reported in an appendix). A more detailed analysis focuses on the impact of structural policies on growth in ESAF countries. The chapter concludes with a summary of its findings.

The Stylized Facts

During the early 1980s, developing countries—on average—experienced virtual stagnation in per capita real GDP. For those nontransition countries that subsequently availed themselves of financial support under the SAF and the ESAF, the first half of the 1980s was a particularly bleak period during which real per capita incomes dropped at an average annual rate of 1.4 percent. In the ten years thereafter, growth in these countries picked up, and the gap between their growth rates and the average of other developing countries was eliminated by 1995 (Table 5.1).

Table 5.1

Growth in Real Per Capita GDP in ESAF Countries and Other Developing Countries

(Annual average, in percent)

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Sources: World Economic Outlook (Washington: IMF, various issues); and IMF staff estimates.

Eighty-four low- and middle-income nontransition developing countries comprising 90 non-ESAF developing countries as defined in the World Economic Outlook less 6 countries classified as high-income by the World Bank (World Development Indicators database).

However, this improvement in growth among the world’s poorest developing countries was not evenly based across different regions. Growth in Western Hemisphere ESAF countries, which was sharply negative during the 1980s, turned around dramatically in the early 1990s, while that of Asian ESAF countries continued to be strong. In contrast, there appeared to be a setback among African ESAF countries, whose growth again turned negative in the early 1990s so that, on average, per capita GDP growth rates in Africa during the past decade remained close to zero. However, a closer look at the individual African countries reveals that the growth picture varied widely, with some countries showing sizable gains throughout this period (Figure 5.1). More encouraging, there appears to have been a marked upturn in growth across the continent since 1994, in part reflecting the devaluation of the CFA franc.

Figure 5.1
Figure 5.1

Real Per Capita GDP Growth in ESAF Countries1

(Period average; in percent)

Source: IMF staff estimates.1Excluding transition economies.

The improvement in growth in ESAF countries was, in general, mirrored in increased investment and saving rates, although both remain lower in these countries, on average, than in other developing countries—the gap is especially large in the case of saving rates (Table 5.2). There was also substantial regional variation in the behavior of saving and investment. In contrast to Asia and the Western Hemisphere, saving showed little improvement in Africa. Although investment picked up in non-CFA Africa and the Western Hemisphere, it stagnated in relation to GDP in CFA Africa and Asia.

Table 5.2

Trends in Saving and Investment Rates

(Annual average, in percent of GDP)

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Source: World Economic Outlook (Washington: IMF, various issues); and IMF staff estimates.

Excludes Guyana.

Eighty-four low- and middle-income nontransition developing countries comprising 90 non-ESAF developing countries as defined in the World Economic Outlook less 6 countries classified as high-income by the World Bank (World Development Indicators database).

A comparison of developments in growth, saving, and investment before and since countries embarked on their first SAF/ESAF arrangement reveals a brighter picture. With respect to real growth, the data shown in Figure 5.2 depict a marked increase in per capita GDP growth, on average, for all ESAF countries in the three years after the start of SAF/ESAF-supported adjustment compared with the three preceding years. Only in countries in the CFA franc zone did per capita GDP continue to decline during the first SAF/ESAF arrangements. The turnaround is most dramatic in non-CFA African countries and countries in the Western Hemisphere. Transition economies also recorded a significant improvement in growth during ESAF-supported programs.

Figure 5.2
Figure 5.2

Real Per Capita GDP Growth in Adjustment Time

(In percent)

Source: IMF staff estimates.1Excluding transition economies.

Saving and investment rates before and after the first SAF/ESAF arrangement are shown in Figure 5.3. Here, too, there were marked improvements after SAF/ESAF-supported adjustment began. Investment picked up sharply in non-CFA Africa, the Western Hemisphere, and transition economies. Saving rates also rose markedly, albeit from a low base, in the latter two regions, as well as in CFA Africa.

Figure 5.3
Figure 5.3

Saving and Investment Ratios

(In percent of GDP)

Sources: IMF, World Economic Outlook; and IMF staff estimates.1Excluding transition economies.2Excluding Guyana.

Overview of the Methodology

The forces underlying economic growth have been the subject of renewed interest in the economic profession since the mid–1980s, particularly following the development of a theory of economic growth in which distortions and policy interventions can be shown to affect not only the levels of income, but also its steady-state growth rate—the so-called theory of endogenous growth.1 Since then, a vast and growing theoretical and empirical literature has emerged on the factors that influence long-term growth and that can help distinguish between high and low growth rates across countries and over time.2 There are several approaches that have been taken in the empirical literature, all based on cross-country data—either cross-sectional, or pooled cross-sectional and time-series—each with its own uses and limitations. One such approach is to estimate, using cross-sectional data and regression analysis, the parameters of an underlying common production function. Although this approach permits the examination of the contribution of accumulation of various factors of production to growth, it leaves unexplained the determinants of factor accumulation and productivity and, in particular, the role of policies in promoting or retarding growth.

Partly in response to this limitation and partly inspired by the development of the theory of endogenous growth, a second, more eclectic approach was developed in which growth is viewed as a function of factor accumulation and other conditioning variables, the latter typically proxying the effects of economic policies. One problem with this approach, as noted by Fischer (1993), is the difficulty of interpreting the results from a regression that includes the investment rate and macroeconomic and structural policy variables on the right-hand side, since most or all of the policy variables would also influence the pace of capital accumulation. Furthermore, including the investment rate in the growth regression gives rise to a potential bias in the estimated coefficients, owing to the simultaneity between the two variables. These limitations gave rise to another empirical approach, which involves decomposing growth rates into the part attributable to factor accumulation and that attributable to changes in factor productivity, imposing constant (over time) and common (across countries) factor shares. Separate regressions are then estimated for growth, capital accumulation, and growth in total factor productivity, with a number of policy and other relevant variables included as regressors (see Fischer, 1993; and Bosworth, Collins, and Chen, 1995). This approach permits the examination of the impact of policies on growth and then, separately, on the principal mechanisms through which the effects of policies are transmitted to growth.

Since the major focus of this chapter is on identifying policy variables and other influences that help to distinguish the growth outcomes of ESAF countries from those in other developing countries, the methodology adopted here focuses on the first of the three regressions in the last approach described above—that is, one in which pooled cross-sectional and time-series analysis is used to examine directly the influence of policies and other factors on growth. Under the maintained hypothesis that growth, capital accumulation, and factor productivity are influenced by policies (as well as by exogenous shocks and initial conditions), the growth equation estimated here can be interpreted as a reduced-form equation.3 This regression analysis is intended to provide a broad overview of the determinants of growth and adds to and complements the conclusions emerging from a recent study of the response of investment and growth to adjustment policies, which was based on the detailed analysis of eight country cases (Goldsbrough and others, 1996; see Box 5.1).

Determinants of Growth

Empirical growth studies have examined a large number of variables as determinants of growth. Given the inherent difficulty of constructing simple measures of policy variables, it has generally proven necessary to use proxies that can also be affected by non-policy-related factors. In view of the complex nature of the interaction between policies and growth, it has often been difficult to identify statistically robust relationships between growth and most of the observable proxies for policies. Nevertheless, the following factors have been identified with some regularity in the growth literature.


The first and most widely examined issue is the one of “convergence” between richer and poorer countries. An important implication of the neoclassical growth model is that incomes in poorer countries will, over time, approach real incomes in rich countries, in part because of the closing of the technology gap. Most evidence on growth rates contradicts this prediction—poor countries typically also have the lowest growth rates. Ample evidence, however, supports the notion of “conditional convergence”—that is, once account is taken of other growth determinants, including policies, there is evidence that poor countries do grow more rapidly than richer ones. This hypothesis is tested in empirical growth models by including, as an explanatory viable, initial-period real GDP levels or the gap between a country’s initial-period GDP and that of a benchmark country, typically the United States.

Human Capital Accumulation

Another widely examined implication of the recent advances in growth theory is that human capital accumulation is a key determinant of growth. The important feature of the new growth theory that gives rise to the implication that policies can affect growth rates is that of nondiminishing returns to capital accumulation. The question of explaining growth is thus one of determining whether diminishing returns are really a constraint, and, if not, how they can be overcome. One possibility is that “knowledge” or human capital accumulation eliminates diminishing returns to capital, implying that labor inputs should be proxied not simply by population or labor force growth but rather by a combination of that and “knowledge.” Empirical studies have included various proxies to capture the accumulation of knowledge, including school enrollment ratios and other more sophisticated measures of schooling (Barro and Lee, 1993; Nehru and Dhareshwar, 1993). Typically, the empirical relationship between growth and these proxies for human capital accumulation has been found to be robust, although the significance of the specific measure of human capital accumulation varies across different samples of countries and time periods.

Macroeconomic Policies

Typically, the effect of macroeconomic policies or stability on growth is proxied by the rate of inflation and some measures of its variability. Fischer (1991, 1993) and others have argued that the inflation rate is the “single best indicator” of the extent to which macroeconomic policies are conducive to growth. Thus, although inflation may affect growth directly, the inflation variable may also capture the effects of policies tied to inflation. Notwithstanding the theoretical appeal of the arguments that high inflation is damaging to growth, the empirical support for this relationship has been mixed. However, more recent studies, particularly those allowing a nonlinear relationship and using panel (rather than purely cross-sectional) data, have tended to support a negative relationship, at least for inflation above the single-digit range. (The issue of the robustness of the inflation-growth association is addressed extensively in Chapter 6, as are questions of its causal interpretation.)

The effects of macroeconomic policies are also examined more directly by including fiscal policy indicators in the growth equation. Budget balances are often included as a proxy for stable and sustainable macroeconomic policy and are typically measured as the ratio of central or general government balances to GDP (see Fischer, 1991, 1993; Levine and Zervos, 1993; and various others).4 The theoretical rationale for including this measure is that, other things being equal, a higher government deficit implies (1) a larger claim by the government on the economy’s financial resources, (2) crowding out of the private sector by lowering access to credit and by raising real interest rates, and (3) a more appreciated real exchange rate, all of which can have an adverse effect on growth. Most empirical studies have tended to find that larger overall budget deficits are associated with lower growth.

Main Findings of Reinvigorating Growth in Developing Countries: Lessons from Adjustment Policies in Eight Economies (Goldsbrough and others, 1996)

This study examined why the medium-term response of growth and investment to reform has frequently been slow, even in countries that have undertaken significant adjustment. It drew upon evidence from eight countries (Bangladesh, Chile, Ghana, India, Mexico, Morocco, Senegal, and Thailand), three of which were ESAF countries. The main findings were as follows:

  • Adjustment episodes were typically triggered by large financial imbalances, extensive structural problems, or both. Most countries had suffered adverse external shocks that typically interacted with an inadequate policy response and heavy external borrowing to precipitate a crisis and a severe external financing constraint.

  • Countries that experienced especially severe episodes of macroeconomic instability, including very high inflation, had growth rates well below the world average during these episodes. By contrast, the confidence generated by a track record of stable, market-oriented economic policies appears to be important in generating growth rates consistently above the world average.

  • The abrupt contraction of domestic absorption resulting from a crisis typically felt heavily on investment—public and private—and gave little time to sustain output by switching resources to tradables. Several countries experienced a “pause” in private investment that lasted two to four years after the adoption of improved macroeconomic policies and structural reforms, reflecting the negative influence on investment of uncertainty and instability. The implementation of mutually consistent policies—an integral component of which is a sustainable medium-term fiscal position—was essential to promote more rapid resource switching and to reduce lags in the response of investment.

  • The largest and most lasting increases in saving were achieved in countries with the best growth records, suggesting a mutually reinforcing effect over the medium term. As also suggested by a number of other studies, the most important policy influence on overall saving appeared to be changes in the level of public saving, although a history of macro-economic stability and public sector reforms (of the tax, public enterprise, and pension systems) also appeared to contribute to increases in saving.

  • Robust empirical links could not be identified between external financing and growth, although the country examples tended to support the view that timely availability of additional financing is likely to enhance growth prospects, provided that supporting policies are in place. Over the medium term, countries with favorable structural policies and improved public saving were the most successful in attracting capital inflows and channeling them toward increased investment, especially in tradables.

  • Countries that began with relatively small structural distortions or made significant progress toward eliminating major distortions tended to experience the most rapid productivity gains, and vice versa. Although there is evidence of complementarities between certain key reforms, no single blueprint emerges for the appropriate sequencing of structural reforms.

  • Countries with a weak growth record tended to have considerable initial labor market rigidities that impeded real wage flexibility; these features remained largely unchanged during adjustment. Patchy evidence suggests that real wage flexibility had important effects on the responsiveness of employment to output and on limiting the negative effects of disinflation on output and employment.

Other macroeconomic policy-related indicators that have been widely examined are the level of external indebtedness and the degree of misalignment of real exchange rates. There has been a great deal of interest, both theoretical and empirical, in the effects of a heavy burden of external indebtedness on economic growth (Borensztein, De Gregorio, and Lee, 1994; Eaton, 1987; Cohen, 1996; and Elbadawi, Ndulu, and Ndung’u, 1996). From a theoretical standpoint, several channels of influence have been identified: higher debt burdens may undermine macroeconomic stability by raising budget deficits; heavy debt-service burdens could raise uncertainty about future increases in potentially distortionary taxation needed to bring about the necessary resource transfer (and possibly also foreign exchange shortages), thus choking off access to private capital markets and damaging private incentives to invest; and, finally, using domestic resources to service debt may crowd out domestic investment, potentially giving rise to a vicious cycle of stagnant growth and greater debt. However, the empirical evidence is mixed regarding the negative impact of external debt or debt service on growth. Fischer (1991), Cohen (1996), and Elbadawi, Ndulu, and Ndung’u (1996) are examples of studies that found that high external indebtedness is negatively associated with growth, while Hadjimichael and others (1995) did not find a significant association between external indebtedness and growth.

Some studies (Elbadawi, Ndulu, and Ndung’u, 1996; Bosworth, Collins, and Chen, 1995; and Ghura and Hadjimichael, 1995) have included the change in the real effective exchange rate as an indicator of the appropriateness of exchange rate policy on the grounds that most (non-oil-exporting) developing countries experienced a major deterioration in their terms of trade during much of the period under consideration, which in turn would imply, other things being equal, a depreciation of the equilibrium real value of the domestic currency. Thus, it is argued that an observed real effective depreciation can be interpreted as a movement toward equilibrium (and sustainable) exchange rates. These studies do find a significant negative correlation between real exchange rate appreciation and growth.


The degree of openness of an economy can affect growth through many channels. International trade not only allows countries to access larger markets and thereby take advantage of economies of scale, but it also improves resource allocation—hence generating efficiency gains—by lowering distortions in internal relative prices. Trade orientation is also postulated to affect growth through the beneficial effects of increased exposure to competition (Grossman and Helpman, 1991) and through positive externalities that result from the transfer of knowledge and technology (Romer, 1986 and 1990). These predictions have been tested empirically using various measures of openness to trade, including ratios of total trade to GDP, trade taxes, and more sophisticated ones such as those constructed by Leamer (1988) and used by Edwards (1992). Leamer’s measures of trade policies were derived by estimating a Heckscher-Ohlin model of trade, with the deviation between the actual and predicted pattern of trade taken as a measure of trade intervention and that between the actual and predicted level of trade taken as a measure of openness.5 Several studies, including Levine and Renelt (1992) and Sachs and Warner (1995), did find a robust correlation between growth and openness to international trade.

Structural Distortions

One widely used proxy for structural distortions is the black market exchange rate premium, which is typically interpreted as a crude indicator of overall distortions, a measure of the appropriateness of the exchange rate, and a more general indicator of policy uncertainties.6 This variable has not been found to be robust in studies of growth determinants. Fischer (1991 and 1993) found, for example, that it is strongly negatively correlated with investment but does not appear to affect the rate of growth, whereas Levine and Zervos (1993) found that it does have a robust negative correlation with growth.

Several researchers have also examined the relationship between the size of the government, proxied by the ratio of government consumption to GDP, and growth. Although this indicator does not necessarily capture the productivity of expenditures, it is sometimes interpreted as a measure of the distortions associated with unproductive government spending, which not only lowers current per capita growth but also, by creating expectations of an increase in future tax liabilities, lowers future growth (Barro, 1991). On the other hand, government consumption includes expenditures that could be beneficial to growth, particularly in the areas of health and education. There is little consensus in the theoretical literature about the extent of government involvement in the economy that is conducive to growth. The empirical support is similarly mixed, with most studies finding that the correlation between government consumption and growth is negative, but not always strongly significant.

The effect of financial sector development on growth is another subject that has recently witnessed a resurgence in interest. Early proponents of financial sector liberalization as a factor influencing growth were McKinnon (1973) and Shaw (1973). More recently, the mechanisms through which the financial system can affect growth have been examined in Greenwood and Jovanovic (1990) and King and Levine (1993). According to these studies, financial sector development is positively associated with growth because financial intermediation enables savers to pool resources and share risks. Saving channeled through financial intermediaries is allocated more efficiently because such intermediation tends to reduce liquidity risks and partly overcomes the problem of adverse selection in credit markets; by expanding the availability of credit, financial intermediaries facilitate innovative activity and the process of “creative destruction.” Roubini and Sala-i-Martin (1991) used various measures of financial repression and found them to be significantly negatively correlated with growth. Similarly, De Gregorio and Guidotti (1992) and King and Levine (1993) found that proxies for the degree of financial sector development such as the ratio of broad money to GDP and the ratio of private sector credit to GDP are significantly positively correlated with growth.

Other Factors

In addition to policy-related variables, proxies for human capital accumulation, and initial conditions, most growth studies include measures of a variety of shocks, such as changes in the terms of trade, disruptive political events (such as coups, assassinations, and revolutions), and weather-related disturbances. Other studies have examined the correlation among growth and natural resource endowments (Sachs and Warner, 1995); the quality of governance, including law-and-order traditions, the quality of political institutions, corruption, and economic freedom (Sachs and Warner, 1995; Mauro, 1996); ethnic diversity (Easterly and Levine, 1996); and a host of other noneconomic features of countries.

Many empirical studies also include regional dummy variables to examine whether there is a significant unexplained growth differential between countries of a particular region and the average for the whole sample of countries under review. They typically find that, even after taking into account identifiable factors influencing growth, there is a significantly negative unexplained growth differential between African countries and the rest of the sample of countries—the negative “Africa dummy.” A few studies, however—notably Easterly and Levine (1996) and Sachs and Warner (1995)—have been able to “explain away” the Africa dummy by including measures of ethnic diversity and regional spillovers proxied by growth in neighboring countries (Easterly and Levine) or by taking into account the lack of physical access to markets and high reliance on natural resource exports (Sachs and Warner).

Specification of the Growth Equation and Estimation Results

In light of the large body of evidence that has already been extracted from the data, the intention here is not to expand or elaborate on the conventional array of growth determinants already identified. Rather, the principal aim is to examine the strength of the identified relationships for the ESAF developing countries. In an important paper, Levine and Renelt (1992) demonstrated that many of the relationships discussed above are not robust to changes in specification and sample characteristics.7 One question that is considered, therefore, is whether growth in ESAF countries is influenced by the same factors as in other developing countries. From there, the analysis examines what an estimated growth equation can reveal about the factors that account for the differences among growth performance in ESAF users and other developing countries, and about the evolution of ESAF countries’ growth over time. To address these questions, a large sample of low- and middle-income developing countries was used with annual data covering the period 1991–95, which broadly spans the pre-SAF/ESAF period and subsequent phases of structural adjustment for most countries under review.

Most of the variables discussed above are considered in the analysis that follows. Macroeconomic policies are proxied by the rate of inflation, budget balances (BUDBAL), measures of external indebtedness, and changes in real exchange rates (DREER). To examine the effect of inflation on growth, however, this analysis follows a suggestion made by Fischer (1993) and used by Sarel (1996) and others to include a logarithmic transformation of the inflation rate in the regressions (LINFL). The rationale for using this specification is twofold. First, it enables us to account for the intuitively appealing notion that moving from inflation rates of 10 to 20 percent is not the same as moving from rates of 110 to 120 percent or 1010 to 1020 percent. Second, the distribution of inflation rates is highly asymmetric, with a concentration of observations in the low-inflation range and a few observations in the very high inflation range. Thus, using inflation rates themselves would tend to place very heavy weight on a small number of high inflation observations. In contrast, the logarithm of inflation has a more balanced distribution.8 In addition, a dummy variable for observations with a negative inflation rate (DEFL) is included to reflect the possibility that deflation may be harmful to growth.

A number of authors have suggested that the negative inflation-growth association breaks down somewhere below 10 percent. Therefore, following Sarel (1996), the possibility of a further nonlinearity in the effect of inflation on growth is examined by including as a regressor a variable, EXTRAΠ*, defined as follows:9

EXTRAΠ* = dumΠ*[In (Π) - In(Π*)],

where Π* is the rate of inflation at which the non-linearity occurs, and dumΠ is equal to 0 if Π > Π* and equal to 1 otherwise. The coefficient on EXTRAΠ* measures the difference in the coefficients on inflation on each side of the “kink.” The bivariate relationship between annual inflation rates and growth suggests that such a break or kink occurs at a rate near 5 percent (see Chapter 6). Sarel (1996), using a different data set and equation specification, found that the break occurs at a rate of about 8 percent. Hence the search for the break point in the sample was conducted over the range from 2 percent to 10 percent. The rate (Π*) at which the kink in the otherwise negative relationship between growth and inflation occurs was found to be 4.5 percent.10

Three indicators of the burden of external indebtedness were used in this analysis—the (logarithm of the) ratio of total external debt to GNP, the debt-service ratio,11 and a dummy variable that takes the value of 1 for the first year of a debt-rescheduling agreement and the value of 0 otherwise.

As regards structural policies, in addition to the logarithm of the black market exchange rate premium, proxies were included for the size of government, openness to trade, and financial sector development. The size of government was proxied by the ratio of government consumption to GDP (GCONS). Openness to trade (OPENIND) was measured by an index constructed from the residual of a regression of the ratio of total trade to GDP on the size of the population—the latter used as a proxy for the size of the economy. The more outward-oriented the economy, the larger should be the regression residual. The degree of financial sector development was proxied by the ratio of average broad money to GDP (DEPTH) and the ratio of private sector credit to GDP.

The equation also attempts to link growth to key features of the economic and political environment affecting private investment decisions. It includes a variable, ECONSEC (based on data taken from Knack and Keefer, 1995), that measures factors affecting economic security such as expropriation risk, repudiation of contracts by the government, corruption, the quality of the bureaucracy, and the law-and-order tradition.12

In addition to the rate of population growth (POPG), several measures of human capital development were considered—gross primary and secondary school enrollment ratios, and the logarithm of life expectancy at birth (LLIFE). Initial conditions (convergence effects) were controlled for by including the logarithm of GDP in 1980 measured in U.S. dollars adjusted for purchasing power parity (PPP) (LGDP80).

The regressions also included three types of exogenous supply shocks: the change in the terms of trade lagged one year (DTOT1); a dummy variable that takes on the value of 1 for wars, episodes of civil unrest or political instability, and the value of 0 otherwise (WAR); and a dummy variable (WEATHER) that is interpreted as capturing abnormal weather conditions such as droughts and floods, and takes the value of 1 when per capita food production falls by 5 or more percentage points and the value of 0 otherwise.13

Two issues remain open to judgment. The first is whether the rate of capital accumulation (proxied by the rate of investment) should be included as an explanatory variable. Omitting the investment rate from the equation raises the possibility of an omitted-variables bias in the estimated coefficients. On the other hand, including it involves the potential for a simultaneity bias in the estimate, given that growth itself can have an important effect on investment. Since the purpose of this chapter is to examine the influence of policy and exogenous variables on growth, and the estimated equation is intended to be interpreted as a reduced form (see the earlier discussion on methodology), it was decided to exclude the rate of investment from the specification. A Hausman specification test suggests that—after controlling for other influences on growth—investment is not exogenous in the growth equation (Table 5.3).14 As regards the potential omitted-variables problem, insofar as many of the right-hand-side variables that are included also affect investment, this bias is not likely to be a major problem.

Table 5.3

Determinants of Growth

(Pooled annual data for 84 low- and middle-income developing countries, 1981–95, as available; dependent variable: real per capita GDP growth)

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Source: IMF staff estimates.Note:

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Indicates significance at the 5 percent level; * indicates significance at the 10 percent level.

A second, and related, issue concerns the direction of causality between the dependent and some of the right-hand-side variables. This problem is most relevant for inflation and the budget balance. It is possible that causation runs from growth to inflation or the budget balance, or that growth, inflation, and the budget balance are all “caused” by some other variable.15 For example, it is possible that an adverse supply shock causes inflation, slower growth, and higher budget deficits. The inclusion of supply shocks of the type discussed above would, to a large extent, mitigate this problem and would strengthen the case for interpreting the relationship between these macroeconomic indicators and growth as causal.

The regression analysis was conducted using annual data for 84 low- and middle-income developing countries for 1981–95. (See the appendix, Tables 5.13 and 5.14 for a complete list of countries included in the regression and the sources of data.)16 Since an important aim of the exercise is to compare factors contributing to growth in ESAF countries relative to a broadly similar group of other developing countries, high-income industrial and developing countries and transition economies were excluded from the sample.17 The sample includes all 30 nontransition ESAF users under review.18 Sample means for the complete set of variables are shown in the appendix (Table 5.6) along with simple pairwise correlations (Table 5.7). The equation was estimated by ordinary least squares, with a correction for heteroscedasticity performed on the standard errors of the estimated coefficients (see Table 5.3).19 The explanatory power (estimated coefficient of determination, R2) is relatively low, a common result in the empirical analysis of growth using annual observations for samples of developing countries.20 However, the value and significance level of the F-test, indicating that all the parameters are jointly significant, provides support for the specification, as does the finding that almost all of the estimated coefficients in the final specification remained relatively robust to changes in the specification.21 The key results from this analysis are as follows:

  • In keeping with the empirical literature, the coefficient on the logarithm of initial-period real GDP, used to test the hypothesis of conditional convergence of real incomes between poorer and richer countries, is found to be negative and statistically significant. The estimate suggests a sizable growth advantage—controlling for policies and exogenous shocks—for countries with low-income levels because of the closing of the technology gap.

    The measure of human capital development used here—the logarithm of life expectancy, lagged five years—is significantly positively correlated with growth. The finding that neither lagged primary nor secondary school enrollment ratios are significant in the equation is not typical to most empirical analyses of the determinants of growth.22 For this sample, however, that school enrollment ratios are highly positively correlated with the life expectancy variable (correlations of 0.78 and 0.73; see the appendix, Table 5.7) as well as the initial GDP variable may explain why it is not possible to identify significant independent effects from all three variables. The life expectancy variable can be seen as a more encompassing proxy, because it captures both the health and education dimensions of human capital development. The estimated effect is strong, suggesting, for instance, that increasing life expectancy from 50 years to 60 years—approximately the difference in the sample means between ESAF and non-ESAF countries (see the appendix, Table 5.6)—would increase per capita growth by almost 1 percentage point.23

  • The population growth rate is found to exert a strong negative influence on per capita growth, notwithstanding the positive contribution to growth associated with the faster growth of the labor force. Coupled with the finding of significant negative correlation (see the appendix, Table 5.7) between population growth and measures of human capital development, this suggests that policies intended to increase human capital development can have both a direct and an indirect positive impact on growth.

  • With respect to macroeconomic and structural policies, budget balances are found to be significantly positively associated with growth, whereas the size of government, measured by the ratio of government consumption to GDP, is significantly negatively correlated with growth. Likewise, the analysis suggests support in this sample for the idea that more open economies tend to enjoy higher growth.

  • As for the relationship between inflation and growth, the estimated coefficients of LINFL and EXTRA5 suggest that, at rates above 5 percent, inflation tends to have a significantly negative effect on growth, whereas at rates below that threshold the effect of inflation on growth is positive. The t-statistic on EXTRA5 indicates that the kink in the relationship between inflation and growth is statistically significant. In addition, the significant negative coefficient on the deflation dummy DEFL suggests that deflation is detrimental to growth.24 These findings should not be interpreted as pinpointing the exact rate at which a break occurs in the relationship between inflation and growth (as noted earlier, Sarel, 1996, found the kink at 8 percent). Rather, they provide evidence that such nonlinearities do exist, so that the estimated effect of intermediate and higher rates of inflation on growth may be underestimated in studies that have not taken nonlinearities into account, and they suggest a range of inflation rates that it would be prudent to target as part of a growth-enhancing policy package, other things being equal (see Chapter 6).

  • Economic security measured by the variable ECONSEC is found to have a positive and significant effect on growth, suggesting that stronger bureaucracies and law-and-order traditions and better governance, in general, are associated with more rapid growth. With respect to shocks, lagged improvements in the terms of trade are found to be positively associated with growth, whereas wars taking place on national territory and other disruptive episodes of civil unrest or instability and weather-related shocks are strongly negatively associated with growth.25

  • External indebtedness was proxied in different specifications by the (logarithm of the) ratio of total external debt to GDP, the debt-service ratio, or a dummy variable that takes the value of 1 for the first year of every rescheduling arrangement that a country made. The first two variables were insignificant in all specifications; this is not surprising in the case of the debt ratio because the numerator is not in net present value terms (owing to data unavailability) and hence does not reflect differences in the concessionality of external debt among countries. The sign in the rescheduling dummy could, in principle, be negative or positive depending on whether the variable captures more strongly cross-country differences in debt-servicing problems or the timing of rescheduling agreements within individual countries. In the former case, the variable would tend to capture mainly the negative effect on growth of countries that encounter frequent debt-servicing difficulties, whereas in the latter case it would mainly reflect the positive effect on growth of resolving uncertainty and, perhaps, reducing the debt burden. Although the coefficient on the dummy tended to be negative, it was not statistically significant and was dropped in the final step of the specification search. Thus, in this sample it is difficult to find strong evidence of debt-servicing difficulties affecting growth, after controlling for the effects of policies and exogenous shocks. Likewise, a strong or robust association is not found between growth and the black market premium, the change in the real exchange rate, or financial depth (measured by the ratio of broad money to GDP). These issues are discussed further below, under “Structural Reforms and Growth.”

Comparative Growth Performance

The next step in the analysis is to use the estimated coefficients reported in Table 5.3 to compare the different influences on growth from policies, shocks, and other factors between ESAF and non-ESAF countries. First, parameter stability across the subsamples of ESAF and non-ESAF countries was tested using a standard F-test (or Chow test). The results suggest that the null hypothesis that the parameter values for the ESAF subsample are (jointly) the same as those for the non-ESAF subsample cannot be rejected at the 5 (or 10) percent level (Table 5.3). This allows the full-sample equation to be used to draw inferences about the contributions of the various determinants of growth in the ESAF countries.26

The growth decompositions were conducted for three five-year periods (1981–85, 1986–90, and 1991–95), with the first period corresponding to the period just prior to the introduction of the SAF. Using the sample means and the estimated coefficients in Table 5.3, it is possible to examine the explained and unexplained sources of the growth differential between ESAF and non-ESAF countries over the period under review (Table 5.4, page 82).27 Was the convergence in the growth differential achieved by ESAF countries during the late 1980s and early 1990s because of good policies or good luck, or both?

Table 5.4

Differences in Growth Between ESAF and Non-ESAF Countries1

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Source: IMF staff estimates.

For each of the three periods, differential growth contributions are calculated by taking the difference (ESAF countries over non-ESAF countries) of the product of the estimated regression coefficient (reported in Table 5.3) and the respective sample mean for each variable. Estimated growth differentials are differences in the fitted growth rates of ESAF countries over non-ESAF countries. See appendix, Table 5.10 for the underlying growth decompositions.

Includes all three inflation terms, including the dummy variable for deflation.

Includes dummies for weather, war, and terms of trade shocks.

The results suggest that over two-fifths of the narrowing in the actual growth differential over the past decade was attributable to improvements in macroeconomic policies, while about a third was due to a more favorable set of exogenous conditions (last column of Table 5.4). These positive influences were partially offset by the negative contribution of structural policies and human resource factors. Despite some trade liberalization, ESAF countries did not make as much progress in opening their economies to external trade as did non-ESAF countries, nor succeed in reducing the size of government, notwithstanding progress in some countries.

Looking at the level of the growth differential in the early 1990s, reductions in inflation and positive exogenous shocks helped to pull up growth in ESAF countries relative to non-ESAF countries, whereas lower economic security and higher budget deficits had a negative effect (column for period III in Table 5.4). An interesting result is that the gap between ESAF and non-ESAF countries in factors affecting economic security accounts for the major part of the shortfall in structural policies in the early 1990s, and, generally, for the 1985–95 period as a whole. Most striking, however, the advantage for ESAF countries—in terms of the potential for more rapid growth—of starting from a lower level of initial per capita income (“technological convergence”) was more than offset by the sizable negative impact of higher population growth rates and lower levels of human capital development.28

As regards exogenous shocks, ESAF countries, after suffering a sharp decline in their external terms of trade in the 1980s, experienced an improvement in the early 1990s, whereas the terms of trade of non-ESAF countries continued to deteriorate. The contrast between ESAF and non-ESAF countries’ terms of trade movements is especially sharp when comparing the early 1990s with the early 1980s. In addition, ESAF countries experienced fewer weather-related shocks in the late 1980s and early 1990s compared with the early 1980s, whereas non-ESAF countries faced more adverse weather conditions during this period.

However, about half of the turnaround in the growth gap appears to be attributable to factors not included in the regressions—possibly the effects of structural reforms that were not fully captured by the measures of policies included in the regression.

Structural Reforms and Growth

As discussed in Chapter 4, a major objective underlying the construction of the score indices of structural policies is to attempt to identify more systematically their links with economic growth.29 Because the data requirements for the construction of such indices for all low- and middle-income developing countries were prohibitive, this exercise focuses solely on the sample of ESAF users. The indices of structural policies in the four areas of interest—exchange and trade systems (EXT), financial sector development (FINSEC), public enterprise policies (ENTPR), and pricing and marketing policies (PRICE)—were discussed in greater detail in Chapter 4. Two types of scores are considered in each area: a period-specific score for each of three five-year subperiods (1981–85, 1986–90, and 1991–95) and a cumulative score obtained by summing the scores for each five-year subperiod.

The first step was to examine, in a multivariate regression framework that controls for other factors, the links between growth and the period-specific and cumulative scores, respectively, in the four structural policy areas. However, with the exception of the pricing and marketing policies variable (PRICE), the indices were statistically insignificant, sometimes of the wrong sign, and generally not robust to changes in specification and sample.30 One possible explanation for this finding is that there is a high degree of multi-collinearity among the individual policy scores and between the policy scores and the other explanatory variables.31

Moving, therefore, to a framework with a smaller set of variables, simple bivariate regressions of period-average per capita growth and the individual policy indicators in each five-year period were estimated using data pooled over time and across ESAF countries. The results, at five-year and annual frequencies, are shown in Table 5.5. On the basis of the uncumulated period scores, price liberalization is strongly positively associated with growth, but financial sector reforms have a somewhat weaker, positive relationship with growth. External and public enterprise reforms, however, do not appear to be significantly correlated with growth. This result may, to some extent, reflect the offsetting, short-run effects on output of trade and public enterprise reform.32 When the scores are cumulated over time, a much stronger positive association emerges between each individual index and growth, suggesting a payoff both to having a relatively undistorted structure to begin with and to making significant early progress with reforms.

Table 5.5

Growth and Structural Reforms1

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Source: IMF staff estimates.

t-Statistics are based on heteroscedasticity-consistent standard errors; ** denotes significance at the 5 percent level; * denotes significance at the 10 percent level.

Combining all four structural policy indices.

With the structural policy score for each five-year period repeated for each of the five years in the period.

The impact of combinations of structural reforms on growth was also considered. Two alternative measures of the structural policy environment covering different combinations of the four individual indicators were regressed on the rate of growth:33 a simple unweighted average (as in Chapter 4) and the largest principal component.34 The results again suggest that, although the uncumulated effects are generally not significant, the cumulative effect of combinations of reforms—particularly in the areas of pricing and marketing, exchange and trade, and the financial sector—have a positive effect on growth (see the appendix, Table 5.11).

An attempt was also made to examine interactions between growth and the various indicators of structural reform in order to capture possible cross-effects or “complementarities” among structural reforms. The different combinations of the four structural reform indices and their respective cross-product terms were thus regressed on growth.35 The results do not show positive cross-effects or complementarities in the effects of different structural reforms on growth (see the appendix, Table 5.12). The coefficient on the cross-product terms is significantly negative (although much smaller than the coefficients on the individual indices) for the combination of price liberalization and external sector reform as well as price liberalization and financial sector reform for the uncumulated five-year scores. The cross-product coefficients are generally not statistically significant for the cumulated scores, with the exception of the combination of financial and external sector reforms. These results suggest that, although structural reforms in certain areas have a significant effect on growth, the quantitative effect is greater when reforms are undertaken singly than when they are combined with certain other reforms. This is consistent with the notion that the marginal effect of individual structural reforms on growth may diminish somewhat as other reforms are undertaken. The evidence does not, however, imply that the joint undertaking of structural reforms in these areas is harmful to growth, nor that implementing reforms sequentially is necessarily superior to undertaking them jointly.36

To sum up, the results suggest that structural reforms have favorable effects on growth, although the results are not very strong, particularly in a multivariate context. Cumulative effects are generally stronger than effects within an annual or five-year period, suggesting a payoff from not delaying implementation of reforms. There is no empirical support for the notion of complementarities among structural reforms, which would have suggested larger effects on growth of undertaking structural reforms simultaneously than individually. Hence, there is little or no evidence of a need for a “critical mass” of structural reforms: that is, a growth dividend from implementing reforms on a broad front. At the same time, the evidence does not indicate any negative overall effects on growth of implementing structural reforms in several areas simultaneously. Hence, by implication, there may be a case for focusing reform efforts selectively in a few areas where distortions are most severe. These findings must be interpreted with caution because of the severe measurement problems involved in calibrating structural distortions.

Concluding Remarks

The design of ESAF-supported programs has been guided by what have become widely accepted “best practices,” at least in countries starting from severely distorted economic structures. One of the questions this study set out to examine is whether the various determinants of growth—particularly those amenable to the influence of policies—identified in the extensive literature are also relevant for ESAF countries. The results confirm many of the findings of the empirical growth literature for the sample of low- and middle-income developing countries considered here. In particular, the analysis shows that in ESAF countries—just as in other developing countries—policies can play a significant role in improving growth. Stable macroeconomic policies, comprising single-digit inflation rates and low budget deficits, together with outward-oriented trade policies and a streamlining of the role of the government are all good for economic growth. In addition, policies aimed at increasing human capital, lowering population growth, and improving governance can all contribute in important ways to raising growth.

An examination of the contributions to growth of the various identified influences suggests that part of the marked narrowing of the growth gap between ESAF and non-ESAF countries can be attributed to stronger macroeconomic policies (inflation and budget deficits) and to more benign exogenous influences (in particular, the terms of trade and weather). However, policies have fallen short in several areas—notably, in reducing population growth, accelerating the accumulation of human capital, opening up to international trade, reducing the size of the government, and improving the quality of governance. The gap between ESAF and other developing countries has widened in these areas.

A more detailed examination of structural policies in the ESAF countries, with the aid of score indices constructed for the purpose, does not produce findings that are sufficiently robust to support firm policy conclusions. This may well reflect the enormous difficulties in measuring differences in structural policies across countries and over time. Bivariate correlations suggest that reductions in structural distortions are associated with more rapid growth over time. But such effects are barely discernible when full account is taken of macroeconomic policies, human capital accumulation, initial conditions, and exogenous shocks.

The results do not allow one to identify any particular aspect of structural reform as more important for growth; nor, however, do they provide evidence of “complementarities” or support for the hypothesis that a package of reforms together (a “critical mass”) has a larger impact than the sum of reforms taken individually.37 Hence, by implication, the findings would be consistent with an argument that reform efforts should focus on a small number of structural areas where problems are most severe.

In sum, we find some empirical evidence across a large group of countries in support of the basic orthodoxy of ESAF-supported adjustment programs. Perhaps reflecting the severe data limitations and the crude statistical tools at our disposal, the factors usually identified as determinants of growth explain only a small proportion of the variation in growth across countries and across time. Nevertheless, the available evidence does indicate that economic growth responds to the achievement and maintenance of macroeconomic stability, reinforced by structural reforms in key areas.38 The analysis also suggests some areas for improvement. More attention needs to be paid to human resource development and to improving institutions—such as civil service bureaucracies, legal systems, and the protection of property—that influence economic security. Deeper inroads also need to be made in opening up economies to external trade and in reducing fiscal deficits and government consumption.

To generate high and sustained growth in ESAF countries, an important challenge for ESAF-supported programs is to reorient government away from market-distorting activity toward increasing investment in human capital, improving the quality of institutions, and promoting open and well-functioning markets, while maintaining financial discipline.

Appendix 5.1. Details of the Analysis

Tables 5.65.14 provide supporting details regarding the data set and empirical results described in this chapter.

Table 5.6

Growth Exercise: Sample Means

(In percent, unless indicated otherwise)

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Source: IMF staff estimates.

A higher number indicates more openness.

A higher number indicates more security.

Table 5.7

Matrix of Simple Correlations: Whole Sample1

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Source: IMF staff estimates.

For a description of the variables, see Table 5.14.

Table 5.8

Determinants of Growth: Specification Search

(Pooled annual data for 84 low- and middle-income developing countries, 1981–95, as available)

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Source: IMF staff estimates.Note: t-Statistics based on heteroscedastic-consistent standard errors are shown in parenthesis; ** indicates significance at the 5 percent level; * indicates significance at the 10 percent level.
Table 5.9

Growth Exercise: Five-Year Averages

(In percent, unless indicated otherwise)

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Source: IMF staff estimates.

In years.

PPP-adjusted real GDP in U.S. dollars.

In each country, takes the value 0 when inflation is above 5 percent; otherwise, the difference between inflation and 5 percent (in logarithms).

Ratio to GDP.

A higher value indicates more openness.

In each country, takes a value of 1 for abnormal weather and 0 otherwise.

In each country, takes a value of 1 for war/civil unrest and 0 otherwise.

A higher value indicates more security.