1. Pre-debt crisis: 1976–83

In the mid-1970s, the Philippines embarked on a strategy for accelerated growth, founded on massive investment in public infrastructure and in a manufacturing base for non-traditional exports. During 1976–83, the share of investment in GNP was raised by around 6 percentage points from the levels prevailing in the early 1970s, to approach 30 percent (Table I.1). While some resources were released by a shift away from domestic consumption, most were provided by higher foreign saving.

Table I.1.

Philippines: Capital Inflows and Macroeconomic Balances

(In percent of GNP)

Source: Data provided by the authorities; IFS; and staff estimates.

^1/Defined as the current account deficit plus official transfers plus, the change in central bank NIR minus exceptional financing (rescheduling, concerted bank lending and arrears).

^2/1975 only.

^3/Ratios calculated from data for 1979–83 only.

^4/National government for 1976–77; public sector (excluding central bank) for 1978–81; consolidated public sector for 1982–89; and underlying consolidated public sector (adjusted for privatization receipts) for 1990–94.

^5/Compound averages.

^6/Ratio of investment to growth in GDP one year ahead.

Table I.1.

Philippines: Capital Inflows and Macroeconomic Balances

(In percent of GNP)

		1971–75	1976–83	1984–88	1989–92	1993–94
Capital inflows 1/		3.2	5.3	-1.5	2.3	5.4
Current account balance		-0.6	-6.1	-0.7	-3.2	-4.8
Consumption		77.9	74.9	81.0	81.7	82.6
	Private	68.9	65.9	72.8	72.0	72.9
	Government	9.0	9.0	8.2	9.7	9.7
Investment		23.4	29.4	17.6	21.7	24.1
	Private	20.3 2/	20.4 3/	12.1	15.7	18.3
	Public	3.1 2/	9.0 3/	5.5	6.0	5.8
Budget balance 4/		…	-4.5	-5.0	-3.7	-2.3
Memorandum items:
	Real GDP growth 5/	6.1	4.9	-0.2	2.1	3.2
	Incremental capital-output ratio 6/	3.5	9.7	6.4	17.6	5.3

Source: Data provided by the authorities; IFS; and staff estimates.

^1/Defined as the current account deficit plus official transfers plus, the change in central bank NIR minus exceptional financing (rescheduling, concerted bank lending and arrears).

^2/1975 only.

^3/Ratios calculated from data for 1979–83 only.

^4/National government for 1976–77; public sector (excluding central bank) for 1978–81; consolidated public sector for 1982–89; and underlying consolidated public sector (adjusted for privatization receipts) for 1990–94.

^5/Compound averages.

^6/Ratio of investment to growth in GDP one year ahead.

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Table I.1.

Philippines: Capital Inflows and Macroeconomic Balances

(In percent of GNP)

		1971–75	1976–83	1984–88	1989–92	1993–94
Capital inflows 1/		3.2	5.3	-1.5	2.3	5.4
Current account balance		-0.6	-6.1	-0.7	-3.2	-4.8
Consumption		77.9	74.9	81.0	81.7	82.6
	Private	68.9	65.9	72.8	72.0	72.9
	Government	9.0	9.0	8.2	9.7	9.7
Investment		23.4	29.4	17.6	21.7	24.1
	Private	20.3 2/	20.4 3/	12.1	15.7	18.3
	Public	3.1 2/	9.0 3/	5.5	6.0	5.8
Budget balance 4/		…	-4.5	-5.0	-3.7	-2.3
Memorandum items:
	Real GDP growth 5/	6.1	4.9	-0.2	2.1	3.2
	Incremental capital-output ratio 6/	3.5	9.7	6.4	17.6	5.3

Source: Data provided by the authorities; IFS; and staff estimates.

^1/Defined as the current account deficit plus official transfers plus, the change in central bank NIR minus exceptional financing (rescheduling, concerted bank lending and arrears).

^2/1975 only.

^3/Ratios calculated from data for 1979–83 only.

^4/National government for 1976–77; public sector (excluding central bank) for 1978–81; consolidated public sector for 1982–89; and underlying consolidated public sector (adjusted for privatization receipts) for 1990–94.

^5/Compound averages.

^6/Ratio of investment to growth in GDP one year ahead.

For the first two years or so, although current account deficits were high (around 5 percent of GNP; see Chart I.1), the external situation appeared manageable. The external debt-GNP ratio was rising, but most of the additional debt was medium- and long-term, and the debt service ratio remained below 20 percent (Chart I.2). Foreign direct investment and other non-debt-creating flows were a significant component of total financing (averaging almost 1 percent of GNP). And the central bank accumulated substantial increases in its net international reserves (NIR), holding gross reserve coverage at 3 ½ to 4 months of imports, despite rapidly expanding imports.

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PHILIPPINES: CAPITAL INFLOWS, 1970–94

(In percent of GNP)

Citation: IMF Staff Country Reports 1995, 114; 10.5089/9781451831252.002.A001

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PHILIPPINES: EXTERNAL DEBT AND RESERVES, 1970–94

Citation: IMF Staff Country Reports 1995, 114; 10.5089/9781451831252.002.A001

1/ Gross official reserves (excluding pledged assets) in months of imports of goods and services.

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By the early 1980s, however, almost all economic indicators had taken a turn for the worse. Far from accelerating, as planned, growth had in fact begun to decline, due in part to the effects of the 1979–80 oil price shock and world recession, while inflation was volatile and generally in double digits. The public sector budget deficit had risen sharply, reaching 9 percent of GNP by 1983 if the mounting quasi-fiscal losses of the central bank are included, and the current account deficit, which had been deteriorating steadily since 1977, rose to an average of almost 7 ½ percent of GNP during 1980–83. Perhaps the most alarming signal of trouble ahead, however, was the tripling of the debt service ratio between 1977 and 1983, reflecting a combination of weak export growth (with declining market shares), rapidly rising debt stocks, and higher world interest rates.

At the same time, the composition of the inflows had become increasingly destabilizing. Sources of long-term finance and investment flows dried up in the wake of the 1979–80 oil price shock. As a result, virtually all the inflows during 1979–82 were debt- creating, and short-term debt tripled in relation to GNP between 1977 and 1982. The central bank also allowed reserves to drop: NIR declined by almost 2 percent of GNP in 1982 alone, and by 1983 reserve coverage was below one month of imports.

Finally, crisis point was reached in October 1983, with a standstill on principal payments to the major commercial banks.

2. Adjustment and recovery: 1984–92

During 1984–85, the economy retrenched. Both fiscal and monetary policy were tightened dramatically (Charts I.3 and I.4), and public and private investment were slashed by a combined 15 percentage points of GNP. As a result, growth turned negative and the current account moved back into balance. There were substantial capital outflows, however, mostly repaying short-term debt, funded by debt rescheduling and other exceptional financing.

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PHILIPPINES: SAVING, INVESTMENT AND THE FISCAL POSITION, 1970–94

(As percent of GNP)

Citation: IMF Staff Country Reports 1995, 114; 10.5089/9781451831252.002.A001

1/ See Table 1 for data definitions.

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PHILIPPINES: GROWTH, INFLATION AND FINANCIAL INDICATORS, 1970–94

Citation: IMF Staff Country Reports 1995, 114; 10.5089/9781451831252.002.A001

1/ Domestic minus U.S. Treasury bill rates, adjusted for relative CPI inflation.2/ Ratios of broad money supply and banking system net domestic assets to GNP.

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Although the adjustment was painful, it succeeded—with help from creditors—in effecting the necessary turnaround in the country’s external position. Despite the initial recession, the debt-GNP ratio was brought down substantially (Chart I.2), thanks to the policy-induced improvement in the current account, combined with a program of debt-for-equity swaps which converted more than US$2 billion of debt between 1986 and 1992. As important as the decline in total debt was its transformation from short-term to longer maturities; by 1992, short-term debt in relation to GNP was back to the levels prevailing in the mid-1970s. The debt-service ratio also declined (even before rescheduling), helped by a steady drop in world interest rates and a marked improvement in export performance; from its peak in 1997, the debt service burden was halved within five years. Finally, reserve coverage was rebuilt to more than three months of imports by 1992.

The emergence from crisis brought with it a resumption of moderate inflows—beginning in the late 1980s—especially of direct and portfolio investment. However, the economy was not yet in the clear. Following three years of buoyant growth and single-digit inflation, financial policies were allowed to slip during 1988–90, as the authorities grappled with a variety of adverse shocks. ² Inflation picked up, growth slumped in 1990, and the current account moved back into sizable deficit again.

3. Resurgence of inflows: 1993–94

Three years later the outlook had been transformed, triggering the boom in confidence that has been a principal factor behind the most recent surge in capital inflows.

Among several reasons for the improvement in economic prospects, a crucial element was the successful restoration of financial stability under the Fund-supported program of 1991–92. This program had brought inflation down sharply to below 10 percent by 1993, from almost 20 percent in 1991. Moreover, there were signs by this time of renewed growth after the 1991–92 recession (Chart I.4). Fiscal consolidation continued in 1993–94, with underlying budget deficits (excluding privatization proceeds) of around 2 ½ percent of GNP.

Also important was an increasing recognition that the wide-ranging structural reforms of the late 1980s and early 1990s had succeeded in opening up the economy and enhancing competition, including through privatization. Critically, in late 1993, the chronic power problem was resolved with private sector participation; and the previously insolvent central bank was restructured and recapitalized.

A third factor was the substantial liberalization of the exchange system in January and August 1992, providing reassurance to potential investors that income and capital could be freely repatriated. Building on this, a Brady-style debt restructuring agreement with commercial banks in December 1992 was seen as confirming the fundamental rehabilitation of the country’s external position, and effectively renewed the Philippines’ access to international capital markets.

Finally, progress was made by the new Administration in easing domestic political tensions, which had been viewed as a longstanding impediment to economic development, especially in the south of the country.

These developments helped to bring the Philippine economy out of its three-year recession. Growth accelerated, reaching 5 percent in 1994, while inflation continued to drop. With the recovery both in economic activity and in the climate for investment came a resurgence of capital inflows, which (as a proportion of GNP) more than doubled during 1993–94 to almost 5 ½ percent of GNP, equaling the average for the 1976–83 period.

Of the approximately US$6 billion that flowed in during these two years, one third was foreign investment; another one third was medium- and long-term borrowing (of which almost three quarters was accounted for by public and private sector Eurobond issues); and less than one fifth was short-term credit. By contrast, during the 1976–83 episode, foreign investment had accounted for less than 6 percent of total inflows, while borrowing had made up the rest, split between short-term and medium- and long-term debt in roughly equal proportions. As of 1994, the debt burden was declining, short-term debt was at its lowest level for 20 years in relation to GNP, and the debt-service ratio was virtually back to its mid-1970s level.

1. Growth potential

A first glance at the figures (Table I.1) would suggest that the capital inflows during 1976–83 were more growth-friendly than in the recent episode. Aggregate investment was higher in 1976–83 than in the preceding half-decade by 6 percentage points of GNP. Not only were all the inflows invested, but consumption actually declined (as a ratio to GNP) during this period.

In 1993–94, by contrast, the consumption-GNP ratio was higher than at any time in the previous 25 years—except for the period immediately following the debt crisis, when investment was drastically cut. And although investment was up on the late 1980s and early 1990s as a share of GNP, it was well below the average for 1976–83 (Chart I.3). Growth itself was also lower in 1993–94 than in the earlier period, by more than 1 ½ percent per annum.

These comparisons may be misleading, however. First, growth rates were undoubtedly boosted in part during the late 1970s simply by the aggregate demand impact of the investment boom and associated fiscal deficits. These were inherently transitory effects. Second, while the quantity of investment was impressive, quality may have suffered in the rush to accelerate growth. The incremental capital-output ratio (see Table I.1) suggests that investments made in the late 1970s and early 1980s were perhaps less efficient, lower-yielding, than those in the recent episode. This is confirmed by data on average post-tax rates of return, which in the manufacturing sector rose from only 2 percent in 1979–81 to about 5 ½ percent by 1988–90. ³

There are several possible reasons why the quality of investment may have improved in the 1990s. One relevant consideration is who was doing the investing. In the earlier period, more than 30 percent of the investment was made by the public sector; there was no significant increase in private sector investment. Part of the public investment was in large, high-risk, capital-intensive commercial projects which subsequently failed; and part was intermediated through state banks with inadequate supervision and risk assessment (World Bank, 1993).

In the recent period, by contrast, more than three quarters of the investment has been by the private sector. Of course, private sector projects can also fail. But in general, private investors may be expected to allocate resources more on the basis of expected returns, will be less influenced (if at all) by political and other noneconomic considerations, and will be more conscious of risk and cost control.

At the same time, the economic environment in the 1990s is much more conducive to efficient private sector investment decisions, thanks to the structural reforms implemented since the debt crisis. Trade liberalization has been especially important in enhancing competition: whereas investment in the 1970s was still oriented toward the nontraded goods sector or import substitution, in the 1990s the manufactured export sector has been a major recipient, especially of foreign investment. ⁴

The increased importance of foreign direct investment in the 1990s also militates towards the more efficient use of capital in general, and imported capital in particular. ⁵ As Khan and Reinhart (1995) note, foreign direct investment is not only likely to be better targeted and more durable but also brings with it various externalities (technology, managerial know-how, access to international markets, etc.) which can have a wider beneficial effect on productive potential in the host economy.

Overall, there are reasonable grounds for believing that the inflows of the 1990s are more likely to be associated with a durable increase in economic growth than was the case in the 1976–83 episode, though it has to be admitted that the evidence is largely circumstantial. Growth prospects would clearly have been better still if domestic saving, which has been flat since the late 1980s (Chart I.3), had matched the rise in foreign saving, allowing a quicker and more substantial recovery in investment in the early 1990s.

2. Vulnerability to reversal

The 1983 debt crisis and its aftermath were an object lesson in the dangers of heavy and prolonged reliance on foreign capital. The fact that much of that capital was borrowed almost certainly added to the burden of subsequent adjustment; but similar disruption to the economy can arise even with equity flows, if they suddenly dry up or are reversed. An important issue, therefore, is the extent to which recent (and continuing) inflows to the Philippines are increasing the vulnerability of the economy to sudden swings in the capital account at some point in the future.

The possibility of a sudden loss of confidence can never be excluded. The experience of many developing countries in the aftermath of the Mexico crisis shows that economies can suffer from (temporary but severe) shifts in sentiment that are unrelated to their own circumstances or performance. In general, however, it is reasonable to assume that the likelihood of a confidence shock will be closely related to the “financial health” of the economy concerned. ⁶

In this respect, as noted earlier, almost all indicators for the Philippines—growth, inflation, the fiscal position, external debt and debt service ratios—have been moving in the right direction during 1993–94. This suggests not only that recent capital inflows are less likely to be reversed than those in the previous episode, but also that—so far, at least—they are self-sustaining, in the sense of being associated with a continuing improvement in the financial health of the economy.

There are some caveats to this conclusion, however. Capital is now more mobile than it was in the early 1980s, both because of the relaxation in exchange regulations referred to above, and because the composition has shifted over time away from bank debt towards marketable securities. Thus, while there may be no reason to expect a sudden reversal under existing conditions, if the economic indicators were to take a turn for the worse—including for reasons beyond the authorities’ control (e.g., external shocks)—capital would be able to leave more quickly and perhaps in greater volume than in the past. One implication of this is that policymakers must be more cautious than otherwise with regard to financial conditions: the risks of allowing sharp increases in inflation, even for brief periods, are heightened, as are the potential dangers of a weakening fiscal position or a sudden deterioration in the current account balance.

A second concern is that some of the funds that have flowed into the country during the past three years may be flight capital that exited during the mid-1980s, or that was accumulated abroad prior to the removal of most exchange controls in 1992. By its nature, the supply of such capital is limited, and could be expected to dry up at some point. This could affect the current account balance as well as the capital account, since some of the inflows through local foreign exchange accounts that are, at present, classified as current services receipts may in fact be returning flight capital. On a related point, the recent pick-up in foreign investment has been driven in large part by privatizations, which are expected to taper off over the medium term. In this respect, the Philippine authorities’ present strategy for medium-term fiscal consolidation (on which, more below) takes on added significance.

A final comparison that is worth making between the 1976–83 and 1993–94 episodes relates to the banks’ balance sheets. One of the potential dangers of large capital inflows, as noted by Calvo et al. (1995), is that when the incoming funds are intermediated through the banking system they can aggravate the maturity mismatch between banks’ assets and their liabilities. Typically, rising short-term deposits are used to fund longer-term credit expansion. A reversal of inflows can therefore precipitate a liquidity crisis in the banking system.

While no direct evidence is available on trends in the maturity structure of banks’ balance sheets in the Philippines, it is instructive to compare the evolution of the money supply and domestic credit (Chart I.4). During the late 1970s and early 1980s, there was a remarkable build up in banks’ domestic assets, from under 20 percent of GNP in 1976 to in excess of 60 percent of GNP by 1983. The rise in the money-GNP ratio during the same period was much more modest, implying that most of the credit expansion was financed by net foreign liabilities, which are predominantly short-term. This is suggestive of an increasing liquidity mismatch.

During 1993–94, by contrast, net domestic assets expanded by less than the money supply, indicating that Philippine banks were backing their rising deposit base (liquid liabilities) mostly by the net accumulation of (liquid) foreign assets. Moreover, this followed a decade of adjustment in the banking system, during which banks eliminated the huge net foreign liabilities incurred in the early 1980s and put themselves in a stronger position to deal with short-term liquidity demands.

1. Short-term: how to deal with the inflows

There is an expanding literature on the policy dilemmas posed by a surge of capital inflows ⁷ A universal finding is that the effect of the inflows on the economy, and the appropriate policy responses, depend on the nature and underlying causes of the inflows, and on their expected duration. What is less often acknowledged, however, is that in practice it may be very difficult to identify the driving factors, and to determine whether inflows are transitory or permanent.

In the case of the Philippines, at least three possible explanations for the 1993–94 inflows have been offered, each having different implications for policy:

• Higher real money demand, due to financial sector reform and/or general confidence effects. Inflows related to this factor should be monetized to avoid unnecessary nominal exchange rate appreciation or price deflation (assuming current inflation is on target). The Philippine authorities gave particular emphasis to this interpretation during the second half of 1994, when inflation came down sharply (to below the program target), despite significant unsterilized intervention and rapid monetary expansion.

• Higher demand for domestic nonmonetary financial assets, due to confidence effects (e.g., a lower risk premium on Philippine bonds). This would tend to push up the price of the relevant assets—most likely, bonds and equities—and cause interest rates to drop. There was evidence of this during much of 1993 and 1994, as the real interest rate differential vis-a-vis U.S. dollar assets declined (Chart I.4) and the stock market soared. The wealth and interest rate effects from this type of inflow tend to stimulate spending and hence inflation, but higher wealth will also shift the demand for money function, implying a higher real money supply in equilibrium. This latter effect should be accommodated through partial monetization of the inflows. For the rest, the appropriate response would be sterilized intervention if the inflows are believed to be transitory (to avoid imposing unnecessary adjustment costs on the trade sector) or nominal exchange rate appreciation if they are expected to persist (in which case the trade deficit must be larger in equilibrium).

• Higher demand for real productive assets in the Philippines, due to increased productivity (e.g., resulting from structural reforms). These inflows—indirect evidence for which was discussed in the previous section—will tend to be inflationary, at least in the near term, since they add to the demand for domestic nontraded goods, which are typically in inelastic supply. ⁸ In this case, external balance will inevitably require real exchange rate appreciation. If higher inflation is to be avoided, therefore, the nominal exchange rate must be allowed to appreciate.

The difficulty for policymakers facing a complex situation of this kind is obvious: an analysis of the inflows suggests as an appropriate response a combination of three different actions—nominal exchange rate appreciation, sterilized intervention, and unsterilized intervention (monetary expansion)—with the relative emphasis on each being unclear, a priori. In the event, during 1993–94, the Philippine authorities did indeed adopt a policy with all three elements. But they found themselves, as a result, in the awkward position of persistently exceeding their announced monetary targets, as well as being pressured by some of the weaker export industries for relief from the effects of a steadily strengthening peso.

In circumstances of this kind, there is a case for adopting a policy regime that attaches less weight to the (intermediate) monetary targets and more to the (ultimate) inflation target. In so doing, the importance of correctly interpreting the nature of the observed inflows is diminished, as are the dangers of making an incorrect interpretation. The Philippines has in fact recently adopted an approach which moves in this direction. Specifically, their Fund-supported program for 1995–96 includes the following key features:

• a ceiling on domestic credit (i.e., net domestic assets of the central bank) which is invariant to the scale or composition of capital inflows and hence allows their full monetization, so long as the last recorded inflation rate is no more than one percentage point above the target path; but,

• a ceiling on base money in any period following an “excessive” inflation outcome (the target rate plus one percentage point or more), implying that—until inflation is back within the acceptable range—any exchange market intervention will be fully sterilized.

In the latter case, the central bank is free to choose whether to use sterilized intervention or to let the exchange rate adjust freely. Although theory prescribes use of sterilized intervention in the face of certain kinds of transitory inflows, the difficulty of knowing whether an inflow is transitory or permanent makes such a prescription of limited use in practice. Questions have also been raised as to the effectiveness of sterilized intervention, and its use on a sustained basis is not recommended. ⁹ In general, if inflows really are transitory then little damage can be done by either monetizing them (if inflation is low) or allowing them to contribute to further appreciation (if inflation is above target).

This regime should be effective in dealing with most kinds of capital inflows: it accommodates noninflationary inflows (those that represent higher real money demand), but forces a tightening (preferably involving an element of nominal exchange rate appreciation) in cases where rising inflation indicates that demand-boosting inflows predominate. As with any form of inflation-targeting, it could lead to problems in the event of long or uncertain lags between monetary growth and inflation: the existence of substantial lags could permit monetization of inflationary inflows for protracted periods before the inflation trigger was activated. What evidence there is in the case of the Philippines points to money-price lags of less than two quarters, however, implying that risks of this kind are not great. ¹⁰

2. Medium-term: planning for potential outflows

While policymakers are grappling with the immediate challenges posed by large capital inflows, they should not lose sight of the quite different set of problems they might face were the inflows to cease or be reversed.

As with inflows, the appropriate response to capital outflows depends among other things on whether they are expected to be temporary or permanent: if the reversal is believed to be temporary, exchange intervention and higher short-term interest rates could provide a buffer to minimize the disruption to the real economy; if it is thought to be permanent, the current account would normally have to adjust, requiring some combination of real exchange rate depreciation and fiscal tightening.

The capacity of monetary policy to respond effectively to temporary shocks is probably greater now, on balance, than in the early 1980s. The increased weight of portfolio investment has created more scope for the central bank to influence capital flows using interest rates. This was evident during 1993, when the authorities’ attempts to drive down interest rates rather too quickly prompted a sharp turnaround in the balance of payments and a weakening of the peso; as soon as interest rates were brought back up, inflows resumed and the exchange rate stabilized. Similarly, in early 1995, reserve outflows in the wake of the Mexico crisis were quickly halted once short-term interest rates were raised. The effectiveness of interest rates as an instrument should increase further as capital markets in the Philippines (especially the markets for treasury bills and equities) continue to deepen.

The country’s reserve position, on the other hand, is somewhat less comfortable than it was in 1980, before the big reserve losses of 1981–83. Official gross reserves at end-1994 were equivalent to 2.7 months of imports, compared to more than 3 ½ months in 1980. Moreover, the true decline in reserve coverage is greater than these figures would suggest, since in 1980 extensive exchange controls gave the central bank effective command over commercial bank reserves as well as its own.

An important policy objective over the medium term should therefore be to rebuild official reserve coverage, ideally to beyond three months of imports. (The three other large economies in the region—Indonesia, Malaysia, and Thailand—have reserve coverage of 4 ½–7 ½ months of imports.) This would not only give the authorities more room for maneuver in responding to temporary external shocks, but could also preempt possible instability by bolstering confidence. For a given supply of foreign capital, a higher rate of reserve accumulation would require somewhat smaller current account deficits than are expected on present policies, and is one of several reasons why the Philippines should aim to boost its comparatively low national saving rate.

In the event of a permanent decline in capital inflows, the country’s ability to achieve orderly adjustment in the current account will depend, among other things, on the flexibility of the fiscal system. To the extent that, for given fiscal policies, real exchange rate depreciation fails to bring about the necessary increase in private saving relative to investment, government saving may have to be raised. While the Philippines did achieve a substantial improvement in public saving during the early 1990s (Chart I.3), most of this reflected higher trade tax revenues as oil import duties were raised and imports rose sharply as a share of GNP. This factor cannot be relied upon in the future, particularly in circumstances where tariffs are being lowered and an improvement in the current account is being sought.

There are two fundamental ways in which the capacity to effect fiscal adjustment in the Philippines could be enhanced. First, on the revenue side, the tax base needs to be broadened, principally by reducing exemptions. This would allow additional revenues to be raised, when needed, with smaller increases in marginal tax rates. As a result, adjustment would be less costly from an economic perspective as well as more feasible politically.

Second, on the expenditure side, the Government’s room for maneuver has for many years been restricted by the fact that a substantial proportion of its total expenditure has gone to interest payments. Interest accounted for almost one third of government spending in 1990 and, though reduced since, it still accounts for more than a quarter of the budget. This ratio can be brought down further only by adherence to a medium-term program of fiscal consolidation that progressively reduces public sector indebtedness. Such a policy would of course have wider economic benefits in the steady state—allowing more infrastructure spending, for instance, or a reduced tax burden. But, by increasing the share of discretionary spending in the budget, it will also enhance the Government’s ability to respond effectively to shocks that require additional fiscal adjustment.