How one Latin American economy undertook far-reaching reforms


How one Latin American economy undertook far-reaching reforms

For decades many of the Latin American economies suffered large fiscal deficits, balance of payments problems, runaway inflation, and distorted financial systems. The depression of the 1930s and the enforced self-reliance of World War II gave an impetus to import substitution. This became the region’s dominant industrial strategy in the 1950s.

Several limited experiments in stabilization and liberalization were carried out in the 1960s, notably in Brazil and Chile from 1964 and in Colombia from 1967. These countries adopted more realistic exchange rate policies-partly through domestic stabilization efforts-and tried to reduce the bias against manufactured exports. They made less progress, however, in reducing import protection. Brazil and Colombia-whose reforms were more extensive than Chile’s--saw much improved export performance.

This text and charts are based on World Development Report 1987. The Chilean experience has also been the subject of a recent book by Sebastian Edwards and Alexandra Cox Edwards, reviewed in this issue by Claudio Loser.

Southern Cone experiments

The most significant experiments in trade liberalization in the 1970s took place in the countries of the Southern Cone of Latin America: Argentina, Chile, and Uruguay. These countries tried to stabilize and liberalize their highly controlled economies against an international background of recession, inflation, declining terms of trade, and the volatile capital flows which helped to provoke the international debt crisis of the 1980s. New governments came to power in the mid-1970s in all three countries and designed far-reaching liberalization programs. These radical reforms were undertaken in the face of entrenched political opposition to economic reform, which had grown out of the failure of several earlier attempts.

All three countries carried out an initial stabilization program of reduced public expenditure and devaluation, together with a program of economic liberalization measures which included removing quantitative restrictions, cutting the highest tariffs, reducing price controls, and reforming the financial system. But important differences in the emphasis and sequencing of policies in the three countries contributed to different outcomes for the three experiments. Chile attached great importance to a radical reform of trade policy, and this reform was achieved before the liberalization of capital account transactions. Argentina and Uruguay liberalized the capital account comparatively early and made less progress in reducing protection. In the early 1980s all three countries faced severe economic crises that were the result partly of international conditions but largely of their own mistakes, particularly in pursuing policies that encouraged a real appreciation of the exchange rate. Chile, whose trade reforms survived the crisis, and Argentina, whose reforms did not, provide an instructive contrast.

Trade reforms

Chile’s trade liberalization was unprecedented for its speed and breadth. Trade reforms followed in the immediate wake of other major reforms (see Chart 1). These included the virtual elimination of a large budget deficit (starting in 1974); the elimination of multiple exchange rates (1973-76); a large real devaluation (in 1973), followed by the adoption of a crawling peg exchange rate; the removal of price controls (from 1973); divestiture of public enterprises (from 1974); and liberalization of domestic financial markets (from 1974). In 1974-75 the government removed quantitative restrictions on imports. It had already started to introduce a series of progressively more liberal tariff reforms, and by 1979 it had achieved a uniform tariff of 10 percent. Exports were neither taxed nor subsidized (although an import duty without a corresponding export subsidy is equivalent to a tax on exports).

Chart 1
Chart 1

Major economic liberalization policies in Chile, 1972–86

Citation: Finance & Development 0024, 003; 10.5089/9781616353704.022.A005

Source: World Bank, World Development Report 1987. Adapted from de la Cuadra and Hachette 1987.

Inflation, although much reduced, still persisted after the stabilization, and the government began in 1976 to use the exchange rate in its fight against inflation. Its use of the exchange rate became more systematic from 1978 on when it adopted a crawling peg exchange rate that entailed a series of pre-announced nominal devaluations at less than the differential between domestic and international rates of inflation. This system, intended to fight inflation expectations, in fact contributed, with the continued indexation of wages and the lifting of controls on capital inflows, to a gradual appreciation of the real exchange rate. This eroded much of the substantial real depreciation that had occurred since 1973 (see Chart 2). Nonetheless, the real exchange rate in the years following 1974 was on average far more favorable to the production of tradables than that for the decade preceding 1973.

Chart 2
Chart 2

Real exchange rate, Imports, and exports in Chile, 1960–86

Citation: Finance & Development 0024, 003; 10.5089/9781616353704.022.A005

Source World Bank, World Development Report 1997.Note: A rise in the index of the real exchange rata indicates an appreciation, and a fall indicates a depreciation.

After a recession in 1975-the result of stabilization measures adopted since 1973 and an adverse movement in the terms of trade from 1974–the economy responded clearly to liberalization. From 1976 to 1981, GDP grew by 8 percent a year. Trade grew even faster-exports after 1973 and imports after 1976-until the beginning of the 1980s, by which time the effects of the real appreciation of the peso were being felt in earnest. In the 1970s Chile began to send new products abroad-for example, fruits, vegetables, and forestry products. Its share in world exports grew, although this was also helped by favorable international markets for its non-traditional products until the beginning of the 1980s.

Chile’s unemployment rate increased to 10 percent in 1974. The 1975 recession helped make the rate higher, and it remained high (between 13 and 17 percent) for the rest of the decade. Effective import barriers came down significantly only after 1976. According to one estimate, trade liberalization in isolation did not lead to net job displacement: lower import protection cut employment in manufacturing, but this was offset by employment gains caused by trade liberalization elsewhere in the economy, particularly agriculture. Jobs were lost as firms went out of business or were taken over; other firms survived by achieving large gains in productivity. This rationalization was achieved with little additional investment.

An exchange rate policy that led to real appreciation, post-1977 measures to liberalize exchange controls, and high domestic interest rates all contributed to heavy borrowing from abroad. The peso’s appreciation was particularly marked from 1979 to 1981. Exports became uncompetitive, and the trade deficit soared. By late 1981 a domestic recession was setting in, and in 1982 the peso was substantially devalued. The recession was so deep that unemployment reached 25 percent (in June 1982), and the financial sector was virtually bankrupted. The uniform import tariff was raised to 35 percent in 1984, but came down to 20 percent in 1985. Thus trade reform survived the crisis, and the rationalization it had fostered left Chile’s industrial sector in a far stronger position to withstand the shocks of the 1980s. In recent years the economy has grown strongly, and unemployment has come down to under 10 percent. Economic liberalization clearly contributed to this recovery.

Can governments ease the trade reform process?

Governments are seldom able to bring about economic reform at the stroke of a pen. They first have to overcome the opposition of groups which fear they may be adversely affected.

Transparency and persuasion

There is sometimes a bias in government decisionmaking: pressure groups can noisily voice their narrow interests, but when benefits are spread widely across the community no single group sees that it has much to gain. For example, it is easier to grasp the costs of closing down an inefficient car manufacturing plant than to see the benefits of cheaper cars and employment opportunities spread across the rest of the economy.

Another bias can arise when governments, to accommodate tensions between a sectional interest and the public interest, pass laws so vague that they appear to satisfy both. The law must then be implemented by administrative decision, and the special interest groups will attempt to influence the relevant administrators.

One way to promote public understanding of the public interest is to set up a “transparency” agency whose job would be to provide an overview of government intervention. The aim would be to help the government and the public see sectoral proposals in an economy-wide framework. Tariff commissions, established in such countries as Australia, Canada, New Zealand, the Philippines, Sri Lanka, and the United States, are intended to carry out this role, but the results have been mixed. The commissions have often spent much of their time working on highly technical questions such as whether an industry has suffered “damage” or “injury,” whether it can be attributed to imports, and whether these imports are unfair in some sense.

Transparency agencies can, in fact, claim some real successes, but the problems they face should not be underestimated. On top of the sheer difficulty of predicting the future, governments are always under pressure to mute their role by diluting their terms of reference.

A possible defense against this kind of pressure would be to make full review a legislative requirement. With sufficient independence and investigative powers a transparency agency could influence other branches of the bureaucracy. A bipartisan agreement that such review would be mandatory could serve as a kind of legislative constraint on government.

Safeguards and compensation

A government trying to convince the public that a certain reform will proceed smoothly might tip the scales by offering guarantees against disruption. These might include strengthened antidumping provisions (a safeguard measure) or additional income support for those who stand to lose (a compensation measure).

Unfortunately, the experience with safeguard measures is not encouraging. In practice, the search for safeguards has become a complicated process which is carried along by its own momentum and has precious little to do with economic efficiency. For example, a recent antidumping case in Australia dealt with cherries in brine from Italy. It turned on the appropriate valuation to be attached to the drums in which these cherries were packed for shipment. It seems that “dumping” could be “proved” if the drums were valued at their price when new--but if, as turned out to be the case, some drums were secondhand, then dumping could be not proved.

Compensation measures are an alternative approach, but they too have had many defects. The costs of identifying winners and losers are very large. This is because of the practical difficulties of sorting out policy changes and their impacts-people win and lose for all sorts of economic reasons, and it is seldom possible to be sure of the cost inflicted on a particular group by any given policy. Compensation measures also create “moral hazard,” in which people are given incentives to behave inefficiently to qualify for compensation.

Buying off pressure groups differs from straightforward compensation--at least in principle. It is a way of overcoming obstacles to change in an overtly political way. Even with this more limited objective, however, the record is discouraging. Far from softening resistance to change, this approach merely channels protest into pressure on governments about who should get the most compensation.

Finance & Development, September 1987
Author: International Monetary Fund. External Relations Dept.