Background and Recent Developments

The historic handshake on the White House lawn on September 13, 1993 between Chairman Yasser Arafat of the Palestine Liberation Organization (PLO) and the late Israeli Prime Minister Yitzhak Rabin set in motion the process of Palestinian empowerment in the West Bank and Gaza Strip. A senes of further agreements between the PLO and Israel defined more precisely the gradual assumption of responsibility by the Palestinian Authority for civilian activities and police in the West Bank and Gaza Strip. The most recent step was the September 28, 1995 signing of the Interim Agreement, which stipulated that the Palestinian Authority would assume responsibility for all remaining police and civilian activities in the major towns and cities of the West Bank by the end of December 1995 and in the rest of the West Bank (excluding Israeli settlements) during the 18 months following the elections of the Palestinian Council, which were scheduled for January 20. The redeployment of Israeli forces from the West Bank is to take place along a similar schedule.

The Palestinian Authority was confronted with a difficult social and economic situation in the West Bank and Gaza Strip. With the reduction in the number of Palestinian workers employed in Israel from a daily average of almost 120,000 in 1992 to less than 30,000 in 1995, unemployment has reached 25–35 percent of the labor force. In addition, much of the population in the West Bank and Gaza Strip does not have access to adequate public services: many schools and hospitals are dilapidated and overcrowded; water and sewage facilities are inadequate; and housing is scarce. Unemployment and a lack of public services are particularly acute problems in the Gaza Strip. Moreover, it was not evident initially that the Palestinian Authority would have the financial capacity to maintain and improve public services.

In addition to the severe short-term economic and social problems, the West Bank and Gaza Strip also faced fundamental long-term constraints to achieving more rapid economic growth through higher private sector savings and investment. Among the more important are the following:

• uncertainty over the future political status of the West Bank and Gaza Strip;

• heavy dependence on Israel for trade and employment;

• insufficient infrastructure, particularly transport facilities, electricity generation and transmission, and telecommunications; and

• a lack of economic institutions, which initially included the absence of a developed banking system, as well as licensing and trade procedures and practices that have increased the cost of private sector activity.

The initial efforts of the Palestinian Authority were geared toward institution-building, with a view to taking over all the functions of the Israeli Civilian Administration, reducing fiscal imbalances, and addressing immediate infrastructure rehabilitation needs. These efforts have already had a profound economic and social impact in the West Bank and Gaza Strip. In the macroeconomic area, fully functioning value-added tax (VAT) and income tax departments of the Ministry of Finance are already in place. The selection and preparation of public investment projects have improved greatly. The Palestinian Monetary Authority (PMA) has begun to carry out its role of licensing and supervising banks, and a Palestinian Bureau of Statistics has been established. Finally, elements of fiscal and macroeconomic policy formulation and management are being put into place, including initial work on formulating an overall macroeconomic policy stance in a medium-term context and improving the regulatory framework for private sector activity.

The Palestinian Authority has also been able to consolidate its fiscal position. After weakening in 1993-94, owing to disruptions in tax administration associated with the transfer of fiscal authority in the Gaza and Jericho Area, revenue performance began to improve in the fourth quarter of 1994 as a result of the Palestinian Authority’s initial fiscal institution-building steps. In 1995, the estimated recurrent deficit of $107 million (3.2 percent of GDP) was less than half the budgeted amount, which enabled the Palestinian Authority to manage with substantially less recurrent external financing than originally envisaged. This favorable outcome was due to strengthened domestic tax and nontax collection. VAT revenue clearances from Israel were also sharply higher as the unified invoice system jointly operated by the Palestinian Authority and Israeli tax administrations began operating sooner than initially expected.

After a slow start attributed to border closures, weaknesses in the newly created institutions of the Palestinian Authority, and the difficulties experienced by donors in mobilizing and committing funds, the public investment program gained momentum during 1995. In the emergency conditions that prevailed, most of the projects were dedicated to delivering minimum public services and rehabilitating a deteriorated infrastructure. Infrastructure rehabilitation gave particular emphasis to renovating and constructing schools, health facilities, parks and other public spaces; improving solid waste disposal; and upgrading and building new housing. These projects have had a tangible and beneficial impact on living conditions in the West Bank and Gaza Strip.

Partly as a result of these measures, private sector confidence revived significantly in 1994–95. This has been reflected in strong residential construction activity, the revival of merchandise trade (from 1995), and the expansion of banking activity.

Medium-Term Policy Framework

With progress being made in institution-building, stabilizing the fiscal position, and emergency infrastructure rehabilitation, the groundwork has been laid for formulating and implementing a more comprehensive strategy for economic and social development. At the Conference on Economic Assistance to the Palestinian People, held on January 9, 1996, in Paris, the Palestinian Authority outlined to donor representatives a strategy that is outward looking and private-sector led and geared toward promoting private capital inflows without debt creation. Under this strategy, the medium-term macroeconomic objectives of the West Bank and Gaza Strip during 1996–98 are as follows:

• attain real GDP growth of 5–6 percent a year;

• create new job opportunities;

• limit annual inflation to about 6 percent, in line with neighboring countries;

• contain deficits in merchandise trade and in the external current account; and

• minimize the domestic and external debt burden.

To attain these objectives, the Palestinian Authority intends to implement a comprehensive package of policies. Of paramount importance will be to restrain the growth of recurrent spending to contain the recurrent budget deficit to $75 million in 1996, and to achieve recurrent budget balance by 1997 and a surplus by 1998. While in 1995 expenditure restraint was exercised largely through ad hoc procedures, in 1996 the establishment of Offices of Central Budget, Treasury, and Internal Audit at the Ministry of Finance—as well as the channeling of fiscal receipts and expenditures through a centralized account—should strengthen efforts to resist increased spending. Because the Palestinian Authority has inherited an effective VAT system from the Israeli authorities, the priorities on the revenue side will be to improve the domestic income tax system in areas such as registration, enforcement, auditing, and exemptions and deductions.

A major push on public sector investment in basic infrastructure reconstruction is intended in the initial years of the program to address immediate deficiencies and to support private sector activities. In this context, the core investment program—a $550 million program formulated with World Bank assistance and endorsed at the October 1995 Consultative Group Meeting—is to be implemented during the next two years. Most of the projects will be in the areas of basic infrastructure, housing, and health and education.

The Palestinian Authority has yet to develop a final position on currency arrangements. It is recognized, however, that introducing a Palestinian currency will first require the establishment of a sound financial system with well-regulated banking and foreign exchange operations and a strong fiscal position. Consequently, priority in institution-building will be given to developing the Palestinian Monetary Authority’s capacity to supervise banks. The liberal exchange system prevailing in the Gaza and Jericho Area was extended to the rest of the West Bank at the end of 1995, when the Palestinian Authority assumed responsibility for banking and financial matters there.

Adoption of an appropriate regulatory framework is crucial for fostering private sector activity, which is currently regulated by a broad array of confusing and sometimes conflicting laws, decrees, and military orders. A legal reform committee will be established to set up and implement a phased action plan for legal reform (including the completion and adoption of the PMA Act and the banking law).

The Palestinian Authority will also review the provisions of the recently approved Investment Law, which provides for significant investment incentives, in order to assess its impact on private sector investment and the fiscal position.

The Palestinian Authority will consider adjusting its trade policies to suit its own development objectives, consistent with agreements with Israel and trade liberalization measures in neighboring Arab countries, the European Union, and the United States. Regarding external debt, the Palestinian Authority will undertake careful review prior to any contracting of concessional loans, and will limit external borrowing on commercial terms to well-justified and exceptional cases, consistent with its capacity to repay.

Restraint on current spending is critical for meeting medium-term economic objectives.

A review of the social security and social assistance systems in the West Bank and Gaza Strip will also be undertaken, with IMF technical assistance.

Donor Support

The above policy framework was endorsed by donors at the Conference on Economic Assistance to the Palestinian People, who also commended the Palestinian Authority on its efforts to date. In this context, donors pledged $73.5 million to cover the recurrent budget deficit in 1996 and about $800 million to finance the core investment program and other priority investment projects. Donors also pledged to mobilize $500 million in undisbursed earlier commitments to finance investment projects, bringing the total to be mobilized by the donor community to $1.3 billion.

Role of the IMF

The IMF has provided extensive technical assistance to the Palestinian Authority. Initially, the focus was on institution-building. In particular, the IMF’s Fiscal Affairs Department has been advising the Ministry of Finance on establishing effective tax administration and public expenditure management systems. The Monetary and Exchange Affairs Department, in collaboration with the Legal Department and cooperating central banks, has assisted in the establishment of the PMA, through the support it provided in the areas of bank licensing and supervision, clearing and payments systems, foreign exchange management, and the drafting of banking legislation. In late 1994, IMF staff, with participation by World Bank staff, began assisting the Palestinian Authority in preparing monthly (and subsequently quarterly) reports to donors on fiscal revenue and expenditure developments, institution-building in the fiscal area, and the formulation of the 1995 budget.

In the second phase, since mid-1995, IMF staff have been assisting the Palestinian Authority in formulating the 1996 budget in the context of a medium-term macroeconomic framework; and a paper on the medium-term policy framework prepared by the Palestinian Authority with the assistance of IMF and World Bank staff was discussed at the donor conference. The IMF’s Statistics Department is expected to intensify its work on establishing a system of macroeconomic statistics and; missions to the West Bank and Gaza Strip to assist with monetary, fiscal, and balance of payments statistics are expected to take place in 1996.

Exchange Rate Issues

Many observers do not think that the current exchange rate system is operating well, said Jeffrey Frankel of the University of California at Berkeley. Among the reasons were the high volatility of floating rates; the possible, albeit small, adverse effects on trade; the failure to explain most exchange rate movements by changes in fundamentals; the effects of regime changes on the variability of exchange rates; the apparent bias in expectations; and the apparent extrapolation in forecasts of short-term movements.

Proposals for reform, Frankel said, included fixing exchange rates more firmly or capital controls. A fixed-rate system—such as a currency board—was not feasible for most countries, apart from small, open economies in desperate straits. As to capital controls, Frankel noted that there was more talk recently about the Tobin tax (a levy on foreign exchange transactions), and that a better case could now be made for it—notably, that it could discourage short-term speculation. He conceded, however, that it remained hard to enforce. Frankel concluded that while foreign exchange markets were not operating perfectly, radical reform proposals had serious drawbacks.

Sebastian Edwards of the University of California at Los Angeles discussed choices of exchange rate regimes by developing countries. The choice of regime, he said, entailed a trade-off between economic stability and volatility. Pegged rates led to lower inflation and less macroeconomic instability, but resulted in higher real exchange rate volatility. Any pegged regime would require some flexibility. He emphasized the high political costs of abandoning pegs. For this reason, countries with greater political instability were reluctant to adopt them.

In discussing exchange rates in transition economies, Jeffrey Sachs of Harvard University said that the same issues applied to most countries. Several unique circumstances, however, had complicated the choice of exchange rate regime by transition economies, he said. These included the choice of an entirely new exchange rate system; political revolution; the legacy of a long history of nonconvertibility; a simultaneous stabilization crisis; and, for many, the task of introducing a new currency. Sachs concluded that:

• it was possible and desirable to introduce trade and current account convertibility immediately, which he characterized as “a linchpin of reform”;

• new currencies should be introduced quickly;

• the choice of regime was not always between pegged versus floating—a country (especially with high inflation) might wish to start with a pegged rate and switch later to a more flexible regime;

• for almost all countries, a flexible rate in the longer term was the only realistic option, as pegged rates sustained over time tended to lead to overvaluation and macroeconomic crises.

Stanley Fischer, First Deputy Managing Director of the IMF, focused his comments on the presentations of Jeffrey Frankel and Jeffrey Sachs. He emphasized that free capital movements and monetary independence precluded a fixed exchange rate; hence, floating rates were the more realistic option. As to the Tobin tax, he said that while it was hard to enforce, it might work in a few years if the major money center countries favored it and found a way to penalize transactions in offshore markets—perhaps as part of the trend toward uniform regulatory requirements for financial institutions. Nonetheless, exchange rate systems would still require flexibility. Fischer agreed with Sachs’s suggestion that transition economies seeking to reduce high inflation adopt a peg initially, though he pointed to some transition countries—Albania and the Kyrgyz Republic—that had stabilized without a peg. Many countries, he said, had failed to have exit strategies—most notably Mexico. Thus, it was important with a pegged rate to watch closely for signs of overvaluation and adjust the exchange rate as needed for more systematic flexibility. A pegged rate system, which also posed risks, necessitated higher interest rates, Fischer noted, for already fragile banking systems.

Michael Bruno, Chief Economist at the World Bank, agreed that an exchange rate anchor was useful in reducing high inflation. But he also emphasized the importance of monitoring the current account in a pegged regime, as well as the structure of government debt and the fragility of the financial sector.

In the open discussion, Sachs argued that the IMF required excessive fiscal adjustment before approving financial support for an adjustment program. He said that the IMF downplayed “policy endogeneity” (that is, that IMF support might facilitate the appropriate policy response and thus outweigh the risks of not seeking prior policy actions). Sachs was also critical of the IMF’s initial reluctance to support currency stabilization funds, although he recognized that the IMF’s Executive Board set policies. Fischer underscored that member governments—rather than IMF management and staff—determined IMF policy decisions. While the Board was concerned about the risks of supporting a failed currency stabilization strategy with a large loan, Fischer said, it recently approved the possibility of currency stabilization funds.

In a seminar on real exchange rates in Latin America, Sebastian Edwards reviewed the lessons of Mexico’s financial crisis, identifying two camps:

• a “bad luck” camp that assumed no policy errors but, rather, a series of unfortunate economic and political developments, and that the perceived overvaluation actually reflected equilibrium changes in the peso rate; and

• a camp attributing the crisis to policy errors, including an overvalued peso and a financial crisis.

Edwards said that the magnitude of overvaluation could not be explained by equilibrium changes and that the capital account surplus was unsustainable. The Mexican stabilization program rested on two pillars: fiscal and credit restraint, and a nominal anchor. While the program was credible at the start, it eroded as time progressed, with inflation getting stuck and the nominal anchor feeding overvaluation. Thus, Edwards concluded, the Mexican crisis was internally generated.

In the ensuing discussion, participants agreed that exchange-rate-based stabilization programs in Mexico—and elsewhere in Latin America—often led to sharp real appreciation and, in some instances, to subsequent collapse.

Assessing Transition Economies

Discussing the experience of transition economies, Jeffrey Sachs observed that it was possible to move from a state- owned to a substantially privatized market economy in five years—as Poland, Hungary, the Czech Republic, the Slovak Republic, Slovenia, and Estonia had done. All of the fast reformers were experiencing growth as of 1995, with some (Poland, Slovenia, and Estonia) enjoying booms. Sachs identified four aspects of transition:

• Systemic transformation. The greater the systemic reform (legal, political, private ownership), the greater the reform. Liberalization is straightforward, he said; the hard part was privatization and legal reform.

• Financial stabilization. Effective stabilization from high inflation requires fiscal adjustment and a nominal exchange rate anchor at the outset.

• Structural adjustment. Measurements of output loss were exaggerated (since much of what was being produced was not in demand). Large declines occurred in chaotic economies with rapid inflation; the adverse social consequences in the former Soviet Union owed to a lack of reform, not excessive reform.

• Achievement of high sustained growth. Sachs forecast that central and eastern Europe would grow for several years at more than 4 percent annually. The remaining challenges were structural. With 20-30 percent of GNP in these economies still in state hands, privatization must be continued and government spending reduced. Most countries, he said, still maintained “top-heavy social welfare states.”

Economic Reform and Growth

Michael Bruno presented a paper on the lessons of inflationary crises—defined as an inflation rate of 40 percent or more for two or more years. Among the main lessons, he said, were that high inflation ultimately forced stabilization and broad reforms; that growth recovered surprisingly well after high-inflation crises, although there was no tendency toward automatic recovery and high-inflation crises were a costly means of promoting reform; and that the timing of aid was important (its scarcity in high-inflation countries appeared to spur reforms).

In discussing China’s reform and growth experience, Eduardo Borensztein and Jonathan Ostry of the IMF said that although China—unlike other transition economies—had been growing well prior to the onset of reforms in 1979, reforms had had a positive effect on investment and growth. As the rate of productivity improvement was bound to slow, the authors argued that sustainability of current growth rates depended on a deepening of structural reforms. Two indicators that reforms were still incomplete were a continued high percentage of investment still accounted for by public enterprises (more than 70 percent) and a continued high rate of accumulation of inventories of unsalable products (5-7 percent of GNP).

Stanley Fischer presented a paper on reform and growth in transition economies, which he authored with Ratna Sahay and Carlos Vegh, also of the IMF. Growth had begun in 15 of 26 transition countries that had adopted reforms beginning in 1990, Fischer said. He underscored the “tight link” between inflation stabilization and growth; among the 26 countries, all countries that had reduced inflation to less than 50 percent had recorded growth within two years. While countries that stabilized and reformed quickly experienced growth relatively soon, Fischer acknowledged the political element in the scope and speed of reform.

Regionalism

Regional agreements set into motion forces that lead to more generalized liberalization, said Peter Petri of Brandeis University, presenting research he had conducted with Michael Plummer, also of Brandeis. Mordechai Kreinin of Michigan State University, commenting on the presentation, said that deeper integration was more feasible on a regional rather than a multilateral basis. Plummer added that inward-looking regional agreements led to their own demise; the Asia- Pacific Economic Cooperation Council (APEC) agreement, in contrast, was a good illustration of a regional accord committed to “open regionalism.”

Speaking on the role of multilateral institutions in the developing country context—with reference to Korea—in an era of globalized capital markets, Chung Lee of the University of Hawaii said that countries that attract foreign direct investment tended to have stable policies conducive to growth. The most appropriate role for multilateral institutions was to finance infrastructure development, provide technical assistance, and help developing countries establish indigenous enterprises, thereby creating opportunities for human capital investment through on-the-job training.

Roberto Perotti of Columbia University discussed research he had conducted with Alberto Alesina of Harvard University on the risks associated with fiscal unions. Perotti explained that advocates of centralizing fiscal policies argue that it offers advantages for both externality and insurance reasons (for example, the tax base is stabilized by being pooled). But Perotti argued that the insurance argument might not hold since the tax rate is endogenous and that with more countries involved in the decision-making process, the tax rate becomes more variable.

European Integration

At a seminar on European integration and institutions, Francesco Giavazzi of Università Bocconi identified four salient issues concerning the European Monetary Union (EMU):

• the timetable (a decision on “ins” and “outs” to be made in the spring of 1998 based on 1997 data);

• arrangements between ins and outs (creating a new exchange rate mechanism);

• rules for the ins (the proposed German stability pact—which calls for, among other things, fiscal deficits not to exceed 3 percent of GDP and to aim for 1 percent); and

• constraints imposed by the Maastricht Treaty.

Giavazzi discussed as well issues concerning institutional design. The EMU, he said, had evolved into an “open partnership,” which raised several issues: the relationship between policy areas that belonged to the open partnership and policy areas in which cooperation was compulsory for all European Union (EU) members; and how to administer an open partnership (including provisions of the German stability pact). The arrangements, he concluded, would require a good deal of flexibility.

Richard Portes of the London Business School saw a 50 percent chance for startup of EMU with a subgroup of EU members in January 1999. While it has not yet been decided whether the European Central Bank will use monetary or inflation targeting, it will conduct open market operations. No agreement has yet been reached on reserve requirements for commercial banks, as these would put banks in participating EU member countries at a competitive disadvantage with those in non-EMU members.

Jürgen von Hagen of the University of Mannheim, discussing research conducted with Barry Eichengreen of the University of California at Berkeley, suggested that the Maastricht Treaty’s rule against excessive public deficits might be counterproductive because it hamstrings national governments’ tax-smoothing and automatic stabilizer capacities. These restraints, he said, are not common in other monetary unions or in federal states. He preferred encouraging fiscal restraint through institutional reforms.

In the open discussion, von Hagen indicated that there is no opposition to EMU in Germany, pointing instead to the importance of developments in France. Charles Wyplosz of INSEAD (France) predicted that unless France saw a strong increase in growth, it was unlikely to meet the 3 percent budget deficit criteria for EMU. In this instance, he saw the possibility for a political compromise or postponement.

David Cheney Editor, IMF Survey

Theoretical Short-Run Effects

According to the Mundell-Fleming model, a fiscal expansion—either through increased government spending or reduced taxes—raises domestic demand and, with no change in money growth, leads to a rise in domestic interest rates. The rise in demand increases imports, which leads to a deterioration in the external current account; and the higher interest rates generate capital inflows that finance the change in the current account. The net effect on the exchange rate depends on the degree of capital mobility. Capital among industrial countries is highly mobile. Consequently, the fiscal expansion will tend to produce an appreciation of the nominal exchange rate. If prices respond with a lag to the increase in domestic demand, the real exchange rate will also appreciate. Likewise, a fiscal contraction should produce a short- term depreciation and an improvement in the current account balance. A scenario is constructed in the IMF study to demonstrate this standard Mundell-Fleming effect, using the IMF’s multicountry macroeconometric model (MULTIMOD). In this scenario, U.S. fiscal policy is tightened to reduce government debt by 10 percent of baseline GDP. This fiscal action has a short-term contractionary effect on consumption and total demand (see table, page 30). The decline in aggregate demand results in a fall in interest rates. As interest rates drop in the United States relative to the rest of the world, the dollar falls initially. The lower interest rate “crowds in” domestic investment, but aggregate domestic demand remains below its level before the fiscal action, which combines with the real exchange rate depreciation to improve the current account balance.

The IMF study cautions that this stylized scenario, which assumes that all other things are equal, does not necessarily take sufficient account of the initial conditions prevailing at the time of the assumed change in fiscal policy. Some depreciation may have already taken place in anticipation of later fiscal actions—such as the depreciation of the U.S. dollar against many other major currencies since 1994—and the exchange rate may not depreciate further once these actions are actually implemented.

Interest Premiums Could Signal Lack of Confidence

The theoretical prediction, as embodied in the above scenario that the short-term effect of fiscal consolidation is to depreciate the exchange rate and improve the external current account, holds true across a fairly wide range of models. But, according to the IMF study, the scenario does not allow for the possibility of changes in the perceived riskiness (from the point of view of investors) of assets in the country implementing the fiscal consolidation. Deteriorating actual and prospective fiscal positions and widening interest rate differentials have at times been associated with depreciating exchange rates. This is because investors have signaled their lack of confidence in the economic policies of a country with a large fiscal deficit by requiring higher yields on government debt. In certain cases, therefore, the adoption of strong and credible fiscal consolidation measures could narrow interest differentials, appreciate the currency, and worsen the current account position.

United States: Effects of Fiscal Consolidation on the Exchange Rate

(Percentage deviation from baseline unless otherwise noted)

Data: IMF, World Economic Outlook, October 1995

¹The estimates for the long run relied the permanent effects of the shock measured as the difference between the steady-slate solution of the model with and without the shock.

²A negative figure denotes a depreciation of the dollar.

³In percentage points.

United States: Effects of Fiscal Consolidation on the Exchange Rate

(Percentage deviation from baseline unless otherwise noted)

		1996	1997	1998	1999	2000	2001	2002	Long Run1
Nominal effective exchange rate2		-2.7	-2.8	-2.8	-2.6	-2.4	-2.2	-1.9	0.4
Real effective exchange rate2		-2.2	-2.5	-2.6	-2.6	-2.4	-2.2	-2.1	0.3
Real GDP		-0.7	-0.2	0.1	0.3	0.3	0.3	0.2	0.2
Capital stock		0.1	0.2	0.3	0.4	0.6	0.7	0.7	0.8
Inflation (GDP deflator)3		-0.3	-0.4	-0.2	0.0	0.0	0.0	0.0	0.0
Long-term interest rate3		-0.3	-0.4	-0.4	-0.4	-0.4	-0.4	-0.4	-0.1
Real long-term interest rate3		-0.2	-0.3	-0.4	-0.3	-0.3	-0.4	-0.4	-0.1
General government balance/GDP3		0.9	1.1	1.2	1.2	1.2	1.3	1.3	0.5
Government debt/GDP3		-0.5	-1.6	-2.8	-4.0	-5.0	-6.0	-7.0	-10.0
Current account balance/GDP3		0.2	0.3	0.3	0.4	0.4	0.4	0.4	0.4
Net foreign liabilities/GDP3		0.0	-0.3	-0.6	-1.0	-1.4	-1.8	-2.1	-7.0
Contribution to real GDP
	Real consumption3	-1.2	-1.0	-0.9	-0.7	-0.7	-0.7	-0.7	0.2
	Real investment3	0.1	0.2	0.3	0.3	0.3	0.3	0.3	0.1
	Real trade balance3	0.5	0.6	0.7	0.7	0.7	0.6	0.6	-0.1

Data: IMF, World Economic Outlook, October 1995

¹The estimates for the long run relied the permanent effects of the shock measured as the difference between the steady-slate solution of the model with and without the shock.

²A negative figure denotes a depreciation of the dollar.

³In percentage points.

View Table

United States: Effects of Fiscal Consolidation on the Exchange Rate

(Percentage deviation from baseline unless otherwise noted)

		1996	1997	1998	1999	2000	2001	2002	Long Run1
Nominal effective exchange rate2		-2.7	-2.8	-2.8	-2.6	-2.4	-2.2	-1.9	0.4
Real effective exchange rate2		-2.2	-2.5	-2.6	-2.6	-2.4	-2.2	-2.1	0.3
Real GDP		-0.7	-0.2	0.1	0.3	0.3	0.3	0.2	0.2
Capital stock		0.1	0.2	0.3	0.4	0.6	0.7	0.7	0.8
Inflation (GDP deflator)3		-0.3	-0.4	-0.2	0.0	0.0	0.0	0.0	0.0
Long-term interest rate3		-0.3	-0.4	-0.4	-0.4	-0.4	-0.4	-0.4	-0.1
Real long-term interest rate3		-0.2	-0.3	-0.4	-0.3	-0.3	-0.4	-0.4	-0.1
General government balance/GDP3		0.9	1.1	1.2	1.2	1.2	1.3	1.3	0.5
Government debt/GDP3		-0.5	-1.6	-2.8	-4.0	-5.0	-6.0	-7.0	-10.0
Current account balance/GDP3		0.2	0.3	0.3	0.4	0.4	0.4	0.4	0.4
Net foreign liabilities/GDP3		0.0	-0.3	-0.6	-1.0	-1.4	-1.8	-2.1	-7.0
Contribution to real GDP
	Real consumption3	-1.2	-1.0	-0.9	-0.7	-0.7	-0.7	-0.7	0.2
	Real investment3	0.1	0.2	0.3	0.3	0.3	0.3	0.3	0.1
	Real trade balance3	0.5	0.6	0.7	0.7	0.7	0.6	0.6	-0.1

Data: IMF, World Economic Outlook, October 1995

¹The estimates for the long run relied the permanent effects of the shock measured as the difference between the steady-slate solution of the model with and without the shock.

²A negative figure denotes a depreciation of the dollar.

³In percentage points.

Components of Interest Premium. The interest premium has three components, which provide different signals about the factors that may be influencing a country’s exchange rate:

• Foreign exchange risk premium. This is the compensation required by risk- averse investors to hold an asset whose only risk depends on its being issued in a particular currency; exchange risk premiums on the currencies of industrial countries are generally assumed to be small and unlikely to exceed 1 percent.

• Political risk premium. Although traditionally associated with the possibility of capital controls, this component can also reflect “default risk"—outright default or debt consolidation, or taxation of interest income and financial wealth. Political risk premiums are also likely to be small in the case of industrial countries.

• Expectation of currency depreciation. Probably the largest of the three, this component reflects several anticipated sources of nominal and real shocks, including changes in equilibrium real exchange rates resulting from demand and productivity shifts or expected changes in economic policies.

Signals of Fiscal Policy Effects. The response of the interest premium can provide information about the channel through which fiscal consolidation is transmitted to the exchange rate. The consolidation may lead to reductions in any of these components of the interest premium, implying in each case the possibility of a short-run appreciation of the currency. For there to be both an appreciation and a narrowing of the interest differential, however, such that the domestic interest rate falls, the fiscal improvement must be durable and be perceived as such by investors.

Fiscal consolidation measures can affect the risk premium as follows:

• Debt reduction may cause a fall in the foreign exchange risk premium by reducing the relative stock of domestically issued liabilities held in the portfolio of both domestic and foreign investors. With risk-averse investors holding assets that are imperfect substitutes, the required rate of return on the government’s liabilities declines with a reduction in the size of the liabilities issued by the government.

• A lower outstanding stock of debt may lead investors to reduce the perceived likelihood of default and other government measures associated with political risk. As the political risk premium falls, the domestic currency could appreciate in response to increased demand for domestic instruments.

• A lower stock of government debt may also reduce expectations of inflation and result in further currency depreciation by inducing investors to lower their expectation of the likelihood that the debt will be monetized. This could be associated with increases in both the current and expected future values of the domestic currency.

Model Simulation

According to the IMF study, changes in interest premiums are not an integral part of most standard open economy macroeconometric models, such as MULTIMOD. These can be introduced, however, in the way of external shocks, to give an idea of their likely effects. The IMF study presents a stylized scenario: it assumes that the Italian authorities implement fiscal consolidation measures that gradually reduce the stock of debt by 30 percent of GDP. This action reduces the premium on Italian lira assets by 250 basis points. The long-term interest rate in Italy falls by 240 basis points and the nominal effective exchange rate appreciates by about 7 percent, which worsens the external position. Although domestic demand is dampened by the impact of the fiscal action, investment and consumption tend to increase in response to the fall in interest rates, which can result in an increase in output.

According to this scenario, in countries where a large interest differential suggests a lack of confidence in economic policies, reductions in the fiscal deficit may bring about an immediate appreciation of the domestic currency; this is an exception to the standard theoretical case in which fiscal consolidation leads to a short-run depreciation. In the standard case, moreover, consolidation and depreciation are associated with a short-run improvement in the current account; whereas, in the reduced interest premium case, consolidation and appreciation are associated with a short-run deterioration in the current account. In this case, improvement in the current account would be possible only if the fiscal consolidation were combined with monetary tightening and a fall in output.

For many industrial countries, the connection between fiscal policy and exchange rates is not obvious.

Long-Term Implications of Fiscal Consolidation

The theoretical direction of the longer-run effects of a sustained change in fiscal policy on the exchange rate appear to be more clear cut than the short-term effects. According to the IMF study, models that incorporate the dynamic effects of reductions in the stock of government debt generally indicate that, in the long run, the real exchange rate will appreciate in response to fiscal consolidation. This brings about a permanent reduction in the stock of government debt and a permanent improvement in the country’s net foreign asset position.

In the first scenario showing the effects of a fiscal contraction in the United States (see table, page 30), the real exchange rate depreciates in the short run but starts to appreciate in the fifth year. The long-term result (in 2023) shows that a fiscal contraction that reduces the long-run level of government debt to GDP will increase the country’s ratio of net foreign assets to GDP. The increase in net interest receipts means that a higher trade deficit can be sustained in the long run. In the long run, the real exchange rate must appreciate to generate the adjustment in the trade flows. Since the United States is a net debtor to the rest of the world, the rise in total national saving results in a reduction in the ratio of its net foreign liabilities to income. This reduction implies lower net interest payments to foreigners and a smaller trade surplus. To induce a smaller trade surplus by lowering imports or raising exports or both, the real exchange rate must eventually appreciate. Therefore, a country that acts to increase national savings, other things being equal, will accumulate more foreign assets and, ultimately, its currency will strengthen relative to other currencies.

The different short and long-run exchange rate effects of fiscal consolidation reflect the working of the same macroeconomic adjustment mechanism, according to the IMF study. The short-term depreciation arises because the fiscal action pushes aggregate demand for domestic output below capacity output; consequently, the relative price of domestic output (that is, the real exchange rate) falls. Over time, however, the increased national saving that comes with the fiscal consolidation, assuming no increase in the money supply, leads to a higher stock of domestic and foreign assets held by domestic residents. The increase in domestic wealth leads to higher consumption and a rise in demand beyond capacity output. This excess demand is equilibriated by a rise in relative prices—that is, a real appreciation.

Malawi: Article VIII

The government of Malawi has notified the IMF that it has accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF Articles of Agreement, with effect from December 7, 1995. IMF members accepting the obligations of Article VIII undertake to refrain from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. A total of 112 countries have now assumed Article VIII status.

Two of the main purposes of the IMF, as stated in its Articles of Agreement, are to facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income; and to assist in the establishment of a multilateral system of payments in respect of current transactions between IMF members. In seeking to achieve these objectives, the IMF exercises firm surveillance over the exchange rate policies of its members, and oversees the elimination of exchange restrictions that hamper the growth of world trade.

By accepting the obligations of Article VIII, Malawi gives confidence to the international community that it will continue to pursue sound economic policies that will obviate the need to use restrictions on the making of payments and transfers for current international transactions, and thereby contribute to a multilateral payments system free of restrictions.

Malawi joined the IMF on July 19, 1965; its quota is SDR 50.9 million (about $78 million).

Press Release No. 95/74, December 28, 1995

Hungary: Article VIII

The government of Hungary has notified the IMF that it has accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF Articles of Agreement, with effect from January 1, 1996. IMF members accepting the obligations of Article VIII undertake to refrain from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. A total of 113 countries have now assumed Article VIII status.

Two of the main purposes of the IMF, as stated in its Articles of Agreement, are to facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income; and to assist in the establishment of a multilateral system of payments in respect of current transactions between IMF members. In seeking to achieve these objectives, the IMF exercises firm surveillance over the exchange rate policies of its members, and oversees the elimination of exchange restrictions that hamper the growth of world trade.

By accepting the obligations of Article VIII, Hungary gives confidence to the international community that it will continue to pursue sound economic policies that will obviate the need to use restrictions on the making of payments and transfers for current international transactions, and thereby contribute to a multilateral payments system free of restrictions. The acceptance of the obligations of Article VIII comes after a new foreign exchange law took effect on January 1, 1996.

IMF Calculates New Currency Amounts for SDR Valuation Basket

The IMF has calculated the revised currency amounts for the five currencies that determine the value of the SDR to reflect the new weights determined earlier this year for the currencies in the SDR valuation basket (see Press Release No. 95/49, IMF Survey, October 9, 1995). Effective January 1, 1996, the value of the SDR will be the sum of the values of the following amounts of each currency:

Currency	Value
U.S. dollar	0.582
Deutsche mark	0.446
Japanese yen	27.200
French franc	0.813
Pound sterling	0.105

View Table

Currency	Value
U.S. dollar	0.582
Deutsche mark	0.446
Japanese yen	27.200
French franc	0.813
Pound sterling	0.105

A revision of the SDR valuation basket is undertaken every five years in accordance with the IMF’s decision of September 17, 1980, unless the IMF’s Executive Board decides otherwise. The weights of each currency m the revised valuation basket are 39 percent for the U.S. dollar, 21 percent for the deutsche mark, 18 percent for the Japanese yen, and 11 percent each for the French franc and pound sterling. These weights are reflected in the currency amounts of the revised valuation basket as listed above, calculated using the average exchange rates for these currencies over the three months ending December 29, 1995, in such a manner as to ensure that the value of the SDR, in terms of currencies, is the same on that day under both the revised and existing valuation baskets.

The SDR basket includes the currencies of the five member countries of the IMF with the largest exports of goods and services during the five-year period preceding the revision, which in the present revision is the period 1990-94. The weights of the currencies in the basket reflect their relative importance in international trade and finance during this period, and are determined on the basis of the value of exports of goods and services of the members issuing the currencies and the amounts of their currencies officially held by members of the IMF.

The weights for the five-year period, 1991-95, were 40 percent for the U.S. dollar, 21 percent for the deutsche mark, 17 percent for the Japanese yen, and 11 percent each for the French franc and pound sterling. The amounts of each currency in the SDR basket during 1991-95 were U.S. dollar, 0.572: deutsche mark, 0.453; Japanese yen, 31.8; French franc. 0.800; and pound sterling 0.0812.

The actual share of each currency in the valuation of the SDR on any particular day depends on the market values on that day of the fixed amounts of each currency in the basket.

Press Release No 95/75. December 29, 1995

As a result of this law and accompanying regulations, Hungary’s exchange system is now free of exchange restrictions on the making of payments and transfers for current international transactions.

Hungary joined the IMF on May 6, 1982; its quota is SDR 754.8 million (about $1.1 billion).

Press Release No. 96/1, January 2

Sierra Leone: Article VIII

The government of Sierra Leone has notified the IMF that it has accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF Articles of Agreement, with effect from December 14, 1995. IMF members accepting the obligations of Article VIII undertake to refrain from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. A total of 114 countries have now assumed Article VIII status.

Two of the purposes of the IMF, as stated in its Articles of Agreement, are to facilitate the expansion and balanced growth of international trade, and thereby to contribute to the promotion and maintenance of high levels of employment and real income; and to assist in the establishment of a multilateral system of payments in respect of current transactions between IMF members. In seeking to achieve these objectives, the IMF exercises firm surveillance over the exchange rate policies of its members, and oversees the elimination of exchange restrictions that hamper the growth of world trade.

By accepting the obligations of Article VIII, Sierra Leone gives confidence to the international community that it will pursue sound economic policies that will obviate the need to use restrictions on the making of payments and transfers for current international transactions, and thereby contribute to a multilateral payments system free of restrictions.

Sierra Leone joined the IMF on September 10, 1962. Its quota in the IMF is SDR 77.2 million (about $114 million).

Press Release No. 96/2, January 5

Selected IMF Rates

Week Beginning	SDR Interest Rate	Rate of Remuneration	Rate of Charge
January B	4.15	4.15	4.25
January 15	4.12	4.12	4.22

View Table

Week Beginning	SDR Interest Rate	Rate of Remuneration	Rate of Charge
January B	4.15	4.15	4.25
January 15	4.12	4.12	4.22

The SDR Interest rate, and the rate of remuneration, are equal to a weighted average of interest rates on specified short-term domestic obligations in the money markets of the five countries whose currencies constitute the SDR valuation basket (the U.S. dollar, weighted 39 percent; deutsche mark, 21 percent; Japanese yen, 18 percent; French franc, 11 percent; and U.K. pound, 11 percent). The rate of remuneration is the rate of return on members’ remunerated reserve tranche positions. The rate of charge, a proportion (currently 102.5 percent) of the SDR interest rate, is the cost of using the IMF’s financial resources. All three rates are computed each Friday for the following week. The basic rates of remuneration and charge are further adjusted to reflect burden-sharing arrangements. For the latest rates, call (202) 623-7171.

Data: IMF Treasurer’s Department

Economic Features

Bhutan’s economy has two strikingly distinct sectors: subsistence agriculture and a modern sector in which hydropower and allied industries feature prominently. Over the past 15 years, the composition of Bhutan’s GDP reflects the growing importance of the modern sector, with the combined share of electricity, manufacturing, and mining rising to 20 percent in 1993 from 4 percent in 1980. Bhutan’s industrial base remains narrow, however, and its private sector is underdeveloped.

Public sector industries producing hydropower, cement, and calcium carbide fueled growth rates in the 1980s that averaged 7 ½ percent a year. In the early 1990s, growth slowed, with few new projects coming on stream, but picked up temporarily to about 6 percent in 1994 and to 7 percent in 1995 with the completion or expansion of several large projects. For the remainder of the 1990s, growth is expected to average around 4 percent a year until new industrial projects come on line at the end of the decade.

Bilateral monetary and trade arrangements closely link Bhutan’s economy with that of India. The national currency, the ngultrum, is pegged at par to the Indian rupee, which also circulates freely in Bhutan, and price movements tend to follow those in India. Goods move freely between the two countries, and India accounts for more than 80 percent of Bhutan’s total trade and a substantial portion of its foreign assistance. To diversify its trade, Bhutan has been cultivating closer relations with other countries, notably Bangladesh. It has also sought to diversify its sources of foreign aid; Japan, Denmark, Switzerland, the Netherlands, Austria, and Kuwait now figure among its major donors.

Financial Policies

Bhutan’s fixed exchange rate and open relations with India leave little leeway for an independent monetary policy and underscore the importance of preserving macroeconomic stability through prudent fiscal policies. Since fiscal 1990/91 (beginning July 1), the authorities have tightened the fiscal stance to ensure that domestic revenue is sufficient to cover all recurrent expenditure, while capital spending is financed almost entirely by foreign grants and concessional loans. As a result, Bhutan’s current fiscal balance shifted from a deficit averaging 2 ¾ percent of GDP during the second half of the 1980s to a small surplus in the 1990s. Foreign assistance in recent years has increased markedly, rising to an estimated 33 percent of GDP in 1994/95. Bhutan’s public debt is modest, and external debt is primarily on concessional terms.

Achieving a balance on current fiscal operations has been a difficult task because Bhutan’s revenue base remains narrow and inelastic. At the same time, demands on current expenditure have mounted, with the rapid expansion of—and high delivery costs for—Bhutan’s education and health care systems. With efforts to broaden the tax base and improve tax administration and enforcement, total tax collections have risen to 7 percent of GDP which is still low compared to other countries at similar income levels. The government relies heavily on profit transfers from public enterprises for much of its revenue, but hydropower revenues—its principal source—have been constrained by capacity limits, international tariffs set by treaty with India, and heavily subsidized domestic tariffs.

Monetary and Financial System. To strengthen its small and predominantly government-owned financial system, Bhutan has taken steps to develop indirect instruments of monetary control, strengthen prudential norms and supervision, and enhance competition within its financial system—tasks hampered by a shortage of skilled personnel and modern technology.

Given its currency peg and the limited scope for independent monetary policy, Bhutan has focused on ensuring that interest rates (which are administered) remain broadly in line with India’s rates. There are no direct controls on credit, and monetary developments have been closely tied to movements in the balance of payments. In recent years monetary aggregates have grown rapidly—in large measure because convertible currency reserves have risen as foreign aid has surged. Reflecting the increased monetization of Bhutan’s economy, the rise in liquidity has not weakened the overall balance of payments, nor has inflation picked up. At the same time, the banking system has accumulated large excess reserves that can be attributed to limited lending opportunities, bureaucratic obstacles, and continuing rigidities in the determination of interest rates.

Trade and Balance of Payments. Bhutan’s balance of payments position has enabled the authorities to build up substantial reserves. External debt and debt service are within manageable levels. Exports increased rapidly in the 1980s with the establishment of export-oriented industries and by 1994, accounted for 25 percent of GDP. But total exports have grown little in the 1990s, while imports have risen rapidly, reflecting work begun on several large industrial projects. Interest payments associated with concessional project loans have risen and this, coupled with a worsening trade balance, increased the current account deficit to about 20 percent of GDP in 1994/95, from less than 10 percent in the early 1990s. These current account deficits have been more than covered, however, by capital account surpluses reflecting rising foreign aid grants and concessional loans.

Bhutan: A Profile

Located in the eastern Himalayas, Bhutan is a small Buddhist kingdom roughly the size of Switzerland. Most of its 675,000 people depend on subsistence agriculture for their livelihood. Forests cover 70 percent of the country, which is also amply endowed with minerals such as dolomite, limestone, and gypsum. Bhutan is distinctive both for its unusual concentration of endangered species and well-preserved flora and fauna, and its commitment to preserving its environment. The country’s nascent modern sector centers on its abundant hydropower and allied industrial projects.

Revenues from hydropower and allied industries and generous foreign aid have allowed Bhutan to focus on developing its infrastructure, building administrative capacity, and providing social services—particularly basic health and education. Despite the difficulty and expense of providing physical and social infrastructure to a highly dispersed population in rugged terrain, Bhutan has built about 3,100 kilometers of roads, improved water supply and sanitation, and operated nearly 300 schools (compared with only 11 in the late 1950s). Mortality rates, incidence of various diseases and infections, immunization rates, and nutrition indicators all reflect marked improvement. Bhutan’s per capita GDP—estimated at about $380 in 1994—is higher than that of much of South Asia, and its income distribution suggests that it has avoided the extreme poverty found elsewhere in the region.

View Full Size

• Download Figure
• Download figure as PowerPoint slide

Sectoral Policies

Bhutan views its industrial sector—notably hydropower—as the principal engine of economic growth for the foreseeable future. To accelerate industrial growth, the government has invested heavily in hydropower; financed and implemented large projects in related sectors; provided the private sector with improved access to credit, markets, and entrepreneurial skill training; privatized large industrial corporations; and provided incentives for regionally balanced growth.

To stimulate an efficient and dynamic commercial and industrial sector, Bhutan also moved in the early 1990s to significantly reduce government holdings in a number of corporations. Privatization has been slow however, in part because of Bhutan’s rudimentary financial markets and limited entrepreneurial experience. A more flexible approach to foreign investment could both benefit the privatization program and provide needed access to modern technology and management skills.

Bhutan is committed to sustaining a minimum of 60 percent forest cover to preserve its rich biodiversity and natural environment. But there still appears to be considerable scope for environmentally sustainable development of Bhutan’s forests with greater investments in forest management and with the removal of domestic price controls on wood that have encouraged excessive use.

Developments and Prospects

Considering Bhutan’s high rate of capital formation—averaging 36 percent of GDP a year during 1987-93—and stage of development, output growth has been low. Most investment is still undertaken by the public sector, while the private sector is underdeveloped. Key obstacles to private sector development include:

• discretionary trading and industrial licensing procedures;

• highly restrictive foreign investment policies;

• tight controls on employment of expatriate workers; and

• discretionary exchange and trade controls on non-rupee transactions.

The authorities recognize that the principal challenge facing Bhutan over the medium term is to improve living standards through more rapid and equitable growth while ensuring the protection of the country’s environmental and cultural heritage. Three areas warrant particular attention: fiscal policy, private sector, development and financial sector reform.

Fiscal Policy. Prudent macroeconomic policies leave Bhutan well positioned for the short term. Over the medium term, however, the gap between domestic revenue and current expenditure is likely to widen: recurrent costs (particularly for education and health) are projected to escalate and civil service salaries will need to be raised at the same time that revenues stagnate awaiting the coming on stream of several new projects. Although the gap is expected to be temporary, expenditures in growth-enhancing activities—such as infrastructure, education, and health—may suffer in the interim. To ensure long-term fiscal stability and avoid damaging cutbacks in productive expenditures, Bhutan needs to improve the enforcement of existing taxes and to increase tax revenues. A broadly based general sales tax on goods and services offers a potentially effective means to do so once the manufacturing and services base is sufficiently diversified. The introduction of modest user fees could also help defray the costs of social services; the current free provision of these services is not sustainable over the long term. On the expenditure side, budget constraints underscore the need to set priorities more systematically and project both revenues and recurrent costs over the longer term.

Private Sector Development. It is increasingly clear that in the absence of transparent and liberal “rules of the game," Bhutan’s private sector will continue to struggle. Bhutan has offered potential entrepreneurs training and has conducted feasibility studies, but considerably more must be done:

• Industrial and domestic trade policies. Government remains a large player in the economy. Limiting the government’s role to providing basic infrastructure and information services, while strengthening the legal framework for property rights, bankruptcy, and environmental protection, could free up resources and create a stable environment for the private sector.

• Trade. Regulations governing imports from countries other than India are cumbersome and subject to discretion. A move toward a more liberal trade regime, replacing several quantitative restrictions with tariffs and reducing peak tariffs (currently 100 percent) would yield major benefits.

• Foreign Exchange. To support trade deregulation, Bhutan will need to eliminate its strict controls on hard currency transactions. A liberalization of the exchange and trade regimes would also help ameliorate the growing reserves buildup.

View Full Size

Bhutan: Composition of Exports

(Percent of total exports)

Citation: IMF Survey 25, 001; 10.5089/9781451937442.023.A002

Data: Bhutanese authorities and staff estimates

• Download Figure
• Download figure as PowerPoint slide

• Labor. Labor shortages and strict regulation of expatriate labor have produced production bottlenecks. More transparent regulations could reduce uncertainty about labor availability.

• Foreign Investment. A more transparent and liberal policy could provide valuable technology and management skills, but the authorities are wary of liberalizing foreign investment regulations until their domestic entrepreneurial capacity has been strengthened.

• Privatization. The authorities’ long- term commitment is for the private sector to take up all commercial activity, other than projects too large to be financed privately. In view of the limited absorptive capacity of Bhutan’s private sector, priority is initially being given to creating a “legal enabling environment,” including work on a commercial code, bankruptcy legislation, a real estate law, and national environmental protection legislation.

Financial Sector Reform. Substantial progress has been made in reforming Bhutan’s financial sector, notably in conducting regular auctions of central bank bills and creating a government securities market. But the continuing buildup of excess reserves in its financial institutions suggests enduring rigidities, principally in interest rate controls and a lack of competition. Deregulation of interest rates would deepen financial markets, foster more efficient allocation of resources, and assist in the absorption of excess resources.

Conclusion

Bhutan has had notable success in broadening its productive base, sustaining sound macroeconomic policies, and implementing significant changes in the country’s social welfare. But as it meets the challenges of providing education and a rising standard of living to its growing population, it will need to broaden its productive base further and develop its private sector. Crucial to the creation of a vibrant private sector will be a phasing out of many of the controls and regulations that currently restrict private sector activity, a strengthening of the incentive structure, a rise in public savings, and a more outward orientation. A liberalized policy on foreign investment could provide much needed technology and managerial expertise, as well as capital. A wider tax base and the introduction of user fees could also further Bhutan’s prudent fiscal policies and ensure the continuance of its social welfare expenditures.