Private Market Capital Flows

The Mexican financial crisis knocked the bottom out of the markets for developing country securities. From late December into early 1995, there was a massive sell-off of these securities, while the new issue markets for bonds and equities were, according to Andrews and Ishii, “virtually dead in the water.” Despite gloomy predictions that developing countries—and Latin American countries in particular—would be unable to regain access to international capital markets, selling pressures in Asian security markets abated quickly, followed by renewed inflows of portfolio capital.

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Bond Issues by Developing Countries And U.S. Long-Term Interest Rate

Citation: IMF Survey 25, 001; 10.5089/9781451937442.023.A004

Data: IMF. Working Paper 95/132

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The situation in Latin American countries began to turn around sharply as early as April 1995, and by May 1995 many Latin American markets posted strong gains. Likewise, beginning in April and continuing through September, international placements of bonds picked up, with Asian issuers leading the pack. Non-Asian entities, led by major sovereign borrowers, also began to return to the international markets. Indeed, six months after the crisis, Mexico itself made a dramatic return, floating two issues that, according to the authors, met with “very strong demand.”

On the surface, according to Andrews and Ishii, the recovery in the markets for developing country securities reflected the “general resilience of these markets.” This resilience attests to the continued strong performance of many—principally Asian—countries and the economic adjustment efforts of countries experiencing financial difficulties. But a closer look at these renewed flows reveals some important changes.

Bonds. International bond placements by developing countries came to a virtual standstill at the beginning of 1995, but increased measurably in the second and third quarters of the year. Of the $39.3 billion in bond placements by developing countries in the first nine months of 1995, Asian entities accounted for about half the total value; bond placements by Western Hemisphere countries amounted to $13.5 billion (see chart, page 63).

Among Asian countries, private companies continued to be the primary bond issuers. In contrast, in the Western Hemisphere, the share of bonds issued by private sector firms declined, while sovereign issues rose sharply as the governments of Argentina, Brazil, and Mexico re-entered the international bond markets.

The share of developing country bonds in currencies other than the U.S. dollar rose substantially during 1995; in the first nine months of 1995, bonds issued in yen and deutsche mark were 28 percent and 8 percent, respectively, of total issues, compared with 13 percent and 3 percent, respectively, in 1994. Asian entities continued past trends of borrowing predominantly in U.S. dollars, while the bulk of borrowing by European entities was denominated in yen. Although Western Hemisphere entities also borrowed heavily in U.S. dollars, the share of yen and deutsche mark issues rose substantially.

According to Andrews and Ishii, the regional differences in the relative shares of bonds issued in U.S. dollars and other currencies after the Mexican crisis reflected the type of entity issuing the bond: private companies, which tended to be the better credit risks, continued to issue bonds in U.S. dollars; sovereign borrowers—chiefly, the governments of Argentina, Brazil, and Mexico—stepped up their placement of bonds in yen.

Equity Markets. The share of developing countries in total international equity placements declined to less than 28 percent during the first nine months of 1995, compared with 37 percent in 1994. Of the less than $7 billion in total developing country placements for that period, nearly 80 percent were accounted for by Asian companies. In contrast, the issuance by companies in the Western Hemisphere was very low.

Security Prices and Yields

The effects of the Mexican financial crisis on the prices, spreads, and yields of developing country securities and bond issues mirrored those observed on private market capital flows: Asian markets were less seriously affected and rebounded quickly, while Western Hemisphere markets endured deeper and more lasting effects.

Equity Prices. The Mexican financial crisis triggered sell-offs across all developing country equity markets. Although some segments of these markets had bounced back by the beginning of the fourth quarter of 1995, the International Finance Corporation’s (IFC) overall total return index for developing countries in October 1995 was about 18 percent below its level at the end of 1994.

The majority of Latin American stock markets fell sharply in early 1995, reaching lows in March 1995 ranging from one third in Mexico to 80 percent in Chile (in U.S. dollar terms) of their mid-December 1994 levels. As investor confidence returned, Latin American stock markets, except for Venezuela, began recovering in the second and third quarters of 1995. But despite some offsetting increases, IFC’s index for Latin America in October 1995 was still about one third below its pre-crisis level.

The setback in Asian stock markets was both less severe and shorter-lived, reaching a low in late January 1995 that was just 10 percent below the level in mid-December, according to IFC’s U.S. dollar index for Asia. By October 1995, IFC’s Asian regional index was more or less back to the level prevailing before the Mexican crisis.

In contrast to these movements in developing country equity markets, equity prices in the United States moved sharply upward in the same period—a gain of more than 31 percent as recorded in the Standard and Poor 500 total return index. According to Andrews and Ishii, this disparity in the implied returns on U.S. and developing country equities suggests that flows of portfolio equity investment into developing countries in 1995 fell off following the Mexican crisis.

Bond Yields and Spreads. The immediate effect of the Mexican crisis on developing country debt securities was a precipitous drop in prices and a rise in yields. Yield spreads increased even more sharply, reflecting declines in U.S. interest rates. (For a U.S. dollar-denominated bond, the yield spread, which gives an indication of riskiness, is the difference between the effective yield on a developing country bond and the yield on a U.S. Treasury bond of the same maturity.) For Latin American developing countries—in particular, Argentina, Brazil, and Mexico—secondary market spreads on issues of Euro- and Brady bonds widened abruptly. (A Brady bond is a debt security issued in exchange for bank claims in the context of a debt- and debt-service-reduction operation.) According to Andrews and Ishii, the peak spreads of both types of bonds for all three countries coincided with price troughs on equities on local stock exchanges.

Secondary yield spreads also widened outside Latin America in the aftermath of the Mexican crisis. But the surge in spreads was less pronounced, suggesting, according to the authors, that market participants discriminated among country risks. For example, at the beginning of 1995, yield spreads for the Czech Republic and China changed only slightly. Yield spreads for bond issues outside Latin America began narrowing in early March, even before spreads for Latin American issues had peaked.

Yield spreads for Latin American bonds narrowed sharply in the second quarter of 1995 and further in the third quarter. Nevertheless, with the exception of Brazil, yield spreads for Latin American Brady and Eurobonds have not returned to their pre-December 1994 levels.

Terms and Maturities. During 1995, terms on new U.S. dollar-denominated bonds issued by Western Hemisphere entities deteriorated considerably—even for the best credit risks that maintained access to the market. At the same time, maturities on these bonds fell to an average of about two years in 1995 from more than four years in 1994. In contrast, the average launch spread on new bonds issued by Asian entities fell to below 100 basis points in late 1994, although they rose to slightly more than 100 basis points in 1995 (reflecting a “flight to quality,” as some major borrowers experienced a narrowing of yield spread). Average maturities for Asian borrowers increased substantially during the first nine months of 1995, although most of this increase was accounted for by large longer-term bond placements by public utilities in Southeast Asia. Terms eased somewhat over the course of 1995, but, according to Andrews and Ishii, borrowers outside Asia are still facing higher spreads and substantially shorter maturities than before the Mexican crisis.

Increased Market for Yen-Denominated Bonds

According to Andrews and Ishii, one of the most striking developments during 1995 was the sharp increase in the relative share of new yen-denominated bond issues by developing countries. Investor demand appears to have been an important motivating force; in recent years, Japanese investors have suffered large exchange losses on their foreign investments and have sought to avoid exchange rate risk by purchasing yen-denominated securities. A steep drop in domestic Japanese interest rates during 1995 provided further incentive.

The favorable demand conditions for yen-denominated bonds may have influenced the placement decisions of developing country borrowers seeking to re-enter the international bond markets on the best terms possible. Some borrowers were apparently able to secure more favorable terms on yen-denominated bonds than for dollar-denominated issues. The authors suggest that more favorable spreads on yen-denominated bonds in Japan (Samurai bonds) may reflect a tendency for Japanese credit rating agencies to assign higher ratings than the major U.S. agencies. These considerations, Andrews and Ishii conclude, may have motivated the governments of Argentina, Brazil, and Mexico to issue Euro-yen bonds.

The elimination in January 1996 of the investment grade requirement for public placements on the Samurai market, coupled with continuing demand for high-yielding securities, suggests that yen-denominated bond issues will continue to represent a large proportion of developing country bond issues.

Prospects for Private Financing

The major setbacks in many markets for developing country securities caused by the Mexican financial crisis of December 1994 were relatively short-lived. Yet, the resumed flows of financing to developing countries have undergone certain changes: a shift toward sovereign borrowers in the case of Latin American countries; a major shift in the currency denomination of new bond issues away from U.S. dollar-denominated to yen-denominated issues; and higher yield spreads and shorter maturities on new bond issues.

The continuing globalization of capital markets and portfolio diversification by investors are likely to contribute to the underlying growth in demand for developing country securities. The greater presence of sovereign borrowers—particularly those countries that experienced difficulties following the Mexican crisis—could indicate the return of private borrowers, echoing a pattern of market re-entry followed in the late 1980s and early 1990s.

In the immediate future, however, the prospects for private capital flows to developing countries remain uncertain. According to the authors, a resurgence of these flows could be impeded by the re-emergence of economic uncertainties in some major countries and concerns about the future path of world interest rates.

Evolution

Since its inception in 1955, Singapore’s Central Provident Fund has stressed thrift and self-help, tying distributions directly to compulsory contributions and interest earnings. The government makes no contribution—except as an employer—and the program pursues no redistributive objectives. Initially, the program sought to boost household savings to finance retirement and investment. By the mid-1980s, the combined contribution rate of employers and employees reached 50 percent; this acted to drive up labor costs, complementing government efforts to induce investment in capital-intensive production. During the 1985-86 economic downturn, the government sharply reduced the employer share of contributions to provide a temporary economic stimulus. A subsequent government review of the program’s longer-term needs led it to lower the overall target for contributions to 40 percent of wages—reached in 1991—and restore the principle of equal employer-employee contributions in 1994.

Designed initially as a retirement program, the Fund has since evolved substantially to meet additional needs. Since 1968, the program has progressively relaxed its criteria for preretirement withdrawals—first for housing and now for an increasingly broad array of financial, real, and human capital investments. These include nonresidential properties, stocks and bonds, medical and educational expenses, and insurance premiums. In the late 1970s, the program also began to earmark contributions for specific purposes, such as retirement, disability, and medical expenses. Withdrawals for consumption are not permitted before the age of 55.

Retirement Benefits

Currently contributors can withdraw their balances at the age of 55 but must leave at least S$13,000 (US$9,200) to finance medical expenses and transfer another specified amount—a “minimum sum”—to a retirement account, which ensures that retirees retain sufficient income for basic subsistence. At age 60, this minimum sum can be used to purchase an approved annuity or finance a pension through the program or a commercial bank. If left with the Central Provident Fund, the monthly nominal pension is unindexed once it begins and ceases once the minimum sum and interest are exhausted—usually after about twenty years.

The relatively low level of the pension—currently US$307 monthly—represents only part of the participant’s retirement benefit. The lump- sum payment—payable at age 55—is for many members at least as significant as the pension. The absence of a government-financed pension also provides an incentive to avoid rapid consumption of the lump-sum benefit.

Effects on Saving and Investment

A dissaver in the early 1960s, Singapore has since become the thriftiest nation in the world, with gross national saving equivalent to 50 percent of GDP in 1994. Contributions to the Fund peaked at 15 percent of GDP in 1985 and still represent 11 percent of GDP in recent years. Members’ balances have shown a similar profile, peaking at 75 percent of GDP in 1986 and declining to 55 percent of GDP more recently.

Although the Central Provident Fund seems a likely major contributor to this high saving rate, Singapore’s rate is best explained by demographic factors, a rapid growth in private disposable income, and a high level of budgetary saving. If the pension program and other savings were perfect substitutes, there would be no effect on total private saving, if the desired level of savings exceeded that mandated by regulation. The degree of substitutability has certainly increased as a result of the gradual liberalization of withdrawal criteria, the authors find. Substantial other private saving suggests that even the high contribution rates do not fully satisfy Singapore’s appetite for saving.

The evidence indicates, however, that the program did initially catalyze Singapore’s saving rate and may continue to boost the saving propensity of low-income households. Existing arrangements favor certain forms and uses of saving, however, and thus represent a potential distortion. The rules particularly favor housing and may be contributing to the significantly higher investment in housing seen in Singapore relative to more developed countries.

The unwithdrawn portion of members’ balances is channeled into low-yielding, though secure, investment; the Central Provident Fund is restricted to passive investment in Singapore government securities. The proceeds of these issues are invested in external financial and real assets by the Government of Singapore Investment Corporation, which seeks to maximize the rate of return and manage risk. Members are therefore sheltered from investment risk but are believed to earn a commensurately lower rate of return—5 percent on average since 1980 and a real rate of return of 2 percent.

Impact on the Labor Market

The combined employer-employee total contribution rate represents a large wedge, Carling and Oestreicher note, between the cost of labor and a worker’s take-home wage. Elsewhere, similar schemes have been thought to impede labor market flexibility and pose an obstacle to lower unemployment. But Singapore’s rates of unemployment and inflation are very low and suggest little if any labor market distortion. The key, the authors believe, is wage flexibility combined with strong employee support. The direct relationship between contributions and benefits and the absence of income tax on contributions, earnings, or withdrawals appear to have won strong employee support for the program.

From the employers’ perspective, the contribution may be seen as a tax, but the Monetary Authority of Singapore estimates that wage increases adjust downward over two years to offset increases in employer contributions. Changes in employer contributions also affect the total cost of labor and explain why increased employer contributions during 1979–84 may have contributed to the 1985 recession and why a sharp cut in that rate in 1986 provided a short-term stimulus. But providing benefits is the ultimate goal of contribution rates, and the government, after a review of its 1980s experience, has resolved to set rates to meet the long-term needs of the Central Provident Fund rather than short-term macroeconomic purposes.

The Central Provident Fund enhances labor mobility by providing full portability. It also discourages voluntary unemployment by making the program’s resources unavailable for unemployment compensation. The scheme does, however, encourage early retirement, since the lump-sum benefit may be taken at age 55, and the pension, at age 60. The government has indicated that it may increase the minimum age for benefits

Ultimately, the mandatory nature of the pension plan allays pressures for budgetary social security outlays.

Effects on Public Finances

Prudent fiscal policy, with persistent budget surpluses, has been a cornerstone of Singapore’s development strategy. The limitation of transfer payments to households contributes to the exemplary record, Carling and Oestreicher observe. Public assistance benefits represent less than 1 percent of budget outlays, and Singapore’s high rate of economic growth, youthful population, and strong family cohesion all help contain demand for these benefits. The Central Provident Fund also contributes by providing retirement income and coverage for some medical expenses. Its role is expected to grow more important as the population ages.

The program does exact a substantial budgetary cost in the form of tax concessions. Contributions are untaxed at entry, and neither contributions nor interest is taxed at withdrawal. Carling and Oestreicher estimate that US$1 billion (1 percent of GDP) in revenue was forgone in 1994. Although these concessions are not high by international standards, it is not clear that they are needed, since participation is compulsory. But they are a part of Singapore’s broader effort to provide incentives for investment and saving. And at least part of the expense may be recouped through the differential between interest paid by the government to borrow funds and the returns earned by the government on funds invested abroad, as well as through the reduced need for social spending.

Conclusion

While broadly similar to programs in other Asian, Latin American, and African countries, Singapore’s Central Provident Fund offers several distinct advantages—notably returns on members’ balances that reflect market interest rates and a direct link between contributions and benefits. Likewise, the requirement that both employees and employers contribute discourages any notion that benefits are a free good, and the minimum sum ensures that at least part of the retirement benefit is taken in the form of a pension and cannot be consumed rapidly. Ultimately, Carling and Oestreicher conclude, the mandatory nature of the plan allays pressures for budgetary social security outlays and ensures that broad coverage is achieved at low administrative cost.

Accelerating the Pace of Sustainable Growth

In an introduction to the volume, IMF Deputy Managing Director Alas-sane D. Ouattara calls upon the international community to pay due attention to the special conditions prevailing in each African country within the larger context of a sound and consistent medium-term macroeconomic policy. Ouattara likewise calls upon African countries to undertake a package of growth-oriented initiatives in support of macroeconomic stability, private-sector-oriented adjusment, higher saving rates, improved debt management, and more effective use of foreign assistance. Debt management and external assistance will play crucial roles in pursuit of broader macroeconomic goals, says Ouattara. He underlines the importance of lowering the stock of debt to manageable levels, including through application of Naples terms by Paris Club and other official bilateral creditors.

If adjustment programs are strictly implemented, they will benefit the private sector and enhance growth.

With respect to external assistance, Ouattara calls for strengthened collaboration between African countries and the donor community in support of the following actions:

• Enhanced transparency and monitoring of public expenditure and adjustment of public wage, subsidy, and pricing policies to improve resource allocation and reorient spending toward basic economic and social infrastructure. The process of public expenditure review and restructuring is gradually being adopted by African countries, as illustrated by the experiences of Ghana, Uganda, and Zambia.

• Strengthened public accounting of the financial operations of parastatals by reducing reliance on budgetary and bank financing and by accelerating privatization efforts. While progress in this area “has not been as rapid as one would have hoped,” potentially useful lessons can still be drawn from the approaches being taken by Mali, Côte d’lvoire, Malawi, Senegal, and Tanzania.

• Formulation of integrated medium-term scenarios for the government budget, the balance of payments, and the public debt to provide a coherent view of domestic resource mobilization efforts, external financing needs, and strengthened domestic and external viability.

• Application of sound debt management practices. Many low-income countries have high debt and debt-service ratios and need to reduce their external borrowing. Mechanisms now in place should help reduce the burden associated with the stock of debt to manageable levels.

To ensure the success of these recommendations, Ouattara urges African countries to aim for the goal of good governance, incorporating an effective system of checks and balances, popular accountability, and sufficient policy transparency. In this vein, he underlines the importance of achieving political stability as a crucial requirement for economic reform.

Major Challenges

Surveying the African continent, Edward Jaycox, World Bank Vice President, highlights some encouraging developments. A large number of African countries have registered positive economic growth, he says, and years of nonaccountable rule and personal leadership have finally given way to far-reaching political liberalization. Major challenges remain, however. Jaycox lists inadequate macroeconomic policy and management, deepening poverty, environmental degradation, and continued dependence on official aid and debt relief among the most severe problems confronting Africa. For these reasons, he says, Africa will continue to rely on the donor community for financial assistance and policy advice. Future assistance, however, hinges on evidence of sound economic performance.

Foreign Direct Investment. While the East Asian economies have enjoyed a “virtuous” economic circle over the past two decades, most African countries have suffered from a “vicious” economic circle, writes Toshihiko Kinoshita, of Japan’s Export-Import Bank. To reverse this pattern, he calls upon African countries to undertake additional efforts to integrate themselves into the global trade system, adopt sound macroeconomic policies, and create a supportive environment for private sector development. To assist in this transformation, Kinoshita urges Asian entrepreneurs to initiate trade and investment in a number of African countries.

J. Jegathesan, of the Malaysian Industrial Development Authority, expands on the subject of prospects for business collaboration between Asia and Africa by outlining a set of principles for the “export-oriented investor.” Jegathesan underlines the central importance of ownership and incentives as key determinants of how much profit the investor retains and shares with the government and local partners. Dahlam M. Sutalaksana, Advisor to the Indonesian Minister of Finance, draws on his country’s successful experience in attracting foreign investment in suggesting promising avenues for African countries. A major goal, he states, is to encourage international participation in the development process. The “core of a good development” strategy, explains Sutalaksana, is for countries to provide suitable legal assistance to investors, keep the economy on a stable growth track, and adhere to a development strategy that meets the needs and expectations of international investors.

Resource Mobilization. East Asia’s successful experience in mobilizing domestic savings provides another valuable lesson for African countries intent on achieving higher standards of living and faster economic growth, says Yasutami Shimomura, of Japan’s Saitama University. Shimomura lists three important factors behind East Asia’s impressive savings rate: superb macroeconomic performance, which creates confidence among households about the future prospects of their economies, thereby motivating savings; cultural factors that support savings during periods of expansion and contraction; and specific schemes, such as the postal savings systems of Japan, Korea, and Taiwan Province of China. Delphin Rwegasira, of the African Development Bank, highlights the importance of an efficient financial sector in Africa for the effective mobilization and channeling of financial resources toward their most productive uses.

Assessing prospects for South-South cooperation, Mitsuhiro Sasanuma, president of a private Japanese firm, asks whether African countries might be prepared to consider adopting some of the institutional frameworks that have proven so influential in Asian development. Drawing on Korea’s experience with rural development and Malaysia’s experience in privatization, Sasanuma suggests that because such technologies have wide applicability, they might prove suitable for Africa as well.

Structural Measures. Adjustment policies to promote internal and external liberalization also have a major impact on growth, according to Roger Rigobert Andely, of the Bank of Central African States. In his review of the adjustment experiences of Cameroon, the Central African Republic, Chad, the Congo, Equatorial Guinea, and Gabon, he observes that the private sector throughout the region initially benefited from surging commodity exports and supportive government policies. Beginning in 1986, however, plunging commodity prices and misguided government policies exacted heavy costs on Africa’s private sector. To reverse this situation, new adjustment measures were implemented in collaboration with the IMF and the World Bank. Unfortunately, writes Andely, the measures were applied at a late stage and in a lax manner. Disaster befell the private sector. Since 1994, however, a combination of currency realignment—the CFA franc was devalued by 50 percent in January 1994—and effective public finance policies have helped create a more supportive environment for private business. Andely predicts that if future adjustment programs are strictly implemented, they will yield major benefits for the private sector and enhance prospects for African growth.

Peter Harrold, of the World Bank, advocates a sectoral approach to adjustment issues. Such an approach, he explains, would focus on investor needs and recurrent expenditures linked to those investments for an entire sector over a four-to-five-year time horizon. All main donors would be asked to sign on to such programs, using common implementation arrangements. Such comprehensive program preparation operations, says Harrold, are both difficult and costly to prepare, but initial results indicate that the subsequent gains derived from investing in them are worthwhile.

Debt Policy. Future economic growth in Africa also depends on its ability—with adequate help from the international community—to devise an effective debt strategy. While the existing debt strategy has been successful in resolving global payments difficulties, this success has yet to be shared by the sub-Saharan African countries, says Michael G. Kuhn, of the IMF.

Theophile Ahoua, Director of the Prime Minister’s Cabinet in Côte d’lvoire, likewise suggests that in view of the size of Africa’s debt burden and the debt-service pressures confronting many of these countries, the indexation of debt payments to debtors’ revenue or debt forgiveness should be seriously considered. R.P. Brigish, of the World Bank, emphasizes that debt distress remains a fact of life for many countries, most of which are in Africa. A sensible approach to debt management must come to grips with this reality. African governments, he says, have to be “clear and firm” at the outset about setting realistic limits to their borrowing—in terms of amounts and end uses. Brigish also calls for greater consensus between African borrowers and international creditors on prospects for the sustainability of their borrowing program.

Katsuya Mochizuki, of Japan’s Institute of Development Economics, maintains that Africa’s current financial crisis derives from the “tragic legacy” of the 1980s’ debt management strategy. The root of Africa’s economic problem today, he says, is to be found in its heavy debt burden. The most viable solution, he concludes, is to make debt- stock reduction a priority, with an “exit strategy”—incorporating a reduced debt overhang, sound domestic policies, and new concessional financial flows—as the ultimate goal.

Future growth in Africa depends on devising an effective debt strategy.

Growth and Aid. Looking to the future, Micah Cheserem, Governor of Kenya’s Central Bank, calls for the creation of African economic models that could be supported by adequate resources over a period of ten years to undertake appropriate economic reforms and finance the development of key infrastructure projects. In any such undertaking, says Cheserem, foreign aid would need to play a major role. The centrality of foreign aid to sub-Saharan African countries is highlighted by Benedicte Christensen, of the IMF. She points out, for example, that in net terms aid flows to sub-Saharan Africa accounted for 13 percent of the region’s GNP during 1990-93, compared with less than 1 percent for middle-income countries. In view of budgetary stringencies throughout the donor community, Christensen maintains that the effective use of aid is as important as adequate volumes. To enhance the effectiveness of foreign aid, she suggests that recipient countries:

• increase the transparency of their use of foreign assistance;

• establish realistic expenditure priorities;

• undertake a careful screening of projects. At present, large amounts of committed assistance to Africa are undisbursed because of inadequate domestic financing and the inability of local officials to implement programs;

• achieve greater consistency between project or sector expenditures and the overall level of government disbursement; and

• design projects and other forms of assistance in a medium-term fiscal context to ensure consistency with a sustainable fiscal position and government debt profile.

Summing Up

Peter Mountfield, Executive Secretary of the Development Committee (the Joint Ministerial Committee of the Boards of Governors of the World Bank and the IMF on the Transfer of Real Resources to Developing Countries), calls for greater sensitivity to Africa’s special difficulties as it strives to integrate itself into a highly dynamic world economy. In view of Africa’s heavy debt burden, Mount-field suggests that new lending by regional banks might increasingly be on softer terms to avoid a further buildup of debt. On a broader canvas, Jack Boorman, Director of the IMF’s Policy Development and Review Department, and Haruhiko Kuroda, Deputy Director General of the International Finance Bureau in Japan’s Ministry of Finance, cite the importance of government support for a strong private sector in Africa and more prudent debt management through policies aimed at attracting non-debt-creating flows.

Economic Policy in Developing Countries

Among the areas Agénor and Montiel explore are the nature and implications of fiscal rigidities and the effect of fiscal deficits on a number of macroeconomic variables. The authors conclude that adequate and credible fiscal restraint is crucial to achieving macroeconomic stability. Excessive fiscal deficits may lead to inflation, exchange rate crises, balance of payments difficulties, real exchange rate appreciation, external debt crises, and high real interest rates.

Financial repression, according to the authors, is a central macroeconomic phenomenon in many developing countries. When a government wants to promote development actively but lacks the direct fiscal means to do so, it uses the financial system to fund development in two ways. First, by imposing large reserve and liquidity requirements on banks, the government creates a captive demand for its own bond issues; it can thus finance its own high-priority spending by issuing debt. Second, by keeping interest rates low by imposing ceilings on lending rates, the government creates an excess demand for credit. It then requires the banking system to set aside a fixed amount of credit available to priority sectors. Financial repression, the authors show, has negative effects on the efficiency of the intermediation process between savers and borrowers (in part, by fostering the expansion of informal credit) and affects the distribution of income because it transfers resources from savers to favored borrowers—the public sector, enterprises in priority sectors—who acquire resources at official interest rates.

In their assessment of exchange rate policy, the authors find that exchange systems in the developing world differ markedly from those in industrial countries. Fixed official rates are much more prevalent but are often accompanied by foreign exchange rationing and the emergence of parallel markets. Developing country economies are also subject to repeated speculative attacks in foreign exchange markets and to balance of payments crises. In their examination of the causes and consequences of these attacks, the authors find that such measures as capital controls may temporarily enhance the viability of a fixed exchange rate but will not prevent the ultimate collapse of the system in the absence of a consistent and sustainable macroeconomic policy mix. The more delayed the fundamental policy adjustment, the higher the potential costs of an exchange rate regime collapse.

The authors also examine short-run stabilization efforts in light of the central problem of high inflation confronting many developing countries. They draw on the extensive literature to summarize experience with alternative approaches to stabilization. A key lesson is that in the absence of a sustained fiscal adjustment, inflation does not stay permanently low.

Medium-Term Issues

Agénor and Montiel devote considerable attention to medium-term issues in development macroeconomics, including growth and stabilization, trade liberalization, and the link between political factors and macroeconomic and structural adjustment programs. In their examination of alternative analytical treatments of growth and its relationship to short-run stabilization, the authors conclude that none of the medium-term modeling approaches that have been widely used in the developing world is at present able to address adequately the complex dynamic interactions in the relationship between stabilization and growth.

The authors address in detail the developing country experience with trade and financial liberalization and its effect on macroeconomic performance and the problems of short-run macroeconomic management during the liberalization process. A key problem confronting recent liberalization programs and structural change is the relationship between structural reforms and stabilization policies. Although many economists have recognized the importance of the link between the two, Montiel and Agénor argue that the extent to which stabilization itself depends on the credibility of structural adjustment tends to be underestimated. They contend also that the pace of reform depends on adjustment costs and the existence of a political consensus. A well-designed liberalization program, they say, must account for—in addition to direct economic costs—the indirect effects arising from the potential loss of credibility and the collapse in the consensus for reform.

Political factors have an important effect on both the adoption and the abandonment of stabilization and structural adjustment programs. The authors’ review of the recent literature on the political economy of stabilization programs and structural adjustment uncovers a variety of channels through which the formal characteristics of the political system affect macroeconomic management. Although they find no strong evidence that policy instruments and macroeconomic outcomes in developing countries respond systematically to the political objectives of government officials, Agénor and Montiel note the general recognition that economic outcomes reflect choices shaped by political institutions, and that economic reforms have long-term political consequences. An important implication of this analysis is the necessity for government officials and policymakers to evaluate the political feasibility of stabilization plans before implementing them. The political context in which stabilization plans and structural adjustment programs are implemented, the authors emphasize, must be taken into account in the design of these programs to ensure sustainability of the reform effort. Identifying the best methods, the authors conclude, while maintaining the feasibility and overall consistency of the program, “remains a major challenge for economists and policymakers.”

Selected IMF Rates

Week Beginning	SDH Interest Rate	Rate of Remuneration	Rate of Charge
February 5	3.92	3.92	4.02
February 12	3.88	3.88	3.98

View Table

Week Beginning	SDH Interest Rate	Rate of Remuneration	Rate of Charge
February 5	3.92	3.92	4.02
February 12	3.88	3.88	3.98

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

Government’s Changing Role

Industrial countries have dramatically changed their spending levels over the past century. In the late nineteenth century, public expenditure averaged a modest 8.3 percent of GDP—ranging from less than 4 percent for the United States to approximately 12.6 percent for France. The dominant view, articulated by classical economists and political philosophers of the period, generally advocated the minimal state. The government’s role was to be strictly limited to national defense, law enforcement and administration, and essential public works.

This mindset began to change with the onset of heavy military spending during World War I. The expanded revenue base that resulted from the war stimulated higher levels of non-military spending as well. By 1920, public spending by industrial countries had accordingly grown to an average of 15.4 percent of GDP.

Rising spending patterns after World War I throughout the industrial countries were not simply a result of larger revenue bases. The primary force behind this development, observe the authors, was the public’s growing acceptance of state intervention in areas not covered by private economic activity. As a result, by the late 1920s, many European countries had introduced rudimentary social security systems. The Great Depression spawned a parallel development in the United States a decade later.

A similar, if more ambitious, pattern repeated itself after World War II, with military spending once again creating the foundations for new welfare demands by the public in Europe, the United States, and Japan. Governments’ inclination to spend was reinforced by the erosion of traditional constraints on public expenditure, according to the authors. West Germany and Switzerland, for example, incorporated legal provisions favoring interventionist policies in their constitutions, or, as in the United States, through their legislatures. Monetary financing of government deficits throughout the industrial world further weakened expenditure control.

Fiscal Considerations. The authors lay out the fiscal dimensions of these spending policies:

• Between 1937 and 1960, industrial country public expenditure, as a share of GDP, increased on average to 27.9 percent from 20.7 percent in most industrial countries, including Austria, Canada, the Netherlands, Sweden, Switzerland, and the United States.

• Between 1960 and 1980, these countries’ expenditures jumped again, to 42.6 percent. In a number of cases—including Belgium, Ireland, Japan, Spain, Sweden, and Switzerland—spending nearly doubled. No industrial country kept public expenditure below 30 percent of GDP, with only Australia, Japan, Spain, Switzerland, and the United States able to stay near that level.

Once entrenched, spending habits were hard to break. Thus, the authors point out, even as the public became progressively disenchanted with the fiscal burden of the welfare state by the 1970s, expenditures continued to rise, albeit at a slower pace. By 1994, average government outlays in the industrial world had reached 47.2 percent of GDP.

Until recently, say Tanzi and Schuknecht, a constantly expanding revenue base made paying for the welfare state relatively painless. In 1960, for example, total government revenue for all the industrial countries, at 28.2 percent of GDP, outstripped expenditures of 27.9 percent of GDP. Balanced budgets predominated. The paper notes that even for the so-called “big spenders”—Austria, France, West Germany, the Netherlands, and the United Kingdom—it was possible to sustain high spending rates without running deficits. By 1994, however, the picture had changed dramatically. While revenue had increased to more than 43 percent of GDP, expenditure had grown even faster.

Social Considerations. Between 1870 and 1960, when the welfare state was in its infancy, the expansion of benefits to the public by government played a major role in boosting economic performance and social well-being, say the authors. Educational levels rose. Longevity increased. Retirement became financially bearable for vast numbers of people. The enormous growth of public spending after the 1960s, however, has not brought about further significant gains in providing economic and social security, say Tanzi and Schuknecht. They further contend that countries with “small” governments have generally fared at least as well, if not better, than those with larger public sectors.

The Road Ahead

The authors see considerable scope for reducing governments’ role in industrial countries. Such a reduction, however, depends directly on the ability of governments to control—if not reduce-subsidies and transfers; the bulk of all future reductions must come from these categories. Tanzi and Schuknecht are confident that if such changes are undertaken in a selective and careful manner, major budgetary savings should result, at minimal social cost. The goal is to preserve existing public sector objectives while controlling the level of public spending. “The clock cannot be set back and, in fact, it should not be set back,” they write.

Any serious effort to control expenditures, say Tanzi and Schuknecht, must include steps to privatize large portions of the economy, including higher education, health care, and some pensions. Governments’ new responsibility, they suggest, would be to set the “rules of the game,” rather than direct the play.

The goal is to preserve existing public sector objectives while controlling public spending.

Tanzi and Schuknecht urge reformers throughout the industrial world to pay greater attention to the recent success enjoyed by a number of newly industrializing economies in preventing the establishment of a welfare state. These economies do enjoy certain advantages. While their overall levels of spending are relatively low—18.2 percent of GDP on average—expenditures on health, education, and training approach industrial country standards, they report. Unlike the larger economies, however, these later arrivals spend considerably less on subsidies and transfers. This, the authors point out, is where the large savings are to be found.

On a larger canvas, the authors note that the success of many newly industrializing economies is the result of fundamental changes in their underlying policy regimes. In Chile, for example, impressive results have been achieved through a mixture of constitutional and quasi-constitutional reforms, which have fundamentally altered the policy rules underlying the operation of the Chilean economy. The main result, say Tanzi and Schuknecht, is the successful implementation of far-reaching financial reform, including a sharp drop in spending—to 21.8 percent of GDP in 1993 from 34.1 percent in 1982. Comparable results have been achieved in New Zealand—in this case, through a strong executive branch able to work its will through parliament. As with Chile, institutional reform in New Zealand has facilitated major changes in the country’s economic policy rules, including a sharp reduction in public expenditure—to 35.7 percent of GDP in 1994 from 45.6 percent in 1988. The authors suggest that growing awareness of these success stories may encourage imitation elsewhere.

Beyond the national level, Tanzi and Schuknecht cite the potential influence of international competition in forcing governments to reorder their fiscal priorities. As the international economy becomes more competitive, they explain, and as capital and labor become increasingly mobile, countries with big and especially inefficient public sectors risk falling behind in terms of growth and welfare.