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dK Public Disclosure Authorized Public Disclosure Authorized Latin America and the Carlbbec i A decade after the debt crisis

World Bank Lan Americaand the Caribbean RegionalOffice Washington,D.C.

September1993 Cow Th iusafio on the cover by JoequinTions.Gmrdm The painti £50w14, Pe y O* Is upodumd here cotey of ChrlW New Yob it I partof a pvate coecion In NewYor. Contents

Prefce vl

Inital Rtson the DebtCsis I TheEconomic Rebom: CGontent and Rcsults 2 The Pafth ead $ Nrote S

Mef Hisial Bacround 8 re forfm 9 Notes 10

2 WdNTbm"k_AdPwt1 I=1t2a 1 f11 xemal and DomesticOdris of the Crlsls 12 The!Adjutment 3 FailedHetedox Staition Attmpts In the Mld-1980t 18 Notes 22 5. A NeWCu.Sm mmImunie ftlqam St_ctwd Re_in * The Crsis of TraditonalBoonomic Thinking In lati Ametica 24 Factoksbehind the Emeng Co _ns 27 lbe MainEtements of the EmeqgngCons and the Refom 34 Notes 34 4. _1- X DebtR c DebtReIlef, and tcrnomicAudment 37 Flsc Pol1cand Wc Equlbuum 42 EvchangeRates, Inflation, and Disinflation SO Notes S3

S urnOpmbugof la*Amuks 54 Fm P i toIaon a"ia Apecs 54 RecentTrade Liberation RefomsIn LatinAmeica SO TheEffects of TkadeLiberalization 60 Rea xche RateBehavlor, Capital Iows, and the Futre of hde om in aAme 63 RegkonalTing Blocsin LatinAmedca 67 Appendix 72 Notes 74 Iv laWnAmwk ond theOiCbbea: A Decodeafte theDebt Crisis

6. pet; tI. mi 7 AnalyticalIssues and PolicyOptions 78 PrivatizadonIn Chie, Mexico,and Argentina 84 LaborMae Regulaton in Latin Ameica 92 Notes 97

7. CapI Maet D Shs, and 19stuent HistoricalBadWound 100 FinancialDeregulatlon in LatinAmerIca 103 Savingsand Investment III Notes 116

L Povrt InK DIb on, aid Hum Reae s 118 Povt and Income Dstibution 119 Human Developmentin Latin America 124 Education,Human Capital,and Socal Conditions 127 The Reductionof Poverty PolicyOptions and Priorities 130 Appendix 135 Notes 136

9. The PathAhead 138 Consolidatingthe Reforms 138 MaintainingPrudent MacroeoDnomic Management 139 Deepeni the Strtudal and InstitutionalReforms 141 AlleviatingPoverty 142 Assung EnvironmentallySusanable Policdes 142 Notes 143

on llegraphy 145

1.1 Selectedmacweconomic indicators In selectedLatin American countries 7 1.2 Evolutionof foreignindebtedness in selectedLatin American countries, 1975-92 9 2.1 Estimatesof capital flightfrom selected Latin American countries, 197984 12 2.2 Capitalinflows and net resourcetansfers, LatinAmerica, 1975-87 13 2.3 Macoeconomicindicators in selectedLatin American countries, selected years, 1975487 14 2.4 Changein real averagewages in selectedLatin American countries, 198147 1S 2.5 Changein real domesticcredit In selectedLatin American countries, 1975-90 IS 2.6 Nominaland real devaluationIn 9?IectedLatin American countries, 1982-87 16 2.7 Emergencyadjustment and Ineffl ent allocationsin selectedLatin American countries,1987.87 17 2.8 Heterodoxplans in LatinAmerica Main fatures 19 3.1 Generaloverview of structuralreforms In selectedLatin American countries, 1965-92 32 4.1 Annualinflation rates in selectedLatin American countdrs, 1984-92 37 4.2 Debtconversion In Chile 39 4.3 Debt reducdionin selectedLatin American countdes, 1989-92 41 4.4 Inflationand seignorageIn selectedLatin American countries, annual averages,1971482 43 4.5 Publicsector bahnce as a percentageof GDPIn selectedLatin Amedcan countries, 1986-91 44 4.6 lbtal and capitalexpenditures of the public sectoras a percentageof GDPin selected latin Americancountries, 1987,1989, and 1991 45 4.7 Taxrevenues as a pecentage of GDPin selectedLatin American countries, 1987-91 45 4.8 Financialpublic sector quasi-fiscadeficit as a percentageof GDPin selectedLatin American countries, 1986-91 45 Contet v

4.9 latIn Amerian conmtrieswith fixedexchange rates, selectedyeas 51 S.1 Import protection in the developingworld, 198S 55 5.2 The opetAngof LatinAmerica, selected comtries and years,1985-92 59 5.3 Realexdcage rates in selectedlatin Americancountries, 1980, 1987,and 1992 60 5.4 Change In tol factor productivitygrowth in selectedLatin Amedcan countries, 197882 to 1987-91 61 5.5 TotaLfactor productivitygrwth in man ing n Mexdco,1940-90 62 5.6 Growthin value of exportsof goodsand nonfactorservices in selectedlatin American countries, 1970-92 62 5.7 Growth In volumeof exportsof goodsIn selectedLatin American countries, 1970-92 62 5.8 Nontraditionalexpors as a shareof aU exportsIn selectedLatin Amerc countries and years, 1980-91 63 5.9 Exportsof manufacturedgoods as a shareof al exportsin selectedLatin American countriesand years, 1970-91 63 5.10 Capitalinflows and net resourcetransfers, Latin America, 1982-92 65 5.11 Net capital Inflowsas a percentageof GDPIn selectedLatin American countries, 1982-92 66 5.12 Economicindicators for selectedLatin American countries, various years 67 5.13 Exportsto MERCOSURcountries as a shareof total exports,1992 68 S.14 Percentageof Importssubject to freetrade in MEIRCOSUR,June 1991to December1994 68 5.15 Exportsto AndeanPact countriesas a shareof total exports,1992 69 5.16 Tariffstutures In the CentralAmerican Commor Matket,selected yeats, 1987-95 69 SAL Total factor productivitv Cross-country results 74 SA.2Total factor productivity growth regressions 74 6.1 Prlvatizationin selectedLatin American countries, 1980-91 78 6.2 Pfrvatizationtransactions exceeding $100 million,1988-91 78 6.3 Ptivatlzationin selectedLatin American countries: A schematicview 85 6.4 Summaryof privatizationsin Chile,1974-90 86 6.5 Pdivatizationin Chile,198589: Methodsof paymentand buyers 87 6.6 Revenuefrom privatizationin Argentina 90 6.7 Minimumurban real wagesIn sdected LatinAmerican countries, 1984-92 93 6.8 Job proctdon legislationin selectedLatin American countries 94 6.9 Basicdcactescs of sodal secuty sstems In selectedLatin American countries 95 6.10 Labordispute resolution in selectedLatin American countries 96 7.1 FinancIaldeeping In selectedLatin American countries, 1980,1983, and 1986 100 7.2 Effectivereserve requirements on bank deposits,1971-8. Comparativehistorical evidence 101 7.3 Annualizedreal depositinterest rates, end of period,in selectedLatin American countries,1980-86 101 7.4 Realinterest rate spreadsin selectedLatin American countries, 1980-86 102 7.5 Financialrerms In selectedLatin American cauntries: A progms report 104 7.6 Regulationson direct foreigninvestment in selectedLatin American countdes 116 8.1 Shareof income receivedb; lowest20 percentof population,selected regions, 1960,1970, and 1978 118 8.2 Income distibution In selectedLatin American and Asiancountries, various years, 1970-80 118 8.3 Populationbelow the povertyline In selectedLatin American countries, 1970 and 1981 119 8.4 Sodal indicatorsfor selectedLatin Americancountries, 1970,1980, and 1990 119 8.5 Incomedistibution In selectedLatin American countries, early and late 1980s 120 8.6 Individualsin povertyand exme povertyin selectedLatin American countries, 1980and 1989 122 8.7 Utban unemploymentin selectedLatin American countries, 1984-92 123 8.8 Averagereal wagesin selectedLatin American countries, 1984-92 124 8.9 Health indicatorsfor LatinAmerican countries, various years 125 8.10 Malnutritionin sdected LatinAmerican countries, 1990 126 8.11 Socidalsecurity contdbutions and other payrolltaxes In selectedLatin American counties 128 vl Lg.th,Amwkendthme ClbewL-DcA k at. thDebtCufss

L12 Iducatlo IndCMicatro selectd latin Anmiecaand East Asian count*9es 1989 129 L13 Sectd Woddank-spponted prope Intended Imptovesoal ptograms 131 LAl Word Dankedg for hm mowes, OIl 1987403 135

2.1 Mondily ndWon ate un hoeeroxplans In Agentina, Brazli,and Peru, 164418 19 4.1 Seonday markt lon pdcesIn pewent of facevalue, first qut of each ye selectedLatn Amican coulntes,1990-93 43 4.2 Annual rwith ratesof domestic aedit In selcted La1t Amercan countes, 1983 a-d1991 47 4.3 Doaestc aedit to the piate sectot as a shareof tot domesticcredit In selectedLatin Amercan countIs, 190, 1985,and 199k 47 5.1 Realebctve xchangerates in sected latin Amern countries, 1977-91 64 7.1 Goss domesticlnvestmt as a pecenta of GDP,sdected latin AmedcamcouitdL and years II 7.2 Gro domestc svi as a percente of GDP,selected latin Anmicancountries and yea 112 7.3 Pvate investmenta a perentage of GDP,selected latin Americancountries and yeas 113 7.4 Publc Inestm as a perente of GDP,sdected latin Amercan countdesand yes 114 7.S Net fegn dirc Investmentas a percentageof GDP,selected latin Amedcancountries andyear 116 Preface

This report provides a histoy of Latn Amenrkas ee s to analyzethei rfors-and someaspects of economicdeveopment duing the past decadeand the dynamic of dcage disusses some of the policylessons-fom the suc- in additon to documenti forms over the cessesand the failure-of t pedod. The point of deade, the eportdiscusses some of the mostImpor- depattureIs the 1982 debt aiss and the main focus tant unolved isues that Latin Americawill fceL is the relorm processthat hu sc spread apdly The report alsodescbes how the multlatera inst- acrossthe region. tutlons, especay the Wodd Bank4have attempted In many cas the rforms ae too tecnt to daw to support the tr om n. firmconclusions about thei outoomesThereis thus The analysisi rsrcted to the economiclessons aneedtobe guar&dv-offelgpreliminy rults- of the rforms, withoutanalyzing In detailthe poUt- and to focuson leadingtndicatos, such as the tewov- Ia dimenions of the ransformationprocess. This ery of productivecapadty, the behavior of pdvate dffict quesio shold be the subjectof a separate capita flows,and the resumptionof aa to inter- su*. naadonalcapital markets.The main emphasis hnw-

VI ThJs teport was wdittenby Sebas Edwards,Chief Economist, LAtinAmedica and the Catibbean Region, The World Bank. Tbhereport Incotpotates detaied commaentsfrom outside teviewers, namely Andrft Dianchi, FAet Fsow, frandsco Gil Dlaz, and Amold Harberger as wel}as Sterle Beza and staff of the Intematlon Monetry Fund. It was also disussed, and useful oDm- ments were received, at a Seminar of the Executive Directors of the Worid Bank. The author s particulasly grateful to Mareo Selowsky,Heywood Pleisig, Nonnan Hicks, and Fnando Losda for their comments and suggestions. He also wishes to acdmowl edge the particlar comments and -ntributions of Nancy Birdsall, Armeane Chokl, U'J Dadush, As11Demirg(-Kunt, Eduado Femandez-Aras, Ahmed Galal, Tom ,laesner, Delfin Go, Matraet Grosh, James Hanson, Emmanuel Jimenez, Ulich lachles Kye Woo Lee, Frank Lysy,Michael Mlchaely, Dan Monrow,Gobind Nankani, John Nash, John Page,Cawos Prmo Baga, Geore Psacharopoulos, D. C Rao, Maurice Schlff,Andris Solano, Jose Sokol,Baran Tbncer, MichaelWalton, ichard Webb,and Di Wood. Joshua Coval assisted with the revslons. S. Shahid Husain, Vlce President, Latin Amedca and the Cafibean Region, The World Bank, provided general guidance and support for this project.

voiI Executive Summary

The debt crisis in 1982 exposed the vulnerablUtyof years had enjoyed stable prices, suddenly saw infla- the Latin American economies to external shocks.' tion surge. Afterdecades of high tariff barriers and government Only as time passed were countries able to make Intervention In virtually every sphere of economic ImporUnt corrections in their policdes, moving lif, Latin America had developed a rigid economic away fom emergency measur and toward deep, structure that could not rf .ct rapidly to changing coheent reform packages.This was partcularly tru world economic conditions. Financed by heavy in the public sector, where imporant institutional external borrowing, governments had expanded reforms were required on the revenue and expendi- public enterprlses and public employment-but had ture sides. In many cases, the lack of foreign funds- failed In efficiently expanding social services to eitherthroughnewmoneyordebt-servicereduction eradicate the worst manifestations of poverty. -delayed the adoption of reforms. Eventually, the international community realized that debt reduc- lnital R oe to the Debt Crsis tion and debt-service reduction were Integal to a long-run solution to the crsis. The BakerPlan grad- The depth and severity of the crisisin Latin America ualy yielded to the Brady Plan. contrasted sharply with East Asia, where debt diffi- The speed and direction out of the emergency caJties were nothing more than a hiccup, temporar- adjustment varied. Chfle, then Mexdcoand Bolivia, ily slowing rapid growth. And the abruptness of the adopted important reform programs early on. But debt crisis forced Latin Amerca to implement major severl countries continued to follow policies based adjustment programs. After years of receiving sub- on govenment intervention and controL Argen- stantial positive transfers of resources from abroad, tina, Brazil,and Peru-with thteirheterodox plans of Latin America had to generate a net resource tans- the second half of the 1980s-are obvious examples. fer to the rest of the world of almost $20 billion In 1982. An Elwiin Cones

Muddlingthfugh at the Stat Adltment lbward the late 1980s, Latin American politicians duwing1982-87 and policymakersbegan to argue that the only way out of long-term stagnation was to make deep struc- The first years after the debt crisis were character- tural reforms that would open their economies. ized by an emergency stabilization. Policies were Many political leaders who had historically favored adopted in the hope of quicky generating the a large public sectorbegan to supportradical reforms required resource transfer, with little attention to that induded fiscal discpline, the opening of inter- long-run cost or efficiency.Many countries adopted national trade, and major programs of privatization. quantitative restrictions on imports, high tariffs, Why this collective shift in thinking? One rea- multiple exchange rates, and inefficient taxes. But son was the failure of the heterodox stabilzation inflation took off. Despite massive spending cuts, progams in Argentina, Brazil, and Peru Another governments still faced large deficits, so they turned was the stellar performance of the East Asian eco to their central banks for financing. And massive nomies. A third was the fast pace of growth of the devaluations to balance the extemal accounts added Chilean economy. The lberalization and modern- fuel to the inflationary process. Countries such as ization of the Spanish economy led by Felipe Guatemala, Paraguay, and Venezuela, which for Gonzalez also influenced Latin America's leaders 2 LatinAmrica and the Caribbean: A Decode after the Debt Crsis

The catalytic role of the multlatetal agenies con- takes time to effidently reduce fiscaldeficts while tributedto this change,too, though their economic cuttailig inflationay financing,access to foreip studiesand policy dialogue.Important In addition iancing Is crucial.The complemenalty is strong was the emergenceof a broadgrc4p of professional betweenextemal financing and astabilizationeffort economiststrained In the bestschools In Europeand basedon efficent fiscalmesurs. the United States They formulated new develop- Many of the costs of abrupt fiscal adjustments ment options and were called on to manage and can be seentoday. Early cuts In capital expenditures implementthe reformprocess. have been costly-because they left the infrastruc- ture vulnerable,with power shortages,deteriorated The Econm c Refn: Contentand Resulb highway systems,and deficent ports. In sevenl countries deficent inftructure Is already con- The new approach to developmentrecowgnizes three strainingshort-term output elements of social welfae: sustainable economic Domesc credit.An Importantpart of most stabi- growth;equity, broadly defined;and the qualityof lizatlonprograms l the regionhas been the control life, alsobroadly defined (includingpreservation of of domesticcredit-to the publicand prvate ses. the environment).To achieve these goals,economic Duringthe early yearsof the adjustment(1982487), policyshould have fur pillar: macreconomic sta- mostof the burdenof creditreduction fell on the pri- bility,an outwardorientation, a vigorousprivate sec- vate sector.But as the adjustment proceeded,and tor, and socal programstargeted toward the poot foreign financing was partally restored thrgh debt restuctuing, interest capitalzation, and debt MaaewnomsicAdjumnntas a Pmcondlon relief,it was possibleto ease editcontrols to the privatesectoz This process has been helped in recent A key policy lesson from Latin AmericaIs that years by fiscalrefoms that increasedtax revenues macroeconomicibility and inflationhave hurt and reducedcurrent expenditures. long-run growth and equity-they have also en- Echange rates. Exchange rate devaluations, couMged capital flight, moving national savings geared to imprvn intemation mpenes, abroad. Starting In the late 1980s, most Latin are another fundamental pillar of the macroeco- Americancountries began ecopgizingftat achiev- nomic stabilition packa. Most countriesIn the inga minimum of macroeconomicstability was a regiongenetated sizable real dqecao, reaching fundamental first step toward successfl market- almost 100percent in 1982487.These real exchange oriented reform and the restoration of private rate adjustmentscontributed geatly to the turn- investment.Countries that tried to skdpthis step by around of the trade account. Tb protect the real moving directly into iberlization found them- exchangerate from the effects of inflation, many selveson a difficultroute that usuallyended in fail- countriesadopted a crawlingrate regime.Although ure, fustration, and reversals. crawlingpegs avoided erosion In competitiveness, Three aspects of macroeconomicpolicies and the frequent devaluatons added fuel to the infla- reform need to be emphasized the quagtativdi- tionary process.Today, an important policy issue is mension of fiscaladjustment-for instance,the way whether the exchangerate shouldbe fixedor flexi- of achievinga fiscaltarget; the role of creditrestric. ble over the long run. tion In stabilization;and the nature of exchangerate policiescomplemenftng stabilization. 7heOpenig ofLain Amrica Fiscaladjusfe Most countries in the region have implementedor are implementng important Tbe drsc reduction of barries to intemational Institutionalreforms to raise public revenueseffi- trade has been perhaps the most remarkableaspect clently and reduce public spending. 1bx reforms of the Latn Americanrefonms Country after coun- have tried to reduce distortions, increase the tax try slashedtariffs and greatlyreduced nontriff bar- base, and improve collection.Gradually, countries tiers, transformingthe region from one that until have started to prlvatize public entepises and recently was characterzed by stronglyinward-orl- reduce excessivepublic employment. ented developmentinto one becomingrapidly inte- But improvingthe quality of fiscal adjustment gratedwith therest of the world.In many countries, takestime. It takestime to implementa modem tax nontraditional exports have grown substantially, system,and It takes time to privatizepublic enter- creatingnew sourcesof employment.Mote impor- prises and rationalizepublic agendes. Becase It tant, for the earlyreformers, trade bealiation has E&eudieSuwrnny 3

reuted In important Increases It productvity Phwuza*foandDe'~'daUon growth. Faced with the need to compete interna- tionally,entrepreneu have geatY Increasedthier Until tently, ail price controls were the back- effldency.But the depth of these refrms has been bone of the eca.nomc system In many L&tin uneven-anging f*om Chile, which early on Amedcancounties. This has changed TKday,the reduced tariffsunilaterly to verylow unfom lev- marketplays the central tole In allocatng eoure els, to Ecuador,which until recentlyhas been hesi- In most countries. Ibealion and deregulation tant about trade refonr, and to the Caribean, affecteve aspectof economic fe. which generallyIs lagging. PrMatzaton. One of the most salent charcters- An Interestng feature of trade refonrmIs that It tics of LatinAmedcan development undl the 1980s has proceededmuch fasr in industrythan In agi- wasthe owhmingroleafthestateasaprodc cultur Quantitative restrictions on agiculttual State-ownedenterprses were usually highy Ineffi- Imports and exporb are still In place In Latin dent and, In many case, they conssttly abused Amedca.They are largelythe result of the desie to their monopoly power Mov, employment in isolateagriculture from fluctuationsIn worldprices state-ownedentapris becamea maor instument and fromdumping. But the approachfollowed unti for politicalpatonage, genating a labor forcewell now-based on nontiff bartier-has seriouseffi- beyond what was justifiedon efficency grunds dlency costs. Severalcountdes are addressingthese Exceptfor Chile, fewcountries Implemented major concemsby replang quantitativeresdctions with pdvatizatlonprogams In the early phases of the variablelevies. adjsent. oday,however, most countdes In the A key deteminant of the successof trade iLberal- regionhave embarked on major effortsto reducethe izaiton is mainining a compew e eal exchange size of the state through the pdvatizaton of fms rate that encouragesexports. The sgnifiant real and financialinstitutions. exchangerate depreciationsin most LatinAmedcan Atgentina,ChUie, and Mexdcoare the leadingpi- countdesare at the heart of the successof the exter- vatizers-followed by Peru and Venezuela More nal sectoLRecently, however, and larly as a result recently hower, some of the smaller counties of Inceased capital infos, severalcountries have (IncludingGuyana and Jamaica)have made Impor- seen their real exchangerates appreciate.This has tant progres In privatizatlon.And, despite some openeda debateon the desirablityof Implementng early hesitation, Brazilhas begun to move in this new policies-such as the Intensificationof trade lib- area e-zation or the control of capital movements-to Importantpolicy issuesrenaln: the method of help reduce the real appreciation.The key Issuein sale,the timing of privatizatlon,the pricesobtdned evaluatingreal exchangerate movementsIs to dis- for the sale of state-ownedassets, and propms for tinguisb beween those stemming from structural competing displacedworkers. The place of pi- changesin the economy and those that resultfrom vatizationIn the sequenceof the adjustmentprcess macroeconomicmismanment. In general, real has becomeincresngly Imporant There is some exchangerate movementsthat respondto strucral meritto the notion that the state shouldquickdy get and real phenomena-such as terms of trade out of productionactivities when it has no compar- changes or world interestrate variations--areeco- ativeadvantage. But if a country'sfiscal accounts are nomicaly justfied and should not be a cause for not under control, there Is a danger that the pro- concemn. ceedsfrom pivatization will be used to financethe There has been a trend towarda LatinAmerican deficit.A fundamentalrequiement for assuringan trading SYStem-with MERCOSUR,the AndeanPact, efficientfunctioning of the newlyprivatized firms- the Central AmericanCommon Market,and CAR!- especily utilities-is a modem reuatory fame- COM-and toward free trade agreementsbetween work Latin American countries and the United States. Labormwat derglati L Surprsinglylabor mar- Theserenewed eforts at regionalintegrton differ ket rems havebeen absent fommost adjusment substantialy from those of the 1960s and 1970s, progrms. Labormaets are the forgotten sector, whichwere an extension of the Import-substituton and discssions of speed, sequence,intensity, and developmentst ategylTday'sefforts,basedoncom- conditionality have many times proeeded as if mon extenal tariffssIgnificantly lower than those labormarkets ate irlevant contemplatedearlier, recogize the need for Latin Butsome of the most see ditotons In Latin Americato compete In the world. Amercaare in labor maket-government woker 4 LatinArka andthe Cabbeon: A Decadeofter te DebtCrisis

tend to have instanttenure,b ningis poorlyreg- lnrstructre ularly power, transport, and ulated, labor taxes are extremely high, dismissal telecommunications.In somecountries, the deted- costs are enormous,and bacward-lookingindexa- oration has alreadybecome a bottleneckfor short- tionlntoducess tflcantneriatotheinflaonary un grwth, and power cuts in the Dominican process. In sequencing reforms,countries (except Republicand Guyana even have macroeconomic Chile and Peru) have chosen to leave labor market consequences. As the recovey proceeds and fiscal deregulationuntd last.This s a poor choice,because pstions are strengthened,it will be possible for under most circumstancs an early reform of the publHcinvestnent to ncrease. But itis crucial to labor marketi highlybeneficial, helpngt reducethe tap-to the maximum-the possibiltlesfor private transitionalcosts of adjustment.U labormarkets ae Investmentin infrastrre. New waysof incorpo- not degulated, there ls a danger that the effectsof raftng the private sector are being considered.For other reformswill be minimal-en negatlte example, privatlzation and concession arrange- ments for the operadonof portsand highwaysare in Finan Dffeglao, Savins, and Invstment placetoday In Chileand Mexdco.The impotance of refrming the regulatoryframework early In the pri- Formany yearsLatin American countries stictly reg- vatzation processhas alsobecome apparnt, partic- ulatedtheir financlalmarkets, not allowingfinancial ulady for natual monopolies. intermediation to evolve acording to market sig- nals.Real Interestrates becamenegative, credit was Poverty,Income Dstuon, andthe Social Sects allocatedaccording to discretionaryrules, and cor- ruption wascommon. Investmentwas misallocated, Socal sectorshave taditionally been neglected in and savingsrates were low. Tday, mostconmtties are Latin America.In 1980, the region had the most implementingImportant financial reforms. uneven distributionof incomein the world and an Earlyattempts to lalize the capitalmatkets in extremelyhigh incidenceof poverty.The debt crisi Argentina,Chile, and Uruguayin the late 1970sran made things worse.In many countries,the number Into two serious problems.First, real Interest rates of people livingbelow predetermined levels of per skyrocketed, encouraging short-term speculative capitaIncome-defined as poverty lines-increased capita inflowsand hurting investment.Second, a after 1982. Independent of what happened to lax superviory systempermitted financil interme- incomeinequality, this phenomenon Is the resultof diariesto engageIn highlyrisky-and often Illegal- the overalldecline in per capita incomes and real operations.In Argentinaand Chile,lax supervision wages.The decline mainly took place in the years led to the collapse of many financial institutions. immediately after the debt crisis-during the emer- Importantlessonscamefrom theseearlyexperiences gency adjustment phase-as Imports and public for improvingthe designof financialsector reform, expenditureswere drasdcally curtiled. The decline parcularly the need to introducemodern pruden- was also the outcome of postponed reform pro- tial regulation In the early stages of adjustment. gram as In Argentina,Nicaragua, and Peru, where More recent debates have foused on the merits of the lack of inflationarycontrol ingered Into the late opening the capitalaccount early. 1980s.There is also evidencethat per capita public A low levelof domesticsavings, one of the most socialspending in educationand health feUlabout seriousweaknesses in the region'smacroeconomic 25 percent between 1980 and 1985, with some position,is limiting the paceof capitalaccumulation recoveryafterward. and slowingnew investmentsin infrastructure.In The keyquestions for countriestoday are: What 1991,the medianratio of grossdomestic savings to additionalsteps must they take to increasethe com- GDPwas 20 percent,more than 10points below that plementaritybetween the reformsto recovergrowth of the EastAsian countries (World Bank1 Wold Devel- and thoseto improvelong-run equity? And is It pos- qpmentRePt 1993).Increasing public savWngs is the sibleto reallocatepublic expenditure-radically and fastest,most reliableway of increasingdomestic sav- quickly-to eradicatethe worstaspects of povertyin ings. In most Latin Ametican countries, higher the short run withoutimpairIng publicfinances and governmentsavings will requirefurther fiscal adjust- the controlof public deficits? ments, including higher revenues and reduced Reformprograms increase the labor intensity of expenditures. growth.1Trade liberalization and reformsthat reduce An important consequenceof the fiscaladjust- taxeson the use of labor and subsidiesfor the use of ment of the 1980shas been thedeteriorationof basic capital shouldbe accelerated.And because school- ExeUe Summary 5

ing Is one of the major determinantsof incomedis- burst of severefiscal defidts. An these institutional trlbutlon In Latin America,investments in human changes can help assure financial and macroeco- capital and sklllsshould be inaeased. nomicstability over the mediumterm. Countries could have been much more aggres- leilation Impoving property dghts, tilding sivein reallocatingpublic resoutces toward targeted procedues, and the enforcementof egal contracts socialservices-without impaidngthe fiscaladjust- is fndamental to the fnmctioningof aedit markets ment or the pursuit of other efficiencyobjectives. and the overallclimate for investment.The Imple- The poorest 20 percnt of Latin Ameticansreceive mentation of modem and dynamic supervisory around 4 percentof GDP.With publicexpenditures fameworks-and antimonopolylaws-should po- usuallyaccounting for 25 percentof GDP,a 10 per- motecompetition and privateimestment In coun- cent reallocationof the budget could have a signifi- tries contemplatg further actions to prlvatize cant Impact on the welfare of the poorest groups. publicutilities, it is necessaryto quiky put in place Many countriescould generatean Increaseequiva- a regulatory frameworkfor the sector Improved lent to 2 to 3 percent of GDPby increaing the tax property rghts and the creation of proper Institu- base, Improving tax collection,and redudng eva- tlons to guide legislationon environmentalIssues sion.Additional taxes can be collectedby eliminat- will help in achievingenvionmental goals. For all ing subsidies to the middle and upper classes this, the creationof a strongercivil service and more through fuel prices,public utility prices,higher edu- dynamicchannels of communicationamong polit- cation funding, and public employment.And a ical authorities, managers,and those in charge of rationalizationand reduction of militay expendi- policyimplementatlon should greatly help to trans- tures can release additional important resources. form plans into realities-and build support for the Well-targetedsocial programs to sharply reduce ustaabity of reforms. infant mortalityand Improvebasic health and edu- There is also a need to implementpolicies that cation canbe financedat moderatefiscal costs What protectthe envlronment,becwse previous develop- is necessaryis strong politicalwill and the abilityto ment strategieshave seriouslyjeopardized It Global managethe politicsof reducingsubsidies to the mid- discussionshave maskedthe magnitudeand relative dle- and upper-incomegroups. seriousnessof the envionmental problemsin Latin America,and there dearly are misconceptionsin the The Pat Ahead advanced countries about the priorities involved. For instance,few knowthat watercontamination Is Despitethe tremendous progressby Latin America by far the most serious envirnmental hazard in in the past few years, much remains to be done. Latin America,closely followedby air contamina- Wherereforms have recentlybeen initiated,there is tion. Andbecause Latin America is 70 percenturban- aneedtocontinuetomoveforward,especiallyinfis- ized, "bown" issues of environment are more cal consolidation,openness, and privatization.All of serious than green" Issues.Often, good economic the reforming countries-arly reformersand new policiesare automaticallygood environmentalpoll- reformers-need to ensurethat the reformsare sus. ces-many reformsto accelerategrowth can also tained and consolidated.Policy reversals have been help the environment common in Latin America'shistory, introducing Much remains to be done in the social sectors, frustrationand skepticismabout reforms. becausepoverty and income inequalitywlll persist To accelerateand consolidatethe refoms, t is for a longtime.The immediate challenge is to Imple- necessaryto build strong, stable, and effcient eco- ment creative programsthat in the short run will nomic, judicial,and social Institutions.There is an deal with the well-beingof the most vulnerableseg- urgent need to deslan new legal structures to mentsof society.For starters, governments wll have impwve thecivil serviceand strengthentax systems to be much more aggressivein cutting regressive and tax administration.These new legal stucres subsidiesand expendituresand rechannelingthose should help eradicatecorruption, assuring that tax funds to programstareted to the neediestgroups. laws are transparentand that evasionis disourged by appropriatepenalties. Strengthening the auton- Note omy of central banks could limit the inflationary 1. n brEcal in thisdocumet dewtes Un Ameic financingof the public deficit and reduce the out- dthdCabbean. Chaptor one Introduction

Aftera decadeof eonmc adument and refms, tensionsand In somecases um, includingseious many LatinAmercan untriesae emerg as new politicalaises. And in many countries,lare capital economic forces.1 Foreig ivestors are moving inflows have rectly financed inangy large tapidlyInto the region.Consutants and academics currt accountdects and put pretures onte eal are analyzingthe Chileanand Meican experences exchage ate. If the market-orientedreforms are to to lean fihand how these countries,which only be sustined, poligmakers will need to address a few years ago semed hopeless, are becoming somepressing issuW , includingmain t a pru- increasingly attrave for international business dentmacroeconomicmanagement,alleviating pov- And politcias and poliqmakes inASteM Europe erty, significantlyincreasing domestic savings, and ae Incs ltuintaMnAmericaforlessons creatingsolid economic,socld, and poitical insti- on how to move towatd a market-orientedeco. tutional foundatonsfor long term growth. nomic sysm It is difficultto date exactlythe beginningof the The optimistic outlook for many countdes in reformsin each count1y,but it is possibleto arue the regionis largelythe result of the deep madret- that the rems only acqired full and generalized orientedreforms initiated in the secondhalf of the force in the late 1980s and early 1990s, after at- 198Os.3After some hesitation-and in some cases tempts to use traditional stuchtalist policies to patal revesals-he vast majorityof the countres solvethe isishad failed.The countriesinitiated the In LAtinAmerica are today on the way to Jmple refoms from vey differentstrtng points. Some menting truly rvoltionay changes. Counties acedvery rapid inflation and highly distorted hat for decadeshad poectd Ine nt industries incentive systemsand others, mild inflation and and encouraged an everxpanding role for the moderateditortons. The eoonomicrole of thestate stae ate rapldiy being uansformed into outwari- and the importanceof state-ownedenteprses also oriented,market-based economies Moteovei the varied. changeshave been acoompaniedin most countries Although the scope and intensity of reforms by a democratizationof political stuctures The havediffeed actosscountries, it helpsto classffy e refoms are begnning to bear fuit in most coun- countriesas eay reformers,recent reformers,very ties, macroeconomic um has been tecent reormers, and futurereformers (table 1.1). achieved,epors are expanding rapidly,productiv- Earlyrefmers geneay are futher along In the ity hasgrown substantially; and anincreasing num- transformation, having made progress in many berofcountesareexperiencngfastergrowth (table areas. Chile is a case of Its own, hsving Initiated 1.1). And, since 1991,prIvate foreign capital has reformsin the mid-1970s,almost d decade before been movinginto the regionat a pace that supises anyoneelse. The Chileanreforms are advanced,hav- even the most optimic obserer 3 ing touched almost every aspect of economiclif Despite this progress,Latin Amerca stDlfaes Mexico started its reforms in 1985 and has also tremendous duDcenges.Physical infr buctue is moved broadly and deeply,building new instiu- deterirating.Theextent of povertyincreased in the tons that have helped consolidatethe new econo- past decade.Infation continuesto be high-having mic system.Some recent and very recentreformers, refused,even in someof the best cases,todrop back such as Argentina,have rapidlyand simultaneously to singledigits. Moeove the economicreforms in dealt with many sectors.But others have moved somecountries have not been acompanied by the timidlyand selectvelyon struchualreforms or have modernization of political institutions-creating been teluctant,or unable, to enact credibleand sus-

6 Introduction 7

tainable programsof macroeconomicstabllzation, much of the region.Once again, advancedreform- such as Brazil. ers as a group have made the greatest progressin Four features stand out In the macroeconomic this area. Fourth,the debt-to-GDPratio has in most indicators for 22 countries (table 1.1). Irtst, In countriescome down to levelssubstantially below almost every country, the early post-debtcrlsls those prevailingwhen the international debt crisis years (1982-86) had severe declines in GDP per erupted In 1982.The rest of this report investigates capita. Second, starting In 1987, GDP per capita In detailthe evolutionof other important variables began to recover In many countries. Intestngly, durig the past decade-savings, Investment, grwth has been strongeramong advanctd reform- Incomedistribution, poverty, productivity, exports, ers than among countries that delayedthe adjust- capital flows,and exchangerates. mert.4 And,with fewexceptions, most countriesIn In analyzingthe latin Americanrefomis, it helps the region had respectable to strong growth in to separatethe tton, p n , and consol- 1992. Third, inflatlon, after acceleratingin the sec- Idatlonof the reforms(Haggad and Kaufman1992). ond half of the 1980s,has declinedsubstantially In Most countres have initiated, at least, some of the Tabe 1.1 Seected ci indcators in seectedLatin Amerian counties Percpito GDPgruwh Iflatian rfte Ratioofdef, (OmstantprICspecent (annuatper) outstandbigand Country disbursedto GDPb apprAate Average Average AvWage Aver yearofrbnns) 1982-86 1987-92 1991 1992C 1982-86 1987-92 1992 1982 1987 1992c Ea* rbms (be* 1986) Boliva -S.0 0.7 1.7 1.3 776.5 15.8 12.1 1.1 1A 0.8 Chile -2.0 5.2 4.3 8.7 21.2 19.1 15A 0.7 1.1 0.5 Mexico -2.6 1.0 1.7 0.5 73.2 48.4 15.5 OS 0.8 0.3 Average -3.2 2.3 2.S 35 290.3 27.8 14.3 0.8 1.1 O.S Weightedavwerage -2.6 1.4 1.9 1.3 79.1 4S.1 1SA 0.5 0.8 0.3 Rectreme (198688) costaRica -1.0 2.0 -0.1 4.9 29.4 20.6 21.8 1A 1.0 0.6 jmaicam -1.2 2.3 0.0 1.3 17.1 28.9 68.1 1.0 1.6 1.4 Trnidadnkd Tobagp -0.6 -2.0 1.7 -0.9 11.1 8.5 6.5 0.2 0.4 0.4 Uruguay -3.0 2.7 2.2 6.8 53.0 80.S 68.5 0.3 0.6 O.S Aeage -1.5 1.3 0.9 3.0 27.6 34.6 41.2 0.7 0.9 0.7 Weightedaverage -1.8 1.5 1.2 4.0 335 43.9 45.6 0.6 0.8 0.6 Veryrecent ebmws (1990s) Argentina -0.9 0.6 7.6 7.5 3165 446.7 24.9 0.5 0.5 OA BrazIl 1.3 -1.3 -0.3 -2.5 157.9 8S0.8 1,157.0 0.3 OA 0.3 Colombb 0.8 2.0 1.2 1.1 20.6 27.3 27.0 0.3 0.5 0.4 E Salvador -1.2 1.0 15 25 17.9 185 11.2 0.4 0.4 0.4 Guatemala -4.0 0.8 0.3 1.6 12.0 19.2 10.0 0.2 OA 0.3 Guyana -4.3 -02 5.6 6.8 16.7 S7.4 14.2 2.0 4.8 7.2 Honduras -2.1 0.7 0.1 1.3 S.9 13.3 8.8 0.6 0.8 1.0 Nicuagua -3.4 -4.9 -3.5 -2.4 123.1 2,1S1.3 20.3 1.2 1.7 5.9 Panama 0.5 -1.1 7.2 S 1.8 0.9 1.8 0.9 1.1 1.1 Paraguay -3.1 1.0 -0.3 -1.0 19.2 24.5 15.1 0.2 0.7 0.3 Peru -1.7 -4.9 1.2 -4.8 102.7 733.1 73.S 0.4 0.6 0.8 Venewela -2.3 1.6 7.8 S.1 10.2 40.2 31.4 OA 0.7 0.6 l&wage -1.7 -0.4 2.4 1.7 67.0 363.0 116.8 0.6 1.1 1.6 Weightedavage 0.3 -0.6 2.0 0.3 1S9.S 623.8 69S.7 OA O.S 0.4 Foturerefomws DominicanRepubic -1.0 0.4 -2.6 5.7 16.7 3S.7 4.5 0.3 0.8 0.6 Ecuador -0.7 0.0 2.1 1.S 29.0 S1.9 S4.6 0.6 1.0 1.0 Haiti -2.2 -4.1 -4.8 -6.7 7.6 8.2 2S.2 OA 0.4 0.3 Average -1.3 -1.3 -1.8 0.2 17.7 31.9 28.0 0.4 0.7 0.8 Wighted average -1.0 -0.4 -0.3 1.9 22.2 41.1 34.2 0.5 0.8 0.7 LotiknAmoc Average -1.8 0.2 1.6 2.0 83.6 212A 77.2 0.6 1.0 1.2 Wighted aveage -0.7 0.1 1.9 0.8 129.2 421.7 4S9.3 OA 0.6 0.4 a GrowthIconsner pdce xlde rd avwage);compounw gwth rt. b. Stockof total atema debtat endof pelod. c. Peliminary. S5u Wbddgank data ndstaff estet 8 LatnAnei*a andthe Caibbean: A De*de afterthe Debt CrOsi

reSftms and have entered the Implementation govemmentsto poWvidesocial servicesto the poor phase5 This includesstabilization policies to attain Between 1960 and 1978, income distribution fiscalbalance and macoeconomic equilbrium and becameIncreasingly uneven in LatinAmerica-and polidestoeliminate mloeconomlcdlstortlonsand by the late 1970s the region had by far the most privatizelarge parts of the state entetprisesectot In unequal distibution of income in the world (see somecountries, this phaseIs veryadvanced.rerms chapter 8). Asa result of weakpublic finance struc- havebeen implementedin many aeas and are bear- ures, more and more countrieswere forcedto rely ing fruit in acceleratedgrowth, rapid productivity on nflationayfinancng to bridgethe gap between Improvements, and higher wages-as in Chile, governmentexpenditures and revenues. Mexdco,and to some extent Argentina But other Afterthe firstofl shock of 1973,the styleof devel- countries-Ecuador, Nicatagua, Peru-have only opment In latin America became Increasingly recently Initiated the implementationstage. And a unsustainable,because a gwing peentage of cap- smallgroup, with Brazilas the most prominent,has ital accumulationwas financedby foreignborrow- barelytaken the firststeps. iMg.The aggregatecuttent accountdeficit for Latin The third broad stage is charctrzed by the America more than doubled between 1972 and polIRAcO'and institutional consoli of the 1982,rIsing from 2.2 percentof GDPto 5.5 percent reformsand a new understandingof the role of the Also after 1973, inefficientstate-enterprise sectors state and the public sectt This mature phase Is grew mpidly,crowding out private initiatives.And attained when there Is recognitionthat reformsare becauseof the maze of regulationsand distortions pwviding sustinable and solid results, and when accumulated after decades of heavy government new institutions increase the transparencyof the intervention, the returns on physickl investment economic and political proesses and shield the werelow. The unsustanabilityof this development economy from the short-run effectsof the poltical strategy was reflected dearly in the very rapid cycle,In most consolidatedcases, the refomst gov- increasesin the region'sforeign debtJGDPratio- ernment has formedbroad and stablecoalitions and from0.19 in 1975and 0.46 in 1982(table 1.2)-and persuadeda lage part of the populationof the merit in the slowdownin economicgrowth. of the new economicorder (Haggardand Kaufman LatinAmedca's policies since World War II con- 1992). Despite the progress in implementing re- trastedsharply with thoseof countriesIn EastAsia- forms in many countries, only two-Chile and Hong Kong, Republicof Korea, and Singapore, Mexico-seem to have reached mature consolida- among others-since the mid-1960s.Most Latin tion. Movingfrom the Implementationto the con- Americangovemments encouraged inward-looldng solidation phase will be one of the most difficult growth and underestimated the importance of challengesfor most countries in the region during macroeconomicstability. But the East Asian coun- the next few years. tries Implementedpolicies that vigorouslyencour- aged exports and preseved macroeconomic Om Hllcal bdg n equilibriums.And domestic savings In EastAsia sig- nificantlyreduced the need to rely on foreignbor- The developmentstrategy followed in most of Latin rowing.7In addition to the derences in growth, Amedca until the early 1980swas characterizedby threethingsstand outin theeconomicperformance high protectionism, govemment-ledindustrializ- in these two regionsduring 1965-80.First, there is a tion, and generalized govemment controls that seri- sharp contrast between East Asia's vigorous export ouslyinterfered with everysphere of economiclife. 6 growth of 10 percent a year and Latin America's Thesepolcies generatedsubstantial growth in many exportsof 1 percenta year.Second, the averagerate countries until the early 1970s.At the same time, of inflationwas three timeshigher in LatinAmerica however, they greatly encorwagedrent-seeg- than in Fast Asia.8 And third, the savingsrate was and even outight corruption-and resulted in a substantiallyhigher in EastAsia.9 rgd economic structurethat made it very difficult The debt crisisunleashed in 1982-and the fail- for these economies to react rapidly to canging ure of traditlonalpolicies to deal with it-reshaped world economic conditions.The big changes were policy viewsin Latin America.It became apparent the two oil shocks of the 1970s,and the 1982debt that the heavyreiance on the state to run the econ- crisis, In addition, increasingburdens on govern- omy was not producing the expected results.The ment budgets, coupled with debilitatedand ineffi- overexpandedstate, Intead of proetng the public dent tax systems, greatly reduced the ability of fom extemalshocks, had greatlyweakened the abil- Introdudion 9

Table 1.2 Evolution of foreign IndebtedressIn selcted LatinAmerican counlrles, 1975-92 Net tnsfr on dek publkadpubltyguanteed Debt/GOPsht (m of dola) Conby 1975 1980 1953 1987 1"2b 1975 1980 1953 1987 199?

BolMa 0.50 0.88 1.40 1.35 0.80 90 1S1 -138 92 171 Chile 0.66 0.44 0.91 1.13 0.48 -219 -517 876 -627 -502 Mexico 0.17 0.30 0.62 0.78 0.30 2,493 1,241 -4,238 -1,707 -8,680 Recentreardm CostaRica 0.3S O.S7 1.33 1.04 0.61 88 229 -176 -65 -273 jamauka 0.6 0.71 1.06 1.57 1.36 129 122 205 -78 -99 Trinidadand Tobago 0.06 0.13 0.18 0.38 0.42 -16 137 7 -252 -291 Uruguay 0.22 0.17 0.65 0.58 0.46 56 95 198 -139 73 veryrecent reomers Argenina 0.15 0.35 0.44 0.54 0.43 -315 852 -114 -1,643 -2,280 Bazil 0.19 0.30 0.48 0.42 0.29 2,073 199 573 -5,413 -1,478 Colombia 0.21 0.21 0.29 0.47 0.36 147 487 443 -1,159 -921 ElSalvador 0.23 0.26 0.48 0.45 0.37 13 68 221 -61 9 Guatemala 0.07 0.15 0.20 0.39 0.2S 18 93 167 -212 -142 Guyana 0.61 1.34 2.47 4.83 7.22 88 44 8 20 -34 Honduras 0.34 0.58 0.69 0.79 1.02 82 167 118 9 -26 NIcaragua 0.39 1.05 1A7 1.68 5.95 lOS 180 231 464 54 Panama OA3 0.84 1.00 1.06 1.13 173 -62 -61 -218 -269 Paraguay 0.15 0.21 025 0.68 0.27 20 79 186 5 -485 Peru 0.31 0.45 0.59 0.63 0.80 666 -258 1,005 198 45 Vnezuela O.OS 0.42 0.47 0.72 OSS -310 -85 -260 -2,274 -702 Aiure reforms DomnkanRepubIc 0.19 0.30 0.43 0.77 0.59 40 261 14 -21 -139 Euador 0.16 0.51 0.2 1.00 0.99 109 408 -256 99 -474 Hati 0.10 0.21 0.35 0.39 0.29 10 27 28 67 3 La Amefa Avrage 0.19 0.32 0.54 0.61 0.38 Total 5,539 3,934 -6,141 -12,884 -16,460 a.Total extnal debt,ouading ad dlsused,at end of perbd. b. _r*nlay. SouxeWd Bankdaa. ity of these economies to react. Politidcans and poll- affais The past five years (1988-92) have seen an cymakers began to sense-at first slowly and then intensification and generalization of this reform faster-that the Inward-oriented policies followed process-with more and more countries opening to since World War 11were no longer sustinable. The International trade and embarking on ambitious pri- differces In performance between Latin America vatization programs. Moreover, policymakers are and East Asia became particularly dear when the moving toward the implementation of sodal pro- East Asian countries ecovered rapidly from the debt grams focused on the reduction of inequalities and crsis. the eradication of poverty. As the 1980S unfolded, economists dealing with Latin America-including the staffs of the World Pmupeds for Refom Bank, the International Monetary Fund, and other multilateral Institutions-recommended with in- What are the prospects for reform? For two of the creasing insistence a shift in the region's develop- early reformers-Chile and Mexico-the reform pro- ment strategy toward market-based policies. At the cess is mature and appears consolidated. In both end of the 1980s, a growing number of political lead- countries, there are second-generation reformist ers began to adopt a new vision of economic policy governments-and strong Indications that new ad- based on market forces, international competition, ministrations, to be inaugurated in 1994, Wmlcon- and a greatly reduced role for the state in economic tinue to support the modemization. In both 10 LatnAmerva and the Catibbean:A Deco fterthe Debt Crisis

geneated someprobems for macroecononicmanagement, by countries, thie reduction of povertyheough effectve prsng realexchage rtes towardappecaton. Foran analysis and foned po mminghas acquired greatimpor- of t magnitudeof heseflows (nduding a compars withEast tance. Moreover, both are well on the way toward Asia),see CAveLekleuin, andRelnlat 1992. c,eatinghe.st new s tt wl 4. Howevei,despite recent growt, only 13 countrIesIn the creating new Institutions that wlu hlp sustain the regionhad hoome per capIan 1991that exceededthat in 1980 new economic structutes over time. For most other Colombi,chI, Paragua,the Bahamas,Barbados, Wke, lmaa, countries, It is too early to know whether the mar- Antigua,Dominica, St. Kittsand Nevis,St. Vincentand the ket-bandwilpogtams be susWne enough togen Grenadines,and St. Lucia. ket-based programswll be sustained enough togen- S. A gwng literaue trles to expqlnwhy the reformswere erate Latn Amerca's takeoff. The economic history InitiatedThere is litle doubtthat the 1982 cris geneed great of the reform process Is,by itself, fascinating and fn1 disappointmentwith traditonal economicpolicies and political of poflcy lessons for the rest of the world. practies. Thishelped the emergenceof new optionson economIc policyand openedthe doorto a returnto democratcnule. Alesina But one of the difficulties in addressing the eco- and Oazen (1991) have discussedhow economicaises usually nomic problems of Latin America is that the region helpeconomic rfom In timesof crisis,the cost of glddiodand Is so diverse. Brazil, with 150 million people and disagweemeare too high.Also see Hlrschnmn1989. 6. Naturally,economic poliies varied from country to country great regional disparities in income and develop and chaned beween the 19SOsand 1980s.The ova tone of ment, contrasts sharply with Costa Rica, small and these pokies howev, was inward-orientedand Interventionist relatively homogeneous A second difficulty is the AmericaChapterdurin3 deals thewith I9"Os. te evokuionof economicthilnldng In Latin low quality of much of the avaltable data. This forces 7. SeeWold Bank(forthcoming) for a detaileddiscussion of us to be cautious and, at times, to offer only prelim- theEast Asian mirace' counties. Iny condusions. Despite the difficulties, it is stI 8. Behindthese averagesare remwarablydiverse records: possible (and useful) to analyze the recent Latin odm American reforims from a broad perspective-to 9. Psowbw 1991)has argued that compasons btween Latin extract general lessons for other countries engaged Amnwcand EastAsia should be handledwith cae-based on two facts.FRst, atin Ame s inferiorpefmance is concentratedin in reform. e ars _aftthe flnt oil shock.Second, and more importantIn the perod beore the debt crisis,economic outcomes In Latin Notes Americawere uneven.Som countries-mo notablyBrazil-grew at a rate compwableto thoseof the EastAsian natons. Otes- 1. Thrughout this reportthe term 'Lain Americarters to hlhd increasingIgns of stagnation.Fsdows viewson thenations of LatinAmerica and the Caribbean. these mattersare addressedIn greater detailIn chapter 3. See 2. Chile'sstuctral adjustmentstarted In thenild-1970s, mak- Maddison1985 for a penetratingcomparison of development Ingthe country a truepioneer in rnaket-orIentedreforms. strategiesand economicperforman in LatinAmerica and East 3. Asis arguedIn chapter S, these argeinlows of cl have Asia. Chapter two Muddling Through:Adjustment from 1982 to 1987

In mid-August of 1982, a group of hlghly ranked major impart substitution projects. In Mexico, the Mexican officialsflew to Washington, D.C., to meet populist governments of Echeverria and 4pez- with the Secretary of the Teasury to inform him that Portillo borrowed heavily to finance spectacular Mexico could no longer meet its international finan- growth in publlc expenditures. The discovery of cial obligations. This announcement, which took additional ohireseres generated a wave of optimism most of the financial world by surprise, marked the that greatly Influenced the Mexican borolng beginning of the worstinternational finandal crisis binge. About half the Mexican debt accumulated since the Great Depression. What was first thought during the L6pez-Portillo administration financed to be a temporarvylliquidity problem soon spread to capital flight (Buffie and Sangines 1988). In Chile, many parts of the developing world. After having public borrowing played no role In the crisis. During enjoyed ample foreign financing for many years, 1975482 the govemment's extemal debt barely Latin America suddenly faced an almost complete increased, with most new foreign debt contracted by cut In commercial bank credit and was forced to the private sector with no public guarantees. The transfer large amounts of financial resources to the opening of the Chilean economy, as part of the over- industrial countries. aU project of economlc liberalization started in During the late 1970s and early 1980s, most 1974-75, allowed the private sector to finance large developing nations, and especially those in Latin increases in consumption-especially of durables- America, had embarked on a foreign borrowing with borrowings from abroad (Edwardsand Edwards binge. Between 1975 and 1982, Latin America's 1991). long-term foreign debt quadrupled, growing from This chapter analyzes the policies In Latin Amer- $45.2 billion to $176.4 billion. In 1982 the region's ica in the five years following the eruption of the total debt-ncluding short-term debt and the use debt crlsis (198287). These years were characterized of IMF credit-stood at $333 billion. This huge in most countries by emeqenc adjus*nendprogratrs increase in indebtedness was made possible by the geared to generate very large trade surpluses in short liberal way the international financial commu- periods. Given the sudden halt in external financing nity-particularly commercial banks-provided after 1982, the countries of Latin America had littie funds to the developing world after the first oil choice but to use every possible tool to achieve the shock In 1973. The pace at which Latin American needed tumaround In their trade accounts. This countries were accumulating debt in the late 1970s resulted In a costly and highly disorderly adjust- and early 1980s-with increases of more than 20 ment-with drastic declines in real income, impor- percent a year-was not sustainable in the medium tant increases in utemployment, and rapid to long run. Some type of adjustment was accelerations In inflation. And as the crisis dragged inevitable.1 The world was shocked, however, by the on into the mid-1980s, several countries experi- severity of the crisis. Instead of seeing an orderly mented with unorthodox adjustment policies that and slow reduction in the flow of borrowing, a emphasized exchange and price controls and de- major crisis brought net capital inflows to a virtual emphasized demand management and fiscal disci- halt in 1982.2 pline. Austral and Cruzado plans in Argentina and The causes behind the rapid growth in borrow- Brazil and the APRAplan in Peru were the clearest ing varied. In Brazil, the accumulation of external attempts at economic heterodoxy. These programs debt was the result of a deliberate development pol- rapidly faltered, however, and after some months icy based on heavy foreign borrowing to finance were abandoned.

11 12 LatinAmerica and the Carbbean: A *ecadeafterthe Debt Crsis

Extron ad Do_nestc Orion of the Clrs and a steady loss of rdblity in the susanability of the stabilizaton and lbelzation progams in The behavior of the world economy during the early the second half of the 1970s (Calvo 1986; Corbo, de 1980s-paclatly the sluggish gowth of ndus- Melo, and lybout 1986). The major fiscal expan- tral countries, the Increase of world real interest slons in Mexico in the late 1970s also generated a rates, and the decilne In commodity pdces-was setious overvaluatlon of the real exdcwe rate. The Important in determining the timing and magn- Mexdcanexchange rate crsis of February 1982 was a tude of the debt craisis.For Latin American nations, clear pteview of the debt moratorium to come later the deterioration of unit prices of non-oil exports that year. and the hike In wodd interest rates eplain almost Chile, too, had a severereal exchange rate appre- 50 percent of the Increase In the region's current cdation In the years preceding the debt crisis. Te account deficit in 1981 and 1982 (Bianchi, Devlln, cause, however, was not the Inabllty to control the and Ramos 1987). fiscal accounts. It was a wage rate policy that was The extenal shock can be better understood by inconsistent with the overal macroeconomic strat- analyzing the evolution of the red intemational egy. As a way of bringin down a stubbom infla- interest rate for these countdes, computed as nomi- tionary process, the Chilean currency was fixed to nal LIBOR (the London interank offered rate) the dollar in June 1979, just as wages were Indexed deflated by the rate of inflation for the region's to past Inflation and capital controls were relaxed. exports. This real interest rate combines In one indi- The real exchange rate appreciated by more than 30 Cator the effects of both the higher intermational percent between 1979 and 1981, provoking signifi- nominal interest rates and the lower commodity cant deprotection of domestic tradables andencour- export prices. For Latin Ametica, it jumped from an aging a cunent account deficit of 14 percent of GDP average of -3.4 percent between 1970 and 1980 to in 1981.4The countries of Central America also had 19.9 percent in 1981,27.5 percent in 1982, and 17.4 major real exchange rate overvaluations during pcent in 1983. As a consequence of these chang- 197381. The commodity export boom of 1975 ig conditions in the world economy, even coun- allowed them to Implement expansionary policies tries with a lae pementage of their debt contracted without Immediate consequences for international at fixed concessionary terms had dramatic inceases reserves. But by the early 1980s, world economic in their interest bill.3 conditions had greatly changed, generating a sharp In many countries, domestic policies also con- decline in their terms of trade. The overvaluation tributed, with inadequate exchange rate manage- became painful as international reserves were ment as perhaps the most important direct cause. rapidly depleted (Edwardsforthcoming), Most countries that eventu4lly ran into payments Perhaps most devastating, the general tendency difficulties allowed their real exchange rates to toward overvaluation fueled massive capital flight become seriously overvalued In the late 1970s and out of the region. In country after country, the early 1980s. This tendency toward ovaluation public began to speculte against the central bank was in most cases the result of nominal exchange by acquiring foreign exchange and moving it rate policies that were inconsistent with an overly abroad. It is not easy to find official data on capital expansive fiscal stance. flight, but many estimates suggest that in most Argentina and Uruguay are prime examples. Latin American countries there was a significant Both adopted a dedining preannounced rate of increase In capital outflows in the years around nominal devaluation as a way to reduce inflation- the debt crisis-and there was a close relation without first controlling the fiscad finances. The between overvaluation and capital fht result a substantial real exdhangerate overvaluation (table 2.1).5

Tabl 2.1 state of capitl flight ftom selected latin Amerkan counties, 1979-84 (billom of dolars) Country 1979 1980 1981 1982 1983 1984 Argentina 2.2 3.5 4.5 7.6 1.3 -3.4 Brail 1.3 2.0 -1.4 1.8 0.5 4.0 Mexdco -1.1 2.2 2.6 4.7 9.3 2.6 ve_ezuea 3.0 4.8 5.4 3.2 3.1 4.0 SoW Omby and Lekh 1987. MuddkngVThough: Adjusttn 1fm 1982to 1987 13

lhe Adb_utent medliteInputs, seriouslyaffectng future growth. A deteriorationin the tms of trade of 20 percent In August 1982, just after Mexico's fotmal an- between 1981 and 1986 made the LatinAmerican nouncement that It wasfacing serious financdal dif- adjustment tougher. countries needed even rger ficulties,the commercal banks gready reducedthe neas in eports to finance thdr resouce tsns flowof new funds to the developingworld-and to fers to the rest of the world. LatinAmerica in particulr Evencountries that did Because of the early emergency adjustment, not face payments problemsand that had avoided Investmentin the region plummetedfrom an aver- macoeconomic disequiibriums,such as Colombia, age of 23 percent of GDPIn 1973-77 to 17 percent were affectedby this reduction in foreignlending In 1983-86. For the major debtors-Argentina, (Thomas1988; Ocampo 1989).It is fair to say that Brazil,Chile, Colombia, Mexdco, and Venezuela-it the reductionof forelgn funds was brutal-almost droppedfrom 19 percentof GDPto 16 percent.6 In 40 percent between 1981 and 1983.Moteover, the most countries,public investment (includingthat major debtors were forced to close their current for infrastructure)and investment in construction account defict in less than three years The Latin wereseverely curtailed. Americancountries engineered a major turnaround To reversethe net transfers,countries resorted to in their trade balance by going from an aggregate a combinationof expenditure-reducingand expen- deficitof almost $2 billion in 1981 to a surplusof diture-switchingpolicies, including devaluations, more than $39 billion in 1984. multipleexchange rates, capital controls,and im- Latin Americawas severelyhit by the sudden port quotas.The adjustmentrequired a boost inreal drying tp of commercialbank loans. Starting in interestratesandmajorrelatvepricechangesorreal 1982,the net transferof resourcestumed negative, devaluations.The policypackages were designed for and between 1982and 1986the annual net trsfer qel nss in the short run-not for efficiency, averaged-$26.4 billion, comparedwith a positive incomedistribution, or welfareconsiderations. So, averagenet transferof more than $12billion a year there were tradeoffsbetween different objectives- between 1976and 1981 (table2.2). In real 1983dol- among them current account improvemenS,infla- lars, the net turnaround of resource transfers tion reductions,and efficiency-enhancingstructural exceeded $70 billion in the three short years reforms. between 1981 through 1983. Bythe mid-1980sthe Latin Americancountries During this early phase, very rapid adjustments were searcling for methods to reduce their debt in the current account and trade balance were Initially,these effortswere channeled through the achievedby contractionsin imports and in Invest- secondarymarket Only in 1989, with the Brady ment. The real value of imports in Latin America Plan,was an officialframework for reducingforeign declinedalmost 25 percentbetween 1982and 1987 debt developed.The main featuresof market-based (table2.3). In most countries,this compressionwas and officiallysponsored debt-reduction schemes are concentratedon imports of capitalgoods and inter- discussedin detail in chapter 4.

Table2.2 CapItl Inflows noetresoumC trSfeS EpedtW-m&ducingPolkies Latn America,1975.87 (billionsof dollars) Durng the emergencyadjustment period, expendi- Netcapito NetInteres' NettwJfer ture-reducingpolicies centered on eforts to cut pub- Yea hflos "o rs lic expenditure,espedally public investment and 1975 14.3 5.6 8.7 governmentwages. Ecuador, Mexico, Urguay, and 19767 17.2 .82 19: Venezuelacut public expenditureby more than 20 1978 26.2 10.2 16.0 percent In real terms during 1982-86 (CEPAL 1979 29.1 13.7 15.4 1988a).Despite such eforts, goverment interest 1981 39.8 18.9 113 obligationson domesticand foreigndebt tose sign- 1982 20.1 38.8 -18.7 ficantly-a result of real devaluations,which in- 1983 2.9 34.5 -31.6 creasedthe domesticcurrency cost of foreigndebt, 1984 10.4 37.3 -26.9 and of higher domtic and international interest 1985 3.0 35.3 -32.3 1986 9.9 32.6 -22.7 rates. These higher obBltions were particuly 1987 1S.4 31.4 -16.0 imporant for Argentina,Mexico, and Peru, where $s c5WMEwc* kswotfLbAm&4 19M9. interestpayments on the publicsector's freign debt 14 LatinAmeo a and the Caribbean:A Decade after the Debt Crisi

TableZ3 MacroeconomkIndkcators In selectedLatn Americancountries, selected years, 197547 Ratioof fica deicdt Changein Changein (centrlgovenment) RatioOf Iwestent lmports(overage epo (average Inflation(awrge to GOP to GDP(average) accumuloted acumulated annualpercent) peprent) per=n country 1982-87 1982 1987 1975482 198287 198147 198187

Bolivia 2,222.2 0.16 -0.01 0.22 0.10 -18.S 5.2 Chile 21,2 0.01 0.00 0.16 0.13 -28.1 43.7 Mexico 80.1 0.15 0.14 0.24 0.20 -50.5 62.8 Recentreformers CostaRica 29.8 0.01 0.03 0.25 0.25 53.8 25.0 Jamaka 19.4 0.15 - 0.18 0.22 54.8 53.5 Trinidadand Tobago 1.7 0.12 0.06 0.28 0.23 23.2 56.3 Uruguay 57.7 0.09 0.01 Q.22 0.14 -12.4 10.0 Veryrecent reormm Argentina 346.1 0.07 0.04 0.23 0.13 -36.0 17.5 Brazil 173.3 0.03 0.12 0.23 0.19 -5.9 44.5 Colombia 24.2 0.05 0.01 0.19 0.19 -3.5 60.1 El Salvador 17.7 0.08 -0.01 0.18 0.12 -11.2 -10.8 Guatenala 14.0 0.05 0.01 0.18 0.12 -25A -25.7 Guyana 20.1 - - 0.30 0.30 -41.8 -24.7 Honduras 45 - - 0.22 0.15 0.1 5.4 Nicaragua 173.1 0.20 0.17 0.17 0.20 -25.2 -43.9 Panama 2.7 0.11 0.04 0.28 0.19 -6A 10.6 Paraguay 22.3 0.00 0.00 0.28 0.24 3.3 41.0 Peru 101.8 0.03 0.06 0.25 0.23 -25.7 -9.7 Venezuela 12.6 0.04 0.04 0.33 0.20 -11.5 8.3 Futurereomes DominicanReubic 15.7 0.03 0.02 0.23 0.21 7.0 8.0 Ecuador 30.9 0.04 0.02 0.26 0.20 -2.8 11.7 Haiti 7.2 0.03 - 0.17 0.14 -14.5 -3.1 Averagelatin America 110.9 0.07 0.06 0.23 0.19 -24.7 33.5 - Notavailab SowuWAold Ban* datau IMF, Govownent Ramra StadtW valow years. were about 20 percent of government outlays. fiscal deficits. As foreign funds dried up, local gov- The exchange rate polides during the period, emments were forced to tum to the Inflation tax and epecial the multiple exchange rates, also pushed to issuing additional domestic public debt. The need up government expenditures for several countries. to rely on inflationary financing put pressure on the Argentina, needing to cover exchange rate guaran- monetary and domestic credit policies, which be- tees after the abandonment of the preannounced came significantly more expansive than the IMFand nominal exchange rate (the tablita),generated stag- the World Bank felt they should have been. Contrary gering fiscal outlays. And Chile and Venezuela to previous experence with IMP-sponsored stabi- adopted preferential (lower) exchange rates for for- lization programs, many ot the early adjustment eign currency debtors, and implicit subsidies that efforts werecharacterized byan acceleration in mon- absorbed public resources (Calvo 1986;Edwards and etary growth, persistent high fiscal deficits,and very Edwards 1991). high inflation (Edwards1989f; Sachs 1989c). Despite the relatively successfulefforts to reduce The restraint of wage increases was, in most public spending, fiscal deficits In many countries countries, another major component of the expen- were higher than before, due mainly to a decline In diture-reducing package and, with few exceptions, tax revenues, generated by the drop in economic the countries of the region experienced significant activity. This problem was compounded in almost declines in real wages between 1981 and 1985 (see every nation by low compliance and very inefficient table 2.4). These reductions were attained mainly by tax administrationsthat fostered evasion. severely controlling public sector wage increases The debt crisi changed the sources of financing despite rapid inflation. Muddig Through:Adjustmentfrom1982 to 1987 15

The adjustment also relied, in many countiles, Asa result, real interest rates increased sharply, keep- on tight domestic credit po}icies,with much of the ing expenditure, particdularlyinvestment, in checkL burden during the early years falling on the private In some countriles,however, the rise In real inter- sector. Most govemments reacted to the sudden cut est rates began before the offical unleashing of the in foreign funds by boroing heavily from the debt crisis in August 1982. In the Southem Cone domestic banking system, crowding out private bor- (Argentina, Chile, and Uruguay), real interest rates rowing. In many countries, private sector credit as a began to climb rapidly In mid-1981 as these econo- percentage of total credit to the banking sector milesovetheated, and the higher interest rates were declined substantially during 198287 (table 2.S).7 an early sign that the need for adjustment was fast

Table2.4 ChangeIn real averagewages In selectedLatin Amercancounties, 198187 (1980=100) Country 1981 1982 1983 1984 198s 1986 1987 E,artyreffomer Chile 109 109 97 97 94 95 95 Mexico 104 104 81 75 77 72 73

Recent refonners CostaRica 88 71 79 8S 92 98 89 Unrjuay 108 107 85 77 88 94 99

Veryrecent refomers Argentina 89 80 101 127 108 110 103 Brazil 109 122 113 105 113 122 102 Colombia 101 1OS 110 119 115 120 120 Peru 98 101 84 70 60 76 80 Venezuela 86 79 77 76 91 90 92 Source: CEPAL,Ecomo* Swyof LdtInAmefca 1982-90.

Table 2.5 Change In real domestc credit In selcted Lain American countries, 1975-90 Accumuatedcane Pvte sector/total 1982-87 (pcent) tdomesccredit Country Total Privte sector 197581 1982-87 1987-90 Earyreformer Chile 118.37 26.73 0.64 0.71 0.63 Mexico -10.07 -38.69 0.41 0.30 0.45

Recentrefrmrs CostaRIca -1.29 7.64 0.63 0.47 O.S4 jamaica -23.S2 39.08 0.43 0.42 0.46 Uruguay 37.0S -6.77 0.80 0.62 0.78

Vety rcentreform Argentina - -24.15 0.76 - - Brazil 193.28 33.66 0.89 O.S6 0.47 Colombia 64.64 31.84 0.70 0.68 0.58 ElSalvador -38.00 -39.36 0.84 0.8 0.67 Guatemala -1S.S4 -0.34 0.79 0.59 0.42 Guyana 63.97 35.23 0.19 0.11 0.22 Honduras 6S.10 57.47 0.73 0.56 0.58 Panama 20.SS 11.41 0.81 0.78 0.73 Paraguay 14.26 -18.23 0.93 0.71 O.S1 Peru 6.1S -31.19 0.36 0.46 O.S1 Venezuela 29.57 27.33 1.59 0.89 0.93

Riturerefomws DominicanRepubik 1.25 18.64 0.61 0.49 0.62 Ecuador 53.S7 7.81 0.87 0.79 0.66

AverageLatin America 101.64 6.29 0.74 0.52

- Not avaUable. Soure RA,intlnal Rnncl Sttstk vaiouyears. 16 LatinAmerica and the Caribbean: ADecade after the Debt Cris approaching. In Argentina the annual real lending Table2.6 NomInalnd real devaluton In selected rate reached 19.3 percent in 1981, much higher than Latn Amerkancounteas, 198N 7 the average of 1.5 percent during 1978-80. As the A ca A w effects of the debt criss were being felt In 1982 and Mt nLoli 1983, the real lending interest rates remained high d h (ercen EffecH (around 12 percent a year) but not as high as in 1981. GOtmmo [1] 2aJ Likewise,In Chle, the annual real Interest rate 1) 12) (3) (11[2) reached 58.1 percent in 1981, much higher than the Emlbfo 6.7 S18,01 8.5 percent average for the two preceding years. Chge 960 511 0.19 During 1982 and 1983 the real lending rate dedined Mexlco 24.1 4,756 0.01 to the still remarkable level of 16 percent (Ramios Recent afms 1986). CosaRka -32.5 94 -0.35 In the SoutheemCone the debt problems further TrinidadJamaIcand Tobago -11.137A 209s0 -0.220.18 shocked aleady weakened financial sectors. In utuay 70.3 2,241 0.03 Chile, the halt of capital Inflows was partally recentrmvn responsiblefor a serious financial crisisin late 1982 ArgentinaVery 33.1 323,874 00 and 1983. By the end of 1982, the foreign debt of the &in 26.9 48,649 0.00 Chilean banking system exceeded $6.6 bllion, Colombia 51.6 329 0.16 remarkable when compared with a mere $0.6 billion ElSalvador -26.5 100 -0.27 in 1978. These funds had been obtained without Gutana 2030 213 0.23 government guarantee, mainly to finance the oper- Honduras -19.5 0 - ations of large private conglomerates-the rupos. Nargua -99.0 597 -0.17 By mid-1982, a large part of these loans went badas Paaa 46. 337 0.14 the grupos ran Into very difficult financial times Peru -4.1 5,637 0.00 because of a number of factors, including the real Vezela 60.1 238 0.25 overvaluation of the peso. In 1982 the foreign funds Fuhr reforersn available to the Chllean banks were reduced by mote DominkanRepublkc 100.1 396 0.25 Oa 75 prcent, a sevete blow to the toubled finan- Ecuador 96.S 786 0.12 cal sectot inJanuary 1983, the government stepped Haf' -13.5 0 - in, liquidating two banks and nationalizng others. Aveage 22.7 2S0,327 0.00 Responding to prwr from International financial instltuions, the govemment took over the foreigr AnMga ng debt of these banks, guaranteeing its payment Agentina andBolivi 23.0 3,266 0.01 Qlarberger 1985b; Edwards and Edwards 1991). Now. I pteit oatwm ania rat#e of *dvau of the bateral) real exchange rates for 198247. Column 2 has te RVenditive-swi0ft Pokidesaccmulaed rt of nsminaldevduton forOhe same period. Column 3 pas axx of dYSWm of nomlnal devaluationi dedkned a the daiooaccsmulate rea devaluation (column 1) to accumulatednomnal After August 1982, most countries also relied on ratewasdepredateddevalodor(cmn 2).l*sfor aevy peretagepolntofexmeaures how muchnomnal thereal devaluton. excag expenditure switching to improve their current A e ofaem for one idex mea at the nom ecage rate account balances-in most cases,a combinationof devhalutln.Alowvatue,adustmenthas been highlbbyconutas.mensthat efetie, thenomnaltanlatd intodevaaluatin a real nominal devaluations and, at least initially, major had te succss with tsrea eect ido* eroded by higwer domtic escalations in import restrictions, through higher kfltm Mrse yet a negativevalue of h effctve Idb meas, tarfft, broader coverage of non-tariff barriers, and eciat.e multipleexchange rates (Bianchl1987). h IMf bs Most countries experienced large real exchange rate depreciations during 198287, with an average nominal devaluations. But the effectveness of these accumulated real devaluation of 23 percent for the devaluations was In most cases rather low-for two group as a whole (table 2.6). And for many, the real reasons.8 Pirst, the accompanying fiscal policies c. ir- devaluation was substantial, exceeding 40 percent ing this early petiod were not always tight and, as and in some cases even surpassing 70 percent, as for pointed out earlier, in some countries the fiscal Chile, the Dominican Republic, Ecuador, and Uru- deficit even increased after the eruption of the debt guay. To achieve such sizable eal exchange adjust- crisis. Second, after the inital devaluations most ments, these countries had to implement veiy lakge countries decided to adopt a crawling peg regime for MuddlingThrough: Adjustment fwm 1982to 1987 17

the nomlnal exchangerate. Althoughavoiding the the compressionof Importsand the tuunaound of erosion of international competitiveness in most the trade account (table2.7). Did the use of quanti- countdes, the frequent devaluationsadded fuel to tative restrictionsdurng the initial phases of the the inflation and genetated infltionary Inertia.9 adjustment-instead of tariffs or more substantial Multlpleexchange rates, another importantfea- devaluation-intrc 1uce unduly high cosb for tute of the early exchange rate poUciesin many growthand efficiency? A well-known proposition in countdes, had three goals. First,by hnplementing internationaltrade theory sthat, froma welfateper- differentexchange rates for capital and curent ac- spective,tariffs are superiorto quotas as a means to count transactions-as in Venezuela-the authori- restrict trade. But, for a small county that faces ties hoped to separatereal transactionsfrom volatile given foteigncurrency prices for Its imports,quotas capital movements. More important, however,by are very effectivefor keeping the value of Imports imposing a free floating exchangerate on capital belowa certain level.As long as countries need to flows,Venezuela tried to discouragecapital ffight establishcredibility for their wllingnessto adjust- without hurting the current account.This sttategy and this credibilityis telated to the abiity to cut failed as the lack of policy coherenceencouraged importsrapidly-quantitative restrictionsmight be even greaterspeculation and capital flight.Second, justifiedin the very short run. Fromthe efficiency, multipleexchange rates supplemented the systemof fiscal, and income distribution perspectives,the protection. Indeed, when different exchangerates maintenanceof qualitativerestictions in the me- are appliedto differentcommerca transactions,the dium or long run has well-known undesirable outcomeIs the sameas that froma differntiated tar- effects.For example,the generalizeduse of qualita- 1ff schedule (Dombusch 1986). This practice was tlve restrictionsin Me-xicoin 1982-84 resultedin a again used by Venezuela, as well as by the large reductionof Import of intermediateinputs, Dominican Republic, Honduras, and Mexico. Third, greatly hurting the Mexican eccnomy by reducing some countries-including Chile, Mexdco, and the level of activity and the prospects for future Venezuela-applied a lower prfenta exchange growth (Buffieand Sangines 1988). Natuly, to rateto the privatesector's repayment of forelgndebt. reducethe efficdencycosts of the quota, it is recom- The reason:to avoida generalbankruptcy of the pri- mendedthat quantitativerestrictions be auctioned. vate sector,which had borrowedheavily from for- This was not done, however,during the early years eignbanks at the previouslyfixed nominal exchange of emergencyadjustment operations. rate. Toward1985-86, some countries began to relax In additionto the multipleexchange rates, many their trade restrictions.In Chile,tariffs were reduced major debtorssupplemented their devaluationpoli- to a uniform 20 percent In 1986. Startingin early des with trade restrictions,hiking import tariffsat 1986,Mexico began to step towardreducing thecov- least temporatily(Bianchi 1987). Nontariffbarriers erageof licenses.In Bolivia,by contuast,quotas were also increasedsubstantially In an effortto accelerate fullyabolished and tariffsgreatly reduced in 198Sas

Table2.7 Emergencyadjustment and Ineffident allocaions In selectedLaWn Amwican countries, 198247 Country Year Exian ofs rade restrktlonsdurhg 198287 Argentina 1984 Decree4070. AlP import requirea pennit AllImports compeing wth local productionare subjectto authrzon (withconsultaions to domestic produoerasscitions) 1985 Tarffsurcharges of 10 percentover impots and 9 percentfor exports Chie 1982 ImpoKsurcharges ranging from 4 to 28 pementImposed on more than30 items;as, two-tierexchange rate established 1983 Importtarffs raied from 10 percentto uniform20 percent 1984 Importtarffls temporarily hiked to 35 percent 1985 Theuniform impoft duty systemIs stabilized at 20 pecent (fromthe earier uniform10 percent) MexIco 1982 Quantitativerestrictions Imposed on all imports(during the 1970-80decade quantve restrictns affectedonly 60 percentof imports) Venezuela 1983 Foreignexchange controls and a two-er offiial exdnwge rate system. Quandiativerestros on 70 prcent of finalcoruumption goods Som:Wiid Bankta 18 Ladn erca and the Caribbean:A Decodeafter the DebtCrsis

part of the stabfflizationprogram aimed at stopping in a stabilization program is brealdng inertia. The hyperlnflatlon. Australand Cruzado plans-in Argentina and Brazil, Despite the early adjustment effort-and the respectively-tried to do this by combining mone- costs-the trade surpluses systematically fell short of tary reforms and incomes policies. Although the two interest payments. In 1986, the interest bill for the plans were correct In pointig out the importantrole region amounted to S.3 percent of GDP and the of indexation, they erred badly in not enforcing the trade surplus 2.3 percent of GDP. During the early necessary-and politically more difficult-policles years, the financing gap was closed, usually after for managing aggregate demand. By Ignoring the long and protracted negotiations, by packages of fundamental role of fiscal equilibrium In attaining funds from the commercial banks and multilateral price stability, these plans collapsed-with no institutions. progress In reducing inflation. Some studies at the World Bank suggested early The Peruvian stabilization program under on that for the great malority of the highlyindebted President Garcia differed from the Austrl and countries It was not possible in the short run to gen- Cmuzadoplans. Disregardinghistory and every basic erate trade surpluses large enough to cover Interest principle of economic theory, it consisted of a price payments without significantly reducing real con- freeze, a pegged exchange rate, wage inceases, tax sumption (Selowskyand van der lak 1986). A typi- cuts, reduced payments on foreign debt Interest, and cal major debtor needed financing in the form of increases In government spending. Repeating some new money for about five years to experience some of the most serious mistakes of previous populist recovery in real consumption (Zpercent a year) and regimes in Latin America, the plan resulted in an in real income (4 percent a year). Once growth re- outburst of Inflation, a reducdon in real income, and sumed, the Indebted countries would be in a strong- a dramatic decline In real wages (Dombusch and erposition to servicetheir obligations. Selowskyand Edwards 1991). van der Tak argued further that, to the extent that Although all three programs sought to immedi- the new money supported structural reforms, the ately defeat Inflation, the programs were also part of eovery would be faster, generating robust and sus- broader economic strategies based on increased gov- Minablegrowth. This view-calling for substantial emment intervention and an inward orientation. At debt restruturing and even debt reduction-slowly the time, these plans-especially the Austral and gained acceptance among the creditor nations. It Cruzado plans-were seen by many observers as al- became part of the official debt strategy In March tematives to "orthodox" IMF-sponsoredadjustment 1989, when the United States unveiled the Brady programs based on fiscal restraint and market-ori- Plan for adjustment packages that combined debt ented reforms. It Is possible to argue that these three reief and market-oriented reforms. programs constituted a final attempt by structural- ists, now under the banner of neo-structuralism, to Fal Ietedox St_eb on At_tmpt Implement a development strategy based on a dom- In the Mld1980s inating government." This section analyzes the most important features of these stablization pro- An important comsequence of the early emergency grams (table 2.8 and figure 2.1). In all cases inflation adjustment programs was a rapid acceleration in declined in the short term but after a few months inflation, particularly in Argentina, Bolivia, Brazil, was back to its original level-or even higher. Mexico, and Peru, where inflation reached or sur- passed tdple digits. In the mid-1980s,and as the debt Argentina crisis dragged on, Argentina, Brazil,and Peru exper- imented with unorthodox anti-inflationary policies The Austral Plan initiated in June 1985 was the best that emphasized exchange and price controls and designed of the heterodox programs. It was based on de-emphasized-in the design or implementation three fundamental elements:12 s-demand management and fiscal discipline. Price, wage and exchange rate management As a At the core of these attempts wasthe belief that Infla- way of breaking Inflationary expectations, a price tionary inertia had become a permanent feature of freeze was decreed In June 1985. A fundamental ele- these economies. ment in this strategy was the control of public ser- When indexation and inertia become ingrained, vice prices. In addition, public wages were frozen, it was argued, inflation takes on a life of Its own, and and the exchange rate was fixed. It was thought that monetary authorities have little choice but to vali- the combination of these measures would put an date It.10 In this view, the most important element immediate brake to the inertial forces. MuddlingThrough: Adjustment from 1982 to 1987 19

Table2*8 Heterodoxplans In LatinAmerka: Main features Exchange Prke Wage Initial Fiscal Monetary Tade Country rateregime oanftls controls devaluation adjustment refom potkyrefomv Argentina,June 1985- Fixed Yes,selective Yes,mainly Yes,40.2% Initial, Yes No December1986 public transitory Brazit,February 1986 Fixed Yes,selective No No No Yes No December1986 Peru,August 1985- Fixed Yes,across Yes,across Yes,12% No No No August1986 theboard theboard Sowre:Argentina-INDEC, Fl, OCRA Brazil-CACX BCO, IBGE, Pert-INF, BCRP.

Fiscaladjustment. By late 1984, the Argentine fis- Figure2.1 Monthly Inflationrate under heterodox cal finances were completely out of hand, with the plans in Argentina, Brazil and Peru, 1984-68 fiscal deficit bordering on 15 percent of GDP. The 120 architects of the Austral Plan decided to tackle this 1 AM problem by enacting a series of revenue-increasing (nn) measures, including higher prices for public services, 80 higher import tariffs, and a forced savings scheme 60 Austrl for workers. There also was great hope that the (Argentina) C reduction of inflation would alone result in higher 40 razo real revenues, through a reversed Olivera-Tanzl 20 effect.' 3 These policies had a quick impact on the deficit, reducing It to 2 to 3 percent of GDP by late 0 1985. But this success was short-lived, with the fis- -20 l, cal defidt surpassing 7 percent of GDP by late 1986. June June June lune June Why the resurgence? Public service prices-which had been fixed as a way to provide a nominal Source:IMF, intntionwl 7einllStat anchor-declined rapidly in real terms, contributing to the deficit from state-owned enterprises. And, the became increasingly overvalued and the extemal effect of lower inflation on tax revenues was small accounts showed alarming deficits. In addition, pub- and short-lived. lic service prices began to rapidly lag in real terms Monetary refbm. The peso was replaced by a new In April 1986, the main anchors of the pro- currency, the austral, and a comprehensive and inge- gram-the exchange rate, public sector wages, and nious system was devised for transforming contracts public service prices-were given up as the govern- signed in old pesos into australes-the desagio. This s.nt announced a "price flexibilization" period. A procedure, based on a sliding scale for exchanging crawling peg system was adopted, wages and prices pesos and australes, was designed to avoid serious were increased, and it was announced that future income redistribution as a result of the decline In adjustments would be allowed "If justified.- At that inflation. For monetary policy, the program aimed point, the magic was broken, and the credibility of at helping remonetize the economy, through the program dissipated. By late 1986, the fiscal increases in domestic credit. deficit had dimbed to 7.2 percent of GDP, and Infla- The initial results of the Austral Plan were spec- tion had once again gained momentum (Kiguel tacular Inflation dropped from 350 percent in the 1991). Despite new efforts to introduce controls, It first half of 1985 to slightly more than 20 percent in was increasingly apparent-even to some of the the second half. This early success was greeted with original plan's authors-that price controls without euphoria. Some observers claimed early victory, and major and sustained fiscal adjustments were the authorities, in their enthusiasm, did not insist doomed to failure. on the need to strengthen the fiscal side and control aggregate demand rapidly. But by the end of 1985, Brazil the economy was already showing some stress. Because inflation had not disappeared, some key rel- In February 1986, the Brazilian govemment of ative prices started to get out of hand. Secause of the President Jose Samey unveiled a bold stabilization persistence of inflation, the real exchange rate plan to respond to the rapid acceleration of infla- 20 LatinAme,ja and the Caribbean: A Decade after the Debt Crsi

tion, which had surpassedan annual rate of 450 per- ftr from balanced.Moreover, the 8 percentIncease cent during the first two months of the yeat As in In wagesdecreed in Februr put sgnficant pressur Argentina,the prgram wasbased on the beldefthat on prices,as did the rapid rate of money creation- indexation was the most important cause of Infla- 200 peroent between Februaryand July. An added tion, so the keyobjective was to put an end to Inf- ptoblemwas that in February1986 many priceswee tion by de-indexingthe econony. In contrastto the fixedat d lum levels,generating all sorb of Austal Plan, no serious considerationwas given, reactionsthat rangedfrom shoges, to largelosses even in the design,to controllingaggegatedemand in state-ownedenterpdses, to lobbyingfor relaxing through fiscaland credit restraint. the price freezein somesectos The main elements of the Cruado pwgram In July 1986, the governmentattempted a new were: plan to control demand,but It wastoo little,too late. * A monetaryreform that replacedthe cruzwwo scalimbalances contlnued to put pressure on with the cruzado,which was then fixedto the dol- prces, and in September1986 the fixed nominal la Explicitmechanim were devisedto convert exhange rate wasabandoned. By January 1987, the contracts originallydocumented in ruzeirosinto automaticwage adjustment was triggered, the cawl- the new cuency. It was thought that this eform ing pegsystem based on mini-devaluationswas fully would greatlyhelp in de-indexingmoney and thus reestablished,and indexationwas once again In full in eliminatinginflation. swng. Instead of redudng inflation to zero, as its * A generalprice freeze,at levelsprevailing on dedsners had promised,the CmzadoPlan left Brazil February28. a legacyof frustration,skeptcism, and even higher * The tansformation ofwagesfrom cuzeiros to inflation. cuzados at a level correspondingto real wagesfor the previous six months. In addition, workers Peru receivedan 8 percentbonus in cruzeiros. * An automatic trgger mechanism for wage In August1985, PresidentAlan Garda assumedthe adjustments,to be put into effectevery time accu- presidency,facing accelerating Inflation, heavy for- mulated monthly inflation reached20 percent. eign debt, and a stagnantecnnomy. His govemment * The elmination of indexation clausesin al pwogm called for a drastic reduction in inflation, contractsof less than one year and the freezingof and a deep pwcess of economic transformation the nominal value of indexedpublic debt bonds for aimedat improvingincome distribution and reacti- one year,4 vating growth. Although this episode differs in The programdid not considerany explicitfiscal many aspectsfrom the Austr and Crmzadoexperi- or monetry target to complementthe pdce freezes ences,It, too, was basedon extensiveprice controls and de-indexationmeasures The architectsof the and a disegad for fiscalbalance. The main objec- program thought that the fiscal package Imple- tlivesof the APRAgovernment were dearly summa- mented in December1985 had alreadysolved the rized by the Plan Nacdonalde DesarolUo: fiscalproblem. This was basednot on seriousanaly- ses of the fiscalaccounts-these have alwaysbeen The new economicpolicy seeks to pass from distorted and unreliable in Brazil-but on wisiful an economy of conflict and speculation to thinking. And it was thought that an expansive one of production and consensus. In this monetary policy was required to remonetizethe economy it is possibleto make compatible economyonce inflationdeclined. 1 s stability,growth, distriution and develop- Inflationdropped raply from60 pecent in the ment in a context of national planning first quart of 1986 to 8.3 percent in the second which finds concrete expressionin dialogue quarter and 2.1 peent In the thrd quarte Thissuc- and social and economic concertation.... cesswas short-lived,however In the firstquarter of Planningof economic developmentwill be 1987-mostly as a result of the inabilityto control full, decentralizedand participatoryand con- the fiscaland creditsides,-nflation reboundedto44 certation wlll center on the effort to make percent.By the secondquarter it was95 pecent. compatible the generation of savings and During mid-1986,aggregate demand increased productiveinvestment wth attention paid to at a rate inconsistentwith the price freeze.Contry the undelayablepriority of attending to so- to what the authoritiesthought, the fiscaldefict was clal needs.We need to reconcile economic MuddllngThough: Adusment fom 1982to 1987 21

efficency with sodal equity in a productive subsidiesand an extraordhiy declne in real tax dynamic which is fndamently sustained collection In 1975-86, tax collection averaged by domestic resoures (Pdenla de la above12percentofGDRButby1988,andasaresult Repfiblicadel Peru 1986) of a sharp deline in compliance,It had faben to only 7.5 perent of GDP.The cental bank'spolicy of The APRAproam was based on four policy multipleechae rates-buying foreignexchange measures: at a high price from exports and selHingit at a low * Rapidexpansion of effectve demand thrugh or subsidiaedprice to impours-s contributedto real wage increases. For the public sector, these the deficit,generating losses equal to 2 percent of Increaseswere financed by moneycreatioa'. GDP. * Devaluationof12percent, followedbyaffixed Inlatel987,pricecontroLshadtobefreed. Open nominal exchangerate. This put an end to a policy Inflationemed, real wagesdeclined sharly, and of frequent exchange rate adjustment (a crawing real output dopped rapidly.By the end of the Garcda peg) in effectsince 1978. adminIstration,thecountrywasapproachinghyper- * Reductionof nominal interestrate ceilings,as inflation, socal confict had escalated, and the a way of providingfinancial relief to firms. prowspectsfor rapid revy lookedgrlm." * Price freezesfor many industial and agricul- tual products. Medco AsIn the CruzadoPlan, there wasno concemfor fiscal adjustment The designersof the APRAeco- Mexico'sstabilization sucoeeded but wasn't hetero nomic blueprint believedthat fiscaldeficits in Peru dox. After hittng 159 percent In 1987, Mexico's were not necessarilyexpansionary, arguing that if Inflationrate was reducedto 11.9 percent in 1992. there is unused capacity,it is possibleto financefis- An important element of the Mexicanstabilization cal Imbalancestogh moneycreation without cre- programwas guiding exchangerate changes, wage ating inflationarypressure. They pointed out that rate adjustments, and price increases. These In- firms,by increasingtheir scaleof operation,would comes policiesbecame official in December1987 be able to lowerprices (Ptesidenciade la Repliblica when a three-partyagreement, the Pactode Solidari- del Peru 1986). dad Social,was signed by govenment, the largest In the short term, the Pemvianhetetodox pro- labor union, and representativesof the privatesec- gram was highly successful Inflation fell sharply, tor. employment increased, and the real wage was Becauseof the incomepolicies in the Mexican pushed up signlificantly.In the last quarter of 1987, adjustment, some authors have classifiedit as the real wage stood 52 percent above the level of another heI_ox experiment: several writings 1985. Growth, too, had been substantial.The eco- group the Austral,Cmzado, and APRAplans with nomy grewby 9.5 percentIn 1986,and by another the Mexicancase as the representativesof hetero- 6.9 percentin 1987.By early 1987, the programwas doxy in Latin AmericaLBut whatever the labels, at the peakof Itssuccess: real GDPhad growncumu- there are fundamental differences between the lativelymore than 20 percentsince the third quar- Mexicanprogamm and the others. ter of 1985, while Inflationhad been reducedfrom First,the cornerstone of the Mexicanprogram 188to 75 percent.Despite the success,the strainwas was a major fiscalreform that turned a primaryfis- strtingtoappearinrisingcostpressumeandagrow- cal deficitof 12 percentof GDPin 1982 into a sur- ing loss of foreign exchange. Although the con- plus equal to 6 percent of GDP by 1987 The straints tightened only graduallyand bottlenecks Brazln and Pervian programsdid not even con- emergedin only a few placesduring the remainder siderfiscal adjustent in their designs.Most impor- of 1987, the continuation of expansionarypolicies tant, the policy sequendngfoLlowed in Mexicowas could no longer be defended after July or August very differentfrom that suggested-but not imple- The Garca governmentdid not see it this way,how- mented-In the AustralPlan. In Mexico,the fiscal ever,and recldessexpansionary policies continued finances were brought under control beforethe to be pushed cheerfully. incomespolicies were implemented.By 1986, a hfll The massiveincrease in the budget deficitcon- year before the Pacto de SolidaridadEconomica y ttlbuted to the accelerationof inflation.The deficit's Sodal, the fiscaldeficit was virually under controL increasewas a consequenceof a massivepolicy of Thiscontrasts sharply with the AustralPlan, where 22 LatInAmedka and the Caribbean: A Decade after the Debt Crisis

the Incomes polides were Imposed with the attempt Notes to cut te deficit. tooaitrthe defidt. 1. Generally,a countrys debt-to-GDP ratio cannot exceed a A second important difference between the certn equilibrumlevel. When hs vel Is achIved the resource Mexican program and the Austral and Cruzado transferequals the dfrence betweenthe rate of growth of real plans: in Mexico,the nominal exchange rate was not GDPand the realInterest rate timesthe stockof debt Mosttatin fixed rigidly. Instead, the Mexican authorities Imple- straintin ce late1970s and eaty 19ess. mented a massive devaluation, which was followed 2. Thereare manygood pieceson the debt crisis.See, for by a brief Interlude with a fixed rate, and then by a example,the artidesIn Sachs1987. system of peannouncedsystemof preanounced dailydaily dvaluations. devaluations.By By 4.3. InFor Chile,more thedetail, real apprecdationsee Edwards 1989r.responded to very large capi-. combing these three elements-a large devalua- tal inflowsbetween 1979 and 1981(Edwards and Edward 1991). tion up front and a brief fixed rate period followed Interestinglyenough, In th early1990s capital infows haveonce by a sliding adjustment-the Mexicans avoided the againpressured real exchange rates oward countries(chaptrs S and9). There were, however appriationsoMe in exCep.. nany real exchange rate overvaluation of the Austral tionsin exchangerate managementin the late1970s. Colombia's epbode. pragnaticapproach toward exchange rate management, iolating Third, contrary to the Australand Cruzadoplans the real exchangerate fromInflation through a crawling peg, allowedit to avoidthe deprotection effects of fthcoffee boom of the Mexican stabilization program wasbut one com- 197S-79and to maintaina reasonable macroeconomic equlbium ponent of a broader program to modemize, deregu- Thofmas1986). late, and open the economy.In Argentina,Brazil, 5. SeeCuddington 1986. It is interestingto note that Korea pnrefils experiencednegative capital flight between1980 and 1984 and Pem, by contrast, there were no efforts to reform (Edwards1988b). the struCte of the economy by increasing the role 6. Becauseof significantcontrols and regulations,invetment of the private sector To the contrary: an increase in in mostof LatinAmerka had, at thattime verylow productty. 7. Interestinglyenough, in mostof thesecountries, the share government control was an important part of their of privatesector credit increased during 1987-91. heterodox plians. 8. Thelow effectivenessis particularly striking when anayzed A foufrt Important difference: in Mexico, the in a historicalperspective. Most episodes of successfuldevaluations lncomes policies were the result of a concerted social In LativnAm incaPrior to er effectivenessindexes. Notethe debtthat crisis for somewere countries-costa hacteized byhigh- Rica, ageement. In Argentina and Brazil,by contrast, the El Salvador,Nicar3gua, Peru, and Trinidad-the realdevaluation price and wage freezes were Imposedby the authori- effectivenessindex was negative. This mems that in thesecases the ties through decrees-withoutthrough the support of orga- ~~~~~~~~~~~~(Edwardsensuing inflation1989e). more than offset the nominal devaluation ni.d labor or the private producers' associations. 9. Therelationship between a crawlingpeg regime and Infla- The Mexican stabilization and reform programs tionaryinertia is addressedIn some detail in chapter4. initiated in 1985-86 represented an important, and 10. For detailedanalyses of theorthodox program see the 1987 issueof El TrimestreEcon6mico edited by Jos#Antonio early,step in the economic transformation of Latin Ocampo. America.These policies reflected,in a dramatic way, 11. Taylor1989 provides the analyticalunderpinnings of the the change In views regarding development strategy neo-stucturalistposition. 12. Thereis anabundance of literatureon the subiectThe that was to sweep the region in the late 1980s and discussionpresented here follows, partlaiy, Kiguel 1991, Ocampo early 1990s. It was indeed the recognition by the 1987,and Frenkel and Fanelli 1987. Mexdcan authorities that traditional policies had 13. TheOliera-Tanzi effect i the erosionof governmentrev- beenthatexhausted rompted them to move enuesin timesof Inflation, due to tax collecton lags. been emchaustecltht prompted them to move 14. Thereare several accounts of the CnzadoPlan. This list is toward the opening of the economy and market-ori- basedon DiasCameiro 1987. ented reforms. Although this turn away from struc- 15. SeeCardoso and Dombusch1987. For the Cruzadoplan fturaism was timid at first, ft has acquired great force a broadhistorical setting, see Rabello de Castro and Ronci 1991. 16. Fordetails on Garcda'spopulist polides, see Dornbusch throughout the region in the last few years. andEdwards 1990. Chapter tr A New Consensus on EconomicPolicy and StructuralReform

Eoonomic thinking In Latin America has changed as five or six yeawsago. Presidents Cesar Gavitia of remarkably in the past decade. The once dominant Colombia and Alberto Fujimori of Peru have also view-heavy state interventionism, inward-looking supported strong market-based reforms. And the trade orientation, and disregard for maaoeconomic new democatic govenmmentof President Patriclo equiflibrium-as slowly given way to a new para- Aylwin in Chile has embraced a development path digm based on competition. The United Nations based on competition, privatizatlon, and markets, Economic Commission for Latin America and the again showing the remarkable doctrinal conver- Caribbean (CEPAL),a historical supporter of inward- gence that has engulfed the region. In Central looking development and structuralism, has recog- America, too, a new group of political leaders is nized that in approaching the end of the century the rapidly adopting the ideas of market-oriented re- most appropriate course emphasizes open trade, forms. Recent political developments in Argentina, competitive forces, macroeconomic balances, free Bolivia,Chile, and Mexico suggest that the leaders' markets, and social programs targeted to the poorest new views on economic strategy are gaining support sectors of society (CEPAL1992b). from voters. There is also an increasing consensus on the need What caused this transformation in economic to redefine the role of the state. Most analysts agree views? A combination of factors were responsible, that the ever-growing state presence from 1950 to including the failure of the heterodox programs in 1980 ended up hurting efficiency and growth, and Argentina, Brazil,and Peru in the mid-1980s and the that the state's focus on production de-emphasized general sense that the state-based development strat- the provision of effective social programs to allevi- egy of the previous decade had run out of steam. ate poverty.1 Today, with the strong support of Many considered the heterodox programs of the multinational institutions, a massi-veprivatization mid-1980s as a final opportunity for structuralism- process is under way in most of the region to severely in its new incarnation as neo-structuralism-to work reduce the state's economic presence in production. (Ocampo 1991b). Once the programs' failure was And most traditional government programs-for clear,politicians turned to the stellar performance of price controls, generalized subsidies,and minimum East Asian countries as examples worth considering, wages-are now seen to have missed the poorest even emulating. Latin American leaders were espe- groups of society and to have benefited the middle cially impressed by East Asia's rapid recovery after and upper classes. the brief slowdown early in the debt crisis. The In the late 1980s,many political leaders who had advice and assistance of multilateral institutions long favored populist policies began to support rad- were also important The World Bank, by focusing Ical reforms to modernize the state. These Include on long-term programs, emphasized the need for fiscal discipline, open international trade, financial deep structural transformations. It also continued its liberalization, and privatization. It also became gen- Insistence on the need to develop povertyallevtat- erally recognized that macroeconomic stability was ing programs, thus changing the way several coun- a requirement for growth. President Carlos Menem tries design social policy. The largely successful in Argentina is perhaps the dearest example of the Chilean experience became a model for many coun- way the region's political leaders embraced new tries, and the collapse of the S',vet Union pulled the ideas and policy prescriptions. The market-oriented rug out from under the MaAxlstcamp that had long policies of his government have differed greatly advocated replacing markets with central planning. from those pushed by his political party as recently The Spanish experience with economic reform

23 24 LatinAmeriw and the Carlbbean:A Decadeafter the DebtCris

under socalst leader FelipeGonzalez also became TheCdsl of Ibdtlolah Ecofknc Thidnkg an important factor that influenced economic Inlatin AnAka thinking In many countries. AlsofostelngtheconvergenceIndoctinalposl- The Great Depressionchanged the economies of tlons was a large group of professionaleconomists LatinAmica. lenns of trade plummeted,In some trained in the best Euopean and U.S.universities. cases,such as Brazil,Chile, and Colombia,by almost Asthey acquiredprestge and gainedinfluence, they 50 percent.Capital Inflows stopped, and real Income developednew progms and helped the dialogue shrank.Compounding the declineIn worlddemand between the region'sgovemments and the multi- for raw materialsIn 1929-30were the protectionist lateralInstitutions. 2 Theseprofessionals became the policiesin Europeand the United States,including core of changeteWms that engineeredthe practical the Smoot-Hawleytadff In 1930 and the British aspects of the transformation within national Abnonral Importations Act of 1931. Most Latin bureaucacies (Haggardand Kaufman1992). Americancountries reactedby abandoningconvert- The agreementon policy mattersshould not be lbilty, devaluingtheir curencies, and Imposingtar- exaggerated,but It Isindiputable that many policy- 1ffbarrers. Dlaz-Alejandro(1981, p. 340) describes makers-and even leadersof politicalpardes now In thesepolicies as follows: opposition-agree on the need to Implementdeep structurl changes to move the region decsively Exchangerate devaluationswere not the only away from the Inward-looldngand Interventionist measures undertaken.... Mnherewere also policies of the past.3The new consensusindudes Increasedtariffs, import and exchange con- four main parts:macroeconomic stablity, openness trols, bilateral clearng agreements and of trade, reduced economic role of the state, and ... multipleexchange rates. (Seealso Furtado poverty alleviation.Despite this emering consen- 1969;and Bianchiand Nohara 1988.) sus, the national programsof individualcountries differ,reflectig the peacliaritiesof specificrealities. It has generallybeen thought that sustainedpro- In somecases reforms have been Implementedwith tectdonismbecame dominant throughout Latin great speed, while In others the processhas been Americain the early 1930s,if not earlier' ButThorp slowerand, at times, even hesitant. A recent refer- (1992)has recentlyargued that In the mid- to late endum rejectinga privatizationprogam in Uruguay 1930s several countries in the region-especially Introducessome doubtsabout the futbureof reforms Argentina, Brazil, and Chile-Implemented sub- there. The recent politicalproblems in Guatemala stantial trade liberalizationpolicies to encourage and Venezuelaadd uncertainty to these processes. opennessand outwardorientation. The eruption of And Brazil'sInability to move decisivelytoward sta- WorldWar 11 put an end to this episodeof export- bilization and reform is a stark exception to the led growth, and once again the Latin American reform-friendlymovement in the region. countriesresponded to the adverseglobal shocks by Despite new agreement on some of the most resortingto protectionismand Inward-lookingpoli- Important elementsof economicpolicy, some oth- des. This time, however,the end of the global dis- ers remain unresolved. In designingmarket-based turbancesdid not brng in a new periodof openness progams, some policymakershave been unsure to worldtrade. By the late 1940sand early 1950spro- about how much the state shouldretreat fromactive tectionistpolicies of Import substitutionwere well economicinvolvement Slowly,however, the viewIs entrenched and, by far, the dominant perspective emergingthat the state should provide socialpro- (Diaz-Alejandro1981). grams targeted to the poor, faciltate the accumu- The creationof the United NationsCommission lation of human capital; invest In some key for LatinAmerica and the Caribbeanhelped provide infrastrucureprograms;and providea dynamicand intellectual underpinnin for the protectionist modern regulatoryframework that fosterscompeti- position. And the writingsof Rail Prebisch(1950) tion, ensures property rights, and protects con- and HansSinger (1950) gave respectability to import sumers.This perspectivehas been stronglypushed substitution.5 Their thinking was based on two by the World Bank, the International Monetuy premises.Fit a seculardeterioration in the Inter- Fund, and the Inter-AmericanDevelopment Bank, national price of raw materials and commodities and recently it has become an important part of without Industhialzationin the developingcoun- CEPAL'sblueprint for the 1990s.But its implemen- tries would widen the gap between rich and poor tation variesconsiderably (chapter 8). countries.Second, to industialize,the smaler coun- A NewConsensus onEconomk Policy and Stuctral Reform25

tries required temporary protection for the newly fiscal Imbalanc became a staple of govemment emerging manufacturing sector This reasoning was policies. But the dominant view did not consider dosely related to the k*9 ndustry argument for these Imbalancesto be overly serious-4n fact, it saw industrialization.' Between the 1950s and 1970s fiscal dsequillbdumaslargelyunrelatedtoinflation. many development economists embraced this pro- Nevertheless, the inflationary problem became par- tecdonist vlew-and devoted enormous energy to ticularly serious in Chile, where consumer prices designing planning models that relied heavily on rose 36 percent a year In the 1950s, with a peak of Import substitution. This view, taught in most Latin 84 percent in 1955.8 American universities with great zeal, clearly domi- By the late 1950s the import substitution strat- nated the thinking of the time. egy begn to mn into difficulties. Most of the easy reblscharrived at this position through a criti- and obvious substitutions of Imported goods had cism of outward orientation, which he considered taken place, and the process was losing Its dynam- incapable of permitting the full development of the Ism (Hirschman 1968).Real industral production in Latin American countries. Industrialization through most countries in the 1960s grew at half the annual import substitution, by contrast, could be "stimu- rate of the previous decade (Elfas 1992). More and lated by moderate and selective protection policy" more politidcansand economists began to agree that (Prebilsch 1984, p. 179). Eventually, however, the Latin America was facing long-run economic prob- protection of incipient industries was anything but lems: the easy phase of Import substitution had moderate, as more and more sectors required addi- ended, and the recurrent crises of the external and tional tariffs and other ypes of government support agritcltural sectors had become serious obstacles to to continue facing foreign competition (Balassa growth. In the Southern Cone, inflation became an 1982; Uttle, Sctovsky, and Scott 1970). increasingly serious source of inefficiencies and dis- The early years of import substitution created tortions. Further, the increasingly unequal distribu- heavy industries In the larger countries and a base tion of Income and the unemployment problem for domestic manufactrng. Dudng the 1950s, were serious challenges for any new economic pro- these polides were largely successful, as industral gram. sectors grew at rapid real rates, topping 8 percent a Most experts pointed out that low rates of year in Brazil and Mexico (ELHas1992). But with domestic savings and Investment were big obstades Industrialization came an impressive array of restric- to growth, but they differed markedly on other tions, controls, and often contradictory regulations, aspects of their analyses-and on the policy pack- in most countries, lobbying developed swiftly as a ages to beat stagnation.9 The simple Import substi- way to secure the rents from the maze of controls. tutlon policies were under attack from two flanks. A And It was only because of import restrictions that small number of economists, sometimes associated many domestic industries survived-a sign of their with the monetarist position, argued for orthodox inefficiency. In careful empirical studies, Krueger programs based on fiscal restraint and a greater (1981) and Balassa (1982) found that this inward- reliance on market forces.'0 And a growing number looking strategy generated rampant rent-seeking of intellectuals in the Marxist tradition-including activities and favored highly capital-intensive tech- the ndencists-argued that there was too little niques, hampering the creation of employment government presence in economic decisions, postu- throughout the region (see chapter 5). Iating a massive move toward full-fledged planning In most countries, import substitution had been in the Eastern European style." accompanied since the late 1940s by an overvalued Facing this two-pronged attack, the structuralist domestic currency that precluded a vigorous non- thinkers eventually came to the conclusion that traditional export sectoLr Agriculture was hobbled their policies had to be reformed-leading to two most by the overvaluation, and the lagging of agri- important developments. First, import substitution culture became one of the most noticeable symp- was expanded from the country to the region, and toms of many countries' economic problems in the attempts were made to create regional integrationist l9SOs and 1960s. Why continued overvaluation of agreements. Perhaps most comprehensive was the the real exchange rate? Politics. It kept down the Andean Pact in 1969, grouping Bolivia, Chile, prices of imported goods cnsumed by urban Colombia, Ecuador, Peru, and (later) Venezuela.But dwellers. the regional arrangements did not tackle the pro- In many countries-especially Aretina, Brazil, tection and distortions of the previous 20 years. Chile, Colombia, Peru, Uruguay, and Venezuela- indeed, the common external tariff proposed In the 26 LatinAmerica and the Caribbean:A Decadeafter the DebtCrisi

Andean Pact was extremely high anduneven, reveal- Edwards1990). More than lS years after the election ing the spread of traditional structurast thinking to of President Allende in Chile, the Garcia adminis- the supranational level (Edwards and Savastano tration in Peru experimented with very similar 1988). Second, capital Inflowswere seen as a way to macroeconomic policies. Not surprisingly, and as supplement domestic savings and finance higher was discussed in some detail In chapter 2, the results rates of capital accumulation. But this option, cen- were also similar, plunging the Peruvian economy tered around officl capital flows through multilat- Into a deep cisis (Lago 1991; Dornbusch and eral institutions, did not give private flowsa big role. Edwards 1990). Nor were there serious recommendations to alter the Between the late 1950s and 1970s there were basic Incentive structure of the economy-or to pro- some isolated attempts to reduce government inter- vide a greater role to market forces In long-run devel- ventlon and introduce greater reliance on market opment strategies (Fishlow 1985). forces: the Chilean reforms of 19S8-61 under The stmcturalist view continued to evolvein the President Alessandri, the Brazilian attempt in the late 1960s and 1970s as the dynamism of the Latin mid-1960s under Minister Roberto Campos, the American economies went into rapid decline. In Uruguayan reforms of the 1970s led by Minister some countries the expansion of exports became an Alejandro Vegh Vulegas, and the Argentine stabi- important part of otherwise traditional economic lization programs under Krieger-Vassenain 1967 programs. Brazilexemplifies this strategy of expand- and Martinez de Hoz in the late 1970s. By and large, Ing manufacturing exports through aggressivegov- however, these were efforts that barely touched the enment policies, including export subsidies and an state and the traditional Latin American distrust for active crawling-peg exchange rate aimed at avoiding markets. And none of these efforts contemplated a real exchange rate overvaluation. Although Brazil's serious privatization of government-owned firms. manufacturing exports-as well as those of In most countries during the 1970s the state Argentina, Colomb A,and Mexico-increased rapid- greatly increased its role in economic affairs. State- ly in the 1970s, the economic base remained fragile owned enterprises grew very fast, and controls and (Coes 1991). After decades of an industrialization regulations became general. Especiallyin Brazil,this strategy based on F:otection, Latin America had trend was a deliberate response to the 1973 oil shock high wages, and its exports could not become the (Fishlow 1989). It was thought that by strengthen- "engine of growth" that they were in East Asia ing govemment intervention, it would be possible (Fishlow 1991). Despite their rapid expansion, to avoid the consequences of future external shocks. exports still failed to relax the foreign exchange con- Growth maintained a rapid pace during most of the straint. So, as was documented in chapter 2, almost 1970s in Brazil. But the events of the 1980s deci- every country in the region resorted to heavy foreign sively showed the deep flaws of this notion of the borrowing to obtain foreign exchange. The rapid state as a social Insurer. Instead of reducing risks,the accumulation of debt made them particularly vul- state distributed additional rents to interest groups, nerable, as was painfully learned in 1982. becoming increasingly unable to provide social ser- The election of Dt SalvadorAllende to the pres- vices. Moreover,the distribution of Income became idency of Chile in 1970 gave left-wing critics- even more unequal, and the Latin American dependencistasand Marxists-the opportunity to economies became increasingly vulnerable to for- implement a socialist-leaning strategy. The Unidad eign shocks. Popular macoeconomics program called for sub- By 1985-86 most of Latin Americawas at a cross- stantial fiscal expansions and massive increases in road. Despite some early accomplishments, the wages.These policies were to generate higher capac- struchuralist policies had run out of steam and the ity use, without leading to higher inflation. It was heterodox fiasco--in Argentina, Brazil, and Peru- even believed that they would reduce inflation. had shown that neostructuralism was not the solu- Macroeconomi policy was supplemented by a deep tion to the region's ailments. Perhaps even more structural program-a "revolutionary" program, in disappointing, despite early promises, inequality of the rhetoric of the day-to nationalize banks, agd- income continued to get worse In many countries, culture, industry, and foreign trade. After a short- leaving poverty at extremely high levels (chapter 8). lived expansion In 1971, the economy spiraled into Some senior members of CEPALbegan to argue pub- chaos. Output declined, inflation soared, real wages licly for Latin America to rapidly change its course. plummeted, and a severe balance of payments crisis In a highly influentlal document, Bianchi and oth- ensued (Larrain and Meller 1991; Dombusch and ers (1987, p. 213) stated that "the debt problem A New Consensuson EconomkPolky and Structrvl Refonm 27

requires a structural transformation of the economy low and steady rates of Inflation. And fourth, East in at least two senses: the growth strategy needs to Asia had significantly fewer regulations in almost be outward-ornted, and lairgelybased on a domestic every sphere of economic life (see Lin 1988; Balassa effort to raise savings and productivity" (emphasis 1988; Bianchi and Nohara 1988; World Bank forth- added). coming). By the early 1990s, a different policy view based Although the two groups of countries had sini- on openness, competition, fteer markets, deregula- lar rates of growth in 1965-80-Latin America with tion, and privatization had captured the imagina- a 6 percent annual average and East Asiawith 7 per- tion of many political leaders, who considered It to cent-their export performance was astonishingly be the only alternative fcr modernizing Latin different While real exports grew at an annual aver- America and reducing the long-standing inequall- age rate of 10 percent in East Asia, they declined at ties. Recently, Enrique Iglesias referred to this phe- a pace of 1 percent a year in Latin America-(see nomenon as the trend toward convergence. He table 1.3 in chapter 1). Moreover,although income argues that this new convergent policy view has four inequality was reduced In East Asia, it increased in main parts: macroeconomic stability, trade open- Latin America (chapter 8). ness, poverty alleviation, and reduced government The marked difference in export behavior across (Iglesias 1992). the two regions perhaps impressed Latin American leaders the most. In particular, the rapid export Factors behind the Emging Consensus expansion in Korea since the 1960s-a country that during the 1950s had not performed much differ- In the mid-1980s, the widespread view in Latin ently from the Latin American nations-became a America was that the state-based development source of keen interest. Lin (1988) reported that in model followed since the 1940s had entered a deep 1949-60 real export earnings grew at a lower rate in and generalized crisis. Slowly a new perception Korea (3.9 percent per year) than in Chile (4.3 per- began to emerge. Three factors helped propel the cent). During that period real GDP grew in Korea at emergence of this new economic synthesis and con- the modest rate of 3.8 percent per annum, not sub- sensus in Latin America: the experience of East Asia, stantially different from Argentina's average of 3.6 the advice of multilateral institutions, and the exam- percent. Of course, the Korean War had a serious ple of Chile.12 effect on the country's performance. Between 1963 and 1990 Korea'smerchandise exports grew, in real She East Asian Expere dollars, at 23 percent a year. This stellar performance has often been mentioned as a premier example of For decades, a majority of the economics profession the positive results of outward-oriented policies in Latin America ignored the developments in East (Krueger1990). Asia. Allinterest in comparative economics was cen- Korea has not always been an open economy, tered on Europe and the socialist countries -includ- however. Throughout most of 1950-63, Korea's Ing China.13 But things began to change in the mid- external sector was highly distorted. Import substi- to late 1980s because of the debt crisis and the tution policies were followed with great zeal: most region's stagnation. As the debt crisis unfolded, a imports were subject to licensing, tariff rates were seriesof comparative studies-including some early high (exceeding 50 petcent in 1959-60) and a mul- ones by CEPALand a series of reports by the World tiple exchange rate system was in effect (Balassa Bank-contrasted the experiences of the Latin 1988). The classical U.S. National Bureau of Eco- American nations with those of East Asia, trying to nomic Research project on trade regimes classified understand why economic performance, especially Korea as a "highly repressed" economy throughout growth, had been so much strongerin East Asia.The these years, with the exception of 1961-62 analyses unveiled four fundamental policy differ- (Bhagwati 1978; Krueger 1978). ences between the two country groups. First, East Polides changed in 1964, when exchange rates Asiahad avoided excessive and variable protection- were unified, a major devaluation was implemented, ist policies. Second, and perhaps more important, and a systematic move toward an outward orienta- East Asian had since the mid-1960s stayed away tion was launched. At the same time, the accumula- from overvalued and volatile real exchange rates. tion of human capital, through improved coverage Third, contrary to Latin America, East Asia main- and quality of education, was encouraged and basic tained a stable macroeconomic environment with infrastructure projects were pursued. Gradually, 28 LatnAewa andthe Caribbean: A Decade after the Debt Crisis

Importtarffs werelowered, Import licenses reduced, -1 percent In Kotea,19 percent in Taiwan(China), and import prohibtions eliminated.By the end of and almost 100 percent in Argentina.These differ- the 1980s, Kora's averageimport tariffshad been ences tumed up In productivitygrwth. Laborpro- reducedto about 10 percentand Inport licensesvir- ductivity Incaed at 8.7 percent a year in Korea tually eliminated(Edwards forthcoming). The tans- durng 197385 and only O.Spercent a year In formation of Korea'sexternal sector accelerated the Argentina(Lin 1988). The vigorousgrowth of other growth of exports and affectedtheir composition, EastAsian countries since the late 1980s-ncluding with manufacturedgoods clhnbing from a mere 17 the second-generation"miracle countries, Indo- percent of exports in 1962 to 75 percent by 1980 nesla,Malaysia, and Thailand-adds impetusto the (Kim1991). idea that openness and marketorientation act pos- Supportiveexchange rate poliies accompanied itivelyon prductivity grwth and can be extremely the Koreantrade lberalizationthroughout 1964-93. rewarding(World Bank forthcoming). Since the devaluationof 1964,the Koreanauthori- TMeconduct of macroeconomicpolicy Is a sec- ties have made a concerted effort to maintaln a ond crucialdifference between EastAsia and Latin highly depredated-that is, competitive-val ex- America(Sachs 1987). hiflation has been signifi- change rate. This contrasts sharply with the Latin cantlyhigher in the LatinAmerican nations than in Americancountries, where exchange rate overvalu -he EastAsian countries (table 1.3 in chapter 1), as ation has been the norm and real exchange rate has the varability of Inflationand thereal exchange volatlity has been rampant. In 1980,Korea pegged rate.The greatadvantage of a stablemacroeconomic its nominal exchangerate to a basketof currencies, environmentis that it reducesuncertainty, encour- allowingperodicadjustmentstoreflectthechanges aging investment. Moreover,if the real exchange In a seriesof domesticand externalfactors. This sys- rate Is stable,investment in the tradablessector will tem allowedKorean exports to remainhighly com- increase-as will exports.Sachs (1987) and Fischer petitivein the world economy,but it alsogenerated (1988) have pointed out that in the adjustment- accusationsby the UnitedStates of unfair tradeprac- reform process in the developing countries, the tices.14 achievementof macrenomic stabilityshouldpre- An aggressiveexport promotion scheme was also cedetrade liberalization.Based on Korea,Japan, and an important part of the Koreantrade liberalization Taiwan(China), Sachs (1987) has argued that mas- strategy. Exports were subsidizedthrough several siveand deeptaff reductionshould take placeonly channels: direct cash subsidies(until 1964), direct after the macro stabilizationis firmlyin place.16 tax reductions(until 1973),interest rate preferences, In a seriesof papers,Sachs (1987,1989a) hypo- indirect tax reductionson intermediateinputs, and thesizes that politics and income distibution are tariffexemptions for importedintermediate materi- important in explainingthe differencesin macro- als. But the subsidieswere reduced ftom 23 percent economicpolicies in EastAsia and LatinAmerica. He to zero between 1963and 1983, so they played an arguesthat exchangerate management-especially important role mainlyduring the earlieryears of the devaluations-has had very differentpolitical con- Koreanexport boom (Kim1991).1S The WorldBank sequencesIn the two regions.In EastAsia, the real (forthcoming) found that in many East Asian exchangerate overvaluation(and delayed orrective nations, including Korea,Singapore, and Taiwan measures)hurt alage numberof tradablegoods pro- (China), the government activelyorganized "con- ducetsin the rual sector,but InLatin AmericaIt hurt tests"among privatefirms, with exportperfonnance only a smallnumber of large(many times absentee) as the main criterionto determine"winners," which landowners,the latifundistas.So, macroeconomic werethen rewardedwith accessto preferentialcredit mismanagementhad high politicalcosts in EastAsia. and other specIaltreatments. A key featureof the and smal ones in LatinAmerica. In Latin America, "contests,"however, is that they focusedon exports by allowingartificially low priceson food and other In general, rather than on encouragingthe expan- tradables,the real exchangerate overvaluationhas sion of specificindustries. In this way sectoraland traditionally benefited the politically powerful industry-specificdistortions were reduced. urban worldngclass. In the 1970s, the overallrate of effectivepro- The inceased interestof somesenior CEPAL staff tection was10 percentin Korea,5 percentIn Taiwan membersin exploringdifferences between EastAsia (China), and 47 pecent in Argentina (Un 1988). and Latin Americaduring the mid- and late 1980s The contrast was even biggerin the manufactrng helped develop the new consensus.In a way, this sector, where the effectiverates of protecton were was iLkePresident Richard Nixon's opening to A New Consensuson EconomkPolky and Structural Reform 29

China. When the Institution that for decadeshad porary)real exchangerate appreciationsduring the defended the structuralst view expresseddoubts transition. This work also pointed out that the about Its validity and recognizedthat there were appropriate sequencing of libeallzation, under lessonsfrom the EastAsian experience with a mar- most cicumstances, requied the early elfimnation ket orientation, It was difficultto dismissthis as of the fiscal deficit,followed by trade reform and purely "neoliberal"propaganda. The Jointproject in (much later)by capital market liberallzatlon.2The 1987 between CEPAL and the Institute of conferencealso dealt with the crucdalrole of credi- DevelopingEconomles in Tolkyoon the comparative bility for successfulreforms-a topic that In the past experiencesof the two regionswas a pivotalevent." few yearshas acquiredgreat popularityIn policycir- And a major study publishedIn 1990by Femando cles.Work at the IMFalso shed light on the dynam- Fajnzylber,one of CEPAVsmost respectedtheoreti- Ics of reform. Ihan and Zahler (1983)argued that clans, washighlyinfluential in pointingout the dif- the consistencyof macroeconomicpolicy during ferencesin performancein the two regionsand the the transition was more important than specfic need for major changesin LatinAmerica's economic sequencing.Corden (1987) argued that in order to policies.This document later became the coreof the avoidovervaluation and possiblereform reversals, It innovative and 'convergent" CEPALblueprint for was advlsableto postponethe liberaliation of the the 1990s,a blueprintthat emphasizesthe need for capital account until the trade reform is consoli- combiningmarket-based structural reforms with tar- dated. geted policiestoward the poor (CEPAL1992b). 18 In the 1980s,the WorldBank undertook a mon- umental comparativestudy of trade liberlization In 'heRole of the Mullateral Instons 19 countdes (Mlchaely, Choksl, and Papageorglou 1991).23The projectnot only analyzedthe charac- The multilateralinstitutions-espeially the World teristics and consequences of different trade Bank and the Intemational Monetary Fund-also eimes, as its predecessorhad done, but went on to helpedforge the new convergencein doctrinalviews investigate the most appropriate ways of Imple- in LatinAmerica. These institutions influenced pol- mentinga liberalizationpolicy. Issues of sequencing, icypositions In LatinAmerica through several chan- speed, and transitional cost were analyzed and nels, including empirical research, economicand comparedacross countries. By and large,the results sector work, lending practices, and policy dia- showedthat countrieswith more Intense,sustained logue.19 liberalizationshave outperformedthose with failed Along traditionof economicstudies at the World libemlization attempts. Moreover,avoiding real Banksupported empiricallythe position tha. less- exchangerate overvaluationwas the most impor- distorted economies outpetformed ones that tant determinantof the successof trade lberalize- impeded the development of markets. Studiesby tion attempts. The findings from this and other Balassa(1982,1985) and Feder(1983) suggested that WorldBank research on structuraladjustment and countries that pursued outward-orientedpolicies reform were discussed widely In Latin America that encouraged exports have grown faster than through conferences,talks, and seminars. These countries that have followed protectioniststrate- effortshelped regionalleaders become aware of his- gles.wAgarwala (1983), in a more comprehensive torical regularitiesand-in Brazil,Colombia, and work, presented data supportng the view that in Mexico-strongly influenced decisions to imple- addition to trade protectionism,other distortions ment trade reforms24 slowedgrowth. And, a seriesof WorldBank studies World Bank studies also investigated the link have pointedout that the catefulderegulation of the between distortions-in particular trade restric- financial sector will generallyresult in a more effi- tions-and the creation of employment Balassa dent allocationof investment.2 1 (1982)addressed the long-termemployment conse- World Bank-sponsored economic and sector quencesof differenttrade regimes.In summarzig workhas alsobeen highlyinfluential in determining the experiencesof 11 countries, Balassapoints out some of the mechanicsof liberalizationattempts. A that, becauseprimary activitiesand manufacturing seriesof studiespresented at a 1983conference, later for exportsare more labor intensive, 'reducingtar- published as Choksi and Papageorgiou 1986, iffs will tend to benefit employment" (p. 65). The addressed the sequencing and timing of reform. most ambitiousstudy on the labor marketeffects of Even at this early stage,most of the essayswarned trade lbealization reftoms was that of Mlchaely, policymakersof the dangers assocdatedwith (tem- Choksi,and Papageorglou(1991), who found that in 30 LatinAmerica and the Caribbean: A Decade after the Debt Crisis

most successful structural reforms the medium-run and intellectuals for several months. As a result of net effects on employment have been positive. This this process the Colior govemment was in a posi- finding has propelled the recent acceleration of tion to act swiftly on the reform front In 1990- trade liberalization reforms In such countries as when most nontariff barriers were eliminated and Argentina, Colombia, and Nicaragua. As political the tariff-reduction program was instituted (Hicks leaders leamed that the political costs of reforms (on 1992a). unemployment) were not as high as once thought, The multilateral institutions also shaped eco- they were wiMingto move more swiftly. nomic reforms in Central America.Through reports, The World Bank has also influenced economic meetings, conferences, and dlscusslons, the World policy in Latin America through Its policy dialogue -Bank, the Intemational Monetary Fund, and the with the different countries In the region. This dia- Inter-AmericanDevelopment Bank have helped per- logue has been based on the Bank's economic and suade a new generation of political leaders of the sector work that explored the areas of greater weak- need to move away from the old interventionist ness In particular countries and proposed specific policies and toward market-based reforms. In Costa activities. Between 1987 and 1992 the Latin America Rica, the early involvement of the World Bank and and the Caribbean Vice Presidency of the World IMF helped pave the way for reforms and an early Bank produced 227 economic reports-induding 84 deal with private banks on debt reduction. And, in general country reports, 33 studies on poverty and Nicaragua, the International Monetary Fund was human resources, and 38 reviews of public invest- closely involved in launching the stabilization pro- ments and expenditures. The discussion of these gram of April 1991 that put an end to hyperinfla- reports-formal and informal-with policymakers, tion. The macroeconomic adjustment efforts in politicians, and intellectuals had Important effects Central America have been largely successful: on decislonmaking.2 Honduras and Nicaragua were the only two coun- A good illustration of the World Bank'sinfluence tries of Spanish America with single-digit inflation and persuasive powers is the Mexican reform. Early in 1992.26 on, there was strong opposition to trade liberaliza- World Bank influence has been particularly tion In some Mexican circles-especially those asso- Important in helping shape policies on human ciated with the Secretary of Commerce and resourcesand social services.Largely as a result of the Industry. But policy discussions, Including a series Bank's advice and financial support, several coun- of public seminars in Mexico, helped create broader tries have Implemented "emergency" social invest- support for these measures, strengthening Secretary ment funds, geared at funding community-based Carlos Salinas and Governor Miguel Mancera's posi- projects that simultaneously provide work to the un- tion within the Mexican govemment. In 1985, employed poor and solve basic infrastructure prob- almost two years after the workon trade had started, lems. Such projects have worked In Bolivia and the World Bank approved a Trade Policy Loan for Jamaica and are now being implemented in Nicar- Mexico, which built the base for that country's agua. In addition, World Bank support has helped sweeping trade liberalization. The World Bank also make Mexico'sPrograma Nacional de Solidaridad an helped create early awareness in Mexicc the extremely successfulinstrument for efficiently deal- need to implement public sector reforms and to ing with poverty and other social problems. And the embark on a major privatization program (Hicks Bank's position on the Importance of targeted nutri- 1992a). tional programs for children, incrteasinglya compo- Brazil provides another example of how the nent of social programs, has come to be accepted by World Bank influenced trade policy through eco- most political leaders in the region (see chapter 8 nomic work and policy dialogue. In 1987, the gov- and World Bank 1992). ernment announced Its intention to Implement a gradual trade reform that did not contemplate Chile as a Model aggressively reducing nontariff barriers. Bank staff considered the program too timid and discussed it In the late 1980s and early 1990s political leaders with the authorities in detail. And to Increase the and their economic advisersbegan to look closely at Brazilian public's awareness of the benefits of open- Chile's experience to gain insights and inspiration. ing the economy, the Bank organized seminars and The Chilean experiment gained greatly in stature conferences. This exchange of ideas generated Bank once It became apparent that the new democratic reports that were discussed with Brazilian officials government of President Patrido Aylwin had A NewConsensus on EconomicPolicy and StructuralReform 31 embraced-and furthered-the main elements of The Aylwln govemment's decision to maintain the market refomis first Implemented during the the main aspects of the market reforms was clearly military regime. In the early 1990s Chile, as well as stated by the Minister of Finance, Alejandro Foxley, Mexico, had clearly become important role models in a 1990 interview: for the entire region. Political leaders and policy- makers increasingly tumed to these countdes for Preserving the former govemment achieve- guldiRnceon how to move on the reform front. ments means maintaining an open economy When the Pinochet government launched the fully integrated into world markets, dynamic reforms, in the mld-1970s, the program was not pop- growth In exports, with a private sector fully ular in the region, and most of Latin America'seco- committed to the task of [economic) devel- nomics establishment expressed great skepticism.2' opment.33 By the early 1980s, the experiment had acquired sig- nificant momentum and was being hailed by the Once In power, the leaders of the new democra- international financial media as a big success.But, as tic Chilean govemment firmly supported some of pointed out above, the debt crlsis and some serious the most fundamental market reforms of the 1970s mistakes in macroeconomic management plunged and 1980s. But they still had some important dis- the Chilean economy into a deep crisis in 1982. At agreements with the former rulers over the social that point, many analysts wrote the experiment off, and redistributive policies. In that regard Foxley was arguing that a small country in South America could equally clear In the same Interview: not indulge In market-oiented transformations. Criticism of the market reforms was particularly Remedying the former government short- severe inside Chile, and prominent economists comings means recapturing the balance grouped In the opposition thlnktank CIEPLAN between economic growth and the deterio- launched attacks against the program.29The attacks rated conditio. s of the middle and, above all, were on three fronts: the reform's excessivereliance the lower classes. on free prices and market forces, the reduced role of the government in economic matters, and the open- What is particularly important, however, is that ing of International trade and financial transactions In seeking funding for new social programs, the new to foreign competition.30 Chilean government strongly and decisively re- Starting in 1985 the Chilean economy began to jected traditional formulas based on inflationary recover with vigor. And by 1989, it had accumulated finance. On the contrM, the new administration a very strong record of growth, surprising most ana- made it clear from day one that the only way of in- lysts, including the domestic critics. As the presi- creasing social spending without generating unsus- dential elections of 1989 approached, the criticism tainable macroeconomic pressures was to find solid of a market-based development path began to sub- sources of government revenues. In addition, the side, and the three presidential candidates presented new government continued the policy of focusing remarkably similar economic proposals. What was social programs for the poor and avoiding the blan- particularly important was that (future president) ket subsidiesthat had previously benefited the mid- Patricio Aylwin's program-drafted mostly by the dle and upper classes. In short, the populist policies CIEPLANgroup-expressed a substantial sense of of yesteryear had no role in the new Chilean gov- continuity on the most important market-oriented enment. policies. The program argued for "low Import tariffs" An important political decision by the new gov- and for ensuring that the economy had 'positive ernment was to address head-on-and during the real interest rates that maintain some relation with first year of the administration-two critical eco- productivity,"31 By early 1990, it was clear to per- nomic reforms: a tax package aimed at funding the ceptive analysts that the incoming government was new soc41 programs, and a reformnof the labor law not going to fiddle with the main elements of the that hac. oeen criticized by union leaders and some market reforns. If anything, the new authorities political commentators. Government officials were were soon ready to move even ftuther In some areas, careful to explain that these two pieces of legislation such as opening the economy and reducing Import were the only Important changes to the economic tariffs. An early and highly significant decision by model of Pinochet. In this way, and especially by the incoming administration was slashing import tackling these issuesearly, the government sought to tarffs by one-third.32 minimize possible negative effects on private invest- 32 LatinAmerica and the Caribbean. A Decade after the Debt Crisis

ment associated with policy uncertalnty This stat- (tax reform and changes In labor leglslation). egy is clearly dscussed in a perceptive document by These have now [March 19911 been mostly Minister of the PresidencyEFardo Boennger (1991): completed, enabling the govenment to guar- antee full stabiity of the rules of the eco- The administration first undertook the task of nomic game for the rest of its term, thus Implementing reforms producing either un- facllitating dynamic behavior by busines.. certainty or cost increases in the economy (1991, p. 35-36)

Table3.1 Generaloverview of structuralreforms In selectedLatin American countrIes,196S-92 Trade Financial Labormarket Country Fcat reform iberilzation marketreform deregutbon Pr_diratiar Argentina ReformIn 1990; Significantsince Freecurrency No majoraction; Aggressivelysince ImprovementIn 1990;export taxes convertibility socialsecuity 1991;140 business taxadministration, eliminated;very weakspot unitsalready sold tax sinplification liited quantitative impermented; restrictions;tariffs expenditures reducedto 0-22% somewhat range undercontrol Bolivia Major,198S; tax SignificantIn 198S; Someaction taken; Somedistortions Startedin 1992 srwucturegreatly lmited useof state-ownedbanks stil remnain simpified;improved quantitative stillwealk supervisory taxadministration restrictions; frameworkweak importtariffs reducedto 5-1596 Brazil No action 7imid;tariffs reduced Uttleaction No reform; Importantsteps gradually;all nontarffl highlydistorted taken;process barriersremoved slowedIn 1993 in 1990 Chile Taxreformn, 1975; MajorIn 1975-79; Majorin 1975-79; Majorreotm in Major,all but SO balancedbudget; quantitative interestrates 1979;labor aws state-owned taxrates Inceased, restrictions deregulated;no refomed1990 enteprisessold 1990;tax laws to be eliminated,uniform creditallocation; changedin 1993 Inport tariffs11% capitalaccount semi-open Colombia Fiscaladjustment Greatlyacceler,ted Interestrates Laborreform in Smallnumber initiated1965-86; in 1991;average deregulated; 1990;some of state-owned two tax reformsIn tariffreduced creditallocation distortionsremain enterprises;no 1991and 1992 from8396 in 1985 maintained; signiffcantaction to 7%in 1990 barriersto entry CostaRica Reformundertaken StartedIn 1966; Urited; interest No majoractiorn Verylimited In 1967;tax averagetariff ratesfreed 1990; someradonalization progress simplifcation reducedto 20%; somecredit of minimumwage underway; somereduction allocationstill legislaton taxadministration In quantittive remains;state banks reformedin 1992; restriction havemonopoly of expenditure coverage;export demandof short- controlweak subskiiesbeing termdeposits phasedout Ecuador No significant Verytimid; 5-35% Firststeps in 1993 No action Processto startIn adjustmentas tariffrange 1993 of 1992 announced1991; taif onmotor vehides50% fJ Salvador Taxreform In Signfcantsince Major;bank None Banksprivadzed; progresssince 1989;al nontariff privadzation productivefirms 1989;weak barrierseliminated; wellunder way, In processof administration; tariffsreduced freeInterest rates; bing p*atzed expenditure to 5-2096range reducedcredit controlvery fraglie adlocation A NewConsensus onEconomk Pofcy and Stbutwal Relomn 33

Table3.1 Generaloverview of stutral reformsIn selcted LatnAmercan countr14%196S-92 (continued) Tradeleform Rnandlal Laboraiket (unty Rscalrehnn RibeaAwlon maiketref on dergfAtIon P*vatzat Guatemala Taxrefomn 1992; VAT In progressince Interestrates freed No sfant Noacion coveragebroadened; 1987;tarf range In1989; credit action exempeionselDmlnabe reduced to 5-30%, alloaton dilminated, tax adminisrtion prgmmed to capitalaccount reformIn progress S-2096 nontarff partallyopen bariercoverage reduced Honduras Parta fiscal Reducedtariff ne Interestrates f eed Noacuon No action adjustment since1992; S-2096; In 1992;some 1990-92;tax exchangerate cedit allocation administrton unificationIn 1990; remalnssupervisory stillweak, pubic nontaf baies problensremain sectordeficit elimbiated1992 3.5%of GDP

Mexico Fiscaladjustment Majorsince 1985; Since1,)88; capital Minor Major,1,000 stae since1985; tax nontarf barrir accountopen; no ownedenteps reform;improved coveragereduced creditallocaton; alreadysoKW 37 taxadministration from90% to 17%; banksalready state-owned tarff range0-20%; pvazed enterprisesto be tiffs average13% privatizedIn 1993 Nicaragua Major,1991; weak Significant,1991; Privatebanks Noaction Signifcantbut administration; tradeprhvatized; allowe, free stionvery serious curentiybalanced tariffsreduced to interestrates; propertyproblems budget(including 1040% range; statebank still grants) greatlyreduced dominates quantitatve restictions Paraguay Taxreforin h Recentiyundertaken; Contemplated- No action Umitedacdonr progress;poor rajor tariffreduction; fa opencapl consttional taxadministration; maximumtaff account problems expendituresunder encounrd control Peru No tax reforrn; Signifcant,1990; In progms;state Deregulation Majoraction since Improvedtax limitedquanttave bankssti very contemplated 1992;30% of state administration; restricions;tariff importantfree but not yet ownedenterprises substantialcontrol range5-15% Interestrates; some Implemeted alreadyprvatied of expendire creditallocation; (incduding capitalaccount open HlerroPeruiron company) Uruguay Taxrefomn In Mld reform; Majorreform No refom;,Indexed Veryslow plebiscite progress;social referenceprkes completed;two publicsector wages In November1992 securityIs major important bankruptbanks; againstmassive fiscaburden quanti e capitalaccount privatizationpolky restrictions alreadyopen abolshed

Venezuela No taxreform; Significant. UtLteaction taken No action Someaction; 77 limitedfiscal quantitative state-owned adjustmentsince restriction enterpri already 1990 coveragereduced sold 1991;tarIff range reducedto 0-25% SoumrWrld Bankdata. 34 LatlnAnerica and the Cartibbean:A Decde after the Debt Crsis

The main _ kmnsof the EmmergneCosesse Fourth, the state should have a greatly reduced and the R4fonm role as a producer, providing moden supervion to some key markets-induding the financial mar- Although there are stlll some important-and often ket-and makdngsure that political insttutions con- deep -4lffetences of opinion among Latin Amet- ducive to true and lasting modemization are can leaders, the region today enjoys a degree of developed. agreement on basic economic policy not previously ThIs new economic convergence, and the fact seen In the post-World War II period. that political groups of different persuasions are What are the basic elements of this emerging working to move the region in broadly the same consensus? Which are the components of the plans diection, has generated a sense of hope in the future for action that belong to (almost) every blueprint for of Latin America. Despite this guarded optimism, the next century? As suggested In this chapter, I is there are many difficult challenges ahead, induding possible to Identify four general areas of conver- the ceation of new institutions that wll help mod- gence: ernize political and economic structure. Moreover, First,there is wide recognition of the need to gen- the recent political crisesIn Brazil,Guatemala, Haiti, erate macroecononic stability through the control and Venezuela indicates the need for the reforms to of public sector deficits.This has been recently artic- be undertaken-andpercehwdasbeing undertaken- ulated byabroad group of political leadersfrom very with complete transpwmy. The suspicion-or, different political persuasions in the following way: worse, the connrmation-of impropriety and cor- ruption is one of the worst enemies of successful Govemnment spending must be kept In line reform. with tax revenues and inflation must be con- To provide a panoramic view of progress In the trolled. Anti-poverty Initiatives are invariably refonns, table 3.1 contains a brief summary on five undermined by high inflation.34 areas-fiscal adjustment, trade libealization, finan- cial market reform, labor market dergulation, and Second, the importance of opening the external privatization-for 16 Latin American countries. sector to foreign competition is recognized. This includes a growing feding that regional economic Note integration, within the context of libelized trade with the rest of the world, should play a key role in 1. Sunkel(1992) has argued that the 'new converge in economktining has ndedto greatlyexage te neatv the region's future. For example, in a clear revision role of stateintervenion in the developmentprocess. Tle issue of Its historl position, CEPAL(1992b, p. 21) has here, of course, is to recognize different moments in Latin ectdy expressed that Ameias developmentprocess. Thi pointI madeIn geater det r texw. 2. Note hat the chief economicsstrategist In a verylarge ...in the long term an internationally com- numberof LtadnAmerican countries holds a Ph.D.In economics. petitive orientation ...promises to be more Thiscontrasts sharply with mostof the Industrialcountr_es- - efficient and equitable, since...additional ex- thop ned taeposr these posito amost iaialy go ports are usually more labor-intensive than 3. SeeLeff 1968for Brazil,and Blanchianid Nohara 1988 on ... import stibstltuton.35 LatinAniaca. 4. RaidPrebisch was a remakableintellectual force shaping eadyLatin American economkic tinking. He wasthe governorof Third, for the battle against poverty and in- the Argentin CentralBank in the 1930sand early 1940s, a period equality, there is wide agreement that unless the when heappied ortodox poicdes.in 1947,he pubdshed thfst social dimensions of development are dealt with donSpandsh of his guagthinking, guidesee to Preblsch Kenes 1984.GeAo Also, Theeysee On chapter the evolu-1 of rapidly, the reforms wil be politically unsustainable tgies 1 2, andSolls 1988. in the long rn. There is now recogition that most S. Aninteresting sumny of Prebisch'sview can be foundIn social pgams of the past, based on generized Prebich 1984. Hrschman(1968) provided an eary lsoul-se- insr assessmentof the disappointingresults experienced under subsidies and abbormatket regulations, overwhelm- import substitution.A review of import substitution theories Ingly favored the middle classesand did a disservice appearsIn Buton1989. For a disassionof trade polces in the to the poorest segments of society. As the Inter- context of Latin America'shistorical development, see Fihlow 1987. American Dialogue (1992, p. xii) has recently put it, 6. See,for example,the popularPaz and Sunkel1971 text- 'income transfer programs should be targeted to the book for discussionon economicpolicy in the context of the neediest and more vulnerable groups of the popula- struturalst and Inward-orientedview. Also see the text on Inter- mntionaleconomics by Ffrench-Davisand Grilffn 1967. Castro and tion. Les (1969) prodkeda popuiar,and widely used, principls text A NewConsensus on Economic Policy and Stuctul Reform 3S

thatdiscussed bask economnic bsues rom a sructWalistpespec- ure f the hetodox progransand the reinpretaton of the tive. Chileexp nce 7. Thispoint was soly madeby DiaAlejandro(1970) In 20. SeeFishlow 1991 and Edwardsforthcoming for some hismonumental stud,y on the externa sector In Argentina Alm methodgkolal rts ofese studies. Diaz-Aleando1976 on Colombia. See Edwards 1988a and 1989e 21. Seefor exaple, Hanon dNeal1985 and Geb 1989. for discussionsof realexchange rate misalignment It canbe 22. Ii (9) howev guedforeay liberalzationofcapl- argued,given the protectionismOhat pevad duringts peri4 ta contrl. that observed-andhighly appreclated-al exchange rat were 23. Thecounre wemeArgentna, Ba1zil, Chile, Colmbi, at an "equilibrium"level. But even under thi interprettion,the Greece,Indonesia, brael. Korea, New ZeaWl, Pakistan,Peru, the highlyappredcated real exchange rates stil discouragenontradi- Phiippies, Porgl, Sigapore,Spaik Sri Lan-, Tkey, Urugua, tionalexports. See chapter S fordetalls. andtsava. 8. SeeSunkel 1960 for the dassicpiece on the structurallst 24. Fora dibsion of theway the Word Bank influenced poi- viewof inflation.Domnbusch and Edwards (1990) examine these Icymakdngin Latin Amera duringthe reformprocess, see kliks Issuesfrom the moreextreme populst perspective. The inflaiony 199. prodMt of Braziland the SouthernCone countrles was abent In 25. SeeHiks 1992a for examples. CentralAmerica, the Caribbean,Mexico, and Venezuela, among 26. Panm of cous, hadsingle-digit ifation. others. 27. Duringth 1970sArgentina and Unguay aso embarked 9. CEPALplayed an Important role in developingthis diagno. n nmrket-orientedretorms, but they wee not asinte thoas sis. in Chile.Foa comparvesdy, smeP s 1986. 10. No seriousrecommendations were made, however, at 28. Onthe eary yea of theChliean expiednt seeWon introdcidngdeep structural changes, such as privatizing goven- 1985,Edwards 19i, Edwardsand Edwards 1991, ani aber mnent-ownedfirms. See Fishlow 1987 for a discussionof these conu- 1982. petingcriticisms ofimport substitution. 29. See,for example,Arldlano 1982, Cortar 1982,Foxley 11.Edwards and Edwards(1991) discuss this problem from 1983a,and Meiler 1984. Durtg the iet reme, themitary Chile'sperspective. Also see Sheahan 1987 and Cardosoand didnot allow open poitical disso Asa result,debats n eco- Hwaege1991. Vuskovk (1970) provides one of themost ewoquent nomicpolicy became a substitutefor politicaldiscussions. The defnsesof thepro-planning position. CIEPLAeconomists played an importnt (and brave) roe In main- 12. Haggardand Kaufnan(1992) have divided the cses tain somesenseof perspective InCie duingthese yeas beind the initiationof the reformsbetween exern ented 30. SeeVadis 1989 for a remarkablyacute crdism of the explanationsand "state-entered" expanatiom overallprogram. VakWs main point is that the implemettion of 13. Ananalysis of LatinAmeris most egous economics market-Oitedpies in Chile-ially throughthe influenceof journal,El TrimestreEconomko, reveals that between1960 and the Unisty of CHago-CahlcUnivt 1980not oneartide dealing with the EastAsian experences was to _'eiberate effortto introduce"foreIgnW Ideologies Into the published. cowntry.But Vskds fails to recognizethat the introductionof mar- 14. RogelloArellano (1990) found that the Koreanreal ket-basedprnipes intoLathin ica followedthe sane petem exchangerate has had one of thelowest lvels of vait Inthe asthat observedIn the transmissionof ideas at othertimes and developingcountries. See Oum 1989 for a descriptionof the oer pas ofthe word See,for emp, AlbertHrsman's 1989 Koreanexchange rate systeff See KDI 1989 for ananalysis of some fascinatingaccount on how Keynesianideas were spread from of theKorea-U.S. frictions. Amerkain thepostwar period. 1S.In LatinAmerica, there has been a controversyabout the 31. SeeEdwards and Edwards1991 for a discussionof the effectvenessof exportsubsidies. See, for examnpe,Nogues and Aylwinprogram Guti 1992. 32. TheAyIwn goverment reduced import tariffs to a unml 16. SeeEdwards 1992a for a generaldiscussion on the fwmI11 percentand has declined to paricipateIn newregional sequencingof economic reform. Also see chapter 4 of thisrepot infation effortsfor fearthat they will be"too proteti See 17. Theresults from thi studlywere published In Bbnchiand chapterS for details.The newly appointed independent central Nohara1988. bankplyed an importantrole in furher openingthe economy 18. Althoughthe changein viws in CEPALi evident to any duringthis period. In a veryincisive aricl, Fontaine(1992) has carefulreader of its documents,there are stni some important dif- arguedthat by 1989the moWty of Chileanvote werestill skept- erencesof opinlonIn thatinstituton. calabout the merits of themarket-oriented refoms According to 19. Severalauthors, most notaby Wiliamson (1990), have hin, the processof convergenceand synthesisbegan with the suggestedthat the newapproach toward development policy In tellecualelites of theSodalistand Chstian Democrat paes. LadnAmerica was Imposed from the outside,espedcaly bythe U.S. 33. Neweek (LatinAmian Editon),March26, 1990. Treasury,the World Bank, and the intnaiona MonetryFund- 34. See,inter-American DOiogue 1992. This group includes theso-cailed "Washington consensus." Although it I not possible kaders asdiWerse as Luis Inado "Lubl da Silvafrom Brzil and to denythat these Instons hadsome role in theforging of the MarioVrga Uosa from Peru. newviews, It Is an exaggeration(rooted In someInstitutional 35. Of course,the ageementi dar for broadtopics than parochaism)to ginethem the central role in thisprocess. A more for detld policy.For exampl, CEPAL (I992b) suggestssubsidiz- accurateinterpretaton would give a fundamentarole to a soul- ing reseachand development In certain sectors, a position that searchingthat began in LatinAmerka in theearly 1980s. As argued manymanteam obsves wouldconsider conducve to serious above,the two more important elments this process were the fall- distorions Chapterfour MacroeconomicAdjustment as a Priority

The debt crisis generated serious macroeconomic debt payments were such a large perentage of dislocations thoughout Latin America. Even coun- exports for many countries-for some, almost 100 tries that traditionally had exemplaty macroeco- percent of marginal exports-there wete few poUti- nomic policies and low Inflation sufferedvery rapid cal Incentives to engage In fiscalcorections or other price increases after 1982. Balance of payment reorms (ugman 1988b). Many Latin Ametican defidts soared, and In most oountries the forein countries were facng a debt-ovhang problem. Since debt burden paralyzed investment Despite early political leaders did not perceive direct short-term signs that the macoeconomic disequllbriums had gains from macroeconomic and strucWal reforms, become extremely serious, many analysts argued the reform efforts were In many cases timid. And that the criss was merely a short-run liquidity pob- with timid teforms, the improvement in the exter- lem that minor debt restructuring, new money, and nal accounts required to solve the crisis did not some reforms would solve. Early on, both the World matedalize. This ciular problem stood in the way Bank and the IMP argued that the Latin American of aggressiveand decisiveearly action toward adjust- countries could "grow out" of the problem without ment. any need for debt-reduction progams (M 1985). The macroeconomic stabilization programs As time passed, the lack of progrs In solving the Implemented by most countries in Latin America in major imbalances made evident that this was more the late 1980s dealt with four basic Issues. than a short-term liquidity crunch. By 1987 credi- Fkst, progams to reduce the burden of the for- tots and debtors began to acknowledge that the elgn debt were designed to break the vicious circle of region's problems were structural and that deep the debt overhang and help smooth the transition measures were needed-tax reforms, foreign debt toward market-based systems. They relied on debt- relief, and institutional changes-to regain macro- equity swaps, debt-onvesion schemes, debt re- economic equilibrium. As discussed in chapter 3, a structurin& and-after the Brady Plan of 1989- rapidly grwing number of Latin Ametican leaders voluntary debt-reduction agreements with commer- realized that susinable growth would require sta- clal banks. ble mac onomic conditions, open extemal sec- Second, fiscal adjustment programs aimed to tors and market-oriented Incentives. reduce the public sector defidit through tax reforms, Most Latin American nations faced three funda- expendture cuts, and (in several countties) sales of mental (and Interrelated) macroeconomic prob- state-ownedenterprises to domestic and foreign par- lems: First, the gap between aggregate expenditure ties. Privatization often was linked to debt-equity and income had to be reduced-permanently and swaps, where forigners exchanged outstanding debt efficiently. Second, inflation, which jumped drama- for stakes in state-owned enterprises. tically after 1982, had to be lwered to 'reasonable" Third, the maaoeconomic adjustment packages levels.1 Third, a stable macroeconomic environment required consistent domestic credit policies to had to be generated to encourge the resumption of relievethepresuresonaggregatedemandandavoid growth. crowding out the private sector. The fatlure of the heterodox progrms in Fourth, exchange rate policies consistent with Argentina, Brazil, and Peru led policmakers to the anti-inflationary effort had to be designed This increasingly agree that the solution of these macro- has been particularly difficult since, under most cir- economic problems required decisive fiscal adjust- cumstances, there is a tradeoff between using the ments, including major tax reorms. But because exchange rate to guide inflation downward-the use

36 MacroeonomlcAdjustme asa Pdodty -

of the exchange tate as a "nominal andior -and and Central America-most cuntries have filed to using it to maintain international competiveness, achieve one-digit Inflation rates. Even In countdes In addition to tackling these four poblems, the where Inflation has dedined substantlaly, the Latin American countries had to build acebity for maaoeconomic situation remains mvnerable. their programs-both to achieve equilibrum at a Moteover, despite several attempts, inflation in reduced cost and to ensure that the maoeconomc il has faied to subside, lary reflecting the reforms would be sustained. politcal realities of that country, where opposng During the early phases of the cisis, the sequenc- fctions of society have reached a stalemate and can- ing of macroeconomic stabiliation and struchual not agree on how to ditribute the costs of dinfla- reform became an important policy issue. Policy- tion.2 makers asked whether fiscal reform should precede structrl reform or whether bothtypes of policies Dedtesth wn Del* Reluf, should be Implemented simultaneously. By the late and nic Adjutent 1980s, most analysts began to agree that in countries with serious macroeconomic Imbalances the most With the sudden halt in foreign capital flows in appropriate sequencing required early and decisive 1982, every country in Latin America had to gener- action on the macroeconomic front, induding solv- ate huge trade surpluses to finance their debt pay- ing the debt-ovehang problem (see Edwards1992a). ments. The initial reaction by the creditor The reasorn the uncerainty associated with very countdes-that the debt crsis was a temporary liq- high inflation, including high variability in relative uidity ptoblem to be solved with a combination of prices, reduces the effectiveness of market-oriented macroeconomic adjustment, debt rescheduling structura reforms. But, in comntries with a mild agreements, and some structural fmsM 4mcame macroeconomic disequilibrum, such as Colombia the approach pushed by the U.S. government and and most of the Cadbbean nations, macroeconomic coordinated by the IMF and the World Bank. The and strucWal reforms cannot only be implemented official approach called for lending new money (up simultaneously-they tend to reinforce each other to $20 billion) to countries that engaged in struc- (Edwards 1992a). tural reforms. Not supdsingly, the banking com- Despite the reduction in nflation since 1989, it munity endorsed thisview, although they argued for Is stili high histoticaily and intemationally (table shifting the burden of new financing to the multi- 4.1). With few exceptions-mostly in the Caribbean lateral and offcial institutions: realism demands an Table4.1 AnnuadInflation res In seketd LatinAmercan countrIes, 1984-92 owent) County 1984 1985 1986 1987 1988 1989 1990 1991 1992 Argenfna 688.0 385.4 81.9 174.8 387.7 4,923.6 1,343.9 84.0 18.6 Boliia 2,177.2 8170.5 66.0 10.7 21.S 16.6 18.0 14. 11.4 Braul 209.1 239.0 59.2 394.7 992.7 1,861.6 1,584.6 475.8 1,131.5 Chge 23.2 26.2 17.4 21.4 12.7 21.5 27.3 187 14.0 Colombba 18.4 22.4 21.0 24.0 28.2 26.1 32.4 26.8 25.7 CostaRca 17.3 10.9 15.4 16.4 25.3 10.0 27.3 25.3 18.1 DominicanRepublic 40.9 28.3 6.5 25.0 S7.6 41.2 100.7 4.0 5.9 Ecuador 25.1 24.4 27.3 32.5 85.7 54.2 49.5 49.0 66.0 ElSahador 9.1 31.9 30.3 19.6 18.2 23.5 19.3 9.8 16.8 Guatemal 7.2 27.9 21.4 9.3 12.3 20.2 59.6 10.2 11.6 H"a 5.4 17.4 -11.4 -4.1 &6 10.9 26.1 6.6 17.5 Honduras 2.7 4.2 3.2 2.9 6.6 11.5 36.4 21.4 5.4 namica 31.2 23.3 10.4 &4 8 17.2 29.7 76.8 13.7 Mexico 59.2 63.7 105.7 159.2 51.7 19.7 29.9 18.8 11.7 Nkaragua 47.3 334.3 747.4 1,347.2 33,547.6 1,689.1 13,490.2 775.4 2.2 Panama 0.9 0.4 0.4 0.9 0.3 -0.2 1.2 1.1 1.2 Paraguay 29.8 23.1 24.1 32.0 169 285 44.1 11.8 17.0 Peru 111.5 158.3 62.9 114.5 1,722.6 2,775.3 7,649.6 139.2 56.6 Trinidadand Tobago 14.1 6.5 9.9 &3 12.1 9.3 95 2.3 7.7 Uruguay 66.0 83.2 70.6 57.3 69.0 89.2 129.0 81.S s56 Verezuea 18.3 7.3 12.7 40.3 33.5 81.0 36.S 31.0 33.4 kAerage 188.3 280.1 64.1 208.9 773.5 1,205.0 1,185.0 198.7 410.7 $mmawCEPI. kan* SWWofLRAmerf. vaua IMF,hln*st, Rvlffnmdelt vaiou Yar 3b LatinAmerka and the Coribbean: A Decade after the Debt Cris

Increased share of new money to be furnished by Secondry-Moaet-basedPrgrams offical sources durng the next severl years (Morgan Guaranty 1987, p. 2). Debt restructg The secondary market for Latin Amerlcan debt opertions, I-sponsored progms, and the World emerged in 1S82 and reached $45 billion in 1988 Bank's structal adjustment loans were the most and $65 bion In 1990. In Chile, more than $8 bil- Important elements of the early official strategy. ion worth of foreg debt wasretred through a vai- Between 1983 and 1988, the Latin American nations ety of secondary market mechanisms. The merits of enpged In 29 debt restrucrng operations with the this approach have been widely debated in academic private banls. and poly circles (see Bulow and "ogoff 1988). The 1984 Issue of the Intenational Monetay Bolivia,Chile, and Mexidcowere particularly actlve Fund's World Economic Oudook and of the World In the use of market-based debt reduction mecha- Bank WoidDevdopmentReport includedhighly opti- nisms. mistic prolections, predicting a steady dedine of the 7Te Bolhlan buyback scheme. In 1985, the new debt-export ratio in Latin American countries until govenument of President Paz Estenssoro inherited an 1990. Thins did not work as expected, however, economy crlppled by stagnation and inflation. The and in the foWowlngyears analysts came to recog- new administration's main objective was to defeat nize that the ptoblem's size had been badly under- hyperinflation and put the country back on a estimated (see IMP 1987). grwth path, so in September of that year it enacted By 1987, it was clear that the debt burden had adrasticstabilizationprogram.Themainpartsofthe generated a debt overhang that greatly reduced, or program were to severelyreduce (even eliminate) fis In some cases elminated, the incentives for reform- cal imbalances, open the economy by dismanding ing the region's economies, and thus seriousy trade restrictions, and fix the nominal exchange rate affected the debtor nations' ability to grow (Sachs (Morales 1987). The program was highly success- 1987). In March 1989, the creditor nations and the ful-reducing annual inflation from more than multilatal institutions recognized that, In many 8,000 percent in 1985 to 60 percent in 1986 and 10 cases, it was in everyone's interest to provide some percent In 1987. But, in early 1987, the Bolivian debt forgiveness-a major breakthough. The Idea economy was still weak, with high unemployment was that for countries facing a very high impliclt and depressed economic activity. The autiorities, margpnal tax on forelgn exhange earings, paral thinking that servicing the debt would greatly ogiveness of the debt would be the same as lower- impair the chances of recovery and growth, sought ing the Implicit tax and thus would encoae innovative solutions to the debt problem. reforms conducive to higher expors and faster In early 1987, Bolivia reached an agreement to growth. In short, it was argued that debt reduction teschedule its $3.4 billion of official debt. At that would move the debtor out of the wrong" side of point the possiblity of a buyback scheme financed the after curve.3 These Ideas were put into practice with donations and foreign aid from the industrial through the BradyPlan, which encourged creditors countries was contemplated for Bolivia's $670 mll- to voluntarly enter debt reduction agreements wth lion in debt to private banks. In July Bolivia's 131 the debtor countdes, creditor banks agreed to amend the refinancing Since 1989, for alleviating the debt burden, the agreements, and in November a special trust account official approach combined two mechanisms. First, was opened at the IMF to receive the donations to debt-reduction schemes based on secondary maret finance the buybacks (see Lamdany 1988). The con- operations were actvely enouraged. Although used ditions were first, that Bolivia's international since the mid-1980s, this technique acquired specal reserves could not be used-only donations from. momentum after 1988, and several countries used other countries could finance the operation. Second, debt-equity swaps to privatize state-owned enter- if donated funds were insufficient to buy all the debt prises. Second, direct debt-teduction agreements offered, the buyback would be pro rata. Third, offers between creditors (commerdal banks) and indi- could not differ across banks. Fourth, unused funds vidual countries became increangly common. would be retuned to donors. Bolivia, established Between 1989 and 1992, Argentina, Brazil, Costa that partcipating banks would have to renounce Rica, Mexico, Uruguay, and Venezuela reached any claims onarears. agreements with their creditots to reduce their debt In additon to this buyback operation a debt-con- burdens. version scheme was implemented whereby bank MaavconomkAdjustment asa Pror 39

debt could be exchanged for 25-year, zerocoupon consequences-increased money creatlon and bonds denominated in bolivianos, Indexed to the excessivepres on the parallel market for foreign doliaz and collateazed with AAA/Aaa2S-year dol- exchange-the Chlean authodres tightly con- Ia bonds. These Investment bonds were offered at trolled access to the progtam through an auction 11 cents to the dolL In 1986, before the buyback system (see Larrain and Velasco 1990). had been considered, the average price for Bolivian In these Chapter XVM operations, Chilean resi- debt in the secondary market was 6 cents. The price dents captured most of the secondaty market dis- increased sharply, however, as soon as the discus- count, which at some points bordered on SOpercent sions on the possibility of the scheme were opened, Three agents shared the discount: the central bank, reaching 13 cents in late 1987 when the fund at the the suppliers of foreign exchange in the parallel mar- WIwas established and the buyback period opened. ket, and the various internediades. Larran (1988) Boliviaannounced in January1988 that the buy- calculated that in 1987 the average discount on back price was 11 cents to the dollar, and the results Chapt XVIIIoperations was 35.7 percent. Of this, of the offer were made public in March: fifty-three the central bank got the lion's share, captuing 20.5 banks had offered $340 millon, about 40 percent of points, and the parallel market suppliers got 3.3 Bolivia's debt with private banks. The cost of the points, with the rest going as fees to the intermedi- operatlon was $28 million. aries.5 Was this deal in Bolivia's interest? The answer Under Chapter XIX, the debt-equity swap or depends on the opporunity cost-if any-of the e !bt-capitalizatlon scheme, foreign investors could funds used. fthesefunds did not aowd out other aid ,uy Chilean pdvate debt at a discount in the sec- there are good reasons to think that the operation ondary market and convert it to intemal debt, which benefited Bolivia. But If the buyback crowded out was then sold in the domestic secondary market. altemative sources of funds, the answer is not so The proceeds went to acquire domestic productive dear Bulow and Rogoff (1988) have argued that a assets-including state-owned enterprises being pri- palbuyback generally does not benefit the debtor vatized by the govemment-or to finance domestic country-for two reasons. First, the creditor pays the investment projects. Particlpants in this scheme average (market) pdce of the debt, while the reduc- could not repatdate profits for the first four years, tion in the debt stock is only margInal. Second,in the and the principal could be repatriated only after 10 soverei case a buyback does notreduce the debtor's years. Chapter XIX operations were not subject to collateral (see Sachs 1989c for an opposite view). quotas and were approved case by case by the cen- Moreover,more recent analyses have suggestedthat tral bank, to identlfy bona fide investors and avoid unilateral attempts to reduce the debt burden- -round tripping" operations. The scheme provided incduding the Bolivian scheme-are not benefidal to a (very) large subsidy to foreign investors. debtor couttries, and concerted approaches are far In evaluating the merits of the Chapter XIXpro- preferrd (Diwan and Rodrik 1992). gram it is necessary to address Its possible crowding- Chil debt conwrsionschemes. Of the major debt- out effects on foreign investment (see Dombusch ors, Chile was the most aggressive in using the sec- 1989a). The question is whether participants in the ondary market for debt reduction. Until early 1993, program would have invested in Chile anyway or, when the scope of the program was greatly reduced more important, whether they would have invested by the Aylwin administration, the Chilean debt had even if offered a significantly lower subsidy. If the been reduced by more than $11 billion-about 40 program has crowded out other investments, its percent of Chile's long-term bank debt-through benefits would be negligible or even negative. But if diverseprocedures in the secondarymarket (table Tabl 4.2 Debtcnversion in ChJie 4.2). This was done mainlythrough a debt-onver- (asof Febmrway1993) sion program and a debt-equity swaps program, known as chapters XVIII and XIX, respectively.4 op° millonsof dos The Chapter XVIII progam allowed (private) Chapt XII 3,280 domestic debtors to bu their own foreignliabilites Caa XX 600 304 indirecftlyin the secondarymarkeS The centran k PoftoaoainDL 136 did not prvide foreignexchange at the officialrate OthOPeroaiO 3,984 for these operations-It had to be obtalned in the Tota 11,323 parallel market To avoid negative macroeconomic SOU BancoCentalde ChE, edlnManwua March1993. 40 lan Americand the Caribbean: A Decade after the Debt Crsis

the progwmattracted new foreigninvestots, It nay count that banksbid differedso much from Mexican have generatedadditional resoures. Laran (1988) expectations. Lambdany (1988) has argued that has arguedthat the patcipation of foregn ban In banks consideredthe collateralas a "safencompo- these schemes, despite equity Investnent being nent and priced princpal accordingly,but viewed their main line of business,Is a sign that there was Interest payments as carryng risk assodated with at least someadditlonality and that the schem as a other Mexican debt and discounted accordingly. whole benefitedChile.' The secondquestion Is whetherthe 2008bonds ben- 7Te Meio 2008 bond.During the earlyyears of efited Mexico. Although most analysts Initially the debt crsis, Mexicotrted several market-based answeredyes, the unveilg of events showedthat mechanismsto reduce Its debS Froma legalstand- this wasnot exactlythe case.In effect,In 1989 and point, the Mexicandebt restructuring of March1985 under the auspicesof the BradyPlan, Mexicowas opened the door for innovative debt-conversion able to obtain a more convenient deal, where $48 schemes.This agreement establishedthat Mexico billion of Its foreign debt became eligible for could enae in debt-equity swaps and In debt- exchangeat 6S cents to the dollar for 30-year,zero exchanges,without being subjectto the sharng pro- couponbonds. visions.Under these terms, the consent of only 51 percent of Mexico'screditor banks was requiredto 7heEarly Debt Crisis and theMultilaterd Instiaons waivethe negativepledge dauses, and a criticallevel of waivers was obtained in Pebruar 1988 (see Even though the multilateralinstitutions failedto Lambdany1988 for detalls). graspthe sizeof the debt crisisduring Its early years, The Mexican bond offer of 1988 captured the they contributedvoluminous resources to the Latin attention of analysts and policymakersIn other Americancountries, enabling debtor nations to Latin American countries. In December 1987, reducetheir resourcetransfer to the restof the world. Mexicoannounced that It was willingto exchange Between1980 and 1986,the WorldBank more than $10 billion of Its debt for 20-yearcollaterized bonds doubled Its net disbursementsto Latin America, that carried a spread over the London interank increasingthem from $1 billion to almost $2.8 bil- offered rate of 1% percent, about twice that on lion. Duringthe sameperiod the net resourcetrans- reschdued debt. The bonds would be amortzed in fer from the Bank-subtracting the Interest one payment on maturity (a provisionthat allowed paymentsfrom net disbursements-increasedfrom Mexicoto prepay) and be colatedzed with a non- $600 million to almost $1 bilion. The IMF also ma.rketable,20-yearzerocouponU.S.Teasurybond, channeled vety substantial resourcestoward the with the acquisitionof colateral tobe financedwith regionimmediately after the eruption of the crisis. intemational reseres. Its net transfersto LatinAmerica-negative In 1980 On 18 January, 1988, Mexico Invited creditor at $173millon-reached almost$6 billionin 1983. banks to presentbids for the amount and for a bid The World Bankwanted to engineera smooth, ratio" determininghow much debt they would ten- sustainableadjustment that would simultaneously der for each dollar of face value of bonds. The accomplishthree objectives.reduce macroeconomic Mexdcanauthorities publicly expressed that they ex- instability,;restore growth, Including a minimum pected an approximatediscount of 50 pecent, but increasein consumption;and reducethe debt over- most independent analysts thought that this was hang. In hilsframework, ensuring some consump- highlyunlikely. Since the secondarymarket value of tion growth duringthe transitionwas Importantfor the Mexicandebt wasaround that markat the thne, economic and political reasons. Without that this would have meant that banks consideredthe growth,countries would lack the will to undertake 2008 bonds as cash. Mexiooreceived 320 bidsfrom reformsto reduce the debt burden and would stag- 139 banks for $6.7 bilion. The bids rangedfrom 60 nate. to 75 cents-gficantly higher than what the Selowskyand van derTak (1986) argued that this Mexicanauthorities expected. Mexico accepted bids adjustment could not be achieved overnight and from 95 banks for $3.7 billion, and used $430 mil- that some countries would require a significant lion in international reservesto buy the collateral. amount of time. They also pointed out that to ex- The averageconversion ratio was 1.43,reducing the ploitoptimally the intertemporaltradeoffs between Mexicandebtby only $1.1billion (see Gil Diaz 1988). the dffent objectivesof the adjustment process, The Mexican2008 bond posed interestingana- the debtor countries needed to receive,during the lyticaland policy questions.The firstis why the dis- early stages,additional foreign resources.In this MaoeconomicAdjustment as a Pdodty 41

way,the debtor countriescould gain time to Imple- and interestpayments were subject to roilingthree- ment the domestc reformsrequired to accelerate yearguarantees (see Cine 1989). growth and reduce the debt burden. A very impor- Forcountries to be eligiblefor BradyPlan nego- tant aspect of this analysisIs that, under some cdr- tatlons, they had to show the willingness-and cunstances, the initialconditions are so severethat some prior action-to engage in serious economic the only way to restorea viabledebt-output ratio Is reform.This new intiative was Intended to reward for the creditorsto forgivesome of the debt. In the countriestruly committedto change and to lift the late 1980s,this argumentbegan to makesome head- debt overhangassociated with aetremelyhigh pay- way amongthe officals of the creditorcountries.' It ments. becameIncreasingly evident that somedebt reduc- In 1989 Mexicoand Costa Rica were the first tlioncould, under severalcirumstances, be benefi- countriesthat reachedbroad agreementswith their dal to both debtorsand creditors. creditorsto reducethe valueof thek debt within the BradyPlan framework.Venezuela and Uruguayfol- TheBrady Plan and Debt Reducon Prams lowedIn 1990and 1991,and Argentinaand Brazil signeddraft agreements in 1992.The volume of debt The disappointing outcome of the Mexico 2008 subjecttoeach arangement waslge (table4.3). For bond and the lack of progressin solvingthe cris Mexico,almost $49 billion was exchangedfor con- for the two other lare debtor-Argentina and cessionalbonds, substantiallymore than the $6.7 Brazil-prompteda change in the officialdebt strat- billion convertedunder the Mexico2008 bond. egy in early 1989. In March,US.'L Ieasuty Secretary Debt was eligible for conversion under three NicholasBrady announced a new initiativebased on options.The first wasa debtbuyback, where the old voluntary debt reduction.His proposal amounted to debt obligationis canceledby a cash payment at a exchangingold debt for new long-termdebt with a fractionof the oiginal liability.For CostaRica, $159 lower face value. The exact conversionratios, and milion wasused to retireold debt at a face value of the detailedcharacteristics of the new instruments, $991 mlllion. This operation, thus, carried a dis- wereto be negotiatedbetween the debtor countries count of 84 percent-each dollar of old debt was and their creditots. To make this new approach exchangedfor 16 cents in cash. attractive to creditor banks, the advancednations The secondoption used dicoed bondsto retre and the multilateralinstitutions devotedsubstantial the original debt. Creditors received long-term resource-on the orderof $30 billion-to guarantee bonds (usually30-year bonds) in exchangefor the the new "Brady concessionalbonds. Typically, originaldebt Instruments.Although the new bonds principal payments on these new securitieswere carrieda marketinterest rate, the exchangebetween backedby 30-year,zero coupon U.S. Treasury bonds, old debt and new bonds took placeat a ratio below Table 4.3 Debt reduction In selcted LatinAmefian countries, 1989-92 (millonsof dollrs) Yearof ODSR Faevoke of Buy-back Discountedbonds Parbond Newmoey Totaldebt Countoy agrament eIgt& debt (dksount) (dsont) nterestrate) (gterst rate) Deoember1991' Argentina 1992b 23,160C n.d.(35%) n.d.(35%) n.d(4-6 %1 0 56,273 Brazi 1992 44,OOOd 0 n.d.(35%)9 n.d. n.dh 118,148 CostaRka 1989 1,6028 991(84%) 0 579(6.S%) 0 3,966 Mexico 1989 48,089 0 20,851(35%) 22,427 4,387(L+13/16) 98,263 Uruguay 1991 1,610 633(44%) 530 0 448(L+1) 3,049 Venezuela 1990 19,098 1,411(55%) 1,794(30%) 10,333(6.759b) 6,060W+7/8) 34,081 n.d.Not yet det e (subecto bnks chdke) a. nKchlingIMF and net short-tem debt. b.Agreement in pincib vth ceitor banksnot yet finaled. c.Esdtmed. in addtion58.6 bim b inhaears, ldng Imputedhnerst d.Esdmaed. in additon 56 bIlib In wareas,kxinkuig nputed intems e. ibuding padue itet f. iterest rateincra from4 percentthe firt yearto 6 pecentin the7t yeaw6 pect fm thOmon. g. re aresevea par bonds offered, wIh dent nmaies/grae perods, nterestraes, and colteal: A. 30/30years, rate 4 peiwntto 6 percentfirst 7 years, 6 pee fom thenon, full coteal prdndpal,12-month int 5:15/9years, rae 4 pet to S perentfirst 6 ya, UBO +13/16 fm then on, 12-nthit collatel for6 yeas. C 20/10yes, U30R+13/16 but Iterestaboe the rae Inbond is cpa4 nocolteral. D: 20/10yeas, 8 perentand inerest above the rate In bondB cqalled, nocoUlteraL E:1I8/1 0yes, UBOR 7/8,no colate. h. Newney equhaet to 18.18pecent of debttendered for debt convesion bonds (note g, optonE). Sow ldd 8arndat 42 LatinAmerica and the Caribbean:A Dode afterthe DebtCris

one to one. The actual conversion ratio was negoti- tries In the region stil suffer from consequences of ated individually and has varied somewhat from the debt explosion of the 1970s and early 1980s. country to country Argentina, Brazil, and Mexico Interest payments on the foreign debt still are very negotiated a 35 percent discount, while Venezuela high percentages of GDP-In Brazilalmost 2 percent obtained only a 30 percent discount. Again, the prn- and in Colombia almost 3 percent. In a few coun- cipal on the new bonds was usually guaranteed by ties-Nicaragua betng the premier example-the U.S. zero coupon bonds. debt is so large (more than three times the GDP) that The third option consisted of exchanging old massive debt reduction agreements will be required debt for new bonds with the same face value-the for a longer-run solution. par bonds-and a below-market interest rate. The Despite these continuing problems, many coun- collateral on the principal and the guarantee on tries sense that the debt crisis Is behind them, interest payments were similar to those on the dis- reflected by the recent increase In prices of some counted bonds discussed above. The recent countries' debt in the secondary market (figure 4.1). Argentine and Brazilianagreements included sevetal And, after almost 10 years of negative net resource types of par bonds. transfers, Latin America received positive transfers In most cases, the debt reduction packages In- from the rest of the world in 1991. The net capital cluded the provision of new money-fresh resources Inflows into the countries increased dramatically in to help cover interest payments on the converted 1992, when they surpassed $20 billion. lb a large debt during the early years and help smooth the extent, this tumaround of net resource transfers transition toward more open, market-oriented eco- reflectsthe fact that many countries In the region- nomic systems. Improving the quality of the adjust- Chile, Colombia, Mexico, and Venezuela-have ment, including the implementation of fiscal regained access to voluntary capitl market financ- reforms, takes time. And because it takes time to Ing.$ This, on its own, shows that the debt crisis is reduce macroeconomic Imbalances efficiently, It Is almost over for at least some of the Latin American Important to have foreign financing during the tran- countries. sition. There is a strong complementarity between a ParadoxicaLly,the recent Increase In capital flows stabilization effort based on efficient fiscal measures into Latin America has caused some serious prob- and external financing (Selowskyand van der Tak lems for the real exchange rate. As capital flows In, 1986). foreign exchange becomes "overabundant," push- There is little doubt the Brady-endorsed debt ing the real exchange rate upward, compromising reduction packages have helped these countries by international competitiveness and fueling political providing additional breathing room and allowing pressures from exporters for compensatory policies them to concentrate their efforts on implementing and from import-competlng producers for increased the reforms required to move toward a sustaInable protecon (see chapter 5). growth path. In Mexico, it has been estimated that the debt relief deal will reduce the net transfer to Fical Plolcyand Mao mli Equilibrium creditors by $4 billion a year between 1989 and 1994-close to 2 percent of GDP. Moreover,World Fiscal imbalances have traditionally been at the Bank estimates suggest that the 1989 debt reduction heart of Latin America'smacroeconomic disequilib- agreement will allow Mexico to grow,on average, at rium. Govenmments'inability, or unwillingness, to a rate 2 percentage points above what would have raise enough tax revenue to cover spending has been attained without the agreement (World Bank forced them to rely on money creation, or seignor- 1991a).Note, however, that several countries-most age, to finance the public sector deficit9 In some notably, Chile and Colombia-have declined to take countries, money creation accounted, on average, part In the Brady Plan. Their authorities have aigued for almost a fourth of govemment revenues during that the strategies followed until now-multilateral 197142. agencies' support, economic reform, and market- The reliance on money creation to finance pub- based debt reduction-have worked well for them. lic expenditures affects the macroeconomy in sev- eral ways. It generates Inflationary pressures, where The Prognosisfor the Debt Crisis the magnitude depends on the size of the public deficit, the growh rate of the economy, and the elas- Is the debt crisis over? The urgency immediately fol- ticities of demand for money (table 4.4).10Under lowing the debt crisis has subsided, but most coun- predetermined nominal exchange rates, It also gen- acoecoAnikAdjusthentasaPr1odly 43

Figure4.1 Secondarymarket loan pricesin percentof regular taxes.1 A shortcoming of this approach, face value,first quarter of eachyear, seleted Laun however, is that the Implied optmal rates of infla- Americancountries, 1990-93 tion are In many cases signfficantly below what Is 80 observed. z6 In recent analyses a growing number of authors 60 i l > k have dealt with the limit of the traditional public finarce motive for inflation, emphasizing the polit- 40 r s * ~ ical economy of the problem (Alesina 1988; Aleslna and Drazen 1991).The aqgument the political con- 20 % C g g g ditions of the country geatdy Influence the reliance on seignorage to finance the public deficit. Very o often polItIdans behave strategically,trying to con- 1990 1991 1992 193 strain their opponents' policy options. This behav- SowuWorldBank,iW R 7ndnRomFo DtoQevkPi untm April1993. lor can result In political gridlock, inefficient tax systems, and thus Inflation. In some circumstances, Table4.4 Inftuon and seignorage in seectedLatin political polarization can be so intense that the gov- Americancountries, annual averages, 197182 emment Is forced to operate on the "wronge side of (percent) the Inflationa Lafr curve (Bruno 1991; Edwards CouW inflation Seignorage and dbelilnl 1991; Dombusch and Fischer 1993). Roliht 30.3 21.6 An important feature of the political economy Brazil 47.4 17.7 approach to Inflation Is that macroeconomic dise- chile 147.6 17.5 quilibrium, Including the use of seignorage to Colombia 22.0 17.1 nance publc upenditures,Isd yrelatdtothe DominicanRepubik 10.0 6.7 Ecuador 13.2 14.4 government's inability to precommit credibly to a El Salvador 11.2 11.4 line of action. Some politically motivated govern- Honduras 8.3 .8 ments mayhave big incentives to run public deficits amaica 17.0 4.7 Mexico 21.2 23.9 longer than they have promised. To implement a iNkaragua 16.8 8.8 credible and lasting reduction in macroeconomic Paraguay 12.8 1S.4 imbalances, institutional reforms that allow the Peru 38.2 20.7 Venezuela 9.2 5.7 authorities to precommit themselves to a course of NOW.rflton Isdefinedas the rate of chgeof th consmmerprkce kidex. actionmust accompany the fiscalcorrections (Calvo Segnrageb thechange In basemoney relative to tobi gownnme 1978; Persson and TabeIlini 1990). This approach S-ww dwarswWTabINl recogizes that stabilization efforts run into serious Sou,~eEdwrds and i 1991. political constraints, as has been the case In Brazll erates serious balance of payments difficulties and durng the last decade. overvaluation of the real exchange rate. The creation The fundamental policy implication of this polit- of domestic money at a rate that exceeds the growth ical economy approach is that the credible reduction In money demand translates into higher demand for (or elimination) of the public sector deficit should be tradable goods, nontradable goods, and financial at the center of stabilization programs. Although In assets. The increases In the demand for tradables many successful anti-inflationary episodes fiscal causes a trade deficit, rapid increases in foreign bor- action has been supplemented by other measures- rowing, and a loss of international reserves. The including income policies-the correcdon of the higher demand for nontradables causes higher public finances has Invariablybeen the most impor- prices for them and a real exchange rate ovemvalua- tant part of those programs. Recallchapter 2, where tion. This situation eventually causes a major bal- the Mexican stabilization program was compared ance of payments crisis requiring austere policies with the heterodox episodes in Argentina, Brazil, and substantial nominal devaluation. and Peru. What dIsnguishes the successful A natural Implication of inflationary approaches Mexican experiencefrom the heterodox efforts is to public finance inflation is that, for given valuesof that in Mexidcohicome policies were implemented some key parameters, there Isan opffmal seignorage, only after the fiscal finances were fully under con- or inflation tax. This optimum depends on the wel- trol fare costs of inflation and of alternative sources of If the debt burden is significant, the need to public sector revenues and on the costs of raising reduce fiscal imbalances efficiently becomes par- 44 LatinAMe and theCaribbean: A Deade alter the Debt Cdsi

ticularly pressing-not only to reduce the gap Mexicoand Nicataguaare two startling cases: between traditionalexpenditures and nonlnfiation- substntialand for Nicaragua truly gigantic- amyrevenues but to financethe tansfer of tesources defcits have been transformedInto we surpluses to the rest of the world. But an efficientrestructur- Nicaraga's adjustment after 1990 was part of the Ing of fiscalfinances-replacing antiquated tax sys- Chamonroadministration's successfl battle against tems with new and modern ones and redefining hyperinflatlon.The control of the public finances, expenditure prorities-takes effort and time. And coupled with other measuresftat includedthe fix- while these reformsae being Implemented,tempo. ing of the nominalexchange rate and the teprivati- ry sourcesof financinghave to be found. This, of zation of enterpries, helped reduce Inflation from course,is often politicallydifficult In many cases, 18,000percent In 1990 to 3.7 percent In 1992. In the multilateral organizations and the debt tellef Mexico, the tumaround In the fiscaldeficit has been plans sponsored by the Brady Plan provided the the centralcomponent of the stbilization program resources to finance these ptogmms, easing the aimedat recoveringthe country'shistorcal macro- adjustment economicstability, and achievingrates of Inflation consistentwith those prevailingin its (future)part- Fiscl Austerity int Late1980s ners under the North American Free Trade Agreement(NAFrA). During the past few years most countries in the Chile Is another interestingcase of defict man- region have made effortsto reducetheir publicsec- agement.In the mid-1980s,and becauseof the debt tor imbalances-to restoremacroeconomic equllib- crisisand the failureof severalfinancial Institutions, rium and fostereconomilc growth. These efforts have Chiledeveloped large public sector deficits (see chap- been basedon a combinationof revenue-increasing ter 7). Thesewere eliminated,however, in 1988-89 policies-including tax reforms, privatization of through reduced spending and a new tax reform. public firms, and impwoed tadministratonand Govemment savings became an Importantcompo- ependiture cuts (tables4.5 thrugh 4.8). nent of the govemment's strategy to accelerate For years,many Latin Americancountries exhi- growth,and by 1989there wasa comfortablepublic bited relatively balanced central go'. rnment ac- sector surplus (see Fontaine 1989). This surplus counts and very high deficitsIn the public sector allowedthe new administrationof PresidentAylwIn ledgers(table 4.5). In most cases,there have been to financean increaseIn socialexpenditures aimed marked improvementsIn public finances. Except at reducingpoverty and Improvingthe distribution Braziland CostaRica In 1991,countries have drasti- of incomein the early 1990s(see chapter 8). caly reduced their public sector deficitssince the Brazl and Argentinapresent two important and mid-1980s. contrasting cases. Between 1986 and 1988, both

Table4.S Publk sector balnce asa percentge of GDPIn seleted LaUnAmerkan counties, 1986-91 Country 1986 1987 1988 1989 1990 1991 rgentIna -4.1 -6.5 -7.0 -21.8 -3.3 -1.8 BraziP -3.7 -5.7 -4.8 -6.9 1.3 -3.0 Chie - -4.3 -0.7 3.5 1.6 0.3 Colombla -0.3 -2.0 -2.2 -2.9 -0.8 -0.1 Costa Rica* - -0.3 -0.3 -2.8 -2.9 - Ecuador -5.1 -9.6 -5.1 -0.9 0.4 - Guyana -5.6 -34.0 -32.5 -47.9 -58.2 -32.8 amaica -5.6 -5.4 -12.8 -6.3 -2.9 -0.4 Mexico - - - -1.6 1.2 3.S Nkaragua - - -36.7 -18.4 -17.8 4.02 Peru - - - -10.7 -6.5 -3.2 Trinidadand Tobago' -9.5 -7.7 -6.5 -4.4 -1.4 -0.9 Uruguay -5.2 -4.2 -S.0 -7.6 -3.6 - Venezuela - -5.4 -9.3 -1.3 - -3.00 -Not avabe. Notr Apositive mmber ia swpiu a negatvenmber lsa defidt. a. Operon nonfinandadedt, indudngnet Intes paym. b. Datare fo nwofana publksector. c. NonIaial publicsector oveM bablae. d. Datarefer to the "reducedpublk sectoi.' . Premy. So50: IF, Gommnt MnW st varousyeas WorldBank Wbbd Ta, 1992,World BDnk data. Maaoeconon*Adjuosmt asa oAdl 45

Table4.6 Totaland capital expenditures of the publicsector as a perentageof GDPIn selectd LathsAmerican countrles,1987, 1989, and 1991 1987 1989 1991 roal Capital Total Ca rota cap Country evenditure epnditre epadW& eedre_ extre epndure Argenta 22.3 3.8 19.0 2.8 21.6 1.5 Brazil 31.9 7.5 34.9 62 28.3 5.2 Chile 34.4 6.9 27.1 5.1 26.3 4.8 Colombia 21.1 7.7 19.2 6.9 20.9 6.7 Costa Rica' 30.3 5.8 33.1 6.8 30.1 4.3 Ecuadorb 31.S 7.1 5.8 7.2 26.2 7.3 Nicaagua 47.0 6.2 35.9 6.2 36.1 5.9 Peru - - - 3.0 - 2.0 Venezuela 32.2 12.0 31.0 11.2 3S.1 13.7 - Not avabe. Note-These ae norfnancal exenditres, so eyexdude ntert paymnsnd intia oiesof pbli finanWsecor the enratban). a Indudesnet lending. b. Lavalble dataare for 1990 and 1991. SowueIMF, Governent Rntmt*l Stt, vaio yearsWAld Oank, W rd es 1992; dWordSan dta.

Table4.7 Taxrevenues as a percentageof GDPIn sekctedLatin Amerien counes,11987-91 Country 1987 1988 1989 1990 1991 Argmen 17.8 16.2 14.9 19.1 20.0 Brazil 18.1 17.8 18.4 23.9 21.2 C*lmbIa 14.9 14.4 14.4 14.4 15.8 CostaRica 22.4 22.0 22.7 22.2 22.2 Quyna 32.8 39.7 38.7 40.7 40.2 Jafnakab 28.6 26.7 27.4 2S.8 27.2 Mexico 8.6 9.6 10.2 10.5 10.7 Nkaragua - 20.9 24.6 16.6 24.0 Tdridad and Tobago' 27.6 25.3 24.6 2S.1 29.7 - Notavailble. a.Indudes rnao adminstatIplus soild secuity tae. b. Cen.tralgwmetIndkde bawdtekvy. c. Centralgovenmt SowwIMF, Goveren nndofaWks, varIousyeams Worcl Bank. Wod Ta 1 WZorand kwdat.

Table4.8 FInancalpubik sector quasi-flscal defidt asa pectge of GDPIn sdectedLatin Ameian countries 19864t country 1986 1987 1988 1989 1990 1991 ArgentIna' 1.6 0.9 0.7 5.9 1.0 0.6 Chlle - 3.9 3.2 1.8 2.2 1.9 penUb _ - - 2.8 1.1 0.5 Urguay 3.9 2.8 3.1 4.0 4.1 - - Notavalable a.Reders tocentral bak b.Cove cenral bank ad BanoAgraO lsses. c. Incudesca bak andInteWavnd ba opeonal lWsse Source:IMf GoI,rnen RnonnStlcs varlu yearWord Bank old Tablf1992; and Wld Rnk*data. countries had significant fiscal disequilibrlums Aftera briefInterlude with fiscalausterity during the closelyrelated to the falureof the heterodoxexper- early years of the Collor de Mello adm traton, iments. Public finances deteriorated rapidly In thecountryslippedbackintoincra ylagepub- Argentinauntil the country suffereda complete lic imbalances, feedingvoracdous inflation that breakdownof macroeconomicmanagement In 1989 reached1,195 percent in 1992. and flirteddangerously with hyperinflation.In late In most countries,the Improvementin the pub- 1989 the new administrationof PresidentMenem lic sectoraccounts has been accomplbhedthrough embarkedon a serious stabilizationprogram that a combinationof higher evenuesand lowerexpen- centered effortson a drsc reduction of the gov- diures. On the reveues side, most programs emiment deficdt Bral foilowed a divergentpath. include tax reformsto impwve the efficdencyand 46 LatinAmerica and the Caribbean:A Decadeafter the DebtCrisis

effectiveness of the tax system; better tax adminis- 1989 had a consolidated public deficit of almost 22 tratlon, including efforts to reduce evasion; higher percent of GDP and a primary deficit of only 0.4 per public services prices to cover costs; and sales of cent of GDP.Because of a remarkable surge in infla- state-owned enterprises (see chapter 6). thon that year, interest payments on the domestic Except In Costa Rica, tax revenues for selected nonfinancial sector debt surpassed 15 percent of countries were higher in 1991 than In 1987. In some GDP. countries, however, the objective of the tax policy A large Internal debt can seriously jeopardize has recently evolved from raising maximum rev- macoeconomic stability when It is concentrated in enue to reducing the efficiency costs of taxation and short-term instruments, as has been traditional in providing appropriate incentives to the private sec- most of Latin America. Changes In short-term in- tor. Once the public sector budget has been under terest rates stemming ftom changing world condi- control, some countries-including Chile in the late tlions,from macro-polcy measures, or purely from 1980s and Mexico-have reduced some tax rates to "perverse" expectations have a huge impact on the encourage privatesavings. public defidt. Recognizing this problem, many In the evolution of public sector expenditure countries are trying to reduce the stock of domestic between 1987 and 1991, there are two interesting debt and lengthen its maturity, with Chile and facts for another selected group of countries (table Mexico perhaps the most active.12 4.6). First, In every country except Venezuela,total An Interesting peculiarity of Ltin America'spub- public sector expenditures were lower in 1991 than lic finances is that In many countries the financial In 1987. A comparison with evolution of tax rev- public sector has recently been the source of sizable enues (table 4.7) clearly shows that the reduction in quasi-fiscal deficits (see table 4.8). In most cases, the expenditures has made the greatest contribution these deficits stem from central bank operations to to fiscal equilibrium in the region. Many countries subsidize a particular group. Two typical sources of reduced expenditures across the board, which quasi-fiscal deficits are dual exchange rates-where adversely affected social progams, so they tried to the central bank buys "expensive" foreign exchange Increase the efficiency of those programs and to tar- at the ongoing rate and sells It 'cheaply' to a par- get social expenditures to the most vulnerable (see ticular user-and bailout of the financial sector. In chapter 8). the bailouts, the central bank usually acquires low- Second, in almost every country, capital expen- quality (or nonperforming assets) from a financial ditures were reduced drasically. In four of the eight institution about to fall. Because this operation is countries with data, capital ependitures in 1991 financed by issuing inte.rest-payingobligations, the were at least 25 percent lower than the already net effect is an operational loss for the central bank. depressed Ievels of 1987. In some cases, large and This was the case In Chile, where the centrl bank inefficdentgovernment projects have been canceled incurred very large losses stemming from the finan- or postponed. In others, public investment in infra- cial aisis of 1982-83. In Argentina, by contrast, the stcre has been cut, generating serious short- main cause of the quasi-fiscal deficit has been the comings in transport and power (Colombia). And in payment of (high) interest rates on commercial some, including Argentina, Chile, and Mexico, tra- banks' legal reserves,saddling the central bank's bal- ditional capital expenditures by the govemmrint are ance sheet with large losses. increasingly being handled by the private sectoi: In Mexico,allowing the private sector to charge tolls on Fscal Adaustmentand Cdit Polcy newly constructed highways has spurred road con- struction. In addition, the Mexican govenment has An important part of the region's stabilization pro- encouraged private involvement in water provision grams has been the control of domestic credit-to and treatment, garbage collection, and electrical the public and private sectors (figure 4.2). During the power-activities traditionally reserved for govem- early years of the adjustment (1982-87), most of the ment companies. burden of credit reduction fell on the private sec- For many countries, interest payments on public tor-in part a consequence of the sudden cut in for- debt-domestic and foreign-are a big part of pub- eign funds to finance public expendiures. Most lic spending. Excluding these payments to concen- governments reacted by borrowing heavily from the trate on the pdmaray deficit shows that most domestc banldng system, crowding out the private countries have achieved substantial adjustments. seCtor-causing real Interest rates to increase sharply Perhaps the most impressive is Argentina, which In and aggregate demand to decine. MacroeconomicAdJustmentas a Priority 47

1983 foced monetary authorities to devise altemative 171% methods for monetary control. Differentcountries haveopted for differentsolutions. Some of the most I advanced-Argentina, Chile, and Mexico-have Flgure4.2Annual grwth ratesofdonmti aedit in developed Increasinglysophisticated systems of Figure4.2 Annualgrowth rates of domesticcredit In mretorain,wlethshveIcas selecebdLatin American countries, IM8 and 1991 open market opetations, while others have incaeas- t L Ingly relied on "monetary stabilization" securities 100 Issuedby the central bank. 80 The openingof the latin Americaneconomies to international transactions-In goods and financial 60 g g assets-has alsoIntroduced some changes in the way monetarypolicy Is conducted In the region.Central 40s 1 =bankershave found that policy inconsistencies can 20 m * m * _ m m be very costly In an open economy. And ft has LLs iwbecome dear In an open environmentthat changes oiia Chile costa Guat-Guyam Hn. mexm In the domestic economic conditions can generate Rlca maa dum sizablecapital movements that greatlyaffect mone- SoWEIf, tntaRnarndlStatb.tary policy. The 1991-92 surge In capital inflowsto the region resultedin large IncreasesIn the money supply-in many cases frustrating central bank Fsgure4.3 Domesticcredit to the privatesector as a monetary programs and putting pressures on the countrles,19 19c5,e, and 1991 realexchange rate (see chapter5). Asthe Colombian countries,1980,1985, and 1991 authoritiesfound out in 1991,it even becomesdif- 00 9|80 ficult to sterilize the increases In international so 198s | reserves.When this is attemptedthrough the sale of domesticbonds, Interest rate differencesare bound 60 | ll ILI _ | _ to appear, creating additional incentives for capital 40 | S _ | | * | to flow into the country, further increasing the quantity of money (seeCalvo 1991).

Fsa Adjusmnt and TaxRefourms: Tre Cases

Ricailecta malamuatb Guyna unu In this section the experiences of three countries- SourwIMF, In _ Rd Sh Chile,Mexico, and Argentina-with tax reformsand fiscaladjustment are addressedin somedetail. Chile As the adjustment proceeded,however, and as providesan exemplarycase of the managementof fureignfinancing was partly restoredthrough debt tax policyto generatemacroeconomic stability and restructuring, interest capitalizations, and debt facilitatethe adjustmentafter the debt crisis.Mexico reductions, governments could ease the credit providesan Important case of a major tax reform restrictionson the privatesectot The privatesector coveringthe revisionof tax rates,the broadeningof shareof total creditthen graduallyincreased toward the tax base,and the improvementof tax adminis- historicallevels (figure 4.3). tration. Argentinashows that it is possibleto reduce The financialderegulation reforms of most coun- the fiscaldeficit through a programthat reliesheav- tries during the past few yearshave had Important ily on expenditurereductions. effectson the conduct of monetary policy.Central ChUle.Between 1974, when the Chilean struc- bankershave had to learn how to manipulatemon- tural reformswere initiated, and 1992, Chile has etary policy through Indirectmeasures, as opposed gone through three tax reforms.The first, imple- to the traditionalquantitative control of credit. For mented in 1975,was the most profound, introduc- example, the reduction and harmonization of ing sweeping changes In the country's public reserve requirements has increased commercial finances.13The main purposesof this reformwere to banks' ability to intermediatefunds, reducing the increaserevenues and reduce the efficiencydistor- authorities'direct control on liquidity.Slarly, the tions of the old system. The prncipal features: gradual elimination of direct credit allocationshas replacementof a cascadesales tax with a flat rate 48 Latn Americaand the Corbbean A Decde afterthe DebtCrisis

value added tax at a 20 percent rate, fill Indexation Imum rate. And, the value added tax was Increased of the tax system,elimination of all tax exemptions to 18 from 16 percent.'4 and subsidies,unification of the corporateand non- lb give credibity to the fiscaladjustment and corporateincome taxesinto a flat businesstax, and reduce public speciuationover whether these poli- integrationof personaland businessIncome taxes. des would be temporary, several institutional The increasedtax revenuesand reducedgovern- reforns wereimplemented. The mostImportant was ment spending rapidly affected the fiscal defcit, the creation,in December1989, of an independent which declined from more than 10 percentof GDP centralbank, whoseboard members are not dlretiy In 1974 to 2.6 percentIn 1975 and lessthan 1 per- subjectto the vagariesof partisan politics.InitiaUy, cent in 1978.In the yearsthat followed,and for the the oppositionto the militarygovernment strongly firsttime In more than two decades,Chlle had a fis- rejectedthis reformon the groundsthat It wasanti- cal surplus-a situation that changed only in 1983 democratic.It was arguedthat, by taking monetary when,in the midstof thetecessive crisis, reduced tax policy away from the control of a legitimately collectionsleft a defidt. elected government,the extent of democracywas In 198S,to stimulatethe economyafter the debt greattlyteduced. By te 1989,however, the incom- crisis, the directon of Chile's public finance ing administrationhad begun to change its view. changed fundamentally.First, fiscal policy foused This sentiment was stronglyconfirmed during the on redirectingpublic expendituresaway from cur- first two years of the AyIwinadminitration, when rent expendituresand toward public investment, the central bank performedefficiently and profes- which increasedGDP by more than 7 percentage sonaly. points between 1985 and 1989. In addition, fiscal A second institutional reform increasing the reform was aimed at encouragingprivate savings credibility of fiscal policy announcements was through lower income tax rates. One of the most enactedin late 1989,greatly restricting the activities Importantcomponents of this reformwas reducing of the public sector as a producet This legislation the tax rate on corporateeamings from 46 to 10 per- placessevere limits on the govemment'sability to cent With aggregateexpenditures under control, it engageIn new joint ventureswith the privatesector was possibleto implementthis cut without threat- and forbids publiclyowned firms from obtaining ening macroeconomic stability.As a consequence of loans from the central bank. The drastdc reduction these policies,investment grew 11 percentbetween of the public sector through the privatization of 1985 and 1988. hi 1989, when the fiscalfinances nearly 600 state-ownedenterprises has also added wereclearly under control-the nonfinancialpublic credibilityto the govenment's intentions of main- deficithad a smallsurphl-the valueadded tax was taning a balancedpublic sector reduced from 20 to 16 peicent to encouage con- Mexko. The Mexican tax reform, initiated in sumption. 1985, replacedthe old systemwith a modern one The newly elected government of President basedon a value added tax and an efficientincome PatricioAylwin implemented a ird fiscalreform in tax. Most domestic tax havens, subsidies, and 1990 to increaserevenues for social progams and exemptionswere eliminated.In particular,the tra- public investment Economists associated with ditionaUy favorable treatment provided to truck Alywin'sConcertaci6n coalition calculated in 1989 owners, publishing houses, forestry,fishlng, and that to implementsignificant social progams aimed livestockraisers, among others, was abolished.And at alleviatingpoverty, annual funds on the order of the greatly improved tax admisttion reduced 4 percentof GDPwere required (llroni 1989).They corruptionand evasion. argued that these resources could be obtained Oncefiscal balance was achievedin 1986,many through reallocatedexpenditures, foreign aid, and tax rates were loweredto provideadditional incen- higher tax revenues.Tb implementthese programs tivesto the privatesecto The corporateincome tax rapidly, the executivesubmitted a legislativepack- wasadjusted for inflationand its rate reduced from age to reform the tax systemto the newly elected 42 percentIn 1986to 35 percentin 1991.TAxes on congress in April 1990.The corporateincome tax dividendswere elminated, and the maximumrate ratewas increasedtemporarilyfrom 10 to 1Spercent for individualincome tax was loweredfrom 60.5 to for 1991-93,and thebase of the tax, definedin 1985 35 percent in 1991. Al tax incentivesfor corpora- as ditibuted profits,was bradened to total profits. tions were eliminated and replaced by an invest- The pogressivity of the personal income tax was ment creditfor firmsthat invest in areasother than increasedby reducingthe incomelevel for the max- Guadalajara, MexdcoCity, and Monterrey. This Mnaoeoomk Adjustme as a AP* 49

cedit Is equal to the present value of depreciation facing the worst economic ccisis In its history. expenditures using aS perct real discountrate. 7b Inflation was 200 percent a month, output was reduce tax evasion by corporations, Medco devised phlummeting,forein debt had not been servioed for an ingenious 2 percent tax on assets,to be fully cred- more than a year, and the nation's morale was at an ited when the firm pays Its corporate Income tax. If all-time low. Fiscal Irresponsibilitywas at the center in a particular year (or years) the fitm Incurs losses, of all of this. Tax collection hit its nadir In mid-1989, it can carry forward the asset tax, fully indexed to when the prices of public services were ddiculously inflation. low and spending was out of control, with the con- To Improve tax collection and further reduce solidated public sector deficit surpassing 20 petcent evasion, other reforms were implemented. The of GDP in 1989. administration of the value-added tax (VAT)was Early on, the Menem administration understood transferred from the states to the federal govem- that the countrys problems required major fisal ment, and a national data base on VATtaxpayers was action.15 Deep reforms had to be undertaken to constructed, greatly helping audits and controls. For increase public sector revenues and reduce expendi- the first time, medium-size firms-with sales of $1.3 tures. A succession of failed programs and unkept million or with more than 200 workers-had to p promises in the previous decade made things partic- vide annual audits by a certified public accountant ularly difficult Reducing the deficit was not enough, The paying of taxes has also been simplifed, since for credibility was needed too. This, of course, all commercial banks can now receive payments required fundamental institutional reforms that from any firm or individual, would allow the govemment to precommit Itself In Largelya success, the Mexican fiscalreform elim- a credibl way. inated a very large fiscal deficit and put in place a With tax revenues at only 9.5 percent of GDP in modem tax system in less than five years. This has the second quarter of 1989, raising them was clearly allowed the authorities to devote an increasing pro- a priority in the new administration's program. So portion of the budget to sodal services through the wascagingataxstrutureuthathadbecomehighly "solidarity program" and other channels (see chap- distorted. It relied heavily on export taxes and inef- ter 8). The success of the fiscal adjustment has also ficient tax surchare, and innumerable exemptions allowed the government to gradually reduce tax greatly reduced the syste's effectiveness.To make rates, providing greater incentives for private invest- things worse, tax administration had deteriorated ment In June 1993, to reinforce the credibility and steadily since the mid-1980s, with the central tax sustainabDlity of its fiscal and macoeconomic office-Direccl6n General Impositiva-lacking re reforms, Mexico announced that its central bank sources and plagued by corruption. would be made independent, as Argentina and Chile The Menem tax reform had five main parts. First, had done previously. averybroad and uniform value added tax was imple- Despite the tremendous fiscal effort of the past mented-initially covering aU goods-and was ex- few years, induding the elimination of the public tended to aU services In November of 1990. Second, sector deficit, Mexico's inflation continues to be a tax on fixed assets-similar to the Mexican tax- high-i 1.7 percent In 1992. Iflation's persistence was put in place in 1990. Third, a tax on all bank has been the result of two factors. First, although a checks was introduced in early 1991.16Fourth, taxes preannounced devaluation rate has anchored the on exports were gradually eliminated. And fifth, the inflationary inertia of prices, some inflation has tax administration was strengthened. Computers remained, resulting in ongoing inflation above were purchased, a list of aUlmajor taxpayers was "world inflation' and in a gradual real exchange rate compiled, and the revenue directorate got rid of cor- appreciation. Second, large capital inflows into rupt officials, dramaticaly raised the wages paid to Mexico since 1991 have been monetized, putting remaining inspectors, greatlyincreased random VAT pressure on domestic prices. These inflows have inspections, and subjected tax evaders to stiff penal- increased the real appreciation and created a policy ties, sometimes closing their businesses. dilemma. The authorities have to decide whether to Tobalance the public books, the Menem admin- use the nominal exchange rate to anchor prices or istration also took major action on expenditures. whether to make periodic adjustments to avoid Central government employment was cut by losses in competitiveness (see chapter 5). approximatly 100000 people in 1991-92, reducing Argentina. When President Carlos Menem took the wage bill by 10 percent and allowing an increase over the govemment in mid-1989, Argentina was in the averagewage of those stll on the govemment 50 Ln Amercaand theCaribbe A Dede afterthe DebtCsis

payroll (accordng to an intenal World Bank fisal adument must be furtheredin the short tun report). The centma govenment also ftansfed and the domesticgoods sector needs to make pgnif- almost200,000prlmaryandsecondaryschoolteach- icant gainsin productivity. ers to the provinces'budgets, under the 1988Law of Copartcipation, which limitedthe federalgoven- Exange btus, In_ln, and Dil_tn ment's contribution to the provincesat 58 percent of tevenues. Strting in 1990, the govenment Asmany Latincountries have leaned painfully,It Is engagedin anaWessive privatizationprogram, rais- not possiblein the long run to maintain a fixed ing direct revenue from sales and eliminatingthe nominalexchange rate with maor fiscalimbalances need to subsidize money-losingoperations (see financed by domestic aedit creation. If domestic chapter 6). In early 1991,the govement passeda infation exceeds "the" international rate of infla- decreethat strictlylinked public expenditures to tev- tion, intetnational reserves will decline, the enues, imposinga de facto balancedbudget provi- exchangerate will becomeovervaluated, and there ston, and public sector prices were increased willbe a speculativeattack on the centralbank's for- drasticallyto covercosts. eign exchangeholdings. 19 Severalcountries in the Despitesignificant progress, the Argentinefiscal regiondealt with their chronicallyhigh inflationby programstill has weaknesses.In particular,pension adopting an adjustable,or aawlingpe& system to payments have been seriouslyunderfunded since periodicallyadjust the nominal exchange rate for the early 1980sto cover the arrearson social secu- differencesIn Infation. The motivebehind this sw rity obligations. The government is planning to tem-first adopted by Brazil,Chile, and Colombia issue 10-year -compensation' bonds, but these durng the 1960s-4s the impossIblity, given an would add a considerableburden to the Argentine expansivefiscal stance, of maintaining a competi- domesticdebt. tive real exchange rate with a fixed nominal ex- Togive the stabilizationprogram credibility and change rate. acceleratethe convergenceof the domesticrate of Theseexperiences contrast sharplywith those of inflation to "world levels," the governmentintro- another group of LatinAmerican nations, mostlyin duced Important institutional reforms in March CentralAmerica and the Cadbbean, that for many 1991 in the ConvertibilityLaw, which fixed the years had fixed exchangerates and low inflation. exhange rate betweenthe australand the dollarand Interestingly,in the late 1970s,almost a decadeafter completelyabolished all exchangeand capital con- the collapseof the Bretton Woods system, many tools.17This law alsoestablished that the quantity of Latin Americancountries stll had fixed exchange money could be expanded only if fully backed by rate systems.This situationchanged, however, with intemational reserves,practically eliminating the the debt crisis.Under heavy internal and extenWal possibilitythat the centralbank wouldfund public pressure,almost every country in the region had to enterptises, the federal govermaent, or the adopt some kind of managedexchange rate regime pwvinces.1 8 Afterthe openingof internationaltrade duringthe mid-1980s(see table 4.9). in 1989-90,it was expectedthat the fixedexchange hitially, policymakersand expertsalike greeted rate woulddiscipline prices. The fact that any alter- the adoptionof more flexibleexchange rate systems ation of the cuarentparity would requirepassage of In Latin Americawith great enthusiasm. It was a new law by congresshas added credibilityto the argued that crawling-pegregimes provided a good government'spromises that the fixedexchange rate way of Isolatingthe real sector from the effectsof will be maintainedand that inflationwill subside. extemal shocksand domesticinflation (Wiiason Althoughthe overal programhas succeededin 1981).But the enthusiasmfor sliding parities was rapidly reducinginflation, it has also createda sig- short-lived. Observers, including the IMP staff, nificant relative price msligment (Dombusch began to argue in the early 1990s that flexible 1992).Pdres of domestic(nontradable) goods have exchangerates allowedcountries to accommodate becomeextremely high, puttng a dent in the coun- inflationand institutionalizeindexation, discourag- try's competitiveness.But the team led by MInister Ing the Implementationof seriousanti-inflationary Domingo Cavallo has shown great resolve In programs.In this view,exchange rate policyin Latin defendingparity and stickdngto the originalpolicy. Americashould return to beingmore rigid-or even A speculativeattack against the peso in late 1992was fixed-t introduce fiancial discipline and credi- fendedoff successfullythrough restrictive credit and bility,eliminate inertia, and anchor prices2M higher interesttates. For this policy to succeed,the Theproposition that fixedexchange rtes should Macnreconom1cAdjtment as a Prorty 51

Tabe 49 LaWn ericancoubies wth fied eane rates,scted yas 1979 1982 1985 1990 1991 Boli"ia DomihanRqlc Guatemabl DokIn Repubi Argentia ChUe Euador Haitm Haiti Nkcagua Costa Ric El Salva Hondras Panm Panam DominkanRepubik Guatemala Nicaragmu Ecuador Haiti Panama ElSalvador Honduras Paagua Guatemala Medco Petu Halti Nkaragua Venevas Honduras Panama Nicamgua Paraguay Panama Venewela Parguay Venezuela Sowue:IMF, AmWl Report on Ece *Angmat aead we Resub vasyam become an integral componmntof the region's govemment ntsredible wll lImprove efforts for macroeconomic stability raised questions society's welfar Here is where fixed exche tates among poliymakers and their advise, questions come Into the picre. It has beenagued fat a fixed addressed here. How Is this system supposed to exchange rate will constain the govemment's abil- work? How has it performed In history? What are ityto surprise the privatesector through unexpected the tradeoffs between fixed rates and a moreflexible devaluations. Promises of fiscal discipline will system? Do preannounced declining pegs, of the become credible, and private sector actions will not tabla type, operate in a similar way? If a fixed elicit successive rounds of inflationary actions exchangerate is adopted, how should the transifton (Perssonand 1Wbeinl 1990; Ewards 1993a). In par- to it be engineered? How does this system affect real ticular, it has been argued that fixed exchange rates exdcangerate behavior and competitiveness? provide a reputatonal constaint on government behavioLThe authorities know that, If the under- &ckange Rates as Anwhors:Analydc Aspects take overly expansive credit policy, they wlll be orced to abandon the parity and devalue. As the Much of the recent enthusiasm for fixed nominal recent (mid-1992)crisis of the exchange rate mech- exchangerates is intellectually rooted In the mod- anism (ER) has shown, exchange rate crises can ern literature on credibility and time consistency. shatter the reputation of politicians. According to this approach, pioneered by Calvo Despite Its eegant appeal, the view has, in its (1978) and Kydland and Prescott (1977), govern- simplest incamation, some problems. PFrI, in these ments tnat have the diwrton to alter the nominal simple settngs, exchange rate policy has a vey lim- exchange rate will tend to abuse their power intro- ited role. In most of these models, its only effect is ducing an inflationary bias to the economy. The rea- to alter domestic inflation and, trough it, real wages. son: under a set of plausible conditions, such as labor But in most modern exchange rate models nominal market rigidities that preclude the economy from devaluations can also help accommodate shocks to reachirg full employment, It wil be optimal for the exchange rate fundamentncluding shocks to government to "surprise"the private sector through the tenmsof trade-helping to avoid mlsalinments unexpected devaluations. By engineering these of the real exchange rate (Dornbusch l991a, unexpected devaluations, the govenment hopes to Edwards 1989e). Second, in economies open to induce a reduction in real wages and thus an shocks, contingent exchange rate nrues can, at least increase in employment and a boost In output in prindple, be superior to fixed rates (Flood and Naturally, the public will be aware of the authorities' Isard 1989). ThIrd, it is not clear why a country that Incentiveand will react by anticipating the devalu- can credibly commit Itself to unilaterally fixdngthe ation sutprises, renderng them ineffective. And exchange rate cannot commit itself to maintaining because of this game between the govemment and a fixed stock of domestic money. the private sector; the economy will reach a high Devaralan and Rodrik (1992) and Kamln (1991), inflation plateau. among others, have addressed the desiability of A key policy implication of this literature is that fixed exchange tates from a more general perspec- defining and implementing constraints that make tive. For example, in Devarajan and Rodrdk(1992), S2 lafn Ame and the Cibbean: A Dea afterthe DebtCdsls

policymakersfae atdeoff in exchangeate pollcy tradition of exchangetate stability povided some exchangerate fiexdblityhasaninflationayybias, but constaints on central bank behavlot2' Between ft alsoallows the coumtryto reducethe vaiabty of 1950and 1973,these central banks werecaeful not output by smoothingtermsof-trade shocks on out- to violate the constraints imposed by fixed paity. put In this model, It snot possibleto tank flxedand But the evidencealso shows that these constmints exible(or active)exchange tate regimes.For lare are not fudlyopetational under severepressure from tms-of-trade shocks it is more likelythat flexible terms-of-tradeshocks. In these four oounties, the exchangerates will be superioLAnd, the more vul- limits of fixed rates on domestic credit creation nerablethe real economy to these shocks,the more becamenonbinding during the late 1970sand 1980s desirableflexible anangements become. By contrast, and could not survivethe combination of populist the greater the govemment'sbuilt-in Inflationary political pures and severelynegative terms-of- bias, the greater its temptation to abuse devah- trade shocks.Overly expansive policies typicaly led tions, and the less desirablea flexdbleanangement to cisis, but the authorities artificiallyheld on to becomes. fixed rates for as long as they could. By hying to Wlliamson (1991)argues that a fixedexchange avoidexchange rate adjustmentafter the debt crisis, rate wouldbe advisableas longasfour conditionsare and in the lght of obviousImbalances, these nations met First,the country in questioniU5smaIl relative could not engineer a tapid adjustment, so they to the rest of the world.Second, the bulk of its inter- incured severeoosts of exchange rate overvalua- national trade Is with the country (or countdes) it tlion, controls, and trade distortions. These four plans to peg Its cuency to. Third, the country episodessuggest that exchange rate flexibilitycan wishesto have a rate of Inflationsimilar to that of greatlyhelp smooth the adjustment in an Intema- the country it is pegging Its currency to. Fourth, tionalenvlronment characteizd by largeshocks. there are Institutionalarrangements to assure that Regardingthe performanceof nominal exchange the commitment to a fixed rate is cdible. Once rate anchors In a stabilizationpackage, recent evi- these four conditionsare met, Willamsn goes on, dence suggeststhat this policy is kely to generate the only remaining argument in favor of flexible some real exchange rate appreciationduring the exchange rates is the response to tenns-of-trade transiton even If the fiscaldeficit is under control- shocks.Although his list of requirementsfor a suc- the case for Chilebetween 1978and 1982 (Edwards cessful fixed exchange rate is plausible,it leaves 1993a;Dnbus 1992;Bruno 1991).Whether this unanswered questions. His analysls is silent on willbecome a maor policyproblem and eventually whether the fixedexchange rate alone providesan forceabandoning the programdepends on the ini- Institutionalconstraint on fiscalpolicy. Nor doeshe tial levelof the realexchange rate, the policiesaimed address whether the fixed exchange rate imposes at de-indexlngother contracts,and the behaviorof reputationalor other constraintson politicians. real exchangerate fundamentals. To be efective, an exchangerate anchor should Latn Amakcn Expeenes withNomin Ehage be adopted froma situationof undervaluationand Bab Anchors be accompaniedby consistentfiscal polcies and by strong and convincing de-indexation policies, as The evaluation of fixed exchangerates as nominal was the case in Mexico duing 1988-91 and In anchors In real worldsituations should concentrate Nicaraguabetween mid-1991 and 1992.If, however on two featuresof this system.Fist, to what extent other contracts, espedally wages, continue to be have these regimesconstrained govenment behav- Indexedto past inflation, the systemwill maintain ior In the long nm? And second, how do these considerableInertia, requirig a siable depreda- regimeswork durng the tansition fom high to low tion, as In Chileduring the late 1970s.If this situa- Inflation?More specifically,does the adoption of a tlionis not managedcarefully, the country can Invite fixed exchmge rate acceleratethe convergenceof a speculativeattack on the currency,provoking a domesticinflation with world levels? major crisisand a return to macroeconomicinsta- Some studies have recently addressed these bility. Isses (see Iigue and Llviatan 1992 and Edwards The merts of fixedexchange rates naturallyvary 1993cand 1993b).The long-run expedences of four from country to country, but some general state- LatinAmedcan nations with fixedexchange rates- ments arepossible. In countriesthat facelarge exter- the Dominican Republic,El Salvador,Guatemala, nal shocks-ether tems-of-trade or financial-a and Honduras,for example-suggestthat a my long more flexibleexchange rate is prefered because It MaawcononikAdjusmetasao fotly 53

allows accommodaing foreign diurbances and bI 1 Exchagof tow hecentral enk ofihie. avoiding ovevauatlon. Maintain competdAve S. Te c t rf to au"Wad" thdahae used real exchange rates has been at the heart of Fat 6. bvIu,n n uhsef the pri the usuatcrscto Asian countries' splendid perfotmanceof the past ionson te desabiq f fdor Investmentsh*d abo be taken few decades. But under flexible (or administered) tOacoIunt. se5a Fbwch.OevsI0 fortem o st viw ecancge rates,exdmptherethete rats, Is always thehe dangerdangerthatthat the 7. AsJdA-pointed RWF*dGII out. work undertaken a oJ, P.entlsl.at the IMF under otho lead. authorities will exhibit a devalinaiy and infla- 8. A nntrnvil poportion of t capbtalInflows has bee tionary bias, abusingtheir discretionarypower and eversedapt f SeeCalve, Lelderman,d 1Relhad 1992, devaluing faster than Is requied. This danger can be acddeptw S of s wepar L greatly reduced though mles that place exchange byflog dsic d utsgimen te s ur rate policy In institutions removed from the politi- catal makets,ths wasa Imitedoptio. Caly, a vidos cyde cal ccle-as in Chile,where exchange rate policyIs devOl9eOoWIoW deU lack ofsoaitead markdts prdlud. ed usingdonmestc debt as a sourceof Iwfinncnand knfation ls.- the purview of the Independent central bank.22And, coutaged growthof the naW secor. See dcpter7 fr a dlis as Calvo (1988) has argued, indexed government waon oftapul mae fwm debt-or more precisely, forelgn-curency-denomi- InOm absene of growth, the nflaieonaypreses assod nated ebt-povidedanothrdisncentie forsm- * wk a debtGOPrafti of 8 wI be equalto W2, whereIs the nated debt-provided another disincentive for owr- ,o of base moneyto GDP SeeEdwards 1988a d obusch deut under exchangerate regimescha atrized andsh 1993. by some discretion and flexibilty. II. Fordassical analys on the op iftion taxand the byad some flexibllty~dicretion re~~nilzlng Iflation tax,see Friednma1971 and Balley Will the macoeconomicrecent progress of most 1=. See Edwa and Tabdli_1991 for an emirca discussion countries be maintained, allowing them to move on the int m IMkatkos#pora of the opm Iaton tax theo towatd I-Nnm m*cri economic spolicy? A t12.key In additon,and as pohitedout In chapter2, devaluatons rqirement is to isolate fimoaepolicy the havoebvOrt ntesom ecan pub sctor fs realdevauations extremesof the political budget cyde, where gov- inceae the eldue of te pubi ectordebt Cahvo(198 pre ernments in officeinflate in the periodsbefore elec- t an Ihrsng dicnsio on the roleof pubik debt Inthe tions-4n the hope that this will generatea boom db yp debt, sWlffufilinexpectations tof high I Infation prsencecan materalzeof nonindexed and Improve their political fortunes. The history of 13. Wihethe Aendegovrnment ended In 1973, Chie faced LatinAmetica is replete with lndidentswhere fiscal a trem macroeconomicdislocaon Ifai srpassed700 balanceis lost and inflatlomtates ovet Somecoun_ percent,and thefli defilit had readed 22 pr etof GDt During1974, the new mflitarygovemnment tacked the deficit tries have recently tded to deal with these isues througharge e_xte cutsand Imrvmnts in tax admnsd- reducng the dependenceof key Institutions-such trton SeeEdwards and Edwards1991. as the central banks-on the vagadesof short-tem 14. Inthe frs haffof 9, theChien ong dedded to politics.Argentina, Chile, Colombia,Mexico, and ItS. Dnaite15ecnttx the dedrateroncote eroning mbal Venezuelahave alreadytaken stepsin this directi anoet,tn tw earlyMenem stlon attempts-Roig/Repanell_ Itisstsltooearlytoknowwhetherthesereformswil and onlr-- oyimted progr 16. See Newfarmer1992 for a detailed analysisof the succeed but there is litle doubt that they a stps Argentinepubli sectoa4usnent under the Coavtop In the right dicion. MacroeconomicInstabiHty 17. Theo" rate was 10,000australes per doger.After the has been at the heart of the Latin Amedcan eco arenCyafotm of 1992,the rate bearmeone Argeninepeso per nomic frustatons of the pastdecades It is high time 18. The Interpretationof 'liquid' Intemaona reservesIs to act seriously toward eradicating It somewhatlax, becauseIt Indudes goverment financal assts denominatedIn foreign cuwny. SeeCanave 1991. Hbahns 19. Thee is nowan exnie liature on speculativeattlaks under fixedexchange rates. The pioneetingpiece is Krugman 1979. See Edwards1989e forcase sdiesL 1. The vreasoabe" kWelfor infion was,and contnes to 20. Thisview, or sone vaiant of It hasbeen adoptedby sev- be, a nmat of somecontroversy. eal LatinAnmican countries in the pasttwo decades-for iace 2. Arbly.cay,It can be arguedthat Brai Isgoing thrugh a In the Southen Coneduring the 1970s,In Ncaagua In 1991,in "warof attiWion"prst ion proes simndarto the one ana- Argentnasince 1991, and to someextent in Mexicosince 1988- lyzedby ina and O en (1991). lnterestlngiy,many of the wi derent degreesof success. Histy hasunequivocally swn, Insightsgenertd fomaly by ti literatureware in the eadyLatin howewr,if publicfnes are not tih controlled,an exdcnge Ameicantheodes of Inftion developed,among others, by Sunkd rae anchoris doomedto fall.Remembe the analysisof the hetero- (1960). doxpgamnu in dwapter2. 3. The hane in the offic positin on the debt cisi was 21. Havinghd the ongestunintepd expeiencesin the infuencedby a veryinportant body of rearch undertaen in the worldwith fixd padti, thesec ts provdea uniqueopportu- ResearchDeparbnent of the IMF.For a set of highlyinfluential nityfor studyngthe behvior of fbeedexdge rtes SeeEdwards papersdealing with theseisues, see Frnkel Dooleyand W m 1993bfr detals 1989.Also see Kmugn 1988b. 22. tes, iMeidco's recentproposed lgilaion to cre- 4. Thesenam stem fromthe reguat that govemthee ate an indepent cna bankkeps exthangerte poly In te operoM In dcptes 18 and 19 of the Compenim of Rubson Mniy of Rnance Chapterfiw The Openingof Latin America

Af decades of protectonism, most of latin In themid-1980s,Latin America's external sector Americabegan to open to the est ofthe worldin the was one of the most distortedin the world.Cental late 1980s. Perhaps the most Impressiveachieve- Americahad the highest1mport protection-4n tar- ment of the reformpwgram is that it has effecvely ff and nontadiffbarriers-among developingC un- put an end to more than four decadesof Importsub- tries, with South Americafollowing closely behind stituton policiesthat encourged what tumed out (table S.1). But by 198748 it was apparent that a to be a larely inefficlentindustral secto permanent solutionto the region'seconomic prob- The processleading to these trade reforms,how- lems requireda fundamentalchange In its develop- ev has not been easy.As recntlya3 the mid-1980s, ment strategy.Policymakers began to reaze that the the protectonist view was still influentialIn many long-standingprotectionist tmde policy was at the parts of Latin America,with the debt crisisof 1982 heart of the reglon'sproblems, and with the help of prvidig fresh Impetus. At first, many analysts the multlateral institutions, especaly the World Intexpretedthe debt cdsis as a failureof "the world Bank,more and more countries reduced their pro- economicorder,"agungthattheonlywayforLatin tecdon duringthe late 1980sand early 1990s.The Americato avoid the recurence of such shockswas pace of tradereform has been rapidand accelerating. to futher isdate itself from the rest of the wold, lbr4ffshave been drasticallyslashed, many countdes thro selective protectonism and government have eliminated Import licensesand prohibitions, intervention (Griffith-Jonesand Sunkel1986). Fuel- and severalare trying to sign free trade agreements ing this sentiment was the viewof many observers with the United States. that the liberalizationreoms of the SouthernCone countdes In the 1970swere faflure Synthesizing Fm.s Pnhtmconlsu to L l this perspective,Taylor atgued that "trade lberal Antk Asp tieu strategy is intellectuallymodrbund (1991a,p. 119)and that thereae "no greatbenefits (plus some Toplace the recent trade Ifberalizationprogams in costs) In followingopen trade and capital market perspective,it is usefuifirst to analyzehow the pro- strategies"(p. 141). He concluded that -develop tecdonistpolicies affected the economicstructure of ment strategiesoriented intenaly may be a wise LatinAmedca and to discussthe expectedeffects of choicetowards the century'send" (p. 141). the libeization policies. Just after the euption of the debt cisis, increased protectionismindeed seemed to be the path Latin Te EonomicC nseqnces of Ptotlonsm countres had chosenas a wayout of their problems. Even ChUe, the strongest supporter of free trade, LatinAmerica's long tradition of protectionistpoll- tripled Its import tarft, but this sudden and drastic des molded the region's economic structure. Per- increase in protectionism was dictated largelyby haps the mostimportant consequencewas that high necessity.Countries in the region, faced with the Import arffs ancd prohibitons dicurged the needtogenerateanalmostinstantaneousrevesalin gowth and the diversificationof exports in most the resourcetansfer of more than S30 bllllon,had countries. Li an early study using data from the little alternativein the short run but to compress 1960s,Baas (1971)found that the LatinAmerican importsby some means or other-so an increasein countriesIn hissample-Brazil, Chile, and Mexico- tarffs and quantitative restrctions was not surpis- had some of the most distortedforeign trade in the Ing. world. Ihese findWs coincidewith those of Little,

S4 TheOpening of LatinAM*o 55

Tblk S.1 bnport protection In the developing world umph of lobbylsts and Interest groups. The outcome 19iS was an extremely uneven protective structure, with (pewcent) some sectors enjoying effective tariff rates in the rotdtfff Covweod thousands and others suffering fom negative rates Reon pMe~ nota,ff bonlb (Edwards 1992c). SouthAmerkca 51 60 The protectionist policdesalso had serious effects CentralAman t 100 on labor markets, with the protection of capital- Carixben I17 23 Nor*tAfkca 39- as intensive industries Impeding the regon's ability to Othe Affca 36 86 create jobs Several studies have shown that open OterAA 5 21 trade regimes in the developing countries foster -. - .~ higher employment and a more even Income dis- b. Meured asa phrte ofkmpot gm coverdby no.ftdffberL tributlon than protectionist regimes. Krueger h aon bothWtamff nlOW bd eere twe wewhtied (1981), after analyzing In detail the experiences of SOuWrVan ndWot 1989. 1o countrIes, concluded that industries In the exportable sector tended to be much more labor- Scitovsky,and Scott(1970) in their ploneerstudy on intensive than import-competingsectors. In the tade policyand industralizaion in the developing conclusion to this massivestudy she argues that world. They argued persuasivelythat the high pro- employment grows ster in outward-oriented tection of manu in LatinAmerica resulted economies and that removing trade distortons In seriousdlscrimination against exports, misalioca- helps create employment In most developing tions of resources,ineffident investment,and dete- nations-results broadly supported by other cross- riorating hicome disbution. Theyargued further country studies, including Balassa (1982) and that the revesal of protectionistpolides shouldbe Michaely,Choksl, and Papageorgiou(1991). at thecenter of any reformulationof Latin Ameica's For income distribution, the protective system development strategy.At the time, however,Latin conferredextremely high benefitson localindustri- Americawas stll moving stronglyin the opposite alists-especlly those obtaning import licses diecton, pushing prtctonit policies globally andconcessions-and on urban workers.Depesing through the formationof customsunions with high the incomesof ral workers,this left the distrlbu- common extenal tariffs. tion of Income In Latin Americasignificantly less Export activitieswere discouragedthrou two equal than that in Asia(see chapter 8). main dhannels.First, import tarffs, quotas,and pro- To sum up, severaldecades of excessiveprotec- hibitionsincreased the cost of importedintermedi- tionistpolicies accomplished the goalof creatingan ate materials and capital goods used In the industal sector In LatinAmedca, but at high cost. production of exportables,reducing their effective Exportswee discouraged,the exchangerate became prtection. For years,a vast number of exportable overvalued,employment creation lagged, and mas- goods,especially those in agriculture,even had neg- siveamounts of resources-includingsklled human ative rates of protection for their value added. talent-were withdrawnfrom the productivesphere Second,the mazeof protectionistpolicies resulted in and devoted to lobbyingfor an ever-favorabletreat- a real overvaluation of the exchange rate that ment of differentsectors of the economy.IThe com- reduced the competitivenessof exports in the 20 paratlve studies of the 1980s revealed the years precedingthe debt crisis.ParadoxIcally, poli- shortcowmngsof the Latin Americandevelopment des that were supposed to reduce Latin America's strategies.In the aftermath of the debt crsis, the depedence on the worldwidebusiness cycle ended long stagnation,and even the rogson, of the up creatinga highly vulnerableeconomic stcture. region'sexport sector-with an averagedecline of 1 The sourxesof foreignexchange were concentrated percenta yearbeween 196Sand 1980-became par- on a fewproducts intensive in natual resources,and tlcularlypainful to analysts,policymakers, and the imports were concentrated on a relativelysmall public. group of essentialgoods (CEPAL 1992b). The proctive trade policies did more than adeLbatlon ExpecudReasut and Pansfilonal throttle exports-they coddledan inefficdentmanu- Problems fachuringsector. Instead of ganting short-termpro- tecon to help launch new actities, high tarffs, The main objectiveof trade liberalizationprograms quotas, and prohibitionsbecame a fixture-the tri- is to reversethe negativeconsequences of protec- 56 LatinAmerca and the Coribbean: A Decode after the Debt C*s*s

tionism,especially its anti-exportbias. According to Twofundamental problems have to be addressed basic theory, a trade liberalizationwill Reallocate in the transion toward freertrade. FIs is the ade- resourcesaccording to comparativeadvantage and quate speed of refomn.For a long time, analysts willreduce wasteand the pricesof Importedgoods. 2 arued for gradual liberalzation programs (Little, Moreover,to the extent that the new trade tegimeis Scitovsky,and Scott 1970;Michaely 1985). Gradual more transparent-say, through a relativelyuniform reformswould give firms time for restructuringtheir Import tariff-it Is expectedthat lobbyingactivities productiveprocesse and thus hold down the dislo- will be greatly reduced, teleasing highly sidlled cation costs from unemployment and bankruptcdes. workersftom "unproductive jobs.Once the nega- Thesereduced adjustnent costswould, in turn, pro- tive effective rates of protection and overvalued vide the needed politicalsupport for liberalization. exchangerates are eliminated,exports will not only Recently,however, the gradualistposition has been gtow rapidly-they will also becomemore divers- under attack.Slower reforms tend to lackcredibility, fied. inhibiting fitns from serious restructuring.More- From a growth perspective, the fundamental over,Argentina showed In the 1970sthat a gradual objective of trade reformsis to transform interna- (andpreannounced) reduction In tariffsallows firms tlonal trade into -the engine of growth.- In fact, hurt by ft to (successfully)lobby against it Faster newly developedmodels of "endogenous"growth reforms, being more credible and giving interest have stressed openness 3 For example, Romer (1989) groups less opportunity to mobilize against them, has developeda model where,by taking advantage tend to be sustainedthrough time (Stocknan 1982). of laWermarkets (the world market),an open econ- Recentempirical work on the short-run unem- omy can specializein the production of a relatively ploymentcosts of trade libezation has also Influ- largernumber of Intermediategoods and thus grow encedthinking on the speedof reform.Contrary to faste The most important channels throughwhich the conventionalwisdom, a World Bank study on openness affects the economy are technological liberalizationepisodes in 19 countries stronglysug- progress and productivitygrowth. Grossman and geststhat, even in the short run, the costs of reform Helpman (1991)and Edwards(1992c), for example, can be small (Michaely,Choksi, and Papageorglou argue that openness affectsthe speedand efficiency 1991).Although contractng Industrieswill release with which smal countries can absorb technologl- workers,the industries expanding because of the cal innovationsfrom the industral world.This Idea, reformwill tend to createa largenumber of jobs.The based on an insight first proposed by John Stuart Michaelystudy shows that the net effecton short- Mill, implies that countries with a lower level of run employment-that is, the effectthat nets out trade distortions will experience faster growth In contacting and expandingsectors-has been negli- total factor productivity and, with other things gible in sustainedand successfulreforms. given, will grow fbsterthan countries that inhibit The secondproblem is the sequencingof reform international competition.4The appendix to this (Edwards1984). This issue, first addressedin the chapter presents empiricalresults that support the 1980sin discussionsof the SouthernCone (Argen- idea that more open economies have tended to tina, Chile, and Uruguay),deals with the macro- experience faster rates of total factor productivity economicconsequences of altemativesequences. It growth than those that distorted intemational is now generally agreed that resolving the fiscal trade. imbalance and attaining some macroeconomic The general implicationsof these theories have reformshould be a priorityin implementinga struc- been widely tested using co-country data.5 tralreform. Most analystsalso agreethat the liber- Although different empiricalmodels have yielded alizationof tradeshould precede the liberalizationof differentresults, the general imustof this researchis the capitalaccount, and that financialreform should indeed that countries with less distorted external be implementedonly after a modem and efficient sectorsappear to grow faster.As Dornbusch (1991b) supervisoryframework is in place.6 has recentlypointed out, opennesspossibly affects The behavior of the real exchangerate is at the growth not through one but through severalchan- heart of this prescriptionfor sequencing.Liberal- nels-4nduding the introductionof new goods,the izing the capital account would,under some condi- adoption of new methods of production, the new tions, result in large capital inflows and in an organization of industries, the expansion in the appreciationof the real exchange rate (McKlnnon number of intmediate goods,and the conquestof 1982;Edwards 1984; Harbsrger 1985a).7 The prob- new markets. lem is that an appredation c r the real exchangerate The Openng of LatinAmetlca 57

wlll send the "wrongesignal to the ra sector,fhus- short nm-avoldable If a depeated al exchange tratingthe reallocationof tesoures calledfor by the rate encouragesexpor and helps keep Impors in trade reform.The effectswill be partculaly serious check. If, as Mlannon (1982) and Edwards(1984) have Manycountries have failedto sustaina depreci- argued, the transitional period is characterizedby ated real exchange rate during the tansition- 0abnormally high capital inflowsthat resultIn tem- mainly because of expansionay macroeconomk poraryreal appreciations. f, however,the opening policies-which has led to speculation, intema- of the capital account is postponed,the real sector tional reservelosses, and the rveral of the reform wlll be able to adjust and the new allocation of efifort In the conclusionto the WorldBank project resourceswill be consolidated.Accordig to this on trade reform, Michaely,Choksl, and Papageor- view,only at this time shouldthe capitalaccount be glou(1991) succinctly summaIze the keyrole of the liberalized. real exchangerate In detemining the successof lib- More recent discussionson the sequencing of eralizationprograms: The long-termperformance reform have expanded the analysisand Induded of the real exchangerate clearlydifferentiates "Ub- other markets. An increasingnumber of authors eraers from "non-balers" (p. 119). Edwards have argued that the reformof the labor market- (1989e)used data on 39 exchange rate crises and and In particulr the removalof distortionsthat dis- found In almostevery case that the overvaluationof coge labor mobility-should precedeboth the the real exchangerate drastcally Increasedthe pro- trade refom and the relaxationof capital controls. tectionism.The trend toward real exchange rate It Is even possible that the liberaliation of trade apprecation in many Latin American countries under highty disbtortedlabor marketswill be coun- since 1992 has generated some concern among terproductve, generating overallwefare losses In ewper. It has been argued that the appreciated the country (see chapter 6). Interestingly,the dis- exchange rates' erosion of International competi- cussions on the sequencing of reform have ad- tiveness could revive protectionist sentiments dressedIn detail only the order for the liberalization (Calvo,Leiderman, and Relnhardt1992). of vadous "real" sectors to proceed. For Instance, only a few stdies, such as Krueger(1981) and e Detmint ofSuccessfiTade Liberalizadon Edwards(1984), have dealtwith the order of reform Policis of agriculture,Industry, govenment (pivatization), financialservices, and education.The oeyquestion Twoeconomic aspects of trade liberalizationare par- here Is how much the specificrefonms can bear al! ticularlyimportant for understanding the politcal their potenti fruits Independently-or whether economy of transition and the lkelihood of sus- the reformsin differentsectors In a broad-basedlib- taining reforms.First, It takes some time for struc- eralizationreinfore each other.8 tural reforms to bear fruit-so even though the As the precedingdission has suggested,the reformswlll have a positiveeffect on the aggregate behavior of the real exchangerate Is a key element economy In the long run, there wl}lbe some short durlng a trade liberalization.According to tradi- rn costs, and these costs will affect some groups tional manualson "howto liberalize," a largedeval- more than others. Second, even In the long run, uation s!houldbe the fhrststep in a trade reform. some groups will lose, seeing their real incomes Bhagwati(1978) and Krueger(1978) have pointed diminished.These wlll be the groupsthat benefited out that a (real) exchange ate depreciationwill fromthe pmereformmaze of regulationsand that, in reduce the rents that Importersreceive from quotas most cases,wlll opposethe reformsfrom the begin- and import licenses, fting relativeprices in favor ning. Politically,then, trade reforms will survive of export-orientedactivities and thus reducing the only if they showsome benefitsearly on-and only anti-exportbias. If these benefits expand, graduallyaffecting more Maintaininga depreciatedand competitivereal and more segmentsof society. exchangerate durng a trade liberalizationis impor- The extensive comparative studies-Little, tantalsotoavoidanexplosioninimportgrowthand Scltovsky,and Scott 1970; Balassa 1971, 1982; a balance of payments cdsis. Under most chrcum- Krueger1978, 1980;Bhagwatl 1978; and Mlchaely, stances,reduced protection will cause an Immediate Choksl,and Papageorgiou1991-provide abundant surgein Import The expansionof exports,by con- evidence on the key determinants of a successful trast, usuallytakes some time.There Is thus the dan- trade reform. These determinants-call them ger of a large trade balance diequilibium In the requirementsfor success-can guide policymakers 58 LatinAmerica and the Cartbbean. A Decode after the Debt Crisis

who want to Implement trade liberallzation poicies NonB anrs that will be sustained: * Exports, particularly nontraditional exports, A fundamental part of trade reform has been the expand at a pace that exceeds the historical tate, elimination, or severe reduction, of nontariff barni- * Productivity gwth increases at a fast pace, ers. In some countties, such as Colombia and Peru, helping genetate rapld growth for the economy as a more than 50 petcent of Import positions in the whole. early and mid-1980s were subject to licenses or out- * Trade balance does not exhibit "unreasonable" right prohibitions. The coverage of nontarrif barri- deficits. If it does, the public will be skeptical about ensreached almost all of Import categories in Mexico the viability of the reform, and will speculate against and In most of Central America in 1985 (table 5.1). the domestic currency. But in almost every country, the coverage of non. * Overall unemployment stays relatively low. turif bariers was dramatically teduced between * Real wages increase, at least in the medium 198547 and 1991-92 (table 5.2).9 And some coun- run, and-for this Increase to affecta broad sector of tries have eliminated them altogetheL The process society-the trade liberalization Is supplemented by has varied from country to country. In some, such as other stmctural reforms aimed at deregulatng and Honduras, the nontariff batriers were initially liberalizing other sectors of the economy. replaced by (quasi) equivalent import tariffs and then slowly phased out In others, such as Chile, ient Trade UberaIzatlon Reforms nontadff barriers were rapidly eliminated without a In Latn Amerka compensating hike In tariffs. Despite the progress of the past few years, the Chile, the pioneer in trade liberalization, unilater- coverage of nontariff barriers remains significant in ally eliminated quantitative restrictions and reduced seval countries-mostly for agricultural products. Import tariffs to a uniform 10 percet between 1975 The region's liberalization programs have proceeded and 1979. After a brief interlude with higher taiffs much slower In agriculture than in other industries, (at a uniform 35 percent), Chile currently has a uni- largely because of the authorities' desire to isolate form tariff of 11 percent with no licses or other agricultute from fluctuations in world prices and orms of quantitative controls. Umuguay imple- from unfair trade practices by foreign countries.10 In merted a reform in 1978, and after a brief reversal, Mexdcoabout 60 percent of agriculture's sector tariff pushed forward once again in 1986. Bolivia and positions were stll subject to import licenses in mid- Mexdcoembarked on their reforms in 1985486,fol- 1992. But as Valdes (1992) shows, this use of quan- lowed by other countries in the late 1980s. The titative restrictions entails serious effciency costs. members of the Caribbean Community (CARICOM) Slowly, however, more and more countries have intensified trade liberalization refotrmsIn the late been willing to address these concerns by replacing 1980s and early 1990s. At the current tine a num- quantitative restrictions with variable levies and by ber of nations, induding Brazil, are proceeding ihtroducing a system of price bands for smoothing steadily with scheduled rounds of tariff reduction price fluctations (Vald6s1992). and the dismantling of quantitative restdctions. It Is stfll unclear, however, whether all these reforms will AwrageTariffs be sustained, becoming a permanent feature of the Latin economies, or whether some will be reversed. Reducing the average protection is perhaps the fun- Recent developments in Argentina indeed suggest damental policy goal of trade liberalization reforms. that in some countries higher tariffs may be tmple- Traditional policy manuals on the subject suggest mented, once again, in the near futurew that once the exchange rate has been devalued and Four basic elements characterize the latin quantitative restrictions have been redut_d or elim- American trade reforms: the reduction of the oDver- inated, tariffs should be slashed in such a way that age of nontariff barriers, inchlding quotas and pro- both their average and range are reduced.- The tar- hibitions; the reduction of the averageimpot tariffs; iff reductlon has been significant In almost every the reduction of dispersion of the tariff structure; country since the mid-1980s. Even nations cautious and the reduction or elimination of export taxes. on the teform front, such as Brazil, have made big These measures have generally been supported by cuts in import tariffs, allowing a more competitive exchange rate policies to maintain a competitive eal environment, and reducing the anti-export bias of exchange rate. the trade regime. TheOpening of LatinAmerti S9

Table5.2 Theopenlg of LatinAmeriea, selected counties and yeas, 198S92 (percent) AwAVecewrof Ave tarffprMteclonP nontwaaif Country 1985 1991-92 198547 1991-92 Eadyrefo*mier solva 20.0 8.0 25.0 00 Chile 36.0 11,0 10.1 0.0 Mexco 34.0 4.0 12.7 20.0 Reent Mea CostaRka 92.0 16.0 0.8 0.0 Uruguay 32.0 12.0 14.1 0.0 Veryrecent rnmrs Argentina 28.0 15.0 31.9 ao Brazil 80.0 21.1 35.3 10.0 Colombia 83.0 6.7 73.2 1.0 Guatemala S0.0 19.0 7.4 6.0 Nicaragua 54.0 - 27.8 Paraguay 71.7 16.0 9.9 0.0 Pem 64.0 15.0 S3.4 0.0 Venezuela 30.0 17.0 44.1 S.0 Aiure refomwes Ecuador SO.O 18.0 S9.3

- Not avtabs a. erageto dwges (tarffsplus paratarffs). urwighted. b. Unweighted. Soe WorldDank data, 197S;and Eran and others 1989.

Countries that embarked on trade liberalization highest disperon in tarf in the world In the In recent years have moved much fLster than 1960s-with a standard deviation of 634 percent- nations that decided to open up earlier. What Is per- closely foWlowedby Colombia and Umguay. Cardoso ceived to be abrupt and rapid In the removal of and He1wege (1991) point out that hi dispersed import impediments has clearly changed. Reforms protective stuctures have high welfre costs, seen only 15 years ago as brutally fast are now seen inreasing uncertainty and dampening Investment as mild and gradual. When Chile Initiated its trade These hig dispersed taffs and nontariff banrers reform in 1975, most analysts thought that the were the result of decades of lobbying to obtain pref- announced tariff reduction from an average of S2 erentlal treatment. As the relative power of the dif- percent to 10 percent in four and a half years was an ferent lobbies changed, so did the tariff concessions extremely aggresslve move that would caue major and the protective landscape. dislocations, Including large increases in unemploy- The reforms have Indeed reduced the range ment. By oontrast, Colombia slashed (total) import between minimum and maximum tarffs since the tariffs by 65 percent in one year, reducing them from mid-1980s. In many cams, this has meant lnvsn 34 percent in 1990 to 12 percent In 1991. This fast tarffs on goods odginly exempt from import approach to liberalization has also been that of duties. Generally, the zero tarffs applied to Inter- Argentina, Peru, and especially Nicaragua, which mediate inputs for manufacturng. 1 Raising these eliminated Its quantitative restrictions in one bold tariffs has not always been easy. Interests that tradl- move and slashed Import tariffs from an average of tionally benefited from the exemptions suddenly 110 percent In 1990 to 15 percent in March 1992. saw their privilege oDming to an end and mounted strong opposition. Also, any tariff inreases gener- Tariff Dispersion ally appear inconsistent with Bberalization rhetoric. How much should the tariff dispersion be The import substitution pursued for decades in Latin reduced? Should the refoms implement a wdfobm America created highly dispersed protective struc- tariff, or is some small dispersion desirable? From a tures. According to an internal World Bank rVport strict welfar perspective unifotm tarffs are advis- Brazl, Chile, and Colombia had some of the high- able only under very spelal cases, but thOy have a est dispersions in effecdve protection in the world In strong admnistrative and pol{tical appeaL In putic- the 1960s. Heitger (1987) shows that Chile had the ular, a uniform tariff system, because of Its trans 60 LatinAmera and the Cardbbean:A Deoade after the DebtCrisis

parency,makes it difficultfor the authoritiesto grant 7tadeLiberalIzation and ProductivityGrowth spedal treatment to particlar firms or sectors arberger 1990). The relaxationof trade impedimentschanged the region's economies. Suddenly, Latin American Exchane Rat Poliy Industries, which had developed and grown behind protective walls, were forced to compete. Many In most countries,the first step in the recent trade firms,unable to survivethe shock, went bankrupt reform processeswas the Implementationof large Others faced the challenge of lowerprotection by (nominal)devaluations, often unifyingthe foreign embarkingon major restructuringsto increasetheir exchange market. They implemented large ex- productivity. change rate adjustmentsas earlyas 1982to facethe The ability-and wilingness-of rms to Imple- urgenciesof the adjustmentprocess. Many of them ment significantadjustment has depended on the adopted crawling-peg regimes-periodic small aedibility of the reform and the distortions in the devaluationsof the nominal exchangerate-to pro- labormarket. If entrepreneursbelieve that a reform tect the gealexchange rate frominflation (see chap- will not persist,there are no incentves to Incur the ters 2 and 4).13Between 1980 and 1987almost every costs of adjustng the product mix and increasing country in a selectedsample experienced very large the effciency of production. In fact, if a reform Is real depredations (table 5.3). In many cases,how- perceivedas temporary,the optimal behaviorIs not ever, these were partally reversedin the past few to adjust, but to speculateprofitably through the years,as a consequenceof laWeinflows of foreign accumulationof Importeddurable goods-the case capital since 1990 and the use of the exchangerate in Argentina during the failed Martinez de Hoz as the cornerstone of the disinflationpolicies. In reforms(Rodriguez 1982).14 most countries,however, the real exchangerate was In studiesof the interactionbetween labor mar- significanty more depreciatedby late 1992 than in kets and structural reforms, Krueger (1980) and 1981, helping reverse decades of discriminatory Michaely,Choksi, and Papageorgiou(1991) found policiesand greatly mncouragingexports. that most successfultrade reforms have boosted laborproductivity, generally because of flexibilityin The Iffects of Trade b l_ labor markets.Labor productivity in Chileanmanu- factring increasedat an averageof 13.4 percent a The trade liberalizationrefrms implemented in year between1978 and 1981(Edwards and Edwards LatinAmerica had three objectives.The firstwas to 1991). And that of Mexican manufacturing in- reduce the anti-export bias of the old rgime and creasedat almost4 percenta yearbetween 1986and thus to encourage exports. The second was to 1991 (Sanchez1992)-.ore than twice the annual increase total factor productivitygrowth through 1.6 percentbetween 1960and 1982 (BSas1992). By greatercompetition and efficiency.The third wasto contrast, countries with rigid and highly distorted increase consumer welfare by reducing the real labor markets-including countrieswith high costs pricesof importablegoods. of dismissal,limits on temporarycontracts,and rigid minimum wage legislation-have generally had Table5.3 Realexdge res In seectedLatn modest improvementsin labor productivityafter Americancountries, 1960,1987, and 1992 trade reform. (1985.100) Asalready discussed, recent growth modelssug- Cwuntry 1980 1987 1992 gestthat countriesmore open to the restof the world Argentina 35.8 80.7 36.g exhibit faster technologicalimprovement and pro- Bolia 88.1 107.9 112.1' ductivitygrowth than countries that isolate them- BreA 70.7 78.0 51.7 selves. What that means Is that countries that open ChIle SS.3 94.8 75.1 Colombia 79.2 115.9 119.9 their external sectors and liberalize trade will expe- CostaRca 6S.8 94.9 88.2 rlencean inacsein total factorproductivtty growth. Mexico 1083.63 123.3 68.7 Theregressionanalysis in the appendix to this chap- Paraguay 74.4 111.4 113.0 ter supports the idea that when such variables as Peru 77.1 46.' 21.7 human capital formation, political volatility, size of ezuela 84.2 1242s.3 govemnment,and developmentgaps are held con- Ve-ezue134.81223 84.2 stant, the openness of the economy is positively Now tcIea iNdai.comfcy deeai agMrstde U.S.dolla. associatedwith the growth of total factor produc- .1991data. ouweCalculated uwing *AW data. tivity (rFP). What Is particularlyimportant is that TheOpeningoLt7AMefta 61

this result appears to be robust with respect to the After the trade reform, the rate of productivty proxy used to measure trade policy orientation. growth In the Mexdcan manufacurig sector Chile and Costa Rica, two of the earlier reform- exceededevery subperlod since 1940 for which there ers, had very large increases In total factor produc- are data (table S.S).20This provides some evidence In tivity growth after their reforms; four other Latin favor of the view that, once the sectors subject to American countries-Argentina, Bolivia, Mexico, Increasedcompetition are considered, Mexican pro- and Uruguay-did not's The results for Chile co- ductivity growth has indeed Improved, a propos}- incide with those of Edwards (1985),who found that ton supported by Weiss (1992),who used regression in the late 1970s, after the trade reforms had been analysis to Investigate the Impact of the trade completed, total factor productivity growth was reforms on productivity and cost margins. about three times higher than the historical aver- How fast wlll productivity growth react to the age.16 Although the outcomes in Argentina and new Incentives? Will the response be rapid, or will it Uruguay are less spectacular, they still exhibit sub- be necessary to wait for a long period of time before stantlal improvements in productivity growth after seeing the fruits of the reforms? Data for Chile pro- the reform. For Bolivia,by contrast, total factor pro- vide some support for the Idea that total factor pro. ductivity growth was flat. Sturzenegger (1992) ducdvlty growth will eactquite fast. Edwards(1985) argues that the very slow improvement in Bolivian found that already by 1979-the year the trade productivity growth has largely been the result of reform reached Its goal of a uniform 10 percent negative terms-of-trade shocks, part!cularly the col- import tariff-aggregate total factor productivity lapse of the tin market.17 growth had reached 5.4 percent, significantly higher Perhaps most puzzling Is the slight decline in than before. More recently, Agacino, Rivas, and aggregate total factor productivity growth for Roman (1992) found that total factor productivity Mexico after the reforms. Martin (1992) shows this growth averaged 3.9 percent a year during 1976-81, finding to be robust for other methods of measuring nearly four times the historical aveage of about I total factor productivity growth, including different percent There also were sigficant variations across procedures for corecting for capacity use. Harberger industries, with wood products and glass industries (1992) also found a slowdown of total factor pro- exceeding the 10 percent annual mark, and non- ductivity growth in Mexico in 1986-90 relative to electric machinery negative. 197542.18 But the aggregate total factor productiv- ity growth in table S.4 obscures the sectoral response. TadeRefms and Exports Accord to new theories on endogenous growth, productivity growth will be faster In sectors where An important goal of the trade reforms has been to protectionism has been reduced,and not in those still reduce the traditional anti-export bias of Latin subject to trade barriers or other forms of regulation. American trade regimes and to generate a surge in Distinctive in the Mexican reform, and unlike exports. Following the East Asian model, Latin Chile's, Is the uneven pace. Most manufacturng- American leaders have increasingly called for the except automobiles-experienced a significant re- transformation of the extemal sector into the duction in protection, but agriculture continues to region's -engine of growth.- As pointed out previ- 'e subject to relatively high tariffs and substantial ously, the reduction of the traditional anti-export nontariff barriers. Moreover, the Mexican land bias is expected through three channels: a more tenure system unti very recently was subject to the competitive-that is, more depreciated-real elidosystem, which severelyrestricted the market for land and distorted economic incentives in many Table5.4 Chaw In tota factor productit growth In other directions. Although most agrCultural sector selectedLatin American countri 1978482to 1987-91 regulations were legally eliminated in early 1992, O I these reforms await practical impact. The reason for annwuaIwgrWthAIe this is that the titling process for assigning property cortny 1978-82vs. 1987-91 rights is in its infancy, and by mid-1993 almost no Argena 1.91 elidoshad yet been converted into private landhold- BotlMa 0.11 t ings. 9 In addition, durling much of the post-debt- Chile 4.96 crisis period, large fragments of Mexico's services cM°ostsRa 0.32 sector-including telecommunications and finan- U,wW 2.02 cal services-were under direct government control NoseF o dothe pedut. pwod Is1972-7a and sbject to distortions. s Mmtn102 62 LadnAmera andthe Caibbeon. A Decadeater theDebt C*sis

Tale 5.5 Totalfactor poducii growth In Chile is particularly Interestng. Because most of manufacturingIn Melco, 1940-90 its lberalizton took place before 1980, there are (pect) enough data points to provide a more detailed eval- Pd_ Growth uation of export response to the new regime. Be- 1940-So 0.46 tween 1975 and 1980-when tariffs were reduced to 1950-60 0.53 a uniform 10 percent and nontariff barriers were 19070 3.00 completeleliminated-ChileanexportsgrewInvol- 19080893.40 ume at 12 percnt a year-many times the 2.6 per- 191155-119-- 40 - cent average of the 1960s. Particuarly Impressive is SThe daa for1940WO efm Vrebsa11 anWOfoser or4 that most of the surge wasIn nontraditional exports aefom r1992. (CEPAL,Economi Srwey of Latn America 1991), Chile's success in the past few years has been tied exchange tate, a reducUon in the cost of imported to a boom In agriculture, forestry, and fishing capital goods and intermediate inputs used in the exports. During the 1960s, Chile was a net importer production of exportables, and a diect shift in rela- of agricltural goods. In 1970, it exported $33 mrl- tive prices in favor of exports. lion In agriculture, forestry, and fishing products- In order for productivity growth to continue to and in 1991, a striking $1.2 billion. And this figure Incease, and fr the extnal sector to truly become exdudes m.nufactured goods using those products the "engine of growth," investment in human capi- as inputs. tal and infrastructure should increase signdficantly There is little doubt that economic policy lies In the years to come (chapter 9). behind the stellar perormance of Chile's agricul- The volume of international trade in Latin Amer- Ta S.6 Groth in valueof exports of goods and Ica, pardcularly exports, ncreased signficantly after nonfactorservles In selectedLatin American countries, the reforms. For the region as a whole, the vohme 1970-92 of exports grw at only 2.0 percent a year between (annualpercentage growth rates in constantprices) 1970 and 1980, but increasedby 5.5 percent a year GuM 1970-80 1982-47 1987-92 between 1980 and 1985 and by 6.7 percent between 1986 and 1990. The pa of the real valueof exports, Bo0a 0.6 0.6 8.1 howeve, has beensomewhat slowet The reason the grami 9.9 9.7 5.5 tems of trade in every subgoup of countries deteri- ChIle 10.2 6.5 10.9 orated in 19801 (CEPAL1992a). Strictly speaking, colombIa 5.7 10.2 109 it Is not possible to fully attribute this export surge Eacador 14.0 3.3 9.1 to the opeming up of reforms. But country evidence Meico 8.3 5.8 3.5 suggests that a more open economy and a more Pa.1uay 7 Peru 2.7 -.4.554 0.589.5 deprecated teal exchange rate helped exports grow Umguay 7.2 4.2 7.1 (seeNogu6s and Gulati 1992).Some countries, espe- Venezla 7.3b 3.6 4.4 claly Cosa Rica,also have a battery of export pro- a. 1987-91. motion schemes, including tax credits, duty free b 1974-80. Import, and Inome tax exemptions. But some authors, including Nogues and Gulati (1992),argue Table5.7 GrowthIn volume of exportsof goods In that these systems have been expensive and not selectedLatin America countrIs, 1970-92 effective at encourng exports.= (annualpercentage growth rates) Although export grwth has been rapid for the Co,ntty 1970-80 1982-87 1987-91 region as a whole, there are non-trvial variations Areta 2.1 0.8 12.8 across countries and in some cases there has even Bolma -1.7 -5.2 13.2 been a decline-Peru, for example (tables 5.6 and Brail 8.2 8.0 1.5 5.7). Also, export performance has not been consis- Ch7le 7.4 7.6 7.4 Colombia 3.6 14.8 7.3 tent over time, with most countries ding much bet- CostaRia 3.8 6.2 7.5 ter duing 1987-92 than intheprevious fiveyeas-a Ecador 14.6 6.8 8.2 reflection of the time it takes forexportso respond MexCo 10.2 6.1 S.5 to greater incentives. Two of the early reforme- Paaguay 2.3 94.2 172 Boliviaand Chile-had verystrong exports behavior Unrguay 5.4 -05 4.8 during 1987-91, while Brzl, which has lagged in Veneuela -5.8 2.1 7.5 mA- m--f- had winker exflt than in the 1970S. Som CM RS i YearboAfor La& AJr, va yers. TheOpening of Latn Amerca 63 tural export sector in the past few years. First,the lib- ness.23Supporting this interpretation, Bonelli (1992) erfalzation of intemational trade substantfally low- found that the export orientaton has raised the pro- ered the costs of imported agrcultural Inputs and ducvity gVowthIn Brazil'smanufacturing sector capital goods, making the sector more competitive. A stated objective of trade reforms has been to In fact, the liberalization of Intemational trade put Increase the diversificationof export. In this regard, an end to the traditional discrimination against agti- nontraditional exports in most countries (including culture, in contrast with Mexico. Second, Chile's manufacturing exports) Increased signifiantly in aggressive exchange rate policy has provided clear the period folimlng the trade reforms, espedally for Incentives for the expansion of exports, though the the early reAwrmers-Chile and Mexico (table 5.9). current real exchange rate appreciation Is a doud in And In mostcountrIes, the shareof the 10 topexport the future. Third, pursuit of a stable mamweconomkc goods in total expofts has declined significantly in policy has allowed entrepreneurs to have confidence the past few years (CEPAL,Economc Suvey of Latin in the system and to plan their activities over the Anmrka, 1992). longer run. Many export-oriented agricultural activ- The force of export expansion in the years to lties require sizable Investments, tndertaken only in come will not only depend on the countries' poli- an environment of stability and policy continuity. cies, but also on two factors beyond their control: And fourth, the strict respect for property rights and the evolution of export prices and access to foreign the emergence of a stable and legal frmework markets. During the last decade most commodity helped agriculture exports. export prices have declined substantially. This prob- Mexico has had a slowergrowth of exports In the lem, however, should be reducei to the extent that post-reform period than during 1970-80, an illusion exports become more diversified. Regarding access stemming from Mexico's very rapid increase in ofl to foreign markets, there are mixed signals. On one production during the 1970s-at more than 18 per- hand, some industral nations appear to be incras- cent a year. When nontraditional exports are con- ing protectionism; on the other, there are hopes that sidered, the post-reform performance is remarkable: negotiations of the General Agrement on Trade and average annual growth of 25 percent for 1985-91 Tarffs (GATI) will finally make progress. (table 5.8). But much of this growth has been in the naquiadoraor in-bond sector. RealExchange Rate Behavior,Capital Inflows, Brazil, after declines in 1990 and 1991, inceased n the Fhtwe of Tn edReonm In La1t the volume of exports rapidly in 1992-by 14.9 per- Ameia cent. It Is too early to tell what the forces ate behind this growth and whether it will be sustained, but Competitive real exchange rates have been at the there is some Indication that the highly depredated heartof most of Latin America'sextemal sector And real exchange rate and the reduced protection it is no exaggeration to say that highly competitive helped inaease Brazil's intemational competitive- real exchange rates have driven the trade reforms and made Latin American products very attractive in Table5.8 NontradWtonalexp~orts as a shareof wolaakt.Thtllhnig hwvr sms exports In selected LatinAmerkan countries and years world markets. That is chan & however, as most 198091 Table S.9 Exports of manufactured goods as a share of (percent) ainexports In selected LatinAmerican countris and Coutrry 1980 7982 1985 7987 1991 years, 1970-91 Argentina 0.27 0.31 028 0.31 0.35 (pernt) BolMa 0.15 0.09 0.05 0.19 0.30 Cbumtry 1970 1980 1982 1985 1987 1991 Bazil' 0.57 O.S9 0.66 0.69 0.71 Chile 0.38 0.22 0.35 0.39 036b ArglIna 0.14 0.23 0.24 0.21 0.31 0.28 Colombia 0.41 0.42 0.41 0.55 0.64c BOIla 0.03 0.02 0.03 0.01 0.03 0.05' Cost Rica 0.36 0.38 0.37 0.42 0,S0 Brazl 0.15 0.37 0.38 0.44 0.50 0.S5 Ecuadord 0.24 0.09 0.12 0.4 0.12 Chle 0.04 0.09 0.07 0.11 0.09 0.11 Mexico 0.13 0.20 0.18 0.38 O.S0 Colombia 0.11 0.20 0.24 0.17 0.19 0.33 Paraguay 0.58 0.71 0.82 0.68 0.69 CostaRka 0.19 0.28 0.25 0.22 0.24 0.25 Peru 0.21 0.23 0.24 0.27 028 Ecuador 0.02 0.03 0.03 0.01 0.02 0.02 Uruguay 0.61 O.58 0.66 0.67 0.71 Mexico 0.33 0.11 0.10 0.21 0.38 0.44' Venezuela 0.04 0.07 0.09 0.13 0.17 Paguay 0.08 0.04 0.09 0.06 0.10 Qll Peru 0.01 0.17 0.16 0.13 0.17 0.19' a. Industialproducts. Unuguay 0.15 0.38 0.32 0.35 O.SS 0.52 b. 1989dat subsequentdata areasifed diferey. Venewelb 0.01 0.02 0.02 0.10 0.06 0.11a c.199Odate. d.Manactrd product. a1990 dat Skw CEMl, &own* Iaifvof aLooMmvk4aousv sses. SaCm SCaMttbkAuofoo lathrAnmka. Varlm-, 64 LatinAmneria and the Caribbean:A Decadeafter e DebtCrki

Latin American coutntties' real exchange rates have ign exhange "overbundant" (see Calvo, appreciated, weakening competitiveness(figre S.1). Ldlder , and Renhardt 1992). These real appreciations, generatng constemation Aft eight years of negative resoure tansfes, for policymakers and political leaders, have been the there was a significnt turnaround In 1991-92 result of two factors: the use of exchange rate policy (tables S.10 and S.11). The Increase In ford hnds as an anti-hinationary toot and the recent massive affected the real exchange rate through increased capital inflows Into Latin-America that have made aggregate expenditure. VWthsome of the new re-

FIgure51 Realeffectlve exchange rates Inselected Latn Americancounie, 1977-91 (1985=100)

250..-, Argentna *0 Solvia

200 800

150 600

100 400

50 200

0 0 1978 1980 1982 1984 1986 1988 1990 1978 1980 1982 1984 1986 1988 1990

120 1so sug Odle

120 100 90

80 60

60 30 1978 1980 1982 1984 1986 1988 1990 1978 1980 1982 1984 1986 1988 1990

200 Combia 20 Ecuador

200

150

1978 1980 1982 1984 1986 1988 1990 1978 1980 1982 1984 1986 1988 1990 TheOpening of LatinAmerbo 65

Figure5.1 Realeffectve exhange rates In sleted LatinAnm an counti 1 7-91 (con (1985=100)

200 . .,120. Mealdco

150 t50 /\t ~~~~~~~~~~100s seu

80

100 AS:1 5R6 40

1978 1980 1982 1984 1986 1988 1990 1978 1980 1982 1984 1986 1988 1990

150 250 Uruguay V _ -uel 12020 90~~~~~~~~~~~~0 90~~~~~~~~~~~~~5

60

---3 ~~~~~~~~~~~100 30

1978 1980 1982 1984 1986 1988 1990 1978 1980 1982 1984 1986 1988 1990

Soure:Mf, IffrnatI RAm SWfta sources spent on nonttadables, including real estate, Table5.10 CapItalInRows and net resourcetrnsfers, there was fresh pressure on thefr relative prices and Latn Americ, 19892 on domestic inflation. Much of the recent capital (bllons ofdolls) movement has been portfolio investment and rela- Not pit teest and Net resoe tively little has been direct foreign Investment. Yea bws proft Iome trnsfers Mexico has received the most forew funds in tl e 198245 S5.3 -111.7 -56.4 region in the past years, allowing itto havea curent 1986- 33.5 -138.7 -105.2 accountdeficlt on the orderof5 to 7 percentofGDP. 19911990 36.317.0 -31.1-35.7 -18.75.2 Having higher capital inflows generate real 1992b 42.8 -21.2 21.6 exchange rate appreciations is not new in Latin a. Anuaaverg. America. In the late 1970s most countries in the b.Ptle.don. region, especially those in the Southern Cone, were sowumapesenl992. flooded with foreign resources that led to large real appreciations. That this previous episode ended in Whether these capital movements are tempo- the debt crisis adds drama to curent concern about rary-and thus subject to sudden reversals as in the possible negative effects of these flows The cur- 1982-is particularly Impoitant In evaluating thelr rent situation, however, Is very dfferent from that of possible consequences. Calvo, Lelderman, and the 1970s,as now the fiscal side is under control and Relnhart (1992) argue that the most Important macweconomic stability is being actively pursued. causes behind the Inlow of resources are externaL' 66 LatinAmerica and the CartbbeanA Dee afterthe DebtCis

Table5.11 Net capitl inw asa percea9e of GDPIn selededlatin AWen counbies,1982-92 Country 1982 1983 1984 1985 1986 1987 1988 189 1990 199t 1992 Argetn 2-5 0.4 2.3 2.8 1.6 2.2 2.8 0.3 O.S 3.0 5.7 Brazl 4.1 2.7 2.4 0.1 0.7 1S -0S 0.3 1.1 0.2 - Chie 4.2 2.6 10.5 8.6 4.3 5.4 5.0 5.5 11.7 3.0 7.8 Colombia 5.7 3.7 2.5 6.4 3.3 0.0 2.4 1.2 0.0 -1.9 - Mexico 5.5 -1.6 -0.6 -1.1 0.9 -0.7 -0.8 0.7 35 7.1 - Peru 7.8 3.8 5.3 2.4 3.6 3.7 5.4 2.9 3.6 -2.2 3.4 Venezuela -1.9 -4.7 -3.4 -1.7 -1.8 1.1 -1.7 -7.9 -7.4 3.7 S.8 - Not aab. a. Pemnt Sou=:WoddDank and IM data.

the recession In the Industral world and the reduc- Between December 1991 and December 1992, the tion In US. Interest rates. Once these global condi- Chilean bilateral real exchange rate appredated by tions change, the authors suggest, the volume of about 10 percent. Asa result, exporters and agdcul- capital flowing to Latin America wlll be reduced. tural producers have mounted pressure on the gov- When that happens, the pressure on the real emmentforspecdaltr eant,aguingthatallowing exchange rate will subside, and a real deprdation the real exchange rate to apprecate broke an will be required. implicit contract This political reaction, more and Theregion'scountrieshavetriedtocopewiththe more generalized throughout the regibn, adds diffi- prssures of real appreciation in severl ways. For cult social and political dimensions to dealing with one, Colombia tried to steilize the acmmulation of the real exchange rate. reservesby placing domestic bonds in the local mar- Although there is no easy way to handle the pres- ket in 1991.4 But to place these bonds, the local sures for real appreciation, experience shows at least interest tate had to be high, attracting new capital two possible avenues for authorities to folow. Fist, flows that, to be sterilized,required new bond place- where the dominant force Is price inertia under a ments. This vicious ycle contibuted to a veylarge nominal exchange rate anchor, a pragmatic crawl- accumulation of domestic debt without affecdng ing-peg system usually helps. This means that, to the real exchange rate. some extent, the inflationary targets have to be less In a dfferent response to the preures, Argentina ambitious-because a periodic exchange rate adjust- recently ttied to deal with the real appcation by ment wlll result in some inflation.25But if this pol- engineering a pseudo-devaluation through simulta- Icy Is supplemented by tight overall fiscal polic, neous Increases in Import tarffs and export subsi- there should be no concetn about Inflationary dies. Although It is too early to know how this explosions. measure will affect competitiveness, preliminar Second, discrminating between short-term computations suggest that the adjustment from the (speculative)capital and longer-term capital should package may be smalL go a long way to help resolve preoccuations with MexDcofollowed a different wute, deciding to the effects of capital movements on real exchange postpone the adoption of a completely fixed rates. If capital flowsare determined to be genuinely exchange rate. In October1992, the pace of the daily long term, and the capital infows help finance nominal exchange rate adjustment was doubled to investment prolects in the tradahles sector, the 40 cents. As in Argentina, It is too early to evaluate change in the real exchange rate is a -true equUib how effectve the measure is In dealing with the real riumT phenomenon-it is a reflection of the change appreciaton. But several analyst of the Mexican in the underlying fundamentalsIn this case no pol- scene have already argued that this measure is Icyaction wll be required. In pactice, however, dis- clearly not enough. cnatig between 'tra- *.tory" and 'permanent" Chile taclded the real appreciation by Imple- capital inflows is difficult and, in the end, policy- menting broad measures-conducting exchange makers must make a judgment call. rate policy relative to a three-curency basket, Im- And third, the recent Chilean expeience sug- posing reserve requirements on capital inflows, and gests that using multiple insutments to accomodate undertakdng significant se zationoperons. the caplnflows usuafy helps. In partcar, allow- Despite this multifront approach, Chile has not fully ing the nominal exchange rate to expeece some eased the presues on the real exchange rate. appreiation wll help avoidlnflationary pressures. TheOpenigofLtinAmed 67

Regtonal Tiadlg So In Leti. A_nes he MAiradoCon,n del Sur

There Is little doubt, as we approach the twenty-firs The main goal of the M13RCOSUR,a trade agree. century, that the world economy is moving toward ment signed by Argentlna, Brazil, Parguy, and a small number of trading blocs. Although the Uruguay in 1991, is to elimte all ta for European Economic Community (EEC) and the intrareglonal trade by December 1994 and toestab- (possible) North American Free Trade Agreement lish a common extenal tariff that would guide (NAFrA)are considered the most formidable, other intnational trade between the member countries trading blocs, with different degrees of cohesion, are and the rest of the world.- Interestngly, MERCO- rapidly emerging. Among these, the Association of SUR groups the two largest countries in South Southeat Asian Nations (ASEAN),with Its dynamic America-Argentina and Brazi-wth two of the and aggressive members, Is especially promising, smallest (table S.12).v And there Is Uttle doubt that particularly ff the often-feared yn zone in the thefutureofMfERCOSUR dependsonthepoliclesof Pacific-Including Japan and the ASEANcoun- Argentina and Brazil. tries-takes shape in the next few years (see Schott But numbers do not capture some important 1991). re t economic developments that are likey to Some new trading blocs in the western hemi- affect the future of this agreement Argentina has sphere are now attracting increasing attention from tecently made subsbtntial pgress in macroeco- policy analysts. Among these are Mercado Com6n nonic stab3Utyand ptlvatlzaton, but Brazil has del Sur (MERCOSUR)and the Andean Pact, which faced economic and political problems. The recent jointly group nine Latin American countries and resignation of Pesident Femando Collor adds fur- have a volume of trade expected to approach $2SO ther uncertainty to the fture of Brazis rfom pro- billion a year by 2000. What makes this new inte- gams-particulaly the ability to control inflation. gration In Latin America particularly interestng is There is widespread agreement that many of the that it strongly favors export promotion and the troubles encountered by early integrationist expansioniof intemational trade throughout most attempts in latin Amedca during the 1960s and of the developing world. 1970s had their roots in the marked differences In

Table5.12 EconomkcIndecators for selectedLain Amerian counies, variousy'eas MERCOSUR AndemnPact Indkator ArgerOa Ora Parwguy U hkay Boft Cobmo Easador Aru Veneuua GDP,1992 (JSSmillon) 154,400 406,500 6,500 11,400 5,300 46,200 12,400 26,300 61,100 GNPper capita, 1992 (US$)8 4,160 2,940 1,410 2,840 680 1.300 1,060 1,080 2,920 GDPgrowth, 1980-92 (annualaverage, percent) 0.6 12 2.7 0.7 0.7 3.4 2.4 -0.7 2.1 Shareof manufuing InGDP,1992(percent) 22 22b 17 2S 16b 20b 21b - 16 Investnentratio, 1992 (percent) 17 19 24 13 16 18 20 16b 23 Merchandiseexports, 1992 (USSmillion) 12,000 36,200 920 1,700 600 7,300 3,000 3,500 14,000 Exportsgrowth, 198092' (annualaverage, percent) 3.5 7.1 7.2 4.2 3.4 5.7 5.0 -_gb 2.0 Totalextemal debt, 1992 (USSmillon) 66,500 118,700 1,800 5,200 4,200 16,700 12,300 21,000 33,700 Infation,1980-92d (annualaverage,pement) 341 373 23 63 170 25 38 287 22

-Not avaIlble. NotwAD 1992 dat areprelinraystimates. a.Cacuatd according to the W1 o* Aft method. b.1991daa c. Exportof goods and nonfacur sev h const pdc. d.Growth In GDP dedlatw, cmpO rat SourWoid Bank, Wld Dw n*eskqtw1993; VOdW Bk dat an stff tmates. 68 latIn Amet andthe Caribbean: ADecade fter the Debt Cris

macroeconomic perfomance, Incuding Inflatlon TlO 5.13 pots to MEIKOSURcounties a share of and exchange rate policdes.23 tot expo, 1992 The dirences In strategy for the speed and bai«e depth of pdvatizatlon and ttade refoim suggt that county o to s (mos ofdole) di-saements could easily erupt between Agentina AVpgn 17 2,100 and Brazil with r d to points dosely related to Btz 11 4,100 MERCOSURTh cuarent structure of protection fot P"agy 37 220 the members of MERCOSUR,discussed below, shows UnAW 34 540 that there may indeed be room for disarment IsIUimFdaS. Argentina has recently slashed tariffs considerably, reduced nontariff baiers, and eliminated epot Tabe .14 Percentageof ImportssubJecto free bade taxes. Meanwhile, Bril Is moving slower on the lb- In MERCOSUR,hme 1991to Decemnber1994 ealizatlon front Ote Perctage Intraregional trade Is significantly more impor- 94 47e tant for Agentina (with 17 percent of Its eWports Debert 54 going to MERCOSURcountries) than for Brazil,sug- June92 61 gesting that Argentina is bound to lose more if ,ec mb 92 675 MERCOSURIs aborted (table 5.13). This could give e93 82 Bral an edge In negodatons for polices toward lune94 89 third parties. If so, and if MERCOSURadopts rela- Decmbr 94 100 tivelyhigh common Import tariffs-with a range of s5wTdeatAfndn. 0 to 40 percent, coresponding to the Brzilan b erlzation taget-it is unlikely that Its members port, and facilitation of forign investment and cap- would gain in the long run. And, for Argentina, join- ital mobility within the Andean group.n ing a trade agreement with a Brazilian-levelcom- Notice thegreat heterogeneity among the coun- mon external tariff is likely to result In "trade tries in the region-in economic structure and in divetsion" that would more than offset any benefits macreconomic policy. Bolivia continues to move derved from trade creation,29 steadily towatd low inflation and pride stabity, but Two malindiferences from prevlous attempts at Peru continues to stuggle with macoeconomic ntegration immediately stand out In the expected management,and Venezuela is in a sort of macro- path of eliminating taffs for intraregional trade economic lmbo because of Its recent political criss. (table 5.14).30The automaticity in the integration Intareglonal trade has been somewhat limited by process within MI COSUR is very high. And the similar actor endowments aross these countries time fameforlntegration Issignficantlyshortet So, and by significant impediments-mainly adminis- even in an agreement dominated by a less than trative and commerial regulations and extremely enthusiastic Brazil, the rules for opening are quite poor land transportation systems. The low level of aggressve and dynamic But whether this ambitious intaregional trade suggests the posiblity of signif automatic intraregional liberalization progmm can icant trade diversion once the customs union is be sustained with Brazil's macroeconomic imbal- launched. Whether this happens largely depends on ances remains an open questlon. the level and structure of the common extenal tar- 1ff, a highly contvsial Issue that theatens the TheRevhIva oftheAndean Pact pact's future. The Andean Pact nations have a much more In November 1990, more than two decades after Its homogeneous structue of protecton than do the launc4, the Andean Pact was renewed by the MERCOSURcountries (see tables S.3and S.1S). But Presidents of Bolivia, Colombia, Ecuador, Peru and there sUllare important differences in the objectives Venezuela.31 The new agreement, the Aca de la Paz, of trade policy. While Bolivia and Peru have been established five ambitious tarets: a free trade zone pusuing aggressive free trade refons, Colombia by 1992, an ageement on the level and suucture of and Venezuelahave been significantly more protec- the common extenal taiff (CEI) by December tionist, arguing that higher tariffs are still needed to 1991, implementation of the CEI by December form a strong Industal base. More recently, Colom- 1995, the liberalization of maritime and air tans- bia has been more inclined to acceletate Its integra- TheOpoen of LatinAmeri 69

Table .S Exporb to AndeanPact counties a share way, the Individual pact members have proceeded of tottaleport 1992 with heierpolices. For eample, Colombiais mov- Pe.ntge VAN ig briskly toward negotiatng a biateral free trade Countsy of tot eot (noisofdaW agement with Mexico. Bolia 13 90 Colombia 13 920 7e Centrl Amrkan CommonMaret Ecuador 3 90 and the Caribba ComMmty Peru 8 270 Venewela 3 S10 -wP-- -~------Dudng the early and mld-1980s, the Cental Amer- Ican Common Market (CACM) begn to break tion into the rest of the world. But the diffens down, largey as a result of the debt cids. Most over commercial polides have already generated countries in the aea responded to the aisis by frictionamong the Actade la Paz sinatories, with imposingmassive nontaff bariers, Induding mul- Peru threatening to abandon the pact If the com- tiple exdcange tates. The most Important conse- mon extemal tuaIffs "excessively"protectionis33 quenceof this lnceaseIn protectionismwas that the In December1991, and In accordwith the Acta CentralAmerican Common Marketcommon exter- delaPaz,anewagreementwassignedbytheAndean maltadff became Irrelevantbecause the members Group's political authorities. The Aca de la Paz had differentimplict tardfs for impors from out- established free trade zones between Bolivia, side the region. In 1986, the Cental American Colombia,and Venezuelaon January 1, 1992,with Common Marketdied when the Cental Amedcan Ecuadorand Peru to join In July 1992.For the com- paymentsclearing mechanism collapsed.&" mon exteral tarlff,the Actof Barahonaestbshed In July 1991,and after seveal yearsof Indepen- an extremely cumbersomemechanism of excep- dently undertadkingtrade adjustments, the presi- tions for both countries and goods.The CERTis to dents of the Central Americannations revitalized have four levels(0, 5,10, and 15 percent),except for the Central American Common Market35 Three Bolivia,which would only have levelsof 5 and 10 important features of the new Central American percent. There also wereexceptions for agricultural CommonMarket areworth notng. ist, the agreed- goods, automoblles, and noncompetng regional on common externaltaiffis to rangebetween Sand products, where tariff leves are stll to be deter- 20 pecent, significmtlylower than the traditional mined. Rulesof originwere not determined,making tariff stucure In most CentralAmedcan countdes It possiblethat the lowest tariffs(those of Bolivia) and a clear move towardtrade liberalization(table willbecome the effectiveCEr for the region. 5.16). Second,the new CentralAmerican Common In May 1992, only a few months after the CET Marketincludes two morecountries: Panama, which agreement, the Andean Pact suffereda blow when never joinedthe originalagreement, and Honduras, Peru decidedunilaterally to suspendthe preferential which had withdrawnin 1969.Third, the members treatment grantedto Importsfrom within the pact- have actively promoted exports to diversifyand part of Its policy to forcea lowerCEr on the pact In increase them (see Saborio and Michalopoulos response,Colombia and Venezuelasuspended CEr 1992).Although it is stilltoo earlyto know how suc- negotiationswith Peru. It is too earlyto say whether cessul these schemes are, Saborio and Michalo- the lmpassewilldelaytheAndeanlntegationmove- poulos (1992) suggest that they have been very ment or kllit. With diplomaticnegotiations under cmstlyfrom a fiscalperwspective, without expanding

Table5.16 Tarff stcures In the Centrl Amican CommonMark, sected year, 19874S (percet) PrereAoem Aveagleg . Cuntry ovegff tarff 1987 1991ranWe 1993range 1995rge CostaRka S2 26 10-5 5-30 5-20 ElSahfador 48 23 S-35 S-25 5-20 Guatenab 50 25 5-37 5-20 5-20 Honduras 41 20 4-35 S-20 S-20 Nkcagua 54 21 5-20 5-20 5-20 a. AdvWan eqwvalmtofaged wetalai. SOO: Sb andMkhdopoulos 1992. 70 Lun Amen*wand the Calbbea A Deade fter the DebtCris

exors beyond what has been obtWned ftroug quently attempted, the share of Intrareonal trade more competitive real exchange rates. remained around 7 pernt, and tade flows remain The new Central American Common Market s a concentrated among the region's four more-indus- far cry fom the aement of the 1960s Tbday, Waltzed countres. instead of promoting forced industia on be- In Feuay 1991 the CAIUCOMheads of state hind protecdve walls, the counties are uniting to decided to rationalze the trade regime, reducing the compete internationally and to rapidly expand common extemal taiff band from 0 to 70 percent expotst down to O to 4S petcent. In October 1992 an addi- The attempts at commercial Integration among tional step toward Integration with the world econ- the very small and extrmely open Caribbean eco- omy was taken when CARICOMdecided to further nomles date back to the mid-1960s. In 1965, aicdes reduce the CETband to S to 20 percent over four to of a Caribbean Free Trade Association (CARWFA) five years. Although the pace of refom is slower were subscribed to by Antlgua, Barbados, and than that of the other recent reformers, this measure Guyan-and were ratfied thee years later by eight Is dearly putting the CARICOMnations on the path other Carbban countries (Dominks, Geada, of lbeization and outward orlentation. Jamaica, Montserat, St. Lucia, St. Kittsand Nevis, St Vincent, and Tdnidad and Tbbago).Belze joined the Medco and the North Amem aFree Thde Agremnt assocation only In 1971. The Caribbe Free Dade Asociation agreement Immediately freed most of As in most of Latin America, protedonism and thetradeamongmembercountriesfromImportand Inward orientation characterized Mexico's trade pol- export duties and from nontariff barrers (see Icy for decades. But sartingin late 1985, as part of a dwards and Savastano 1988). A five-yearschedule major strucural adjustment plan, Mexico embarked for elntingintrarg gonaltariffi was designed for on an ambitious unilateral trade liberalization pro- the few Import-substituting products exempt from gram. Impor tadffs were halved, and import license the regulation. But the agreement did not consider coverage was reduced from 92 to 20 percent. a common extenal tariff. After almost a decade of Intensive, and often Intrareglonal trade increased signficantly after confrontational, trade negotiations, the United the establisent of the Carbben Fee Trade States and Mexdco agreed In November 1990 to Association, ring from 7.8 to 11 percent between move toward a free trade agreement. In February 1967 and 1973. But gains from integration favoted 1991, Canada, Mexco, and the United States started the more developed oountries of the agreement, negotiating a North American Free Tade Agree- which accounted for more than 90 percent of ment, and later that year the U.S.Congress approved intraregional trade. Given this asymetry in the dis- fast ttack treatment for the agreement. On August tdbution of benefits, the less-developedcountries of 12,1992, the three parties announced that an agree- the Carlbbean Free Trade Assition pressed for ment had been reached on the exact nature of the broader integration to give them more favorable proposed agreement. treatment. Responding to their concerns, the Both the US. and Mexdcannegotiators originally Carbbean Community (CARICOMwas established expected that the U.S. government would submit in August 1973. Its objectives went beyond com- the agreement to Congress in the summer of 1992. mnercialintegration to the harmoniation of mone- But US. politics-and some deep disagreements tay and fiscal policies and the creation of planning over details of the agreement-have delayed its sub- agendes for agdcultual and industi develop- mlssion to Congress until late 1993. The three most ment. In addition, a common exernal tariff was Important areas of contention have been: defining established for Imports from nonmember countrles. rules of orliln for specificproducts, incduding auto- Despite the almost immediate adopton of the com- mobiles; establishing the nrles for agricultural trade; mon external tariff, the oil shock prompted protec- and assuring envlronmental and labor protection. tionist responses-In the form of resticdve Import Of these, perhaps the most important problem is licensng-from Guyana and JamacL This action defing mles of origin. The final agreement estab- not only reduced intaregional trade-Its share in Ashes that, for motor vehicles to be subject to free total trade dropped to 8 percent In 1975 and 7 per- trade within NAFIA, their regional value added cent in 1976-it provoked antagonism and etalla- should initially be at least 50 percent. This figure, tory responses frm other CARICOM membets, however, will Increase slowly for a period of eight Although some conciliatory measures were subse- yes until It reaches 62.5 percent. For most agricul- TheOpening ofiObih Amedo 71 tuat Items, the agreementpoposes a veryslow tar- the Oranzation for Economic Cooperation and iff eliminationover 15 years PresidentBill Clinton IDevelopment(OECD) also underlieMexico's vision has pointed out that, as long as some aborand envi- of freertade as a fundamentalpart of Its national ronmental issuesate addressed,he wHlisupport the devebpment strategyfor the next decades.But for agreement R is too earlyto know,however, whether this policyto tuanslateinto futher gains In produc- the US. Congresswlll ratifythe agreement tivityand welfae, Mexdcowill haveto furtherreduce As Nogu4sand Quntanilla (1992) argue, the tariffs and licensecoverge-and broaden the re- heavy media coverageof NAFrAnegotiations has ormsto all areasof the economy,espedally agricdl- overshadowed the broader commitment by the ture. AlthoughMexdco has come a long way,it still Mexican governent toward freer trade. Afterbe- has a long road to a protecive structure similarto cominga memberof GATrin 1986,Mexico has con- that of Its most important trade partners. sistently and systematicallypursued freer trade Many Latin AmetIcan leaders hope that the polides. This is reflectedin the reductionin trade Implementadonof NAFrAwll} open the door to imlpediments,in the signingof bilateraltrade agree- other bilateralfree trade agreementsbetween Latin ments with Chile (in 1991),and in the urent dis- Amerian nations and the United States.Chile has cussions to sign free trade agreements with for some time been lobbying to this effect and is Venezuela(in 1993),Colombia, and CentralAmer- likelyto be the firstSouth American country to sign lca.The recent negotiationsto becomea memberof ts type of agreement 72 LoWnAmera and the Cibbeara. ADecade after the Debt Crsls

A_pendix rate of growth of world total factor productivity ProductivityGrowth a" Connsdhl Pol: (that is At. A.e. , Is a parameter between zero An o c ANy andonethatmeasuresthecountty'sabilitytoabsotb ptoductivity Imp ents originating fom the Seveal reseahers have found that fctot accumu- test of the world and Is assumedto be a negative latlon eplains betweenhalf and two-thirdsof long- functionof the levelof trade distortionsIn the econ- mn gowth (Flsche 1988).The lage unexplained omy (8): residual in gowth accountlng exeses has been attruted to "technological progresst or ">puc- P (8); ' < 0, (5A2) tvitty gains."From a policy ppective, a key ques- tion is what determnes these productivity where 8 is an Wo of trade distorions that akes a Improvements. In particulaa,It is Important to higher value when internationaltrade-n Imports undestand whether national domestic polices- or exports-becomesmore distorted. Induding financial and trade policies-can affect Parametera is the basicrate of domesticproduc- the pace of productivity rowth. If so, policmakers tivity growth or Innovation,which for simplicityIs willhave moredegrees of feedom to pursueavenues assumedto be exogenous.On the other hand, (y(At- that will enhancelong-run performance.w AYA) is the catch-up tetm that says that domestic The recent Interest In -endogenous' growth productivitygrowth wfllbe fasterin nations whose models has revivedapplied research on the determi- stockof knowledgelags further behind the world's nants of grwth. Someauthors have emphasized the accumulatedstock of appropriableknowledge. 37 role of openness In determiningthe pace at whkh In this setting, the time path of domestictotal countries can absorb technologicalprogress from factorproductivity Is:- the rest of the world(Grosan and Helpman1991). Edwards(1992c), for example,has recenty assumed A = . (1, ) A; e4"+ (SA.3) that there are two sourcesof total factor productiv- L. + a Ity (MTP)growth: a purelydomestic source stemming ) fom local technological Improvements(innova- + oe ton), and a foreignsource related to the absorpton of Inventionsgenerated In other nations (Imitation). Itfoiows fromequation SA.3that the long-runrate More spefically, assumethat a countrys abllty to of growth of domestictotal factor productivitywill appropriateworld technicalInnovations (or to imi- depend on whether (-oa-3ow)> 0. If (y-a-fr) > 0, tate) dependson the openness of the economy (v), totalfactor productivityIn the steadystate will grow and on the gap between the countrys total factor at the rate of world productivity,03 This means that productivityand vthe world's stockof total factor the levelof domestictotal factor productivity(and productivity. The first channel Is the -openness of GDP)wil be a function of the trade intervention, effectediscussed by Lewis(1955): more open coun- with higher trade distortionsresultlng in lower real tries have an advantageIn absorbingnew ideasgen- income.A key Implication of this resultIs that coun- eratedin the restof the world.In this context "more triesthat engageIn trade Iberalizationprograms will open' shoid be interpretedas refeing to a less-dis- be characterized,during the transition betweentwo torted foreipgtrade sector The secondchannel is a steadystates, by higher ratesof productivitygrowth 'catch-up' effect,common to growthmodels based and thus by fasterGDP growth. on notions of "convergence." Asecond case appears when (y-a-pn) < 0. Long- If the aegate productionfunction isdefined as run total factor productivity growth (8A) will yt = A((K,44 total factor productivityIs At =yt I() depend on how large the world'srate of growth of and total productivitygrowth is (A/A). The role of tol factorproductivity (c) is relativeto the domes- the two sources of technical progress discussed tic rate of productivityImprovement If o > (a- above-Innovation and Imitation-can be captured 8)/(l-f), domestictotal factor productivity will grow by the followingsimple expression: In the steadystate at the world rate co.If, however,ec <(a-0I(l-,, and (y-a-pw) < 0, the long-runequi- A . 4A~-A'-A librum rate of total factor productivitygrowth will _= a + + 1 A (A5A.1) be equalto (a+>O-8) and will depend negatively on 8, the country'slevel of trade distortions.39That is, wherea and yare parameters,Ais the levelof world more open countries(those with a low 8) wil grow (appropriable)toal factor productivity,and tois the fasterduring a steady-stateequilibrium because the TheOpening of LatinAmera 73

domestic source of technological Inventions Is raw data from the IM. strong enouh to drive, even In the steady state, the o Catch-upWm. Following the recent literature aggregate rate of technological Innovations.40 on endogenous growth (Barro 1991; Edwards The model developed above sgets that total 1992c), Inital GDP per capita-for 1971 in thls factor ptoductivity growth depends on trade distor- case-was used as a measure of the gap between the tions in the economy-and on a catch-up term that countrys level of productivity and that of the world. measuresthe gap between the countrys and "the This variableis denoted as GDP 1971,and the data world's" level of productivity. More specifically, are from Summersand Heston (1988).The coeffi- equationsof the followingtype can be estimated: dent of this varable is expectedto be negative. * Humancapital. Two Indicesare used. The first PI = be+ 018. -.. b29 +Yanxv F r,, (SA.4) Is the attainment of secondaryeducation In 1981, and the secondis the Increasein secondaryeduca- wherepn Is the averagerate of growth of total factor tion coveragebetween 1961 and 1981.When alter- productivityin country n, 8; is, as before,an index native indices, such as secondary and higher of trade distortions,g, is the catch-upterm, the x,'s education,were used, the results were not altered. are other possibledeterminants of total factor pfo- Thedata wereobtained from the WorldBank's World ductivitygrowth, and tt is an error term. DevelopmentReport 1993. The coefficientof tfis vari- Barro(1991), Edwards (1992c), and Roubiniand able is expectedto be positive. Sala-i-Martin(1992), among others, have suggested * 7he roleofgovemment This index is definedas that in addition to openness,four factorswill affect the share of government over GDP, taken from productivitygrowth human capital, usualy mea- Summersand Heston (1988). Barro (1991) argues sured by schooling attainment; the Importanceof that this coefficientshould be negative, capturing governmentin the economy measuredby the ratio the effectthat increasedgovernment activities tend, of governmentexpenditure to GDP;the degreeof in general,to crowdout the privatesector. political instability;and the Inflation rate. In the * Politdcalnstblity.This variable was definedas estimationsof equation SA.4reported above,these the averageperceived probability of govenmment variableshave been incorporatedas possibledeter- dhange, obtained from Cukierman,Edwards, and minants of productivity growth. Variableswere TabelLnl(1992).41 Its coefficientIn the total factor defined In the followingway: productivitygrowth equations Is expectd to be neg- - Total factor productivitygrowth. A problem ative, reflectingthat in politicallyunstable sinta- faced in the estimationof equationsof the type of tions econornic agents do not devote their full SA.4refers to the measurementof total factor pro- energiesto economicobjectives. ductivity growth. In particular, it is difficult to * Inflatlontax. This variablewas defined as the obtain long time seriesof capital stocks for a large averagecollection of inflation tax for 1971-82 and numberof countries.This appendix uses three mea- computedas wm,where a is the rate of Inflationand suresof total factorproductivity growth constructed isthe ratio of MI to GDP.The coefficientof this varn- by Edwards(1992c). able is expectedto be negative,reflecting the effects * rade distortions.Traditionally, studies that of higher inflation on uncertainty and economic have investigated the relationship between trade activity. policy and economic performancehave had diffi- TablesSA. 1 and SA.2summarize the resultsfrom cultiesmeasuring trade distortions.This problem is the estimationof severalversions of equation SA.4. taclded by using two variables.The first proxy for Table SA.1 contains weighted least-squaresesti- trade distortionsin most of the basicestimates is the mates-with population in 1971 as weight-for all ratio of total taxes on foreigntrade-import tariffs three measuresof total factorproductivity growth.4 plus export taxes-over total trade, measuredas an Table SA.2presents instrumental variablesregres- averagefor 1971-82.Because this variable,denoted sionsfor the TFP1defuiition of productivitygrowth TAXTRADE,measures the "true" extent of trade dis- (when the other two indices wereused, the results tortions with error, an instrumental variabletech- werenot alteredsignificantly). nique that tries to correctfor measurementerror is Ascan be seen from these tables, the resultsare also used in the estmation of the total factor pro- highly satisfactory.Almost every coefficient has the ductivitygrowth equation.The secondproxy Is the expectedsign and Is significantat conventionallev- 197142 averagetrade dependencyratio-imports els. Particularlyimportant for the discussionin this plus exports as a percentage of GDP.These two chapter is that in every regressionthe proxiesfor indices of trade distortions were constructedwith trade distortionsand openness are highly signifi- 74 LatInAmeico and the Cabbeon:A Decadeafter the DebtCris

Tabe SA.1 Totalfactor productlvlty Cross-cowntryresults DeffNon of Equat1 I Equatfon2 EqutIon3 Eqaton 4 EquionS Equation6 TFPgmowth TFPI TFP1 FP2 TFP2 TFP3 TFP3 Constat -0.013 -0.012 -0.018 -0.00S 0.074 0.030 (-1.041) (-1.326) (-1.418) (-0.439) (6.163) (1.772) GDP1971 -1.85SE-06 -728EQ7 .E-t06 -t.0-06 -3.69E-0 -1.48E-06 (-SI433) (1.929) (-2.960) (2.451) (-3.673) (-2.187) TAXTRADE -0.076 - -0.074 - -0.199 - (-3.033) (-2.620) (-4.902) Tradedependency - O.017 - 0.025 - 0.025 (3.147) (3.910) (2.480) Govemment -6.14E-04 -4.20E-04 -6.SOE-04 -4.110E-04 -2.0OE-03 -2.OOE-03 (-2.429) (-1.708) (-2'92) (-1.433) (-s.1S7) (-4.827) Education 1.19E-04 1-56E-07 S.9E-06 1.30E44 - 1.20E-04 (11536) (2.130) (0.67S) (1.560 (0.895) A Education - - - - 1.60E-04 - (1.453) PoitkaicInstbility -0.017 -0.017 -0.026 -0.043 -0.014 -0.023 (-2.117) (-2.480) (-2.846) (-5.253) (-1.670) (-1.802) nflationtax - 8.3E-05 - .8E-0S - -2.7E-05 (0.540) (0.487) (0.921) .2 0.400 0.351 0.492 0.487 0.598 0.416 N 54 52 54 52 52 52 Notet-zdsfts areIn parentheses; N I thenumber at obrvatons R2 sthe codficent of detminauton. See Edwads 1992c for a 1stof the countue consideredinthis rgrsion. a.For exact explanatIons onhow TFP1, TFPZ and TFP3 were coatucted, see Edwards 192c. Sou, Edwards192c. TableSA.2 Totalfactor productMtygrowth regressins As pointed out above, both the TAXTRADEcoef- (instrumentalvadables; dependent variable TFP1) ficdentand the trade dependency ratio are imperfect Equoti Epobn 8 proxies of trade ditortions. In partlcular, they do Constant 0.036 0o50 not capture directly the role of quantitative restric- (1.689) (2.037) tions on trade. To deal with this measurement error GOP1971 -3.4E-06 -3.7E-06 problem, Instrumental variable versions of some of (-Z.766) (-2.677) these equations were also esimated. In reestimating TAXTRADE -0.171 -0.185 equations SAA1and 5A.3 the trade penetration ratio (-2.432) (-2.M14) of imports to GDP was used as an Instrument for Govemment -4.9E04 -s.E04 TAXTRADE44 The results,presented in table SA.Z (-1708) (-22) confim those disssed previously and provide Education 3.00E-05 ~~4.80E-05 (2.130) (0.675) additional support for the view that, after control- PoliticalInstability -0.029 -0.040 ling for other factors, countrieswith more open and (-2.333) (-2.823) less distorted foreign trade sectors have tended to Infltion tax -8.1E-05 -2.SE-05 exhibit faster growth of total factor productivity (0.766) (0.939) over the long run than nations with a more distorted R2 0.248 0.392 external sector. N 52 52 NoWt-statistic are In pareths N t th nber ofobservadons 32 I thecoeficidt of determIatn. The foowing Instruments were used: a COstl, GDP71,gomMt e*ducation,trade d,mder yp, orts 1. Aswas dsuwed In some deti Inchapter 3, mostautho GOPratio, politkal hstabt d irfationtax. These eqtapfltdlO e8 ageethat the ImportSubsiution process rapidly ran hnt difficul- weiWh bypopulaton In 1971. tiesonce kwbchnoog consumegoods had been wsubstltuted. Sme Edwvads1992c. Ascountries td to movetowards produdng more sophistated goods-inducingcapital goods and machinery-they faced an cant. Moreover, the computation of standadized Iasigy uphOIbanle SeeHh n 1968and Flshlow1985. beta coefficients indicates that trade impediments Asosee the dscsion in cdpter 8 arethe secondmost Important explanatory variable 2. Thisamounts to the kPrtant textbooknotion that free trade increasesthe level of domesticwelfare, but modem of total factor producvity growth, after the catch- apOpahesgo beond ts go&land aboconider the accelation up term. of grwth asa goalof tradepoliy. SeeEdwards 1992c. The C'peg of Loth Ame.*e 75

3. Tradlionalneodassica growth models canc ad on the Colombia, Costa Rica,the Dominican Repulic, El Salador, effet of naionaleconomic poli on the kLlof Incomeper capi- Guateala Honduras Mexiod,Nlwagua, Pam, Pru Ungu8% ta The newgeneration of endogenousgrwth mode hassfed and nezuela.Habger (1992) pents dat on TFFPgro attetion to the relationshipbetween poliies and the econoTm bebfoeand alfer a win of tadeform eples, find ingin rateof growth.See Lucas 1988. am th p grhxoeed _ the be _ 4. In chpt 17 of his Pndplksof Polmit 6conom(1864), 16. It can be arguedhow_e, ta muh of the Inmse In MIl saidthat a countryta producs for a lg mkt tan Ils Chls TFPgrowth has been the resultof th cd fe structural own can Introducea more extendeddiviion of labor,can make eformpaaemplemnwted ther greateruse of machiner,and Is more likely to makeInetion and 17. fn asees of recentstuies, Ocamo (1991b)has calculsat- Improveents in the proc of production*Arthur Lels nmaesa ed totadfactor pductvity growthIn ColWmbi findig tt e similarpropositio in be classicbook on economicgrowth (Lewis nreae In protcolusm I 19824S wusaOcomanid by a sap 1955). dedinein productiitygrowth. S. SeeTybout1992forageneralsurveyonemplricalmndelson 18. But, according to Harberger's data, TFPgrowth In he relationshipbetween trade orientation and the growthof total 1986490exceeds e vel for immeite posti msThe aclu- bctor producHty.Also see Edwards 1992c and De Gregodo 1992. af TFPgrowth numberscalculated by Harbergerare 3.8 for 6. Lai (1985)presents a dissentingview. Hanson (1992) has !50-60, 3.9 for 1960-7S,-2S for 197S582,-8 for 1982468 arguedthat undersome ciumstances the capitalaccount shdd ud 0.8 for 1986-90.An importn di_frencebetween the Mattn be liberalized early on. Seechapter 7 for a discussionof the rd Harbergercop osk that Halbergerdoes not corect for sequencingof finncial reform, diernt degreesof capadtywe. 7. Thiswould be the caseIf the capial accountis openedIn 19. Saoeoeres asset thatthe tlmingps will talkefi the contextof an overallilberalatlon program,whre the country to ten yeas. becomesattractive for foreignInvestors and specuato 20. Becausethese figures come fom two diffrent souces 8. Thisdiscussion is reltd to second-bestwaysis of poliy theymay not be fuly compabl and ths suid be i_tepreted asures. SeeEdwards 1992b for a formalmultisector model to withcam. anayzethe wefare cnequences of alterative reformpages. 21. Tradeiberalitlon aiks at inaeasinga conty's totalvol- 9. Theseunwe(ghted aveges arenot conparableto thoseIn umeof tade tnd texdboo onds it i expectedtt trade table5.1. Thee hasbeen a long discussionin appliedintermatonal wil be balaced at the end of the rfm But thereare circuro trade theory on whether tariffsand nontarff barriersshould be stances,hcludhg the needto pay the counts foreign debt measuredas weighted or unweightedaverges. Both views have n wkhh radewil not grow In a balnced wayaft a refon. meritsand limtatons. An obviousproblem of the weightedaver- Thishas been the tmein mostLatin Aneran coun_ies age(where the weightsare the importshares) i Vmoretbat restric 22. Thisremains controversi. Sme SUthorS(for example, tive distorionstend to havea verysmaii weight. In the exteme Sahs 1987)have pointed to the Koreanexperince to suggestthat case,probitive tariffsthat effecivelyban the importof a patko- govemmentpolices in supportof exportscan be beneficial.For a lar item will havea zeroweightf Cordon(1966) pmvides an eary brW acount of the Kon experee seedcpter 3. andstill highlyrelevant discussion of theseisues. 23. In addion, the reductonIn intera demandcoudd hae 10. Theissue of protectn localproducers from dumping Is unleaed the recentrapid grwth In export ImportantIn the designof the new liberalizedtrade regimes. The 24. AnImportant peculiary of the Colombiancase Is that the crudal problemIs to enactlegilation that can distinguishtrue original Inflow of foreign exchangecame through the tade caes of unfairtrade pracicesfrom simpleases of Increasedfor- account. eign competition stemming from more efficient productive 2S. Morespecifically, the om-41t iftonay goal will be processes.At this time, the approvalof a dynamk and flexible postponedwth thisopon antidumpinglegislation should be high on the region'sagenda for 26. The legaldocument that setsthe basisfor MERCOSURIs legaland institutional reform. the Asundn Treaty,which has Its origins In an Integrationact 11. Theterm "tariffs"is someties misbleadnbecaue many signedbetween Argentina and BrazilIn 1986. New acts were countrieshave traditonally reliedon both importduties (that is, signedbebween these twvo cuies in 1989and 1990. For detai tariffs proper) and Import duty surchargesor paratariffs.See seeNogu6s and Qulntf 1992. Harberger1992 for a discussionon the mechanicsof reducing 27. Chle, whichwas invited to join but declined,is movig uneventadffs. bridsytoward Integration with Argtina through the signingof 12. Thissystem with verylow (or zero)tariffs on intermet biera agreements Inputsand high tariffson final goodsgenerated very high efctWve 28. Baldineill(991) dbcussessome of the most Impormnt ratesof pJtedtion or protectionto domesticvalue added. In recnt ma n--economicpogdes in the MERCOSURcounbe years,some autors haveargued that effeciveprotection Is mis- 29. Thehgher the commonexrnal tWiff,the more iklelyit is leading.1rpe reason is thateffectve rates of protectioncannot pro- that a customsunion wvi havenet negatv welfare fes on its videmuch infoamuaon on the generalequlilbrium consequencs of membersTe reasonis that In this casethere wil be addtonal tariffcharges (Dixit 1986).DespIte this, effective rates of poection trade diversion.Commodities that, at the original tarwff,were arestill useful,since they provide an Indkationof the "InWeflcy Importedfrom the leas expensivesource will be Importedfiwn a a countryis wllilngto acceptfor a sector. less fdRentregional member. On tradecation ad tradediver- 13. Somecountries, notabl Brazil,alle, and Colwm ox- sion see,for example,Donbuch 1989b.Notke, howewer,that perimentedwith cawing pegsas early as the 1960s.But only GATrdoes not aliowfor a connon tif exceedingthe mnte's Colombiarnalntained a regimethat avoidedreal exchange rate averagebefore the unin. It isundear, however, whether this prova- overvaluation. sin canbe eorced. 14. See,Corbo,Condon, and de Meo 1985 for a detailed 30. On pastattempts at integrationIn Latin A ica, see micaoeconmic wountof ac4usunent for a largegroup of Chlean Edwardsand Savastano 1988. manufactuingfirms. 31. Chik, anorlignal signatory of the Pact,decined to partd 1S. The originaiTFP growth data comefrom Martin's1992 pate. studyon sourcesof growthin Latn Anica. Thecountries in table 32. Nogus andQnt (1992)prode detaledaount SA initiatedthe reform before1988. To computesers on TFP of the Actade i PaL growth, Martin (992) analped the contrbutionsof capila and 33. The new politicaldeveopnts in Peu, espel te lbor andexpWtiy incorporatedchanges in capitaluse. The coun- Fu4lmw"coup," add cosdeae uncrta to the intation tres consideredin Martin'sstud aAgenna,ae Boivia,Chile, procs. 76 LatinAmea and theCaribbean: A Deade afterthe DebtCO*i

34. hi collapsewas prtilly the resu of Ncaagtasaccu- noogi progress,it Is alsopossible under some circumsans, uatWonofvery We debt SeeSaboro and NOchaopoulos1992. thatmove open econonle wil ehbit higherlongn rowth. 3S.The detaIls of theagreeet appearin te Dedltion of 41. lheseauhors computed i ndexfom a probitanalysis SanSvador, uly17, 1991. ongoverent dcange uingpoed datafor 1948-81. 36. Thisappenix Is based on Edwards 1992c 42 Insimple ordinay least squres estimnat hetrosedusd- 37. It s assumedth not all nventonsgenerated In the ty wasdetected. Danm (991) andEdwards (992c), amongothers, word canbe freey approprded. thatsen A couldbe inter alo useweihted least aes Inequatons of thisMme. pretedas the accumulatedstock of InnovationsIn the more 43. In equationI te stndardikedbeta coefident of TAX- advancedouns tht hWavespled over to therest of thewod. TRADEIs-O.75; that of GDP 1971 is -0.78. Habger (1959)proides an eat dwision ang the nesdls- 44. Theinstruments tmlves don'thave to be meaured ussedhete. . fee of emr. of course,the use of instruntal varablesIsnot the 38 Thi of cours,is e sotion to dfferent equatonSA.1. onlyway of dealingwith mes ument er. Edwards(1992c) used 39. in thiscase, ( - oJm rweversedregrssions to constructnteals for a d_ifnt proxyof 40. inCromn andHelpmnan's (990) mio modelof tech. open# Insandard grobt equatos Chapter six Privatization and Deregulation

Long before the 1980s, Latin American countries The srge In privatization In the late 1980s was a embarked on Isolated attempts to Introduce some response to economic, political, and financald fac- market forces Into their highly controlled economic tors. In some countties, policymakers saw privatiza- systems. The Alessandri administration In Chile In tion as a way to achieve fiscal equilibrum. The sale the late 1950s and the modemnizationeffort led by of publicly owned entpises generated cash and Krieger-Vassena inArgentina during the 1960swere reduced the need to finance their losses. It was two interludes of reduced regulation. But what dis- argued also that the divestiture of publicly owned tinguishes these early episodes from today's struc- firms would lead to increases in efficiency and pro- ural reforms is that they made no efforts to ductivity growth. And the rapid sale of public enter- privatize government-owned firms.1 And during prises toa large and diverse group of new owners was some episodes-such as the Alessandri reforms in seen as a way of ensuring a sustainable reduction in Chile in 1958-64-the promotion of market forces the size of the public sector even went hand in hand with Initiatives to increase The WorldBank did much to enoumrageand sup- the state's role as a producer.2 port the privatization effort after 1987. Bank adjust- Today's emphasis on privatization, part of the ment loans increasingly incduded substantial new vision of economic development discussed in divestitures of public property as conditions for chapter 3, began to gain great force in the late 1980s, releasing funds. And Bank technical assistance setting it apart from previous efforts. More than any helped countries to Implement the details of their other policy,privatzation is changng the economic privatization prgrams-and perhaps more impor- landscape in Latin America.Between 1985 and 1992, tant, to put together modem and efficientregulatory more than 2,000 publicly owned finrs-including frameworks. public utilities, banks, irsurance companies, high- Policymakers in Latin America, as wel as in ways, ports, airlines, and retail shops-were priva- Eastern Europe and other parts of the world, have tized.3 Despite hesitation in Bolivia, BraZil, and rapidly discovered that sucCessful privatization Uruguay, the process continues to move strongly processesrequire major legislativerefomL Needed in throughout most of the region.4 The initial force particular are profound regulation reforms that behind it is the expansion of secondary markets for encourage competition, curb abuses in the newly Latin American foreign debt In Chile and Argen- privatzed sectors, and regulate privaffzed monopo- tina, a large part of the privatization deals Involving lies.And under the new market-oriented system, tra- foreigers has been parly financed with debt-equity ditional labor market regulations become out of swaps.5 date, imposing a heavy burden on the economyand The focus on massive p.ivatization appeared late on the poorer segments of society. in the efforts to tackle the debt crisis, and a clear The pace of privatzation has varied In Chie and reflection of its minor role ealty on is that the word Mex!co, about 90 percent of the state-owned enter- "privatization" is not mentioned even once In the prises have already been divested. In Bolivia and subject index in the pioneer collection, edited by Ecuador the process has been much slower, and In Jeffrey Sachs in 1989, of papers ataconferencein late Uruguay, the process has recently run into difficul- 1987. A mere two years later, the situation had re- ties. Interestingly, both Chfie and Mexico have vered. In the volume edited by John 'Iliamson in maintained control of the largest state-owned enter- 1990, for a confeece In late 1989, the sb ject index pses-CODELCO in Chile and PEMEXin Mexico- for privatization issues covers almost a fu page. partly for historical and political reasons. The

77 78 LatinAme candthe Cagbbea ADecadeaf the DebtCdss

nationalizationof oil was such a pivotalmoment in efficientway of dealingwiti externatlies, partlcu- Mexico'shistory that even a eformmorlentedleader larlynatual monopoliesand oligopolles.ft wasgen- such as PresidentCalos Salnas finds It difficultto emilyseen as a way to servethe public interestand overtum. The same is true for CODELCOIn Chile. advancesocdal oectives, such as broadlyproviding The nationalizon of the lage copper mines was someservices at low prices.And it wasthought that decidedIn 1971bya historicvote by both chmbers a large publc sectorwould reducethe vulnerabllity of the Chllean congress.Table 6.1 providessome of the economyto extemal shocks.In many cases, geneal data on the nitude of the privatzation the enthusiasm for a large state-ownedenterprise effort In selectedcountries. Table 6.2 presentsa list sectorwas relatedto national securityand strongly of some of the recent large (over$100 million)pti- supportedby the localarmed fores (Fishlow1989). vatizatlontransactions In LatinAmedca. Moreover,In Allende'sChile and AlanGarda's Peru, the creationof a dominantpublic sectorbecame the Anmtki3 bsu ansd Polky Optois central tool In effortsto build a socialist-oriented soclety Bythe mid- to late 1970s,the state-owned Throughoutmost of LatinAmerica, the Importance enterprisehad movedbeyond the strategicsectors, of staft-owned enterpdses (SOEs)grew steadily and most countriesowned firms In Industriesthat betweenthe 1950sand early 1980s-a fundamental werecompetitive and functioningefficiently. 7 prt of the stutuast ideologyand Import substi- In almost every country, the growth of state- Wion developmentstte Thiswas consdered an owned enterprse was accompaniedby massivereg- Table6.1 Pdva m insdecud LadnAaken ulatory legislationseverely restdcting the freedom swnuls 19>9 of the private sectot The authorities tightly con- Number"e Ofwof trolled entry and exit into certain industries,regu- Num,-berf PSRlPO- total lated prices and quantilties, and subjected the

Cam"b o esphdze creation of new finns to endless bureaucracy (see De Argent-n - 45 is Soto 1986).The financialsector was submitted to Bra 42 6 particulatly serious restrictions that affected the allbo- ChNe 501 96 cationof credltand the interest ratespaid to depos- MeXIco 1,001 87 itors and chargedto borrowers.Labor relations also Veneul 77 62 became increasingly igid, reducing the competi- a. or dat 7mwe for19741. fveness of the region's labor force and impeding $eWmoM U dAL Tabe6.2 P*svatztlontanacio eceding $100mUilSon 1988-91 Grmnsaction value Sale Coty Entrpse Date (mUons of dollars) technique' Sector Mexico Bsancom 10/91 2,5S0 Prvate offer Banking Mexco i_name 9/91 Z300 Prvate offer Banking Venebuea CANTV 11/91 1,885 Prvate offer Telecommunications Mexico Telmx 12/90 1,760 Privateoffer Telecommunications gral Usimlnas 12/91 1,430 Privateoffer Steel Meo Mexican de Cobre 10/88 1,360 Privateoffer Mining Aua ENTed 11/90 1,244 Privateoffer Telecommunications Mexco CWaanea 9/90 475 Pivate offer Mining eio Auovas de Mexico 11/88 339 Privateoffer Airline Argetna AernAgentsnas 4/90 260 Privateoffer Airline Mexico Ban Corie 6/91 248 Privateoffer Banking Mexico Mutbnc Mercanli 6/91 204 Private offer Banking Mexio lanas 6/91 182 Private offer Bankirng Mexico Skartia 1 11/91 170 Private offer Steel Chle Compafia de Tdfonos 1/88 170 Privateoffer Telecommunications Mexico SidekmexNoith 11/91 145 Private offer Steel Venezuela VlASA 9/91 14S Privateoffer Airline Mdexio Mexicans deoAv6n 6/89 140 Privateoffer Aililne Onagl Aracruz 5/88 130 Publicoffer Pulp and paper Meo NikkoHotel 10/88 110 P*rateer Hotel Mexio Tere hsMexkanos 11/88 106 Privateoffer Chemical Coombia Papel"l 8/90 100 PrivateofFer Pulp and paper a. Does not KIud. sles susequetfst t shton{ (uch as empyee offers, intenatmi Public offers)or debt.quity swap compoents. Saw= Nu Nds, andSwlg 1992. Piatizatfonand Deregulfton 79

employment creation. The effort to regulate and The massive privatizatlon presented gigantic control a very broad range of private activities challenges to the region's govetnments They had to stemmed from an atavic distrust of markets and dedde which enterprises to sell, how to sell them competition. With their traditional structuralist (cash or credit), who to sell them to (locals or for- tnkin policymakers throughout most of latin elgnets), and whether to restructure them before America saw market failues everywhere They also putting them on the market. Perhaps the most dfffi- thought that by regulating labor markets it was pos- cult task, and one not always tackled, was the cre- sible to shield the poor from the vagaries of cyclical ation of a new regulatory framework for a private fluctuations. sector getting rapidly involved in areas previously A major shortcoming of this thinking was the restricted to government. inability to confront the costs of massive regula- A critcal first issue was distinguishing between tion-including 'government failures" and the sectors that can be self-regulated-those character- encouragement of outright corruption. Another was ized by open competition or at least contestability- not realizing that overregulation landed large gains and those that require active govenment to small groups that were able to drcumvent the eg- regulafton. Most privatfzed firms fall in the first cat- ulatory maze and obtain industrial licenses and egory, but a small and very Important group of import permits. Rather than increasedefficiency and industries, including utilities and the financial sec- equity, the result was corruption, increased income tor, work more effidently when subject to a modern Inequality, a growing underground economy, a regulatory framework. It is difficult to build a foun- lethargic public sector, and an antiquated private dation for developing regulations that credibly com- sector motivated by rent-seeking.6 mit the govenment to not expropriate the private By the mid-1980s, state-owned enterprises in sector's newly acquired assets-particularly from most counties were incurring heavy losses that utilities (Spiller 1992). And given the less than fueled inflation, burdened public finances, and com- sophisticated institutional setting, most countries promised the provision of services. The debt aisis have had to design regulations that deal with exter- made evident the cost and ineffective uses of the naUities transparently and keep transaction costs overregulatory path: despite structuralist rhetoric, down. This has been espedally difficult in the finan- the mammoth public sector and sweeping regula- cial sector, where extenalUties often stem from tlons did not shield Latin American economies fiom asymmetric information and where moral hazard major extnal shocks. and adverse selection are pervasive (Stiglitz 1993). Facedwith the urgent need to taclde massive fis- Central to the design of the new regulatory cal imbalances In the late 1980s, policymakers saw framework is the role of the state in the develop- the sale of publicly owned assets as a natual source ment. A serious statement of this role should not be of liquid resources in the short run. And many sup- based on simplistic dichotomous choices-full inter- porters of the reform argued that rapid privatization vention or no intervention. Instead, It should deal would provide some political foundations for the with the nature, scope, and quality of intervention. economic transformation, with the broad distribu- tion of shares to the population creating thousands Prh*aon of supporters of the new economic system (Hachette and Luders 1992). Initlally, however, the privatiza- When the early Latin American reformers embarked tion ran into serious political opposition: groups on their pdivatizatlon efforts, very little was known that for decades had benefited from overfegulation by academics and managers about how to do a mas- and an increasingly large public sector-unions in sive divestiture of public property. This forced the the state-owned enterprises, bureaucrats, and some authorities to Improvise and leam on the job. There private agents that had been able to "capture" the naturally were mistakes made and, especially in regulators-wanted to keep their advantages.9Only Chile, the process ran into difficulties and partal slowly did the privatization process gain political reversals With time, however, new information was support In many countries through schemes that slowly acquired, and some general princples were distrlbuted a percentage of the shares in privatized established on how to tacke the problems faced dur- firms to the workers (usually at a low price). And as Ing major divestiture. Although there is no general the quality of services from p.tvatfzed firms Im- agreement on all aspects of privatization, the knowl- proved, consumers began to support new rounds of edge of the subject today is much greater than It was pdvatization. a few years ago.10 Many lessons are related not to 80 LatinAmeri andthe CadibbeamA Decadeafter the Debt Cdss

economics or finance but to the political economy For example, the sale of a controlling interest Is usu- of privatization. It has become dear that avoiding- ally consistent with a speedy privatization that raises or at least reducing-political opposition frominter- significant revenues In the short run. Public offer- est groups Is as important as setting up a ings of shares, by contrast, can spread ownership. 'technically" correct program. Some countries, such as Chile, have offered some Some of the most Important lessons deal with shares at prefential prices to small Investors, creat- the need to distinguish different sectors and firm ing a broad constituency of shareholders that sup- sizes when designing a privatiation program. port the privatlzation process and are concemed Falling to do this resulted in serious problems in with how the private sector is regulated. Publc offer- Chilean privatization of the mid- and late 1970s ings In foreign stock exchanges-such as Argentina's (Edwardsand Edwards 1991). In general, small man- offer of YPFstock in New York in June 1993-can ufacturing firms can be sold early on and rapidly, increase the international appeal of certain firms while the divestiture of banks, large monopolies, and can signal the government's seriousness about insurance companies, and public utilities with privatization. And employee buyouts generally monopoly power is substantially more complicated. reduce some opposition to privatization. In most of these cases, It is desirable to define a dear Most Latin American countries have resorted to regulatory frameworkbefore putting the firms in the combinations of the modes. In some cases, two or latter group on the block-not easy in many coun- more liave been used during the sale of a particular tries, since they have little, if any, experience with firm-the telephone company, ENTel,in Argentina, modern regulatory legislation. The World Bank has and the electric utility, ENDFSA,in Chile. By prag- taken an active approach toward this issue, provid- matically combining methods, the authorities ing financial and technical support to countries hoped to make progress with several objectives- designing new regulations. and to minimize political opposition. Govemments usually have several objectives To avoid excessive concentration and monopo- when they privatize-increasing revenues, increas- listic behavior, some countries break up public ing efficiency, redudng the size of the public sector, monopolies before offering them to the private sec- and spreading ownership broadly. rypically there toi In Argentina, the Buenos Aires telephone com- are tradeoffs. Maximizing government revenue may pany and the natural gas distibuton company were require selling large blocks of shares to single bid- divided into several independent finns before being ders, usually local conglomerates or foreign multi- sold.13 Complementing this breakup is a new regu- nationals. But spreading ownership may require latory framework to curb abuses by the newly priva- selling shares ata very low price-even a zero price- tized utilities. Argentina, Chile, and Mexico have to broad segments of the population. When the made efforts to agree on future expansion programs objectives are not dear and ranked early on, serious and price-setting mechanisms with the buyers of conflicts are bound to appear, miring the privatiza- public utilities. But in Argentina, the regulatory tion effort in political difficulties.1 frameworkwas put together only after the telephone Independent of privatization's main objectives, company had been sold, increasing the uncertainty it is fundamentally important for sales to be abso- for potential buyers and reducing the offered price. lutely transparent and without suspicion of Impro- The sequence for privatization of firms in differ- priety. For example, the lack of transparency of some ent sectors is important. Should banks and other early privatizations in Argentina and Chile Injected financial institutions be sold early on, or should they deep suspicion in the system. Without tansparency be maintained as public property for a longer time? there will usually be political opposition-people in McKinnon (1991) argues that the privatization of many countries feel they "own" public firms and banks should, because of moral hazard considera- they become frustrated if they perceive that all the tions, "come near the end of the reform process." fruits of privatization are going to private parties. McKinnon's position is based in part on Chile in the Chokes durkngprva*zaton. It helps to dstdnguish 1970s, when banks were sold early to emerging- at least four modes of privatization: sale of a con- and not fully solvent-conglomerates which used trolling percentage of shares to a private company or them to finance the acquisition of firms privatized consortium; initial public offering of shares on a later. The newly privatized banks engaged in stock exchange, domestic or international; em- extremely risky and finandally questionable opera- ployee buyout; liquidation of the firm and sale of its tdons, accumulating large volumes of bad loans- assets.12 Each mode can help attain particular goas many t-' interrelated companies owntd by the same Pvtzation andDeregution 81 conglomerate. Because of an implicit govenment the private sector, the government ceases to be guarantee on deposits, the public did not distinguish responsible for their finances. This can save aWe between the solid banks and the financially trou- volumes of public funds, as in Chile during the fist bled. This process-which developed because of the round of privatization. If pratized firms become lack of an appropriate supervisoty framework- profitable and pay taxes, divestiture will also ended up in a major financial alsis In 1982-83, improve public finances In the longer run. But when when some of the largest Chilean banks became a profitable firm is privatlzed, the public sector insolvent and the government had to take them ceases to teceive those funds. In the aggregate, most over. Latin American countries' privatizations have had This Chilean episode shows the need to imple- an overall positive fiscal impact (Galal, Saez, and ment a modem supervisory framework bWorepriva- Torres 1992; Kiked, Neilis, and Shirley 1992). tizing banks. But it is unclear whether this is a The restructuring of firms in distress has become reason, as McKinnon (1991) argues, for delaying the increasingly Important in the design of privadzation divestiture of financial institutions beyond what is pbns. Should the government restructure state- required to put the new regulations in place. It is owned enterprises-financially and technologi- possibleto argue that there are some compelling rea- cally-before they are sold or should this task be left sons for privatizing banks during the early stages to the new owners? The way this problem is handled of thle reform-but only after the new regulatory haseconomicandpoliticalconsequences.Ifthegov- framework is firmly Ln place. First, to move from a ernment undertakes the restructuring, it can sell the protectionist environment to a competitive one, firm at a higher price. But governments do not have manufacturing and other firms will have to engage a comparative advantage in restucturing inefficient in major restucturing activities that will allow them stae-owned firms (Seabright 1993). And restructur- to increase productivity. This requires financing, ings tend to be expensive, with the acquisition of which in most circumstances is difficult to obtain new equipment and the dismissal of workers. from a largely inefficient and old-fashioned state- Moreover, labor legislation in most Latin American owned banking system. Second, a banking system countries does not consider economic distess as a dominated by large government-owned banks usu- valid cause for "Just" layoffs (see the discussion later ally stands In the way of macroeconomic stabili- in this chapter). So, dismissals will require substan- zation efforts. The public-bank culture usually tial resources to finance severance payments. Chile continues to prevail, and credit is granted at a pace and Mexico solved this problem partially by work- inconsistent with overall macroeconomic equillb- ing out agreements with the unions, with workers rium. This has been true in Nicaragua, where the in- consenting to layoffs In exchange for a fraction of ability to control the state-owned BancoNacional de the firm's stock Desarrollo jeopardized the macrmeconomic stabili- Many Latin American countries have recently zation program.14 Moreover, delaying the prlvatiza- moved to privatizing their social security systems. tion of the banking system can delay the creation of Pioneered by Chile in the early 1980s, these efforts a dynamic and modem capital market, hurting re- have been followedby Argentina, Mexico, and Peru. source allocation and intermediation (seechapter 7). The efforts have two main objectives. The first is to Massivedivestiture programs of the tpe in Latin replace financially troubled, pay-as-you-go pension America have important consequences for public schemes with fully funded capitalization systems finances. First, the proceeds of the sales are public based on individual retrement accounts. The sec- revenue, improving the fiscal accounts In the short ond is to develop a large presence for institutional run. Most experts have argued that these revenues investors in the emerging capital markets. Privately should not be considered permanent income and administered pension funds also open newchannels thus should not finance increases in curent spend- for privatization. In the second round of Chilean Ing. Although political leaders, in theory, have divestitures in the mid-1980s, pension funds had the agreed with this prescription, some governments opportunity to buy shares at subsidized prices, (Argentina, Brazil) have relied on privatization rev- spreading ownership (Luders 1991). enues to delay the other deficit-reducingmeasures. The procedures for privatization-particularly Second, many Latin American state-oned enter- who is allowed to bid and how the shares are paid prises have for a long time faced financial problems .sr-have Important consequences. Should workers requiring large and continuous injections of funds receive a proportion of the shares, either free or at by the government, and once these firms are sold to reduced prices? What should the role of foteIgners 82 LatinAmedco and the Cgbearn A Decadeafer theDebt Crisls

be In the privatizaton effort? And when foreignr as a topic. In Chile, recent discussions of the possi. can bid, how should they pay for the firms-In cash ble privatlzation of the national copper corporation, or through some debt-equity swap? CODELCO,caused serious political fallout.19 Argentina, Chile, Mexidco,and Nicatagua-to Benfits of prIazation. Recent studies have sug- reduce poltica opposition to the divestliure-have gested strongly that privatization Increas effi- used preferential treatment of workers In privatzed cdexny-msured by ptoductvity growth-in the firms. But this practice has important dsrbutional newly ptivadzed compaies, and in the companies conquences, benefiting segments of the labor maing In the public sector (Glade 1991; KikeI, force that, ftrough political pressur, already have Nellis,and Shirley 1992; Hachette and Luders 1992). extraced sizable rents from society.I5 Morv, Galal, Saez,and lTrres(1992) report that labo pro- these programs disriminate against public employ- ductivity increased significantly after several large ees who work In sectors usually not subject to pri- Chilean and Mexican privatizatlons. For the Mexi- vatization-Incudig defense, education, and can telephone company, total factor productivity health. So, schemes distributing some shares to increased more than 1S percent in 1991 alone. In brad segments of the population-hrou the Coiombia, in at east hee of fou privatizations- newly privatzed social security system or some automobile assemb!y,a large refuse collection com- other mechanism-are preferable to those that con- pany, and a bank-there have been Important centrate on workers in the privatlzed fims Increases in productivity and efficiency (Zuleta and Mobt Latin American countries previously others 1992). In what is pobably the most ambitious restricted the partcipation of foreign-owned ums in detailed study on prlvatization in the region, certaIn sectors of the economy.16 But many restric- Hachette and Luders (1992) performed econometdc tions on foreign ownerhip are now being relaxed." tests based on individual firms' financial statements One of the most interestng feaures of the new eco- to test whether privatization inaeased efficiency in nomic landscape In Latin America Is that foreign Chile. They found a statisticaly signifit, al- companies now own or control companies in sectors though quantitatively small, efficiency advantage that until very recently were considered to be out-of- for privatized firms. bounds and stmteg1c,- incduding telecommunica- Privati2ation should also improve consumer wel- tions and air transport.18 Perhaps more interesting, fare. But detmining the size of the effects is not Latin American firms have begun to bid for compa- easy,since it involves quantlfying differnt elements nies being privatized in other countries within the related to the prices of services,alternative rationing region. Chflean fimis tecently acquired Argentine schemes, and profits accIng to foreigners. Despite companies in the electric disttion sector, and these difficulties, there have been attempts to pro. Argentine and Braziliancompanies pesented bids In vide orders of magnitude for the welfare conse- the Mexican privatization. quences of privatizatlon (Galal, Saez, and lbTrres Most govemments have restdcted, explicitly or 1992). implictly, the percentage of a privatization that can Consumer welfare has been found to increase be financed through debt-equity swaps. In some througi- reduced prices, improved quality and ex- cases, such as Brazil,this has been the subject of con- panded services. In Argentina water prices declined siderable debate. The new admistation of and service quality increased after the privatization Prestdent Itamar Franco has strongly argued for of the water distribution company. In Colombia, reducing the proporton of debt in these operations. there is evidence sggesting ftat consumer welare There is a tendency for political problems todevelop increased through price reductions in the automo- when foreign firms are perceved as reaping sub- bile and bankdng sectors.20Galal, Saez, and Tores stantial benefits while local groups and consumers (1992) argue that, although agegate welfare has experience some losses, as was the case with the pri- inrased in most privatizatlons, consumer weare vaffzation of EN'l7 in Argentina and TELMEXin in some cases will be huit because of expected Mexico (Galal, Saez, and rres 1992). Despite sig- increases in real prices (ME in Mexico).This is nificant attitude changes about foreign partidpation not completely clear, however, since the new and in investment ptojects, in many countries the Issue old regimes use different mechanisms to ration ser- of foreign ownership of certn firms is stll polffl- vices. Pubili phone companies throughout Latln cally sensitive. In Mexico and Venezuela, the priva- America were Infamous for their rationing through tlzaffon of the oU giants PEMEXand PDV5A- queuing, with a 10-year wait to obtain a phone line whetherto foteiers or nationals-Is out of bounds not uncommon. The expectations under the prva- Pdvattn andDeuehn 83

tized regime are that the ability of consumers to especiaLlythose for telecommunications, electricty, obtain services will incease significantly-but at and water provlsin (Spler 1992). Becwse of their higher prices. assets, public utilitles are vulnerable to expropria- tion-administtative or outright-by the govern- Retation ment. So, without approptiate Institons, efforts to pdvatize utles wll genetate only limited Interest, Economic regulation establlshes legal rules that and bidders offer what ae perceived to be 'low' restrict or alter the free functioning of markets. In prices. The recent privatlzation of the telephone the presence of "market failures"-natural monopo- companies In Argntina and Venezuelaprovides two lies, information asymmetries, and extemalities, for contasing cases to underscore this point. In Argen- example-well-designed regulatory frameworks can tina, a controlling share of the telephone company increase social welfire by inducing firms to act in a (ENIlb)was sold before a credible regulatory frame- manner that somewhat resembles competitive work had been put in placend three bidders behavior Regulation can take many forms, includ- offered prices deemed to be very bw. in Venezuela, ing the administrative determination of price caps, the design of a transparent and modern regulation rate settngs, barriers to entry or exit, and minimal system before the saleattracted seven bidders that of- service provision (Spulber 1989). The tendency in fered very attractive prices. Interestingly, after some many parts of the world has been to "overregulate,' hesitation and conflict, Argentina enacted a modern encouraging rent-seeking, corruption, and ineffi- and efficient regulaborysystem-but only after the dlency. This is certainly the case in most of Latln telephone company had been sold, generating sig- America, where the historical costs of regulation nificantcapitalgainsforthetwofognconsortiums have tended to greatly outstrip benefits. One of the that won the initial bidding (see Spiller 1992). most challenging tasks the Latin American countries The ability to create a regulatory framework that face as they move away from the centralist models allows the government to commit credibly to its of the past is designing modern and efficientregula- pronises and not ewropriate the privatized firm's tory frameworks that protect consumers and en- assets depends on three institutional factors. The hance efficiency without choking private Wtiatlave first relates to the customs and traditions for prop- From an analytical perspective, regulation is erty rights--in many Latin Amcdcan countries, pri- equivalent to having incomplete contracts between vate agents have vivid memories of past abuses and private firms and regulators-such that both parties epopriation, making credible regulatory rules constantty face a temptation to behave strategically, somewhat difficult The second is the independence taking advantage of contingencies not fully specified and efficdencyof the judiciary and the transaction in tne regulatory "contract or simply walldng away costs in resolving conflicts between different parties. from the contract Consider the interaction between And the third is the form of political organization a privately owned utility and the regulatory author- and degree of politlcal polaization. ity. The regulators have an incentive to promise a Seveal Latin American countries-especially "high" price to the utiLty, as a way of inducing it to poorer ones-have weak judiciarysystems that oper- expand capacity. But once the firm has made the ate under antiquated conditions and are plagued by investment to increase production, the regulator will financal problems. Moreover,the judiciaryin marn be tempted to renege on Its promise and set a "low" instances is not independent from poliffticalforces, price for the utility's output This is a typical case of introducing suspicion to the conflict-resolution time inconsistency, where the interaction between mechanism. So, institutional reforms to strengthen strategically motivated agents can be harmful for the judicial system-helping it modemnizeand gain soclety.21 Such behavior usually yields socially sub- some Independence-will have a great positive Im- optimal outcomes, because firms anticipate the gov- pact on the creation of a modemnstate and, eventu- eminent's behavior and invest less than they would ally, in the consolidation of the market-based otherwise.22Thisundesirable, third-best resultcan be reforms. avoided if the appropriate type of safearding insti- The political system affects the form and credi- tutions are in place and if regulators can crediblypre- bllity of regulation in several ways. In highly arbi- commit themselves to a course of action. trary political regimes-where the executive can The development of efficient tegulatory frame- change rles and lawswith a stroke of the pen-t is works and safeguarding institutions is an important difficult to enact credible legislation-based regula- prior requirement for the priratization of utilities- to-y frameworks. But in countties with effectively 84 LtIn Anuerk and the Corbbeam A Dewe afterte Debt Crsis

functiongpresldentlaldemocracies,theedblity divestture in the mid- and late 1970s Meico fol- of tegulation based on specdficlaws coud be quite lowedIn the mid-1980s,and Atgenta in 1989.And sgnificant,but the level of cedity will depend more recently other countres, including Peru and on political polaztion. If there is a high (and Venezuela,have moved aggressivey.This section healthy)degree of competiton among poltcal par- discussessome of the mostsalient features of the pri- ties, it 1s unikely that the rules of the game will vatzaton experiencesIn Chile,Mexico, and Agen- change, keepingcredibility high. SpiUlet(1992) has tina. Table6.3 presentsa schematicovetview, and retly used this Institutionalview to explaindif- includesInformation on the Peruviancase for oDm- ferences in utility reguatory fameworks across parativepurposes. latin Ametican coumtries.He aWguesthat Chile's firly independent judiciaryand competitiveptesi- Chfle dentlal political system explain why reguation in thatcountrylsbasedonvetyspecificIawsthatestab Between 1974 and 1990 the Chilean government li criteriaforentry and for ratedeteminatonand privatizedmore than 500 fims In two rounds, the adtustments."But Jamaica's Independent judiclary, firstin the mid- and late 1970s,and the seconddur- very strong tradition of respect for coumdecisions, ing the mid- and late 1980s (table 6.4). The two and two-party parliamentay tegime have deter- effots were separatedby a brief interludebetween mined the use of lcenses or contractsfor regulation 1982 and 1984when, as a resultof the finandal cri- In that country.ss sis dbcussedin chapter 3, there was a partial rever- In industries with informational asymmetries saland the governmenthad to take overmore than -particulaly the financial sector-the costs of SObanks and firms. monitoring firms' actions affectoptimal Interven- The first round of prvatiztion (1974-82)had tion and regulation. As Is discussed in detail in two distinct parts The first was the sale of firms chapter 7, govemments in Latin Americahave tra- seizedby the UnidadPopular during 1970-73 to the ditlonally been unable to overseebans' actions. originalstockholders. 26 The secondconsisted of the This has led to some serious financial crises in sale of many banks and firmsto the private sectot Chile,Colombia, and Uruguay,ending up with the Someofthesecompanieshadbeennationaizeddur- virtual nationalization of lare proportionsof the IngtheAllendeadminitration,while othershad tra- financl sectoL ditbona1ly been under govemment controL The For regulatoryagenies to maintain some inde- process,centralized with a spedal unit in the gov- pendence and not becomemere agents of the gov- emient holding company,CORFO, relied on two emnmentor be "captured0 by the tegulated firms, methods for the sales:bidding and dirc sales.In they must select their staffs on technical criteria many cases,CORFO rejected all bidsand engagedin and have financial autonomy. In Argentina and negotiations with the two highest bidders, intro- Chile, recent legislationto create regulatorycom- ducingsomeabitrarinesstotheprocessandmaking missionsindudes provisionsfor funds, thus help- it politicallyunpopular. The typical sale involveda ing to add transparency to the regulatoryprocess small down payment, with the balance in yearly But in many countries, the main constraint for insWtilments. implementing a credible and moden regulatory In the firstround, commeral banks werepriva- systemIs not funds,but sidlled technical persomeL tized first Despiteexplicit legilation to avoid con- In a study of the East Asian mirace," the World centrated ownership, the controlling interests in Bank (forthcoming) agues that an independent most banks were bought by emerging local con- and technocratic civilservice, larely Isolatedfrom glomerates,the grapos(see chapter 7). Immediately politicalpressures, was at the heart of the extreme- after banks were sold, many manufacturingfirms ly rapid gwth In that part of the world durng wereoffered to the privatesector. Between 1974 and the past few decades A definitivemove toward a 1978,114fims wereprvatized and 259 seizedfirms modem state clearly tequires new UisUtutions, were rethed to their stocholders. including a strong, technicallysophisticated, and Luders(1991) desaIbes this early tound as a independent civil service. "debt-led"privatization, where buyers-mostlygnu- pos-4orrowed heavily to pay for firms. This bor- In Chin Mlio, m_ A _Ma rowing took place through weebasic channels. First, as discussedabove, the conglomeratesused Chile has pioneeted the privatitzaon procs in the recently privatized banks to obtain loans to Latin Amedca,engaging In a firstround of massive financepart of their purchases.Second, and pethaps Mk#Wotn andDeAguWon 85

Table63 Prhvaltlon Insdected Latn Amern counies: A schematview

Item Asgenth RfVrouwd Seodwiund M'du Peru Approximate 1989 1974 1984 1984 1991 sting date Mainobjectiv Reducesie of Maxdmize Spreadowrship; Redwcasize of Reducesate- governwmet govermentn reduceI"wmotac government; entrpise- Inceaseedfenty revenues ofgoverment modenize Induced and govement reducese d Menecorm fical dei, renues gov wrmt moderne Penuvian ecoron" Numberoffims 45 470 sob 908 12 prvatized" Pecentageofstate- 1S 82 96' 79 20 ownedenterlrises

Roleof foigne Sigrfiant firms VeryIrnrt Sgni Majorrole in Foges fromIdustal mosyIn the ugh someaeas eaged natJomand Latin formd Joint debt-equity (eg.telecom- to participate Anmeicancounais venu ss muncs,

Debt-equityswaps Yes;peetage No Yes;case by No Notto date aloweddedded cas limted caseby case percentage Pdolcl opposion Signicat lntg, Yes;not voied Yes Veyminor Yes nowgeneraWly be eof supored poitia situation ciwricyga9ns Someto date Maor Sgnificat Yes;vey large Tooeary to estructuring producity Insome cue know to Impove Im ms productivity Workersoffered No No Yes;on case Yes;workers have Yes shafesat bycasebasis dghtof fs prertial pries rua by low Govemet cedit No Yes No No;cash only Cashonly to dat- someloan fromBanco de laNac6n to financelayoffs Sequencing Airlineand Bankfist; Rulesofthe g9m SmalfMms fis; Sall enterprises phonecompay manufacturing rvatizatlon; pubicuties ft reguly first;einty f&msnext; regulatoy bonb ffa&ew* st gas;water rgu y frewor* rW banks; re frmerk lat firm andpubli suta-owned utiliie enteprise Scopeof divesre Partal Ful Partl controlling Part Insome FullIn most pa-kagessold aes govement cases ~and a.Untl 1991. SAaaarutedd SamwVld B* dat 86 LatinAmerka and theCaribbean: A Decde afterthe Debt CIsi

Te 6.4 Summayof pdvlvtlmu In CM1,197440 vesal In the pdvatization process constituted a Numberd serioussetback for the govenment's program.The Stge Year cwts Metod authotities qdickly decided that these firms and banks had to be privatizedonce again. But, the sour Fistphase 1974 Over32S experienceofthe earlierprivatiation Indicatedthat chrgereturn this time they had to use a differentscheme. In the Seendphase 1975-78 228 'Debt4ur second rund of privatizatlon, the govemment 5eaa d-dhesftfe exprssly avoideda situation of having a few (tech- Fintphase 1984-86 About50 Or:ous llically Isolvent) conglomerates buy largenimbers diesiure of of firms *oddsector The outcomeof the firstround of Chilean priva- Secondphase 1985-90 About30 Wldespmdsakte ation-incdudl the partia revers, the failureof ofstate-owned w*wprles_ some of the larest banks, and the bankruptcy of SOmm:l 991. large conglomerates-was a diect consequence of the way the governmentchose to sell the firmsand more Important, the govemment encouraged banks. Fist, despite existing(and antiquated)legis- higher indebtednessby directlypoviding substan latlon, no real effort was made to supervise the tial credit to prospectivebuyers And third, foreign newlypdvatized financal sector As early as 1976, banks were eager to provide loans to the Chilean when the BancoOsomo collapsed, govemment offi- conglomerates,either to acquire new firms -arto dais knew that the gpos were using banks to financethe operationsof ongoingconcens. acquirenew fins, whoseshare priceswere Inflated There has been a long debate in Chile over to provide collateralfor new loans, which were in whether these early firmswere sold at a "fairWprice tum used to buy stillother companies.Second, the or whether buyers were subsidized.Although the governmentwanted to get as much revenueas pos- eary procedure sometimes lacked tansparency, siblefrom privatization,with little concem for the there is no evidence of wrngdoing thwugh the concentrationof propertyand politicalpower. delibeate underpricingof asset Many of the firms During the second round, started in 198S, the sold early went for low pricesbecuse they were in authorities' main objectiveswere to shrink govern- poor financialcondition and had many redundant ment and spread ownership. The first step in this personnel.Political instability and the lackof a cred- second round consistedof reprivatizingfirms that ible regulatoryframework that committedthe gov- failedin the financialcrisis of 1982.This time, how- ernmenttomaintainlgapro-pdvate-sectoratttude ever, the governmentdid not provide credit-and also reducedthe marketvalue of theseassets did check the financial credentials of buyers. Ib sellmany companiesquicly, the govemment Financialinstitutions-induding two of the largest made no effort to restructurethem beforeofferng banks-were privatized through "popular capital- them tothe pubUc,expecting that buyerswould take ism," with privateindividuals allowed to buy up to steps to improve efficiencyand placing very few $7,000in shares at a discount (see Luders1991). restrictionson layingoff redundant workers. Medco During the late 1980s,the governmentgreatly was different,with the authorities making serious broadenedthe scopeof privatizationby sellinglarge efforts to avoid increasing unemployment by public utUitiesand firms that had alwaysbeen in restrictng layoffsin the prlvatizedfirms. governmenthands, includingthe larest steel mill, The cost of restructuing the new firms turned the national airline, and most utilities, inIcuding out to be much higher than what the gmpos telephones,electricty, and water.The government expected. For years, many companies-including exercisedgreat pragmatismby combiningdifferent those in the exportsector supposedly favored by the modes of privatization, even for a single firm new policies-incurred we losses. The gnqws (table6.5). Shares were sold-usually ata discount- increasinglytapped the credit marketto coverthose to workers,foteignets, pension funds, and localpri- loses,generating what Harbere (1985b)has called vate companies.To avoid the distributiveimpact of a lfalsedemand for credit,"and putting severepres- sellingshares only to the privatlzedfirm's workers, sure on Chilean real interestrates. the govermmentoften offered shares to anyone By1982, with the Chileaneconomy in a deepcri- employedin the public sectot Foreignerspartlcl- sis, many srpos becameinsolvent, and the govern- pated activelyIn this second round, taking advan- ment took ov 50 firmsand banks.This unexpected tage of the Chapter XIX scheme-the attractive Prvatizatbanand DeregulmtIon 87

Tabe 6.5 P nvatizationIn Chle, 196589: Methodsof paymentand bywes bWptpde ehod of*/a'tif ure Rirstbuyer &E Wntepk hEtodWofdesUtn ur irstbuyer CAP StockmrketA VariedInvestors EN')ESA Stockmarktet Varedinwestors Direcsale to worker Ownworkers Pensionfunds Redemnptionof equiy Directsate to worker Ownworkers CHILGENE Stockcmarkcet vafled britr Publicsector Pensiofds DMecsale to publkc Directsale to worker Ownworer b SettletelSitd SMafiInvestors CHILMMTO Stockmarket VadledInetors ENTe Stockmnafket VariedInvestors Pensionfunds Pensionfunds Directsale to workers Ownworker Direcsale to Worker Ownworkers CKILQUINTAmarket Stock VariedInvestors ~Directsale Chileanarmy CMIQUINTAmarket Stock VadedInvenors ~~Exprpriationsettlemtentd Small investor CHILEFILMSDirec saleto Workers fundsrk IANSA Directsale Sugarbeet CHILEILMSAuction DomesticInvestors Direcsale to workersnwrk CiT Stockmarket VariedInvestors Stockmarket VariedInvestors Pensionfunds ForeignInvestors ODircsale to workers Ownworkersb ISEGWLES Stockmarke VariedInvestors PubgicsecwDr Direcsale to worker Ownworkers employeesS ID tckmr Auction Forigninvesors IEVD toksSSe IncreaseIn equity Foreigninvestor LABORATORIOStock market Variedinwestors ECOM Direc saleto worker Ownworkers CHUL Pensionfunds EDELMAG Direc saleto public Smallregona Dect saleto worker Ownworkers investors LANCHILE Stockmfarket VariedInvestors Directsale to worker Ownworkers ELECDA Direcsale to pubkc Regionallnwestors Auction Domesticand Stockmarket Variedinwestor foreigninvestor ExpropriationsWoertemnd Smial inwestor PEHUENCHEDirec sal to workers Ownworkers EMECO Auction Domesticnwestors Subscriptonof newshare EMEL0 Direcsale to workers ENDESAemployee ENDESA EMELARI Directsale to public Regionallnwestrs PILMAIQUEW'Auction ForeignInvestors Directsale to worker publicsector PUJWNQJEAAuction lnvestorb Expopratinsttimen' SalInvbestos SACRET Directsale to workers Ownworker UpmpdtionseftkentdSmdhestmSCHWACER Stockmarket VariedInvestor ELIQSA Directsale to publi9c Regionallnvestrs Pen~sionfunds Directsale to workes Ownwvorker Directle to worker Ownworker Stockmarket VariedInwestors Expfopriationsettniemnt Small investor EMEIAT' Aucpdtion s Eowm westL SOQUIMICHStock market Variedinvestors BAELAT*Auction EMEL ~~~~~~~~~~~~~~~~Pernsionfunds ENDESAemployees Direcsale to workers Ownworker ENAEX Auction ForeignInwestors TELE-CHLEAuction Foreigninvestor

Directsale FAMAEO______

- Notavallabe a.The total nurmerof share In CAPs equity was 438,089,1898, ofwhkch 83.3 percet belonged toCORFO InApr 1986.In June 1986 CORFO wiftdrew 288,641076shares, forwhich CAP paid 50.25 per unit. As a resultt'he arumkmntoftde shares private ownership Increased from 16.7 to 49 percent, wit a correspondingdedlre In COFO~s ownerhip b. Onlynewly Issued shares. c.These crompanes were partIly sold to thegeralW public oal fromdhat regbrv This was calle "regonalpopular capIftasm." d. TheAllernde government IntesiidI agrarian reform arom 1971 to 1973,mWpreratin mnyW farms Some fomer ownrws sed thegovernment. A 1987law authorIzed thegwomwiet tD settieth daimdrs in shareof public enteprise at book value- e.Orioginly a ubsdlasyof ENDE5A. FAMAEI an enterprise D of te hlon a ny. g. MIM a nopsonyIn th maretfor sug beetsIn Chlle IL uWhteInvestor Isforegn or domestic is unknown. Sao=wGalal,ez, and Torres 1992 debt-converion program described in chapter 4. the market in are with high competition or con- During the second phase of privatietion, the testablty, but whae markets are impedect, the go- goverment introduced sweeping regulatory re- esment would regulate technical aspects- fom, inludin the opeting and sering rues including saety-and price-setting. These ambi- for utilties. Enty and price st wouldatg be left to ttous rorms, howev tan Into some problems . 88 LancAmeficaandthe Caribbean:A Decoadefer.he ODebtCs

Galal (1993) has argued that the General Law of The procedureIn the Mexicanprivatization has Telecommuircat1orsof 1982was ambiguousabout been simpleand effective,with the whole ptocess the regulatory rights to approve concessional handled by a decentallzed unit in the Finance requests-and did not establsh an efficient and Ministry.There ate usualy three steps in a Mexican transparentprocedure for settingrates. These short- divestiture.The first is the valuationof the firm to comngs wereremedied In 1985and 1987,when the be prlvatzed; this s done by an Investmentbank. authorityof the regulatorybody wasclaified, and a Tis value is then used for reference,but does not clearprocedure based on a rate-of-retur framework constitute a minimum "reserve"price during the wasestablished for detetminingtelecommunication sale.The secondstep Is to publiclyoffer the firmfor tarIffs.27 sale, under remarkablystraightforward conditions: Many observersforecast that the new ChUean cashonly. If the firmis considered"too large,"only democraticgovenment would put an end to the a controllingpecentage is sold.The third step is the divestitures,and even repealsome of the privatiza- actual sale, with the ministerial-levelIncome and tions of the military regime.Nothing of this kind Expenditres Commissionmaking the final deci- happened. After some heated debate on the sub- sion-in most casesselling to the highestbidder (Gil ject, the government of PresidentAylwin decided Diaz1992). to continuethe privatization,recently announcing The Mexicanprivatizatlon program has enjoyed that during 1993 share packages in six firms, substanti politicalsupport-clearly more than in including some railway lines and transportation any other countryqWhy? It was designed In close companies,would be sold to the private sector (El consultationwith labor unions and the privatestc- Mfecurlo,Edid6n Intemacdonal, 7-14 January toL And, accordingto exidstingregulations, unions 1993).There is little doubt that, now thattthe pub- have the right of first resal in any privatization. lic associatesthe rapid growth of the pascfew years They can buy any percentage of the firm being with the new economicapproach, there willbe nc offered,with the conditionnot to resellthat stakefor turning bacdc a given period. Between 1984 at*d 1991, unions boughtcontrolling packages in 16 companies-and Maeco unions from very large companies, including TELMEXand AEROMEXICO,bought substantial Between1983 and 1991, the Meican government packagesof sharesat a discount.Another important privatized about 1,000 state-owned firms. The factor was that the govemment entered informal processcontinued in 1992and Isexpected to end in agreementswith buyersthat there would be no lay- 1993with the sale of 37 additionalfirms. At the end offs,even in firms,such as TELMEX,where there was of the program,the numoer of state-ownedenter- clearlabor redundancy.29 prisesIn Mexicowill have been reduwedfrom 1,155 In 1991,the governmentbegan to privatizethe in 1982 to fewerthan 80 in 1994. In many ways 19 banks nationalizedat the outset of the debt cri- the Mexican divestitureprogram has been exem- sis. Beforethe prlvatizationthe Mexican govern- plary, proceedng smoothly, with little political ment Implementeda regulatoryreform requiring oppositionand few problemcases (Sanchez 1992). increaseddisclosure of informationand establUshing TheMexdcanprivatizatlonprogrambeganslowly penaltiesand enfrcement powersto avoid impru- in 1983. During its first phase (198387), 64 small dent practices.Tle process,completed in 1992,has and medium-sizefirms were sold, mostly to manu- been hailedas a big success,because every bank was facturingcompanies operating in fairlycompetitive sold at severaltimes its book value. At the time of sectorsthat did not require significantregulatory privatization,Mexican banks werefairly inefficient changes. The revenueswere rather modest-with by intemational standards, with operating costs grossproceeds of about $26 bllion. almost twice those of U.S. banks. But observers Startingin 1988, the privatizationprocess accel- expect that productivitygrowth will increase as a erated, with very large public firms,including ser- resultof increasedcompetition-both among them- vice monopolies, put on the block These firms selves and from new institutions (Gavito-Mohar, included tht telephone company TELMEX(with Garcia,and Legarreta1992). revenuesof $18 billion),the two airline-:'.t banks MexicanIndustrial conglomerates have bought nationalizedImmediately after the debt crsis, and a most of the banks to expand into the financial gigantic steel complex. This second round raised sphere.What makesthis situation interesting-and more than $12 billion. delicate-is that in Mexico, unlike most of the Pdvatlrn andDeguk#ton 89

regon, banks can investIn equities So,unlike Chile members a' a smal fraction of the original fee. In the 1970s,the InterrelatedownesWp of the con- Femandezestimated that of each $1,000charged for glomeratesand the bak willbe out In the open.lb moving containers, the nonunion member per- avoid finandal cdses, s ng of the tecent formingthe job obtaned only $S50.The difference regulatorylegislation will be crucial.Given the dose representsthe rents obtainedby the union for hav- links between banks, brokerg houes, and manu- Ingthe right torestrict entry.In Bazil, wherea 1934 facturingfirms, it wil be exceedinglyImportnt to lawgrants a monopolyto the stevedoresunion, the putttogether a systemof consolidatedaccountilng for situationis not verydifferent. Nor wasit differentin conglomerates.Only In this casewill the authorities Chilewhere, until 1981, the stevedoresunion had be able to monitor the soundness of individual an absolutemonopoly and chatgedmore than twice banks, avoidingcollusion and unexpectedsurprises the cost of pefming someoperations.30 (seechapter 7). Mexicobegan to deregulateand modemize its Bybeginning the privadzatfonwith smallfinrs, ports In mid-1991.The new regulationestablished and only slowlymoving to laer and more sophli- free entry of service firms,eliminated service seg- ticated companies, the Mexcan goverment mentatior, freed suboontractingacross firms, freed avoided large and costy mistakes. Having post- the dehrmination of service rates, and restrcted poned the sale of banks does not seemto have hurt the number of unions to one per company. The the process in any sinfcant way. This, In part resultshave been spectacular in one year, the cost reflectssome Importantpeculiarities of the Mexican of servicesdeclined by more than 30 percent, and financialsystem: despite having been privatizedIn the volume of containers handled In Vetacruz 1992, banks continued to operate with few rgua- increasedby 47 percent Argentinaand Chilehave tions and controls. An Important feature of the also made important progress toward increasing MexicanprogramIisthattheine nalncome the efficiencyof ports. Chile put an end to the and ExpendituresCommission, which has the fin unions' monopoly in 1981, when barriersto entry wordon al mattersrelated to privatization,operates were virtually eliminated.31The new legislation with complete unanimity,making It Imperativeto reduced port operating costs by 50 percent in two workoutagreementsamongthedifferentministries, years(Wiecav 1985).In Argentina,the new port and avoidpolitical conflicts and sensitivepublic dis- aw greatlyreduced the unions' monopoly power agreements(Gil Diaz 1992). allowing for the contracting of servicecompanies The Mexicanprlvatization program has boosted and replacingthe per-t charge systemby freely efficiency and productivity (lTAM 1992). At contracted salariespaid biweekly. AEROMEXICO,labor productivitymore than dou- A second important piece of leglslation In bled between 1981 and 1990,and total factorpro- MexicoIs the new Lawof Navigationand Maritime ductivity went up more than 20 percent Trade, which allows private parties to build and MEXICANA,the secondairline, also had substantial operate ports. The new specialzed ports-for ce- gains after privatization:labor productivitywas up ment products,mining, and petrochemicals-have by 47 percent,and total factor productvity 12 per- greallyreducedthe csts of transport(Sanchez 1992; cent And for many services-ncluding the tele- Femandez 1992). In Argentinatoo, private ports phone companyand the airlines-aggregatewelfre have been restrucured, Increasingthe volame of Increased.A recent WorldBank study estimatesthe gan expors from 18 percentin 1983to 56 perent aggegate welfare gains from the privatizationof in 1991. ThLMEXat more than 10 percentof its marketvalue, The transport regulationshave also affectedthe and those from AEROMEXICOat 6 billionpesos (in trucking industry,and Mexdcoprovides a partlcu- 1992prlces--Mndon 1992). larly tellingexample of the costs of regulationsand The deregulationof ports and transport stand the benefitsof reform.Until 1988,trucking activities out as one of the most Importantachievements of in Mexco were tightly restricted and subject to Mexico'smodemization progrm. For example,the severe barriersto entry The govemment had the control of all operations In the Mexican port of rght to provide concessionsto private parties for Veracruzby four unions had resultedin huge ineffi- one or moreof the nine establishedroutes. In most dencles (Femandez1992). Acommonpractice-one cases,only companieswith a concessioncould pr- observedin many other countries in the region-Is vide trukingservices. The one exceptionto this rule for members of the union to chae exorbltant was for truckerswho obtained specal permits that prices, only to subcontract the jobs to nonunion allowedthem to ttansportone (and only one) type 90 Latb Americ and the Caribbean:A Decade after the DebtCris

of good on a particular route. Companies with con- Table66 Reenue from prlvadutlon InArgenna cessions or with permits were subject to loading and (es of December3,1992; milliofsofdoanrs) unloading restrictions, and many tmes trucks were allowed to unload In a given city but prhibited Ent cash Bonds IkbWes from loading, so they had to make the Tun trip EN ph*fcompany) 2,270.9 5,000.0 0.0 empty (Femandez1992). AerofufessAgentinas 260.0 1,610.0 0.0 With this maze of regulations, the Mexidcan W fandrsdiot 13.9 0.0 0.0 trcking ndusty was highly uneliable, and the Pols Petropl 14.14.5 12.141.0 0.0 costswerealmostSOpercenthigherthan theywould Indudor 17.8 50.6 0.0 have been in a competitive environment in June Mon6nmosWIllcos 9.3 26.5 0.0 1989 the trucldng industry was reformed, estabLsh Ctou ecaon Tea 1,387.4 0.0 0.0 Ing fee entry,subject to safetyrequirements. Any Seconayotraction areas 458.3 0.0 0.0 truck could now move reely, loading and unloading LUaUao Hol 3.7 12.0 0.0 in any city, port, or railway station. And in 1990 fe AltosTandanorHontos Zapla 59.83.3 29.70.0 0.0 were deregulated and completely freed.As the num- Graineliators 6.0 0.0 0.0 ber of lcensed trucks rose bv 62 pecet In two years, SOMISA 140.0 12.1 250.0 fees declined by as much as 50 percent in some Natra gas(wen fims) 218.0 1,095.0' Ekaitry 823.0 routes, and the quallty of servce greatlyimproved SEGA entralPuerto 92.2 0.0 0.0 emandez 1992). SEGBACen Costnera 90.1 0.0 0.0 The deregulation of transport services in Chle SEGBAEe in 30.0 397.91 0.0 SEGSAEdesur 30.0 481.0' 0.0 and Mexlco has had an important effect on, these Hl9hways concession 0.0 0.0 countries' ability to compete internationally. By Rways Concession 0.0 0.0 reducing costs of shipping by almost SOpercent, Reaestatle 107.0 0.0 0.0 uniferscatte market Concession 0.0 0.0 small and medium-size firms that would othervise SltosBuenos Aires Concesion 0.0 0.0 be marginal, have been able to expand their export SlosQuequ6n Concessin 0.0 0.0 activities (Femandez 1992; Gil Diaz 1992; WIse- CaentralAto Vaft 22.1 0.0 0.0 carver 1985). Effortsto deegulate maritimeanid land PeealDocHtippdme 61.5 0.0 0.0 transport in Colombia and Venezuelaare also show- Cena Pedode Mendoa .&5 0.0 0.0 Ing promising results. A1so,the tecent decision by Ceta Gieme 10.0 76.' 0.0 the Brazlian senate to deregulate ports in that coun- EDELAP 5.0 134.0' 0.0 try may well provide impetustry raay to weH BmzilimBrazilianpr(Mde exports-exports. Impetus Total 5,455.7~~2,184.1' 6,794.9 1,073.0 a. sdos at csh Va1l A1XEntln~a $our Pesal communiaio wih Subsecrtaa de Pvtatacle, vgetna,1993. Argentine state-owned enterprlses have long been a financial drag on the tteasury. During the 1980s, schemes (table 6.6). Drawing on the experience of their financing requirements surpassed 50 percent of other countries, the government has strengthened the total nonfinancial public sector deficlt, directly the regulatory framework for public utilities and contributing to hypeinflation in 1989. And toward othersectorswherethegovemmer+formerlyhadan the end of that decade, it was dear to analysts and important presence. polcymakers that the countrys macroeconomic The Aretine privatization programresponded Instability required a massive restructring and to three objectives. Rrst, to reduce Inflation and sta- d estiturof public entepses. The ReformAct of billizethe macroeconomy, the Menem administra- 1989 established that publicly owned enterprses tion urgently needed to reduce the fiscal burden of were deile for privatizatlon, and the plan Imme- state enterprises The most effective and rapid way diately ran into political opposition, espedaly from to do this was to divest most public enterpdses. the militant Peronist unions. But slowlyas the Second, the reduction of the state and a major qualit of services provided by the newly prlvatized decentalization were integral components of the firms improved and the structural adjustment pro- Menem dnisation's vision of a modem gram began to bear fruit in other spheres-the pri- Argentina. And third, the modenization process vatization began to win increasing support required a maor impwovement inthe quality of pub- Between 1989 and 1992, 51 firmswere prlvatized lic services, including telecommunications, electric- for about $14 billion in cash and debt-reduction ity, tansport, and portsL A long history of failed Pft*adonad ereguht 91

attempts to increase the effidency of state-onmed The Argentine govemment ecogdzed early on enterprlses convinced the new admni tionthat that a suceul pratzation process rquired a this couid be achievedonly through major private modernregulatory famewor, but the lmplementS- participationIn these areas.32 tion of new rgatoy lws was slow and ofte Since 1989, the privatizationprocess has been cked transparency.The telecommunIcaons wm- coordinated by a spedal unit In the Mlnistryof pany (ENTel)was put on the madet beforethe new Economics and headed by the Underecetary of regulations had been fly Implemented, and the Privatizatlon. Actual sals have been by ad hoc con- lack of tasrncy in the rulesaffect Ulthis dus- nmssionsthatinduded representativesfromthecen- tzy disuaded potential bidders from paidpatng tral unit, sectoral policy areas, auditing bodies, and because of concem about possble ftur exprpria- in some cases prvica govemments (Alexander tions of ther assets (ill and Abdala 1993).The most and Cortd 1993). Legislative approval and overht important element of uncertnty was the possb- for most privatizations provide political legiimay Ity that tariff would be fixed below levels required to the process. The initial roun. fprivatization was to dbtain a milimum rate Of un. EventUl appwved by the EmergencyLaw of 1989;during the three consorums bid for 60 percent of the shares of second round a bicameral commission had the rght the two newly created telephoie companies They to approve specific sales of state-owned assets. paid $214 mfllion In cash, phls $S0 billon in Intersingly, if the commission failed to reach a Argentinefore debt for theinital stake The gov- .consensus on a spedci privatization, the executive emient retained 40 prcent of the shares, with 10 could act on its own (Alexanderand Corti 1993).Tb percent sold to the telephone company woes, 2S reduce the monopoly power of the privatized firms, percent to the general public, and 10 peret to state-owned utilities were broken into two or more telecommunications cooperatives. companies before the privatization-the case for lb dispel buyers' concers about future changes telecommunications, electricity, and natural gas. in the rules, the govemment created a new regula- The Argentine govnment used severai prvati- tory agency-Comisi6n Naclonal de Telecomuni- zation procedures. The most popular was creating caclones-and gave it power to determine prices as new corporations that owned or operated public well as regulate concessions and entry requr- assets. To increase the attraciveness of firms to be ments. Funded by a tax on tel"mmm-atlon re- privatized, the old state enterprisesretained most lia- enues, the commission comprised fhe members bilities. Shales of the companies were then offered appointed by the President of the Republic. Thefist to the public and sold through a two-envelope- group of commssones lacked tehial expertse competitive bidding process. The first envelope and were not fully mmitted to the privatization induded the technical characistics of the offer, process or the notion of privatelyopeted utities. while the second dealt with its financial featurs In As a result, the commission emnainedinactive and some cases, instead of selling the actual asset, the failed to resolve some of the most seious problems government has offered operating concessions for faced by the sector. A particularly serious Issue up to 99 years, the case for some highways, ports, emerged when the Convetibty Law of 1991 and railways.In others, concessions were granted to banned all indexation formulas, leaving the newly bidders that requir the lowest amount of subsidy etermined telephone auiffa vulnerable to inf- for 10 years. For the urban-rural railway system, the tionary erodon (Herrera 1993). The Commission's winning bidder requested a subsidy of about $100 unwillngness to replace the indexation fotmula million a year, a fifth of the almost $500 million that greatly reduced the credibility of the nrles for newly the govenment had been feeding into the system privatzed fSms (Hil and Abdala 1993). In early every yeaL 1992, and partially due to World Bank sgsions, Other procedures have been used as well. Gov- the telecommunication commissioners were ernment holdings in chemical and industral firms replaced by a new team that was highly committed were sold to majority stockholders, and some to Argentina's new development path. The new assets-especially real estate-have been auctioned commsion acted rapidly, making quick dedsions to the highest bidder. A percentage of the shares of on pending petitions for rates and entry Intfonew the petroleum company, YPF,have been sold as an areas such as mobile and cellular phones. ongoing concern through a combination of macha- An intrting feature of the Agentine pdvatira- nisms, including a public offering of American tion, and one that sets it apart from those of Chile Depositay Recipts in New York. andMexico, isthatItstatedwithverylageandcon- 92 LathnAmerA and the Caibbean: A Decadeafter the Debt Crisis

t overslal companles-the national atrlines and the payhasbeenaround$7,200peremployee, $690mll- telephone company. This was largely the result of a lion In total, a cost partly covered through World political decision. The Menem admtinstration real- Bank adjment loans. ized that the only way to signal a decisive commit- An important lesson of the Argtine privatiza- ment to privatization was to move swiftly,putting tion process is one of humiity. Even when the major enterprises on the blodc At first, observets authorities are convinced of the need to modernize were skeptical about the government's ability to dif. the regulatory framework, the new regulation is fuse union opposition. But, as the process pro- likely to become operational only slowly. And It Is ceeded, more and more analysts %ameto realize that lkely that mistakes will be made on the way. More it could Indeed be one of the biggest and fastest ever generally, It takes time to build credible Institutions, Another important feature of the Argentine pri- making Utespecally Important to lay the foundation vatlzation-worulsome to some-is that a small for new Institutions early on and to be alert to the number of local conglomerates acquired controlling need foxmaking corrections when problems arise. packages in many of the privatized firms.33This has increased the industrial concentration, especially in labor Market Re atbns In Latn Ameri_ public utilities. Although the government is trying to speed the modernization of the regulatory frame- Most policy discussions on the mechanics of struc- work, Including pdce-setng mechanisms, It is too tual adjustment and market-oriented reforms eariy to know whether monopolistic practices will Ignore labor market deregulation. And yet, labor be avoided. That makes it important to monitor the markets in many countries are highly distorted, new regulatory framework closely to see whether it introducng efficiencycosts and making adjustment fosters the development of naural monopolies in more difficult. private hands. A dynamic and flexiblelabor market Is an Impor- The privatizatlon program Is having a big impact tant part of market-oriented policies. It helps realo- on pubiic finance, reducing the deficit of public cate resources and allows the economy to respond enterprises from 3.4 percent of GDP in 1989 to an rapidly to new challenges from Increased foreign antcipated -0.06 percent of GDP In 1994 (Kikeri, competition. Moreover, freeing the labor market of NeUlis,and Shirley 1992). For the system as a whole, distortions Improves the disftfrution of income this reduction-primarily In subsidies and trans- because it encourages employment expansion and fers-will more than offset the reduction In Income wage increases In the poorest segments of society. In from the small number of profitable operations. most Latin American countries, labor market distor- The privatizations also allowed the govemment tions have been segmented, with protected and to reduce greatly its public (foreign and domestic) unprotected sectors coexisting side by side. debt. Asof the first quarter of 1993, the face value of Removing the most serious distortions usually public debt had been reduced by about $14 billion. increases the unprotected sector wage rate, reduces And the government has received about $6 billion the protected sector wage rate, and increases overall in cash. This has provided welcome breathing room employment in consolidating public finances, at the heart of the The extent of labor market regulation in Latin adjustment progam. America contrasts sharply with the extreme flexibi- Another important effect of the privatization lity in the highly successful East Asian economies- process has been the drastic reduction in the payroll Hong Kong, Indonesia, Korea, Malaysia, Singapore, of public enterprises: fom 250,000 in 1989 to about Tiiwan (China), and lbailand. Recent studies by the 60,000 by the end of 1993. This major reduction in World Bank (forthcoming), Krueger (1993), -and public employment has been accomplished through Nam (1993)argue persuasively that the flexibility In transfers to the newly privadzed firms, early retire- labor markets has been one of the most important ments, and "voluntary" quits with severance pay. determinants of these countries' economic miracle. The reductions prior to privatization allowed the It has allowed small and medium-size firms to adapt government to obtain higher prices and the buyers rapidly to new market conditions, to remain inter- to start with fairly leancrews Additionaly, generous nationally competitive, and to take advantage of severancepaymentsrenderedexistingcollectivebar- technological advances. Interestingly, rezat C'scus- gaining agreements void, allowing buyers to negoti- sions on European economic problerw%and slug- ate from scratch with the remaining labor force gishness have increasingly focused on iOe -osts (Alexander and Corti 1993).34The cost of severance associated with rigid and protected labio .n.ckets. PI*zotfon andDeregulation 93

Experts point out that unless labor distortions are celved as a tax on labor use they wlll have serious reduced In Europe, recovery will be slow and painful effectson the way fim deal with labor. In a recent (Fiancial imes, June 22, 1993). extensive study on labor regulations in Latin Textbooks usually mention minimum wages as America,Cox-Edwards (1992) concludes that, given the predominant labor matket distortion to be the way severance payments have been legislated, removed in market-oriented reforms. But this is not these are viewed by firms not as a delayed payment, the most pressing Issue In Latin America today. With but as a tax. few exceptions, minimum wages have declined Consider the main characteristics of employ- throughout the region In the past fewyears and have ment protection legislatimn in 10 countries lagely become a nonbinding restriction (table 6.7). (table 6.8). First, there are severe restrictions on tem- This of course does not mean that (potential) hikes porary contracts in almost every case-in sharp con- in minimum wages will not hurt employment in the trast with labor legislation in the United States, future. where the "employment at will" doctrine prevalis.36 The most serious labor market distortions in In principle, resttictng temporary hires increases Latin America can be dassified in three categories: labor costs, dicouraging employment, and intro- high costs of dismissa that reduce flexibility and duces rigidities, slowig responses to changes in the make restructuring difficult and slow, high payroll international competitive scene. Second, there is a taxes that reduce the incentives to expand employ- steep difference in severance payments for "justi- ment and the international competitiveness of local fied" and "unjustified" dismissal. What is partlcu- firms, and antagonistic labor-management rela- larly important is that in most countries "just" tions, encouraging confrontation and costly settle- dismissal excludes economic reasons, such as finan- ment procedures.35 cial distressand increasedforeig competition.So, finns reducng the size of their labor forcehave to Hi8hCosts of Dismissal incur high costs to compensateworkers that have been "unjustly"laid off. LatinAmerican labor legislation has a longtradition The amount of severancepay for "just"dismissal Of trying to protect employment stability-through varies significantlyacross countries. Colombia, Urn- a seriesof measures,including placing severe limita- guay, and Venezuelarequire one month's pay per tons on temporaryhiring, and imposingsubstantial year of sevice. But in Uruguuy,there are ceilingsof costs-severancepayments-on "unjust"disissals. six months' pay.Mexican law establishesa payment These policieshave increasedthe cost of labor,dis- of three months' wages. Boliviadoes not require couragingemployment creation, and have strongly compensationfor "just dismissal,but workersare disouraged trainingactivities. entitledto one month per year of servicefor volun- The impact of employment protection laws tary retirement.Dismissed workers in Ecuadorre- argelydepends on how firmsperceive them. If spe- ceive25 percentof the final month's pay per year of cificrules, such as severancepayments, are seenas a service,plus up to three months' wages.Paraguayan "delayedpayment scheme," their effectson hiring lawmandates that individualsbe paid 15 days of pay and other decisionswill be small.But if they are per- for each three years of service.In her comparative

Table6.7 MInimumurban realwages In selectedLatn Anmican countrles,1984-92 (1980-100) CountY 1984 1985 1986 1987 1988 1989 1990 1991 1997 Argentna 167.5 1?3.1 110.0 120.8 93.5 42.1 40.2 S6.0 44.5 raz 87.4 88.9 89.0 72.6 68.7 72.1 S3.4 S9.9 55.4 Colombia 113.5 109.4 114.2 113.0 109.9 110.8 107.9 104.3 103.2 Costa Rka 104.4 112.2 1187 117.9 114.6 119.4 120.5 111.8 - Chie 80.7 76.4 73.6 69.1 73.9 79.8 87.5 9S.6 100.0 Mexico 72.3 71.1 64.9 61.5 54.2 50.8 45.5 43.6 42.0 Paraguay 93.8 99.6 108.3 122.6 135.2 137.5 131.6 125.8 115 Peru 62.3 54.4 56.4 59.7 52.0 25.1 23.4 1S.9 16.3 Uruguay 88.8 93.2 88.5 90.3 84.5 78.0 69.1 62.0 61.5 Venezuela 66S 96.8 90.4 108.7 89S 72.9 59.3 S5.1 -

-Not avaWae.

Scum CEPAL,E *uW of L.th,Anko, vaumaisyeaes. 94 LatinAmea andthe CarbtWn:A leade a*ft theDebt Crsis

Tab66 lobpoecdon bglaion In sected i A meran_ countries RsrkonsonResbkAdswi tenyo"w hobe Uway Aofunmnotk Severwncwih SencehrqWm=#w S0ewntowfor CoY coft" perdod b dmssl 'wftwase lust cse" ecotOmcase Argetn 2 yeas,non 3 months 1-2months No eerancepay wr S*W¶ P renewabe

olv Rewabl 3 monfds 3 monhs Noseeae pay - rT - once frai 2 year,non- 12monnt 1 month FUND .4[FUND]_I

Colombia 3 yeas nof- 2 months 4Sdaysb FUND FUND{1S40days wagesrT renewabl Chile 1 yew,non 12monfts I month Noseveane pay 1.4 .2[1 t[t11

Ecuador 2 yeus, non- 3 months 1 month 0.25-[W I]+FUND 0.25 [WJ-FUND reneavAle 4(3f*) If 1c3 (1') If 2525

Medco No - 1 month W3 .4- [20days wages' rT-V

NkIaagua 2 years,non- 12 month 1-2 onvths wrT . 2¶W1J go renewable

Pefu 2 yeas non- 3 monft - FUND -FUND+[W* renevAble

Venezea Renewable 3 months 1-3 months [10-30 days wages)*T 1.5lO-30 days'wages]'T once NoteWrapftsn a fmondiywa Trapemnt yewso tetureanthe job. a h ts cms lw etalIhes a m um W.Thus, te Iaapon sern&e. b. Amb*wnin sewerance paymet equIv41nto 45 drjYvw"ge IspW" In caseof dirsmssals c. InIds cam thekw eabsh a madun T Thus,te sasoa ca an sevnce. 14.Tbuwden d po bon the anplys. ft&e to poved nsaof'Justcas may lad toa pnltyod up to50 pi1t onr the nomal severane (tW). 5:aanCo*Edw_ds 1992. study Cox-Edwards(1992) fond out that, by and Can firmsdevise ways to educe the costs associ- We, veance payments in Latin Amedca are ated with mandated severance payments? Cox- hghe thfa in a nmber of othe countdes,includ- Edwards (1992) argues that employers have two Ing Germany,Spain, and the United ingdom" waysof doing this. First,they can maintain a vey A thid charctrc of labor pitection legisla- youngwork force with a high turnover Second,they tion Is that severancepayments for "unjust cause" can avoid,as much as possible,dismissing workers, aredlrectlyrelatedtotheworkierstenureinthefirm, espedally older workers.These policieshave effi- typclly taking the form of "x monthly salariesper dency consequences.Concentrating on a young year of service."This Introducessome seious-and labor force distorts the choice of actvities on the arbItrazy-distorions. For example,firms wllg tend basisof age, and largelyIgnores efficiency consider- to retain older worr, even if they are lessproduc- ationsand marketprices. However,avoiding labor tive than younger ones Relating severancepay- dismissa altogetheramounts to treatinglabor as a ments to yeas of servicealso reduces the employes' fixedfactot In this case,hiring decisionsare subject Incentiveto invest In tranin epecially If ft is not to delays,and If marketconditions tun unfavorable, firm-spefic. Thereason the valueof inceased skills seveance paymentsbecome an actual, realizedloss is higher in other firms not affectedby the burden for the employerand a bonus for the employee. of a tenure-relatedseveace cost. This, in tum, Possiblyone of the most imporant reforms of lncreasesthecompensationrecentlytrainedworkers labor regulationsIn Latin Americawould be twansw wll be offeredin other firms,encouraging them to forming part of the severance payments into lea thefr cumt jobs. deferted compensation,already done panaly in P"&lzon andDeregulaioon 95

some countries In Bolivia, workers have access to High PawoUTaxes the same severance payment in all sepatation cases (quits and layoffs) after five years on the job. Other Payroll taxes increase the cost of labor, dlscouraging countl-ncluding Brazl and mote recently employment ceation and reducing labor mobUlity. Colombia and Peru-have replaced the traditional Whether particular levies, such as social security mode of severance pay based on amonth' pay times contributions, are perceived as pure taxes or as the number of years of service fora aTimeof Servke delayed compensafton It is Importnt to determine Fund. In Brazil It Is the Pondo de Gamantiado how much th eydistort the economy. In most Latin Tempo de Servico (FGTh), and in Peru the American countries, social security benefits-pen- Compensacl6n por Tiempo de Sericdo (CIS). In sions and health provisions-are not related to con- both, the severance pay Is accrued in case of separa- trbutions to the system. Mesa-Lgo (1991) and tion ("lustified" layoff and quits), and a fraction of Cox-Edwards (1992) have argued that this imbal- the salary (8 percent in Brazi and 8.33 percent in ance results in a lare percentage of contributions Peru) is accumulated in a fund in the name of the being considered a pure tax and benefits as an enti- employee. Chilear law allows workers to choose this tement type of arrangement, instead of the traditional sev- In many countries, as Mesa-Lago(1991) points erance payment, after seven years on the job. In out, the sodal security system is financially insol- these cases, employers are required to deposit the vent, impoing increasing costs to the economy as a equivalent to one-twelfth of the annual salary to a whole (table 6.9). There are several possible direc- savings account in the employee's name. tions for improving effidency (see chapter 8). The Severance payments based on an accumuladon most important feature of any future social secuity of funds, as long as benefits are determined by con- system for efficiency is that participants perceive it tibutions, will not interfere with employers' deci- as part (although a delayed part) of the wo s slonswithrespecttoage-eaningsprofilesanddonot compensation, not as a tax that increases the costs discourage Investment in training on the job. But, in of hiring. A stem repladng pay-as-you-goregimes, most cases, including Brazil and Chile, severance where there is no link between contrbutions and payments are not lmited to the fund. Irrespotive of benefits, with a combination of individual capital- themethodsdesignedbylawtodeterminepayments ization accounts and minimum services assured by in case of separation, employets are often requed to the govemment has been operating in Chlle since pay an additional severance in case of 'unjustifiedc the early 1980s and Is being implementated in dismissal, including that for economic cause. Argentina, Peru, and Mexico. Nicaragua and Venezuela have the most strin- From efficiency and equity points of view,labor gent constraints on dismissals. Mexico appers to be legislation should notbe used as a way to protect the the most lbeal. Argetina, Bolivia,and Peru have poor-because more often than not it works in the somewhat trasparent sym Te Chilean law is opposite direction (see chapter 8). Nor should it be the clearest and provides comprehensive legal pro- used to pwvide income transfes. Most traditional tecdon to both employers and workers against regulations in the labor market-including mini- bteach of individual contracts. mum wages, high costs of dismissal, and pay-as-you- Table6.9 Bask dc eristcs of sodal seuity systemsIn selected Lotn Americancowunes Deadesbdw.m &pnuatIonwrd Sodalseury poeoffr expediu as a Popuatin pensionlw Eeononkd8y Stutoy pwreage Pens_ineV aged65 Countiy andthe 1980s Tota acthe Canut rfte of GOP contnbutosut orodei 6 79 69 46 10 0.32 8.2 3 25 18 25 3 0.33 3.2 Bral 6 96 96 26 5 0.18 4.0 Colombia 4 12 22 20 4 0.05 3S Chile 6 67 62 21 11 0.46 5.5 Ecuador 5 8 23 21 3 .1S 3.5 Mexico 4 53 42 18 3 0.08 3.6 Nkiaagua 3 9 19 16 2 0.08 2.4 Peru 5 17 37 21 3 0.09 3.6 Wneuea 2 45 50 14 3 0.06 2.8 a. ToWlsttuqy peceage of psyro tobe ca_ btFed by t Inuredpaw, Owmpicyrw, ndthesat b. Deendeny raft umbr of penioners dMked by dobvoenwo buor c. Asa poentu* of tol popultv $mu C*wrEwa 192. lable 6.10 Labordispute resoluton In selectedlatin Amerkancountres RWghOfen Esm RightOf eWioyee kmbonIbn Torenouc unkon whkhkJutdola Towvge rep_*cm memrh and Tobdc out lb tenmpxad ountry procedurerests Tostke Madrnum whiton strike returnto wor* .v . rep eworker dVdont ofsGtke rgentln Civi courts Mustbe caed by union abt No,If workersail to No No,unless the No No maxum condlationdcans areexhausted. accept arbrato. bIe Minstryof Laborprnounces bgal. Yes,if the employer kxcs out worker l01hia Laborcowrts 24days after presention of No. Strikesupends No Yes Yes peon to lbor Isector. laborcontracts No mmum. The Inspite ofte aortyof unn or2/3of km manystrikes workersmust agree. strt before unideiin krazil Laborcours Yes,In the contextof coctive No Yes.Strike does Requires contr prior No, nlessthe strike Is No maxium negotiaon. Quorum not suspend auodzaton. dedared mabusive requWd for union decsion. Decded contact. by the court by head cut vote. Chil Laborcour have Yes,In the contextof colectve No Yes Yes,If the ste Yes,from the flday of If mo tan half ojsdction over cotc nootlaons. alectsnmwe t1a qestionsarisingout the i if the lsi offeris tewods have ofthe applicaton halfe workers. equivalent to the retmrnedto work, of the Yes,If the i leads prevouscont adjusted te stie ends. to ppage for the conuer prkce of essentialwork. Index.Only after 15 das Colombia Laborcourt Whn Aer directn peiod. No.Stike supends No Z daysof a dedared No, uns dtre lsa rik 60days Mustbeagreeoonhasecretballot aborcontras. of serious satre,thitenty of mat of enerps danageto he Labormay cal for an fadlie bntration. Ecuador Laborinspectorate If det negotiatinsfall, as tongas Yes No No No theabsokut majority of workersesle One the tbund agrees. Solidari s dispt strk ends Mexico Laborcourts Trparite boardmust delare k No,uess the board No No No nmaimm "existentor legal. deddesthe sbikeIs 'Impu to the Nkiarua Civilcourts Yes,If agred by headcount maorit. Yes Wrkerscan go Yes.After conlaon, Protbl No nmximu Coecte barginngisnot a backto work. if authod by - . Bu wages ar Labor Inpecorate. paid wWay. Peru Ministryof Labor Yes,If the naot approves.Very No. Strikesuspends Not regulated. No Not regulated No ataxmumn few Retitatkwion lbbor contrac Venemb Labori torate If directnegoaio fail,as long No. Strikeswpends No Not reated Not reguated No maxinm asthe absolute majotf laborcontracts. Wores agres.ASolikaft st

SouxwCox.Edwads 1992. PdvazotIonand Deregultion 97

go socialsecurity regimes-increase the cost of hir. agemen.relations In latin Amerca Is an imporant ing and hurt employment,espedaly among those unfinishedpart of the recent structrl efoms In with low skillsand low net wages.The role of labor general,modetn, flexiblelegislation would be dc - legslation, Including social secl"t, shoiud be to actried by Incentivesto rolve conflictsquidkly promote the efficient use of labor and to protct and faily. Thisrequires clear rles of the game, mod- workers ftom abusive practices Social progams em institutions,an efficent judliday, and a system should be handled through altemative channels, where both parties Incur costs if the conflict including direct and focused transfers (see chap- becones potracted In most countries,howevet, the ter 8). situation Is far from that, becausethe asymmetric costs for unions and employeesdo not penalliz AntagonistcLabor-Mageme Relations delayingagreements.

The existinglabor legislation In most of LatinAmer- NOtW Ica predates the region's recent market-oriented 1 n W of serice InBuo Ars In192 Is reformsand encourageslong and costlybagahining amexos 1 processes(table 6.10). Except in Chile,which imple- 2. The laed rol of th govemmentas a poducer was mented labor reform In the early 1980s,the process pu d bythe Coporacido de Fowentode la Prducd6n, CORFO. Seethe disusonsWinFfench.Dsvls 1973. is very smilar across countries. Unions with legal 3. Te.° nthly Im LatinFnon provkdesusel and representation propose a collectivecontract, and detaiednormati on pivzon in theregion employersmust respond.The state becomespart of 4. During1992, the Bolivianprivatizatlon efforts stalled se the negotiationsfrom the beginning,and the final plebiscitebecae alrecte bids on mostfte prlatizatonmao ofwe* tdelcmmunications r*edA In Unrgay,and a agreementapplies to a}lworkers represented. oher sectors,and the recet Braillanpwc uphva hassowad Traditionally, strikes have been one of the most theprvtatin pro important mechanismsto resolvedlsputes between S. Rall te dission I dCpter4 on the debt-equl- ty swapsprogrm Theuse of debt to buy pubikChieanfims has gat- unions and management.39 In general terms, stikes ed m- coby inBare. are mechanismnsthrough which the seriousnessof 6. On theuse of pubic owrship asa wvyto dealwth exer- the workers' prposal Is weighed against the sed- see forxampl g 1993. 7. Flsdow(1989) disAses the increasinglymorta te of ousnessof the employer'sdiagement. In theory, the te In Bra afterthe flrstoDl shodc-the _azoa peiod. each party should risk somethingdurig the bar- He ponts out that in spite of a rhetork favoing privatesector gaining process-to make delays in reachingagree- develpet, the stt greatlyieased Its economicrme both ments costly to both parties, encouraginga speedy tDlrt garthmajor fiacn noea tntofthe _a and efficientresolution of the conflict But,in most tweflms LatinAmerican cases, the costs of strkng are lower 8. Ofcouse, te weresome excepftos Fora broadanlysis for employeesthan employer In most countries, f the evouton of s owentepe andpaon he union members'costs of strikingawe lower than In 9. Regulato are -captured-when an Interest group can other pars of the globe,including the UnitedStates drec or nWey dctewhat t do See,for exampl Sgigr 1971anbeke 1983. and mostof Europe.In a fewcases, workers are paid 1O. Interesdngly,many Latin Amercan professlonalshave their wages even if they are on stike. The most becomecostm to Easternhropean govemnus onp dtvat important cost to firms during a strikeis that they tbI. usually cannot hire temporary replacementsand .Seethedscnonthe lanpatpogram n thus are forcedInto stoppage. 12. SeeSeabrght M3forinilarcasification. A particularlynegative consequenceof current 13. An Imporunt technicalIsue In privatizting of large labor legislationin some latin American countries lyb or hodzotay.o Itsrwhethe It Is more efient to breakthe up vertica- Isthat the length (andcosts) of strikestend tobe pro- 14. 8ano Nadoralde Desmo personnelthavcotne to cyclical,increasing durng recessions.When sales operatewithi the populistmode th daractied the Sandint are slow,the coststo the employerof stoppingactiv- adi aowdng out pwvateinesme and reducingthe country'sablity to meetthe InternationalMoneay Fus targets. itlesdue to the stike are relativelylower than dur- 15. In mst countries,workers In sate-owed eneesp are Inga boomperiod, when the firm'sgoal Is to increase part of the procted sectorand tendto receivhigher sald thn production In order to take advantageof the expan- thei erpart Inthe unprotectedsect4r. See Hatger 1971. sion. Of course,If they lose wages durng stdkes, 16.or instanehe owiginalAndanPct dsteri t set workersmay be lessprone to doso duringrecessions. 17. This Issue-involvingfinandal markets,savings, and lThissystem then increasesthe socialcost of nego- inOtfi-- &dssed ingreater deail pr.wha Watlon,reducing output aordastan dH eacquisiiotof ehlw s Argentnhesebuyn grou Reformingthe legislationgoverning labor-man- led by Spains Ibera ha rn Intosrous dhi lufle, fordqn the 98 LatWnAmeri andthe Cariben A Decadeafar the Debt Cisis

go mt to buybak someof th are frm boes lcapart- hypotlcaW0ef1ident ir_ml Taft ae setfor ft yeaswit klo-b ne. tloneladkadus antoW eveyto montfis(al 199I). 19. A hhran oMia d tho coalito leadi partY(lb 28. Thegovermet neverthelesw) si on snm In or- Christianiemocat) had to regn under ie afler sgsing tt fMs, In Oudnoil Sthegiant.im% P 1h. govnmet wed CODEC 1O1sprvatu. Its le commltm to pftUmbht andresmchtw whvn,In 20. Note that Zueta and o s (1992)h agued tha 1987,It alowedAMWC, a state-ownedafl% to go bank- heau of themave ch I othereconofk conditis, Itb rnt not dew if te reductIon cosarur pries and the rs In 29. Therehae bee a fewexcetIons, ncudnW te two ar serviceiency can be awbued to te divestr. esAEROMICO and Mec de A n 21. In th "ga, te asumption ta th fms nwme ft 30. In ChOeth uon memrs obtned th cactr and deding the k of Wnestmentan ta th goment movs te subcontracedth w*poft Wh In tunmsubcontracted to next, enacting rat atmt Sine emO ha alreadymove tse awos depo wh pfwhormeddo taL th gvernmentwillv keInsTt asgven n ming Itsded- 31. Crel*, the6i constraintsreer to fty regulato don.See Laffont and Tkole 1993 M . Sbe 1989fr theoral 32. Mems maineconomk stratst, DomingoCavo. anays of gulaonbased an strategicbdewAor by fis, pollt- atId d hisvWion of a OnewArgentfn In his1985 book VtVr cdam,an guators. a Crew'. 22. On the generateconomics of time inconstsy, see 33. Theseconglomerates are the Techintgroup. Perez- Banhd andFic 1989.For a dcical trrment of the sub. Compan,Comardal La Paa-Sokdal, nd t Astragroup. ject seeCairo 1978. 34. Thebawgaing pros wasstill s ct to the outdaed 23. Thi approachtoward regulations as bee Ifnced by Argentinelbor lgislation. NortWsnawsis (1989,1990) of the oleof iions n economic 3S.Much of te dison In thissecton is basedon Cox- dewdopment Edwards992. 24. Forthe specificsof Cis regult spem of elctric 36. Note, howevt,that In contrastto the WnedStats utes, seePhilippe 19. mostLatin Aneran co on ladcknmplomen inan. 25. In Jam, themajort paty canaltc anylegiaon at 37. Thefksan recentarguedthtium seve- wili, but long-termcontas (or lines) hmverdoly ben ancepy is relatvl high-usully abouttwo-hirds f sary fow honored.If confits regadi the inton of the co s four mohs, vey lowwhen compared wit te LatinAmerican arisethe courts ae called ito acion, dta Intabe 6.8. 26. Thesefims had not beennationalied. The Allende 38. Assemblyacve tht equire ited trag andcan administrationused an obscue piee of legisonfron th 1930s ace,mmodehigh tuwoverbecome reatvey more atbacte. to intrvene"in csoanieswhe prductswere In "swt sup- Finecrafts and industria activites tht requirea highdegr of ply.,See dcapter 4 of Ewadsand dW ds199 for dtl Aso training,and whe prsonel turnoverImpose a high cosk seeLarrn andMeller 1991. become i ess 27. Ihe acualprice4etting pode is qfte s _ophisti 39. This,and the puaraaphs that foow, aretaken frm Cox- Frst.lng-run margin costsare acFultte second,the capita Ewds 1992. assetprlcng modeIs usedto demine the "fir retawed a Chapter seven Capital Market Deregulation, Savings,and Investment

For many decades, the Ltin Ametican countres firms to finance expansion prorams more easiy. imposed tight controls on the financal sector, with The creation ofa tasparent maket-based system of widespread ceilin on Interest rates, credit allocated credit allocadon Is expected to result In a decine In bysocdalplannersandbureaucratstosectorsdeemed lobbying activities and Inceased productivity of exciting and promising, and the creation of new Investmeit. financial Inttut ons often blocked In order to Accordingto the traditional llteratmu on finan- reduce -speculative and unproductive- activities. clal lbealiation (MciUtnnon1973; Shaw 1973), the Basedon simplistic I tions of Keynesianthe- degulation of capitadmarkets wil affect eemnomic ories, It was thought that by contolng Interest growth through hh savings rates and improwved rates at "reasonably lowv levels and by expanding Investment allocations. The higher savin allow an the scope of government direct intervention, invest- incrase in capital accumulation, and the better allo- ment would greatly increase.' cation of investment pushes up the marginl pro- These policies weveto increase agegate savings, ductivity of capital.3 King and Levine (1993) suggest accelerate capita accumulation,boost the efficency that the link betwueenthe financial sector and eco- of Investment, and contribute to overall growth. nomic perftmance takes place through a differt Nothingofthesorthappened. These policiesinstead avenue. Accotding to them, fatcial Lncentives resulted In little monetization, generated significant have an advantage In procesfing bmaton on the lobbying acttvities for credit quotas, reduced the creativity and Inventiness of entrepreneurs So, a quality of private investment, hurt productvity well-developedfinancial sector can fibs* promis- growth, and discouraged financial intermediation Ing projects that will increase pocuctivity growth and savings. McKinnon (1991) reports that the ratio and. monitor the progess of the entrepreneurs of loanable funds to GDP in a group of Latin selected. In a formal theoretical model the authors American countries during 1960-85 was only three- suggestthat countries with more developed financul quarters that of a comparable group of Asian sectors will have an advantage in sorting out highly nations 2 productive innovations and thus will grow fster Although the dominant development paradigm than countries with repressed financial sectors This of the 1960s and 1970s favored controls on the approach diffe from the taditional McKinnon and financial sector a small group of economist began Shaw view In two Important respects. Flrst, the pro- to argue, with increasing force, that relaxing finan- cesi of bm is at the center of the capital cila controls was a fundamental requirement for marketesfunctions.Andsecond,productivitygrowth accelerating growth in the region (see LIders 1968), (not the accumulation of physical capital) is the fun- a position reinforced by the writings of McKinnon damental source of economic development. King (1973) and Shaw (1973). Not until the 1980s, how- and Levine (1993) have presented preliminary ever, did this view begin to gain general acceptance empirical evidence to support their modeL Using an among the region's policymakers and political lead- 80.country data set, they find that, after controlling ers as part of the neweconomic synthesis. hnfluenced for other factors, higher degrees of financial inter- by the experience of other reglons,Latin Americahas mediation are positvely associated with long-run made the reform of the financial sector an Important productvity gowth. part of most progrms for strucual adjttment That the acquion and processing of lnjma- Allowing the financial sector to develop is epcted ionon investment ptolects is a fundamental role of to increase financial Intemedation, and enable capital markets and nas impotant policy implc-

99 100 LatinAmec andthe Carbean:A Deadeafter the Dbt Cis

dons. Since iomadon is a pubic -tat Is, a though stil subject to Important distrdons. In goodforwhichconsumptionbyoneindlvidualdoesBolivia, the DominicanRepubli4 Ecuadorx , Peu, not peclude comumptionby others-competitive Nlcagua,andVeneauela,itfitthetextbokdescdp- makets wlM1pre less oMationthan Is sodally tionof financialrepresson almost peectly. Intest desirable.4Stlglit (1993)has agued tht thismeans rateswere sub ject to controh, the allocationof credit that financialInsdtutions, knowing the difficaltof wasdecided abltr, securitiesmarkets were dis- monitoring,will be tempted to act reckly by couaged,anddweresnicantbarrierstoentry either underadng excessivelydsky actions or com- for new finanidalInstitutions. In almost evety coun- mtting fraud. It also means that the publl4 aware tr, finandal regulationsand controls were tans- of the Incentiveproblem that fnancial institutions lated Into a low level of finandal intennediation. face,will entrustasmaUervolume of resourcesthan Except in Hondurs and Venezuela,the tatio of under the (hypothetcl) case of ful infonnation.5 brad monq to GCPPwas below 30 pecent In the This, of course,Is a marketfailure that govenmuent early 1980s(table 7.1).' inteventon can, in teory, minmize. Many histocal inefficiendes In the Latin The publicgood nature of infmaton and the Amedcan financial sector can be traced to the informationasymmeties cottute the fundamen- region'smacroeconomic Imbalances. High and van- ta theoreticalrationale for desgni a regulatoy able rates of infatton dscourged the public from frmework in finandal markets. Without such a holding deposits in the domestic financial sector, framewotk,financdal Insttutions are bound to get helping generatethe vey low degees of financial overextended,make bad loans,and eventualy col- depth reported. In most countdes, overvaluedex- lapseat a huge cost to society.6But it Is not easyto change rates encoured specuatlon against the designregutlons that avoidmoal hazardswdhout localcurency and reducedthe volumeof resources Intrdtcng distortions that reduce the finandal intermediatedby localfinancl institutions.More- market'sability to Identfy entrepreneursthat have over, the need to coUlecta sizableinfation tax led thegreatest potental to Innovateand fosterproduc- cental banks to Imposevery high reserverequire- tity growth. Implemening such a regulatory ments on commercialbank, reducingtheir abilty fmework is one of the most seriouschaRenges for to intermediatefunds (table7.2). financialsector refom In LatinAmerica. In most Latin Americancountries the banidng In designingregulatory legslaton for the finan- stem has traditionaly been at the heart of the cial sector, the avalabiity of Informationcm be fimancialsector, with other ndttudons repressedor greatlyincreased through actons mandated by the nonexdstent Macoeconomic instilty prluded governmentbut undertakn by the pdvate sectot issuinglong-term securities, forcing frms to rely on Haviln credit rating agenciesand outside auditors inefficientsources of funds to financenew projects monitor thle accounts of financdalinstitutions ate Securitymarket capitalation decined in the fit only two examplesof quasi self-regulation.Over- half of the 1980sand was still underdevelopedin regulatingthe financialsector is to be avoided,espe- cially intervenng throu direct govenment Table7.1 Rndal deepeWngin seected Latin actions. Overregulaton-posbly dtsasto-c Anmlan coUnbies,1980,1983, and 1986 erode the efficiencyof the capital made, create M as a peruntageo GOP) opporunities for rnt-seeing and helghten cor- Cofb 1980 1983 1986 ruption. Argna 22.6 16.3 Aswith other reforms,the progess in financial b1315.5 12.1 513 Brazi 13.1 11.0 13.2 dergulation has varied across the region. Some Chile 15.0 19.9 17.9 countries have moved faz while others have only cohmbb 22.9 28,0 27.5 recentlybegun creatingmodern and dynamiccapi- Ea ador 19.3 17.1 20.9 tai markets Guatema 20.5 24.0 Honduras 26.1 30.6 22.331.7 Me"ico 23.6 23.9 24.3 gptorkmd _ _-spmi Peru 12.7 11.6 12.0 uguay 20.3 20.3 15.8 __ _ ),_~~~~~~~~enzul 31.5 41.9 42.3 In the early 1980s,the sophisticationof the finan- verage 20.3 21.4 20. cial sector varied greatlyacross Latin Amedrcan Stld devikon SA.4 8 9.4 countdes.In Argetin, Bazil,Chile, and runguay, Ndt CW*dabdby u*g stodsat Owendof ON peodd for M2. the bankig system was somewhat developed, so=mearrisewndos1o. CpitMatDert gukttr Sa ) andInvesmt 101

most of the tegonIn thelate 198s. xept in Chle, vate bnk almost impossible.Because of this uaze Istittional Investots have not had a sigficant of regula$ as, the regon developeda very Ineffi- role In financdalmarket development dent financld sectorwith high unit costs and sub. Becauseof the egulations,stock makets became stantial spreads between deposit and leding stagnant durng the eary 1980s. in most countdes, interest ates (table 7.3). they have been emely thin, hlW conentrated For many years, the Latin Amerc countdes on a few stodcs.Government red tape dcourged controlled Interest rate movements C:eilingswere fims fromssuing newshates, and specualtorscould often set belowongoing ates of Inftion, genrat- easily manipulate stock pdces. In Brazil,six stocks ing negativ real Interest rates For a Soup of 11 accountedfor 70 percentof the daiy tading In the countdes, the venagera rate of Lntereston bank late 1980s Few stock exchangeshad trained staff deposits was negative In most countdes In most and adequate equipment. Smal Investors were years between 1980 and 1985 (Morrlsand others deterredbecause of the lackof transpary In most 1990;table 7.4). Thesenegative rates hurt resource operations allocation,inuding the fundng of new productive Most Latin Americancountdes ereted s3g projects,and geatly encouragedcapital flight. cant barriers to entry Into the financial sectot Makdngefficiency worse in most countdes were Permitsfor new instutions wereeither not granted stict guidelines for sectoral cedit allcations, or subject to nstatW red tape. In Urguay, the Implementedtough four main channels Fst banldng law ftoze the number of banks and bank government-owneddeveopment banks lent to cer- branches at the 1965 level6 In Costa Rca and tan sectors at below-marketinterest rate Some- Nicaragua,the govenmmenthad the exclsive dght times, the central bank performed the role of a to own and operate commercialbanks Elsewhere, developmentagency, providing subsidized loans to govemment-ownedbanks operatedwithout a hard favoredsector-usually agdcultue, housing, and budget consUint, makdngthe srvival of smallpdl- smallenterptises. Second, commerial bank had to

Tabe7.2 Effectivereswve requiremn on bankdepost 197140:Comparative hstora eviden COWt 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 UnitedKngdom 5.3 6.1 9.6 7.2 6.9 8.4 6.6 5.4 5.4 2* UnitedState 7.8 6.7 6.6 6.6 6.7 5.3 5.2 5.4 5.2 4.6 WestGtmO 10.3 12.5 12.3 11.8 10.2 10.8 10.2 10.5 10.5 87 Brazl 34.4 28.3 30.2 20.4 28A 32.7 34.7 32.5 36.2 33.4 Chne 52.0 57.1 S5.8 37.2 35.9 60.7 S.3 41.3 33.1 28.2 ColombIa 33.1 30.4 32.3 29.7 29.3 31.5 34.3 48.6 S2.2 45.2 Me,dco 20.7 47.8 50.6 6S.8 79.2 31.2 52.S 50.0 S05 51.4 Uruguay 32.5 30.9 34.9 332 3S.9 34S 37.2 29.S 1S.3 11.9 SauwcMd 1991.

Table 7.3 Annualz real deposit Interst tes, end of period, In seeted LaUn Amercan countries, 198046 ent) COntry 1980 1981 1982 1983 1984 1985 1986 Aena 3.6 8.0 -20.5 18.9 21.8 24.3 16.3 soliva -19.9 -10.9 -66.7 -66.2 -89.S -97.S -19.6 Brai 3.8 S.6 6.5 8 10.2 12.7 4.3 ChIle 8.9 34.5 41.9 0.9 14.5 -0.7 3.2 Colombb 7.7 7.8 10.8 11.6 16.1 9.1 10.4 Ecuador -1.9 -6.1 -9.2 -24.6 -2.5 -0.3 -0.2 Guatem -1.6 1.4 a6 4.3 5.4 -8.2 -1:.0 Honduras -7.4 1.1 1.7 1.7 S.2 6.3 S.1 Mex"co -0.1 3.0 -1 1.S -22.4 -8 8.0 -2.9 Peru -16.2 -6.0 -4.8 -20.2 -7.7 -49.1 20.S UruguWy 5.2 13.9 37.9 10.8 S.4 -4.7 -6.7 Venwebe -S.4 -1.2 S.6 6.8 1.4 -1.4 -1.7 Avege -2.3 4.0 -0.1 -5.8 -2.4 -9.2 -2.6 Averagewihout Boia -0.7 S.4 S.9 -0.3 5.S -1.2 -1.1 StanUkdid dation 8.6 11.3 26.8 22' 27.7 31.7 11.4 Stanrdfdevdaon wihu Bol" 7.0 10.8 18.S 14.4 9.2 17.7 10.7 Lara ariandoths 199. 102 LatInAMeo andthe Caibbeaw A Deade afWerthe Oe CO*k

liW 7A RealInterest rat sprds In sekeed LatnAmerin _ount,1980-6 (pret) CGunty 1980 1981 1982 1983 1984 1985 1986 endan 11.4 16.1 14.6 206 15.0 20.S 3.5 b" 6. 6CS 3.3 5.6 0.7 1.5 19 CHoe 4.6 15.4 S.0 9.7 18.0 5.0 S.2 Co sm6W 0.9 1A 0.6 3.3 0.6 0.2 8.0 Ecudor 4.S 5.1 4.4 4.3 0.8 2.4 3.9 GuAtemaa 1.8 1.8 3.0 2.9 2.9 2.5 2.2 Hondwas' 5.7 7.7 7.6 8.2 85. 8.8 8.9 Meo' 5.6 9.7 13.7 17.7 13.7 18.9 26.4 Penu 5.4 4.2 4.9 7.4 7.4 52 6.4 Uruguay 10.4 9.6 8.4 11.4 6.9 11.3 20.3 Venezuea 1.0 2.1 1.9 3.8 1.7 3.6 3.6 khae 5.3 7.2 7.0 8.6 6.9 7.3 9.8 a. ~ee annualteat h as Sswa.Moeb an oth 199.

lend a set part of their portfolioto specdficsectors. loans was common, and unsecuredloans (often to Third, the central bank prvided preferental redis- firms related to the banks) were permitted. And count rates for the loans commercialbanks granted almosteverywhee, the govemment provided (im- to specificIndustries. And ft cmmerca banls plicit)free deposit Insce regardlessof the sound- were subject to different sve tequirments, ness of bank portfolios, creating a serious moral depending on the dhaterscs of their loan port- haad, and banks usualy did not make provisions folios.During the eady and mid-1980s,a substantal fo bad loans. In Argentina,Mexico, and Uruguay, shareof total credit in many countdes was diectly the provisionsstood at less than 25 eCentof non- allocated through these nonmarket mechanisms. perfming loansin 1985 (Morrisand others 1990). An estimted 25 pecent or more of loans were lntitutional consaints and defects in legisla- direcly allocatedIn Mexdcoin 1986,30 petent in tion and regulations weakened the supevisory Colombia,more than 40 perct in Aretina, and authorities' ability to ensure finandal stability. 80 percent in Brazil The WoddBank has estimated Among the most serious institutional constaints the subsidiesimplicit in Brazil'sdifferent officiall werelow wagesfor financialexaminers, overlapping controlled credit progams at almost 8 percent of rsponsibiities across regulatoryagencies, and an GDPper year (Moris and others 1990). absenceof computerizedsystems for offsitesurveil- The argumentfor diectly allocatingcredit is that lanceand iformation gatheringand auditng prac- unless resourcesare admnistratively directed,the tices. LegIslationand regulation did not clearly tageted sectorswould receve less than is socialy define the process for resolvingcommercial bank optimal. But the evidencedearly suggeststhat ad- distressor the rightsof differentparties. So there was min,stativey allocatedaedit reachesthe intended little incentivefor the claimantson a bank--depos- uses in few cases,endig up nstead with a few large itors, equity holders, and regulators-to resolve borowas who enjoy large rents (McKlnnon1991). financialcrises quicldy.9 That raisesthe questionof how to allocatedevelop. The combination of inadequate regulation,lax ment credit-often provided by the multilateal supervison, and fhf deposit insurance in many Institutions-in a way that entais little or no dis- casesencouaged al parties-financial institutions tortons. and the public-to engage in excessivelyrisky be- One of the worst historicalproblems of the Latin havior,particarly in the SouthernCone countdes Americanfinancial sector was the lack of an ade- during the late 1970s.Agentina, Chile, and Uru, quate supervisoy framework.Financial institutions, guay had freedinterest rates and allowedcommer- subject to very lax prudential rles, engaged In cal banksto greatlyexpand their activities.The lack highly dsky ventures.Information disclosures were of information disclosurerequirements generated minimal or none_dste The quat of the loan situationsof adverseselection, where "good" and portfolio was not analyzed.lxternal auditorswere bady riskswere not disnghed. Asinterest rates seldom requiredto inspectthe books in detail. And increased,rskier borrowerswere willing to payeven the rollng over of questionableloans was allowed. higher rates, hampering the soundness of banks' Moteovaer,the accrualof intereston nonp i portolios. CpUl Market gWon, dmandas, Iestmen 103

Mcdinnon (1991) argues that macroeconomic invests, and the reaton of modem, efficient instlty made this worse-an Increasinglyhigh supervisorylegsation (table7.5). varianceIn prolectyields made it particularlydiffWl cult for bank to tell dent tisksapart Morever, R Ovnw because of (Impliidt) insurance, a moral hazard developed, with bank and depositors perceiving Mostcountries have completelyelminated intrest that the monetayauthorltywould coverther losses rate cellings,and in the majodty of them interest under bad" statesof nature-as endedup beingthe rates are currently detemined by market forces cae in the three countries(Ramos 1986). (table 7.S). Countriesthat maintained preferential The debt crisisof 1982 crushedan aleady weak interestrates fot selectedactivites-such as Colom- and inefficent Latin Americanfinandal sector The bla, Mexdco,and Venezuela-haveopted to link the sudden drying-upof foteignfinancing and the past subsidizedrate to marketinterest rates. ypically,the lending practicesof many instutions meant that cost of fundsfor the favoredsectors sset at a cetain firmscould not pay their loans-or even the Inter- percentageof the rate prevailng in the marktLThis est-to local banks The proporion of nonperorm- allows the prerential rate to move with market ing loansskyrocketed, In sm casesto morethan 20 fores, a marked Improvementover the practie of pecent of the total (Morrisand others 1990).The completelyfixed rates for certain operations. The acial sectors of Argntina, Chile, Colombia, new practiceis more tansparent,and it deinks the *Mexico,and Uruguaywete hit hardest.In Argentina, sizeof the subsidyfrom inflation. theaestpdvatecommerclalbankand42smaland The diect allocationof credit has been geaty medium-sizefinancial insdtutions had to be liqt- reducedand, exceptfor developmentlines of credit dated (Baliflo1991). In Chile, 11 financa inttu- from the multUateral instituions,most countries tions, whose portfolios repesented almost 15 have eliminated forced sectora loans. Argentina, percentof total loans,were liquidated in 198142. A Bolivia,Chile, and Jamaica have recently adopted year later, the crisishad widened, and the govem- auction systems to ditrbute development credit ment took over seven insolventbanks, liquidating among eligibleuses This practice,set up with the two.Theotherfivebankswererehabilitatedandwere assstane of the WorldBank, forces credit uses to prvatzed through the saleofshare packages tosmail reveal their willingnessto pay for funds, consider- investors and privately managed pension funds ably reducing the inefficien cossbof subsidized (Lartain1988; Velasco 1992). In Uruguay,the central creditschemes. bank tded to protect depositorsby sellingthe trou- The deregulationof interest rates and the ellmi- bledbanks toireigners, but the banksfirst had tobe nation of direct credit allocation have often been restrucured and purgd of bad loans. The crss supplementedwith the reduction and rationaliza draggedon until 1986,when new fallurestook place tion of reserverequirements. The combination of and the new governmenthad to intervne in four these policieshas allowed the financial system to commercial banks (Pez-Campanero and LIone expand Its Intermediation,put pressureon firmsto 1991). increasethe qualityoftheir investmentprojects, and The debt crids put an end to an era of amplefor- forced banks and other lenders to make a greater elgn savins In the mid- and late 1980s,It became effort in identifyg promising invest Despite clear that the task of increasingdomestic savings this progess, and mostly due to macroeconomic would be fumdamentalfor the yearsto come. More hmbalancesand uncertainty, the financial instru- and more experts agreed that this would requirea ments In most countries are still concentratedon new and dynamicapproach toward capital markets. very short maturities-with Chileand Mexicoper- haps the majorexceptions. This and the slowgrowth ""am"alV mg_ m In Laft Ameik and low capitaization of securitiesmarkets are major shortcomingsof the region'sfinancial sector. Most recent reformshave tried to taclde the most Most countries have also reduced barriers to seriousproblems, focusing on sixareas: the deregu- entry duing the past few years.Despite the generl lation of Interest rates, the elimination of direct tendencyto encouragecompetition and new insti- credit allocation rules, the reduction and harmo- tutions-domestic and foreign-there has been lit- nitdon of resev.e requirements for commercial tie action. In many Instnces, the new regulations banks, the relaxationof barriersto entry,the encour- are too recent to have producedsignificant results agement of security markets and of insttutional and the private sector has concentratedon acquir- 104 LatInAmerca and the Cardbbean: A Decde after the Debt Cbsis

Tbble7. Rnarnal noms In sedctedLaefn Amecan countries: A progressreport hn te D(rected Rers Ran s SBwdtles lafonal Supensoay Country detmla*b ova m eats oentry madet hwstar$ ftmewok Arna Market. ElWnated Lowered. Freeerh. DereguWd. Epectedto Strenghened detemined. exceptfor Foreign-owned Increaein In1992 when multiateral banksalowed. iportn Coin institutions' withpension Nadonalde creditilnes fnd form. atores received increased responsibility. Boll Feey SeverelY Ratolized Greatly Noimporta Expected improvedafter detemind reducedafter In1988. reduced developen:t to increase,. te refon since19S5. thedoseof4 since1991. yet ofthesuper- Lurgespreads. lrgest pubik intendencyof f=na.dal banks. insittons zil Mostymarket- SeverJnic Not Reducedafter Stllsect to Veryminor Notvety delermined, stillremain completely 1991with the subsanti role. effidentto butsome stae-owned ratbinlized eliminationof distoons date.it needs secto stil entpris can yet. apowt reorm. borrowat sub- bofrowat below- sidizedrates. marketrates. Chile Freey Eilminated RadonalizedNew Rapidly Increasingly ModifiedIn demined exceptfor across Instiutons expn . importan mid-1980s. sincemid- sectoriaacrdt depositsand enouaged. Degreeof roleof private Modemand 1970s. iinesfrom institons. Numberof market pensionfunds effient Risk Spreadshwe muMlateral banksinreased capitaltion since1981. dasslfication declnedin Instiions, to 13domestc low. ofportfolios psafewyear whkhare and22 foreign. required. auctioned. CoombiaFreely Pernt of Resevesused Barriers Someattnpts NotImpotant Refomiedin determined, directedact asmonetry reduced. made;few yet prindple; althoughsome toagrkutre control Gowenment- resulsyet bankssubject sectorsstill reducedto Instrument; ownedbanik to BaselAccord subjectto 6 percent Inasing stil Importnt standards. sbszed rates.of deposits. varWt. Meico Feely ElimiaedIn Reserve in pdrnpl, Inreingly Pensionfunds Reformed. determined commercial rqureme newlaw of dynamic. refomexpected Banks subject since1988. banks;some emiaed 1991aows ectedby to haveimpact to Basel Deeopment directedoans for pes freeentry; some foreign invest- In shot run. Accord bankslend at conespondingdenominated resons for orsWkely Foreign Intheory. below-marketto multilteral deposits. foegnowned flucuatng Institona Portfoliorisk rates. lines. banks(30% in 1991-92. Investorsplaying analysis maxinum). Addtmonal ineasingrole. required. freforms required. NkaraguaFreely Yes,through High,not fully Privatebanks No None. Being determined ftee arge tionalized. faceno fomWal deveopments developed. since1990. ge n barrs; yet Current Wryhigh In ownedbanks. signifint framework realterms. competon defident Verylarge fromgoverment spreads banks. VenezuaFreely Somecredit Reducedto Inprincdple Newdrft law Not Newlaw determined. dirctedto 1S%for al freeentry for proposed; import ofsuper- Agriuture agrkcdr deposts locallyowned approvalnot IntederLyin andhousing peent bank expected. draftfomn. ratesare below hasdedined. Resictonsfor manke foreignbank Smm:AoW Bankdaz Captl MarketDereguloon, Savings, and investment 105

ing diested finandal institutions, rather than on in ordet Fltst, the fact that most of the Latin developingnew ones.But in a few countries,such as Americanreforms have been undertaken In the Nicaagua, new private banks have rapidly enteted midst of a major cisis suggeststhat a more gradual the market, helping expand the scopeof the finan- approach,with selectivedirect interventions, would cal sectot have been very difficult to Implement. When Exceptin Chile and Mexico,there are few Insti- reformswere Initiated, the overwhelmingfeeling tutional investors But the socdalsecurity reforms hi was that the previousapproach of direct govern- severalcountries are expected to add considetable ment involvement had failed badly and that the forceto localfinancal markets,as in Chile. Latin Americacountries had to move towarda radi- Almostevery country has made a seriouseffort cally differentmodel. Second,the mostlyhands-off to adopt a moder regulatorysystem to mnimize approach followed in virually every countrY in destabilizng practicesrooted in moral hazrd and LatinAmerica has resultedIn very high real interest adverseselection. The reformsfall into three main rates, enugng moral hazrd, and placing the categories:requirements for the capitaladequacy of financialsector at risk." Thishas made the develop- different financial Intermediaries,regulations gov. ment of an efficientsupervisory and monitoringsys- eming the disclosureof informationand the actlvi- tem particularlyurgent. ties of supervisotyagencies, and norms that dearly define the steps to be taken when some financila Chile institutions face distress.This new legislationis to createa modem financialsector, resient to isolated The deregulation of the Chilean finandal sector risky practicesand to fluctuationsin the economy. began In early 1974,Immediately after the militaiy Mostcountries have tried to developrles requirng ovetrew the UnidadPopular government. Chile's banks to abide by the BaselAccord. capital market was then highly repressed:interest Despiteserious effortsin almost everycountry, rateswere controlled and negativeIn real terms,bar- putting together a modem regulatoryframework riers to entry were severe,directed credit was the has proven more difficultthan expected.The lack norm, reserverequirements were high and uneven, of trained personnel-ncluding inspectors and and financialdeepening hita historicallow, with the accountants-has in many casesslowed the process, ratio of broadmoney to GDPbarely above S percent. as has the rivalryamong differentgovernment insti- The firststep In deregulationwas to lowercommer- tutions with overlappingresponsibilities. cialbank reserverequirements, which during thelat- The goal of financialderegulation in most Latin ter days of the Unidad Popular govemment had Americancountries has been to withdrawthe gov- been raised to 100 percent for marginal deposits. ernment from partcipating directlyin credit alloca- Next, barriers to entry were relaxed, with finance tion and interest rate setting (table 7.5). According houses-the finaderas-alowed to operatein May to the dominant viewin the region,the government of 1974.These institutions, able to freelydetermine should be restrictedto monitoringand setting pfu- interest rates paid on deposits,concentrated their dential regulation and supervision,an approach operations on consumption loans. The freeing of that differsfrom the one in most East Asiaecono- interestrates wasbroadened in October1975, when mies, wherethe governmenthas traditionallybeen ceilingson bank deposit rates werelifted. The next more active in financial markets. in Japan, Korea, step was the privatization of banks, which were and Taiwan (China), the government authorities mostly bought by the newly formed conglomer- have channeled substantialresources to successful ates-the grus. exporters at preferential rates, fragmenting the The one area where Chile did not make early financialsector into an offical marketand an Infor- progresswas enacting a modem supervisoryand reg- mal (or -curb-) market(World Bank forthcoming).' 0 ulatoryframework. Banks and other institutionshad Despitethis segmentation in the East Asia econo- great leeway to engage in all sort of transactions, mies, deposit Interest rates in the officialsegment includingproviding large loans to interrelatedfirms. remained mostly positive, a sharp contrast with Monitoringwas lax, requirementsfor information Latin America,where negative real rates were the disclosurewere minimal, the examinationof bank main featureof financialrepression. books was pro forma,and the quality of bank port- It is hnpossible to know now how the Latin folioswas not assessed.Aggavating all wasan Impli- Americanapproach to financal reformwill compare cit depositinsurance scheme that encouragedmoral with that of mostof EastAsia, but twocomments are hazard, greatlyweaning the financialsectoLr2 106 LatinAmerica and the Caribbean:A Decadeafterthe DebtCrisis

The sweeping deregulation of the domestic finan- framework for the financial system, including a new clal sector contrasted sharply with the authorities' banking law, was put in place in 1986. guarded attitude towatd international capital move- In designing the new banking law, the Chilean ments. Between 1974 and 1979, capital controls were authorities had two goals. The first was to set up an very tight, initially to discouragecapital flight But as Incentives system that would avoid the problems of Chle became an Increasinglyattractive intemational monitoring, moral hazard, and adverse selecton risk, these controls began to prevent capital from that had plagued the system during the early years flowing in. Only In mid-1979 was a very limited of the reforms. Very strict information disclosure degree of capital mobility allowed. Inflows shot up, requirements were Imposed, the extent of banWing reaching the staggering level of 12 perent of GDP In secrecy waslimited, and banks were required to have 1981. Severalauthors have argued that the relaxation the quality of their portfolo evaluated twice a year of capital controls In 1979 was premature, encourag- by independent risk-rating agendes. The coverage of ing overborrowing ane generating forcesthat greatly deposit insurance was also reduced, and depositors overvalued the real exchange rate (Edwards 1985; were informed through a wide public information Harberger 1985b). campaign that no additional bailouts would take The effect of the Chilean financial reform of the place. 1970s on financial intermediation and the stock The second goal of the new banking law was to market was spectacular.The ratio of broad money to establish an explicit mechanism for dealing with GDP increased from 5.3 percent in 1974 to more any future bank difficulties.The Idea was to develop than 15 percent in 1981, and the ratio of effective a semi-automatic system that would avoid govern- bank reserves dropped from 72 percent in 1972to 28 ment bailouts. The law established in great detail the percent In 1982. The number of banks Increased steps to be taken when a bank failed to meet reserve from 19 in 1973 to 35 in 1981, and real credit to the or debt-equity ratio requirements: if a bank faces dif- private sector increased by more than 1,000 percent ficulties, It can rapidly enter an agreement with Its during that period. creditors to transform the debt into bank equity Despite these achievements, the early Chilean (Ramlrez and Rosende 1992). Once the bank is out fnancial reforms had three weak spots. First, as of trouble and starts generating profits, it has to already mentioned, the lax supervision of banks and repurchase the shares from its debtors. other financial Intermediaries allowed them to accu- The reform of the social security system-initi- mulate an unsustainable proportion of nonper- ated in May 1981-was a key step in the develop- forming loans.13 Second, real interest rates remained ment of Chile's financial markets. A largely extremely high throughout the period-real deposit insolvent pay-as-you-goregime was replaced with a rates averaged more than 25 percent in 1981, capitalization system based on individual retirement putting severepressure on the financial health of the accounts managed by private companies known as manufacturing sectotL And third, despite the very Administradoras de Fondos de Pensiones (AFPs).I5 fast expansion in financial intermediation, the Workers can choose their AFNand shift their funds reforms did not boost domestic savings, as many freely among them. A detailed and modern regula- supporters of the program had expected (seebelow). tory framework-enforced by the Superintendency In 198142, the Chilean authorities reacted to of AFPs,created for this purpose-ensures free deter- the crlsis by taking three broad measures: first, a mination of fees and commissions and free entry number of financial institutions were rehabilitated, into the Industry, creating the conditions for mar- and their loans were restructured. Private sector kets to work competitively and efficiently. Unlike debts to the banking system were rescheduled into the case for banks, the Superintendency of AfPs longterm loans with an interest rate of S to 7 percent established very precise norms from the first day to in real terms, in 1983 and 1984. The central bank secure the diversification and transparency of the bore the costs of this operation. Additionally, the AFPs'investments. central bank purchased the nonperforming portfolio Today,pension funds are the largest institutional of the commercial banks. These, in turn, committed investors In the Chilean capital market, with assets themselves to repurchasing these 'bad loans' with of 26.5 percent of GDP in 1990, compared with 0.9 their profits (Larrain 1988; Ramirez and Rosende percent in 1981. The average real return on the 1992). Second, failed banks were reprivatfzed investment of Chilean pension funds between 1981 through the "popular capitalism" procedure des- and 1990 was 13 percent The real return of individ- cribed in chapter 6; and third, a detailed regulatory ual accounts (after subtracting fees) varied between Capl MarketDeregultMo, Savngs, andhmstment 107

9.2 and 10.4percent Theseimpressive results in part high-yieldptoducive projects toward lossmakin reflectthe fast expansion of a previouslyunderde- (and conuption-ridden)publicly administered pro- veloped financial market16 The dynamismof the gramsof housingand Investment The centralbank Chilean capital maiket over the past 10 yearshas paid intereston mandatoryreserves, to compensate forced constant revisionsto the norms goveniing private financial Institutionsand keep the systm the eligiblesecurities for AFPInvestments. Initialy, workdng.But since alnost nio assets were left for these instttutionscould not hold common stockor moneta absorption,its capadty to arryout mon foreign securities. But these regulations were ety policybecame severely teduced. recently relaxed by the Aylwin admlnistration, The Alfonsin govenmmenttook some steps broadening the scope of instruments in the APP towarddereguating the fianclal sector in October portfolios.This has providedadditional impetusto 1987,when interestrates wete freed and the attitude the local stock market, allowing firns to finance toward troubled banks became more resolute. An expansion plans with increasingefficiency. effort was also made to imprve portfolio manage. In 1990, Chlle took important steps to improve ment in both the National Mortage Bankand the the allocationof developmentcredit, Implementing NationalDevelopment Bank. But the public sector a systemfor auctioninglong-term credit lines from borrowing requirementsremained substantl and the multilateralagencies, with the assistanceof the continuedto crowdout the privatesector WorldBank. The localfinancial institutions that suc- In early 1988,the govemmentowned 36 banks cessfullybid for these funds can charge a market- accOuntingfor 45 percentof banking depositsand clearing interest rate to the final uset To avoid providing 71 percent of bank credit. More than collusion, only institutions that meet certain 140,000people workedin the financial sector, 60 requirementscan bid. Thissystem-also adopted by percentof them in officialbanks. After the failuteof Bolivia and under consideration in several other the mPrimaveraPlan" in 1988, funds flew out of the countries,including Argentina-greatly reduces the domestic financial system, dangerusly reducing traditional ineffidency of developingcredit ear- central bank reserves.In a desperate attempt to marked for specificuses. avoid a final run on scarce foreign exchange, the The receptioninternationally has been that sec- authorities freed the exchangerate, and the eon- ondary marketprices for Chilean forelgndebt have omy plunged into a whirlpool of Instabiity that surpassed90 percent, and internationalinstitutions ended in the hyperinfation of July 1989. are eager to participateIn the new Chilean "mira- The convertibilitylaw of Marh 1991marked the de." Aspressures to lift controls on capital inflows begnning of a new era in financialderegulation. It mount, Chileanobservers cannot avoidrecalling the establihed a fixedexchange rate with the dollarand late 1970s and early 1980s, when overborrowing severelylimited the government'sability to finance helped overvaluethe real exchangerate and fuelthe the public deficit.And for credibility,the monetary great financialcrisis of 1982.Theauthorities are now base had to be fully backedby liquid International acting with greatprudence, gradually tkdng stepsto reserves. relax capital controls.Despite the evident progress President Carlos Menem signed an omnibus in financial deregulation,Chile's domesticsavings decreein October1991, orderng the reformof the remain low,a sourceof concem In many circles. state, and deregulatingthe financial market. This decree was followed by numerous resolutions: Argenta exemptingthe issuanceof securitiesfrom the stamp tax; abolishing the tax on securties transfers; The Argentinecapital market sufferedfrom struc- exemptingstock, bond, and securies transactions tural problemsfor decades.17 The governmentrecur- from Income tax; allowing brokerage houses to rently tumed to the financialsystem to deal with its freelydetermine fees and commissions;grantng the budgetarydifficulties, particularly after the debt cri- securitiesand exchangecommission the authority sis,when subsequentadministrations were forced to to authorlze markets for future contracts and incur debts with the bankingsystem in the formof options;hflly eliminatng capitaland exchangecon- compuLsoryreserve requirements.These reached trols; and rationalzing reserve requirments by more than 65 percentof depositsIn December 988, eliminatingdiscrimination accordlng to the type of reducing the loanable capacity of banks and thus loan. their profitability. The intermedWion process The Convertibtlty Law reformed the norms became extremelyInefficient, diverting funds from relatedto the not-capitalizinginterest, allowing par- 108 LatinAmerka and the Caribbean:A Decadeafter the DebtCrisis

ties to reach agreements based on market Interest with the large overhang of the current scheme, rec- rates. In August 1991, a law protecting dollar- ognizing payment arrears or confiscatng unpaid denominated deposits was enacted, and a few weeks benefits. Neither option is fiancialy or politically later a bill modIfying the law of comnmon invest- easy. Moreover, trade unions have successfully ment funds was passed. Other legislation was resisted the approval of the social security reform by approved that introduced tax exemptions to make congress. Whether the government can change the investments in securities more attractive and the political tide on this issue will depend on President corporate bonds law was reformed. Menem and Minister Domingo Cavallo's persuasive To make the financial sector more dynamic, the powers.19 Foreign Investments Law was amended, granting foreign and domestic capital equal treatment,and Bolivia the ForeignCapital Investment Registerwas con- verted from an approvalmechanism to a simplesta- Hyperinflationstrangled financial intennediation In tisticallist In addition,Agentina becamea member Bolvia in the mid-1980s,but the financial system of the World BankGroup's Multilateal Investment has sincebeen recoveringrapidly. The deposit base GuaranteeAgency in October1990, providing Insur- almostdoubled from $465 million in 198Sto $820 ance coverageagainst political risks. The govern- millionat the end of 1990and more than $1.7 bil- ment has also signed investment guarantee lion at the end of 1992. The ratio of M2 to GDP agreementswith BeWum,France, Germany, Great almostquadrupled during that period, reflectingthe Brtain, Spain, Switzerland,and the United States. credibilityof the system.But the economy remains And it is studying a program for auctioning long- dollarlzed-with around 90 percentof depositsand term development credit from multilateralinstitu- loans denominated in dolla-and most time tions similarto the ones in Boliviaand Chile. depositsheld for 120days or less.Nominal boliviano The Argentineprivatization program proceeded interest rates remain high in real terms, with inter- quicldy,but there has been littleprogress on the sale est rates on dollar certificatesof deposits(CDs) far of government-ownedfinancial institutions. The higherthan In the UnitedStates, reflecting the coun- federalgovernment has expressedthe intention of try risk. retainingownership of the largestbank-Banco de Since198S, the main financialreforms have been la Naci6n Argentina-and provincialgovernment liberalizinginterest rates and the exchange rate.20 bankscontinuetohaveadominantroleinthefinan- Reserverequirements on commercialbanks have dal market.Some local observers point out that the alsobeen loweredand rationalized,and strict lever- government is also interested in keeping control agelimits have been established.The supervisionof over some discretionaryallocation of credit. Since the financial system was moved from the centrai the central bank became fully independent, the bank to a new autonomous superintendencyof Bancode la Naci6n has been the only channel for banks.Since late 1988,all financialinformation has directlyaffecting the financialmarket. to be reported to the regulatory agencies, and Stockmarkets have not evolvedin a smoothway accountingpractices have been harmonized across during the first stage of the Argentinereform pro- institutions,allowing the superintendencyto scruti- gram.The BuenosAires Stock Exchange boomed in nize banks' portfoliosand limit their credit expo- 1990,when volumestraded increasedtenfold. Since sure. then, severalspasms have tested the confidenceof Publiclyowned financialinstitutions previously domesticinvestors. The stockprice index crashed48 financedunproductive ventures, impairing the pro- percentin the second half of 1992,and then recov- ductivityof investment and imposingheavy losses ered strongly until mid-January1993, with some on the economy,but the financialreforms reduced forecastsof a price-earings ratio of 13.1 for 1993, the volume of credit directlyallocated by the gov- against 16.9 for 1992.18 errnent. Even so, the qualityof the public banks' The Argentine government is committed to loan portfoliois still much weakerthan that of pri- reformingthe social security system,replacing the vate Institutions.In mid-1991the governmentcom- inefficientand Insolventpay-as-you-go regime with mitted itselfto close the BancoAgricola, the Banco a capitalizationsystem similar to the one In opera- Minero,and the Fondode Explorac6nMinera-and tion In Chile since 1981. This would give great to stop the lending operations of the Banco del impetus to the financial market,but, beforeimple- Estado.It has alsoreduced the number of workersin menting this program,the governmenthas to deal the publicbanks' sectorand strengthenedthe docu- CapitalMarketDereguation, ns, andInvestment 109

mentation requirements for large borrowers in an An additional weaknessof the Bolivian financal effort to lmit lending concentration. sector is that the four public financial institutions As a result of these reforms, the primary market are very weak and the capital base of the financial for securities is grmwing,pardcularly for central bank system is very low.The debt-equity ratio was 11.8 In Instruments (CDs) auctioned weekly without prior 1990. The new banking law foresees a minimum announcement of the volume intended for sale. capital of SDR3 million for a financial institution. Interest rates on these CDs have generally exceeded Several World Bank missions have advised the gov- deposit rates by more than two percentage points. emient to liquidate insolvent public and private More recently, however, a reduction In CD rates has Institutions and continuing efforts will be needed to been observed, along with an Increase in maturities, solve problems discussed here. indicating an increase In public confidence In the systenL Colmnbia Despite broad reforms, the Bolivian capital mar- ket continues to be thin-and concentrated. The Colombian financial sector, like that in most of Dominating the system, the 13 private local banks Latin America,was highly distorted and regulated in hold 70 percent of assets, loans, and deposits. There the 1960s and 1970s.The control and ownership of are also three state banks, four foreign banks, one banks was highly concentrated, interest rates were mining fund, 12 savings and loans, and various subject to ceilings, forced credit allocation was very cooperatives. As for most of the poorer nations in important, securities markets were discouraged, and the region, the central bank finances a big part of supervision was lax. Then, in the early 1980s, bankng credit through development credits, pro- Colombia had a serious financial crisiswhen two pri- vided by donots and multilateral agencies. As of vate conglomerates at the center of a web of interre- 1991, agriculture and industry accounted for almost lated and questionable financial transactions failed. half the total loans outstanding. To Improvethe alo- That made it necey for the government to take cation of development credit, the central bank has over two medium-size banks-the Banco Nacional adopted a system for auctioning these creditUnes to and Banco del Estado, which held 5 percent of private banks, very similar to the one in Chile. In deposits. The takeover led to tighter govemment addition to these "formal0 institutions, there is a regulation and thus the flight of deposits from the very active informal financial sector, estimated to be banking system, shaking an already weakened finan- as large as the formal system. Much of Bolivia's cal sector, and sharply reducing profitability of underground economy, including drug-related some of the most important intermediaries. acUvities, is channeled through this informal mar- In 1982, the two largest banks (Banco de Colom- ketY bia and Banco de Bogota) and the largest finance Although Bolivia has made a serious effort In the company (Corporacion Financlera Grancolombi- past few years to Improve the performance of the ana) ran into serious financial problems and also had capital market, many problems remain unresolved. to be taken over by the authorities. All in all, Realinterest rates are still high, discouraging invest- between 1982 and 1986 the Colombian government ment. Spreads are also high, reflecting the underde- intervened in more than 20 financial institutions, veloped Intermediation structure. The spreads seem including banks, brokerage houses, and insurance to be Induced by structural causes rather than policy companies (Montes-Negret1988). causes, such as unduly high operating costs and vol- The experience shows how private securities umes of nonperforming loans. The system of con- markets can deteriorate even with fairly stable rates tractual savings (insurance, pensions, and social of Inflation and stable fiscal policies. By the end of security) is especially problematic, because It dis- the 1980s fewer than 100 companies were listed on courages the demand for securities. Perhaps more the stock exchanges, compared with 400 in the important, the superintendency of banks lacks per- 1960s. And privately issued securities-stocks and sonnel for some of the more important tasks. Bolivia bonds-amounted to 2 percent of the financial sys- thus shows that it is necessary not only to reform the tem's liabilities, compared with 20 percent in 1965.22 existng legislation in the smaller and poorer The transaction costs of either offering securities to nations, but also critical to provide the supervisory the market or trading secuities were very high-for personnel with the right skills to perform their jobs. primary offerings, almost 600 basis points over the Without these personnel, the new supervisory rules basic cost of funds. Wealth also became more con- will be largely irelevant. centrated during most of the 1980s as the float-the 110 LatlnAmr andthe Caribbean:A ecafterthe DebtCrisis

percentage of free voting shares relative to total the distortions In direct credit, the govemment has shares In circulation-was often no greater than 10 introduced substantal flexibillty on the interest pecent for most compantes.23 rates charged. Fixed nominal interest rates and rate The deterioration in Colombia's securities mar- ceilings have been replaced by a system of flexible kets durlnq the 1970s and 1980s can be traced to charges, where preferential rates are linked to mar- three funhdmental factors. Govemment interven- ket interest rates. ton increased inthe indn of savings, both In 1991, the Colombian congress approved a through government ownersp of intermediaries general law (Ley Marco 9/91) that liberalized inter- and through an extensive network of directed credit national capital transactions and reduced the extent and forced investment programs. Real trade restrc- of exchange controls. Partly as a result of this legis- tions-coupledwith a significant government pres- lation, capital inflows increased significandy in ence through the ownership of certain nonfinancial 1991, putting pressure on the money supply and companies-lessened the incentive to raise capital generating a large real exchange rate appreciation. and undertake investments to remain competitive. The govemment responded by increasing (mar- And capital controls and entry bariers impeded pro- ginal) reserve requirements and attempting to ster- vision of financial services by both offshore and ilize the foreign capital Inflows-policies that drove domestic institutions (on the stock exchanges). up the interest rate differentiahls,attracted additional These polides created disincentes for companies capital iows, and provoked an additional round to raise capital through public offeidngsand permit- of real appreciation. ted easiet retention of control. Despite the policy package for modernizing the The financial crsis ofthe 1980s made evident the financial sector, there are still many lagging areas, serious shortcomings of the Colombian financial induding the development of secudties markets. sector. In the early 1990s, as a part of a grand pro- Specificlegal and regulatory reforms at a microeco- gam to modemize the economy, the Cdombian nomic level, coupled with institutional reforms, are government decided to reorm the financial market needed to generate an incentive-neutral environ- In December 1990, the Colombian congress passed ment for companies to Issue securities and for a law allowing the executive to implement sweeping investors to demand them (Glaessner and Mas reforms, and in April of 1991, the Gaviria adminls- 1991). For the offeing of securities, legal and regu- radon presented itsrefotm program, which, accord- latory changes are needed to define more dearly the Ing to an intemal World Bank report on Colombia's rights of parties in bond or preferred equity offering financial sector reform, is expected to be completed and increase the diversity of instruments (for exam- by the end of 1994. The most important measures in ple, by permitting commodity indexed debt or asset the package nclude relaxing barrers toentry, reduc- backed securities). ing and rationalizing reserve requirenents, and free- There is also a need to change regulations that ing most (but not all) interest rates. discourage controlling shareholder groups to issue lb increase competition in the banking sector, free voting shares. And tougher enforcement of tax the govenment has privatized some of the banks provisions for companies of all sizes wil reduce the that failed during the first half of the 1980s. Its also incentives for small and medium-size enterprises devising ways to strengthen the Banco de Colombia not to undertake public offerings as part of efforts to to sell it to private interests From a supervisory per- evade taxes. Finally, stramUning regulatory proce- spective, an effort has been made for all banks to dures for public offerings-by permitting such comply with the capitalization standards in the processesas self-registrationand reducing regulatory BaselAccord. overlaps-will bring down the very high transaction Forced bank investments In government secui- costs now associated with public offedngs. ties have been sharply reduced. And direct lending Another important shortcoming of the Colom- requirements to the agriculture sector have been bian financial reform is that it has failed, as have limited to 6 percent of total loans for large and many other countries in the region, to boost medium-size farmers and to 1 percent for small domestic prlvate savings. Increasingly, analysts farmers. Although a marked improvement, this still and policymakers are coming to the conclusion leaves a significant distortion. It is expected that the that although microeconomic-oriented financial proportion of loans directed to large and medium- reforms are a necessary condition for increasing size farmers wlll be reduced gradually, until they savings, they are not a sufficient one. To get a major become fully market determined in 1994. To reduce jump in aggregate domestic savings there will have CapitalMarket Deregulation, SaWngs, and Investnent 111

to be additional macroeconomic measures to Investmentwas drasticallyreduced to accommodate ensure long-termstability and further fiscaladjust- the sudden drying up of capital flows. For public ments. investment,the cuts were so deep that some coun- tries could not even maintain their rastructure. Savtugsand Invesbme_t Althoughthere has recentlybeen a markedrecovery, fewcountries have had their Investnent ratiosreach Savingsare at the heart of development increased the levelsbefore the debt crisis(figure 7.1). savings allow faster capital accumulation and higher A sustained acceleration in growth wil require economic growth.24 One of the Important stylzed significantincreases in the volume and quality of factsof worldhistory is that massiveincreases in sav- investment. Even if structural reforms boost pro- Ings have precededsignificant takeoffs In economic ductivity growth, there will be a clear need to growth.A.W. Lewis (1955) recognized this in hisclas. Increasethe rate of capitalaccumulation beyond Its sical essay on development in dual economies, current levels.How will this higher investment be where he argued that a central problemin the the- financed? Becauseavailability of foreign funds Is ory of economicdevelopment is to understandhow likelyto be tight, most countries will have to rely a communitypreviously saving a low percentageof heavily on higher domestic savings to increase GDPincreases savings dranatically. investment.2 The Increasein the volume of savings LatinAmerica has traditionallyhad a low rate of and the qualityof investmenthave been overriding domestic savings. In 1980, gross domesticsavings goalsof the structuralreforms that many economists were on average20 percentof GDP,slightly higher have long advocatedfor the region. than in 1965, when they stood at 19 percent. Compare that with East Asia, where the average The RecentBehavior of Savingsin Latin Amera grosssavings ratio shot up from 23 percentof GDP in 1965 to almost 30 percent in 1980.f Despitethe The early financial liberalizationliterature argued availability of foreign resources to supplement that one of the most important objectivesof these domesticsavings, the averageinvestment rate was reformswas to generate,among other things,a sig- also rather low in Latin Americaduring 1960-80- nlficantincrease in domesticsavings. In the orignal gross investment averaged 23 percent of GDP modelsof financialrepression of McKYnnon(1973) Maldngthings worse,domestic and foreignsavings and Shaw (1973),allowing real interestrates to rise had for decades financed projects with doubtful to market levelsaltered the intertemporal rate of ratesof return. Andthe mazeof distortionsand reg- substitution,encouraging aggregate savings (see Fry ulations that traditionallyaffected Latin America's 1988). But empiricalstudies for many countries- financial sector hurt the efficient allocation of industrialand developing-find only a weakelasfic- resources,the efficiencyof (private)investment, and ity of aggregatedomestic savings to interest rates. perhaps more important, the growth of productiv- Boskin(1978) found a very low elasticityfor the ity.26 United States.Several studies of developingcoun- The debt crisishad important consequenceson tries,including Glovannini (1983), failed to find any the behavior of investmentthroughout the region. effect of interest rate changes on private savings. During the years of muddling through (1982-7), McKlnnon (1991) recently acknowledged that

Figure7.1 Grossdomestic Investment as a percentageof GDP,selected Latn Amedcancountries and years

Nate: 11-92 data based on avaab119 520 k dat 112 LatinAmerho and the Caribbean:A Oecadeafte theDebt Crisis

"aggregate savings, as measured In the GNP security reforn discussedabove-eaching almost accounts, does not respond stronglyto higher real 23 percentof GDPIn 991. ButIn Mexdco,aggregate Interest rates" (p. 22). domesticsavings have graduallydeclined. It is too What explains this? First, in financial models, earlytosaywhatthe finalimpactof the recentfinan- higher real Interest rates resultIn portfolio readjust- cdalreforms will be on aggregate savings, but a large ments, including a higher degreeof financialtnter- body of evidenceindicates that they will not gener- mediation, but not necessarly In higher agWate ate a massiveInaease in the short- to medium tun, savingsas defined In national accounts.Moreover, as thought by the earlysupporters of financdalliber- In generalequilibrium macroeconomic settings, en alizationpolicies. increaseIn interestrates tends to have two offseKting The evidencesuggest fitat savingsrespond lit- effts on savings:an intertemporal substitution tle with respectto Interestrates has prompted ana- effectaway ftom current consumption,tending to lystsand poliqmakersto consideralternative policy increase domestic savings, and a negativewealth mechanismsto encouragesavings. Some countries, effectfrom higher interest rates, tending to redulce such as Cile in the mld-1980s,reled on tax reforms savings. Depending on which force dominates, to discour consumption.0sAnd some authors higherinterest rates will be assodatedwith either an have suggestedthat shifftingthe tax base from increaseor a declinein aggregatesavings. Incometo consumptionwill encourage thrift These Despite the unresponsivenessof savings to polides rely on the assumptionthat there is a high higher interest rates, finandal reforms still have intertemporalsubstitution in consumption.But, as important effectson gowth by improvingthe qual- pointed out above, the existingevidence does not ity of aggregate investment, especily private support this contention and sheds some doubtson investment.Gelb (1989),Fry (1988), and McKinnon the effectiveness of taxbased mechanisms to (1991) have found robust evidencesupporting the increaseaggregate savig9 propositionthat a reductionin the repressionof the Evidencefroir a score of countries-including capital market will increase the productvity of the East Asia miracle nations-suggests that the investment Interestingly,thils work also suggests increasein privatedomestic savings ratios is a rather that redudng financial instability,and especially slow process (WorldBank forthcoming). Thi evi- inflation, has an important positiveeffect on the dencealso indicatesthat a drasticincreaseof private return to investment.And recentwork by Kingand savingshas usuallybeen the result of two factors: Levine(1993) supportsthe Idea that moredeveloped macroeconomicstability and an insfttutionalenvi- financl sectorsare associatedwith fasterWtoal fac- ronment that instlls confidence in small savers, tor productivitygrowth. such as the postal savingssystem in EastAsia. This In the majority of selectedcases, savings have suggeststhat if macroeconomicstabilization be- increasedsince the mid-1980sbut are still below comes durable, private savingswill increase.More their 1980 level (figure7.2). Chile and Mexico,two important, the development of new Institutions, of the earliestreformers, provide contrasting stories. such as new socl security systemstailored after In Chile, gross domestic savings have increased Chile's,could be Important in inaeasing privatesav- steadilysince 1980-pardy as a result of the social Ings fromtheir historicallevels.

Figure7.2 Grossdomestc sings asa percentageof GDP,selected latn Ameriancountries and yeas 35 30 25 1980 t991992

Note:t99t2 da basd aal t9. our*WordBankdata. CapitalMarketDeregVuation,SavIngs,andInvestment 113

So, the surest and most direct way to increase foregoingview on the impotance of public sav- aggregatedomestic savings in the short and medium ings-and thus futher fiscaladjustments-in latin runs Is to raisegovernment savings thughhanges Americaduring the yearsto come. in the public deficit Corbo and Schmidt-Hebbel Increasinggovernment savins does not imply (1991) used a 13-countrydata set to analyze the that thesecountries should at the sametime increase macroeconomicconsequences of higher publicsav- public investment Both dedsions should be kept Ings. In particular,they investigatedhow much an separate. WWhetherspecific public Investments Increasein governmentsavings would depresspri- shouldbe undertakenshould be decidedproject by vate savings.They found out that although govern- project This requiresImplementing highly profes- ment savingscrowd out privatesavings, the effectIs sTonalprocedures for appraisingpublc investment far belowthe one-to-onerelationship suggested by projects. And in countries where an expansion in the simpleRicardian equivalence doctrine.30 Over- publicinvestment is not justified,the govemment all, their empiricalanalysis strongly indicates thatan should stll IncreaseIts savings and channel those increasein public savingswill mean higher aggre- resourcesto the capital market. gate savings.They also found that Tncrasingpublic savings through reducing expenditures is more InwshnentandInfirstrctu effectivethan increasingtaxation. Thebest combinationof highertax revenuesand Forthe ratio of grossprivate Investment to GDPfor reduced exPenditures to Tncreasepublic savings selectedcountries, it is possibleto detect a familiar depends on the specifc characeistcs of the coun- U-shapedbehavior in many of the case private try. If tax complianceIs lowand the tax effortclearly investment experienceda drasc dip in the mid- subpar,an increaseIn tax revenueswil be calledfor 1980s,only to recoverin the early 1990s(figure 7.3). But under most cicumstances, some reduction in In some countries,the recoveryhas been complete, expenditureis likely to be optimal.In most countries but in others,the privateinvestment ratio is stfilsig- In the region,cutting the militarybudget isa way to iificantly below its 1980 level-as in Bolivia, both financethe expansionof socialprograms and Colombia,and Paraguay. generate higher publicsavings. Thevolume of privateinvestment is only part of Some Important recent research at the World the story.In most countries,there has been a sgnif- Bank (forthcoming)suggests that there has been a icant change in the compositionof private invest- virtuous circlebetween ,rowthand privatesavings ment. Afterdecades of stagnation, investment in in East Asia. Using time series econometrictech- agriculture and agriculturelated activiftes has niques, Bankresearchers have found in the miracle soaredin Chile.This has resulted in surgesin pro- countries that higher growth increasesdisposable ductivitygrowth and in agriculture-relatedexports incomeand encouragesprivate savings. Higher sav- -from less than $40 milion in the early 1970sto ings, In tun, permit higher capital accumulation almost $1.3 billion in 1991. Moreover,the real and thus reinforcesthe highergrowth. How does an return to investmentin Chile has been extremely economyget this virtuouscircle going? By inreas- high in the past few years, encoaging growth In ing public savings during the earlier phases of the the privatelyadministered pension funds. A grww- process.This East Asiaevidence thus supports the ing proportionof privateinvestment has abo been Flgure7.3 PrIate Investmentas a percentageof GDP,selected Latin American countries and y-ss 25 i6 20

10 * -192 *_ *

10

Argentina Bowa Chie Colombia CostaRkia Mexico Peru Uruguay Note:Prfite Inves5rntb dered as thedlbren been grosdomesinstm andc_onid pubic besmnt 1991-92data based onaiwbit. Sow$eP hffmaand Madsy 193. 114 LatinAmerca and the Caribben: A DADeafter theDebt Cisis

directed to the mactuing s which has lic investmentduring the 1980sIs the deterioration gone through a rapid expansion in export-related in the region's infrastructure (see Flelsig 1992). activides(Edwards and Edwardsfortcoming. Recent empirical studies for many countries- In Argentinaand Mexdco,the compositionof pri includingthe UnitedStates-have pointed out that vate Investmenthas alsochanged greatly in the past Investmentin infrastructurehas a particularlylarge few years. Both countries have had Important effecton growth. Aschauer(1989) has argued that increasesin investment in "nontraditional"activi- due to significantextemalities, infrastrucureinvest- ties and, especialyIn Mexico,there has been a great ment will have alnost twicethe effecton growth as effort to restucture firmsand increasetheir export will private investment. These findings have potential. Kessel(1992) has pointed out that the promptedanumberofpolicymakets-lncludingthe structuralreforms have restructuredMexico's petro- Clint a administratlen in the United States-to chemicalsector, with new investmentsIn modem emphasizethe need to step up capitalaccumulation technologiesthat will allowthe sectorto withsand in basicinfrastructure. new competitionand, in some productlines, move Although the extemalities argument is emi- aggressivelyinto exports.The privatesector in both nently plausiblefor some types of infrtuctue, it ArgentinaandMexicoIsnowchannelingalaWepart is important not to push this Idea too far.The eco- of its Investmenttoward infrastructure,induding nomic historyof LatinAmerica is replete with cases privatelyrun ports and roads (chapter6). of giganticpublic projects-many of them in inif- Public investment sufferedin the aftermath of structure-with very low, and even negative,social the debt crisis,and in mostcountrieswith data avail- retums. In general, public investment projects able, public goss domesticinvestment was signifi- should be assessedfrom a microeconomicperspec- cantly lower in 1990 than in 1980 (figure 7.4). tive and be undertaken only If their social rate of Moreover,in several countries, net public invest- return exceedsa certain predeterminedlevel. Not ment has been negativeduring the pastdecade-the followingthis rule Isa clearinvitation for retuing result of three factors.First, the need to reversethe to the practicesof the past, whereexceedingly friv- intemational transfer of resourcesin the early and olous projects were implemented in the name of mid-1980sforced almost every country in the region someallegedly worthy cause. to reduce expendituresand in most cases,public A systematic economic appraisal of projects Investmentshouldered a dproporionate share of would require developingan appropriate lnstitu- this adjustnent. Second,the fiscaladjustments of tional setting,with qualifiedpesonnel to undertake the late 1980s were accomplishedlargely through thistask at a largescale. This has been done in Chile, major reductionsin public expenditures,including wherealmost every large public sector project Is sub- publicinvestment And third,the reducedrole of the ject to a stern batteryof tests.But most other coun- state in the developmentprocess has also affected tries have been slow in putting together project public investment. Many activitiespreviously con- evaluationunits. Forexample, during the execution sidered to be exclusivelywithin the realmof gov- of the 1991budget, the Argentinegovemment exer- einment activities-including utilities-are now cised little,if any, project analysisaccording to an perfomiedby the privatesector. internalWorld Bank report The World Bank,with An importantconsequence of the declinein pub- Its longtradition of projectappraisal, could do much

Figure7.4 PublcInvestment as a percentageof GDP,selected Latin Amerian countriesand years 12 10

6 1986 4 2

Argenina solhma Chie ColomblaCost Rica Mexko Peru urugits Note1991-92 dat basedon avaIldty $m5 Peffem andMadray 1993. CapitalMaret Degutaton,Savings, and Investment 115

to help these countries implement seriousproject Accord, sicng foreipnersi ghtsto control man- analysis procedures for screening public projects. ufacstrng firmsand pladng broadcontrols on their Such procedurescould allowthe authoritiesto alo- abilityto remitprofits to ther home countries.Nor catescarce funds effidently,making sute that infra- could fotelgners partipate in sectors deemed structureprojects do not crowdout alternatves with 'strateg;.." Asa resultof these regulationsand the higher socal returs, Includingprograms to allevi. inward-lookingpolides in most countries,diect for- ate poverty. eigninvestment did littlefor capitaccumulation- One of the morestatling aspectsof public sector in most countriesamountng to less than 1 percent investment In LatinAmerica is that most countries of GDPa year during the 1970s (Edwards1991). have extremely low budgets for maintenanceand Manyanalysts have arguedthat in the aftemnath operation.This has resulted,throughout the region, of the debtcdsis, direct foreign investment should be in an extremely rapid rate of deteriorationof the a growing source of foreign funds for the less stockof capital. What makesthis situationparticu- advanced countries. But the volume of resoures, larly serious Is that maintenanceoutlays are typi- likelyto be limited,will haveto be shaed by a grow- cally small relative to investment costs-yet they ing numberof potental hostcountries, including the have extremely high social rates of return. Pre- nations of EasternEurope and CentralAsia. Caidoso liminaryanalyses suggest that one of the mosteffec- and Dornbusch(1990), after pointingout that bank ttve waysto Improvethe qualityof infrastructurein loans and bond Issuesare unlkely to be a major the region Is to expand the maintenanceand oper- sourceof foreg funds during the years to come, ations budgets (FIelsig199). Paradoxically,con- argue that 'the immediateobvious candidate (for straints on lending In many of the multilateral providingfegn resoures) is direct foreigninvest- institutions discouragea more efficientand exten- ment. Unfortunately,the roleof directforigninvest- sive use of maintenance. Changes in these regu- ment has never been very larget(p. 1434). lattons-to allow multilateral institutions to A fundamentalrole of directforeign investment cofinance maintenance-would go a long way to- is allowingthe host countryto come in contact with ward ensuring a marked improvementin the qual- new techniquesand new management styles.So, ity of the region'sinfrastructure. even If its volume Is modest, direct foreigninvest- A major challengeIsensuring that the newlypti- ment plays an important role in helping with the vatized Infrastructureand utilities can raise the diffusionof innovations,encouraging the Imitation funds required for their expansion, espedaliy for of best practicesin more advancedcountries, and the World Bank, which for many decades has helping generate a faster pace of productivity helped finance public infrastructureprojects but is gowth. not allowedby charterto financethe privatesector Under these circmstances, what makespattlcu- dicly. Chile shows that, contrary to popular ar countriesattractive for foreigninvestors? A first, belief,the privatesector can raisea substantialvol- and obvious,factor is the set of regulationsdirectly ume of funds, at fairly long maturities,to finance affecing directforeign Investment activities, indud- major infrastructureexpansions-as with the elec- ing restrictionson the remittancesof profits.Most tric utility, ENDESA.Two main factors lie behind latin Americancountries have introduced sinf- this ability to fund large projects: consolidated cant reformsto their legislationfor direct foreign macroeconomicstability again and an institutional investment, and foreign firms, rather than being and regulatoryenvironment that enablesthe gov- chasedout of these countries,are now being lured emment to crediblycommit itself to not expropri- In through a vadety of schemes(IMF 1992). Bolivia ate the utilities'assetsIn tne future.Elsewhere In the approved a new law in 1990 ensuing equal treat- reglon, the ability to fund these substantialprojects ment for foreignersand localsIn all sectors,except wlll develop more slowly-and the World Bankis minng and hydrocarbons.Venezuela went through active in efforts to implementcreative techniques successiverounds of liberalizationof restrictionson for lengtheningbond maturitiesand improvingthe direct foreigninvestme it between 1989 and 1990. accessof utlities to long-termfinancial markets. And Brazilgreatly relaxed the restrictionson the repatriationof profitsin mid-1990.The regulations Diec ForeignI?linent affecing directforeign Investment In the reglonare now quite liberal(table 7.6). In the early 1970s,the countriesof the AndeanPact One of the most importantdeteminants of the implemented Resolution 4 of the Cartagena distribution of direct foreign investment acaoss 116 Ln AmerkaandtheCa in,A Deaoefrthe DebtCrWs

Tale 76 Regbon on direc foreign Inves1mentIn selcted Latn Ameican counties Sedtrsrestkted Setorsre#kted C&*Vh &Wtt Reskctbon P* rel on Ncd Country toste tonanol by ewsnoloWvd prfiltemes bydebt.eqdtsaps Arntna None None Allsecto None Yes azl OR1,ga, tek 8n transot Yes,ecept None Yes comnunkations medi, healt Incomputers cle None None Allsects None No,pogrn cancelledealy 1993 Clomb AkCoholIc DefenseWoxc Allsects None,up to No beverages matesdposal egitered hIwesmt Mexco Petoleum, Transportmedia Mostsectors None No hydrocarbons, nucdearenergy Peru None None Allsectors None Yes Venebela None None Allsectors None SouwwFeirett 1991; W.FAnW aReport of diExeoirwSoe4 varousyears.

Figure7.5 Net foregn dic Investme asa peretage of GDP,selected Ladn American countefes and years 3.5

3.0

2.5

2.0 19

1.0

0.5

0

SmmuInter.kink DO.dopnwntSank 1990 and 1992. countties is the soundness of economic polidies. This has indeed been the case in some of the early ForeignInvestors tend to stay awayfrom countries reformers-ChIleand Mexico,which have seen dra- with major distottions and controls and are matic increase In direc foreign investmentin the attractedto nations with consistentand predictable past fewyears (figure 7.5). Note, however, that direta macroeconomicpolicies. In a recenitstudy of 58 foreignInvestment is still a relativelysmall ptopor- contries, Edwards(1991) found that polices that tion of GDP,Indicating that the Latin American move the economy toward greter openness and nations must persver In their efoDrtSto increase internationalcompetitiveness, as wellas reducethe domesticsavings. ieof the govemment,hav an Importantpositive effect on direct foreip Investment.So the reforms HaoS

In most Latin Americn coutules during the past 1.ktet a'. Prbsh nthelectua ttwe ofCEA fewyes havepoitonedthemverywelaspossble NW 4 Waso rciientes ioffds from diect forep Investment economicsin LatnAmerica. in his 1947book ofroduc6na Capftl Madt Oregulton, Saving and Inestmt 117

Kynes he devoted eal chaptersto dsuig Intest rate 198t1-1 behvior. in ths work heagues tht governmentInteven 15. In th reformedsyste, th ste pay a ftmdnt roe aimedat contollnginteet rae wouldgenerate an acceeration In rguti andmnitog t oprationof the managme in growth(p. 104- He lter pointsout that lower intet rates anIes r "soliarty In the bae thro a InWi- encouragesav and oththd goenmet sol "lowe Internt mm pou An Mnpotantfeature o th newsoda cuIy sy-s. rate to a l we ful emplomnt Is acived' (p. 138).And tn Is t it Ibobpgtay rIihat eveWy dependent w lates, itIs) requiredthat th Ste assme controlove ertain (nmake onbuo eqWlto 10paunt of dis- vaables,... [cludngl itest ates. erdng ismt, It is posbe income. alkelythat It shouldbe sodalied a the oly meansto adhevefl 16 F whrdai, seeEdwards an Edwardsfothcntn emplbyrent,sce the manipublaonof the int re wi notbe In ry 1993the Chiln goernm wan ed thatIt was sulficient(pp. 1 3940,trated fromSpanish). radno thetrtin forAlPsto inwt inthe stock marke 2. TheLatdin Amican countis areArgeia Bra, Chile, 1?. Th dacssionof the Agen d rawspay on andCotombi and the Asianare tndA, Philippines, SriLank, and unpubs workby Fernado Losad key 18. uenosAires ease back afr mrl coat rid," fwna1 3. fry (1988)amwma tee hoies andsme tessrelat. m Febuay4, 1993. edto hem. 19. Asof atelune,the Argnne IWmhouse oonf s had 4. On the theoryof publikgoods, see Samuesons cassic approeda hyldd socialds itYsYsefm 19S4treatment 20. Therate of eane wih tea o I freeydetemIned S.Stigl andWIss (1981) have shown a If ms re high indlyauctions(Carlga 990). leveraged-asfinancial istiuons uy are-hey will tendto 21. SeeS n 1992fora rentdi of thedrug actas dsk loes gam9blingwith othe peopleWsmone sctorin th BAm econony. 6. Thecollpse of man banksfn Argentina e, Cholb 22. 7heIncease In poaWl anddrug-related vIlence aso andUruguay during the lae 19705and eary18Os wa closely aJetedthe curI markeEntprenes aed that e public rdawedtothe lack of adequate rg o listingof dteIr ropaniescould make tm the targetof trorst 7. Inmoreadvwanced natons, t srao Iin thengeof90 to attack 10 percentMclnnon 1991). 23. Th materialIn ts ndte nextpagraph draw rmm 8. Newban coudbe fanned, but they wee foriddenfom G er1992. kingdeposts See Prezapanero andLeone 11. 24. Recentmodes of endogenosgrowth hae proWidedan 9. On Issuesseeth Imor thsestd by Gaee and equibrm (tmdysta d analial frueworkth at Mas1991. This paagraph draws on their worL thispropoon. See,for example,the fari of Ak modelsplo- 10. Fnroa theoreticalpoi of vim it an beargued ta this nerd by RebWo(1991). See G kovtz1989 for a detaid rvey "stm solveste publicgood and ext problmstypi of an helnks between savings and dvopmet cpI muketsl (Sgtz 1993).There Is some evidence suggeti 25. Theseda aretaen fom Ibr Dop Report1991. ta financialmrkre senton hurtinvestment In some counI 26. See,for example,te dicussionIn W*W Develpment ties SeeEdwafds 1988b on Korea. Report199r. .1. It Is possibleto arguethat, If a gradualEast Asian 27. Despe e inease Incaplal flowmdKussed Ih dptas approachhad been folW d t rateswould be snlat 4 nd5, the av _abltyof freig savin contuesto below hon lower. a Idorca perspecdtiMoreom, it Ishighl unlk thatforeign 12. Theimpldt insutancescheme was esthed I lae savgswi continueat theircurraent lvls in thesteady sate. The 1976and ealy 1977 when the government baled out the deposi- potentl re Ofddrectfeign invemwent isdisused at theend of torsfrom two faillingfinancial institutons: 8anco Osomo and thisdapw. FnanderaLa FamUiia. See Edwards and Edwads 1991. 2 nhat provon was aled in the1990 tax reform Se the 13. ineti enough,this reAty rmewok contrast- dscion inhdr 4. Asosee Edwards and Edwards 1991. ed shrplywith the tight controlof te pensonfunds discussed 29. Of course,from an efflcency point of vew,it h stil advis- befo SeeGalgher 1992. ableto imlnmt a taxsysem that geres thesmalle posibe 14. Thesehigh real Interest rates ware the result of a conba nunberof distortos tlonof fats, incudingincreasing high expetations of devalua. 30. NcardianequivaWen suggest that frornan economic tlonin 198041,a gwing deand fotcrit to finncel s pespecvethere is no dffller bebweenfinacing govenment es cunredby grupos-ownedfirms-the 'fase demandfor vadit exenditur roughtae or gounmenthrowing. SeeBaro disused inhter 6-and a highcounty- premiumdurng 1974. Chapter eight Poverty,Income Distribution, and Human Resources

latin America's inabilit to deal effectively with health will have important direct effects on eco- povert and inequality is perhaps the learest-and nomic growth In the region. As a larger part of the saddest-failure of traditional policies. Decades of population acquires basic human capital, growth govenment control and regulations generated an wDltend to accelerate sgnificantly (Baro 1991). increasingly unequal distribution of Income in the Although economic growth between 1960 and region. It Is the only region In the world where the 1980 improved living standards-as measured by share of income going to the poorest 20 percent of educational attainment, health conditions, nutri- the population consistently declined between 1Y2) tion, and other social indicators-a large percentage and the late 1970s (Sheahan 1987). Moreover,the of the region's people still lived in poverty. Even pcentage of income received by the poorest 20 per- though many of the pofices to reduce poverty- cent In the late 1970s was lower in Latin America agarian reforms, minimum wage laws, and labor han inany other part of the developing world (table market regulations-were well intentioned, they 8.1). This income inequality is partcularly strdng made limited progess. In 1981, more than a third of when compared with that of resource-poor Asia Latin America's people had incomes below the (table 8.2). povet line (table 8.3). Nowthatthestrucburalrelorm iswellunderway The debt criss in 1982 marred an already bat- In most Latin American countries, one of the main tered social picture. The sudden halt in foreign challenges Is to reduce poverty and reverse decades financing, the deterioration in the terms of trade, of increasing inequalities. Addressing the needs of the poorest strata of society is not just a social issue- Table82 IncomedktbWon In selectedLain It is a political issue. Only if poverty is reduced and Ameria andAsian countries, various years, 1970-80 the lving conditions of the poor are improved will (P)tet) the structural reforms of the past decade be sus. Shareof Shareof tained and not reversed. Moreover,attending to the omefo, hcomeso1 needs of the poor for education, nutrition, and y Argentina 1970 11.0 35.2 l1rai 1972 7.0 50.6 Table&.1Share of nome recehvedby lowest20 CoslaRka 1971 12.0 395 pacentof popudon, selectedr ns,19601970, ElSalador 1976-77 15.0 29.5 and o9e8e Medco 1977 9.9 40.6 Panama 1973 7.2 44.2 Peru 1972 7.0 42.9 Abot Venezea 1970 10.3 35.7 Regin 1960 1970 1978 Medin 10.1 40.1 Sub-SahaanAfrica 5.2 4.1 6.2 HongKong 1980 16.2 31.3 Mddke st and Indonesia 1976 14.4 34.0 NorthAica 4.9 5.0 5.3 Korea,Repubc of 1976 16.9 27.5 EastAslaandPachkc 5.3 6.0 6.2 Malaysia 1973 11.2 39.8 SouthAsia 4.5 7.0 - Phlippines 1970-71 14.2 38.5 Souhern Europe S.S 4.3 5.0 iballnd 1975-76 15.2 34.1 latin America 3.7 3.4 2.9 Median 14.8 34.1 - Not avable. Not The sampleI resrcted to he group tt the WbordBank dasfes a. he1980 ediftion Wld es rento thse figu mosarecent as milddle4romeeconomies." ea*5n" SowUbdd BankWofd Oeve Repot1982 and WoIf Deveop. sorm ank wroaes, 1980.Imnt^ Rp? 1d986.

118 Poverty,Income Dlstdbution, and HumanResowuc 119

Table83 Populaionbelow the poverty One In selcted Table8.4 SodalIndicators for selcted LatinAmerican Latin Americancountries, 1970 and 1Sl1 countries,1970, 1960, and 1990 (percent) Indictor 1970 1980 1990 Countiy 1970 1981 Uliberatepopullonas ArgertIna 8.0 8.0 perentageof popuaton 111Il 49.0 43.0 aged1S and older 29.0 23.0 1S.3 Chile 17.0 16.0 fnrollmetrtiosages6-11 71.0 82.3 87.3 Colobnia 45.0 43.0 Grossenrolment ratios, CostaRica 24.0 22.0 secondaylevel 31.6 47.4 54.9 Honduras 6S.0 64.0 Populton perphsiclan 2,053 1,315 1,083 Mexico 34.0 29.0 Peentageof population Panama 39.0 37.0 wIh accesto sfe water 53.7 70.1 79.8' Peru 50.0 49.0 Infantmortal rate Venezuea 25.0 24.0 (perthousandh birth) 84.9 63.0 48.2 Averageforten Udn Ufeexpectancy at birth Amerin counties 39.0 35.0 (yas) 60.1 64.3 67.5 SwwThedataeas reported In Cadoso adWHelWege 192a.Thedata NotVimonre roon for 1970are from Altimir 1982, those for 1981are *om MolhUa1989. a.Data are for 1988. Soww Takenfrom Hiks 19924Wti Sad data anda CEPALStsta and the need to Implement significant macroeco- *a0 199. nomic adjustment programs drove real Incomes down througout the region.In 1991,only 10 of 30 hide seriousInequalities within the countries.When countries in the region had a GNPper capita above more detailed data are analyzed, it becomes clear that of 1980: Antigua, the Bahamas, Barbados, that socialIndicators have not alwayscontinued to Blize, Chile,Colombia, Dominica, Jamaica, St Kitts improveIn all segmentsof sodety Third, the reduc- and Nevis,and St Vincent This declinein real per tion in sodal spendingIn many countries has been capitaGDP naturally affected overall well-being and coupledwith increasedefficency In usingfunds and In most countriesinreased the incdence of poverty in the support of nongovernmentalorganizations Today,there are morethanO 10 millionmalnourished (NGOs)for social programs.While publicly pro- childrenunder agefive In LatinAmerica, and a geat vided inputs have declinedsubstantlally, the total many of the region'speople do not receiveappro- availabilityof effectiveInputs has not been reduced priate health or educational services. Although by that much-and maybenot at all (Grosh1992a). many countriesreacted to the crisisby implement- For many years, the accelerationof economic Ing emergencysocial progms, the overal level of growth was consideredthe main vehiclefor reduc- povertyand inequality neverthelessincreased. One Ing poverty and inequality. The -right type" of direct consequenceof most countries' adjustment growth-based on comparative advantages, em- programsin the 1980swas the reductionof govem- ploymentcreation and productivitygtowth-was to ment spending on socl programs.'An important generatehigher wagesand better economiccondi- manifestationof the increasein the levelof poverty tions for the poor.Faster growth isnot enough,how- is the rapid growth of the informalsector in many ever, because it takes a long time for its fruits to countries. spreadto the mostvulnerable and poorestsegments Somewhatsurpisingly, many socialindicators- of society.That is why many institutions,including infant mortality,school enrollment, and life expect- the World Bank, are pushing a two-prongedap- ancy, for example-continued to improve despite proach toward human resources-supplementing these problems (see table 8.4). The World Bank faster growth with targetedsocal progams to pro- (1993)provides a seriesof possibleexplanations for vide servicesto the neediest(World Bank 1992). this "puzzle.- First, there mat be a significantlag betweenchanges in the "inputs"of socialprograms Povertyancom Ditrbutlom (publicspending) and changesin "outcomes,"sum- marized by social indicators.Recent data showing Alack of adequatedata makesthe analysisof poverty that the rate of improvementin these indexesis lev- and income distributionin Latin Americadifficult eling off providesome support for this view.Second, and ftustrating.Litte Is known about nual living aggregatedata may be misleading,hiding what Is conditions,migration patterns, or the Informalsec- really going on within each countty. The World tor. Moreover,much of the data agegate and hide Bankhas arguedpersuasively that countrywidedata major differencesacross regions, racial groups,and 120 LatinAmeica and the CodrbbeanA Decde afterthe Debt Cdris gend Despitethese problems, seval institutfons calorieIntake is computedand pricedfor each coun- have made seriouseforts to obtain an approximate try.The foodbasket Is then Increasedby a certainfac- pictue of human conditionsIn the reglon (CEPAL tor to allow fot the consumption of other items 1985, 1988b;World Bank 1992). -and thus to calculate the poert threshold. In Poverty is not only widespread In Latin LatinAmerica, It has becomea traditionto multiply America-the bottom 20 percent of population the food basketbya factorof two to constructurban receiveless than 4 perent of total income-but it povet basketsand by 1.5 to computerural baskets. hasalsoincreasedduringthepastdecade. The World Householdswith a (monetary)income below this Bankargues that "muchof the povertyin the region hypotheticalbasket are definedas being "belowthe relates to the exceptionallyhigh degreeof Income povertyline." 2 inequalityaffecting Latin America" (1993, p. 16). The data requirementsfor constructingpoverty In eight out of the twelve countrieswith more linesare significant.A detailedprofile of Incomedis- than one observation, the income distribution- tribution is needed, and consumption surveysare measured by the Gii coefficlent-deterioratedIn necessary.Obtaining this informationis expensive the 1980s(table 8.S).In the other four countries- and time-consuming,particularly when analyststry Colombia,Costa Rica, Parguay, and Uruguay-it to obtain povertylines for more than one moment improved.Tb be stessed, however,is that these data All this implies that compadsons of poverty lines are poor and to be interpeted with caution. For overtime shouldbe interpretedwith great care. many countries, the information is only on the Usinga uniformpoverty basket for all countries urban sector, and in some casesthe "early 1980s" in the region-defined at $60 (198S) purchasing data refer to 1985 or 1986, when the region had powerparity a month-the percentageof the popu- aleady been affectedby the debt crisisand wasfac- lationbelow the povertyline dedined in four of the Ing dramaticadlustments. twelve countrieswith comparablefigures-Colom- The public policy literature has moved away bla, Costa Rica, Paraguay,and Uruguay,the same from matve measuresof well-being,such as Income four that had their Gini coeffcient improve.3 ditribution, and has emphasized absolutesodal indicators,such as the percentageof the population Causesof Poverty livingunder poverty conditions.As a result, there have been seriousefforts to construct povertylines Whyare somepeople poor? Latin America's unequal In Latin America,generally defined as the incomea distributionof incomeis generallyseen to be at the householdof a predefinedsize requires to maintain heart of povertyIn the region.What determinesIn- a "minimal"standard of living.This standard of liv- comeinequality in a countryata giventime? Altimir ing is, in turn, constructedaround food consump- and Piflera (1979) emphasL*-dthe crucial role of tion, with the assumption that an adult should education.Fisbein and Psacharopoulos(1992) used consumeno fwer than 2,500calories a day.A typi- data on 10 countries-Argentina, Bolivia,Brazil, cal consumption basket that covers this required Colombia,Costa Rica, Guatemala, Honduras, Pana- ma, Uruguay,and Venezuela-to analyzethe deter- Tabe8.S Incomeditibution In selectedLatin minants of income Inequalityin the 1980s.They Amefian counbis, eay and late 1980s decomposedTheil's inequality indices, trying to iso- (Cnicoeffcients) latestructl variablesthat arebetter able to explain County Eady1980s Lae 1980s inequality:education, age, type of employment Argi (uenosAIres) 0.389 0.461 (employed, self-employed,employer), and sector of olivia(urban) 0.479 0.515 employment (agriculture, mining, manufacturing, gramb 0.574 0.625 and so on). Thesefour variablesexplained about 50 Colombia(urban) 0.578 MIS1 CostaRs 0.4AS 0.410 percent of the variabilityof the Theil Index in ten Guatemabl 0.532 O.S28 countries. aonduras 0.376 0.446 Educationappears to be the single most impor- Paraguay 0450 0.400 tant determinant of inequality at a given time. To Peru 0.427 0.438 investigatefurther the determinants of Incomedis- Uruguay(urban) 0.452 0.420 tribution, Fiszbeinand Psacharopoulosestimated a Veniezuea O.512 0.498 statisticalmodel to computethe probabilityof being a. Eavdly ealuesmtenstr c=Whmdue todrfferensuDr poor (strictly,of having Income in the bottom 20 So rPshwepoulos1992 and1993. percentof the distribution).In addition to the four fvWf, IncotmeDisbon, andHuman Resoures 121 structural varables, they added gedet Along the Honduras matemal motaliBtyIn rual areas is five lines of previousresults, they found that education times the nadonal aveage (624 per 100,000).in E was overwhelminglythe main determinant of the Salvador,80 percent of infant mortalty occurs In probabflityof being in the bottom 20 pecent of the mral areas. In Mexdco,Infant mortalityIs twice as income distriution. For example,In Panama,peo- high in the pooter statesthan In the wealtier ones. ple with zero to fiveyears of education have an 83 In many countries,ethnicty Isdiety related to percentesimated probabilityof being in the lowest povertyand inequality.In 1989,almost 60 percent 20 percent of the distribution. For Argentina,the of Guatemala'sindigenous population had only 0 to correspondingfigure is 69 percent,and for Brazil,42 5 yeas of education,compared with 24 percentof percent. Bycontrast, people with 13 or more years the nonindigenouspopulation. In Bolivia,12 per- of education have, in most countries,only a 5 per- cent of the indigenouspopulation had no educa- cent likelihoodthat they will be in the bottom 20 tion, whlfea mere 2 percent of the nonindigenous percentof the distribution. populationfell in that category. Detailedstudies of Brazilduring the 1960sand 1970sconfirm the importanceof educationin deter- MacmcnoicaInsta and Cyikal Varions mining inequality.Using disaggregated data for six in Poiwfl andIneqaity metropolitan areas, Baros (1992) and Cardoso, Barros,and Urain (1993) found two-thirdsof the Income distributionfor many yearswas thought to increaseIn inequalitybetween 1960and 1970to be change only slowly,a belief based largdy on data rooted in education. But these authors also found from the advanced nations, sugting significant that the importance of education declined as an persistence in distrbutlonal data. Most analysts explanation of inequalityIn Brazilduring the past arguedthat without such major shocls as a war or decade.Their analysisstrongly suggests that unem- revolution,the distributionof Income would only ployment and macroeconomicinstability provide change gradually,the result of policies aimed at most of the explanation for cyclical changes in improvingeducation and other socialservices. inequalityin the 1980s. Newresearh on someLatin American countries Most studieson the subject find the probability suggeststhat the Income distribution can change of being at the bottom of the distributionalscale to substantiallyin a short period.Cardoso, Barros, and be higher for females.Marquez (1992) found that In Urain (1993) showed that the Gini coeffcient In Venezuela,households headed by singlemothers are Brazilexhibited large cyclicalvariations between significantlymore likely to be below the poverty 1980and 1991,with educationplaying only a minor line. Moreover,he found that poor womentend to role. Usingdisaggegated data for sixBrazilian met- be older, having reduced ability to improve their ropolitan areas, they found that macroeconomic skills through training and increasesin education. Instability-measuredby the Inflation rate and by The World Bankstates that "workingwomen con- changesIn the real exchangerate-have had signif- tinue to be concentratedin low paying, low pro- icantly negative effects on Brazil'sdistribution of ductivity jobs...where there is little chance of income.More specifically,real exchange ate over- advancement"(1992, p. 15). valuationhurts the poor, as do Increasesin the level Countrwde aggregate data hide significant and vadabilityof Inflation. variationsIn povertyand Incomedistribution witn A multicountrystudy by Cardenasand Urrutia particular countries, with Brazilproviding perhaps (1992)confinns these results.Using data from 110 the starkest example. Calvacati de Albuquerque countries to investigate changes In the UNDP (1992)found that RioGrande do Sulhas socialIndi- human developmentindex (HDI),4 they found tat cators comparableto those of Koreaand Portugal, higher inflation,as well as more variableinfation, but that Paralbais not significantlydifferent from haveslowed improvements In the HDI Theirregres- Kenya. These regionaldifferences are reflectedin sion results also suggest that faster growth and almostevery social indicator illiteracyranges from greatersoCal expendiftne improve soCal indicators. 11 percent in the urban south to more than 55 per. Macroinstability Is bad for povertyfor two main cent in the rural northeast, and mean years of reasons.First, the overvaluationof the real exchange schooling from 5.2 in the southeast to 1.7 In the rate hurt labor-intensiveexports-and thus em- nrualnortheast ployment and wages. Second, the poor are s4gn- Other countries also have lare regionaldiffer- ficantly more vulnerable to maaoeconomic entials In human development and poverty. In imbalances,as they do not have the ability to pro- 122 LatinAmerica and the Carbbean: A Decade after the Debt Crisis

tect themselves from the direct and indirect consew economic policy to putsue social or redistributlve quences of the inflation tax. That is why programs goals. Every time this princple has been violated, to reduce macroeconomic imbalances-particularly the poor have been sevetely hurt programs to reduce Inflation-tend to improve the distbution of Income. The imptovement in Incme Disrbutudon,Po", andGrowth Bolivia's poverty data is largely the result of ending hyperinfation in 1986 (see table 8.6). Over the medium and long rn, faster growth is the Repeated experiences with populist policies in main determinant of reduced poverty, reduced Latin America dramatically show the links between lnequality, and improved social conditions. macroeconomic disequilibriums and income disti- CArdenasand Utrutia found in their cross-country bution. Inflation Is one of the most regressivetaxes, analysis that GNP growth wasthe main determinant affecting the poor In a disproportionate way. of improved social conditions. Morley also makes Dombusch and Edwards (1991) have argued that this point when he argues that "economic growth is although populist episodes have had specific and a potent force for poverty reduction" (1992, p. 4). unique characteristics in different nations, they tend This is clear for Brazil, Colombia, Costa Rica, and to have some fundamental common threads. In par- Mexico In the decade that preceded the debt crisis, tcular, populist regimes have historically tried to when accelerated growth substantally reduced deal with income inequality problems through the poverty. Morley (1992)points out that the per capita use of overly expansive macroeconomi policies. growth of 41 percent in Costa Rica between 1961 These policies, which have relied on defict financ- and 1971 was accompanied by a reduction in ing, general controls, and a disregard for basic eco- poverty of one-half. A slowdown in growth-or nomic equilibria have almost unavoidably resulted worse, a period of decining GDP,such as the 1980s in major macroeconomic crises that ended up hurt- throughout most of the region-will generally be Ing the poor. As the case studies in Dornbusch and associated with Increases in the proportion of peo- Edwards (1991) show, at the end of every populist ple below the poverty line. experiment, inflation is out of hand, macroeco- Faster economic growth reduces poverty through nomic disequilibria are rampant, and real wages are two channels. First, it increases employment, im- lower than they were at the beginning of the proving the opportunities for productive activities episode. The overriding lesson: do not use macro- among the poor. This suggests that the "type" of

Table 8.6 Individuals In poverty and extreme poverty In seected Latin American countries, 1980 and 1989 (percent)

Povety reerepowety Country 1980 1989 1980 1989 Argentina (Buenos Aires) 3.0 6.4 0.2 1.6 Boiva (urban) 51.1 54.0 22.5 23.2 8razil 34.1 40.9 12.2 187 Chile - 10.0 - 1.5 Colombia (urban) 13.0 8.0 6.0 2.9 Costa RkI 13.4 3.4 5.4 1.1 Dominican Republic - 24.1 - 4.9 Ecuador (urban) - 24.2 - 4.0 ElSalvidor (urban) - 41.5 - 14.9 Guaternala 66.4 67.0 36.6 39.5 Honduras (urban) 48.7 54.4 21.6 22.7 Jamaica - 12.1 - 1.1 Mexico 16.6 22.6' 2.5 7.38 Panama 27.9 31.8 8.4 13.2 Paraguay (Asuncion) 13.1 7.6 3.2 0.6 Peru (Urna) 31.1 4 0j5b 3.3 10.1 Uruguay (urban) 6.2 5.3 1.1 0.7 Venezuela 4.0 12.9 0.7 3.1

- Not avallable. Note Povertyis deflnedas having an Incomeof S60or mssper peson per monrt extremepoverty is deined ashaving an Incomeof $30 or lessper person per month. a. Basedon unweightedsample whkh maynot accurateWyreflect actual population. b. Estimatebased on extrapodationfrom 198S-86powertfigure. Soue Psadharapodos1993. PbvertyIncome DI&btM and HumanResows 123

growth issimportant In determining how fast poverty and employment, but at a modest pace, sugges_t Is reduced. Growth that emphasizes labor-intensive that growth alone will not be enough to reduce sectors generally Is more effective In reducing poverty quickdy.The World Bank (1992) recently poverty than growth biased against exports and estlmatedthatUfGDPgrowswata4. .pepetayearand employnent In contrast, highly regulated econo- if Income distribution Improves with growth-as it mies discourage labor-intensive investments, and has historically-the ncidence of poverty in Latin have created a very large Informal sector (De Soto America could be reduced to 11 percent by the year 1986).The second channel is related to wages.Toithe 2000. Although growth of 4.2 pewent a year is much extent that growth is associated with productivity higher than the region's 1.7 percent aveage over the increases, wages will also rise and the poor will see past decade, it is not beyond reach. Indeed, as the their conditions Improve. Again, the type of growth reforms take hold, the region's gowth could supass is important in determining how this channel oper- S perent per year6 ates. Growth based on comparative advantages and The effects of strucual adjustment pollcies on reduced tade distortions is more conducive to faster poverty and the distrbution of income will deter- wage inceases for the poor, especially in the rural mine the political support-and the durability-of sector. And investment in human capital accunula- the reforms. In the midst of a major cisis, politica! tion-especlally at the preschool or primary level- leaders can initiate major reforms with little support greatly helps incease productivity, real wages from the public.7 The deeper the crisi, the greater grwth, and reduced inequality. the incentives to attempt new polices, and the The debt criss-and the adjustment period that greater the tolerance of the public toward novel eco- followed-reduced employment and real wages in nomic approaches (Haggad and Webb 1993; Latin America, and urban unemployment has been Haggard and Kaufman 1992). In this sense, the debt extrenely high (table 8.7).3 Although now on the crsis gave the leaders from traditional Latin decline in many countries, unemployment in late American political parties-Peronistas in Atgentina, 1992 was still alarmingly high. Moreover,given the MRIin Mexico, Accl6n Democratica in Venezuela- demographics of the region, significant increases in a unique opporunity to implementpompettion the labor supply in many of the countries over the policies. And in some countries, the crisis esulted in next few years, will put added pressure on employ- the election of candidates that favored reforms, as in ment Real wages in 1991 were below their 1980 Brazil and Peru. level, with three exceptions-Sao Paulo in Brazil, But initiated reforms are not durable reforms. Chile, and Colombia (table 8.8). The figuresshow, in With time, memories of the crisis fade, and unless a an almost shocking way, what the debt crsis and the broad political constituency emeges, the sustain- subsequent adjustment meant for social conditions ability of the reforms wlll be in jeopardy. What does In the region. It take for a wide political endorsement? Twothings. As growth has begun to recover, so have wages First, growth has to accelerate significantly.And sec-

Table 8.7 Urban unemployment In selected Latin Amerkcan countrbi, 1984-92 (average annual percentage rates) Country 1984 1985 1986 1987 1988 1989 1990 1991 1992 Argentna 4.6 6.1 5.6 5.9 6.3 7.6 7.5 6.5 6.9 Boliia 6.9 5.8 7.0 7.2 11.6 10.2 9S 7.0 6.8 Brazil 7.1 5.3 3.6 3.7 3.8 3.3 4.3 4.8 5.9 Colombia 13.4 14.1 13.8 11.8 11.2 9.9 10.3 10.0 10.5 Costa Rca 6.6 6.7 6.7 5.9 6.3 3.7 5.4 6.0 4.3 Chile 18.5 17.0 13.1 11.9 10.2 7.2 6.S 7.3 5.0 Ecuador 10.5 10.4 10.7 7.2 7.4 7.9 6.1 8.5 - Guatemala 9.1 12.0 14.0 11.4 8.8 6.2 6.4 6.5 - Honduras 10.7 11.7 12.1 11.4 8.7 7.2 6.9 7.6 - Mexico 5.7 4.4 4.3 3.9 3.5 2.9 2.9 2.7 3.2 Panama 12.4 15.7 12.7 14.1 21.1 20.4 20.0 19.8 18.0 Paraguay 7.3 5.1 6.1 5.5 4.7 6.1 6.6 5.1 6.0 Peru 8.9 10.1 5.4 4.8 7.9 7.9 8.3 5.9 - Uruguay 14.0 13.1 10.7 9.3 9.1 8.6 9.3 a9 9.3 Venezuela 14.3 14.3 12.1 9.9 7.9 9.7 10.5 10.1 8.0

- Not avalae. a. Peiminary. $9e= CEPAL,Ecnrkvey dof LatnAr,wIke varowW bsues. 124 Ltn Amerfcaand the Coribbean:A Decadeafte the DebtCrsis

Table8.8 Averagereal wagesIn selectedLatin Amerkan countries, 19W92 (1980u100) Cmty 1984 198S 1986 1987 1988 1989 1990 1991 199? Argentina 116.9 106.1 102.0 93.5 92.7 84.6 80.3 76.2 75.6 BrazU 10S.1 111.8 121.5 105.4 103.2 102.3 87.6 87.8 105.5 Colombia 118.1 114.6 120.1 119.2 117.7 119.4 113.4 11S.3 116.7 Costa Rica 84.7 92.2 97.8 89.2 85.2 85.7 87.2 83.1 - Chfle 97.2 93.5 9S.1 94.7 101.0 102.9 104.8 109.9 114.9 Mexko 74.8 75.9 71.5 71.3 71.7 75.2 77.9 83.0 8S.0 Peru 87.2 77.6 97.5 101.3 76.1 41.5 36.2 41.8 42.5 Uruguay 72.2 67.3 71.9 7S.2 76.3 76.1 70.6 73.2 75.1 - NotavaRable. a. Prilnaty. $owme:CERAL Ecn SufrvwyfLednAmabk,vaiou issues. ond, and perhaps more Important, the benefits of tion. The nmin determinant of Infant mortality In this faster growth must accrue to a large part of the Latin Ametica is low weight at bith, and most population. If, however, the refoLms maintain or experts agree that the best way to reduceinfant mor- increase the degree of Income inequality, political tality is to target food supplements to undernour- polarization will increase the probability of policy ished, prgant, and lactating mothers. In most of reversals. Alesina and Tabellini (1988) and Latin America, this targeting is done through "ma- Aizeman (1990) argue that unequal income distri- temal and child health care" programs. Although bution wlll tend to paralyze governents, prevent- these have progmms helped lower mortaUty rates, ing them from moving forward with structural many are somewhat unsatisfactory and should be refrmns. Along similar lines, Dornbusch. and redesigned to improve efficiency (World Bank 1993). Edwar& (1991) point out that a poor and worsening A traditional problem with health services in distribution of income has often been at the heart of Latin America is an emphasis on funding and subsi- populist experiments. dizing curative medicine rather than basic preven- tive care. This inefficient approach is also highly HumanDv p IniLatin A_ "m regressive,since the benefits tend to go to the mid- dle and upper classes. Recent efforts to change this A broad evaluation of living conditions requires emphasis have been hampered by the lack of ade- understanding how social variables-including quate medical support staff, including nurses, tech- those for nutrition, health, and education-behave nicdans,and nurses'aides. Another problem recently through time. Therefore, this section discuss the identified by the World Bank is that the lack of evolution of some of the most important indexes of proper distdbution channels for drugs stands in the human development during the past decade.8 way of expanding curative care (Psacharopoulos 1992). Health and Popuation As in most of the world, aquired Immune defi- ciency syndrome (AIDS)has become a major public In most countdes in the region, health indicators health problem in Latin America,with more than 1 continued to improve during the 1980s (table 8.9). mlllion people-Including 200,000 women of child- But in many, the rate of improvement has recently bearing age-estimated to be HIV positive. Pre- slowed. This is so for infant mortality rates in the vention programs will have to become a priority if Dominican Republic and Venezuela; and for life an explosion of AIDScases is to be avoided. A cost- expectancy in Ecuador, Guatemala, and Honduras effectiveway of dealing with the AIDSproblem is to (Grosh 1990). Indicators of health, like those for focus on preventing and treating sexually transmit- poverty and inequality, vary greatly within each ted diseases, which usually facilitate AIDStransmis- country. In Peru, the Infant mortality rate is 5.6 times sion. Unfortunately, cultural and religious views higher for mothers with almost no education than prevent more aggressiveHIV prevention campaigns. for mothers with 13 or more years of schooling. This For decades, the lack of adequate sanitary condi- ratio is 5.3 times in Colombia and 4.8 times in tions has been at the heart of Latin America'shealth Bolivia. In Bolivia, the indigenous non-Spanish- problems, and diarrhea and other water-borne dis- spealdng population has a 35 percent higher infant eases have caused a high percentage of the region's mortality rate than the Spanish-speaking popula- infant deaths. During the 1980s, more than 80 mil- Pover4syncomeDitributo, andHumn Resources125

Table&9 Healthindicators for latin Amerian countres,various yea Lieepectny Under-fivemortA rate Oableswith low atbWirh (ye) (per1,000 be bits) b bhw*h(percent bomunder 2.5 klograms) Country 1980 1990 1980 1990 (mostentestm e) Anfiguaand Barbuda 71 74 - 24 &2(1982) Argentina 69 71 46 3S 6 (198) Bahamas 67 69 - - 4.8(1984) Barbados 72 7S - 12 19.0(1975) Belize 64 68 - 29 - Bolivia 54 60 207 160 15(1985) Brazi 63 66 103 83 8 (198S) Chile 69 72 43 27 7(1985) Colombia 66 69 78 50 15(1985) Cosa Rica 72 75 31 22 9 (198S) Dominica - 75 - 20 10.5(1983) DominicanRepublik 63 67 102 78 16(198S) Ecuador 63 66 107 83 10(1985) ElSaivador 57 64 110 87 15(1985) Grenada 67 70 - 38 12.2(1975) Guatemala 58 63 130 94 10(1985) Guyana 61 73 - 71 11(198S) Hait 52 70 197 130 17(1985) Honduras 60 65 140 84 20 (198S) Jamaica 71 73 29 20 8 (1985) Mexico 67 70 83 49 15(1985) Nicaragua S8 65 132 78 15(1985) Panama 70 73 43 31 8(198S) Paraguay 66 67 70 60 6(1985) Peru 58 63 144 116 9(1985) St Kittsand Nevis - 70 - - 13A.(1975) StLucia 68 72 - 23 9.7(1985) St Vincent 67 70 - 27 10.0(1982) Suriname 65 68 - 38 13.0(1985) Trindadand Tobago 68 71 29 17 3.9(1984) Uruguay 70 73 43 25 8 (1985) Venezuela 68 70 S0 43 9(1985) - Notava1Wae SowrWoidSak SodalIndkom of DevlOpmen varos years, and WIad Dewkpme Reportvaos yes UNEF,The Stte ofthe Wolds ChUr, vau years;and WHO,vai years. lion urban and 18 millon rural dwellers obtained the increased use of contraceptives, has brought drinkable water services,but sanitary conditions are down fertility rates In the region. But in the poorer stUllfar from optimal, as the outburst of cholera in countries, the total rate of fertility remains high, In the late 1980s showed. A particularly serious prob- some cases exceedin five children per mother-as lem is the Inadequate treatment and disposal of in Bolivia,Guatemala, Honduras, and Nicaragua. sewage,related to the neglect of infrastructure main- Excessfertility has serious socdalconsequences. 10 tenance In the 1980s. Most countries in the region There is a strong negative correlation between fertil- lack the required institutional support for ade- lty and educational attainment poor, uneducated quately maintaining infrastructure investment, a women tend to give birth at a very early age and to problem reflected at many levels, including World have more children. As a result of the very high rate Bank loans, which usually do not have maintenance of unwanted pregnancies among poor women, the components.9 To upgrade existing water and sewage number of street children has shot up-S&o Paulo, facilities will take $10 billion to $15 billion, and Brazil, is estimated to have more than 2.5 million. another $10 billion will be needed during the next Addressingthe fertilit problem- in Latin America decade to provide water and sewage to those who is a very efficient way of dealing with women's currently lack these services (Yepes1992). poverty and health.11 In particular, reproductive For more than two decades, there have been seri- health services allow for early inteventions in fam- ous efforts to control the rate of growth of popula- ily planning and in the prevention of other serious tion. An expansion in family plannin&ginduding diseases, Including AIDS. 126 LatInAmefa andthe Caribbean: A Decode after the Debt Crisis

Although most Latin Ametican counatieshad There Is a clear link between nutritional pro- active family planning progams dudng the 1970s gramsand the efficiencyof the educationalsystem: and early 1980s,problems developed. Many women well-fedchildren are more attentive in school and did not fullyunderstand how contraceptivesshould are able to leam faster.More specifically,programs be used, and treatment was often providedunder to increasethe nutritional Intake of children up to unsanitary condiions. The weaklessof these pro- three years of age are likely to have significant gramswas evident In the vety high rate of discon- effectson leaming abilities-and very large social nuitr many poor women abandoned systematic retuns-increasing productivity and, eventually, family planning methods shorty after joiningthe the ability to obtain high-paying jobs (Psacharo- pograms. So greatereffort is needed to developthe poulos 1992). institutional capacity that will assure the sustain- Generalfood subsidiesfor staples,such as rice or ability and continuityof famly planning programs. beans, are an inefficientand regressiveway of tack- ling nutritionalproblems. Such programs,very pop- Numtton ular among politicians,usually end up benefiting the richer segment of the population at very high Latin Americacontlnued to Improvenutritlon dur- costs to the budget and efficiency.Countries are ing the 1980s,with malnutrition (14 percent)now moving away from these general subsidy schemes two-thirdsthat of the developingworld as a whole and adoptng targetedprograms to reach the poor (WorldBank 1992). Despite this progress,there still and malnourished-as In Chile, Mexdco, and are more than 10 milion malnourished children Venezuela. belowthe age of five-mostly in Braziland Mexico. For some years now, one of the most popular On average,less than .25 percent of GDP is ways of targeting nutritional subsidieshas been spent on nutritional programs (table 8.10).12The throughschool feeding programs (Grosh 1993). New WorldBank (1993) estimated that, dependingon the evidencesuggests, however, that the efficiencyof country,effective nutridtonal progams costbetween these programsmay not be as high as once thought $30 and $S0per beneficiarya year.Quadrupling, or If childrenare fedat school,they tend to receiveless even doubling, the resrces for nutritional pro- food at home. There are significantleakages In the gramswould mean verymodest changes in resource distribution channel, with only a fraction of the aBocation,but would go a long way towardelimi- food usuallyreaching the targetedpopulation. And nating malnutrition.With the politicalwill, it would the food offeredhas verylittle variety,greatly reduc- be possibleto increase the fundingto targetednutri- Ing the appeal of the programto the beneficiaries. tional programs-through a combination of mea- Unking nutritionalprograms to the primary health sures,including greater public sectorefficiency and systemcould be more effective.The most efficient reducedspending In other areas,including the mil- way of doing this Is distributingthe food subsidies itary. in coupons or food stamps and letting the benefi- Table8.10. Ma h_lnon in selected Latin Americancnties, 1990 Maoshmd Chidrencoved Costper didren byednprogmi benfidaty Pawxtge COW"y (thousd) (thounds) (U.S.doars) of GNPspent ArgntIna- 968 35.0 0.02 olma 760 482 21.1 0.49 Bazil 5,024 13,957 16.9 0.28 Chile 35 1,342 47.8 0.34 Colkxbmi 488 1,198 13.9 0.11 CoslaRka l1 6S 43.9 0.35 DominkanRepubIk S8 107 28.8 0.07 Ecuador 264 173 32.9 0.31 ElSalvador 123 111 31.3 0.20 Guatemaa 503 254 7.5 0.14 Honduras 165 140 30.7 0.53 Mexico 1,585 5,038 10.3 0.05 Paguay 25 22 20.5 0.06 Peru 429 2,705 57.5 0.96 Unuguay 21 140 28.7 0.31 Venezuela 275 448 12.2 0.09 - Not avaae. Sm 9Mwgrv191. Povt IncomeDistribution,andHumonResources 127

clary obtain the food in the marketplace (Grosh care. And fourth, the poorer groups of society are 1993; Psachatopoulos 1993; Castafieda 1992). often exduded from social secudty. In Brazil, only 18 percent of the poorest Income groups-which Socil Seuity account for more than 40 percent of the popula- tion-are covered by sociaisecurity, and they receive Many families, especially from the middle classes, only 3 percent of the benefits (McGreevey 1990). obtain basic income support and health services In most countries, the contributions to the through the social security system (Mesa-Lago, health side of social security are independent of mar- 1991). Moreover, social security is one of few social ltal status, family size, and age. But the benefits auto- services with spending incteases In the 1980s. But matically extend to dependents. Changes In the age most social security Institutions are inefficient and structure of the population have reduced the active underfunded, siphoning funds from general rev- populadion willing to support these systems (Cox- enues. Unless some substantial reforms are Imple- Edwards 1992). mented, there could be major financial crises. The Despite these problems, there Ishope for reform. Insolvency of the social security system is still a seri- More than a decade ago, Chile embarked on a major ous, unresolved fiscal problem In Argentina, Brazil, reformnof Its social security system, replacinga tra- Guatemala, and Venezuela, among others. Unless ditional-and financially troubled-pay-as-you-go solved, it could jeopardize the macoeconomic pension system with one based on individual retire adjustmentprogrms (see chapter 7). ment accounts. In the new system, the provision of in most "mature" social security systems- health services Is also based on choice. Workers con- Including those of Argentina, Brazil, and Mexico- tribute 7 percent of their taxable income to an Insur- the ratio of pensioners to contributors is vey high, ance progmm, but they can choose between a public Imposinga heavy burden on the worldng popula- system, managed by the national health fund tion. For example, Argentina has one retiree for (FONASA),or private health providers (ISAPRES). every three contributors, and Chile has almost one About 80 percent of Chileans are affiliated with the for every two. A question is whether participants in public system and 20 percent with the private. The sodal security systems see their contributions-or a Chilean reform has had three important results. It fraction of them-as payroli taxes.13 If they do, the has eliminated the traditional drag on public sytms introduce an additional burden to the labor finances.It has substantially improved the efficiency market, reducing employment creation. Cox- of the system.14 And it has provided a definite boost Edwards(1992) argues that, except in Chile and to the Chilean capital market by creating several Peru, there Is only a very weak acft trial connection large institutional investors. between contributions and benefits (table 8.11). With administrative costs exceeding 15 percent Educaion Human Capital, and Sodal of expenditures, as opposed to 3 percent in the Conditions industial nations, there clearly is room for increas- ing the managerial efficiency of social security insti- For a long time, economists have argued that the tutions (World Bank 1993). And with clear accumulation of human capital-through Increases duplication of efforts by two or more institutions in the coverage and quality of education-is a pillar serving the same region or population, there Is room of successfuldevelopnment strategies.l 5 This Idea has for increasing the efficiency of entire systems. gained renewed popularity in the past few years Sodal security systems are economically ineffi- thanks to the development of a new family of dent and soclaly inequitable in most of the region's growth models that incorporate the posibility of countries. First, most of these pension funds encour- increasing returns to scale and positive externalities age early retirement,burdening the country when (Romer 1989; Lucas 1988).16 retireesare in the prime of their productive yeas. * Azarladisand Drazen (1990) argue that once a Second, pensions are often unrelated to the Individ- certain thresholdis achieved in education, econo- ual contributions to the system, particularly for mywide externalities will increase productivity higher-income Individuals, who can often obtain growth and thus overall economic performance. lavishpensions after having made small and limited e Lucas (1993) suggests that the South Korean contrbutions to the general pension funds. Third, "miracle" since the mid-1960s-with living stan- as health providers, social secuity systems encour- dards doubling every 11 years-has been propelled age expensive and highly technological curative by increases in productivity, fueled by the accumu- 128 LatinAmerc andthe Cabbean: A Decodeafter the Debt Crisis

Tabe8.11 Sodalsert contIbutlonsand otfer payrolltaxes In selectd LatinAmeicam countries (latestavailable labor code) Contritins PercentAditkal- Percent Pew"t Benelit towv,dcost kmly Pet toward toward heath coveae ted Workes' ohr Heth ce Country core (prtcent) mr conwensotfonprogm sPensom and

ArgentIna 31 Nonein 9 Insuance is Benefit4dinedpension, Medial care extended to pubiksystem premium inhed byspouse dependents.sability. andminor children. Maternityave. UnemploymentInsrance. Low-costmortgages. Bolivia 10 NoneIn 8.5 1.5 BenefIt-einedpension, Medical care extended to publicsystern Inlited byspouse depederns.D .ablt. andminor children. Maternityave. Brazil -0-28-30 go 1-3 ISA Beneit-definedpension, Medical care extended to Inheritedby spous dependents.Disability. andminor children. Maternityiave. UnemplominInsurance. Cotombia 7 5 6.5 Incuded 2.0 Benefit-delInedpension, Medical care exteded to Inheritedby spouse dependents.DIabilty. andminor children. Matemityleave. Public sectortraining. Chile 7 Vaieswth 10 0.9-3.4 Conibuiondeined Choiceof plan. plan abovea mininumlevel. Maternityleave. Ecuador -- 20.2 O- Incuded Benefit-deinedpension, Medical care extended to Inheritedby spouse dependents.Disabilt. andminor chiidren. Matermityleave.

Mexico 1 - 18.05 - * 0.26-6.56 5.0 Benefit-definedpension. Medial care extended to inheritedby spouse dependents.Disability. nd minorcildre. Matenityleave. Low-cost mortgages. 2 Contibutiondefined. NIcaragua9 NoneIn 8 Included Benefit-definedpension, Medical care extended to publicsystem inhertedby spouse dependents.Disabiiity. andminor children. Maternityieave. Peru 9 Mayvary 9 Insurance 75 ContrIbutiondefined Choiceof healthplan. withplan premium abovea minimurnlevel. Pubkicsector training. Low-costmortgages. VenezuelaPublic 6.75 Included 5.0 Benefit-definedpension, Medical care extended to sector Inhetedby spouse dependents.DlsabDlty. andminor chidren. Maternityleave. Unemploymentinsurance. Pubicsector Uining. Prvate 23-25 sector SourceCox-Edards 1992. latfon of human capital. A seriesof recent empirical by Barro (1991) for a large craoss-sectionof coun- studies support this view-that a highly educated tries-and by Edwards (1992c) for a group of devel- labor force, whose skills Improve rapidly year after oping nations. year, has been behind the tremendous economic * In an important paper Pyo (1993), carefully success in South Korea and other East Asian coun- constructing time series for the stock of human cap- tries. ital In Korea for 1955-90, finds that the increase in * Fukuda (1993),inaneconometricstudyonthe education coverage has greatly contributed to that growth experiences in that part of the world, finds country's fast rates of growth. that secondary school enrollments play a signicant * In another study that tries to undetstand why role in explaining cro-untry differences In the Gang of Four-Hong Kong, Korea, Singapore, growth. These results support those reported earlier and Taiwan (Chlna)-outperformed almost every Pwerty,lnme DktdWtn, andHumLn Resoces 129

comparison group in the past 25 years, Easterly is particularlyhigh for investng in primay edc (1993) finds that education showed a rmakably tion (Selowsky1969; Psachar los 1992).Psacba- robust effect In explaining cosscountry gvowth. ropoulosand Ng (1992)used householdsurvey data Independentof the econometic techniqueappled to estimateprivate and socia rates of turm for pri- and the data used to definegrowth, primary and sec- may, secondary(genetal and vocational),and uni- ondary education attainmentshad largeand signif. versity education. The socialrate of retun for icantly positive efficientsIn growth regressions. primaryeducation exceeded that of secondaryedu- A comparison of educational attainment on a cationin 11 of 14 cases-the excepions beingChile, group of LatinAmerican countries in 1989, reveals CostaRica, and Hondutas.And In 13 of 18 countries, significantdifferences (table 8.12). And a compari- the privaterate of return for priary educationwas son of the LatinAmetican average with Hong Kong, higher tian that for seconday education. Despite Korea, and Singapore shows that the East Asian these rehurns,net ptimaryschool enrolment tatios tigersdo significantlybettet are below85 percentin many LatinAmerican coun- Education contributes to agegate (macroeco- tres-for example, in Bolivia, Brazil, Colombia, El nomic)growth, and to an individual'sability to eam Salvador,Guatemala, Haiti, and NicaraguaBy com- more.Many studiesshow that education(plus expe- parison,the net primaryeducation enrollment ratio rience)Is one of the most importantstatcal deter- in EastAsia is l00 percentof primary-school-aechil- minants of workers' rewards In the labor market. dren (WorldBank, WorldDeepmet Rpwt 1992, Cox-Edward(1984), using panel data forthe greater table 29). Santiagoarea in Chilefor 197480, found a signifi- In 1989,latin Americaspent an averageof $118 cantly positivecoefficient of education in Mincer, a year per primary education student, down from type earnings equations (Mincer 1958). She also $164 In 1980, and much lowerthan the EastAsian found that the higher the degreeof education,the nations (Wolff,Schiefelbein, and Valenzuela1993). lowerthe vulnerabilityof eamings to cyclicalfluc- This t Agetry reductionhas affectedsome of the tuatlons in the economy." And as reportedearlier, most important inputs Into education. Teachers' education Is a major determinantof the probability salades have declined drastically,greatly affecting of a given Individual having earnings below the morale, the availabilityof textbookshas been re- poverty line (Psacharopoulosand Flszbein1992). duced, and preschoolfinancing has been cut This Education,then, does many things for the devel- has had an important effecton the qualityof educa- opment process-both at the macroeconomiclevel, tion, induding children'sability to learn and retain whereit Is a keysource of growth, and at the micro- conceptsas they moveup the educationalladdet economiclevel, where it Is a basicvehicle for mov- In mostcountries, access to earlyand preschool ing out of poverty. A series of studies on Latin educationIs insufficientAnd women lag behind in America,as weJIas other parts of the world,suggest almostevety educationalcategory, including "head stronglythat the rate of return-private and social- start" type programs,despite the fact that the sodal

Table8.12 Education Indkators for seectedLatn American and EastAsian countries, 1989 (percent, except where otherwisespecfed) Pr*WY Seconday Terttaty Pdmtrmypupl/ contry enolmtneVt(MIIoIiIr e,niWW texh' rtio ArgentIna - 74 41 19 8razil 84 39 11 23 Chile 89 75 19 29 Colombia 69 52 14 30 CostaRlca 86 41 27 32 ElSahador 70 26 17 40 Guatemala - 21 - 35 Jamaica 99 61 5 34 Mexico 100 53 iS 31 Peru 95 67 32 29 Trinidadand Tobago 91 83 6 28 AverageLatin Amerka 87 50 18 27 HongKong 100 73 - 27 Korea,Republkcof 100 86 38 36 Singapore 100 69 - 26

- Not svaIable a. As a perge of the dglble populin. Soe,e WoUrldBan*, W*IDen xnatReport 1992. 130 Lain Anmfwcc the Ca n:A Deae afterthe DebtCisis

return on women's early training Is exceedingly work force to face Intetnational competition, high. Womens education not only inceases pro- Increase wages and Hlng standards, and reduce ductive employment opportunities, but also has poverty and inequalty. But is Is a time-consuming positive indirect effects on fertility and nutritional process that will not bear fruit in a year or two. attainment (Pacaropoulos 1993). QualIty of education should be upgraded through One of the biggest problems in latin America's increased funding and better management and allo- educational systein Is tepetition, with extremely cation of educational resouces. Rapid increases In high rates that rank among the highest In the devel- the resourcesdevoted to preschool and primary edu- opng world. In Bolivia,the repetition rate goes from cation are likely to produce very high retums. 16 percent In Bent to more than 35 percent in Teachers should be trained using modem tech- Chuqulsaca. fls estimated that the cost of repetidon niques, ther skills periodically renewed, and their exceeded $4 blillon for the region as awholein 1990. salaries increased. And parents should have more of Interestingly, the rate of repetition in the English- a say in decisionmaldng-to get them more directly spealdng Caribbean countries is sigificantly lower involved in the educational system. tha In the rest of the region (Psacharopoulos If Latin America continues to neglect education 1993).18 and fails to take measures that will greatly Improve The average quality of Latln America'sprimary the quality and coverage of the system, the likeli- education is very poor (Wolff, Schiefelbein, and hood of sustining the structua reforms will be Valenzuela 1993). For example, an intemational greatly reduced. As the East Asia mirade countries comparative study of the reading abilities of nie- have shown, a solid educational base is required for year-olds found that Venezuelan students ranked increasing productivity and competing intemnation- last amongcountries. Students did better In iTndad ally. More than that, a broad, high-quality educa- and Tobago but were stll significantly below the tional system usualy is a ticket to social peace, average. A 1992 study on science and mathematics harmony, and prosperity. achievement for 13-year-olds found that Brazilian students from SSo Paulo and Forteza were The Reduction of Pover FPol Options outscored by students from China, Israel, Jordan, and Pirties Korea, and Taiwan (China)-and by students from every developed country in the sample. The only In designing policies for human resources, it is country Brazi outscored was Mozambque. And a Important to recognize that the tegion's socal prob- 1992 study of mathematics and science for 13-year- lems have two main dimensions. The first is the deep olds in Argentina, Colombia, Costa Rica, the strutural deficiency in providing social services. Dominican Republic, and Venezuela found that, Demanding resourc and time, the structural defi- except for elite schools, test performaice generally cdendes will require substantial long-term policy was significantly below that of "aveageM countries, initiatives-major decentralization iniftiatves, in- such as Thailand and the United States.19 creased coverage and quality of education, anda sig- Latin Amedca's neglect of primary education nificant upgrading of nutritional and health contrasts sharply with Its heavy subsidies o higher programs. education. This unhappy combination has had seri- The second dimension is the immediate need to ous regressive ditrutive effects, reducing the provide relief to the poorest segments of society, tra- resouces available to the poor, leaving iiteracy ditionallyneglectedandhitpalcularlyharddurlng rampant (Psacharopoulos 1993).Although the qual- the adjustment period. The urgencies at the social ity of higher education (especially In the sciences) level are such that rapid action and creative pro- has to improve signifcatly If the region is to com- gms are needed to reduce the most serious conse- pete successfully in the world economy, this has to quences of the crisis. Several countries have recently be done in an effective and fair way. University stu- undertaken programs to strengthen the safety net dents usually acquire a very high eaming capacity Despite these efforts, poverty continues to be sed- and can pay (at least afterward) for their education. ous, and efforts to alleviate it should have a high pri- An efficient scholarship and loan system could ority in the policy agenda. broaden accessto university training and pemit the During the past few years, the World Bank has recovery of costs. greatly Increased Its involvement in the region's The newly emeging economic structure in Latin social progmms. The Bank recognizes that long-run America requires a dynamic and highly productive structral programs and short-term emergency pro- 1over*Intome Dblthitk,n andHnr Resouces131

gramsneed to emphasizethree elements: the adjustmentefforts. Some of theseprogams have * Improvingthe use of resources,by reducing been basedon traditionalpublic work effortsby the wasteand incaing administrativecapadty - centtal govenments, as In Chile Others haveopted * Increasing the avaaillty of resources, for more deentalized models,whee the commu- through higher governmentbudget allocations and nity takesa strongrole in the design,administration, more effective use of private nongovernmental and supervisionof the progrms. Mcdco'sSolidarity organIzatIonsI programand the Boliviaemergency program are the * Makingsure the benefitsof these programsgo premierexamples of this decentaized apprach. to the intendedbeneficiaries. Duringthe 1970sand 1980s,Chile Implemented Thisthird objectiverequires mech'hanisms that allow two emergencyemployment programs to provlde the authorities to identify the poor and channel some minimal support to those affected by the resourcesto them. adjustment policies.The Minimum Employment World Bank lending for projects with a social Program(PEM) was created in 1975 when unem- content has increasedin Latin Americafrom $223 ployment had reachedrecod highs. The program, millionin 1988to a proposed$870 millon In 1993. administeredby localgovemments and supervsed Bank programshave covered many countriesand by the National Planning Office, paid a reduced almostevery dimensionof hunan resources(table salaryto unemployedworkers who for a smallnum- 8.13; see also appendix to this chapter).And while ber of hours performedsome menial publicworks. many of the Bank-sponsoredprojects are long term At first,the governmentseverely restricted entry to -tacing the deeperstruralroots ofpoverty and the program.Slowly, however, most of these restric- inequality-other projectshave centeredon provid- tions werelIfted, allowing more of the unemployed Ing emergencyrelief to the poorestof the poor The to take part This expansion In coverageexplains Bankhas alsosupported sodal initiativesthrough its why,despite the economicrecovery and a reduction analyticalwork-with studies of trgetng, ethnic in the real value of minimumemployment program dimensionsof poverty,and womenin development. compensation,the proportion of the labor force The results from these studies have establbhed a employedbytheprogramremalnedalmostconstant fuitful policy dialogue with the member coun- between1977 and 1981. tries-and have helped them design new policies, Afterthe onset of the debt crsis, the number of inluding sodal securityreforms. individuals employed by minimum employment programin the GreaterSantiago Area increased from In entg EmenrencyPrograms about 23,000in May 1982to 93,000in May 1983. A new emergency pwgram-the Employment Severalcountries have socal emergencyprograms to Programfor Heads of Households (POIj-was amelioratethe consequencesof the debt crsls and launched in October 1982. It employed about Table8.13 SelectedWorld Banksupported prect tendd to Improvesodal programs Eduon Wmens Emergency Child Heal coage traning Woterand sodialfunds cre support rempojec Nun andqly prmgrms sanitaton BOivi Bol"a Argentina Colombia Argentina Brazil Bolivia Guatemala Colombia Bolva Ecuador Boliva Colombia Brazil Guyana jamaicab Brazil Honduras Brail Ecuador Honduras Chie Mexico Chile Guyana Nicaagua Domirdan Venzueb Colombia Repubik Dominican Ecuador Repub ElSalvador Euaador Guatemab ElSalvador Hait Guatem"a Jamalca Haiti Mexico Jonakac Venezuela Mexico Venevuela NoteIncldes curent awd proposed proects. includeshealt sector reoms b.Prehool program. s9wr VAlkdBnkd. 132 LatinAme nd theCaribbean:A Decafterthe DebtCrisi

100,000 indvtiduals in the Greater Satago Aea in mismaagement Nicaaa emerged from the Mayof 1983. Combined, the two programs absorbed 1980s with Its economy in shambles. Income per more than 10 percent of the labor foce of the capita had dropped by two-thlrds, hypernflatlon Greatr Santiago Area in May 1983 (Banco Central had taken over, and exports were a quarter of what de Chile 19 91).;e they had been 10 years before. The new government The two Chilean emergency progams had tuee put together a comprehensive economic package to main characterstics. First, the compensation paid to eliminate ifation and end the balnce-of-pay- participants was intended to discourage people from ments crisis. lb deal with poverty the new adminis- considering it a long-term solution to their poverty tration developed emergency progamms,the most problems. Second, to obtain payments, partcpants important being the Fondo de Inversion Sodal de actually had to work, and strong constant efforts Emergencda (FISE),sponsored by the World Bank kept the program from becoming an unemployment and funded by the Bank and bilateral donors. Insurance scheme. And third, the number of hours ailored after the Bolivian emergency social of work required was small enough as to allow par- fund, the FISE has a budget of $66 milon for tcipants to search for permanent Jobs.21 As eco- 1993-94. And, as in Bolivia, the aim is to provide nomic conditions improved, the coverage of the temporary employment in infrastructure projects to programs was greatly reduced, until they were the poor. Recent evaluations suggest, however, that phased out in the late 1980s. the ptogmm Is facing some difficulties common to The Bollvian government established, with the this type of scheme. The labor component of the help of the World Bank and a series of multilateral proposed project Is rather low, with only modest ce- and bilateral agencies, an Emergency Sodal Fund ation of employment It is estmated that the pro- (ESI) in 1986. Its main objective was to prvide gram would create the equivalent of 4,000 full-time employment opportunmies to those affected by the jobs, implying a very high cost per new job. Another debt criss, the stabilzaution program, and the col- problem is that the govemment lacks the admins- lapse of the intemational tin market Unlike Chile's trative capacity to implement the required number minimum employment program, the Bolivian fund of projects. concentrated more on infrastructure prolects It was In addition to E, Nicgua has two broad also demand-dven: managers approved or rejected regionaly based social emergency programs: funding requests for small projects implemented by PRODEREand PMA.These two progmms, and a few private contractors hired by local govemnmentsand smaller ones, are coordinated through the Programa supervised by the central emergency sodal fund de Recondiladon Nacdonal. PRODEREhas a budget administration. The emergency social fund sup- of approximately $14 million for 1993-half for ported projects in four areas: basic infastucture, seven municipalities in the north and half for the ncluding road maintenance, '.igation, and drain- municipality of Rio Blanco. There is a genea sense age; socal infrastructure in health, education, and that there probably are too many programs, with sanitation; social assistance, including school feed- small budgets Moreover, most efforts to strgthen ing progams and vaccination programs; and credit the safety net have focused on the rural sector, with- for micterprses, through NGOs (Newman, out providing enough support for the cities. Juargensen, and Pradham 1991). As In Chile, the These problems reflect the generl point that In emergency socdalfund was designed as a temporary many cases government and the multilateral orga- progam, with a three-year lfe span-1986-89. Data nizations and bilateral donors run into difficulties collected by the World Bank suggest that the emer- due to the lack of organizational and institutional gency social fund succeeded in many ways capacity. In many countries, especally the smaller (Psacharopoulos 1992, box 4.2). It concentrated on and poorer ones, there Is little doubt that providing those with a greater need for jobs-workers were technical assistance to help the govenment im- mostly unskilled heads of household. Second, par- prove its ability to manage social programs is a cru- ticipants increased their eamings by 67 percent, on cdalstep In defeating poverty. average. But as Newman, Jurgensen, and Pradham Mexicohas an innovative decentralized program (1991) argued, the lack of institutional capacity to to reduce poverty through the implementation of generate projects in some of the poorest areas infrastrucure projects. This program, part of the reduced the scope of the progam. And although broader National Solidadty Program (PRONASOL), most wores employed by pivate subcontractors prvides funds to the 1,300 poorest municpalities were poor, they were not the poorest of the poor. for small infrastructure projects. There are two mnain After years of an armed conmfictand economic differences between this program and the emer- Povet, Intoe DlstutoM and HumanReoures 133

gency schemes in Bolivia,Chile, and Nicaragua. The difficultiesin administeing targeted pro- First,the local govenments In Mexdcohave sgnifi- grams-4ncludingthe problemsIn ident the cant autonomy, with authority and responsibilities poor-have prompted some authonsto argue that over supervison and auditing.Second, to obtain the the LatinAmerican countries are not readyfor such funds, the local communities have to provide policdes.But a recent studyof 30 targetedprogrms matchingresources, induding maatrialsor laborser- thoughout the regionshows that In most casesthe vices.22By going diectly to the Interestedgroups, actualcostof umnnlngtheseprograms was extremely and sldpping the central bureaucacy, Mexico has modest In 29 of the 30cases, the admnsative cost mobilizeda largesegment of the population. was below$25 a year per recipient with a median Recentanalysis suggeststhat this program has administrtve costof about $10 a yearper recipient been largelysuccessful, especally in poor mralareas (Grosh 1993). Along the same lines, Musgrve and urban shanty towns. About 40,000 small pro- (1991)found that the cost of targetingfood supply lects have been implementedeach year since 1989, pograms hadaange between$30 and $S0per per- with 12 millionpeople connected to ddnable water son a yean and schools and hospitals rehabiltated in a very Sincethe late1970s, Chile has Increasinglyrelied cost-effectivefashion (World Bank 1992). The on targeted social progams. Although these pro- decentralizationin the selectionand supervisionof grams ran into some difficultiesduing the early projects has been at the heart of PRONASOL'ssuc- years,the authoritiesimproved them, and there is cess. Recently, El Salvador, Guatemala, and wide agreementthat the Chileanapproach to tar- Hondurashavebeguntoexperimentwlththese type geting has largely succeeded. Castafleda (1992) of progrms, butIt is too earlyto assesstheir succes. reports that 90 percent of the food disbuted trough the preschoolnutrition programswent to Taelng SocalProgams the poorestthree dedles of the population-80 per- cent to the nrualsector. And after the basic housing One of the biggestshortcomings of traditionalso program was reformed in the early 1980s, it was programsin Latin Americahas been that their ben- gearedincreasingly toward the poor In 1969only 20 eficdarlestend to be the middleclass, not the poor, percent of housing subsidieswere receivedby the maldng many of the progams regrve. In the past poorest three decUles,but in 1983 this percentage decadepolicy analysts and expertshave arguedthat had increasedto 50 percent. targeting social programs to the truly poor iS an Oftenthe replacementofgeneralsubsidiesbytar- Important feaure of successfl sodal polides. geted progms runs into political opposition, The first step in deslgning targetedsodal pro- becausegroups that benefitmost from generalsub- gramsis idenfifyingthe poot Who are they? Where sidies-the middleand upperclasses-are politically are they? This is not an easytask in countrieswith organizedand very vocal. They stronglyresent the limitedinformation. Experts have consideredthree govemment'sremoval of what they considerto be ways of facingthis problem (Grosh1993). The first an entitlement,particulady the subsidiesto univer- Is based on vindividualassessment," where the sity educationand gasoline. Bycontrast, the groups authoritiesuse certaincriteda to classifyeach mem- that would benefitmost from targetedprograms are ber of the population as "poore or "not poot" usuallypolitically weak-the marginaied, the dis- Naturally,this procedurerequires detailed infonna- enfranchised,and the very poor in ural areas. tion, not alwaysavailable in the poorercountries. A Althoughtheir politicalvoices are slight,they dearly second criterion is based on "group targeting," constitutethe most deseing groups for receiving where complete groups of the population-identi- directgovenment assistance.23 fied by geographicallocation, gender, ethnicity, age, or other broad characteristics-are clsssified as Evahat Poliy Options poor" and are targeted to receive the benefits. Third, "self-targeting"mechanisms are designedto Poverty alleviation will require significantefforts encouragea processof self-selection,where the poor and decisiveaction. Progressin this area is likelyto and nonpoor are separatedon their own, without come from two mutually reinfordng sources.First, active partidpatlon by the authorities.These mech- govemmentsshould continue to adopt policiesfos- anismsrely on stigma,high transactioncosts, or the tering stronger growth, higher employment, and lower qualy of products distbuted to discourage fastergwlng salaries.Second, governments should the nonpoor from participatingand thus to reach increasethe pvison of basic social servicestar- the target geted to the poorest segmentsof the population, 134 Lan Amefca and the Carbbean.A Deoadeafr thedet Crisis funded through more efficient resourceuse and new should be avoided at all costs. budgtay allocations. Extensive studies In the past few years-many of There are sevea ways to raise more resou them at the World Bank-have provided abundant Fist, in most countries, a mote effident tixadmin- evidence of the relative effectiveness of diffent isratlon-I-Incuding a more severe tax enfoxrement socia proganms. Based on this accumulated evi- system that heavily penalzes fraud and evasion- dence and on the constaints the region faces, it is can stillyield sipificant resoures to gratly expand posible to lbstsome of the desiable featuresof deep, the soial wsctors.An increaseIn govetnment rev- tageted antipovertyprogams. At the top of the list enue of 1 peroentof GDPspent on nutridonal pro- is Improvingthe qualty of educationand replacing grams would increase the resources curntly higher-educationsubsidies with prmary education devotedbyafactorof five,andeffectivelyputanend support Second Is strengthening primary health to malnutritionin the region. care,through the traiing of nursesand nurses' aids, Second,it is imperativethat the authoritiesser- the impoved availabilityof medicines,and the care- ouslyconsider cutdng other programs-4n order to ful selection of the most appropriate health-care devote the idled resourcesto financing targeted technology.Third, recurnt costs shouldbe covered social expenditures.An obviouscandidate for sig- to ensure that the benefits from social projectsare nificant cuts is the militarybudget In most coun- sustained,and will not disappearas physicalcapital tries, a reduction of militay outlays of 0.5 to 1.0 detedorates.And fourth, comprehensive social secu- pent of GDPis feasibleand wouldgo a long way rity reform that providesminimal coverageto the toward expanding the prvision of public sevices poor and puts an end to the current implicittax on for the poor.4 labor would go a long way toward encouraging Third, in somecountries, there may be no alter- employmentcreation, raising real wages,and reduc- native to raising taxes to obtain the resourcesfor a ing poverty.Although these four factorsprovide the minimalcomprehensive attack on poverty.What is basisfor implementingsocial progrms, the govern- particularlyimportant-as the recurrentbouts with ments in the regionand the multilateal institutions populsm have shown-Is to recognize that the should continue their efforts to discover increas- inflation tax is highly regressive,imposing severe inglyeffecivechannelstoattackpoventyandreduce burdens to the poorestsectors. This form of taxation inequality. PovertyInome DL ktn andHumaon Resm . 135

Appendix

Tabe 8A.1 Worl Bank endingfor humm resoumes,fiscal 19493 cauntryl Amount fisadyear Pret tile (mlOfs o*s) AWd 1989 SocialManagement TA 28 1991 WaterSupply and Sewerage Sector Loan 100 1993 SocialSecurty Reform 400 Bahs 1987 NewProvidence Islad WaterSupply andSewerage RehabilItation 10 1989 SecondTechnical and Vocational Traning 10 Barhbados 1993 ThirdEducation and TrainIg 20 BEe 1992 PdrmaryEducation Development 7 SdMb 1987 EmergencySocial Fund-Phase I 10 1988 SecondEmergency Social Fund 27 1990 SodalInvestment Fund 20 1990 IntegratedHealfth Development 20 1991 MajorCties Water and Sewer Rehbitaton 3S 1993 EducationReform 2S Bazu 1987 SkillsFormation 75 1988 Nortst EndemkiDease Control 109 1988 Waterfor Municpalits andLow-Income Areas 80 1988 RioFlood Recontruction and Prevention 175 1989 AmazonBasin Malaria Control 99 1989 WaterSector in the Stateof Slo Paulo 280 1990 NortheastBasic Health Servies 11 267 1991 InnovationsInBask Services 11 245 1991 ScienceResearchandTralning 1S0 1992 WaterSector Modernization 250 i992 WaterQuality and Pollution Control 245 1993 WaterQuality and Pollution Control (Minas Gerals) 1993 WaterPofiution and Quality Control 125 1993 NortheastBasic Education II 220 -Chil 1991 SecondValparaiso Water Supply and Sewer S0 1992 PrimaryEducation Improvement 170 1992 TechnicalAssistance and Hospital Rehabiltt 27 1993 Environmentand Institutional Development 12 1993 HealthSector 119 cambbe 1988 WaterSupplyand Sewer Sector Loan 150 1989 SecondSubsector Loan for PrimaryEducation 1990 CommunityChild Care and Nutriton 24 1993 SecondHealth Servkes S0 1993 PollutionAhation and Sanitation 200 CostaRkca 1992 BaskEducation Rehabilitation 23 DominiknRwubik 1991 PrimaryEducation Development 1S EastenCabbean Stes 1987 FourthCaribbean Development Banic Reg. Vocationaland Technical Education 6 1987 SecondGuayaqui and Guyas Province Water Supply 1992 FirstSocia Developmnent 89 1993 SecondSocial Devebpment 70 ElSahcdbr 1988 EarhquaeReconstruction 6S 1"1 SocalSector Rehalitatlon 26 Guatemak 1987 WaterSupply Rehabitatn 23 1989 SecondBasic Education 30 1993 SocialInvestment Fund Sector Loan 1S 136 LotnAme,*o and the Codbbea.t A Decodeter theDebt Crisis

Tab SA.1World Bank lending for humanresources, scal 19793 (contInued) Cownty/ Amount fgsmoy PAqlctltwe (millnsof dlas) Guyn 1990 Strucnal AdjustmentCredIt 78 1992 SIMAP/Heasth,Nution. Waterand Sanitation 10 1993 PublcAdminsraton 6 1989 Port-Au-PrInceWater Supply 20 1990 Healthand Population 28 1991 Fi Education 13 1991 Economkand Social Fund lt Honduras 1987 RuralPrimary Education Manaemet 4 1991 Strural Adjustent Loan 90 1991 Socialinvestment Fund 20 1992 SecondSocial Investment Fund 10 1993 Nutritionand Health 13 Pamaka 1987 Popuiationand Health I 10 1988 EducationProgram Preparation and Stxdent Loan 8 1990 SocialSectors Development 30 1993 SecondEducation 30 Meio 1987 Indutial TechndicaDevelopmen 48 1988 ManpowerTraining 80 1991 BasicHealth Care 180 1991 ThirdTechnial Traiaing 152 1991 WaterSupply and Sanitation Sector Loan 300 1992 Sdenceand Technology infrastucture 189 1992 PrimanyEducation 250 1993 InikalEducation 80 1993 LaborMarket and Production Enhancement 150 Niargw 1993 Socallnvestrent Fund 10 Paraguay 1993 WaterSupply 23 St.Luda 1990 WaterSuppy 2 l**nda d Tobago 1991 Educadonand Training for YouthEnVbyment 21 Uruguoy 1988 WaterSupply Reabtion 22 1989 SecondTechncal Asstance 6 Kwuua 1991 SocialDevelopment 100 1992 StudentLoan Reform 58 1992 LowIncomeBarrios Improvement 40 1993 EndemicDisease Control 94 NotewDolar fuS arerounded to nerest millon.FY93 figures awe mid-yew estimats. SUowncodBank data.

No$ the late1980s. The ditonal cuntry is Guatma Wd Bank 1992).But this country-spec approach pvides a verydifferent 1. An exceptionto this hasbeen social securty spending, pictureof te numberof poorpeople. For example, when the beatedIn grae detai bow. Foran analysis of the evoutionof county-spedcbasket is used to measurepoverty, the percentage govenmentspending Inthe early 1980s, see Hcks 1992. of the peoplebelow the lineIn Vnezuelain 1989Increases to 79 2. Householdswith inome below the cost of thefood basket pect In Colombia,there i a decineIn te povertyheadcount aredefined as being below the "destitutionline, a condidionalso frommore than 60 pent usngthe Colmbt basketto lessthan alled"extreme povewty" 8 percentusing the commsonbenhmak. These arge vaiaion 3. Usinga commnonpov ie acrosscountries allows for iusate thedffities assoatedwith the measurement and con- meingf aos-countrycmpansom See Wod Dank1992 for a parisonsofpovety and socal condis acrosscountries and time. methoddlogicaldicussi onthe meritsof common-basktpover- 4. TheUNDP index i a wghted averageof threesocial din- ty Ihnecomputations. The pchsng powerparty PP dolr cator: life epecn, adultU t acy,ani inome percapita. Its havebeen constucted by Summeand Heon to avoidartifcial usefilnessfor analyzingthe evolutionof humanconditions has datafluctuatons due to exdcae ratechanges. Notice that if beenubectto onidra blovesy. country-specficbets are usedto measurethe evolutionof S. Emplymentand unepoyment stass in theregion afe powe"t,five (e thanfour) counties exhibit an imp nmentin ofdoubful qualy. They hve ptia covere andare not reliable. PoA lnaInwmeDisttonandHwmnResours 137

Mot counribeslack dat on rua unpoyme forn analysts 15. T.W.Sdntz (196, 19 isthe indIsbpute modern pla- to 'yon urbn dat SoItpr thesestats withar neero fIs view.Alo seeHaberger 19S9 and Padwapco 6. Theprospect for Brvazl-4heargs cutr wih fte mos Ir uequa distributinlof income-isnot to goodat th im 16. Seedhe dcusson on newendnos growthmodes in 7.In1t, the refms havebeen support by a smallcowl- chapterS. swtuenc,mosdy export 17. Aeie of st ddctedby GeorgePahropouos at 8. Thisdicso drawexenvy fm WoMSn 192 te WoMSan raded similarconduslons. See, for examp, the 9. RecenevIdence based on statsca anaOsisfor a score esaysIn Psahro 1992. countie wgest Inratuc Investuenti patIclay 18 Highrepetdon ra a nWrldof factorsI not Oproduct spiin overto ote sectors(Do Long and Summ rs abily truet a lawWvMd of repeon s higheduce. 1992).As dapter 7 arguedone should be careulIn Inetpt toal stndard In fac, then id.al tion i whemraw of thiseidce for Lan Americncountie h Phoy of the egion repetitionae low nd sbanddiedte resutsreaigh. Is rete h largeand high1y unpcte lrweste proect 19. CostaMca ws te xcepn wheresecond-We schoo Havig the adequatfraework to determinehe sodelreturnon hadvery rng scoes publk Inftuncture projectsIs a necessaryfst step,before 20. Thesepgm wereabo implemetedIn otherregons expandingInvestent In this area. ofdt countryThe minimum employment prgram wasdratcally 10. Mis ndte paragraphsa folb drawfrm anunpub. reducedIn Febnuy1984. By December 1988, th employment shedmwemandum from Sandra Newhose progranfor heads of houeholde nployednly about 5.000 IndO - 11. iegal abortionshave readied a vey argenumber In the vwus Inte entiecounty. region.For tance,It s estmatedtht In Bra tee areabout 4 21. SeeEdwards and Edwards foroing andCastalfeda mllon illegalabors a yew,exceeding the number of birt by 1992for evalto ofthe PEM program. 33pecnL 22. In NicaraguasFRSE, seri arenot coridered'nmth- 12. SeeSelowsy 1992 for a dscussionon howbudgetary ig rsource reallooou improv nutrwiol prom 23. In 1984the pam n governmenreplaced general food 13. Inthe theoreticallye socialsewu sytem,partid, ans sid wfitha foodstamp systm trgt to racing te poor, wod coder partof theircontbutons as defred pay mu espedayschol-ag children.See Grosh 1993 for anevauaton. andpart as Iurane premums 24. It isimprtant however,not to exagg the potent, 14. Therei sti roomfor addiftonaleffkincy bpc nmert of thissource of resourceAvailable daa sugget at mlta bud- andthe mnbl pensionasu by thenew system may be too getsIn LatnArica aresomewhat on the low se whencvi- lowto cover"reqrmen Fordeis onthe Chian sym, see paredwih toseIn othe developing areas (UND 1992). Caem1991. 25aSomeof thesearesummizedIn Psadhopouosl93. Chapter nine The Path Ahead

For decades, the state grew relentlessly in most Latin ble for Latin America. Implementation of the American countries. Regulationwas piled on aegula-reforms has not been easy.In many cases there have tlon, and the public sector, backed by promises of been adjustnent costs and in most countries there better economic conditions for the majority of the has been polUticalopposition. Despite tese con- people, expanded insatiably. But state-led develop- straints, the process of modemization has moved ment produced an unequal distribution of Income forvard in most countries. and vulnerable and inefficient economies. By the Despite the pogess In implementing reforms, it late 1970s the traditional development strategy had Is important to avoid premature euberance and run out of steam. The debt difficulties of 1982 enthusiasm. There is still much to be done, with unmasked the shortcomings of traditional policies numerous reforms Incomplete and issues unre- and unleashed a major crisis for the state. The solved. Only In Chile and Mexico has the reform decades of protection and heavy regulation, instead ptocess entered the consolidation phase, with broad of isolating the region from foreign disturbances, political support for the main pilars of the new eco- had built weak economic structures unable to with- nomic system-openness, market orientation, stand the cyclical shocks of the late twentieth cen- macroeconomic stabffity,and poverty alleviation- tury. Moreover, the state was tired-unable to and with a very low probability of a policy reversal. provide social services or reduce poverty. Compared Both countries have second-generation reformit with the resilient, fast-growing economies of East governments, and the current political debate Asia, the Latin American economic systems looked dearly suggests that the main presidential candi- particularly inadequate. dates will run on proreform platforms. And both As the 1980s unfolded, Latin American leaders countries have institutional reforms geared toward began to agree that the region was facing a serious ensuring the durability of the new economic system. crsis and that the transition to the twenty-first cen- But In the rest of the region, the reform process is at tury required major economic reforms. Politicians, different stages of Implementation-with different after decades of advocating increased involvement degrees of politcal popularity. of the state in everyday economic life, began to argue for competition, privatization, intemational C l l the Reforms openness, and a greater role for market forces. Most Latin American nations have gone through a true Perhaps the most important question the Latin economic revolution in the past decade. Countries American countries face Is how to maintain the that only a few years ago were subject to an almost momentum and continue to move forward toward sumrealstic array of controls and regulations are a more efficient and socially just economic system. today boldly experimenting with creative market- Although in many countries the reform agenda con- oriented solutions to decades-old problems. The tinues to advance, the excitement of the initial years reforms of the past few years are creating a new eco- Is subsiding in a few.In others, interest groups hit by nomic structure that, in many countries, is begin- the transformations have recently stepped up their ning to bear fruit. Growth is accelerating in many opposition to some of the market-oriented policies.1 countries, especally for the early reformers. And in a few, the socal and poverty alleviation pro- Inflation has subsided in almost every nation except grams have lagged-fostering increased inequality, Brazil. And productivity growth has, in some coun- social tension, and political upheaval. Tb accelerate tries, reached levels that many considered impossi- and consolidate the reforms, it is necessary to build

138 fthPth Ahed 139

strong and stable economic, Judicial, and social reform process vigotously, providing funds and institutions. There is an urgent need for new legal technical assistance that will help smooth the tran- structures to improve the civil service and sitlon to a modern economic system. The new strengthen tax systems and tax administration. emphasis on social projects is entirely appropriate Moreover, to avoid a retum to populist practices, and promises to be hig productive. At the same social problems have to be tackled effectively and time, the multllateal ttutions shouldconstantly new institutional settings have to assure stability monitor the rms-d usetheir leveragefullY tc and protect the economy from short-term and short- ensure that Impatience, short-sightedness, and sighted political impulses. This will keep economies short-term political pres do not derail the on the path to growth and prosperity and effort strengthen the region's nascent democacies. The duee fundamental poicy elements for the In short, consolidating the new economic sys- future-prudent inacroeconomic management, fur- tems in Latin America requires prudent macroeco- thef structural and institutional refms, and the nomnic management, deeper structural and alleviation of poverty-often reinforce themsdves. institutional reforms, and decisive programs of Efforts to maintain macroeconomic balance, avoid- poverty alleviation. To support these actions, the ing inflation and the overvaluatlon of real exchange state's economic role needs to be redefined and mod rates, wllMprotect the purhsing power of the poor. ern institutions need to be built. As Latin America And social security reforms will increase the effi- moves toward the twenty-first century, the state ciency of the labor market, helping generate pro- should stay away from spheres where the private sec- ductivity increases and impmving public sector tor operates efficiently-and act decisively whete finances and the overallmacroeconomic balance. the private sector hesitates or falls. The state should provide social services for the poor, support quality Ma_itaing Pny Macnt-1 education, contribute to the provision of basic infra- a e structure, provide a stable and credible regulatory system, assure a macroeconomic environment con- Despite significant progress in the past few years, ducive to export expansion, and develop rules and mostcountries'macroeconomiescontinuetobevul- regulations that protect the environment. nerable. In Bolivia,the Dominican Republic, and El The experience of the pioneer reformer, Chile, Salvador, the public sector deficit has tumred suggests that productivity growth is at the heart of upward. More important, with upcoming elections economic progress, making absorption and adapta- in almost every country, public finances could be tion of technological progress essential to a devel- subject to political pressures. To safeguard the con- opment strategy. lechnological progress ensures tinuity of the reforms, the nostalgia for populist international competitiveness and generates rapid episodes should be suppressed, and a prudent real wage increases. Such progress, of course, must macroeconomic management maintained. An have a high-quality educational system that pro- intensified fiscal adjustment can generate higher vides the base for absorbing technological improve- public sector savings. Monetary policy should be ments and developing new tedciques efficiently cautious, and the real exchange rate realstic. In the and oost-effectively. years to come, the following macroeconomic issues A key lesson from Chile-one sometimes diffi- will be particularly important cult to accept-is that it takes time for the reforms * In the short run, monitorng the large inflows to produce sustained rapid growth, low and stable of portfolio capital, avoiding overborrowing and inflation, booming exports, and permanent wage unnecesy appreciation of the real exchange rate. increases. It takes time for resources to be reallo- * Devising policies that encourage domestic sav- cated. It takes time for new projects to come to frui- Ings, especially private savings. tion. And it takes time to open new international * Making sure that investment in infrastructure markets. Now that the urgencies of the debt crisis recovers to levels compatible with rapid growth. seem distant, impatience is taldng over in some * Developing institutions that will add trns- countries. But as Brazil has vividly shown, attempts parency to macroeconomic policy and isolate to skip phases in the refonn process-particularly to macroeconomic management from short-run polit- bypass macroeconomic stabilization-are often Ical pressure. costly and ultimately unsuccessful. Multilateral and Unifying these four policy areas is the need to bilateral institutions should continue to support the maintain-and, in such casesas Brazil, achieve-fis- 140 LatInAmerica and the Caribbean:A Decade afterthe DebtCrisis

cal discipLIne.The importance of this message can- growth s likely tobe significant in the coming years, not be overemphasized as the region's history has there will still be a need toincease domestic savings repeatedly shown, fiscal imbalances have often led and investment closer to those levels in the success to serious crises that encourage speculation, retard ful economies of East Asia. If not, bottlenecks are growth, and increase poverty and frustration. likely, seriously affecting growth and the political Almost every country In the region has received sustalnablUityof the reforms. large volumes of foreign portfolio capital during the Increases in public savings are the fastest and the past few years. These Inflows-surpassing S percent most reliable way of increasing domestic savings. of GDP In Chile and Mexico-are coming because of Moreover, East Asiashows that when higher public low interest rates in the United States and the per- savings are accompanied by reforms that create safe ception In international financial markets that the and dependable financial Institutions, private sav- Latin American reforms are succeeding. The Ings are likely to increase (World Bank forthcom- increased foreign resourceshave challenged the abil- Ing).4 In most countries, government savings should ity to manage monetary policy, pressured real be increased through higher revenues and lower exchange rates and allowed countries to run large expenditures. On the revenue side, Improved tax current account deficits and accumulate sizable administration and tax compliance will help, step- international reserves. ping up the prosecution of tax evaders and increas- There is little doubt for most countries that the ing the penalties for tax evasion.5 On the current capital inflows will not continue in the long expenditure side, eliminating subsidies that accrue run2 Once International financial conditions mostly to the middle classes and reducing govern- change-and intemational investors have the ment waste should be high on the agenda. Reduced desired amount of Latin American securities in their military allocations are another possible source of portfolios-the volume of foreign resources flowing Income, but its potential should not be overesti- Into the region will decline. And that wlll require an mated.6 adjustment. If public finances remain under control, Almost every country during the past decade or the adjustment Is likely to be gradual and smooth.3 so has neglected investment in infrastructure. Roads But if macroeconomic management Is less than pru- are not maintained, power capacity not expanded, dent, capital inflows could gdnd to a sudden halt, and ports not modernized. Yetinfrastructure invest- unleashing potentally serious macroeconomic dis- ments have positive externalities and very high locations. social rates of tetum (Aschauer 1989;Uchimura and The reform of social security systems should be Gao 1993). Policies for infrastructure investment an important, and urgent, component of economic should do two things. The first Is to increase public programs in the next few years. If adequate, these investment-but to ensure high social rates of reforms will have three effects.They will reduce the return, Individual projects should be subject to rig- fiscal burden on the central govemment, helping orous economic evaluation. The second is to put in achieve fiscal balance. They will introduce choice in place a credible regulatory framework that ensures the health provision system, improving its efficiency property rights and thus encourages private sector and fairness. And they will reduce labor market dis- investment in Infrastructure. This is particularly tortions, encouraging employment and productiv- important for ensuring that newly privatized utili- ity growth. For the reforms to be fully effective and ties continue to expand their capacity.7 credible, an adequate regulatory system is needed Institutions determine the course of economic that closely monitors operations, avoiding corrup- policy. At the macroeconomic level, the consolida- tion and recldess behaviot tion of the procompetition reforms will be greatly Low domestic savings are one of the biggest helped by the creation of institutions that ensure the weaknesses in the region's macroeconomic position. transparency of policymaking, help avoid short- Despite significant progress in deregulating the fi- term political pressures, and allow the authorities to nanclal sector, savings-particularly private savings crediblyprecommit themselves to a course of action. -continue to be low, limiting capital accumulation Clear and mandatory budgetary processes make up and slowing new investments in infrastructure. In a basic but important institution often absent in 1991, the median ratio of gross domestic savings to Latin America. It would help if each national legis- GDP was 20 percent, more than 10 points below that latre were required to approve a consolidated bud- of the East Asian economies (World Bank, World get for the entire public sector before the start of the Developnwt Report 1993). Although productivity fiscal year-and if the executive were legally (and ThePath Ahead 141 factually) constrained by it.0 Making central banks efficiently. The reform of the social secuity system Independent Is a second institutional reform that will reduce labor costs and will encourage the cte- would add to t'Necredibility of macroeconomic pol- ation of a strong and modem capital market. Icy-as has been recently done In Argentina, Chile, * Prvaization. In such countries as Bolivia, the Colombla, Mexico, and Venezuela, among others. Dominican Republic,and Ecuador, the state contin- This (partially) isolatesmonetary policy and in some ues to do much In the production process. cases exchange rate policy from pardsan short-term Streamlining the state through privatization Is Ilkely political battles. Indeed, the Independence of the to increase overall efficiency, allowing the public central bank has been directly related to long-term sector to concentrate on helping the poor, providing macroeconomic stability (Cukierman and others education, and supportng investments in infra- 1992). For political legltimacy, a truly Independent structure. But the privatizations should go hand in central bank has to have broad support from the hand with putting modern regulatory framewotks In population at large. Even If the electorate initially place. has mixed views, It can, with time, come to support * Bade. The opening of foreign trade has been this type of institution strongly-as in Chile after one of the most impressive achievements of the 1989. reforms, but there stil are some Important addi- tional steps. The consolidation of regional trade Deepenlng the StnKtural and Institutlaol agreements-such as MERCOSUR,the Andean Pact, Refons the Central American Common Market, and the Caribbean Community-should be a priority. Despite significant progress, the modemization * Plic sectorreom To increase efficiency and process in most countries is far from over. In some- accountability, there Is a need to continue restruc- the Dominican Republic,Ecuador, and Guatemala- turing the public sectoL Decentralization should be the transformation has just begun, and many pushed forward, the civil service reformed, and the economic reforms stiUlneed to be undertaken. In judiciary system modernized. In many countries it others, the structural reforms are more advanced, is fundamental to reform the relationship between but important Institutional changes, including the the central government and the provinces. In mod- creation of modern regulations and rules, are still em economies It is fundamental to have dynamic- lagging-as in Colombia, Costa Rica, and Uruguay. and transparent -conflict resolution systems, to In other countries, including Brazil,the stabilization give confidence to all parties. and reform agenda faces serious and generalized * Education. Most efforts should be directed political constraints and has made very lited toward increasing the coverage of primary educa- progress. And the evidence from Chile and Mexico tion and improving its quality, but other areas strongly suggests that incomplete reforms stand in should not be neglected. An outward-oriented the way of a major economic takeoff. Whereas development path, based on technological absorp- broad-based reforms foster synerism and positive tion and productivity growth, requires solid higher spillovers, parial reforms erode credibility and education. Efforts should thus be made to reform encourage the postponement of investment and secondary curriculums and involve the private sec- restructuring proiects (Edwards 1993c). tor in university education. Some of the most Important areas for deepening These reforms would give a boost to the Latin the reforms are: American economies-developing an efficient and * Labor mnkets.In almost every country, labor competitive external sector and encouraging future markets have been forgotten In the reform process. productivity growth and technological innovation. International evidence shows that flexible and More important, they would help taclde poverty at dynamic labor markets have been fundamental In Its roots and provide the institutional requirements the East Asia success story (World Bank forthcom- for a modem state. But in some countries, these sec- ing). But labor markets are extremely rigid In Latin ond generation reforms could prove politically diffi- America, and labor use is subject to substantial taxes cult. Interest groups have stepped up their that discourage employment creation. opposition to the transformation and are lobbying * Socil secuity ssems. Most countries stlll rely the govemment for special treatment. If the process on tradional and inefficient systems that Impose a remains transparent, prudent macoeconomic man- heavy burden on the budget, distort the labor mar- agement is maintained, and the concerns of the poor ket, and fal to provide pensions and health services are addressed, this opposition wlll probably be neu- 142 LatinAnrika and the Caribbean:A Decadeafter the DebtCrisis

talized. Multilateral nstitutions should continue to Countries should be much more aggresslve In ptovide tedhnical assistance, helping reform-on- reallocating public resources toward targeted social ented goverments explain the dangers of anachro- services-without impairlng the fiscaladjustment or nistc views. the pursuit of efficiency.Wlth public spending usu- ally accounting for 25 percent of GDP, a 10 percent AfeltuW Poet realocation of the budget can have a significant Impact on the welfare of the poorest groups. Many The Latin American countries have for too long countries could generate an Increase equivalent to 2 neglected the socal sectors, resulting in staggering petcent to 3 percent of GDP by inaeasing the tax poverty indexes and In the most unequal income base, Improving tax collectlon, and reducing eva- distribution in the world. Tday, the poorest 20 per- slon. Additional taxes can easily be collected by cent of Latin Americans receive about 4 percent of eUminating subsidies to the middle and upper GDP, so a fundamental task is to address poverty classes for fuel prices, public utility prices, higher with vigor and urgency-improvig lhing condi- education, and public employment. And a rational- tions and providing stability for the new economic ization and reduction of military expenditures can system. Failures to act aggressively on poverty will release important resources. Well-targeted social likely encourage distutive conflicts, prompting programs to sharply reduce Infant mortality and discontent and perhaps even a return to populism, improve basic health and education can be financed dinigisme, and chaos. As history shows, populist at moderate fiscal cost. Needed for all this are strong poLcies may be attractive In the short run, but they political wil and the ability to manage the politics end up in chaos and stagnation. Only if the region's of reducing subsidies to the middle and upper development becomes inclusive, allowing all seg- classes. ments of the population to benefit, will the new sys- Many Latin American countries have used labor tem be durable. legislation-such as that for minimum wages, The new apptoach toward poverty and the social restrictions on dismissal, and restrictions on tempo- sector should be based on policies conducive to rary hiring-to improve income distribution and growth, employment, and higher wage There is reduce poverty.But these policies have failed-badly. abundant evidence suggesting that economic Instead of helping the poorest groups of society,they gowth is the most Important way out of poverty. Introduced serious distortions that discouraged But there should also be progams directed toward employment creation and created a small group of the poor, vigorously implemented in the short run. highly paid jobs in the "protected" sector.In address- These would tacke Immediately the most serious ing the needs of the poor, it is important to avoid consequences of poverty-including malnutrition, past mistakes. Social concerns should be addressed access to health, and the provision of drinkable with direct and well-focused instruments-not water Introducing distortions In the labor market These What additional steps do countries have to take instruments should be dynamic and flexible, stimu- to increase the complementarity between the re- lating jobs and allowing the economy to respond forms required to reover gowth and those required rapidly and productively to changing interational to improve long-rn equity? Is it possible to reallo- competitive conditions. That Is one of the biggest cate public expenditures radically and quiddy to lessons from the East Asian miracle. eradicate the worst aspect of poverty In the short run without impairng public finances and the con- Assring EniWronentaly Sustainable Policies trol of public deficits? Reform programs should Increase the labor There is a two-way relationship between develop- Intensity of growth by trade libealization and re- ment and the environment. Environmental quality forms that reduce taxes on the use of labor and sub- is part of the improved welfare that development sidles for the use of capital should be accelerated. attempts to bring. Environmental damage, by con- Becauseschooling is one of the major determnnts trast, can undermine future productivity, ruining of Income distribution in Latin America, invest- the prospects for growth. ments in human capital and sidlls should be Awareness of the environment-seriously ne- increased. And since the poor in most countries are glected until recently in most of Latin America-has concentrated among the Indigenous people, pro- been growing and many countries are closely mon- grams should be targeted toward them. ltoring the environmental impact of projects. The ThePath Ahead 143

emergence of environmental issues as a key element Market:based policies to protect the environ- of the poUcy debate Is reflected in the NAPTAnego- ment are usually easier to implement than regula- tiations between Mexico and the United States. But tory orders, especially in Latin Amerlca, where much remains to be done, and strengthening envi- administration is weak. But command and control ronmental agencles and policies should become a measures are essential when markets do not exdst priority. and when property rights cannot be enforced. To be Aggravating the environmental damage is the fully effective,however, regulations have to be com- persistence of poverty, because the poor often settle bined with proper Incentives to produce good In unsuitable areas. Poor farmers encroach on the results. A clear system of property rights is essential rain forest of the Amazon and the Central American for providing Incentives to conserve renewable highlands of Guatemala, Honduras, and Nicaragua, resources and the World Bank Is financing projects so employment opportunities in nonfarm sectors to darify land title records. It is also Important to are needed to relieve land pressures.9 Inadequate assure that the drive to increase exports does not treatment of wastes contaminates water sources.Few result in the reckless depletion of the region's nat- in the industrial countries know that water contam- ural resources or in environmental degradation. ination isby far the most seriousenvinrnmental haz- Strengthening national environmental institu- ard in Latin America, closely followed by air tions has not proved to be an easy task. Environ- contamination. With 80 percent of Latin America mental agencies are new-and often politically urbanized, "brown" issues of sewage, water, and weak-so financing Is a serious problem. They tend smog are substantially more serious than "green" to be underfunded and dependent on foreign issues of deforestation.10 Poor sanitation is very resources, injecting uncertainty into long-run pro- costly because it hits agricultual and marine exports grams. The assistance of the multilateral agencies and tourism.' throu&h increased funding and technical support Subsidies frequently turn out to cause much will be crucial to strengthen the environmental environmental degradation, encouraging excessive agencies of the region-and to move steadily toward use of water, power, pesticides, or ferdlizers. a balanced and sustainable development path. Subsidized water use, a major problem In Mexico The economic history of Latin America may be City, damages the underground structure of pipes. likened to Gabriel Garcia MArquez's classic novel Excessive pumplng of water for irrigation depletes OneHMude Yearsof Solftude-with events seeming aquifers. In many countries, water for irrigation has to repeat themselves endlessly, following irregulat been priced "too low," and the collection of charges and magical cycles of sorrow and fustration. The Is so poor that revenues seldom cover operating recent reforms that have engulfed the region have costs. Subsidized power generates excessive energy broken this melancholiccircularity. After decades of consumption, diverting scarce resourmes to fund timid performance and spiraling inequalities, there unnecessary new capacity. Cheap fuel has encour- are rays of hope. aged excessive vehicular use, polluting the air in Mexico City, Sao Paulo, and Santiago. Cheap credit NOtes for ranching has contributed to the conversion of forest areas into cattle ranches-on soils not suited b to. opostion Is a ctsic middle-classreaction to the for that use. reforMn. Reducing population growth could be an impor- 2. Currentaccount defidts of 5 to 7 percentof GDPare, tant ompoentf a sund nvirnmentl poicy; undermost circumstances, notcompatible with long-rn solveny tant component of a sound environmental poRcy, whenGDP is growng at 3 to S percent,regardl9ess of the lvel of especially In some Central American countries. An Inteestrates. increase in international openness can also reduce 3. In mostcases, the adlustmentwill requirea realexchange pollution. Export products must comply with inter- ra depredation.Its magnitude willf depend on suchfactors as the national environmentalnationalenironmentalstandards, standards, andnd foreignforeignrafte queslon. ofprdctivity growth and the fiscal position of thecountry In firms competing in local markets press govemments 4. In thisway a virtuouscirce can develop: higher public sav- increase accumutationand growth. Withadequate to raise standards for domestic industries. But there institudions,ings highercapital growth results in higherprivate savings, fuher can also be some offsetting effects, because opening inaeasesin capl acumulauin andeven fastr growth. the economy can encourge additional industrial S. in manycases, this wil requirea broadrevision of taxlgis- resources. Road liton anda modernmtionof the judidalsystem. acivity, which will use more natural 6. Infact recentfigures from the UNDP show that, except in constructon by public and private agents must be HondurasandNicaragua, military expenditures InLatin Amercae am controlled, to protect fragfle soils, belowthe averagein the developingcountries. In that regard, 144 Lan Amerkaand the CalbbeanA Deca afterthe DebtCdIss hoevw, reductionsInwast and npOM"and dpkdt)subsds non* an ment gods s giv the ltapu holectrk stl provdethe mostproming sourceof inceasedsaIngs In veserioi,whose lBe pn h beenreduced Oa* beauseo te manycouis, an aceeationof prvattn wouldaso affect headimetato of thePaa rbw,a resultof nenve cuti- publi mostlythroughfthe reduon ofsubsidies d tara. vatn Insoe Brut fa by centaland rgoal goemrmentsto noney4ostgstae 10. TheWW bankhas had a dedIe rolein bnprovi envi- ownedentrpris romea potdion In Lain Amera Ovethe past two yaes, 3S 7. Mullatl flndal hiuons wi havean Imptnt rie boa thatIncuded envonent dauseswere appmved, totaing In helpingthe couniesdese way to reselong4rm fund. aboutS1.5 Butthe main ad ementof theSn hasbeen In for pvatzedutiDties and Inhascture prect to debunkte fls pecptn of envrmntl concemas a *Iux- 8. Surpdnsngl*,many lutin Amean countrs lacka wel. ure goodand to howthat airand water poltion hurtovwrall defnedand mandatory budget poc, theabse of whIchhas pruci beendosely reted to fi bxity. 11. Therent d raepdmic in PeFuhave cost the eeono- 9. Anotherexample of heIntiae coelationbetween eo. y waroundS1 billon. Bibliography

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