THEWORLD BANK ERS6

Public Disclosure Authorized DiscussionPaper

DEVELOPMENT POLICY ISSUES SERIES

Report No. VPERS6

MacroeconomicAdjustment in Public Disclosure Authorized DevelopingCountries: A PolicyPerspective

Mohsin S. Khan Public Disclosure Authorized August 1986

Office of the Vice President Economics and Research Public Disclosure Authorized

The views presented here are those of the author,and they should not be interpretedas reflectingthose of the World Bank. MACROECONOMICADJUSTMENT IN DEVELOPINGCOUNTRIES:

A POLICY PERSPECTIVE

by

Mohsin S. Khan

August 1986

The author is Chief, MacroeconomicsDivision, DevelopmentResearch Department, World Bank, on leave from the InternationalMonetary Fund.

The author is grateful to Willem Buiter, Mansoor Dailami, Indermit Gill, Nadeem U. Haque, Malcolm Knight, Anne Krueger, Ricardo Martin, Costas Michalopoulos,and Peter Montiel for helpful comments and suggestions. The World Bank does not acceptresponsibility for the views expressedherein which are those of the author(s)and shouldnot be attributedto the World Bank or to its affiliatedorganizations. The findings,interpretations, and conclusionsare the resultsof researchsupported by the Bank; they do not necessarilyrepresent official policy of the Bank. The designationsemployed, the presentationof material,and any maps used in this documentare solely for the convenienceof the readerand do not imply the expressionof any opinionwhatsoever on the part of the World Bank or its affiliatesconcerning the legal statusof any country,territory, city, area, or of its authorities, or concerningthe delimitationsof its boundariesor nationalaffiliation. Abstract

Broadly speaking, a comprehensivemacroeconomic adjustment program is expected to have the following objectives: a sustainablecurrent account position, a stable and high rate of economic growth that would allow for a steady rise in per capita consumption,a reduced rate of inflation, and a manageable level of foreign debt. Given these multiple objectives,the package that is designed would typically include a variety of policy measures that simultaneouslyrestrain aggregate demand and increase the availabilityof resources. These policies may be grouped as follows: demand-management policies; structuralpolicies; exchange rate policies;and external financing policies. The purpose of this paper is to describe how these policies can be expected to achieve the goal of macroeconomicadjustment. The focus is primarily on the theoreticaland empirical links between policy instruments and the ultimate objectives. An examinationof these links is necessary before issues of the appropriatemix of demand-management,structural, exchange rate, and external policies, and the sequencingof these policies in a program, can be properly addressed. Table of Contents

Page No.

I. Introduction ...... I

II. Demand-Management Policies ...... 5

A. Monetary Policy ...... 6

B. Fiscal Policy ...... 9

III. Structural Policies ...... 11

A. Policies to Improve Efficiency and Resource Allocation ...... *...... *...... 12

B. Policies to Increase the Rate of Growthof Capacity Output ...... 15

IV. Exchange Rate Policies ...... 20

A. Determiningthe Extent of Exchange Rate Adjustment ...... 22

B. Policies to Achieve a Target Real Exchange Rate ...... 23

C. Effects of Exchange Rate Changes ...... 25

D. Exchange Rate Systems and Regimes ...... 26

V. External Financing Policies ...... 28

VI. Conclusions ...... 34 MacroeconomicAdjustment in DevelopingCountries: A PolicyPerspective

MohsinS. Khan

I. Introduction

In recentyears developingcountries have found themselvesin serious economicdifficulties, including worsening balance of paymentspositions, risingrates of inflation,and decliningrates of growth. The predicamentof these countrieshas led to a heightenedinterest in the subjectof macroeconomicadjustment, and particularlyon how to eliminatethe disequilibriumin the economiesthat gave rise to these problemswithout sacrificinggrowth in the process. The basic questionthat is currentlybeing asked by academics,policymakers in the developingworld, and the internationaleconomic community at large,is what policiescan be employed, and in what combination,to achievethe goal of macroeconomicadjustment.

The need for macroeconomicadjustment arises when a countryhas a fundamentalimbalance between aggregate domestic demand and aggregate supply. This demand-supplyimbalance can be a resultboth of external factors,such as a deteriorationin the termsof trade and an increasein foreigninterest rates, as well as inappropriatedomestic policies that expand aggregatedemand too rapidlyand reducethe rate of growthof productive capacityof the economy. In principle,a countrycan avoid adjustmentby borrowingabroad or imposingcontrols on trade and payments,or a combination of the two, and the disequilibriumin the economycan persistfor an extended period. There are, however,costs associatedwith this type of strategythat are well known. These includea wideningcurrent account deficit, increasing -2-

inflation, overvaluationof the domestic currency and loss of international competitiveness,an inefficientallocation of resources because of distortions in relative prices, reduced economic growth, and a heavier foreign debt burden.

This type of disequilibriumcannot continue indefinitely,and in the absence of appropriatepolicy actions to correct the underlying imbalances, living standards in the country would be adversely affected. Moreover, the steady loss of internationalcompetitiveness and an increasing level of foreign debt would affect the country's creditworthinessand thus its ability to obtain additional foreign financing. Naturally, a cessation of foreign financing would impose adjustment on the country, and as recent experience in a number of countries has shown, this forced adjustment is likely to be very disruptive. The fundamentalobjective of an adjustment program is to provide for an orderly eliminationof the imbalancebetween aggregate domestic demand and resource availabilitybefore the point at which the economy becomes seriouslydistorted and external resources are exhausted. To achieve this objective the adjustment program necessarilyhas to include a variety of policies that simultaneouslyreduce aggregate demand and increase the availabilityof total resources. Following Khan and Knight (1982), (1985), these policies can be broadly grouped according to whether their primary impact is on the level of absorption-- demand-managementpolicies -- on the level of current and potential output -- structural policies -- on the compositionof absorption and production as between tradable and nontradable goods - exchange rate policies -- and finally, on the level of capital flows

-- external financing policies. -3-

Demand-managementpolicies typically include monetary and fiscal measures designed to affect the aggregate level or rate of growth of demand relative to production. On the other hand, structural policies are intended to increase the supply of goods and services in the economy at any given level of domestic demand. Included in structuralpolicies would be, among others, measures to increase the level and efficiency of investment,reductions in tariffs and eliminationof other trade distortions,removal of subsidies, raising the efficiencyand profitabilityof public sector enterprises, measures to raise public and private savings, and increases in producer prices. Policies to improve internationalcompetitiveness and expand the supply of tradable goods through both reduced consumptionand increased production principallyinvolve changes in the real exchange rate. Exchange rate policies, therefore,have both demand-sideand structural characteristics,and thus are treated separately. Changes in the net flow of foreign financing, includingthe financingdirectly provided by international

institutions,also affect absorption,and if they assist domestic capital

formation, raise potential output as well. External financing polic:ies generally include measures to ensure that the supply of funds, both from

official as well as private external sources, are at a sustainablelevel,

changing the maturity and compositionof foreign debt, and reducing capital

flight from developing countries.

Generally speaking,comprehensive and long-term macroeconomic

adjustment would involve elements of all four of the policies listed above.

Programs aimed at adjustment with growth cannot rely exclusivelyon demand-

management policies, nor for that matter solely on structural policies. In

fact, these policies are closely interrelated. For example, the achievement -4-

of a higher growth rate in the medium term generally requires an increase in productive investment,while stabilizationrequires a reduction in the

savings-investmentgap. The policy package, therefore,must be designed to reduce the level of aggregatedomestic demand and simultaneouslyto cause a shift in the compositionof demand away from current consumptionand toward fixed capital formation. Exchange rate policies will assist in the adjustment process by dampening demand and creating incentives for investment in the tradables sector. External financing policies would set limits to the current and future availabilityof foreign resources, and this in turn would define both the degree and speed of the necessary adjustment.

The crucial question that arises in the design of adjustment programs

is how should these policies be combined in the overall package? The relative emphasis placed on various policies will depend primarily on two sets of criteria. First, the objectives of the authoritiesand the constraints

(institutional,timing, and structural)that they face. The choice in this case would inherentlybe country-specificand there is limited scope for generalizations. Second, the nature, magnitude, and timing of the effect of various policies on the key macroeconomicvariables, which would determine not only the mix of policies but also the sequence in which these policies are enacted. This is a more general issue that would have relevance for developing countriesat large.

The purpose of this paper is to describe how demand-management,

structural,exchange rate, and external financing policies can be expected to affect the targets to which they are directed and thereby achieve the goal of

macroeconomicadjustment, characterized by a sustainablecurrent account

position,a low rate of inflation,a stable and high rate of economic growth, -5-

and a manageable level of external debt. While an attempt is made to cover the main links between policy instrumentsand the ultimate objectives, the survey does not deal with all of the possible effects of macroeconomicpolicy measures. For example, no attempt is made to discuss the distributional effects of adjustment policies, even though it is recognized that the pattern of income distributionis often a key objective for policymakers. Such exclusions were considered necessary in order to limit the scope of the paper. Nevertheless,the paper will highlight a number of the important theoretical and empirical questions that need to be addressed in the course of designing macroeconomicadjustment programs.

The remainder of the paper proceeds as follows: Section II discusses the role of demand-managementpolicies. Structural policies to increase the efficiency with which resources are utilized, and the overall supply of resources, are described in Section III. Section IV takes up questions of how to determine the size of the exchange rate change and the effects of a devaluation on the economy. This section also discusses briefly questions relating to the exchange rate systems and rules a country might adopt.

Section V on external financing policies describes the methods for judging the sustainabilityof foreign borrowing and the issue of capital flight from developing countries. The concluding section brings together the main points of the paper and discusses the issues that arise in combining the various

policy measures into a comprehensiveadjustment package.

II. Demand-ManagementPolicies

Macroeconomicadjustment is often viewed as synonymouswith policies

to restrain aggregatedemand and absorption,and has accordingly received -6-

considerableattention in the literature. 1/ The two main instrumentsfor controllingabsorption are monetary policy and fiscal policy. 2/

A. Monetary Policy

The standard view of the transmissionmechanism between monetary policy and aggregate demand emphasizes the role of interest rates. In the closed-economycase an increase in the supply of money causes individualsto purchase real and financial assets in an attempt to restore portfolio balance. This lowers market interest rates and stimulatesaggregate demand.

A basic descriptionof the way monetary policy works in a small open economy, on the other hand, is that which appears in versions of the monetary approach to the balance of payments. 3/ In such simple models, under fixed exchange rates, the public disposes of surplus cash balances produced by an expansion of domestic credit through purchasing foreign goods and securities,leaving domestic output and prices unaffected. Under flexible exchange rates, a similar expansion in domestic credit results in an increase in the money supply, a rise in the domestic price level, and a depreciationof the exchange rate.

Most developing countries,however, possess neither the range of financialassets nor the degree of integrationwith internationalgoods and

1/ IMF adjustment programs, for example, are described by some observers as being primarily demand-oriented. See Dell (1982) and Diaz-Alejandro (1984). While demand-sidepolicies were stressed in earlier Fund work on financial programs,namely by Polak (1957) and Robichek (1967), (1971), this is not necessarily a valid descriptionof present-dayprograms.

2/ The demand-sideeffects of exchange rate policies are treated separately in Section IV.

3/ See Frenkel and Johnson (1976) and IMF (1977). -7-

financial markets that would make these descriptionsof the effects of monetary policy directly relevant. How then does monetary policy work, and what are its effects on aggregate demand in situationswhere financialmarkets are underdeveloped,interest rates are set below market-clearingrates by the government, a relatively free curb market operates, 4/ and there are foreign exchange controls? Since such features would tend to be present in many

developing countries, these questions would appear to be the more appropriate

ones to consider for such countries.

If exchange controls are effective then the authoritiescan control

the monetary base via their control over the availabilityof foreign exchange

and over credit extended by the central bank. Starting from portfolio

equilibrium,a fall in the supply of bank credit to the private sector will

cause borrowers to shift towards the curb market, thus leading to an increase

in the curb market interest rate. Since this rate would represent the

marginal cost of funds in the economy, the interest-sensitivecomponents of

aggregate demand will decline. In particular,the implicit value of real

assets will fall relative to their production costs and demand for such assets

would be reduced. 5/ With the decline in aggregate demand there would be

downward pressure on inflation. Similarly,a decrease in the money supply

leaves the private sector with too little money in its portfolio relative to

loans and real assets. The resulting decrease in the supply of curb market

loans leads to a rise in the curb market interest rate. Aggregate demand is

4/ The assumption of the curb market allows one to analyze interest rate effects on aggregatedemand. In the absence of such a market, monetary policy would only have wealth effects.

5/ This is basically the well-known Tobin's Q mechanism. -8-

again reduced as a result of the reduced demand for real assets. If, on the other hand, exchange controls are ineffective,then the power of monetary policy to affect aggregate demand would be diminished. Some of the effects of a reduction in the money supply would be offset by changes in foreign exchange claims or liabilities. Therefore, the effects on the curb market interest rate and on the demand for real assets are weakened. In the limit, the propositionsassociated with the monetary approach to the balance of payments would become operative.

While it is possible to argue that even in a world of credit and foreign exchange rationing changes in the growth of money would be neutral in the long run, it is clear that during the adjustment process a restrictive monetary policy would be associated with a reduction in capacity utilization and a rise in unemployment,since prices would normally tend to be sticky downwards. 6/ The estimated size and duration of the deflationaryeffect would naturally depend on the responses of aggregate demand and aggregate supply to a tighter monetary policy. More specificallyin this context, as argued by Khan and Knight (1982), the relevant factors would include: (i) the speed with which the initial monetary disequilibriumis offset by internationalreserve movements (an effect that depends on the presence and effectivenessof exchange controls); (ii) the stickiness of domestic prices, which in turn will be conditionalon wage-settingbehavior and the degree of excess capacity in the economy; (iii) the effect on investment of a rise in

6/ The consequencesof macroeconomicpolicies on the labor market in developingcountries is certainly not well establishedat the theoretical level, and consequentlythere is also very little empirical evidence available on this relationship. -9-

the cost, or a reduction in the availability,of credit; and (iv) the extent to which the policy measures were anticipated at the time that currently prevailing wage contracts were negotiated. 7/ To determine the aggregate demand effects of monetary policy requires investigatingboth theoreticaland empirical validity of these factors.

B. Fiscal Policy

The effects of fiscal policy, whether through reductions in government expendituresor increases in taxes, on aggregate demand and absorption are much debated. Public sector spending on currently-produced goods and services is itself a component of total domestic spending and this, of course, represents its direct contributionto absorption. If government

purchases are limited to nontradablegoods, they also representan addition to

aggregate demand for domestic goods. Public sector spending on traded goods will, however, only contribute to a worsening of the trade balance while

having no effect on real aggregate demand, or on output and inflation.

It is the indirect effects of public sector purchases that have

generated some controversy. At issue is the extent to which an increase in

public expenditurereduces or increases private spending, thus resulting in an

increase in total spending. There are a variety of mechanisms through which

private spending would fall as a result of increased public spending. For

example, increased public spending could raise domestic economic activity and

thereby the private sector's demand for money. If interest rates adjust to

7/ It has been argued by Lucas (1972), among others, that the greater the extent to which changes in monetary policy are anticipatedby the private sector, the smaller would be the effect on output. For a discussion of the applicabilityof rational expectationsmodels to developing countries, see Corden (1985). - 10 -

maintain portfolio equilibrium,the higher interest rates associated with the increased demand for money would, other things equal, tend to reduce the aggregate demand. This is, of course, the familiar "financial crowding-out" proposition. Even if interest rates do not adjust immediately,and portfolio

imbalances persist, the excess demand for money may cause households to curtail spending in order to accumulate cash balances. 8/

Private spending can also be reduced if the increased public spending gives rise to an equal tax liability for the private sector, either in the present through tax financing or in the future due to the need to retire public debt. This is the well-known "Ricardian equivalence"proposition

developed by Barro (1974). 9/ Finally, if nominal wages are flexible, or if

the increase in public spending was foreseen at the time wage contracts were

entered into, the domestic price level could rise sufficientlyto reduce

private spending by an amount equal to the increase in public spending,

thereby leaving total real aggregate demand unchanged. 10/ The validity of

rational-expectationsmodels relating public sector and private sector

expenditureshas yet to be tested for developing countries, and the debate has

remained essentially on a theoreticalplane. 11/

8/ See Khan and Knight (1981) for a model utilizing this type of effect.

9/ For a discussion of this effect in the context of developing countries, see Corden (1985).

10/ This "policy neutrality"result has come to be known as the Lucas-Sargent- Wallace (LSW) proposition;see Lucas (1972) and Sargent and Wallace (1975).

11/ Even the empirical evidence for developed industrial countries does not suggest that changes in public sector saving are entirely offset by private saving. - 11 -

Tax receipts from the private sector have no direct effect on absorption. They do, however, affect private disposable income and may thereby have an indirect effect on private spending. The effect of a given tax on private spending is likely to depend on whether the tax is viewed as permanent or temporary (temporary taxes are expected to reduce saving), the characteristicsof the recipient which affect the marginal propensity to consume out of current income (includingdemographic factors such as age and household size), and the nature of the financial system (which will affect the extent to which the taxpayers are liquidity-constrained).Transfers are essentially the negative of taxes. Their effects on domestic absorption can be expected to be the opposite of the effects of taxes described above.

Although domestic absorption is not directly affected, a transfer should increase private absorption, though not necessarily total absorption. The effect on the latter will depend on how the government finances the payments of transfers.

In summary, the effects of fiscal policy on aggregate demand would appear to be more complex than standard Keynesian macroeconomictheory would

suggest. At this stage it is debatable whether on balance a restrictionary fiscal policy would reduce aggregate domestic demand and growth or not.

Ultimately, the issue is an empirical one and will accordinglyrequire more

testing.

III. Structural Policies

Structural policies differ from demand-managementpolicies in two

respects. First, they place more emphasis on growth rather than the control

of domestic demand and immediate improvementin the current account. In - 12 -

developing countries the goal of achievingmore efficient resource allocation

and increasedgrowth may sometimes conflict with that of reducing the current

account deficit in the short run. Since these countries import a large

proportionof capital goods, programs that place a greater emphasis on

structuralmeasures frequently take a different view about the objectives

regarding the current account in the early years of the adjustment program

than do programs that aim primarilyat reducing excess aggregate domestic

demand. In particular, to the extent that major adjustmentsin aggregate

domestic supply require an initial rise in the level of domestic investment,

reductions in current account deficits would not necessarilybe sought in the

early years of the program.

Second, substantialtime may be needed for structuralpolicies to

show results. Major shifts in resource allocation may entail a significant

rise in fixed capital formation in expanding sectors, combined with the

release of capital and labor from contracting sectors. Such major adjustments

tend to occur slowly, so that the time frame for a program involving

structuralmeasures has to be longer than one that focuses on reducing

aggregate demand.

Structural policies can take a wide variety of specific forms

dependingon the economy in question and the types of problems faced by the

domestic productive sector. They can, however, be categorizedunder two broad

headings: policies to improve efficiency and resource allocation;and

policies to increase the level or rate of growth of capacity output.

A. Policies to Improve Efficiencyand Resource Allocation

This category basically includes all types of measures to reduce

distortionsthat drive a wedge between prices and marginal costs. In a number - 13 -

of developing countries distortionsare fairly pervasive in factor markets, credit markets, and goods markets. The distortionscan arise, for example, from price, wage, and interest rate controls; imperfectcompetition; taxes and subsidies; and trade and payments restrictions. The attractivenessof policies designed to improve the efficiencywith which scarce resources are utilized lies in the fact that such measures can potentially increase the output that can be produced from a given stock of resources without necessarily lowering the level of current consumption. Nevertheless,attempts to eliminatemajor distortionspresent certain practicaldifficulties. First, if capital and labor are not mobile among different sectors of the economy, changes in the patterns of relative prices and incentivesmay necessitate an extended period of adjustment during which some factors, in particuLar labor, may be unemployed. Second, many government policies that create distortions may have been designed to achieve objectives other than economic efficiency.

These policies typically would include among others, employment programs,

consumer subsidies,price controls on essential commodities,and restrictions

on imports of luxury goods. Thus, political realitieshave to be recognized

when advocating changes based purely on efficiency grounds. Finally, the

theory underlying micro-orientedpolicy measures is not sufficientlydeveloped

to be able to yield precise answers on the effects of such policies. For

example, well-known considerationsassociated with the theory of second best

suggest that if a country has a number of significantdistortions, the

elimination of only some of them will not necessarilyresult in an overall

gain in efficiency and welfare.

By their nature, distortions tend to be both microeconomicand

country-specific. Nevertheless,two sources of inefficiencythat have - 14 -

macroeconomicsignificance have gained importance in recent years, and accordinglyreceived considerableattention from researchers. First, there are the inefficienciesthat result from imposing artificialbarriers to foreign trade. Tariffs, quotas, and other restrictionson trade and payments reduce the levels of trade and specialization,and tend to foster the developmentof import substitute industriesthat often fail to attain the degree of efficiency and flexibility shown by firms that are continuously exposed to internationalcompetition. A number of studies (i.e., Balassa

(1982) and Krueger, et al (1981)), have shown that at the broadest level, the countries adopting outward-lookingdevelopment strategieshave fared better in

terms of growth, employment,economic efficiency,and adjustment to external

shocks than those that have taken a more inward-lookingapproach to development. The outward-orientedstrategies have been typically

characterized,inter alia, by the provisionof incentives for export

production and the encouragementof import competition for most domestically

produced goods. The relative success of outward-lookingpolicies has led to

considerableefforts to encourage developing countries to liberalize their

trade systems. 12/

A second source of inefficiencyin a number of developing countries

arises from controls on producer prices. For example, agriculturalpricing

policies often cause the prices of agriculturalcommodities to deviate from

prices that would be established in competitivemarkets or prices in the

internationalmarkets. Such policies have a strong impact on the level and

12/ See Edwards (1984) and Krueger (1985) for a discussion of trade liberalizationin developing economies. - 15 -

allocation of agriculturalproduction, and on consumption. In many developing countries government marketing boards control the purchase of a major portion of domestically-producedagricultural commodities. If the marketing board attempts to increase its revenues (or reduce its losses) by holding the prices it pays below world levels, this policy can act as a tax on output. This type of tax creates disincentivesboth to domestic supply and exports, and can result in an increase in imports and a drain on the government budget. In an adjustment program, therefore, an initial upward adjustment in the prices offered to domestic producers by the marketing board is frequentlyneeded.

Indeed, there is now empirical evidence that suggests that pricing policies to increase the return to producerswould tend to stimulatethe output of major agriculturalcommodities, particularly in the longer term. 13/ Another example in this area is pricing policies for energy and energy products.

Again if these prices are held below world market prices, the government has to absorb the cost of subsidies in its budget. Aside from the budgetary effects, a policy of subsidizingenergy tends to slow down the shift to less energy-intensiveproduction techniques and patterns of consumptionby not providing the right incentivesfor efficient use of energy.

B. Policies to Increase the Rate of Growth of Capacity Output

The rate at which the aggregate potential supply of output can be

expanded depends, among other things, on decisions about the proportion of

current output to be invested in productive capital rather than consumed, as

13/ See Bond (1983). - 16 -

well as on the nature and quality of the capital stock being added. 14/ The appropriate structural policies for this objectiveare those that tend to

favor investment and savings. As there is now general consensus that

investment in developing countries is largely constrainedby the availability

of resources, policies that encourage public and private savings have to be

given a special importance in adjustment programs that emphasize growth. On

the public sector side this involves steps to improve the fiscal position,

while in the case of private savings the focus has to be primarily on interest

rate policies.

Interest rate policy is considered to have a significantinfluence on

the supply of (domestic and foreign) savings as well as the level and

composition of investment. 15/ In many developing countries the financial

systems are tightly controlled by the governments,with ceilings placed on

nominal interest rates. Under inflationaryconditions such controls have

resulted in highly negative real rates of interest on domestic financial

instruments for extended periods. 16/ Consequently,real financial savings

have grown less rapidly than the real economy and disintermediation,

particularlyin the form of development of parallel or curb markets in credit,

has been a serious problem. When such developmentsoccur, they can severely

restrict the availabilityof real credit through the financial system and

14/ See Krueger (1986) for a discussion of the role of capital formation in the growth and developmentprocess. See also Sen (1983).

15/ This view is generally referred to as the McKinnon-Shawhypothesis; see McKinnon (1973).

16/ The real interest rate is defined as the nominal interest rate adjusted for anticipated inflation. - 17 -

thereby inhibit the level and efficiencyof investment. Since available credits are often first allocated to large firms and state enterprises, credits for small- and medium-sizedfirms and householderscan be especially limited and severely rationed, with the consequencethat uneconomic projects are undertakenat the expense of more efficient ones. To increase the availabilityof real credit, interest rate policy could be used to encourage

the accumulationof domestic financial assets by offering holders of these assets a sufficientlyattractive return. At the same time, other structural and institutionalreforms could be undertaken to increase the general

efficiency of the financial system.

The above considerationsindicate why raising real interest rates on

domestic financial instrumentshas to be a key element in adjustment programs.

In setting the level of nominal interest rates, considerablejudgment must

thereforebe exercised regarding the future course of inflationduring the

program. Nonetheless,establishing the perception that holders of domestic

financial instrumentswill earn positive real returns that are to some degree

competitivewith the real yields that can be obtained on comparable foreign

instrumentsis necessary in promoting balance of payments adjustment,

increasingforeign direct investment,and preventing capital flight.

Any changes in interest rates and other financial reforms, however,

must also be coordinatedwith the other policy actions that are a part of the

stabilizationprogram. The experiencesof a number of developing countries

with financialreforms suggests that this coordinationis especially important

during the early phases of the stabilizationprogram. In particular,certain

combinationsof policies can potentiallybe a source of instabilityfor a

financial system undergoingmajor structural change. Two examples appear - 18 -

particularlyrelevant in this context. First, it is crucial that the fiscal accounts be brought under control to avoid the sharp changes in the flow of funds in and out of the financial system. Second, interest rate policy has to be coordinatedwith exchange rate policy to ensure that capital movements do not destabilizethe financial reform.

While most of the attentionhas been on the relationshipbetween savings (financialand real) and rates of return, there are other aspects of

savings behavior that have to be considered. One important issue is the relationshipbetween public and private savings, which was referred to earlier

in connection with the concept of Ricardian equivalence. If in fact public and private savings are substitutes,then clearly an adjustment program that

called for increasedpublic savings, as typically programs do, would cause a

reduction in private savings. In the limit, if the offset is complete, total

domestic savings may remain unchanged with the private sector reducing its

savings as the public sector improved its fiscal position. A second issue

relates to the the effects of capital inflows on domestic savings, both public

and private. If an increase in foreign savings, i.e., a rise in the current

account deficit, results in lower domestic savings then total resources

available to the country would be unchanged. 17/ In general, if the supply

curve for foreign financing is upward sloping, the level of domestic savings

(and investment)will depend directly on the amount of foreign savings the

country can generate. Even though such offsets are unlikely to be complete in

reality, care has to be taken to ensure that other policies, such as increases

17/ The net effect on national savings would obviously depend on the extent to which foreign and domestic savings are substitutes. - 19 -

in real rates of return and improvementsin the availabilityof savings instruments,are able to compensate for the possible negative effects of public and foreign savings on domestic private savings.

Despite the importance attached to private investment in the adjustment process, there is a serious lack of understandingof the factors that influence investment decisions in developing countries. Although in recent years a broad consensus has emerged on the forms of several key macroeconomicrelations in developing countries -- such as the aggregate consumptionfunction, money demand, imports, and exports -- no such convergenceof views is apparent in the case of private investment. The theoretical literature on investment is quite rich and has yielded a well- defined class of models, generally of the flexible acceleratortype. There

is, however, quite a large gap between the modern investmenttheory and the models that have been specified for developing countries. Because of

institutionaland structural factors present in most developing countries,

such as the absence of well-functioningfinancial markets, the relatively

large role of the government in the capital formation process, distortions

created by foreign exchange constraints,wage rigidities,and other market

imperfections,the assumptionsunderlying the standard optimizing investment

models typically are not satisfied in those countries. As such, the standard

models have to be adapted to allow for the structuralfeatures of developing

countries,but this has not been an easy task in general. 18/ What is needed

in particular is a clearer idea of the theoreticaland empirical links between

18/ See Blejer and Khan (1984) for a discussion of the issues and an attempt to specify a model that takes such factors explicitly into account. - 20 -

policy variables and private capital formationso as to evaluate the influence that government can exercise over private investmentdecisions that change the current and future growth rate of the economy.

Assuming that measures are implementedthat are successful in raising investment,what would be their impact on growth? This question can be addressed by formulatinga growth model that relates the rate of growth of output to increases in various factors of production,such as the capital stock (of both domestic and foreign origin) and the labor force, as well as technical progress and the use of imported inputs. Attempts at this type of analysis have only been partially successful. One of the problems is that the identifiablefactors listed above are only able to account for a relatively small proportion of the variation in growth rates over time or across countries. There is a large unexplained source of growth remaining,which could reflect efficiency changes in investment,changes in human capital

(education,skills, and health), or exogenous events. What precisely these factors are, and whether they can be influencedby government policies, is a task that will undoubtedly occupy macroeconomicresearchers.

IV. Exchange Rate Policies

Exchange rate action to improve internationalcompetitiveness and increase the incentive to produce tradable goods is often the centerpieceof any adjustment effort. Since devaluation,in the terminologyof Johnson

(1958), is simultaneouslyan expenditure-reducingand expenditure-switching policy, it affects both domestic absorption and domestic supply, and thus contains elements of both demand-sideand structuralpolicies. - 21 -

The basic demand-sideand supply-sideaspects of devaluationhave been discussedextensively in the literature. 19/ Consider, for example, a situationwhere excess real domestic demand shows up in a current account deficit. A devaluationincreases the level of foreign prices measured in domestic currency terms and thus the price of tradable goods relative to nontraded goods in the domestic economy. On the demand side, the effect of a devaluationon domestic absorption is unambiguouslynegative: the main demand-sideeffects are a reduction in private sector real wealth and expenditure,owing to the impact of the rise in the overall price level on the real value of private sector financial assets, and on real wages and other factor incomes, of which nominal values do not rise proportionallywith the devaluation. For these reasons, devaluationdecreases domestic demand and reduces current absorption.

On the supply side, however, the effects of the devaluationtend to move output in the opposite direction. If the prices of (variable)domestic factors of production rise less than proportionatelyto the domestic currency price of final output in the short run, devaluationwill have a stimulative impact on aggregate supply. 20/ Thus both the aggregate demand and aggregate supply effects of a devaluationwork toward reducing the excess demand in the economy and the current account deficit. Whether total output rises or falls during this process obviously depends on whether the contractionaryeffects on aggregate domestic demand are outweighed by the supply-stimulatingaspects of this policy. This depends, among other things, on the relative sizes of the

19/ See, for example, Cuitian (1976) and Dornbusch (1981).

20/ For a discussion of the supply-sideaspects of devaluation,see Khan and Knight (1982), (1985). - 22 -

price elasticitiesof imports and exports, on the relative shares of tradable and nontradablegoods in total production,and on the other policies that are adopted at the same time.

The above analysis is, of course, very standard,but it does highlight the importance of getting the "right" real exchange rate in the adjustment process. However, although exchange rate action may be the obvious way to correct a misalignmentof relative prices and thereby improve

internationalcompetitiveness, there are still a number of difficult

theoreticaland empirical issues involved. Here we consider four such issues, namely: (a) determinationof the degree of overvaluation,and thereforethe

size of the real depreciationrequired; (b) achieving the target value of the

real exchange rate; (c) determinationof the effects of a change in the real

exchange rate; and (d) the exchange rate regime or exchange rate rules that

the country should adopt.

A. Determining the Extent of Exchange Rate Adjustment

Ascertainingthe "equilibrium"exchange rate against which the

current rate is compared, and thus the extent of the required devaluation,has

proved to be a fairly intractableproblem, even for developed countrieswith

sophisticatedfinancial systems,well-developed forward markets for

currencies,and few distortionsin foreign trade and payments. Consequently,

in the case of developing countries it has become common practice to base

judgments on the appropriatenessof the exchange rate at least in part on

Purchasing Power Parity (PPP) calculations,such as indices of real exchange

rates based on some combinationof export and import weights. However, these

indices are only suggestive and can be useful when domestic rates of inflation

have been considerablyhigher than-those abroad. One should generally be

careful in attaching an excessive degree of importance to small changes in - 23 -

such indices. The use of a PPP-based index to judge the appropriate level of exchange rate requires an assumption that some past level of the rate was correct and then setting up that past level as a target. The size of the required devaluationis then determined by the difference between the target and actual values of the real exchange rate. However, it should be remembered that the choice of the target rate can be quite arbitrary, and thus subject to error.

The question of the appropriate real exchange rate is made more difficult once it is recognized that it is an endogenousvariable that responds to a variety of factors. For example, as shown by Khan (1986), exogenous foreign shocks such as worsening of the terms of trade, an increase in foreign real interest rates, or a slowdown in the growth rates of partner countries,will all tend to depreciate the long-run real exchange rate.

Similarly, domestic supply shocks will alter the equilibriumreal exchange rate. Consequently,the "right" real exchange rate is conditionalon the state of the world, and in any realistic setting, changes in the latter are likely to occur. In judging the appropriatenessof the level of the real exchange rate these factors affecting its long-run behavior have to be taken into account.

B. Policies to Achieve a Target Real Exchange Rate

Having determined the appropriatelevel of the real exchange rate, either through PPP calculationsor through some more sophisticatedmodel-based approach, it is then necessary to choose a set of policies that would achieve this target. Clearly a nominal devaluationby itself would not be sufficient. It is well known that in the absence of supporting policies that limit the increase in domestic prices, a nominal devaluationwill only have a transitoryeffect on the real exchange rate. In the long run, domestic prices - 24 -

will rise by the full amount of the devaluationand the real exchange rate will return to its original level. Broadly speaking, therefore, any

sustainablereal exchange rate change requires policies to restrain aggregate demand and factor costs. The extent to which a devaluationwill affect the real exchange rate, as well as the length of time over which the effects

persist, are a direct function of the supportingpolicies -- fiscal, monetary,

trade, and wage policies -- that are put in place.

To calculatethe effects of a devaluationon the real exchange rate

requires in the first instance informationon substitutionelasticities

between tradable and nontradablegoods in consumptionand production and the

share of tradable goods in total expenditure.21/ This, however, is only the

first-roundeffect which will only be sustained if supporting policies are

implemented. To determine the long-run value of the real exchange rate

requires detailed specificationof these other policies. Without such

information the level of the real exchange rate, for a given nominal

devaluation,could not be predictedwith any certainty.

If it is establishedthat the alignmentof relative prices is

inappropriate,say because the existence of an unsustainablecurrent account

balance, it is possible to correct this situation, in principle, through

policies other than exchange rate adjustment. In general, however, the latter

is likely to be a much simpler way of achieving the correct alignment than are

deflationarypolicies designed to force down domestic prices and wages, which

21/ A limiting case is when prices of nontradable goods are constant. The impact of a devaluationon domestic prices is then simply the product of the exchange rate change and the share of tradable goods in expenditure. The depreciationof the real exchange rate would, therefore, be equal to the nominal devaluationadjusted for the resulting increase in domestic prices. - 25 -

in most countries tend to be resistant to downward changes without substantial falls in output and employment.

C. Effects of Exchange Rate Changes

One of the standard criticismsagainst devaluationas a policy of adjustment is that it tends to induce stagflationand increases unemployment.22/ As mentioned previously,whether a devaluationexerts a net contractionaryor expansionaryeffect on domestic output and employment depends on the relative strengthson the effects it has on aggregate demand and aggregate supply, and the time period in question. As long as devaluation succeeds in altering the real exchange rate by raising product prices in domestic currency relative to factor incomes, it should exert a stimulative effect to the extent that the short-runmarginal cost curves of the relevant

(tradable goods) industries are upward sloping. Naturally, the longer a real exchange rate change persists, the larger are the gains to be achieved.

Furthermore,if the wealth and distributionaleffects of devaluationstimulate savings and investment,a long-run gain of increasedpotential output will likely be realized.

Despite the controversysurrounding the output and employment effects of exchange rate policy, there is surprisinglylittle empirical evidence available on the subject. 23/ Furthermore,the relatively few studies examining this question yield mixed results. Basically, the direction and magnitude of the growth effects depend on such issues as the extent and duration of the real exchange rate change, the structure of production,and

22/ See, for example, Diaz-Alejandro(1965), Cooper (1971), Krugman and Taylor (1978), and Hanson (1983).

23/ See, for example, the studies described in Khan and Knight (1985). - 26 -

the responses of trade flows to relative price changes. If devaluationdoes alter the sectoral distributionof income, as it is designed to do, it will not be completely costless to some sectors. On the other hand, no strong empirical evidence can be brought forward to support the propositionthat devaluationnecessarily reduces the overall growth rate and increases unemployment. Given the state of empiricalknowledge it would be dangerous to draw strong conclusionsone way or the other. Of more relevance are the short-term and long-termeffects that devaluationhas on trade flows, and here the empirical evidence points to the existence of relative price elasticities that satisfy the Marshall-Lernerconditions. What needs exploring is whether the result carries over to the case where imported inputs are important in the export production process and where imports are constrainedby foreign exchange availability.

D. Exchange Rate Systems and Regimes

Unlike the developed industrialcountries there are very few developing countriesthat operate a freely-floatingexchange rate system.

Most either maintain fixed parities or follow some type of crawling-peg rule. 24/ While there may be advantages to maintaininga fixed peg, such a system also has a number of disadvantageswhich have been dealt with at length in the literature. One of these drawbacks is that the policy leaves a country vulnerable to speculativeattacks and may result in exchange rate crises if the authoritiesare unwilling to alter the peg. 25/

24/ The 1985 Annual Report of the IMF lists 50 developing countries as having fixed pegs to a single currency, 38 as pegged to a currency composite, 29 that follow an exchange rate rule, and only 7 countriesare classified as floating.

25/ See, for example, Blanco and Garber (1986). - 27 -

At the other extremefrom countrieswith fixedexchange rates are high-inflationcountries where continualexchange rate adjustmentis built into the economicsystem. Indeed,exchange rate changescan be regardedin some cases as merelya particulartype of indexation.For these countries, the key decisionis at what rate the domesticcurrency should be depreciated; this dependson a numberof considerations,especially the policiesbeing simultaneouslycarried out with respectto the interestrate, fiscalpolicy, and domesticcredit expansion. Recentlysome writershave questionedthe use of exchangerate rules,arguing that they increasefluctuations in outputor increasedomestic inflation, and thus are inconsistentwith macroeconomic stability.26/ Also at issue is how and when rules that are designedto keep the real exchangerate constant,or slowlydepreciate over time, shouldbe changedwhen circumstancesdictate.

Confrontedwith persistentbalance of paymentsproblems, some countrieshave resortedto a dual exchangesystem as an alternativeto a uniformexchange rate adjustment.Under the dual system,certain selected transactionstake place at an officialexchange rate, which is maintainedby officialintervention, while the remainingtransactions take placeat a generallymore depreciated("free" or "parallel")exchange rate, which is usuallydetermined by marketforces. Dual exchangemarkets have not always been successfulin achievingthe objectivesthat motivatedtheir adoption. In particular,they have been largelyineffective in preventingspeculative capitalflows from affectinginternational reserves, as uncertainties concerningthe viabilityof the officialexchange rate have generallyproduced leads and lags in importsand exportsin the officialmarket. Similarly,the

26/ See, for example,Dornbusch (1982) and Adams and Gros (1986). - 28 -

large differentialsthat often arise between the free and the official exchange rate have motivated the over-invoicingof imports and the under- invoicing of exports in the official market, thus contributingto a further erosion of internationalreserves. In addition, dual exchange rates are equivalent to a series of implicit subsidiesand taxes that may work against

some of the objectives of the country. For example, commodities that receive

export promotion incentives are sometimesassigned to the official market,

thus implicitlytaxing their export and defeating the initial purpose of

export promotion. In summary, there is a need to study the workings of dual

exchange rate systems in more detail to determine the reasons why they have

not survived, and what lessons can be learned from the experienceswith such

systems.

V. External Financing Policies

It is generally thought that as developing countries face a scarcity

of capital they should be net foreign borrowers during the development

process. This idea has been formalized in a number of studies showing that

countries can attain a desirable growth path by supplementingdomestic savings

with foreign savings. The rate at which they borrow abroad, or in other words

the "sustainable"level of foreign borrowing, depends on the relationships

among foreign and domestic savings, capital formation and growth. The main

lesson of the "growth with debt" literatureis that country can and should

acquire foreign savings (in the form of net imports of goods and services) as

long as this provides the basis for paying the required rate of return to the

supplying country over the time period during which the resources are made

available.27/ The justificationfor paying this rate of return is usually

27/ See the useful survey by McDonald (1982). - 29 -

thought of as the increased output made possible by the additional real capital that can be accumulatedwith the aid of net foreign savings. 28/

Theoreticallyit is possible to calculate the sustainablelevel of net resource transfers, based, for example, on informationon the nature of

the constraintson the supply of foreign loans and the availabilityover time

of new loans that vary both in terms and maturity, but in practice this is a nearly impossible task since such informationis not often available. 29/

Consequentlyit is thus necessary to make approximationsto the relationship

between debt and the capacity to service debt through calculatingratios of

debt to exports or debt to GNP. However, it is very difficult to determine

the "sustainable"level of such ratios. If a country can profitably employ a

stock of foreign savings that is large relative to domestic savings, it

follows that its debt to exports ratio will be high relative to a country that

has a lesser capacity to profitably utilize foreign savings. The equilibrium

level of such ratios will thus vary from country to country and for a given

country over time.

The main practical value of the existing empirical measures is that

they can provide signals to the danger of situations in which debt can grow

28/ It might also be optimal for countries to utilize external debt to smooth consumptionover time in the face of various internal and external shocks. A more general criterion would be that the pattern of distributionof world savings should be welfare enhancing. See Williamson (1973).

29/ Furthermore,any such calculation is by definition conditionalon the assumptions of the future path of the interest rate on existing and new debt. What might be considered sustainableat a given interest rate may prove to be unsustainableif the interest rate should rise above the assumed value. Since most commercialdebt carries a floating interest rate, calculationsbased on some fixed rate are bound to be only conjecturalat best. - 30 -

explosively. If additional external debt increases investment income payments by more than it increasesthe capacity to make such payments, this must be reversed through net exports of goods and services. If it is not, additional debt will be incurred in order to make payments, and the stock of foreign debt will grow faster than debt service capacity. A convenientway of stating this condition is that the real interest rate paid on additional debt must be less than or equal to the expected growth in the volume of exports. 30/

While it may be difficult to see the relationshipbetween empirical indicators for debt capacity and the criteria for foreign borrowing that emerge from the theoreticalliterature, there are neverthelesscircumstances in which the proxies are useful. For example, an unexpected rise in the external real interest rate can make the payments associatedwith existing debt excessive relative to the outlook for a country's debt service capacity. Moreover, a country's debt service capacity could deteriorate because of unwise domestic policies that reduce the expected return of foreign borrowing in terms of export capacity. Finally, less favorable external factors such as slow growth in trading partners or adverse changes in the terms of trade could introduce the possibilityof explosive growth of debt.

Therefore, the theory of real resource transfers is probably most useful as a warning in circumstanceswhere concepts such as debt to GNP, debt to exports, or debt-serviceratios are changing or are expected to change rapidly. Such possibilitieswould call into question the sustainabilityof the country's external position.

30/ Strictly speaking, this result assumes that the rate of growth of imports is less than or equal to the rate of growth of exports. - 31 -

In recent years the sharp decline in the availabilityof foreign financinghas created difficult adjustment problems for a large number of developing countries. When private creditorshave already determined that the sustainabilityof the country's position is doubtful, the short-term outlook for the current account is constrained since only official financing may be available. In this case, to the extent that the country cannot influence official capital flows, the short-runadjustment path for the current account is largely determinedby forces outside the control of the adjustment program.

The issue remains, however, as to what policies (perhaps involving debt reduction relative to domestic output for some interval)will allow a quick and relatively costless eventual return to a normal growth path for debt.

The theory of "growth with debt" is not well-suitedto guide policy during such transitionperiods. 31/ The obvious solution is that the necessary adjustment should be accomplishedat the minimum cost in terms of loss of output, but this is obviously not an easy task. One practical considerationis that imports should not be compressedbelow the level which causes an unnecessaryreduction in the rate of economic growth and, to the extent that exports require imported inputs, the growth of exports. It should be recognized,however, that there may be little room to maneuver where credits from private sources are no longer available. Official financial assistance obviously plays an important role in these circumstances,and an adjustment program can also advance the time in which the country's access to the internationalcapital markets and thus to foreign savings is restored.

31/ For a discussion of some of the issues that arise, and the policies that may be implemented,see Selowsky and van der Tak (1986). - 32 -

In discussionsof capital flows in the context of developing countriesattention has focused almost exclusivelyon foreign borrowing by these countries. Recently some advances have been made to analyze the other side of these flows, namely the acquisitionof external claims by residents of developing countries. 32/ The interest has been triggered because of what has been termed the phenomenon of "capital flight." It has been argued by some studies that the outflow of capital has caused serious economic difficulties for developing countries. For example, Cuddington (1985) and Dornbusch (1985) contend that capital flight in a number of countrieshas caused the build-up of gross foreign debt, an erosion of the tax base, and to the extent that there was a net real transfer of resources from the countries, a reduction in investmentand growth.

Since the availableestimates of capital outflows from debtor countriesare surprisinglylarge, it stands to reason that capital flight is of concern to policymakersin these countriesas well as to international institutions. If increases in foreign debt in the past merely financed capital flight rather than productive investment,then what is to prevent future lending from leaking out in the same way? Furthermore,following from the first question, what policies if any, can be enacted to prevent a repetition of large scale private capital outflows from debtor countries facing acute financing needs?

While there is some theoreticalsupport for the notion that expected devaluationsand interest rate differentialsdrive capital abroad, in general, the effects of changes in the macroeconomicenvironment on preferences for

32/ See, for example, Cuddington (1985), Dooley (1985), Dornbusch (1985), and Khan and Haque (1985). - 33 -

where wealth is held are not that straightforward. A change in the macroeconomicenvironment will generallybe recognized by both residents and nonresidentsat the same time, limiting the incentives for trade between these groups of investors. Some market imperfectionis usually needed in order to predict changes in the location of investments. For example, in the case where a government is supportingan unrealisticexchange rate and where there are no opportunitiesfor the private sector to acquire domestic securities denominated in foreign currencies,private capital outflows would be expected. In this case the "differenceof opinion" between the government and the private sector (both resident and nonresident)will lead to a change in the preferred location of investments.

In addition to the macroeconomiccauses behind capital flight, there are a whole host of incentives that may affect the decisions of investors on where and in what form to hold their wealth. The key to these "micro" incentives is the actual and expected taxes, subsidies,and controls that various governmentsimpose on holdings of wealth within their jurisdiction.

For example, countries that have taken over large debts have a clear need to generate revenue. To the extent this is likely to fall on investment income, residents will attempt to find a tax haven outside the country. The effort to impose a differentialtax on investmentincome will be very counterproductive since revenue can very rapidly fall to zero as the tax base shrinks.

Of course, it should be recognized that it is highly unlikely that the governmentwill be able to prevent all private capital outflows even in the best of circumstances,since many of the causes are well beyond its control. What the authoritiescan do is to try and change existing

incentives,both macro and micro, in the economy to minimize the amount of capital flight, and thus direct more resources, both domestic and foreign, - 34 -

towards expanding the productive base of the economy, and increasing its current and future debt-servicingcapacity.

VI. Conclusions

This paper has had a twofold purpose: first, to identify the policies that would be called for to achieve macroeconomicadjustment, and second, to describe the links between these policies and the ultimate objectives of an improvementin the balance of payments, a reduction in inflation,and an increasedrate of economic growth. The resulting package would be a fairly complex mix of policies designed to simultaneouslyreduce aggregate demand and increase aggregate supply and the production of tradable goods. As has been shown in this paper, the links between policies and the ultimate objectives are equally complex and there are large gaps in knowledge on both the theoreticaland empirical fronts.

The set of policies considered here would be broadly acceptable to most economists concerned with the issue of macroeconomicadjustment in developingcountries. For example, in one of the few concrete expositionsof an adjustment strategy,Diaz-Alejandro (1984) describes a policy package that contains many of the same elements as described in this paper. Considering the case of a country that has an unsustainablebalance of payments deficit and high inflation, Diaz-Alejandro(1984) proposes that the policy package should contain the following: fiscal and monetary restraint to reduce aggregate demand; eliminationof distortions;incomes and wage guidelines; a gradual liberalizationof imports; provision of incentives for exports; a crawling-pegexchange rate regime, with emphasis on undervaluationof the real exchange rate to support export promotion and import liberalization;and positive real interest rates to encourage savings. The "real economy" - 35 -

approach advocated by Killick and others (1984) is yet another example of a specific set of proposals for adjustmentthat is quite consistent with the package described here. This real economy approach basically emphasizes structuralpolicies at the sectoral level, in addition to demand-oriented policies.

While there may be agreement on the policy measures to be implemented,there is certainlya lack of consensus on how these policies work to achieve the principal goals. This is specially true in the case of policy measures that are essentiallymicroeconomic in nature but have macroeconomic implications. It has to be recognized that the analytical basis for a number of micro-orientedpolicies typically included in an adjustment program is relatively weak. The theory underlying the effects of eliminatingdistortions

(real and financial) is not well-suitedto policymakingas it very quickly gets into welfare-relatedissues. For example, whether the removal of consumer subsidies or a devaluationraise overall efficiencyand production, when there are significantdistortions in the economy, or not, are still very much open questions.

Even on the macroeconomicfront there are serious theoreticaland empirical issues that are still up in the air. For example, as pointed out in this paper, both the direction and size of the effects of fiscal policy on aggregate demand are ambiguous. The subject of devaluation in a developing economy is yet another importantexample of which existing analysis does not yield definitive conclusions. The available literaturegives only a limited amount of informationon the important policy questions of precisely how a

devaluationis expected to work, how to determine the size of the required

depreciation,and whether a nominal depreciationcan alter the real exchange

rate sufficientlyto generate a shift in resources between sectors. A third - 36 -

example is the issue of savings and resource mobilization. Since raising private savings is a key element in programs emphasizinglong-term growth, it is crucial to establish the theoreticaland empirical links between private and public savings, interest rates, and exchange rate policies. Finally, and perhaps most importantly,there is still much to be learned about the factors

.hat drive growth in developing countries,and in particular of the relationship,or trade-off, between short-run stabilizationand long-run growth.

Many of these questions will clearly have to be answered through concerted empiricalanalysis. Even when the theoreticalunderpinnings of the relevant relationshipsare clear-cut, it has to be stressed that economic theory provides a guide only to the basic equilibriumrelationships, and does not provide informationon how long it takes for a change in an exogenous variable or policy instrument to have an impact on the endogenous variable.

Such questions concerning dynamics and lags in adjustment obviously have to be approached from an empirical standpoint,and thus empirical analysis will be crucial in the design of an adjustment package. Furthermore,in many instancescomparisons of alternativemodels may prove necessary to decide which are the more appropriateto form the basis of the policy package.

This paper has provided only very general guidelines on the type of measures that should be included in an adjustmentpackage. The issues of the appropriatemix of demand-management,structural, exchange rate, and external financing policies,and the sequencingof these policies,which are basic from an operationalpoint of view, were not directly addressed. An analysis of these issues would require in the first instance detailed theoreticaland empirical knowledge of the relationshipbetween policies and the ultimate objectives. However, this would not in itself be sufficientsince the ways in which policies are combined depends on a number of other factors. These - 37 -

include, among others, the relative weights assigned to objectives of the program. If, for example, an improvementof the current account is considered a higher priority, more stress would be given to demand-managementand exchange rate policies. On the other hand, the achievementof higher medium- term growth would call for more emphasis on structuralpolicies. Equally important in the decision about the mix of policies would be the initial conditions,such as the external payments situation, the outstandingstock of foreign debt, the rate of inflation, and the level and growth of per capita

income, when the program is implemented. The time period over which adjustment is to be achieved also has an obvious bearing on the choice of

policies to be undertaken. Since structuralpolicies generally act with a

lag, the longer the time horizon of the adjustment the easier it would be to

utilize such policies. Finally, the choice would be dictated by the

structuraland institutionalcharacteristics of the country in question. For

example, in countries where indexationis importantand inflationhas become

ingrained in the system, policies directed towards restrainingaggregate

demand may be very costly in terms of output and employment. All these

factors argue strongly for the tailoring of adjustment programs to the

circumstancesof the individual country.

Nevertheless,it is crucial to have an analytical frameworkwhich can

be adapted to the particular country undergoing adjustment. Only then would

it be possible to predict the effects of alternativecombinations of policies

on the importantmacroeconomic variables in the system. The advances in

macroeconomictheory for developing countrieshave been significantin recent

years, but as this paper has tried tolshow, there are large number of issues

in the area of macroeconomicadjustment, and the policies to be applied to

this end, that are as yet unresolved. References

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