FINANCE (^DEVELOPMENT is published quarterly in English, Arabic, Shuja Nawaz ADVISORS TO THE EDITOR Chinese, French, German, Portuguese, and Spanish by the Inter- EDITOR Nancy Birdsall national Monetary Fund and the International Bank for Recon- Peter Clark struction and Development, Washington, DC 20431, USA. Laura Wallace K- Burke Dillon A<5<5icTANiT pniron Stephen Eccles Opinions expressed in articles and other materials are those of the Ab&is i AIN i tui i UM Richard Haas authors; they do not necessarily reflect Fund or Bank policy. Javed Hamid Gita Bhatt Gregory Ingram Second class postage is paid at Washington, DC and at additional mailing offices. EDITORIAL OFFICER Anthony Lartyi English edition printed at Lancaster Press, Lancaster, PA. Postmaster: please send Johannes Linn change of address to Finance & Development, 700 19th Street, NW, Washington, DC _^ , ClaudiO Loser 20431. English edition ISSN 0015-1947. Richard otoddard Gobind Nankani Telephone: (202) 623-8300 • Fax Number (202) 623-4738. ART EDITOR Alan Tait

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©International Monetary Fund. Not for Redistribution September 1991 • Volume 28 • Number 3

FINANCE ^DEVELOPMENT A QUARTERLY PUBLICATION OF THE INTERNATIONAL MONETARY FUND AND THE WORLD BANK

Research Challenges for Development Economists Lawrence Summers 2

Lessons from Economic Development Vinod Thomas 6

Challenges in Human Development Elizabeth King 9

Economic Policy and Economic Growth William Easterly 10

Governance and the Development Process Pierre Landell-Mills & 14 Ismail Serageldin

Exchange Rate Policy and the IMF David Burton & 18 Martin Oilman

Controlling Military Expenditures Military Expenditures in the Developing World Daniel Hewitt 22 Guest Article Reducing Military Expenditures in the Third World Robert S. McNamara 26

Extending Help to Women Farmers in LDCs Katrine Saito 29 Interview Setting the Development Agenda Alejandro Foxley 32

Challenge of Sustaining Growth with Equity in Asia Attila Karaosmanoglu 34

How Mobile is Capital in Developing Countries? Nadeem U. Haque & 38 Peter Montiel

Accessing the International Capital Markets Kumiko Yoshinari 40

Protection in Sub-Saharan Africa Hinders Exports Dean DeRosa 42

Madagascar: Crafting Comprehensive Reforms S. Rajcoomar 46

Books The Economics of the Dollar Cycle edited by Stefan Gerlach and Peter Petri and The Political Economy of American Monetary Policy edited by Thomas Mayer James Boughton 49 The Competitive Advantage of Nations by Michael Porter Gregory Ingram 50 Socially Relevant Policy Analysis edited by Lance Taylor Peter Montiel 50 Cheating the Government: The Economics of Evasion by Frank Cowell Peter Stella 51 Blueprint for a Green Economy by David Pearce, Anil Markandya, and Edward Barbier Herman Daly 52 Sharing Innovation: Global Perspectives on Food, Agriculture, and Rural Development by Neil Kotler Peter Haze// 52 Books in Brief 53 Other Books Received 53

The Editor welcomes views and comments from readers on the contents of the journal. The contents of Finance & Development may be quoted or reproduced without further permission. Due acknowledgement is requested.

©International Monetary Fund. Not for Redistribution Research Challenges for Development Economists We need to understand more deeply a number of critical issues that confront the World Bank and its member countries before we can transform knowledge into effective actions Lawrence Summers

-L»-I.uch of what is said about the propen- How can we help lift billions out of the tive transfers to the developing world during sity of economists to disagree is vastly exag- poverty trap and set them on the path to sus- the 1980s reflected, in large part, the commer- gerated, as evidenced by the striking degree tainable development? This article argues cial banks' response to the debt crisis, the of consensus in the advice that the broad that more than ever before, the central prior- prospects for large net transfers from institu- mainstream of economists has given on the ity for the World Bank, and indeed for the en- tions like the Bank have declined as well. transition in Eastern Europe. But certainly, tire aid community over the next decade, is to Over the 1975-80 period, the World Bank there is much we do not know. Despite rapid create and help implement improved strate- Group made net transfers to the developing technological progress that has created all gies for economic development. These strate- countries of $9 dollars per person in the devel- sorts of new economic opportunities, living gies must rely, to a greater extent than before, oping world (in 1991 dollars). Over the next standards over the last decade have actually on the transfer and transformation of knowl- five years, these net transfers are projected to declined on two continents—Africa and Latin edge, so as to compensate for the expected decline to just over $2 per person in the devel- America. It seems that we, as economists, paucity of development assistance in the wan- oping world. For a large number of countries have more ability to identify and reject quack ing years of this century. To put it bluntly, that do not qualify for concessional IDA prescriptions that violate necessary condi- since there will not be much development flows, there will actually be a negative flow of tions for development and growth, than we money over the next decade, there had better money to the Bank (see table). have to provide policies that ensure sufficient be a lot of good ideas. Resource transfers will be limited. Yet this conditions. potential financial constraint need not dimin- Money vs. ideas ish the effectiveness of our role. While aid Consider the historical volume of transfers flows are crucial, the reality is that improving to the developing countries and the projected the efficiency of development assistance to volume of aid for the next decade. For the de- the developing world will often make a This essay is based on the keynote speech delivered veloping world as a whole, aggregate net greater contribution to growth. Consider, for by the author at the World Bank Annual Conference on Development Economics in Washington, DC, in transfers in 1991 dollars totaled $50 billion in example, the following comparison: a two April 1991. The full text of the speech will be appear- 1980. Over the last five years, however, these tenths of one percent increase in total factor ing in a special supplement of the World Bank transfers were significantly negative on aver- productivity in developing countries would Economic Review and the World Bank Research age. A restoration of the earlier levels of flows contribute more to their GDP growth than an Observer in 1992. is not in sight. While the cessation of net posi- additional $100 billion of capital invested at

2 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution historical rates of return. program should be helping to set the priorities ing apples to oranges. But seeking to compare This suggests that, in the end, what will for tomorrow, as well as responding to the their returns analytically must surely make make the greatest difference for development needs of today. To this end, the Bank will con- more sense than investing in both to ensure are well-implemented, good strategies, and tinue working on its current areas of opera- that the better one is included in the portfolio. not simply on the transfer of resources. tional emphasis—the environment, reform of Making comparisons of investment returns Consider the most widely cited of all foreign socialist economies, debt, adjustment, and so across different types of investments will de- aid successes—the Marshall Plan. During the forth. Against this background, the Bank will mand techniques of analysis that go beyond Marshall Plan years, the United States need to re-examine and revivify its work in a traditional cost benefit analysis, to cover a va- granted the recipient countries less than 2.5 number of traditional areas. riety of externalities that different types of percent of their incomes per year, and less Evaluating infrastructure invest- projects produce. For example, recent trade than one third of the resources transferred ments. Perhaps the most traditional role of theory has shown that the gains from free were used directly for investment. Yet what government is investing in public goods— trade go beyond reduced "deadweight loss tri- the Marshall Plan did, and on a major scale, broadly defined—and getting as much return angles" (i.e., reducing the additional costs in- was to help provide economic stability and al- from those investments as possible. Helping curred by consumers as a result of trade re- low governments to provide an enabling envi- governments make necessary infrastructure strictions), to include increased efficiency, ronment in which the private sector could reduced rent-seeking, and the gains associated flourish. with the exploitation of economies of scale Public inaction vs. action and increased product variety. Yet these gains World Bank net transfers are hard to quantify with standard methods. With money scarce, ideas are needed. But to the developing world Similarly, improved transportation no doubt what type of ideas? The great lesson of re- (In millions of 1991 US dollars; produces many economic benefits beyond re- search and experience in the 1970s and the ducing travel time, yet such considerations 1980s was that governments that tried to oc- have not been fully or even partially accom- cupy the commanding heights of their 1975-80 1990-94 modated in our analyses of the attractiveness economies found themselves looking a long of this type of lending. Our goal must be to de- way down, to stagnating growth and deterio- Net transfers vise ways of making more systematic and IBRD 14,290 rating performance. The policy lesson is clear -13,678 more complete evaluations of different types IDA 14,078 22,374 enough: Governments must get out of produc- of projects that recognize the full range of ing and allocating goods and services—activi- Total net transfers 28,368 8,696 their impact. ties that are best performed through competi- (In US dollars) Pushing market development. A dif- tive markets. That message has been heard Net transfers per ferent kind of infrastructure that government around the world and to great effect. One need capita 9.01 2.05 provides is the development of markets that only consider the booming economy of Source: World Debt Tables, and other World Bank otherwise would not exist. Advocates of lais- Mexico, the vast increases in agricultural pro- sources. sez faire would do well to remember that there ductivity obtained in China, or the bold re- was no commercial mortgage market in the forms being undertaken in Eastern Europe, to United States immediately after World War II. see its power. It took the Federal Housing Administration to The market message was new and true. demonstrate that loans for houses were feasi- But it is only part of the story. Getting the investments was, after all, an important ratio- ble and that lenders could collect those loans government out of economic activities is not nale, perhaps the central rationale, for the and make a profit, while allowing people who the correct answer every time. Sometimes, creation of the Bank. Economic logic suggests could not otherwise afford homes to purchase governments will be called on to do more of that the Bank's capital should be allocated to them. That experience, and its message, is rel- what they must do, and to do it better—mak- activities that produce the highest returns. evant for institutions and places where capital ing the tangible and intangible infrastructure But that is not the way the Bank and other de- markets are much less developed than they investments that underpin a healthy private velopment institutions operate. Our portfolio were in the United States even after World sector and rapid growth, and ensuring social is highly diversified, with investment in many War II. and economic justice. sectors in most countries. Why? I fear that we There is also a major and obvious need to Undertaking such activities effectively is practice a kind of diversification out of help countries and companies guard against much more difficult than divesting them, ignorance. Not knowing what types of pro- the enormous risks they face from highly especially in a resource-constrained environ- jects have the highest returns, we invest in volatile international financial and commodity ment. We have concentrated attention in re- many different things, as do our member markets. Countries are also exposed, in com- cent years on governments' errors of commis- governments. plex ways, to changes in interest rates, and in sion. It is time for more work on governments' Yet, there is every reason to think that there their own and their competitors' exchange errors of omission. The Bank's research are large differences in the social rate of re- rates. The challenge is to find ways, and to agenda for the next few years, therefore, will turn to different types of project lending. The help governments find ways, of using more ef- address the pivotal issue of helping govern- Bank's own operational evaluations suggest a fectively the vast world capital markets to ments become more effective in identifying large variation in the rate of return to projects spread risk and permit it to be borne more ef- and performing the central functions that only in different sectors. This raises, as a vital ficiently. Often this will involve enabling spec- they can do. question for research, the challenge of making ulators in developed countries to take on risks tough judgments about the social return to that developing countries can ill afford. In What do we need to know? different types of investment. Of course, com- some cases—for example, in the case of devel- An important dimension of any research paring bridges to power plants is like compar- oping country oil importers and oil ex-

Finance & Development I September 1991 3

©International Monetary Fund. Not for Redistribution porters—this can be done within the develop- cancer would add only three years to the aver- in the labor market. We must rechannel some ing world. age life expectancy in the United States, and of the energy we have directed at understand- Attracting capital. Capital market de- much less in poorer countries. ing the capital market to understanding the velopment also involves attracting capital. As What are the roots of the differences? What labor market. That will involve fathoming mentioned at the outset, recent trends suggest can be done to reduce them? The very differ- more accurately the impact of labor market that the flow of capital to the developing ent experiences among countries must demon- regulations on output and participation rates, world will, even in fairly optimistic scenarios, strate the vast potential of strategically de- so their removal would become a more signifi- be much smaller in the near future than it has signed, relatively inexpensive government cant part of our adjustment programs. But it been in the recent past. Commercial bank interventions. But how? The answer must go also means finding ways of harnessing labor flows to many developing countries will not well beyond targeting programs to reach spe- markets to provide employment not for a be restored any time soon. The downside risk cific groups. Differences in life expectancy or small fraction of workers at very high wages, associated with lending to the developing illiteracy of the kind described above cannot but for a much larger number of workers in la- world became obvious during the last decade. be ascribed simply to the failure of some coun- bor-intensive industries. Human capital is a As a result, in the coming years, investors will tries to concentrate on the lower social strata principal asset of the poor. Raising its return demand a large potential upside to their in- of their population. They must reflect differ- has to be a central investment, and, therefore, vestments in developing countries, so as to ences in all social strata. The problem of deliv- a research priority. balance the downsides they faced in the past. ering those services seems to me an important Population is another area, nearly unique In order to replace commercial bank lending, one for the Bank's future research. among areas of development policy, where the developing world will need equity flows Beyond the comparisons across countries, there is a disjunction between widespread and direct foreign investment on a large scale. and of potentially equal or greater impor- seemingly compelling beliefs and the current The Bank and the International Finance tance, is a micro-dimension. We do not have state of the scientific literature. Perhaps this is Corporation (particularly the latter) have done well crafted and tested systems of comparing not surprising given how much emphasis in important work in catalyzing those flows. But smaller "control" groups of people within recent years has been devoted to the determi- equity flows are still very small on the whole. different parts of a society and tracking their nants of population growth and how little to We need to think about ways of leveraging socio-economic development over time. its consequences. them more effectively, because it is equity not Medicine has agonizingly come to the conclu- It is widely believed that population growth debt flows that will effect large transfers or sion over the last century that only double is a major barrier to economic development large foreign-financed investment in develop- blind evaluations of drugs or carefully con- and a perpetuator of poverty in developing ing countries during the next decade. trolled statistical evaluations of surgical countries. Robert McNamara represented the Achieving economic justice. The procedures have any validity at all. Without views of many when he equated population World Bank is committed to poverty reduc- such comparisons, mistakes are incessant. growth and nuclear war. Yet a relatively re- tion. But poverty alleviation is a means, not Obviously, the scope for controlled evalua- cent National Academy of Science report pro- an end; it is a way of allowing people to live tions is greater in some settings than in vided a dramatic shift in viewpoint, reaching healthier, longer, more comfortable, and ful- others. In the real world, not every ceteris can a rather agnostic view about the conse- filling lives. We know a great deal about the be paribus. But, I would suggest that too often quences of population growth. It seems likely distribution of income, and a fair amount we, as development economists, operate in a that improving our understanding of the pop- about how to change it, but, as evident in the kind of statistical Stone Age. We would learn ulation question will require recognizing that work done for the World Development Report much from maintaining a standard policy of reducing population growth has differing con- 1991, there is little hard quantitative evidence setting up baseline groups to use as controls sequences in different circumstances. Changes on the effect of social sector interventions on in evaluating social sector projects or, to in population growth are likely to have differ- health, literacy, nutrition, and so forth. Any the extent that matched enterprises can be ent outcomes when they are brought about by effort to quantify the financial effects of lives found, even projects directed at restructuring declines in death rates of older adults, declines saved and relate them to the value of original enterprises. in child death rates, responses of families to social sector investments is problematic to Social services are important. So is raising changes in social security arrangements, and say the least. But it is not unreasonable to ask the income of those who work, and that means specific efforts at promoting family planning. for some amount of information bearing on causing their skills to be more highly valued The impact of changes in population is also what can be accomplished through social sec- likely to vary across places. Where a large tor programs. fraction of the population lives off the land, Economic growth and social progress are population growth is likely to be more perni- related, and rising tides do lift all boats. But cious than where the land has diminished in there are vast differences in social sector importance as a factor of production. performance among countries at similar in- Lawrence Summers Beyond the traditional question of the im- a US citizen, is Vice pact of population on growth, there are a host come levels. Among low-income countries, President, Development Indonesia, Sri Lanka, and the Republic of Economics, and Chief of other questions that need to be answered, Yemen have almost exactly the same per Economist of the Bank. He so as to guide a rational population policy. capita income. Yet, life expectancy is 51 years is on leave from his position How strong are the links between population in Yemen, 60 in Indonesia, and 70 in Sri as Professor of Economics growth and environmental degradation? Is it Lanka. Among upper middle-income coun- at Harvard University. really population pressure that is pushing mi- tries, Brazil and Uruguay have essentially the gration into Rondonia in western Brazil? How same income level, but life expectancies differ much extra pressure does population, as dis- by six years. To put these figures in perspec- tinct from other problems, put on African tive, consider that eliminating all forms of soils? What are the links between population

4 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution growth and inequality in the wage structure? equality shape political forces differently, or World Bank Conference on Development Does population growth affect the wage struc- so, at least, it has been argued. Just how sus- Economics in 1990, there has never been a ture? What are its fiscal consequences? And ceptible these things are to change, one cannot famine in a country with a free press. These will investments in population policies pay off say with certainty. The view that govern- facts raise the question of whether democracy, for governments? ments should simply swear off selective poli- while not essential to growth, may in a whole Gauging more accurately the impact of cies if they cannot do them well may be a bit set of ways improve development perfor- population growth on development perfor- naive. The same political forces that make mance on other dimensions. It is time that we mance is only the beginning of what we need governments unable to implement those poli- look in much more detail than we have in the to know about demographic change and its cies well may make governments unable to re- past at the relationship between democracy consequences. Over any but the longest hori- sist engaging them. and development. We need, as well, to begin zon, there is very little that can be done about Understanding more fully the political roots to think about what we can do, beyond the rate of population growth. We need more of economic success and failure is an intellec- economic policies that promote growth, to im- effective policies to deal with the increasingly tual task of great importance. By itself, it can prove the performance of governments. aged population of the developed world—and contribute to judgments about where assis- Recent events press yet another question we must think through the pressures for mi- tance is and is not likely to be effective. related to governance. What is the future of gration that are rapidly building. If current Beyond this question, there is the issue of nation states as independent actors? On the projections hold, over the next two decades crafting appropriate policy advice that reflects one hand, pressure for integration and cooper- the developing world will account for 95 per- political realities, which insulates results from ation mounts, as in the European Community. cent of labor force growth, but for less than 15 inherently political pressures, as in the case of On the other hand, pressure for devolution in- percent of capital investment. This calls for ei- countries that rely on foreign companies to creases in a number of countries. This raises ther transferring capital to places like Africa collect custom duties; or that create dynamics questions of managing the transition to more where the labor force is growing more that push the politicians in the appropriate di- autonomous constituent states within a na- rapidly, accepting large flows of migratory la- rection, as in the case of making them substi- tion-state to preserve the stability that is es- bor, or recognizing that an important force tute shorter prohibited for seemingly endless sential to growth. permitted lists of goods that can be imported. will be operating to increase inequality over Conclusion the next 20 years. There is a very sensitive and closely related Governance. Beyond the questions of question—that of the links between democ- In a world that is short of money, it is im- what governments must or can do, is an issue racy, civil liberties, and economic perfor- portant to have ideas. Research spawns ideas. that may well be the most important, and per- mance. We have learned an important lesson Focusing the development research effort over haps the most difficult to grapple with: the over the last decade: authoritarian regimes are the next decade in the areas discussed above question of governance. We have learned over not necessary to bring about growth. Growth, can be given the Pascal defense. To para- the last three decades that the heavy hand of on average, proceeds at about the same rate in phrase Pascal, if there is no God and I go to government retards growth, and we have seen democratic and nondemocratic regimes. We church on Sundays, I will have wasted some that, contrary to economists' beloved trade- know two other things. Since World War II, time. If there is a God and I fail to go, the costs offs, very often even as governments retard there has been no war involving two demo- will be transcendently greater. So, too, with growth, they are also insensitive to objectives cratic nations, and in the last 50 years, as the search for new ideas. The payoffs to suc- that are thought to conflict with growth. Amartaya Sen pointed out at the Annual cess dwarf the consequences of failure. • Concerns about the environment or inequal- ity, which go beyond the bottom line, are not met more effectively by the heavy hand of government. That much we know. We are much less clear on the right line between the invisible hand and government's helping hand. It may Do you want be fair to assert that the rhetoric surrounding the use of selective credit policies in Japan and to receive FINANCE East Asia is not very different from the your copy of ^DEVELOPMENT rhetoric that surrounds development banks by air? and other tools of selective credit policy in Finance & Development Is normally sent without charge. other parts of the world. But the results have by surface moll. Since we are a quarterly Journal, and surface mail Is relatively been dramatically different. In a sense, the slow. It may be a few months before your copy reaches you. policies must have been different also. Failed Air mail delivery Is available to those readers who are willing to pay US$20 a year to cover the cost of mailing and handling, policies in Asia have been reversed much When applying for a subscription, please advise us if you wish more quickly than failed policies in Latin to pay for airmail service. Regular readers may send us America or Africa, and have not, therefore, payment with their request to change to air mail delivery. mushroomed or bred the same kind of corrup- tion. But in a deeper sense, the underlying pol- icy intention has been the same in both places. Write to: Why the difference in outcomes? It must go SUBSCRIPTION SERVICES Finance & Development back in some way to politics—broadly de- International Monetary Fund fined. Perhaps differing degrees of urbaniza- Washington. DC 20431 USA tion or differing amounts of underlying in-

Finance & Development I September 1991 5

©International Monetary Fund. Not for Redistribution Lessons from Economic Development What have we karned about the path to successful development? Vinod Thomas

"uring the past 30 years, developing learned from the tremendously diverse Instead, the most crucial determinants appear countries have roughly doubled their average record. Rapid industrialization, pushed by the to be investments in human and physical cap- incomes and achieved striking gains in heavy hand of government through discrimi- ital, along with the strengthening of market health and education. A few have seen their nation against agriculture and infant-indus- competition. The Report concludes that coun- living standards rise fivefold, a rate of try protection, was a favored strategy for tries must strive to create a market-friendly progress that is extraordinary by historical many years. Today, there is clear evidence environment, in which governments allow standards. Several developing countries have that such distortions impede development. markets to function well, while intervening ef- managed to double average incomes in a ficiently when markets prove inadequate. much shorter time period than did the indus- trial countries in earlier periods of their de- Paths to development velopment (see Chart 1). Chart 1 Throughout history, the pace of develop- At the same time, the picture in many parts Periods during which output per ment has been influenced by factors beyond of the developing world has been dismal. person doubled In selected countries the control of individual countries. Over the Despite the vast technological advances of the past 30 years, the average growth of develop- Years 20th century, about one quarter of all devel- 0 10 20 30 ing countries has tracked the average growth oping countries have witnessed an actual fall of industrial countries remarkably (see United Kingdom, in living standards in the past 30 years. As a 1780-1838 Chart 2). Yet, faced with similar external fac- United States, result, more than one billion people, one fifth 1839-86 tors, individual countries have performed of the world's population, live on less than Japan, quite differently—in the past, some countries, 1885-1919 for example, Nigeria and Mexico, even re- one dollar a day—a standard of living that Turkey, Western Europe and the United States at- 1957-77 gressed after favorable price shocks. A study Brazil, tained 200 years ago. 1961-79 of 33 countries did not find a statistical asso- The sharp contrast between success and Republic of Korea, ciation between differences in growth rates 1966-77 failure is the starting point of the World China, and the magnitude of external shocks, and an Development Report 1991. Why have country 1977-87 analysis of 40 countries suggested that im- experiences been so different? The processes provements in domestic policies and institu- driving economic development are by no Source: World Bank, World Development Report 1991. tions could be a more powerful source of bet- means fully understood. But, much can be ter performance than improvements in external conditions. What actions, then, will promote rapid eco- nomic development in the 1990s? On the ex- The World Development Report 1991 has been prepared by a team led by Vinod Thomas ternal side, lower trade barriers, lower real in- that included Surjit S. Bhalla, Rui Coutinho, Shahrokh Fardoust, Ann E. Harrison, Daniel Kaufmann, terest rates, and larger capital flows will Elizabeth M. King, Kenneth K. Meyers, Peter A. Petri, T.N. Srinivasan, and N. Roberto Zagha. The improve development prospects for all. But, International Economics Department prepared the data and projections. Clive Crook was the principal edi- tor. Stanley Fischer played a principal role in the initial stages of the Report's preparation. The work was how well individual countries do under better carried out under the general direction of Lawrence H. Summers. global conditions—or even despite poor Copies are available from World Bank Publications, P.O. Box 7247-8619, Philadelphia, PA ones—will depend crucially on domestic fac- 19170-8619 USA, $16.95, in English, French, and Spanish. tors as elaborated below.

6 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution Domestic sources of growth Chart2 dicators, such as life expectancy, literacy, and infant mortality. In Chile and Jamaica, how- In more than 60 developing countries exam- The annual change in per capita GDP in ever, investments in people improved these in- ined, changes in the use of capital and labor OECD and developing countries, 1965-90 {in percent) dicators, even in periods of slow growth. made a large contribution to changes in out- These varying country experiences show that put. But, more significantly, differences in different levels of investments in human re- growth performance arose less from differ- source development and their quality have ences in the growth of capital than from strongly contributed to these differences (see growth in total factor productivity. Countries accompanying article by Elizabeth King). that have registered the highest growth Competitive microeconomy. Domestic rates—namely, the economies of East Asia— and external competition has very often were the ones with the highest productivity spurred innovation, the diffusion of technol- growth. In countries where growth has stag- ogy, and an efficient use of resources. Japan, nated, there has been little improvement in the Republic of Korea, Singapore, the United productivity. 1965 States, and Europe's most successful econo- But, what drives productivity? The answer mies have all established global competitive is technological progress, which in turn is af- advantage through the rigors of competition. Source: World Bank data. fected by history, culture, education, institu- Conversely, in much of the developing world, tions, and policies. Technology is diffused and systems of industrial licensing, restrictions on assimilated through investments in physical entry and exit, inappropriate legal codes con- and human capital and through trade. Pre- omy rewards those who build up their human cerning bankruptcy and employment, inade- liminary analysis links the growth in produc- capital more generously than does a distorted quate property rights, and price controls have tivity and output to education and economic one, and microeconomic efficiency makes it all weakened the forces of competition and policy. The levels of schooling of the labor easier to keep inflation low. held back technological change and the force significantly contribute to increases in Investment in people. Improving peo- growth of productivity. productivity and output. A better policy envi- ple's education and health is key to economic An efficient domestic economy also re- ronment also triggers higher productivity and performance, and therefore, to development. quires public goods of correspondingly high output. Increasing the quantity and quality of invest- quality. These include, most fundamentally, a The evidence goes further. In addition to ments in people thus rightly forms a central regulatory framework to ensure competition, the individual effects of education and policy part of the development agenda. But markets and legal and property rights that are both on productivity and growth, there seems to be in developing countries cannot be relied upon clearly defined and conscientiously protected. an interactive effect when they are combined to provide people—especially the poor—with In addition, investment in infrastructure, such (see Chart 2). Such an interaction appears adequate education, health care, nutrition, and as irrigation and roads, which provide high even stronger when considering productivity, family planning. returns, is essential. rather than output. These results do not show Many governments are investing far too lit- Global links. When international flows of causation, but they suggest the benefits of in- tle in human development with predictable re- goods, services, capital, labor, and technology vesting in education and improving the policy sults; in Brazil and Pakistan rapid growth have expanded quickly, the pace of economic climate simultaneously. alone was insufficient to improve the social in- advance has been rapid. Openness to trade, in- A detailed study of the World Bank's in- vestment, and ideas has been critical in en- vestment projects confirms the importance of couraging domestic producers to cut costs by policies in raising the efficiency of invest- introducing new technologies and to develop ments. The rate of return to public and pri- new and better products. The positive effect vate sector projects implemented under poli- of import competition on firms in, for in- cies that do little to distort prices is stance, Chile, Mexico, and Turkey, and consistently higher than under policies that greater competition in export markets on result in more distortions. A substantial im- firms in Brazil, Japan, and the Republic of provement in policy is associated with a 5-10 Korea confirm the decisive contribution to ef- percentage-point increase in the rate of return ficiency that the external economy can make. for projects, or a 50-100 percent increase in Removing barriers to international trade the average return. means that a country's own population is not Market-friendly approach a constraint to achieving economies of scale. Singapore, with a population of about 2.7 mil- In creating the best environment for lion, exports about $35 billion worth of manu- changes in productivity to take place, govern- factured goods annually—nearly twice as ments must look carefully at how the state much as does Brazil with a population of and markets interact. The four critical ar- about 147 million, or three times as much as Sources: International Currency Analysis, Inc., various eas—human resources, the domestic econ- years; World Bank data. Mexico with a population of about 85 million. omy, the international economy, and macroe- Note: High distortion reflects a foreign exchange premium The international flow of technology has of more than 30 percent; low distortion, a premium of 30 conomic policy—are interrelated, and because percent or less. Education is measured by the average taken many forms: foreign investment; for- years of schooling, excluding postsecondary schooling of such links, if handled properly, promise to of the population age fifteen to sixty-four. High education eign education; technical assistance; the li- is defined here as more than 3,5 years; low education, render disproportionate benefits. For exam- 3.5 years or less. censing of patented processes; the transmis- ple, a relatively undistorted domestic econ- sion of knowledge through labor flows and

Finance & Development I September 1991 7

©International Monetary Fund. Not for Redistribution It has often been argued that a democratic polity makes economic development more For policymakers everywhere: difficult to achieve. Reform almost always seven lessons in reform comes at the expense of certain vested inter- Successes provide the "dos," failures, the "don'ts." ests, and macroeconomic stabilization usually means at least a temporary rise in unemploy- ment: the claim has been that only authoritar- Lack of ownership undercuts the programs. For success, a program needs to be viewed as a coun- try's own, and nationals need to participate in its design and development. ian governments can make such hard choices. Flip-flops in reform hurt credibility. Flexibility is important, yet bold, seemingly irreversible steps This is patently false. Evidence from large by the government build confidence, especially in countries with a record of policy reversals. samples of countries offers no support at all Institutional demands must not be glossed over. Policymakers should emphasize the need for de- for the view that individual freedoms hold veloping institutional capacity from the outset, as institution building takes time. growth back. Neither does it endorse the no- Attention to macroeconomic instability is fundamental. In very unstable and inflationary settings, tion that authoritarian governments, on aver- up front and substantial reduction of the fiscal deficit is paramount. age, show greater promise for achieving rapid Vulnerable people must not be forgotten. Special programs of assistance to the poor must be put in growth. Looking beyond growth to the other place, and programs to compensate and retrain discharged civil servants are often needed when the elements of economic development, the lesson public sector retrenches. Partial attempts often fail. There is a premium on simultaneously taking complementary actions, of experience is clear: political freedoms, and such as external liberalization and domestic deregulation. civil liberties—such as a free press and the It pays to be realistic. Policymakers and external agencies need to be realistic in preparing the fi- free flow of information—seem to be associ- nancing plan to support the reforms. It also pays not to promise too much too soon, yet to be loud ated with progress in health and education in and clear about the importance of reforming. large groups of countries. Clearly, economic policies are not chosen in a vacuum. All but the most repressive govern- ments need to retain a measure of popular support for their actions. Often this support exposure to foreign goods markets; and tech- ments can meet the goals of microeconomic ef- has been bought with an assortment of dam- nology embodied in imports of capital, equip- ficiency and macroeconomic stability at the aging policy interventions (such as high tar- ment, and intermediate inputs. Policies to pro- same time. iffs, currency overvaluation, and industrial li- mote these flows include greater openness to censing), as well as corruption and wasteful investment and to trade in goods and ser- Rethinking the state public spending. One of the most questionable vices, as well as appropriate education and The experience in fostering investments categories of public spending is that on the on-the-job training. Nontariff barriers, which and better policies suggests how governments military. In many countries it is well in excess are especially distorting, need to be phased and markets can interact most productively of the combined public expenditures on edu- out, and tariffs reduced, often substantially. as well as avoid costly conflicts. Put simply, cation and health. Stable macroeconomy. A stable macro- governments need to do less in those areas Governments sometimes intervene in the economic foundation is one of the most impor- where markets work, or can be made to work, market to address political instability and tant public goods that governments can reasonably well. Governments need to let do- other political constraints. But the result is provide. When government spending has ex- mestic and international competition flourish. that all too often, the combination of perva- panded too far, the result has often been large At the same time, governments need to do sive distortions and predatory states leads to deficits, excessive borrowing, or monetary ex- more in areas where markets cannot be relied development disasters. A vicious circle of pansion, and problems in the financial sector. upon. Above all, this means investing in peo- harmful interventions entrenches special in- These have been quickly followed by infla- ple, building social and physical infrastruc- terests. Reversing this process requires tion, chronic overvaluation of the currency, ture, and protecting the environment. It also political will and a political commitment to and losses of export competitiveness. Exces- requires a strengthening of political and eco- development. sive borrowing can also lead to domestic and nomic institutions and more efficient policies Institutional development also assists in po- external debt problems and the crowding out for income redistribution and growth. litical and economic progress. The establish- of private investment. Strengthening the con- ment of a well-functioning legal system and fidence of the private sector is now a basic judiciary, and of secure property rights, is es- component of efforts to spur renewed growth sential. Reform of the public sector is a prior- and generate employment in several countries ity in many countries. That includes civil ser- with previous experience of macroeconomic vice reform, rationalizing public expenditures, instability, including Argentina, Bolivia, Vinod Thomas reforming state-owned enterprises, and priva- Indian, is the Chief Ghana, the Philippines, and Turkey. tization. Related economic reforms include Economist of the Bank's A government can maintain a prudent fis- Asia Region and was Staff better delivery of public goods, supervision of cal policy by looking carefully at the division Director of the World banks, and legislation for financial develop- of economic tasks between the government Development Report 1991. ment. Strengthening these institutions will in- and the private sector. That is desirable in He holds a PhD from the crease the quality of governance and the ca- any case. In reappraising their spending prior- University of Chicago and pacity of the state to implement development ities, implementing tax reform, reforming the has taught at Vassar policy and enable society to establish checks financial sector, privatizing state-owned en- College (USA) and the and balances. terprises, and using charges to recover the University of Sao Paulo. Experience also suggests that a relatively cost of some state-provided services, govern- equitable distribution of income and assets

8 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution broadens the base of political support for dif- institutions and achieving development. What start of the program, are more likely to suc- ficult changes. But caution is needed. Redis- are the lessons on the nature of economic re- ceed, whereas the social cost of not reforming tribution through distorting prices (such as form (see box)? Swift reforms help to neutral- rapidly can be very great, as Argentina, Cote subsidized credit) can be damaging, and the ize the resistance of interest groups opposed d'lvoire, Peru, countries in Eastern Europe, benefits often go to the less needy. Many of to change; at the same time, more gradual re- and others discovered in the 1980s. There is the policies recommended in the Report are forms may allow time to address their con- no single formula for success, but swift and expected to tilt the distribution of income in cerns. Countries such as Chile, Ghana, comprehensive reforms—with strong, accom- favor of the poor. Indonesia, the Republic of Korea, and Mexico panying measures to reduce poverty and pro- Finally, economic reform itself is an essen- show that packages of comprehensive reform, tect the environment directly—will usually be tial means for strengthening market and state with at least some bold changes made at the the right way forward. Q

Challenges in Human Development Elizabeth M. King Economist, World Bank

An the past century, vast progress has been achieved in social wel- Reducing poverty. More than one billion people in the develop- fare—the ultimate goal of development. This advance has usually ing regions today live in poverty. World Development Report 1990 taken place hand-in-hand with economic growth, but even where concluded that this number could be reduced by a two-part strategy of growth lagged, the quality of life improved. Governments have played labor-intensive economic growth and efficient social spending, which a leading role—public spending on classrooms and textbooks, safe together expand opportunities for the poor. But these may not be drinking water and sanitation, nutrition and immunization programs, enough. Safety nets may be needed to protect the most vulnerable and family planning clinics have been critical, especially for the groups. world's poor. But the demands of the future require better targeting, The role of the state new and more efficient methods of delivery, fewer regressive subsi- dies, and closer partnership with the private sector in the provision of Success in development requires a careful balancing of the roles of certain services. the government and the private sector across a broad range of policies. The agenda for human development in the 1990s differs widely The evidence shows that investing in people makes sense not just in from country to country. Even so, most countries face similar human terms but also in hard-headed economic terms. But in this area, challenges. more than in any other, except macroeconomic policy, the state must Slowing population growth. Nearly 95 percent of the growth generally take the leading role. in the world's population in the next 25 years will be in developing Over the past decade, social programs have come under severe fi- countries. High fertility rates and poverty together form a vicious cir- nancial pressure during economic adjustment programs. It will often cle that threatens the welfare, or even the survival, of their popula- make sense to shelter some social programs from short-term economic tions, especially mothers and children. Income growth has generally pressures for the sake of long-term investments in human development slowed population growth, but family planning programs and a rise in and the quality of life. education levels have made this possible even for poorer countries. Many well-designed and well-targeted programs have worked—and Improving health and nutrition. The World Health Organi- not necessarily with a heavy drain on public resources. Several coun- zation and UNICEF estimate that 43 percent of about 15 million child tries have encouraged community participation and support for social deaths each year could be prevented through vaccinations or other services. Korea's educational expansion in the 1950s shows that this low-cost interventions. But, apart from reducing infant mortality rates need not create inequities. In health, countries are experimenting with and increasing life expectancy, two other tasks are urgent: providing private insurance schemes as a way to meet the future demands, espe- nutrition to improve the mental and physical well-being of children cially for expensive curative care. Relying for some services on non- and adults, and improving the control and treatment of disease. One governmental organizations helps to broaden access to adequate edu- lesson is that creative delivery of nutritional initiatives pays off; a sec- cation and health care, but public subsidies, if any, should be linked to ond is that there is no single, off-the-shelf solution to designing a na- the quality of services provided. tional health strategy. Each country must choose the mix of curative When economies are badly managed, investments in people may go and preventive health services, and of public and private delivery that to waste. For example, countries that grew between 1975 and 1985 is most cost-effective in its institutional and epidemiological context. have infant mortality rates 25 percent lower than countries that did not Building technical capacity. Building and strengthening tech- grow. Policies that encourage innovation and investment, and that in- nical capacity—the ability of people to use and modify new and exist- crease the demand for workers who are better educated and better ing technologies—will be crucial in catapulting many countries on the trained, provide the crucial environment for development. • path toward sustained growth. The government could play two roles: expanding better-quality primary and secondary education, and devel- oping incentives to increase the supply of and demand for more spe- For a fulkr discussion of these issues, see "Investing in People," World cialized technical training. Development Report 1991, Chapter 3.

Finance & Development I September 1991 9

©International Monetary Fund. Not for Redistribution Economic "oes economic policy affect the long-run countries have per capita incomes below growth rate of nations, and if so, then how? those that existed at independence nearly This sweeping question has fascinated three decades ago. The daily calorie supply Policy and economists at least since Adam Smith pub- per capita declined over 1965-87 in 16 of the lished "The Wealth of Nations" in 1776. The 37 low-income countries. Ten countries—all existence of a large number of poor non-in- in Sub-Saharan Africa—have average levels Economic dustrial nations—which contain most of the of consumption below the poverty line sug- world's population—confirms the question's gested by the World Development Report obvious importance today. If economic policy 1990. Many Latin American countries are in Growth strongly affects the long-run rate of growth, the grip of the decade-long debt crisis, during then the cumulative implications of such pol- which per capita growth has been negative. A critical examination of icy for human welfare are such as to dwarf The average per capita growth rate of all de- the relative roles of culture, most other economic issues. This article ar- veloping countries in the 1980s was 0.1 per- gues that per capita growth will take place cent. Comparing the performance of these technological advances, only if the after-tax productivity of capital countries to the booming economies of East and economic policies and the rate of saving are high enough to Asia, one wonders whether economic policy keep up with population growth. Since capital could have made a difference to these sad out- William Easterly productivity is affected by economic policy, comes. policy determines not only the level of An influential recent trend in the growth, but whether growth takes place at economics literature—the so-called "new all. growth literature"—has been to argue that in- Although it is conventional to speak of all deed policy does have an important impact on non-industrial countries as "developing," less growth. This strikes some as obvious. Yet, than half of these countries show clear evi- the claim is more profound than it may ap- dence of consistent per capita GDP growth pear, because there are at least two good rea- over the past three or four decades. The table sons—closely interrelated—why it may not classifies countries according to whether they be true. First, growth may be determined have positive or negative per capita growth mainly by factors that do not respond to rates, and also whether their growth rates are economic policies, such as culture. Second, the "significant" in the statistical sense. "Signi- nature of economic production may be such ficant" growth means that the underlying that sustained growth is not possible without trend is sufficiently stronger than the year-to- such non-economic factors as technological year variation to allow one to confidently advances. identify an upward trend. We find that only 41 out of 87 developing countries had signifi- The role of culture cant positive per capita growth in the post- The idea that growth (and relative income war period (by contrast, all Organization for levels) depends mainly on culture has a Economic Co-operation and Development strong hold on popular conceptions. Certainly countries were found to have significant posi- many have noticed the strong correlation be- tive per capita growth over this period). tween growth performance or income level The implications of zero or negative per and non-economic characteristics of nations, capita growth are ominous. Some African such as a temperate climate, European ethnic

10 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution origin, or a Protestant religious establishment. vesting in capital. However, faster capital ac- the source of the continual increase in per With the recent success of East Asian nations, cumulation cannot be a permanent source of capita incomes. Higher or more efficient in- the list of cultural characteristics supposedly growth, because as the ratio of capital to labor vestment would cause a one-time increase in favorable to growth has been broadened to in- rises, less and less output is yielded by each output (and thus a temporary growth acceler- clude a Confucian ethical system. A more additional unit of capital. Most economists ation), but it could not raise permanently the elaborate version of the cultural hypothesis is find this plausible—if an office worker's pro- rate of growth. Since the level and efficiency put forward by Michael Porter of the Harvard ductivity is raised by one computer, and a lit- of investment is the only factor that responds Business School, who argues that an array of tle more by a second computer, it is unlikely to economic policy, this implies that policies business practices, corporate attitudes, geo- to be raised still further when the tenth com- have only a one-time effect on output, and not graphic accidents, societal and institutional puter arrives. Eventually, the additional pro- on the rate of growth. characteristics, and government behavior all duction yielded by additional investment Why should technological change not be re- determine the "competitive advantage of will be so low that per capita growth will ap- sponsive to policy? Again, the logic of Solow's nations." proach zero. approach is unavoidable. If technological Facile generalizations about culture and Since healthy per capita growth is in fact change were responsive to policy, this would growth are suspect on several grounds. First, observed in many countries over long periods, imply that it could be increased by greater the correlation between cultural characteris- Solow proposed that technological change is economic inputs. But as these inputs increase tics and income levels implies little more than relative to labor, the additional output they the obvious fact that industrialization has yield also falls to zero, so accumulation of been geographically concentrated. Naturally, these inputs could not be a source of per capita growth. Economic policy thus cannot geographic neighbors share many cultural Per capita growth performance characteristics. There are good economic rea- of developing economies affect technological change and overall sons why industrialization has been an un- and territories, 1950-85 growth. even phenomenon. Industrial production will The constraint posed by the limited supply tend to congregate in certain zones if there are Positive but Positive and of labor on economic growth is similar to that Negative insignificant significant benefits to industrial producers of locating growth growth growth posed by another input that has long preoccu- where other producers already exist. Differ- pied economists: natural resources. Since the ences in economic policy may determine Afghanistan Argentina Algeria days of Thomas Malthus, doubts have been Angola Bangladesh Barbados where these clusters form. After the fact, an Benin Chile Botswana expressed about the long-run feasibility of observer would notice the cultural character- Bolivia Congo Brazil continuous growth in view of the limited sup- istics of the industrialized zones and erro- Burundi C6te Burkina Faso ply of resources such as agricultural land and Central African d'lvoire Cameroon neously conclude that culture determined Republic El Salvador China hydrocarbon fuels. Analysis in the tradition of growth. Chad Ethiopia Colombia Solow has suggested that this constraint has Ghana Fiji Costa Rica been avoided through technological change Culture is also suspect as the driving force Guinea Guatemala Cyprus behind growth because we observe great dif- Guyana Haiti Dominican (still unrelated to economic policy) that ferences over time in a given country's Madagascar Honduras Republic increases the productivity of land and other Mali Jamaica Ecuador growth. The Republic of Korea hardly grew in Mozambique Kenya Egypt natural resources. per capita terms over 1913-50, but grew over Senegal Liberia Gabon The "new growth literature" has reinstated Somalia Mauritania Hong Kong an important role for policy by challenging 4 percent per capita over 1950-89. Culture is Sudan Mauritius India very slow to change but growth performance Zaire Nepal Indonesia the view that investment cannot be a source of is not—the correlation coefficient of growth Zambia Nicaragua Jordan growth. According to this view, external bene- Nigeria Korea rates across subsequent five-year periods is Papua New Lesotho fits and spillovers are associated with invest- very low in the postwar period. In addition, Guinea Malawi ment, which offsets the natural tendency of culturally similar countries with distinct poli- Peru Malaysia the productivity of capital to fall as the ratio Philippines Malta cies show very different growth rates, such as Rwanda Mexico of capital to labor rises. Paul Romer of the the two Koreas. Policies themselves could also Sierra Morocco University of California at Berkeley points out Leone Myanmar the importance of goods such as technological be determined by culture. But the same prob- The Pakistan lem remains—there is far more variability Gambia Panama blueprints that can be used an unlimited num- over time in policy than there could plausibly Togo Paraguay ber of times once the initial investment is Uganda Singapore be in culture. Uruguay South Africa made. Romer has also suggested that the tech- Sri Lanka nological knowledge gained in the course of Technology and economic growth Suriname making an investment raises the productivity Swaziland The best-known traditional growth model Syria of capital. This argument was originally sug- —that of Nobel laureate Robert Solow—ar- Taiwan Prov. gested by Nobel Laureate Kenneth Arrow, of China who called it "learning-by-doing." Robert gues that economic growth is determined by Tanzania technological change, which depends on non- Thailand Lucas of the University of Chicago has pro- economic factors such as scientific discovery Tunisia posed that the benefit to the general level of Turkey rather than economic policy. The logic is com- Zimbabwe knowledge from individual expenditures on pelling. In Solow's approach, total production education and training more than makes up 18 28 41 depends on labor and capital. Labor supply is for the diminishing productivity of capital as Source: Summers and Heston data set, Review of Income determined by the rate of population growth, and Wealth, March 1988. more and more is invested. which is assumed not to respond to economic A more general view is that the accumula- factors. Output can also be increased by in- tion of all of the inputs to production can be

Finance & Development jSeptember 1991 11

©International Monetary Fund. Not for Redistribution influenced by policy. Although the rate of property rights, low marginal tax rates on in- To get out of such a trap may require foreign population growth typically varies only come, market-determined prices, and a stable assistance, but even this assistance is unlikely within a narrow range, the productive contri- macroeconomic environment. to be effective unless policies are favorable to bution of labor can be raised virtually without In such an environment, the private sector growth, as described earlier. Even then, initial limit through investment in education, train- will be able to respond to rapidly changing progress may be slow because of the initial ing, and health. Investment in this kind of productive opportunities. A healthy level of low level of education and infrastructure, and "human capital" is conceptually no different investment will itself generate new invest- the low propensity to save at low incomes. from investment in "physical capital," such as ment opportunities, as investors learn about Over 1960-89, there were 25 decade-long plant and machinery. Moreover, the kind of new technologies during the process of invest- episodes of national per capita growth over 5 technological knowledge that is treated as im- ment. The technological advances that are so percent, but none of them began at per capita pervious to economic incentives in traditional spawned will tend to relax the constraints im- incomes below $500 (in 1985 prices). growth analysis can also be thought of as posed by labor and land, as technological ad- Governments can also play a positive role "capital" that can be accumulated through in- vances economize on the use of such fixed in- by themselves investing in capital that is un- vestment in research and development. puts. For example, the Green Revolution in likely to be provided by the private sector in a Although developing countries may use the developing countries occurred as farmers market economy, such as legal systems, basic mainly technologies from industrialized coun- responded to incentives to adopt new and health and education, roads, water supply, tries, they must still invest in adaptation of highly productive technologies that and electrical distribution systems. Such in- foreign technology to local conditions, a pro- economized on the use of land. vestments raise the productivity of private cess whose costs are often underestimated. Conversely, high implicit or explicit taxes capital and thus increase the incentive for pri- Finally, the effective contribution of natural on the rewards from making new investment vate investors. Public investment in railways resources can be increased through invest- can severely depress the amount of invest- and highways was instrumental in the devel- ments in improving their productivity (such ment that takes place. With low investment, opment of many countries, from the United as land improvement), or manufactured prod- there is little opportunity for learning about or States in the 19th century to Mexico and ucts can be substituted for them. This view of adapting advanced technologies. Low invest- Colombia in the 20th. The lack of such trans- growth implies that, far from being limited by ment can also worsen the problem of environ- portation investments is said to have severely "non-economic" factors such as population mental degradation. If there is not sufficient hampered development in countries like growth, natural resource availability, or tech- incentive for investing in advanced land-sav- Myanmar (formerly known as Burma). nological progress, growth responds perma- ing technologies, primitive technologies will Similarly, the lack of sufficient public infras- nently to the quantity and quality of invest- lead to deforestation and soil erosion. Those tructure in Nigeria has lowered private capital ments made in each country. developing countries where per capita growth productivity, because firms are forced to in- is absent—mostly in Sub-Saharan Africa— vest in their own inefficient electrical genera- How policy influences growth are generally those where political instability tors and water treatment plants. Given the focus on technology and human and traditional ownership systems imply high Efficiency and growth capital in the new views of growth, govern- uncertainty about property rights, and ments may be tempted to identify and subsi- marginal tax rates (sometimes implicit rather As mentioned earlier, policies that cause in- dize the right kinds of investment—those than explicit) in the modern sector are high. efficiency—less output for a given amount of they think have extra "learning-by-doing" Many of these same countries are also experi- inputs—have been traditionally thought to payoffs for technological progress or labor encing severe deforestation. lead to a one-time loss of output, but not to a productivity. Unfortunately, there is usually However, the new growth theory also raises permanently lower rate of growth. Calcu- little prior information about what kinds of in- the interesting possibility that a country's de- lations of this one-time loss seldom exceed 2 vestments will produce large technological or velopment depends in part on where it starts. percent of GDP. On these grounds, many have productivity benefits. Technological advances There may be large "start-up costs" to build- argued that inefficient policies—such as con- and the adaptation of foreign technology are ing a market infrastructure and forming an trols on prices and interest rates, high import notoriously characterized by surprises—ad- educated entrepreneurial elite or educated la- tariffs or restrictive import quotas, and differ- vances are made where they are least ex- bor force. Poor countries—such as those in ential tax rates for different activities—are pected, while highly touted technologies too Sub-Saharan Africa—may stay poor because not particularly critical to a country's long- often prove disappointing. Governments often they are unable to bear these start-up costs. run prospects. However, this view is incorrect, make things worse by spending resources according to some of the new perspectives on —resources that must be raised from taxes on growth. Less output for a given amount of in- private initiative—on artificially favoring puts implies that there is less left over to rein- "high technology." vest in further accumulation of inputs, if all William Easterly Governments can play a more positive role inputs can indeed be increased by investment. a US citizen, is Senior The drop in the amount available for invest- by creating an atmosphere where private in- Economist in the vestors, both domestic and foreign, have the Macroeconomic ment permanently lowers the growth rate. incentive to invest in increasing productive Adjustment and Growth The losses due to inefficient policies are com- capacity. Such an atmosphere is one where in- Division of the Bank's pounded, over time until the sacrifice of a dividuals can keep most of the rewards from Country Economics country's long-run welfare becomes very seri- their investment in new productive capacity, Department. He holds a ous indeed. whether it be their own education, the adapta- PhD from MIT. Inefficient policies such as subsidies, price tion of a new technology, the improvement of controls, and trade intervention imply that their land, or traditional investment in plant some investment will be directed into activi- and equipment. This requires clearly defined ties that have a low economic return, lowering

12 Finance & Development j September 1991

©International Monetary Fund. Not for Redistribution the average productivity of investment. With nomic instability tends to attract resources ward-looking India and Myanmar in Asia. a rapidly growing labor force, as in many de- into unproductive financial engineering and Growth in Brazil and Colombia accelerated veloping countries, low productivity of invest- speculation. The only good news about the re- with opening in the 1960s. Many studies have ment may imply an increase in income just sponse of the informal or traditional economy found that higher government consump- sufficient to keep up with the increase of the is that it can limit the damage resulting from tion—implying higher taxes, spent for unpro- population. Insufficient income is left over for misdirected government policies by evading ductive purposes—is associated with lower increased capital accumulation, so the econ- them, even if the damage still will be great. growth. Other studies have found that mea- omy would remain stuck at a low income For example, the interventionist government sures of macro instability, such as high and level. Conversely, efficient policies foster in- of Idi Amin caused formal sector output in variable inflation, are associated with lower vestments in activities with the highest re- Uganda to fall at 2 percent per year over growth. Finally, there have also been findings turns. With high productivity of investment, 1970-78, but the traditional sector continued that political repression or instability tends to income growth can exceed that of population to muddle along with 3.4 percent growth per lead to lower growth, perhaps because of the sufficiently to allow part of the additional in- year. A similar example is Peru in the last two implied uncertainty about keeping the re- come to be reinvested, establishing a virtuous decades, where Hernando de Soto in The wards to one's investment. circle of growth. Other Path has documented a thriving under- The responsiveness of growth to economic A particular type of inefficiency common in ground economy in the face of complex con- policies suggests there is hope for reversing the developing countries reflects policies that add trols over the modern economic sector. poor growth performance experienced by most to the diversion of resources to a parallel or The evidence that inefficient policies have developing countries in the 1980s. Multilateral underground economy. These include high permanent effects on growth is substantial. institutions such as the World Bank and IMF taxes in the formal sector that tend to drive Numerous studies have found that trade inter- can contribute to the revival of growth by pro- production underground where it can escape vention tends to lower growth. For example, viding capital to help cover "start-up costs" taxes. Quantitative allocation of inputs at sub- Argentina grew rapidly in its neutral, out- and by providing support for reform of ineffi- sidized prices causes resources to be invested ward-oriented phase prior to 1930; it has stag- cient government policies, the achievement of in lobbying for these inputs. Controls on the nated as it turned inward. Outward-oriented macroeconomic stability, and the creation of es- financial system combined with macroeco- Thailand and Malaysia have outperformed in- sential public infrastructure. •

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Finance & Development j September 1991 13

©International Monetary Fund. Not for Redistribution Governance and the Development Process While much debated, better governance is being seen by external agencies and domestic partners as essential for sustainable development Pierre Landell-Mills and Ismail Serageldin

VJTovernance—the exercise of political The Bank's report recognized two distinct fore issues of technical management and ac- power to manage a nation's affairs—is being but intimately intertwined dimensions of gov- quisition of skills. It also highlights the need increasingly identified as a critical determi- ernance: one is political (related to the degree for institution building in the broadest sense nant of the economic performance of develop- of genuine commitment to the achievement of and for adequate public investment in human ing countries. The dominance of quantitative good governance and the need to arbitrate eq- resource development. economics in the development debate in re- uitably among competing interests), and the The state plays an indispensable and po- cent years is seen as having led to the neglect other is technical (related to issues of effi- tentially creative role in establishing the envi- of crucial issues of political economy and the ciency and public management). ronment for economic activity, thereby deter- role of institutions. An interdisciplinary ap- mining the distribution of assets and benefits. proach may lead to a better understanding of State and society This role also implies the possibility that the the factors blocking development. The current widespread trend toward the apparatus of government may be captured by The upsurge of interest in governance re- disengagement of the state from productive a self-serving elite to plunder a nation's flects five reinforcing perceptions. First, the activities, while re-emphasizing the state's wealth, thus obstructing development. success of market economies is being con- crucial responsibilities in providing public, In most societies, deep social divisions trasted with the failure of centralized plan- social, and infrastructural services and creat- must be reconciled if the conditions for good ning. Second, in many countries, popular dis- ing an enabling environment for private oper- governance are to be established. Governance content at the abuses of authoritarian regimes ators, is having a major impact on issues of often involves compromises and conse- is spurring a search for more democratic and governance. Privatization and economic liber- quently even a competent and well-inten- responsive forms of government. Third, the alization significantly reduces the power of tioned regime may not be able to fully achieve inefficiencies of state enterprises and public state bureaucrats. So does the new popular the conditions for good governance. Unfor- agencies at a time of fiscal crisis have policy of decentralization of governmental ac- tunately, ethnic disputes are at times deliber- prompted a re-examination of the role of the tivities that "empowers" local communities ately exaggerated to mask the rapacious ac- state. Fourth, there is heightened concern (i.e., gives them more opportunities to decide tions of the ruling elite and their supporters. that widespread corruption is siphoning on matters that affect them), who are then ex- However, sheer lack of capacity also limits away both domestic and foreign aid re- pected to assume greater responsibilities for the ability of public authorities to fulfill their sources. And fifth, a resurgence of problems delivery of public services. responsibilities, even when they are fully of ethnicity is greatly complicating the task of But empowerment will not assure better committed to the task of nation building. nation building. governance unless the responsible public Economic and social progress are not the In the World Bank's 1989 report on Sub- agencies are competent. This brings to the only objectives of good governance. Civil lib- Saharan Africa, "From Crisis to Sustainable erty and the ability to participate in the politi- Growth," issues of governance were broached cal system can also be viewed as elements of with unprecedented frankness. Governance a full and meaningful life that should con- was seen as encompassing a wide range of tribute to the well being of individuals and concerns: the effectiveness of a state's institu- the development of societies. tional arrangements, decision-making pro- Sovereignty and interdependence cesses, policy formulation, implementation capacity, information flows, and the nature of Although the quality of governance is a the relationship between rulers and the ruled. key determinant of a country's development

14 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution performance, donors have been reticent in the no demonstrable direct correlation between of the ultimate beneficiaries of development past to address issues of governance lest they development and democracy, to be effective projects and programs that they finance in be seen as interfering in a country's internal agents of development, governments need to both design and implementation. There is affairs. However, in an increasingly interde- be perceived as legitimate through some form now a wide consensus in the development pendent world, no state can develop in isola- of political accountability. The classic mecha- community on the desirability of such partici- tion from the global order. Poor countries are nism for ensuring political accountability pation and few governments would openly particularly vulnerable to events in the rest of built into most constitutions is to subject the oppose the concept. Nonetheless, even for the world. Consequently, they have come to political leadership (and even other public offi- regimes that were not notably repressive, depend heavily on the international commu- cials at the national, provincial, and local lev- such grass-roots "democratic" initiatives have nity for financial and technical assistance for els of government) to a credible electoral pro- frequently been regarded as potentially their development. As donor governments cess with limited periods in office. External threatening. and their publics are becoming increasingly agencies can assist, and indeed are currently A sound judicial system. There are few aware that their assistance is greatly affected assisting, in promoting political accountabil- aspects of governance where consensus is by the quality of governance in the recipient ity in various ways. First, by helping to medi- more firmly established than on the need for countries, they have become more and more ate conflicts and second, by helping to orga- an objective, efficient, and reliable judicial concerned to promote better governance. This nize and monitor elections. Occasionally, system. An essential concomitant is the cre- has raised the issue of sovereignty. donors have acted by withholding external fi- ation of honest law enforcement agencies and The concept of sovereign nations underlies nancial support from governments that have a speedy and affordable court administration. all aspects of the present international order. clearly lost popular support to the point where Some external aid agencies have been reluc- Nonetheless, sovereignty is constrained by a they cannot govern effectively. tant to assist in strengthening judicial sys- web of international, multilateral, and bilat- Freedom of association and partici- tems because the link to development is seen eral agreements that create mutually binding pation. Closely allied to the preceding con- as indirect. More particularly, it is feared that obligations within an established system of cern is the question of whether a country's cit- involvement in law enforcement will risk as- international law. Since poor countries gener- izenry enjoys the freedom to organize sociation with inequitable or unjust law en- ally have fragile polities and weak systems of according to specific interests. Institutional forcement. While very real, these risks can be accountability, with few autonomous institu- pluralism can be seen as an important mecha- exaggerated compared to the importance of tions and little countervailing power to that nism for diluting and disseminating exclusive instituting legal accountability. A sound judi- exercised by the government at the center, ex- central political power. But it is not always cial system is a prerequisite for effective polit- ternal donors and development agencies have conducive to stability, particularly where peo- ical and bureaucratic accountability. the potential to exert considerable influence in ple have shown a strong tendency to organize Bureaucratic accountability. To be promoting good or bad governance. This can along ethnic lines. fully effective, measures to achieve political embroil them in fundamental issues, such as At the national level, freedom of association and legal accountability need to be accompa- the link between government and the gov- means the freedom to establish religious nied by additional arrangements to make bu- erned, and between state and society, which groups, professional associations, women's reaucracies more accountable. This requires are both culturally and politically sensitive. groups, and other private voluntary organiza- monitoring the performance of public agen- Given the risk of ethnocentric and cultural tions to pursue political, social, or economic cies and officials and an effective, and politi- bias, external agencies need to be extremely objectives. Clearly, it is the latter three that cally autonomous system dedicated to correct- cautious in proposing specific solutions for would be of principal interest to external ing bureaucratic abuses and inefficiencies. improving governance. Through dialogue and agencies concerned with assisting develop- A critical dimension of bureaucratic ac- analysis, options can be examined, but ulti- ment. Donors can provide critical financial countability is transparency. This implies, for mately it must be the responsibility of the and technical assistance to such organiza- example, making readily available for public sovereign state to determine its own home- tions, which can empower groups that are oth- scrutiny all public accounts and audit reports grown solutions. For their part, external agen- erwise marginalized within the existing politi- (including those of all parastatal organiza- cies, within the legal limits of their statutes, cal and economic system. Surprisingly little tions), a practice that many public officials have an obligation to judge whether those so- has been done in this sphere, mainly because strongly resist and donors increasingly de- lutions appear credible, to assist and monitor this aspect of institution building has not at- mand. So basic is this to the concept of good their implementation, and to modulate their fi- tracted significant donor attention. governance that the question of sovereignty nancial assistance accordingly. The situation is different at the local level. should not arise. Every citizen, as well as ev- Considerable assistance has been successfully Fostering better governance ery donor, has a right to expect transparency provided by donors to grass roots community in the management of public funds. Although there are many different views as organizations and cooperatives, often chan- At the core of bureaucratic (and political) to what constitutes good governance, some of neled through nongovernmental organiza- accountability is the need for rigorous sys- which are ethnocentric or culturally deter- tions (NGOs). The involvement of foreign tems of financial management and procure- mined, it is possible to specify a minimal core NGOs may reduce the risk of corrupt local ment, with swift and tough penalties for of characteristics that are generally agreed counterparts, but ultimately systems of ac- malfeasance. Sound methods of accounting upon. These are discussed below. In large countability must be built into the institu- and auditing, and of customs duty and other measure, these derive from, or are related to, tional design of each organization (e.g., the revenue collection, are readily available. The the Universal Declaration of Human Rights, self-policing of cooperatives via cooperative same is true for procurement. External aid which can be viewed as representing the unions, as happens in the Cameroonian credit agencies have been too often tolerant of finan- moral consensus of the international commu- union movement). cial abuse and indeed have at times indirectly nity of nations. This leads to the broader role of external shown complicity in corrupt practices by re- Political accountability. While there is agencies in promoting the active participation sponding to improper pressures from their

Finance & Development / September 1991 15

©International Monetary Fund. Not for Redistribution own suppliers. The financing of unwarranted with poor results. International and multilateral insti- "commissions" by export credit agencies is The failure of external assistance for public tutions. Since, except in the case of the newly but one example. management is partly because political com- created European Bank for Reconstruction Fostering markets and helping to create mitment was lacking, but it is also due to the and Development, the statutes of international quasi-market mechanisms (e.g., contracting poor design of the interventions. Two under- and multilateral institutions expressly rule out the provision of services such as refuse lying features merit attention: first, capacity out political considerations, the focus of their collection or road maintenance, through com- building is a long-term venture and external action must be on the technical aspects of gov- petitive bidding procedures) is also a useful agencies need to evolve approaches that will ernance. Thus, the World Bank and UN way to foster accountability, and donors can enable sustained long-term support programs Agencies have been active in assisting coun- usefully support such initiatives. Other instru- to be adopted. Second, external agencies can- tries in strengthening their public administra- ments that can be considered include the not be fully effective unless they adopt a col- tion (including the administration of justice), appointment of ombudsmen and watch-dog laborative approach in partnership with the reforming public enterprises, and building in- committees, holding public hearings, and governments concerned. Much is to be gained stitutional capacities. This is entirely the right conducting opinion polls. In addition, loosen- from a more concerted effort to help govern- focus, though much more could be done to im- ing administrative controls and simplifying ments define clearly a single comprehensive prove the effectiveness and sustainability of the regulatory framework may facilitate com- program of administrative reform and capac- technical assistance in this area. In addition, petition and reduce the opportunities for ity building that all concerned can support. there has been increasing effort to promote in- corruption. Examples of such programs abound—includ- stitutional pluralism by fostering local gov- Freedom of information and expres- ing in Ghana, Gambia, the Central African ernment, NGOs, and grassroots organizations sion. Openness is crucial for accountability. Republic, and Madagascar, to name but four with the objective of mobilizing local human The need for the free dissemination of infor- in Africa supported by the World Bank. The and financial resources in the provision of mation goes well beyond facilitating account- African Capacity Building Initiative—to build community services. This support for institu- ability. Efficient markets depend on good in- a critical mass of African policy analysts and tional development can usefully be extended formation as does the exercise of freedom to economic managers and to set up or rejuve- to assisting the growth of other private participate in economic and political decision- nate local management institutions—recently voluntary organizations, such as professional making. Unfortunately, vital data such as that launched by a group of donors is a good ex- associations and chambers of industry and relating to national accounts, trade, balance of ample of what can be done. commerce. payments, employment, cost of living, house- Bilateral agencies. Such agencies may hold expenditures, and the like are frequently Roles of external agencies choose to use their influence to promote politi- withheld by governments from their citizens, There are many different categories of ex- cal accountability and respect for human and yet openness is essential for a soundly ternal agencies and each has its distinct role in rights. This would be most effective if it were based public debate of the performance of a fostering better governance depending on its focused particularly on encouraging the rule government and its agencies. Informed policy mission and mandate. External agencies gen- of law. Helping to organize fair elections by discussions are at the heart of a healthy politi- erally can more easily address the technical as- furnishing both resources and observers is an- cal process. Moreover, good social and eco- pects of governance, but by no means exclu- other possibility. The practice of supporting nomic data are important for business plan- sively so, depending on their nature. particular political parties, however, clearly ning, while their absence is a hindrance to undermines good governance by distorting development. the political process. There are many ways for external agencies Important opportunities exist for bilateral to assist in the collection and dissemination of donors to promote honest government by economic and social data and other informa- Pierre Landell-Mills channeling funds in ways that reduce the tion needed for informed public debate. Yet, British, is Senior Policy chances of corruption. This could be done by their efforts in this field so far have been Advisor, Africa Technical untieing aid from procurement restricted to Department of the Bank. slight. The need is for sustained and coordi- the donor country, by insisting on open com- nated programs to assist in building national petitive procurement procedures, and by out- capacities for data collection and dissemina- lawing bribery or the payment of excessive tion, as well as to encourage public debate by "commissions" by their suppliers. The United financing seminars and public information States has taken the lead on this, but other programs. It is not enough for the information members of the Organization for Economic to be available; analysis and research are also Co-operation and Development have so far needed, and this should not be a monopoly of been reluctant to follow. Ismail Serageldin Nongovernmental organizations. There the state. Donors can contribute to this Egyptian, is Director, process by funding independent research or- Technical Department in are two special contributions that industrial ganizations and by supporting the autonomy the Africa Region of the country NGOs can make to promote better of the universities. Bank. governance. One is to support developing Capacity building. Good governance re- country NGOs and hence foster pluralism. quires not only political commitment and sys- The second is to campaign against human tems for ensuring accountability, the sound rights abuses in a manner that is seen to be administration of justice, and freedom of in- completely apolitical. Amnesty International's formation, but also competent public agen- efforts in this area are well known. cies. This is an area where external agencies Another category of activities where NGOs have been active for many years, but still can play a key role is to foster twinning ar-

16 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution rangements or networks between groups in inertia, it is sometimes useful to set a become less predictable and efficiency can be different countries with common concerns or timetable for specific agreed actions (consid- reduced. Over the longer term, however, most shared missions—this could cover profes- ered to be crucial for the achievement of pro- links may be mutually reinforcing. sional associations, trade unions, chamber of gram objectives) linked to the release of exter- The pace of change is likely to be strongly commerce and industry, and other special in- nal funds. Moreover, in certain instances, the influenced by economic circumstances. Eco- terest groups. weight of the donor community may be nomic crisis can precipitate radical political needed to counterbalance the private agendas change and lead to a rapid change in the per- Persuasion not coercion of the ruling elites. ception of what is and what is not possible. It While recognizing that the world order re- The effectiveness of external interventions can also provide an opportunity for bold and mains strongly anchored to the principle of will be a function of their sensitivity to local rapid transformation of societies. A number of the sovereignty of nations, external agencies conditions and the degree of popular local developing economies have begun to take can contribute significantly to fostering good support that is engendered. Although close that opportunity. Their experience may serve governance in those countries seeking their coordination among agencies is a prerequisite to guide others along the path to good assistance. Their role in this regard is likely to for a coherent approach, the success of exter- governance. • generate much debate internally and in the nal interventions is likely to depend mainly on countries that they seek to help. As a general persuasion and on the progressive evolution principle, institutional reforms are unlikely to of internal power structures brought about by be sustained unless they are home-grown and education, income growth, and pluralistic in- underpinned by a genuine political commit- stitutional development. A detailed paper on this topic was presented by the ment. Thus, it is self-evident that a collabora- The many facets of good governance are authors at the World Bank Annual Conference on tive approach is likely to be more effective not all conceptually independent nor are they Development Economics in April 1991 in than coercion over the long run. To be sus- invariably complementary. Conflicts may eas- Washington, DC. The proceedings of the conference tainable, reforms cannot be imposed. How- ily arise, at least in the short run. If open and will be published in a supplement of the World Bank ever, as has been the case in the context of participatory processes are pursued, for exam- Economic Review and the World Bank Research structural adjustment lending, to overcome ple, government policies may temporarily Observer in 1992.

THE

The growing integration of capital markets has strengthened DETERMINANTS incentives for greater international coordination of economic and financial policies. Structural changes in these financial AND SYSTEMIC markets, however, may have undermined the effectiveness of monetary and fiscal policy and complicated market CONSEQUENCES access by developing countries. These are among the findings of this study of capital flows in the 1970s and OF 1980s, which is Number 77 in the IMF's Occasional Paper INTERNATIONAL series. CAPITAL FLOWS Available in English. ISBN 1-55775-205-2. 1991.

by US$10.00.* Morris Goldstein Donald J. Mathieson (An academic rate is available only to individual full-time students and and faculty of degree-granting universities and colleges: US$7.50.)

Timothy Lane To order, please write or call: INTERNATIONAL MONETARY FUND Publication Services Telephone: (202) 623-7430 Box FD-102 Telefax: (202) 623-7201 700 19th Street, N.W. Cable Address: INTERFUND Washington, D.C. 20431 U.S.A.

Finance & Development / September 1991 17

©International Monetary Fund. Not for Redistribution Exchange Rate Policy and the IMF How, within its broad responsibilities, the IMF assists its members in choosing an exchange arrangement and implementing exchange rate policy David Burton and Martin G. Oilman

.1-rfxchange rate policy is of more than aca- the IMF assesses the appropriateness of ex- their economic and financial policies at foster- demic interest to many people. After all, the change rate policy and formulates its policy ing orderly underlying economic conditions, exchange rate—a key price in any econ- advice. As developed and developing coun- orderly economic growth, and reasonable omy—affects the cost of imported goods and tries alike ponder how best to conduct ex- price stability—all seen as essential for main- the profitability of export industries, influenc- change rate policy, the IMF is finding that taining a stable exchange rate system. ing the rate of inflation, output, and employ- there is no single policy prescription—rather, Since the mid-1970s, there has been a ten- ment. The choice of exchange arrange- advice must be tailored to fit the policy priori- dency among member countries to adopt or ment—that is, whether the exchange rate is ties and institutional realities of the country maintain exchange regimes that in principle pegged, floating, or something in between— concerned. allow greater flexibility. While currency pegs also influences the extent to which an econ- accounted for 82 percent of the arrangements omy is affected by booms and recessions Evolution of arrangements in 1975, they declined to 72 percent in 1983, abroad and defines the scope for independent Although exchange rate policy cannot be and 66 percent in 1990 (these include the CFA monetary policy at home. viewed in isolation from other macroe- franc zone and the Common Monetary It is not surprising, therefore, that ex- conomic policies, narrowly defined, it con- Area—both in Africa—and the Eastern change rate policy has long been a controver- cerns the way in which the domestic currency Caribbean Central Bank). The growing cate- sial subject, no less so in recent years when price of foreign currency is determined. From gory of countries maintaining more flexible practical questions about exchange rate pol- the time of the establishment of the IMF until arrangements embraces a wide variety of icy have come to the fore. Eastern European 1973, the international monetary system was schemes. Most of them follow a "managed" countries have introduced new exchange sys- based on par values—the original Bretton float (i.e., the authorities adjust the rate peri- tems as part of their radical programs of Woods system. With a few exceptions, mem- odically in a discretionary manner), although structural reform. Participation in the ber countries maintained a par value for their the actual flexibility of the rates ranges from Exchange Rate Mechanism of the European currencies in terms of gold, either directly or those that behave as if they were pegged to Monetary System has expanded, with the indirectly through a peg to the US dollar. those where the nominal rate can appreciate members seeing advantages in exchange rate Under this system, a par value could only be or depreciate relatively freely. Other types of stability. And many African and Latin changed if, after consultation with the IMF, it flexible arrangements include: (1) the EMS, American countries have been questioning in- was established that exchange rate action where members' rates are pegged to each flation-linked devaluations, which often seem- was necessary to correct a "fundamental dise- other but the system floats independently ingly lead to ever higher rates of inflation in quilibrium." against outside currencies; (2) independent the absence of sound domestic policies. With the breakdown of the Bretton Woods floats, such as those followed by Japan and At the center of the debate sits the IMF, system, as a result of growing financial the United States, where the official exchange which, under its founding Articles of strains and external imbalances, the world rate is determined essentially by the market Agreement, shoulders major responsibilities moved to what has become known as a sys- with only very limited efforts at management in this area. It is charged with: tem of "generalized floating." This implies or intervention; and (3) adjustment of the rate • overseeing the international monetary that there is no numeraire, or anchor, for the according to a predetermined set of indica- system in order to ensure its effective opera- system as a whole, a role previously played tors, as is done by Chile and Madagascar. tion; by gold. Even so, individual countries are free One complication, however, is that a large • ensuring that members collaborate with to peg their currencies to any other currency number of developing country members it and other members to assure orderly ex- or basket of other currencies, such as the —about 40 in 1990—maintain dual or multi- change arrangements and promote a stable IMF's Special Drawing Right (SDR), or to al- ple official exchange markets (among indus- system of exchange rates; and low the exchange rate to vary according to trial countries, Belgium and Luxembourg ter- • helping to establish an unrestricted mul- market forces or some other type of adjust- minated their long-standing dual market in tilateral payments system; indeed, the IMF is ment mechanism. The freedom of IMF mem- May 1990). In addition, parallel exchange endowed with jurisdictional responsibility for bers to choose their exchange arrangement markets, which differ in the extent to which limiting the use of exchange restrictions by was formally authorized in the Second they are officially tolerated, exist in about 70 member countries. Amendment to the IMF's Articles in 1978. At member countries where access to the official This article attempts to clarify these exten- the same time, the amended Articles empha- exchange market is restricted. To the extent sive responsibilities, as well as to explain how sized the need for member countries to direct that a significant proportion of external trans-

18 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution cult to apply in practice as they depend on both the policy objectives of the authorities and the nature of the shocks to which the economy is prone. (For a detailed discussion, see publication listed in box.) There is also an important unresolved issue as to whether a pegged rate, by providing a visible nominal anchor, is more conducive to the maintenance of financial discipline than a more flexible ar- rangement. Indeed, the available evidence suggests that both flexible and pegged rates can be consistent with price stability. In general, therefore, IMF staff have abided by a member country's preferred arrange- ment, and tailored their overall policy advice accordingly. For example, in countries where a particular exchange arrangement may rule out changes in the exchange rate (e.g., mem- actions take place at parallel exchange rates, change rate policy has to be judged in the con- bers of a currency union), the burden of any the classification of the official arrangement text of a comprehensive analysis of a coun- external adjustment required must fall on may in some cases thus be misleading. try's economic situation. Such an analysis al- budgetary and monetary policies, incomes lows the IMF to assess the consistency of policy, and structural measures that would Role of the IMF exchange rate policy with a country's external help to contain costs and improve competi- Member countries are obligated to notify and domestic policy goals. And it makes pos- tiveness. Where an exchange rate change is the IMF of their choice of arrangement, infor- sible an evaluation of whether a country's ex- possible, the staff may recommend that ap- mation that is then used as part of the bilat- change rate policy can be maintained without propriate financial policies be used in combi- eral and multilateral surveillance process. The the imposition or the tightening of exchange nation with an exchange rate depreciation to IMF's Executive Board regularly devotes ses- (and trade) restrictions, which would impede achieve an improvement in the balance of sions to exchange rate policy, with discus- the international free flow of goods and capi- payments. sions tending to focus on developments in in- tal and tend to distort relative prices and re- In some cases, the economic and institu- dustrial countries. Exchange rate develop- duce economic efficiency, thereby adding to tional circumstances and policy priorities of a ments are also analyzed in the semi-annual inflationary pressure at home. country may suggest a particular exchange World Economic Outlook, which provides the While assessments cover a broad range of arrangement. For example, a pegged ex- basic analytical framework for the IMF's re- policies and have devoted increasing attention change rate as a nominal anchor may be at- view of the world economy and the exchange to structural issues, they typically focus on tractive when reducing inflation is particu- system as a whole and which is discussed by the stance of fiscal and monetary policy, be- larly important, whereas greater exchange the Executive Board. On the national level, cause over the years, the IMF has found that rate flexibility may be necessary if interna- the main vehicle for surveillance is the Article disciplined domestic financial policies are the tional reserves are at a low level and strength- IV consultation, a sort of annual check-up for necessary prerequisite for the maintenance of ening the balance of payments is a top prior- member countries, which usually concludes relatively stable exchange rates and the ity. The role played by such considerations is with an Executive Board discussion of the avoidance of restrictions. A review of recent illustrated by the different exchange rate poli- country's economic situation and policies, individual consultations with members sug- cies adopted by Eastern European countries with particular attention given to exchange gests that assessments of exchange rate pol- that have recently embarked on radical re- rate policy. The Board's views are then con- icy, broadly defined, are more likely to be un- form programs. veyed to the member's Government in the favorable in cases with relatively large fiscal In Poland, for example, in late 1989, when form of a summing up by the Chairman of the deficits and/or rapid credit expansion. In this the stabilization and reform program was be- Executive Board as well as by its Executive setting, unsustainable balance of payments ing formulated, price increases were spi- Director. deficits are likely to emerge, which without ralling out of control, making the reduction of The advice provided by the IMF, in terms policy correction, would lead to the intensifi- inflation a top priority. At the same time, a of the appropriateness of exchange rate cation of exchange restrictions, the emergence substantial proportion of domestic financial policy, reflects not only the diverse economic of a parallel exchange market, rising inflation, assets were denominated in US dollars, re- structures and varied exchange arrangements and a depreciating exchange rate in some flecting the erosion of the zloty's value. of members but also the IMF's overall objec- combination, depending on the nature of the tives: (1) to help promote orderly growth and exchange arrangement. reasonable price stability in individual mem- Policy advice ber countries; (2) to help members correct mal- adjustments in their balance of payments; and The IMF's exchange rate policy advice For a fuller discussion, see "Exchange Rate Policy (3) to promote the expansion of world trade, roughly falls into four general areas: in Developing. Countries," by Bijan Aghevli, Moshin as a means of helping to create favorable con- Choice of exchange arrangement. Khan, and Peter Montiel, IMF Occasional Paper ditions for sustained economic growth and While economic theory provides some general No. 78, $15 ($12 for academic orders), available high employment in member countries. principles on which to base a choice of an op- from IMF Publication Services, Washington, DC Viewed from this broader perspective, ex- timal exchange arrangement, these are diffi- 20431, USA.

Finance & Development I September 1991 19

©International Monetary Fund. Not for Redistribution Initially, the authorities devalued the zloty, as adopted a similar exchange rate strategy in the real exchange rate—adjusting the nominal a way of ensuring adequate competitiveness early 1991, as part of its radical reform pro- exchange rate to offset any deviation of do- in light of price and trade liberalization. But gram, pegging to a basket of currencies after mestic inflation from that in partner coun- then the exchange rate was pegged to the US an initial devaluation, even though its reserve tries—may leave an economy without a nomi- dollar, as it appeared that such an arrange- position was somewhat less strong. nal anchor and could lead to high inflation, ment—supported by restrained monetary and By contrast, Bulgaria and Romania, both of particularly if financial policies are lax. The fiscal policies—could be effective in providing which embarked at the start of 1991 on bold objective of real exchange rate targeting is to a nominal anchor for prices and restoring con- reform programs supported by IMF arrange- preserve competitiveness, thereby protecting fidence in the domestic currency. In May ments, adopted flexible exchange rate sys- the balance of payments. But a danger is that 1991, after inflation had been substantially re- tems. In both countries, the choice of a the targeted level for the real exchange rate duced, the zloty was devalued by 14 percent floating rate—Romania also temporarily may be too low—it is difficult to know what and pegged to a basket of five currencies. maintained a pegged rate for certain transac- the equilibrium real exchange rate should be, The use of a pegged exchange rate as a tions—was conditioned by the very low level especially as it is affected by many domestic nominal anchor was feasible in Poland's case of international reserves at the start of the and foreign shocks—with a nominal deprecia- because its international reserves were at a program, the limited availability of external fi- tion resulting principally in higher prices. The reasonable level when bolstered by the avail- nancing, and, given the extent of the distor- higher prices in turn may trigger a further de- ability of a secondary line of defense in the tions to be removed under the program, major preciation of the exchange rate under the real form of a $1 billion stabilization fund, pro- uncertainties about what would be a sustain- rate rule, possibly leading to a spiral of rising vided by a group of countries to help support able exchange rate. inflation and further depreciations. To the ex- the reform effort. Yugoslavia followed a simi- While the IMF recognizes that a variety of tent that increases in the money supply can be lar approach in late 1989 when, as part of its flexible exchange rate systems may be appro- fueled by a balance of payments surplus, such adjustment program, the dinar was pegged to priate in certain circumstances, there has been a spiral could arise even with non-accom- the deutsche mark. Czechoslovakia also growing concern that policies, which target modative credit policies. Similar problems can arise if exchange rate policy aims to limit the differential with a parallel exchange rate to less than a target amount. Appropriateness of a particular rate under a pegged or managed arrange- ment. In evaluating pegged exchange rate systems, the question frequently arises whether an adjustment to the level of the peg is needed, especially in cases where a country Peg: single currency (46). The country links its exchange rate to the value of a major cur- has a current account deficit too large to be fi- rency—usually the US dollar or the French franc—but does not change the rate frequently. nanced on a sustained basis. The assessment About one half of all developing countries have such an arrangement. generally depends on the magnitude of the re- Peg: currency composite (40). A composite, or basket, is usually formed by the currencies of quired reduction in the deficit and on the major trading partners to make the pegged currency more stable than if a single-currency peg were used. Currency weights may be based on trade, services, or major capital flows. About downward flexibility of prices and wages. An one fourth of all developing countries have composite pegs. improvement in the current account usually requires a reduction in the relative price of Flexibility limited vis-a-vis single currency (4). The value of the currency is maintained nontraded to traded goods, which is difficult within certain margins of the peg. This system is currently used by four Middle Eastern to achieve without a depreciation in the ex- countries. change rate if wages and prices are sticky Flexibility limited: cooperative arrangements (10). This applies to countries in the exchange downwards. rate mechanism (ERM) of the European Monetary System (EMS) and is a cross between a peg Generally, where the imbalance is relatively and a float; EMS currencies are pegged to each other, but float otherwise. small, the IMF advises that reliance should be placed on fiscal and monetary policy to reduce More flexibk: adjusted to indicator (5). The currency is adjusted more or less automatically domestic demand relative to output, thereby to changes in selected indicators. A common indicator is the real effective exchange rate that restoring a sustainable balance of payments reflects inflation-adjusted changes in the currency vis-a-vis major trading partners. This cate- position free of restrictions on current account gory also includes cases where the exchange rate is adjusted according to a preannounced transactions. However, where the needed cut schedule. in the balance of payments deficit is relatively More flexible: managed float (22). The central bank sets the rate, but varies it, sometimes large, and especially when the flexibility in frequently. Adjustments are judgmental, usually based on a range of indicators, such as inter- prices and wages is judged to be limited, an national reserves, the real effective exchange rate, and developments in parallel exchange exchange rate depreciation may be recom- markets. mended—again in the context of disciplined More flexible: independent float (27). Rates are market-determined. Most developed coun- financial policies—so as to limit the cost of tries have floats—partial for the EMS countries—but the number of developing countries in- the decline in domestic absorption in terms of cluded in this category has been increasing in recent years. its adverse effect on output and social disloca- The list excludes Democratic Kampuchea, for which no current information is available. For tion. A depreciation can achieve this by help- members with dual or multiple exchange markets, the classification is according to the major market. ing to switch demand from imported to do- mestically produced goods and to encourage export production. Experience with adjust-

20 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution ment programs over the years suggests that adopted bold economic adjustment programs putting a new regime into place. an exchange rate depreciation is indeed effec- in which the dismantling of restrictions and The provision of technical assistance can tive in cushioning output and does not sup- the opening of the economy to foreign compe- take a number of forms, often simply a part of port the argument that a devaluation is on tition played a key role. the routine annual consultations. But for balance contractionary. This experience shows that certain precon- many developing countries, in particular, the Even though a devaluation may help to ditions must be established for moves toward bulk of exchange rate assistance comes sustain output, it invariably has implications convertibility to have a reasonable chance of through specially designed IMF programs. for income distribution. In particular, while an success. These include: (1) a realistic exchange One of these is run by the IMF's Central exchange rate depreciation typically raises rate; (2) appropriately disciplined monetary Banking Department, which provides resident the earnings of the rural poor engaged in ex- and fiscal policies; (3) an adequate level of in- experts to central banks and fields short-term port production, it may also lower the real in- ternational reserves; and (4) the elimination of missions to address specific operational prob- comes of the urban poor employed in the pro- most price controls. The first three are neces- lems, especially where significant exchange duction of nontradables, at least in the short sary to ensure that the removal of restrictions system reforms are being pursued. Recent ex- run. Given that some poverty groups may be does not lead to an unsustainable weakening amples of this type of assistance include hurt by a devaluation as well as by other ad- in the balance of payments and possibly a re- Bulgaria, Czechoslovakia, Ghana, Nigeria, justment measures, the IMF strongly encour- versal of the move to current account convert- Peru, the Philippines, Poland, Romania, and ages its members to take steps to protect the ibility. The fourth is necessary to ensure that Sri Lanka. poor, for example by targeting subsidies and convertibility results in greater efficiency via The other program is run by the IMF's social expenditures on them. an alignment of the structure of domestic rela- Exchange and Trade Relations Department, Removal of exchange restrictions. A tive prices with those prevailing in the world often in conjunction with the Central Banking central element of the IMF's mandate is pro- market. Department, usually in the context of the de- moting currency convertibility—essentially, Technical assistance in designing or sign or implementation of an adjustment pro- the unrestricted use of a country's currency modifying systems. Advice in this area can gram that is supported by an IMF arrange- for international transactions, allowing it to be either policy oriented or operational. The ment. Such policy-oriented technical advice be freely exchanged for foreign currencies (see former focuses on the choice of appropriate has been recently provided to Bulgaria, "Heading for Currency Convertibility," by exchange rate policy, the type of exchange ar- Egypt, Guyana, Jamaica, Mongolia, Romania, Martin Gilman, Finance & Development, rangement (including the exchange control Uganda, and Venezuela. In some of these September 1990). But it should be noted that regime), the level of the exchange rate and its cases, where problems arose with the func- this concept, as defined in the Articles of compatibility with the stance of other macroe- tioning of interbank exchange markets al- Agreement (Article VIII), is a limited one: conomic policies, and the sequencing of steps ready in place, the assistance was diagnostic members are obliged to maintain financial to move from one regime to another. and prescriptive. In other instances, such as convertibility (the absence of limitations on Operational assistance concentrates on the ac- Egypt and Uganda, the task was to help mod- the making of payments and transfers), but tual operation of a given exchange system, as ify existing exchange arrangements in a way not commodity convertibility (the absence of well as the practical modalities, including in- that was compatible with a medium-term ad- restrictions, such as quotas and bans, on the stitutional and administrative machinery, of justment program and the sequencing of other underlying transactions). In addition, the reforms. In the formerly centrally planned IMF's concept applies almost exclusively to economies, the purpose was to help put in current transactions. Nevertheless, the IMF place a system that could function effectively, also advocates freedom for capital transac- while rapid structural reforms, including tions and encourages its members to under- price and trade liberalization, were being take trade liberalization, as trade restrictions David Burton implemented. have similar effects to exchange restrictions a British subject, is an Conclusion and can dilute the benefits of currency con- Advisor in the IMF's vertibility. Countries are allowed to maintain, Exchange and Trade The IMF has been mandated global respon- Relations Department. He on a transitional basis, exchange restrictions holds a PhD from the sibilities for the international monetary sys- that were in place when they joined the IMF University of Western tem, which make the conduct of exchange rate (Article XIV status). New restrictions are sub- Ontario. policies of all its members—creditors and bor- ject to the IMF's temporary approval under rowers—a central focus of its activities. With Article VIII, but members are expected to re- the objective of promoting an open and non- move them as soon as circumstances permit. discriminatory international monetary sys- As it has turned out, most industrial coun- tem, the IMF and its staff continuously moni- try members achieved current account con- Martin G. Gilman a US citizen, is a Deputy tor and analyze exchange rate developments vertibility by the beginning of the 1960s; in Division Chief in the IMF's in a multilateral context and bilaterally with fact, only Greece remains under the transi- Exchange and Trade each member country and provide advice and tional Article XTV arrangements. A large Relations Department. He technical assistance on all aspects of ex- number of developing countries have also holds a PhD from the change rate policy. The IMF does not offer a moved to dismantle restrictive exchange sys- London School of single best exchange rate policy prescription, tems: by the middle of 1991, 70 members had Economics. but rather tailors its advice to country circum- adopted Article Vin status, including, most stances. In doing so, it has found that disci- recently, countries such as Cyprus, Indonesia, plined financial policies are the essential pre- Korea, Portugal, Swaziland, Tonga, and requisite for stable exchange rates and the Turkey. Moreover, many members have avoidance of exchange restrictions. •

Finance & Development /September 1991 21

©International Monetary Fund. Not for Redistribution Military Expenditures in the Developing World Developing countries continue to allocate, on average, over 5 percent of their GDP and up to 20 percent of central government expenditures for the military, a major drain on their financial resources Daniel P. Hewitt

.following the thaw in the Cold War, the cies is crucial. Accordingly, this article, which sight on the optimal level of military expendi- world has been awash in talk of the "peace is based on a longer study (see box), examines ture or on the steps nations should take to at- dividend," a concept that appears to be easier military expenditures in 125 nations over tain them. Furthermore, the article follows the to launch than it is to define or to collect. 1972-88 to show the distribution of world convention of economics by avoiding specula- Major decreases in military expenditures ap- military expenditures between categories of tion on why governments support military pear to be certain in Eastern Europe, but the nations and geographic regions and to pro- expenditures and the merits of so doing. situation in industrial countries seems un- vide an insight into the allocation decisions of Instead, the primary purpose of this inquiry clear. Meanwhile, many developing countries individual nations. Although collecting reli- is to describe the trends in military and other continue to spend relatively large amounts on able estimates of military expenditures is dif- government expenditures, and delineate, the military, despite their deep, and in many ficult because under-reporting is common, the where possible, the economic consequences of cases, growing economic difficulties. Some re- data does provide a useful indication of over- political choices on such expenditures. cently have cut back their military expendi- all magnitudes, and accurately depicts trends. Overall trends, 1972-88 tures in the face of mounting financial con- Among the primary conclusions of the straints. However, over the past two decades, longer study, a wide diversity is found to ex- Together, the United States and the Union developing countries have consistently allo- ist in the level of military expenditures by dif- of Soviet Socialist Republics on average ac- cated a higher proportion of GDP to the mili- ferent groups of developing nations. How- counted for nearly one half the total military tary than industrialized nations. Further, de- ever, in recent years (1983-88), the level of expenditures of 125 countries over 1972-88, veloping countries can ill-afford sustained military expenditures in proportion to GDP and the five next largest spenders accounted high levels of military spending since this among developing nations has fallen by over for about 20 percent of the total. Industrial contributes to low growth and domestic 25 percent from 6.3 to 4.7 percent; simultane- countries averaged 53 percent of the total (see economic hardship by diverting funds from ously, regional differences have contracted Table 1), while the share of the Eastern social programs, economic development pro- considerably. Additionally, substantial evi- European countries was 30 percent in the jects, and the private sector. dence exists indicating that military expendi- 1970s and 21 percent in the 1980s. In order to establish a sound basis for fu- tures react to financial constraints. Low-in- The rest of the world consists of develop- ture action, a solid understanding of past poli- come nations and heavily indebted nations ing nations of varying income levels. Their have consistently spent less on the military share of total world military expenditures av- than average. Further, in an analysis of the eraged 20 percent, but was considerably functional breakdown of government expen- higher at times. Based on data from the ditures, an overall contraction in the alloca- Stockholm International Peace Research This article and a companion article, to appear in a tions to the military is observed to have oc- Institute that was adjusted for our study (see later issue, are based on two recent studies by the au- thor: "Military Expenditure: International curred in response to the debt crisis of the box on data), the peak share of developing Comparisons of Trends" and "Military Expenditure: 1980s. countries was 26 percent in 1981, while the Econometric Testing of Economic and Political While the trends and determinants of lowest level was 15 percent in 1972. In 1988, Influences," available as IMF Working Papers, military expenditures describe behavioral the share was down to 17 percent. On aver- from the author. choices, economic theory offers limited in- age, developing countries spent between 4.7

22 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution and 6.5 percent of their combined GDP on the centage of GDP spent on the military may be Among the 16 countries that are estimated military (in 1988 and 1977, respectively). a relatively large use of scarce resources in to have spent in excess of 10 percent of GDP The regions with the lowest levels of mili- terms of foregone benefits in some countries. (see Table 2), there are no industrial countries, tary expenditures in proportion to GDP were Latin America, the Caribbean, and Sub- Saharan Africa. Military expenditures in the Middle East and North Africa were higher; the proportion of GDP in the Middle East av- . . Table 1 • eraged 12 percent, and its share of world mili- Average military spending around the world: tary expenditures rose from 3 percent in 1972 ' ' Adjusted SIPRI data, 1972-88 to 11 percent in 1982-84, before falling back to 7 percent in 1988. The Asian developing In percent of nations allocated 8 percent of GDP to the mili- World military Central government tary in the 1970s and 5 percent in the 1980s. GDP expenditure expenditure? As an indication of the distribution of ex- 1972-88 1972-88 1972-88 penditures by economic classification of coun- Industrial countries3 3.8 52.7 14.3 tries, the share of the 31 small low-income Eastern Europe 9.2 25.4 20.7 economies of world military expenditures was 0.6 percent. The share of world military ex- Developing countries 5.9 22.0 20.0 penditures of the 15 most heavily indebted na- Asian developing 6.3 8.1 27.2 Middle East 11.6 8.0 23.1 tions was 3.5 percent. The share of the seven North Africa 9.6 1.8 17.1 net creditor nations was 5.5 percent, account- Sub-Saharan Africa 3.7 1.5 12.8 ing for one fourth of the entire military expen- Latin America and Caribbean 2.3 2.5 8.6 ditures of the developing nations in our study. Total 4.9 100.0 16.5 Rankings by expenditures Developing country groupings: Rankings of military expenditures as a per- Net creditor nations 9.4 5.4 25.0 centage of GDP provide a basis for identify- Heavily indebted 2.8 3.5 10.9 ing the nations that have chosen to spend a Small low-income economies 3.6 0.6 12.2 Sources: Author's estimates, based on SIPRI and ACDA data. large amount on the military and those that 1 These are weighted averages derived by converting annual figures into US dollars, using official exchange rates, and have not. By implication, such an approach then averaging the yearly ratios. sfhis column shows SIPRI military expenditures as percent of central government expenditures; adjusted SIPRI serves only to show where countries stand rel- military expenditures to central government would be higher. sjhe country categories are derived from the IMF World Economic Outlook, with minor modifications to reflect the entire ative to other countries. On an absolute basis, time period covered in this study. average levels of military expenditures could be inordinately high or low. Even a small per-

Finance & Development I September 1991 23

©International Monetary Fund. Not for Redistribution whereas two are low-income nations: Ethiopia the resources available to the government, fi- higher than average military expenditures. and Mozambique. Among the 20 countries nancial assistance helps increase military Among the developing nations, the ratio of that spent 1.6 percent of GDP, four are indus- spending. Among the political factors, the military expenditure to central government trial nations—Japan, Luxembourg, Austria, presence of international war or civil war led expenditures in Latin America and the and Ireland—and six—Niger, Sierra Leone, to higher levels of military spending; nations Caribbean was well below the global average; Ghana, Nepal, Haiti, and Bangladesh—are governed by monarchies, military govern- in Sub-Saharan Africa, it was slightly below low-income nations. ments, and socialist governments tended to the world average, while in the Middle East The empirical explanation of why certain spend more than those characterized as multi- and Asian developing nations, it was well countries spent more and others spent less are party democracies. Finally, the results con- above. explored in numerous studies. In a companion firm that the geographical characteristics of a study (to be reported in a later article), econo- nation, such as size and border length, tended Military imports metric estimates explain 55 percent of the to influence the level of military spending. An issue that is much discussed in the con- variation of military expenditure as a percent The proportion of central government ex- text of military spending by developing na- of GDP. In absolute terms, military expendi- penditures allocated to the military is another tions is the extent to which imports of military tures are found to rise nearly proportionally way of ranking countries. But this measure of equipment have used up scarce foreign ex- to GDP and to rise somewhat less than pro- resource allocation decisions and the relative change in those countries. The ratio of mili- portionally to central government expendi- burden of military spending must be inter- tary imports to total imports averaged 7 per- ture. Small low-income economies are found preted with caution, because such outlays de- cent among developing countries over to allocate less to the military as a percentage pend on the size of the government and the 1972-88. The ratio was generally below aver- of GDP than the average; the heavily indebted level and nature of decentralization, as well as age in Sub-Saharan Africa, Latin America and countries also spent less and apparently cut on the size of the military. The average ratio the Caribbean, and Asian developing nations, back in the 1980s relative to the 1970s. worldwide of military expenditure to central while it was nearly double the average in the Further, public and publicly guaranteed ex- government expenditures was 16.5 percent Middle East and North Africa. ternal credit tended to engender increased mil- during 1972-88. The industrial country aver- Certainly there are individual countries itary spending in recipient developing na- age was somewhat lower, while Eastern whose arms imports have been a high propor- tions. This result indicates that by increasing European and developing countries had tion of total imports. (For some countries, arms imports even exceed official merchan- dise imports, indicating that arms imports were not fully included in official trade data.) However, particularly for low-income and heavily indebted countries, the actual cash Data on military expenditure payment for arms imports has often been a very low proportion of the assessed value, since much of the military equipment pur- The sources for data used in this and the companion econometric study are the World Bank, chased by these countries had a high grant el- the United Nations, the Stockholm International Peace Research Institute (SIPRI), the US ement and favorable financing arrangements. Arms Control and Disarmament Agency (ACDA), and the US Central Intelligence Agency, in addition to external Fund publications. In a number of cases, published national accounts Michael Brzoska ("Military Trade, Aid and were used as a supplement. The military expenditure figures are derived primarily from Developing Country Debt," World Bank SIPRI. Working Paper) estimates that half the pur- The SIPRI estimates are useful because they are in local currency. Further they are more chases from the United States and the Soviet reliable than other major sources of such information because their coverage is clearly de- Union were financed through loans or grants fined, comprehensive, and consistently applied to each country. SIPRI data were adjusted in and half were paid for in cash. two ways. First, SIPRI does not provide estimates of military expenditures of the Soviet Union and China, two extremely important military powers. ACDA estimates were used for Budgetary tradeoffs China's military expenditures, while Dmitri Steinberg's estimates of Soviet spending Since the availability of resources is limited ("Trends in Soviet Military Expenditure," Soviet Studies, October 1990), were adjusted for in the medium term, once a nation chooses to possible overshooting. The second major modification to the SIPRI data involved expanding the coverage and fund a given level of military expenditure, definition of military expenditures to take account of foreign-financed expenditures in the ways of financing must be located. Thus, military expenditures of the recipient nations. The SIPRI definition excludes financial expen- there is always an opportunity cost to military ditures and it is likely that most foreign military purchases are off-budget in developing spending. Although the transmission mecha- countries and, therefore, omitted form the SIPRI estimates. It is preferable to define the mili- nisms are complicated and vary from country tary expenditures of a nation as consisting of all military expenditures, regardless of the to country, the opportunity cost of military ex- means of financing, consistent with IMF accounting methods. Ideally, this can be accom- penditures can be categorized into three basic plished by adding the off-budget military expenditures to the SIPRI figures. However, there options. A government can increase its overall is no sure way of knowing to what extent foreign purchases are off-budget items for individ- budgetary expenditures, which in general will ual countries. To correct for the measurement error, an alternative set of military expendi- lead to lower levels of current private con- ture figures was derived—the adjusted SIPRI military expenditures. A formula was used to estimate the off-budget military expenditures from arms imports data provided by sumption. It can decrease social expenditures, ACDA, supplemented with US foreign military aid figures. No adjustment was made for in- which will lower the quality of social services. dustrial nations or net creditor developing nations (see the working paper for a fuller de- Or a government can cut expenditures de- scription and a list of country categories). signed to increase the productive capacity of the nation, such as public infrastructure and economic services, and thereby diminish

24 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution to GDP increased 15 percent; the share of so- .':;;• w;^^7;-'.'f-*&'-.--.<' \;^f/,<>.:M^i^^:l.\r''--- cial expenditures, of military expenditures, Ranklngs of countries by adjusted SIPRI military expenditures and of economic services all fell about 15 per- - ' • ;: as proportion of GDP, 1972-88 cent. The heavily indebted nations displayed . rj; ' • * $l* alphabetical ei^ a similar pattern. However, the small, low-in- ••-• 1 --•-••- >—• • -'--'—* —• »—' come economies were able to increase expen- ditures on economic services while increasing In excess of 20 percent of GDP military expenditures somewhat and decreas- Angola, Iraq, Israel, Jordan, Oman, Syria, Yemen People's Democratic Republic ing social expenditures substantially; their ratio of government spending to GDP rose Between 10 and 20 percent 3 percent. Cuba, Egypt, Ethiopia, Libya, Mozambique, Nicaragua, Saudi Arabia, USSR, Yemen These results should be treated with cau- Arab Republic tion, since allocation decisions of governments are political in nature. What happens in one Below 1.6 percent country in one particular year may have no Austria, Bangladesh, Brazil, Costa Rica, C6te d'lvoire, Dominican Republic, Fiji, Ghana, bearing on what will happen in another year Haiti, Ireland, Jamaica, Japan, Luxembourg, Mauritius, Mexico, Nepal, Niger, Panama, or another country. The data do, however, Paraguay, Sierra Leone show that military expenditures tend to react Source: Hewitt, 1991. to financial constraints. In fact, on the basis of Note: The ratios are based upon SIPRI data and adjusted for possible off-budget items. See the box on the author's longer paper more expenditure patterns and empirical find- ings, it is possible to speculate that military expenditures are a so-called "superior good" among developing nations. Middle-income de- veloping countries spent more relative to GDP than low-income developing nations. Many countries that faced a financial squeeze re- economic growth. Some tentative conclusions military fell 23 percent on a weighted average sponded by cutting military expenditures sub- on how governments, on average, have ac- basis. The share of military expenditures fell stantially. commodated military expenditures are avail- in 21, did not change in 13, and increased in Conclusions able from a number of sources. 17. The share allocated to social expenditures The patterns of military expenditures have fell 17 percent on a weighted average basis. The most basic lesson from economic anal- changed over the past two decades. Three Although there is a great deal of variation ysis is that when a country allocates resources changes are apparent from world-wide data. among the regions, the same general pattern to the military, there are opportunity costs. First, world military expenditures as a pro- is observed in the Middle East, North Africa, For instance, the evidence in the study on portion of GDP were lower in the 1980s than and Asian developing nations: social services which this article is based indicates that mili- in the 1970s. Second, the proportion of central retained high priority, while the military and tary expenditures have, in many nations, di- government expenditures to GDP increased in economic services were cut substantially. In verted resources from economic services or the 1980s relative to the 1970s. Finally, the Sub-Saharan Africa, a somewhat different development expenditures. The likely conse- proportion of military expenditures to central pattern emerges. The ratio of government quences of this trade-off is a lower rate of eco- government expenditures fell (which follows spending to GDP fell 5 percent; though the nomic growth. In this sense, excess military automatically from the first two trends). share of military expenditures fell substan- expenditures must be designated as "unpro- Among the developing nations, military ex- tially, the share of social expenditures fell ductive expenditures," and justification for penditures fell as a proportion of central gov- much less, and the share of economic services military spending must be based rigorously ernment expenditures in all regions. rose significantly. In Latin America and the on the security needs. These patterns might at first seem para- Caribbean, the ratio of government spending Additionally, from a worldwide perspective, doxical. Why did central government expen- there is a strong case for coordinated de- ditures rise and military expenditures fall si- creases in military expenditures (see accompa- multaneously? A major reason may be the nying article by Robert S. McNamara). Al- rise in interest costs. The share of interest though military expenditures may provide payments in central government expenditures benefits to a given nation, they have a nega- rose nearly 80 percent in a sample of 51 devel- tive impact on the welfare of rival nations, and Daniel P. Hewitt oping countries, ranging from 35 percent to therefore on a worldwide basis, national mili- a US citizen, is an 100 percent for the different country groups. Economist in the tary expenditures do not enhance global wel- Therefore, changes in expenditure patterns Government Expenditure fare. A coordinated reduction in military ex- between the 1970s and 1980s present an in- Analysis Division of the penditures that does not change the strategic stance of retrenchment; governments had to IMF's Fiscal Affairs balance will increase economic well-being in seek ways of funding their higher interest lia- Department. the world. Finally, the evidence indicates that bilities. Meanwhile, social expenditures were military expenditures are quite reactive to fi- protected in the majority of cases while mili- nancial constraints. Thus, without controls or tary expenditures and expenditures on eco- pressure to do otherwise, foreign financial as- nomic services were cut back. Among the 51 sistance both enables and encourages a nation developing countries studied, the share of the to spend more on the military. •

Finance & Development I September 1991 25

©International Monetary Fund. Not for Redistribution GUEST ARTICLE

Reducing Military Expenditures in the Third World Developing countries should seek to reduce their military expenditures, as a percent of GDP, by 50 percent during this decade Robert S. McNamara Former President, The World Bank

M,Lilitar, y expenditures in the developing • Substantial limitations on arms exports human lives, have had their roots in historical countries in 1988 approximated $170 billion, from arms producing nations; and enmities within and among developing coun- 4.3 percent of GNP. They were only slightly • The tying of financial aid in developing tries. They have resulted from the desire for less than total expenditures for health and ed- countries to reductions in military expendi- regional dominance on the part of some Third ucation and they have quintupled in constant tures by these countries World governments, attempts by developing dollars between 1960 and 1988, increasing at could lessen the risk of war among Third governments to alter their social order, and a rate twice that of income per capita. World nations and lead to cuts in their mili- the persistence of substantial inequities Can such large outlays, in countries so tary expenditures, as a percent of GNP, of within developing nations. drastically in need of capital to accelerate the more than half by the end of the decade. The In view of the diverse reasons countries rate of economic and social advance of their end of the Cold War offers dramatic opportu- have for going to war, we must conclude that five billion inhabitants, be reduced? My an- nities for the nations of the world to move in in the world of the future, conflicts within and swer is: Yes. This article will put forward the this direction. The international organiza- among nations will not disappear even proposition that a combination of the follow- tions, including financial institutions such as though East and West cease to fight their ing actions: the World Bank, can catalyze the process proxy wars in the South. But a different • United Nations Security Council guar- thereby accelerating economic and social de- world would emerge if the Great Powers and antees of territorial integrity; velopment without reducing security. their allies agreed on and adjusted their for- • Continuing reductions in both conven- eign and defense policies in accordance with tional and nuclear arms by the Great Powers; A world of conflict the conditions stipulated above. • Tight control of the proliferation of The past 45 years have seen some 125 wars Reducing military budgets weapons of mass destruction and the means and conflicts in the Third World, leading to to deliver them; 40 million deaths. It is often suggested that As we move to limit both nuclear and con- the Third World has been turned into an ideo- ventional forces, while providing for collective logical battleground by the Cold War and the action against military aggression wherever it rivalries of the Great Powers. That rivalry may occur, military budgets throughout the This article is derived from a longer paper delivered at the World Bank Annual Conference on has undeniably been a contributing factor world—in both developed and developing Development Economics in Washington, DC, in and some of the most costly wars have di- countries—can be reduced substantially. April 1991. That paper will be appearing, along rectly involved one or more of the Great Over 1978-88, the Third World imported with others presented at this conference, in a special Powers. Others grew out of the decolonization $371 billion of arms (nearly $450 billion in supplement of the World Bank Economic Review process. Many of these conflicts, however, in- 1988 prices), more than three quarters of the and the World Bank Research Observer in 1992. cluding some of the most costly in terms of arms traded internationally. While these fig-

26 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution ures reflect the relative lack of domestic pro- duction capability in the Third World and a Sources of military aid legitimate concern to protect national sover- eignty, there is clearly great scope for reduc- ing Third World military expenditures by re- ducing arms imports. Reliable and detailed data on security assistance are not widely available. The United States is one Both supply and demand for arms must be of the few countries that provides such data. The three main components of US security assistance addressed. The United States and the Soviet are the Military Assistance Program (MAP), which provides grants; the Economic Support Fund (ESF), which provides balance of payments help and finances commodity import programs, increas- Union have tended to use arms transfers as a ingly on a grant basis; and the Foreign Military Sales (FMS) program, which enables countries to means of maintaining political support in purchase military hardware and services on credit. strategically located Third World nations. For In fiscal year 1989, seven countries—Greece, Honduras, Kenya, the Philippines, El Salvador, many of the Western European and some Thailand, and Turkey—received 80 percent of the $468 million MAP funds. Nine—Egypt, Greece, emerging Third World suppliers (in particu- Israel, Jordan, Morocco, Pakistan, Portugal, Tunisia, and Turkey—shared the $4.3 billion FMS pro- lar, China and Brazil), economic considera- gram. Two of these—Israel and Egypt—accounted for 75 percent of FMS credits, and all these cred- tions have been paramount. The sale of its were "forgiven," that is, converted into grants. Nearly 80 percent of the $3.6 billion under the ESF weapons and arms production technology has went to five countries—Egypt, Israel, Pakistan, the Philippines, and El Salvador, with Israel and helped to make the domestic defense indus- Egypt getting nearly 60 percent of the total amount. In fact, these two countries received nearly two tries of these smaller producers economically thirds of the $8.4 billion in FMS, ESF, and MAP fund, allocated by the United States in FY1989. While very little is publicly known about the scale and terms of Soviet security assistance, it is viable and has opened the door to nonmilitary clear that the Soviet economy is less and less able to support any kind of massive aid beyond its exports. Over the last decade or so, economic borders. For domestic political reasons, planned cuts in military aid to Cuba may not proceed in considerations have become increasingly im- 1991, but India, for example, hitherto a major recipient of Soviet military supplies, now must pay in portant for the Soviet Union as well. hard currency for weapons and arms-production technology imported from the Soviet Union. But the demand for weapons is strong too, Another source of military assistance for some Third World countries has been the oil surplus and many Third World governments have ac- countries of the Middle East. Saudi Arabia, Algeria, Kuwait, and the United Arab Emirates have tively sought to purchase arms. One of the provided varying amounts of grants and credits, primarily to other Muslim countries, such as most important demand factors is involve- Egypt, Iraq, Pakistan, and Sudan. ment in conflict—internal or external. Of the top 15 Third World arms importers during 1978-88, who together account for about three quarters of arms imported by the Third World, 13 have been party to conflicts of some evidence—suggests that general pur- organizations should agree, as well, to ac- many years' duration. In addition, Third pose balance of payments or budgetary fi- tively assist countries in finding negotiated World governments acquire arms to protect nancing from abroad enables a government to solutions to conflicts. against perceived internal and external spend more on the military than would be oth- There is, of course, the danger that reduc- threats, to bolster their claims to regional erwise possible. It is, therefore, bad economics tion of tensions and military forces of the East power status, as a symbol of unity and inde- and bad policy for donor nations and interna- and the West—and the effectiveness of new pendence, and to reward the armed forces for tional financial institutions to continue to be- high-tech weapons—may lead industrial support against internal opposition. have as if the funding of stabilization, adjust- country arms producers to seek new markets The availability of financing is an impor- ment, and development programs can be for their products in the Third World. This tant factor in arms purchases. Seven of the separated from the financing of military approach would succeed only if the Third top 15 arms importers have had access to expenditures. World countries have the financing for such petrodollars. Another five have been recipi- Reducing the demand for arms purchases. To the extent that such financing ents of grants or heavily subsidized credits. is provided by suppliers through credits, Some Third World countries have received fi- Wars and arms procurement (both domes- grants, or barter arrangements, curtailment of nancial assistance from oil rich countries that tic and abroad) have created a heavy military such facilities would keep down Third World has allowed them to acquire arms from expenditure burden for a number of Third military outlays on imports. abroad. World countries. To the extent that security Not all weapons must be imported. More assistance takes the form of loans, involves Domestic considerations than 54 developing countries have some do- barter trade, or causes additional security-re- While external security considerations play mestic arms production. Of these, 10 produce lated outlays, it adds to that burden. To re- an important role in determining military ex- nearly all the major weapons manufactured in duce the demand for arms in the Third World, penditures in many Third World countries, the Third World. The investments that have whether the arms are imported or produced many such countries continue to allocate large made this possible have been significant, par- locally, we should introduce into the system of proportions of their budgets to the military ticularly in terms of foreign exchange. Collective Security a guarantee by the without any obvious external threat. Others Security Council and regional organizations of continue to spend large amounts on security Financing military outlays the territorial integrity of member states. The even after external threats have disappeared. An important but difficult factor to assess strengthening of regional bodies, such as the The reason often is the desire of the armed in the financing of military expenditures is Organization of American States and the forces to preserve a strong internal posture. In the fungibility of external resources, that is, Organization of African Unity, as well as the some countries, this is the primary objective the ability of governments to either divert creation of such groups for Asia and the of such expenditures. such resources or free up other resources for Middle East as regional arms of the Security When governments have armed themselves military acquisitions. Common sense—and Council, would help this process. International against their own people in an attempt to

Finance & Development jSeptember 1991 27

©International Monetary Fund. Not for Redistribution maintain themselves in power, the general strive for a political system that allows all International financial assistance should be public often has limited access to the policy- groups to articulate their demands and is capa- linked to movement toward "optimal levels" making process and the formal economic sys- ble of producing workable compromises be- of military expenditures, taking into account, tem. Under such conditions, elite groups fight tween competing interests. The greater the of course, sources of external threat to a coun- for power and some groups are discriminated power of the security forces, the less likely the try. The "conditionality" inherent in such an against or repressed. In such situations, inter- possibility of democratic governance. approach could take the form of the proposal national or regional conflict resolution strate- When security forces claim a role in guar- contained in Facing One World, the report of gies need to be matched by internal conflict anteeing internal security for a society, they the "Independent Group on Financial Flows resolution strategies. are not, in most cases, seeking to make all cit- to Developing Countries," chaired by former In this regard, equitable development and izens equally secure. Indeed, their actions of- German Chancellor Helmut Schmidt. This distribution of resources play a key role. In ten create greater instability. All too fre- group, which included former Presidents or many parts of the Third World, economic sys- quently, the security forces are not protecting Prime Ministers of Nigeria, Peru, Canada, and tems function primarily to benefit a relatively a majority of the population from a minority the Republic of Korea, urged that in allocat- limited number of people, and political sys- bent on pursuing its own political and eco- ing foreign aid decisions, special considera- tems are manipulated to continue the domi- nomic objectives; instead, they are seeking tion be given to countries spending less than nance of the elites. Indeed, one of the most im- "regime security" (which often means "mili- 2 percent of their GNP in the security sector. portant effects of military expenditure, which tary regime security"). The huge savings that many countries could has serious implications for political and eco- Conditionality make by reducing their security expenditures nomic development, is the degree to which it to this level could be used to address pressing strengthens the political influence of the armed The role of the military is, of course, the economic and social needs. Even though the forces at the expense of civilian groups within prerogative of each government. The interna- application of conditionality may be con- Third World societies. The greater the political tional community nonetheless needs to iden- tentious, it is an essential part of the solution power of the security forces, the less likely it is tify ways in which it can encourage countries to the waste represented by excessive mili- that the requirements for democratic gover- to reduce their security-related expenditures tary spending in poor countries today. nance will be met. It is, therefore, necessary to in favor of development.

Global Investment Needs, Savings, and Military Spending

IMF Managing Director, Michel Camdessus spending takes several forms: prestige projects, unproductive spoke in July at the United Nations Eco- administrative machinery, military spending beyond the mini- nomic and Social Council (ECOSOC) meet- mum required for national defense, and spending associated ing in Geneva on the growing need for with protectionism. Everyone will understand that I recom- global savings in the years ahead and the mend attacking first those expenditures whose external impact need to fill the gap between investment and is the most harmful because they result in mounting waste be- savings. In that context, he spelt out the im- yond national border: here I refer most particularly to military portance of curtailing "unproductive spend- spending and protectionism. ing, " including that on the military. I know that people will say that savings in the latter area can only be made gradually and the effects will be visible only after Here is an excerpt from his ECOSOC speech: some time; even so, however, there is broad scope for genuine Broadly speaking, it appears that the additional—and I progress. Allow me to give two examples of this, keeping in stress additional—demand for saving might well exceed $100 mind the size of the additional requirements of about $100 bil- billion in 1991 and thereafter. A large sum, indeed, which lion to which I referred earlier. would be higher still if allowance is made for substantial finan- First, with regard to military spending which might be ex- cial support for the Soviet Union, but is still considerably less pected to decline somewhat with the reduction of East-West than 1 percent of the GDP of the industrial countries. The prob- tensions and the settlement of several regional conflicts. lem is daunting, but it is not insoluble if all countries seek to Imagine that in such a climate all countries were to decide to re- stimulate savings through appropriate financial policies and to duce their military spending to the level of the worldwide aver- reduce dissavings—particularly public ones—through fiscal age of 4.5 percent of GDP recorded in 1988. In this case, annual policies focused on cuts in unproductive spending. This kind of worldwide savings of $140 billion would be generated.

28 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution Extending Help to Women Farmer's HI IJL/V^S What works and why

X hroughout the developing world, women sion, which is generally provided by male of the delivery of these messages. While the have long played a pivotal role in agriculture, agents to male farmers on the fallacious as- recommendations are relevant for most exten- both as laborers and decisionmakers. Besides sumption that the message will "trickle sion systems in use by governments, paras- being the main ones responsible for food pro- across" to women. Bias is also evident in the tatals, and private agencies, particular atten- duction—in Sub-Saharan Africa, women ac- message itself, which tends to ignore the tion is paid to the "training and visit" system count for at least 70 percent of the food staple unique workload, responsibilities, and con- of agricultural extension, favored by the production—they figure prominently in other straints facing women farmers. World Bank (see "The World Bank and the agricultural activities, including food process- Troubled by this highly inefficient use of training and visit system," by Joslin Landell- ing and marketing, cash cropping, and animal resources, not to mention suboptimal levels of Mills, Finance & Development, June 1983). husbandry. Moreover, as more men migrate agricultural production, many policymakers Why women farmers need help to cities and other countries for work, increas- and donors—such as the World Bank, which ing numbers of women are becoming heads of has invested about $2 billion in agricultural After nearly two decades of studies, it is households, managing farms on a day-to-day extension in 79 countries since the mid- clear that regional differences aside, women basis. 1960s—have begun to work with countries provide most of the labor and make many key If these women are to carry out their exten- on innovative approaches. Pilot programs decisions in agriculture. In Malawi, for exam- sive and multifaceted roles in agriculture and now underway are providing useful guidance ple, women perform 50 to 70 percent of all respond to market incentives more efficiently, on how best to fully integrate women into the agricultural work and account for 69 percent they need effective agricultural extension ser- agricultural extension system and the most of all farmers. But women face special con- vices. Yet the evidence clearly shows that, de- likely problems to emerge in different socio- straints in carrying out agricultural activities, spite a growing awareness of the need to economic environments. This is a relatively reach women farmers, these services—con- new field and much remains to be learned. sidered to be a prerequisite for widespread Even so, it is possible to craft guidelines for This article is based on World Bank Discussion and sustained agricultural development—are (1) better identifying the information and Paper No. 103(1990), "Agricultural Extension for generally geared toward male farmers. This technology needs of women, thereby helping Women Farmers in Sub-Saharan Africa," by is sometimes by design, but more often by de- to develop more appropriate messages for Katrine Saito and C.Jean Weidemann, and on con- fault. Bias is evident in the delivery of exten- them; and (2) improving the cost-effectiveness tributions by Nancy Axinn and Nadine Horenstein.

Finance & Development / September 1991 29

©International Monetary Fund. Not for Redistribution making it more difficult for them to operate ef- tural norms affect interactions between agents holds need extension services ("landless" in fectively in factor markets, if they can obtain and farmers—often, male extension officers this context frequently means having a small access at all. As a result, most women have may not meet with female farmers—and be- patch of land that, when intensively culti- less access to—and higher effective costs tween male and female farmers. In many vated, can contribute significantly to the fam- for—information, technology, inputs, and parts of South Asia, for example, the strict ob- ily's survival); and credit than men. The end result is depressed servance of "purdah" (separation of sexes) re- • geographical variations and local condi- productivity. sults in women remaining in the "inside" la- tions that define production possibilities and Land. Typically, women must farm more bor force. From within the compound, women constraints. In South Asia, women farmers in fragmented, smaller plots than men, and they undertake various agricultural tasks, particu- the hill and mountain regions of northern are less likely to have secure tenure. This acts larly processing, but cultural conditions make India, northern Pakistan, Nepal, and Bhutan as a strong disincentive to investing in new it difficult for male agents to give them need advice that differs sharply from that techniques. In many parts of the world, land advice. needed in the tropical plains. title is in the name of the male head of house- Education. Throughout the developing To date, diverse collection methods have hold, and women are allocated land that is far world, women tend to be less educated than proved effective in planning services for fe- from their villages and far from other plots men, severely compromising access to agricul- male farmers, including seasonal calendars they cultivate—posing problems of childcare tural extension and the ability to comprehend (providing a sense of the farm "enterprise" as and transportation. and use technical information. Because of well as times of peak labor by gender), sea- Technology. Lack of suitable farm and their lower level of education—in most of sonal labor profiles, and household record- household technology also impairs women's Africa, the adult male literacy rate is almost keeping. Lengthy costly surveys should be efficiency, restricts their time, and saps their twice that of women, and in Bangladesh and avoided. Indeed, one of the most successful energy for participating in extension. In India, more than 80 percent of rural women approaches uses the quick, inexpensive, infor- Zambia, weeding can be performed six times are illiterate compared with 60 percent of ru- mal survey technique of Rapid Rural faster with animal traction, but few women ral men—women are less able to respond to Appraisal (which involves local populations can afford this technology, and in many cases, written extension messages and, in some in the early discussions and design of pro- cultural traditions discourage its use by cases, cannot be chosen as contact farmers. jects), combined with a two- to three-day field women. visit. Another useful technique, requiring only Credit. In most of the developing world, Improving the message a few hours, is to question carefully selected women are bypassed by formal credit sys- Given these gender-related constraints, it is groups of women farmers, preferably without tems, because of lack of collateral (usually clear that accurate information at the local the inhibiting presence of their husbands and land title), lower levels of numeracy and liter- level—what women farmers do, how they do other male authority figures. acy, lack of information, burdensome bureau- it, and why they do it—is essential if the re- All of this information must then be fed cratic procedures, distance and cost of travel search and extension services are to produce into research systems that have the ability to to credit institutions, and cultural attitudes. and deliver technical advice that is both generate new knowledge and techniques to Available credit is also often limited to the needed by the farmers and appropriate to improve productivity and sustain rural fami- production cycle (most women work in pro- their circumstances. Information is needed on lies. Linkages with both national and interna- cessing) and to cash crops for export (which the following topics: tional research institutions must be strength- women are less likely to grow). Without • the division of labor between men and ened, and their research agenda broadened to credit, women are less likely to be able to af- women by crops, livestock, and farming oper- include crops and livestock produced by ford the inputs recommended by extension ations (this may involve "men's" versus women (particularly vegetables and small ani- agents, if they come into contact with them at "women's" crops—traditionally, cash versus mals), tasks normally performed by women all. subsistence crops—or complementary roles (such as weeding, food processing, preserva- Mobility and time. Women tend to be for the same crop). In the production of irri- tion, and storage), and technologies and farm- less mobile and enjoy less uncommitted time gated rice in The Gambia, Senegal, and ing systems suitable to the circumstances of than men, making it more difficult for them to Burkina Faso, for example, women specialize women farmers (such as home gardens or al- participate in training courses outside their in transplanting, weeding, winnowing, har- ley cropping). Tools and machines also need villages and inhibiting their ability to respond vesting, and threshing, while men prepare the to be developed—when possible, produced lo- to opportunities. A study from Burkina Faso, fields and maintain the irrigation system. In cally—that are suitable for women (i.e., multi- for example, shows that women contribute as South Asia, caste and class differences tend to functional and of appropriate size and much time per day to food and cash crop pro- be the dominant influences, with women of strength), and most important, distributed duction as men—in addition to food process- lower caste generally having more limited ac- widely. ing and fetching water and fuelwood—with cess to the factors of production (including Transmitting the message men averaging twice as much time resting. water and public land), as well as to extension Similarly, surveys from Pakistan reveal that services and credit; Once the relevant message—which is agricultural and household activities typically • who owns or controls factors of produc- highly location specific—is formulated, the take up to 12-15 hours of a woman's day, sig- tion, crops, or income derived from the sale of challenge lies in transmitting it to women nificantly more than the time spent by men on produce—women are most likely to invest farmers. There are many ways to do this with- productive work. In addition, women must time and resources in production when they out transgressing cultural mores. The answer contend with less cash for transportation and retain control of the harvested crop; is to find a method suitable for the local tradi- less likelihood of owning transport. In some • the types of women farmers—farm tional culture, financial and human resources, countries, sociocultural and religious barriers managers in their own right, farm partners and institutional arrangements. also limit their mobility. with their husbands, or laborers. In parts of Using women extension agents. Cultural norms. In most countries, cul- South Asia, even women in "landless" house- Whether the gender of the agent matters

30 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution varies greatly depending on the sociocultural have been integrated into the extension ser- of inputs; and they help lessen the sociocul- context. Even so, evidence suggests that com- vice and are working very effectively in the tural difficulties of male/female interaction. In munication with women farmers is definitely highly successful nationwide Women in Chile, for example, existing village groups enhanced when female agents are used. But Agriculture program. have been carefully selected and successfully how can the number of women agents be Given that male agents will remain the used for extension delivery; family groups quickly increased? How can they be inte- norm for many years, efforts must also be were found ineffective since women had diffi- grated into the extension system? How can made to help men overcome attitudes that can culty speaking up. male colleagues be convinced to accept them? undermine programs—one recent study of Recruiting more women as contact farm- How should conflicting family responsibilities five African countries found that most male ers—or links with extension agents—can also be dealt with? And how can adequate logisti- agents perceived women as wives of farmers, be helpful, but at present, the selection crite- cal support (including transportation) be rather than farmers in their own right. ria—such as the requirement for land owner- ensured? Training and supervision is one way. Using ship in South Asia—often discourage the par- One answer is to sharply boost the number women extension agents as the initial con- ticipation of women. In Kenya, however, the of women in agricultural schools, as these tact—to introduce groups of women farmers problem has been effectively tackled by en- schools will be the main source of trained ex- to male agents—is another. This strategy has couraging local chiefs, ministers, and political tension agents—in Africa, only 13 percent of worked particularly well in northwestern leaders to support such involvement by the students are female. To accomplish this, Cameroon, and a similar approach has been women at local gatherings and in the media; more girls should be enrolled in secondary suggested in Bangladesh, where male block emphasizing the selection of women farmers schools, and agricultural schools should insti- supervisors form teams with their female during training sessions; and encouraging ex- tute targeted growth rates for female enroll- counterparts. tension agents to select contact farmers on the ment, or economic incentives, such as tempo- Using women contact farmers and basis of merit, rather than patronage. rary tuition subsidies. Boarding facilities for women's groups. Using farmers' groups, Improving access to training. A cru- female students should be made available (as rather than individuals, as the recipients of cial link in the extension chain is making sure at Nepal's Institute of Agriculture and Animal extension has been found to be a particularly that the client is able to receive the message. Science), and parents of secondary school cost-effective way of reaching farmers, espe- Faced with dual responsibilities at home and girls should be informed of opportunities in cially women. In many developing countries, on the farm, women often cannot attend agriculture. Admission policies of intermedi- there is a long tradition of women forming courses at residential farm training centers, ate agricultural institutions should be re- groups to exchange labor, mobilize savings even if transportation is provided. It is impor- viewed to ensure that female enrollment is en- and credit, provide self-help, and carry out so- tant, therefore, that training be brought to couraged (for example, until 1980, none of the cial and ceremonial functions. Such groups of- them. One way is through mobile training agricultural schools in the Republic of Yemen fer a channel through which resources and in- courses, but the mass media hold the greatest were open to girls), and the curriculum offered formation from government and donors can potential. should be the same for both sexes. flow. Indeed, the advantages are numerous: Radio has a long history as a communica- Then, to retain women in the extension sys- they provide economies of scale through max- tion tool, particularly in agriculture. Its low tem, efforts should be made to assure equal imizing the farmer-to-agent ratio; they save cost and wide reach make it a relatively sim- treatment with men and accommodate those travel time and increase the time spent on the ple, effective technology, especially among il- who are married. This means equal access to actual task for the extension agent; they facili- literate farmers and those in purdah. The key, staff housing, equipment, and transportation. tate adoption of new techniques through peer however, is making sure that the broadcasts Moreover, the practice, common in many learning (groups can be especially effective in fit into the women farmers' work schedules countries, of expelling women extension reinforcing knowledge among illiterate and that the vernacular is used. Pakistan, for agents once they marry or become pregnant, women, who can then rely on collective mem- example, has made a practice of agricultural must be stopped. One way of coping with a re- ory); they allow members to pool resources for broadcasting in local languages. Radio mes- luctance of women to accept rural posts if production or collateral to obtain credit and sages should also slightly precede the mes- their children attend urban schools is to select other inputs; they serve as an effective means sages from extension agents. Evidence from new female agents from the local government for sharing expensive equipment and provide Ghana has shown that female farmers ques- area where they will serve. a vehicle for effective large-scale distribution tion extension agents about subjects already But the training and recruitment process discussed on the radio. takes time, and in the shorter term, one solu- Television is less widely used, because of tion is to redeploy female agents already production and equipment costs. But with its teaching rural women subjects related to agri- rapid spread across parts of South Asia, it culture. In many African countries, home must be regarded as the media of the future— Katrine Saito economists constitute a large female profes- even in places where there is not yet electric- a British subject, is a sional cadre—Nigeria, for example, has some Senior Economist in the ity, video machines have been found (in South 4,500, and even Sierra Leone, a much smaller Bank's Women in Asia, generators are used). Videotapes offer a country, has over 200. They are particularly Development Division. She low-cost way of reaching large numbers of common in former British colonies, where joined the Bank staff in women farmers, many of whom can choose to they are known as domestic or home scien- 1974 after having at- watch at a convenient time. They are tists, and some are also trained nutritionists tended the Universities of increasingly popular in Yemen, where Muslim and community development workers. In re- Woks and Edinburgh. women can view programs in seclusion. They cent years, a number of countries have begun are also used in Latin America for training, to experiment with this approach. In Nigeria, and in India to strengthen farmer-to-farmer home economists with agricultural training sharing of technical information. B

Finance & Development I September 1991 31

©International Monetary Fund. Not for Redistribution Setting the Development Agenda The new Chairman of the Development Committee, Alejandro Foxky, Minister of Finance of Chile, was interviewed by the Editor o/Finance & Development recently. In a wide-ranging discussion, Mr. Foxky touched upon a number of key issues affecting development today and the work of the Development Committee

Here are edited excerpts from Mr. Foxky's remarks:

The role of the Development Committee appropriate response on the part of the commercial banks and support of the multilateral institutions. Is the Development Committee just a "talking shop"? I don't The Chilean experience with negotiating our debts with the think so. The Committee tackles very important policy issues. commercial banks has been good and may be worth emulating. Take the last meeting in April 1991. The Committee discussed We have made progress in our return to the voluntary capital and supported the work of the Interna- markets. We issued, for example, bonds tional Finance Corporation (IFC), one of worth $320 million that were subscribed the main institutions of the World Bank to by 20 of the largest banks at a compet- Group. If the IFC's capital is doubled, itive commercial rate. from $1.3 to $2.6 billion, it will have very significant and positive implications for Aid flows to needy regions developing countries, because many pri- There is, no doubt, a demand for re- vate companies that have not been able sources in the wake of the Middle East to have access of IFC financing will then war. There is also potentially a demand have access. This was one of many key for additional resources in Eastern issues discussed at the Spring meetings. Europe. But I think it would be a disaster Others included the impact of the Middle if the international community did not re- East crisis, poverty reduction, foreign di- alize that the problem of poverty in the rect investment in developing countries, African countries is as acute as it has the impact of industrial country policies ever been and that the better-off coun- on development, the Uruguay Round, the tries of the world have to show solidarity debt strategy, global environment issues, with those that are worse off. There were and the IMF quota increase. some very eloquent statements during In light of criticisms that the Com- the Spring 1991 meetings by several mittee agenda is overloaded, I think we need to focus much Ministers in this respect. So, I feel that the Committee has the more on fewer issues. That would produce a more useful mandate to actively promote additional aid flows for the discussion. African countries. External debt One of the agreements reached in the Development Reduction of military expenditures by the Committee in April was to ask the Paris Club to further review developing countries and implement additional debt reduction schemes for the poor- As President Conable said, the World Bank cannot tell a est countries, along the lines suggested by a number of creditor country how much it should spend on the military. But, all countries, including the so-called Trinidad terms. these countries have to be able to manage their fiscal policy in a Rather than talking indefinitely about the debt problems of way consistent with macroeconomic equilibrium. If you are the middle-income countries, we should be proposing ways for overspending in one area, say defense, then you are bound to these countries to go back to the capital markets. We have to have trouble, either because you will not then be spending try and turn the debt situation around, from a problem to an op- enough on health, education, housing, or infrastructure—which portunity—an opportunity to go back to the markets—because should be major priorities for any government, or you will end the economic situation of most middle-income countries today up having a very high rate of inflation. The Development is better than it was ten years ago. Of course, this requires an Committee communique speaks about the "possible reallocation

32 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution of public expenditures, including exces- acceptance of foreign investment as an sive military expenditures." We do not important component of the development want a very militarized world. We want a effort. We used to have many prejudices world that is more humane, where gov- against foreign investment: that it would ernments are willing to invest more in not be beneficial for the country because people, to build their human capital. there would be too little reinvestment within the country; and that the profit re- Privatization and foreign mittances would debilitate the develop- investment in developing ment effort, and so on. I do not see that economies anymore. I see that countries are, rather, We should avoid the temptation of sim- competing for investment, and there is a plifying solutions. There are many coun- general trend toward liberalization of tries where you do not have yet the entrepreneurial capacity, rules concerning foreign investment. This is a positive trend. spirit, and other prerequisites for effective privatization. One can be very mechanistic and say, "Lets privatize everything." But Regional trading blocks and multilateralism then, who is going to run the companies? And how efficiently I do not believe that regional blocks run counter to multilater- are they going to be run? In several countries, the state does alism. The multilateral agencies should, in fact, encourage free have to play a key role, not only in providing social services but trade agreements between countries to facilitate moves in the also in running some key companies because the professional direction of a freer multilateral trading system, but not in the talent resides more in the state than in the private sector. What direction of forming blocks or economic fortresses. We might has to be done in those cases is to stimulate, induce, and facili- even think of a new conditionality—so to speak—in which the tate the process of emergence of an entrepreneurial class, so that multilateral would finance, say, joint ventures between coun- it can take charge of the process of development and of the pro- tries entering into a trade block, under the condition that the ductive activities in the economy. block would then work to move the economies of its members One of the emerging views on the development process is the toward multilateral liberalization and not the other way around.

The Bank/IMF Development Committee

The Development Committee was established by the Boards of funding of environmental initiatives and the impact of industrial coun- Governors of the World Bank and the International Monetary Fund in tries' policies on developing countries. 1974 and is formally known as the Joint Ministerial Committee of the The Committee is composed of 22 finance and development ministers, Boards of Governors of the Bank and the Fund on the Transfer of Real who are also governors of the World Bank or IMF. In addition, its meet- Resources to Developing Countries. The Committee has a unique char- ings are attended by 18 observers from regional development banks acter: It is the only joint ministerial body of the Bretton Woods institu- and other official international organizations. The President of the tions, and it gives principal attention to issues affecting developing World Bank and the Managing Director of the IMF attend all meetings. countries. The Chairman of the Committee is selected from among its members The Development Committee is an advisory body to the Boards of and traditionally is a national of a developing country. The Committee Governors of the Bank and the IMF. In practice, however, the also periodically elects an Executive Secretary, who traditionally is a Committee can exercise a significant degree of influence on the policies national of an industrial country and is responsible for carrying out its and operations of the Bretton Woods institutions that fall within the work in the intervals between meetings, under the general direction of framework of its mandate. the Chairman. The central mandate given the Committee at its creation was to con- The Committee meets twice a year, once at the time of the Bank/IMF sider the broad question of the transfer of real resources to developing Annual Meetings (in the fall) and once in the spring. Staffs of the two countries, including international trade and payments, as well as for- institutions regularly provide issues papers and progress reports on eign capital flows of all kinds. The Committee was intended to provide agenda items. In addition, the President of the Bank and the Managing a comprehensive overview of international activities affecting develop- Director of the IMF present reports providing their perspectives on the ment and to coordinate international efforts to deal with problems of issues under consideration. A Steering Committee, composed of repre- development financing. It was requested to advise and report to the sentatives of the two staffs and chaired by the Executive Secretary, Boards of Governors on all aspects of the transfer of resources to devel- meets regularly to coordinate institutional support for the Committee. oping countries and to suggest ways in which its recommendations The Executive Directors of the Bank and the IMF play an active role in might be implemented by appropriate parties, including the Bank and reviewing and commenting upon all documentation prepared for the IMF. In recent years, the Committee has focused on a broad array Committee meetings, as well as in framing issues for their respective of important topics deriving from its mandate, ranging from the financ- Ministers. The conclusions and recommendations of the Committee are ing requirements of low-income countries in Sub-Saharan Africa to the contained in a formal communique issued at the end of each meeting. Robert Ayres

Finance & Development I September 1991 33

©International Monetary Fund. Not for Redistribution Challenge of Sustaining Growth with Equity in Asia Despite the general picture of relative success, Asia needs to tackle some major long-term development problems Attila Karaosmanoglu

A hhe 1980s are often described as a "lost Of course, the new found prosperity of the with a significant improvement in social indi- decade" for the developing countries. Indeed, rapidly industrializing economies of Asia, cators. By 1988, China had a life expectancy there were many countries in Asia and other such as Indonesia, Malaysia, the Republic of at birth of 70 years, daily calorie supply of parts of the world where the growth in per Korea, and Thailand (see table) accounts for a 2,630 per capita, infant mortality rate of 31 capita incomes during this period was negli- large part of the success of Asian countries. per thousand, and, near universal primary ed- gible or negative. However, for the region as a Despite a decline in their terms of trade, and ucation enrollment. India, though lagging be- whole, Asia registered remarkable growth. In an accelerated decline in their share of ODA, hind, had also made significant progress in fact, during this decade, Asia's per capita in- these countries registered a high per capita all these areas. come grew by 5.2 percent per year, which was growth rate during the 1980s. By 1989, these However, while China and India benefited impressive both in relation to its own past countries made dramatic progress in reducing from the liberalization process in the 1980s, performance (nearly twice the rate during the the percentage of population below the strains were beginning to be evident by the 1960s and 1970s), and in relation to other poverty line to less than 20 percent. In addi- end of the decade. China reaped the fruits of parts of the developing world. tion, an increasingly favorable environment reforms in rural sectors in the early 1980s, but The success of Asia during this period was was created for private sector development, the next stage of decentralized management in spite of unfavorable external conditions. with governments playing an active role in in the urban and industrial sectors proved The region experienced a decline in its terms building physical, social, legal, regulatory, more difficult. Serious inflation developed by of trade and higher international real interest and technical infrastructure. As a result, these 1988, requiring a strong policy response. For rates. It had its share of natural disasters and countries were in a position to handle the India, the liberalization process was associ- political upheavals. Nor was external aid shocks of the early 1990s and maintain sus- ated with significant improvement in indus- large; in fact, Asia's share of overseas devel- tained growth, while continuing to reduce trial and export growth, but problems opment assistance (ODA) continued to decline poverty. emerged by the end of the 1980s. On the ex- in the 1980s. What is unique about the suc- The principal source of acceleration in the ternal front, foreign exchange reserves de- cess of Asian countries was the nature of region's growth rate was the remarkable clined and the debt-service burden increased their structural reforms, which were volun- surge in the per capita growth rates for to alarming levels. The budget deficits were tary, sustained, gradual, and effective. These China—a spectacular 8.3 percent per year, high and inflation was approaching double- reforms covered a broad spectrum, including from 3.3 percent per year in the 1970s—and digits. The accumulating short-term macro- prudent fiscal and monetary management, India, whose per capita growth during the management problems were combined with trade liberalization, encouragement of private 1980s was 3.3 percent per year, three times continuing problems in terms of distorted sector development, and support for social the rate in the preceding two decades. Income trade policies, a weak financial sector, restric- sectors. growth in these countries was also associated tive labor markets, inefficient parastatals, and

34 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution constraints on the private sector. longer-term development problems of pov- private foreign investments and technology For other countries in Asia, the 1980s was a erty, linked tightly to rapid population growth transfers. decade of low and declining rates of growth. and the deteriorating environment. Concern The Philippines' economic situation is a Per capita income for this group in the 1980s over these issues has intensified in recent cause for concern. One of the earliest countries declined by about 0.6 percent per year, similar years. But even under the very difficult condi- under adjustment programs, it suffered dur- to the rate for developing countries outside of tions prevailing in many of the countries in ing the 1980s from political unrest, declining Asia. Within this group, the Philippines expe- Asia, there is reason for hope that their re- per capita incomes, increasing macro imbal- rienced the sharpest decline (1.7 percent per sponse to these problems will be positive and ances, and growing poverty problems. A re- year), with Myanmar, the Pacific Island coun- improvements attainable. sumption of growth with equity will require tries, and Papua New Guinea following Growth and structural reforms. The designing programs that will not only address closely behind. For Bangladesh, Laos, Nepal, experience of the rapidly industrializing open structural problems but also redirect re- and Sri Lanka, per capita income growth rates economies of Asia have shown that growth is sources from consumption by the top few to were low or declining. Many of these coun- essential for poverty alleviation, that struc- broad-based development. The private sector, tries combined the problems of policy distor- tural reforms are essential for growth, and defined to include big businesses as well as tions with problems of capacity building and that private sector development is of critical the small, medium, and informal sector, will unsustainable population growth. significance for competitiveness and sus- play a key role. It is in this context that Asia faced the tained economic performance. While some Population and demography. Asia's Middle East crisis in 1990. Many feared that strains have emerged in recent years, the un- population is large, youthful, and rapidly the shock would be severe, not only because derlying economic structures and policy direc- growing in size. More than half the world's 5 of higher oil prices (the third oil shock), but tions in these countries are such as to enable billion people live in Asia, nearly 35 percent of also because of higher interest rates, losses in them to maintain the growth momentum of whom are below 15 years of age. Looking at workers' remittances, and a sharp decline in the past. measures of density of settlement, Asia (ex- exports to Iraq and Kuwait. However, the The emerging consensus on development cluding Pakistan) has 354 people per square shock proved much less severe than had been strategy—recognition of the importance of in- kilometer of agricultural land compared to 55 expected. It was less severe on the fiscal front centives, integrated markets, and private en- for Latin America, 58 for Sub-Saharan Africa, because Asian governments quickly adopted terprise—is now widely accepted by the au- and 116 for the Middle East and North Africa. measures to deal with the potential losses: do- thorities of most Asian developing countries. Bangladesh has over 1,000 people per square mestic fuel prices had been increased in oil However, the pace of structural reforms essen- kilometer of agricultural land. Asia is beset to- importing countries by late 1990. The impact tial to attain these objectives has slowed down day with a population problem imposing high of the shock, however, was more severe on the in many countries of Asia. In these economies, environmental and economic costs that will balance of payments, with estimated losses by the trade barriers are still high, investment constrain sustainable development. the end of 1990 of $1.3 billion in India, $0.5 bil- and commercial activity is still overregulated, Four basic demographic factors affect the lion in the Philippines, and $0.3 billion in financial markets are distorted, and the labor growth of population: (1) age structure of the Bangladesh—the countries most affected by markets are seriously segmented. There are population; (2) mortality rate; (3) fertility rate; the oil shock in Asia. Additional external as- also compelling reasons for streamlining the and (4) mean age of childbirth. Even under the sistance was mobilized to help with the short- public sector and improving policies toward best of conditions imaginable—that is, an im- fall. In addition, the relatively mediate fall in total fertility fast return to pre-crisis oil rates to replacement lev- prices in early 1991 and a els—the population of the Asia: growth of GDP per capita, 1960-89 continued expansion of ex- (In percent) Philippines and Bangladesh port revenues in most coun- would be 50 percent higher tries, helped. By early 1991, 1960-70 1970-80 1980-90 by 2025, while that of India, the shock had largely dissi- about 40 percent larger. A Indonesia 1.0 4.8 3.1 more realistic fertility de- pated, with the notable excep- Korea 6.0 7.7 8.4 tion of India. Malaysia 3.5 5.4 2.2 cline scenario would result Thailand 5.2 4.3 5.1 in even higher increases in The unfinished agenda population. Thus, while the overall China 3.6 3.3 8.3 Despite encouraging trends India 1.3 1.0 performance of Asia in the 3.3 in fertility, demographic pros- 1980s is a cause for confi- Bangladesh 1.0 0.9 0.8 pects for low-income Asia dence, there is no room for Lao, People's Dem. Rep. — — 0.4 are unfavorable for two rea- complacency. Except for the Myanmar 0.1 2.4 -1.0 sons. First, in most coun- rapidly industrializing, open Nepal 0.7 0.1 2.1 tries, fertility is still substan- Papua New Guinea 4.2 -0.2 -0.3 economies (Korea, Thailand, Philippines 1.9 3.5 -1.7 tially above replacement Malaysia, and Indonesia), Sri Lanka 2.0 3.1 2.5 levels. Second, the impact of most of the Asian countries Pacific Islands 1.8 2.4 -0.5 lowered fertility in slowing were facing the risk of population growth has in macroeconomic imbalances Asia 2.4 3.2 5.1 many instances been totally and slow, or decelerating, Other developing countries 2.7 3.0 -0.4 or partially offset by parallel growth rates. In most of these Source: Wbrld Bank. declines in mortality and the cases, the structural reform mean age of childbearing, as problems were embedded in well as by larger cohorts of

Finance & Development I September 1991 35

©International Monetary Fund. Not for Redistribution women of childbearing age. India is a good bly Indonesia, the high rate of growth has or potential, on a case-by-case basis, for retarget- example: between 1980 and 1987, the total fer- will effectively control the poverty problem. It ing social sector expenditures and changing tility rate fell from 4.5 to 4.0, but the corre- is in the countries of South Asia, as well as the policy to reach the poor. sponding annual rate of population growth Philippines and Indochina—characterized by The environment. The region's focus on actually rose from 1.97 to 2.06. slow output growth, poor resources, and rapid environmental issues is in part driven by the Without doubt, these problems loom larger population increase—that significant prob- severity of poverty and the rapid growth of for the poorer South Asian countries because lems of poverty still persist. In many of these population. The combination of demographic, their capacity to cope with them is much more countries, a targeted approach of investments economic, and climatic conditions in Asia are constrained by tight budgets, the already and programs designed to reach the poor can producing enormous pressures on the envi- heavy pressure on environmental resources, serve as an effective complement to an overall ronment that will need to be addressed in the the sparseness of existing infrastructure and growth strategy. Considerable recent work near term if further environmental degrada- institutions, and high fertility rates. For these has been done to clarify problems and ap- tion and potential environmental catastrophes countries, the urgency of accelerating the de- proaches of targeted poverty interventions. are to be avoided in the long term. cline in fertility rates is well recognized. At For example, the provision of irrigation and As Asia's population continues to grow, the the same time, raising the mean age of child- agricultural services in poor underserved re- proportion of the regional population living in bearing is also critically important; a decline gions would be an effective strategy in such cities will also increase. By 2025, some 50 will significantly offset the benefits of lower countries as China, Philippines, and India. cities will have in excess of 4 million people fertility rates. Hence, these findings point to Investments in drinking water and electricity each, compared to 20 cities currently. South a greater emphasis on making temporary in such regions can also improve the produc- Asia is expected to have the highest ratio of birth control methods available to young tivity of the rural poor. To reach the landless population in such mega-cities by 2025. Many mothers to encourage a higher mean age of rural poor, including women, both direct and of these cities will have 10 million people or childbearing. indirect approaches are necessary. An in- more. Few governments have policies or pro- Patterns of poverty and poverty re- crease in the productivity of agriculture will grams under consideration to cope with the duction. Population growth is tightly linked raise farmers' incomes, as well as the demand projected rates and associated needs of to the persistence of poverty. The dimensions for farm and off-farm labor. More direct pro- urbanization. and rough distribution of poverty in Asia grams will need to involve Asian NCOS, Forest areas are declining in most areas of. have been known for some time, both in the many of which have an excellent record of the region. Rates of decline are highest in poor countries of South Asia and in East Asia, motivating the poor and delivering well- South East Asia and most severe in South where the industrializing high-growth econ- targeted credit, employment, and training Asia. This has resulted largely from the de- omies have achieved dramatic reductions in programs. mand for increased agricultural land, commer- the proportion as well as the total number of In the area of social infrastructure, the exis- cial logging, and fuel wood collection. In addi- people living in poverty. The Bank's recent tence of wide disparities between poor and tion to losing the natural resources provided analytical work, however, has brought to light nonpoor in both social indicators and in terms by the forest, deforestation causes soil ero- some important characteristics of poverty in of access to quality services opens up a wide sion, water loss, flooding, desertification, and Asia and pointed the way toward effective area of possible interventions on a sectoral ba- the silting of irrigation reservoirs. Soil erosion public interventions to hasten its reduction. sis. One promising approach to these prob- is estimated to cost Java alone about $400 mil- • Asia's poverty and its population is con- lems is through analysis of public expenditure lion annually (soil productivity loss plus costs centrated in five countries (India, Bangladesh, in the social services. Primary education in of clearing silt from irrigation facilities, rivers, Indonesia, the Philippines, and China), which India, for example, receives a comparatively and dams). Deforestation also leads to a loss contain about 540 million poor, and within low proportion of public spending, leading to of habitat—about one quarter of the world's those countries, poverty tends to be concen- severe inequities in educational attainment. biological resources are at a high risk of ex- trated regionally. This is also true for dispari- This is not the case for hospital admissions in tinction in the next 20-30 years. ties in social indicators and the availability of India, where the poor enjoy proportionately Although gross water resources are gener- social and economic services. greater access. By contrast, data for Indonesia ally sufficient throughout the region, several • The impact of population growth, partic- show that access by the poor to hospital care local rates of consumption in South Asia and ularly in the densely settled rural areas, on the is very low compared to the better off. China are unsustainable, with available water quality of environmental resources tends to Differences among countries in level of access supplies being used up. For example, $400 aggravate Asia's problem of poverty. Forests by the poor are significant, and indicate the million was spent each year in 1985,1986, and are cut down, soils eroded, and soil nutrients 1987 to supply water to inhabitants in exhausted under pressure from land and fuel drought-stricken rural Gujarat (India). Fur- hungry poor. ther, water quality is declining regionwide • The status of women in South Asia, par- Attila Karaosmanoglu and this decline is expected to accelerate to be- a Turkish national, is low already intolerable levels. Waste water ticularly in regard to health and education, is Vice President of the abysmally low and strongly associated with World Bank's Asia severely pollutes 70 percent of China's 78 poverty status. Higher female than male mor- Regional Office. monitored rivers, and the country is treating tality rates are a particularly disturbing indi- only 2 percent of its total waste water. In cator of inequitable access to services. An in- India, only 217 of 3,110 towns and cities have creasing number of women are landless heads any form of sewerage treatment, and munici- of household, joining a traditional and very pal sewerage systems serve only 4 percent of large group of rural landless poor, especially India's population. In the absence of clean sur- in South Asia. face water, groundwater resources are also be- For Malaysia, Korea, Thailand, and possi- ing depleted, and since shallow wells dry up

36 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution first, the impact is felt disproportionately Left unchecked, these two countries in the India, Malaysia, and Indonesia. next 20 years will triple their carbon dioxide among the poor. Conclusion Atmospheric pollution in Asian countries is emissions and offset a 40-50 percent reduc- a matter of both national and international tion by the industrial countries. Consequently, Overall, Asia's prospects are good. Despite concern. Air pollution is a major threat to hu- Asia presents the greatest single threat to the the seriousness of problems, the favorable man health in cities like Beijing, and children world's environmental balance in atmospheric economic policy and institutional context pro- in Bangkok show increasing levels of toxic pollution. vide the foundations for progress. However, chemicals in their blood stream from automo- The World Bank's borrowers have initiated the 1990s forces policymakers to confront bile emissions. In addition, the rapid increase a number of efforts to address environmental some particularly disturbing developments: in atmospheric emissions in Asia's newly in- concerns. Most countries have either pre- the rise of serious macro imbalances, accentu- dustrializing nations contribute to global pared, or will prepare, environmental reports ated in some cases by the impact of events in problems such as acid rain and possible cli- or action plans in anticipation of the June 1992 the Middle East; the danger of losing momen- mate change. UN Conference on the Environment and De- tum in the implementation of structural re- The "greenhouse gases" implicated in velopment in Brazil. These will highlight envi- forms in the more vulnerable economies; the global warming are produced mainly by the ronmental problems at the national level and increasingly ominous interaction between large developed countries (the United States, identify regional issues related to natural re- poverty and population in countries with a the countries in the European Community, source management, human resource develop- high incidence of poverty; and finally, the ac- and the Union of Soviet Socialist Republic ment, and the need for concessional aid to celerating environmental deterioration in produce about 50 percent of greenhouse support recommended investment programs. many countries, which threatens the produc- gases), but the rate of increase is greatest in A major World Bank program with UNDP tive base of society. These developments the developing world, particularly in Asia. has sought to identify strategies to improve should temper the usual optimism bestowed Presently, Asia produces about 20 percent of conditions in Asia's largest cities, while many on the region as a whole and direct more the world's greenhouse gases. Emissions in Asian countries are studying means to miti- forcefully the attention of donors to an impor- India and China are growing by a startling gate urban and industrial pollution. To help tant subgroup of Asian countries that must 6-7 percent per year, while industrial world address global concerns, work sponsored by cross many hurdles before joining the ranks emissions are growing by less than 1 percent. several donors has been initiated in China, of their rapidly growing neighbors. •

^^^Hhc first in an annual series designed H to complement the World Develop- I ment Report. The GEP study presents the analytical underpinnings of WDR's discussion of in- ternational economic trends and examines a the economic links that bind both in- dustrial and developing economies in the global economy. It will focus each year on one key linkage; this year's is trade in pri- mary commodities. The study also includes a discussion AND THE outlining the characteristics of four pos- sible scenarios of growth during the 1990s, ranging from extreme economic un- DEVELOPING certainty to robust confidence in the qual- ity of economic management. 180 pages / US$10.95 COUNTRIES Order Stock #11838

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Finance & Development I September 1991 37

©International Monetary Fund. Not for Redistribution How Mobile is Capital in Developing Countries? Much more than is commonly assumed, reveals a new study Nadeem U. Haque and Peter J. Montiel Research Department, IMF

\^>ontrols over the international movement controls—for example, through over- and un- considerations: first, internally consistent of capital, often assumed to be pervasive and der-invoicing of imports and exports respec- time series of reasonable length were avail- stringent in developing countries, are neither, tively, smuggling, and bribery—appear to re- able in these countries in the two data sources according to the results of our recent research flect the ineffectiveness of such controls. we employed; second, among the countries into the effective mobility of capital in 15 di- Moreover, by keeping large amounts of their that satisfied the first criterion, the sample verse developing countries. As a result, capi- earnings or flight capital abroad, residents re- had to maintain a geographical balance and tal moves in and out of countries, both legally duce the ability of domestic authorities to represent a wide range of developing coun- and by evasion of controls, with much greater control the use of those resources with local tries. Our sample consisted of six Asian coun- frequency and ease than one would expect. instruments, such as interest rates or credit tries, four African countries, three Latin This has important consequences for eco- ceilings. At times, financial pressures (either American countries, and two European coun- nomic policy-making. for inflows or outflows) may be strong tries. It also included four low-income coun- The degree of capital mobility has an enough to lead to the official relaxation of tries and three heavily indebted countries. important bearing on the short-term effects of controls. The results should, therefore, be fairly repre- stabilization policies—including monetary, But not much is known with certainty sentative of developing countries in general. fiscal, and exchange rate policies—in devel- about the nature and extent of capital con- In order to test for capital mobility, we be- oping countries. A high degree of mobility in trols, and hence capital mobility, in develop- gan with the following two well-known a fixed exchange rate regime reduces the abil- ing economies. Empirical research has pro- propositions: (1) the interest rate in the do- ity of a government to devise an effective duced meager and rather mixed results. Much mestic market in a completely open economy monetary policy, which depends on control- of the earlier work to find out how far (i.e., when the capital account is open) is de- ling demand through monetary aggregates. changes in domestic credit policies affected termined by the uncovered interest rate parity By allowing external finance to move into an decisions by individuals and firms to move fi- (i.e., the sum of the foreign interest rate and economy, a high degree of capital mobility nancial resources in or out of a country has the expected depreciation of the exchange may nullify the contractionary effects of a typically shown that developing economies rate); and (2) the interest rate in a closed econ- nominal devaluation, or limit the crowding have limited domestic monetary autonomy, a omy is determined purely by domestic money out of private investment by an expansionary finding consistent with a high degree of capi- market equilibrium. Consequently, we as- fiscal policy. The strength of the effects tal mobility. But little work has been done to sumed that the domestic market-clearing in- varies with the degree of capital mobility. establish the extent of mobility across differ- terest rate in developing countries can be That, in turn, depends on the effectiveness of ent economies. expressed as a weighted average of the un- capital controls. covered interest parity interest rate and the The study Existing controls domestic market-clearing interest rate that To test for capital mobility, our study used would be observed if the private capital ac- The vast majority of developing countries annual data from 15 developing countries for count were completely closed. maintains significant legal restrictions over the period 1969-87. The size of the sample To measure the effective degree of capital capital movements, apparently motivated by was determined by data availability and the mobility in our diverse sample of developing the desire to facilitate monetary control and need to make the analysis manageable. Save countries, we estimated money demand equa- the management of their balance of payments. for the series on debt, the data were drawn tions by replacing the interest rate variable According to the IMF's Annual Report from the International Financial Statistics with the weighted average described in the on Exchange Arrangements and Exchange files of the IMF. Debt data were taken from box on methodology. This yielded an esti- Restrictions (1989), many developing econo- the World Bank's World Debt Tables. The mate of the weight attached to the uncovered mies do not allow the free flow of financial countries included in the sample were Brazil, parity interest rate, which represents an index capital. As a result, developing countries are Guatemala, India, Indonesia, Jordan, Kenya, of effective capital mobility. often assumed to have closed capital accounts, Malaysia, Malta, Morocco, the Philippines, Results of study except for borrowing by the public sector. Sri Lanka, Tunisia, Turkey, Uruguay, and The reality is different. Massive episodes Zambia. The results showed that 10 out of the 15 of capital flight and fairly routine evasion of The choice of countries was guided by two sample countries had high capital mobility;

38 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution that is, the polar case of a completely finan- cially closed economy can be ruled out, but A note on methodology not that of a completely financially open econ- omy (see box). The governments of these ten countries have little control over domestic in- In a completely open economy, the domestic interest rate would be equal to the interest rate that pre- terest rates and the money supply. Four other vails abroad, plus the expected rate of depreciation of the exchange rate (a situation known as inter- countries fall in the intermediate category of est parity). On the other hand, in a completely closed economy, the domestic interest rate adjusts to partial capital mobility—neither a completely clear the domestic money market. In an economy where capital controls are less than perfect, but open nor a completely closed economy. In not completely ineffective, interest rates would be influenced both by interest parity and by domes- these countries, the domestic interest rate tic money market conditions. Consequently, the domestic interest rate can be viewed as a weighted would be subject to partial control by the gov- average of these two polar extremes. ernment, at least in the short run. In only one If the three interest rates—the open economy rate, the closed economy rate, and the rate that actu- ally prevails—were available, then the weighted relationship could be estimated, and the weighting country, India, do the results suggest that factor would provide an estimate of the degree of effective capital mobility. An estimate of 1 as the capital is immobile. weight for the interest parity rate would indicate perfect capital mobility, while an estimate of 0 These results indicate that, on average, (zero) would suggest complete capital immobility. Values between 0 and 1 would indicate the degree over the period 1969-87, domestic market-de- of capital mobility. termined interest rates for this rather diverse Since the interest rate that would prevail if the capital markets are completely closed is a hypo- group of developing countries tended to move thetical construct, and since data for the market-clearing interest rate are not available in most de- quite closely with external rates and were rel- veloping countries, our method for estimating the degree of capital mobility relies on the estimation atively less influenced by domestic financial of money demand, where the demand for money is a function of the interest rate, income, and the developments—except to the extent that such lagged money stock. Substituting the weighted average for the domestic market-clearing interest developments were expected to lead to ex- rate in this specification gives us money demand as a function of the interest rate parity, the unob- servable closed economy interest rate, and other variables. change rate adjustments. The effective degree In the presence of completely effective capital controls, the interest rate would adjust to clear the of capital mobility may well have varied over money market. The unobserved closed economy interest rate can, therefore, be calculated as a func- time for some of the countries in the sample. tion of income, lagged money, and the closed economy money supply (i.e., the money stock net of However, scarcity of data prevents us from the monetary effects of private capital flows). Since all these variables are observable, substitution verifying this. of this result for the unobserved closed economy interest rate in the money demand equation gives us variables that are all observable and in which the degree of capital mobility can be directly esti- ... and their implications mated as the coefficient of the interest parity variable. The finding of a high degree of capital mo- For a detailed explanation of the methodology and results, see "Capital Mobility in Developing bility in developing economies has important Countries—Some Empirical Tests," available as IMF Working Paper WP/90/117 from the authors. implications for macroeconomic policy in these countries. First, this means that fiscal policy has relatively powerful effects, com- pared to monetary policy, on domestic de- mand and the trade balance. Second, mone- tary policy is relatively ineffective in a fixed exchange rate regime, with variations in do- fects are of limited duration. In spite of preva- cently in many developing countries—and in mestic credit lending to be offset by capital lent capital controls, capital flows proved to high domestic market-determined interest movements. Monetary policy, therefore, is ef- be sufficient to maintain fairly close interest rates. The latter are, in turn, likely to imply fective in influencing capital flows and the parity relationships with external interest high real interest rates, with adverse conse- balance of payments. rates over this period. quences for the level of economic activity and The results also suggest that capital con- The empirical effectiveness of this kind of for medium-term economic growth. High capi- trols tend to be ineffective, or at least their ef- interest arbitrage undermines a key argument tal mobility coupled with expectations of de- used to support policies of "financial repres- valuation may thus help explain, at least to sion" in developing countries. Maintaining some degree, the unsatisfactory performance low administered interest rates in the formal of private investment in many highly in- Estimated degree of capital mobility in selected developing financial system will not stimulate domestic debted countries over the past decade. countries, 1969-87 investment, since the marginal cost of funds Although the empirical finding of a high will be given by the market-determined rate in degree of capital mobility implies a loss of pol- ! ;U 3^;'>^^^^;f^,^j^rr"'; '.. informal loan markets, and this rate will effec- icy autonomy, governments should not try to tively move in line with external interest limit the degree of capital mobility for at least rates. Below-market controlled interest rates two reasons. First, there are familiar effi- will, under such circumstances, lead to ineffi- ciency reasons for allowing domestic prices to cient allocation of capital, reducing growth, '#&¥*•' ;-' '-"" ••' ; reflect external opportunity costs. Second, as Morocco '.;" and transferring income from domestic savers indicated previously, our findings suggest ^J^pgrws Partial capital mobility to favored domestic borrowers. that measures to limit the degree of capital The results also underline the importance mobility tend to be ineffective in developing of avoiding exchange rate misalignment in de- countries. The best policy under these circum- liiigjjay Malta Capital immobility veloping countries. Anticipated exchange rate stances would be to avoid exchange rate over- Zanl|i3: Turkey India - • i adjustments will quickly be reflected in capi- valuation through appropriate fiscal, mone- tal outflows—as has in fact been the case re- tary, and exchange rate policies. •

Finance & Development /September 1991 39

©International Monetary Fund. Not for Redistribution Accessing the International Capital Markets Companies from developing countries are now looking beyond their local financial markets to raise funds. How the IFC helps Kumiko Yoshinari Senior Investment Officer, Capital Markets Department, IFC

Ji\. Frankfurt-based investor buying shares only benefit the company but also interna- used in many developing countries differ sig- in a Mexican company? This is not as novel tional investors. Developing country compa- nificantly from those used in the industrial as it sounds. Since late 1989, an increasing nies are thus increasingly able to diversify countries; and (4) in most cases, the terms and number of companies located in developing their funding base beyond the local financial pricing of securities issues require the ap- countries (especially those in Latin America) markets, which still remain limited in size proval of the developing countries' authorities have been obtaining funding in the interna- and scope. In addition, the beneficial impact on a case-by-case basis. tional capital markets. They had done so, in a on the economies of developing countries Over the past five years, the International limited way, prior to 1982. But many of these should not be ignored. Such securities issues Finance Corporation (IFC) has become in- companies, with the exception of some in help introduce new financial instruments to creasingly involved in helping companies in Asia, were unable to obtain external financ- the domestic capital markets and harmonize developing countries raise financing through ing during most of the 1980s, largely because disclosure and accounting standards. All international offerings of investment funds the debt crisis in developing countries elimi- these developments could lead to a more ac- and individual corporate securities. This ef- nated investor interest in them. Now, with tive local capital market and consequently, in- fort gained momentum with the establish- growing confidence in their countries' creased mobilization of domestic savings. ment of the International Securities Group economic adjustment efforts, many compa- But it is not so easy for a developing coun- (ISG) in mid-1989 to provide investment nies have returned to selling securities on in- try firm to issue securities abroad. This is banking services to corporate clients in devel- ternational capital markets. In June 1989, a largely because (1) securities issued by com- oping countries. ISG (now part of the Mexican bank—Bancomext—issued a $100 panies from developing countries generally Securities and Syndications Division) serves million unsecured bond with a yield close to require more effort in placement and sales to developing countries and the international, fi- 17 percent. Since then, several Mexican is- investors compared with a similar undertak- nancial, and business communities in the fol- suers (including such well-known names as ing for a company in a developed country. lowing capacities: Telmex, Pemex, Cemex, and Nafinsa) have is- Investors generally prefer to purchase securi- • as an advisor to companies in develop- sued securities (e.g., bonds, floating rate ties of companies they are familiar with, or ing countries, encouraging them, when appro- notes, and convertible bonds) at increasingly are well known among investors. Also, the priate, to investigate the long-term advan- attractive rates abroad, followed by Chilean economic and political situation of the coun- tages of issuing securities abroad; and Venezuelan companies also eager to tap try in question is just as important and often • as a partner with some of the prominent the international capital markets. needs to be described in detail to potential in- international investment banks, in bringing Through such security issues, many devel- vestors; (2) the company's accounts and other companies from the developing countries to oping countries are gradually seeing their se- information are typically not disclosed in a the international capital markets. IFC is ac- curities markets integrated into the vast net- sufficiently detailed manner to meet require- tively involved in executing the securities of- work of the world financial markets. This is ments of institutional investors in the major fering, including direct sales to institutional not surprising as these securities issues not capital markets; (3) accounting standards investors; and

40 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution • as a provider of information to the world companies are likely to issue securities of suf- ratios—and have a potential for significant investor community on investment opportu- ficient volume to ensure some liquidity in the capital gains. nities in securities of emerging markets. ISG's financial markets. This is an important con- Once the structure of the offering is estab- efforts are complemented by IFC's Emerging sideration for investors, since active trading lished, the instrument must be "priced" by as- Markets Data Base, which provides detailed will enable them to sell the securities they ini- sessing likely demand. Usually, the financial financial information on over 800 companies tially purchased, with relative ease and at an intermediaries are called upon to use their in- listed on the stock exchanges in 20 develop- attractive price. vestor contacts and experience in evaluating ing countries. The company's track record (e.g., prof- the price at which an instrument is likely to Initially, IFC attempted to provide compa- itability and debt-servicing record) and the be sold. But this is often difficult in the case nies in the developing world access to the in- nature of its business are also important con- of securities issued by companies from devel- ternational capital markets through country siderations. Utilities, for example, generate oping countries, since there are few compara- funds, which invest in a large number of relatively stable income, making such compa- ble companies whose existing securities is- companies in a specific country. This was a nies particularly attractive compared with sues could serve as the benchmark for logical first step, as the professional fund other developing country companies, whose determining prices. managers select the companies in which in- earnings and performance are typically When the company agrees to the proposed vestments are made, and investors them- volatile. Export-oriented companies (includ- structure and pricing of the instrument, the fi- selves do not need detailed knowledge of var- ing commodity-based companies) are also nancial intermediaries then proceed to place ious companies in each developing country. good candidates for international securities the issue with investors (i.e., sell it). However, In addition, foreign investors initially consid- issues. Export receipts in foreign currency before proceeding with the marketing of the ered country funds "safer" than investing in help the company meet debt-servicing obliga- issue, approval for the offering must be ob- specific companies, given that these invest- tions even in times of rapid devaluations of tained from the authorities in the developing ments are typically diversified across several the local currency. Above all, it is important country in which the company resides, and in industries in a given country. Most of the to identify companies that are strongly posi- certain cases, in the country where the securi- companies in which country funds invest are tioned (relative to competitors) in those sec- ties are issued. There must also be a clear un- quoted on local stock exchanges. tors most likely to benefit from the country's derstanding on the tax treatment of income IFC has been instrumental in establishing economic growth. and capital gains realized by the investors 26 country funds (including debt-to-equity Arranging the securities issue. Once and on the ability to repatriate such gains conversion funds), targeting markets as di- the appropriate company is identified, one or freely. vergent as Argentina, Brazil, Chile, Hungary, several financial intermediaries (e.g., IFC and Placing the securities issue. Given the Indonesia, Malaysia, Mexico, the Philippines, investment banks) proceed to structure the se- risks involved in purchasing these securities, Portugal, the Republic of Korea, Thailand, curities, that is, determine the nature and what types of investors participate? Initially, and Turkey. In addition, IFC has helped cre- terms of the offering. This process involves a large proportion of investors interested in ate several multicountry and regional funds. discussions with the company's management securities issues (particularly bonds) of a de- We estimate the total current market value of to arrange for the financial instrument most veloping country company tend to be "flight country funds invested in developing coun- appropriate to the company's funding needs. capital" investors—that is, if a company from tries at over $10 billion. With country funds In some cases, the company needs additional country X wishes to tap the international having become a well-accepted product, IFC equity to increase its capital base in undertak- markets, one can expect significant participa- is going a step further by assisting individual ing a planned expansion. In other cases, the tion by investors of this country who hold as- companies located in developing countries to company may have a very low debt-to-equity sets abroad. This is natural given these in- issue securities internationally. Investors who ratio and may primarily need debt financing. vestors' familiarity and stronger ties with the were initially only willing to risk investing in Quasi-equity instruments, such as convertible company. developing country companies on a di- bonds or bonds with equity warrants, may be As the number of companies in developing versified basis through country funds are appropriate for a company unwilling to issue countries undertaking such issues increases, gradually becoming interested in specific shares because of the current low valuation of however, the core group of investors gradu- companies. its stocks, but would face a high cost if it ally shifts to international institutional in- Helping companies gain access to the inter- were to issue a debt instrument with no eq- vestors, such as pension funds, insurance national markets is a three-stage process. uity component. companies, and other financial institutions. Identifying the appropriate develop- In determining the appropriate structure Such investors seek to further diversify their ing country company for securities is- for the securities issue, the company's needs assets and realize a high investment return. sues. For countries that are "newcomers" in must be balanced against investor prefer- As shown by IFC's Emerging Markets Data terms of corporate access to the foreign capi- ences. In certain cases, the company may not Base, the performance of stock markets of de- tal markets, initial securities issues should have the full range of choices in the instru- veloping countries is not, on the whole, generally be undertaken by large companies. ments it is able to issue. Certain companies in strongly correlated with the performance of Such companies usually have significant pro- highly indebted developing countries may not industrialized markets. Even when the stock ject-related funding needs and would be best be able to issue debt instruments at reason- markets of the industrialized countries are able to appreciate the importance of diversify- able costs. Investors, quite naturally, will be performing poorly, those of the developing ing funding beyond the local capital markets; cautious about purchasing debt securities of a countries could be performing well. This dif- they are typically quoted and actively traded company located in a country with serious ference in performance enables the equity in- on the local stock exchange. In addition, for- debt-servicing difficulties. The same in- vestor to diversify risk by buying developing eign investors are most likely to be interested vestors may, however, be willing to purchase country securities. More and more interna- in larger companies, not only for reasons of equity securities, if such securities are inex- tional investors are becoming aware of this name and prestige but also because larger pensive—that is, in terms of price to earning advantage. •

Finance & Development I September 1991 41

©International Monetary Fund. Not for Redistribution Protection in Sub-Saharan Africa Hinders Exports High rates of protection hurt the export performance of many African nations, including the poorest Dean DeRosa

ab-Saharan African nations face major In opting for protection and against a more policies to promote exports. obstacles as they tackle their extensive eco- outward-oriented development strategy, This article presents an overview of the ex- nomic problems: loss of international compet- African countries frequently cite weak world tent and structure of nominal protection in a itiveness, low productivity, and mounting ex- market conditions for primary commodities large sample of Sub-Saharan countries. It also ternal debt, among others. While not all of traditionally exported by African countries analyzes the effects of this protection on the their problems are of their own creation, one and heightened protectionism in many indus- real exchange rate and level of exports of is definitely so. Recent research shows that trial countries. Liberalization of imports, on these countries. protection of domestic economies and prod- the other hand, is seen by these countries as The information on protection presented ucts against international competition is re- producing trade imbalances, making their ex- here is based on the Trade Information sponsible for major economic losses for most ternal payments positions more precarious. System (TIS) of the UN Conference on Trade countries in the region. While plausible on the surface, this posi- and Development (UNCTAD). The TIS is an Structural adjustment programs supported tion is not borne out by an examination of the inventory of import control measures in de- by multilateral agencies, such as the IMF and evidence. The commodity terms of trade of veloping countries established to support ne- the World Bank, have emphasized, among Sub-Saharan exports did fall substantially in gotiations to expand South-South trade on a other things, the need for countries to open the 1980s, but so did the terms of trade of preferential basis. It classifies restrictive im- their economies. This can be done by adopt- other regions, including East and Southeast port measures as tariffs, "para-tariffs" (other ing more flexible exchange rate policies, liber- Asia. Yet, the other regions showed higher fiscal charges applied to imports), and nontar- alizing exchange and trade regimes, and al- rates of real growth of exports and output. iff barriers—principally, various forms of lowing domestic relative prices to adjust to Sub-Saharan Africa has also had more favor- quantitative restrictions, foreign exchange re- levels close to those in the world markets. If able access to industrial country markets strictions, minimum price systems, and state they follow this course, it is argued, many than exports from other developing regions, trading monopolies. Tariffs and para-tariffs African countries—including the poorest mainly because primary commodities from are measured in familiar ad valorem terms. countries in Africa—could restore interna- the region face low tariff rates and quantita- Nontariff barriers, on the other hand, are mea- tional competitiveness, increase the produc- tive restrictions, and such exports are fre- sured in terms of frequency ratios, that is, the tivity of their investments, and enjoy a higher quently eligible for preferential treatment un- percentage of tariff-line items within an ag- level of economic growth, led in particular by der the import duty schemes of most gregate trade category that are affected by a a more robust export sector. industrial countries. given import regulation. The inventory in- If Sub-Saharan countries had opted for cludes information on the import restrictions open economic policies, they would have un- of 23 Sub-Saharan countries (see footnote to leashed a strong supply-side response from Table 1), which together accounted for nearly The detailed study on which this article is based is domestic producers. Specifically, to balance 60 percent of the region's recorded trade in available from the author. An earlier article consid- increases in imports under more liberal trade 1987, the most recent year for which pub- ers the related issue of the trade effects of simulta- neous exchange rate adjustments by Sub-Saharan arrangements, the real exchange rate would lished TIS data are available. (Since 1987, African countries; see "Witt Contemporaneous have adjusted—typically, to a depreciated several Sub-Saharan countries, including Devaluations Hurt Exports from Sub-Saharan level, increasing the profitability of exports Ghana, Tanzania, and Uganda, have begun to Africa?" by Joshua Greene and Dean DeRosa in and so increasing export revenues without undertake important structural reforms, in- Finance & Development, March 1991. the need for special programs or incentive cluding changes in their trade policies and

12 Finance & Development I September 1991

©International Monetary Fund. Not for Redistribution practices. The UNCTAD information pre- use of quotas (Kenya) and prohibitions gies than otherwise and reduce competitive- sented, however, still describes essential as- (Madagascar). Other frequently employed ness except behind high tariff walls and other pects of the trade regimes of most of the sam- nontariff barriers include minimum price sys- forms of protection. ple countries.) tems and state trading monopolies. Middle-in- come countries frequently administer prices of Protection and export performance Extent of protection imports. All the sample Sub-Saharan coun- The levels of protection in Sub-Saharan The low-income Sub-Saharan countries en- tries had state trading monopolies. Except in countries are substantially higher than in force the highest rates of protection, with a Angola, Mozambique, and Tanzania, where most other developing countries. Such dis- high frequency of nontariff measures (see state monopolies controlled a high proportion crimination against foreign goods reduces the Table 1). Because of widespread discretionary of imports in 1987, minimum price systems scope for greater economic efficiency and wel- licensing of imports and restrictive foreign ex- and state trading are much less frequent than fare and hinders the region's exports. change controls, the average frequency of either quantitative restrictions or foreign ex- There is a close relationship between pro- nontariff barriers is over 90 percent in the change controls in most countries. tection, the real exchange rate, and the level of lowest-income countries (below $300 per Detailed data underlying the summary pre- a country's exports. Essentially, restrictions capita income) and over 75 percent in the up- sented in Table 1 reveal a fairly common pat- on imports impose a tax on exports. When a per low-income countries (between $300 and tern of nominal protection in the 23 sample country restricts its imports, the import-com- $500 per capita income). By comparison, the countries for broad categories of primary peting sector increases its use of domestic re- frequency of these barriers is substantially commodities and manufactures. Foremost, sources in order to expand output to meet a lower, at about 50 percent—but still very they reveal that the Sub-Saharan countries larger share of local demand for traded goods. high—in the middle-income countries (per maintain escalating rates of tariff and other This causes the cost of domestic resources to capita income above $500). forms of protection against increasingly labor- rise, making exports based on those resources Both tariff protection and the frequency of intensive goods. In addition, for food security less competitive and, as a consequence, re- foreign exchange controls are somewhat reasons, these countries apply high rates of sults in an appreciation in the real exchange higher in the upper low-income countries than protection against food imports, especially ce- rate of the country. The subsequent decline in the other sample countries. Whereas the mid- reals such as maize, rice, and wheat. Finally, exports often will match the protection-in- dle- and lowest-income countries enforce aver- among other items, imports of labor-intensive duced fall in imports, with the result that age rates of tariff and total fiscal charges (in- apparel and other textile products are fre- there is no improvement in the external bal- cluding para-tariffs) in the range of 20-30 quently controlled, especially through mini- ance to the extent that the stance of macroeco- percent, the average rate of import duties in mum import prices and the operations of state nomic policies remains the same. the upper low-income countries is about 40 trading monopolies. Given that the Sub- In the case of trade liberalization (treated percent. The average for the upper low-in- Saharan countries themselves are predomi- below), the same economic process works in come countries results mainly from the high nantly low-wage economies, the emphasis on the reverse. Lowering tariff and other barriers rates of import duties in the two most popu- restricting labor-intensive imports is some- to imports reduces the implicit taxation of ex- lous countries in the group—Kenya and what incongruous. An explanation may be ports by reducing the extent of import substi- Sudan. The three groups of countries exhibit a that organized labor in the modern sector of tution in the local economy, thereby lowering similar pattern of foreign exchange controls. these countries (the sector that competes with the cost of domestic resources and causing the Discretionary import licensing is by far the imports) enjoys a wage rate higher than com- real exchange rate to fall. The resulting in- most widely applied quantitative restriction. petitive levels. This, in turn, may encourage crease in the profitability of exports ensures Some countries, however, rely heavily on the adoption of more capital-intensive technolo- that exports expand sufficiently to match the

i*w*i • • •• :'•'.?-• ••-. '.r'^-'i---^'. : : : . Import restrictions In Sub-Saharan countries, 1987 -' ' .-: - : P - - - '-'',- ' £ / ' ^ , • '• .';~.-'^,'..'^ '

Frequency of nontariff barriers (NTBs)1 Tariff and other charges" Foreign state Mean Total All Quantitative restrictions exchange trading tariff charges? NTBs Licenses Quotas Prohibitions restrictions^ monopolies

(In percent)" Low-income countries 30 34 89 51 3 3 40 14 Lowest income 24 29 95 64 0 2 39 21 Upper low-income 41 43 77 28 9 6 43 Middle-income countries 22 30 48 29 1 1 18 All countries 29 33 81 47 3 3 36 14

Sources: UNCTAD Secretariat, Handbook of Trade Control Measures of Developing Countries, 1987, and Handbook Supplement, 1987 (Geneva: UN Conference on Trade and Development, 1988). ... Indicates that statistics are not computable. The low-income countries in the sample were: Lowest income: Burkina Faso, Burundi, Guinea, Madagascar, Malawi, Mozambique, Tanzania, Uganda, Zaire, and Zambia. Upper low-income: Benin, Central African Republic, Ghana, Kenya, Sierra Leone, Somalia, and Sudan. The middle-income countries were: Angola, Cameroon, Congo, C6te d'lvoire, Senegal, and Zimbabwe. ' Percentage of tariff lines affected by NTBs, excluding restrictions on imports of alcohol and tobacco. sCustoms duties plus customs surcharges and surtaxes, stamp taxes, certain other fiscal charges, and tax on foreign exchange transactions. ^Advance import deposits, multiple exchange rates, and licensing or other restrictions on the acquisition and use of foreign exchange. "Statistics by country are simple averages of rates of protections across trade categories. Averages for country groups are computed using 1987 population levels as weights.

Finance & Development I September 1991 43

©International Monetary Fund. Not for Redistribution TableZ ESIImalOu eiivcm on export* »! llll|*wr* iiueraiizaiion ay Sub-Saharan African countries

Upper estimates1 Lower estimates? \folume \folume Relative Primary All Change in Relative Primary All Change in prices commodities Manufactures goods value prices commodities Manufactures goods value npereent) (In millions <'"—<> cME* " of US dollars)* Low-income countries 38.5 34.5 57.8 37.3 1,670.0 16.7 15.0 25.0 16.2 735.7 Lowest income 37.5 32.6 56.3 36.1 976.1 15.8 13.9 23.8 15.3 396.2 Upper low-income 40.3 37.9 60.4 39.5 693.8 18.2 17.1 27.3 17.8 339.5 Middle-income countries 15.1 10.7 22.6 11.7 984.9 8.8 6.5 13.2 7.0 568.5 All countries 34.1 30.0 51.1 32.5 2,654.8 15.2 13.4 22.8 14.5 1 ,304.2

Source: Comparative static analysis using the multi-commodity model for each country, using 1 985 trade flows, 1 987 import duties, and NTS frequency ratios, and assuming constant international terns of trade. Primary sources of data are UNCTAD Secretariat, Handbook of Trade Control Measures of Developing Countries and Handbook Supplement, 1987 (Geneva, UN Conference on Trade and Development, 1988); and World Bank, Trade Analysis and Reporting System (based on UN Series D Commodity Trade Tapes). 'Assuming import duties are reduced to 10 percent and administered imports are increased by 25 percent. ^Assuming import duties are reduced to 10 percent and administered imports are increased by 10 percent, sprice of exports relative to nontraded goods. 4Additional export value per annum, measured in 1985 dollars.

increase in import demand. mestic prices. In the simulation exercise, non- percent in the upper case and about 15 percent Empirical model. To measure the ef- tariff barriers were simply regarded as restric- in the lower case (see Table 2). Countries with fects of protection on the 23 Sub-Saharan tions imposed by national authorities to the highest rates of tariff and nontariff protec- countries' exports, a simple, multicommodity achieve quantitative limits on imports. tion showed the most "overvalued" real ex- model of trade and exchange rate adjustment Accordingly, as indicated by the frequency of change rates because of protection. In the case was used. The model assumed that the inter- nontariff barriers in each trade category, im- of Somalia, the extremely overvalued ex- national terms of trade of these countries are ports of each country that are predominantly change rate—which led to increases in the exogenously determined. It employed a com- subject to nontariff barriers were assumed to price of exports of between 140 and 56 percent mon set of assumed values for price elastici- be strictly controlled, and the model assessed after the liberalization—resulted from the ties of import demand and export supply of the effects of increasing the volume of these country's high frequency of nontariff barriers, five broad categories of traded goods (foods, imports by, alternatively, an upper estimate of combined with an especially low level of agricultural raw materials, mineral fuels, min- 25 percent and a lower estimate of 10 percent. recorded official exports in relation to im- erals and metal ores, and manufactures) in Results. The empirical results, which are ports. In other countries (e.g., Guinea, Central each of the sample countries, selected on the essentially long-term in nature and do not in- African Republic, Cote d'lvoire, and Congo), basis of published estimates of long-run price clude possible short-term costs of adjustment, where protection was low and recorded levels elasticities for foreign trade by African and indicate that import liberalization increases of exports relative to imports were consider- other countries. the value and volume of exports through the ably greater, the estimated effect of protection The multicommodity model was used to adjustment of export prices (relative to non- on the price of exports and the real exchange gauge the trade and exchange rate effects of traded goods). After the liberalization, the rate was relatively modest—as low as about 5 far-reaching import liberalization in each of price of exports (which is the inverse of the percent. the 23 Sub-Saharan countries under review. real exchange rate in the model) was esti- On export performance, the empirical re- This liberalization was represented by the re- mated to be higher, on average, by about 34 sults suggest that protection in the sample duction of import duties to a uniform rate of countries reduced the combined annual ex- 10 percent and an increase in the volume of ports of the 23 Sub-Saharan countries by be- administered imports by alternative "upper" tween about 3.5 percent and 2 percent of gross and "lower" a priori estimates of the extent to domestic output (GDP) each year, or between which nontariff barriers restrict imports. $2.7 billion and $1.3 billion a year in 1985 dol- Reduction of import duties to 10 percent Dean DeRosa lars. These estimates represent the loss of ex- a US citizen, is a Senior amounts to a substantial proportional reduc- Economist in the port revenues by the sample countries, on av- tion of ad valorem duty rates in most sample Developing Country erage, by between about 32 and 15 percent countries. For the high-tariff, upper low-in- Studies Division of the annually. Because of their higher rates of pro- come countries, the reduction is about 70 per- IMF's Research tection, the low-income countries "lost" the cent, while for the remaining countries, the re- Department. He holds a most potential export revenue, between about duction is about 50 percent of existing duties. PhD from the University of 37 and 16 percent on average. The other coun- The implications of nontariff barriers could Oregon. tries also experienced appreciable losses of not be well captured by the simple model, be- potential exports—between about 12 and 7 cause these barriers take many different percent of their total exports on average, as a forms and often have indirect effects on do- result of protection.

44 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution Disaggregated by commodity categories, tions are poorly administered and often in- Conclusion the results indicate that producers of primary clude special exemptions. Thus, even if Sub- commodities suffered the largest losses in ex- Saharan countries were to dismantle import The economic analysis and empirical find- port earnings because of the restrictive trade controls and reduce import duties to a uni- ings summarized in this article support the regimes in their own countries. Notably, they form rate of 10 percent, and if they were si- view that high rates of protection in the Sub- also suggest that protection appreciably in- multaneously to enforce customs duties with- Saharan countries are an important factor in hibits the expansion of nontraditional ex- out exemptions, total duty revenues would the economic condition of these countries to- ports. To the extent that export supply elas- not necessarily fall precipitously. The empiri- day and especially contribute to their poor ex- ticities are higher for manufactures than cal results suggested that some low-income port performance. More robust export perfor- primary commodities in Sub-Saharan coun- countries (Burundi, Kenya, Madagascar, mance and economic growth, however, tries (that is, exporters can quickly produce Malawi, and Tanzania) would experience lit- cannot be regained by simply reforming trade more manufactures to meet increased de- tle change in their fiscal revenues under a lib- policies, particularly to the extent that restric- mand), the simulated import liberalization eral import regime. In most instances, how- tive import measures reflect other political promotes greater proportional expansion of ever, the sample countries were estimated to and economic rigidities. Countries must, nontraditional than traditional (i.e., primary experience significant reductions in import therefore, pursue trade liberalization in asso- product) exports. duty revenues (relative to GDP) of about 1-2 ciation with other policy reforms. The most Finally, although the results are not sum- percentage points. To preserve the level of important areas needing reform frequently in- marized in Table 2, the multicommodity overall domestic savings, these losses might clude industrialization policies that discrimi- model estimated the impact of import liberal- have to be offset by improvements in the rev- nate against agricultural and rural develop- ization on total import duties and found that enue yield of other fiscal measures, where ment, economic policies that inhibit financial the net effects on revenues would be moder- available. In any case, in all instances losses development (including the growth of capital ate in some cases but substantial in others. in import duties, if any, should be weighed and foreign exchange markets), and regula- Although many of the sample countries rely against the expected enhancement of export tory and institutional arrangements that hin- heavily on international trade taxes for fiscal performance and economic growth engen- der wider investment by domestic as well as revenues, in some countries customs regula- dered by import liberalization. foreign private sector enterprises. •

NEW FROM THE INTERNATIONAL MONETARY FUND

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Finance & Development I September 1991 45

©International Monetary Fund. Not for Redistribution Madagascar: Crafting Comprehensive Reforms As it sought to overcome the constraints of the socialist economic structure that it had introduced in the 1970s, Madagascar began implementing a series of reforms from the mid-1980s, with help from the IMF and the World Bank S. Rajcoomar

Ihhee heavy weight of administrative con- thorities followed a prudent monetary policy, eral debt reschedulings by the Paris Club and trols, extensive nationalization, and a poorly initiated the structural reform process, and re- other official creditors and by commercial coordinated investment program that added moved some of the distortions between traded banks, as well as a significant amount of bi- to the burden of external debt—this list of ob- and nontraded goods. Helping this process lateral debt cancellation. Both the IMF and stacles to sustainable growth and financial were substantial inflows of capital and sev- the World Bank assisted the Malagasy au- stability is only a partial litany thorities to help change the of the misguided policies pur- economic course of the country sued in Madagascar during most over the 1980s, with a series of of the past two decades. The re- w,«-^.«.rsi,«*-*M£*&&-• arrangements and loans. sults were slow economic While a number of structural M'^-^ii^^^^m witw h Madaaasean 19liO»^ •-J*° ',4^,* ^j jf^^f™^*^;!" "**^ ' "" ***" w^w^BP^W^I^BwW^^y'- "^p^^^^* "*" £'K< growth, a decline in real per ; : ~ ""Vis £ problems remain and self-sus- capita GDP, and substantial im- tained growth is not yet assured, Approved balances in external and domes- Type of arrangement/facility Date approved amount the nature of the reforms under- tic accounts. Recent efforts by taken by Madagascar over the the Malagasy authorities provide (In millions past few years reflects the im- strong evidence of the gains that IMF arrangement and special facilities ofSDRs) portance of comprehensive can be made by moving to a sta- Stand-by (2 years) June 27, 1980 64.5 change and long-term commit- ble and more open economic Compensatory financing facility July 15, 1980 29.2 ment. In this case, the move 109.0 order, provided the political will Stand-by (14 months) Apr. 13, 1981 from a socialist planned econ- Stand-by (1 year) July 9, 1982 51.0 to attack fundamental problems Compensatory financing facility July 9, 1982 21.8 omy to a competitive market-ori- exists, and domestic efforts Stand-by (1 year) Apr. 10, 1984 33.0 ented one has been phased over are supported by international Compensatory financing facility June 27, 1984 14.4 a relatively short period, despite assistance. Stand-by (1 year) Apr. 23, 1985 29.5 the deeply rooted problems of Madagascar initially focused Compensatory financing facility May 28, 1986 16.1 the previous economic regime. on the attainment of financial Emergency assistance May 28, 1986 16.6 Eventual success, however, will stabilization, with complemen- Stand-by (18 months) Sept. 17, 1986 30.0 depend on how well these poli- tary measures to open up the Structural adjustment facility Aug. 31, 1987 46.5 cies are maintained over time economy to competition. It also Stand-by (10 months) Sept. 2, 1988 113.3 and on external conditions. tried to reform and restructure Enhanced structural adjustment facility May 15, 1989 76.9 Background the public enterprise sector, for- (In millions of mulate a new social policy, and Bank adjustment operations US dollars) In attempting to introduce a institute a strict public expendi- Industrial sector adjustment credit Jan. 15, 1985 60.0 Malagasy-style socialism, the ture control program. As a re- Agricultural sector adjustment credit Aug. 5, 1986 60.0 Government, in the mid-1970s, sult, the external current account Industry and trade adjustment credit June 30, 1987 100.0 adopted the Charter of the deficit was reduced significantly, Public sector adjustment credit June 29, 1 988 127.6 Revolution. Madagascar with- reflecting in large part a sharp Sources: IMF, Treasurer's Department, and World Bank, Statement of Development Credits, drew from the Franc Zone and cut in the fiscal deficit, while December 1990. imposed administrative controls gross international reserves rose in most areas of the economy, in- markedly. Meanwhile, the au- volving the nationalization of

46 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution several sectors, including the banking sys- tem. As a result, the economy grew at a slow •""''- """''• x pace, with real GDP rising at an average an- •'^;, nual rate of less than 2 percent, implying a steady decline in real per capita GDP. 1980 1985 1986 1987 1988 1989 To accelerate the growth rate, a large-scale investment program was implemented be- (In percent Qf GDP) tween 1978 and 1980. Given the absence of External current account balance -14.0 -8.7 -2.9 -6.0 -5,7 -3.5 proper coordination, and an efficient system Domestic savings -1.4 0.9 6.2 4.9 7.2 9.1 Overall budget deficit 14.3 3.8 3.3 3.5 3.5 4.2 of project implementation, this had little last- 1 ing impact on the country's productive capac- Debt service ratio 18.1 88.6 89.8 98.6 105.1 100.0 ity, but ended up quadrupling its external 'In percent of exports of goods and services, before rescheduling. debt. At the same time, the Government pur- sued an expansionary financial policy that was aggravated by unfavorable movements Madagascar: in its terms of trade. Quantitative restrictions selected on trade were intensified, resulting in sub- economic fee were abolished. Moreover, the complex stantial external and domestic disequilibria, indicators, system of export taxation was simplified con- pronounced distortions in relative prices, 1980-89 siderably and replaced by ad valorem taxes and an accumulation of external payments (Annual percentage change) on traditional exports, involving a substantial arrears. reduction in the rates. Against this background, since the early On the import side, a liberalized import 1980s, the authorities have implemented sev- regime was introduced in 1987, covering 25 eral economic adjustment programs, sup- percent of imports. This import regime was ported by the IMF and the World Bank, subsequently replaced by an open general li- aimed at reducing domestic and external fi- cense system for all imports, thereby elimi- nancial imbalances (Table 1). These pro- nating the discretionary system of foreign ex- grams, which were designed to open the econ- change allocation. The Government also omy to competition, included far-reaching abandoned the requirement that importers structural reforms in the areas of internal and provide domestic currency to cover 100 per- external trade, the financial sector, public en- cent of the value of imports, allowing com- terprises, social policy, and public expendi- mercial banks to decide on the need for such ture programming. Meanwhile, the authori- guarantees, which in no case could exceed 20 ties implemented a prudent demand percent of the value of imports. A comprehen- management policy. By the end of the 1980s, sive reform of the tariff system was begun in Madagascar had achieved considerable 1988 to promote efficient import substitution progress on the macroeconomic front: the ex- and export industries within the mixed pub- ternal current account deficit was reduced lic/private sectors. The aim was to reduce the significantly, owing largely to the improve- effective rate of protection significantly, to 35 ment in the overall fiscal position, the pursuit percent over four years, and to decrease of prudent monetary policy, and a narrowing sharply the dispersion of tariffs by limiting of distortions in relative prices between Sources: Central Bank of the range eventually to 10-50 percent. Madagascar; Ministry of traded and nontraded goods (see chart and Economy and Planning; Progress in this area has been encouraging, and IMF staff estimates. Table 2). At the same time, the authorities ac- and the program is expected to be completed corded a greater priority to the social and en- on schedule. In the meantime, a significant vironmental aspects of adjustment. liberalization of invisible transactions has regularly adjust the exchange rate in light of taken place, with an emphasis on incentives Structural changes the differences in the relative inflation rates for investment and exports. External reform. Although the Govern- vis-a-vis Madagascar's trading partners. The Public enterprise reform. In 1988, ment was initially reluctant to adjust the ex- currency's exchange rate declined to the with the assistance of the World Bank, the change rate to a realistic level, it became evi- equivalent of FMG 2,014 per SDR at the end Government formulated a three-year program dent by 1982 that the widening external of 1989 from FMG 335 at the end of 1981. to rehabilitate the public enterprise sector and current account deficit and difficulties in ob- Despite some initial resistance, the authori- to reduce its predominance in the economy. taining adequate external assistance would ties took comprehensive measures in 1987-89 After full implementation of the process of require substantial remedial action. Over to reduce administrative barriers to exports liquidation, divestiture, or restructuring, the 1982-87, the exchange rate was devalued on and to eliminate government export public enterprise sector was expected to be several occasions in the context of successive monopolies and export licensing require- cut to about half its initial size by 1991, while stand-by arrangements with the IMF, lower- ments. A new export law allowed exporters to all the remaining public enterprises were to ing the value of the Malagasy franc (FMG) by export freely all their products (with the ex- be reorganized or financially rehabilitated. a cumulative total of 80 percent against the ception of vanilla) at prices negotiated di- Although some progress was made in several basket of currencies to which the currency rectly with foreign importers, while the state areas, the privatization and rehabilitation pro- was pegged. A mechanism was also set up to export monopolies in pepper, cloves, and cof- gram was delayed, and a central entity was

Finance & Development I September 1991 47

©International Monetary Fund. Not for Redistribution established only in late 1990 to coordinate the Fiscal reforms. The Government's fiscal technical assistance report. Regarding capital overall reform program. The Government strategy has been geared toward generating expenditures, the system of annual formula- adopted a number of measures to limit the fi- additional saving, reinforcing the incentive tion of a three-year rolling public investment nancial burden of public enterprises on the framework through tax reform, and con- program was improved, with the plan elabo- budget. A moratorium was imposed on the tributing to the rehabilitation and expansion rated each year by August 31. Public invest- creation of new public enterprises in 1988, of the productive capacity of the economy. In ment policy has rightly placed strong empha- while the level of bank credit and budgetary addition to withdrawing progressively from sis on the rehabilitation and development of transfers to 22 unviable public enterprises directly productive activities, the authorities the country's economic and social infrastruc- has been limited to the 1987 amounts. An assigned a higher priority to improving es- ture, thereby providing essential support for overall ceiling on credit to public enterprises sential public services—notably social ser- private sector productive activities. was also fixed under successive IMF sup- vices and infrastructure—and enhancing the Sectoral reforms. While the initial ad- administrative capacity of the most critical in- justment effort centered around financial sta- stitutions. This reorientation of priorities of bilization, the Government formulated vari- ous sectoral programs to stimulate domestic production, particularly in the area of liberal- ization of trade in agricultural products. The strategy involved a sharp reduction in admin- Africa istrative controls and the streamlining and simplification of the regulatory and legal framework. With the liberalization of the in- ternal marketing of all agricultural products, Madagascar: basic data, 1989 Area: 587,000 square kilometers the Government began to remove controls Population: (In millions) 11.3 from virtually all agricultural producer GDP per capita (In SDRs) 175 Share of agriculture in GDP 30/3 prices, consumer prices, and profit margins. It Value of exports (In millions of SDRs) 249 approved a new investment code and enacted Of which: coffee (60) legislation to establish industrial free trade vanilla . -' (33) Exports as a percentage of GOP . 12.9 zones; by the end of 1990, more than 100 fran- Imports, c.i.f., as a percentage of OOP 15.2 chises had been awarded under these two External debt as a percentage of GDP 118.5 codes. Lessons and prospects ported programs (including no credit to a few the public sector demanded a prudent fiscal Although the Malagasy economy has unviable enterprises). policy, with a gradual improvement in rev- recorded substantial improvements in recent Financial sector reform. In order to enue performance and strict control on expen- years in the context of successive adjustment further establish a dynamic and competitive diture; this allowed the Government to repay programs supported by the IMF and the financial system, thereby helping to stimulate a substantial proportion of its borrowing World Bank, many structural, institutional, private saving, in 1988, the Government em- from the central bank. and financial problems continue to constrain barked on a program of restructuring the On the revenue side, the main focus was on the prospects for growth. The Government state-owned domestic banking system by a continuation of the rationalization of the tax will need to consolidate the gains obtained to opening it to private domestic and foreign in- and tariff structures and a broadening of the date, while accelerating the pace of funda- vestors. A critical element of this operation tax base. The monitoring and control of the fi- mental reforms. Given Madagascar's vulnera- was the restructuring of the portfolios of all nancial operations of the Central Government bility to external shocks and heavy reliance three banks. This involved the liquidation of were also enhanced, and the structure of pub- on foreign assistance, unfavorable exogenous all non-performing and doubtful assets, lic spending improved. The Government initi- developments are likely to have an immediate followed by the partial privatization of two ated the reform of budgetary and manage- adverse impact on the economy. The fragility banks (with the participation of foreign ment procedures on the basis of an IMF of the economic and financial recovery was partners). clearly exposed in 1990, when the country's Along with the reorganization and deregu- international reserves declined to their lowest lation of the financial system, the monetary level in several years as the terms of trade authorities were able to gradually reduce re- deteriorated further. liance on direct credit control in favor of indi- With the experience of several countries rect instruments of monetary control. This in- S. Rajcoomar confirming that progress in structural reform from Mauritius, is a Senior volved the modification of policies relating to Economist in the Indian is a slow process, Madagascar must trans- minimum reserve requirements, the removal Ocean Division of the IMF's form its economy more rapidly to enhance its of the ceilings on credit for individual banks, African Department. He flexibility and resilience in dealing with such and the phasing out of the system of prior holds degrees in Economics shocks. In this regard, the immediate priori- credit authorizations. The authorities took ini- from East Anglia, ties should include quicker reform of the pub- tial steps to broaden the recently introduced Birmingham, and St. lic enterprise sector, improvement of the pub- money market, improve the mobilization of Andrews Universities, lic investment program, and streamlining of small savings, and widen the array of finan- where he also taught. the institutional, legal, and regulatory proce- cial services offered by banks, including ex- dures that have played a major role in cons- port financing. training output. •

48 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution I •!•!•]Li^l

Stefan Gerlach and Peter A. Petri (editors) decisively rejected by experience—even "need not be left to journalists," and he in- The Economics of the Dollar if those positions make for nice models" vited some two dozen economists to write (p. 117). Peter Garber reviews the debate papers analyzing Federal Reserve policy Cycle over whether the dollar's strength in the making. The overwhelming impression The MIT Press, Cambridge, MA, USA, 1990, vii + 381 pp., $37.50. mid-1980s was just a speculative bubble, one gets from reading these papers is and he argues that we cannot answer that that the individual policymakers and their Thomas Mayer (editor) question until we first are able to evaluate responses to political pressures and The Political Economy of the fundamental determinants of the dol- bureaucratic biases are as important as American Monetary Policy lar's value; but that prior issue has also the economic theories that underpin proved elusive. their work. Several chapters argue that Cambridge University Press, New York, NY, USA, 1990, ix +314 pp., $42.50. As for the future, there seems to have Federal Reserve decisions cannot be been a reasonably general agreement at adequately explained by estimating reac- Here are two books dealing with different the conference that if the United States tion functions, or by appeal to maximiza- facets of monetary economics: one inter- hoped to balance its external accounts, it tion of either the public welfare or the pol- national, the other domestic. Both pro- should not only reduce its budget deficit icymakers' own self-interest. The Federal voke thought more by explaining why the but allow the dollar's exchange value to Reserve is subjected to pressure from right policies are hard to formulate than decline further as well. That argument both the Congress and the Administra- by trying to find easy answers to difficult was made by James Tobin, Ralph Bryant, tion, but its leaders have worked hard and questions. Rudiger Dornbusch, and others. It is with much success to maintain a measure To start with the international issues: worth noting, then, that three years later, of independence from those pressures. Why did the US dollar rise so dramatically the dollar had depreciated by a further The Fed's policies consequently have in the first half of the 1980s and then fall 10 percent in effective terms, while the been formulated and implemented with even more sharply in 1985-87? How did budget deficit had remained stubbornly discretion and have not generally been that cycle affect the world economy? And high. The US current account deficit had subjected to formal rules. was this a problem that calls for a policy declined from around 31/2 percent of GNP Most of the authors represented in response, or should the market be left to just under 2 percent, but further Professor Mayer's book are critical of the alone to determine exchange rates and progress was proving difficult. This con- Federal Reserve, and many of them would payments balances? In December 1987, figuration of events is only part of a com- prefer a system of rules that would subject an outstanding group of academic econ- plex picture, but it does tend to vindicate both the Fed and its political overseers to omists gathered at Brandeis University to the mainstream view of what was greater accountability. Even those favoring wrestle with these questions and to try to required. discretionary countercyclical policy, such assess the implications of the dollar cycle On the domestic front, "Fed watch- as Elmus Wicker, find that the practice of it for economic policy. The papers pre- ing"—studying the decisions and the deci- has fallen far short. Suggested reasons for sented at that conference have now been sion-making process of the US Federal the failures of Fed policies include incom- collected and edited by two Brandeis pro- Reserve System—has long been a fa- plete use of available information (Wicker), fessors, Stefan Gerlach and Peter A. vorite pastime of financial journalists, reliance on poor forecasts (Raymond Petri. The result is a generally quite clear bankers, and others who in various ways Lombra and Nicholas Karamouzis), reluc- and policy-directed compilation, which in- depend on the Fed for their livelihood. In tance to admit mistakes (Mayer), an ab- cludes some stimulating discussion of the 1987, an American journalist, William sence of incentives to establish account- papers as well. Greider, carried this vocation to an appar- ability (Edward Kane), and the reluctance The questions posed above are obvi- ent extreme with an 800-page book or inability of the Congress to develop ef- ously daunting, and it should not be sur- (Secrets of the Temple: How the Federal fective oversight (Nicholas Beck and prising that even the finest economists Reserve Runs the Country) that studied James Pierce). are hard pressed to find convincing an- the institution, its leaders, and its role in What is missing from these studies is a swers. Consequently, the most interesting American society in more depth (and with clear set of prescriptions for improve- papers in this volume are those that es- more vituperation) than one would have ment. It is doubtful that any of these au- chew trying to build castles in the sand thought imaginable. Most monetary thors would argue that Congress could be and try instead to explain why we cannot economists, on the other hand, have counted upon to establish a set of rules know all that we seek to know. Paul been content to study the results of mon- that would lead to better outcomes. Krugman, for example, discusses the fail- etary policy, without devoting much time Independence and discretion in the imple- ures of many popular explanations for the to the human processes that give rise to mentation of rules will always be required, swings in the dollar's value, and he con- those results. and perhaps the strength of this book cludes with a call for a modest but elusive Thomas Mayer, for the past three —like that of Gerlach and Petri—is that it reform: We cannot draw lessons for pol- decades a University of California eco- avoids looking for simple solutions for an icy, he notes, "until there is some willing- nomics professor and a student of US extremely complex problem. ness to abandon positions that have been monetary policy, decided that the topic James M. Boughton

Finance & Development / September 1991 49

©International Monetary Fund. Not for Redistribution Michael E. Porter tional industry. How these industries were hard measurement. This work would be The Competitive Advantage of chosen from the many hundreds of possi- much enhanced by more use of statistics Nations ble cases is not explained. A few are pre- and less use of example. sented as self-contained case studies in The author persistently refers to his an- The Free Press, New York, NY, USA, 1990, xi 855 pp., $35. Part II. An analysis of these cases leads alytic framework of four principle determi- Porter to identify four major determinants nants as a theory. The framework is not Porter's objective in writing this volume is of international competitiveness: factor tested in a rigorous way, nor is it used to to extend his earlier work on the competi- conditions (land, labor, and capital); de- predict which firms will emerge as interna- tive strategy of firms to the national con- mand conditions (composition and size of tionally competitive in which countries. text. He hopes to learn why some nations home market demand and its relation to The author states that his framework prosper and others do not. Much interest- foreign demand); related and supporting could be used for predicting future indus- ing information is presented—a virtual industries (presence of such industries try evolution (p. 175), but he never uses it shower of anecdotes that is often repeti- that are already internationally competi- for this purpose. What the book presents tive—but the author is more successful at tive); and firm strategy, structure, and ri- is a rich set of hypotheses about the de- presenting suggestive hypotheses than at valry. Other minor determinants are terminants of export success, with little developing or testing a theory. chance and government policy. The four analysis of the relative importance of vari- The first few pages quickly shift from major factors provide an organizing ous determinants. the basic issue—the determinants of framework used to analyze why selected The analysis of government policy is national productivity and productivity industries are internationally competitive. very modest and is covered for develop- growth—to a focus on the success of in- Porter describes the current competi- ing countries in only five of the book's 735 dustries in international markets, which tive situation (in terms of industrial pages. Governments should foster a absorbs the rest of the book. Porter terms exports and economic performance) of competitive environment, promote educa- such success "international competitive- eight countries (Germany, Italy, Japan, tion, invest in infrastructure, and expand ness," which he defines as significant ex- Korea, Sweden, Switzerland, the United research capacity. In addition, increasing ports of goods and services, or significant Kingdom, and the United States) in Part the level of savings and investment and foreign direct investment by an industry. III. Then in Part IV, he goes on to make promoting the development of efficient The empirical link between national pro- suggestions about appropriate strategies capital markets are deemed crucial for ductivity and international competitive- for companies to pursue and appropriate growth. The author is not enthusiastic ness is not presented, but merely as- policies for governments to implement, about the efficacy of macroeconomic pol- serted. No mention is made of what along with presenting diagnoses and sug- icy in general, nor of devaluation in partic- determines the productivity of industries gestions for the eight countries reviewed. ular as a stimulant for international com- producing nontraded goods. For exam- The problem posed in the book is the petitiveness. However, he sees a greater ple, one reason for the high level of pro- matching of industries and nations, each role for government policy in developing ductivity in the United States is the high of which has many varied attributes. The than in developed countries. productivity of US service industries, but question is: Which nations are the best lo- This book is a bountiful source of infor- these industries are not big exporters. cations or home countries for which in- mation about specific industries, and it And success in exporting commodities dustries? The analysis is carried out by provides a useful taxonomic device for an- and simple manufactured goods need not reviewing the findings of the numerous alyzing successful industries. Firm man- imply high productivity. case studies on almost an individual ba- agers will find much that is relevant, but Part I covers over one hundred case sis, and the transition from these in- there is little in the way of specific recom- studies of industries in ten leading devel- stances to the overall performance of the mendations for government policymakers oped nations. Each of these case studies country is unsupported. This leads to a or for the analyst of developing countries. is of an internationally competitive na- lack of clarity, much repetition, and little Gregory K. Ingram

Lance Taylor (editor) neoclassical) approach as well as to the far of greatest interest. Socially Relevant Policy CGE methodology, which lends itself to a Taylor identifies structuralism with a Analysis much greater degree of microeconomic number of general hypotheses about de- detail than is typically found in small veloping country macroeconomics. These The MIT Press, Cambridge, MA, USA, 1990, x + 379 pp., $37.50. mainstream macroeconomic models. The include the recognition that (1) many book consists of a lengthy overview es- agents possess significant market power; The phrase "socially relevant" in the title say by Lance Taylor, followed by twelve (2) LDC macro-causality tends to run from of this book does double duty. The book is chapters consisting of applications to indi- "injections," such as investment, exports, essentially a collection of structuralist vidual countries by various authors. The and government spending, to "leakages," computable general equilibrium (CGE) overview essay appropriately provides a such as imports and saving; (3) money is models for developing countries, and the useful description of the tenets of struc- often endogenous; (4) the structure of the phrase "socially relevant" is meant to ap- turalism and a brief synopsis of CGE financial system can affect macroeco- ply both to its structuralist (as opposed to methodology. Of these, the former is by nomic outcomes in important ways; and

50 Finance & Development / September 1991

©International Monetary Fund. Not for Redistribution (5) in the LDC context, imported interme- ample, departs substantially from CGE that devaluation can be contractionary if diate and capital goods, as well as direct tradition by incorporating a fairly detailed imported intermediate inputs are impor- complementarity between public and pri- financial sector. This is necessitated by tant, that targeted food price subsidies vate investment, are likely to be empiri- that chapter's focus on the effects of de- are superior to income transfers and gen- cally important. In spite of the occasional valuation in a "dollarized economy" (i.e., eral price subsidies, or that raising admin- polemical tone of the essay, many of where a large number of US dollars are istered prices can be stagflationary. these hypotheses would command wide held by residents). Overall, the quality of All told, whatever one thinks of the agreement among developing country the exposition in the applied chapters is CGE methodology, this is a collection of macroeconomists, suggesting that struc- good, and the workings of the country sensible papers that address, in a careful turalism—at least in this sense—may models are fairly transparent. The analy- way and with attention to country circum- have made its point. sis is indeed focused on "socially rele- stances, policy issues that repeatedly The country-specific applications, which vant" questions, such as the optimal de- confront developing country macroe- comprise the rest of the book, embody sign of food subsidy programs in Mexico, conomists. As the papers here illustrate, many of these structural features. The the distributional effects of price controls the macroeconomic tradition that this CGE methodology is applied consistently in Nicaragua, the effects of raising admin- book reflects continues to contribute to in these chapters, though the structures istered prices in India, and so on. In gen- the formulation of responsible macroeco- of the models differ in major ways de- eral, the findings are reasonable and nomic policy in developing countries. pending on the policy questions being ad- would not offend many nonstructuralists. Peter J. Montiel dressed. The chapter on Mexico, for ex- It is not surprising to find, for example,

Frank A. Cowell be viewed by society as fair, if the rules An optimal strategy would depend on a Cheating the Government: The of the game are not simple and well number of factors. One important guide- Economics of Evasion understood. line is to allocate resources so that an ap- The middle chapters proceed with the propriate relation is maintained between The MIT Press, Cambridge, MA, USA, 1990, xii + 267 pp., $27.50. development of models of taxpayer be- the cost of enforcement and the revenue havior and the empirical evidence sup- received directly from those audited, and This book is a comprehensive state of the porting them. The standard theoretical indirectly from any increase in general art primer on the economic analysis of tax results are presented—that evasion de- honesty. A second consideration, one evasion. Though he makes no concession pends on the probability of being caught, having important equity implications, is to those who cringe at mathematical mod- the severity of the penalty, and the risk the appropriate trade off between penal- elling, Cowell succeeds in combining aversion and income levels of individuals. ties and enforcement effort. At a more technical elegance with a healthy dose of Another important factor, and one that microeconomic level, the design of opti- facts and anecdotes, excellent writing, Cowell has examined in greater depth mal audit strategies depends on the infor- and frequent wit. The notes to the elsewhere, is the availability of tax avoid- mation available to the government. This chapters are a particularly rich source of ance strategies, tax shelters, and the pos- area has been researched quite actively material. sibility of "exiting" to the informal or under- of late and indicates that significant im- The basic premise of the argument is ground economy. Building on the models provements over "blind" audit strategies that the problem of tax evasion or, more of taxpayer behavior, the last chapters ad- are available that may greatly improve the generally, cheating the government, is in- dress the issue of the appropriate govern- efficiency of the tax collector. An improve- trinsic to public finance. Self-interested in- ment response. ment in the use of information—mainly dividuals will not voluntarily finance the An important theme underlying the last from tax returns—may, however, lead to optimal amount of public goods, preferring chapters, on policy agenda and policy de- an exodus to the underground economy. instead to maximize their own consump- signs, is that, although, on paper, eliminat- The possible resultant economic losses tion, while enjoying the public works pro- ing evasion is a trivial task—merely in- would mitigate the gains from effective vided by others. This creates a need for a crease the penalty to the point where no enforcement. government tax enforcement strategy. sane individual would dare cheat—there The primary strength of the argument in The first few chapters are devoted to are significant problems with this solution, this book may be, for some readers, a the definition of the problem and an exam- primarily that in most societies the nature source of disappointment. Having care- ination of its scope. Cowell compels the of the crime must bear some relation to fully constructed a treatise on tax evasion, reader to admit that the line between ille- the nature and magnitude of the punish- the author maintains his intellectual hon- gal evasion and legal avoidance is fine in- ment. Tax evasion is not viewed in most esty by shunning sweeping arguments deed and clearly varies from country to societies as a particular evil act and un- and proposals. The issues are fundamen- country. This point is important later on duly harsh penalties for evasion would not tal, complex, and interesting. Readers of when optimal enforcement policy is dis- be enforced. In addition, high penalties "Cheating the Government" will obtain cussed and provides an entry into the is- raise the issue of the potential venality of much useful insight, but will find no quick sue of the appropriate extent to discour- tax collectors, who would be all the more and simple solutions to the puzzles posed age evasion or avoidance. Furthermore, tempted to make side deals. Con- therein. the existence of ambiguity in the tax law sequently a more sophisticated strategy Peter Stella implies that harsh penalties may not for tax enforcement is necessary.

Finance & Development / September 1991 51

©International Monetary Fund. Not for Redistribution David Pearce, Anil Markandya, and Edward B. capital. In spite of the difficulties of defin- natural capital stock criterion would only Barbier ing constancy of capital, their case seems hold on the average for the set of projects Blueprint for a Green Economy very convincing. Certainly ecologists in the program and not for each project. Earthscan Publications Ltd., East Haven, CT, USA, would also find this approach more satis- This does not seem to help at all and in 1989, xvi +192 pp., $13.95. factory. So too, should economists, since fact sacrifices efficiency by "socializing" this is a generalization of J.R. Hicks' defi- the costs of sustainability among all the Originally written as a report to the UK nition of income as the maximum annual projects in a program, instead of making Department of the Environment, this little consumption that still leaves capital intact each project bear its own full marginal so- book is both a primer on environmental at the end of the year—only capital is now cial opportunity cost—a principle elo- economics for politicians and a challenge taken to refer mainly to natural capital. quently defended elsewhere in the book. to economists to wake up to the critical For those involved in environmental Nevertheless, the basic principle is a pow- importance of the environment for eco- projects, the chapters on project appraisal erful one and the question of the best way nomic theory and policy. The topics cov- and on discounting the future will be of to apply it merits more discussion by ered include the meaning of sustainable special interest. The most promising sug- economists. development, valuing the environment, gestion for integrating sustainability into The chapter on discounting is the best environmental accounting, project ap- project appraisal is simply to require that short discussion I have seen of the issue. praisal, discounting the future, and mar- every project be sustainable—that is, that The authors' basic point is that the dis- ket-based incentives for environmental it not degrade the natural capital stock on count rate should reflect the combined in- improvement. The book is intended for the which it depends either for regeneration of fluence of time preference and productiv- layman, even though some rather ad- its raw material inputs or absorption of its ity, and should not be altered to take vanced discussion is encountered in the waste outputs. If a project does either of account of environmental externalities. chapter on discounting. In general, the au- these things, as frequently must be the The latter should be incorporated directly thors have done an admirable job of ad- case, then that project must be coupled in the cost and benefit estimates of the vancing the discussion, while at the same with a joint or shadow project that will re- project and not indirectly in a doctored dis- time remaining within the intellectual con- build the degraded natural capital, such count rate. Indeed, they argue, it is hard to fines of neoclassical economics. But, the that the two together meet the condition of know which is more environmentally book bears the mark of its origins—a gov- maintenance of natural capital stock. The friendly, a high or low discount rate. A high ernment report done under a deadline two are then considered as a unit and discount rate speeds up depletion of non- with no time for second thoughts and pol- ranked against other sustainable projects renewables and rotation periods of renew- ishing. A more polished discussion of the by conventional criteria. This seems to me ables, and thus seems unfriendly to the same material is provided by Pearce in his a proper principle, even though there will environment. But a low discount rate lets recent text with R. Kerry Turner— surely be difficulties in carrying this a greater total number of projects be ap- Environmental and Resource Econo- through. What is really surprising, how- proved, all of which also put demands on mics—which is also highly recommended. ever, is that the authors then immediately the environment. It is hard to tell a priori On the definition of sustainable devel- retreat from this principle saying that "at whether the total investment effect will be opment, the report rejects the "nondeclin- the level of each project such a require- greater or less than the more rapid ex- ing utility approach" as fundamentally ment would be stultifying. Few projects ploitation effect—another topic that should non-operational and advocates a defini- would be feasible." They advocate apply- engage the discussion of economists. tion in terms of constant total capital ing the principle at a program (multi-pro- Herman E. Daly .stock, later sharpened to constant natural ject) level, so that the nondegradation of

Neil G. Kotler land farming technology in India; the Iringa ment endeavors must begin with a proper Sharing Innovation integrated nutrition project in Tanzania; the understanding of those needs and a clear growth of Chile's fruit and vegetable export vision of how to reinforce a community's Global Perspectives on Food, industry; and the "Operation Flood" dairy ability to act. Remarkably, there is very Agriculture, and Rural Development development program in India. With few little emphasis in the papers on the role Smithsonian Institution Press, Washington, DC, USA, exceptions, the authors played vital roles in of the public sector, other than with re- 1991, v + 265 pp., $12.95 (paper). the developments they describe, and un- spect to maintaining a conducive policy This very readable book presents the pa- like books written by "outside" experts, environment. pers and proceedings of an international there are clear messages here from key The book includes a verbatim account colloquium on food and agriculture held at practitioners about the factors that they of the discussions that followed the the Smithsonian Institution, in conjunction think led to success. presentation of the papers. While some with the awarding of the 1989 World Food Despite the'diversity of experiences re- useful condensation might have been Prize to Dr. Verghese Kurien, chairman of ported, a clear message emerges about achieved with the aid of rapporteurs' re- the National Dairy Development Board the importance of involving local, commu- ports, there are sufficient gems (e.g., ("Operation Flood") in Anand, India. nity-based, and often private institutions in Dr. Kurien's informal comments on what The papers review a number of success any development project. Farmers and ru- really makes Operation Flood work, stories in agricultural development: the ral communities must have the freedom pp. 224-28) to make much of the discus- Awe community project in Nigeria; the and flexibility to act in accordance with sion a useful read. green revolution in Asia; advances in dry- their own perceived needs, and develop- Peter Haze//

52 Finance & Development/ September 1991

©International Monetary Fund. Not for Redistribution BOOKS in brief Other Books Received

Kate Phylaktis and Mahmood Pradhan (editors) David Sahn (editor) Listed below are some of the books we received but International Finance and the Less Seasonal Variability in Third World were unable to review because of lack of space. Developed Countries Agriculture Rudiger Dornbusch and Steve Marcus (edi- St. Martin's Press, New York, NY, USA, 1990, xli + 193 pp., The Johns Hopkins University Press, Baltimore, MD, USA, tors), International Money and Debt: $59.95. 1989, xiv + 366 pp., $44.50. Challenges for the World Economy, ICS With fears about the impact of the debt crisis This well-ordered book uses a solid set of case Press, San Francisco, CA, USA, 1991, x + 200 on the world's financial system having abated, studies to illuminate the important theme of pp., $12.95 (paper). attention has now shifted to how individual production risk and food security. The case J.L. Dubois and D. Blaizeau, Connaftre les debtors are coping with the crisis. This book studies, drawn from Africa and Asia, evaluate conditions de vie des menages dans les strikes a nice balance between a number of the impact of seasonal variability in climate on pays en developpement, Ministere de la theoretical and empirical issues that arise in food security and malnutrition and examine Cooperation et du Developpement, Paris, this context. The opening paper by Moshin how food is obtained in times of seasonal France, 1989, Vol. 1,165 pp., FF72; Vol. II, 312 Khan on evaluating the effects of IMF-sup- scarcity, both in the labor market and on the pp., FF84; and Vol. III., 175 pp., FF72. ported adjustment programs is a readable and farm. The implications of seasonal variations Richard E. Feinberg, John Echeverri-Gent, comprehensive guided tour of the work that for marketing and price policy and the impact and Friedemann Miller, and contributors, has been done in this area—and of its limita- of technology and policies on seasonal food Economic Reform in Three Giants: U.S. tions; Peter Stanyer offers a well-argued pes- security are also considered. A final chapter Foreign Policy and the USSR, China, and simistic view of the securitization of bank debt reviews the policy implications of the case India, Transaction Books, New Brunswick, NJ, as a solution to the problem of debt overhang; studies. USA, 1990, viii + 247 pp., $24.95 ($15.95 Paul DiLeo and Eli Remolina are rather more paper). optimistic about the ability of debt conversions Helmut Forstner and Robert Ballance, to ease debtors' financial problems; Carmen Li Competing in a Global Economy, Unwin and Mahmood Pradhan examine the link be- Ralf Hussmanns, Farhad Mehran, & Vijay Verma Hyman, Winchester, MA, USA, 1990, xvi + 225 tween financial liberalization and bankruptcies Surveys of economically active pp., $49.95. in Argentina; Kate Phylaktis looks at the effects Population, Employment, Unem- David Glover and Ken Kusterer, Small of capital controls in Argentina, Chile, and ployment and Underemployment Farmers, Big Business Contract Farming, Uruguay; and Alvin Marty analyzes the interac- and Rural Development, St. Martin's Press, An ILO manual on concepts and methods tion between inflation, financial intermediation, New York, NY, USA, 1990, vii + 170 pp., $45. and economic growth. The comments that fol- International Labour Office, Geneva, Switzerland, 1990, xvi + J. Orstrom Molher, Technology and Culture 409 pp., $32. low each paper, which give us a taste of the in a European Context, Handelshojskolens controversies surrounding some of these is- A critical issue in the economic analysis of de- Forlag, Copenhagen, 1990, 48 pp., 88 DKK. sues, are welcome—all the more so in that the veloping economies is the nature and role of David Pearce, Edward Barbier, and Anil commentators do not merely suggest refine- labor. Most LDCs are labor-rich. But concepts Markandya, Sustainable Development: ments at the margin, but also point, where ap- of employment, unemployment, and underem- Economies and Environment in the Third propriate, to more fundamental shortcomings. ployment are hard to define in such World, Earthscan Publications, London, economies. This ILO manual should help England, 1990, xi + 217 pp., £9.95. statisticians survey economically active popu- Pascal Salin, Macroeconomie, Presses Directory of Nongovernmental lations, giving policymakers better information Universitaires de France, Paris, France, 1991, Organizations in OECD Member on labor markets and their roles in developing vii+ 388 pp., FF125. Countries countries. D.S. Tyagi and Vijay Shankar Vyas (editors), Development Center of the Organization of Economic Co- Increasing Access to Food: The Asian operation and Development (OECD), Paris, France, 1990, 708 Experience, Sage Publications, Newbury pp., $50. Park, CA, USA, 1991, 455 pp., $27.50. John K. Whitaker (editor), Centenary This updated and improved edition provides Essays on Alfred Marshall, Cambridge concise descriptions of the aims, development University Press, New York, NY, USA, xii + 298 education work, and development activities of Credits: Composition: Betty Maguire, IMF pp., $49.50. 2,542 NGOs in the OECD member countries. Graphics Section. Art on the cover and pages The volume also offers indexes to facilitate ac- 2, 6, 10, 18, 22, 26, David Wisniewski. Charts: In-Ok Yoon, IMF Graphics Section. World cess to information on the work of NGOs in the Bank photos: Ivan Andrews. IMF photos: FAREWELL development field. It includes entries in English Denio Zara and Padraic Hughes-Reid. With this issue, we and French. Useful guide for development say goodbye to our planners and practitioners. Art Editor, Dick Stoddard, who is retiring after 19 New readers who wish to receive Finance & Development regularly should years with Finance & Development. apply in writing to Subscription Services, Finance & Development, International During his tenure, Monetary Fund, Washington, DC 20431, USA, specifying the language edition Dick helped make and briefly stating the reasons for their request. The contents of Finance & this journal more Development are indexed in Business Periodicals Index, Public Affairs Infor- readable and acces- mation Service (PAIS), and Bibliographie Internationale des Sciences Sociales. sible to the intelligent layman with his graphics and overall design. An annual index of articles and reviews is carried in the December issue.

Finance & Development / September 1991 53

©International Monetary Fund. Not for Redistribution International Monetary Fund announces.

The IMF's Statistical Systems in Context of Characteristics of a Successful Exchange Revision of the United Nations' Rate System A System of National Accounts by Jacob A. Frenkel, Morris Goldstein, and Paul Masson IMF's Statistical Department and edited by Vicente Galbis This study, Occasional paper 82, identifies the key Experts from the IMF, UN, OECD, EC, and statistical characteristics of a successful exchange rate system. It institutions examine issues pertaining to external sector focuses on regimes in the industrial countries and transactions, public sector accounts, and financial flows considers the implications for the operation of the and balances. international monetary system. US$35.00. English, (paper) xxvii + 599 pp. 1991. US$10.00. English, (paper) ISBN 1-55775-215-X ISBN 1-55775-159-5 Stock # S082EA Stock # ISSCEA Currency Convertibility and the Transformation of Legal Effects of Fluctuating Exchange Rates Centrally Planned Economies by Joseph Gold by Joshua E. Greene and Peter Isard This volume discusses some of the major legal effects of This study, Occasional Paper 81, examines the problems fluctuating exchange rates in both public international in establishing currency convertibility—and the optimal law and national law. The problems and similarities in timing—in formerly planned economies transforming the solutions are reviewed, and the author recommends toward market-oriented systems. further developments in the law. US$10.00. English, (paper) ISBN 1-55775-214-1 US$37.50. English, (cloth) xviii + 473 pp. 1990. Stock # S081EA ISBN 1-55775-173-0 Stock # LEFEEA Domestic Public Debt of Externally Indebted Countries Financial Liberalization, Money Demand, and by Pablo E. Guidotti and Manmohan S. Kumar Monetary Policy in Asian Countries This study, Occasional Paper 80, discusses the evolution by Wanda Tseng and Robert Corker of domestic public debt in several indebted countries and Occasional Paper 84 examines the financial reforms its relationship with their external debt and underlying undertaken by nine Asian countries in the 1980s fiscal developments. It examines the links between (Indonesia, Korea, Malaysia, Myanmar, Nepal, the domestic and external debt, taxes, subsidies, and Philippines, Singapore, Sri Lanka, and Thailand), and government spending, and reviews strategies for their implications for money demand and monetary managing domestic public debt. policy. US$10.00. English, (paper) ISBN 1-55775-208-7 US$10.00. English, (paper) ISBN 1-55775-220-6 Stock # S080EA Stock # S084EA To order, please write or call: Economic Reform in Hungary Since 1968 International Monetary Fund by Anthony R. Boote and Janos Somogyi Publication Services This paper, Occasional Paper No. 83, examines Box FD-103 Hungary's reforms since 1968, and discusses the 700 19th Street N.W. Government's medium-term adjustment program, Washington, D.C. 20431 U.S.A. unveiled in the fall of 1990, which aims to install the key elements of a market economy in three years. Telephone: (202) 623-7430 US$10.00. English, (paper) ISBN 1-55775-216-8 Telefax: (202) 623-7201 Stock #S083EA Cable Address: INTERFUND

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