Public Disclosure Authorized x~ I,, C Public Disclosure Authorized .,m -- tA Public Disclosure Authorized U . L,j Public Disclosure Authorized Crisisand Reform in Latin America Crisisand Reform in Latin America FROM DESPAIR TO HOPE Sebastian Edwards Publishedfor the World Bank OXFORD UNIVERSITY PRESS OxforrdUniversity Press OXFORD NEW YORK TORONTO DELHI BOMBAY CALCUTTA MADRAS KARACHI KUALA LUMPUR SINGAPORE HONG KONG TOKYO NAIROBI DAR ES SALAAM CAPE TOWN MELBOURNE AUCKLAND and associated companies in BERLIN IBADAN © 1995 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. Published by Oxford University Press, Inc. 200 Madison Avenue, New York, N.Y. 10016 Oxford is a registered trademark of Oxford University Press. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press. Manufactured in the United States of America First printing August 1995 The findings, interpretations, and conclusions expressed in this study are entirely those of the author and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. Library of CongressCataloging-in-Publication Data Edwards, Sebastian, 1953- Crisis and reform in Latin America: from despair to hope / Sebastian Edwards. p. cm. Includes bibliographical references and index. ISBN 0-19-521105-7 1. Structural adjustment (Economic policy)-Latin America. 2. Economic stabilization-Latin America. 3. Latin America- Economic policy. 4. Latin America-Economic conditions-1982- 1. Title. HC125.E39 1995 338.98-dc2O 95-6551 CIP Contents PREFACE Vii 1. INTRODUCTION: THE LAUNCHING OF THE REFORMS 1 The Reforms, 1982-93: A Brief Overview 6 Plan of the Book 10 PART I. THE DEBT CRISIS AND EARLY ADJUSTMENT: 1982-87 15 2. MUDDLING THROUGH: ADJUSTMENT FROM 1982 TO 1987 17 Was the Debt Crisis Anticipated? 18 External and Domestic Origins of the Crisis 22 The Adjustment 23 Heterodox Stabilization Attempts in the Mid-1980s 33 Fiscal Control and Incomes Policies: The Mexican Pacto 39 3. THE EMERGENCE OF A NEW LATIN AMERICAN CONSENSUS 41 The Crisis of Traditional Economic Thinking in Latin America: An Overview 43 Factors behind the Emerging Consensus 48 How Broad is the Emerging Consensus? 58 PART II. AN ERAOF ADJUSTMENT AND REFORM: 1987-93 67 4. MACROECONOMIC ADJUSTMENT AS A PRIORITY 69 Debt Restructuring, Debt Relief, and Macroeconomic Adjustment 71 Fiscal Policy and Macroeconomic Equilibrium 83 Exchange Rates, Inflation, and Disinflation 99 Summary and Conclusions 105 Appendix 4-1: Debt and Debt Service Reduction Agreements 106 Appendix 4-2: Inflationary Inertia and Nominal Exchange Rate Anchors 107 V Vi CONTENTS 5. THE OPENING OF LATIN AMERICA 115 From Protectionism to Liberalization: Some Analytical Aspects 117 Recent Trade Liberalization Reforms in Latin America and the Caribbean 124 Effects of Trade Liberalization 129 Real Exchange Rate Behavior, Capital Inflows, and the Future of Trade Reforms in Latin America 137 Regional Trading Blocs in Latin America 142 Appendix 5- 1: Productivity Growth and Openness: An Econometric Analysis 164 6. PRIVATIZATION AND DEREGULATION 170 Privatization and Deregulation: Analytical Issues and Policy Options 171 Privatization Programs in Chile, Mexico, and Argentina 183 7. CAPITAL MARKET DEREGULATION, SAVINGS, AND INVESTMENT 200 Financial Repression in Latin America: Historical Background 203 Financial Deregulation in Latin America: Regional Trends and Selected Experiences 208 Savings and Investment 224 Appendix 7-1: Financial Development and Productivity Growth 249 8. POVERTY,INCOME DISTRIBUTION, AND HUMAN RESOURCES 252 Poverty and Income Distribution 256 Education, Human Capital Formation, and Social Conditions 273 Labor Market Regulations in Latin America 277 Addressing the Social Agenda: Policy Options and Priorities 286 PART Ill. LOOKING TOWARD THE FUTURE 293 9. THE MEXICAN CRISIS OF 1994 AND THE FUTURE OF THE LATIN AMERICAN REFORMS 295 The Mexican Peso Crisis of 1994 and Its Lessons 296 Latin America after Mexico 303 Conclusions 313 Appendix 9-1: The Simple Economics of Current Account Sustainability 314 NOTES 319 REFERENCES 331 INDEX 353 Preface DURING THE PAST FEW YEARS, THE LAIIN AMERICAN COUNTRIES HAVE gone through major economic reforms that have greatly changed the region's economic landscape. What started as an isolated and slow process-Chile was the sole reformer in the 1970s-has become a sweeping movement affecting virtually every country in the region. The economic system that had emerged in the 1930s, based on heavy government intervention, protectionism, and broad regulations, has given way to one based on market orientation, open- ness, and competition. Perhaps the greatest sign of change is the eagerness with which most nations in the region have pursued free trade agreements with the industrial world. This contrasts sharply with the economic isolation- ism and autarkic attitude of only a decade or so ago. What makes the current reform process particularly attractive is that it has taken place at a time when democratic rule has returned to virtually every country, Cuba being the glaring exception. This book deals with the history of the Latin American economic reforms. It analyzes the economic developments in the region from 1982 to 1994. The starting point is the debt crisis of 1982, and the discussion then focuses on the heterodox plans of the mid-1980s, the stabilization programs of the late 1980s, the opening to international trade, the privatization and deregulation process, and social security reforms. Finally, the book describes the circum- stances that led to the Mexican peso crisis of December 1994. Throughout, the discussion emphasizes the evolution of social conditions in the region, including poverty and inequality. The analysis addresses a number of important conceptual issues that have preoccupied economists for a long time. Among other topics, it deals with the sequencing of reform, the speed of trade liberalization, the role of ideas in the launching of a reform process, alternative modes of privatizing state-owned enterprises, the effectiveness of exchange rates as nominal anchors, and the vii viii PREFACE use of emergency social funds as a way of providing a social safety net during the transition. An important conclusion of the analysis is that many of the lessons from the Latin American countries will be useful to other nations embarked on reform processes, including Asian and Eastern European countries. The book ends with an analysis of the eruption of the Mexican crisis of 1994 and an evaluation of Latin America's challenges for the future. In the last chapter, I argue that there is an urgent need to reduce the region's legendary degree of poverty. Social unrest in a number of countries has recently reminded regional leaders that a significant number of people, more than 110 million by some counts, still live in abject poverty. Simply put, this means that if Latin America is to achieve social peace and stability, and if the market-ori- ented reforms arc to be consolidated, the political coalition that supports the modernization process will have to be expanded. This, in turn, means that the rate of economic growth will have to accelerate significantly and the fruits of progress will have to be distributed more evenly. I started working on this book in July 1992, when I was at UCLXsAnderson Graduate School of Management. S. Shahid Husain and Marcelo Selowsky, then vice president and chief economist, respectively, of the World Bank's Latin America and the Caribbean Region, persuaded me that the time was ripe for evaluating the Latin American structural adjustment program. In March 1993, I finished a draft that was circulated broadly and discussed extensively in numerous seminars at the World Bank, research institutions, and universities. I am grateful to many colleagues for their comments, sugges- tions, and criticisms. They helped to improve the manuscript greatly. In Sep- tember 1993, a revised and shortened version of the original manuscript was circulated at the World Bank Annual Meetings under the title "Latin America and the Caribbean a Decade after the Debt Crisis." In revising the manuscript, I especially benefited from long and detailed comments by Andres Bianchi, Albert Fishlox, Arnold Harberger, and Fran- cisco Gil Diaz. Fernando Losada assisted me diligently, and almost always with a good sense of humor, throughout the many stages of this project. The finished book is the product of a team of capable professionals, led by Alfred Imhoff, that included Vicki Chamlee, Gaudencio Dizon, Elizabeth Forsyth, Audrey Heiligman, and Cindy Stock. I am particularly grateful to Jennifer Abner, who not only typed the final version efficiently but has made my life manageable since I came to the World Bank. Sebastian Edwards JVashington, D. C. August 1995 CHAPTER 1 Introduction: The Launching of the Reforms LATIN AMERICA ENTERED THE POST-WORLD WAR II ERA WITH GREAT optimism. International reserves were at record levels, an incipient manufac- turing sector was developing vigorously, and faith in the ability of government policies to secure growth and cure social ills was almost unlimited. Moreover, the creation of the Bretton Woods institutions generated