Policy reform and the resolution of the debt crisis

Carnegie-Ro~es~r ConStance Series on ~ b ~ Nor~-Holland

Po/icy 30 (1989) 11~ 128

POLICY REFORMAND THE RESOLUTIONOF THE DEBTCRISIS A COMMENT SEBASTIAN EDWARDS* University of California, Los Angeies and National Bureau of Economic Research

Anne Krueger has written an interesting and important paper on the prospects for solving the debt c r i s i s in the near future.

In a nutshell,

Krueger's argument is that there are two main requirements for the resol u t i o n of the c r i s i s . only then w i l l

F i r s t , world trade should grow at a healthy rate;

the indebted countries be able to s u f f i c i e n t l y increase

exports and generate the required trade surpluses. This expansion of world trade requires, in turn, that the industrial economies grow at respectable rates and that protectionist sentiments and policies are curbed. The second requirement is that the developing countries undertake far-reaching policy reforms that would result in an improvement in overall performance and growth. She suggests that the existing multilateral agencies - - and presumably a newly created one - - should provide new money to those countries seriously engaged in policy reform. Krueger provides important information regarding the role of capital flows in the development process, the origins of the debt c r i s i s , and the nature of the emergency phase of the adjustment, but says very l i t t l e about the details of what she considers to be the overriding requirements for regaining creditworthiness. proposed solutions - -

Although her c r i t i c a l revision of some of the

the new f a c i l i t i e s ,

changing the nature of the

l i a b i l i t i e s , and the "radical" schemes - - is persuasive, the paper does not go into a detailed discussion of what is meant by "policy reforms...[that are{ s u f f i c i e n t l y far reaching...", nor does i t discuss the specific ways in which these policy reforms - - which presumably include trade and financial l i b e r a l i z a t i o n and privatization - - should be implemented. In t h i s comment, thus, I w i l l concentrate on a number of specific issues related to the role of policy reform,

and in particular trade

l i b e r a l i z a t i o n , in the process of resolving of the debt c r i s i s .

0 167-223i189/$3.50 © 1989, ElsevierScience Publishers B.V. (North-Holland)

Manyof my

comments will be in the form of questions on the implementation of policy reform.

I. WHAT KIND OF TRADE REFORMS? Anne

Krueger

has been a pioneer

of the modern

literature on policy

reform in the poorer nations; she has long advocated that the developing countries undertake

steps toward

liberalizing

their external

sector.

It

comes as no surprise, then, that she now considers trade liberalization as a pivotal aspect other

authors

believe

that

in any longer-term solution to the crisis.

--

and

trade

indeed the reform,

supporters

coupled

with

of

the

Baker

A number of plan

privatization

and

--

also

finsncial

liberalization, is the most reasonable (only?) strategy that will allow the poor countries to regain creditworthiness

at the same time as they resume

growth. A problem with most of this recent literature, including this paper, is that

it

Moreover, meaning

of

is

seldom

through

clear

what

"trade

liberalization"

the years we have witnessed

"liberalization."

This

exactly

means.

some sort of shift in the

has introduced considerable

confusion

into the policy debate, with people never being sure what other participants really mean.

For instance, in a recent paper presented at the World

Bank-IMF Conference on the debt crisis

and adjustment with growth, Sachs

(1987) questioned the idea that "trade liberalization" policies are indeed a required component of successful debt strategies. advocated "outward-oriented" policies.

As an alternative

he

Waking reference to the experiences

of the East Asian countries -- Japan, Korea, Singapore, Taiwan, and Hong Kong -- Sachs argued that these countries'

success was to a large extent

due to an active role of government in promoting exports in an environment where imports had not yet been fully liberalized, and where macroeconomic (and especially fiscal) equilibrium was fostered. Sachs

depends

liberalization

on

how

outward

are defined.

orientation, Unfortunately,

Whether one agrees with

export with

promotion,

its vagueness

and

trade

Krueger's

paper has not helped solve the confusion that plagues this literature. In the more traditional policy literature of the 1960s and 1970s trade liberalization was defined in a very general way; what economists usually meant was some relaxation of trade and exchange controls. by now

classical

NBER

study on

trade

regimes

directed

In fact, by

in the

Bhagwati

and

Krueger, a liberalization episode was defined as a more extensive use of 116

the price mechanism that would reduce the anti-export bias of the trade regime. 1

In her review a r t i c l e on the problems of l i b e r a l i z a t i o n delivered

at the World Bank conference on the dynamics of l i b e r a l i z a t i o n ,

Krueger

(1986) argued that even a ( r e a l ) devaluation in the presence of QRs ( q u a n t i t a t i v e r e s t r i c t i o n ) constituted a l i b e r a l i z a t i o n episode. These are indeed very broad and mild d e f i n i t i o n s of l i b e r a l i z a t i o n . very few people w i l l

raise an eyebrow about them.

In f a c t , today

I t i s unclear from my

reading of the current paper i f t h i s type of reform i s what Krueger has in mind. Recently, however, "trade l i b e r a l i z a t i o n " has acquired a more d r a s t i c connotation, meaning ( f o r many people) an elimination of QRs coupled with a severe reduction of import t a r i f f s

to a uniform level of around 10 percent.

Moreover, trade l i b e r a l i z a t i o n has, in many ways, become synonymous with free market oriented p o l i c i e s with minimum or no government i n t e r v e n t i o n at any l e v e l ; l i b e r a l i z a t i o n has been taken as a synonym f o r laissez f a i r e . The difference between the old and new d e f i n i t i o n s of "trade l i b e r a l i z a t i o n " i s , of course, one of degree or i n t e n s i t y .

While a devaluation

in the presence of qRs, or the replacement of qRs by (quasi) equivalent tariffs,

i s a mild form of l i b e r a l i z a t i o n , the reduction of t a r i f f s

(with

no QRs) to a uniform 10 percent or, for that matter, the complete e l i m i nation of t a r i f f s ~

is a very d r a s t i c l i b e r a l i z a t i o n .

In order to c l e a r l y

understand the d i f f e r e n t issues involved in p o l i c y discussions i t i s , then, crucial to specify the i n t e n s i t y of the l i b e r a l i z a t i o n we are r e f e r r i n g to. Unfortunately, necessary to

this

is

not always done.

produce some s y n t h e t i c ,

without ideological biases, w i l l

It

is clear,

clarifying

then, that i t

pieces t h a t ,

put things into perspective.

is

hopefully It

i s im-

portant to pause and r e f l e c t ; to make an inventory of what we know, of what we t h i n k we know, and of what we do not know! This type of analysis, a l though humbling, should be of great help f o r policy evaluatiG~ and design. There i s l i t t l e doubt that a successful export promotion p o l i c y requires some kind of trade l i b e r a l i z a t i o n . In f a c t , the h i s t o r i c a l evidence c l e a r l y shows that those countries that have successfully embarked on that kind of strategy have had a more " l i b e r a l "

trade regime than those coun-

t r i e s f o l l o w i n g indiscriminate import s u b s t i t u t i o n . The successful outwardoriented countries have generally had lower coverage of p r i o r

lsee Bhagwafi (1978) and Krueger (1978).

117

licenses

systems, lower average t a r i f f s ,

less dispersion in their t a r i f f s , and less

episodes of real exchange rate overvaluation. Although the evidence supporting the merits of outward orientation is abundant, there

is no well-developed theoretical

model - -

or empirical

evidence for that matter - - linking very low (or zero) import t a r i f f s to higher 9rowth.2

Nor is there evidence suggesting that a completely "hands-

off" policy on behalf of the government is the most desirable alternative. In fact,

the success of the East Asian countries with export-led gro~h

suggests that

some selectively

determined degree of

intervention

specially aimed at supporting exports -- played a key role. and important question becomes one relating

--

The d i f f i c u l t

to the optimal degree of

government intervention or to the optimal level and structure of import tariffs.

This is indeed one of the most d i f f i c u l t question of economic

policy, whose answer (even at the pure abstract and theoretical level) w i l l depend on the existence of other distortions, the completeness of markets, and the availability of other policy tools, among other things.

II,

FOREIGNCAPITALAND TRADEREFORM

Krueger argues that

the

existing

multilateral

private banks and even some new multilateral

institutions,

the

agencies especially created

for this purpose should provide new funds to those countries

seriously

engaged in policy reforms. The idea is to have a smooth transition from an i l l i b e r a l to an open economy. The new funds would mainly be used to finance needed increases in imports - -

not matched in the short run by corre-

sponding increases of exports - - and to finance new investments. An important question is whether, rather than encouraging refor,l, these capital inflows will make liberalization less likely. For a long time Rona~d McKinnon has strongly argued against providing financial assistance to countries embarked on a liberalization effort.

In a recent piece where

he evaluated the (less than successful) Southern Cone experiences with liberalization, he wrote: [Olfficial International

2See Luca~

agencies such as the World Bank or the

Monetary Fund should not t r y

(1988) f o r a discussion

of

these issues.

118

to buy trade

liberalization by giving aid.

Never t r y to bribe someone

into liberalizing, because you are injecting capit~l at the time the liberalization occurs, and you mak~ the liberalization much harder to sustain. en~)hasis in the original|

!McKinnon 1984, p. 478;

McKinnon's point has mainly to do with real exchange rate behavior. Successful trade liberalization requires a real exchange rate depreciation, while the absorption of foreign capital requires a real appreciation. What capital inflows do, then~ is preclude the real exchange rate from devaluing sufficiently.

There is now empirical evidence supporting this view.

A

series of studies on real exchange rate behavior in the developing countries have indeed found that increased capital inflows result, with other things given, in a real exchange rate appreciation (Edwards, 1989, forthcoming). The recent experience of the Southern Cone is educational. Argentina attempted to liberalize i t s trade regime at the same time as absorbing major quantities of foreign capital. The real overvaluation generatc~ by these capital inflows, plus other policy mistakes, resulted in the ~ade reform policies having very l i t t l e credibility. Domestic firms used the newly obtained foreign capital to lobby against the reform instead of investing in those sectors where the country had a comparative advantage (Rodriguez 1983, Calvo 1986). The Chilean case is somewhat similar. The absorption of large amounts of foreign capital after April 1980, coupled with the pegging of the nominal exchange rate resulted in a (quasi) fatal real overvaluation that exceeded 30 percent and greatly contributed to the Chilean crisis of 1982 (Edwards, 1985). I t has been argued that one way of avoiding these problems is by adopting a very active nominal exchange rate policy consisting of a crawling peg. According to this system, in order to avoid overvaluation, the nominal exchange rate is frequently devalued at approximately the rate of domestic inflation. This recommendation, however, ignores two important points. First, the absorption of the foreign capital requires a real appreciation. I f the real exchange rate cannot adjust because the nominai rate is constantly devalued, the transfer of foreign capital fron, the rest

119

of the world to the country w i l l not take place. 3

Second, a policy of

accelerating the rate of nominal devaluation to combat real appreciation w i l l usually fuel domestic i n f l a t i o n .

I I I,

LIBEKa,LIZATION AND STABILIZATION

Krueger's paper does not deal with the important issue of the interrelation between disinflation policies and trade liberalization reform. She does not address the question of whether i t is convenient to implement farreaching trade reforms in countries suffering from high rates of i n f l a t i o n , nor does she ask whether i t

is appropriate to implement trade reforms at

the same time as disinflation programs are being pushed. This problem is particularly important, since a f a i r l y large number of the major debtors s t ~ l l face very high rates of inflation and have not solved their macroeconomic disequilibrium. In the three major Latin ~erican debtors - Argentina, Brazil, and Mexico -~ i n f l a t i o n is s t i l l above i t s level prior to the c r i s i s . 4 In other writings Krueger has dealt with this issue.

In fact her

article in the Brookings volume on i n f l a t i o n and stabilization (Krueger, 1981) is possibly the f i r s t piece de~oted to a systematic treatment of the relation between trade liberalization and stabilization policies. According to her, in theory there are few connections between the causes of inflation and those determining the nature of a country's trade regime. From there she goes on to argue that as long as a crawling peg system i s adopted, and the real exchange rate is maintained at the "appropriate" possible to reforms.

level, i t

is

basically separate the effects of stabilization and trade

She points out that " . . . i n principle the interaction between

different types of inflation and trade regimes can be minimal" (p. 83). Krueger's main message is that liberalization and stabilization programs

~The o n l y e x c e p t i o n s t o t h i s is when the a d d i t i o n a l e x p e n d i t u r e c a p i t a l f a l l s cOmpletely on imports o r t h e accumulation of f o r e i g n forthcOming}. In t h e case of t h e debt c r i s i s j i f t h e new funds are payments, t h e degree o f o v e r v a l u a t i o n may be reduced, b u t i t is v e r y f u l l y avoided.

f i n a n c e d by t h e f o r e i g n assets (Edwards, (~989} f u l l y used t o make debt u n l i k e | y t h a t i t w i l l be

4 A f t e r t h e f a i l u r e o f t h e h e t e r o d o x A u s t r a l and Cruzado p l a n s , A r g e n t i n a and B r a z i l see~ t o be p a r a l y z e d in the a n t i i n f l a t i o n a r y front. M e x i c o , on th~ ~ t h e r hand, Se~nS t c be making sOme progress w i t h i t s "Plan de ~ o l i d a r i d a d . "

120

can indeed be undertaken si~Jltaneously. However, as noted above i t is unclear whether i t is indeed possible to engineer a major disinflation while maintaining a crawling peg regime and a depreciated real exchange rate.

In theory, disinflation programs w i l l have

a higher probability of success i f domestic prices are (so~what) anchored to world prices.

This anchoring process, of course, requires (at least for

some time) a pegged nominal rate (and not a crawling peg). inflation

has

an

inertial

component, the

disinflation

I f domestic process will

i n i t i a l l y result in real exchange rate appreciation, hurting the chances of a successful major liberalization. Table 1 contain~ data on the evolution of the real exchange rate in 14 major successful stabilization programs.

In order for a country to qualify

as a "success~ in this exercise, i t had to meet the following requlre~.~ents: an inflation of (approximately) 50 percent per annum or more had to be reduced by at least one-half in no more than three years.

The table con-

tains all such cases since 1955 for which data can readily be obtained from the IFS.

As can be seen, in the majority of these "successful" s t a b i l i -

zation programs, g out of 14, the disinflation process was accompanied by real exchange rate appreciation.

Although this evidence is by no means

conclusive, i t suggests that there is a nontrivial tradeoff between stabilization and liberalization.

At this point an open question refers to ways

of designing successful policies that would allow countries to (at least p a r t i a l l y ) escape this tradeoff.

Surely just adopting a crawling peg will

not do the t r i c k in every (and not even in many) countries. A crucial objective of any stabilization program, and indeed of those undertaken by the major debtors, is to reduce the magnitude of the fiscal deficit.

Many times there will be an important trade-off between a trade

liberalization that fiscal objective.

reduces import t a r i f f s

and the achievement of thi~

Surprisingly, the policy and theoretical literatures on

trade liberalization policies have, most of the times, tended to ignore the fiscal

role of t a r i f f s

policy

discussions on trade

traditional public.

in the developing nations.

trade theory,

Most theoretical and

liberalization assume, along the

that t a r i f f

lines of

proceeds are handed back to the

In r e a l i t y , however, things are very different: governments do use

t a r i f f proceeds to finance their expenditure. This is particularly the case in many of the poorer developing countries, where for ulfferent

insti-

tutional reasons taxes on international trade represent a high percentage of government revenue. As long as tariFC rates are below the maximum revenue t a r i f f , there 121

Table I

D i s i n f l a t i o n and Rear Exchange Rates

GROUP 1: Country

DISINFLATION W!TH REAL APPRECIATION Years

Inflation

FI~R Index

Argentina

1976 1979

443.2 159.5

i00.0 43.0

Chile

1974 1977 1980

504.7 91.9 35.1

100.0 81.9 67.6

Costa Rica

1982 1985

90. I 15.1

100.0 94.5

Iceland

1983 1985

86.1 32.0

100.0 82.3

Nicaragua

1979 1982

48.2 24.8

100.0 64.6

Philippines

1984 1985

50.3 23.1

100.0 89.7

Ghana

1977 1980

116.5 50.1

100.0 78.8

Uruguay

1968 1970

125.3 17.0

100.0 80.7

?aire

1960 1971

53.3 5.8

100.0 85.2

GROUP 2:

DISINFLATION WiTH REAL DEPRECIATION

Dang ! adesh

1974 1977

54.7 8.6

100.0 209.6

Somalia

1980 1982

58.8 22.6

100.0 160.0

Turkey

1980 1983

110.2 32.9

100.0 146.0

Uruguay

1973 1976

97.0 50.6

!00.0 119.1

1979

108.6

1982

36.2

Za i r e

Notes: The RER index r e f e r s t o the b i l a t e r a l increase in the index denotes real depreciation.

122

I00.0

133.5

index with r e s i d e r t o the U.S. d o l l a r . An Data constructed Nith raw data fro~ the IMF.

will be a trade-off between trade liberalization and the generation of the government surplus required to finance debt servicing.

While the reduction

of tariffs will generally reduce distortions, it will also have a negative effect on goverrnent finances.

!f the reduction of goverr~ent expenditure

is not enough to reduc~ the deficit sufficiently, what is required, then, is to replace trade restrictions by less distortive taxes that are capable of generating the same (or a higher) amount of revenue. This, of course, means that major reforms of the t~_x system would be required in most countries.

As long as this tax reform effort also focuses on efficiency

aspects, it will tend to be concentrated on the imposition of a value-added tax {VAT), among other taxes.

This is not easy and ~akes time, as a number

of efforts to implement sweeping tax reforms have rec~.ntly shown.

Tax

reforms are not only politically difficult to approve, but from an administrative perspective they are many times very difficult to get goi~j. This is particularly the case in the poorer countries where the preexisting tax syste~ is often rudimentary.

Indeed the recer,t Indonesian tax reform has

shown clearly the difficulties involved in these types of efforts. {See Conrad and lillis, 1984). However, in middle-income countries where there is an operating tax system of some sophistication, a major tax reform can be implemented with some speed. The Chilean tax reform of 1975 is, in that sense, a good example; in little over a year a major tax overhaul that introduced a VAT, full indexation, and unification of corporate and r~ncorporate tax rates was successfully i~lemented {Edwards, 1985). Although in most cases the implementation of a major tax refo~u will take a substantial amount of time, there are some policies conducive both towards improved efficiency and higher revenues in th~ short run.

The most

obvious one is the replacement of QRs {i.e., licenses, prohibitions and so on) by i~ort tariffs.

A well-known feature of QRs is that unless they are

auctioned, the government misses the revenue associated with the trade restriction.

As recognized elsewhere by Krueger (1978), by replacing the

QR by a tariff it is possible for the government to recapture this revenue. The replacement of QRs by tariffs has two other potentially desirable effects.

First, there is the possibility of a positive effect on income

distribution.

This is because in most cases large (or even multinational)

firms or ~ j o r established merchants get the import licenses and, thus, the rents.

By replacing the QRs by tariffs these rents are passed on to the

goverr~ent, allowing it to reduce other taxes, or even to increase expenditure on social programs.

Second, the replacement of tariffs by QRs will

generally increase the effectivene-~ of devaluations. 123

The reason is that

the effects of devaluations are s i g n i f i c a n t l y different under quantity rationing ( i . e . , import quotas or licenses) than under import t a r i f f s .

In

the l a t t e r case a (real) devaluation w i l l result in a higher price of both importables and exportables relative to nontradables. while the domestic price of

exportables w i l l

importables w i l l usually not be affected.

UnderQRs, however,

still

increase, that of

All the devaluation w i l l do is

reduce the rents received by the party that got the license. C r e d i b i l i t y is a fundamental ingredient of successful structural reforms.

I f the public attaches a nontrivial probability to policy reversal,

i t w i l l t r y to anticipate t h i s event, genera%ly introducing strong destabil i z i n g forces into the structural adjustment process.

On the other hand,

c r e d i b i l i t y on the trade reform is very closely related to the macroeconomic policies being pursued alongside the trade reforms. Latin America's history is replete with frustrated economic reforms that have failed due to the lack of c r e d i b i l i t y .

In that respect, the

frustrated Argentinian trade reform during the Martinez de Hoz period is very educational.

Due to the lack of c r e d i b i l i t y on the future of the

preannounced trade reform, firms used foreign funds in order to survive in the short run.

As Carlos Rodrfguez ((1983), p. 28) has put i t

in his

evaluation of the Argentina experience of 1978-82, As

a

consequence of

the

lack

of

credibility

on the

continuity of the economic program, many firms - would have disappeared due to the t a r i f f

which

reductions - -

decided to get into debt in order to remain operating while waiting for

a change in the economic strategy [emphasis

added]. A fundamental aspect of establishing c r e d i b i l i t y is related to the perception that the public has of the internal consistency of the policies being pursued. In that respect, for example, the inconsistency of the Argentinian fiscal policy - - which maintained a very large d e f i c i t - - and the preannounced exchange rate policy severely undermined the degree of c r e d i b i l i t y of the reform process. The i n a b i l i t y to establish consistency between fiscal and exchange rate policies has many times been at the heart of the trade reform c r e d i b i l i t y crises in Latin America (Edwards, ICBg). An important question is whether a gradual ( i . e . , slow) trade reform would be less or more credible than an abrupt one. Theoretical models of c r e d i b i l i t y of economic policy are only now being developed, and have not yet reached ,evel that enables us to answer t h i s question with enough precision. In principle, i t is possible to argue that gradualism has 124

characteristics

that work in both directions, at the same time enhancing

and compromising credibility. On the one hand by reducing the unemployment effect and by allowing for I firmer fiscal equilibrium, a gradual trade reform will tend to be more credible; on the other hand a slow reform will allow those groups negatively affected by it {i.e., the import substitution manufacturing sector) to organize and nobly against the policies. At the end, as is so often the case in economics, whether gradualism will enhance credibility will depend on factors specific to each country. What is clear, however, is that policymakers should always pay special attention to the establishment of credibility when pursuing important long-te~) structural refo~s of the type proposed by Krueger for restoring creditwurthiness in debtor countries.

125

REFERFNCES Bhagwati, J.

(1978)

Anatomy and Consequences of Ezchonge Control Regimes, NBER, Cambridge, HA., Ballinger Publishing Co.

Calvo, G.

(1986)

Fractured Liberalism: Argentina Under Martinez de Hoz, EconomicDevelopmentandCulturalChange, 34: 511-31.

Conrad, R. and G i l l i s , M. (1984)

The Indonesian Tax Reform of 1983, Harvard Institute for Internaticnal Development, Discussion Paper No. 162.

Edwards, S.

(1985)

Stabilization With Liberalization: An Evaluation of Ten Years of Chile's Experiment With Free Market Policies, Economic Development and Cultural Chonge, 33: 223-54.

(1989)

Real Exchange Rates, Devaluation and Adjustment: Exchange Rate

Policy In Developing Countries, MIT Press (forthcoming). Krueger, A.O. (1978) Foreign Trade Regimes and Economic Development. Liberalization Attempts and Consequences, Ballinge~ Publishing Co. for NBER,

(1981)

Interactions Between InFlation and Trade Regime Objectives in Stabilization Programs, Economic Stabilization in Developing Countrie.% (eds.) W.R. Cline and S. Weintraub. Brookings Institution: Washington, D.C.

(1986)

Problems of Liberalization, Economic Liberalization in Developing Countries, (eds.) A. Choski and O. Papageorgious. Oxford: Basi 1 Blackwell.

126

Lucas, R.E. (1988)

On the Mechanics of Economic Development, JournoI of Monetary Economics, 22: 3-42.

NcKinnon, R. (1984) The International Capital Market and Economic Liberalization in LDCs, The Dev~opingF.conomies, 22: 476-81. Rodriguez, C.A. (1983) Politicas de Estabilizaci6n en la Economi~ Argentina, 19781982, CuadernosdeEconomia. Sachss J. (1987)

Trade and Exchange Rate Policies in Growth-Oriented Adjustment Programs, OrowtlPOr~entedAd]u~tment Programs, (eds.) V. Corbo, H. Goldstein and M. Khan. Washington, D.C.: International Monetary Fund and the World Bank.

127