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Portugal, Turkey and Peru: Three successful stabilization programmes under the auspices of the IMF
WorldDevelopment, Vol. 11, No. 1, pp, 65-70, 1983. Printed in Great Britain.
03OS-750X/83/010065-06SO3.001C 0 1983 Pergamon Press Ltd.
Portugal, Turkey and Peru: Three Successful Stabilization Programmes Under the Auspices of the IMF CHRISTINE A. BOGDANOWICZ-BINDERT* Lehman Brothers Kuhn Loeb, New York Summary. - This article reviews IMF stabilization programmes in three countries - Portugal, Turkey and Peru. It describes the reasons for the crisis in each country, the nature of the recovery programmes, the results achieved, and the lessons to be learned. In this way, the author tries to show under what conditions adjustment policies can be successful.
banks played a crucial role, first lending without restraint, thus delaying the crisis, then suddenly curtailing loans, helping to precipitate the crisis.
1. INTRODUCTION This article reviews three successful stabilization programmes: Portugal (June 1978), Turkey (June 1980) and Peru (September 1978). For each case we will describe the reasons for the crisis, the nature of the recovery programmes, the results achieved, and the lessons to be learned. Due to a lack of adequate data, this article does not address the impact of stabilization on income distribution. This is an important question which deserves further research. The situations of these three countries have some common elements. All three experienced a foreign exchange crisis. In each case the crisis was caused partly external factors such as a deterioration in the terms of trade, the recession in the industrial countries, and a decline in capital inflows. In each case the unfavourable external position was aggravated by an uncompetitive exchange rate and an unattractive interest rate. Each crisis was further exacerbated by domestic policy failure: large fiscal deficits resulting from liberal wage policies, inefficiency of state enterprises and poor pricing policies (controls and subsidies). Finally, all three of the recovery programmes we will describe followed stabilization programmes that actually failed. These three cases are also interesting because they typify problems often encountered by countries in crisis. Portugal needed to redirect its trade due to the loss of its colonies. Turkey had to reorient its economy outward after developing behind a wall of highly protectionist barriers. In the case of Peru, private foreign
2. PORTUGAL (a) Basic problem Beginning in 1974, Portugal’s balance of payments, traditionally in surplus, moved into deficit. The GDP growth rate, which had averaged 7.4% a year between 1968 and 1973, increased by only 1.1% in 1974 and declined by 4.3% in 1975. Despite price controls and a fixed exchange rate, inflation reached almost 30% in 1974. By 1977, the current account deficit has soared to $1.5 billion or 9% of GDP, and Portugal was facing a major foreign exchange crisis. (b) Background A main objective of the 1974 April Revolution was to raise the living standard of workers and small farmers. To this end, an important nationalization programme was introduced and wages increased by 25% in real terms between 1973 and 1975. The exchange rate was held
*The author is Vice President, Lehman Brothers Kuhn Loeb, New York. The views expressed are those of the author and do not necessarily reflect those of Lehman Brothers Kuhn Loeb. 65
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constant. The loss of international competitiveness caused producers to shift from exports to local markets, and consumers preferred imported goods to domestically produced ones. Negative real interest rates induced the stocking of imports; and due to a lack of confidence, tourist receipts and workers’ remittances fell dramatically. The catch up in real wages produced a major shift in the distribution of income: the share of wages in the national income rose from 52% in 1973 to 69% in 1975, and profits were squeezed. The external deficit, by draining liquidity from the banking system and producing a credit squeeze, reinforced the deflationary effect of the decline in profits. Real GDP, which had grown by 7.4% between 1968 and 1973, slowed to 1% in 1974 and declined by 4.3% in 1975. In the spring of 1976, the authorities embarked on a reflationary programme to counter the recession. Government spending was sharply increased. At the same time, a legal limit was imposed on nominal wage increases, and price controls were liberalized to assist the private sector. There was some unannounced depreciation of the escudo in early 1976, but this experiment was abandoned soon thereafter. Interest rates were kept low to hold down the cost of working capital and encourage a recovery in construction and exports. Domestic credit was allowed to expand rapidly, mainly as a result of massive central bank financing of the budget deficit. The response of growth to these measures was impressive. In 1976 and 1977, GDP grew by 7 and 5% respectively. However, with an increasingly uncompetitive exchange rate, the recovery was mainly directed to more and more protected domestic markets rather than to the export markets. In 1977, inflation rose back to its 1974 level (27%) and imports boomed, while exports and workers’ remittances continued to lag. Consequently, despite an increase in world trade in 1976, the deficit on the external current account increased to the equivalent of 9% of GDP in 1977. An import surcharge was introduced in May 1975 and expanded in early 1976, increasing the level of effective protection to a range of 60-80%. Under severe pressure, the authorities devalued the escudo by 15% in February 1977, but once again found that in the absence of supporting measures, this move only fueled speculation. By the end of 1977, the country’s initial foreign exchange reserves were depleted and 50% of the gold stock had been pledged against shortterm loans.
Despite its ample foreign exchange reserves and low level of extemai debt in 1977, Portugal faced a major foreign exchange crisis and difficulties borrowing encountered major abroad. By then it was clear that Portugal had no choice but to correct the principal weaknesses of the economy: overconsumption, overvaluation of the escudo, disincentives for savings due to negative interest rates, price controls, subsidies and wide budget deficits. (c) The response to the crisis In June 1977, a group of 14 countries met in Paris and agreed to provide Portugal with $750 million over 18 months. This exceptional financial assistance was made conditional upon an upper credit tranche arrangement with the Fund. The balance-of-payments support was mainly intended to allow for a phased relaxation of restrictions. The main objective of the programme was to restore a sustainable since position, the balance-of-payments external position was constraining growth. The attainment of the balance-of-payments objective was to be assured by the correction of relative prices, and to a lesser extent, by demand management policies. Hence the programme relied heavily on interest rate and exchange rate policies. Both were administered flexibly in light of the net foreign assets position. Interest rates were raised substantially and a crawling peg was introduced for the escudo. In addition to these measures, limits were imposed on domestic credit expansion and credit to the private sector. (d) Economic results The recovery of the Portugese balance of payments turned out to be rapid and substantial. The external current account deficit, equivalent to 9% of GDP in 1977, was eliminated by 1979. This turnaround was achieved with a minimal loss of momentum in the rate of growth (3.3% in 1978 and 4.8% in 1979). The external recovery can easily be traced to the exchange rate policy. The country’s competitive position (measureci by relative unit labour costs) improved by 20% beyond its 1973 level. Nominal wage increases remained below their legal limits in both 1978 and 1979, reflecting unemployment pressures. As a result, real wages dropped by 17% below their 1976 level. Exports of goods and on factor services rose by 15% in 1978 and by 28% in 1979. The
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volume of imports declined by 2% in 1978, but increased thereafter. The effect of the interest rate increases was also striking. Despite the fact that interest rates remained negative in real terms, the decrease in the negative margin (from 9 to 3% by the end of 1978) was sufficient to induce a shift from consumption to savings. This shift was evidenced by a decrease in stockbuilding and imports. The exchange rate and interest rate policies also affected workers’ remittances, which increased by about 50%. However, the public sector deficit remained higher than had been projected. In combination with the spectacular improvement in the balance of payments, the fiscal situation led to a slight increase in the rate of inflation. (e) Lessons to be drawn The worsening balance-of-payments situation resulting from the deterioration of the terms of trade and the social policies of the new govemment was turned around within a one-year period. The success of the Portugese programme can be attributed to the fact that there was a radical and rapid shift in policies, supported by external assistance. The correction of relative prices, by restoring competitiveness and confidence, resulted in a marked improvement in both the current and capital account of the balance of payments. The programme was supported by a major influx of capital from bilateral sources. The external support was due to the political concerns of the OECD countries, in particular the United States and Germany. These two countries alone contributed two thirds of the total ‘Paris credits’. The commercial banks played no significant role in the recovery. At that time, Portugal’s commercial debt was low, since the banks had not lent much during the Salazar regime and had lent even less after the 1974 Revolution. Moreover, short-term trade was financed to a great extent by the Bank for International Settlements (BIS). The response of the private sector was slow, and it took two years before private investment grew significantly. Foreign private investment is only now starting to pick up. 3. TURKEY (a) Basic problem By the end of 1977, Turkey was faced with
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67
an acute shortage of foreign exchange, a large balance-of-payments deficit, and a growing stock of external arrears. Unemployment and inflation were high and rising, while the growth rate was declining. (b) Background Although the world environment did affect the Turkish economy adversely, the 1977 crisis was mainly the result of domestic policies. These included large public sector deficits, preferential treatment for enterprises geared towards the domestic market, and lack of incentives for the export sector. Prices and interest rates were controlled and the exchange rate held constant. As a result, while exports increased by 19% between 1970 and 1975, imports increased by 38%, which led to a nearly ten-fold increase in the trade deficit. (Imports other than oil increased by 35%.) Furthermore, decreased significantly workers’ remittances from 1975 on, primarily as a result of the unrealistic official exchange rate. The financing of the balance-of-payments deficit was accomplished almost entirely by running down reserves and increasing short-term liabilities including external arrears. (c) The response to the crisis Gradual stabilization programmes were initiated in 1978 and again in 1979. Both these programmes failed, primarily because they were not ambitious enough and because the authorities were unable to sustain the adjustment effort. There was no real shift in policies, though small adjustments were made. The devaluation of the lira was not supported by other measures, and prices were not adjusted sufficiently to improve the financial position of state enterprises. By January 1980, the authorities realized that they had no choice but to embark on a comprehensive and far-reaching economic proEconomic policy was completely gramme. reoriented with an emphasis on exports, with a greater reliance on market forces and a turning away from government regulations and controls. The exchange rate was kept flexible after an initial devaluation of 33%. Price controls were eliminated and the authorities adopted a flexible interest rate policy (rates charged by the banks now range from 60 to 120% and average 70-7570). The trade and external payments were liberalized. State
WORLDDEVELOPMENT
68
Economic Enterprises (SEES) were denied subsidies and special conditions for bank financing; the SEES were also placed under independent The investment management. programme was rationalized and priority was given to the key sectors of agriculture, energy, and transport. (d) Economic
results
The results of the 1980 stabilization programme are impressive. Marked and rapid progress was achieved on the balance of payments, inflation and growth fronts. Inflation, which had been running well over lOO%, fell to about 40%. GDP, which had declined in 1980, grew by about 4.5% in 1981, mainly because of the better export performance. There was significant improvement in both the trade and current account balances. Exports rose by 55% in 1981 compared to 25% in 1980 (half of the exports being manufactured goods). The value of work taken on by Turkish contractors in the Middle East rose from $1.5 billion to $7.5 billion over the past eighteen months; tourist receipts doubled to $400 million. Imports continued to grow, which alleviated the supply situation. The improvement in price performance, achieved despite the flexible exchange rate policy, can be traced to both fiscal and interest rate policies. Containment of the budget deficit was achieved by keeping expenditures constant in real terms while increasing revenue. Moderate wage increases and smaller subsidies for agriculture products also contributed to the improvement. The flexible interest rate policy brought about a marked shift from real to financial assets. Accordingly, savings increased substantially. As in Portugal, the commercial banks played no essential part in the recovery. Turkey is, in fact, still encountering problems in mobilizing bank credit. Commercial banks have taken a wait-and-see attitude, as has the private sector. In addition, the still prevailing high tariff protection and export compensation schemes will need to be phased out before there can be a real ‘test’ of the competitiveness of Turkish industry. (e) Lessons to be drawn The success of the programme can be attributed to its coherence, to the shift of policies, and to the continuing political commitment
of the authorities despite adverse short-term effects on employment and real wages. The programme relied on a package of measures based on market forces which included liberalization of exchange rate and price policies, reform of state enterprises and the tax system, liberalization of trade and exchange systems, and tight demand policies. The response to price incentives was spectacular, particularly in terms of the balance-of-payments and agriculture output. The adjustment process was greatly facilitated by huge capital inflows resulting from debt rescheduling, balance-of-payments support from OECD countries (led by the U.S. and Germany) and an increase in workers’ remittances. This permitted the higher level of imports which was necessary to sustain growth and alleviate supply bottlenecks. Another important element was the personal commitment and clear authority of a key minister, Mr. Ozal, to the programme. This was important not only for the implementation of the programme itself but also for the image Turkey was projecting abroad.
4. PERU (a) Basic problem By mid-1978, Peru was facing a major economic crisis with a decline in real GDP, a high level of inflation, and a decline in net international reserves to a negative level of $1.2 billion. With a debt service of approximately $1 billion falling due to 1978, the economy was near external bankruptcy. One gauge of the severity of the external crisis was, that for several months in mid-1978, private imports were virtually suspended.
(b) Background Expansionary monetary and fiscal policies pursued during most of the 1970s led to large public sector and balance-of-payments deficits, and to increased recourse to foreign borrowing mainly from commercial banks. This situation was exacerbated by a sharp deterioration in Peru’s terms of trade from 1975 to 1978. The large public sector deficits resulted mainly from ambitious spending programmes in areas such as petroleum exploration, transportation, copper production and irrigation. Moreover, the role of state enterprises in the economy was greatly
THREE SUCCESSFUL STABILIZATION PROGRAMMES expanded. The sharp rise in the investment/ GDP ratio initially produced an increase in real economic growth but, meanwhile, the savings/ GDP ratio lagged behind and the financial position of the public sector deteriorated. This was mainly due to unrealistic pricing policies for public seotor goods and services, significant increases in nominal wages and, beginning in the mid 197Os, healy defence spending. These growing public sector deficits were financed by both domestic and foreign borrowing, which placed substantial pressure on available resources. Expansionary credit policies led to rising inflation rates and to overvaluation of the Peruvian sol, which had remained fixed vis-ir-vis the US dollar. As the ability to borrow diminished, serious balance-of-payments pressures emerged. The role of the banks in the Peruvian crisis was crucial. Essentially, the banks switched from a position of providing large capital inflows from 1974 to 1976, to a position of expecting large repayments by 1978. The foreign banks’ confidence in Peru dropped dramatically by 1977, precipitating the crisis.
(c) The response to the crisis The first in a series of stabilization programmes was undertaken in mid 1975. It consisted mainly of adjustments of controlled prices and a slowdown of credit to the public sector. This effort was not sustained, however, and in the first half of 1976, easier monetary and fiscal policies were again pursued. In response to a sharp decline in net foreign assets, the authorities announced a second stabilization programme in June 1976 in conjunction with the negotiation of a $400 million loan from a consortium of private banks. This more ambitious programme included a major devaluation and tighter fiscal and monetary policies, followed by the adoption of a ‘crawling peg’ in September 1976. Controlled prices were increased; in particular, gasoline prices were doubled. This new stabilization effort was also reversed in 1977, and a highly expansionary fiscal policy was resumed. By the third quarter of 1977 the inflation rate was again climbing, and Peru faced an acute foreign exchange shortage which prompted the authorities to undertake a third stabilization programme. This programme also failed, mainly because the authorities were unable to effectively control public sector spending. To some extent, the failure of the programme can also be attributed to the lack of specific fiscal policy
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commitments. As a consequence, the programme lacked the instruments that could have helped achieve its objectives. In addition, a wave of protest against the increased food and fuel prices led to a rollback of the increases and elimination of the system of mini-devaluations. By mid 1978 the government embarked on a fourth and comprehensive stabilization programme aimed at strengthening public finances, stemming the loss of international reserves, and promoting more efficient use of private and public sector resources. This programme was supported by an IMF stand-by arrangement, a programme loan from the World Bank, and considerable debt relief (both Paris Club and commercial banks). The programme also benefited from an improvement in the terms of trade (minerals including copper and oil) and the completion of the transandean pipeline. In addition, Peru became a net exporter of oil in 1978. The 1978 programme was technically similar to that of 1977. It relied heavily on interest rate, exchange rate and pricing policies. (Fuel prices were raised by 60%, milk and bread by 40%, and most subsidies were eliminated.) In addition, fiscal policy was further tightened. The new fiscal measures included new taxes (including a 10% surcharge on imports of all nonessential goods), higher indirect tax rates, expenditure cuts, and increased prices of the goods and services of state-run enterprises. The sol was initially devalued by 15% and a crawling peg system was established. Interest rates were increased substantialljr.
(d) Economic
results
The flexible exchange rate policy and the sharp reduction in credit to the public sector brought about a strong improvement in the overall financial situation. The balance of payments improved rapidly, and the Central Bank began to build up gross reserves while reducing exchange restrictions and eliminating all existing multiple currency practice. Imports fell dramatically, from a peak of $2.4 billion in 1975 to only $1.7 in 1978, while exports rose from $1.3 billion to $1.9 billion over the same period. In 1979, exports increased by 79% in response to the exchange rate policy which especially benefited non-traditional exports (fish products, textiles, chemicals, etc.). However, inflation remained high due mainly to the much better than expected turnaround in the balance of payments.
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70 (e) Lessons to be drawn
The real failure of stabilization policy in Peru was that it was not implemented earlier and more vigorously. The need for stabilization was evident by 1975. The large inflows from private banks from 1974 through 1976 only helped to finance unsound economic policies, particularly high budget deficits. Allstabilization efforts prior to 1978 failed because they were not consistently applied and sustained over a sufficient period. All the adjustment policies were similar in their basic framework and goals to the one which succeeded. The success of the 1978 programme is due to the rapid shift of policies and a commitment to liberalize the economy and maintain tight demand policies over a sufficient period of time. It was also aided by substantial debt relief (both Paris Club and commercial bank debt). As in the case of Portugal and Turkey, a small and efficient team coordinated the programme and monitored its implementation very closely.
5. CONCLUSION The three countries we described typify some of the crisis elements commonly found in countries facing acute financial difficulties. Though the causes were partly external, the crises resulted also from inappropriate domestic policies: overvalued exchange rates, low interest rates, large fiscal deficits due to price subsidies, poor control over expenditures, inefficient state
enterprises and protective exchange and trade systems. We have tried to show that adjustment policies do in fact work. Indeed, recovery can be very swift: dramatic results can be achieved within a year from the inception of the recovery programme. All three cases showed dramatic success on the balance-of-payments front. Contrary to expectations, the growth rate actually increased within one year. Furthermore, contrary to conventional wisdom, unemployment hardly increased: in fact, in Portugal it even decreased slightly. On the negative side, there was no improvement in the inflation rate except in the case of Turkey, and the cost of the programme was mainly borne by wage earners. This was, however, inevitable, since one of the goals of the recovery programme was to reduce consumption and shift resources into investment. Based on the experiences of Portugal, Turkey and Peru, the following conditions are necessary for a stabilization programme to be successful: - the policy package has to be comprehensive; mutually reinforcing measures must be undertaken from the outset of the recovery year since quick results make it easier to resist political and social pressures. Emphasis on exchange rate, interest rate and price policies is essential; - domestic policies must be supported by one form or another of external assistance; - sustained political commitment is crucial. One man/team behind the programme can greatly facilitate its implementation.
03OS-750X/83/010065-06SO3.001C 0 1983 Pergamon Press Ltd.
Portugal, Turkey and Peru: Three Successful Stabilization Programmes Under the Auspices of the IMF CHRISTINE A. BOGDANOWICZ-BINDERT* Lehman Brothers Kuhn Loeb, New York Summary. - This article reviews IMF stabilization programmes in three countries - Portugal, Turkey and Peru. It describes the reasons for the crisis in each country, the nature of the recovery programmes, the results achieved, and the lessons to be learned. In this way, the author tries to show under what conditions adjustment policies can be successful.
banks played a crucial role, first lending without restraint, thus delaying the crisis, then suddenly curtailing loans, helping to precipitate the crisis.
1. INTRODUCTION This article reviews three successful stabilization programmes: Portugal (June 1978), Turkey (June 1980) and Peru (September 1978). For each case we will describe the reasons for the crisis, the nature of the recovery programmes, the results achieved, and the lessons to be learned. Due to a lack of adequate data, this article does not address the impact of stabilization on income distribution. This is an important question which deserves further research. The situations of these three countries have some common elements. All three experienced a foreign exchange crisis. In each case the crisis was caused partly external factors such as a deterioration in the terms of trade, the recession in the industrial countries, and a decline in capital inflows. In each case the unfavourable external position was aggravated by an uncompetitive exchange rate and an unattractive interest rate. Each crisis was further exacerbated by domestic policy failure: large fiscal deficits resulting from liberal wage policies, inefficiency of state enterprises and poor pricing policies (controls and subsidies). Finally, all three of the recovery programmes we will describe followed stabilization programmes that actually failed. These three cases are also interesting because they typify problems often encountered by countries in crisis. Portugal needed to redirect its trade due to the loss of its colonies. Turkey had to reorient its economy outward after developing behind a wall of highly protectionist barriers. In the case of Peru, private foreign
2. PORTUGAL (a) Basic problem Beginning in 1974, Portugal’s balance of payments, traditionally in surplus, moved into deficit. The GDP growth rate, which had averaged 7.4% a year between 1968 and 1973, increased by only 1.1% in 1974 and declined by 4.3% in 1975. Despite price controls and a fixed exchange rate, inflation reached almost 30% in 1974. By 1977, the current account deficit has soared to $1.5 billion or 9% of GDP, and Portugal was facing a major foreign exchange crisis. (b) Background A main objective of the 1974 April Revolution was to raise the living standard of workers and small farmers. To this end, an important nationalization programme was introduced and wages increased by 25% in real terms between 1973 and 1975. The exchange rate was held
*The author is Vice President, Lehman Brothers Kuhn Loeb, New York. The views expressed are those of the author and do not necessarily reflect those of Lehman Brothers Kuhn Loeb. 65
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constant. The loss of international competitiveness caused producers to shift from exports to local markets, and consumers preferred imported goods to domestically produced ones. Negative real interest rates induced the stocking of imports; and due to a lack of confidence, tourist receipts and workers’ remittances fell dramatically. The catch up in real wages produced a major shift in the distribution of income: the share of wages in the national income rose from 52% in 1973 to 69% in 1975, and profits were squeezed. The external deficit, by draining liquidity from the banking system and producing a credit squeeze, reinforced the deflationary effect of the decline in profits. Real GDP, which had grown by 7.4% between 1968 and 1973, slowed to 1% in 1974 and declined by 4.3% in 1975. In the spring of 1976, the authorities embarked on a reflationary programme to counter the recession. Government spending was sharply increased. At the same time, a legal limit was imposed on nominal wage increases, and price controls were liberalized to assist the private sector. There was some unannounced depreciation of the escudo in early 1976, but this experiment was abandoned soon thereafter. Interest rates were kept low to hold down the cost of working capital and encourage a recovery in construction and exports. Domestic credit was allowed to expand rapidly, mainly as a result of massive central bank financing of the budget deficit. The response of growth to these measures was impressive. In 1976 and 1977, GDP grew by 7 and 5% respectively. However, with an increasingly uncompetitive exchange rate, the recovery was mainly directed to more and more protected domestic markets rather than to the export markets. In 1977, inflation rose back to its 1974 level (27%) and imports boomed, while exports and workers’ remittances continued to lag. Consequently, despite an increase in world trade in 1976, the deficit on the external current account increased to the equivalent of 9% of GDP in 1977. An import surcharge was introduced in May 1975 and expanded in early 1976, increasing the level of effective protection to a range of 60-80%. Under severe pressure, the authorities devalued the escudo by 15% in February 1977, but once again found that in the absence of supporting measures, this move only fueled speculation. By the end of 1977, the country’s initial foreign exchange reserves were depleted and 50% of the gold stock had been pledged against shortterm loans.
Despite its ample foreign exchange reserves and low level of extemai debt in 1977, Portugal faced a major foreign exchange crisis and difficulties borrowing encountered major abroad. By then it was clear that Portugal had no choice but to correct the principal weaknesses of the economy: overconsumption, overvaluation of the escudo, disincentives for savings due to negative interest rates, price controls, subsidies and wide budget deficits. (c) The response to the crisis In June 1977, a group of 14 countries met in Paris and agreed to provide Portugal with $750 million over 18 months. This exceptional financial assistance was made conditional upon an upper credit tranche arrangement with the Fund. The balance-of-payments support was mainly intended to allow for a phased relaxation of restrictions. The main objective of the programme was to restore a sustainable since position, the balance-of-payments external position was constraining growth. The attainment of the balance-of-payments objective was to be assured by the correction of relative prices, and to a lesser extent, by demand management policies. Hence the programme relied heavily on interest rate and exchange rate policies. Both were administered flexibly in light of the net foreign assets position. Interest rates were raised substantially and a crawling peg was introduced for the escudo. In addition to these measures, limits were imposed on domestic credit expansion and credit to the private sector. (d) Economic results The recovery of the Portugese balance of payments turned out to be rapid and substantial. The external current account deficit, equivalent to 9% of GDP in 1977, was eliminated by 1979. This turnaround was achieved with a minimal loss of momentum in the rate of growth (3.3% in 1978 and 4.8% in 1979). The external recovery can easily be traced to the exchange rate policy. The country’s competitive position (measureci by relative unit labour costs) improved by 20% beyond its 1973 level. Nominal wage increases remained below their legal limits in both 1978 and 1979, reflecting unemployment pressures. As a result, real wages dropped by 17% below their 1976 level. Exports of goods and on factor services rose by 15% in 1978 and by 28% in 1979. The
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volume of imports declined by 2% in 1978, but increased thereafter. The effect of the interest rate increases was also striking. Despite the fact that interest rates remained negative in real terms, the decrease in the negative margin (from 9 to 3% by the end of 1978) was sufficient to induce a shift from consumption to savings. This shift was evidenced by a decrease in stockbuilding and imports. The exchange rate and interest rate policies also affected workers’ remittances, which increased by about 50%. However, the public sector deficit remained higher than had been projected. In combination with the spectacular improvement in the balance of payments, the fiscal situation led to a slight increase in the rate of inflation. (e) Lessons to be drawn The worsening balance-of-payments situation resulting from the deterioration of the terms of trade and the social policies of the new govemment was turned around within a one-year period. The success of the Portugese programme can be attributed to the fact that there was a radical and rapid shift in policies, supported by external assistance. The correction of relative prices, by restoring competitiveness and confidence, resulted in a marked improvement in both the current and capital account of the balance of payments. The programme was supported by a major influx of capital from bilateral sources. The external support was due to the political concerns of the OECD countries, in particular the United States and Germany. These two countries alone contributed two thirds of the total ‘Paris credits’. The commercial banks played no significant role in the recovery. At that time, Portugal’s commercial debt was low, since the banks had not lent much during the Salazar regime and had lent even less after the 1974 Revolution. Moreover, short-term trade was financed to a great extent by the Bank for International Settlements (BIS). The response of the private sector was slow, and it took two years before private investment grew significantly. Foreign private investment is only now starting to pick up. 3. TURKEY (a) Basic problem By the end of 1977, Turkey was faced with
PROGRAMMES
67
an acute shortage of foreign exchange, a large balance-of-payments deficit, and a growing stock of external arrears. Unemployment and inflation were high and rising, while the growth rate was declining. (b) Background Although the world environment did affect the Turkish economy adversely, the 1977 crisis was mainly the result of domestic policies. These included large public sector deficits, preferential treatment for enterprises geared towards the domestic market, and lack of incentives for the export sector. Prices and interest rates were controlled and the exchange rate held constant. As a result, while exports increased by 19% between 1970 and 1975, imports increased by 38%, which led to a nearly ten-fold increase in the trade deficit. (Imports other than oil increased by 35%.) Furthermore, decreased significantly workers’ remittances from 1975 on, primarily as a result of the unrealistic official exchange rate. The financing of the balance-of-payments deficit was accomplished almost entirely by running down reserves and increasing short-term liabilities including external arrears. (c) The response to the crisis Gradual stabilization programmes were initiated in 1978 and again in 1979. Both these programmes failed, primarily because they were not ambitious enough and because the authorities were unable to sustain the adjustment effort. There was no real shift in policies, though small adjustments were made. The devaluation of the lira was not supported by other measures, and prices were not adjusted sufficiently to improve the financial position of state enterprises. By January 1980, the authorities realized that they had no choice but to embark on a comprehensive and far-reaching economic proEconomic policy was completely gramme. reoriented with an emphasis on exports, with a greater reliance on market forces and a turning away from government regulations and controls. The exchange rate was kept flexible after an initial devaluation of 33%. Price controls were eliminated and the authorities adopted a flexible interest rate policy (rates charged by the banks now range from 60 to 120% and average 70-7570). The trade and external payments were liberalized. State
WORLDDEVELOPMENT
68
Economic Enterprises (SEES) were denied subsidies and special conditions for bank financing; the SEES were also placed under independent The investment management. programme was rationalized and priority was given to the key sectors of agriculture, energy, and transport. (d) Economic
results
The results of the 1980 stabilization programme are impressive. Marked and rapid progress was achieved on the balance of payments, inflation and growth fronts. Inflation, which had been running well over lOO%, fell to about 40%. GDP, which had declined in 1980, grew by about 4.5% in 1981, mainly because of the better export performance. There was significant improvement in both the trade and current account balances. Exports rose by 55% in 1981 compared to 25% in 1980 (half of the exports being manufactured goods). The value of work taken on by Turkish contractors in the Middle East rose from $1.5 billion to $7.5 billion over the past eighteen months; tourist receipts doubled to $400 million. Imports continued to grow, which alleviated the supply situation. The improvement in price performance, achieved despite the flexible exchange rate policy, can be traced to both fiscal and interest rate policies. Containment of the budget deficit was achieved by keeping expenditures constant in real terms while increasing revenue. Moderate wage increases and smaller subsidies for agriculture products also contributed to the improvement. The flexible interest rate policy brought about a marked shift from real to financial assets. Accordingly, savings increased substantially. As in Portugal, the commercial banks played no essential part in the recovery. Turkey is, in fact, still encountering problems in mobilizing bank credit. Commercial banks have taken a wait-and-see attitude, as has the private sector. In addition, the still prevailing high tariff protection and export compensation schemes will need to be phased out before there can be a real ‘test’ of the competitiveness of Turkish industry. (e) Lessons to be drawn The success of the programme can be attributed to its coherence, to the shift of policies, and to the continuing political commitment
of the authorities despite adverse short-term effects on employment and real wages. The programme relied on a package of measures based on market forces which included liberalization of exchange rate and price policies, reform of state enterprises and the tax system, liberalization of trade and exchange systems, and tight demand policies. The response to price incentives was spectacular, particularly in terms of the balance-of-payments and agriculture output. The adjustment process was greatly facilitated by huge capital inflows resulting from debt rescheduling, balance-of-payments support from OECD countries (led by the U.S. and Germany) and an increase in workers’ remittances. This permitted the higher level of imports which was necessary to sustain growth and alleviate supply bottlenecks. Another important element was the personal commitment and clear authority of a key minister, Mr. Ozal, to the programme. This was important not only for the implementation of the programme itself but also for the image Turkey was projecting abroad.
4. PERU (a) Basic problem By mid-1978, Peru was facing a major economic crisis with a decline in real GDP, a high level of inflation, and a decline in net international reserves to a negative level of $1.2 billion. With a debt service of approximately $1 billion falling due to 1978, the economy was near external bankruptcy. One gauge of the severity of the external crisis was, that for several months in mid-1978, private imports were virtually suspended.
(b) Background Expansionary monetary and fiscal policies pursued during most of the 1970s led to large public sector and balance-of-payments deficits, and to increased recourse to foreign borrowing mainly from commercial banks. This situation was exacerbated by a sharp deterioration in Peru’s terms of trade from 1975 to 1978. The large public sector deficits resulted mainly from ambitious spending programmes in areas such as petroleum exploration, transportation, copper production and irrigation. Moreover, the role of state enterprises in the economy was greatly
THREE SUCCESSFUL STABILIZATION PROGRAMMES expanded. The sharp rise in the investment/ GDP ratio initially produced an increase in real economic growth but, meanwhile, the savings/ GDP ratio lagged behind and the financial position of the public sector deteriorated. This was mainly due to unrealistic pricing policies for public seotor goods and services, significant increases in nominal wages and, beginning in the mid 197Os, healy defence spending. These growing public sector deficits were financed by both domestic and foreign borrowing, which placed substantial pressure on available resources. Expansionary credit policies led to rising inflation rates and to overvaluation of the Peruvian sol, which had remained fixed vis-ir-vis the US dollar. As the ability to borrow diminished, serious balance-of-payments pressures emerged. The role of the banks in the Peruvian crisis was crucial. Essentially, the banks switched from a position of providing large capital inflows from 1974 to 1976, to a position of expecting large repayments by 1978. The foreign banks’ confidence in Peru dropped dramatically by 1977, precipitating the crisis.
(c) The response to the crisis The first in a series of stabilization programmes was undertaken in mid 1975. It consisted mainly of adjustments of controlled prices and a slowdown of credit to the public sector. This effort was not sustained, however, and in the first half of 1976, easier monetary and fiscal policies were again pursued. In response to a sharp decline in net foreign assets, the authorities announced a second stabilization programme in June 1976 in conjunction with the negotiation of a $400 million loan from a consortium of private banks. This more ambitious programme included a major devaluation and tighter fiscal and monetary policies, followed by the adoption of a ‘crawling peg’ in September 1976. Controlled prices were increased; in particular, gasoline prices were doubled. This new stabilization effort was also reversed in 1977, and a highly expansionary fiscal policy was resumed. By the third quarter of 1977 the inflation rate was again climbing, and Peru faced an acute foreign exchange shortage which prompted the authorities to undertake a third stabilization programme. This programme also failed, mainly because the authorities were unable to effectively control public sector spending. To some extent, the failure of the programme can also be attributed to the lack of specific fiscal policy
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commitments. As a consequence, the programme lacked the instruments that could have helped achieve its objectives. In addition, a wave of protest against the increased food and fuel prices led to a rollback of the increases and elimination of the system of mini-devaluations. By mid 1978 the government embarked on a fourth and comprehensive stabilization programme aimed at strengthening public finances, stemming the loss of international reserves, and promoting more efficient use of private and public sector resources. This programme was supported by an IMF stand-by arrangement, a programme loan from the World Bank, and considerable debt relief (both Paris Club and commercial banks). The programme also benefited from an improvement in the terms of trade (minerals including copper and oil) and the completion of the transandean pipeline. In addition, Peru became a net exporter of oil in 1978. The 1978 programme was technically similar to that of 1977. It relied heavily on interest rate, exchange rate and pricing policies. (Fuel prices were raised by 60%, milk and bread by 40%, and most subsidies were eliminated.) In addition, fiscal policy was further tightened. The new fiscal measures included new taxes (including a 10% surcharge on imports of all nonessential goods), higher indirect tax rates, expenditure cuts, and increased prices of the goods and services of state-run enterprises. The sol was initially devalued by 15% and a crawling peg system was established. Interest rates were increased substantialljr.
(d) Economic
results
The flexible exchange rate policy and the sharp reduction in credit to the public sector brought about a strong improvement in the overall financial situation. The balance of payments improved rapidly, and the Central Bank began to build up gross reserves while reducing exchange restrictions and eliminating all existing multiple currency practice. Imports fell dramatically, from a peak of $2.4 billion in 1975 to only $1.7 in 1978, while exports rose from $1.3 billion to $1.9 billion over the same period. In 1979, exports increased by 79% in response to the exchange rate policy which especially benefited non-traditional exports (fish products, textiles, chemicals, etc.). However, inflation remained high due mainly to the much better than expected turnaround in the balance of payments.
WORLD DEVELOPMENT
70 (e) Lessons to be drawn
The real failure of stabilization policy in Peru was that it was not implemented earlier and more vigorously. The need for stabilization was evident by 1975. The large inflows from private banks from 1974 through 1976 only helped to finance unsound economic policies, particularly high budget deficits. Allstabilization efforts prior to 1978 failed because they were not consistently applied and sustained over a sufficient period. All the adjustment policies were similar in their basic framework and goals to the one which succeeded. The success of the 1978 programme is due to the rapid shift of policies and a commitment to liberalize the economy and maintain tight demand policies over a sufficient period of time. It was also aided by substantial debt relief (both Paris Club and commercial bank debt). As in the case of Portugal and Turkey, a small and efficient team coordinated the programme and monitored its implementation very closely.
5. CONCLUSION The three countries we described typify some of the crisis elements commonly found in countries facing acute financial difficulties. Though the causes were partly external, the crises resulted also from inappropriate domestic policies: overvalued exchange rates, low interest rates, large fiscal deficits due to price subsidies, poor control over expenditures, inefficient state
enterprises and protective exchange and trade systems. We have tried to show that adjustment policies do in fact work. Indeed, recovery can be very swift: dramatic results can be achieved within a year from the inception of the recovery programme. All three cases showed dramatic success on the balance-of-payments front. Contrary to expectations, the growth rate actually increased within one year. Furthermore, contrary to conventional wisdom, unemployment hardly increased: in fact, in Portugal it even decreased slightly. On the negative side, there was no improvement in the inflation rate except in the case of Turkey, and the cost of the programme was mainly borne by wage earners. This was, however, inevitable, since one of the goals of the recovery programme was to reduce consumption and shift resources into investment. Based on the experiences of Portugal, Turkey and Peru, the following conditions are necessary for a stabilization programme to be successful: - the policy package has to be comprehensive; mutually reinforcing measures must be undertaken from the outset of the recovery year since quick results make it easier to resist political and social pressures. Emphasis on exchange rate, interest rate and price policies is essential; - domestic policies must be supported by one form or another of external assistance; - sustained political commitment is crucial. One man/team behind the programme can greatly facilitate its implementation.