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Finance & Development, December 1980
Article

Stabilization programs and income distribution: A review of the short-run impact of Fund-supported programs in Bolivia, Ghana, Indonesia, and the Philippines

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1980
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Omotunde Johnson and Joanne Salop

Prolonged balance of payments (BOP) deficits associated with rapid domestic inflation and overvalued currencies tend to characterize the economies of the countries requesting the use of Fund resources in the upper credit tranches. In most cases, these symptoms are associated with excessive domestic demand that is typically the product of government budget deficits financed by borrowing from the banking system. The International Monetary Fund makes its resources available to a country, under certain conditions, in support of stabilization efforts designed to address the basic causes of the difficulties. The policies contained in such programs differ, but invariably limit the rate of bank credit expansion. They may also include currency depreciation if the exchange rate is judged to be seriously overvalued. Further, the country often undertakes not to increase exchange and trade restrictions, if not to relax them.

In the last few years, there has been an increasing interest in whether the measures contained in these stabilization programs exacerbate inequalities in the distribution of income within the countries concerned. This article summarizes the main findings from recent research into the effects on income distribution of stabilization programs in Bolivia (1972-73), Ghana (1966-70), Indonesia (1966-74), and the Philippines (1970-76). The general conclusion is that BOP adjustment necessarily has implications for the distribution of income. In the programs examined, the effect of the measures on income distribution was largely determined by domestic political factors and by the country’s underlying institutional structure, economic organization, and resource endowment.

See “Distributional Aspects of Stabilization Policies in Developing Countries,” IMF, Staff Papers (March 1980).

Economic theory

Countries seeking to draw in the upper credit tranches generally have an imbalance in internal and external payments; the stabilization programs typically involve measures aimed at restraining domestic demand combined with currency devaluation. It is crucial that the program affects both the domestic and the foreign trade sectors. If measures solely to restrain domestic demand were taken, employment would suffer in those sectors of the economy producing exclusively for the domestic market. Alternatively, if only currency depreciation—or, for that matter, a tariff on imports and a subsidy on exports—were relied on, profits from producing exports and import substitutes (that is, traded goods) would rise, but only in the short run. Subsequent wage and price inflation in domestic nontraded industries would quickly erode the initial relative price advantage secured for traded goods by the devaluation.

When demand restraint and currency depreciation are used in tandem, however, overall expenditure falls, relieving upward pressure on domestic prices, and, at the same time, demand is encouraged to switch from imports—made more expensive in local currency terms by the depreciation—to domestic products. This added demand for local goods reduces unemployment in the nontraded sector, which is further eased by expansion in the export sector, as the local currency price increases to the domestic exporter. BOP adjustment is achieved once the traded sector has expanded sufficiently relative to the non-traded sector to produce a sustainable external position.

Both the measures taken to change the underlying structure of the economy and the structural change itself have distributional implications. The distributional effects of measures aimed at particular groups or activities are relatively easy to trace. Changes in producer prices under public sector control, for example, affect employees of the activities concerned; holding public sector wages constant in the face of general inflation affects employees of government agencies; and selective credit restraint in a climate of excess demand for loanable funds affects those seeking credit. The decision as to whose demand to restrain tends to be a domestic political one. Less political discretion is possible with the devaluation-related increase in prices, which affects people differently according to how closely their wages and financial assets are indexed to prices and according to their production and consumption patterns.

The structural changes in the economy required to effect BOP adjustment—the reorganization of production toward exports and import substitutes and away from purely domestic goods—have different effects on the various income groups in the economy. In particular, income earners in the export sector tend to experience a rise in their incomes relative to those in the nontraded goods sector. Furthermore, export firms can become more profitable at the same or increased output levels only by lowering the ratio of their wage rates to the prices charged for their commodities. The overall real wage to labor need not fall if nontraded goods represent a large share in the domestic price index, since wage rates can rise relative to the price of non-traded goods without impeding adjustment. This suggests that the distributional impact of adjustment—in terms of a sustained reduction in the prices of nontraded goods compared with traded goods, and the resulting changes in incomes earned in the associated activities—is largely determined by the conditions of supply and demand within a country.

The programs

Stabilization programs associated with the use of Fund resources in the upper credit tranches typically include policies to reduce real domestic aggregate demand as well as specific provisions for changing relative prices within the economy. As fiscal deficits are a principal source of external and internal imbalance, strong emphasis is placed on reducing them. But although programs generally contain targets for budget deficits, the associated performance criteria for monitoring them are usually in the form of ceilings on net credit to government and on short-term and medium-term external borrowing by the public sector. The private sector would also contribute to deficits when lower costs and excessive availability of credit encourage unsustainable levels of domestic consumption and investment. Limitations on this source of excess demand tend to be subsumed in the overall ceilings on net credit. Programs also include measures that more directly affect prices. The most commonly used measures of this sort are currency depreciation and the relaxation of foreign exchange restrictions, the liberalization of price controls on the private sector, and the rationalization of the prices of public enterprises so that prices cover costs as far as possible.

In each of the four countries in our study, a combination of these measures aimed at restraining domestic demand was used. Since deficits in public sector finances contributed significantly to the external disequilibria in all four cases, the stabilization programs emphasized fiscal restraint. In general, the authorities cannot totally determine how the burden of increased taxes and decreased fiscal benefits is to be borne. The choice of policy instruments will vary—according to the political power of various income groups as well as the authorities’ perceptions of the causes of the BOP problem and of the effects of different policy instruments. The incidence will also vary; an important factor influencing who bears the brunt of additional taxes is often the ease with which the additional taxes can be collected. In the majority of developing countries, the immediate burden of increases in taxation tends to fall on producers of exported goods, consumers of imported goods, income earners in large firms in the modern private sector, and wage and salary earners in the public sector. Among the programs reviewed, this effect was most apparent in Bolivia and Ghana, where the relative taxation of tin and cocoa producers, respectively, increased under the program.

Measures aimed at restraining demand through reducing expenditures often include cuts in subsidies, particularly where these absorb a significant portion of the government budget. In these situations some of the burden of the adjustment will be borne by consumers of subsidized foodstuffs. Similarly, wage and salary earners in the public sector as a whole generally experience some decline in their real rate of remuneration, so that their relative income position tends to deteriorate. Egalitarian considerations often result in especially steep cuts in the real salaries of higher-ranking civil servants. However, the brunt of any downward adjustment of government expenditure relative to gross domestic product (GDP) is most commonly borne by the public sector employees and the private domestic suppliers associated with projects which have to be postponed. These tend to be highly capital-intensive ventures in construction and public utilities. This effect of adjustment was particularly evident in the programs in Ghana and the Philippines.

In each country, a large exchange rate change accompanied the program. While the currency of each country had been overvalued, the specific problems associated with overvaluation differed. In Bolivia, for example, domestic costs had been rising faster than world prices for tin, its major export, as well as for other exports. As a result, public and private export enterprises faced increasing financial difficulties, with unfavorable consequences for both domestic employment and government finances. The same was generally true in Ghana where, during the period preceding the devaluation, domestic costs and prices had run well ahead of import prices even as cocoa prices were falling on world markets.

In Indonesia, there had been a period of very high domestic inflation, and a complex exchange rate system had been instituted. In the Philippines, the program was primarily concerned with the very high debt service obligations but the currency had been overvalued for some time, having been maintained through an elaborate system of exchange controls, tariffs, and quotas, all of which favored the production of import substitutes. At the same time, very little had been done to encourage exports. The rapidly growing labor force made for an increasingly onerous unemployment problem, since production was limited by domestic demand, and ultimately by the foreign exchange constraint. Currency depreciation was, therefore, an important ingredient in moving toward a strategy that would permit domestic growth as part of the achievement of internal and external balance.

Wages and prices

The challenge to internal policy in these countries was to prevent increases in the prices of nontraded goods from wiping out the relative price change consequent to the devaluation. Where monetary and fiscal restraint were maintained, the devaluation achieved a sustained decrease in the ratio of the prices of nontraded goods to those of traded goods. Where, however, the planned restraint was relaxed, excess domestic demand tended to pull up the prices of nontraded goods, reversing the change in the internal terms of trade and the associated movement in earnings.

In Bolivia the failure to maintain the demand restraint provided for in the program—which had authorized a uniform wage increase to workers regardless of salary level—led to domestic price increases that by early 1974 had completely eroded the decrease in the price ratio of traded to nontraded goods obtained by the devaluation of October 1972. In Ghana, in contrast, the ratio of the GDP deflator to the domestic price index for imports fell with the devaluation in 1966 and remained below its predevaluation level at least until 1970. Similarly, in the Philippines, import prices rose much faster than did those for nontraded goods during 1970, the first year of the program. While the trend was reversed in 1971, it reflected mainly increases in domestic food prices that resulted from unfavorable supply factors rather than from unrestrained demand.

Stabilization also has different effects on various categories of wage earners. It is not always necessary to reduce real wages to achieve external and internal balance. Nevertheless, where hired labor is an important factor of production in the export sector, the prospects that export volumes will rise relative to real GDP depend upon a fall of the nominal wage in the export sector against the price of exports in domestic currency. Moreover, movements in this ratio are apt to be good indicators of movements in the ratio of the prices of nontraded goods to those of traded goods, since the nominal wage in the export sector is likely to keep pace with prices there if the prices of nontraded goods rise as fast as export prices.

The situation in Bolivia illustrates the effects of devaluation when demand restraint is not pursued. Nominal wages rose in the mining sector by more than 100 per cent between October 1972 and January 1974, when the average peso price for exports rose by just under 100 per cent. In contrast, in the Philippines, nominal wages for skilled and unskilled workers rose by 10 per cent and 15 per cent, respectively, from 1970 to 1972, when export prices rose by 20 per cent. In Ghana, real wages in those medium-scale and large-scale establishments for which data are available rose in 1966 and 1967. Between 1967 and 1969, real wages rose marginally in the private sector but fell in the public sector. Only in construction in the private sector do real wages appear to have fallen significantly between 1967 and the end of 1969.

Political factors and controls

In contrast to the distributional effects that are transmitted through a change in the internal terms of trade and are largely determined by the structure of the economy, the authorities possess considerable discretion over whose demand is reduced in the initial phase of the program. Hence, official decisions in this area tend to be influenced by political factors. Often, for example, those with the most to lose from a program aimed at a more equitable distribution of income tend to be those with the most power. If their interests are not provided for in the program, they will tend to interfere with its implementation.

Bolivia was a case in point. Exporters were able to secure a reduction in the tax that was initially planned to be levied on the inflated value of postdevaluation export receipts. This violated organized labor’s conception of relative equity, and strike threats brought about a sizable bonus for the workers. Similarly, in the Philippines, vested interests delayed the legislative authorization for the tax increases needed for the adjustment effort. In contrast, changes in government had preceded the programs in Ghana and Indonesia, and support for these changes was predicated to a large extent on dissatisfaction with the economic instability that had characterized the previous periods. Hence, there existed in these countries a firmer basis of support for the restrictive measures to be undertaken.

In general, there are some fairly important economic reasons for being sanguine about the equalizing effects of successful programs on the distribution of income. One of these is connected with the dismantling of exchange controls. In an economy where market transactions are dominant, controls and other institutional distortions of the price mechanism prevent the economy from organizing production in the most efficient manner. More important, controls and restrictions create artificial scarcities and bring a bonanza to those who gain access to the artificially scarce rights; these may not be the most efficient producers and are typically not the poorest groups.

Indonesia and the Philippines are examples of countries that had relied heavily on exchange controls to maintain their external positions in the face of overvalued currencies. In Indonesia, the complicated system of multiple exchange rates that had evolved during a period of extremely high inflation fostered a black market for foreign exchange on which U.S. dollars sold for four times the highest official rate and for more than 40 times the lowest official rate. On the other side of the market, the availability and cost of foreign exchange to purchase imported inputs had differed significantly between users. This tended to result in excess profits for firms or individuals acquiring import licenses and in a somewhat arbitrary distribution of foreign exchange and profits. In the Philippines, the major beneficiaries of the Government’s development strategy in the 1950s and the 1960s were those who owned businesses in the industrial sector. Selective access to rationed credit at low interest rates, together with exchange controls and other policies favoring import substitution, created opportunities for profit for some people. The removal of some of these distortions under the program tended to reduce the gains of those who had enjoyed special privileges.

Employment

Perhaps the most important distributional impact of successful stabilization efforts is on employment. When successful stabilization occurs under favorable economic conditions, the effect can be particularly conducive to increasing employment opportunities. Such conditions include situations where the export sector has greater potential for growth than the non-export sectors; and where growth has been constrained due to a lack of foreign exchange for imports and general uncertainty about the economic situation—whether produced by inflation, severe exchange controls, or overvalued currencies. These conditions existed, for example, in Bolivia at the time of devaluation, when many small tin mines had closed because production costs were too high relative to the selling price and because investment in mineral production had been too low to permit a sustained increase in output and employment.

The Philippine and Indonesian programs also had significant effects on employment. As part of the general movement away from a strategy of import substitution, the Philippine program stressed improved competitiveness for exports, with currency depreciation playing a critical role. This allowed for growth in employment opportunities from demand generated abroad, and tended to relieve the BOP strain that otherwise would accompany attempts to provide jobs for a labor force growing at 3 per cent annually. In Indonesia, real output and employment rose throughout the period of the program. Increased employment opportunities, especially in Indonesia with its rapidly expanding population, are favorable to enhancing equality.

In Ghana, there was evidence that prices were so low in the cocoa sector that farmers had simply stopped tending some existing trees, indicating potential for expansion. Employment could, therefore, be quickly increased in the agricultural sector by a currency depreciation that would allow producer prices to be raised without endangering the viability of the Cocoa Marketing Board, which was the official exporter of all Ghana’s cocoa production. At the same time, however, the low rate of growth in the initial stages of the program caused employment in the modern sector to decline in 1966 and 1967; this employment picked up in 1968 and 1969.

The findings from the four case studies reviewed support the view that stabilization programs inevitably have repercussions on the distribution of income. Domestic political considerations largely determine who bears the burden of reducing and restructuring aggregate demand to achieve sustained external balance. Apart from the problem that vested interest groups often frustrate policy efforts aimed at improving income distribution, the adjustment needed for external balance may itself exacerbate inequalities in the short run. Thus, real wage rates may have to fall and real profit rates increase so as to encourage increased foreign capital inflow and private domestic capital formation. Similarly, because the mobility of labor and capital is limited, earnings in export industries will tend to rise at the expense of their counterparts supplying the domestic market. The final and perhaps most important effect of a successful program is the increased inflow of capital and the correspondingly increased rate of investment. But this effect is only evident over the long term, as are its distributional effects.

Domestic political considerations largely determine who bears the burden of reducing and restructuring aggregate demand to achieve sustained external balance.

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