Broadly speaking, unless a balance of payments problem is temporary—in which case financing would be suitable—adjustment is necessary. Adjustment refers to those changes in expenditure, saving, and production that are needed to produce a sustainable balance of payments situation, namely, one where any deficit on current account can be financed by normal capital inflows.
Most balance of payments problems in non-oil developing countries are not temporary and cannot be tackled by financing alone. Where adjustment is required, a certain amount of financing may also be desirable to avoid abrupt changes in the economy. In most cases the financial assistance that the Fund makes available to a member is associated with an economic adjustment program. Indeed, the Fund is obliged by its Articles of Agreement, and by the fact that the resources at its disposal are limited and must revolve, to satisfy itself that the economic program it supports will, in the medium term, bring about adjustment and a viable balance of payments. The adjustment policies that typically form such a program were discussed recently in “Issues in the use of Fund resources” by Andrew Crockett in the June 1982 issue of Finance and Development.
Recent examples of adjustment
Republic of Korea. Various factors combined during the late 1970s in Korea to produce a rapidly deteriorating balance of payments. A policy of cheap credit to encourage an ambitious investment program, particularly in the heavy and chemical industries, led to excessive demand pressures. On the supply side, there were shortages of skilled labor, in part because of a speculative housing boom that occurred when many construction workers were departing for the Middle East. Price and wage inflation rose, and external competitiveness was eroded—with adverse effects on exports and, hence, output growth.
Some measures were introduced in 1979 to moderate domestic demand pressures, but these could not prevent a deterioration of the balance of payments, partly because of unforeseen external developments—especially the increase in oil prices, slower growth of export markets, and rising protectionist tendencies abroad. The current account deficit continued to rise and, as the immediate prospect was for a further increase, a stabilization program supported by two successive stand-by arrangements with the Fund was initiated in early 1980.
The main policy changes in 1980 included a substantial increase in interest rates, a depreciation of the exchange rate, higher energy prices, and more restrictive fiscal and monetary policies. The impact of these on growth was compounded by civil disturbances and a major crop failure; as a result, real gross national product (GNP), which rose by 6 per cent in 1979, fell by about the same magnitude in 1980. Partly because of these developments, financial policies were eased somewhat in the latter part of 1980, but considerable financial stringency prevailed for the year as a whole. Inflation still accelerated temporarily in 1980, under the impact of the depreciation, the increases in energy prices, and the crop failure. The current account deficit widened, but only by about half of the price-induced increases in the oil import bill, implying that substantial external adjustment took place.
In 1981, policies continued to emphasize prudent demand management and wage moderation through an extensive public education campaign. The rewards of the stabilization efforts were mainly reaped in 1981 when aggregate output growth was resumed, reflecting especially rapid export growth through the third quarter of the year, as a result of the gains in competitiveness achieved in 1980. Inflation also decelerated sharply and the current account deficit declined. However, private investment remained sluggish and the growth of exports has slowed since the fourth quarter of 1981, resulting from both a weakening of world demand and a decline in the price competitiveness of exports.
Peru. Between late 1977 and the end of 1980 Peru had three continuous stand-by arrangements with the Fund. Expansionary policies since the early 1970s and rapidly growing public expenditures had put increasing pressure on prices and the balance of payments, both of which were aggravated by the increase in the oil price. Inflation rose sharply between 1973 and 1976, the balance of payments current account deficit rose to 11 per cent of gross domestic product (GDP) in 1975, external debt grew rapidly, and international reserves fell. The exchange rate was allowed to appreciate by 25 per cent in real terms between 1975 and 1977 in an effort to curb the rise in inflation.
The stabilization program introduced in 1976 broke down in 1977 under pressure for more government expenditure, and a similar fate befell the program of late 1977. The third attempt, in 1978, was successful, however. The public sector deficit was brought down from an average of 10 per cent of GDP in 1975–77 to 2 per cent in 1979, and the exchange rate was devalued and attached to a crawling peg. The balance of payments current account deficit fell rapidly, helped by large improvements in the terms of trade in 1979 and 1980. The adjustment was successful in that the balance of payments improved, while saving (both public and private) rose without much fall in investment, and output growth was quickly resumed. But inflation remained high, partly because of corrective price increases, and it still proved difficult to keep the public sector deficit under control. Some of the earlier problems reemerged in 1981.
Portugal. The balance of payments difficulties of Portugal arose from the 1974 oil price rise, the loss of its African colonies, and some consequences of the 1974 revolution—such as rapid growth in real wages and public expenditure. International competitiveness deteriorated because the depreciation of the exchange rate did not keep pace with the more rapid growth of wages and prices in Portugal than elsewhere. This, together with lack of confidence, discouraged the repatriation of migrant workers’ earnings and caused capital outflows, especially in 1977. Although the public sector deficit had grown rapidly from 1973 to 1977, there was not much generalized excess demand; unemployment was high and there was excess capacity in the export sector (including tourism).
Sources: IMF, International Financial Statistics. Additional data from national sources.
Period of extended facility and upper credit tranche program.
The economic program supported by Fund lending in 1978–79 therefore emphasized expenditure-switching rather than expenditure-reduction. The major instruments were faster depreciation of the exchange rate, wage restraint, relaxation of import controls, and an increase in interest rates. The balance of payments improved dramatically, mainly because of sharp increases in exports, workers’ remittances, and capital inflows, stimulated especially by the exchange rate and interest rate changes. The growth rate of output rose in 1979 after falling for two years. Both saving and investment were higher as a percentage of GDP in 1979–80 than in the years of balance of payments crisis, with the increase being greater for saving and, within total saving, for saving by the private sector. It was also intended to reduce the public sector deficit, although the outcome was that it increased. Some of the improvement in the balance of payments was a temporary stock adjustment. Partly because of this—and because of the rise in oil prices, continued structural weaknesses, and the high pressure of domestic demand—the current account deficit increased again in 1980 and 1981.
Panama. With the exception of two short gaps, Panama has had Fund stand-by arrangements in the upper credit tranches since June 1978, following first credit tranche arrangements in 1973–76 and 1977–78. The problem can be traced to adverse external developments in 1974–78: the world recession; the fall in prices for its major export, sugar; and the decrease in private investment because of uncertainty about the Canal. The authorities countered the recession by increasing public expenditure, especially on large investment projects. The public sector deficit rose to nearly 19 per cent of GDP in 1976; as most of it was financed abroad, official external debt rose rapidly, reaching 82 per cent of GDP at the end of 1978. Since the U.S. dollar circulates freely in Panama, the overall balance of payments is always in equilibrium, and the current account deficit is automatically limited to the availability of finance and is not in itself a problem.
The aims of the economic programs supported by the Fund were to reduce the public sector deficit, and hence the growth of official external debt, and to create the conditions for the recovery of private investment. Public investment was reduced, as was expenditure on emergency employment-creating measures, and new revenue measures increased receipts. The ratio of official external debt to GDP declined to 62 per cent at the end of 1981. Output growth from 1978 was more satisfactory than it had been in the mid-1970s, partly because of the recovery of private investment that had resulted from the conclusion of the Canal treaties.
Gabon. Large imbalances arose in Gabon in 1973–76 when public investment grew very rapidly following the first oil price increase. The Government deficit rose to over 20 per cent of GDP; inflation was also over 20 per cent and external debt grew rapidly. The expansionary phase came to an end in 1977 and was followed by a recession and financial crisis. A stabilization program supported by a stand-by arrangement was introduced in 1978. The overall government balance was brought into surplus and inflation declined, but there was a large drop in output in both the oil and non-oil sectors.
To consolidate the gains that were made, a medium-term program supported by a precautionary arrangement under the extended Fund facility was introduced in 1980. The main aims were to resume orderly growth with relatively low inflation; to reduce external debt; to reestablish adequate reserves; to expand the production base of the non-oil economy; and to use in a more orderly fashion the enlarged resources derived from the second oil price rise. The principal policy instruments were the investment plan, more efficient pricing, and wage and credit restraint. Fund resources were to be made available in case of need, but this need did not arise and they were not utilized.
The objectives of the program were mostly achieved. Real output in the non-oil sector grew again, although at a rather low rate, partly because sharp declines in export volume and prices, brought on by a fall in demand, affected the uranium, manganese, and forestry sectors. There were also some problems in implementing the investment plan, and the modest structural change achieved has not yet been reflected in growth because of production lags. Government expenditure targets were largely achieved. Revenue performance improved markedly, helped by an unexpected depreciation of the CFA franc against the U.S. dollar, in terms of which oil revenues are denominated. As a result, the Treasury position continued to improve, with the government budget recording large surpluses. External debt declined and reserves were built up to a relatively satisfactory level.
Note: The June 1980 arrangement, under the extended Fund facility, expired in December 1982.
Sri Lanka. The external position of Sri Lanka deteriorated over the 20 years previous to the mid-1970s because of a serious worsening of the terms of trade and stagnation of the export-oriented agricultural sector. Persistent balance of payments difficulties led to an increasingly restrictive exchange and trade system with a bias against exports. Price controls, consumer subsidies, and food rationing distorted prices and reduced saving and investment.
The programs supported by a stand-by arrangement with the Fund in 1977–78 and an extended arrangement in 1979–81 aimed to reduce controls over prices, trade, and payments; to bring prices, including the exchange rate and interest rates, closer to market clearing levels; to shift budgetary resources from subsidies to investment; to increase saving; and to raise the growth rate. They began well, with the growth rate, investment ratio, and foreign aid inflows all rising, and the overall balance of payments in equilibrium. However, some signs of excess demand emerged toward the end of 1979 and became widespread in 1980, mainly because of the large increase in public expenditure, especially investment. The adverse effects of this on the balance of payments and inflation were compounded by the effects of drought on tree crop output and the deterioration in the terms of trade. Mainly as a result of restrictive fiscal and monetary measures, the situation improved in 1981. Despite the setbacks of 1980 and problems remaining in the export sector, the programs of 1977–81, as a whole, contributed to raising the growth rate of the economy and to increasing its efficiency by replacing controls with price incentives.
Burma. For almost a decade up to 1974, the economy of Burma hardly grew at all in per capita terms. Agriculture dominated the economy, and agricultural output per capita fell—mainly because producer prices were kept fixed while input prices rose—and there was relatively little investment. Exports, which were based on agricultural production, therefore suffered and the volume of imports had to be held down. The tax base was similarly eroded and the Government had recourse to bank borrowing which, together with increased bank borrowing by state economic enterprises, exacerbated inflationary pressures after 1972. In 1975 there was a change in policy, and the Government sought to provide more incentives to increase output and mobilize resources. As a result output grew more rapidly, helped by favorable weather, but inflation also rose, partly because of corrective price increases. In the mid-1970s the Government sought to raise the investment rate and to borrow much more abroad on concessional terms.
Note: The June 1981 arrangement, a stand-by, expired in June 1982.
1Years beginning April 1 except consumer prices, which are calendar years.
Sources: IMF, International financial Statistics. Additional data from national sources.
Period of extended facility and upper credit tranche program.
In support of this program, Burma had stand-by arrangements with the Fund from 1977 to 1979. The size of the foreign trade sector in relation to the economy as a whole grew sharply, especially on the import side. The current account deficit grew, as planned, and was covered by a larger capital inflow so that the overall balance was kept under control. Growth continued at a satisfactory rate, and inflation was low, partly because of price controls. There continued to be many inflexibilities in the economy aggravated by the controls on imports and prices. A major problem was the unused capacity in many state economic enterprises arising from a shortage of imports; another was the rising public sector deficit and consequential inflationary pressures associated with the controlled output prices of the state undertakings. A program supported by a new Fund arrangement was introduced in 1981, with the aim of liberalizing imports and prices, albeit at some temporary cost in terms of a higher current account deficit and inflation. The evidence to date suggests that it was broadly successful.
Some aspects of adjustment
Although these seven countries are not necessarily representative of all countries with Fund-supported programs, nor even of those where a reasonable measure of adjustment took place, their experiences can illustrate a number of general aspects of adjustment following Fund-supported programs.
The nature of the initial problems and their causes differ widely. In some cases there was an unsustainable current account deficit caused primarily by excessive domestic demand pressures (Korea, Peru, and Sri Lanka in 1980). In Portugal the rise in the current account deficit was more the result of a decline in international competitiveness than of excess demand. However, excess demand also played the major role in creating the external problems of Panama and Gabon. Official external debt rose rapidly as ambitious public sector investment programs were financed mostly abroad; official international reserves also fell to low levels. The existing balance of payments difficulties of all these countries were aggravated by external developments, especially terms of trade movements and the weak growth of export markets. Sri Lanka until 1980 and Burma had rather different problems. They both wished to increase investment and liberalize imports and prices (Burma only from 1981) in order to grow more rapidly. Although they did not initially have balance of payments problems, the change of strategy could have created some unless appropriate adjustment had taken place.
The main policy instruments that are included in successful programs reflect the differences in the nature of the problem and its causes. Thus the programs of Korea, Peru, Sri Lanka in 1981, Panama, and Gabon (especially 1978–79) emphasized the restraint of demand. Since private sector investment was the major cause of the excess demand in Korea, credit restraint was the centerpiece of the program there. The main problem in the other countries was the overall deficit of the public sector, which they sought to reduce. Discrete exchange rate changes, together with further currency depreciation in some cases, supported demand restraint in Korea and Peru, and also formed a central part of the programs in Portugal and Sri Lanka. As befitted their initial position of balance of payments equilibrium with unsatisfactory growth, the main policy measure in Sri Lanka (until 1981) and Burma was an increase in the rate of public investment. This was supported by the liberalization of imports and prices (from 1981 in Burma). Most other countries also sought to improve economic efficiency by reducing price distortions. In Gabon special emphasis was placed on the structure of the investment plan—to improve the efficiency of the reduced level of investment and, hence, to increase the growth rate of the non-oil economy.
The link between the type of problem and the type of program can also be seen in the actual outcome. The growth of GDP improved in five out of seven countries (Portugal, Panama, Gabon after 1978, Sri Lanka, and Burma) and declined temporarily only in Korea and Peru. This division corresponds roughly to that between programs emphasizing demand restraint (Korea, Peru, Sri Lanka in 1981, Panama, and Gabon in 1978–79) and others, except that Panama achieved satisfactory growth despite considerable fiscal restraint. In the countries where the growth rate rose, the increase in supply was brought about through various channels: the utilization of excess capacity in Portugal; improved external competitiveness in Portugal and Sri Lanka; a rise in private investment in Panama and Sri Lanka; a rise in public investment in Burma and Sri Lanka; and improved resource allocation in Portugal, Sri Lanka, and Gabon. Some of these changes, especially the improvement in competitiveness, also raised supply in South Korea and Peru, even though other factors caused the growth rate to decline temporarily.
Successful adjustment is more likely to occur if policy is flexible in the face of unexpected developments, as is suggested by the experience of these countries. Some of them were able to take advantage of favorable changes in their environment. For example, in Peru the terms of trade improved, and in Panama the Canal treaties were concluded. Although Gabon failed to profit from the oil price rise in 1974, it did not repeat this mistake after the second oil price rise. On the other hand, successful adjustment can still be achieved even when unfavorable events occur. In 1980 Korea experienced a crop failure, a reduction in export demand, a deterioration in its terms of trade, higher interest rates, and civil unrest, and yet kept on the path to successful adjustment. Unexpected developments, even favorable ones, can undermine adjustment efforts, but a flexible policy response can still produce the desired changes.
Even when adjustment is generally successful, some difficulties can emerge. Some of the countries discussed failed to keep demand pressures fully under control, either during (Portugal and Sri Lanka up to 1980) or after (Peru) the period of the arrangement with the Fund. Although the programs in Portugal and Sri Lanka did not always emphasize demand restraint, successful adjustment could have been undermined if demand pressures had not been kept under control. (It almost was undermined in Sri Lanka until restrictive policies were introduced in 1981.) In Peru the re-emergence of demand pressures in 1981 led to a new extended arrangement with the Fund, which was approved in June 1982. Other outstanding problems included the deteriorating international competitiveness of Korea during 1981; the difficulty of improving the quality of public investment in Gabon, Burma, and Sri Lanka; and price distortions in a number of countries.
Adjustment should be a continuous process. Even if major efforts are made from time to time, at all other times policy should be sufficiently flexible to react to changing circumstances so that the most favorable environment for growth, inflation, and the balance of payments is maintained. Most of the countries discussed had either an extended arrangement or a series of shorter stand-by arrangements with the Fund. The first attempts at stabilization and adjustment were not always successful (as in Korea in 1979, Peru in 1976–77, and Portugal in 1977), mainly because the extent of the problem was underestimated. After some success in adjusting was achieved, further problems came close to reversing it in these cases. This suggests that successful adjustment is most likely to occur when political support is mobilized to sustain the stabilization program over a period of years. The longer the introduction of the program is delayed, the greater the effort needed to see it through, and the greater the chance of failure.
WilliamR. Cline“Economic Stabilization in Peru, 1975–78,” inWilliam R.Cline and SidneyWeintraub (editors) Economic Stabilization in Developing Countries (Washington, DCThe Brookings Institution1981).
AndrewCrockett“Issues in the use of Fund resources,”Finance & Development (June1982).
ManuelGuitiánFund Conditionality: Evolution of Principles and Practices Pamphlet No. 38 (Washington, DCInternational Monetary Fund1981).
HansO. SchmittEconomic Stabilization and Growth in Portugal Occasional Paper No. 2 (Washington, DCInternational Monetary Fund1981).
JohnWilliamson (editor) IMF Conditionality articles on Peru and Portugal (Institute for International Economicsto be published in1983).