Adjustment and growth in the 1980sand 1990s

Economic performance in the 1980s has variedwidely among countries and continents. After asharp recession at the beginning of the decade, theindustrial countries are well into their seventh yearof uninterrupted growth, although at rates lowerthan those of the 1950s and 1960s. In parts of Asia,where much of the world's poverty is concen-trated, economic growth in the 1980s has beenfaster than in earlier decades. But in Africa andLatin America hundreds of millions of people haveseen economic decline and regression rather thangrowth and development (see Figure 1.1). In somecountries in Latin America real per capita GNP isless than it was a decade ago (see Figure 1.2); insome African countries it is less than it was twentyyears ago.

Why have some countries fared so much betterthan others during the 1980s? Economies differgreatly in their structures, in their domestic devel-opment strategies and policies, and in the extent towhich they have been affected by external shocks.Higher real interest rates, reduced internationalcapital flows, and lower commodity prices havemade adjustment both necessary and difficult, par-ticularly for the highly indebted countries, Butsome governments have been more successfulthan others in pursuing short-term adjustmentand longer-term structural reform. In addition,markets and agents have varied in the speed withwhich they responded to new policies and tochanged incentives.

6

The prospects for growth in the developingcountries in the coming decade depend primarilyon their own actions, but also on the environmentcreated by the actions of the industrial countries.The industrial countries can promote growth in thedeveloping economies in three ways: by adoptingfiscal and monetary policies to maintain their owngrowth while reducing real interest rates, by en-suring the success of the Uruguay Round of tradenegotiations and thereby keeping the internationaltrading system open and the volume of trade ex-panding, and by ensuring that the internationalcommunity provides the external resources thatthe developing countries need for growth andadjustment.

The international economic environment

The world economy in the 1980s was dominatedfirst by sharp recession, then by steady and pro-longed growth in the industrial countries, highreal interest rates, declining real commodityprices, massive movements in exchange rates, andthe collapse of voluntary private lending to manydeveloping countries. The recovery of the indus-trial countries from the recession of 1982 has beenstrong and so far without interruptionthe secondlongest recovery since World War II. But the mix offiscal and monetary policies and the resulting pat-tern of trade and growth have changed over thepast eight years.

Figure 1.1 Growth of real GNP in developing countries by region, 1965 to 1988(average annual percentage change)

Sub-Saharan East Asia South Asia Europe, Middle Latin America andAfrica East, and North the Caribbean

Africa10

6

4

2

0

LI 1965-73 U 1973-82 U 1982-88

Figure 1.2 Real GNP per capita in developing countries by region, 1965 to 1988(period average in 1980 dollars)

Sub-Saharan East Asia South Asia Europe, Middle Latin America andAfrica East, and North the Caribbean

Africa2,000

1,600

1,200

800

400

0

LI 1965-73 U 1974-82 U 1983-88

Note: GNP is measured at 1980 prices and exchange rates.

/

7

The early years of the recovery were led by briskgrowth in the United States, where tax cuts andincreased spending on defense provided the impe-tus. The expansionary U.S. fiscal policy, combinedwith anti-inflationary monetary policy worldwide,led to high real interest rates (especially in theUnited States), an appreciating dollar, and a boomin imports and consumer spending in the UnitedStates. As a result, the U.S. current account deficitdeteriorated by $100 billion between 1982 and1984. This, in turn, led to expectations of a declinein the dollar, which were fulfilled between 1985and 1987.

In the Federal Republic of Germany and Japan,expansionary policies in 1987 and 1988 were con-sistent with low inflation because of the decline inoil prices and the appreciations of the yen and thedeutsche mark. The transition to domestic-ledgrowth was particularly successful in Japan, wherethe growth of consumption, imports, and espe-cially investment (a rise of 11 percent in 1988) sup-ported continued growth in the world economy.

The worldwide stock market crash of October1987 clouded the outlook for economic growth atthe beginning of 1988. But vigorous and concertedresponses to the crash by monetary authorities inthe leading financial centers, some fiscal adjust-ment in the United States, and cheaper oil all com-bined to permit steady growth with low inflation inthe industrial countries in 1988. Indeed, growth inthe high-income countries of the Organisation forEconomic Co-operation and Development (OECD)was markedly higher in 1988 than in 1987 (4.2 per-cent compared with 3.4 percent). Only at the endof the yearas fears grew that pressures on capac-ity would increase inflation and that the new U.S.administration would not attack the budgetdeficitdid exchange and interest rates show someof the volatility that had characterized the earlierstages of recovery.

Interest rates

Real interest rates in the 1980s have been higherthan at any time since the Great Depression. Theyclimbed during the early part of the decade, asmonetary restraint brought down inflation whileraising nominal interest rates. One explanation forthe persistence of high interest rates is that nomi-nal rates are affected by the fear that inflation willreturn. This may help to account for high long-term nominal interest rates, but it cannot explainthe persistence of high short-term rates.

Another explanation for high interest rates is the

8

decline in the world's saving rate, which appearsto have fallen (the data are imprecise) by 2 percent-age points in the 1980s, to 11 percent in 1987. Partof this decline is a result of the increase in the U.S.federal budget deficit, which in 1987 amounted toabout 8 percent of world saving of just under $2trillion. Lower saving by other governments anddeclining private saving rates in many countriesalso played a role.

World growth can now be maintained with a pol-icy mix in which monetary policy loosens as fiscalpolicy tightens, with the extent of monetary ex-pansion determined by concerns about future in-flation. This combination, including a significantreduction in the U.S. budget deficit and other in-creases in world saving, would help to reduce realinterest rates. That, in turn, would contribute tohigher investment and thus to growth led from thesupply side.

Lower interest rates would assist growth in de-veloping countries by reducing the cost of financ-ing new investments and easing the burden of theexisting debt. The low interest rates of the 1950sand 1960s are unlikely to return, however; real in-terest rates on safe government bonds may be ex-pected to remain well above the postwar averageof 1 percent.

High interest rates have reduced the extent towhich developing countries can rely on foreignborrowing to finance development. Higher real in-terest rates lower the ratio of debt stock to exportsthat a country can sustain and thereby make nettransfers of resources to lenders necessary sooner.Ratios of debt stock to exports that may have beensustainable at the interest rates of the 1970s are notsustainable at the interest rates of the 1980s.

More than in the past, developing countries willhave to rely on their own saving to finance invest-ment. This underlines the need for greater effi-ciency in their financial systemsboth to encour-age saving and to allocate investment moreeffectively.

World trade

Growth in the developing world has been affectednot only by the growth of imports by the industrialcountries but also by the changing source andcomposition of import demand. Figure 1.3 showsthe relationship between world economic growthand world trade. The recession of 1982 hurt worldtrade overall, but developing country trade fellproportionately more. In general, the volume ofworld trade fluctuates more than world growth,

and developing country trade is even more vola-tile. Resilient economies can absorb these shocksand rebound rapidly. For example, open econo-mies that depend on manufactured exports, suchas some of the newly industrialized economies ofEast Asia, were particularly hard hit by the slumpin world trade in 1982. But these outward-orientedcountries experienced faster export growth duringthe 1980s, and their economies have grown muchmore quickly than those of countries that pursuedmore inward-oriented policies.

Export growth not only contributes directly toeconomic growth but, more important, also per-mits more imports and a rapid modernization ofproduction. The result is efficient domestic indus-try that meets the market test of international com-petition. High export growth among East Asiancountries and low export growth in Latin Americaand Africa have significantly changed the regionaldistribution of developing country exports duringthe 1980s (see Figure 1.4).

The volume of world trade increased by morethan 9 percent in 1988the fastest growth in the1980s. Trade patterns have been strongly affectedby the expansion of domestic demand in Japan andthe delayed effects of exchange rate movements.Import volume in Japan was up by 17 percent in1988, compared with an 8 percent increase in theEuropean countries; the yen moved significantlymore against the dollar than did the European cur-rencies. The middle-income countries of East Asiasharply increased their exports to Japan, and EastAsian intraregional trade increased by 30 percent.

Oil and commodity prices

Massive swings in the price of oil and a prolongeddecline in the real prices of other commoditieshave posed short- and long-term adjustment prob-lems for producers and consumers alike in the1980s. The real price of oil (deflated by the unitvalue of manufactures) more than doubled from1978 to 1981, peaking at six times its 1973 level. Itthen drifted downward for several years, collaps-ing to its pre-1973 level late in 1988, when the mar-ket price dipped below $11, before quickly re-bounding to $20 in the first part of 1989. The realprices of most other commodities continued to de-cline during the 1980s, except for minor price run-ups such as the revival of metal prices in 1988 (seeFigure 1.5).

The large swings in the relative prices of com-modities (especially oil) have made it harder forgovernments (especially in commodity-producing

Figure 1.3 Growth of output and trade,1980 to 1988(annual percentage change)

12

10

8 World trade

4 -'7W

Developing countries' trade

0

246

World output

1980 1981 1982 1983 1984 1985 1986 19871988

Note: Trade growth is defined as the average of the growth ratesfor export and import volumes.Source: IMF and World Bank data.

countries) to manage demand and exchange rates.Oil price increases and the surge in the value of oilexports put upward pressure on the producers'exchange rates and thereby harmed non-oil ex-ports and encouraged imports. This difficultyknown as the Dutch diseasehas been faced byhigh-income countries (such as the Netherlandsand the United Kingdom) and low-income coun-tries (such as Nigeria and Egypt) alike. When thecommodity boom passed, trade deficits followed.Moreover, in some countries oil taxes supportedpublic spending programs that have since beendifficult to curb. As a result of the decline in theprice of oil since 1982, gross domestic product(GDP) in the oil-exporting countries grew by only1.6 percent annually between 1982 and 1988, com-pared with 5.0 percent between 1973 and 1982.

Countries that depend on commodity exportsshould save morerun larger current account sur-pluses or smaller deficitswhile export revenuesare temporarily high. It is difficult, however, todistinguish between temporary and permanentchanges in commodity prices. Was the upturn inmetal prices in 1988 part of a medium-term trend,

9

Figure 1.4 Growth of export volume in developing countries by region, 1965 to 1988(average annual percentage change)

12

10

4

Sub-Saharan East Asia South AsiaAfrica

7

/ -

[1 1965-73 U 1973-82 El 1982-88

Note: Exports are measured at 1980 prices and weighted by U.S. dollar value.

or was it a temporary blip? Moreover, despite theuncertainties, it may be politically difficult for poorproducers to take a conservative view of the likelycourse of commodity prices. Some exporters of oiland other commodities, such as Chile, Indonesia,Kuwait, and Morocco, have succeeded in spread-ing risk, both by diversifying production andthrough financial and fiscal management. Butmany others, to their detriment, have not.

Structural adjustment policies and challenges

"The setback to development in Africa, Latin Amer-ica, and Eastern Europe in the 1980s followed twodecades of rapid growth. Yet this growth was oftenfounded on development strategies that failed toemphasize economic efficiency and international

10

Europe, MiddleEast, and NorthAfrica

Latin America andthe Caribbean

competitiveness and that drew finance fromabroad by distorting the domestic financial system.External shocks precipitated the crisis of the 1980s.But internal structure determined how countrieswould respond. Faced with changed circum-stances, countries now have no choice but to ad-just. During the 1980s governments of countries atall income levels and, remarkably, of all ideologicalstripes have come to recognize the need for re-forms to increase economic efficiency andflexibility.

At the most abstract level, adjustment programsuse changes in fiscal, monetary, and sectoral poli-cies, in regulations, and in institutions to alter rela-tive prices and the level of spending and therebyredirect economic activity. The real exchange rateand the real interest rate are key relative prices.

6

0

2

They affect both economic activity and saving, aswell as exports and imports and the rate of invest-ment. Changes in taxes, subsidies, and quantita-tive controls move resources between sectors. En-suring that adjustment achieves a balanced changein spending and an appropriate sectoral realloca-tion is critical for growth and development. Thedomestic financial system plays an important role.It mobilizes domestic saving and directs it to themost profitable investments.

Structural adjustment is complicated and slow.It is especially difficult nowand all the morenecessarybecause many developing countriesare in dire financial straits. Countries need externalresources to offset the costs of adjustment. In the1980s both the International Monetary Fund (IMF)and the World Bank have helped finance economicprograms contributing to the adjustment process.Fifty-nine countries received long-term structuraladjustment loans from the World Bank between1980 and 1988. The programs consist of a series ofoperations, worked out with the borrower, that areconducted within a medium-term macroeconomicframework which is often supported by the IMF.

Many governments have made progress towardrestructuring their economies, especially with re-gard to trade reform and exchange rate policy. Butfurther reforms will be necessary. In some casesindustrial policies in support of earlier import-substitution strategies have maintained a protec-tionist stance, despite trade reform. In other casesinefficient financial systems continue to distort in-terest rates. In many countries the failure of fiscalreforms is undermining the adjustment achievedso far and preventing further progress. Unsustain-able fiscal deficits create economic uncertainty,contribute to high inflation, and subvert the do-mestic financial system.

In East Asia the newly industrialized economiesand several others have pursued sound macroeco-nomic policies and maintained the competitive-ness of their exports. They have generally adaptedwell to the shocks of the 1970s and early 1980s. Thepopulous economies of South Asia have alsoachieved good results. Their success has more todo with macroeconomic stability, prudent fiscaland external borrowing policies, and rural mod-ernization than with internationally competitivetrade policies. But economies are not prisoners oftheir geography. Chile has pursued one of themost wide-ranging programs of economic liberali-zation, despite setbacks in the early 1980s, andseems to be shedding the problems that besetmany of its neighbors.

Figure 1.5 Real commodity prices, 1970 to 1988

Index (1979-81 = 100)150

125

100

75

50

25

0

Nonfuel primary commodities'

AAI"Metals and minerals

Note: Real prices are annual average prices in dollars, deflated bythe annual change in the manufacturing Unit value (MUV) index,a measure of the price of industrial country exports to developingcountries.a. Based on a basket of thirty-three commodities.

Challenges for successful adjusters

Successful adjusters, especially those in East Asia,not only increased domestic saving and main-tained high investment during the 1980s (see Fig-ure 1.6) but also achieved export-led growth. Inthe future their growth will need to depend less onexternal demand; domestic consumers shouldreap some of the fruits of successful investment inmanufacturing. Domestic saving rates may there-fore return to their somewhat lower levels of the1970s.

Maintaining competitiveness requires supportfor the development of infrastructure and humancapital. In most countries such programs are gov-ernment funded. They call for long-term invest-ment strategies. Sound fiscal policy is a pre-requisite.

Moreover, as the successful adjusters becomemore integrated with the international capital mar-kets, and as they compete with the next generationof exporters of manufactured goods, the efficientallocation of domestic saving will become evenmore important. A domestic financial system

11

1970 1975 1980 1985 1988

Figure 1.6 Saving and investment rates in developing countries by region, 1965 to 1987(percentage of GNP)

30 20 10

Note: Saving and investment are measured at current prices.

0 0 10 20 30

based on market principles will contribute to thisend.

Adjustment in Sub-Saharan Africa

The gravest development problems are in Sub-Saharan Africa, Unfavorable external conditions(including a prolonged fall in the terms of trade ofprimary goods exporters) and inadequate domesticpolicies have caused economic, social, and envi-ronmental decline.

After reasonable growth in the 1960s and early1970s, the region's economic performance deterio-rated. Export growth was robust before the 1973 oilshock but stalled thereafter; it has recovered some-what but not to previous levels. Saving and invest-ment rates fell sharply in the early 1980s (Figure1.6) and are today less than two-thirds of the de-veloping country average. The collapse in saving is12

partly attributable to fiscal deficits, which ex-panded during the 1980s. Private saving did notincrease eitherbut it is extremely difficult to in-crease saving when income is falling. Most impor-tant, the combination of slow growth and rapidlyexpanding populations reduced per capita in-comes and left many people close to starvation.Average caloric intake is no higher than twentyyears ago.

Nevertheless, some adjustmentpainfully slowand not always sustainedis occurring. Manygovernments have started to reduce their role inthe economy and are focusing their spending onpriority areas. This means curbing spending on thecivil service, on subsidies, and on state-owned en-terprises. Some African governments (for exam-ple, in Ghana) have cut spending by creating aroster of the civil servants to ensure that only bonafide workersand no "ghost" or "phantom"

Gross domestic saving (S) Gross domestic investment (I)

0.1 1965-73

Sub-SaharanAfrica

2.0 E 1974-82

LI 1983-872.1

0.5East Asia 0.4

1.8

2.2South Asia 3.3

4.0

0.4Europe,Middle East, 1.5

1.4and North Africa

0.1Latin America andthe Caribbean

1.43.7

workersare on the payroll. An alternative is torelease workers with a lump-sum benefit. This in-creases the short-run cost of reducing the size ofthe government, and may encourage the betterworkers to leave, but in some countries it has pro-vided an impetus for the development of privateentrepreneurship. A sweeping removal of subsi-dies may not be possible, but targeting them to thetruly needy further reduces costs; many subsidiesbenefit urban dwellers who are relatively well-off.Ghana's program has kept adjustment on trackwhile helping the poor. Subsidies to unprofitablestate-owned enterprises are a big drain on bud-gets. Several African countries have experimentedwith privatization (Niger and Togo), liquidation(Benin, Ghana, and Mali), or rehabilitation undermanagement contracts (Senegal). Not all of theseefforts have been successful.

It is essential to correct overvalued exchangerates. This promotes a more sustainable pattern ofconsumption, encourages the export sector to di-versify, and may yield faster export growth. Côted'Ivoire and Mauritius show how quickly ex-porters can respond to improvement (and deterio-ration) in real export prices.

Adjustment also aims to reverse the bias againstagriculture. Taxes in many poor countries (not onlyin Africa) discourage domestic food productionand encourage food imports. Better incentives andagricultural modernization can raise the incomesof the rural poor, increase food security, and gener-ate foreign exchange. Policies of this sort includeprice decontrol (Mali, Niger, Nigeria, Somalia, andUganda) and the reform or abolition of agriculturalmarketing boards (Nigeria, Senegal, and Somalia).Higher farm output has also been achievedthrough broadly conceived extension services,which combine changes in farming methods withimprovements in credit delivery, marketing, andthe supply of inputs.

Regional integration has been a political aspira-tion since African independence. Cooperative ar-rangements have continued in Francophone Africabut have often broken down elsewhere. Small in-ternal markets and low purchasing power are bar-riers to international competitiveness and the ra-tionale for regional integration. As governmentshave moved to more market-oriented policies, atleast one impediment to integration has been re-moved. But even if agreement on its political as-pects could be reached, the benefits of integrationwifi not be attained unless regional transport andcommunications systems are upgraded.

Even as economic performance improves, it willbe offset by rapid population growth in much of

Sub-Saharan Africa. In several countries (Kenya,Senegal, and Somalia), fairly strong economicgrowth in the 1980s has yielded low or nega-tive growth in per capita GNP. Excessive popula-tion growth also exacerbates the problems of foodsecurity, education, urbanization, and environ-mental degradation.

Adjustment in the highly indebted countries

The shocks of the 1980s also hit the highly in-debted middle-income countries, most of them inLatin America, extremely hard. High commodityprices and cheap external financing fueled publicinvestment and social welfare programs during the1970s. When the external environment deterio-rated and commodity prices fell, many countriespostponed adjustment and continued to rely onexternal borrowing. Sharply rising real interestrates and falling commodity prices raised the costof external capital dramatically in the 1980s, whichled to a halt in voluntary financing. Wrenching ad-justments became necessary.

Per capita incomes in the middle-income debtorsdeclined on average during the 1980s. Restrictivedomestic policies and real devaluations reducedimports, which often led to trade and even currentaccount surpluses. These policies, combined withthe lack of external financing, meant that net in-vestment in some countries, such as Argentina,fell to zero.

The task of adjustment encompasses trade re-form, fiscal and public sector reform, and controlof inflation and debt. Most of the countries havemade substantial progress in at least one of theseareas. But the macroeconomic situation remainsunstable, and rates of investment are still low (Fig-ure 1.6).

Primary budget deficits (that is, excluding debtservice payments) have been reduced, but publicsector borrowing requirements remain high. Con-solidated, inflation-corrected deficits are stillnearly double the average for the developingworld as a share of GDP, and interest paymentsaccount for a big share of spending. Since domes-tic financial markets are in most cases too shallowto provide financing on the required scale, centralbanks have accommodated government spend-ing by expanding the monetary base. Inflationis higher than elsewhere; several of the coun-tries have seen triple- and even quadruple-digitinflation.

Heterodox anti-inflationary programs (based onwage and price controls and the fixing of the ex-change rate) have been tried, sometimes repeat-

13

edly, in Argentina, Brazil, and Mexico. Most ofthese attempts have met with outright failure.Their chief defect has been a lack of fiscal improve-ment. Stabilization programs that leave the funda-mentals inconsistent with low inflation are boundto fail. Where the fiscal deficit has been cutappropriatelyas in Mexicothe programs havebeen more successful.

Some highly indebted countries (Costa Rica,Côte d'Ivoire, and the Philippines) have adoptedfiscal programs with moderate success, althoughthe programs have yet to be sustained. Often, sev-eral years of austerity have been followed by aburst of spending that reverses the earlier gains.Such instability retards saving, investment, ex-ports, and growth. Nonetheless, some debtorcountries have made good progress on fiscal re-form. Chile, Colombia, Mexico, Morocco, andUruguay have all reduced their budget deficitsthrough tax reform, higher revenues, and lowerspending.

Some countries, again including Chile, Mexico,and Morocco, have also pursued trade reform. Forexample, since 1985 Mexico has liberalized its traderegime and maintained its competitiveness. CostaRica and the Philippines have focused on labor-intensive manufactured exports; in these countriesthe share of manufactured exports increased stead-ily between 1982 and 1987, and manufactures nowaccount for about half of all exports.

Adjustment in the centrally planned economies

The centrally planned economies face a formidablechallenge in moving toward decentralized deci-sionmaking and greater reliance on markets. Theprices of many of their products have little to dowith costs. The responsibilities of managers forproduction and investment are badly defined. Fi-nancial systems are rudimentary, and the tools ofmacroeconomic management are underdeveloped.Few mechanisms allow labor and capital to be re-allocated as economic conditions change.

Governments in many of these economies haverecognized the need for reform. The task is daunt-ing, but the benefits could be immense. The expe-rience of China during the past ten years demon-strates this. The reform of agriculture, the openingof the economy to foreign trade, technology, andinvestment, and the new reliance on incentives inthe industrial sector have led to an average growthrate of more than 10 percent a year during the1980s.

Although prices still play a relatively modest role

14

in the Chinese economy, the exchange rate adjust-ments of the early 1980s were essential in makingChinese enterprises more competitive. China hasbecome a major exporter of manufactures in a veryshort time. The Chinese government also avoidedrelying too much on external borrowing. It post-poned ambitious industrial investment programsin the late 1970s and again in the early 1980s. Morerecently it has faced difficulties in macroeconomicpolicy. Domestic credit has been allowed to ex-pand too quickly, which has led to inflationarypressures and shortages.

Economic reforms in Eastern Europe, althoughsimilar to those in China, have had less spectacularresults, and some countries are in considerable dif-ficulty. Several factors explain this. One is that lowcosts of production, at present exchange rates,have enabled China to compete successfullyagainst middle-income exporters of manufactures.In contrast, costs in Eastern Europe are generallyhigher; competing against the newly industrial-ized economies of East Asia and the lower-incomemembers of the European Community (EC) hastherefore been difficult. Moreover, some of thecountries tried to modernize their industries withheavy investment financed by foreign borrowingand without reforming economic management.This proved costly when real interest rates rose inthe 1980s.

Development issues

The slow pace of adjustment in many countries is amajor concern. But the task is neither simple norpurely economic. It requires institutional capacityand political skill. It is inhibited by vested inter-ests, for it affects acquired rights, income, benefits,rents, and costs. Where economic structures havebeen in place for some time, the pain of adjust-ment can be enormous. If reform is to last, it mustnot be rushed. The burden will have to be fairlyshared. And support from the international com-munity must be forthcoming.

Poverty, population growth, and the environment

In many countries poverty cannot be separatedfrom rapid population growth. As per capita in-comes rise, population growth rates eventually de-cline. That process has been at work in such coun-tries as the Republic of Korea and Thailand, as itwas earlier in the high-income economies. But thedemographic transition is still at an early stage insome low-income Asian countries, such as India

and Bangladesh. Africa's population is growingfaster than has that of any other region of theworld in this century. In some countries fertilityrates are close to the biological limit. This strainsthe capacity of the economy to maintain the stan-dard of living and reduces the ability of the gov-ernment to provide social services, including edu-cation and health. Yet some societies remainunconvinced of the need to reduce populationgrowth.

The links among poverty, environmental degra-dation, and population growth are often direct. Asmore and more people in poverty press upon lim-ited natural resources in rural areas, they begin todeplete the stock of renewable resources. In SouthAsia the long-term deforestation of watersheds hascaused severe erosion. Population pressure on thefragile land base in Africa and the Middle East hasbecome serious. The arid and semiarid areas of theworld are likely to face a crisis of water scarcity by2000. Desertification and deforestationoftenirreversiblehave reduced the land available foragriculture, wildlife habitats, and recreation.

But not all environmental degradation resultsfrom the pressure of population growth. Intensiveuse of hydrocarbons by high-income countries anddeforestation in sparsely populated tropical areasare starting to have global effects. The same is trueof the growing amounts of hazardous materialsthat are generated mainly by industrial countries.Some developing countries are experiencingserious air and water pollution. Increasinglyalthough with differing degrees of urgencydeveloping country governments are attemptingto curb the adverse externalities of growth.

Protectionism and trade

The acknowledged success of outward-orienteddevelopment is partly responsible for the move to-ward market-based policies. Moreover, the high-income countries recognize the role of trade in pro-moting growth and industrial development in thelow- and middle-income countriesand thus haveaccorded them a variety of concessions and prefer-ences. (These include the Generalized System ofPreferences, the EC's Lomé Convention, and theU.S. Caribbean Basin Initiative.) Despite this, anddespite the encouraging growth in world trade inrecent years, the world's trading system has be-come markedly less liberal. Governments have re-duced conventional tariff protection but haveraised other barriers to trade instead.

Specific "safeguard actions" taken by industrial

countries increasingly discriminate against the de-veloping countries. Voluntary restraint agree-ments for steel, bilateral agreements for textiles,the tighter Multifibre Arrangement (MFA), andlower quotas on sugar and other agricultural prod-ucts have their greatest effect on the exports of thedeveloping countries. The share of developingcountry exports that face nontariff barriers (NTBs)is roughly 20 percent, about twice the share of in-dustrial country exports. Much of the discussion ofNTBs focuses on manufactured goods, but the pro-portion of agricultural exports from the developingcountries facing NTBs is higher (26 percent, com-pared with 18 percent for manufactures).

Another disturbing departure from the principleof nondiscrimination embodied in the GeneralAgreement on Tariffs and Trade (GATT) is the in-crease in bilateral trade agreements. Bilateral ar-rangements couldalthough they need notnecessarilydiscriminate against nonmembers(see Box 1.1). If they do, they might greatly harmthe world trading system.

The rise of bilateralism and the increasing use ofnontariff barriers underline the importance of theUruguay Round of trade negotiations. These talksare tackling complicated issues such as trade inservices, the protection of intellectual propertyrights, and the politically contentious matter of ag-ricultural trade reform. Progress on agriculturewould be particularly welcome for some of thehighly indebted countries, such as Argentina andBrazil. Agreements on trade in financial servicesmight prepare the way for greater integration ofdomestic financial systems and international capi-tal markets, resulting in improvements in effi-ciency and resource allocation.

Many developing countries have significantlyliberalized trade in the course of their broad struc-tural adjustment programs. These steps have ben-efited the countries taking them. However, it isoften believed that countries which liberalize uni-laterally lose a bargaining chip that might havebeen used at the GATT negotiations to increasetheir access to export markets. In fact, credit isgiven in the GATT for the binding of (that is, ac-ceptance of treaty limits on) tariffs. Such commit-ments can be negotiated and traded even after tar-iffs have been unilaterally reduced.

Developing countries can also improve their ex-port prospects by following an appropriate ex-change rate policy. Many developing countrieshave corrected their overvalued exchange rates inthe 1980s; real effective exchange rates have de-clined for most developing countries (see Figure

15

Box 1.1 Project 1992 and the developing countries

The European Community (EC) plans to "complete theinternal market" by 1992 by removing barriers to thefree circulation of goods, services, and factors of pro-duction. The aim is to promote European specializa-tion, strengthen competition, and increase efficiency.But Project 1992 is bound to have substantial implica-tions for non-EC countries. The EC market accounts forabout 30 percent of the export earnings of the develop-ing countries.

To achieve the free movement of goods and serviceswithin the EC, three measures will be required, each ofwhich has an impact on the developing countries. Thefirst is the abolition of border controls. These are used toenforce national quantitative restrictions (QRs). Theyaffect mainly imports of textiles and clothing coveredby the Multifibre Arrangement, but other imports fromdeveloping economies, such as bananas from LatinAmerica and toys from Asia, are also affected. The ECmay convert national QRs into community-wide QRs.What happens will depend on the outcome of the Uru-guay Round.

The second measure is the elimination of technical bar-riers to trade. This will proceed along two separate ave-nues: mutual recognition (most barriers) and harmoni-zation (health, safety, and environmental regulations).The principle of mutual recognition implies that prod-

ucts legally marketed in one member state, whethermanufactured in the EC or imported into the EC, cancirculate freely throughout the EC. This should be es-pecially welcome to relatively small suppliers in thedeveloping countries, since the added costs of techni-cal barriers are particularly onerous for them.

The third measure is the opening up of public procure-ment. This will extend to four key areas not covered bythe relevant GATT code: energy, telecommunications,transport, and water supply. To the extent that publicprocurement concentrates on high-technology sectors,the change will matter more to the industrial than tothe developing countries.

If Project 1992 promotes faster domestic growth with-out raising external trade barriers, Europe will importmore, and the developing countries would benefit. Thedistribution of the new demand among exporters willdepend on its composition and on existing trade pref-erences. The main focus of Project 1992 is on trade inmanufactures. The effects of the single market on de-veloping countries will depend on their competitive-ness and on the EC's trade policy toward them. Thenature of EC trade preferences toward different groupsof developing countries may also change as a result ofthe introduction of a unified market.

1.7). Countries with an appropriate real exchangerate have usually experienced faster and more sta-ble growth than the rest. As development pro-ceeds, it becomes even more important to adoptand maintain an industrialization strategy that isneutral toward production for domestic or foreignmarkets.

In the Uruguay Round the developing countriesare for the first time playing a significant role inmultilateral trade negotiations. Thirteen develop-ing and industrial countries have formed theCairns Group to promote their common interestsas agricultural producers. The developing coun-tries have recognized their stake in the world trad-ing system. This reinforces the need for a success-ful conclusion to the Uruguay Round and foradherence to the spirit as well as the letter of theprinciples of the GATT. The proposed strengthen-ing of the GATT, including its surveillance of coun-tries' trade policies, should help to bring thisabout. The failure of the Uruguay Round wouldnot only hamper the growth of world trade butalso represent a rejection of the development strat-egy that has been promoted by the international

16

community and multilateral organizations, at thevery time that developing countries are coming toaccept it.

The debt problem

Although many developing countries have haddifficulty in servicing their external debt, from thestart of the debt crisis in 1982 the focus has been onthe seventeen highly indebted middle-incomecountries whose debts are primarily to the com-mercial banks. This reflects the systemic risk thatthe failure of creditor banks might have posed tothe international financial system in the early yearsof the crisis. Although some banks remain at risk,the debt strategy they have followed since 1982 hassought to remove this systemic risk by building upappropriate provisions for doubtful assets. In thepast few years the debt problems of Sub-SaharanAfrica have won official recognition. These prob-lems differ from those of the other highly indebtedcountries in that the debt is owed mainly to gov-ernments. Nonetheless, virtually all the debtorcountries have been adversely affected by the rise

in real interest rates and the decline in commercialbank lending since 1982.

Systemic collapse has been avoided. But formost of the highly indebted countries the debt cri-sis has become a growth crisis as well. In 1988 theygrew by less than 2 percent, failing to respondboth to high export demand and to the rapidgrowth of the high-income countries. (Export vol-ume increased by about 6 percent, and dollar unitvalues rose by more than 15 percent in a delayedreaction to the sharp depreciation of the dollar.)Their situation did show one sign of improvementduring 1988, however. The ratio of debt stock toexports declined for the first time since 1982. Nev-ertheless, two major Latin American debtors (Ar-gentina and Brazil) experienced significant eco-nomic instability during the year.

Korea has shown that it is possible to grow out ofa heavy debt burden. But when commercial cred-itors are reluctant to increase their exposure incountries with debt problems and domestic sav-ings are transferred abroad to service the debt, bor-rowers cannot finance the investment they need togenerate growth. The resources for investmentcould come from higher domestic saving or fromrepatriated capital. Before 1982 the highly indebtedcountries received about 2 percent of GNP a yearin resources from abroad; since then they havetransferred roughly 3 percent of GNP a year in theopposite direction. Domestic saving would havehad to rise by 5 percent of GNPor in other wordsby about a quarterto offset this change in nettransfers. Despite strong fiscal contraction in somecountries, none of the countries has succeeded inrestoring adequate net investment (see Box 1.2).

The Baker initiative of 1985 stressed the need tomaintain net flows of funds from official and pri-vate lenders. Although net flows of long-term cap-ital from official creditors averaged nearly $6 billiona year over the past three years, net flows fromcommercial banks fell to an average of less than $2billion a year.

During 1988 and 1989, governments and creditorbanks alike concluded that debt reduction wouldhave to be an element in resolving the debt crisis.Creditor governments agreed at the 1988 Torontosummit to grant debt relief to the poorest and mostheavily indebted countries, such as the countriesof Sub-Saharan Africa. The Paris Club subse-quently agreed on the equivalence among the vari-ous types of debt relief granted by different credi-tor governments. For private creditors, the menuapproach that has been developed since 1986 hascreated a variety of voluntary methods of debt re-

Figure 1.7 Real effective exchange rates indeveloping countries by region, 1978 to 1988

Index (1978 = 100)

140

130

120

110

100

90

80

70

60

50

Latin Americaand the Caribbean

Europe,Middle Eastand North Africa

East Asia

Sub-Saharan Africa

1978 1980 1982 1984 1986 1988

Note: The real effective exchange rate is the trade-weighted ex-change rate adjusted for relative inflation. An increase in theindex indicates an appreciation of the currency. The regionalindex values, which are based on a total sample of eighty-threedeveloping countries, are annual averages weighted by the dol-lar value of exports.Source: IMF and World Bank data.

duction. These include debt buybacks (in which adebtor buys back part of its foreign debt with ei-ther international reserves or new foreign ex-change), exit bonds, and debt-equity swaps. In allthese cases the benefits for the debtor vary accord-ing to the discount at which it acquires its existingdebt. In 1988 the commercial banks reached a ma-jor refinancing agreement with Brazilat $82 bil-lion, the largest on recordwhich contained finan-cial innovations allowing for debt reduction. Butfor the highly indebted countries in general, thenet reduction in external obligations achieved todate has been small.

The prolongation of the debt crisis, and particu-larly its manifestation in the low growth rates ofheavily indebted countries, led the internationalcommunity to reevaluate the debt strategy in 1989.

17

Box 1.2 Debt concepts

A variety of concepts are used to measure and assessthe economic burden of external debt.

Debt stock, which is often reported as debt outstand-ing and disbursed, measures the total debt liabilities ofthe debtor. The payment obligation arising from this isdebt service and comprises interest and principal pay-ments. The debt stock does not necessarily predict thedebt service because currency revaluations, interestrates, and the maturity structure of the debt all affectdebt service.

Two concepts describe the net effect of borrowingand repayments on the flow of financial resources. Netflows refers to disbursements minus principal repay-ments. It measures whether new financing exceedsdebt being retired. If debt levels remain prudent, netflows should be positive in all but the most advancedlow- and middle-income countries because of contin-ued external financing for domestic investment. Nettransfers refers to disbursements minus interest andprincipal repayments. Negative net transfers implythat total debt service payments exceed gross inflows,that net real resources are being transferred from theeconomy, and that a trade surplus is thus required.When the real interest rate exceeds the growth rate,any borrower must expect eventually to make nettransfers to its creditors. At that stage the borrower'sincome should have risen sufficiently for its saving tofinance the transfer. The increase in the real interest

Box table 1.2 Long-term lending to developing countries, 1981 and 1987(billions of dollars, unless otherwise noted)

rate in the early 1980s forced many developing coun-tries to make net transfers abroad much earlier thanthey had expected.

Moratoria (the suspension of contractual debt servicepayments), arrears (overdue service payments), newmoney (additional borrowing), rescheduling (changingthe time profile of repayments without altering the to-tal debt obligation), and debt relief are all ways of alter-ing either the pattern or size of repayment flows.Forward-looking and sustainable changes in debtstructure are more likely to create the environmentneeded for domestic investment and growth than arearrears or annual renegotiations.

Box table 1.2 shows how the burden of debt of thedeveloping countries has changed during the 1980s.Debt stocks in Latin America and Sub-Saharan Africahave grown as a share of GNP during the 1980s, butprivate credit flows now represent a much smallershare of gross disbursements, especially to LatinAmerica.

Net flows remain positive, except to middle-incomeEast Asia; these countries are repaying debt out of effi-ciently invested borrowing. In most developing coun-tries net transfers have turned sharply negative. Exceptin Sub-Saharan Africa and low-income Asia, resourcesare being transferred to creditors at rates significantlyhigher than those at which resources were received in1981.

Note: Data are based on the sample of 111 Countries participating in the Debtor Reporting System.Gross disbursements minus principal repayments.Gross disbursements minus the sum of interest and principal payments.

18

Alldevelopingcountries

Sub-Saha ranAfrica

Middle-income

East Asia

Low-income

Asia

Europe,Middle East,

andNorth Africa

LatinAmericaand the

Caribbean

Item 1981 1987 1981 1987 1981 1987 1981 1987 1981 1987 1981 1987

Total long-term debt out-standing and disbursed 503 996 50 109 50 102 60 142 134 260 209 384

As a percentage of GNP 23 42 26 85 28 40 8 16 30 47 27 52

Gross disbursements oflong-term lending 124 87 11 9 14 11 11 21 28 27 61 20

Private sources 92 49 6 3 10 8 5 10 17 18 53 10As a percentage of total 74 56 58 32 75 73 45 48 62 68 88 49

Multilateral sources 12 22 2 4 2 2 3 6 2 5 3 6

Net flows' 77 16 8 5 10 9 6 11 14 3 39 5

Private sources 53 2 4 1 7 8 2 4 7 7 34 1

Multilateral sources 10 12 2 3 1 0 2 5 2 2 2 3

Net transfersb 35 38 6 2 6 16 4 5 4 12 16 19

Although the details of the new strategy are stillbeing worked out, the overall framework is clear.Debt reduction will receive official support and of-ficial funding from the IMF and the World Bank,provided it takes place in the context of strong,effective adjustment programs. The strategy willcontinue to treat each country separately and islikely to evolve as particular countries reach newagreements with their creditors and official agen-cies. It will aim to reward those countries that havetried hardest to restructure their economies. Veryfew creditor governments will be willing to con-tribute resources directly, but they are reviewingregulatory and accounting obstacles that might im-pede debt relief by private creditors. They will alsoencourage the creditor banks to waive the clausesin existing agreements that make debt reductiondifficult to arrange.

The new strategy recognizes that debtor coun-tries will continue to need new money fromabroad. The question arises whether debt reduc-tion is consistent with new lending from existingcreditors. The stakes for banks in some of thelarger countries are high enough for them to con-tinue to provide new money, even as they simulta-neously agree to reduce debt. But some banks willnot want to reduce debt and provide new moneyat the same time. Official financing will continue.Increasingly, countries will have to look to newforms of external finance, such as direct and port-folio equity investment, and to the return of flightcapital.

The most critical component of the debt strategyremains continued adjustment by the debtor coun-tries. Without strong adjustment, no debt strategycan restore growth. It is the goal of the new strat-egy to ensure that countries that do pursue seriousadjustment policies will be able to return togrowth.

The debt crisis ifiustrates the fundamental ten-sion between dependence on private markets onthe one hand and government intervention on theothera theme that recurs later in this Report. Be-cause commercial banks were heavily exposedwhen the debt crisis began in 1982, creditor gov-ernments intervened to ensure the stability of theinternational financial system. Individual debtorgovernments, such as those of Argentina, Chile,and Yugoslavia, acquired large amounts of privatedebt in the belief that doing so would help them topreserve relations with the commercial banks. Ifthe exposure of the banks had been small enoughto pose no threat to their solvency, they mighthave reached agreements with the debtors on their

own. And then the crisis would have taken a verydifferent course.

Growth prospects

Uncertainty after the stock market crash of 1987reduced expectations of growth early in 1988.Those expectations were confounded by a year ofstrong growth, which has bolstered the prospectsfor a gradual return to trend growth of about 3percent for the high-income OECD countries. Ex-pansion in Japan and Europe, especially in Ger-many and the United Kingdom, broadens the basisfor sustained growth. Moreover, the high rate ofinvestment in 1988 should increase capacity andproductivity, which will help to ease inflationarypressures.

Lingering uncertainties, however, cloud themedium-term forecast. They concern the policychanges needed to reduce large domestic and in-ternational imbalances and to offset growing irifla-tionary pressures in several of the large econo-mies. The United States can continue to run acurrent account deficit only if foreign investors andgovernments are willing to purchase its assets.This, in turn, depends on their expectations withregard to economic stability in the United States,the U.S. fiscal deficit, and U.S. interest rates rela-tive to those in other economies. Moreover, withinEurope, major imbalances could strain the Euro-pean Monetary System. The scale of these interna-tional imbalances, concern about inflation, andneeded adjustments in monetary policy are likelyto cause volatility in interest rates and exchangerates over the near term.

Accordingly, the World Bank has prepared twoviews of the next decade. One scenario is predi-cated on adjustment with growth. It assumes thatcredible policy actions are taken to reduce the mac-roeconomic imbalances within and among the in-dustrial countries. Such measures include a pro-gram to reduce the U.S. budget deficit, followedby an easing in monetary policy (more so in theUnited States than elsewhere). Real and nominalinterest rates therefore fall, as compared with the1980-88 averages, and the dollar depreciates fur-ther against the currencies of the other big indus-trial countries. Structural adjustment policies ofthe kind discussed above enable the low- andmiddle-income countries to take advantage ofgrowth; the lower interest rates ease their debtburden. This combination of plausible adjustmentsby both high-income and low- and middle-incomegovernments yields, overall, good prospects for

19

Table 1.1 Selected economic indicators in the adjustment-with-growth and low scenarios

20

world growth through the year 2000. Even so,many low- and middle-income countries would beunlikely to achieve the high growth rates they ex-perienced in the 1960s and 1970s.

The alternative is the low scenario. It assumesthat the appropriate policy actions are taken nei-ther in the high-income countries nor in certain ofthe low- and middle-income countries. Crisis isaverted through continued financing of the im-balances, but the low scenario entails great macro-economic uncertainty, higher real and nominal in-terest rates, increased protectionism, and lowergrowth.

Key factors underlying these two scenarios aresummarized in Table 1.1. With adjustment, realGDP growth in the high-income OECD countriesaverages 2.6 percent over the medium term (1988-95) and rises to trend growth of about 3 percent bythe year 2000. Inflation measured in local curren-cies averages about 4 percent a year. Some adjust-ment by the United States as well as other in-creases in world saving lower real interest rates to3.0 percent from their average of 5.5 percent in the1980s. Merchandise exports of the low- andmiddle-income countries should grow by morethan 5 percent a year, with the demand for manu-factured exports rising at more than 7 percent ayear. A bias toward investment helps to raise com-modity prices in nominal terms, but in real terms(deflated by the unit value of manufactures) theyare expected to continue to decline through 1995.This underlines the need for the developing coun-tries that rely on primary commodity exports todiversify their economies.

Note: The adjustment-with-growth scenario assumes the adoption of policies (by the major industrial and developing countries) that reducestructural rigidities and imbalances and allow for a gradual return to trend through the year 2000. The low scenario assumes that some neededpolicy changes are not made, interest rates remain high, growth falters, and there is increased protectionism.

Average six-month rate on Eurodollar deposits.Nominal interest rate deflated by the GDP deflator for the United States.

Without appropriate policy changes, the low sce-nario shows growth in the high-income OECDcountries slowing to 2.4 percent a year in the me-dium term and through 2000. That is significantlyless than the average for the 1970s and 1980s.Growth in trade is correspondingly lower. Moreimportant, the failure to right macroeconomic im-balances keeps real and nominal interest rates high(about 4 and 10 percent respectively). Lower exter-nal demand and higher interest rates reduce theprospects for growth in the low- and middle-income countries to below the averages of the1980s.

How does the adjustment-with-growth scenarioin the high-income countries affect the growthprospects of the low- and middle-income coun-tries? The answer largely depends on their ownpolicy adjustments and on population growth.East and South Asian countries, which have stablemacroeconomic environments and a substantialshare of manufactures in exports, are expected togrow at about 6 percent a year (see Table 1.2).Some of them are likely to "graduate" to the high-income category. Moreover, because their popula-tion growth is expected to slow, per capita incomein some countries rises by more than 5 percent ayear. Per capita income in the region as a wholerises by 4.3 percent a year. Prospects for internalfinancing of investment in physical and humancapital are good. Even in the low scenario, theAsian development effort is expected to continueto succeed.

As structural adjustment proceeds, real GDPgrowth in Sub-Saharan Africa is expected to aver-

(average annual percentage change)

Indicator

Trend

for1965-8 7

Recentexperience,

1980-88

Scenario for 1988-95

Adjustmentwith growth Low

High-income OECD countriesGDP growth 3.1 2.7 2.6 2.4Inflation (local currency) 6.4 5.6 4.2 4.1Nominal rate of interesta 8.8 10.2 8.6 9.5Real rate of interestb 3.0 5.5 3.0 4.0

Low- and middle-income countriesMerchandise export volume 3.8 5.4 5.1 4.1

Manufactures 12.0 10.0 7.4 5.7Primary goods 1.3 2.5 2.8 2.7

Merchandise import volume 4.3 0.5 5.7 4.6

age 3.2 percent a year through 1995, before acceler-ating in the second half of the decade. But withpopulation growing at nearly the same rate, percapita real income for the region stagnates. Evenwith an optimistic view of adjustment, the region'sper capita income will not return to the level of themid-1960s over the projection horizon. More, andmore effective use of, external financing will beneeded to keep Sub-Saharan Africa from fallingfurther behind. These prospects reinforce the viewthat policies-internal and external-require con-tinued adjustment.

If certain countries in Latin America and in Eu-rope, the Middle East, and North Africa make thenecessary economic adjustments, and if these poli-cies revive investment, these regions could do bet-ter over the next decade than they have in the1980s. Per capita income is expected to grow againin Latin America, but at only about 1 percent ayear; this rate is probably insufficient for the eco-nomic revitalization that is necessary for LatinAmerica to keep pace with other parts of theworld. Per capita income should grow morestrongly than hitherto in the developing countriesof Europe, the Middle East, and North Africa. Butwithout internal reform, external stimulus, andlower interest rates, there is a real danger that theeconomic situation in much of the middle-incomeworld could deteriorate further.

Debt reduction scenario

Recent discussions of debt relief suggest a thirdscenario. This combines a reduction in the debtburden of the highly indebted countries with the

Table 1.2 Growth prospects in the adjustment-with-growth and low scenarios(average annual percentage change)

shift in the macroeconomic policy mix of the indus-trial countries that is part of the adjustment-with-growth scenario. Under this illustrative scenario,debt stocks are reduced by 20 percent over threeyears.

The reduction in net resource transfers in theform of interest payments associated with the re-duction in debt stocks could be as much as $5 bil-lion to $6 billion over three years. If the reductionin interest payments is used to import needed in-vestment goods, investment rates would rise byseveral percentage points. As a result of the debtreduction, GDP for the highly indebted countriescould be about 1 percent higher at the end of thethree years.

Even though all countries are treated similarly inthis scenario, some countries fare better than oth-ers because countries react differently to increasesin imports and investment. For example, the po-tential increase in GDP for Argentina, Brazil, Mex-ico, and Nigeria could be as much as 2 percenteach. Recent initiatives envisage different coun-tries receiving different levels and kinds of debtreduction on the basis of their adjustmentprograms.

The models underlying this scenario tie invest-ment directly to resource flows and thus omit twokey unquantifiable elements in debt reduction.First, a reduction in the debt overhang is likely toincrease the probability that the country can meetfuture interest obligations; this will significantlyimprove the investment climate and thereby bothincrease investment and at some stage encouragethe return of flight capital. Second, if debt reduc-tion leads to a sharp decline in new money, and

Country group

GDP growth GDP per capita growth

Trendfor

1965-87

Recentexperience,

1980-88

Scenario for1988-95 Trend

for1965-87

Recentexperience,

1980-88

Scenario for1988-95

Adjustmentwith growth Low

Adjustmentwith growth Low

Low- and middle-incomecountries 5.0 4.0 4.6 3.7 2.7 2.0 2.7 1.8

Excluding China and India 4.8 2.6 3.8 3.0 2.2 0.2 1.5 0.7Sub-Saharan Africa 3.4 0.5 3.2 3.1 0.6 -2.5 0.1 -0.1Asia 6.2 7.3 6.0 4.9 4.0 5.5 4.3 3.2Europe, Middle East,

and North Africa 4.6 2.9 3.5 2.8 2.4 0.7 1.6 0.8Latin America and

the Caribbean 4.7 1.7 3.1 2.3 2.1 -0.6 1.2 0.4Seventeen highly indebted

countries 4.6 1.3 3.2 2.3 2.0 -1.2 1.0 0.2High-income OECD countries 3.1 2.7 2.6 2.4 2.3 2.1 2.1 1.9

21

Figure 1.8 Domestic and external liabilities in selected developing countries,1975, 1981, and 1987(percentage of GNP)

120

100

80

60

40

20

0

1975

Côte divoire

1981

I

1987

80

60

40

20

0

Domestic liabilities

Long-term external debt

India

1975 1981 1987

Note: Domestic liabilities are defined as total liquid liabilities of the financial system (International Financial Statistics, line 551), expressed inlocal currency. External debt is total long-term debt outstanding and disbursed, expressed in U.S. dollars at current exchange rates.Source: IMF and World Bank data.

possibly even to an increase in negative net trans-fers, investment will drop. These considerationsreinforce the view that continued and powerfulstructural adjustment by the debtor countries re-mains the most important ingredient in dealingwith the debt problem.

22

80

60

40

20

0

1975

Beyond the debt crisis

All the evidence points to continued low capitalflows to the developing countries in the comingdecade. Official flows cannot fully offset the sharpreduction in private flows. This underlines the

Thailand

1981 1987

Table 1.3 Selected capital flows to developing countries, 1981 and 1987

need for developing countries to adopt economicpolicies that increase domestic saving and ensurethat resources are used as efficiently as possible. Inthis, the financial sector can play a crucial role.

There is little doubt that over the past fifteenyears many developing countries have relied toomuch on external borrowing and too little on do-mestic resources. In a sample of thirty-eight devel-oping countries for which data on the liabilities ofthe domestic financial system were available, ex-ternal debt at the end of 1986 exceeded domesticdebt by more than 50 percent. For Latin America,external debt was on average two-and-a-half timesgreater than domestic bank liabilities. This showshow much these countries have come to dependon external financing. Figure 1.8 illustrates therange of experience. In countries with rapidly ex-panding external debt and shallow domestic finan-cial systems, such as Côte d'Ivoire and the Philip-pines, external liabilities were two to five timesgreater than domestic bank liabilities. India andThailand, in contrast, have relatively deep domes-tic financial systems; they have consciously limitedtheir recourse to external financing.

One lesson of the debt crisis is that commercialbank lending at floating rates is not the ideal formof financing for long-term development. It exposesthe borrower to interest rate and exchange ratefluctuations, and it does not tie the borrower'spayments to the outcome of the investment. Alter-native forms of finance-foreign direct and portfo-lio investment and commodity bonds, for exam-ple-distribute risk between creditor and debtor.Borrowing countries may also hedge their cur-rency exposures by adjusting the currency compo-sition of reserves and borrowings to reflect thelikely impact of exchange rate and commodityprice changes on their future cash flows.

Foreign direct investment has been an important

Note: Data are based on the sample of 111 countries participating in the Debtor Reporting System. Data exclude Certain countries with significantflows associated with offshore banking activities.Source: OECD and World Bank data.

source of financing for economies at all levels ofincome (see Table 1.3). It frequently brings addi-tional benefits: access to new technologies or tomarkets in which the foreign investing firm is ac-tive. It is also likely to bolster competition in do-mestic markets. During the 1980s foreign direct in-vestment in developing countries has been stable,averaging $10 billion to $15 billion a year (about10-15 percent of total capital inflows). The relativestability of the aggregate flow masks importantchanges in its size, sourcing, and composition indifferent low- and middle-income countries. Thedirection of foreign direct investment is stronglyinfluenced by political and economic stability andby policies toward trade and capital flows. Restric-tions on profit repatriation and access to foreignexchange are especially important (see Box 1.3).Foreign direct investment has to be servicedthrough profit remittances, and it may be a moreexpensive source of finance than borrowing. But aslong as it provides access to international markets,better technology, and greater domestic competi-tion, it should be welcomed by most developingeconomies.

Other forms of risk sharing between developingcountries and the international capital marketshave been very little developed to date. Some oilbonds have been sold, and some deals have beencollateralized by commodity exports. The rapid fi-nancial innovation of the past decade can be ex-pected to spread to developing countries in duecourse.

Foreign aid also remains an important source ofexternal finance, particularly for low-income coun-tries in Sub-Saharan Africa. Some industrial coun-tries, notably Japan, have expanded their overseasdevelopment assistance in the 1980s. By early 1989Japan had extended nearly 90 percent of the $30billion program announced in 1987 to "recycle"

23

(billions of dollars)

Official development assistance Foreigndirect

investmentTotalOfficialgrants

Country group 1981 1987 1981 1987 1981 1987

All developing countries 24.5 30.4 14.5 20.0 10.2 9.5Sub-Saharan Africa 7.1 11.1 4.9 7.3 1.3 0.8Middle-income East Asia 1.8 2.2 0.9 1.5 1.8 2.5Low-income Asia 5.3 7.2 2.7 3.5 0.2 1.3Europe, Middle East, and North Africa 8.2 6.3 5.1 5.0 1.3 0.8Latin America and the Caribbean 2.1 3.6 0.9 2.7 5.6 4.1

Box 1.3 Foreign equity investment

Economic policies that promote sustainable growth arealso likely to attract foreign equity investment. Investorsurveys show that growth and stability of the hosteconomy are key factors in determining the attractive-ness of a foreign investment. In part, this is becauseequity investment is relatively illiquid and sometimesrequires a lengthy development phase before earningpositive returns. When the foreign investment pro-duces for the host market, as in Brazil and Korea, theinvestor's concern with the long-term macroeconomicenvironment is reinforced.

Industrial and trade policies also strongly influenceforeign investment. Outward-oriented strategies sup-ported by tax, foreign exchange, and other policiesusually attract more foreign equity investment, espe-cially to the export processing sectors. Transparent andconsistent investment policies are important. Singa-pore, for example, treats foreign investments on essen-tially the same terms as domestic investments. It has

attracted large flows which, along with domestic in-vestment, have contributed to rapid growth.

Mauritius shows that policies to provide incentivesfor foreign investment can work, provided the macro-economic environment is stable. To attract foreign in-vestment and diversify from its traditional reliance onraw sugar, it adopted an Export Processing Zone pro-gram in 1970. Mauritius successfully expanded theshare of manufactures from almost nothing to 24 per-cent of total exports by 1977. But growth slowed in thelate 1970s and early 1980s, partly because of failures inmacroeconomic policy (currency overvaluation, fiscaloverexpansion, and a tax policy that discouraged do-mestic saving). Foreign investment plummeted. Thecountry adopted a structural adjustment program inthe early 1980s that called for better credit allocation, anexpansion of term finance for the private sector, andinvestment policies aimed at further export diversifica-tion. Growth and foreign investment have revived.

funds to developing countries. Saudi Arabia con-tinues to provide 3 percent of GDP in developmentaid, and Kuwait has recently provided 2 percent.In general, however, low oil prices in the 1980shave prevented the high-income oil-exportingcountries from maintaining their aid programs.

Moving beyond the debt crisis calls for effort bydebtor and creditor alike. Credible and sustainablestructural adjustment is necessary to encourage

24

the return of flight capital and to ensure that do-mestic and external resources are made availableand are put to productive use. And creditors needto be more imaginative in their lending; they musttailor the form and maturity of financial flows tothe characteristics of the projects being financed.The creativity of the international capital marketsshould be brought to bear on the problems of thedebtor countries.