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Economic Reform in this
Era of Globalization
16 country cases
Economic Reform in this
Era of Globalization
16 country cases
Eco
no
mic
Refo
rmin
this
Era
of
Glo
baliza
tion
G-2
0
Economic Reform in this
Era of Globalization
16 country cases
Copyright © 2003 G-20 SecretariatEditing, design, and layout by Communications Development Incorporated, Washington, D.C.
TABLE OF CONTENTS iii
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . v
Overview . . . . . . . . . . . . . . . . . . . . . . . . 1
Australia . . . . . . . . . . . . . . . . . . . . . . . . . 9
Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Canada . . . . . . . . . . . . . . . . . . . . . . . . . 31
China . . . . . . . . . . . . . . . . . . . . . . . . . . 41
France. . . . . . . . . . . . . . . . . . . . . . . . . . 53
Germany . . . . . . . . . . . . . . . . . . . . . . . 61
India. . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Italy . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Japan . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Republic of Korea. . . . . . . . . . . . . . . . 101
Mexico . . . . . . . . . . . . . . . . . . . . . . . . 113
Russia . . . . . . . . . . . . . . . . . . . . . . . . . 123
South Africa . . . . . . . . . . . . . . . . . . . . 141
Turkey . . . . . . . . . . . . . . . . . . . . . . . . 151
United Kingdom . . . . . . . . . . . . . . . . 163
United States . . . . . . . . . . . . . . . . . . . 173
Table of Contents
PREFACE v
The G-20 economies range widely in in-comes and institutional structures, and inthe level of integration with the global econ-omy. They account for almost 65 percent ofthe world’s people, about 70 percent of theworld’s poor and more than 75 percent of theworld economy.
At a meeting in Montreal in October 2000the G-20 Finance Ministers and Central BankGovernors discussed globalization, its impli-cations for growth, inequality, and economicsecurity, and its challenges to public policy. Thediscussion revealed broad agreement—in theMontreal Consensus—on the main elementsof a sound policy approach to meeting thesechallenges. At the same time Ministers rec-ognized the need for further work to developa deeper, shared understanding of globalization,its effects on economies and societies and theways of maximizing its benefits. To this end,the members agreed to prepare case studiesoutlining their respective experience with eco-nomic integration.
At the fourth Ministerial meeting in NewDelhi, India in November 2002, a decision wastaken to publish this collection of case studies
to help inform the ongoing global dialogue onhow countries can reap the potential benefitsof global economic and financial integration,and ensure that these benefits are widely andequitably distributed, while avoiding potentialvulnerabilities to crises.
The overview summarizes some commonthemes from the Workshop held in Australiaand the case studies prepared by Australia,Brazil, Canada, China, France, Germany, India,Italy, Japan, Korea, Mexico, Russia, SouthAfrica, Turkey, the United Kingdom, and theUnited States.
This publication does not attempt to pro-ject a common view on the issues at hand.Rather the case studies reflect the diversity ofG-20 members’ experiences with, and ap-proaches to, increasingly global markets forgoods, services, and capital.
I am confident that by outlining, from theperspective of policy makers themselves, the keychallenges and opportunities they face in deal-ing with increasingly integrated markets, thispublication will provide useful insights to fur-ther progress in ensuring a process of global-ization that benefits all.
Jaswant SinghFinance Minister
India
Preface
OVERVIEW 1
The steady liberalization of world markets forgoods and services over the last half century hascontributed to an enormous increase in globalprosperity and welfare by increasing produc-tivity and workers’ incomes, promoting greatercompetition, and expanding consumers’ accessto higher quality products at lower prices. Inthe G-20 benefits have flowed to formerly verypoor economies and to industrial economies.
Continuing the recent progress in reduc-ing poverty and inequality in the G-20 and inthe broader world requires improving recentpolicies and sustaining robust global growth.Closer international economic integration canprompt faster growth in living standards, butit is only one part of a comprehensive devel-opment policy. Governments have critical rolesin creating a stable macroeconomic environ-ment, and in investing in the institutions, ed-ucation systems, health systems, and socialsafety nets essential for inclusive, stable, sus-tainable growth.
The case studies of G-20 members in thisbook are not a consolidated G-20 view ofglobalization. Instead, they reveal the diversityof experiences and policies. Some commonthemes emerge nonetheless.
Cross-border capital flows can boost aver-age growth rates by allowing savings with other-wise low returns in rich countries to financehigher-productivity investments in poorer coun-tries. But short-term capital flows can increasethe variability of growth rates, unless carefullymanaged in the receiving countries. They canalso increase the vulnerability to crises if thereare unsustainable tensions among domestic eco-nomic policies, or if economic institutions andprudential supervision are inadequately devel-oped. So, while openness to internationalfinancial flows brings important and long-lasting
benefits, it can raise the cost of bad macroeco-nomic and structural policies, weak institu-tions, and political uncertainty.
Member experiences show that openingto international capital flows needs to be closelymonitored. Careful sequencing is important toprovide time to build domestic economic in-stitutions and prudential supervision. The in-ternational community also has an importantrole—developing codes and standards based onshared experience, conducting surveillance andpeer reviews, and providing technical assis-tance. A broader political challenge is for lead-ers to create a domestic climate supportive ofpolicies that will build wealth. Such reforms canbe enacted in balanced, timely policy packagesthat reduce the risk of crises.
As with economic adjustments arising fromchanges in factor and commodity prices, thechanges from economic globalization can causelosses to some members of society. So effectivesocial policies are an important element of a com-prehensive public policy response to sustain apolitical consensus supporting open markets.Good social policies are also critical to meetingthe economic challenges of globalization. Gov-ernments and the international communitymust work together to ensure the provision ofefficient and affordable programs that help withtransitional impacts of change—as well as thosethat provide the skills and knowledge for peo-ple and businesses to respond to the rapidlychanging demands of the global market.
Countries that have embraced closer inter-national economic integration and minimizedor avoided economic crises have made largeand sustained strides against poverty—on ascale unprecedented in human history. There isno evidence of a correlation between globaliza-tion and increasing national inequality. Instead,
Overview
2 OVERVIEW
inequality has widened in some countries, nar-rowed in others, and changed little in the rest.The different outcomes seem to reflect differ-ent starting points, different national policies,and different national economic experiences. Al-though national inequality has widened in somecountries, absolute living standards for the poorhave not necessarily declined.
G-20 MEMBERS’ EXPERIENCES
Market opening measures leading to greaterflows of goods, capital, and knowledge have cre-ated greater prosperity and higher living stan-dards for G-20 members, which have becomemore integrated with one another and thebroader global economy over the past 20 years.Tariff rates have been cut, and cross-bordercapital flows have increased. As trade and in-vestment have risen, international specializationhas increased, productivity has grown, real eco-nomic output per capita has increased, andbasic social indicators have improved (table 1).The impact on welfare from consumers’ abil-ity to purchase a wider range of goods and ser-vices at lower prices is more difficult to measurebut also important.
Contrary to the belief of many critics,globalization has not led to widening incomedisparities. The numbers in extreme poverty inthe G-20 have fallen dramatically over the last20–30 years, and for the group as a whole, mea-sures of inequality have declined modestly1.
The diversity of country experiences inthe G-20 case studies suggests that while mar-ket opening is desirable, it is not sufficient tomaximize globalization’s benefits. Fully bene-fiting from the forces of globalization requireswell-developed domestic institutions, coherentand sustainable macroeconomic policies, andeffective structural policies. Structural reformsare needed to ensure that economies can ad-just flexibly to changing patterns of demand.Good health and education systems are neededto support productivity and provide the skillsand abilities necessary for workers to producethe goods in demand on global and domesticmarkets. And effective social safety nets areneeded to facilitate adjustment to changes inemployment associated with developments in
global markets—and to sustain a political con-sensus in favor of open markets.
The case studies of countries that have suf-fered financial crises in the last decade show thatpremature or poorly sequenced capital accountliberalization can highlight inconsistencies inmacroeconomic policies and increase the riskand magnitude of financial crises. Why? Be-cause short-term capital inflows can be easilyreversed. Better information flows and com-parisons of country performances by partici-pants in globalized financial markets havemade policy coherence and sustainability moreimportant—and raised the costs of delayingcorrection of unsustainable policies.
The case studies add to other evidenceshowing that economic integration has led tosignificant improvements in living standards.The benefits are broadly based, and there is noevidence that opening markets to trade and in-vestment flows increase income inequality.
The G-20 experiences do not suggest thatmoving away from open markets would en-hance economic performance, overall social wel-fare, or equity. They show that even members thatsuffered economic crises have not shied awayfrom the opportunities provided by integrationwith global markets. Instead, they have set aboutbuilding policies and institutions to maximize thebenefits from economic globalization.
SOME RECURRENT THEMES FROM THE
CASE STUDIES
TRADE LIBERALIZATION
The experiences of G-20 members show thatthe process of integration into world marketsfor goods and services has contributed much toimproved living standards. Access to foreignmarkets has allowed exporters to reap the ben-efits of returns to scale and scope, while importshave improved the quality and choice avail-able to domestic consumers. The competitivediscipline that comes from the actual or po-tential entry of foreign competitors has en-sured that the benefits of more efficientproduction are passed on to consumers—inthe former of lower prices and higher quality—rather than appropriated by participants in
OVERVIEW 3
TABL
E 1
Eco
no
mic
glo
bal
izat
ion
—se
lect
ed G
-20
ind
icat
ors
Ave
rag
e ta
riff
rat
esTr
ade
FDIi
nfl
ow
sG
DP
per
cap
ita
Life
exp
ecta
ncy
at
bir
th(p
erce
nt)a
(per
cent
of
GD
P)b
(per
cent
of
GD
P)c
(PPP
dolla
rs)d
(yea
rs)e
1980
–84
1985
–90
1991
–95
1996
–99
1960
1980
2000
1980
1990
1999
1960
1970
1980
1990
2000
1970
1980
1990
2000
Arg
entin
a28
.027
.513
.911
.010
.024
.118
.20.
91.
38.
45,
559
7,30
28,
245
6,51
29,
219
6770
7274
Aus
tral
ia16
.014
.210
.77.
425
.626
.834
.91.
12.
61.
68,
865
12,1
7114
,334
17,0
43
20,3
9071
7477
79Br
azil
47.
64
5.8
21.0
15.7
18.8
20.2
20.1
0.8
0.2
6.2
2,23
53,
057
5,19
94
,924
5,4
5959
6366
68C
anad
a12
.09.
18.
76.
1—
50.7
78.0
2.2
1.3
4.0
8,94
712
,307
16,1
6718
,933
20,5
5972
7577
79C
hina
49.
538
.839
.916
.70.
018
.74
3.9
—1.
03.
967
378
31,
067
1,85
83,
117
6267
6970
Fran
ce11
.08.
78.
09.
620
.836
.851
.00.
51.
12.
77,
543
11,6
6815
,103
18,0
9319
,558
7274
7779
Ger
man
y11
.08.
78.
09.
6—
40.
756
.10.
00.
12.
57,
685
10,8
49
14,1
1315
,932
17,7
9970
7375
77In
dia
74.3
99.4
61.9
27.8
9.6
12.7
19.6
0.0
0.1
0.5
753
868
938
1,30
91,
746
49
5459
63In
done
sia
33.0
27.9
20.1
13.2
—4
2.0
62.4
0.2
1.0
–1.9
1,01
91,
194
1,87
02,
516
3,07
04
855
6266
Italy
11.0
8.7
8.0
9.6
20.7
39.3
44
.20.
10.
60.
65,
916
9,68
913
,153
16,3
2017
,759
7274
7779
Japa
n10
.07.
06.
36.
018
.125
.718
.30.
00.
10.
33,
988
9,71
513
,429
18,7
8920
,410
7276
7981
Kor
ea23
.118
.910
.911
.58.
063
.272
.70.
00.
32.
31,
105
1,95
44
,114
8,70
412
,152
6067
7073
Mex
ico
24.7
16.7
12.8
16.9
14.9
15.7
62.4
1.0
1.0
2.5
3,15
54
,320
6,28
96,
097
6,65
562
6771
73Ru
ssia
——
9.4
11.7
——
54.5
—0.
01.
7—
—8,
203
7,76
24
,523
—67
6965
Saud
i Ara
bia
2.2
8.0
12.3
12.7
0.0
84.5
55.0
–2.0
1.8
–0.6
3,71
97,
624
13,2
849,
101
8,22
552
6169
73So
uth
Afr
ica
29.0
17.4
10.2
8.2
——
39.7
——
1.1
3,04
14
,04
54
,390
3,96
63,
858
5357
624
8Tu
rkey
31.0
26.4
26.7
12.3
—15
.44
1.2
0.0
0.5
0.4
2,51
83,
450
4,0
735,
44
16,
552
5761
6670
Uni
ted
Kin
gdom
11.0
8.7
8.0
9.6
31.7
42.
14
3.7
1.9
3.3
5.9
8,64
510
,767
12,9
2816
,411
18,7
1472
7476
77U
nite
d St
ates
8.0
6.5
6.3
9.0
7.1
17.2
20.3
0.6
0.8
3.0
11,3
2815
,030
18,5
7723
,214
27,3
3171
7475
77G
-20
aver
age
24.0
22.1
15.9
11.8
14.3
33.3
44
.00.
50.
92.
44
,822
7,04
49,
236
10,6
8011
,952
6368
7172
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4 OVERVIEW
protected industries. By spurring innovation,competitive discipline has been an importantdriver of efficiency and productivity growth inits own right.
The case studies illustrate that trade liber-alization requires the effective management ofthe accompanying structural adjustment—andthat public investments in education, training,and social safety nets are important to maximizeits benefits and ensure they are available to all.
CAPITAL ACCOUNT LIBERALIZATION
The case studies reveal a range of experienceswith opening economies and financial marketsto foreign investment. Some members have hada highly open capital account regime through-out their modern economic history. Some haveliberalized at different paces in recent decades.And some are slowly reducing controls on cap-ital movements.
The diversity of starting positions—and theinteraction of capital account arrangementswith unique domestic economic structures,policies, and regulations—mean that it is notpossible to formulate a guide to the pace andsequencing of liberalization for all countries tofollow under all circumstances. Instead, the casestudies provide instructive lessons that couldhelp countries liberalizing their capital ac-counts. The most important of these lessonsis that maximizing benefits from open capitalmarkets requires sound economic policieswithin well-regulated, supervised, managed,and capitalized financial systems.
Members’ experiences confirm that differ-ent forms of cross-border capital flows posedifferent issues for regulatory and prudentialcontrol—and for stability. Foreign direct in-vestment flows tend to remain stable, to arisefrom a long-term commercial relationship, andto bring benefits in technology and managementpractices that can strengthen the recipient econ-omy’s economic performance. Short-term bor-rowings and portfolio investment flows, muchmore quickly reversed, are rarely the result oflonger-term investor commitment to a coun-try. Thus, they sometimes contribute to exter-nal crises, particularly in the context ofinconsistencies in host-country macroeconomic
policies, weaknesses in the domestic financialsector, and poor prudential supervision.
STRUCTURAL POLICIES
Closer global economic integration delivers itsbenefits by permitting greater specializationand by lifting domestic economic performanceto global levels through intensified competition.The benefits imply structural change. The casestudies show that benefiting fully from accessto external markets requires an economy tosmoothly allocate additional resources to theproduction of goods in strong demand and towithdraw resources from sectors where demandis declining.
The countries in the case studies have pur-sued a variety of structural policies to facilitateadjustment, reflecting the different startingpoints of their economies, the nature of theirexternal liberalization efforts, and their do-mestic political preferences and social choices.In general, countries that have pursued poli-cies fostering the responsiveness of firms, house-holds, and workers to price signals have beenmost successful in meeting the challenges ofglobalization. This implies that structural re-forms in seemingly domestic areas are, in fact,important to equipping the economy to re-spond to international opportunities.
Paradoxically, broader packages of economicchange may involve fewer costs than narrowerchanges (because the losers from some changesmay be gainers from others). Reforms in widelyused sectors such as transport, power generation,and telecommunications have particular poten-tial to improve overall economic performance bylowering costs and thus speeding the dividendsfrom adaptation to global opportunities.
Transparency and sound financial sector reg-ulation and supervision. Many of the case stud-ies suggest that problems experienced afterliberalizing the capital account were due mostlyto inadequate transparency and insufficientlydeveloped prudential and regulatory mecha-nisms. The international community has re-sponded by developing standards and codes foreconomic and financial transparency and forpolicy in such key areas as financial sector reg-ulation and supervision. It has also helped
OVERVIEW 5
countries identify weaknesses in these areasthrough stronger surveillance, notably the Re-ports on Observance of Standards and Codes(ROSCs) by the IMF and the Financial Sec-tor Assessment Program (FSAP) undertakenjointly by the IMF and World Bank. G-20countries have played an active role in thisprocess. At the first G-20 Ministerial meetingin Berlin in December 1999, the group en-dorsed the ROSC and FSAP exercises andagreed that member countries should partici-pate in them.
Better information flows and comparisonsof country performance by participants inglobalized financial markets have made cred-ibility and sustainability in government policyand regulation more important. Policy incon-sistencies now tend to be more quickly iden-tified and more severely punished byinternational markets. The case studies illus-trate that building structural and institutionalsupports for a more global economy is a processbest approached systematically, usually with in-ternational technical assistance or foreign fi-nancial expertise. Building domestic institutionsand the effective machinery of prudential su-pervision is time-consuming—but essential.
Labor market reforms and competition pol-icy. Strong labor market and competition frame-works are the structural policies most criticalto ensuring smooth adaptation to the new,higher-productivity opportunities offeredthrough open international markets. Labormarkets are important in minimizing the ex-tent and duration of unemployment. The casestudies highlight that those countries with less-flexible labor markets encountered difficultiesin allowing labor to move quickly to emergingsectors and reallocating other complementaryresources, such as capital, from sectors experi-encing a temporary or permanent decline in de-mand to expanding sectors.
The role of government. The experience ofthe G-20 members indicates that a thoroughassessment of the appropriate role of govern-ment in the economy, including regulationand state ownership of firms, can help coun-tries benefit fully from open international mar-kets. There is no single “appropriate” level ofgovernment intervention for all countries.
Instead, what is appropriate will vary dependingon the historical, cultural, and institutionalbase of the country. But it is important for gov-ernments to actively consider, and periodi-cally re-examine, the role their interventionsought to play in the economy—to ensure thatthe costs are justified by the need to achieveother public policy objectives. In addition, theprocess of assessment adds transparency andcredibility to the reform agenda.
SOCIAL POLICIES
A recurring theme in several case studies ishow supportive social policies contribute togood economic performance. Opening marketsadds to the pressures for far-reaching structuralchange. But the need for policies to help peo-ple and countries adapt to change also arisesfrom other sources, such as technological ad-vances or changes in relative prices that can alsocause economic and social dislocation. Goodsocial policies help in adapting to all changes,whatever their source.
The experiences of the countries studiedshow that effective social policies help sustaina political consensus that supports open mar-kets. First, good policies ease the transitionfor those negatively affected by the perma-nent structural changes that can result frommarket-opening measures. Second, they pro-vide social insurance against risks that are notprivately insurable, such as the consequencesof large shifts in demand. And third, they helppeople adjust to changing market conditions.
A well-developed education system and ahealth care system that provides portable cov-erage help contribute to an economy andlabor market that is flexible and better ableto adjust to shocks. Other types of socialpolicies, such as labor retraining, matter for
BOX 1The Benefits of World Trade Organization Membership
All G-20 members have chosen to be members of the World Trade Organization (WTO).G-20 governments have judged that membership in the WTO (and its predecessor, theGATT) has tended to improve access to external markets and has increased attractivenessas a destination for stable foreign direct investment. Membership also provides open, rules-based dispute resolution and a voice in the negotiation of global trade rules.
Most G-20 members have steadily reduced tariffs over the past 20 years, enjoying a cor-responding increase in trade as a percentage of GDP from about 33 percent in 1980 toabout 44 percent in 2000.
6 OVERVIEW
those directly affected by economic change.In the absence of effective social policies, theaccelerated changes from integration in in-ternational markets can lead to oppositionfrom those fearful of redundancy or of seeingtraditional skills devalued. Even when thenet benefits of liberalization for society arelarge, local areas of loss can be a powerful ob-stacle to change. Such opposition may un-dermine broader support for the reformprocess.
The degree to which policies should insu-late people from adverse outcomes—ratherthan helping them to adjust—is of great prac-tical policy importance. The case studies sug-gest that the best social policies will achieve theirequity and social insurance objectives whilecontributing to flexible and efficient labormarkets. The policies chosen will inevitably re-flect a complex interplay of social preferences,political structure, historical, and institutionalconditions. This is consistent with the obser-vation in some case studies that labor marketrigidities—although often resulting from well-intentioned, equity-oriented motives—can becounterproductive, exacting a high cost in eco-nomic efficiency and performance while fail-ing to help the poor and marginalized.
BROADENING THE BENEFITS OF
GLOBALIZATION—OPTIONS FOR ACTION
Both the case studies and the workshop onglobalization, poverty, and inequality haveidentified useful policy lessons.
NATIONAL POLICIES
Globalization has not reduced national gov-ernments’ capacity for vital interventionsthrough domestic policy. No member gov-ernment claims that it faces significantly re-duced national capacity for action. The casestudies also confirm that fully benefiting fromglobalization requires well-developed domes-tic institutions to support coherent and sus-tainable macroeconomic and structural policies.
The policies essential to maximize the ben-efits from globalization include:• Liberalized trade and investment regimes.• Cautious liberalization of the capital ac-
count, especially as it affects short-termcapital flows.
• Institutional development, particularly inthe legal and financial sectors, and carefulregard to sound prudential regulation in thefinancial sector.
BOX 2Capital account liberalization—lessons from G-20 experiences
Openness to cross-border capital flows is an important complement to open markets for goods and services,since integrated global capital markets allow poorer countries to finance investment beyond the limits per-mitted by domestic savings. Foreign direct investment (FDI)—a particularly stable and long-term form ofinternational capital flow—also conveys the benefits of exposure to more advanced technologies and man-agement than may be available domestically. OECD data show that developing countries, as a group, re-ceive almost twice the inward FDI in proportion to their GDP as developed countries.
The case studies show how G-20 members have reduced barriers to cross-border capital flows over the past20 years, enabling the consolidation of progress in economic and financial development, and set the stagefor stronger growth and higher incomes. But they also show that without the necessary institutions andregulatory framework, particularly in the financial sector, volatile short-term capital flows can contributeto crises. Creating an environment to help countries obtain the benefits of an open capital account whileminimizing vulnerability to crises has been an important impetus behind efforts by the international com-munity to develop and promote standards and codes for economic and financial transparency—and poli-cies for financial sector regulation and supervision.
Moreover, the Mexican crisis of 1995 highlighted that strictly implemented regulatory and institutional changesare required in addition to domestic reforms in institution building, property rights, and contract enforce-ment. To be successful the reform process must also remain flexible enough to address new domestic andglobal economic developments.
Korea’s 1997 crisis reflected the culmination of structural imbalances, institutional shortcomings, and ex-ternal shocks from the Thai and Indonesian crises. But the crisis proved a catalyst for domestic support forcomprehensive economic reforms.
French and Chinese accounts of financial sector liberalization illustrate how measured approaches can de-velop domestic institutional and regulatory strengths, in step with opening to global capital markets.
The case studies show that members have refrained from reversing the broad direction of capital account lib-eralization in the face of crises. Instead, they have worked to build the institutions, prudential supervisory poli-cies, and skills that reduce the risks of future crises. This determination to avoid reversing a policy of liberalizingthe capital account can be viewed as the authorities’ recognition of the long-run benefits of liberalization.
OVERVIEW 7
• Effective social programs and safety nets tofacilitate the structural adjustments requiredto make the most of new opportunities.
THE INTERNATIONAL FINANCIAL INSTITUTIONS
A common theme in the case studies is the im-portance of international institutions in facil-itating the reforms to fully capitalize on thepotential benefit of globalization. In particu-lar, these institutions can highlight other coun-tries’ best policy practices and identify desirablereforms.
STATISTICAL IMPROVEMENTS
Better comparability in national statistics wouldmake the benefits of globalization clearer andimprove analysis of the policies to maximizethem. They would also promote broader un-derstanding of trends in poverty and inequal-ity. The Sydney workshop on Globalization,Poverty, and Inequality identified possible sta-tistical action for countries:• Participation or financial and technical
support for the International ComparisonProgram (ICP). The ICP will producemore comprehensive, better quality, more
timely, and better disseminated PurchasingPower Parity data. Such improvementswould greatly facilitate public under-standing of progress against poverty—andareas of remaining challenge.
• Better quality national household surveydata on income or consumption, and bet-ter international comparability of suchdata, through supporting principles suchas those enunciated by the Canberra Groupand comparisons such as those facilitatedby the Luxembourg Income Study.
NOTES
1. For a range of estimates arriving at theseconclusions by different methodologies, seeDavid Dollar, “Global Economic Integrationand Global Inequality”, in Globalisation, Liv-ing Standards and Inequality: Recent Progressand Continuing Challenges, pp. 19–27; andXavier Sala-I-Martin and Sanket Mohapatra,Poverty, Inequality and the Distribution of Incomein the G20, background paper to the NewDelhi G-20 Finance Ministers and CentralBank Governors’ meeting, November 2002,available on the G-20 website.
AUSTRALIA 9
Australia’s experience with globalization falls intwo waves, the first in the late 19th and early20th centuries (bracketing Australian federa-tion as a modern nation in 1901) and the sec-ond in the current era. Between these twowaves Australia followed policies that had the(probably unintentional) effect of weakeningAustralia’s links to the global economy, at a timewhen globalization was in retreat because ofWorld Wars I and II and “beggar thy neigh-bor” responses to the Great Depression. This“de-globalization” reduced Australia’s economicperformance in both absolute terms and rela-tive to other OECD economies, against whichits performance is usually benchmarked. Con-versely, in recent years policy reforms havereintegrated the Australian economy with theglobal one, leading to strong improvements inproductivity and income growth.
Despite Australia’s increased integrationwith the global economy, macroeconomicvolatility has decreased. There has been stronggrowth in average incomes—yet, as in manyOECD economies, the distribution of indi-viduals’ disposable incomes (after taxes andtransfers) widened a little over the past twodecades. But a targeted social safety net and areformed tax system ensured that the house-hold income distribution did not widen inthe second half of the 1990s1.
The reform process was not without fric-tions. And as with any national economic ad-justment where the rest of the world’s practicesare also evolving, the process remains incom-plete. Financial sector deregulation outpacedsupervisory and corporate governance reformsfor a period, and there were forced mergers ofsome minor banks and several large corpora-tions. But those problems were corrected with-out reintroducing regulation.
Australia has enjoyed considerable benefitsfrom its policy reforms supporting globaliza-tion. Moreover, the policy challenges of glob-alization have been met without adverse effectson aggregate employment and economic sta-bility, and without contributing to poverty orinequality.
TWO WAVES OF GLOBALIZATION
Throughout the 19th century the Australiancolonies flourished through primary indus-trial exports. As an exporter of raw materialsto the British Empire, the modern Australianeconomy was effectively born globalized.
From white settlement in the late 1700s, asteady increase in population and economic ac-tivity took place, burgeoning in 1851 with thediscovery of gold in Victoria. Immigration thenaccelerated, increasing the population from justover 400,000 people to around 1 million in adecade—and to about 3 million by 1890 (Cat-ley 1996, p. 44). Between 1860 and 1870 realper capita gross domestic product (GDP) grewby about 5 percent a year. In 1870 the averageper capita income of the Australian colonies wasaround 40 percent higher than in any other na-tion (Andersen and Garnaut 1987, pp. 15–17)—and 75 percent higher than in the United States(The Economist, 17 March 1984, p. 16).
But in 1888 the land and building boomcollapsed, partly due to a slump in Britain, lead-ing to a 25 percent cut in Australia’s exportprices and a drying up of capital inflows. Im-ports fell, government revenues shrank by aquarter, per capita income fell by around 10percent, and unemployment rose sharply (Cat-ley 1996, p. 45). The depression of the 1890shad a lasting influence on Australian policythroughout the early 20th century. Heavy
Australia
10 AUSTRALIA
reliance on primary exports left the economyhighly susceptible to fluctuations in worldcommodity prices, perhaps reinforcing the de-sire of Australian policymakers for employ-ment and stability in the more diversifiedindustrial economy they were trying to foster.
From federation in 1901 until the 1970s,Australia’s economic development was shapedby inward-looking, protectionist policies thatsought to build manufacturing industries be-hind a wall of tariffs. This approach was asso-ciated with a decline in Australia’s high livingstandards relative to other nations. This do-mestic policy framework interacted with thetwo World Wars and the Great Depression toprogressively disengage Australia from theworld economy. Between 1900 and the mid-1980s growth in per capita GDP was weakerthan in any other industrial country, causingAustralia to fall from 1st to 14th place in termsof GDP per capita (Andersen and Garnaut1987, pp. 15–17). Moreover, Australia’s shareof world exports fell from 1.7 percent in 1960to 1.1 percent in 1987 (Kelly 1992, p. 14).
The oil price shocks and stagflation of the1970s led, through regulated and inflexiblelabor markets, to persistently high unemploy-ment in the 1980s. Australian governments rec-ognized the untenability of the protectionisttradition, and significant and wide-rangingreforms were set in motion (see also below, in
the section on labor market reforms). As Kelly(1992, p. 15) summarizes:
The decade of the 1980s saw the advancetowards a multi-racial Australia, the demiseof protection, the start of the long-awaitedassault on arbitration, a loss of confidencein State power and a turning away fromgovernment paternalism, a shift towardsmarket power and deregulation to varyingdegrees, efforts to secure better enterpriseproductivity and work place reform, a deepersense of national self-reliance, a reappraisalof welfare as a need not a right, and an em-phasis on individual responsibility as well asindividual entitlement. Australia’s economicorientation was more outward-looking andits aspiration was to become an efficientand confident nation in the Asia Pacific.
REFORMS TO OPEN MARKETS
The transformation of the Australian econ-omy was pervasive, and its benefits took timeto emerge. But by the early 1990s the benefitsof reintegrating with a globalizing economywere becoming clear.
LIBERALIZATION OF CONTROLS ON DOMESTIC
MARKETS FOR GOODS, SERVICES, CAPITAL, AND
ACCESS TO FOREIGN MARKETS
Australia’s market-opening reforms are per-haps most evident in the removal of trade andindustrial protection measures and in the free-ing up of capital markets and flows.
Removal of trade and industrial protectionmeasures. The effective rate of protection in Aus-tralia rose steadily from the beginning of the20th century until the 1970s—a significant fac-tor in the fall in the ratio of trade to GDP (fig-ure 1). The move away from protection beganin 1973, commencing with a 25 percent cutin all tariffs in an effort to ease inflation andincrease competitiveness and productivity.
The economic stress caused by oil priceshocks, however, saw certain industries—such aspassenger motor vehicles, textiles, clothing, andfootwear—reprotected by quotas that persistedinto the 1980s. But such protection was unableto sustain employment levels in the protected
Figure 1. Australian exports, 1901–2002
Percentage of GDP
Korean WarCommodity Boom
10
15
20
25
30
35
2001–02 1991–
92 1981–
82 1971–
72 1961–
62 1951–
52 1940–
41 1931–
32 1921–
22 1911–
12 1900–
01
Source: Australian Bureau of Statistics 2001a; Butlin 1962.
AUSTRALIA 11
industries. Protection of textiles, clothing, andfootwear, for example, more than doubled in the1970s, yet employment levels fell (Higgins 1989).The share of manufacturing in GDP peaked inthe early 1960s and declined through the 1990sas the service sector grew strongly.
After the lowering of tariff barriers in the1970s and the adoption of a floating exchangerate in 1983, the ratio of exports and importsto GDP increased steadily. In the 1940s and early1950s the share of exports in GDP (at currentprices) was around 20 percent (see figure 1). Itfell to about 15 percent in the late 1950s andstayed there until the 1980s. But by 2001–02exports accounted for about 22 percent of GDP.This strong growth in exports was accompaniedby a change in their composition—away fromagriculture toward services and elaborately trans-formed manufacturing (figure 2).
Destinations for Australian exports havealso changed. During the 1930s nearly 60 per-cent of Australia’s exports went to then-traditional trading partners in Europe—particularly France, Germany, and the UnitedKingdom. By 1996–97 such countries ac-counted for only 7 percent of Australia’s exportsof goods and services, while three-quarterswent to partner economies in the Asia-PacificEconomic Cooperation group.
Freeing up of capital markets and flows.Through the late 1960s and early 1970s a na-tional mining boom and associated rises in thestock market saw capital inflows to Australia ac-celerate sharply, with considerable inflationaryeffect. The government responded with measuresaimed at reducing capital flows to contain in-flation and ease pressure on the exchange rate.
By 1981 it was apparent that while perhapseffective in the short term, there was no reasonfor frequent or sustained use of capital controls.That year, a Committee of Inquiry into the Aus-tralian Financial System suggested that capitalcontrols be available only during the transi-tion to a more market-oriented foreign ex-change system, and spurred Australia to embarkon a relatively rapid transformation from oneof the world’s most regulated financial sectorsto one of the more liberal (see below).
The phasing out of protectionist policies, to-gether with financial deregulation and structural
reforms in labor and product markets, led to anacceleration in economic growth rates. Duringthe 1960s Australia’s growth performance slippedbelow the OECD average. Below-average growthcontinued until the 1990s. But the 1990s (es-pecially the second half ) saw high productivitygrowth, strong growth in GDP and GDP percapita, low inflation, and falling unemployment—not only from Australia’s perspective, butalso relative to other major industrial countries(figure 3).
Figure 2. Sectoral composition of exports from Australia, 1974–2002
Rural
Percentage of GDP
0
2
4
6
8
10
2001–02
1998–99
1994–95
1990–91
1986–87
1982–83
1978–79
1974–75
Source: Australian Bureau of Statistics 2002.
Elaborately transformed manufacturing
Nonrural Services
Figure 3. Average annual per capita GDP growth rates in Australia andother OECD countries, 1960s–1990s
Percent
Source: Australian Bureau of Statistics Catalogue 2000a; OECD data.
0
1
2
3
4
5
1990s1980s1970s1960s
Au
stra
lia
OEC
D
12 AUSTRALIA
Had Australia continued to underperformthe average OECD growth rate for real percapita GDP over the past three decades by thesame margin that it underperformed it in the1960s, per capita GDP would now be almost12 percent lower (A$3,500) than the actuallevel (Parkinson 2001).
DIFFERENT TREATMENT OF DIFFERENT TYPES
OF CAPITAL
Capital controls. Australia has long relied on cap-ital inflows to supplement the domestic savingsof its relatively small population. As a result sus-
tained current account deficits were standardfor most of the 19th and 20th centuries. In theyears preceding the mining boom of the late1960s, foreign capital predominantly consistedof direct investment—while in the early 1970sportfolio capital and institutional loans some-times exceeded direct investment as sources ofinternational capital. In the context of a fixedexchange rate (between the Australian andU.S. dollars), capital inflows were often infla-tionary and accompanied by speculation on thefuture of the exchange rate. But in the early1970s the fixed exchange rate was abandoned,marking the first significant change in the ex-change rate since 1949 and leading to a seriesof discrete shifts in the level of the peg.
As noted, during this period the Australiangovernment implemented measures aimed at re-ducing capital inflows. The central feature wasa variable deposit requirement, introduced in1972, that acted as a market-based restrictionon capital inflows. Under this scheme a portionof foreign loans had to be deposited in the Re-serve Bank of Australia (in Australian dollars) inan interest-free, nonassignable account untilloan repayments were made. By raising the costof overseas borrowing, the variable deposit re-quirement effectively served as a tax on suchfunds. The requirement was suspended in 1977.
In 1981 the Committee of Inquiry into theAustralian Financial System concluded thatwhile the variable deposit requirement hadbeen effective in the short term, there was noreason to reintroduce it or to make frequent orsustained use of it—or of other instruments likeit (such as inflow or outflow taxes). Such con-trols on capital inflows imposed costs on bor-rowers and on overall economic activity bydistorting resource allocations.
Foreign investment controls. Responding to ris-ing nationalist sentiment, foreign investmentpolicy became more restrictive between the late1960s and mid-1980s (figure 4). This approachcontributed to an increase in the share of the cur-rent account deficit financed by borrowings andportfolio debt inflows. It also may have reducedthe efficiency of capital allocations (figure 5).
More recently, broader liberalization poli-cies and the move away from protectionistpolicies have seen increased liberalization of the
Figure 4. Changes in foreign investment policy in Australia, 1970–99
1970s
Source: Evans 1999.
Foreignborrowing
control
Lifeinsurance,uraniumminer limits
MiningequityeasedSmallfirms
exemption
Screeningeased,
nationalinterest
test
Screeningsimplified:small firms,new and
commercialproperty
andbanking
Increasedequitylimits
newspaper,uraniummining,airports,Telstra,Qantas
Banks andtelcos(Optus
Vodafone)easing
Real estate
restrictionsincreased
particularlyresidential
realestate
Easing ofbenefitstest and
opportunity test
Opportunitytest
Shelf coy.Real-estate
exemptionBankingopened
Screeningof asset
aquisitionReal estate
restrictionsand
Australianequitytargets
Oil explorerexemption
Foreigntakeoversscreeningand netbenefits
testBorrowing
limitseased
1980s 1990s
More restrictive
More open
Figure 5. Changes in capital productivity in Australia, 1970–99
Source: Australian Bureau of Statistics 2000a.
–1.2
–1.0
–0.8
–0.6
–0.4
–0.2
0.0
Percent
1995–99
1990s
1980s
1970s
AUSTRALIA 13
foreign investment regime, while maintainingthe pre-establishment screening process. Butsince the mid-1980s the regulations guiding thevetting procedures have been eased consider-ably, resulting in a more open, efficient,investor-friendly regime2.
ROLE OF REGIONAL ECONOMIC ARRANGEMENTS
Regional economic arrangements have notplayed a big role in the “reglobalization” of theAustralian economy. That said, the Australia-New Zealand Closer Economic Relations TradeAgreement of 1983 and the APEC goal of in-creasing economic prosperity and improvingsocial conditions (particularly through freeand open trade and investment, as enunciatedat the 1994 conference in Bogor, Indonesia)have contributed to the consolidation of do-mestic policies.
The benefits of the agreement with NewZealand are indicative of the benefits of regionaleconomic arrangements. Its central provisionis the creation of a free trade agreement con-sistent with World Trade Organization (WTO)requirements. All tariffs and quantitative re-strictions on trade in goods between Australiaand New Zealand have been eliminated. Theagreement also covers services and addresses theharmonization of a range of nontariff measuresthat affect the free flow of goods and services—including those related to quarantine and cus-toms issues, standards, and business laws. Thetangible economic results that Australia has seenfrom such arrangements have helped increasedomestic support for policies with an increas-ingly global focus. (Australia has also benefitedfrom peer reviews through international com-parisons, particularly through the work of theOECD and the International Monetary Fund’sarticle IV process).
REFORMS OF DOMESTIC ECONOMIC POLICIES
Reforms of Australia’s domestic economic poli-cies have been invaluable in repositioning theeconomy to allow for maximum exploitationof the benefits of globalization. The forward-looking medium-term framework now in placefor fiscal policy and monetary policy means that
each is anchored by a clear primary objectivethat it is best suited to achieving: fiscal policyto ensure adequate public saving, and mone-tary policy to maintain low inflation.
Thus macroeconomic policy is directed atkeeping the economy growing at a strong butsustainable rate—avoiding excess demand pres-sures that would create inflation and widen thecurrent account deficit. This approach is es-sential to sustain economic expansion andavoid the boom-bust cycle that has plaguedAustralia, contributing to higher unemploy-ment in the 1980s and early 1990s (see below).
DEVELOPMENTS IN KEY MACROECONOMIC
POLICY VARIABLES
Until the early 1990s Australia’s economic per-formance was constrained by the tendency forinflation and current account pressures toemerge after even brief periods of strong eco-nomic growth. Policy periodically allowed—or even contributed to—the emergence ofexcess demand pressures. Subsequent policytightening to control rising inflation and cur-rent account deficits contributed to short-termeconomic downturns. Policy was occasionallyreactive, short term in its focus, and unclear inits objectives.
Fiscal policy. To ensure the transparencyand accountability of its finances, Australia’s fed-eral government now operates under the 1998Charter of Budget Honesty Act (seehttp://www.treasury.gov.au for the completecharter). The charter requires the governmentto present its long-term fiscal strategy witheach budget, along with short-term fiscal ob-jectives and targets. The government mustalso explain the broad strategic priorities onwhich the budget is based and specify the keyfiscal measures against which fiscal policy willbe assessed.
The charter also requires comprehensiveeconomic and fiscal outlook reports to be re-leased at the time of each budget, at mid-year,and within 10 days of the issuing of a writ fora general election. Among other things, thesereports must contain fiscal estimates for the cur-rent budget year and following three fiscalyears, the economic and other assumptions
14 AUSTRALIA
used in preparing those estimates, and a state-ment of risks that may have material effects onthe fiscal outlook.
In addition, the charter requires the prepa-ration of an intergenerational report to assessthe long-term sustainability of current gov-ernment policies over a 40-year period, takinginto account the financial implications of de-mographic changes. The report is to be re-viewed every five years.
The government retains necessary policyflexibility within this framework. The medium-term strategy was formulated partly in re-sponse to a perceived structural deteriorationin the current account deficit, associated witha decline in public saving. The strategy aimsto achieve budget balance, on average, over thecourse of the economic cycle—reducing thegovernment’s direct contribution to the currentaccount deficit through ongoing budget deficits.
This fiscal policy framework has signifi-cantly improved Australia’s fiscal positionand contributed to its strong economic per-formance in recent years. In 2000–01 and2001–02 expansionary fiscal policy supportedthe domestic economy in the face of a weakerinternational environment. The medium-term fiscal strategy allows fiscal policy to re-spond to short-term economic fluctuationsand since 2000 has helped Australia maintainsolid economic growth relative to otherindustrial countries. Since 1995–96 the
Australian government’s general net debt hasfallen from 23 percent of GDP to 7 percent,compared with an OECD average of about44 percent in 2000.
Monetary policy. The Reserve Bank of Aus-tralia’s charter requires that it exercise monetarypolicy in a way that contributes to the stabilityof the Australian dollar, to the maintenance offull employment, and to the economic prosperityand welfare of the Australian people. Since 1993these objectives have found practical expres-sion in an inflation target, with the bank seek-ing to limit annual inflation to 2–3 percentover the 10-year economic cycle (figure 6). Thistarget is the centerpiece of the monetary policyframework. It guides decisionmaking on mon-etary policy and provides an anchor for privatesector inflation expectations.
This objective was formalized in the 1996Statement on the Conduct of Monetary Pol-icy, issued by the treasurer and by the gover-nor of the Reserve Bank. This agreement alsoensured the bank’s operational independencefrom the government. With this indepen-dence, however, comes the need for trans-parency and accountability.
The bank’s conduct of monetary policy isexplained through several channels. It pub-licly announces any policy change, giving de-tailed reasons for it. In addition, each year itpublishes four statements on monetary policy,which contain detailed analysis of the economyand financial markets and an account of theconsiderations for the policies adopted by thebank. The bank’s governor also appears twicea year before a parliamentary committee toanswer questions about bank policies.
Australia’s experience shows that re-integration with the global economy need notcome at the cost of increased volatility in thedomestic economy. Variance in Australian GDPover the economic cycle has declined markedlyover the four economic cycles of the past 40years (Simon 2001). This is partly because theincreasingly diversified Australian economy ismore resilient to any single shock to the termsof trade, and partly because recent externalshocks have not been as large as they once were(for example, the oil price shocks of the 1970s).Improving the arrangements for fiscal and
Figure 6. Average annual inflation in Australia, 1900s–1990s
Source: Australian Bureau of Statistics 2001a; Butlin 1962.
–2
0
2
4
6
8
10
12
1990s1980s1970s1960s1950s1940s1930s1920s1910s1900s
Percent
AUSTRALIA 15
monetary policies and setting them in amedium-term framework have also helped sta-bilize the economy.
MICROECONOMIC REFORMS
Structural reforms increase economic efficiencyby making an economy more competitive anddynamic and by removing distortions that mis-allocate resources. Australia has made significantmicroeconomic reforms over the past 20 years—and while the reform process is never com-plete, Australia has in recent years enjoyed thebenefits of a stronger, growing economy that ismore flexible, adaptable, and resistant to externaleconomic shocks. Reforms have been particu-larly notable in labor markets, competitionpolicy, the financial sector, and the tax system.
Labor markets. For most of the 20th centurysuccessive governments obligated employers topass on to employees the benefits of Australia’scomprehensive protectionist measures, with ar-bitrated wages and working conditions result-ing from national wage cases. This led to asystem of national wage regulation, with arbi-trated wages based on “awards” in wage cases thatvaried according to price movements and judg-ments about the economywide capacity to pay.There was little room for market forces.
Reforms to workplace arrangements, labormarket regulation, and wage arbitration assis-tance began in the mid-1980s. More decen-tralized wage setting became a necessary partof market opening, and particularly impor-tant once the exchange rate was floated in1983. It became increasingly evident that thetension between international economic pres-sures and centralized wage setting was ham-pering productivity and economic growth.
Both major political parties argued for ashift to a decentralized enterprise bargainingsystem make the labor market more respon-sive to changes in the economy and to reduceimpediments to job creation, employmentparticipation, and productivity growth. Com-bined with other reforms and solid economicgrowth, these labor market reforms have con-tributed to a significant and sustained reduc-tion in unemployment, particularly since theearly 1990s (figure 7).
Another labor market reform was the en-actment of the Workplace Relations Act in1996, which helped link remuneration moreclosely to enterprise performance and whichappears to have contributed to productivitygrowth (OECD 2000, January, pp. 86–99).During the second half of the 1990s produc-tivity growth rates reached levels not seen sincethe late 1960s. The increase in productivitygrowth has been particularly noteworthy be-cause it has occurred across all measures ofproductivity—labor, capital, and multifactor(table 1). Only a handful of OECD economieshave experienced such improvements; mosthave instead seen a continuous slowdown inproductivity. Indeed, in the second half of the1990s Australia’s productivity growth rates ex-ceeded those of the United States.
Competition policy. The overall aim of struc-tural reform has been to increase productivity
Figure 7. Unemployment in Australia, 1901–2001
Percent
Source: Reserve Bank of Australia data; Australian Bureau of Statistics 2001c.
0
5
10
15
20
2000–01 1990–
91 1980–
81 1970–
71 1960–
61 1950–
51 1940–
41 1930–
31 1920–
21 1910–
11 1900–
01
Century average
TABLE 1Average annual productivity growth in Australia, mid-1960s–1990s(percent)
Decade Labor Capital Multifactor
1970s 2.8 –1.0 1.41980s 1.4 –1.2 0.41990s 2.8 –0.4 1.51995–99 3.5 –0.2 2.0Long-term average (1964–99) 2.3 –0.9 1.1
Source: Australian Bureau of Statistics 2000a.
16 AUSTRALIA
growth in the Australian economy by reducingstructural rigidities and developing and main-taining a competitive market environment.The low productivity rates that Australia ex-perienced in the 1970s and early 1980s—rel-ative to previous decades and those of othercountries—gave impetus to competition pol-icy reform. (In 1993 an Independent Com-mittee of Inquiry into National Competition,known as the Hilmer Committee, reportedthat low productivity in infrastructure indus-tries was one reason Australia’s per capita growthrate was below the OECD average in the threedecades preceding the 1990s.)
The substantive removal of tariffs and quo-tas, which reduced barriers to foreign trade, wasaccompanied by reforms aimed at increasingcompetition in the nontradables sector. Thesereforms were intended to ensure that govern-ment businesses and privatized public mo-nopolies did not enjoy unfair advantages overtheir competitors. Sectors previously domi-nated by government-owned monopolies—such as communications and utilities—havebeen a primary focus of reform, and have ex-perienced very rapid productivity growth.
Moreover, the sectors where reforms havegenerated the strongest productivity gains areamong those with the most pervasive down-stream effects on the costs and global com-petitiveness of other industries. This providesa reminder of the superiority of pursuing poli-cies that capitalize on gains from reforms andcompensate the losers, rather than compro-mising reforms.
As recommended by the Hilmer Com-mittee’s 1993 report, in 1995 the federal andstate governments agreed to implement theNational Competition Policy. This policy in-volved introducing competition in areas dom-inated by public sector infrastructure andsystematically reviewing legislation that re-stricted competition.
The Productivity Commission has esti-mated that reforms related to the NationalCompetition Policy could eventually increaseGDP by 2.5 percent. The commission hasalso estimated that, by increasing export com-petitiveness, the reforms will raise exports by3.4 percent (Productivity Commission 1999a).
Financial sector. Prior to the formation ofthe Australian Prudential Regulation Author-ity in 1998, prudential regulation of the fi-nancial sector was segmented, with a range offederal and state authorities responsible forsupervising different types of financial insti-tutions. In the 1970s and part of the 1980s anoligopoly of large, domestically owned bankswas protected from foreign and new domesticcompetition by a policy of not granting newbank licenses. This policy resulted in a bur-geoning nonbank sector that was subject to lessregulation. But during the 1980s the Aus-tralian banking system was transformed—from one consisting of a small number ofmajor banks, four state banks, and a largenumber of credit unions and building societiesto one where the major banks still dominate,but there are now more smaller banks andopen entry into banking.
In the 1980s financial sector reforms lib-eralized reserve requirements for domesticbanks, enabling them to strengthen their com-petitive position relative to nonbanks and in-coming foreign banks—and so increasing theirmarket share. Reforms also removed maturityrestrictions on bank deposits and ceilings oninterest rates for deposits and loans.
These reforms dramatically liberalized thebanking sector. A marked expansion in theoperations of foreign-owned banks furtherbroadened and deepened capital markets andspurred improvements in the allocative effi-ciency of funds. In addition, competition andnew technology led to more sophisticated fi-nancial services.
In the second half of the 1980s bank loansincreased considerably. Growth in outstandingloans increased from 13 percent in 1984 tonearly 21 percent in 1989, and there was aswitch in borrowers from the public to the pri-vate sector as huge investments in real estate oc-curred. This growth had many causes, including:• Competition and deregulation, which
made banks more willing to lend.• Salary and promotion structures within
banks that rewarded the development ofnew business.
• An increase in liquidity, even though in-terest rates were high.
AUSTRALIA 17
• Asset price inflation and a taxation sys-tem that encouraged borrowing in suchcircumstances.As a result, following monetary tightening
in 1988, the level of nonperforming loans soared,and two smaller banks experienced financial dif-ficulties that necessitated direct support from theirstate government owners. These two banks werelater incorporated into larger banks. Two ofAustralia’s largest banks also incurred large losses.
These commercial problems were graduallyworked out of the system, but there was a con-tinuing sense that the financial sector was evolv-ing too quickly, with a breakdown in traditionalbarriers between different types of financial in-termediaries potentially limiting traditional,institutionally specific forms of supervision. AFinancial System Inquiry initiated in 1996 ledto the reworking of financial sector regulation,with the creation at the federal level of twofunctional—rather than sectoral—regulators:the Prudential Regulation Authority for pru-dential supervision and the Securities and In-vestments Commission for investor andconsumer protection.
In addition, the Reserve Bank’s role wasstrengthened and redefined to independentlyfocus on monetary policy, overall financial sys-tem stability, and regulation of the payments sys-tem. Finally, wide-ranging corporate governancereforms have been implemented through theCorporate Law Economic Reform Program,covering issues such as takeovers, fundraising,directors’ duties, accounting standards, financialproduct markets, clearing and settlement facil-ities, and the distribution of financial products.
Tax system. Until recently the tax system inAustralia dated from wartime revenue needsand relied on unusual features, including asingle-stage sales tax on goods collected at thewholesale level. As the importance of servicesin the economy increased and channels of dis-tribution changed, it became clear that revenuesecurity was being undermined by the relativedecline in the base of the wholesale sales tax.Moreover, there were many different indirecttax rates, which created allocative inefficiencyand classification problems.
Marginal effective direct tax rates werehigh for many low-income earners because
the rates interacted with income-tested tar-geting of social welfare payments, creating un-employment traps and poverty traps. Moreover,the highest marginal income tax rates came intoeffect at relatively modest income levels, rais-ing further concerns about equity, distortionsin people’s decisions on whether to pursuework, and disincentives to savings.
Another concern was the growing fiscalimbalance between the federal and state gov-ernments. The federal government raised rev-enue from the main tax bases linked toeconomic activity, and distributed much ofthat revenue to states for local spending.
In 1998 the federal government announcedplans for a major overhaul of the tax system,the main features of which were:• Introducing a 10 percent tax on the con-
sumption of most goods and services.• Abolishing the wholesale sales tax and var-
ious minor indirect taxes.• Replacing grants to states with revenue
from the goods and services tax.• Reducing income tax rates by changing
tax brackets, causing marginal and aver-age income tax rates to decline for mostAustralians.In addition, in 1999 the government an-
nounced a range of changes to the business taxregime. These included:• Reducing the company tax rate from 36
percent to 30 percent.• Reducing the capital gains tax for indi-
viduals.• Improving venture capital and scrip-for-
scrip measures to assist startup and inno-vative enterprises.These reforms, which went into effect in
July 2000, have led to a broadly based tax sys-tem that provides a more competitive, robustfoundation in the face of increasing globalcompetition for investment (OECD 2000,January, pp. 121–25).
POLICIES TO SUPPORT INVESTMENTS IN
HUMAN CAPITAL
Australia’s efforts to promote human capital de-velopment are perhaps best seen in three keyareas: health care, education, and research and
18 AUSTRALIA
development. In addition, the governmentprovides a comprehensive social safety net.
Health care. Australia has a compulsory na-tional health care scheme, called Medicare, runby the federal government. This scheme, in-troduced in 1984, aims to provide all Aus-tralian residents with access to essential,high-quality health care, with priority based onclinical need. It provides rebates for a largeportion of general and specialist medical fees,as well as hospital care. Pharmaceutical drugsare also subsidized. (For a detailed discussionof the health care system, see OECD 1995,May, pp. 71–114, or http://www.health.gov.au).
Health care spending as a share of nationalincome is around the OECD average, and inrecent decades the health status of Australianshas improved significantly. The system promisesuniversal coverage through a blend of publicand private arrangements for the funding andprovision of medical services.
Education. While there is no central gov-ernment system of primary and secondaryeducation in Australia, there are few signifi-cant differences among state systems—andover the past decade in particular, state gov-ernments have worked to further standardizetheir systems. Education is compulsory be-tween the ages of 6 and 15, and about three-quarters of students complete grade 12, thefinal year of secondary education—twice theproportion of 1980. In addition to the pub-lic education system, there are numerous pri-vate (nongovernment) schools, trainingorganizations, and community educationproviders, which receive varying levels of gov-ernment funding (Australian Bureau of Sta-tistics 1999b). (For a detailed discussion of theeducation system, see OECD 1996, Decem-ber, pp. 130–57.)
Substantial changes have occurred in theAustralian system for post-compulsory edu-cation and training in response to the deteri-orating labor market prospects of low-skilledworkers and the need to improve the interna-tional competitiveness of Australian indus-tries. Australia’s tertiary education sectorcomprises universities, colleges of technicaland further education, and private and com-munity vocational education providers. In the
1980s tertiary institutions were encouragedto consolidate in an effort to increase effi-ciency. The number of universities was halved,student places increased by half, and totalspending rose considerably.
Universities were also expected to earnmore revenue from other sources, such as con-sulting, designated research, foreign studentspaying full fees, and commercial activities.The partial deregulation of the tertiary sectoropened up previously unexploited export mar-kets, as many universities looked to Asia insearch of fee-paying students. By 1993 a num-ber of universities were among Australia’s top500 export earners.
In addition, vocational training has beenreorganized to extend entry-level training to awider range of enterprises, in an effort to max-imize its workforce relevance and introducecompetition in its provision.
Research and development. Another policyinitiative aimed at capitalizing on Australia’sre-entry into the global arena involves re-search and development. The A$2.9 billionBacking Australia’s Ability program, an-nounced in 2001, aims to complement theachievement of fiscal responsibility and macro-economic and structural reforms, and to sup-port and encourage innovative activities. Theprogram has provided funding to encouragequality research and development and to up-grade university research facilities. Througha network of cooperative research centers,there is also a drive to link universities withbusinesses, enabling the commercializationof new technologies and developments (seehttp://www.itr.gov.au).
Social safety net. Australia has long had acomprehensive social safety net. Unemploy-ment benefits are funded from general taxrevenue rather than employment-based levies,and are paid at a flat rate intended to allevi-ate poverty rather than maintain previous in-come levels. Payments are targeted to peoplein need through the application of income andasset tests.
The retirement income system comprisesa publicly provided, means-tested old age pen-sion, mandatory private superannuation sav-ings, and voluntary savings (including
AUSTRALIA 19
voluntary superannuation savings). Australiahas had a publicly provided old age pensionsystem since 1908. It has retained its originalcharacter of a targeted benefit provided on thebasis of need, as determined by income andasset tests. Because it provides a basic standardof living to people most in need, rather thanmaintaining pre-retirement income, it remainsaffordable for the government. Indeed, theAustralian system is increasingly seen as amodel for other countries. World Bank (1994),for example, finds that the Australian modeloffers the best prospects for simultaneously im-proving national saving, ensuring intergen-erational equity, providing higher incomes inretirement, and being fiscally sustainable in anenvironment where the population is aging.
Retirement incomes above the level of thepublicly provided pension depend on self-provision. This includes mandatory savingsthrough the superannuation contributionscheme, introduced in the early 1990s, and vol-untary savings through superannuation and ac-cumulation of other assets such as the familyhome, other property, and investments.
Poverty rates (as measured against a rela-tive poverty line) have declined slightly overthe past two decades, from 14.6 percent ofAustralians in 1982 to 13.3 percent in 1999(for a description of poverty measures andrates, see Australian Bureau of Statistics2001b). Moreover, when taxes and transfersare taken into account, the living standards oflow-income earners increased substantiallybetween the early 1980s and mid-1990s—despite a slight widening in the pretax distri-bution of wages and earnings in the early1990s (figure 8). And though the Gini coef-ficient fluctuated somewhat during the inter-vening years, in both 1994–95 and 1997–98it was stable at 0.32 (Australian Bureau ofStatistics 2001b).
Unemployment, rather than low wages, isthe main cause of low income levels. Thus theimportance of lowering unemployment tolower poverty has contributed to successivegovernments’ strong emphasis on sound macro-economic and microeconomic reforms, to raiseAustralia’s growth potential and reduce un-employment.
SEQUENCING OF DOMESTIC REFORMS RELATIVE
TO MARKET OPENING REFORMS
Although reductions in protectionism com-menced in the 1970s and core financial sectorreforms were implemented relatively rapidly inthe 1980s, the broad range of reforms in otherareas was not carried out in a predeterminedsequence. As the Productivity Commission(1999b, p. 18) noted: “implementation of re-form over time was governed by a number ofcompeting factors:• there was some prior knowledge of major
policies that warranted reform;• new reform areas and priorities emerged
after some reforms were implemented andrevealed other structural weaknesses in theeconomy;
• industry protection in some industries waslocked-in for periods under long-termarrangements; and
• there were political pressures and socialconsiderations about the pace and directionof reforms.As a result, reform did not proceed accord-
ing to a predetermined blueprint or timetable …and although calls came from a number of quar-ters for a broad range of reforms to be imple-mented in close succession or in optimalsequence, reforms in Australia were implementedgradually, sequentially in a number of important
Figure 8. Gini coefficients for real equivalized household incomesin Australia, 1981–94
0.2
0.3
0.4
0.5
0.6
1993–941989–901985–861981–82
Source: Johnson, Manning, and others 1995.
Private household income
Disposable income
Final income
20 AUSTRALIA
respects, and in an order determined in part byopportunity and political judgement.”
INTERACTION BETWEEN MARKET OPENING
AND SOCIAL, LEGAL, AND ECONOMIC
INSTITUTIONS
Australia was fortunate that its basic social, legal,and economic institutions were well developedbefore the reforms of the 1970s–90s. Even so,reforms to industry structure and labor marketscan take decades to take effect, while financialsector changes can have effects very quickly. Thefinancial sector deregulation of the early to mid-1980s contributed to a deterioration in loanquality, several corporate collapses, and someforced mergers of minor banks. Had prudentialsupervision and corporate governance arrange-ments been reformed earlier in the process of re-globalization, those transitional costs might havebeen reduced. That said, the stresses that did arisewere dealt with quickly and without resort to un-necessary regulation.
General conclusions are hard to draw be-cause every country’s circumstances differ. Aus-tralia’s experience does not suggest that reformsshould wait for perfect sequencing accordingto some preconceived blueprint. Sometimes theopportunities for rapid reform must be seizedwhenever political circumstances allow. Butclearly, financial deregulation places particularweight on good financial data, good corporategovernance, and good prudential supervision.
ASSESSMENT: BENEFITS AND CHALLENGES OF
GLOBALIZATION
Though globalization offers many potential ben-efits, it also poses serious challenges. Successfulglobalization requires that both be carefully con-sidered. In addition, international institutionshave a role to play in facilitating reforms.
BENEFITS
Australia has received large and dramatic ben-efits from globalization. The reintegration ofthe Australian economy with the global econ-omy over the past 30 years has significantly im-proved economic performance, enhancing
living standards. After many years of reform,Australia has developed a vibrant, flexible,outward-looking economy that has proven re-silient to the shocks of the East Asian finan-cial crisis in the late 1990s and the currentglobal slowdown. By 2000 per capita GDP wasaround A$1,900—6 percent higher than ifAustralia had grown in the 1990s at the aver-age rate of the 1980s (Parkinson 2001).
Despite weak global economic conditions,the Australian economy strengthened in 2001.It also remained solid in the first half of 2002,with 3.8 percent annualized growth. In2001–02 Australia’s economy was among thestrongest in the industrial world.
CHALLENGES
At each stage of Australia’s reform process,change has led to vocal criticism—particularlyin areas such as reducing industry protection,decentralizing labor markets, and privatizingpublic enterprises, where changes were exten-sive, vested interests were strong, and payoffsfrom reform were not immediate.
There has been a tendency to take forgranted the higher incomes and improved eco-nomic performance of the past decade, and todissociate them from the policy changes thatmade them possible. There are also concernsthat traditional areas of employment have de-clined, that large parts of the labor force havesuffered losses, that there is more uncertaintyabout the future, that earnings differentialshave widened, and that successful Australiancompanies may in the future move offshore orotherwise reduce their links to Australia.
These concerns point to a need to betterexplain, to a wider audience, that:• Australia’s reglobalization has followed
from domestic reforms—not just frominternational trends—and has led to bet-ter living standards.
• Better policies have helped reduce thevolatility of GDP despite closer interna-tional economic integration and deregu-lated financial markets.
• Taxes and transfers have reduced the effecton inequality of the widening earningsdistribution.
AUSTRALIA 21
• Changing work patterns have been driven notjust by globalization, but also in response toextensive social changes such as higher femaleparticipation in the workforce and extendedperiods of study and retraining.
ROLE OF INTERNATIONAL INSTITUTIONS IN
FACILITATING REFORMS
International institutions have played a role inAustralia’s reform process by exposing policy-makers to other countries’ best policy practices(for example, through the International Mon-etary Fund’s article IV process and through gen-eral IMF and OECD analytical work). Peerreviews of Australian policies (through theOECD) and international chronicling of Aus-tralia’s relative economic performance havealso been beneficial.
NOTES
1. Smeeding (2002) reports a modest risein Australian income inequality over the past10 years. But the Australian Bureau of Statis-tics recently reported that there has been nosignificant change in income distributionacross income quintiles since 1994–95 (seehttp://www.abs.gov.au). Similarly, the Ginicoefficient has not changed significantly in thismore recent period.
2. Generally speaking, foreign investmentpolicy is nonrestrictive. But the treasurer doeshave legislative authority to veto or restrict in-vestment if it is “contrary to the national in-terest”. The government decides what iscontrary to the national interest based on theconcerns of the general public. Thus restrictionson foreign investment are stronger in sensitiveareas such as the media and developed resi-dential real estate. Regulation is governed bythe Foreign Acquisitions and Takeovers Act of1975 (see http://www.firb.gov.au).
REFERENCES
Australian Bureau of Statistics. 1999a. “De-velopments in Australian Exports: A Longer-term Perspective.” In Year Book Australia.[http://www.abs.gov.au].
———. 1999b. Schools Australia.[http://www.abs.gov.au].
———. 2000a. Australian System of Na-tional Accounts. Catalogue No. 5204.0.[http://www.abs.gov.au].
———. 2000b. Balance of Payments Aus-tralia. Catalogue No. 5338.0. [http://www.abs.gov.au].
———. 2001a. Australian National Ac-counts. Catalogue No. 5206.0. [http://www.abs.gov.au].
———. 2001b. Australian Social Trends.Catalogue No. 4120. [http://www.abs.gov.au].
———. 2001c. Labour Force, Australia.Catalogue No. 6202.0. [http://www.abs.gov.au].
———. 2002. Balance of Payments and In-ternational Investment Position. Catalogue No.5302.0. [http://www.abs.gov.au].
Andersen and Garnaut. 1987. AustralianProtectionism. Sydney: Allen & Unwin.
Catley, Bob. 1996. Globalising Australia’sCapitalism. Melbourne: Cambridge Univer-sity Press.
Caves, Richard. 1984. The Australian Econ-omy: A View from the North. Sydney: Allen &Unwin.
Evans, Edward. 1999. “Economic Nation-alism and Performance: Australia from the 1960sto the 1990s.” Ninth Colin Clarke MemorialLecture, June. [http://www.treasury.gov.au].
Higgins, C. 1989. “Colin Clarke: An In-terview.” Economic Record 65: 303–05.
Johnson, David, Ivan Manning, and others.1995. Trends in the Distribution of Cash Incomeand Non-Cash Benefits. Report to the Depart-ment of Prime Minister and Cabinet. NationalInstitute of Economic and Industry Research.
Jones, E. Lionel. 1993. Coming Full Cir-cle: An Economic History of the Pacific Rim.Melbourne: Oxford University Press.
Kelly, Paul. 1992. The End of Certainty: TheStory of the 1980s. Sydney: Allen & Unwin.
———. 2000. Paradise Divided: TheChanges, the Challenges, the Choices for Australia.Sydney: Allen and Unwin.
OECD (Organisation for Economic Co-operation and Development). Various.OECD Economic Survey of Australia.[http://www.oecd.org].
22 AUSTRALIA
Parkinson, Martin. 2001. “Measuring theImpact of a Global Economy on AustralianBusiness.” Address to the Australian FinancialReview CFO Summit, June. [http://www.trea-sury.gov.au].
Productivity Commission. 1999a. Impactof Competition Policy Reform on Rural and Re-gional Australia. [http://www.pc.gov.au].
———. 1999b. Microeconomic Reformsand Australian Productivity: Exploring the Links.[http://www.pc.gov.au].
Simon, John. 2001. The Decline in Australian
Output Volatility. Research Discussion Paper2001-01. Reserve Bank of Australia. [http://www.rba.gov.au].
Smeeding, Tim. 2002. “Globalisation, In-equality and the Rich Countries of the G-20: Evidence from the Luxembourg IncomeStudy.” Paper presented at the G-20 workshop,Sydney. [http://www.rba.gov.au/PublicationsAndResearch/Conferences/2002/smeeding.pdf].
World Bank. 1994. Averting the Old Age Crisis. Washington, D.C. [http://www.worldbank.org].
BRAZIL 23
Preparing Brazil for competing in the globaleconomy has been one of the major objectivesof economic policy. But it has not been the onlyone—indeed, it has not been the most impor-tant one. In a country with low social indicators,most of them related to unequal income distri-bution, the main target of economic policy is toachieve sustained growth leading to a higher percapita product and better distribution of in-come. So several measures have been aimed atinternal goals, even though they may have con-currently fostered the Brazilian competitive pres-ence at the international level. Inflation, fiscalbalance, and flexible exchange rate, for instance,may be listed under this category, side by side withsocial policies that sharply reduced infant mor-tality and illiteracy and increased life expectancy.In some areas (education and infant mortality,for instance), Brazil has reached targets set by theMillennium Development Goals. But in otherareas (such as health) much remains to be done.
Recent policymaking has given Brazil astable and predictable fiscal and monetaryframework. Some of the main results:• Inflation has been brought down from
three digits (even four digits) to less than10 percent. With rigorous control of pub-lic expenditures and increased tax collec-tion, along with innovative legislationaiming at fiscal accountability, Brazil has en-joyed 18 quarters of primary surplus in arow, currently around 4.5 percent of GDP.
• Average economic growth from 1995 to2000, at about 2.9 percent of GDP, washigher than the 0.6 percent in the six previ-ous years. It then reached 4.6 percent in2002, but fell to 1.5 percent in 2001. For2003 growth is estimated at 2.0 percent.
• Exports and imports in GDP reached only18.8 percent in 2001; even though this is
the highest level since 1985, the share oftrade in GDP has been historically low—around 13–14 percent, with exports usu-ally below 10 percent and imports below7 percent.
• Average tariffs fell from 51 percent in 1988to 11.7 percent in January 2002.
• The trade balance evolved from a deficit of$6.6 billion in 1998 to a surplus of $17 bil-lion in the last twelve months ending April2003.
• Foreign direct investment amounted to$24.7 billion in 2001, covering the deficitin current account of $23.21, and to $143billion for 1995–2001.
• Net external debt was $163 billion in2001, half of it private, with no short-term public debt.Economic measures implemented within
the stabilization plan fostered Brazil’s com-petitive presence in international markets,providing economic gains to the Brazilianpeople. Macroeconomic measures weremarked by credibility and consistency, greatlyenhancing transparency and strengtheninginstitutional structures. And policies to addressproblems of income disparities have becomemore effective.
But globalization has not induced consis-tent growth of real GDP per capita over time,at the same pace as growth in foreign trade (de-spite lower tariffs). Nor has it increased the shareof manufactured goods in total exports, eventhough exports of manufactured goods have in-creased both in volume and in amount. Glob-alization may have contributed to a higherdependence on volatile short-term capital(ranging from minus $400 million to plus$54 billion during 1989–2001) and to higherunemployment (which has risen in years of
Brazil
24 BRAZIL
higher participation of foreign trade in theGDP). And it may even have led to a more per-verse concentration of income (the Gini indexrose from 59.6 in 1990 to 60.9 in 2000).
LIBERALIZING TRADE FLOWS
The rationale for trade openness in Brazil hasbeen to optimize production and to maximizebenefits of returns to scale and scope. Recentimprovements in global transportation andcommunication, associated with technologicalchange and market opening, broadened the di-vision of labor and fostered competition. InBrazil, newly found competition has ensuredthat benefits of increased efficiency be passedon to consumers, in the form of both lowerprices and higher quality. The reduction oftariffs over the last 15 years has played an im-portant role in the process.
Important changes were introduced in Brazil’sindustrial development policy in the late 1980s.To make Brazilian industry competitive and toconvert tariffs into an industrial development pol-icy instrument, several reforms were introducedto the Brazilian tariff structure in July 1988. Asa result of those reforms, the average rate of im-port tax on overall imports was reduced from 51percent on June 30 1988 to 41 percent on July1, 1988, with the peak tariff reduced from 105percent to 85 percent. Despite the sharp reduc-tion, Brazilian imports remained at the samelevel, due to the maintenance of high import taxrates and the maintenance of other barriers.
Starting in 1990, deeper reforms were in-troduced, such as the elimination of all restric-tions to processed and semi-processed importgoods and the further reduction of tariffs. In theaftermath of those reforms, the average tariff de-creased from 32.2 percent in 1990 to 25.3 per-cent in 1991, 16.5 percent in 1992, and to14.3 percent from July 1, 1993 to December 31,1994. The peak was reduced from 85 percentin 1991 to 55 percent in 1992 and to 40 per-cent from July 1, 1993 to December 31, 1994.
Mercosul’s Common External Tariff (CET)contributed to further reductions of Braziliantariffs. The average tariff decreased to 12.6 per-cent in January 1995, followed by further de-creases in October 1995 (to 11.2 percent) and
in January 1996, remaining at 11.1 percentuntil November 1997. In that month, Decreeno. 2,376/97 imposed a linear increase of 3 per-cent on all tariffs, which raised the average to13.8 percent. From January 1995 to Novem-ber 1997, the tariffs ranged from 0 percent to20 percent. From November 1997 to Decem-ber 2000, the tariff structure remained un-touched, even though a few items were addedto the list. During this period, the average re-mained at 13.8 percent, the modal tariff at 17percent, and the median tariff fluctuated be-tween 15 percent and 17 percent.
On January 1, 2001, Decree no. 3,704came into force, introducing changes in theCET in order to deduct 0.5 percent from the3 percent that had been added in November1997. As a result, the average tariff was re-duced to 12.9 percent, the amplitude rangedfrom 0 percent to 22.5 percent, and the modaltariff decreased to 4.5 percent and the me-dian to 14 percent. But the reduction wasshort-lived. In March 2001, changes intro-duced in the automobile regime of MERCO-SUL (Resolution CAMEX no. 7, dated March22, 2001) increased the CET to 35 percent forthe import of vehicles listed under Chapter 87of Mercosul’s Common Nomenclature. Sothose products were excluded from the list ofexceptions, and the amplitude was enlargedfrom 0 percent to 35 percent. Even though themodal and median tariffs remained at the samelevel as in 1997 (4.5 percent and 14 percent),the average tariff increased to 13 percent. OnJanuary 1, 2002, the new CET entered inforce and Resolution CAMEX no. 42, datedDecember 26, 2001, not only transferred tar-iffs to the Harmonized System of 2002 but alsodeducted an additional 1.5 percent from the3 percent that had been added in November1997. As of January 1, 2002, the CET covers9,623 items with an amplitude ranging from0 percent to 35 percent and an average tariffof 11.7 percent.
The average, median and modal tariffsmentioned above do not take into considera-tion the 974 items included in the exceptionlist (557 in medicines and drugs, 317 in com-puter and telecommunication goods, and 100in miscellaneous goods).
BRAZIL 25
With the multilateral negotiations underGATT’s Uruguay Round, Brazil committednot to impose tariffs on industrialized goodshigher than 35 percent ad valorem from Janu-ary 1, 1999 onwards. From January 1, 1995 toJanuary 1, 1999, tariffs in effect in 1986 (whenthe Uruguay Round was launched) had to begradually reduced, in equal installments, to theceiling of 35 percent. In this way, for a given in-dustrialized good, such as passenger cars (tariffof 105 percent in 1986), Brazil committed notto increase tariffs above the following ceilings:91 percent in 1995, 77 percent in 1996, 63 per-cent in 1997, 49 percent in 1998, and 35 per-cent in 1999. For goods protected by tariffsbelow or equal to 35 percent at the time nego-tiations were engaged within Uruguay Round,not included in the former list of concessionsin GATT, the consolidation of 35 percent en-tered in force automatically as of January 1,1995. Tariffs below 35 percent included in theformer list of concessions had been preserved.
For agribusiness, the Agriculture Agreementnegotiated in the Uruguay Round led to the con-solidation and reduction of all tariffs over theimplementation period. To do so, all nontariffbarriers were converted into tariffs. For devel-oping countries, reductions were at least 24percent on average over a period of ten years.Brazil consolidated a ceiling of 55 percent foragriculture products (today, a tariff of this mag-nitude is imposed only on rice and processedpeaches).
The initiative of opening the Brazilianmarket to trade was aimed at improving the ef-ficiency of the industry, by exposing its differentsegments to external competition. This policywas supported by measures to modernize Brazil-ian industry, such as the temporary reductionof tariffs imposed on machinery, equipment,and spare parts.
Both and progressive reduction of tariffsand the elimination of other instruments tolimit imports led to the use of other resourcesauthorized by the GATT/WTO to protectBrazilian companies. Since 1991 Brazil has ef-fectively used anti-dumping and compensatorymeasures, by promoting several processes of in-vestigation on anti-dumping and illegal sub-sidies measures practiced by its trade partners.
STRENGTHENING THE FINANCIAL SYSTEM
The globalization in trade has been a gradualprocess through the mechanism of economicblocs. But the financial sector can already beviewed as a global village, with currency aglobal commodity. According to estimates,$11 trillion are flowing unendingly from onecorner of the globe to another in search ofhigher profits, no matter the language.
Globalization has reached deeply in theBrazil, which has the largest and probably themost complex financial system in Latin Amer-ica, a system that has developed in the contextof high inflation over the past 30 years. The in-stitutional reforms and important legal andnormative changes in this period were largelygenerated by efforts to combat inflation. Thelong period of coexistence with inflation pro-duced a situation in which the gains generatedby noninterest bearing liabilities, such as demanddeposits and deposits in transit, compensated foradministrative inefficiencies and even for thegranting of credits of doubtful return.
With the new price stability in Brazil aftermany failed attempts, the adjustments requiredfor survival in the global economic environmentwere beyond the capacity of Brazilian financialinstitutions. In a universe of 265 banks, withmore than 16,000 branches and 11,000 serviceoutlets, many institutions have gone under, gen-erating enormous financial and social costs.
The Brazilian government is fully awarethat the most valued asset of the banking in-dustry is its credibility. A run on the banks canresult from a loss of credibility at just a few in-stitutions. Such an event would have a dominoeffect, generating grave problems for all banksand even for productive sectors of the economy.But solutions based on such special mecha-nisms as intervention, liquidation and tempo-rary administration as permitted by legislationhave a social cost that is much higher thanmeasures taken beforehand with the aim oftransferring control of the institutions to moreefficient hands.
The steps in Provisional Measure no. 1,179and Resolution no. 2,208, both of which wereissued on November 3, 1995, introduced theProgram of Incentives to the Restructuring
26 BRAZIL
and Strengthening of the National FinancialSystem (Proer) to mandate bank mergers andincorporations, based on rules set down bythe Central Bank. This system, which fol-lowed closely upon the crisis involving theBanco Económico—the 22nd bank to be sub-jected to intervention/liquidation since im-plementation of the Real Plan in 1994—wasviewed as a means of resolving problems be-fore they appeared and facilitating the processof National Financial System adjustment. WithProer, society’s investments and savings areguaranteed. National Monetary Council Res-olutions no. 2,197, dated August 31, 1995, andno. 2,211, dated November 16, 1995, intro-duced unconditional adherence to the depos-itor protection mechanism, thus avoiding thepossibility of localized future problems affect-ing the entire system and society.
Provisional Measure no. 1,182, issued onNovember 17, 1995, just two weeks after issueof Provisional Measure no. 1,179, gave the Cen-tral Bank the legal instruments that it neededto lead the financial system to a new model. Au-thority was granted to the Central Bank tomaintain only healthy financial institutionswith the necessary liquidity and solidity. Con-sequently, even though the responsibilities of theCentral Bank were significantly expanded, theinstitution was finally given the instrumentsrequired to overhaul the entire system. Withthese new instruments, the Central Bank couldact preventively and with much greater effi-ciency. What the Bank was able only to suggestin the past, it can now mandate.
In ten articles, Provisional Measure no.1,182 creates the concept of the individual re-sponsibility of controllers—applicable also tofinancial institutions submitted to interven-tion or extrajudicial liquidation. This conceptalready existed in the Temporary System ofSpecial Administration. Parallel to this, it ex-tended the concept of the inalienability ofproperty to controlling stockholders and facil-itated federal government expropriation of thestocks of institutions in difficult situations forpurposes of future privatization. Propertiesconsidered by law as inalienable or not subjectto lien are excluded from the concept of in-alienability. Among them are stocks held by state
governments, labor debts, and balances in theEmployment Guaranty Fund.
If a situation of equity or financial insuf-ficiency is found, the Central Bank can re-quire capitalization of the financial institutionin an amount deemed necessary for its recov-ery, transfer of stock control, merger, incor-poration, or split-up. If the Central Bank’sdemands are not complied with in the prede-termined time period, the monetary authoritycan decree the special system judged to besuitable to the specific situation at hand (Tem-porary System of Special Administration, in-tervention or extrajudicial liquidation).
In cases of intervention, extrajudicial liq-uidation, or the temporary system of special ad-ministration, the Provisional Measure grants theCentral Bank autonomy to authorize the in-tervening party, liquidator, or board of direc-tors to transfer or assign properties and rightsto third parties—and to transfer rights andobligations to another company and even toproceed to the stock reorganization of the in-stitution.
When it initiates administrative proceed-ings against a financial institution, the CentralBank can—for precautionary purposes—remove anyone under indictment until the in-vestigation of responsibilities is concluded. Itcan also impede indicted administrators fromassuming positions of authority or managementin financial companies in general. Moreover,the Central Bank can impose restrictions on theactivities of these institutions. For example, ifit uncovers irregularities in foreign exchange op-erations, it can forbid the bank from operat-ing in foreign exchange. If the administrativeproceedings cannot be concluded within 120days, any precautionary measures that mayhave been taken lose their validity.
The federal government may expropriatethe shares of banks subject to the TemporarySystem of Special Administration. In eachcase, the expropriation decree specifies thetime period for the transfer of stock control.The shares will be placed in public offer,with the explicit condition that the institu-tion will remain within the private sector, thuseliminating any possibility of federalizationof the bank in question. Even when the
BRAZIL 27
process of intervention has come to an end,the Central Bank will still have authority toverify the existence of any irregularities thatmay have been committed by the controllersof the institution. There is also the possibilityof choosing another bank (or other legal en-tity) to carry out this task.
Today, the specter of a bank crisis in Brazilis no longer the major concern of economic au-thorities. The efforts made to strengthen thenational financial system are of such importancethat their success is the key to guarantying thesuccess of the Real Plan. After all, the banks areelements of fundamental importance to sus-tained economic growth, the Real Plan’s over-riding goal.
In the opinion of the professionals and ex-ecutives who now operate on the financialmarket, the new financial system will be sub-divided into three distinct markets: retail(with few and very large institutions), in-vestment (with few and highly agile institu-tions), and specialized (in vehicle sales, forinstance). Current opinion is that the num-ber of institutions will diminish, while the sizeof the system will increase—since it will haveto accompany the process of economic growthand, therefore, will have to provide bankingservices to a larger array of people and busi-nesses. Also by way of prediction, it is possi-ble that the entire financial system will havebeen restructured by the coming decade.Aside from the mergers, incorporations, andreductions in the number of banks, there willbe a totally new reality in the area of services:cheaper credit for the population.
By means of credit lines, the Central Bankwould promote mergers, incorporations, andtransfers of stock control as a means of pre-venting problems before they occur in theBrazilian banking system. For this, the Cen-tral Bank has been given new instruments toprevent situations of risk. These measures in-clude punishing and removing administra-tors and controllers of financial institutions.The idea behind Proer is to generate the leastpossible cost for the Treasury and for society,while preserving the interests of depositors.The program also involves a deposit insurancesystem up to a level of R$20,000, thus covering
95 percent of the universe of depositors, pre-cisely those who have less access to informa-tion on financial institutions. In this way,these people will be protected in cases of in-tervention or liquidation.
UNCERTAIN BENEFITS FROM GLOBALIZATION
Globalization has had an ambiguous impact onthe Brazilian economy. Data indicate thatBrazil’s insertion into the global economy hasnot induced growth of real GDP per capita.Nor has it increased the participation of man-ufactured goods in total exports. But it mayhave contributed to a higher dependence onvolatile short-term capital, to higher unem-ployment rates, and to an even more perverseconcentration of income.
Some social indicators have improved no-ticeably in the last decade: The infant mortalityrate is down from 43.0 per 1,000 live births in1992 to 29.6 in 2000. Life expectancy at birthis up from 66 years in 1992 to 68.6 in 2000.The adult illiteracy rate is down from 17.2percent in 1992 to 13.3 percent in 2000—andin rural areas from 35.8 percent to 29.0 per-cent. But other economic and social indicatorshave not been helped by globalization or by theinsertion of Brazil into the global economy.
Analysts may affirm that Brazil’s externalopenness was hurt by the overvaluation of thereal from 1994 to early 1999. Even though theshare of imports and exports in GDP (as an in-dicator of trade openness) increased from 14 per-cent to 19 percent in 1999–2001—that is, afterthe devaluation of the real—it remained stablefrom 1987 to 1998, ranging from 11 percentto 16 percent. The fact is that the participationof foreign trade in the Brazilian GDP has notrisen significantly, from 1987 to 2001, despitea sharp fall in average tariff from 51 percent to13 percent. Data suggest that foreign exchangefluctuations may have had a more significant im-pact on trade openness than reduced tariffs.Contrary to the results in other countries (Mex-ico, Chile, China, the Republic of Korea, tomention a few), the Brazilian real GDP percapita has not increased consistently in stepwith growth in foreign trade (figure 1). Eithersuch a relation is not verifiable or Brazil has not
28 BRAZIL
been sufficiently exposed to the globalizationprocess to benefit from its advantages.
One might expect that increased opennesswould entail more participation of manufac-tured goods exports in total exports. Brazil isamong the 10 largest economies in the worldand has the largest industry in Latin America.As a result of lower tariffs, a flexible exchangerate, and increased productivity, it would be ex-pected to have exports of manufactured goodsrise in relation to GDP. Instead, that share intotal exports has remained stable over the last75 months, at around 55 percent (figure 2).
A negative aspect of financial liberalizationis the high volatility of foreign investment in
portfolio, and Brazil is no exception. Givensteep variations in the exchange and interestrates, foreign investment in portfolio rangedfrom minus $400 million to plus $54 billionduring 1989–2001 (figure 3).
Social implications may also be pointed out.Globalization is too recent a phenomenon toestablish a correlation between trade opennessand unemployment in Brazil. The unemploy-ment rate has risen in recent years, especiallyin years of higher participation of foreign tradein the GDP (figure 4). But as it is a relativelyclosed economy it is not clear that increasedopenness led to higher unemployment in Brazil.Many other factors may have contributed tounemployment, most of them deriving fromstabilization. But the fact that unemploymenthas not decreased deserves attention when-ever the impact of globalization on the Brazil-ian economy is examined.
Apparently globalization has not mitigatedthe perverse concentration of income in Brazil.In 1992 the average income of the 10 percentrichest people represented 57 times the aver-age income of the 10 percent poorest (and 21times the average income of the 40 percentpoorest), and in 1999, 53 times and 22 times,respectively.
CONCLUSION
Brazil has gained some of the benefits associatedwith globalization. It currently enjoys more ac-cess to capital, better technology, greater choicesof goods, larger markets and economies of scale,and more efficient allocation of resources. Butthe data suggest that globalization has not con-tributed to higher growth and income per capita.Nor has it reduced inequality (regional and so-cial) and economic insecurity (volatility in fi-nancial markets and economic activity).
The Brazilian experience suggests fourmajor lessons of general applicability in the in-ternational community.
First is the importance of macroeconomicpolicymaking characterized by credibility andconsistency, with greater transparency andstronger institutional structures—to insulatethe country from external shocks. In Brazil,this policymaking greatly reduced the impact
10
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Figure 1. Uncertain benefits from openness
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Figure 2. Participation in total exports
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BRAZIL 29
of external shocks. The adoption of an inflationtarget, the fiscal balance obtained through theimplementation of innovative legislation, andthe flexible exchange rate preserved the gains at-tained by stabilization, structural reforms, andstrong and effective regulatory framework forfinancial and capital markets. Transparencywas stimulated by enacting laws and by pub-lishing verifiable data, such as the statistics dis-seminated through IMF’s Special DataDissemination Standard (SDDS).
Second is the necessity of focus on socialpolicies aimed at both reducing income dis-parities and improving labor market flexibil-ity. Such a focus serves three purposessimultaneously, all converging to higher incomeper capita and a better distribution of income.It increases productivity by accumulating the“human capital”—that is, investments in ed-ucation and skills. It also reduces income dis-parities, enlarging the internal market andproviding gains of scope and scale to help do-mestic companies reduce costs and becomemore competitive overseas. And it combines so-cial policies with flexible labor markets to pro-tect workers from changes in externalconsumption patterns and help minimize eco-nomic fluctuations, both regional and sec-toral. There is still much to do in improvingsocial indicators and making labor marketsmore flexible. But recent dramatic improve-ments demonstrate that the country can becompetitive in high-technology exports, suchas airplanes, by relying on its human resources.
Third, external liberalization in an envi-ronment of uncertainty may lead to only par-tial gains from competing more in the globaleconomy. In Brazil, interdependence can befound in financial and capital flows, but traderelations are still less than they might be, giventhe magnitude of the economy. Limited exportsaffect domestic companies both on the supplyside (due to the limited inflow of hard currencyto pay for imports of equipment and raw ma-terial) and on the demand side (circumscribingtheir reach to the domestic market). By doingso, it prevents them from obtaining gains of scaleand scope on international markets. Brazil is notcomparable with the Republic of Korea, Mex-ico, Chile, or China, where one can find a
strong correlation between trade openness andincreased real GDP per capita.
Fourth, the Brazilian experience stresses theimportance of structural reforms to attract FDI—to finance current account deficits and, above all,to complement internal savings to financegrowth. This highlights the paramount impor-tance of the state in running the process and insetting out a regulatory and supervision frame-work to ensure gains for the population. Struc-tural reforms and privatization have not lessenedthe size of the state. But they changed from anentrepreneurial state to a managerial one. Thischange inaugurates a more flexible state and re-leases resources to be invested in social policies.
–10
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Figure 3. Net foreign investment in portfolio
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Figure 4. Uncertain relation between unemployment and trade openness
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30 BRAZIL
REFERENCES
Brazil, Ministry of External Relations.[www.mre.gov.br/cdbrasil/itamaraty/web/ ingles/relext/mre/orgreg/mercom/index.htm]
Brazil, Presidents’ Office. “7 Years The RealPlan—Stability, Growth and Social Develop-ment.” [www.presidencia.gov.br/publi_04/7anos-esp.htm]
Brazilian Institute of Geography and Sta-tistics. [www.ibge.gov.br]
Central Bank of Brazil. “PROER—Pro-gram of Incentives to the Restructuring andStrengthening of the National Financial Sys-tem.” [www.bcb.gov.br/ingles/himf1602.shtm]
Freitas, Carlos Eduardo de. “Recent De-velopments in the Brazilian SupervisoryFramework – Consolidated Supervision inBrazil.” Paper prepared jointly by the
Supervision Directorate and the PublicFinance and Special Regimes Directorate for presentation at the Annual Washing-ton Conference of the Institute of Inter-national Bankers, March 5, 2001, Washing-ton, D.C. [www.bcb.gov.br/ingles/public/recdevsupfram.pdf ]
International Monetary Fund. Interna-tional Finance Statistics. Washington, D.C.
National Bank for Economic and SocialDevelopment. [www.bndes.gov.br/english/priv.htm]
Sales, Adriana Soares. “The Brazilian Pay-ment System—Current Design and Future Out-look.” Central Bank of Brazil. [www.bcb.gov.br/htms/public/notastecnicas/2002nt17braziliancurrentpaymentsystemi.pdf ]
World Bank. “Globalization and the G20:Selected Indicators.” Washington, D.C.
CANADA 31
International markets for goods, services, andcapital have been of critical importance to theCanadian economy throughout its history. For-eign countries represent key markets for Cana-dian production and sources of capital neededto finance growth and development. An edu-cated and productive labor force, stable andwell-developed political and legal systems andinstitutions, and access to domestic natural re-sources and to the nearby U.S. market havecontributed to Canada’s prosperity. In addi-tion, Canada shared in the general expansion ofglobal trade and investment in the decades fol-lowing the World War II. Solid economic growthprovided the means to finance social programsthat both reinforced economic performanceand provided a high degree of social protection.
Over the last century, changes in the globaleconomy, in particular the steady integrationof international financial markets and the in-creasing competitiveness and pace of change inworld markets for goods and services, posed sig-nificant challenges for Canadian economicand social policy. They also created new op-portunities. Although part of a process underway through much of the postwar period, thistrend towards globalization, and the associatedneed for a policy response, accelerated in thelast quarter of the 20th century, especiallysince the mid-1980s.
This case study looks at Canada’s experi-ence in three areas, with particular emphasison the period since the mid-1980s. • Market-opening measures, which allowed
Canada to expand and consolidate its long-standing orientation toward world markets.
• The interaction between domestic macro-economic, structural, and social policiesand the increasingly globalized interna-tional environment.
• The impact of these policy directions incontributing to strong and equitable eco-nomic growth and the role of Canada’smembership in certain key international in-stitutions in helping create and sustainsupport for domestic policies in these andother areas.
CANADA’S EXTERNAL ORIENTATION IN
HISTORICAL PERSPECTIVE
EXTERNAL TRADE
Orientation toward global commerce has beenof crucial importance to the Canadian economysince long before the country’s independence.The first permanent European settlements inwhat is now Canada were land bases for fish-ing fleets attracted by the abundant fish stocksof Canada’s east coast. Later, the wealth fromthe fur trade and timber-cutting became a keyfactor motivating European exploration of theinterior of the continent, which in turn createdthe foundation for later settlement and agri-cultural and urban development.
In the 19th century, recognition that tradecontributes to higher living standards wasstrong among the British colonies that wouldlater unite to form Canada. This was manifestin the establishment of free trade policiesamong these colonies, and a “reciprocity” (bi-lateral trade) arrangement with the UnitedStates established in 1854. The termination ofthis arrangement by the United States in 1866was arguably an important factor behindCanada’s Confederation in 1867. Lack of suc-cess in re-establishing this arrangement—combined with an economic depression in the1870—accentuated protectionist sentimentsand led Canada in 1879 to establish a regime
Canada
32 CANADA
of tariff protection known as the “National Pol-icy” (Masters 1963). As in other countries,protectionism gained strength amid the des-peration in the Great Depression of the 1930s,notwithstanding the continuation of prefer-ential trading arrangements within the BritishEmpire, and later the Commonwealth.
The period after World War II can thus beviewed as one in which Canada gradually re-versed its protectionist policies through mul-tilateral trade liberalization under the auspicesof the GATT. As the postwar period pro-gressed, and multilateral trade liberalizationbegan in earnest with the establishment of theGATT in 1947, the focus shifted toward re-ducing tariffs on manufactured goods. Thenatural pull of north-south economic forces alsoled to various bilateral trade arrangements withthe United States in particular sectors, most no-tably in autos through the Auto Pact.
INTEGRATION WITH INTERNATIONAL CAPITAL
MARKETS
Access to global capital markets has also playedan important role throughout Canada’s eco-nomic history, providing the capital to financeinvestment in key sectors. Capital inflows werevery important in the late 19th and early 20thcenturies. Like other countries then on theperiphery of the industrialized world, Canadaborrowed externally to finance essential infra-structure investment. The flows during this“first period of globalization”, sizable relativeto those today, would from a modern per-spective be a source of concern.
Openness to international capital flows, inthe form of both foreign direct and portfolio in-vestment, remained a key feature of the Cana-dian economy in the postwar period. Whilecapital controls became common across manyindustrial countries, Canada maintained a ba-sically open capital account, reflecting the con-tinuing importance of external capital to thefinancing of domestic investment. Canada’s de-cision to eschew major restrictions on capital ac-count transactions was unusual in the BrettonWoods period. Indeed, the consensus during thisperiod, on which today’s international archi-tecture is based, was that the dynamics of
international capital markets sometimes con-tributed to domestic and external monetary in-stability. Exchange rate instability, viewed asinhibiting growth in international trade, was par-ticularly problematic. The policy choice ex-plicit in the Bretton Woods architecture was tocreate the conditions for an expansion of worldtrade and related payments by reducing move-ments in exchange rates, in an environment oflimited capital mobility.
With the benefit of hindsight, a contem-porary observer might interpret the policychoices in this period as part of the “impossi-ble trinity” of international finance. Any coun-try can maintain at most two of the followingthree policies: an open capital account, an in-dependent monetary policy, and a fixed ex-change rate. A key rationale for the BrettonWoods system was to permit countries to main-tain fixed exchange rates, to permit the or-derly expansion of trade. The capital controlsin place in many countries allowed them tomaintain fixed exchange rates without sacri-ficing their ability to pursue a monetary pol-icy geared to domestic stabilization.
Canada’s policy choices in much of theBretton Woods period implied a different setof preferences, as the country operated a flex-ible exchange rate arrangement from 1950–62in the context of an open capital account andan autonomous monetary policy. This mix ofpolicies was a response to some circumstancesof the Canadian economy. First, Canada’s de-cision to maintain flexible exchange ratesthrough most of the postwar period reflects inpart the continued importance of commodityexports—and a recognition of the role of flex-ible rates in helping to provide a cushionagainst the terms of trade shocks associated withcommodity price movements.
Second, Canada’s long and generally unin-terrupted history of integration with globalcapital markets, especially during times in whichcapital controls were commonplace in many in-dustrial countries, illustrates the authorities’recognition that access to foreign capital con-tributes to investment and growth. Not onlyhave open capital markets provided foreignsavings to finance domestic investment, butthey also promoted access to external business
CANADA 33
and financial expertise and other benefits. It isalso well known, however, that international fi-nancial market integration can pose seriousrisks to macroeconomic stability if domestic fi-nancial markets are underdeveloped and do-mestic financial institutions are poorly managed,capitalized, regulated, and supervised.
The long history of stability of Canada’s fi-nancial sector, in an environment of open cap-ital markets, reflects in large measure thestrength of Canada’s financial sector policies,both regarding the regulation and supervisionof financial institutions and the efforts to de-velop sophisticated domestic capital markets.Just as access to foreign capital is important toaugment the supply of available resources forinvestment, deep domestic capital markets arenecessary to provide appropriate options for do-mestic borrowers to fund themselves in localcurrency and at longer maturities. Canada hashad a well-established bond market for manydecades. But, a money market—essential formeeting the demand for short-term domestic-currency-denominated funds, for the effectiveoperation of monetary policy, and for the pru-dent management of the public debt—wasvirtually nonexistent until the 1950s.
MARKET-OPENING REFORMS
LIBERALIZING CONTROLS ON DOMESTIC
MARKETS FOR GOODS, SERVICES, AND CAPITAL
Despite steady progress through multilateraltrade liberalization in the decades followingWorld War II, the manufacturing sector (withthe exception of such areas as the auto indus-try, which through a special arrangement wasalready highly integrated with the U.S. mar-ket) entered the 1980s still exhibiting ineffi-ciencies associated with short production runsand slow uptake of new technology and in-novation. Indeed, by the late 1980s, it was rec-ognized that inefficient domestic production—resulting in part from still inadequate open-ness to international trade in certain key sec-tors, despite several rounds of multilateraltrade liberalization, together with the possi-ble loss of access to the U.S. market—was pos-ing a threat to the standards of living of
Canadians and to the country’s capacity to sus-tain high levels of social protection.
It was in this environment that the gov-ernment began to pursue a vigorous agenda ofbilateral and multilateral trade liberalization,beginning in 1989 with a Free Trade Agreement(FTA) with the United States. This agreementwas expanded in 1994 to include Mexico underthe North American Free Trade Agreement(NAFTA). Bilateral negotiations with othercountries have also been concluded or arebeing pursued. Multilateral trade liberaliza-tion initiatives include a new round of WTOnegotiations and the creation of a Free TradeArea of the Americas (FTAA).
Parallel to trade liberalization efforts, theenvironment for foreign direct investment(FDI) was also significantly liberalized. In-vestment has played an important role in link-ing Canada to the world economy, where thegrowth of global FDI exceeds that of globaltrade or production. Historically, Canada hasrelied significantly on foreign investment forits economic development. Today the stock ofFDI in Canada represents approximately 26percent of GDP, up from 18.5 percent in 1985.The performance of foreign-owned firms hasbeen a key factor sustaining economic growth,generating substantial research and develop-ment activities, productivity gains, and a strongexport orientation.
A significant shift towards a more openattitude on FDI occurred in 1985 with the pas-sage of the Investment Canada Act (ICA).Most important, the ICA allowed notificationto replace reviews for nonresident investmentor acquisitions of Canadian businesses with as-sets less than $5 million. FDI policy was fur-ther liberalized with the Canada–U.S. FTA,NAFTA, and the GATS. In 1992 certain re-strictions were removed on foreign ownershipin the oil and gas sector.
DOMESTIC ECONOMIC POLICY REFORMS
STABILITY-ORIENTED MONETARY POLICY
Like many other industrial countries, Canada ex-perienced high inflation through the 1970s,with a second less intense, but still pronounced
34 CANADA
inflationary episode at the end of the 1980s. Aprotracted period of tight monetary policy—leading to recession and substantial excess capacityand high unemployment—was required in bothinstances to reduce inflation and break en-trenched inflation expectations. By the early1990s inflation and inflation expectations hadbeen “ratcheted down” to the lowest levels seenin a generation. To consolidate this performanceand to provide an anchor for monetary policyand inflation expectations, the government andthe bank of Canada announced targets for in-flation control in 1991. These targets, renewedon several occasions, have provided a solid andcredible basis for monetary policy in Canada.
ACHIEVING SOUND PUBLIC FINANCES
Addressing the fiscal situation faced by Canadain the early-1990s proved more difficult. Sincethe mid-1970s, fiscal deficits at all levels of gov-ernment had been on the rise. This trend wasnot effectively stemmed by tax increases andexpenditure restraint efforts in the 1980s. Fur-thermore, the high interest rates required at theend of the 1980s to contain inflationary pres-sures and the subsequent deep recession of1990–91 caused fiscal balances to deterioratesharply. By 1992 the total government deficit(federal, provincial, local, Canada PensionPlan, and Quebec Pension Plan) peaked at9.1 percent of GDP.
Despite a gradual recovery from the reces-sion, the government was by the mid-1990sfaced with a still very difficult fiscal situation,one that caused some to speak of a “vicious cir-cle”. High real interest rates resulting fromstrong government demand for savings, to-gether with risk premia as investors becameconcerned about future debt service capacity,dampened economic growth and led to a fur-ther deterioration in the public finances. Ad-dressing the weakness in the public financeswould thus have been a pre-eminent policy pri-ority regardless of the degree of Canada’s in-tegration with international markets. The needto ensure that Canada was well-placed to meetthe challenges of a more demanding interna-tional environment made deficit reductionparticularly compelling.
Beginning in earnest with the 1995 bud-get, the government made important efforts toachieve fiscal sustainability, accompanied bysimilar actions at the provincial level of gov-ernment. As a result, the balance of the totalgovernment sector improved rapidly, movingfrom a peak deficit of 9.1 percent of GDP in1992 to a small surplus by 1997. Since thattime, governments have continued to pursuefiscal discipline, achieving surpluses and re-ducing the debt burden. In 2001 the totalgovernment sector recorded a surplus of 2.4percent of GDP, while the net debt was reducedto 43.6 percent of GDP1, below the G-7 aver-age and down 24.4 percentage points from itspeak in 1995.
It is well accepted that strong, sustainablepublic finances are critical to the economicwell-being of countries at all levels of devel-opment. Sound public finances engender con-fidence in the ability of a government tocontinue to provide essential public goods, in-cluding both macroeconomic stability and keysocial programs. Fiscal sustainability is evenmore important for countries whose financialmarkets are internationally integrated. By pro-viding investors with external investment op-tions, they create an environment less tolerantof inappropriate policies.
In Canada’s case, the forces of globalizationalso had a substantial influence on the meth-ods used to achieve successful deficit reduction.The fiscal improvement was accomplished al-most entirely through reductions in programspending. This reflected the view that Cana-dian tax levels had already become sufficientlyelevated, particularly in comparison with thosein the United States, and that further increaseswould harm Canada’s competitiveness andability to attract and retain investment.
And unlike the general (and unsuccessful)expenditure restraint in the 1980s, the deficitreduction seen in the 1990s resulted from athorough review of all program spending. Thereview did not focus exclusively on achievingcost savings. It also aimed to ensure that gov-ernment programs supported an efficient Cana-dian economy capable of meeting thecompetitive challenges of an increasingly de-manding global marketplace.
CANADA 35
STRUCTURAL POLICIES TO IMPROVE
EFFICIENCY AND COMPETITIVENESS
Canada’s pursuit of trade liberalization as thecenterpiece of its market-opening strategy re-flected the view that the competitive disciplinefrom openness to international markets is es-sential to achieving the government’s ultimateobjective of sustained and equitable gains instandards of living. Yet the government’s ap-proach also recognized that openness must becomplemented by broad-based efforts to im-prove the economy’s internal efficiency andproductivity—and thus its capacity to competeon international markets. Particular efforts wereundertaken in four main areas.
First, Canada revised its regulatory frame-work in key areas, including transportation, thefinancial sector, and telecommunications. Theoverall aim of these reforms was to enhancecompetition and efficiency in these importantsectors, and to ensure that remaining regula-tions were truly effective in achieving publicpolicy priorities, including strong sustainedgrowth. The second half of the 1980s andearly 1990s saw significant changes as the gov-ernment made regulatory reform a major pol-icy priority. It deregulated the transport, energy,and telecommunications sectors to make themmore responsive to market forces. More re-cently, it undertook major reforms in the fi-nancial sector, culminating in June 2001 withlegislation to promote the efficiency and growthof financial institutions, foster domestic com-petition, and better protect consumers. Canadaalso updated key elements of its framework leg-islation, particularly the Competition Act andthe Patent Act.
Second, beginning in the 1980s, the gov-ernment reviewed its ownership of public en-terprises, leading to privatizations in areas wheregovernment ownership was no longer necessaryto achieving public policy objectives, where itcompromised the sector’s efficiency and com-petitiveness, or where it was necessary to en-hance the effectiveness of improvements to theregulatory environment. These privatizationswere especially significant in the transporta-tion sector. These included the sale of AirCanada in 1988, Canadian National Railways
in 1995, and Canada’s air navigation system in1996. In telecommunications, new legislationin 1993 aimed to increase reliance on marketforces for the provision of telecommunicationsservices. To date this has largely focused on in-creased competition in the market for long-distance service, however steps are underway toincrease competition in the provision of localtelephone service as well.
Third, the government significantly re-oriented its role in economic developmentspending. Although driven in part by fiscal ex-igencies, it also reflected the recognition thatmany programs in this area had not achievedtheir objectives and that Canada continued tolag in R&D and productivity growth. Thiswas worrisome in the era of the new economy,with growth increasingly driven by innovation.As a result of this reorientation, and to makeprograms more efficient, the focus of economicdevelopment shifted from government-directedassistance to joint public-private initiatives—and from direct grants to repayable contribu-tions and tax measures.
The government has committed to work-ing with Canadian industry, the provinces,communities and the public on private sectorsolutions to further broadband Internet cov-erage in Canada, particularly in rural and re-mote areas. To that end the 2001 budgetannounced funding of $105 million over threeyears to support broadband Internet expansion.In September 2002 the government announcedthe Broadband for Rural and Northern De-velopment Pilot Program, with two parts. Thefirst provides funding in support of the devel-opment of detailed business plans identifyingdemand and sustainability of broadband in-frastructure. The second provides funding forthe implementation of the business plan.
Fourth, Canada moved to put in place amore competitive tax regime, in response to agrowing consensus that the FTA with theUnited States highlighted the need to addresscertain tax-related obstacles to trade. One suchobstacle was the federal manufacturers sales taxthat made Canadian exports less competitiveand favored imports over domestically pro-duced goods. This tax was replaced in 1991with a value-added tax. Also important in this
36 CANADA
respect was the decision, announced in the2000 budget, to begin a phased reduction infederal corporate and personal taxes over thenext several years. This decision, made possi-ble by the dramatic improvement in the fiscalsituation, reflected the recognition that taxstructures are critically important in retaininghighly skilled labor, and the need to enhanceCanada’s attractiveness as a location for newinvestment.
SOCIAL PROTECTION AND HUMAN CAPITAL
INVESTMENT
Canadians have long put a high priority onpublic policy measures to protect the less for-tunate from adverse economic and social out-comes, and help achieve meaningful equalityof opportunity. This consensus is deeplygrounded in Canadian values. Yet many ofCanada’s social programs also represent a prag-matic economic policy response aimed at im-proving aggregate social welfare in anenvironment of risk and uncertainty. These un-certainties are particularly important forCanada, a small open economy, typically aprice taker on world markets—historically ori-ented toward production of natural resourcecommodities whose prices are often volatile,leading to swings in employment and incomeacross different sectors and regions.
From this perspective, social programs inCanada provide insurance against risks that areprivately uninsurable, either because the mag-nitude of the necessary transfers would exceedthe resources available to any private insurer—or because market failures, such as moral haz-ard or adverse selection, militate againsteffective private insurance against these risks.Programs in this category include those thatinvolve direct income transfers, such as em-ployment insurance and public welfare, aswell as the public health care system. Canada’ssocial programs also serve an important re-distributive function. Although the primary ra-tionale for this rests in the value placed byCanadians on social equity, it can also be seenas a means of improving economic welfare, byredistributing rents earned in such sectors asnatural resource extraction.
Canada’s social programs have become moreimportant amid the uncertainty associated withthe rapid changes in technology, competitiveforces, and patterns of demand associated withglobalization. In the 1990s it became clear thatthese programs must change, to ensure their fis-cal sustainability and, more important, to en-sure that they protect Canadians while givingthem the tools and incentives to prosper. To helpachieve these objectives, the government un-dertook reforms aimed at better targeting so-cial assistance programs, ensuring their fiscalsustainability, and providing Canada’s provinceswith greater flexibility in allocating federalfunds in line with their own priorities.
Among the most important of the changeswere those to Canada’s employment insuranceprogram. In 1996 this program was reformedby reducing expenditures on income supportand increasing spending on measures to helpthe unemployed find and keep employment.Changes to the income support element of theprogram included reductions to the benefitrate and the number of weeks of benefits avail-able, as well as a slight increase in the length ofemployment required to qualify for benefits. Atthe same time, additional funds were providedfor training courses, costs of self-employmentand mobility, and re-employment incentives.
Efforts were also made to ensure the long-term sustainability of some programs. One ex-ample was the Canada Pension Plan, anearnings-related plan financed by employer andemployee contributions, reformed to avoid un-sustainable increases in the contribution rate thatwould otherwise be needed as the large baby-boom generation retires. Instead, immediateand moderate increases in the contribution ratewere made, and a new policy was adopted al-lowing funds to be invested in financial markets.This will result in the build-up of a large reservefund to help finance future pensions.
Although many of the changes to Canada’ssocial programs were driven by the need to re-store fiscal sustainability, this period also providedan opportunity to improve their effectiveness.Even at the peak of the restraint efforts, the fed-eral government did not stop reinvesting inhuman capital development, and this acceleratedsharply once the deficit was eliminated. In some
CANADA 37
cases, programs were more carefully targeted tothose who need them. Particular measures weretargeted toward improving the health care sys-tem and helping vulnerable groups such as urbanaboriginals, youth at risk, and children fromlow-income families. The government has alsoput spending priority on initiatives to help Cana-dians adapt to the demands of the knowledge-based “new economy”. For example, the CanadaFoundation for Innovation was created to mod-ernize Canada’s research institutions in key areas.In addition, the government introduced theCanadian Opportunities Strategy to help Canadi-ans finance education and acquire the knowledgeand skills to participate in, and benefit from, op-portunities in a knowledge-based economy.
The overall result of these reforms is thatCanada’s social programs became more efficientand effective. Incentives to labor market par-ticipation have been enhanced. Innovationhas been fostered. And access to knowledge andskills at all stages of life has been improved.
CANADA’S POLICY RESPONSE TO
GLOBALIZATION
Since the mid-1980s Canada has embarked onpolicy initiatives to create a macroeconomic andstructural environment conducive to greaterproductive capacity while better enabling firmsand workers to respond to the challenges as-sociated with new technologies and a fast-paced global market. Some of these effortswere in traditional areas of economic policy.Others were in areas traditionally regarded associal policies, but which had come to beviewed as crucial in combining improved eco-nomic performance with the continued highlevels of social protection valued by Canadians.
These policies included decisive measuresto address Canada’s fiscal problem, whichhad threatened to create a cycle of higher in-terest rates, higher deficits, and deterioratingeconomic performance. They also included ef-forts toward trade liberalization, most no-tably the FTA with the United States, aimedat enhancing market opportunities and at-tracting new investment. Trade liberalizationwas complemented by a range of internalstructural measures, such as privatizing key
public enterprises, reorienting governmentbusiness programs, reducing internal barriersto trade, reforming tax policy, and improvingthe regulatory framework governing key areasof the economy, such as transportation, fi-nance, and telecommunications.
THE BENEFITS
By expanding the scope for competition, in-novation, and efficiency, the reforms to fiscal,monetary, and trade and investment policies, andto internal structural policies generated positivespillovers in other sectors of the economy, andhave contributed to making Canada much morecompetitive, open, and prosperous. Through theFTA and NAFTA, trade as a proportion ofGDP has grown rapidly, from about 25 percentin 1989 to some 40 percent by 1999.
Most important, the Canadian economyhas performed strongly overall. Over the past fouryears Canadian real GDP growth averaged 4.4percent, the strongest in the G-7. Employmentgrowth has also led the G-7 economies, result-ing in a decline in unemployment to a 26-yearlow of 6.8 percent in 2000. Despite this stronggrowth performance, underlying inflation has re-mained low and stable as costs were held backby a doubling in labor productivity growth in thelast four years relative to the previous two decades.This is due to strong business investment andtotal factor productivity gains. The above de-velopments have helped to push the averagegrowth of real disposable income per capita upto 2.8 percent per year, above that of the UnitedStates since the end of 1997.
The external current account balance alsomoved from a record deficit in 1993 to a recordsurplus in 2000, reducing Canada’s foreign in-debtedness relative to GDP to its lowest levelsince the 1950s. This, and the substantialprogress in reducing the public debt burden, hasgiven the federal government more flexibilityto address domestic economic priorities—andthe central bank more room to lower interestrates in the recent global slowdown.
Just as important as the effect of these re-forms on measurable GDP growth is the posi-tive impact on the less-easily measured, butequally important variables of economic welfare.
38 CANADA
Canada’s success in achieving low inflation andsound public finances has created a climate ofgreater certainty in which individuals and firmsalike can make decisions with confidence.Market-opening measures and complementarystructural reforms—including deregulation inkey sectors and changes to competition policy—have expanded consumer choice and contributedto lower prices and higher real incomes. The con-tinuing priority attached to Canada’s social pro-grams has supported the investment in humancapital essential to economic growth. These so-cial programs equip Canadians with the toolsto prosper in the global economy while pro-tecting them from its vicissitudes.
In assessing these reforms, it is easy to over-state the extent to which the policy initiativesin key areas—such as deficit reduction, mon-etary policy, and trade and structural reforms—were a conscious and meticulously plannedresponse to the challenges of globalization. In-stead, it would be more correct to regard themas motivated primarily by the general objectiveof improving the efficiency of the Canadianeconomy and raising the standard of livingand economic security of Canadians.
Little in the Canadian experience suggeststhat globalization has fundamentally changedideas of what constitutes “best policy”. In-deed, the most important of the domestic pol-icy initiatives would have been highly desirablefor increasing competitiveness and efficiency,while promoting equity and social protection,in an economy for which openness to theglobal economy was not a realistic prospect. Itis therefore more accurate to assess the Cana-dian experience as one in which the more de-manding external environment resulting fromglobalization increased the importance of pol-icy reforms that would have been essential inany case to ensure the strongest possible sus-tained growth in living standards.
CHALLENGES AND UNCERTAINTIES
While it is clear that the policy reforms inCanada since the mid-1980s resulted in a moreopen and dynamic Canadian economy, theirimpact must be tempered by the recognitionthat the reform process was incremental and
sometimes ad hoc. A key question relates towhat changes to the sequencing and pace ofthese reforms would have been appropriate inorder to maximize their benefits. Althoughspecific conclusions are difficult to draw, it iscertain that there was room for improving onthe general approach that Canada followed.
In the late 1980s, it would have been im-possible to accurately forecast the breadth anddepth of global economic change, particularlythe rapidly emerging knowledge-based econ-omy. Since the reforms were not part of a co-hesive plan to adjust to globalization, but oftena response to fiscal imperatives or domestic in-dustry pressures, the lag between reforms mayhave limited their impact, a view supported bythe OECD in its 1999–2000 annual review ofCanada (OECD 2000). According to some an-alysts, if tax reforms had been implemented atthe same time as macroeconomic reforms,greater benefits would have been realized (Mar-tin and Porter 2001). Similarly, if a more com-prehensive series of labor market reforms hadbeen undertaken earlier, overall economic per-formance would likely have been enhanced, andthe costs of reducing inflation in the early1990s might have been reduced.
Some factors that influenced the pace, se-quencing, and impact of the reforms in Canadacannot be automatically transported to all othercountries. For example, the nature of Canada asa federal state, with distinct region economies,clearly influenced what was feasible in someareas. Further, Canada’s location next to theUnited States and its huge volume of trade withthat country strongly influenced its policy deci-sions. Policy in certain areas was often driven bythe need to compete with the United States asan exporter and as an investment location. Pol-icy in other areas less directly affected by prox-imity to the United States did not receive thesame impetus.
Perhaps inevitably, given the absence of acomprehensive plan for these reforms at theiroutset, reforms have sometimes had unin-tended consequences, both positive and neg-ative. Indeed, some outcomes are puzzlingeven in retrospect. For example, the increasein both exports and imports following the im-plementation of the FTA and NAFTA was
CANADA 39
larger than expected—perhaps evidence thatthe welfare impacts of these trade liberalizationmeasures were also larger than expected. Butthis strong trade performance was not matchedby unambiguous evidence that Canada haslaunched itself on a permanently higher pro-ductivity trajectory, either in absolute terms orin comparison with the United States.
INTERNATIONAL INSTITUTIONS AND A STRONG
POLICY CONSENSUS
Canada’s macroeconomic and structural pol-icy responses have been greatly facilitated byits membership and active participation insuch international organizations as the IMF, theOECD, and the WTO.
The annual consultations with the IMF andOECD have been useful forums for discussingpolicy options in both macroeconomic and struc-tural areas and examining them in an interna-tional context. The discussions have provided theopportunity to examine other countries’ policyresponses to similar challenges and draw lessonsfrom their experience. In particular, Canada’spolicy agenda over the past 10 years has beenstrongly supported and reinforced by the IMFand the OECD. For example, in the early 1990s,the IMF consistently and strongly advocated acomprehensive fiscal consolidation program forCanada. Consistent with the government’s pol-icy agenda, this helped foster public support forimplementation. Since the elimination of the fed-eral budget deficit in 1997–98, five consecutiveyears of budget surplus have given the govern-ment the flexibility to increase its investment inkey areas, cut taxes, and pay down the debt.Both the IMF and the OECD have been verysupportive of the government’s decision to usepart of the budget surplus to pay down the debt.This, together with strong economic growth,has resulted in a significant reduction in Canada’sdebt-to-GDP ratio over the past five years.
Canada’s membership in the GATT/WTOhas been one of the primary mechanisms sup-porting trade liberalization. Through severalrounds of negotiations in the postwar period,Canada has progressively negotiated reciprocaltrade concessions with other GATT/WTOmembers. Initial rounds focused on tariff
reductions, but soon moved into other trade-related areas such as standards, investment, gov-ernment procurement, and trade remedies. Thissystem was effective because trade concessionscould be marketed more effectively domesti-cally if the benefits of reciprocal trade concessionsby key trading partners could also be seen. More-over, once tariff concessions were granted, theycould not be reversed. The Dispute SettlementMechanism has provided further incentive to en-sure that policies are consistent with WTO rules.Under this system, members may challenge thetrade-distorting policies of others—and may begranted the right to retaliate if other membersfail to comply with WTO rules.
Canada’s trade policies are reviewed everytwo years through the Trade Policy ReviewMechanism of the WTO, other WTO mem-bers identify areas where further trade liberal-ization is possible. This provides an externalrationale for trade policy liberalization, whichcan help in garnering domestic support. Someproblem areas identified so far include tariffpeaks in textiles and clothing, high tariffs andsupply management programs in agriculture, thelack of consistency in standards and governmentprocurement practices across the provinces,and regulatory barriers in telecommunications,transportation, and finance.
NOTES
1. Excluding government employee pen-sion liabilities, in order to be comparable withother countries’ debt measures.
REFERENCES
Masters, Donald. 1963. The ReciprocityTreaty of 1845: Its History, its Relation to BritishColonial and Foreign Policy and the Develop-ment of Canadian Fiscal Autonomy. Toronto:McClelland and Stewart.
Organisation for Economic Co-operationand Development. OECD Economic Surveys:Canada, 1999–2000: 8.
Martin. R., and M. Porter. 2001. “Cana-dian Competitiveness: A Decade after theCrossroads.” C.D. Howe Institute WorkingPaper 2001-1: 18.
CHINA 41
China’s financial sector reform has resulted insignificant institutional improvement and sus-tained strong economic growth performance.Between 1978 and 2000 its real GDP grew atan annual rate of 9.6 percent, and per capitaGDP at 8.2 percent. Total trade (imports plusexports) rose from $21 billion a year to $474billion, annual growth of 9.4 percent. Foreignexchange reserves jumped from just $840 mil-lion to $166 billion. Meanwhile, foreign directinvestment grew from zero to a cumulative$350 billion.
It was in 1978 that the first steps weretaken to reform and open China’s financialsector. Since then China has pursued an in-novative reform path crafted to meet its dis-tinctive economic and social conditions. Anetwork of financial intermediaries and mar-ket mechanisms suited to the emergence of amarket economy has been established, under-pinned by a legal framework and official super-visory system.
China will continue to draw on the expe-riences of developed countries and other de-veloping countries to achieve a sound,comprehensive, and effective financial system.
FINANCIAL REFORM OVER THE PAST 20 YEARS
Five key reform elements can be distinguished.First, a central banking system has been devel-oped and refined structurally, for more effectivemonetary policy and greater macroeconomic sta-bility. Second, a diverse network of financial in-termediaries has been established. Third,financial markets have been developed. Fourth,an effective system of financial regulation andsupervision has been put in place. Fifth, the fi-nancial sector has—gradually and cautiously—been opening up to the outside world.
ESTABLISHING AND IMPROVING THE CENTRAL
BANKING SYSTEM
Since 1978 the People’s Bank of China (PBC)has undergone four major reforms. The firstdates to 1978, when it became independent ofthe Ministry of Finance, transforming it from anarm of the ministry to a stand-alone bank, ex-ercising functions proper for a central bank andundertaking commercial banking business. Thisreform put an end to the old situation where pub-lic finance dominated banking, and, in partic-ular, introduced for the first time a real distinctionbetween budgetary issues and finance.
The second reform began in 1984, when thePBC was specifically designated as the centralbank of China, no longer allowed to do com-mercial business. This took away the dual man-date of financial authority and commercialbank and established the PBC unambiguouslyas a monetary authority. The third reform, in1995, promulgated the Law of the People’sBank of China, legally establishing the statusand functions of the PBC as those of a centralbank. Then there was the fourth reform in1998, a breakthrough in the organizationaland management structure of the PBC. The oldbranch structure, with 32 provincial branchesorganized along administrative lines, was con-solidated into a nine-branch structure, witheach branch covering an economic region. Thischange strengthened the independence of thecentral bank in implementing monetary policyas well as financial supervision and regulation.
BETTER CONDUCT OF MONETARY POLICY
Monetary policy instruments in China havebeen gradually refined with the transformationof the economic system, the development of
China
42 CHINA
financial institutions, and the maturation of themarket. Until the early 1990s, China reliedmainly on such direct means as quantitativecredit control to influence the evolution ofthe money stock. A major overhaul of the sys-tem of monetary control was introduced in thelatter half of 1992 at a time of overheating, withaccelerating consumer price inflation (figure 1)and exchange rate fluctuation. Identifying asthe key objective a tightening of monetarypolicy (bringing monetary growth to a level justbelow the growth of nominal GDP), a com-bination of policy instruments was brought intoplay for reserve requirements, central banklending rates, and open market operations.Instead of controlling the quantity of credit,the authorities began to employ the monetaryaggregate as their operating target.
Since 1998 there have been further re-forms in the mechanism of monetary control.The PBC has abolished credit quotas for state-owned commercial banks, completing the tran-sition from direct to indirect control of the totalsupply of money and credit. The reserve re-quirement system has also been reformed, in-tegrating the excess reserve accounts with therequired reserve accounts and restoring thepayment and clearance functions of the re-serve accounts. Commercial banks are nowallowed to provide consumer credit where con-ditions permit. Efforts have been enhanced touse the open market operations, increase the
variety of financial products for transaction, andpromote market-based flotation of financialpolicy bonds. The permissible range of com-mercial bank lending rates has been widened.
ESTABLISHMENT OF DIVERSIFIED FINANCIAL
INSTITUTIONS
The first task in building a diversified networkof financial institutions was to establish a state-owned commercial banking system. Chinabegan to set up state-owned commercial banksin the late 1970s. The Agricultural Bank ofChina specialized in rural credit, the Con-struction Bank of China in fixed asset invest-ment, and the Bank of China mainly in theforeign exchange business, all reinstituted in1979. In 1984, with the refocusing of the PBCas central bank, the Industrial and CommercialBank of China was set up to serve a target clientbase industrial and commercial enterprises.
Next, the operations of the state-ownedcommercial banks were strengthened, begin-ning in the latter half of the 1980s. To satisfy theneeds of enterprises for diversified financing,the sectoral barriers among the commercialbanks were removed. In 1994 three banks wereformed to undertake the policy financing pre-viously assigned to the specialized banks: fixedasset investment, agricultural procurement, andinternational trade. The former specialized banksbecame commercial banks in the sense that,even though wholly state-owned, they engagedin commercial financial business only. To ensurethat they really would be commercial banks, re-forms were carried out to strengthen the man-agement of each state-owned commercial bankon a consolidated legal person basis, delink themfrom their nonbanking arms, and improve in-ternal management and risk-control mechanisms.
The Commercial Banking Law of the Peo-ple’s Republic of China was promulgated in 1995to provide a legal framework for standardizing theoperations of the commercial banks. In 1999four financial asset management corporationswere set up, taking over 1.3 trillion yuan of non-performing assets from the four state-ownedcommercial banks. The government has alsotaken various measures to increase the capitaladequacy of the state-owned commercial banks.
Figure 1. Macroeconomic performance
–5
0
5
10
15
20
25
20001998199619941992199019851980
Economic growth Inflation rate (retail price index)
Percent
CHINA 43
These reforms have expanded the scope of busi-ness of the state-owned commercial banks, sep-arated policy and commercial business,strengthened internal management and risk pre-vention, and improved competitiveness.
China has not neglected the development ofa variety of other financial institutions. Since 1984other banks with different ownership structureshave been set up, as well as various nonbankingfinancial institutions, such as securities, insurance,trust, and finance companies. So, even thoughthe state-owned commercial banks still play adominant role, many other financial institu-tions are active in the market. By the end of 2000,apart from the three policy banks and the fourwholly state-owned commercial banks, therewere 10 share-holding commercial banks, 99city commercial banks, 1,695 urban credit co-operatives, 39,255 rural credit cooperatives, 71enterprise group finance companies, 12 finan-cial leasing companies, nearly 100 trust and in-vestment companies, 100 securities firms, 13insurance companies, and 191 operationalforeign-funded financial institutions.
The reform of the financial system helpedincrease the strength of the financial sector. Bythe end of 2000, total assets of the financial in-dustry reached 19.7 trillion yuan, more thantwice the GDP of that year, and a 65-fold in-crease over the two decades. Assets of the whollystate-owned commercial banks alone came to124 percent of GDP; assets of the policy banks,17 percent; share-holding commercial banks, 16percent; city commercial banks, 6 percent; urbancredit cooperatives, 1.6 percent; and rural creditcooperatives, 17 percent. Total deposits in thefinancial institutions reached 12.4 trillion yuan,138 percent of GDP. Aggregate loans topped 9.9trillion yuan, also exceeding GDP. Interestingly,associated with this rapid financial deepening,bank lending began to assume a major role inthe financing of national fixed asset investment.In 2000 lending by wholly state-owned banksfinanced 41 percent of fixed asset investment inChina, up from 7 percent in 1980.
The insurance sector, though much smaller,has also grown. The total assets of insurancecompanies reached 337 billion yuan in 2000, 4 percent of GDP, with premium income of160 billion yuan, 2 percent of GDP.
The reform of the financial system alsoimproved the quality of financial services. Pre-viously all that was available was elementarybanking, based on deposits and loans. Nowmany other financial services are widely used,including securities, insurance, trust and in-vestment, leasing, and investment. Such linesas international settlement, exchange, real es-tate, consumer credit, and banking cards aredeveloping, and such intermediate business ascompany financing, finance consultancy, com-missioned transactions, fee collection, andsalary accounts are rapidly expanding.
ESTABLISHMENT OF A COMPREHENSIVE
FINANCIAL MARKET SYSTEM
A money market had already emerged inChina by the early 1980s. Since then, it hasbeen developing rapidly, with a variety of in-struments (table 1). Apart from interbanklending, it is also possible to trade in financialproducts such as negotiable bills and short-term government bonds (repurchase of gov-ernment securities). The volume of trade hasalso been increasing rapidly. In 2000 transac-tions on China’s money market exceeded 3 tril-lion yuan, 35 percent of the GDP that year anda 10-fold increase over the late 1980s. Thefunctioning of the money market has also im-proved, providing a venue for the commercialbanks to get short-term liquidity and creatingconditions for the open market operations ofthe central bank.
TABLE 1China’s money market, 1986–2000(billion yuan)
CommercialInterbank Negotiable banks PBC
Year lending Repurchases bills discounts discounts
1986 30.0 01987 230.0 01988 524.0 0 01989 293.4 0 01990 264.1 0 01991 292.7 0 01992 450.0 0 01993 250.0 0 01994 n.a. 0 01995 820.2 0 242.4 141.2 84.41996 587.1 0 389.0 226.5 135.01997 414.9 30.7 460.0 274.0 133.21998 98.9 102.1 384.1 265.0 120.01999 323.9 395.7 507.6 249.9 115.02000 672.8 813.3 744.5 644.7 266.7
44 CHINA
Since the opening of Shanghai and Shenzhenstock exchanges in December 1990, greatprogress has been made in developing China’scapital market (figure 2). The issuance volumeof government securities, corporate shares, andbonds has greatly increased. Enterprises have be-come more dependent on direct financing. Andthe overall financing structure of firms and theasset structures of individuals’ portfolios have un-dergone profound changes. The capital marketis doing more in resource allocation, and its ef-ficiency has been constantly improving. At theend of 2000, 1,121 companies were listed athome and abroad, with a total market value of4.8 trillion yuan, roughly 57 percent of theGDP. About 50 million Chinese invest in stocks.
ESTABLISHMENT OF AN EFFECTIVE FINANCIAL
SUPERVISION FRAMEWORK
In 1998 China reformed the organizationalstructure of financial supervision and regula-tion by establishing securities and insuranceregulatory authorities separate from the PBC.
The PBC, as the regulatory authority and su-pervisor of the banking industry, has done muchto strengthen financial supervision and regula-tion since 1993. It has increased supervisory de-partments, defined the functions of banks,nonbanking financial institutions, and insuranceand auditing firms, and clarified responsibilities
for financial supervision. The division of laborbetween the PBC headquarters and branchesin financial supervision has been redefined, andthe focus of the branches has been shifted fromcredit allocation to financial supervision. Withthe overarching goal of monitoring risk, finan-cial supervision has evolved from general verifi-cation of administrative procedures and financialmanagement into a comprehensive supervisioncovering market access, business operation, riskmonitoring and control, and market exit. Ef-fective measures have been taken to contain riskfor financial institutions with excessive risk ex-posures, explore approaches for market exit, andimprove the capacity to handle financial risks.
The China Securities Regulatory Commis-sion, as the supervising authority of the securi-ties industry, has improved its regulatoryframework by setting up and maintaining directcontrol over its local offices in major cities. It hasresearched and formulated policies and plans aswell as the necessary laws and regulations for thedevelopment of the securities and futures mar-kets. It has also investigated the securities com-panies, taken needed corrective actions, andformulated and implemented schemes aimed atpreventing and warding off risks confronting se-curities companies. The commission has alsobeen suppressing illegal over-the-counter stockexchanges. Problems with the provincial secu-rities exchange centers have also been dealt with.The futures market has been standardized, withsome futures exchanges reorganized into secu-rities brokers and dealers. The implementationof these reform measures has greatly enhancedthe supervision over the securities market andmade its operations more standard.
The China Insurance Regulatory Com-mission, since its establishment in 1998, hasworked out policies, laws and regulations, de-velopment strategies, and plans to develop theinsurance industry and cultivate the insurancemarket. It has carried out supervision, regula-tion, and business guidance over the operationsof the insurance sector. This has included in-vestigating and sanctioning firms in violation oflaws or regulations, protecting the interests ofthe insured, taking precautions against and re-ducing risks in the insurance industry, and safe-guarding the stability of the insurance market.
Figure 2. Stock market development
Number of companiesMarket value
0
10
20
30
40
50
20001999199819971996199519941993199219910
200
400
600
800
1,000
1,200
Trillion yuan
CHINA 45
STEADILY OPENING THE FINANCIAL SECTOR
VIGOROUS ENCOURAGEMENT OF ENTRY BY
FOREIGN-FUNDED BANKS
In line with the overall goal of opening up theChinese economy, there has also been a measuredpolicy of financial opening, with the entry offoreign-funded financial institutions encour-aged by lifting the geographical restrictions onestablishing foreign financial institutions. Atthe beginning, foreign financial institutionswere allowed only to come to the special eco-nomic zones and selected coastal cities. Grad-ually this was extended to all major cities. Thescope of business opened to foreign financial in-stitutions has also been gradually expandedfrom foreign currency business only to being par-tially allowed to conduct yuan business.
At the end of 2000, 87 foreign financial in-stitutions and enterprise groups from 22 coun-tries and regions maintained 191 operationalfinancial establishments in China, including 7joint venture banks, 6 wholly foreign-ownedbanks, 7 finance companies, and 158 bankbranches. Thirty-three foreign banks have beenpermitted to conduct yuan business. Apartfrom that, 166 foreign banks from 38 coun-tries and regions have set up 248 representa-tive offices in China. The total assets of foreignfinancial institutions in China have greatly in-creased, reaching $34.4 billion by the end of2000, with a total loan balance of $18.6 bil-lion. The resources of the foreign banks comemainly from their headquarters abroad, whichprovide about 70 percent of total funds.
Sound Chinese financial institutions havebeen actively encouraged to explore overseasbusiness. Chinese banks and insurance com-panies have set up branches in 24 countries andregions on five continents, with an aggregateemployment of 30,000.
INTRODUCTION OF A UNIFIED EXCHANGE RATE
AND CURRENT ACCOUNT CONVERTIBILITY
From the beginning there has been a gradualrelaxation of exchange controls. In 1979 amethod of foreign exchange earning retentionwas introduced. The following year a foreign
currency swap center was established, and adual exchange rate system introduced, distin-guishing between the price for trade-related for-eign exchange purchase and the official publicexchange rate. In March 1988 the restrictionson the exchange rate at the swap center werelifted, allowing it to float within a certain rangeof the official rate.
1994 saw a major reform of foreign ex-change administration and exchange rateregime. A single managed floating exchange ratewas introduced on the basis of market supplyand demand. An interbank foreign exchangemarket was set up with the establishment of theChina Foreign Exchange Trading Center inShanghai on April 1, 1994, for the surrenderand purchase of foreign exchange related to cur-rent account transactions.
In 1996 China further relaxed foreign ex-change control. Since then, the foreign ex-change surrender and purchase system hasbecome applicable also to foreign-funded en-terprises and restrictions on their use of foreignexchange under current account were removed.Foreign banks in China and Chinese-foreignjoint venture banks have been allowed to han-dle the foreign exchange surrender, purchase,and payment business of foreign-funded en-terprises. Individuals have since been allowedto exchange more foreign currency for per-sonal needs. Restrictions over the nontrade,nonregular use of foreign exchange for cross-border exhibitions and investment promotionhave also been removed. Foreign organizationsand individuals in China have been allowed toremit their lawful income out of China. Withthe implementation of these measures, Chinamet the requirement of Article VIII of the Ar-ticles of Agreement of International MonetaryFund and announced current account con-vertibility of the yuan as of December 1, 1996.
Reform of the foreign exchange systemhas facilitated vigorous growth of internationaltrade and foreign direct investment, resultingin big increase of China’s foreign exchange re-serves (figure 3). China’s export volume in-creased from $18.1 billion in 1980 to $249.2billion in 2000, a 14-fold increase. Between1979 and 2000 Chinese and foreign busi-nessmen signed 363,000 direct investment
46 CHINA
contracts, with actual use of direct investmenttopping $350 billion. In 2000 foreign-fundedenterprises in China exported $119.4 billion,48 percent of total exports. Foreign-funded en-terprises are now important in promoting theChinese economy.
China’s foreign exchange reserve has also ex-panded considerably, from $840 million at end-1980 to $165.6 billion at end-2000. Theincreased foreign exchange reserves have helpedenhance China’s overall national strength and itsresilience to risks. In the face of the Asian financialcrisis in 1997 and the accompanying drastic de-preciation of Southeast Asian currencies, theChinese government undertook to maintain astable yuan exchange rate, which not only pre-vented the spread of the crisis into China but alsostabilized Asian economies and finance.
FINANCIAL REFORM AND ECONOMIC
RESTRUCTURING—IN PARALLEL
Overall economic restructuring in China since1978 has gone through three phases. The firstwas from 1978 to 1984, when the reform fo-cused on the countryside with the householdproduction responsibility system being intro-duced in the villages. Pilot programs were car-ried out in allowing enterprises greaterautonomy. Also on a pilot basis, enterpriseswere shifted to a regime in which they paidtaxes instead of handing over all profits to thegovernment. In this early phase, 4 special
economic zones and 14 coastal port cities wereto open to the outside world.
The second phase was from 1984 to 1991,when the focus of reform was in the cities. Pilotschemes to reform state-owned enterpriseswere introduced and efforts made to encour-age the development of private enterprises andtownship enterprises.
The third phase was from 1992 to 2000,when comprehensive reforms centering on therestructuring of the state-owned enterpriseswere carried out. Key elements included mod-ern enterprise management systems, macro-economic restructuring, reform of the foreignexchange and foreign trade systems, and hous-ing and social security reform.
The tasks of the first two phases were tobreak up the old system, while the third aimedat establishing a new socialist market econ-omy system.
China’s financial reform can be seen, forthe most part, as proceeding in parallel with thewider economic restructuring, reflected in theway the diversification of financial institutionsmirrors the diversification of enterprise owner-ship. The development of the financial market,particularly the stock market, can be seen asanalogous to the transformation of the operat-ing methods of enterprises. Reform of the for-eign exchange system went hand-in-hand withreform of the foreign trade and investment sys-tem, as did reform of state-owned commercialbanks and state-owned nonfinancial enterprises.
STEADINESS AND GRADUALISM IN FINANCIAL
REFORM
There are two ways of making an economictransition: radically and gradually. Proceedingfrom its national conditions and realities, Chinachose the road of gradually transforming its eco-nomic system, “navigating across the river byfathoming the course through underwaterstones”. Reform began in the rural areas, wherethe planned economic system was relativelyweak, and was rolled out to cities step-by-step.The price reforms were done by introducingmore and more relaxed control into governmentregulation with a view to the final removal ofprice controls. Opening to the outside world
0
50
100
150
200
250
20001995199019851980
Figure 3. Reserves, exports, exchange rate
Yuan–U.S. dollarexchange rate
Exp
ort
s
0
2
4
6
8
10
US$ billions Exchange rate
Res
erve
s
CHINA 47
was piloted in coastal areas first, and when suf-ficient experience had been gained, rolled outto the inland areas. Ownership reform was car-ried out by developing the non-state-ownedsector while making adjustments in the state-owned sector. Reform of the state-owned en-terprises began with allowing the enterprisesmore autonomy and increasing their retentionof profits, and evolved into the establishmentof modern enterprise management systems andreadjustment of the behavior of the state-ownedsector.
Financial reform has also been gradual.State-owned commercial banks were set upfirst, and then financial institutions with otherownership structures began to develop. Later,strengthening and reforming the other finan-cial institutions was tackled before that of thestate-owned commercial banks. The moneymarket was established and deepened before theforeign exchange and capital markets were de-veloped. Gradual relaxation of quantitativecontrol of credit came ahead of open market op-erations, rediscounting, and other indirect waysof macrocontrol and regulation. Restrictions onmoney market interest rates were removed be-fore the relaxation of control over governmentbond and bank lending interest rates.
THE REFORM AND OPENING OF THE
FINANCIAL SYSTEM HAS BEEN LED BY THE
GOVERNMENT
The establishment of financial institutions andthe formation of financial markets in China isquite different in one important respect frommany western developed countries. Rather thanevolve spontaneously, markets and institutionshave emerged under the leadership of govern-ment, in response to its perception of the needsof economic development. For example, the es-tablishment and reform of the state-ownedcommercial banks, the development andstandardization of small and medium-sized fi-nancial institutions, the building up and de-velopment of the financial market have all beenled and guided by the government. This has en-abled Chinese financial institutions and finan-cial markets to rapidly meet the need ofeconomic reform and development.
With the growing role of the market in theChinese economy, the government has shiftedthe emphasis in financial reform from admin-istrative directives to legislation. Among themany laws and regulations promulgated since1995 are the Central Bank Law, CommercialBanking Law, Securities Law, Insurance Law,Law on Negotiable Bills, and the Decision toPunish Crimes Undermining Financial Order.
IDENTIFYING MONETARY POLICY TARGETS
COMMENSURATE WITH NATIONAL CONDITIONS
IS THE KEY TO MAINTAINING MACROECONOMIC
STABILITY
The monetary policy objective set for the PBChas also evolved over the years. The Regulationsof the People’s Republic of China on BankManagement, issued in 1986, set for monetarypolicy the dual goal of stabilizing the currencyand developing the economy. At that time,with the reform of investment and financing notyet accomplished, the condition of industrywas such that capacity constraints meant thatthe supply of many products fell short of de-mand. As a result, when the local governmentsurgently wanted to develop the local economies,the central bank was under enormous pressureto increase credit and money supply. In someyears, the two goals of stabilizing the currencyand developing the economy seriously con-flicted, and when this happened the develop-ment goal usually prevailed over that ofstabilizing the currency. So, although the eco-nomic growth rate remained high, inflationsurged, especially in 1988 and 1993.
In 1993 the Decision on Matters Relatingto the Establishment of a Socialist MarketEconomy made at the third plenary session ofthe 14th CPC Central Committee and theDecision on Reform of the Financial System ofthe State Council clearly redefined the objec-tive of the Chinese monetary policy as main-taining a stable currency and promotingeconomic growth. In March 1995 the Law ofthe People’s Republic of China on the People’sBank of China (Central Bank Law) was pro-mulgated, designating that as the ultimate ob-jective of China’s monetary policy in explicitlegal terms, correctly sorting out the relations
48 CHINA
between having a stable currency and promot-ing economic growth, and formally rejectingdual objectives for monetary policy. As a result,the Chinese economy entered a stage of highand steady growth and low inflation.
THE OPENING OF THE FINANCIAL MARKET HAS
BEEN GRADUAL
With the Chinese economy opening to the out-side world, the financial sector was also openedgradually. In 1981 foreign financial institutionsbegan to set up representative offices in China.In 1985 foreign financial institutions were al-lowed to open operational branches in the fivespecial economic zones of Shenzhen, Zhuhai,Xiamen, Shantou, and Hainan. In 1990 Shang-hai became the first coastal open city outside ofthe special economic zones to bring in opera-tional foreign financial institutions. After that,another seven coastal cities, including Dalian,were also allowed to do so. In 1992 AmericanInternational Assurance (part of the AIG group)set up its branch in Shanghai, marking the startof experimentation with opening the Chineseinsurance market. In August 1994 Beijing and10 other inland cities were added to the list oflocalities open to operational foreign financialinstitutions. In December 1996 foreign finan-cial institutions were allowed to conduct yuanbusiness in Pudong, Shanghai, and the practicewas later extended to Shenzhen.
The greatest advantages of gradual open-ing are that, since there is no need to accom-plish everything at one go, there need not betoo great a macroeconomic impact. Experiencecan be constantly assessed and the plan adaptedappropriately to ensure that practice fits na-tional conditions.
An important lesson the Chinese author-ities drew from the Southeast Asian financialcrisis is that in the process of financial liberal-ization, some countries had been overhasty inrelaxing financial controls by interest rate lib-eralization, deregulation, premature openingof the capital market, and establishing off-shore financial markets. Premature adoption ofthese measures contributed to the outbreak ofthe financial crisis. In contrast, drawing fullyon the lessons of previous experience, the Chi-
nese government strengthened its manage-ment of the capital account following intro-duction of current account convertibility,preventing the crisis from spreading to China.
PRIORITIES AND TARGETS OF THE NEXT-STEP
FINANCIAL REFORM AND DEVELOPMENT IN CHINA
With China’s entry into the World Trade Or-ganization, its financial sector will face hugechanges, manifest in the following areas. First,the system of supervision and regulation isnot yet prepared for the complexities of the newsituation. Second, the financial market is notso developed that it can be relied on to avoidany threat to macro instability and to ensurean optimal allocation of resources. Third, thereis still a gap between the management andoperational capacity of the wholly state-ownedcommercial banks and that of the world’s lead-ing banks. Fourth, there are still hidden prob-lems in the rural financial system.
For these reasons, China must continue todeepen its financial reform, strengthening in-stitutions and markets and improving the su-pervision, regulation, and control mechanismsof the financial sector. A sound monetary pol-icy will continue to be needed, adjusting mon-etary conditions appropriately to facilitateeconomic restructuring and growth. Overall, theChinese financial sector’s capacity to deliverservices will have to be improved to enhance thesector’s competitiveness. Efforts will be made toprevent and dissolve financial risks and enhancethe quality of bank assets. Comprehensive re-forms will be carried out in wholly state-ownedcommercial banks, bringing them into line withbest contemporary banking practice. The ruralfinancial system will be reformed to redouble fi-nancial support for farmers and agricultural de-velopment. The strong balance of paymentsperformance will be maintained. The managedfloating exchange rate system based on marketsupply and demand will be further improved.
IMPROVING THE MONETARY POLICY SYSTEM
RELYING ON INDIRECT INSTRUMENTS
China will continue to pursue a sound mone-tary policy and seek refinements in the conduct
CHINA 49
of monetary policy, by relying mainly on indi-rect policy instruments. First, open market op-erations will be expanded, and the quality of therelevant decisionmaking will be improved to en-sure that the timing and scale of open markettransactions are optimized. Transaction fre-quency will be increased, and fine-tuning mea-sures will be taken as the occasion warrants.While an increasing volume of repurchase trans-actions can be expected, there will also be moreuse of outright transactions. Flexibility will beexercised in selecting modes of transaction to givefurther play to the open market in guidingshort-term interest rates on the market. Therole of the primary dealers will also be given morescope in activating the market, transmittingmonetary policy, and expanding the effects ofopen market operation. Market infrastructurewill be strengthened through improvements inthe settlement and clearing system.
Second, rediscount business will be furtherdeveloped. While expanding the range of billseligible for discount, the ceiling on discountinterest rate will be gradually lifted in supportof the market-based interest rate reform. Thepurpose is to enhance the role of rediscount inguiding market interest rate and commercialbank behavior.
Third, the required reserve system will befurther improved. The basis for calculatingthe required reserves will be improved by in-troducing the concept of average balance in theaccounting period. Verification of the requiredreserve will also be improved accordingly.
Fourth, efforts will be made to graduallyincrease market influence over the degree towhich interest rates vary around the centralbank rates, with money market interest ratesas the key intermediate rate determined bymarket supply and demand. In sequencing in-terest rate liberalization, foreign currency in-terest rates will be reformed before those in localcurrency, rural rates before those for urban fi-nancial institutions, and bank lending interestrates ahead of deposit interest rates.
So, the main elements of the reform willinvolve relaxing restrictions on the yield atissue of domestic enterprise bonds, leavingthese to be determined by the market; liftingcontrols over the deposit and loan interest
rates of rural credit cooperatives and allowingthem to set their interest rates according to thesupply and demand of funds and the risk levelof lending; and gradually expanding the al-lowable spread of lending rates for financial in-stitutions in urban areas, to exercise control overretail deposit interest rates and a flexible man-agement of large-amount deposit interest rates.
COMPREHENSIVE REFORM TO GEAR THE
STATE-OWNED COMMERCIAL BANKS TOWARD
MODERN BANKING
The basic objectives in the reform and devel-opment of the wholly state-owned commercialbanks are to introduce best modern bankingpractice; to innovate the ownership system;to optimize ownership structure and corporategovernance; to reform operations, manage-ment, personnel, and distribution; and to im-prove branch network. Quantitative targetswill include keeping the average nonperform-ing loan ratio under 15 percent and minimumcapital adequacy ratio at 8 percent.
The guiding principles of the reforms are“overall planning implemented through dif-ferentiated handling; dealing not only withevident problems but with their root causes;and achieving set goals within the designatedtimeframe”. The focus of the reforms is torenew the banking system, turn the four whollystate-owned commercial banks into share-holding banks in ways suited to their respec-tive conditions, and altogether achieve a fullymodern banking system by around 2005. Themain contents of the reforms will include:• Ownership and shareholding reforms. Wholly
state-owned enterprises are now more orless analogous to government departments.This has to change fundamentally, and thedistinctive features of a financial enterprisemust be taken into account if it is truly tobe able to function on a commercial basis.Internal corporate governance must be builton sound principles. The supervisory board,the board of directors, and the manage-ment will have clearly defined responsibil-ity. Then, viable wholly state-ownedcommercial banks should be allowed to re-organize into share-holding banks, with the
50 CHINA
state holding the controlling share to createthe conditions for being listed in the future.
• Improving the institutional setup. The branchlayout will be based on cost, efficiency,and profitability considerations. At thesame time, internal structures must ensureboth an effective division of labor and in-ternal controls.
• Exercising a prudent accounting system, grad-ually alleviating historical burdens, and im-proving the quality of assets. In this respect, itis necessary to make proper readjustments toaccounting standards; reform the system ofprovisions for and writing off loan losses; ex-plore ways of reforming the tax rates forcommercial banks; roll out the risk-based five-category loan classification system alreadybeing introduced; and evaluate the issue ofnonperforming loans resulting from policyfactors with a view to relieving the com-mercial banks of their historical burdens.
• Enhancing capital adequacy through variouschannels. An improved capital replenish-ment system for commercial banks has tobe established in mutual support with re-form of the ownership structure.
• Strengthening external supervision mecha-nisms. Two steps can be taken to increasethe transparency of the wholly state-ownedcommercial banks and bring the informa-tion disclosure of the Chinese banking in-dustry up to international standards. Thefirst is to modify the accounting system ofthe banking industry and provide incentivesfor the commercial banks to disclose in-formation not directly relating to their per-formance and gradually increase disclosurefrequency. The second is to increase thedisclosure of information in business per-formance and financial situation. China will also encourage the commercial
banks to carry out business innovation andpersonnel and salary reforms to enhance the in-centive system.
STEPPING UP THE REFORM OF THE MANAGEMENT
SYSTEM OF RURAL CREDIT COOPERATIVES
Established according to the cooperative prin-ciple, the rural credit cooperatives are intended
to help the vast number of farmers expandtheir market-based production and to supportthe development of agriculture and the ruraleconomy. The focus of deepening reform in therural credit cooperatives should be to clarifyownership and improve governance. The or-ganizational form of rural credit cooperativesneeds to be rethought in the light of the actualconditions of the cooperatives concerned. Theirmanagement has to be strengthened, with self-discipline and self-developing operationalmechanisms put in place to ensure better in-centives for good performance.
With the expanded spread of allowable in-terest rates and a continuation of low tax rates,the policy environment will remain support-ive of the rural credit cooperatives, enablingthem to deal with inherited burdens, lowerrisks and bring them under more effectivecontrol. Gradually, insolvent credit cooperativeswill be disposed of. The business of the ruralcredit cooperatives has to develop in a com-prehensive way, and their services have to befurther improved to help the farmers get bet-ter access to loans. Shared services and self-regulatory umbrella groups or associations ofcooperatives could be part of the solution forthe rural credit cooperatives, while supervi-sion by the PBC of the cooperatives has to beimproved.
SPEEDING UP DEVELOPMENT OF THE
FINANCIAL MARKET
The financial market is an important vehicle fortransmitting monetary policy. Its level of de-velopment affects not only the efficiency ofcapital allocation but also the operating effi-ciency of the central bank’s monetary policy. Inthis connection, China must accelerate thedeepening of the financial market and devel-opment of the money market. For one thing,there need to be nationally integrated multi-layered money markets open to all financial in-stitutions. Efforts are also needed to furtherstandardize and develop the interbank lendingmarket, increase the number of market partic-ipants, develop the mechanisms for financingsmall and medium-sized financial institutions,and strengthen market regulation.
CHINA 51
The financial institutions should developover-the-counter bond transactions for bothcorporate and individual customers. What isenvisaged is an integrated bond market struc-ture consisting mainly of the interbankmarket supplemented by over-the-countertransactions with commercial banks. At thesame time, the development of the bondmarket will also require better custody andsettlement services. There needs to be a net-work of money market brokers and marketmakers. The financial institutions will beencouraged and guided to develop nego-tiable bills discount business. Efforts willalso be made to promote the development ofregional bills market and to try issuing fi-nancing bills so as to increase the range of billseligible for discount.
A second need is to promote the devel-opment of the Chinese capital market. Im-proving corporate governance in the securitiesindustry, building up the market system, andenhancing supervisory and regulatory skillsconstitute three priorities in the future cap-ital market reform. To protect the interestsof investors and standardize the operations ofthe listed companies, China will, accordingto the criteria set by the OECD and in thelight of the actual conditions in China, workout principles for corporate governance, en-hance the level of information disclosure bylisted companies, and improve supervisionand regulation.
A third need is to establish a scientific andreasonable normal financing relationship be-tween the money market and the capitalmarket—to support the development of thecapital market, ward off financial risks, and givefurther play to the role of monetary policy inmacroeconomic development. Access by se-curities dealers to the lending market must beput under close scrutiny to prevent illegal lend-ing by the securities dealers. The stock-pledgedloan business of the commercial banks will befurther standardized, with strict review andapproval over the qualifications of the com-mercial banks and securities companies con-ducting such business. Securities dealers willbe encouraged to finance through bond re-purchase and bond issuance.
IMPROVING THE MANAGED FLOATING
EXCHANGE RATE REGIME
Although the single managed floating exchangerate based on market supply and demand, inplace since 1994, has served China and the re-gion well it is still too rigid. It needs to be im-proved so that the exchange rate can betterreflect real market supply and demand as wellas changes in balance of payments performance.
The objective here is to increase the flexi-bility of the yuan exchange rate system andwiden the range of float. To this end, China willgradually increase the role of the market in in-fluencing the exchange rate, widen the range offloat for the interbank market exchange rate, ad-just the limits on banks’ working positions,and reform the foreign exchange surrender sys-tem. Efforts will also be made to further developand improve the foreign exchange market bypromoting forward foreign exchange surrenderand purchase business, extending business hoursfor interbank foreign exchange market, pro-moting big-volume agent trade and increasingthe variety of products for the foreign exchangemarket. The intervention mechanism of thecentral bank will be improved by shifting theexchange rate target for the yuan from the U.S.dollar to a basket of foreign currencies, reduc-ing the frequency of central bank interventionin the foreign exchange market, and strength-ening monitoring and early warning over theforeign exchange market.
ACTIVELY CREATING CONDITIONS AND THE
GRADUALLY RELAXING CONTROL OVER CAPITAL
ACCOUNT
Although current account convertibility wasintroduced in December 1996, strict controlis still exercised over capital account items. In-ternational experience suggests that capitalaccount convertibility requires a stable macro-economic environment, a sound financial sys-tem, effective supervision and regulation, anda resilient overall national economy. Chinawill act cautiously and pragmatically, gradu-ally creating the basic conditions for capital ac-count convertibility. Thus the authorities’capacity for maintaining macroeconomic
52 CHINA
stability through instruments of monetaryand fiscal policy, as well as the exchange rate,will be strengthened. Efforts will be made toenhance the ability of domestic industrial,commercial, and financial enterprises to buildthe capacity to use, earn, and repay foreign ex-changes. It is also important to improve thefiscal balance and promote price stability. Thefinancial market will be standardized, the se-curities market expanded. Supervision andregulation of financial institutions will alsofocus on their ability to absorb internationalcapital shocks.
FURTHER OPENING THE FINANCIAL MARKET IN
AN ORDERLY MANNER
Against the backdrop of increasing global-ization, China has worked out a preliminarytimetable for opening the financial market.In the year of China’s entry into the WTO,foreign banks will be allowed to conduct for-eign currency business with Chinese enter-prises and individuals. Two years after that,they will be permitted to conduct yuan busi-ness with Chinese enterprises. In anotherthree years, they will be allowed to conductyuan business with the Chinese individuals.Within five years of China’s entry into theWTO, the number of cities where foreignbanks are allowed to conduct yuan businesswill gradually increase. Foreign banks will notbe under geographical restrictions in con-ducting yuan business and will fully enjoy na-tional treatment.
STRENGTHENING FINANCIAL SUPERVISION AND
ENSURING FINANCIAL AND ECONOMIC SAFETY
The quality of central bank supervision and en-forcement of prudential rules in line with in-ternational standards constitute an importantguarantee for economic and financial safety. Thecentral bank must speed up the reform of the su-pervisory and regulatory system, enhance the in-dependence and professionalism of the financialregulatory authorities, and improve its ability tocoordinate financial supervision and monetarypolicy, control moral hazard, and identify andcope with banking risks. To this end, reform ofthe banking supervision system will be carriedout in accord with the principles of separatingregulation from supervision (separating admin-istrative and planning work from direct super-vision), supervising legal persons (the focus ofsupervision to be on the financial institutions aslegal persons, rather than on their branches),and clearly defining responsibilities (the super-visory groups and individuals carrying responsi-bilities for direct supervision). The purpose is toincrease the ability and quality of supervision bythe central bank. While reforming bank super-vision, China will also reform the accounting sys-tem, enhance the self-discipline and supervisionof the industry, and give full play to the super-visory role of law firms, accounting firms, ratingagencies, and other intermediary organizations.
In short, China is aiming to enhance thequality and efficiency of its financial system, to thebest modern standards and as soon as possible, tofacilitate the economy’s stability and development.
FRANCE 53
France’s liberalization of its capital controls, im-plemented between 1983 and 1990, was an in-disputable success. The process occurred quickly:between 1984 and 1988 France switched fromhigh protection to an almost entirely deregulatedenvironment, phasing out all controls on thetrade balance and the current account. More-over, the process was not detrimental to macro-economic fundamentals. On the contrary, itwas accompanied by a restoration of economicstability. The trade balance improved signifi-cantly, and the French franc stabilized. The lastadjustment of the exchange rate occurred inJanuary 1987, with a 3 percent devaluation ofthe franc relative to the Deutsche mark.
The franc’s strong resilience to the cur-rency crises of the early 1990s indicates the suc-cess of these efforts. Unlike some Europeancurrencies, the franc was never forced out ofthe European Monetary System—though itsdefense demanded repeated use of joint foreignexchange interventions, reducing the Bank ofFrance’s official currency reserves. France’s ap-proach to liberalization enabled it to join theEuropean Monetary Union when it was cre-ated in 1999, with a conversion rate that main-tained the 1987 value of the franc. Moreover,countries such as Greece, Japan, Portugal, andSpain have used progressive approaches simi-lar to France’s to liberalize their capital controls.
The reasons for France’s success are diverseand partly due to noneconomic and external fac-tors, such as political commitment and eco-nomic recovery from 1986 onward. Still, threefeatures of France’s liberalization policies madedecisive contributions to their success: the poli-cies were pragmatic, integrated, and flexible:• Pragmatic approach. Ideology played as
small a part in the process of liberalizationas it had previously played in the institution
of capital controls. From the beginning thepriority was not to expedite the process atany price (through a “big bang” approach)but to ensure an incremental process—while eliminating any possibility of retreat,which would have imposed heavy credi-bility costs. Enormous attention was paidto sequencing, and the government movedto the next stage only after the previousone had achieved satisfactory results.
• Integrated design. The process was not fo-cused solely on removing capital controls.Each stage of capital control liberalizationproceeded hand in hand with macroeco-nomic stabilization and structural reformbecause both were crucial to strengtheningthe economy and so ensuring the durabil-ity of the reforms.
• Flexible implementation. Implementationwas flexible, enabling faster liberalizationwhenever the economy allowed it. As a re-sult the entire liberalization process wascompleted in 1990—six months ahead ofschedule.This chapter analyzes France’s experience
with capital controls and the evolution of theirliberalization in four stages since World War II.
RATIONALE FOR FINANCIAL ACCOUNT
CONTROLS FROM WORLD WAR II TO THE
1980S
France has long recognized the advantages ofliberalization. Still, at several points in the20th century it resorted to capital controls toprevent adverse dynamics that would inducea major worsening of its economic funda-mentals. France’s stance during this period canbe summed up this way: as much liberty as pos-sible, as much control as necessary.
France
54 FRANCE
Most of France’s capital restrictions wereimposed in the wake of exogenous shocks.Thus exchange rate controls were tightenedin 1939. But in 1958, in the wake of politi-cal stabilization, payments related to current
transactions were liberalized, ensuring freeconvertibility for current operations by non-residents. In 1961 France, like other WesternEuropean countries, restored current accountconvertibility, accepting the obligations ofthe International Monetary Fund (IMF) ar-ticles of agreement—which define members’obligations on, among other things, con-vertibility of foreign-held balances and avoid-ance of discriminatory currency practices andrestrictions on current transaction payments.Surveillance concerns the appropriateness ofchanges such as the introduction of capitalcontrols and substantial modifications in thisarea for balance of payments purposes.France’s capital controls have always respectedthe IMF articles of agreement.
Until 1966 foreign exchange controls fo-cused exclusively on capital flows, but at theend of that year a law abolished residual foreignexchange controls. The magnitude of theevents in May 1968, however, forced theFrench authorities to re-establish such controlsin November 1968.
1945–65: The “Treasury network”• Banking system organized under the direct con-
trol of the government (a result of the national-ization of 1945).
• Administrative control of savings and credits.• System of credit quotas.• Financing of the economy lay in the hand of the
Treasury, which was financed by the central bankand commercial banks (through Treasury bonds).Bank credit was limited by discount ceilings.
1966–83: The supremacy of the universalbank• Birth of the universal bank following laws in
1966 and 1967 allowing the free creation ofbranches.
• Creation of capital markets—opening of the cur-rency (monetary) market, creation of the mort-gage market, settlement of the Commission desopérations de Bourse—to ensure that banks and theeconomy had the required financing and to easereserve requirements.
• Persistent quotas on credit (1968–69, 1972–86)in a system dominated by financial intermediaries.
• Diversification of deposits to channel savings tobanks (creation of housing savings in 1966 and1969).
1984–97: Liberalization and Europeancoordination
Liberalization• Widening and deregulation of capital markets or-
ganized by the government (1982–85)• Regulatory harmonization of credit institutions
and banking deregulation (banking law of 1984).• Removal of credit quotas in favor of regulation
based on the leading interest rate of the Bank ofFrance.
• Privatization from 1986 on, with two waves:1986–88 and 1993–95.
• Implementation of a system of prudential con-trols, partly within the framework of the centralbank’s coordination process (based on Basleguidelines).
European coordination• Gradual phasing out of banks’ reserve require-
ments (1991).• Liberalization of bank activities in the European
framework (1988–93).• Harmonization of prudential regulations
(1989–96).• Enforcement of the EU directive on investment
services (1996) through France’s law on mod-ernization of financial activities.
BOX 1Steps toward financial deregulation in France, 1948–97
–6.0
–4.0
–2.0
0.0
2.0
4.0
6.0
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
Percent of GDP
Figure 1. Commercial balance and current account in France, 1980–2000
Commercial balance Current account
FRANCE 55
Capital controls were not conceived as away to escape market pressures. On the con-trary, the French authorities benefited fromthe protection offered by regulation to grad-ually increase the role of the market within thefinancial system. Although from 1945 to 1965the government assumed control for financingthe economy (through administered yields ofsavings, grants to public financial institutions,and selective credit distribution; see box 1),from 1965 to 1983 the government partly dis-entangled itself from the direct financing of in-vestment and promoted the development ofbanking intermediation.
Starting in 1966, various laws increased theautonomy of banks, allowing them to distrib-ute long-term credits financed by short-termresources. In addition, barriers to the openingof branches were abolished, giving banks theopportunity to build up networks to collect re-sources. New laws also provided the frameworkfor the creation of groups, ensuring through theprinciple of nonyielding deposits cheap andabundant resources to commercial banks. Andwith the creation of the mortgage market, therefinancing market was widened.
From the first oil shock until the early1980s, commercial banks’ refinancing was easedby the possibility of discounting medium-termcredits to the central bank. French banks alsoincreasingly turned to external markets. In1980 more than 90 percent of the cash in cir-culation was invested in commercial banks,confirming the hegemony of the universal bank.
In the early 1980s deterioration in France’scommercial and current account deficits andthe large differential in its nominal interestrates with Germany put pressure on the ex-change rate by offering speculative opportu-nities against the French franc (figures 1, 2, and3). Thus in 1983, after speculative attacksagainst the exchange rate and three devaluationsof the French franc in 18 months, the au-thorities decided to tighten exchange controls.These measures were intended to prevent eva-sion through the use of leads and lags in cur-rent account transactions and to prohibit allforward exchange transactions by importersand exporters. In 1983 severe cuts in foreigntravel allowances were also imposed.
At that point, however, the costs of capitalcontrols had become huge, both economically andpolitically. Capital control regulation entailedsignificant management costs for both the pub-lic administration and the private sector. Beyondthese costs—which prevented small and medium-size companies from developing exports—tightcapital controls were significantly detrimental tothe internationalization of French companies.Not only did they limit export dynamics, they alsohampered the takeover of foreign companies.
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
Percent
Figure 2. Interest rate differential between France and Germany, 1980–2000
–2
0
2
4
6
8
10
12
14
3-month loans 10-year loans
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
Percent
Figure 3. Exchange rate of the Deutsche mark and U.S. dollar relative to theFrench franc, 1980–2000
–25
–20
–15
–10
–5
0
5
10
15
20
25
30
MarkDollar
56 FRANCE
Capital controls also threatened the role ofParis as a major financial marketplace. By dis-couraging nonresidents from investing in do-mestic securities, they limited incentives tomodernize the functioning of the market at atime when national savings had dropped sig-nificantly due to a fast-rising public deficit.
France’s liberalization process, starting in1983, was partly driven by international dereg-ulation and by the development of the EU. Sev-eral measures were introduced:• Deregulation and opening of capital markets.• Unification of the legislative framework
of credit institutions (through the bankinglaw of 1984).
• Modernization of the management of gen-eral government debt by fitting out Trea-sury bonds.
• Suppression of the squeeze on bank credit(in 1987).
• Reduction of government intervention infinancing, which fell sharply between 1985and 1992.
• Privatization of the largest industrial andbanking groups (starting in 1987).Liberalizing capital controls was not easy.
Nevertheless, the phasing out of capital con-trols was carefully designed and implementedin only a few years. To ensure price and do-mestic currency stability during the process, thepace of capital control liberalization had toremain in line with improvements in macro-economic fundamentals. In most cases thatmeant that liberalization had to be gradual. Butgiven the degree of global financial sophisti-cation and market pressure, a gradual approachwas difficult to implement. Thus sequencingand macroeconomic consistency were two keyissues in capital control liberalization.
The first two periods of the liberalizationprocess both involved an important leap for-ward. From 1984 to 1986 emphasis wasplaced on the most pressing priority—namely,liberalization of trade-related operations.From 1986 onward, liberalization effortsmainly concerned the financial system. Thelast step, from 1987 to 1990, was dedicatedto phasing out residual foreign exchange trans-actions and liberalizing foreign direct invest-ment inflows.
LIBERALIZATION OF TRADE AND THE MOVE
TO A MARKET-FINANCED ECONOMY,1984–86
In 1983 most operations involving financial re-lations abroad were controlled. Whereas mostcapital restrictions on the financial sector in-volved state-owned banks, which experiencedvery tight credit controls, most foreign ex-change controls affected companies involvedin international trade and were especially detri-mental to the smallest ones—those most ill atease with administrative proceedings and leastable to cope with the costs.
The liberalization process began with thephasing out of restrictions on French citizens.Such restrictions were the most politically sen-sitive because they were considered to interferewith privacy and individual freedom. As ofmid-1983 discretionary private transfers wereallowed under a ceiling that increased gradu-ally through 1986. At the end of 1983 the fa-mous carnet de change (foreign exchangevoucher) limiting currency buying from Frenchtourists was removed. The year after, the freeuse of credit cards abroad was re-established.
At the same time, decisive measures weretaken to restore fundamental macroeconomicbalances. Decisive steps were taken to restoreprice stability. In 1982 and 1983 wages wereprogressively de-indexed. This important re-form paved the way to a better control on in-flation anticipations, leading to a sharp anddurable decrease in inflation. Meanwhile, therestructuring of French companies speededup. The capital base of the largest companieswas improved through nationalizations thatshored them up with fresh capital and helpedrestructure the main industrial sectors. Theprofitability of the French corporate sectorimproved markedly. This enabled French com-panies to finance their development more withtheir cash flow rather than with bank loans.
In 1985 the launching of the Single Marketprocess provided a further incentive to removebarriers on trade. In 1985 currency hedging forECU-denominated imports was allowed. Thatsame year, restrictions on export credits werelifted. In mid-1986 a decisive step was taken: cur-rency hedging was totally liberalized and some
FRANCE 57
flexibility was introduced in foreign cash man-agement. In late 1986 administrative controls oftrade transactions were entirely removed.
The liberalization of capital transactionspresupposed a prior mutation of the financingstructures of the French economy. Financialderegulation took place in France within acouple of years, from 1984 to 1986. Duringthis short period the French economy movedfrom a situation characterized by a wide rangeof administrated rates, a relative scarcity of fi-nancial instruments, and credit rationing andregulation (known as encadrement du crédit) toa market-based economy. These huge changesaffected both the conduct and the efficiency ofmonetary policy.
The Banking Act of 1984 can probably beconsidered a cornerstone for these changes. Thisact, replacing 1941 and 1945 legislation, re-moved old divisions between investment andcommercial banks. It also introduced new, uni-form prudential rules for all financial institutions.
The deregulation process can also be tracedback to 1984, when the end of the encadrementdu crédit was announced for January 1985.This credit rationing had been introduced bythe French monetary authorities in 1972 tohelp the monetary authorities control mone-tary aggregates. But the conduct of monetarypolicy turned out to be more complex than ex-pected because the regulation was subject tomany exemptions for a wide range of subsidizedcredits. It also created many distortions, lead-ing to artificial pressures on interest rates andgenerating high administrative costs. With thedemise of direct credit control, the Frenchmonetary authorities began to rely exclusivelyon interest rates and legal reserve requirementsfor monetary management.
The monetary authorities also reformedthe money market by dividing it into two dis-tinct segments. The first, the interbank mar-ket, was open only to financial institutionsand was the segment on which the Frenchcentral bank operated. The second, the newmoney market, was gradually opened to alleconomic agents and focused on debt instru-ments of all maturities (from overnight toseven years). Moreover, banks were allowedto issue certificates of deposit, while firms were
permitted to float commercial paper. At thesame time, the purchase of Treasury bills wasopened to everyone.
The crowning change occurred in late 1986with the reform of the Bank of France’s moneymarket intervention techniques and the end of“fixing”—which had meant that every morningthe central bank announced the price at whichit would deal during the day, setting a standardfor all transactions. Once this practice ended inDecember 1986, prices started to vary contin-uously, and different prices started being quotedsimultaneously. In line with the reform in moneymarkets, from 1986 onward the Bank of Francestarted to intervene more frequently on themarket, either through outright transactions orthrough very short-term repurchase and with-drawal transactions for fine-tuning purposes,without any formal announcement. Because ofall these changes, the French economy—whichhad been enormously reliant on banking forfinance—became increasingly dependent oninternal finance and capital markets.
Although it is difficult to assess the impactof all these changes on the transmission mech-anism of monetary policy, some econometricresearch has indicated increased efficiency.Comparing two periods, 1987–91 and1992–96, Pfister and Grunspan (1999) showthat the responses of money market rates andbank lending rates became quicker and largerin the second period (Pfister and Grunspan1999). The same conclusion can be drawnabout the impact of changes in interest rateson the exchange rate, because the interest raterise required to alleviate exchange rate pressurebecame progressively less important.
The link between foreign exchange controlsand structural reforms is utterly clear duringthis period. France never considered foreign ex-change controls a substitute for monetary pol-icy, but the restoration of structural conditionsconducive to price stability was clearly a pre-requisite for relaxing such controls. In fact,foreign exchange liberalization measuresentailed significant costs for France’s currencybalance that would have been incompatiblewith a continuous strain on foreign exchangereserves. Macroeconomic improvements andthe positive effect on confidence in France’s
58 FRANCE
economic policy—along with the credibility ef-fect resulting from membership in the Euro-pean Monetary System—eased pressure onthe franc and made possible the moves towardforeign exchange liberalization.
LIBERALIZATION OF MOST CAPITAL
TRANSACTIONS, 1986–87
Until the mid-1980s the financial sector inFrance was controlled by the state through awide range of tools: compulsory reserves fromcommercial banks in the central bank’s books,direct credit control, shareholding control of thestate in the largest banks, and subsidized loansto the industrial and agricultural sectors.
The mutation of the banking sector was ac-celerated by the desire to boost the competi-tiveness of the Paris marketplace and by thestate’s need to deal with rapidly increasing bor-rowing requirements by attracting nonresi-dent savings. These factors led to deep reformof the French debt market. A structured mon-etary market was created with three kind of is-suers: the state (with Treasury bills called Bonsà taux annuel, or BTAN, and Bons à taux fixes,or BTF), banks (with certificates of deposit),and private companies (with commercial papercalled billets de trésorerie). The long-term debtsegment was also restructured.
The sovereign debt market was organizedaround regular issuance of bonds (obligationsassimilables du Trésor), all fungible in a smallnumber of main lines. For market-making asystem close to that of primary dealers wasadopted with selection among both Frenchbanks and subsidiaries of foreign ones of Spé-cialistes en valeur du Trésor. Meanwhile, thestock market was dramatically modernizedthrough dematerialized shares and electronictrading. In 1986 a futures market for bonds wascreated. In addition, commissions and fees forfinancial markets were completely deregulated.
These important changes made it possibleto remove some important restrictions to cross-border financial operations. The legalframework for foreign currency-denominatedloans abroad was relaxed in 1986. Franc-denominated loans abroad were allowed soonafter. And in mid-1986 French residents were
freely allowed to buy securities listed on for-eign equity markets.
The framework for international invest-ment also began to be loosened significantly.The acquisition of foreign real estate by Frenchresidents was fully liberalized. (It had previouslybeen subject to authorization by the Bank ofFrance.) In addition, investments by French res-idents in foreign corporations were relaxed in1986. At that time, only investments in hold-ing corporations were still subject to prior au-thorization from the Treasury (except forinvestments in South Africa, which were pro-hibited for political reasons).
Deregulation of foreign direct investmentin France also made significant progress dur-ing this period. In 1986 the 10 million francceiling, above which additional interest-takingfrom nonresident companies in French com-panies were subject to administrative autho-rization, was removed.
TOWARD TOTAL LIBERALIZATION OF CAPITAL
FLOWS, 1988–90
Residual restrictions on capital flows were re-moved between 1988 and 1990. In 1998 thelegal framework for exporting companies wassimplified. In mid-1989 controls on the ag-gregate foreign exchange positions of com-mercial banks were abolished and replaced byprudential regulation. At the end of the year res-idents were allowed to freely open and keep for-eign currency—denominated accounts inFrance and foreign currency—and franc-denominated accounts abroad as well as tohold monetary gold abroad.
All remaining administrative restrictions onforeign direct investment in France was alsophased out during this period. In 1998 the set-tlement of nonresident-owned companies inFrance was fully liberalized and the creation ofcompanies by nonresidents became entirelyfree. In 1990 the legal framework for invest-ment by European Union companies in Francewas softened considerably.
This liberalization process did not mean aretreat in the statistical accuracy of the Frenchbalance of payments or in the fight against fi-nancial crime and money laundering. Banks are
FRANCE 59
subject to compulsory monthly declarations tothe Bank of France (with direct declarations bylarge exporters), and specific legal provisionswere designed to prevent money laundering.Cash transfers are limited to 50,000 francs(8,000 euros). Moreover, banks must alert anadministrative crime-fighting unit any timeaccount movements raise suspicions of moneylaundering.
The liberalization of capital movementswas finalized through prudential deregulationand liberalization of foreign direct investment
(box 2). In addition, the Bank of France wasgranted full independence thanks to newstatutes implemented in 1993.
REFERENCE
Pfister, Christian, and Thierry Grunspan.1999. “Some Implications of Bank Restruc-turing for French Monetary Policy.” BIS Con-ference Papers 7, The Monetary and RegulatoryImplications of Changes in the Banking Indus-try. Bank for International Settlements, Geneva.
The liberalization of international capital flowsto France was accompanied by the implementationof a prudential framework derived from decisionsmade at the international level (the Basle commit-tee) and at the European level. The importance ofsupervision and prudential rules has increased fol-lowing the increased risks due to globalization andthe difficulties due to the growing size of banks.
Derived directly from European Union direc-tives, prudential regulation in France rests on twocomplementary principles: liberalization (mentioned
in the banking law) and harmonization of regula-tions. Prudential rules are mainly based on classicalbanking risks. Norms have been elaborated for re-porting banks’ counterpart risks and exchange raterisks. Norms based on banks’ assets and liabilitieshave also been constructed to reinforce the re-quirements and prevent liquidity risks. France’sframework of prudential rules is quite strict—relativeto financial institutions in other major Europeancountries, those in France have to respect very spe-cific rules.
BOX 2Steps toward prudential deregulation in France, 1990–2000
GERMANY 61
Globalization has clearly had a favorable im-pact on productivity and economic develop-ment in Germany. The positive effects havebeen enhanced by the institutional setting—companies enjoy the economic freedom, po-litical stability and legal security that enablethem to make full use of the benefits of inter-national interpenetration. Advantageous macro-economic conditions arising from thelow-friction interaction of fiscal, monetary,and wage policies have contributed to this de-velopment, as have state reforms, such as theprivatization of state enterprises and liberal-ization of markets through the European single-market program, GATT, and the WTO.
The German economy also benefited fromthe early liberalization of capital flows in com-bination with a sound financial system and amonetary policy that was strictly oriented towardprice stability. As a result, interest rates remainedrelatively low, the Deutsche mark became the sec-ond most important international currency andGermany developed into a major internationalfinancial center, contributing to growth and em-ployment in Germany. The German experiencealso shows, however, that, in the context of freemovements of capital, monetary policy can onlybe geared independently if the exchange ratehas sufficient flexibility.
Social harmony has been preserved bymeans of comprehensive social security sys-tems and state redistribution designed to cush-ion the adverse effects of accelerating structuralchange. In the light of rising unemployment,however, action must be taken with a view toreintegrating more quickly and more fully thosewho have become redundant—say, by intro-ducing more flexible tools in labor market andwage policy, concentrating welfare policy on thelosers from structural change or reducing the
burden of contributions on enterprises andhouseholds. This could further minimize therisks of globalization and harness its benefitsto a greater extent for the German economyas a whole.
INDICATORS OF GLOBALIZATION
The increasing integration of the global econ-omy in products and production factors has ledto noticeable changes in Germany. Foreigntrade in goods and services has intensified.Cross-border investment is on the rise. Andcapital flows have become more liberalized.Foreign direct investment in Germany andinvestment by German enterprises abroad havebeen growing much faster than gross domes-tic product (GDP) since 1950, with annualgrowth rates averaging more than 30 percentin the 1990s (figure 1). Foreign trade linkages—the development of imports and exports—have also increased significantly, though not tothe same extent as direct investment.
This process—beginning with the found-ing of the Federal Republic of Germany in1949 and the subsequent economic reinte-gration of West Germany into the interna-tional division of labor in the 1950s—is froma qualitative viewpoint not fundamentally new.Instead, it is the resumption of developmentsinterrupted by the outbreak of World War I.
Globalization, apart from the rapid rein-tegration of Germany into the global economyafter World War II, has been a gradual process(figure 2). The degree of openness—the pro-portional role of imports and exports inGDP—has risen distinctly, moving from 20.4percent in 1950 to 56 percent in 2000 in nom-inal prices. In constant prices the increase be-comes more obvious, as the prices in foreign
Germany
62 GERMANY
trade have risen less on average than the priceindex of total GDP. This has been influencedby the worldwide liberalization of trade throughGATT and the WTO, the progress in Euro-pean integration, and such technological andeconomic developments as the drastic reduc-tion in transport and communications costs.
The almost constant rise in the degree ofopenness (in constant prices) was interrupted byGerman reunification in 1990. West Germanenterprises concentrated their marketing effortson eastern Germany after reunification, givingother markets lower priority. In the 1990s, ac-tivity in foreign trade gained noticeable mo-mentum with high growth rates in imports andexports, at times running into double digits.
The openness of the economy was sup-ported by the integration of Germany’s finan-cial markets into the global financial system andthe growing attractiveness and increasing im-portance of the Deutsche mark. Facilitated byan early liberalization of capital movements,Germany’s cross-border assets and liabilitiesincreased from less than 20 percent of GDP atthe beginning of the 1960s to about 130 per-cent in 2000 (figure 3a). German investorscurrently hold nearly a fifth of their financialassets in foreign instruments. Likewise, Ger-man borrowers use external sources of capitalto a similar extent. Purchases of German se-curities by foreign investors increased fromless than 10 percent of the total net amountissued during the 1970s to about 60 percentbetween 1996 and 2000 (figure 3b).
The international orientation of the Ger-man banking sector is reflected by the steadilyrising share of cross-border bank activities. In1960 lending to nonresidents accounted for lessthan 2 percent of the total assets of the Germanbanking sector. In 2000 that share amountedto 16 percent (figure 3c). German banks pro-vide financial services around the world, directlyand through almost 400 foreign subsidiaries andbranches. Total assets of foreign subsidiariesand branches account for 35 percent of thebalance sheet total of domestic institutions.
The internationalization of the Germaneconomy was mirrored by the enhanced role ofthe Deutsche mark, which in the 1970s be-came the second most important investment andreserve currency after the U.S. dollar. By the endof the 1980s, Germany’s share of global foreignexchange reserves peaked at about 20 percent butbegan to decrease as developing countries, whichtraditionally favor the U.S. dollar, substantiallyexpanded their foreign exchange holdings andsome euro area countries reduced their Deutsche
0
10
20
30
40
50
60
20001995199019851980197519701965196019551950
Percent
Figure 2. Degree of openness, 1950–2000
Current prices
Constant 1995 prices
Note: Data refer to West Germany for 1970–90 (excluding Saarland and West Berlin until 1959), Germany for 1991–2000.
Source: Council of Economic Experts, Federal Statistical Office.
10,000
100
1,000
2000199519901985198019751970
Index: 1970=100Log scale
Figure 1. Indicators of globalization, 1970–2000
GDPImports and exports
FDI
Note: Data are in current prices and refer to West Germany for 1970–90, Germany for 1991–2000. FDI equals the sum of FDI inflows and FDI outflows.
Source: Federal Ministry of Economics, Council of Economic Experts, Federal Statistical Office.
GERMANY 63
mark reserves in the run-up to European Mon-etary Union. By the end of 1998, when theeuro was launched, the Deutsche mark share haddropped to 12 percent. At that time, 10.5 per-cent of international bonds and notes and 14percent of international bank loans were de-nominated in Deutsche marks (figures 4a–c).The international integration of Germany’s fi-nancial markets has facilitated financing activ-ities for domestic borrowers. But marketconditions in Germany were at times heavily in-fluenced by external developments, affecting—at least temporarily—the impact of domesticmonetary policy.
Given the German economy’s increasingglobalization, two questions are of particularinterest:• What have been the overall economic ef-
fects of the process of globalization?• Which governmental measures have max-
imized the benefits of globalization andminimized its risks?
INSTITUTIONAL FRAMEWORK IN GERMANY
The economic and legal framework in Ger-many is based on a “social market economy”.The most important elements of this eco-nomic order—which arose in West Germanyat the end of the 1940s and, on reunification,took hold in eastern Germany—include pri-vate ownership of the means of production, freeprice formation, the guarantee of free compe-tition, freedom of foreign trade, a low-inflationpolicy regulated by an independent centralbank, and a policy of social equalization by gov-ernmental redistribution.
Highly relevant to harnessing the benefitsof globalization are these fundamental elementsand the interplay of individual institutionalplayers in the economy. Through the pursuitof a sound fiscal policy, a stability-orientedmonetary policy, and a wage policy guided byproductivity growth and the labor market sit-uation, favorable macroeconomic conditionscan be created to encourage growth and em-ployment in the face of exogenous import orsupply shocks. The interaction among fiscal,monetary, and wage policies has been relativelysuccessful in the past few decades, apart from
the severe conflicts surrounding distribution pol-icy after the first oil crisis in 1973 and the wagepolicy in eastern Germany after reunification.
The advantages of globalization in Ger-many have been extensively exploited. In-creasing internationalization has exposed
0
30
60
90
120
150
200019951990198519801975197019651960
Share of GDP (%)
Figure 3. Financial indicators of the internationalization of the German economy
Liabilities
Assets
3a. Cross-border assets and liabilities
0
10
20
30
40
50
60
200019951990198519801975197019651960
Share of net total issues (%), 5-year moving average
3b. Purchases of domestic securities by nonresidents
0
5
10
15
20
200019951990198519801975197019651960
Share of bank balance sheet total (%)
3c. Bank loans to nonresidents
64 GERMANY
German enterprises and business locations tomore competition with foreign players. Moreintensive competition, increasing returns toscale in the production process and the ex-ploitation of differences in international busi-ness locations have enhanced the efficiency ofenterprises, bringing growth in productivity(table 1).
Moreover, the institutional framework fa-vored German enterprises concentrating oncapital-intensive and knowledge-intensive goodsand services in the international division oflabor, generating a higher net added value. Ger-man enterprises in the automotive, machine-
building, chemicals, telecommunications, andelectronics industries, characterized by mediumto high technological intensity, feature a highshare and intensity of export—a share that is stillincreasing (table 2). These increases in pro-ductivity, alongside constant or rising terms oftrade, have resulted in welfare gains and leftroom for wage increases for employees.
The effects of globalization on the Germaneconomy cannot be clearly separated from theeffects of technical progress. Both occur at thesame time, reinforcing each other. Increasinginternational competition forces enterprisesto step up their efforts in product developmentand optimization of production processes.Technological developments, such as the in-troduction of containers for maritime transport,have led to lower transaction costs and facili-tate an increasing integration of internationalmarkets. There is no precise empirical answeras to which effect will ultimately dominate. Butit clear that inter and intrasectoral structuralchange in Germany has gained momentum asa result of globalization.
Implementation of the international divi-sion of labor and specialization of productionhas been facilitated by the legal security, eco-nomic freedom, political stability, and social sat-isfaction prevailing in Germany. Such socialaspects as state redistribution by progressive in-come taxation and social security as pension,health and unemployment insurance, and sup-plementary welfare benefits, have madeglobalization-driven change more palatable tothe German public. But labor-intensive in-dustries such as textiles, clothing, and leatherprocessing have lost their international com-petitiveness in the lower price segments, whichin turn has led to job losses.
Developments in eastern Germany after re-unification emphasize the importance of socialequalization for maintaining social satisfac-tion and avoiding political unrest. The vast ma-jority of eastern German companies becameuncompetitive in 1990/91, with radical struc-tural change the inevitable consequence. So-cial cushioning of the blow of structural changewas particularly important.
Compensation of the “losers” of the struc-tural upheaval in Germany can be seen in
4a. Shares in global foreign exchange reserves
Deutsche mark (12.1%)
Yen (5.3%)
Other, including unidentifiablecurrencies (16.9%)
Figure 4. Market share of the Deutsche mark in international financialmarkets, end of 1998
a. Cross-border positions of the banks in the industrial countries reporting to the BIS.Source: IMF, BIS.
U.S. dollar(65.7%)
4b. Shares in international bonds and notes outstanding
Deutsche mark (10.3%)
Yen (11.7%)U.S. dollar(45.2%)
4c. Shares in international bank assetsa
Deutsche mark (13.9%)
Yen (12.5%)
U.S. dollar(42.3%)
Othercurrencies(32.8%)
Othercurrencies(31.3%)
GERMANY 65
income distribution. In recent decades, thedistribution of household incomes has changedlittle despite rising unemployment. The systemsof social security and progressive taxation havemaintained the status quo. The Gini coefficient,a measure of the distribution of income, hasrisen only slightly in both western and also east-ern Germany (table 3).
POLITICAL REFORMS
In addition to the national institutional setting,the benefits of globalization have been maxi-mized in two different ways:• Improving the quality of Germany as an
economic location—asserting a leadingposition on the international market andexploiting the benefits of the increasinginterpenetration of the domestic and for-eign markets.
• Introducing legally binding internationalregulations through national, regional, andworldwide political reforms in educationalpolicy, the privatization of state enterprises,and the liberalization of financial and com-modities markets.
EDUCATION POLICY
The average level of education is on the rise—thanks to education policy, which in recentdecades has focused on fostering higher edu-cational qualification in schools and universi-ties as well as on expanding the dual system ofin-service vocational training. This can be seenin the higher numbers of qualified schoolleavers, university graduates, and qualified in-service trainees per year. With their higherqualification, employees have become moreproductive—a prerequisite for making betteruse of the opportunities offered by structuralchange.
Due to the accelerated pace of structuralchange, educational policy also plays an im-portant role in the further training and quali-fication of employees. Unemployed workersnot having the required expertise and skillsneed retraining—with help from the state—tofacilitate their integration into the job market.Although the need for lifelong education has
been a stronger focus of educational policyover the past few years, efforts still need to bereinforced for underskilled workers.
TABLE 2Structure of German foreign trade with respect to technologicalintensity, 1976–78 and 1992–94(percent)
1976–78 1992–94
High-technology industries a Share of exports 10.7 15.0Share of imports 11.6 18.8Intensity of exports c 34.3 46.1Import penetrationd 27.3 46.7
Middle-technology industriesb Share of exports 54.6 54.8Share of imports 29.4 36.6Intensity of exports c 34.3 39.6Import penetrationd 15.7 26.4
Other industries Share of exports 34.7 30.2Share of imports 59.0 44.6Intensity of exports c 15.3 19.4Import penetrationd 16.9 22.6
Total manufacturing Intensity of exports c 24.0 30.6Import penetrationd 17.3 26.6
Note: More recent data not available due to statistical changes in the OECD STAN Database. Data refer to West Germanyfor 1976–78, Germany for 1992–94.a. Among others, information technology, telecommunications, and aerospace.b. Among others, chemicals, electronics, machinery, and cars.c. Exports in percent of gross output.d. Imports in percent of domestic consumption (gross output + imports – exports).Source: OECD.
TABLE 3Development of income distribution, 1984–98(Gini coefficients)a
West Germany East Germany GermanyMarket Net Market Net Market Net
Year incomeb incomec incomeb incomec incomeb incomec
1984 0.4276 0.2778 — — — —1988 0.4099 0.2665 — — — —1991 0.4064 0.2770 0.3920 0.2254 0.4254 0.29671995 0.4304 0.2891 0.4439 0.2316 0.4380 0.28561998 0.4446 0.2919 0.4815 0.2435 0.4550 0.2885
a. A Gini coefficient of zero implies a completely equal distribution of incomes; one implies a completely unequal distribution.b. Gross income before taxes and transfers.c. After taxes and including transfers.Source: Council of Economic Experts, Federal Statistical Office.
TABLE 1Indicators of economic development, 1950–2000
Period 1951–60 1961–70 1971–80 1981–90 1991–2000 1951–2000
GDPa 8.9 4.4 2.7 2.2 1.5 4.0Per capita GDPa 7.6 3.5 2.6 2.0 1.2 2.9Productivityb 5.8 4.2 2.6 1.7 1.7 2.7Rate of inflationc 1.9 2.5 5.0 2.6 2.2 2.8
Note: Data refer to West Germany for 1951–90, Germany for 1991–2000.a. Constant 1995 prices.b. GDP per employee, constant 1995 prices.c. Annual average change in consumer price index.Source: Federal Statistical Office.
66 GERMANY
LIBERALIZATION AND DEREGULATION OF
FINANCIAL MARKETS
Capital controls in Germany had been widelydismantled by 1958 when full convertibility ofthe Deutsche mark for residents and nonresi-dents was introduced. In the 1960s, the liber-alization of interest rates followed, and in the1980s and 1990s German authorities made sig-nificant efforts to strengthen the attractivenessof German financial markets by adjusting or re-moving domestic regulations that had narrowedthe available array of financial instruments.
An independent monetary policy geared tomaintaining price stability, the increasingly freeflow of capital among industrial countries, andthe Bretton Woods regime of fixed exchange ratessoon proved to be incompatible policy objectives.To mitigate inflationary pressures from strongspeculative capital inflows, Germany introducedmeasures from 1960 onwards to stem the grow-ing international demand for Deutsche mark as-sets, including a ban on the payment of intereston nonresidents’ deposits in domestic banks, acoupon tax levied on the interest nonresidentsearned on domestic bonds, and the require-ment of holding non-interest-bearing cash de-posits against borrowings from abroad. (For anoverview of the restrictions and the subsequentliberalization measures see appendix A.)
Abandoning the peg to the U.S. dollar in1973 enabled the Bundesbank to regain con-trol of the money supply. Floating was a par-ticular precondition for the targeting ofmonetary aggregates introduced by the Bun-desbank in 1974. Most restrictions on capitalinflows were then quickly removed. The ex-perience of the Bretton Woods era was rein-forced by the developments in the EuropeanMonetary System in the early 1990s. Divergenteconomic developments called for different poli-cies in the member countries. With more EMScountries having fully liberalized their capitalaccount transactions, greater flexibility in theExchange Rate Mechanism (ERM) was realizedwith the widening of the permissible fluctuationmargins to ±15 percent in 1993.
The Bundesbank’s constant efforts to en-sure a high degree of price stability have resultedin the prevalence of long-term financing in
Germany. In the same vein of fostering soundfinancing structures, the German authoritieshad not permitted the issuance of new typesof paper such as floating rate notes, zero-coupon bonds, double-currency bonds, bondslinked to currency and interest rate swaps, orcertificates of deposit. In 1985–86, in an effortto promote Germany as an international fi-nancial center, those regulations were abol-ished in connection with other measures toderegulate the German financial markets. Over-all, the efficiency of German monetary policyhas been safeguarded in an environment ofliberalized and deregulated financial markets.
LIBERALIZATION OF COMMODITIES MARKETS
AND PRIVATIZATION
In addition to the liberalization of financial mar-kets, numerous commodities markets, such astelecommunications and electricity, have alsobeen liberated from restrictive state regulations.In both sectors, the opening of the market wasoriginally triggered by the European single-mar-ket program. Liberalization has also been achievedin the financial services sector (banks and in-surance companies) and in the transport sectorthanks to the European single market as well asthe gradual abolition within the European Com-munity and European Union of nontariff tradebarriers such as product standards.
This process has been accompanied on thepart of the German government by increasedprivatization (for example, of DeutscheTelekom on the telecoms market), to make theformer state monopolies more competitive.The partial privatization of the national postalservice, Deutsche Post, and the national rail-way company, Deutsche Bahn, has been ini-tiated and in part already completed.
Through GATT and the WTO, success-ful multilateral negotiations have led to a sub-stantial reduction in tariff and nontariff tradebarriers. The Uruguay Round of the GATT ne-gotiations included a further reduction in cus-toms duties (figure 5), the inclusion of textilesand agricultural in the regulations of the WTOand the admittance of services for the firsttime. Moreover, acceptance and the efficiencyof the world trading system received support
GERMANY 67
in the form of the agreement on internationalrules for the settlement of disputes. Importersand exporters in all WTO member states nowenjoy even greater market access.
MINIMIZING THE RISKS AND MAXIMIZING THE
BENEFITS OF GLOBALIZATION
The stepping-up of liberalization and priva-tization has raised the intensity of competi-tion on major markets (see export intensityand import penetration in table 2). It hasalso accelerated the pace of structural changeand resulted in lower prices, which have madeenterprises more competitive. It has also be-come possible for new, innovative technolo-gies, such as mobile telephony, to be morewidely used. Intensive entrepreneurial com-petition favors technological developmentand product differentiation, which can in-crease national and international sales andthus overall employment.
The unemployment trend in Germanydemonstrates that the economic benefits ofstructural change can be put to even betteruse. The unemployment rate has been rising ap-preciably since the mid-1970s (figure 6), partlybecause the demands posed by the acceleratedpace of structural change were not adequatelymet. Underskilled workers, in particular, are thepeople who have lost out in the structuralchange over recent decades. Their unemploy-ment rate in 1999, at about 24 percent in west-ern Germany and about 55 percent in easternGermany, was clearly above the average (11.7percent). Almost half the unemployed in west-ern Germany received no vocational training.Extensive retraining and further training mea-sures have, however, only succeeded in slowing,rather than halting, this negative trend.
One reason for the particularly sharp risein unemployment among underqualified per-sons is the divide between their productivityand remuneration. When wages rise fasterthan productivity, it is less profitable to employpoorly qualified persons. Technical progress andgrowing international competition from de-veloping and newly industrializing countrieshave led to the substitution of simple labor withcapital or to the relocation of production fa-
cilities to countries with lower labor costs. Thewage drift—with higher wages in Germanythan in the international market— is too smallto integrate all employees who have become re-dundant as a result of structural change. Thereis potential for making greater use of the ben-efits of globalization for all employees.
The downside of the all-embracing wel-fare system and state redistribution is thegreat burden borne by enterprises and private
0
10
20
30
40
19931979196719621949
Tariff rate (percent)
Figure 5. Tariff reduction within GATT, 1947–93
Note: Average tariff rates of GATT members after completion of each round.Source: WTO.
Formation of GATTGeneva 1947
Annecy 1949
Torquay1950–51
Geneva 1956
Dillon Round1960–62
Kennedy Round1964–67
Tokyo Round1973–79 Uruguay Round
1986–93
0
2
4
6
8
10
12
14
2000199519901985198019751970
Percent
Figure 6. Unemployment rate, 1970–2000a
West Germany
Germany
a. Unemployed persons as a share of the civilian labor force, national definition.Source: Federal Labor Office.
68 GERMANY
APPENDIX A
RECORD OF IMPORTANT MEASURES FOR CONTROLLING CAPITAL IMPORTS INTO GERMANY,1958–84
1958December• Introduction of full convertibility of the Deutsche mark for residents and nonresidents.
1959May• Removal of the ban on the payment of interest on foreign deposits with domestic banks and
the authorization requirement for nonresidents’ purchases of money market paper and thetaking up of foreign loans with maturities of up to five years.
1960June• Ban on the payment of interest on foreign deposits with domestic banks, on the sale of do-
mestic money market paper to nonresidents, and on securities transactions under repurchaseagreements between residents and nonresidents.
1961September• Entry into force of the Foreign Trade and Payments Act and adoption of the principle of basic
freedom of foreign trade and payments; no material change to the existing state of capitaltransactions.
1965March• Introduction of coupon tax on nonresidents’ interest income from domestic bonds.
households in taxes and social insurancecontributions. The overall burden—the pro-portion of the GDP accounted for by taxesand social insurance contributions—rose fromsome 34 percent in 1960 to some 43 percentin 2000. This growing burden has reduced theincentives for companies and private house-holds, turned labor into a more expensivefactor of production, and weakened the in-ternational competitiveness of enterprises.There are still opportunities for maximizingthe benefits of globalization, for example byconcentrating welfare policy on the obviouslosers in the process of structural change orreducing the marginal burden in the tax-transfer system, particularly for poorly qual-
ified persons, to give them greater incentivesto take up employment.
Lower tax and social insurance contribu-tions would improve the position on the in-ternational market of domestic companies aswell as that of Germany as an economic loca-tion and unemployment could fall—withoutjeopardizing the necessary solidarity with theobvious losers in the process of structuralchange. The reforms implemented in recentyears, such as consolidation of state finances ortax and pension reform aimed at lowering con-tributions and raising incentives, are a step inthe right direction. But these reforms must befollowed through if the necessary reduction ofcontributions in real terms is to be sustained.
GERMANY 69
1968November• Introduction of the authorization requirement for the acceptance of foreign funds by domestic
banks in so far as it does not serve the proper handling of merchandise, services, and capi-tal transactions with foreign countries.
1969February• Removal of the authorization requirement for the acceptance of foreign funds by domestic banks.December• Removal of the ban on the payment of interest on foreign deposits with domestic banks, on
the sale of domestic money market paper to nonresidents, and on securities transactions underrepurchase agreements between residents and nonresidents.
1971May• At the beginning of the dollar crisis, reintroduction of the authorization requirement for the
sale of domestic money market paper to nonresidents and for the payment of interest on for-eign deposits with domestic banks.
1972March• Introduction of the cash deposit requirement for borrowings abroad. Exceptions are, in par-
ticular, credits in connection with the use of customary terms of payment and credits relatedto specific goods and services supplied. The cash deposit ratio is initially 40 percent with anexemption limit of 2 million Deutsche marks.
June• Introduction of the authorization requirement for nonresidents’ purchases of domestic bonds
from residents.July• Raising of the cash deposit ratio to 50 percent and reduction of the cash deposit exemption
limit to 500,000 Deutsche marks.
1973January• Reduction of the cash deposit exemption limit to 50,000 Deutsche marks.February• Extension of the authorization requirement for the purchase of domestic securities by non-
residents to equities. Introduction of the authorization requirement for residents’ borrow-ing abroad.
June• Introduction of the authorization requirement for the assignment of domestic claims to non-
residents.
1974February• Raising of the cash deposit exemption limit to 100,000 Deutsche marks and reduction of
the cash deposit ratio to 20 percent. Restriction of the authorization requirement for the saleof domestic securities to nonresidents to bonds with (remaining) maturities of up to four yearsand removal of the authorization requirement for residents’ borrowing abroad.
70 GERMANY
1974 (continued)September• Removal of the cash deposit requirement and the authorization requirement for the assign-
ment of domestic claims to nonresidents.
1975September• Removal of the authorization requirement for the payment of interest on nonresidents’ de-
posits with domestic banks and further relaxation of the authorization requirement for thepurchase of domestic bonds by nonresidents.
1980March• Allowance of the possibility of assigning official borrowers’ notes to nonresidents.• Authorizations for the purchase of domestic bonds with (remaining) maturities of more than
two years are normally granted.November• Authorizations for the purchase of domestic bonds with (remaining) maturities of more than
one year are normally granted.
1981March• The purchase of any domestic bonds and money market paper by nonresidents is normally
approved.August• Removal of the existing authorization restrictions on the purchase of domestic bonds and
money market paper by nonresidents.
1984December• Act governing the abolition of coupon tax on interest received by nonresidents from domestic
bonds, with retroactive effect from August 1984.
Source: Deutsche Bundesbank.
INDIA 71
India’s experience with globalization over the pastdecade has been somewhat different from thatof most other G-20 countries, both in terms ofthe approach taken and the associated benefits,concerns, and policy challenges. Recognizing thevarious benefits and costs of globalization—and taking into account lessons from othercountries that embraced globalization muchsooner—Indian authorities have adapted thecontent, sequence, and timing of internationalintegration policies to minimize potential shocksand maximize benefits. This cautious approachhas been guided by the perceived tradeoffs be-tween risks and returns and by the authorities’low tolerance for risk. But since the East Asianfinancial crisis that started in 1997, there havebeen major shifts in international views onglobalization—and today mainstream viewsclosely resemble India’s approach.
INDIA’S GLOBALIZATION POLICIES
Although India’s interface with the global econ-omy started earlier, deeper globalization was trig-gered by the country’s external debt crisis in1991. Though Indian policymakers were notenthusiastic about economic openness (Desai1999), the crisis induced a more systematicapproach to globalization policy. These effortsinvolved:• Removing restrictions on current payments
and transfers to make the current accountconvertible, in accordance with article 8 ofthe International Monetary Fund (IMF) ar-ticles of agreement.
• Liberalizing underlying current accounttransactions—particularly dismantling tar-iff and nontariff trade barriers.
• Switching to a market-determined exchangerate—which, along with comfortable
foreign exchange reserves, provided key“self-insurance” against globalization shocks.
• Prudently managing the capital account toensure a shift in capital inflows in favor oflonger-maturity debt and nondebt flows.
• Adopting a cautious, calibrated approachto capital account convertibility.Moreover, measures ensuring a sound macro-
economic environment, a strong and resilientfinancial system, and above all an increasedmarket orientation of the domestic economygreatly influenced the course of globalization interms of content, timing, and sequencing.
LIBERALIZATION OF QUANTITATIVE TRADE
RESTRICTIONS
Prior to the 1990s India had one of the world’smost complicated and protected trade regimes,with imports regulated by both quantitative re-strictions and high tariffs. India started dis-mantling quantitative restrictions in the 1990sas a part of the reform process. Of more than10,000 tariff lines on imports, 6,161 werefreed in April 1996. Import restrictions on488 tariff lines were removed in 1996–97,391 in 1997–98, 894 in 1998–99, and 714 in1999–2000.
As part of World Trade Organization(WTO) commitments, the required disman-tling of restrictions maintained on balance ofpayments grounds was completed in March2001 for the remaining 715 items. As a resultaction has been completed on removing re-strictions on all tariff lines (2,714 items) no-tified to the WTO under balance of paymentscover. Quantitative restrictions, however, arestill maintained on about 5 percent of tariff lines(538 items), as permissible under articles XXand XXI of the General Agreement on Tariffs
India
72 INDIA
and Trade on grounds of health, safety, andmoral conduct. With the progressive liberal-ization of quantitative restrictions on imports,the tariff lines freed for import increased from61 percent in April 1996 to 95 percent inApril 2001.
RATIONALIZATION OF THE TARIFF STRUCTURE
During the 1980s there was a sharp increasein tariff rates, with the average import-weightedduty rising from 38 percent in 1980 to 87percent in 1990. At the start of reforms, thepeak effective tariff was 355 percent.
India embarked on tariff rationalizationin the early 1990s. Significant policy initiativeswere also introduced for the tariffication of non-tariff measures. Between 1990–91 and1998–99 the peak tariff dropped from 355percent to 45 percent. During 2001–02 a 10percent surcharge on customs duties was abol-ished, lowering the peak tariff from 38.5 per-cent to 35 percent. The budget for 2002–03further lowered the peak tariff, to 30 percent.
The government plans to lower the peak tar-iff to 20 percent in 2003–04, and an inter-ministerial working group has been set up torecommend modalities in this regard. Oncethe group’s report has been finalized and its rec-ommendations examined, it is expected that by2004–05 there will be only two basic rates forcustoms duties: 10 percent for raw materials,intermediates, and components, and 20 percentfor final products. Existing rates will be ad-justed and subsumed in these two basic rates,with some exceptions for WTO bindings andsome higher tariffs for agricultural products.
Procedures have also been rationalized andsimplified, including pruning of notifications,elimination of many end-use exemptions, uni-fication of rates for similar items, and merg-ing of basic and auxiliary rates. In addition, in2001–02 the number of rates with ad valoremrates was reduced to four categories of 5, 15,25, and 35 percent.
CURRENT ACCOUNT CONVERTIBILITY
The removal of restrictions on payments andtransfers for current account transactions gath-
ered momentum after the restoration of nor-malcy on the external payments front follow-ing the 1991 crisis, leading to the formalacceptance of article 8 of the IMF articles ofagreement in 1994. With a convertible currentaccount, authorized dealers were allowed to pro-vide foreign exchange for current paymentsand transfers up to specified limits withoutnotifying the Reserve Bank of India. Sincethen those limits have been raised considerably.As a result all genuine foreign exchange needsfor current account transactions are met directlyby authorized dealers.
One of the main concerns about makingthe current account convertible—that a surgein demand for current payments would widenthe current account deficit to unsustainablelevels—was not borne out, and the currentaccount position has stayed within sustain-able levels in subsequent years. Anotherapprehension—that with an open current ac-count and regulated capital account, hiddencapital flight might increase in the guise ofcurrent transactions—also did not turn out bea major cause for concern. In fact, net capitalflows were large enough to meet the financinggaps in the current account, leading to com-fortable reserve buildup.
RESTRUCTURING OF THE CAPITAL ACCOUNT
Until the early 1980s there was little need fora comprehensive policy framework to attractalternative forms of foreign capital, because for-eign exchange made available through exter-nal assistance—with a large grantcomponent—provided nearly 80 percent of fi-nancing requirements (Rangarajan 1996). Highlevels of official imports were sustained mainlyby external aid.
External commercial borrowing. Duringthe 1980s India increased its reliance on com-mercial loans because external assistance fellshort of growing financing needs. Under thepolicy for external commercial borrowing,initially a very cautious approach was pur-sued by allowing a few select banks, financialinstitutions, public entities, and private cor-porations to raise commercial capital in the in-ternational market in the form of loans, bonds,
INDIA 73
and euronotes. Interest rates and maturities forcommercial loans improved during the 1980s.
Despite significant diversification in cap-ital inflows in the 1990s, annual approvals forexternal commercial borrowing were raisedonly gradually. Borrowing policies continue toemphasize low borrowing costs, long maturityprofiles, and end-use restrictions (with pro-ceeds to be used for imports of capital goodsand services and to finance project-relatedrupee expenditures).
Foreign direct investment and portfolio flows.The need to supplement debt capital withnondebt capital—with a clear prioritizationin favor of the latter—characterized govern-ment policy for foreign direct and portfolio in-vestment in the post-reform 1990s. In 1993 theHigh-level Committee on Balance of Pay-ments recommended shifting the composi-tion of capital inflows in favor of nondebtflows and strictly regulating short-term debtflows, as well as discouraging volatile foreigndeposits and dissociating the government fromthe intermediation of aid flows. This major shiftin policy was reflected in the liberalization ofnorms for foreign direct and portfolio invest-ment in the 1990s.
Even in the immediate post-independenceperiod, the government tried to attract pri-vate foreign investment by promising equaltreatment of national and foreign firms in in-dustrial policy, reasonable facilities for profit re-mittances consistent with the foreign exchangeposition, and fair compensation for national-ization of assets. Despite subsequent changesin policies toward private foreign investment,these three promises have always been kept. Butby the early 1970s the government wanted toattract foreign investment on its own terms. Ac-cordingly, the Foreign Exchange Regulation Actof 1973 required firms to either dilute their for-eign equity holdings to 40 percent or seekfresh permission from the Reserve Bank ofIndia.
Foreign investment was essentially viewedas a vehicle for transferring technology notavailable domestically and as a means for pro-moting export-oriented production. Good ex-port performance was seen as a way to raiseequity participation above 40 percent. Li-
censing was the preferred mode for technologyacquisition, and in cases where unbundlingof technology from equity participation proveddifficult, equity participation was allowed.
The restrictive policy environment enun-ciated in the Foreign Exchange RegulationAct of 1973 continued during the 1980s, withoccasional liberalization for certain categoriesof investments. Toward the late 1970s it wasrealized that a number of oil-exporting coun-tries had accumulated large surplus funds—but, due to the emphasis on appropriatetechnology, they could not invest in India.In 1980 such countries were permitted to in-vest up to 40 percent in specified industries inIndia without any transfer of technology. Inaddition, a “fast channel” was introduced in1988 to expedite clearance of foreign direct in-vestment (FDI) proposals from major invest-ing countries.
In the 1990s major liberalization measureswere introduced as a part of overall structuralreforms. Restrictions were lifted on companiesformerly covered by the Foreign ExchangeRegulation Act, allowing them to borrowmoney and accept deposits from persons res-ident in India, to carry out trading activities(other than agriculture and plantation), to ac-quire, hold, transfer, sell, lease, and gift anymovable property in India, and to allow the useof trademarks by any person or company.
The liberalization process started with au-tomatic approval of up to 51 percent for in-vestment in select areas. Subsequently, theareas covered by automatic approval and thelimits on investment were raised, culminatingin permission for 100 percent participationin certain areas (particularly oil refining,telecommunications, and manufacturing ac-tivities in special economic zones) and bring-ing FDI in all but a few negative list itemsunder the automatic route. The requirementof balancing dividend payments with exportearnings, which was earlier limited to a shortlist of 22 consumer goods, was completelywithdrawn. The limit of 1,500 rupees croresfor FDI in projects relating to electricity gen-eration, transmission, and distribution was re-moved. FDI in nonbank financial activitiesand insurance was also permitted.
74 INDIA
Restrictions on portfolio investmentthrough purchase of both traded primary andsecondary market Indian securities were alsoliberalized. As opposed to the earlier restrictionpermitting nonresident Indians and overseascorporate bodies to acquire up to 1 percent (in-dividually) and up to 5 percent (together) ofthe paid-up capital of Indian companies, theceiling was initially raised to 24 percent, withinvestment by foreign institutional investors al-lowed in 1992. Subsequently the limit wasraised gradually—and finally, in 2001, foreigninstitutional investors investment was per-mitted up to the sectoral caps and statutory ceil-ings prescribed for FDI in different sectors,provided the general body of the respectivefirms makes a decision to that effect.
Portfolio investment by foreign institu-tional investors through investment in generaldespository receipts (GDRs), American de-spository receipts (ADRs), and foreign cur-rency convertible bonds (FCCBs) floated byIndian companies in international marketswas also permitted, and over time the initial re-strictions on the end use of GDR, ADR, andFCCB proceeds were removed. Foreign in-vestment responded favorably to the liberalizedpolicy environment and to the general im-provement in macroeconomic conditionsbrought about by growth-supporting struc-tural reforms. By 1993–94 FDI and portfolio
flows taken together emerged as the most im-portant source of external finance, and netnondebt flows exceeded debt flows in the formof deposits by nonresident Indians, externalcommercial loans, and external assistance (fig-ure 1). Foreign investment has remained themost important form of external financing forIndia.
Approach to capital account convertibility.India considers the liberalization of its capi-tal account a process, not a single event. In itsgradual and cautious approach to capital ac-count convertibility, initial reform measureswere directed at current account convertibil-ity, leading to acceptance of IMF article 4 byAugust 1994. For operationalizing capital ac-count convertibility in India, a clear distinc-tion is made between inflows and outflows,with asymmetrical treatment of inflows (lessrestricted), outflows associated with inflows(free), and other outflows (more restricted).Different restrictions are also applied to resi-dents relative to nonresidents and to individ-uals relative to corporations and financialinstitutions. A combination of direct andmarket-based instruments of control is used,meeting the requirements of a prudent ap-proach to management of the capital account.The policy of ensuring a well-diversified cap-ital account with a rising share of nondebtliabilities and low percentage of short-termdebt in total debt liabilities is amply reflectedin India’s policies for FDI, portfolio invest-ment, and external commercial borrowing.
The Committee on Capital Account Con-vertibility (chairman: S.S. Tarapore), whichsubmitted its report in 1997, highlighted thebenefits of a more open capital account butat the same time cautioned that capital ac-count convertibility could put tremendouspressure on the financial system. To ensure astable transition, the report recommendedcertain signposts and preconditions. Threecrucial ones relate to fiscal consolidation,mandated inflation targets, and a strengthenedfinancial system. The second phase of finan-cial sector reforms and the ongoing measuresfor fiscal consolidation could enable India tomeet the initial conditions for capital accountconvertability.
0
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1995–96
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1993–94
1992–93
1991–92
1990–91
Percent
Figure 1. Net debt and nondebt flows to India, 1990–2001
Nondebt flows Debt flows
INDIA 75
International developments—particularlyinitiatives to strengthen the international fi-nancial architecture for dealing with problemsarising in the capital account of a country’s bal-ance of payments—will also influence the tim-ing and sequencing of capital accountconvertibility in India. In the aftermath of theEast Asian crisis, India’s approach to capital ac-count convertibility has been firmly vindi-cated. The vastly altered and liberalized policyenvironment for the external sector is reflectedin the Foreign Exchange Management Act of1999, which replaced the Foreign ExchangeRegulation Act 1973. The new act sets out asits objective “facilitating external trade andpayment” and “promoting the orderly devel-opment and maintenance of foreign exchangemarkets in India”.
FINANCIAL SECTOR REFORMS—SETTING THE
PACE OF GLOBALIZATION
At the policy level, a strong and resilient do-mestic financial system has always been viewedas a precondition for greater cross-border in-tegration of the economy. Reforms in the fi-nancial sector have generally comprised:• Deregulation of interest rates. • Reductions in statutory preemptions. • Stronger regulatory and supervisory systems. • Implementation of international norms
on capital adequacy, asset classification,income recognition, and provisioning.
• Promotion of competition by allowing pri-vate and foreign banks to operate alongsidepublic banks.
• Improvements in payments and settlementsystems.
• Development of the market for govern-ment securities.
• Market borrowing at market-related in-terest rates, while doing away with auto-matic monetization of fiscal deficits. Specificmeasures for improving credit delivery andstrengthening loan recovery. Ongoing initiatives include plans to intro-
duce an asset reconstruction company, corpo-rate debt restructuring framework, and legalreforms to support both (as well as debt re-covery) implementation of prompt corrective
action, promotion of FDI in the banking sec-tor, disinvestment in public banks, creation ofa credit information bureau, and switching toa real time gross settlement system. Internal sur-veillance of the financial system has also beenstrengthened significantly, using a combina-tion of information collected through onsite andoffsite supervision and market information.
Thus in the Indian brand of globalization,policy initiatives were prioritized in favor of lib-eralization of current account transactions,leading to significant liberalization of traderestrictions in the reform decade and meetingthe requirements of an open trade regime at theglobal level. A prudent approach to manage-ment of the capital account ensured externaldebt sustainability, a diversified capital ac-count, and a shift in net inflows in favor of non-debt and longer-maturity foreign capital. Anappropriate exchange rate regime meeting therequirements of the Indian brand of global-ization and a comfortable reserve level in termsof all known measures of reserve adequacyhave helped enhance India’s ability to dealwith unanticipated shocks induced by global-ization. The prudently managed capital ac-count has also helped contain the transmissionof pure contagion from global financial mar-kets. In fact, external sector performance dur-ing the reform decade imparted considerablestrength and resilience to the growth and de-velopment of the Indian economy.
IMPACT OF GLOBALIZATION ON THE INDIAN
ECONOMY
Measuring the impact of globalization is asdifficult as measuring globalization itself. InIndia, where internal liberalization efforts wereimplemented along with measures for en-hancing the country’s openness to the globaleconomy, it is even more difficult to assess theimpact of globalization because critical macro-economic variables would have responded toboth sets of measures, making it difficult to dis-entangle the joint effect. At times, certainstructural changes quite unrelated to the pol-icy measures directed at internal reforms andstronger globalization may also have influ-enced macroeconomic variables.
76 INDIA
Thus one can only analyze the behavior ofmacroeconomic variables generally perceivedto respond to globalization. In a sense one canonly draw inferences from the behavior ofeach relevant variable during the globalizationprocess, without attempting to attribute it en-tirely to globalization. Following such an ap-proach, this section assesses the behavior of theoverall economy in the context of globalization.
GROWTH
In examining the growth-inducing effects ofglobalization, it is important to assess whetherthe average actual growth during the reformyears was higher than the growth recordedduring the previous decades of planned de-velopment. Average GDP growth of about 6.1percent during the reform years (1992–93 to2000–01) was somewhat higher than thegrowth exhibited during the immediatelypreceding decade (5.6 percent) and signifi-cantly higher than in all other previousdecades (figure 2).
The average 6.1 percent growth duringthe reform years, however, hides the real per-formance on growth due to the large degree ofdispersion around the average. There was athree-year phase during the reform years(1994–97) when average growth was about7.5 percent. There were also years of lower
growth, as in 2000–01 at 4.0 percent. This rateof growth, however, when assessed in the con-text of the global slowdown, was still one of thehighest in the world.
A major indicator to examine the impactof globalization is the extent of synchroniza-tion of business cycles. In India, despite grow-ing cross-border integration in trade andservices, there is little evidence of major syn-chronization of growth, even though in re-cent years global business cycles—particularlythe strong slowdown in economic activity thatstarted in mid-2000—have contributed to theweaker activity in India (figure 3).
SAVING, INVESTMENT, AND THE DEGREE OF
FINANCIAL OPENNESS IN INDIA
A high correlation between saving and invest-ment is an indication of a lower degree of de-pendence on external capital for growth. Thewell-known Feldstein-Horioka puzzle showsthat the degree of capital mobility may not bevery high across countries. In India, because ofthe conservative approach to the current ac-count deficit (as a percentage of GDP), thesaving-investment gap has generally remainedvery modest.
In the 1990s, however, net capital inflowsgenerally exceeded the saving-investment gap,leading to large accretion to foreign exchangereserves. (Reserve accretion since the early1990s has been in excess of $54 billion.) Un-less the degree of productive absorption offoreign capital in the country increases furtherand exports (of both goods and services) groweven faster to raise the current account deficitfrom its present level of about 2 percent ofGDP, the benefits from deeper financial inte-gration with the global economy are likely tobe rather limited.
In other words, achievements in trade in-tegration should determine the degree of fi-nancial integration. In the past decade, however,net capital flows were much in excess of net cur-rent account flows, suggesting the presence ofsignificant financial integration relative to in-tegration on the current account. Restrictionson residents in terms of cross-border financialtransactions have not constrained the country
2
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6
7
1992–20011981–901971–801961–701951–60
Percent
Note: 1991–92 was the crisis year.
Figure 2. Real average annual GDP growth in India, 1951–2001
INDIA 77
from achieving the type and level of financialintegration required to harness the benefits oftrade flows by running a sustainable current ac-count deficit and building appropriate self-insurance in the form of adequate foreignexchange reserves.
DEGREE OF TRADE OPENNESS
Degree of trade openness is an important in-dicator for analyzing globalization’s impactsince it explains the role of exports and importsin the growth process. It also suggests the de-gree of sensitivity of national GDP to fluctu-ations in net exports in response to both globalbusiness cycle developments and changes inglobal trading regimes.
The trade openness of an economy hastwo distinct but often interrelated dimensions:ex ante openness and ex post openness. Exante trade openness relates to the restrictive na-ture of policy toward exports and imports.The levels of tariff and nontariff measures ap-plied by a country on cross-border trade flowsare the most important indicators of ex antetrade openness. Ex post trade openness, onthe other hand, refers to actual levels of importsand exports in relation to domestic economicactivities. At any point in time high (low) lev-els of ex ante openness may coexist with low(high) levels of ex post openness.
A major problem in the analysis of tradeopenness is that openness is neither directly ob-servable nor strictly defined. The simplest mea-sures of trade orientation, therefore, use theshare of trade flows in GDP. This ratio showsa decline in India’s trade openness in most ofthe 1980s, then a rising trend from 1987–88through 2000–01 (figure 4). Given the pre-dominant share of services in GDP, it may bemore appropriate to consider trade in bothgoods and services as a percentage of GDP. Thisindicator suggests that India’s trade opennesshas increased almost unabatedly since 1987–88.
Over the past five decades Indian exportperformance (in terms of U.S. dollar value) al-most mirrored global performance, eventhough the degree of openness exhibited majorimprovement only in the 1990s and India’smarket share in global exports generally de-
clined until the early 1990s. (It fell from around2 percent in the 1950s to about 0.5 percent inearly 1990s, then recently recovered to about0.7 percent.)
TERMS OF TRADE
Deterioration in terms of trade has been amajor concern among many developingcountries because it can weaken the benefitsof participating in a globalized system oftrade and distort the resource transfer system.Between 1970 and 2000 India’s gross and net
2001200019991998199719961995199419931992
Percent
Figure 3. GDP growth in India and worldwide, 1992–2001
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Figure 4. Merchandise trade in India, 1980–2001
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78 INDIA
barter terms of trade exhibited a stable pat-tern with low periodic dispersion, indicatingthat deterioration in terms of trade has notbeen a major concern for India during thephase of globalization. The income terms oftrade—representing the capacity to import—generally improved during the 1990s, sug-gesting larger opportunities offered by greatertrade integration.
INDIA’S SOFTWARE BOOM—THE MOST VISIBLE
BENEFIT OF GLOBALIZATION
India’s strong performance on the softwarefront was largely facilitated by the globalizationprocess. In the second half of the 1990s soft-ware exports exhibited compound averagegrowth of 62.3 percent, as against 46.8 percentgrowth in domestic market sales. In U.S. dol-lar terms software exports registered average an-nual growth of 46.1 percent during the entire1990s. This rate of growth has been unprece-dented both in terms of overall growth andgrowth in exports.
In 2000–01 software exports hit a peak of$6.3 billion (figure 5). A recent survey of 200software companies found that external mar-kets accounted for 82.5 percent of their rev-enue (with the United States alone accountingfor more than 60 percent). Thus software is ex-pected to enhance the benefits of globalizationfor India. Still there is a long-run concern ofa possible “Dutch disease” effect, with fast
growth in one export item weakening theprospects of other tradable sectors—by notonly switching resources from slow-growing ex-ports to the fast-growing sector but also by ex-erting pressure on the exchange rate toappreciate, which would weaken the prospectsof slow-growing exports without hurting thefast-growing sector.
NONRESIDENT INDIANS AS A FORCE OF
GLOBALIZATION
Cross-border movement of labor has generallybeen limited by the very restrictive immigra-tion policies of industrial countries. Despite therestrictive international regime for labor mo-bility, nonresident Indians—both skilled andunskilled—have taken advantage of the limitedscope for migration and with their committedwork in foreign countries provided a strongchannel of connectivity between the Indianeconomy and the global economy. The threemain flows through which India has benefitedfrom this channel of globalization are privateremittances, deposits by nonresident Indiansin Indian banks (both in Indian rupees and inforeign currencies), and FDI investment bynonresident Indians. (Portfolio investment bynonresident Indians has generally been quitemeager.)
Private remittances grew by more than 60percent a year in the 1990s, from $2 billion in1990–91 to $12.8 billion in 2000–01, match-ing the performance of software exports dur-ing this period (figure 6). These flows do notincrease the country’s external liabilities and soprovide strength to India’s balance of pay-ments. Deposits and FDI from nonresident In-dians, however, have not shown any majorspurt, though they remain important andsomewhat stable forms of foreign capital forIndia.
GLOBALIZATION THROUGH TRADE IN SERVICES
Given that services account for more than halfof the GDP of India and that services alsodominate the economic activity of India’s maintrading partners, exports of nonfactor serviceswill have to assume greater importance over
0
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2000–011999–001998–991997–981996–971995–961994–951993–94
Billions of U.S. dollars
Figure 5. Software exports from India, 1993–2001
INDIA 79
time in India. Trade in services, though grow-ing, still lags significantly behind merchan-dise exports. Exports of services as a percentageof merchandise exports, however, showed asignificant increase in the second half of the1990s. At 42 percent in 2000–01, this shareis one of the highest in the world, particularlyin relation to about 10–20 percent for Chinaand the Far East, Germany, Japan, Mexico,Russia, South Africa, and even about 26 per-cent for the United Kingdom and the UnitedStates (Raipuria 2001).
This suggests that even though India’s de-gree of trade integration with the global econ-omy is not very high, services exports seem tobe of much greater importance in recent yearsin relation to the world average. Unlike China,the Republic of Korea, Mexico, Poland, Rus-sia, South Africa, and Thailand, where tourismand transportation services account for themajor share of services exports, in India otherservices account for the largest share. Thismakes India’s pattern of services exports akinto that in advanced countries like Germany,Japan, the United Kingdom, and the UnitedStates and some developing countries likeBrazil, Malaysia, and Turkey (Raipuria 2001).
THE IMPACT OF FDI ON GROWTH,TECHNOLOGY, AND EMPLOYMENT
It is difficult to assess the direct contributionof FDI flows to the growth process. Informa-tion collected from annual surveys of selectforeign-controlled rupee companies however,offer some pointers about the contribution ofFDI firms to the growth process in India. It isgenerally believed that FDI serves as a vehiclefor promoting export-led growth. But thesefirms export only about 10 percent of their do-mestic sales, and their export intensity in-creased only modestly in the 1990s. It appearsthat lure of India’s large domestic market con-tinues to be one of the primary factors caus-ing FDI flows.
Positive externalities associated with FDIin the form of technology transfers are an-other factor that could contribute to growth.In developing countries technology transfersmust accompany investment in domestic re-
search and development (R&D) to enhanceadaptation and absorption. The relationship be-tween technology imports (comprising im-ports of capital goods and payments for royaltyand technical know-how fees) and domestictechnology efforts in terms of R&D expendi-ture did not exhibit any complementarity.Rather, foreign exchange spent on technologyimports as a percentage of domestic spendingon R&D increased significantly in the 1990s.
FDI firms outperformed overall growth inindustrial production in the 1990s. Higherrelative growth in output in itself, however, doesnot explain the linkage between capital flowsand growth—though it suggests the presenceof more productive sectors in India that FDIfirms could explore.
FDI firms are often believed to use trans-fer pricing mechanisms to create a gap be-tween the visible and invisible patterns ofresource transfers. Use of imported inputs inrelation to total inputs could broadly indicatewhether FDI firms are using transfer pricingmechanisms by relying on large-scale, artifi-cially inflated imported inputs. But the shareof imported raw materials in total raw mate-rials used by FDI firms has more or less hov-ered around just 20 percent. If one takes a viewonly on the basis of this indicator, the trans-fer pricing effect does not seem to be verystrong for India.
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Figure 6. Contributions by nonresident Indians, 1990–2001
Remittances Deposits FDI
80 INDIA
SIGNS OF INFLATION CONVERGENCE DUE TO
GLOBALIZATION?
Free cross-border movement of goods is ex-pected to lead to a certain degree of convergencein commodity prices around the world, thoughtransportation costs and nontransparent bar-riers to trade could cause some price differencesto persist. India’s inflation environment hasgenerally remained quite benign in the post re-form period, both in relation to the inflationlevels of developing countries and in terms ofthe stability of general prices.
The first half of the 1990s was characterizedby double-digit inflation (based on wholesaleprices)—with the sole exception being 1993–94,when the inflation rate was 8.4 percent. Dur-ing 1990–91, 1991–92, and 1992–93 the gen-eral price level came under severe pressurefollowing the balance of payments crisis. Dur-ing these years inflation was 10.3 percent, 13.7percent, and 10.1 percent. In more recent yearsannual inflation has fallen, to 4.9 percent inMarch 2001 and to 1.4 percent in March 2002.
The recent downward trend in the infla-tion rate reflects a number of structural and pol-icy factors that have undergone major changefollowing economic and financial liberalization.The period also coincided with a global trendof low inflation. While agricultural shocks stillplay a relatively large role in the inflation en-vironment, the large cushion provided by arecord buffer stock of food grains and the widereach of the public distribution program havehelped minimize the impact of such adversesupply shocks on food prices and the generalinflation rate.
As far as manufacturing prices are con-cerned, the inflation rate has come under theinfluence of competition, deregulation of pricecontrols in several core sectors, and the absenceof adequate demand due to the industrial slow-down. There has been evidence that somemanufacturing segments recorded higher pro-ductivity growth in the post-1991 period. Themanufacturing sector has been also goingthrough restructuring and experiencing higherprice competition. This seems to be pushingdown the markup rate, especially in indus-tries that import. Another important factor
for prices in manufacturing relates to the fallin world manufacturing prices.
CONVERGENCE OF THE MONETARY POLICY
STANCE
In the context of the synchronization of busi-ness cycles across the globe in recent years, aperception is gaining that the monetary pol-icy stance of central banks may also becomesynchronized. Thus globalization could lead tosome loss of monetary policy independence.With the introduction of financial sector re-forms in India, the monetary policy frameworktended to rely more heavily on the use of in-direct instruments rather than direct instru-ments like reserve requirements. As a result theimportance of the Bank Rate—which can in-fluence the cost and availability of credit in theeconomy and send appropriate signals on thestance of policy—has gained prominence in therecent period.
The Bank Rate, which was a discount ratein the earlier period, remained nonoperationalfor quite some time due to the absence of a de-veloped bill market and the prevalence of di-rected lending. With financial sector reforms,the Bank Rate was activated and made essen-tially a signaling rate in April 1997, linking itto rates at which accommodation is providedby the Reserve Bank of India. In the recent pe-riod, the behavior of the Bank Rate seems tohave followed the Fed cycle somewhat, mostlyin terms of direction rather than magnitude.The interest rate stance, however, continues tobe influenced primarily by internal consider-ations, even though external developmentshave been assigned greater importance than inthe past due to the growing (though modest)cross-border integration of the economy.
INTEREST RATE PARITY
In the context of globalization of finance, it isexpected that the risk-adjusted return on fi-nancial assets in different countries will tendto converge. One common approach to ex-amining this aspect is to plot the behavior ofinterest rate differentials against the corre-sponding forward premiums. The argument
INDIA 81
being that, an instrument in a particular cur-rency fetching a lower interest rate must fetcha premium to compensate investors for thehigher interest rate they could have received byholding the instrument in another currency.When investors are risk averse, expected returnson different instruments would depend notonly on the parity conditions but also on therisk premiums. In the presence of time-varyingrisk premiums, the complexities related toidentifying sources of risk and measuring riskgreatly complicate the empirical testing of par-ity conditions.
When interest rate differentials based onmonthly average call money rates in both In-dian and U.S. markets are considered, one-month swap premiums seem to exhibit arelatively stronger linkage with the interestrate differentials. Despite the remaining re-strictions on capital account transactions, thesensitivity of domestic financial markets to in-terest rate differentials seems to have increasedduring the reform years.
EXCHANGE RATE BEHAVIOR
In a globalized system of trade and finance thedifferent channels of contagion become strongerand, as a result, the exchange rates of develop-ing countries with sound economic funda-mentals may at times exhibit significantvolatility. Recognizing this aspect, the ReserveBank of India (RBI) closely monitors devel-opments in financial markets at home andabroad in its conduct of exchange rate policyand from time to time takes monetary and ad-ministrative actions considered necessary. Itwas explicitly clarified in the bank’s AnnualMonetary Policy statement of 1998 that “RBIwill not hesitate to use its reserves, when war-ranted, to meet sharp day-to-day supply-de-mand imbalances in the market...It will ensurethat lumpy and uneven demand, particularlyfor oil imports and debt servicing obligationsof the Government, does not cause any dis-turbance in the orderly functioning of the for-eign exchange market”. Keeping in view the roleof destabilizing expectations, the RBI reiteratedin the Mid-term Review of its Monetary Pol-icy in October 2000 that “in the very short-run,
expectations about the likely behavior of a cur-rency next day or over a week or fortnight canplay a major role in determining its movementagainst foreign currencies, particularly the U.S.dollar. Given the bandwagon effect of any ad-verse movements, and the herd behavior ofmarket participants, expectations can often be-come self-fulfilling. This is particularly true ofthin developing country markets, where netvolumes are relatively small. The day-to-daymovement in currency markets is further com-plicated by volatility in private capital flows,which are highly sensitive to short-term do-mestic and international developments as wellas future expectations”.
The adverse implications of disorderly ex-change market conditions for the real sector ofthe economy also warrant close monitoring ofthe exchange rate. In view of the above factors,as stated by the RBI in its Annual MonetaryPolicy Statement of April 2002, “India’s ex-change rate policy of focusing on managingvolatility with no fixed rate target, while al-lowing underlying demand and supply con-ditions to determine the exchange ratemovements over a period in an orderly way, hasstood the test of time. Despite several unex-pected external and domestic developments,India’s external situation continues to remainhighly unsatisfactory. RBI will continue tofollow the same approach of watchfulness,caution and flexibility while dealing with theforex market. It is a matter of satisfaction thatthe recent international research on viable ex-change rate strategies in emerging markets haslent considerable support to the exchange ratepolicy followed by India”.
The exchange rate of the Indian rupee gen-erally avoided contagion, even though marketcorrections for perceived misalignments oftencame alongside major adverse internationaldevelopments. For example, the real appreci-ation of more than 10 percent (both trade andexport based and in relation to the March1993 level, when the exchange rate of therupee became market determined) generallypreceded market corrections. But some of thesecorrections coincided with adverse interna-tional developments like the East Asian crisisin the second half of 1997, the Russian crisis
82 INDIA
and the fear of Chinese devaluation in 1998,and the September 11, 2001 terrorist attackson the United States. The Indian rupee, how-ever, was one of the most stable currenciesamong emerging markets in the past decade,with no major accumulation of real apprecia-tion at any point. Perceived misalignmentshave been corrected in an orderly fashion.
POVERTY IN THE POST-REFORM PERIOD
India’s poverty levels fell considerably duringthe reform years. While the population belowthe poverty line declined by 8.5 percentagepoints during 1983–93, during the reform pe-riod (1993–94 to 1999–2000) it declined by9.9 percentage points. Unlike in the pre-reformperiod, when the absolute number of poorpeople remained almost unchanged at around320 million, during the reform years the num-ber fell, to 260 million in 1999–2000. Thereare difficulties in comparing poverty estimatesacross time in India in the context of analyz-ing the impact of globalization because of thehigh degree of sensitivity of the poverty mea-sures to the behavior of monsoon—arisingfrom the concentration of poor people in ruralareas (accounting for about 70 percent of thetotal) and the excessive dependence of therural masses on agriculture. Due to the dif-ferences in the methodology for measuringthe incidence of poverty, as observed in theIndia Development Report 2002 “...even whenone does not accept the faster decline (inpoverty) over the 1990s, one can concludethat the accelerated reforms and deregulationand liberalization of the 1990s have not ad-versely affected the trend of decline in poverty”.
INCOME INEQUALITY IN THE REFORM PERIOD
Estimated Gini coefficients for 1973–97 showthat the pattern of inequality did not changemuch between the pre-reform period and thepost-reform period (Oommen 2000). In thecontext of the Kuznets inverted “U” pattern re-lationship between inequality and growth, ithas been argued that tolerating some short-runhigher inequality in exchange for higher growthmay lead to higher growth and lower inequality
in the long run. The debatable issue here is, ifglobalization can lead to both higher growthand lower poverty, should higher inequality betolerated in the absence of any established de-velopment alternative that can achieve all threesimultaneously?
REGIONAL DISPARITIES IN GROWTH
Growth disparity across different states of Indiahas been a major concern for policymakersduring the entire period of post-independencedevelopment strategy. The pattern of per capitastate domestic product suggests that regional dis-parities did not deteriorate during the reformdecade. If one uses 1980–81 as the benchmarkyear, there are only four states—Maharastra,Punjab, Gujarat, and Hariyana—where percapita state domestic product (at 1980–81prices) was higher than per capita GDP for allof India. The trend remained more or less sim-ilar in 1990–91. With the advent of the reformprogram in the early 1990s, the only state thatjoined the other four was Tamil Nadu. At theother end of the spectrum, the states at thebottom in terms of real per capita state domesticproduct continued to be Orissa and Bihar. Thissuggests that regional disparities did not widenin the post-reform period.
LESSONS AND POLICY CHALLENGES
In India the globalization process has been animportant part of the overall process of eco-nomic reform—even though, given the rela-tively small share of external transactions inoverall economic activity, internal reforms havelargely shaped the evolution of the macro-economy during the past decade of economicreforms. India exhibited one of the highestgrowth rates in the decade of economic re-forms, both in relation to other economiesand to its own pre-reform performance. De-spite having a market-determined exchangerate, its exchange rate remained the least volatileof all flexible exchange rate regimes. It avoidedthe contagion from a series of financial crisesthat engulfed emerging markets in the 1990s.
The financial system also acquired consid-erable strength and resilience during this period,
INDIA 83
helping the authorities avoid a large-scale sys-temic crisis. A well-managed capital accounthelped ensure sustainability of the external ac-count and limited exposure to identifiable vul-nerabilities. In addition, high foreign exchangereserves imparted significant confidence to themarket. Low and stable inflation in the secondhalf of the 1990s provided an atmosphere con-ducive to investment, growth, and social ad-vancement. Most important, poverty fellconsiderably during the decade.
Globalization, however, also posed a num-ber of challenges. In the context of the signsof increasing (though still modest) synchro-nization of business cycles, the earlier high in-sulation of national output and employmentfrom global developments seems to be declin-ing. Given the possible asymmetric effects ofglobal business cycle fluctuations during al-ternating phases of boom and bust, stabilizingmacroeconomic policies to counter the largeamplitude of the business cycle has emerged asa major policy concern. The complexity ofthis challenge appears even more severe nowdue to the increasing degree of external impacton domestic activity—over which the nationalauthorities have little control. Like many otherG-20 members, the usual concern has alsobeen the possible ineffectiveness of nationalpolicies in a globalized system, leading to asearch for measures that could help the au-thorities regain policy independence.
Globalization is generally believed to yieldconvergence in prices, interest rates, and taxrates across countries because differences (ad-justed for country-specific factors and risks) inthese critical variables are expected to trigger ap-propriate movements of goods, capital, and in-come until the rates are equalized. Thoughcomplete convergence is a distant possibilitydue to the limited degree of India’s globalization,it is quite possible that national interest rates andtax rates will be less effective now than when theeconomy was relatively closed. Dealing withthe problem of inefficiency in a globalized sys-tem of trade and finance has also emerged as animportant challenge for the policy authorities.
The policy of avoiding financial crises whileattaining the dual goals of higher growth andlower poverty has generally shaped the broad
contours of globalization in India. Corre-spondingly, it has also significantly altered the roleof the state in the economic affairs of the coun-try. Growth without trickle-down effects andhigher growth at the cost of financial stability arethe two major downside risks associated withglobalization, and the need to limit India’s ex-posure to such risks has motivated the nationalauthorities to take a cautious, measured ap-proach to globalization. The pace and timing ofspecific reforms have been guided by the relativeprobability and intensity of the benefits andcosts of any particular measure to the economyas well as the long-run sustainability of the mea-sure, so policy reversals are generally avoided. TheIndian approach to globalization seems to indi-cate that avoiding highly disruptive as well as ex-treme forms of globalization and tailoring thepace and content to each country’s circumstancesmay be the ideal strategy for globalization in anumber of emerging markets.
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84 INDIA
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ITALY 87
The Italian economy, like those of other Euro-pean countries, underwent a deep transforma-tion after World War II, turning into afast-growing industrial economy and setting upa financial system able to allocate abundanthousehold savings1. Regulation took differentforms and intensities in the specific segments ofthe financial market. Controls were broad in thebanking system and in foreign exchange markets,less pronounced in stock and bond markets.
There are many reasons behind this ex-tensive system of controls, and their economicrationale has changed over time. In the 1960sthe priority was channelling financial resourcesto the fast-growing industrial sector. The 1970sand 1980s, unlike the previous decade, werecharacterized by a highly unstable interna-tional macroeconomic environment, heavily af-fected by the breakdown of the Bretton Woodssystem of fixed exchange rates and by the oilshocks of 1973 and 1980. Working with in-creasing domestic macroeconomic imbalances,the country’s regulatory system aimed to par-tially insulate domestic financial markets fromexternal shocks: gaining some degrees of free-dom for monetary policy; preventing exchangerate instability, all the more after joining theEuropean Monetary System in 1979; securinga smooth flow of bank credit to the industrialsector; and guaranteeing the orderly place-ment of a fast growing public debt.
At the end of the 1980s, as monetary uni-fication gained momentum in Europe, a num-ber of forces led Italian authorities to graduallylift the system of domestic and foreign ad-ministrative controls. The main factor behindthis process was, first, the need to fully inte-grate Italy in the single European market and,later on, to satisfy the requirements for adopt-ing the single currency.
At the same time, Italy made an effort toreform and modernize its financial markets,particularly money and bond markets. Thedrive to improve the efficiency of thesemarkets—making them deeper and moreliquid—came from interrelated needs: makingItalian markets competitive in a context ofgrowing European and international financialintegration; easing the management of thehigh public debt; and improving the trans-mission mechanism of monetary policy.
This note describes the broad contours ofthe process of reform and liberalization of fi-nancial markets in Italy in the 1980s and early1990s. It focuses on reforming the domesticmoney and bond markets and on dismantlingcapital controls. One reason for consideringthese two processes jointly is that they rein-forced each other: the abolition of capital con-trols would have been risky without makingItaly’s financial system more competitive andattractive to foreign investors. Other importantsectors of the financial market will not be in-cluded because they require separate analysis:a process of radical reform and liberalizationhas completely reshaped Italy’s banking system,nonbank financial intermediaries, institutionalinvestors, and the stock market (Ciocca 2000).This note, not meant to be exhaustive, sketchesthe subject in a deliberately simplified way. Inaddition, the topic is analysed from an insti-tutional point of view, leaving more analyticaland policy-related issues in the background.
THE REFORM OF THE MONEY AND FINANCIAL
MARKETS AND THE LIBERALIZATION OF
CAPITAL MOVEMENTS
In 1987–90 two major sets of structural re-forms in money and financial markets took
Italy
88 ITALY
place: those aimed at strengthening the do-mestic money and financial markets (table1), and those aimed at eliminating restric-tions on capital movements (box 1). The re-forms helped the Bank of Italy reduce the
volatility of the market demand for treasurysecurities and improve its ability to conductmonetary policy through the use of indirect,more market-oriented instruments (Pas-sacantando 1996).
1981–87 1988 1989 1990 1991 1992 1993 1994
DEBT MANAGEMENTCentral bank direct credit Prohibition of
any direct financing
New debt instruments First issue of First issue of 7-year BTPs 10-year BTPs 30-year BTPs;CTE (1982) CTOs and of 1st global
5- and 7-year bondCCTs
PRIMARY MARKETCentral bank purchases “Divorce”
(1981)
Auctions Treasury bills: Competitive Uniform pricemid month for 12-Month for CCTs(1981) – Treasury bills;Competitive uniform pricefor 3 months for BTPs(1983) and for 6 months (1984)
Abolition of floor price 3-month 6-, 12-month BTPs and Treasury bills Treasury bills CCTs
SECONDARY MARKETOrganized spot markets Screen-based Treasury bills Reform of
market for traded on MTS with government MTS introduction securities of market(MTS) specialists
Derivatives Future Italian Futures Options on contracts on Market; futuresBTPs traded Eurolira on BTPson LIFFE futures traded on
traded on MIFLIFFE
MONEY MARKETOrganized market Screen-based
market forinterbank deposit (MID)
Liquidity facility Credit to Mobilization No creditbanks acting of compulsory facility toon the reserve banks actingTreasury bill deposits on Treasuryprimary bill primarymarket (1984) market
Settlement system Electronic Real-time CATclearing and for securitiessettlement clearing
Source: Bank of Italy.
TABLE 1Government debt financing and organisation of financial markets: main reforms
ITALY 89
CHANGES IN MONEY AND BOND MARKETS
One proximate factor that stimulated the in-novations was the deterioration of market con-ditions. Until 1987 the continual decline ofinterest rates eased the financing of the bud-get deficit. But in the summer of 1987 the ex-pectations of rising interest rates, due to areversal of the downward trend of inflation,greatly weakened the demand for long-termgovernment securities and led to increasingfears of a subscription crisis. The average ma-turity of newly issued government securitiesplummeted in 1987, from three years andthree months in April to less than eight monthsin December. Since then long-term bond is-sues have not been fully subscribed.
A first set of measures was adopted in thepublic debt management (see table 1). For anumber of years the Treasury relied mainly onshort-term bonds and treasury credit certificates(CCTs), which are floating-rate medium-termnotes. The CCTs made it possible to lengthenthe maturity of public debt at relatively low cost.Risk premia on fixed-rate securities would in facthave been particularly high in a period of highand variable inflation. However, CCTs alsohad some negative consequences since theymade the cost of debt servicing very sensitiveto interest rate variations and created a direct,positive link between disposable income and
interest rate changes. In the latter part of the1980s and in the early 1990s the Treasurywidened its range of instruments and increasedthe proportion of longer-term fixed-rate secu-rities. The range of maturities now available,from three months to 30 years, is comparableto that found in the most highly developed fi-nancial markets.
Another important set of measures in-volved the techniques of placing governmentpaper. Between July 1988 and March 1989 theTreasury progressively eliminated floor pricesat treasury bill auctions. In August 1992 italso completely liberalized the price at auctionof long-term bonds. Competitive bid auctions,in which buyers purchase securities at theirbid prices, were extended to all treasury bill is-sues. In 1988 and 1989 uniform price auctionswere adopted for long-term bonds. The ex-tension of auction systems to all issues—andthe design of the most appropriate system foreach segment of the market—improved thetrade off between the cost of borrowing and theneed to ensure the availability of funds(Buttiglione and Prati 1991; Buttiglione andDrudi 1994).
A third set of reforms radically reshaped thesecondary market for government paper. Awell-developed secondary market with opera-tors that ensure continuous trading indirectlyspurs demand on the primary market for two
1976Exchange control violations directly affecting theexternal accounts become criminal offenses.
1981Rationalization of exchange regulation concerning fi-nancial transactions. Depenalization of minor ex-change violations.
1986Delegation to government to reform the exchangecontrol system, on the principle that all externalcommercial and financial transactions are allowed un-less explicitly prohibited.
1987New exchange control law laying down the princi-ple of freedom, but retaining some restrictions, which
may be lifted by exchange authorities administratively.Effective October 1, 1988.
Remaining restrictions:• Foreign exchange monopoly.• Limits on daily foreign exchange position and on
external creditor position in both lire and foreigncurrency for banks.
• Permanent restrictions on short-term capita1movements for nonbank residents.
1988Codified exchange control law incorporating the1987 decree. Depenalization of exchange violations.
1990Completion of liberalization: abolition of all re-maining restrictions (on money instruments).
BOX 1Chronology of main changes in exchange control legislation
90 ITALY
reasons. It increases the liquidity of publicdebt instruments, and it increases the infor-mation content of interest rates. A screen-based secondary market for governmentsecurities was launched in May 1988. Turnoveron this market reached 1.3 percent of GDP in1993. In the early 1990s derivative marketswere introduced.
A fourth set of measures affected the moneymarket and the settlement system. Improve-ments in securities trading required paralleldevelopments in the procedures adopted by op-erators to adjust their liquidity positions andsettle the underlying obligations. Market par-ticipants need smooth clearing and settlementsystems to minimize transaction costs andcounterparty risk (Angelini and Passacantando1993). The key reforms in this area were acomputerized clearing and settlement systemin 1989, a screen-based market for interbankdeposits in 1990, which also experienced arapid growth of turnover, and the reform of thecompulsory reserve regime in October 1990.
Between 1987 and 1990 capital move-ments were progressively liberalized to complywith the requirements set by the single mar-ket of the European Monetary System (seebox 1). The most important measure becameeffective on October 1, 1988, when most cap-ital movements, except those involving mon-etary instruments, were liberalized. The fearthat liberalization would create massive out-flows of capital proved unfounded. Indeed,substantial portfolio adjustment by Italian res-idents was more than matched by a simulta-neous capital inflow, for a net inflow of funds.Annual gross financial transactions with foreigncounterparties, as recorded in balance-of-pay-ments statistics, rose from 60 percent of GDPin 1987 to more than 350 percent in 1993.
AFTER FINANCIAL LIBERALIZATION—ITALY’SSEARCH FOR STABILITY
THE SPEED OF LIBERALIZATION: GRADUAL VS.BIG BANG APPROACH
The bulk of the abolition of capital controls wascarried out between October 1988 and De-cember 1990. Italy’s experience can be placed
between a gradual approach and a big-bang so-lution since the abolition of controls, when car-ried out, relied on a solid domestic financial andcredit system. The reaction of Italian residentswas much more gradual than the authorities’moves: the adjustment of residents’ portfolioswas slow, also in international comparison. Sev-eral factors explain the persistent home bias ofItalian investors. On the retail side Italian se-curities and tax-related considerations providedhigher returns. In the wholesale market the roleof institutional investors was very limited, par-ticularly pension funds, usually more prone todiversify internationally their assets.
While external liberalization could rely ona sound financial system, it could not count onstrong underlying macroeconomic variables.Two severe currency crises hit Italy in the firsthalf of the 1990, caused by the interactionbetween huge budget deficits, large currentaccount deficits, full capital mobility, and,until 1992, fixed nominal exchange rates.
MACRO IMBALANCES AND CURRENCY CRISES IN
THE 1990S
The real appreciation of the exchange rateafter 1987, while putting downward pressureon domestically generated inflation, widenedthe current account deficit, which resultedalso from the significant absorption of savingscaused by the high public deficits (Fazio1995b). Doubts about the sustainability ofthe exchange rate regime emerged, with noclear signs of the political resolve to correct thefiscal imbalances. Italy’s exchange rate policyin the 1980s and early 1990s shows how lib-eralization and underlying imbalances can in-teract to provoke a currency crisis. In thesecond half of the 1990s Italy aligned its mon-etary, fiscal, and income policies to strengthenits external position and benefit from the in-creased integration of goods and capital mar-kets (Fazio 1995a; Rinaldi and Santini 1998).
Italy’s exchange rate policy and externalposition until 1990. Despite the balance-of-payments deficits associated with the oil crises,Italy still had a modest net creditor position inforeign assets in 1984, thanks to the substan-tial current account surpluses accumulated in
ITALY 91
the 1960s and early 1970s. The restrictivemonetary policy pursued in the 1980s and thestability of the exchange rate reduced inflation,but they did not eradicate it. Large fiscal deficitsled to substantial growth of the public debt and,despite the high domestic saving rate, Italy be-came a net external debtor in 1985.
At the end of 1986 the real effective ex-change rate based on consumer prices was upmore than 26 percent from that in January1979, one of the lowest levels in the 1970s.Measured on the basis of producer prices, theloss of competitiveness was only 12 percent, butit has to be set against large gains by France andGermany. Italy’s external current account re-mained almost continuously in deficit until1992, owing to the loss of competitivenessand the growth in domestic demand fueled bythe fiscal deficit.
In 1990, after two years of small fluctua-tions of the lira around its central rate, Italymoved to the narrow fluctuation band of theExchange Rate Mechanism. The removal ofcontrols on short-term flows completed theprocess of liberalizing capital movements—with an immediate positive effect. There wasan inflow of capital, albeit mainly short-term,and interest rates declined. As the trade deficitdeteriorated, Italy’s net external liabilitiesmounted, mainly in short-term borrowings. In1992 the country’s net debtor position reached165 trillion lire, about 11 percent of GDP.
On the basis of consumer prices, the realeffective exchange rate of the lira was around35 percent higher in September 1992 than inJanuary 1979. On the basis of producer pricesthe rise was less than 20 percent.
The lesson from this experience: mone-tary policy can be effective. But if other poli-cies do not pull their full weight, disequilibriadevelop elsewhere. In Italy’s case, high inter-est rates were accompanied by a slowdown ofinvestment and growth, a mounting publicdebt, and growing foreign debt, with risks forthe preservation of monetary stability.
The crisis of 1992 and Italy’s withdrawal fromthe European Monetary System’s Exchange RateMechanism. On September 13, 1992, with se-vere tensions affecting international markets,the decision was taken to realign the lira’s
central rate by 7 percentage points, to regainthe competitiveness lost since the previous re-alignment within the System in January 1987.The general crisis of the Exchange Rate Mech-anism later forced the pound sterling and thelira out of the System. The outcome was areal exchange rate of the lira in early 1993more than 20 percent below the level of Au-gust 1992.
The greater price stability of the late 1980smade a decisive contribution to holding downthe rise in labor costs. In 1992 the governmentconcluded a first agreement with the socialpartners to keep future increases in wages andsalaries in line with the target rate of infla-tion, set to diminish rapidly. The Finance Lawfor 1993 contained measures producing a sub-stantial reduction in the public sector deficit,on a scale comparable to the adjustments afterthe oil crises. Consumption and output had al-ready contracted sharply by the end of 1992.From 1993 onward the trade balance showeda large surplus.
Despite the devaluation of the lira, infla-tion remained moderate as a result of the laborcost agreement, the monetary tightening, andthe slowdown in domestic demand. After ac-celerating a little in the spring, inflation aver-aged slightly above 4 percent in 1993.
In the second half of 1993, following theagreement on incomes policy, money marketrates were brought down to a more moderatelevel, though they remained higher than the av-erage of the other industrial countries. Someof the hot money that had flowed to Italianbanks up to August 1992 began to flow outagain towards the end of that year, and outflowscontinued throughout 1993. As a result a morenormal composition of the external debt wasalso restored. There was a further, albeit smalleffect on the exchange rate.
In the second half of 1993 the effective ex-change rate of the lira and interest rates returnedto an acceptable equilibrium. The official dis-count rate was lowered to 8 percent in Octo-ber. The real effective exchange rate of the lirarecovered to a level slightly above the averagefor 1979 and close to the average for 1980.Yields on 10-year government securities stoodat around 9 percent.
92 ITALY
Correction of imbalances and the exchangerate crisis of 1995. The second half of 1993 wasalso the bottom of the economic cycle. Thefourth quarter saw a slight upturn fuelled byexports and investment. For the year domes-tic demand fell by 5.5 percent and GDP by 1.2percent. Exports of goods and services rose bymore than 9 percent, while imports fell by 8percent. After a long string of deficits, the bal-ance of payments on the current accountshowed a surplus of 18 trillion lire, against ashortfall of 34 trillion the previous year.
The export- and investment-led recoverywas consolidated in 1994. GDP grew by 2.2percent, and there was a surplus of 25 trillionlire on the external current account. As mea-sured by the cost-of-living index, the 12-monthrate of inflation fell to 3.6 percent in July1994. In the second half of the year there wasa slow but continual rise in costs and prices,owing to the pressure of demand, the robustgrowth of industrial production, and the con-sequent reduction in idle capacity.
A tight rein was placed on the monetaryand credit aggregates. There was virtually nogrowth in the money supply, and credit to theprivate sector expanded by less than 2 per-cent. In real terms all the aggregates contracted.
Inflation increased toward the end of theyear, primarily owing to the depreciation of thelira and the rise in international raw materialprices. The 1995 hike in indirect taxes in thespring fiscal adjustment package also affectedinflation.
The nominal effective exchange rate of thelira at the end of 1994 was 7 percent lower thanin the second half of 1993. For most of 1994the lira followed the dollar, whose depreciationagainst the Deutsche mark and the yen was alsoreflected to some degree by the other weakcurrencies, such as the pound sterling, theCanadian dollar, and the Swedish krona. Bycontrast, the French franc and the other cur-rencies more closely linked to the Deutschemark recorded a slight, continual apprecia-tion during 1994.
In December 1994 and the early part of1995 the Mexican crisis erupted. Wide and dis-orderly fluctuations of the exchange rates ofthe main currencies ensued. The dollar fell 10
percent, with the other weak currencies fol-lowing in its wake. The Deutsche mark appre-ciated in just a few months by more than 5percent and the yen by around 16 percent. Thelira fell sharply; by mid-March, with domesticpolitical developments also a factor, it had de-preciated by more than 15 percent with respectto its average value in December. The exchangerate crisis remained acute until mid-April.
In February 1994 rates rose in response tothe shift in U.S. monetary policy, reversing thedownward trend of market interest rates in allthe main countries. Liquidity began to tightenin Italy as early as June 1994. In mid-Augustofficial interest rates were raised by half a per-centage point. The rise in market rates waslarger in Italy than elsewhere. In February1995, with worsening inflation expectationsand a weakening lira, it was decided to raise thediscount rate by another 0.75 points and thaton fixed-term advances by 1.25 points.
Both the rigorous fiscal measures adoptedin March, bringing an annual adjustment equalto 1.5 percent of GDP, and the monetary tight-ening aimed to halt the fall in the internal andexternal value of the lira. As early as 1994, theworsening of the exchange rate and inflation wasaccompanied by a further, marked accelera-tion in industrial production. Economic activityis boosted in countries whose currency depre-ciates. In those where it appreciates, there is anadverse impact on productive activity.
In February 1995 the U.S. Federal Re-serve raised official rates again. In Germany andJapan, currency appreciation, stable or de-clining prices, and sluggish economic activityled the monetary authorities to lower officialinterest rates in the spring.
The further tightening of monetary policy in1995 and the recovery of the lira. In early 1995Italy’s annualized monthly inflation rose tobetween 5 and 6 percent. On May 26, witheconomic activity growing rapidly, the offi-cial discount rate and the rate on advanceswere raised by another 0.75 percentage pointsto check the deterioration in inflation expec-tations. Control of liquidity was made evenmore stringent. And the effects of the mone-tary and fiscal tightening on domestic demandbegan to appear.
ITALY 93
Compared with its lowest value in thewake of the Mexican crisis, the lira’s exchangerate had already recovered by more than 8 per-cent between mid-April and mid-May. The dol-lar and the other weak currencies alsoappreciated, while the Deutsche mark andparticularly the yen lost part of their earliergains. The recovery of the dollar continued overthe summer, partly as a result of massive andcoordinated intervention and the further re-duction in interest rates in Germany and Japan.
By mid-September the effects of the ten-sions triggered by the Mexican crisis had beenlargely absorbed. Compared with December1994, the depreciation of the lira, which hadexceeded 15 percent in March, was no morethan 3 percent. The turbulence reversed partof the gains recorded by the weak currencies.The depreciation of the lira, moving in line withthe dollar, increased again to around 5 percent.
Market yields on 10-year government se-curities, above 12 percent in the closing monthsof 1994, reached 13.7 percent in the period ofthe lira’s maximum depreciation, between themiddle of March and the middle of April1995. After falling later to 11 percent, they rosein response to the turbulence to around 11.5percent. The differential with Germany wasabout 5 percentage points.
Inflation abated considerably over the sum-mer. In the third quarter the annualizedmonthly increase in the cost-of-living index,net of indirect taxes and seasonally adjusted,was 1.5 percentage points less than in the sec-ond. The tightening of monetary policy, therecovery of the lira, and the slowdown of thecyclical expansion braked inflation. So Italy’sexperience in the 1980s and 1990s shows thata rigorous monetary policy can curb inflation.
Public finances. The prospects for the in-ternal and external value of the lira dependedcrucially on those for the public finances. Theadjustment that began with the measuresadopted in 1992 significantly curbed the ex-pansionary trends that for many years hadmarked public expenditure. Major reformswere carried out in health services, public em-ployment, local finances, and social security.The reform of the pension system was of majorimportance. The Italian pension system was out
of line with those of other leading Europeancountries, mainly owing to the lower retirementage and the more generous link with earnings.
In 1995 the rising trend of the ratio of pub-lic debt to GDP was halted, thanks to privati-zation proceeds. At the end of 1995 the ratio ofgeneral government debt to GDP was at 123.8percent, compared with 124.3 percent at the endof 1994. This ratio remains much higher thanin other industrial countries. It needs to be re-membered, however, that Italian householdshave a particularly high saving rate and carry lit-tle debt. This leads them to accumulate finan-cial assets, notably public debt securities. Inrelation to GDP, total financial wealth in Italyis in line with that of the other leading countries.
The high rate of domestic saving made itpossible to limit the country’s external debt.The surpluses earned on the current accountof the balance of payments recorded from1993 onward allowed Italy’s net external debtto fall gradually until the country became a netcreditor in 1999.
CONCLUSIONS
In the second half of the 1990s several inter-acting forces—the need to make Italian finan-cial markets and securities more competitive andthe run-up to the single market and singlecurrency—led Italian authorities to modernizedomestic financial markets and liberalize cap-ital flows. The approach was gradual in mar-ket reform and modernization, whereas thetight deadlines for the single market led to a rel-atively quick dismantling of capital controls(the bulk between October 1988 and Decem-ber 1990). While the direct and indirect ben-efits of liberalization are undisputable, Italyhad to bear severe costs due to two currencycrises. The severe macroeconomic imbalancesin the 1980s were at the root of the currencycrises of 1992 and 1995. And capital mobilityexposed those imbalances, forcing authoritiesto correct them. Against this background, onepossible lesson of Italy’s experience for othercountries, especially emerging economies, isthat financial liberalization—and the sequencingof the related steps—has to be accompanied bythe correction of structural imbalances.
94 ITALY
NOTE
1. The description of the development and thefeatures of Italy’s financial system in the post-warperiod—a mixture of private initiative and pub-lic sector intervention—goes beyond the scopeof this note. But for a number of reasons in the1980s, at the early stages of the process of Eu-ropean monetary unification, Italy’s financialsystem was characterized by a relatively high de-gree of regulation. The aim of this paper is to pro-vide an historical perspective of the major changesoccurred in Italy in the 1980s up to early 1990s,when the liberalization of capital flows was com-pleted. So, it does not include the recent devel-opments that contributed to create the currentorganization of the Italian financial system.
REFERENCES
Angelini, P. and F. Passacantando. 1993.“Central bank’s role in the payment system andits relationship with monetary policy and su-pervision.” In F. Bruni, ed., Proceedings of theConference organized by the “Paolo Baffi” Cen-tre for Monetary and Financial Economics, heldat Bocconi University, Milan, February 5th,1993. Bocconi University, Milan.
Buttiglione, L. and F. Drudi. 1994. “Theauction mechanism for the settlement ofmedium-and long-term securities of the Ital-ian Treasury.” Bond Markets, Treasury andDebt Management: The Italian Case. London:Chapman & Hall.
Buttiglione, L. and A. Prati. 1991. “Lascelta del meccanismo di collocamento deititoli di Stato: analisi teorica e valutazionedell’esperienza italiana.” In Temi di Discussione146, January. Banca d’Italia.
Ciocca, P. 2000. La nuova finanza in Italia.Bollati Boringhieri, Torino.
Fazio A. 1995a. “L’instabilità nei mercatidei cambi.” Lecture delivered at the JohnsHopkins University, April 29, Bologna.
Fazio A. 1995b. “Monetary Policy andthe Budget in Italy.” Hearing of the Governorat the European Parliament, September 25,Brussels.
Passacantando, F. 1996. “Building an In-stitutional Framework for Monetary Stabil-ity: the Case of Italy (1979–94).” BNLQuarterly Review, 196: 83–132.
Rinaldi, R. and C. Santini. 1998. “Italy:Two Foreign Exchange Crises.” In S. S. Rehman,ed., Financial Crisis Management in RegionalBlocs. Boston: Kluwer Academic Publishers.
JAPAN 95
Foreign exchange transactions, capital flows, andfinancial businesses have been liberalized grad-ually, with dynamic economic growth and anincreased current account surplus since WorldWar II. Foreign exchange regulations were abol-ished in 1964 to comply with Article VIII ofthe IMF’s Articles of Agreement. The gradualliberalization of trade and investment and co-ordination of ministries and agencies concernedhelped cope with Japan’s huge current accountsurplus. And short-term capital flows were lib-eralized after 1970, with Japan’s robust eco-nomic growth, current account surplus, andaccumulated foreign reserves. The Foreign Ex-change and Foreign Trade Control Law allowsregulation of capital flows as a means of riskmanagement for immediate threats to the bal-ance of payment and markets (but these regu-lations have never been applied). Domesticliberalization has proceeded more slowly, dri-ven by foreign exchange and capital transactions.
POSTWAR PERIOD TO 1960
The Foreign Exchange and Foreign Trade Con-trol Law was promulgated in December 1949and banned foreign exchange transactions ex-cept by government or ministerial ordinances.Under this law, private entities were bannedfrom holding foreign currency. Residents wereobliged immediately to sell any foreign currencyto the government through authorized for-eign exchange banks. Initially, the exchangerates between customers and the foreign ex-change banks, and between the banks and thegovernment, were officially fixed. All foreigncurrencies were government controlled—therewas no room for a foreign exchange market.
With the revival of the Japanese econ-omy after World War II, foreign trade shifted
gradually from the government to the privatesector. The private sector could time receiv-ing export proceeds and paying import oblig-ations to move a large amount of capitalacross the border (leads and lags). So, new reg-ulations were set out to restrict such actions.
Foreign currency was allocated for externalpayments through gaika yosan seido, an institu-tional budget for foreign currency. Nonresidentscould not exchange yen into foreign currency, andyen-denominated financial assets held by for-eigners were limited. The Foreign Capital Lawalso began regulating investment, such as foreigndirect investment and technical transfers.
Foreign exchange controls were intendedto use Japan’s limited foreign reserves effectivelyby priotizing transactions and restricting unim-portant ones.
FROM 1960 TO 1973—END OF THE FIXED
EXCHANGE RATE REGIME
BECOMING AN ARTICLE VIII NATION
OF THE IMF
After World War II, the Japanese economyachieved high growth rates and a rapid ex-pansion of trade while facing balance of pay-ment difficulties. Under these conditions,the government published “The Outline ofthe Plan for Liberalizing Trade and ForeignExchange” in June 1960 as a step toward ac-cepting Article VIII of the IMF Articles ofAgreement and joining the Organisation forEconomic Co-operation and Development(OECD). In July, nonresidents were per-mitted accounts to deposit yen for currenttransactions settled in yen, a step toward therevival of yen convertibility. In September1960, restrictions on borrowing without
Japan
96 JAPAN
collateral and regulations on the foreign ex-change spot position of foreign exchangebanks were removed.
These ambitious measures stagnated andwere partly reversed in 1961 and 1962 whenmeasures against the shortage of foreign cur-rency were implemented, in effect until Janu-ary 1963. For example in June 1962 the reservedeposit requirement system required foreign ex-change banks to have 20 percent of their debtsdenominated in foreign currency. From 1962to 1963, when the short-term inflows of for-eign capital seemed to increase, the reserve re-quirement was raised to 35 percent. In late1962, the period of deferment was shortenedfor the share remittance of principal and in1963, it was abolished. Capital transactionswere further liberalized with a unified systemof permission of foreign capital. Under theForeign Capital Law, outflows were liberal-ized—but inflows strictly examined. Withother transactions, capital inflows were liber-alized and outflows not permitted. In 1963 theprocedures to control capital inflows and out-flows were unified.
The first official intervention by the Japan-ese government in the foreign exchange mar-ket was in April 1963, in preparation to removethe exchange controls on current transactions.Before then, foreign currency had been boughtand sold passively through a special governmentaccount for foreign exchange under officialexchange rates. Since that intervention, theforeign exchange rates fluctuated within therange of 0.75 percent around 360 yen per dol-lar and the government intervened in the for-eign exchange markets flexibly within thisrange. With this development, the trading vol-ume in the Tokyo foreign exchange marketexpanded rapidly.
In April 1964 Japan accepted Article VIIIof the IMF Articles of Agreement and removedexchange controls on current transactions. Thegaika yosan seido was abolished and replaced byan import quota system. Yen could be freelyconverted into foreign currency for import ofgoods and services. With the removal of the ex-change controls on current transactions, cap-ital transactions concerning trade were alsoliberalized. In the 1960s, as Japan’s foreign
trade expanded, capital transactions necessaryfor international trade increased.
When Japan became an Article VIII nationof the IMF and joined the OECD, 92 percentof trade items had been liberalized, with only192 remaining.
LIBERALIZATION OF CAPITAL FLOWS
The next industrial challenge for Japan in the mid–1960s was to liberalize capitaltransactions—not only removing the restric-tions on the flow of foreign capital, but alsochanging industrial policies by controlling cap-ital that directs economic activities. Liberal-ization in capital transactions developedprogressively in close consultations with manyinternational institutions and through variousdomestic deliberations, because this policy af-fects foreign capital and the liberalization oftrade, such as tariffs in each industry.
In July 1964 the OECD strongly urgedmembers to deregulate their capital transac-tions. Japan reserved 18 of 37 items under theOECD requirement, meaning liberalizationof capital transactions was comparativelybehind.
Discussion of capital liberalization indi-cated the future direction for liberalization:• For government, to establish a well-devel-
oped industrial system, promote reforms incompanies, and support technical devel-opment.
• For industry, to introduce foreign capitalin a voluntary, independent, and respon-sible way while strengthening cooperationamong companies and establishing coop-erative bodies within industry.
• For foreign interests, to bring capital inan orderly way, supporting coexistence,coprosperity, and adherence to the do-mestic legal and economic order.In July 1967 the first set of capital liber-
alization measures was implemented: the“automatic authorizing rule” and the “50percent rule” were introduced for 50 indus-tries. In 1969 the second set of capital lib-eralization measures was applied to 155 moreindustries, liberalizing about 30 percent of allindustries.
JAPAN 97
CAPITAL CONTROLS IN JAPAN AFTER
BECOMING AN ARTICLE VIII NATION OF THE
IMF
Except in fiscal 1967 when the current balancefell into a deficit with the expanding economy,increases in exports kept the current balance insurplus until fiscal 1970, increasing foreignreserves.
With foreign reserves rising rapidly in fis-cal 1968, restrictions were contemplated—amajor policy shift. Japan’s foreign reserves wererising while many countries suffered short-ages. And short-term inflows were disturbingdomestic financial markets and foreign ex-change markets.
Not until 1969 were measures to restrictthe rise in foreign reserves implemented. As ex-ports were growing and the official discount ratewas raised, so it was expected that the othercountries would ask Japan to revalue the yen.In 1970 exports continued to increase, thoughseveral trade financing measures were imple-mented and restrictions against short-termcapital inflows were introduced.
1973 TO 1980—TRANSITION TO A
FLOATING EXCHANGE RATE
EXCHANGE CONTROLS DURING THE
TRANSITION TO A FLOATING EXCHANGE RATE
After Japan shifted to a floating exchange rate,exchange controls were still strict and the ex-change rate was determined by the govern-ment, just as under the fixed exchange ratesystem. But the current account balance fell intodeficit, which grew because of an overheatingeconomy, appreciating yen, and the first oil cri-sis in 1973. The yen depreciated as prices roserapidly and the current balance deteriorated.
EXCHANGE CONTROLS DURING THE PERIOD OF
APPRECIATION AND DEPRECIATION OF THE YEN
At the end of 1973, the regulation restrictinga net increase of inward securities investmentwas removed, and the reserve deposits for non-residents holding yen were lowered. In Janu-ary 1974, a voluntary guideline to restrict the
net increase of outward investment was intro-duced for banks, securities companies, invest-ment trust funds, and insurance companies. Aregulation to restrict the net increase of bankdeposits in foreign currency held by residentswas also introduced.
In 1976 the current account surplus ex-panded, and in 1977 the external assets of theprivate sector began to increase. The yen beganto appreciate. The government intervened tobuy dollars, ease the regulation on capital out-flow, and strengthen the capital inflow regula-tions. In June 1977 the regulation on the balanceof residents’ deposits in foreign currency wasremoved, and the measure that prohibited resi-dents from acquiring short-term foreign securi-ties was abolished. In April 1978 foreign currencydeposits converted from yen were permitted upto the amount of 3 million yen. Regulations oninward investment were temporarily strengthenedwith the yen’s extreme appreciation. In March1978 nonresidents were prohibited from ac-quiring yen-denominated bonds, except thosewith maturities shorter than five years and onemonth and those issued by foreign entities. Asa result, it was very difficult for nonresidents toinvest in yen, and the spread between the euro-yen rate and the gensaki rate (which should bezero without exchange controls) was large fromlate 1977 to early 1979.
These regulations on inward investmentwere eased following U.S. President JimmyCarter’s announcement of measures to protectthe declining dollar, and were completely abol-ished by February 1979. In May 1979 the ma-turity term of import usance was extended, andshort-term impact loans from abroad were per-mitted. Nonresidents were permitted to partic-ipate in the gensaki market, and CD markets opento nonresidents were founded. As a result, cap-ital flows became more active, explained by thefact that the euro-yen rate was almost identicalto the gensaki rate. In March 1980 regulationson interest rates for yen-denominated depositsof foreign official institutions were abolished.
CAPITAL TRANSACTIONS
In September 1970 the third set of capital lib-eralization measures was implemented in 323
98 JAPAN
industries. In August 1971 the fourth set of cap-ital liberalization measures was announced.The regulatory framework was changed toallow up to 50 percent participation by foreigncapital as the principal. Targeted industries forliberalization were significantly expanded. Amidfurther external disequilibrium, the fifth set ofcapital liberalization measures was implementedin 1973. At that time, full participation of for-eign capital was set as the principle, except for17 industries with a sunset clause. Still, condi-tions were placed on the acquisition of equitiesusing foreign capital for a takeover, includingapproval of the targeted company’s manager.
AMENDMENT OF THE FOREIGN EXCHANGE
AND FOREIGN TRADE CONTROL LAW
After the G-7 Summit in 1976, Japan had torecognize its position as an economic super-power. While Japan’s current account balancerecovered steadily, other economies stagnated.It became difficult to ignore external economicconditions, leading Japan to promote liberal-ization and internationalization with an in-creasing current account surplus.
After early 1977, given the internationalfriction caused by a rapid increase in its cur-rent account surplus, Japan moved to modifythe Foreign Exchange and Foreign Trade Con-trol Law to demonstrate its openness to the in-ternational economy. In May Japan decided tocompletely deregulate foreign exchange con-trols. The foreign exchange banks were dereg-ulated, including abolishment of the regulationon short-term capital transactions and easingthe regulation on medium- and long-termcapital transactions, and deregulation of for-eign currency liability by foreign exchangebanks. And as a positive step for the TokyoRound of GATT, tariff reductions and en-hanced financing for imports were announced.
In January 1978 further measures for theliberalization of exchange controls were an-nounced. The broad range of measures per-mitted flexibility in the standard settlementsystem, guarantees, remittances, gold transac-tions, real estate transactions, technology im-ports, foreign deposits, foreign directinvestment, carrying out of yen, licensing of for-
eign exchange banks, and hedging operationsfor outward securities investments.
In May 1979 seven measures for promotingcapital inflow were announced. They extendedmaturity terms of import usance, abolished theregulation on prepayment for exports, abol-ished the waiting period to covert yen-denom-inated foreign bonds into dollars, eased usageof proceeds from long-term impact loan, freedshort-term impact loan, and allowed nonresidentparticipation in auctions of yen-denominatedforeign bonds and gensaki transactions. Withthese measures, the amended Foreign Exchangeand Foreign Trade Control Law was put intoplace well before its formal promulgation.
In December 1980 the amended ForeignExchange and Foreign Trade Control Law wasofficially implemented, shifted the principle offoreign exchange transactions from prohibitionto freedom. This amendment legally estab-lished the liberalization of exchange rate trans-actions and with the liberalization of currentand capital transactions, the legal structurewas completely changed.
Under the amended Foreign Exchange andForeign Trade Control Law, capital controlscan be activated only when it is extremely dif-ficult to maintain equilibrium in the balance ofpayments, foreign exchange rates fluctuate sig-nificantly, and cross-border capital flows have aserious impact on financial capital markets—butthey have never been activated. The amendedlaw liberalized deposits in foreign currencies atJapanese foreign exchange banks by residents (in-cluding selling yen), and loans in foreign cur-rencies from Japanese foreign exchange banks(such as yen impact loan). For inward-outwardsecurities investments through specified securi-ties companies, notifications to the authority be-came unnecessary. As a result, residents came tohold foreign currency-denominated assets freely,substantially changing Japanese foreign exchangecontrols and removing almost all restrictions onthe convertibility of the yen.
The expansion of foreign currency-denominated financial transactions inside Japanhas been a primary factor promoting liberaliza-tion of interest rates on short-term yen financing,since they are in effect equivalent to those de-nominated in yen, by hedging through forward
JAPAN 99
exchange contracts. This shows how liberaliza-tion of foreign exchange transactions can promotea domestic financial liberalization. Foreign cur-rency deposits bear foreign exchange risk and can-not be substituted for a yen-denominated deposit.But they are identical to a yen-denominated de-posit with market interest rates if foreign ex-change risk is avoided through hedging.
A loan from abroad with covered transac-tions by future contrasts can be identical to ayen-dominated loan with market interest rates.It is also outside the “window” operations bythe Bank of Japan. Though these transactionscost the participants, since they involve handlingcharges, liberalization of foreign currency-de-nominated deposits and loans from abroadhave a similar effect as liberalization of do-mestic yen-denominated deposits and loanswith market interest rates because the transac-tion cost is relatively small for large transactions.
THE 1980S
LIBERALIZATION OF CAPITAL TRANSACTIONS
The Foreign Capital Law was abolished fol-lowing the amendment of the Foreign Ex-change and Foreign Trade Law. In 1984restrictions were abolished for investments bynonresidents in designated Japanese companies(Shitei Kaisha), and the reporting period for fi-nancial statements by foreign companies wasextended from three months to six monthsafter the day of settlement.
In the final report of the “Japan–U.S. Struc-tural Impediments Initiative” published inJune 1990, Japan announced its plan to liber-alize foreign direct investment. It then beganto enact laws to promote imports, facilitate in-ward investment, implement loans to foreigncompanies through a favorable interest ratefacility, and provide information through theJapan External Trade Organization. In 1992 theForeign Exchange and Foreign Trade Law wasmodified again, and ex ante reporting of FDIwith government examination was replacedby ex post reporting in principle, with partialex ante reporting in some cases. The deadlinefor reporting was changed to no later than 15days after the transaction.
FINANCIAL LIBERALIZATION
Around 1980 U.S. and European banks andsecurities companies stepped up their requestsfor the liberalization of Japan’s financial andcapital markets and the greater participation offoreign companies in the Japanese economy.They argued that Japan’s markets should becommensurate with its status as the world’s sec-ond largest economic power. Domestic re-quests for liberalization also soared.
Two reports—“Current Status andProspects for Financial Liberalization and theInternationalization of Yen” and “Report by theWorking Group of Joint Japan–U.S. Ad HocGroup on Yen/Dollar Exchange Rate, Finan-cial and Capital Market Issues”—expressedpositive attitudes toward financial liberalization.With this turning point, Japan began to fol-low the worldwide trends toward liberalizationand globalization. Some believe that the lib-eralizing of foreign exchange transactionsaround 1980 gave impetus for the financial lib-eralization. The plan included:• Liberalizing deposit interest rates. As pro-
posed in “Prospects” and the “Report”,permit smaller denomination of CDs withfree interest rates, make their terms of is-suance flexible, and introduce large-sum de-posits with market interest rates.
• Facilitating short-term financial markets.Japan’s short-term financial markets devel-oped rapidly with the increase of gensaki andCDs exceeding 20 trillion yen. But thosemarkets were less flexibile and diverse thanthose in the United States. To enlarge andenrich such markets, a yen-denominated BAmarket is planned. It will help interna-tionalize the yen by promoting yen-denominated trade. Additional methodsof financing for the short term will increaseshort-term capital investments and the pro-curement opportunities for corporations.
• Diversifying the financial businesses. Diver-sification of businesses is as important asinterest rate liberalization. “Prospects” spec-ifies plans to improve and increase the flex-ibility of businesses, such as securities andinternational business, while respectingthe creativity of the private sector.
100 JAPAN
• Expanding euro-yen trade. The “Report”promoted the liberalization of euro-yentrade. Short-term euro-yen loans for bothresidents and nonresidents were liberal-ized, as were medium-to-long-term euro-yen loans for nonresidents. Euro-yen CDsand euro-yen bonds were also liberalized.
• Liberalizing foreign bonds denominated inyen. In 1984 yen-denominated bonds is-sued by nonresidents were liberalized.
• Establishing a Tokyo offshore market. TheTokyo offshore market was founded inDecember 1986 for nonresidents to pro-cure necessary financial resources withfewer regulatory limitations. Facilitationof yen-denominated investments and fi-nancing from abroad was expected to helpadvance the internationalization of theyen. The Tokyo market was expected to be-come a large international financial centerlike that in New York and London.In June 1987 the “Current Outlook for
Liberalization and Internationalization of Fi-nancial and Capital Markets” was released. Itoutlined the current status of liberalizationand the problems to be solved. The report in-dicated that liberalization and international-ization were proceeding and insisted that Japanshould serve as one of the key international fi-nancial centers with more consideration oncooperation with other countries. The reportsuggested:• Further liberalizing deposit interest rates.• Enhancing short-term financial markets.• Improving futures markets.• Improving capital markets.• Liberalizing the business of financial
institutions.• Collaborating with other countries to su-
pervise banks and improve their capital.• Solving the problems of business fields
handled by financial institutions.• Improving methods of access by foreign fi-
nancial institutions.
1990S—FINANCIAL SECTOR REFORM
Framed in 1992 and implemented in 1993, fi-nancial sector reform aimed to move from in-direct to direct finance, using the “subsidiary”
system to enhance participation in each fi-nancial sector. By allowing the establishmentof 100 percent subsidiary companies, the prob-lem between industries could be solved whilemaintaining the basic boundary between theindustries. Also, the interest rates on term de-posit were completely liberalized in June 1993.
In 1996 discussions on the financial bigbang started. In May 1997 the Foreign Ex-change and Foreign Trade Control Law wasamended as the frontrunner of the financial bigbang. The 1980 foreign exchange control sys-tem was more liberal than those in Europe. Butas cross-border transactions were rapidly lib-eralized in European countries, the ForeignExchange and Foreign Trade Control Law hadto be amended to make the Tokyo market in-ternationally attractive. Specifically, cross-bor-der transactions were liberalized by theabolishment of the ex ante permission and re-porting system in principle, foreign exchangebusinesses were liberalized completely, andregulations of foreign exchange banking wereabolished, ensuring free participation and thewithdrawal of foreign exchange businesses.
THE FINANCIAL BIG BANG
To make full use of Japan’s household savingsof 1,200 trillion yen, free and fair financial mar-kets were needed. In addition, the Japanese fi-nancial market was expected to become aninternational financial market equal to that ofNew York and London. Three important prin-ciples of market structural reform—free, fair,and global—were advocated. A sequence of lib-eralization measures were achieved: liberaliza-tion of subject of investments (such as removalof ex ante regulations on development of newfinancial products by securities companies);liberalization of markets (such as that of deal-ing equities using over the counter markets);liberalization of market intermediaries (such asreplacement of the license system of securitiesbusiness with the register system); and liber-alization of prices (such as that of brokeragecommission fees for equities). With the re-moval of the license system in the securitiesbusinesses, liberalization of financial businessesadvanced dramatically.
REPUBLIC OF KOREA 101
Narrowly defined, globalization may refer toeconomic liberalization and integration basedon global standards. But its implications for in-dividual countries are far more than just eco-nomic, as they extend into the realm of social,political, and even cultural development. In-deed, the Republic of Korea has rapidly trans-formed its economic and social landscape overthe course of its outward-looking economicdevelopment. With export promotion and for-eign capital inducement serving as the main en-gines of growth, Korea was required to align itssocioeconomic institutions and policies withglobal market standards. But in contrast to thehigh level of economic integration in trade,the financial sector had been little exposed toglobal competition until the outbreak of the EastAsian crisis in 1997. Consequently, the dis-crepancy between global and local standardsgrew in the financial sector, and impeded thedevelopment of economic institutions and poli-cies suited to a globalized market environment.
In this sense the unfolding of Korea’s cri-sis in 1997 provides an excellent case for thestudy of the crucial issues surroundingglobalization—particularly the complex dy-namics of capital market liberalization. The1997 crisis was not just a simple liquidity cri-sis. Rather, it reflected a culmination of struc-tural imbalances and institutional shortcomingsin Korea’s economic system magnified by adelay in alignment of local to global standards.
Given this prognosis, structural remedieswere called for. Indeed, the crisis providedcritical momentum for Korea to address thechallenges posed by globalization. The econ-omy was made fully open to financial flows,which—unlike trade flows—had not beenfully liberalized. Increased economic open-ness served as an important catalyst for
comprehensive economic reforms on the do-mestic front and expedited Korea’s transitionto a fully open market economy. Thus thiscase study focuses on capital account liberal-ization and related institutional reforms.
OVERVIEW
The most unique feature of Korea’s economicdevelopment is the government’s strong lead-ership in resource allocation. Industrial policyhas been at the heart of this leadership. The gov-ernment selected so-called strategic industriesand firms and provided them with formal andinformal incentives, particularly financial favorsin the name of policy loans. Entry barriers werealso implemented to protect firms in strategicindustries from competition. The results wererapid growth of investment and output, largelyled by family-controlled business conglomer-ates, referred to as chaebols in Korea.
But the government’s visible hand in fi-nancial resource allocation in the early stage ofKorea’s development was also the prelude tomore extensive government control and per-vasive moral hazard in the later stage. Fruits ofbusiness success accrued to owners and em-ployees of chaebols while investment failureswere often passed on to the public. Prudentialregulation and supervision of the financial sec-tor were insufficient. The emergence of highlyleveraged chaebols with enormous marketshare in both product and factor markets in-creased Korea’s vulnerability to cyclical shocks.
Deteriorating macroeconomic performancein the late 1970s, especially in terms of risinginflation and growing imbalances in the ex-ternal current account, gave rise to criticism ofthe government-led development strategy thathad been maintained for two decades. The
Republic of Korea
102 REPUBLIC OF KOREA
first major momentum for liberalization wasprovided by the heightened economic insta-bility of 1980, triggered by domestic politicalunrest and the second oil shock. The globaltrend toward economic liberalization since thebeginning of the 1980s also affected, at leastpartly, Korea’s domestic liberalization process.Consequently, macroeconomic policy instru-ments were redirected toward price stabilityduring the first half of the 1980s, while in-dustrial policies were partially lifted, with thegradual phaseout of policy loans.
In contrast to the ardent macropolicy re-forms, however, progress in micropolicy re-forms, particularly in the financial sector, laggedbehind. Indeed, when Korea returned to re-markable economic growth with large currentaccount surpluses in the second half of the1980s, rising pride about the Korean eco-nomic system began to outweigh suggestionsfor further reforms toward global standards.And the government’s control in the financialsector, albeit lower than in the 1970s, contin-ued despite the privatization of banks.
In the late 1980s financial liberalizationresurfaced as an important policy agenda asKorea significantly improved its balance of pay-ments. In 1990 the exchange rate system was re-formulated to allow greater flexibility. In thedomestic market, interest rate deregulation wasimplemented in a more systematic way, althoughthe process was often hindered by market reac-tions. But the most meaningful step in terms offinancial globalization was made in 1992, whenthe domestic equity market was opened to for-eign investment. After that capital account lib-eralization made steady progress before it wasfurther accelerated in line with Korea’s accessionto the Organisation for Economic Co-operationand Development (OECD) in 1996.
The 1990s also witnessed significantprogress in trade liberalization. The inceptionof the World Trade Organization (WTO) pro-vided critical momentum for import liberal-ization, although trade liberalization had beenevolutionary in the context of the outwardlooking development strategy. In fact, it was inthe mid-1990s that the government first usedthe concept of globalization as key rationale forits comprehensive economic reforms.
Despite the increasing exposure to globalforces, however, much-needed reforms were notcarried out in a timely manner. The govern-ment’s basic modus operandi for financial pol-icy changed only slightly. Business practices andthe mindset of the private sector also under-went little change. Fundamental market in-frastructure, such as an institutional frameworkto ensure transparent corporate governanceand sound practices of financial institutions,was not properly established. As a result struc-tural imbalances between global and local stan-dards intensified. In short, in the 1990s Koreawas slow to adapt itself to rising global stan-dards, and was hit by the 1997 crisis.
The 1997 crisis was a turning point inKorea’s economic history, representing painfulevidence of the challenges posed by globaliza-tion and Korea’s limited responses. Althoughit was a crisis of the capital account and not thecurrent account, which was relatively new toKorea, its impact was not confined to the fi-nancial sector because it also represented col-lapsed confidence of the global communityin Korea’s old economic system. Indeed, dra-matically increased economic openness after thecrisis served as an important catalyst for up-grading economic institutions and legal frame-works to be on par with global standards.
DOMESTIC ECONOMIC POLICY REFORMS
MACROECONOMIC POLICY REFORMS
In 1980 the adverse impact of the second oilshock hit Korea hard. Economic growth plum-meted to a negative figure, while inflationsoared to almost 30 percent. The external bal-ance also worsened significantly, with a currentaccount deficit of more than 8 percent of GDPand government budget deficit over 3 percentof GDP. Political instability added further un-certainty to the economy. Even facing suchhardships in every dimension, however, thegovernment placed top priority on economicstabilization rather than growth promotion—and the results were quite successful, with pricestability fully restored by the mid-1980s. Thisreorientation of macroeconomic policy wasfirmly preserved for almost a decade. At the
REPUBLIC OF KOREA 103
same time, many important macropolicy re-forms were successfully carried out in the early1980s.
Monetary policy. One of the important ide-ological changes in 1980s was that monetarypolicy should aim at promoting price stabilityrather than supporting industrial policies. De-spite the recession, monetary policy was dras-tically tightened in the early 1980s, asmanifested by a sharp fall in the growth rateof base money to virtually 0 percent during1980–82, down from around 30 percent in thelate 1970s (figure 1). As a result inflation sub-sided to about 3 percent, down from 20–30percent in the late 1970s. Such success in thedisinflation policy provided an important plat-form for globalization in that it significantly re-duced economic uncertainty associated withinternational transactions.
However, management of M2 targetingexhibited potential problems. For example,even when domestic liquidity supply was clearlyexcessive in the late 1980s, as reflected by anexplosive increase in the base money and manyother financial variables, the government em-phasized the M2 target (see figure 1). Anotherproblem was the way the central bank con-trolled monetary aggregates. The central bankassigned monetary stabilization bonds to com-mercial banks through closed windows ratherthan open and transparent markets.
This convention, along with the M2 tar-geting, was almost abolished with the currencycrisis. First, to cope with the collapsing currencyvalue, the International Monetary Fund (IMF)raised overnight interbank call rates dramatically.That is, the monetary authority began to usethe short-term interest rate as an explicit in-termediate target, with monetary aggregates asinformation variables only. In the swirl of fi-nancial crisis and drastic financial reforms, thestability of monetary aggregates was seriouslydamaged (figure 2), further justifying the interestrate targeting. The decline in the need to hit aquantity target then reduced the authority’sguide at the bank windows.
Today the monetary policy is conductedunder the new legal mandate of inflation tar-geting, with the short-term interest rate as theintermediate target. This scheme, along with
the free-floating exchange rate, appears to beconsistent with the environment of the Koreancapital market, which is now completely open.
Liberalization of interest rates was anotherimportant reform related to monetary policy.Although there were recurrent objections tothis, interest rates set by the government in the1970s were liberalized throughout the 1980sand 1990s in a gradual manner, as can be seenfrom the steadily reduced discrepancy betweencurb market and institutional interest rates(figure 3). The preferred interest rates appliedto policy loans were also gradually abolished.
Percent, averages
Figure 2. Growth rates of monetary aggregates in Korea, 1972–2002
–20
–10
0
10
20
30
40
50
60
20022000199519901985198019751972
M2 Reserve money
Trillion won, yearly average
Figure 1. Trends in M2 and M3
0
200
400
600
800
1,000
200019991998199719961995199419931992199119901989198819871986
M2 M3
104 REPUBLIC OF KOREA
EXCHANGE RATE SYSTEM
With the rapidly expanding current accountdeficit in 1980, the balance of payments hadto be stabilized. The won-dollar exchange ratethat had been fixed since 1974 was devaluedby 20 percent in January 1980, then a multi-ple currency basket system replaced the fixedexchange rate regime. Under this new systemthe government still set and announced the ex-change rate, but the substantial differentials be-tween domestic and foreign inflation ratesbegan to be explicitly considered.
Because Korea had accumulated a sub-stantial current account surplus by the end ofthe 1980s, confidence regarding the balance ofpayments was built up among policymakers,and the exchange rate system was further re-formed into the market average exchange ratesystem in 1990. This new system was an ad-vancement toward free market rates in that theexchange rate was basically determined throughdemands for and supplies of foreign currenciesin exchange markets, rather than by discre-tionary judgments made by the government.
Nevertheless, the foreign exchange mar-ket was not completely left to market forces.And market participants were inclined to be-lieve that the exchange rate would not deviatemuch from the range that the governmenthad in mind. This belief, however, was changedwith the currency crisis in 1997. Finally, the
completely free-floating exchange rate systemwas introduced with the full-scale capital mar-ket opening in December 1997.
FISCAL POLICY
Fiscal policy was also reformed in the early1980s. Many tax incentives supporting strate-gic industries were phased out, and the zero-base principle was applied to budget planning.Specifically, the automatic budget increase forgovernment projects year after year came to ahalt, and each project was required to providejustification for the increase.
A prominent result of this policy was thenegative growth rate of government expendi-ture (in real terms) in 1981. As a result the con-solidated budget deficit gradually approachedbalance in the early 1980s, and the balancedbudget policy became a tradition. Although arather rigid government attitude marred fiscalflexibility (such as automatic stabilizers), thislong-standing tradition of the balanced bud-get preserved the fiscal soundness that playedan important role in the Korean economy’s re-covery from the currency crisis.
MICROECONOMIC POLICY REFORMS
Financial market. Throughout the 1960s and1970s domestic financial markets and institutionswere subject to extensive government supervision.Interest rates were regulated, while credit allo-cation was largely in the hands of government-owned banks. In the 1980s the governmentbegan reforming policies to improve financialmarket efficiency. Two policy measures are no-table: privatizing banks and fostering the devel-opment of direct financial markets.
The government divested nationalizedbanks between 1980 and 1983 based on thepremise that establishing a market-based own-ership and governance structure should be thefirst step to improve the efficiency of financialinstitutions and markets. The privatization ofbanks, however, did not produce the intendedeffects because the banks lacked experience.
The development of capital marketsyielded more pronounced and lasting impactson financial markets and industry. The major
Percent
Figure 3. Trends in interest rates in Korea, 1981–97
0
5
10
15
20
25
30
35
40
199719951993199119891987198519831981
Curb market rate
Bank loan rate
Yield rate of corporate bond
REPUBLIC OF KOREA 105
motivation for capital market developmentwas to provide firms with alternative source offunding and to mitigate the concentrated own-ership structure of the industrial sector, par-ticularly chaebols. The main focus of thegovernment’s effort was given to the develop-ment of the corporate bond market and stockmarket. Most notably, institutional investorssuch as investment trust companies and banktrust departments were established in the late1970s and early 1980s. These financial inter-mediaries in direct financial markets rapidly in-creased their share in financial flows.Accordingly, the dominance of banks in the fi-nancial market gradually dwindled, as reflectedin the growth pattern of M3 relative to M2.
The rapid expansion of the nonbanking sec-tor continued throughout the 1990s as entry bar-riers in the sector kept being lowered. Accordingly,competition for funds intensified between banksand nonbanks. These developments, in con-junction with weak internal governance of banks,undermined the profitability of banks and madethe financial sector vulnerable to cyclical shocks.But the regulatory and supervisory system wasunable to properly respond to the situation.Capital account liberalization took place in thisshaky environment, exposing the economy to po-tential systemic risks that were eventually real-ized in the 1997 crisis.
After the crisis most banks were effectivelynationalized as the government injected pub-lic funds to support their recapitalization. Giventhis, bank governance reform remains one of themain tasks for financial sector reform. However,the regulatory framework was greatly upgraded.To foster market competition and discipline inthe nonbanking sector, entry barriers were fur-ther lowered and foreign participation liberal-ized. Global standards were instituted for bankregulation and supervision, including promptcorrective actions and new accounting and loanclassification standards, among others. In ad-dition, the deposit insurance system was re-formulated to better deal with systemic risks andpotential moral hazard by providing only par-tial coverage to deposit-taking institutions.
Corporate governance. In the early 1980schaebols began increasing their influence in thefinancial sector through the ownership of
nonbank financial institutions such as mer-chant banks, security companies, investmenttrusts, and insurance companies. Their in-creasing control weakened external gover-nance of corporate management and createdthe possibility of inefficient—and oftenreckless—corporate investment. In addition,the lack of an outsider director system and oftransparency in accounting information ag-gravated agency problems.
The government-business risk partnershipbecame increasingly dysfunctional in the eraof liberalization and democratization. Thedesirability and effectiveness of the state-ledmonitoring and incentive system were greatlyreduced, but few financial institutions or in-stitutional investors were ready to step in toserve these functions. Moreover, the govern-ment was slow in promoting competition andcreating conditions for autonomous financialinstitutions to develop. Quantitative restric-tions on credit and in-group investment werethe main instruments of competition policy.Although these measures were intended toaddress the problem of economic concentra-tion and to contain potential systemic risks,they were insufficient in compensating forthe lack of market discipline imposed on cor-porate management and investment.
Labor market and social safety net. AfterKorea was politically democratized in 1987,workers demanded wage increases as well as full-fledged rights to organize and take collectiveaction. Business executives complained thatlifetime employment practices impeded cor-porate restructuring and flexible adjustmentto rapidly changing global markets. A grand bar-gain between labor and management wouldhave involved enhanced worker rights and so-cial security in exchange for increased labormarket flexibility. Repeated attempts by thegovernment to broker such an agreement be-tween the two sides, however, resulted in pro-tracted gridlock. In fact, only in the wake of the1997 crisis did the two sides agree to increaselabor market flexibility and enhance workerrights. After the crisis the government strength-ened the social safety net to address not onlysoaring unemployment but also structuralchanges in employment practices.
106 REPUBLIC OF KOREA
CAPITAL ACCOUNT LIBERALIZATION
Though the nominal anchor approach of the1970s was replaced by a more flexible real tar-get approach in 1980 with the introduction ofthe multiple currency basket peg system, ex-change rates remained policy variables in Koreathroughout the 1980s. Therefore, Korea’s poli-cies on capital flows in the 1980s were domi-nated by the necessity of balancing the currentaccount and were pursued in a passive manner.Hence in the first half of the 1980s, when cur-rent account showed deficits, various regula-tions on banks and corporations were lifted toinduce capital inflows.
But in the mid-1980s, when the current ac-count balance began to show large surpluses inthe wake of the realignment of major currencies,the policy stance toward capital inflows changeddramatically (figure 4). Foreign commercial loansto domestic firms, with the exception of publicenterprises, were prohibited. Overseas issuanceof bonds and depository receipts by residents wasalso restricted. In addition, banks were advisedto reduce their exposure to external debt.
GRADUAL LIBERALIZATION IN THE 1990S AND
THE 1997 CRISIS
Characteristics of liberalization policy. As theKorean economy achieved fast economic
growth, internal demand for low-cost capitalin the private sector kept rising, strength-ened by liberalization pressures from capi-tal-exporting countries. Hence, in tandemwith the reform of the exchange rate policyin 1990, capital account liberalization wasconsidered in its own right for the first time,and the government began adopting liberal-ization measures.
The approach adopted can be summarized as:• Liberalize capital flows by domestic banks
first.• Liberalize trade-related short-term capital
flows for nonfinancial corporations.• For other capital flows, either defer liber-
alization or liberalize with restrictions.The major rationale behind the policy
stance had much to do with the government’sconcern for macroeconomic stability, particu-larly the adverse impact of substantial capitalinflows on the exchange rate, export compet-itiveness, inflation, and the like. Given theconcern, the government preferred gradualliberalization as a way of controlling associatedrisks and, in particular, intended to use banksas risk managers. As a result, other than do-mestic banks, liberalization was limited.
Specifically, overseas issuance by domesticfirms of foreign currency-denominated bondswas deregulated in 1991. And in January 1992the Korean stock market was opened to foreigninvestors. Commercial loans by domestic firmsfrom foreign agents, which had been prohib-ited since 1986, were allowed in 1995.
Still, explicit quantity restrictions and dis-cretionary or informal controls remained preva-lent. For equity investment a 10 percentaggregate ceiling on foreign ownership of listedfirms was imposed, which continued until thecrisis. With regard to commercial loans byfirms, restrictions on the uses of funds existedand government approval was required. Like-wise, the overseas issuance by domestic firmsof foreign currency-denominated bonds wassubject to discretionary quantity control.
Thus most capital flows led by firms orthrough the stock market were not fully lib-eralized. Moreover, capital flows in other formsand domestic financial markets other than thestock market remained closed. Exceptions were
Billions of U.S. dollars
Figure 4. Net capital inflows to Korea, 1980–98
–15
–10
–5
0
5
10
15
20
25
1998199619941992199019881986198419821980
Foreign directinvestment
Portfolioinvestment
Others (banks’external debts)
Capital accountbalance
trade-related short-term financing and foreigncurrency borrowings of banks. Various re-strictions on deferred import payments and thereceipt of advance payments for exports werelifted step by step over the 1990s. For banksno explicit quantity regulations existed onlong-term or short-term borrowings in for-eign currencies.
When Korea joined the OECD in 1996,the gradual approach toward capital market lib-eralization and financial market opening re-mained intact. To fulfill its obligations as amember of the organization, the Korean gov-ernment announced a blueprint that would re-move barriers to foreign portfolio investmentand foreign direct investment—but gradually,over 1998 to 2000.
Lessons from the 1997 crisis. An investment-led boom between 1994 and 1996 generateda strong demand for low-cost capital, while theupgrading of Korea’s sovereign credit ratingin early 1995 attracted foreign credit suppli-ers. Combined, these developments led to asharp surge in net capital inflows. As dictatedby the policy stance, debt instruments carriedmost of the increased capital inflows duringthese years. Though portfolio investment in-creased rapidly, stock investment was limited—reflecting the ceiling restrictions mentionedearlier. Consequently, the surge in net capitalinflows was tantamount to a sharp increase inKorea’s external debt (figure 5), of which asubstantial portion was short-term borrow-ings of banks. In November 1997 foreign cred-itors ran to claim these short-term borrowings,leading to the crisis.
Given the consequences, some argue that theliberalization sequence was incoherent and cri-sis-inviting since short-term capital movementswere substantially more liberalized than long-term flows. However, though it is true thatlong-term capital flows were controlled in Korea,it would be an exaggeration to say that short-term flows were liberalized greatly. Neither firmsnor banks could sell their short-term debt in-struments in domestic currency to foreigners.Only liberalized were trade-related financingof firms and short-term foreign currency bor-rowings of banks. Moreover, though it is a factthat short-term foreign currency borrowings of
banks triggered the crisis, the policy stance inthis area cannot be considered a culprit. Short-term transactions of banks are not only difficultbut also undesirable to control ex ante becauseimpacts of related operations on balance sheetsoften matter for days. As such, ex post controlor supervision is the right way to address any po-tential problems.
The crisis may have been caused by the lib-eralization policy not being supplemented bysupervisory and regulatory reforms. Whilepursuing the bank-centered liberalization pol-icy, the government failed to promptly in-duce more prudent risk management of banks.A new financial safety net consisting of pru-dential regulation and supervision and ex-plicit deposit insurance should have beenestablished in line with the liberalization mea-sures. Hence, moral hazard-inducing elementswere intact while new risk taking opportuni-ties were provided. Furthermore, the expan-sion of banks’ overseas business aggravatedthe situation. Based on the reasoning thatoverseas activities of domestic banks and cor-porations do not hamper domestic macro-economic stability and help competitivenessof corporations, overseas business of banksand corporations was encouraged in the mid-1990s. Banks exploited this new opportunityaggressively, leading to large foreign currencyliabilities in overseas branches that exceededthe external debts of domestic branches.
Billion won
Figure 5. Trend and composition of external debts in Korea, 1995–2003
0
50
100
150
200
200320022001200019991998199719961995
Total
Short-term
Long-term
REPUBLIC OF KOREA 107
108 REPUBLIC OF KOREA
POST-CRISIS DEVELOPMENT
Capital account liberalization policy took a rev-olutionary turn after the crisis. As a way of over-coming the crisis, the Korean governmentdecided to pursue full-blown liberalization of thecapital account and opening of financial mar-kets, a sharp contrast to the former gradual ap-proach. All types of domestic capital markets,including short-term money markets, were com-pletely opened to foreign investment by theend of 1998. Furthermore, in April 1999 thegovernment abolished the restrictive ForeignExchange Management Act and replaced it withthe Foreign Exchange Transaction Act, chang-ing the regulatory system for capital accounttransactions from a positive to a negative. As aresult all capital account transactions related tothe business activities of financial and nonfi-nancial firms have been liberalized, placingKorea in the ranks of advanced countries interms of capital market openness.
MARKET OPENING AND DOMESTIC
INSTITUTIONS
Domestic institutions interact with marketopening in many important ways. Increased im-port liberalization leads to intensified compe-tition in the domestic market and puts pressureon the government to overhaul economic in-stitutions and policies. The government mayalso have to respond to possible social dislo-cations caused by liberalization. The openingof the capital market increases the potential riskof sudden reversals in capital flows and sotends to induce the government to strengthenprudential regulation and adopt sound macro-economic policies to avoid serious imbalances.
Moreover, as capital account liberalizationin a fast-growing economy is likely to result ina huge influx of foreign capital and increase theamount of financial resources relative to profitopportunities, it is essential to have autonomousfinancial institutions to carry out objectivecredit analysis and impose discipline on cor-porate management. Accountable private risktaking, as opposed to public management of pri-vate risks, has to be an integral part of institu-tional reforms designed to improve financial
resource allocation and corporate governance.Deregulation without protection is likely toaggravate moral hazard. Therefore, to mini-mize the risks of globalization, particularly fi-nancial liberalization, fundamental governancereform and meaningful privatization shouldbe carried out.
Moreover, as traditional barriers to tradeand investment have been progressively dis-mantled, national institutions tend to be sub-jected to unprecedented scrutiny by the globalcommunity. Globalization increases demandsfor institutional harmonization, and multina-tional organizations put pressure on individ-ual governments to adopt global standards intheir institutions, affecting resource allocationand governance. These considerations suggestthat domestic institutional development shouldbe an essential part of market opening reformsand vice versa.
The progress of Korea’s economic devel-opment was largely the reflection of Korea’sexport-driven and state-led development strat-egy. Although the success of the export-drivendevelopment strategy may provide the mo-mentum and impetus for further liberaliza-tion, Korea’s experience suggests that suchtrade-liberalization linkages may have limitedeffects on important institutions, particularlythose affecting financial resource allocationand corporate governance. This was particu-larly so in Korea. Given the long tradition ofindustrial policy centered on credit allocationby the government, the political economy ofinstitutional reform in the realm of financialresource allocation was extremely complex.Indeed, major reforms in the financial sectorand corporate governance were carried outonly in the wake of the 1997 crisis.
In the post-crisis period a series of policymeasures was implemented to improve cor-porate governance and protect the propertyrights of minority shareholders. From 1998, allpublicly listed firms were required to have atleast one outside director, to promote effectivemonitoring of management. Institutional in-vestors were no longer required to follow theshadow voting rule. Also, minimum share-holding requirements were significantly re-duced for exercising shareholder rights, such
REPUBLIC OF KOREA 109
as the right to file derivative lawsuits againstcompany executives for mismanagement.
Korea also overhauled the FDI regime andrelated institutions. The ceiling on foreign eq-uity ownership in the domestic stock marketwas eliminated in May 1998. Moreover, thegovernment fully liberalized foreign land own-ership by amending the Foreigner’s Land Ac-quisition Act in 1998. In November 1998 theForeign Investment Promotion Act was en-acted to replace the Act on Foreign Direct In-vestment and Foreign Capital Inducement.The new legislation focused on creating aninvestor-friendly environment by streamlin-ing foreign investment procedures, strength-ening investment incentives, and establishingan institutional framework for investor rela-tionship management, such as the “one-stopservice”. Last but not least, the Foreign Ex-change Transaction Act was enacted in April1999 to liberalize foreign exchange control.These post-crisis developments are expected toenhance market competition and discipline
BENEFITS AND CHALLENGES OF
GLOBALIZATION
Globalization offers benefits but poses chal-lenges. Countries must address both, and indoing so can draw on international institutions.
BENEFITS OF GLOBALIZATION
From a theoretical standpoint, the welfare im-plications of globalization have yet to be fullyinvestigated, partly because globalization is amultifaceted concept that incorporates a widespectrum of socioeconomic development andphenomena. It seems to be even more difficultto quantify the benefits and costs of global-ization because reliable measures of economicand social changes induced by globalization arenot readily available, nor are the direct effectsof globalization easily pinned down due tothe inherent endogeneity of such changes.
Nevertheless, some indirect evidence of thebenefits of globalization can be constructed ifthe scope of the discussion is narrowed down tothe growth effect of globalization. The growingliterature on economic growth has attempted to
identify the sources of long-run growth withinthe framework of growth accounting as well ascausality regressions. Among many explanatoryvariables for economic growth explored in theliterature, the degree of economic openness andthe quality of institutions seem to be of partic-ular relevance for the discussion of the benefitsof globalization as they are the first things to beaffected by globalization.
Indeed, a cross-country study for 78 coun-tries by Hahn and Kim (1999) shows that thedegree of economic openness and the qualityof institutions are the most important factorsexplaining regional differences in economicgrowth over 1960–89. Specifically, these twofactors together provided East Asia with addi-tional growth of more than 1 percentage pointa year (about 35 percent of the predictedgrowth differences) compared with other de-veloping regions over the sample period. Oncethe effect of economic openness on the qual-ity of institutions is controlled, the total growtheffect of the economic openness variable turnedout to be the most important variable ex-plaining growth differences between East Asiaand other developing regions, up to almost 1percent a year. Although desirable, a separateaccount of the benefits of capital market open-ing for Korea seems to be premature at this timegiven the limited availability of data for thepost-crisis period.
CHALLENGES OF GLOBALIZATION
Korea’s 1997 crisis indicates the enormity ofchallenges posed by and risks associated withglobalization. Although Korea has experiencedminor balance of payments crises from time totime over the course of its economic develop-ment, the 1997 crisis was fundamentally dif-ferent from previous ones in that it was a crisisof the capital account, not the current ac-count. This implies, at least for Korea, that themajor challenge of globalization was capitalmarket opening.
In retrospect, the foremost challenge posedby globalization was how to achieve capitalaccount liberalization in an orderly manner. Or-derly capital account liberalization requires,in principle, domestic regulatory reforms and
110 REPUBLIC OF KOREA
institution buildup in advance of capital mar-ket opening. But the reality was the opposite.
Pressure by the international communityfor domestic reform had little effect on do-mestic reforms given that domestic reform isa sovereign issue whose political economy isquite complex, and that Korea’s financial link-age with international market was weak at bestbefore the crisis. Also, deregulation often causedproblems in the short run given the absence ofproper market mechanisms to substitute forsuch control. Under these circumstances, re-forming prudential regulations and corporategovernance—which is crucial for the propermanagement of potential risks associated withglobalization—was not a primary concern.
In view of these challenges, a more practi-cal policy option would be to interweave andcoordinate capital account liberalization and an-cillary domestic reforms as a single policy pack-age. Such an approach would also increase thelikelihood of achieving a positive synergy be-tween capital account liberalization and do-mestic financial reform. Increased foreignpresence in the domestic market could have apositive spillover effect on the practices and in-stitutional framework. The improvements inprudential regulations and corporate gover-nance standards, in turn, may facilitate smoothliberalization of the capital account.
Another challenge worth mentioning wasrelated to labor issues. Import liberalizationunder WTO initiatives triggered fear amongworkers, particularly in manufacturing, aboutnegative fallout on their employment status.The combined effect of import liberalizationand rigidity in the labor market is likely to bean increase in involuntary unemploymentrather than widening wage differentials be-tween skilled and unskilled workers. In addi-tion, increased capital mobility and availabilitywas perceived to have undermined the bar-gaining power of labor, again threatening jobsecurity. These concerns translated into con-flicts across segments of society as well as strongmarket sentiments against globalization—despite the fact that consumers will benefitfrom increased competition in the market.
Last but not least, the shortage of humancapital suited for the new institutional setup
and globalized market environment was anobstacle in Korea’s globalization. This was par-ticularly the case in the financial sector,which—in contrast to the tradable sector—hadbeen effectively closed to foreign competitionuntil the 1997 crisis. New institutions and aglobalized market environment called for anew mindset and business practices, and effi-cient learning by doing was pivotal. But learn-ing was difficult due to the lack of technicalexpertise and benchmarks. One resolution toexpedite learning would be to import appro-priate human capital from abroad, but such anoption was largely out of consideration be-cause of its negative implications for domes-tic employment and negative sentiments againstforeign participation in domestic markets.
ROLE OF INTERNATIONAL INSTITUTIONS
Despite limited human capital resources suitedfor globalized markets, Korea had been rela-tively lukewarm about seeking technical assis-tance for reforms from internationalinstitutions. Only after the 1997 crisis didKorea seek technical assistance on financialmarket opening and related institutional re-forms from the IMF and World Bank. But thisdoes not mean that international institutionsplayed little role in Korea’s economic reforms.Indeed, pressure by the international com-munity, particularly the OECD and WTO,had great bearing on Korea’s pre-crisis reforms,although it fell short of overcoming domesticresistance and inertia to changes.
As noted, Korea’s need for technical assis-tance was largely in the realm of capital accountliberalization and related domestic reforms,especially the interpolation of paced progressin prudential regulatory reform and corporategovernance. A relevant question is how to en-sure that these two processes go hand in handat a reasonably fast but manageable pace. Inpractical terms, there is no easy answer.
One possible solution is that multilateralforums on capital account liberalization setbinding agreements not simply with respect tothe scheduling of market opening, but also tothe required ancillary reforms. As for the par-ticulars of the ancillary reforms, international
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organizations such as the IMF and WorldBank could provide technical assistance fordeveloping appropriate standards and rules indeveloping countries and monitor ex postwhether progress is made on time in view ofinterim targets. In doing so, the pace of mar-ket opening and ancillary reforms should becarefully deliberated in a case-by-case mannerby incorporating country-specific informa-tion, including the politicoeconomic capacityto implement reforms.
Another method for ensuring that liberal-izing countries make necessary prudential andcorporate governance reforms involves an in-centive structure provided by advanced coun-tries, most of which are capital suppliers. Thiswould require first that advanced countriesstrengthen their regulatory frameworks to bemore responsive at the margin to financial
risks in borrowing countries. In view of suchan assessment by advanced countries, bor-rowing countries would then have better in-centive to initiate domestic reforms andupgrade financial supervision. Such an ex anteincentive structure can be reinforced by expost measures, including more active involve-ment by private lenders in the resolution ofcrises. In this regard, recent discussions onprivate lenders’ bail-in should be translatedinto a concrete and operational framework.
REFERENCE
Hahn, Chin Hee, and Kim Jong-il. 2000.“Sources of East Asian Growth: Some Evi-dence from Cross-Country Studies.” Thematicpaper for the World Bank Global ResearchProject. Washington, D.C.
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The episodes of financial distress in severalemerging economies over the past few years, andthe negative effects on the most vulnerable insociety, have generated debate on advantages ofglobalization. To assess the impact of global-ization in Mexico, this study reviews the last 20years, arguing that globalization has broughtsubstantial benefits since Mexico’s insertioninto the world economy in the mid-1980s.Even so, globalization has also posed challengesto policymakers and other economic agents. Ingeneral, globalization has proven to be a valu-able driving force behind designing institu-tions and formulating sound economic policies.The ongoing process Mexico embarked onmore than 15 years ago shows that, to fully profitfrom globalization, governments must under-take the appropriate economic policies and in-stitutional framework—and develop socialsafety nets to protect the most vulnerable seg-ments of society.
MARKET-OPENING REFORMS
In the early 1980s the Mexican economy wascharacterized by debt overhang, lax monetaryand fiscal policies, the absence of a competi-tive industrial and commercial platform, aweak domestic market, and excessive govern-ment intervention in the economy. The dete-rioration of the terms of trade and the reductionin foreign credit worsened this situation. TheMexican economy was heavily regulated andprotected from international competition. Thebalance of payments and public finances werehighly dependent on oil-related activities whilenonoil exports played a limited role, as mostindustries produced for the domestic market.The crisis of the early 1980s triggered a majorshift from the import substitution industrial-
ization model that had been implemented fordecades, to an export-led growth strategy. Forthis shift, a number of economic reforms werecarried out.
The first efforts were targeted to restruc-turing the public sector. Fiscal policy reformand the divestiture of state-owned assets weretwo key ingredients of this reform. By 1982public accounts had substantially deteriorated,and the fiscal deficit reached 16 percent ofGDP. Drastic cuts in public spending steadilyreduced it from 41 percent of GDP in 1982to 28 percent of GDP in 1990.
A major privatization program contributedto the referred fiscal consolidation efforts.From 1983 onward, the majority of state-owned companies were privatized, closed, ormerged—reducing their number from morethan 1,000 at the end of 1982 to roughly 250in mid-1991. The purpose of this programwas threefold. First, it helped bring down thefiscal deficit through the merger and liquida-tion of unprofitable enterprises. Second, it fos-tered a more entrepreneurial private sector,which had to take over inefficient state-ownedcompanies and convert them into drivingforces in a market-driven economy. Third, itsent a strong signal to domestic and foreign in-vestors about the commitment of the govern-ment to structural reform.
The authorities also pursued an ambitioustrade liberalization policy. In 1986 Mexicojoined the GATT in an effort to stimulatenonoil exports, enhance economic efficiency,and impose pricing discipline to domesticfirms. The success of this policy became moreevident in the late 1980s, when the nonoil ex-port sector became the driving force of eco-nomic growth. Automobiles and computers,together with maquiladoras settled under special
Mexico
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fiscal programs along the northern border, be-came the most dynamic sectors of the economy,turning around the composition of exports inMexico. The share of oil-related products in ex-ports fell from nearly 90 percent in 1982 to 25percent in 1990 (a decade later it was less than10 percent).
The consolidation of an export-orientedeconomy was achieved in the early 1990sthrough the implementation of preferentialtrade arrangements. In 1994 Mexico signed theNorth American Free Trade Agreement(NAFTA) with the United States and Canada,and similar trade arrangements were subse-quently pursued with other trading partners,including Bolivia, Chile, Colombia, CostaRica, El Salvador, Guatemala, Honduras, Israel,Nicaragua, Venezuela, the European Union,and the European Free Trade Association.
As a result, trade flows increased threefold(from $117 billion in 1993 to more than $326billion in 2001), and foreign trade doubled itsshare in the economy (from around 30 percentof GDP in 1991 to around 60 percent in2001). Since NAFTA’s implementation, theMexican industry has been able to boost its U.S.market shares in leading U.S. import sectors,such as motor vehicles and parts (from 8.7percent to 15.9 percent), electrical equipment(from 3.0 percent to 17.3 percent), and com-munications equipment (from 8.2 percent to22.2 percent).
Another important part of the market-oriented reforms that has shaped the Mexicaneconomy: deregulation, which included dis-mantling price controls, and liberalizing the for-eign investment regime. Price controls hadpreviously been imposed to secure primarygoods and services at low and stable prices. Al-though price controls remained in the 1980sas part of the anti-inflationary programs, thenumber of price-controlled goods and serviceswas substantially reduced. By the early 1990sa substantial improvement in the balance ofpayments led to a virtual equalization of thefree and controlled exchange rates, and in No-vember 1991 the controlled exchange rateregime, imposed a decade earlier, was abrogated.
Before the 1980s FDI faced very restric-tive regulation. But, this changed as the halt
in foreign borrowing associated with the debtcrisis in 1982 increased external financingneeds. Attracting FDI was also seen as a cru-cial step for stimulating competition and de-veloping a more efficient economy. Followingseveral legal reforms in the 1980s, a new lawwas enacted in 1993, repealing prior regula-tions and gradually allowing for up to 100 per-cent foreign ownership in areas comprisingnowadays more than 90 percent of the eco-nomic activities accounted for in the nationalaccounts. Accordingly, annual FDI flowssteadily expanded from $1.5 billion in 1984to $4.3 billion in 1993, and up to $24.8 bil-lion in 2001, including the acquisition of Ba-namex by Citigroup.
The benefits of rapid global economic in-tegration have, however, been unevenly dis-tributed across the country, concentratedprimarily in the regions with better infra-structure and closer to the U.S. border, whichhost most of the maquiladora industries es-tablished throughout the 1990s. This indus-try accounts for a large share of the country’sexports (48 percent of total exports and 53 per-cent of manufacturing exports in 2001). Theextent to which regions have been able to ben-efit from the integration with the internationaleconomy has also been limited by Mexico’shistorical pattern of industrialization and ur-banization in a handful of cities.
Given the strong relationship between FDIand the growth of exports since the openingof the economy, FDI flows have been distrib-uted unevenly across the country, affecting re-gional economic growth. Following the regionaldivision established by the National Develop-ment Plan 2001–2006, Mexico’s Central regionhad 67 percent of $96.2 billion in FDI between1993 and 2001, followed by the Northeast(19 percent), the Northwest (8 percent) and theCenter-West (5 percent). The South-Southeasttook barely 1 percent of the flows.
Due to the concentration of FDI in man-ufacturing and services, the region that bene-fited most from the opening of the economywas clearly the North, the more urbanized andindustrialized one. By contrast, the agriculture-based economies of the South could not expandtheir exports or attract FDI. Regions more
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exposed to global economic integration havealso shown the most improvement in such so-cial indicators as health and education.
DOMESTIC ECONOMIC POLICY REFORMS
With the stabilization programs, the renego-tiation of debt, and the structural changes ofthe 1980s, Mexico was able to resume growthafter nearly a decade of economic stagnation.Between 1988 and 1993, economic growth av-eraged 3.1 percent a year, while inflation wasbrought down from three-digits to single-digits, reinforced by a steady decline in the fis-cal deficit (from 5.2 percent of GDP in 1989to 0.7 percent of GDP in 1993). The economyconsolidated the shift from an inward- to anoutward-looking development strategy. In ad-dition to having a sound export-oriented in-dustry, Mexico gained access to internationalcapital markets following the 1989 foreignpublic debt renegotiation.
But behind this apparently successful storywere factors that eventually led to the 1995 fi-nancial crisis. These included the semi-fixed ex-change rate, the quick and substantialavailability of external capital, current accountimbalances, poor institution building, and thecumulative effect of repeated political shocksin 1994. The depth of the crisis, in turn, wasinfluenced by the substantial amount of creditextended by the banking system under suchconditions that its collection would have beenin doubt even without a crisis.
The banking sector, nationalized in 1982,experienced drastic changes as financial liberal-ization was pursued after 1988. With controlson interests rates lifted and quantitative controlson credit eliminated, significant financial deep-ening took place. But, with commercial banksremaining under government control until theearly 1990s when credit institutions were pri-vatized, the sector lacked both a professionalmanagement structure and a well-developedbanking supervision scheme, due in part to thepolitical stature of government-appointed CEOs.
The easing of borrowing and lending regu-lations in a recently privatized banking sectorlacking professional managers and supervisors—coupled with substantial capital inflows and a
sharp reduction in the government’s financialneeds—led to an explosive credit expansion inthe early 1990s1. With nonperforming loansrising and net indebtedness more burdensome,the Mexican financial system accumulated struc-tural problems that made it particularly vulner-able to the impact of the peso devaluation inDecember 1994.
For most of the credit expansion period, theexchange rate was kept within a widening butrelatively tight band—as part of the governmentcommitment to use it as a nominal anchor.But the sustainability of the exchange rate wasseverely questioned in late 1994 due to the ac-cumulation of serious imbalances in the currentaccount, caused to a large extent by the creditexpansion and lax fiscal policy. And then in1994 there was a significant increase in inter-est rates. The reference interest rate rose from10.8 percent in mid-February to 22.1 percentin mid April, and it remained high, both innominal and real terms, for the rest of the year.This increase in interest rates posed a monetarypolicy dilemma. The central bank requiredhigh interest rates to defend the semi-fixed ex-change rate regime, but was aware of an alreadybattered banking system whose fragility inten-sified as interest rates remained high.
The inconsistencies created by suchdilemma eventually led to the balance of pay-ments and banking crises, aggravated by ex-ogenous shocks throughout 1994, including asubstantial rise in the U.S. interest rates andmounting domestic political tensions (in-cluding the assassination of a presidential can-didate). Together, these elements provided thesetting for a steady drain in international re-serves, until the exchange rate ceiling had tobe abandoned in December 1994. The peso de-valuation prompted several damaging effects.Inflation and interest rates skyrocketed. Eco-nomic activity collapsed. And the burden of ser-vicing domestic and foreign debt increased.
Along with a strict stabilization program in1995, including cuts in public expenditure anda tight monetary policy within a newly adoptedflexible exchange rate arrangement, the au-thorities were forced to manage the threat of asystemic banking crisis. It then became clear thatsuccessful integration with global financial
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markets could not be achieved without ad-dressing structural weaknesses in the financialsystem, including inefficient management, lackof transparency and information disclosure, apoor market discipline and poor credit cul-ture, weak prudential regulation and supervi-sion, and ineffective judicial systems andbankruptcy laws. Implementing a far-reachingreform aimed at developing a sound domesticfinancial system and a solid regulatoryframework—to enable Mexico to cope with anew era of sudden and unanticipated swings incapital flows—became a top policy priority.
A profound restructuring of the bankingsector has been under way since early 1995.One of its main components has been theadoption of internationally accepted account-ing, capital requirements, and risk manage-ments standards, as well as the creation of a newInstitute for Bank Deposit Insurance. Re-strictions on FDI were gradually eased, and by1999 up to 100 percent foreign ownership ofcommercial banks was allowed.
Simultaneously, the adoption of a floatingexchange rate arrangement in late 1994 allowedthe exchange rate to adjust to external shocks,reducing the possibilities of speculative attacks,encouraging an increasing preference for longer-term direct investment over portfolio invest-ment, and preventing long-lasting misalignmentsof the real exchange rate. Moreover, the float-ing regime in Mexico has allowed the economyto grow, maintaining the current account deficitat sustainable levels and reducing inflation.
The crisis showed the vulnerability to short-term capital flows, and policies were imple-mented to foster long-term productiveinvestment. The policies included openingnew infrastructure sectors to private invest-ment (railroads, ports, airports, satellites) anddeepening trade liberalization. Further inte-gration with international capital and tradeflows was instrumental for building up a sus-tainable external sector. Between 1998 and2001, FDI financed on average 96 percent ofthe current account deficit, up substantiallyfrom 28 percent observed in 1990–94.
Along with a strict fiscal discipline, an ac-tive debt management policy has resulted in asteady decline in foreign public debt, reducing
the country’s vulnerability to short-term cap-ital flows. Recall that one of the underlying fac-tors that exacerbated the magnitude of the1995 crisis was the accumulation of short-term dollar-indexed government securities.The subsequent partial replacement of exter-nal debt by domestic debt has been facilitatedby the growth of local institutional investors,such as pension funds, fostered by the 1997 so-cial security reform. Domestic debt strategy hasalso focused on lengthening the average ma-turity of the public debt to reduce the vulner-ability of public finances to external shocks,while deepening domestic financial markets.
The Central Bank established proper for-eign exchange regulations for the banking sys-tem. Specifically, regulation now encompassesforeign exchange positions, limits on liabilitiesdenominated or linked to foreign exchange, liq-uidity coefficients, and information require-ments. These regulations improve the abilityof individual institutions to face adverse shocksand make the financial systems more capableof handling the volatile capital flows that char-acterize open and global economies.
The 1995 financial crisis also highlighted theneed for a consistent social protection strategyto minimize the consequences of economicshocks and strengthen human capital. Non-priority investments were delayed, but the ex-penditures for basic education, health, and othersocial programs were maintained. There werealso specific measures to protect the poor fromthe heaviest burden of adjustment, includingtraining scholarships to serve as a sort of safetynet in the absence of unemployment benefits,direct support for agriculture and livestock ac-tivities, and the creation of temporary jobs.
Social policy in Mexico distinguishes be-tween actions geared towards the general pop-ulation and those targeted for povertyalleviation. The former focus on health care,labor, and social security issues. The latter arebased on an integral approach, which includeprograms for human capital development (in-cluding a shift from pure income transfers totransfers conditional on recipients investing inhealth, education and nutrition), physical cap-ital development, and income generation, suchas public works and micro-credit schemes.
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The reforms address more efficiently the needsof the population given the rapid changes fromeconomic globalization the demographic fea-tures of the population2.
Acknowledging the North-South disparity,the Mexican authorities are strengthening socialsafety nets, as well as actions to address chronicpoverty. This includes a review of social policyand expenditures involving an assessment ofvulnerable groups, risks, and prevention andmitigation measures. Mexico has developedover the past few years a consistent social pol-icy by reducing poverty and enhancing humancapital formation through higher and more fo-cused public spending. The policy revolvesaround six strategic guidelines: increasing bud-getary resources for social spending, enhancingthe redistributive impact of social spending,targeting spending in poverty alleviation pro-grammes, decentralizing social spending, in-creasing transparency and accountability, andincorporating regional considerations.
MARKET OPENING AND INSTITUTION-BUILDING
In the early 1990s the government realizedthat the reforms launched in the mid-1980swere still insufficient to complete the openingof markets. One of the obstacles to achieve sus-tainable growth and development had its ori-gins in institutions. Among the symptomswere ill-designed institutions, poorly definedproperty rights, lack of contract enforcement,high transaction costs, and flawed policies. Itwas therefore necessary to carry out a series ofinstitutional reforms and modifications in theregulatory framework in different sectors, start-ing with land ownership, central banking, andeconomic competition.
Land ownership. In 1992 a reform in landownership transformed communal (ejido) lands.With this reform, the ejido land became privateproperty, and property rights were clarified.Through this reform, irregularities in landtenure have been reduced, with property rightsrespected more, and contracts enforced3.
Central banking. In 1994 a constitutional re-form allowed Mexico’s Central Bank to becomeautonomous and establish price stability as its
main objective. The autonomy is based on threefeatures: administrative independence, the powerto determine domestic credit, and the creationof a board, whose members serve in overlappedperiods and cannot be removed unless theycommit a serious fault. This move reflected theacknowledgement of the negative effects of in-flation on economic development and the im-portance of entrusting responsibility formonetary policy to an independent central bankwith clearly defined power and objectives.
Competition. The Federal CompetitionCommission, created in 1993 as a result of anew Federal Law of Economic Competition,has technical and operational independence andis responsible for competition enforcement.It plays a fundamental role in fostering com-petitive markets through the approval ofmergers and acquisitions—and through theprevention, investigation, and elimination ofmonopolistic practices in all sectors of theeconomy. Its institutional framework is simi-lar to that of the U.S. Federal Trade Com-mission. Among its main achievements standsthe resolution in December 1997, by which itfound that the main telephone company hadsubstantial market power in five relevant mar-kets, paving the way for further action by thesector’s regulatory agency4. Other examplesinclude actions against anticompetitive collu-sion promoted by municipal governments andstate-owned companies.
The 1995 crisis was a reality check on theefficacy of the institutional reforms institutedin the early 1990s. It showed that reforms hadto be more strictly enforced, that they had torespond to a more rapidly changing economy,and that Mexico was already inserted into theglobalization process, with all its benefits andchallenges. That led to a second generation ofreforms.
Following the 1995 banking crisis, the au-thorities set up a new regulatory and institu-tional framework for the financial sector, stillbeing consolidated. The new Institute for BankDeposit Insurance became operational in June1999, with three main responsibilities: to es-tablish a protection system for banking savings,to conclude the recovery of the banking insti-tutions, and to administer and sell the assets
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under its charge. Bank savings now have lim-ited coverage, establishing the necessary in-centives to instill additional market discipline.In the same spirit of fostering conflict resolu-tion between financial institutions and its cus-tomers, the National Commission for theProtection and Defense of Financial ServicesUsers was created in 1999.
In April 2000 a new bankruptcy law andlegal framework for granting collateral was en-acted, to improve the allocation of business re-sources and facilitate access to credit. The newlegal framework is intended to maintain a bal-ance between firms and their creditors to pro-tect the legal rights of both. Altogether, theselegal and institutional changes will maximizethe value and viability of a firm in financial dis-tress, establishing a more leveled playing fieldfor addressing financial globalization.
A year later, Congress approved several in-stitutional and regulatory changes to achievea modern and sound banking sector. Amongthe most significant is the reformed credit in-stitutions law, which strengthens bank sur-veillance and supervision by increasing therole of external auditors and introducingprompt corrective actions based on banks’ cap-italization levels. It also reduces regulatorycosts by establishing a clearer definition of fi-nancial authorities’ responsibilities and avoid-ing duplication. And it enhances the corporategovernance of credit institutions by allowingshareholders to have greater access to infor-mation, introducing independent board mem-bers, and creating an audit committee at theboard level, led by one of the independentboard members.
To achieve long-term sustainable growthrates, Mexico needs a mature capital marketthat can serve as an alternative source of fi-nancing, especially when bank credit is tight.For this purpose, an additional overhaul ofexisting financial legislation was needed. As partof the financial reforms, the securities marketlaw was reformed to strengthen issuers’ cor-porate governance structures, guarantee mi-nority shareholders’ rights, and avoid insidertrading and market manipulation. In addi-tion, a new mutual fund law was enacted to en-courage greater retail participation in the
securities market under a better regulated en-vironment, including enhanced minority share-holder protection and greater transparency toavoid conflicts of interests between fund man-agers, and brokerage houses and banks.
Congress also approved new amendmentsto the Credit Institutions Law, as well as the Pen-sion System Law and the Organic Laws of theForeign Trade Bank (Banco de Comercio Exte-rior), the Bank of of National Savings and Fi-nancial Services (Banco del Ahorro Nacional yServicios Financieros), and Nacional Financiera.These new regulatory framework is designed tostrengthen the banking system by introducingindependent board members, establishing clearmechanisms to control their impact on aggre-gate demand, forcing institutions to make pe-riodic public reports, and strengtheningtechnical assistance and support programs.
Congress approved, in addition, changesand additions to the Law of the Retirement Sav-ings Systems, in order to reach, on a voluntarybasis, the rest of the economically activepopulation—including independent workers,federal state workers, and workers from pub-lic entities, states, and municipalities. Withthis amendment, individuals can make com-plementary contributions that can be with-drawn when they reach age 60. One of the mostinteresting features of this new law is lifting therestriction on buying foreign securities, whichallows for greater investment flexibility anddiversification. The new investment limit is 20percent of assets under management of theAfores (organizations in charge of managing re-tirement savings funds). But a temporary limitof 10 percent will apply until Congress re-evaluates the subject in April 2003.
Institutional developments in infrastructure,albeit incomplete, were also enhanced after the1995 crisis. In telecommunications, for instance,the government announced new measures toliberalize the sector while building up a more ap-propriate institutional and regulatory frame-work. Note that the privatization of the telephonemonopoly, TELMEX, in 1991 was done in theabsence of a new law and regulatory framework.As a result, monopolistic practices hamperedthe sector’s development until 1996, when bar-riers to entry for competitors in long distance and
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local services began to be dismantled under theresponsibility of a new sector-specific regulator—the Federal Telecommunications Commission—and once new legislation was enacted. Thisexperience shed light on the importance of cre-ating a regulatory framework to accompany theprivatization effort.
Further attention to institutional and reg-ulatory aspects was required as other infra-structure sectors were opened to privateparticipation. The Energy Regulatory Com-mission was created in 1995 to oversee theopening of the natural gas industry5. Other in-frastructure areas opened to private participation(railroads, seaports, and airports) also experiencedsignificant legal and institutional changes6.
Deregulation of economic activity has alsoled to institutional changes. To address theissue of high transaction costs due to ineffi-ciencies in government procedures, a new spe-cialized commission—the Federal Commissionfor Regulatory Improvement—was created inMay 2000. It is to revise the national regula-tory framework, and make an assessment andpropose regulation improvements so that trans-action costs are reduced. Its legal mandate is toensure transparency in drafting federal regula-tions and to promote cost-effective regulationsthat produce the greatest benefit for society.
Social security reform entailed a signifi-cant institutional and regulatory overhaul aspart of broader efforts to tackle the financialviability of the previous pension system. Byshifting from a pay-as-you-go system to a fullyfunded individual capitalization scheme, the re-form strengthened the link between contri-butions and benefits, enhancing overallfinancial soundness. Within this scheme, theNational Commission for the Retirement Sav-ings System, established in 1997, increasestransparency and competition among privatepension fund managers.
CHALLENGES AND BENEFITS OF
GLOBALIZATION
Despite of the high economic and social costsof the 1994 crisis, Mexico deepened its inte-gration with the world economy. It did not re-treat. That brought several positive outcomes,
but significant challenges remain to benefitfully from the process.• Faster and stronger economic recovery. Unlike
the 1982 crisis, when it took the rest of thedecade to recover, in 1995 the existing linkswith the world economy, particularly theU.S. economy, enabled Mexico to reactivateeconomic growth in a very short period.GDP, after falling 6.2 percent in 1995, grew5.2 percent the following year, and until2001 it averaged 4.4 percent. This would nothave been possible if Mexico had not devel-oped a strong foreign trade sector. Opennessto trade and access to international capitalflows made it possible to increase exportsfourfold in the 1990s, while drastically shift-ing from oil-based to manufactured exports.
• Incentives for sound economic policymaking.By exposing and punishing economic mis-management, globalization has contributedto the soundness of domestic economicpolicies. And within this context in 2000Mexico secured a presidential transitionwithout economic disruption, for the firsttime in three decades. The incentives formaintaining responsible domestic economicpolicies have since proven highly effective,given the ability to attract significant long-term capital inflows under even less favor-able external conditions.
• Appropriate exchange rate arrangements. Thefloating exchange rate adopted in 1995 al-lowed the Mexican economy to grow, whileannual inflation was drastically reduced from52 percent in 1995 to 4.4 percent in 2001,the lowest ever. The exchange rate regime hasalso been efficient in absorbing large exter-nal shocks, limiting short-term capital in-flows, and keeping the current account deficitsustainable. It shows that a floating exchangerate can be good for emerging markets.
• Modern and well-supervised domestic fi-nancial systems. The 1995 crisis exposedwith unprecedented fierceness the dangersand risks of having a poorly developed andsupervised domestic banking system. Sincethen, a profound restructuring has put thesector on new footing. But with the task un-finished, globalization poses strong incen-tives for policymakers to permanently
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upgrade financial regulation—to avoidexcess risk-taking from financial institu-tions and to minimize the negative effectsof sudden and unexpected capital shifts, akey feature in current global financial mar-kets. This concern stems from the need topromote financial intermediation in lessregulated markets, and to maintain the ef-fectiveness and credibility of fiscal andmonetary policies.
• Institutional and regulatory developments.Along with opening the economy, Mexicomade significant institutional changes, in-cluding the consolidation of an autonomouscentral bank, and the creation of new reg-ulatory institutions, ranging from economiccompetition agencies to specialized regula-tory authorities in finance and infrastruc-ture. The pace picked up after the 1995crisis, as the risks of a new global market-place were clearly exposed. Despite these im-provements, the institution-building is notover and still requires a strong governmentcommitment to adapt institutions to anever-changing international context—tolower transactions costs and enhance trans-parency, consistency, and accountability inpolicymaking. Globalization has thus provento be a valuable driving force for institutionalchange in Mexico.
• Regional convergence. Globalization can be apowerful tool for developing countries likeMexico to converge with more developedcountries in social, economic, and institu-tional development. But this is far frombeing a smooth and automatic process. It re-quires strong policy actions, domestic andinternational. With the benefits of tradeand capital integration concentrated in thecentral and northern regions, the Mexicangovernment is launching a strategic medium-term program to integrate the southern re-gion, both with the rest of the country andwith Central America.
• Better standards of living. All the foregoingfactors pave the way for improving the liv-ing conditions of a large segment of thepopulation. By fostering sound domesticpolicies to deliver growth, avoid economicand financial crises, and enhance regional
convergence, globalization can contributedecisively to improve the overall standardsof living. But policymakers still need to ad-dress exclusion of a significant portion of thepopulation from globalization, aggravatingstructural poverty. The challenge is to in-vest more in human capital so that the pop-ulation is better equipped for seizing theopportunities of globalization, while re-ducing the downside effects associated witheconomic shocks and downturns throughappropriate social safety nets.
• A stronger relationship with international fi-nancial institutions. Mexico has strongly ben-efited from international financial institutions(IFIs) in coping with the challenges of glob-alization. In addition to broader measures toimprove the international financial archi-tecture, IFIs can support domestic initia-tives to plug into the global economy. InMexico the authorities are convinced that IFIscan help national authorities ensure that fi-nancial openness is accompanied by ade-quately developed financial supervision andregulation. For this reason, Mexico has de-cided to undertake IMF/World Bank-spon-sored initiatives, such as the Financial SectorAssessment Program and several Reports ofthe Observance of Standards and Codes.
NOTES
1. From December 1988 to November1994 credit from local commercial banks to theprivate sector rose in real terms by 25 percenta year, while credit card liabilities rose at a rate31 percent a year, direct credit for consumerdurables at 67 percent a year and mortgageloans at 47 percent a year. All these rates ofgrowth are in real terms.
2. Mexico is experiencing a demographictransition. The population pyramid’s base hasbeen narrowing during the last years, as thepopulation growth has declined consistentlyfrom about 3.5 percent in the 1970s to less than1.8 percent at present. This demographic tran-sition prompted the reforms of the retirementsystem in 1992 and 1997.
3. Article 27 of the Constitution was oneof the main legacies of the Revolution, and it
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was meant to regulate land ownership afterthe promised agrarian reform. This law al-lowed communities that were granted land toown the usufruct of the land but not the landitself. The law failed to take into account thediversity of land quality and population den-sity in the different regions of Mexico, hencethis form of ownership was not efficient inevery region of Mexico and thus became ob-solete. More often than not, this land was soldor leased illegally by the ejido owners for pur-poses other than agriculture.
4. The five relevant markets were localtelephony, interconnection services, nationallong distance, international long distance, andresale of international long distance.
5. The 1995 natural gas reform was aimedat allowing private participation in distribution,transportation and storage, while keeping nat-ural gas exploration and production as a state-run monopoly. The mandate of the EnergyRegulatory Commission is to promote com-petition, protect consumers’ interests, facilitatean adequate coverage and encourage reliable,
stable, and safe supply and provision of services.Its ultimate objective is to achieve the efficientdevelopment of the energy sector to benefit in-dustrial, commercial and residential users, bycombining the regulation of natural and legalmonopolies.
6. Railroads: Privatization began in 1996and consisted in separating regional assets fromrailroad services. Currently, all railroad trafficis privately managed and approximately 18,000kilometers are granted in concession. Ports:Reform and modernization started in 1993.The reform decentralized the port infrastruc-ture and created a new figure (the IntegralPort Administration) while pending for pri-vatization. Air transportation: In 1995 a newAirports Law allowed the granting of conces-sions for the construction and operation ofairports. The structural change process in-volved the integration of four regional groupswith 35 terminals. At present, three regions arein the hands of private investors. Only theMexico City Airport privatization is pending,since a new location has to be decided.
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Russia differs from other G-20 countries inthat it was integrated in the system of interna-tional trade and financial relations at the timewhen its entire political and economic systemunderwent dramatic changes, caused by thecountry’s transition from the administrative-command economy to market economy inthe late 1980s and early 1990s.
A major element of market reforms was theliberalization of external economic activity,which was designed to remove the adminis-trative barriers and replace them with marketprinciples in that sphere of the Russian econ-omy. The legal framework for the liberalizationof external economic activity was provided bythe presidential decree of November 15, 1991,which allowed all resident enterprises, regard-less of their ownership, to engage in foreigntrade without special registration. The decreemeant a virtual end to the state monopoly offoreign trade. As a result the composition ofparticipants of external economic activity haschanged, requiring new approaches to regu-lating foreign trade.
The role of the regulatory and redistribu-tion mechanisms in external economic activitychanged dramatically. The lifting of quantita-tive limits in favor of tariff regulation trans-formed import tariff from a nominal duty intoa major instrument of foreign-trade policy. Aswitch to convertibility of the ruble on currenttransactions was, like the liberalization of ex-ternal economic activity, part of market re-forms. Owing to a shortage of goods in the early1990s, lack of confidence in the domestic fi-nancial system and in economic policy, thetransition to ruble convertibility caused the ex-change rate of the national currency to de-crease many times in nominal terms. At thesame time, rampant inflation in 1992–94
strengthened the ruble in real terms. Thesefactors had significant effect on the structure ofthe Russian economy in the transitional period.
As a result of liberalization of external eco-nomic activity and the growing role of themarket factors of demand and supply, the ge-ographical and commodity structure of thecountry’s foreign trade has been transformed.It should be noted that the commodity struc-ture of Russia’s foreign trade still reflects the se-rious deficiencies that appeared at the earlystages of the liberalization of external eco-nomic activity in Russia, a result of a pro-found and drawn-out economic slump and ashortage of productive investment.
Russian exports increased by 56 percentfrom 1994 to 2000, while imports fell by 11percent (figure 1). This is a result of the 1998ruble devaluation and 1999–2000 price dy-namics in world commodity and raw materi-als markets.
Russia
Billions of U.S. dollars
Figure 1. Merchandise trade indicators
0
50
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150
2000199919981997199619951994
Turnover Exports Imports Balance
124 RUSSIA
The share of mineral raw materials, mostlyfuel, expanded from 44 percent of customs-registered commodity exports in 1994 to 54percent in 2000. This growth shows that theRussian export sector is still oriented to raw ma-terials, making the country’s foreign currencyreserves and financial condition dependent onworld energy markets. More than 30 percentof Russian imports in 2000 were machineryand equipment and 23 percent foodstuffs andagricultural raw materials (figure 2).
The share of countries from the Com-monwealth of Independent States (CIS) in-creased slightly in Russian imports from 1994to 2000, while the share in Russian exports ofnon-Commonwealth countries expanded sig-nificantly. The EU share in Russian exports in2000 was unchanged from 1994 at about 35percent, while the share of eurozone countriesexpanded a little (figure 3). As the EU share inRussian imports contracted, the share of theUnited States expanded.
Annual net inflow of foreign direct in-vestment in Russia is small. In 2000 foreign di-rect investment went mainly to industry (42percent), transport (21 percent), and tradeand public catering (19 percent). The majorrecipients of FDI in industry were the food andfuel industries. Recent years have seen the ex-pansion of transport’s share in FDI and a con-traction of the share of the fuel sector. In1996–98 there was considerable growth in netinflow of foreign portfolio investment in Rus-
sia, resulting from the purchase of govern-ment securities by nonresidents, but the crisisprovoked the ever expanding net repatriationby portfolio investors of capital they had in-vested in Russia earlier.
Institutional and structural reforms helpedcreate a market economy in Russia, based onprivate business initiative, free competition, andlaws regulating economic activity. The reformsalso created the necessary preconditions forgreater stability of the Russian economy.
Currently the Russian government con-ducts budget policy on the principle of a deficit-free federal budget. In 2000–01 consolidatedbudget revenues of the federal and regional gov-ernments exceeded their expenditures. A bud-get surplus envisaged by the draft federal budgetfor 2002 will allow the government to use a partof surplus revenues for debt payments andcreate a financial reserve for future needs.
Russia has laid down the foundations forcentral bank implementation of an independent,transparent, and accountable monetary policyaimed at stabilizing the national currency. Do-mestic price growth is now many times slowerthan it was in the early years of the economicreforms. There has been a continuous slow-down in the inflation rate since it peaked in 1998as a result of ruble devaluation. The real exchangerate of the ruble has until now been lower thanin August 1998. The dynamics of the ruble ex-change rate have become more predictable underconditions of the floating regime.
Greater stability of the Russian economyand the acceleration of structural reforms in-crease Russia’s opportunities for benefitingfrom its participation in the global economy.These benefits lie not only in trade. It is alsoimportant for Russia to attract foreign capital.An inflow of foreign investment, know-howand technology may help Russia become lessdependent on raw materials exports and solveits long-term debt problems.
LIBERALIZATION OF EXTERNAL ECONOMIC
ACTIVITY
The measures taken by Russia to liberalize ac-cess to its goods, services, and capital marketsand, at the same time, liberalize the access of
0
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2000199919981997199619951994
Percentage of total exports
Figure 2. Commodity composition of merchandise exports
Mineral resources
Metals and metal products
Machinery, equipment, and vehicles
Chemical products and rubber
Jewels and precious metals (crude and processed)
Wood and pulp
Foodstuff and agricultural raw materials (excludingraw materials for textilemanufacturing)
Other products
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Russian goods, services, and capital to foreignmarkets were largely symmetrical. From theoutset Russia has adhered to the principle ofruble convertibility on current transactions,consistently removed nontariff restrictions inforeign trade and, whenever possible, loweredforeign trade tariffs. At present Russia has mostfavored nation trade agreements with mostcountries. With some countries that hold keypositions in the world economy it has agree-ments on the encouragement and mutual pro-tection of investments, and it is also conductingnegotiations on joining the World Trade Or-ganization (WTO).
At the same time, Russia continues to im-plement foreign exchange regulation and con-trol measures on foreign currency operationsrelated to capital movement. The main condi-tion for gradual liberalization of the foreignexchange operations related to capital movementis macroeconomic and financial stability inRussia and harsher measures to combat thetransfer of capital abroad as a means of tax eva-sion and concealment of illegal income. TheBank of Russia is taking efforts to ease up therequirements of foreign exchange legislationand further liberalization of this legislation.
FOREIGN TRADE
In 1992 Russia introduced a uniform proce-dure for licensing and setting quotas on exportsand imports of goods, services, and works byall economic agents. In accordance with thatprocedure, licenses were granted on the basisof a signed or initialed contract with a foreigncounterparty and, depending on the situation,a document confirming the delivery of a com-modity within the established quota or a cer-tificate confirming the purchase of an exportquota or permission by the corresponding fed-eral agency for the export of specific goods(works, services). The system of export quo-tas included general quotas on the export ofgoods, services and works, quotas for govern-ment needs, quotas for industrial enterprises,regional quotas and quotas for auction sales.
In 1994 the Russian president issued a de-cree that abolished export quotas and licens-ing for all goods and services except oil and
petroleum products and also commoditieswhich Russia had to export under intergov-ernmental agreements. At the same time, Rus-sia cancelled, with few exceptions, all customsprivileges, including budgetary provisions forcustoms duties and benefits granted to the ex-porters of goods and services for federal gov-ernment needs. In 1995 export quotas on oiland petroleum products were cancelled. TheFederal Law on the State Regulation of ForeignTrade Operations, passed in 1996, included aprovision saying that the export of goods, ser-vices and works from the Russian Federationand their import to the Russian Federationshall be conducted without any quantitative re-strictions (barring exceptional cases).
When quantitative restrictions were lifted,customs tariff became the principal regulatorof foreign trade. In 1992 Russia imposed ona temporary basis export customs duties ongoods taken out of the country. In 1995–96export duties on all goods were gradually lifted.In 1999, however, to stabilize the economic sit-uation after the 1998 crisis, increase federalbudget revenues, and regulate foreign trade, thegovernment reimposed export duties on goodstaken out of Russia beyond the CIS countries,and later beyond the member-countries of theCustoms Union (now the Eurasian Commu-nity). Import tariffs were lowered all the timethey were in effect.
0
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Percentage of total exports
Figure 3. Major trading counterparty composition of merchandise exports
EU CIS United States35
.25
22.2
55.
33
33.6
2
18.5
85.
52
32.1
0
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65.
68
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27
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419
.21
7.15
34.0
914
.69
6.46
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013
.38
4.51
126 RUSSIA
The fact that the number of foreign trade-related requirements made by the InternationalMonetary Fund (IMF) under the ExtendedFund Facility arrangement in 1996 were con-siderably fewer than those made under theStand-by Arrangement in 1995 and that theserequirements only concerned the completionof export liberalization and the lowering of theaverage weighted import tariff rate should beregarded as the recognition of progress made byRussia in liberalizing foreign trade. There wasno requirement to liberalize external economicactivity among the conditions set under theStand-by Arrangement in 1999.
CURRENT FOREIGN EXCHANGE TRANSACTIONS
The Russian Federation Law of 1992 “OnForeign Exchange Regulation and Foreign Ex-change Control” stipulated that current foreignexchange operations may be conducted by res-idents without any restrictions. The law allowedresidents and nonresidents freely to transfer,bring, and transmit foreign exchange to Rus-sia and also transfer, take out, and transmit fromRussia foreign exchange that had been earliertransferred, brought, or transmitted to Russiain compliance with customs rules. By joiningArticle VIII of the IMF Articles of Agreementin 1996, Russia assumed the obligation not toimpose any restrictions on payments and trans-fers on current operations and refrain fromdiscrimination in its foreign exchange policy.
Russia’s foreign exchange legislation re-quires residents to repatriate their export earn-ings in foreign currency. To increase the amountof foreign currency in the domestic foreignexchange market, the Russian government re-quires exporters to sell a part of their foreigncurrency earnings. Seeking to overcome the af-termath of the August 1998 crisis as soon aspossible and stabilize the domestic foreign ex-change market, the Russian authorities in 1999increased the part of foreign currency receiptsthat the exporters were required to sell from50–75 percent. The improvement of themacroeconomic situation in the country andthe stability of favorable trends in the Russianeconomy allowed the government in August2001 to return to the 50 percent requirement.
CAPITAL TRANSACTIONS
Foreign exchange transactions related to cap-ital movement and credit relations betweenresidents and nonresidents are regulated bythe Russian Federation Law on Foreign Ex-change Regulation and Foreign Exchange Con-trol and Bank of Russia regulations.
Until recently most of the foreign exchangeoperations related to capital movement wereconducted on the basis of Bank of Russia per-mits. Now this procedure has been expandedto operations such as direct and portfolio in-vestments abroad; payment of title to propertywhich home-country legislation regards as realestate; granting a deferral of payment and de-livery for a term of more than 90 days on ex-ports and imports of goods, works, services, andresults of intellectual activity; granting by res-idents, other than credit institutions, financialloans to nonresidents for the term of morethan 180 days; and some other operations re-lated to capital flow.
However, for some kinds of foreign ex-change operations related to capital movementthe Bank of Russia established a simpler regis-tration procedure (when, for example, nonres-idents grant residents financial loans for a termof more than 180 days and when residentsrepay the principal on such loans) and in somecases Bank of Russia permission is not required.
In 1999 resident legal entities were allowedto take without any restrictions foreign ex-change from nonresidents as direct invest-ment. In June 2001 Russia liberalized theprocedure for resident legal entities makingdirect investment in CIS countries to theamount of up to $10 million.
In addition, the amendments passed inJuly 2001 to the Russian Federation Law onForeign Exchange Regulation and Foreign Ex-change Control permitted resident individu-als to transfer to and from Russia uponnotification a maximum of $75,000 in foreignexchange with the purpose of acquiring title toforeign currency-denominated securities andrealizing this right.
As the macroeconomic situation has im-proved in Russia, the Bank of Russia is con-sidering a possibility of further liberalizing the
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procedure for taking long-term loans by resi-dents and granting sureties and guarantees inforeign currency connected with the fulfill-ment of obligations under credit agreements.Plans are afoot to allow resident individuals ona notification basis to open accounts in banksin Financial Action Task Force on MoneyLaundering member-countries.
Exercising its powers, the Bank of Russiamakes a list of Russian issuers’ ruble-denominated securities, with which nonresi-dents may conduct operations using theaccounts specially designated for this purpose,determines the range of operations which non-residents may conduct with Russian issuers’ruble-denominated securities using such ac-counts and establishes the procedure for open-ing and keeping nonresidents’ ruble accounts.
In 1996 Russia began to make changes inits foreign exchange regulation regime thatgave nonresidents access to its primary andsecondary government securities markets. InAugust that year the Bank of Russia estab-lished a special procedure for attracting foreigninvestment to the government securities mar-ket, using the ruble C-type accounts speciallydesigned for nonresidents’ investment opera-tions. In accordance with that procedure, alloperations conducted by nonresidents in theGKO-OFZ market using C-type accountswere conducted through the authorized banksthat managed such accounts. The Bank ofRussia adopted in 2000 and enforced in 2001a new instruction establishing the procedurefor nonresidents conducting operations withthe special C-type accounts, which made iteasier for nonresidents to buy foreign exchangewith the interest and dividends the holders ofthese accounts received. The instruction alsoset the procedure for using the money kept inC-type accounts for making investments inthe Russian economy by buying stakes in Russ-ian companies or granting them target loans.
RISK HEDGING
The futures market in Russia is still in themaking. It was adversely impacted by the 1998crisis. Until 1998 most of the transactionswith derivatives had been conducted over the
counter. The principal market participantswere commercial banks and it is mainly foreigninvestors that hedged their risks. The basichedging tools in the over-the-counter futuresmarket were forward currency deals, exchangerate swaps, exchange rate options (these madeup a small portion of the market), currencyswaps (these also played a minor role), and shareoptions (most of these were bank contractswith nonbank financial institutions). Deriva-tive trade was rudimentary: the underlyingderivative assets were interest rates and creditinstruments.
As nonresidents were given bigger access tothe Russian securities market in 1996, a com-pensation mechanism was created for the con-version of currencies related to nonresidentinvestments in the GKO-OFZ market. Anauthorized bank would transact a spot deal,buying foreign exchange from a nonresident,and then conducted a reverse (compensation)spot deal with the Bank of Russia to guaran-tee the timely execution by the authorizedbank of its obligations to the nonresident inbuying GKO-OFZ bonds. While transactinga spot deal to buy foreign exchange from a non-resident, the authorized bank concluded a for-ward deal with him to sell foreign exchange,which like a spot transaction was covered bya compensation forward deal with the Bank ofRussia to buy foreign exchange.
As the conduct of each compensation spottransaction by the Bank of Russia to buy for-eign exchange from an authorized bank in-creased Russia’s international reserves by thecorresponding amount, the conclusion of acompensation forward contract guaranteedthe authorized bank the fulfillment of itsobligations on forward deals with nonresi-dents. The exchange rate of the forward dealswas calculated on the basis of an estimated levelof currency yields of operations in the GKO-OFZ market, which was a curb on the max-imum level of yields. Limits were also set onthe maximum monthly amount of nonresidentinvestments and the minimum period afterwhich nonresidents could withdraw theirmoney from the GKO-OFZ market. FromMay 1997 to January 1998, Russia, guided bythe obligations it assumed under Article VIII
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of the IMF Articles of Agreement, graduallylifted all the aforementioned restrictions.
A special characteristic of derivatives ex-change market development in Russia is thatstandard contracts in which the underlyingassets were foreign exchange and securities ap-peared there before the contracts for com-modities, although organized commoditymarkets began to operate as early as 1990–92.This specific reflected market participants’ de-sire to hedge, above all, profits and losses,which depended on the exchange rate dy-namics of the ruble against the U.S. dollar.
In October 1992, the Moscow Commod-ity Exchange conducted the first trading ses-sion in currency futures based on the ruble rateagainst the dollar. In addition to the MoscowCommodity Exchange, the Moscow CentralStock Exchange became a major trading floor,while the Russian Commodity and Raw Ma-terials Exchange was the leading trader in gov-ernment securities futures. In 1994 the MoscowCommodity Exchange conducted the firsttrading in commodity futures, in which the un-derlying assets were wheat and granulatedsugar. From 1996 trade in U.S. dollar futuresand later in futures contracts for governmentand corporate securities has been conducted onthe Moscow Interbank Currency Exchange(MICEX). In April 1998 trade in ruble-dollarfutures began on the Chicago Exchange.
The 1998 crisis had a devastating effect onthe Russian futures market. The decision takenby the Russian government and Central Bankto suspend operations connected with residentpayments to nonresidents affected Russianbanks’ settlements with foreign participants inforward deals. The losses incurred by foreignexchange sellers on forward contracts, causedby a sharp fall of the exchange rate of the ruble,and the worsened financial condition of Russ-ian banks created an acute problem of non-payments on earlier contracts. Market trade inunderlying assets contracted significantly andeventually operations in the exchange and over-the-counter derivatives markets were suspended.
After the crisis Russia’s futures market begangradually to recover. Market turnovers expanded,the number of market participants grew, the vol-ume of open forward positions increased and the
range of market instruments broadened. How-ever, the post-crisis recovery of the derivativesmarket is slower than the recovery of other seg-ments of the Russian financial market. A majorrole in accelerating this process may be playedby enhanced government regulation of the stan-dard instruments market and the developmentof an appropriate legal framework ensuring itsfunctioning. This is an important condition ofgrowth in the number of participants who areinterested above all in risk hedging.
FOREIGN INVESTMENT REGULATION
Apart from some rules aimed at protecting thenational financial system at the early stages ofits development, Russia has not used any re-strictive measures with regard to foreign in-vestment inflow.
The Federal Law on Foreign Investment inthe Russian Federation, which has been inforce since 1999, provides state guarantees ofthe rights of foreign investors making invest-ments in Russia for commercial purposes ex-cept capital investments in banks and othercredit institutions and insurance companies.The guarantees granted to foreign investors arethe same as those granted to their Russiancounterparts.
The relations involved in making foreigncapital investment in banks and other credit in-stitutions and insurance companies are regu-lated by the Federal Law on Banks and BankingActivities and Federal Law on Insurance inthe Russian Federation. These laws impose re-strictions on foreign capital participation in theRussian banking system and on the sphere ofactivity of insurance companies with foreigninterest and insurance companies that are sub-sidiary to foreign investors, which are neces-sary at the current stage of development ofthe Russian financial services market. Non-residents have to apply for permission to ac-quire a stake or increase their interest in creditinstitutions or insurance companies.
FOREIGN EXCHANGE REGULATION RESULTS
Foreign exchange regulation and foreign ex-change control by the Bank of Russia aim above
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all at reducing capital outflow and preventingthe legalization and export of the proceeds fromcrime. Here are some of the facts on the effectof foreign exchange regulation in Russia. Ac-cording to balance of payments data, the amountof export earnings that was not repatriated andthe sum of import advances that were not re-paid in time in 1999–2000 was at a 10-year lowof 4 percent of total foreign trade turnover. Es-timates show that in 1992–93 almost half of allexport earnings was not repatriated.
DOMESTIC ECONOMIC POLICY REFORMS
Institutional and structural reforms in Russia en-compassed the entire spectrum of economic re-lations in the period when the country switchedto market economics. The outcome was not ab-solutely positive in all cases. For example, thetransfer of state enterprises to private owners, im-plemented in the form of large-scale privatiza-tion, did not everywhere create the necessaryincentives for reorganizing enterprises or en-hancing their efficiency. Nevertheless, these re-forms helped create a market economy in Russia,developed the preconditions for greater eco-nomic stability and involved Russia deeper inprocesses of globalization.
INSTITUTIONAL AND STRUCTURAL REFORMS
During the last decade the fundamental insti-tutional and structural reforms were imple-mented in the Russian Federation. In additionto guaranteeing private property and free busi-ness activity, these reforms ended the state reg-ulation of prices and salaries, abolished thestate monopoly of foreign trade and made theruble convertible on current transactions. Forall the deficiencies of the mass privatizationprogram implemented in Russia in 1994–95,it fulfilled the task of transferring enterprises tomarket relations. In 1991 Russia passed theLaw on Competition and the Restriction of Mo-nopoly Activities in the Commodity Marketsand in 1999 the Federal Law on the Protectionof Competition in the Financial Services Mar-ket came into force. The 1998 Federal Law onInsolvency (Bankruptcy) established grounds fordeclaring a debtor insolvent (a debtor declar-
ing his insolvency) and set the procedure (con-ditions) for implementing bankruptcy-preventing measures, appointing outsidemanagement and regulating other relationsarising in connection with the debtor’s insol-vency. This law applies to all legal entities thathave the status of commercial organizations(except government-owned enterprises), non-commercial institutions, consumers’ coopera-tives, charities, and other foundations. Thespecific application of this law to credit insti-tutions and other relations connected with theinsolvency of credit institutions are regulatedby the 1999 Federal Law on the Insolvency(Bankruptcy) of Credit Institutions.
In the early years of the reform a chronicbudget deficit was observed, as the budget andtax systems remained largely the product of theredistribution mechanism of the planned econ-omy. The principal systemic problem of theRussian budget was an imbalance between ex-penditure commitments and revenue collectionframework. The major steps taken to over-haul the budget and tax systems were the ter-mination since 1995 by the Bank of Russiaproviding direct credits to the government,the creation of new fiscal institutions such asthe Ministry of Taxes and Duties and Tax Po-lice and the adoption of the Budget and TaxCodes, especially the Tax Code provisions onfederal value added tax, income tax, a single so-cial tax and excise duties.
Economic growth in 1999–2001 helpedto resolve the budget deficit problem, but thisachievement cannot be regarded as a permanentbasis for tackling such long-term problems asthe reduction of the foreign debt burden un-less further reforms are implemented in thebudget system and the economy as a whole. Thestrategic budget policy priority of Russia is theeffective and fair taxation of natural resourcesand real estate, a consistent reduction of taxeson nonrental incomes and the final abolitionof turnover tax. A major element of the re-form strategy is the transformation of the pen-sion system. As for the envisaged institutionaland structural reforms in the economy, partic-ular importance is attached to reorganizationof the natural monopolies, comprehensive re-form of the social safety, reform of fiscal system
130 RUSSIA
and the banking sector, healthcare and educa-tion systems, the adoption of new labor legis-lation, guarantees of the right to privateownership of the land and reform of the judi-ciary. A key direction of the industrial structuralpolicy is the transformation of the automo-bile, machine-building, aerospace, and ship-building industries.
As a result of the implementation of eco-nomic reform and liberalization of external eco-nomic activity, Russia saturated its domesticconsumer market with goods and services, im-proved in quality and more varied. The num-ber of private enterprises increased sharply, theirshare in enterprises of all forms of ownership ex-panded. Competition appeared, especially inthe sphere of small businesses. The number ofjobs in the private sector of the economy rose.
The number of the unprofitable enter-prises in the Russian economy still remainssignificant enough despite of some reduction.Moreover the share of the overdue debt in thetotal amount of accounts payable of the non-financial enterprises and organizations is stillrather high. Innovative activity of the enter-prises remains insufficient. Overcoming ofthese problems requires further structural re-forms in the economy and strengthening theprocedure of law enforcement.
BUDGET POLICY
One of the fundamental principles of the Russ-ian budget system is to ensure a balanced bud-get. This means that the amount of projectedbudget expenditures must correspond to thetotal amount of budget revenues.
The four new sections of the Tax Code thatcame into effect in 2001 expanded the taxablebase of the value-added tax (VAT), cancelledsome unjustified VAT benefits, established thecountry of destination principle in levyingVAT and excise duties on nonenergy prod-ucts and services, and introduced a flat personalincome rate and a flat social tax (premium),which is designed to raise funds for the exer-cise of citizens’ right to state pension and so-cial security and medical care.
The current fiscal policy priorities are tostrike out the federal budget expenditure
obligations for which there are no sources offinancing and ensure the passage of a Tax Codesection on profit tax, which would provide forthe possibility of deducting all justified pro-duction costs, deferring losses for a 10-year pe-riod and gradually canceling tax benefits andexemptions. The draft federal budget for 2002materialized the idea of using budget surplusfunds to create a financial reserve (figure 4).This change has been introduced in responseto the Russian president’s proposal for creat-ing a two-part budget, one designed to meetthe government obligations and the otherbased on revenues received thanks to a favor-able foreign trade situation. The latter shouldbe regarded as a strategic reserve.
MONETARY POLICY
Under the Russian Constitution, the Bank ofRussia is an independent body guided in its ac-tivities by the 1990 Federal Law on the Cen-tral Bank of the Russian Federation (Bank ofRussia) in its 1995 version with subsequentchanges and amendments. This law stipulatesthat the main objectives of the Bank of Rus-sia are to protect the ruble and guarantee its sta-bility, including its purchasing power andexchange rate against foreign currencies, todevelop and strengthen the banking system,and to ensure the effective and smooth func-tioning of the settlement system.
The ultimate goal of the monetary policy isto reduce inflation to a level that would createconditions conducive to sustainable economicgrowth (figure 5). The monetary policy is imple-mented in the conditions of a floating exchangerate regime, which is designed to make the rublerate correspond to the economic fundamentalsand to keep up the country’s international reservesat a level commensurate with the changing eco-nomic situation. Control over the money sup-ply remains a major means of guaranteeingexternal and internal stability of the ruble. Theimmediate objective of the monetary policy is thedynamics of the monetary base. The operationalprocedure is based on control over net interna-tional reserves and net internal assets of themonetary authorities, which the Bank of Rus-sia implements using all the tools at its disposal.
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Since 2001 in formulation of monetarypolicy the Bank of Russia applies elements ofinflation targeting. Russia’s monetary policy in2002 will also be based on two key principles:using some elements of inflation targeting andemploying the M2 aggregate of money supplyas an intermediate target.
Now in conditions of the strong balance ofpayments the following basic monetary policyinstruments are used: the deposit operationswith commercial banks to sterilize of excess liq-uidity, interest rates on Bank of Russia opera-tions, refinancing of banks, and open marketoperations. The efforts made by the Bank ofRussia aim at building a flexible system ofmonetary policy instruments correspondingto the changing macroeconomic environment.It is also important to create favorable condi-tions for interbank lending market activity,restore confidence in government securitiesand strengthen on this basis a major sector ofthe financial market such as the governmentdebt market. Work is underway to design amechanism to refinance banks using promis-sory notes, rights of claims under credit agree-ments, and mortgages as collateral.
EXCHANGE RATE POLICY
The exchange rate policy pursued by the Bankof Russia in accordance with its legislated pur-poses and functions is designed to protect theruble and guarantee its stability. The Bank ofRussia is guided by the need for the exchangerate of the ruble to correspond to the eco-nomic fundamentals.
In July 1992 Russia introduced the pro-cedure for setting a single exchange rate of theruble against foreign currencies on the basis ofthe results of foreign exchange trading on theMICEX. The Bank of Russia regulated thedemand for foreign exchange and its supply inthe exchange interbank currency market inthe economic interests of the country, withoutsetting quantitative targets for exchange rate dy-namics.
In July 1995 the Bank of Russia began topeg the ruble to the U.S. dollar, a policy whichwas initially implemented by setting limits onmarket exchange rate fluctuations. In July 1996
a new procedure for setting the official rate wasintroduced in order to enhance the stability ofthe foreign exchange market and protect do-mestic producers and household savings. In ac-cordance with that procedure the official rublerate was set on the basis of daily Bank of Rus-sia quotations, while the pegging of the rubleto the dollar took the form of limits set on ratefluctuations, which provided for a smooth andpredictable slide of the exchange rate.
In January 1998 the Bank of Russia startedto set a central exchange rate of the rubleagainst the dollar for a three-year period, al-lowing the market rate to sway by 15 percent
–200
–100
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Figure 4. Balance of consolidated government budget
–12
–6
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Annual average growth rates (percent)
Figure 5. CPI growth rates
0
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20001999199819971996199519941993
872.5
307.9
197.1
47.814.7 27.8
85.7
20.8
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both ways. The financial crisis in Southeast Asiaand interconnected outflow of nonresidents’funds from the Russian financial market inconditions of high borrowing requirements ofthe government, along with the Russian cur-rent account surplus decline, have resulted insignificant pressure on the ruble and sharp re-duction of official international reserves in thethird quarter of 1998. In that situation theBank of Russia in August 1998 took the deci-sion to switch to a floating exchange rateregime.
Under this regime efforts were focused onsmoothing sharp fluctuations of the exchangerate and replenishing international reserves. Toreduce speculative pressure on the ruble ex-change rate and smooth its sharp fluctuations,the Bank of Russia uses such exchange rateand monetary policy tools as currency inter-ventions, deposit operations with credit insti-tutions, and, in exceptional cases, changes inreserve requirements.
BANKING SYSTEM
The main principles guiding the activities ofcredit institutions in Russia and the list ofbanking operations are laid down in the 1990Federal Law on Banks and Banking Activitiesin its 1996 version with subsequent changesand amendments. According to the FederalLaw on the Central Bank of the Russian Fed-eration (Bank of Russia) the Bank of Russiaconducts the state registration and licensing ofcredit institutions; sets minimum authorizedcapital requirements for credit institutions,capital adequacy and liquidity ratios, and max-imum risk levels; regulates the size of the openposition of credit institutions on foreign ex-change, interest, and other financial risks; es-tablishes the procedure for creating reserves forhigh-risk assets and determines their mini-mum level; and performs other regulatory andsupervisory functions.
The passage in 1999 of the Federal Law onInsolvency (Bankruptcy) of Credit Institutionswas a major step forward in converting Russ-ian banking legislation to generally accepted in-ternational standards. The law set the procedurefor preventing bank bankruptcies, declaring
credit institutions insolvent, and initiatingbankruptcy proceedings against them.
Implementing anti-crisis measures and thefirst stage of the post-crisis restructuring ofthe banking system (September 1998–99), theRussian government and Central Bank ac-complished on the whole the tasks set in theirjoint document “On Measures to Restructurethe Banking System of the Russian Federa-tion”, adopted in November 1998. In 1999Russian lawmakers passed the Federal Law onthe Restructuring of Credit Institutions. Draw-ing on the world practice of restoring bankingsystems and guided by the Federal Law on theRestructuring of Credit Institutions, the Russ-ian authorities created the Agency for Re-structuring Credit Organisations (ARCO).
The efforts made by the executive and leg-islative branches of power, the Bank of Russia,ARCO, and credit institutions prevented acrisis of the system of payments and a sys-temic banking crisis and led to the creation ofa legislative and organizational framework forthe restructuring of credit institutions. Thanksto them, Russia had overcome the most dam-aging after-effects of the financial crisis of1998, preserved the viable core of the bankingsystem and helped banks resume providingbasic services to the economy. The amend-ments passed in June 2001 to the laws regu-lating credit institutions created additionalfavorable conditions for the banking sectorreform. As a result, today Russia has a market-oriented albeit insufficiently advanced bank-ing sector, and some of the banking laws andregulations closely match international stan-dards. Late in September 2001 the Bank ofRussia and the government intend to adopt ajoint strategy of banking sector development.
The strategic purposes, practical tasks, andconditions of effective reforming of the Russianbanking sector during the coming five-year pe-riod were formulated in the document “JointStrategy of Development of Banking Sector ofthe Russian Federation” prepared by the gov-ernment of the Russian Federation and the Bankof Russia. The strategic objectives are to increasethe banking sector’s stability to a level that wouldpreclude the possibility of an outbreak of systemicbanking crises, ensure that the banking sector
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improves its performance in accumulating house-hold and corporate savings and transformingthem into loans and investments, restore andstrengthen trust of domestic and foreign in-vestors and depositors, especially individual de-positors, in the Russian banking sector, preventthe use of the banking system for unfair com-mercial practices, and further upgrade the gov-ernance of state-owned banks.
The major result of the banking sector re-form during the coming five-year period shouldbe essential increase of its reliability. Increaseof an intermediary role of banking sector in theRussian economy and gradual approach of theRussian banking sector’s parameters to para-meters of banking systems of countries lead-ing in economic results among the group ofemerging market economies are also expected.
LABOR RELATIONS
A major step towards revamping the system oflabor relations in accordance with market prin-ciples in Russia was guaranteeing citizens theconstitutional right to the free realization oftheir work abilities and free choice of an oc-cupation. The main reforms of labor legisla-tion expanded the sphere of labor relationsregulated by law taking into account the exis-tence of different forms of property ownership.They also allowed citizens to realize the con-stitutional principle of freedom of work andequal job opportunities, recognized interna-tional standards and treaties on labor relationsas an independent source of Russia’s law, de-veloped the principle of social partnership onthe basis of collective agreement, limited theterm of labor contracts, required concludinglabor contracts in writing, allowed employersto dismiss workers for violation of labor dis-cipline without consent of the local tradeunion, guaranteed trade unions the right to de-mand punishment for executives who violatedtrade union laws or the terms and conditionsof collective agreement, granted recognition tothe unemployed status, and provided socialsecurity guarantees to the unemployed.
However, the applicable labor legislation,whose fundamental principles were laid downin 1971, remained archaic for the most part,
divorced from the civil legislation based on mar-ket principles and encouraging illegal prac-tices. At present the lower house of Russianparliament, the State Duma, is consideringthe draft of a new Labour Code, containingprovisions on social partnership, the repre-sentation of workers and employers, the reg-ulation of social and labor relations on acollective basis through negotiation, easing upthe procedure for terminating labor contract,and the practice of combining several jobs atone workplace. The aim of the new labor lawis to ensure the effective protection of work-ers’ rights and interests, legalize salary incomes,stimulate workforce mobility, and facilitatethe implementation of structural changes at en-terprises. In the middle term measures are tobe taken to formulate the principles and cre-ate the organizational basis of a wage rate reg-ulation system as part of the social partnershipsystem, which would take into account thedifferences in the complexity of the work doneand the qualification of workers. Steps will betaken to improve the system of compulsory in-surance against accidents at work and occu-pational diseases.
SOCIAL SAFETY NETWORK
Under Section 2 of the Tax Code of the Russ-ian Federation the employers who make pay-ments to hired workers, as well as individualentrepreneurs, tribal and family communitiesof the small peoples of the North engaged intraditional businesses, farm managers, andlawyers should pay a flat social tax, which islevied, depending on the category of taxpayer,on payments and other remuneration paid byemployers to their workers in all cases or in-comes derived from entrepreneurial or otherprofessional activities minus the expenses in-volved in obtaining these incomes. The aim ofa flat social tax is to raise funds for the exer-cise of citizens’ right to state pension and so-cial security and medical care. The tax will goto the following state extra-budgetary funds:the Pension Fund, the Social Insurance Fund,and the Compulsory Medical Insurance Funds.
The Federal Law on Employment in theRussian Federation, passed in 1991, guaranteed
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the unemployed benefits and stipends for theperiod of vocational retraining, provided for thepossibility of participating in public works,and mandated the compensation of expensesto persons who have voluntarily changed theirplace of residence at the proposal of the em-ployment services. The government took stepsto assist employment amid massive layoffs andorganize the training of the unemployed in thefundamentals of business, but its efforts pro-duced little effect as there was no money in thebudget to finance these programs, enterprisesneeded fewer workers as a result of structuralchanges in the economy and production de-cline, there were significant income differencesbetween different territories, people had nomoney to start up a business, and many smallbusinesses were controlled by crime. The gov-ernment’s middle-term program for the labormarket includes measures to cushion the effectof mass redundancies by organizing consulta-tions on employment possibilities for workersslated for dismissal, improve the system of dis-semination of information on vacancies inorder to cut the time jobseekers take to find newemployment, increase the social status of pub-lic works, change the entitlements and proce-dure for paying unemployment benefits, andprovide vocational guidance to unemployedand young people before they have reached em-ployable age.
People who have found themselves in a dif-ficult situation and people who are unable totake care of themselves and need constant ortemporary social care are guaranteed the rightto social protection in the form of financialaid and free social, medical, psychological, andlegal assistance mainly from the budget-fi-nanced government network of social services.The level of social safety provided by the gov-ernment social services was low in Russia be-cause the federal and regional governments didnot have enough money in their budgets to meetall the needs of the socially vulnerable popula-tion groups, while nongovernmental organi-zations had no commercial interest inparticipating in the social safety net. Themedium-term program to enhance the effec-tiveness of social care and improve the qualityof social services is based on the principle of di-
recting aid to those who really need it and en-visages the development of targeted programsand competitive methods of raising funds forsuch programs. It also envisages the introduc-tion of a contract system under which a recip-ient of aid would assume reciprocal obligations(employment, participation in public works),replacing benefits for working people with cashpayments, separating and redistributing, if nec-essary, the powers of different levels of gov-ernment in the sphere of social support, workingout standard requirements for the governmentsocial services on the basis of the governmentsocial care standards, creating a system of eval-uation of the quality of the implementation ofsocial programs, and providing the entire socialsphere with information technology.
EDUCATION, HEALTHCARE, AND SOCIAL POLICY
The brunt of financing education, healthcareand social policy in Russia is borne by regionalgovernments. The largest share of expendi-tures on education, health, social policy, cul-ture, the arts, and mass media in the structureof consolidated budget expenditures was reg-istered in 1996–97. In later years this share con-tracted as growth in all budget expendituresslowed. However, the share of budget expen-ditures on health and social policy in1998–2000 was larger than in 1994–95. Theshare of budget expenditures on education inthose periods was practically the same. In 2000the share of budget expenditures on education,health, culture, the arts, and mass media was28.5 percent of consolidated budget expendi-tures compared with 24 percent in 1994. Therewere several factors that impacted the levels ofgovernment spending on education, health,and social policy: on the one hand, the Russ-ian education and healthcare systems becameincreasingly commercialized; on the otherhand, paid services were affordable to a smallpart of the population. There were no com-mercial alternatives to the government pensionsystem.
Education is one of the principal areaswhere Russia intends to enhance the role of eco-nomic mechanisms by drawing a more distinctdividing line between the spheres covered by
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paid and free education, work out nationaleducation standards, organize an independentsystem of certification and quality control ofeducation, and award targeted social grants. Inthe field of healthcare Russia plans to create alegislative framework for the completion ofthe transition to the insurance principle ofpaying for medical aid, which would helpeliminate the chronic shortage of funds andguarantee the population basic medical services.The reform of the pension system will be basedon the creation of a transparent system of ac-cumulations for old age, depending on one’scontribution made during one’s working life.
IMPACT OF EXTERNAL FACTORS
Major external factors influencing the Russ-ian economy include the dynamics of worldcommodity prices and cross-border capitalmovements.
INFLUENCE OF THE WORLD COMMODITY
MARKETS
The dynamics of world energy prices is key toRussian export performance. In the periodfrom 1994 to the first half of 2001 the shareof energy products in total Russian exportshad constantly expanded. In the last 18 monthsexport dependence on the price of oil andother energy resources has increased. The shareof energy resources in total exports in the pe-riod of 2000 to the first half of 2001 expandedto 53–55 percent, of which the share of oilamounted to 24–25 percent. It is estimated thata fall in the average price of oil by $1 a barrelleads to the reduction of Russian exports of oiland petroleum products approximately by$1–1.2 billion a year. A fall in the averageprice of oil in 1998 by $6.50 a barrel comparedwith 1997 led to a $7.5 billion drop in exportsof oil and petroleum products, while a rise of60 percent, or $10.50 a barrel, in the averageprice of oil in 2000 ensured more than half ofall growth in exports.
Changes in the price of oil affect the dy-namics of gas prices with a time lag of three tosix months. Natural gas is the second most im-portant Russian export commodity. In 2000
and the first half of 2001 natural gas accountedfor 18–20 percent of Russian exports. The2000 growth in gas exports increased by one-quarter the value of Russian exports apart fromoil and petroleum products. As a result, thanksto a price growth in world energy markets in2000 by more than 64 percent year on yearamid the expansion of physical volumes of en-ergy exports by almost 4 percent on average,Russian energy exports increased 70 percent,ensuring three-quarters of increment in totalRussian exports.
In 2000 the enterprises of the major ex-porting industries received more than 70 per-cent of total profit of the Russian industry.About 21 percent of total fixed capital invest-ments was made by the leading exportindustry—the fuel industry. The increase ofmerchandise exports promoted achievement in2000 of a high current account surplus (morethan $46 billion) and growth of official inter-national reserves of Russia (by about $16 bil-lion during the year). Thus, net export proceedsinfluenced essentially the developments ofRussian GDP and in many respects deter-mined foreign exchange and financial posi-tions of Russia. The extent of consumerdemand and a level of investment activity alsoto a considerable degree depend on expendi-tures of export and adjacent industries.
INFLUENCE OF CAPITAL MOVEMENTS
In 1995 Russia found its economic systemlargely reformed and its new priority now waseconomic stability and growth, which couldonly be achieved by slowing inflation. In thatperiod Russia made the historic decisions tostop financing the budget deficit with Bank ofRussia loans and peg the ruble to the U.S.dollar. The development of the government se-curities market accelerated as a result, andoverall these decisions helped reduce inflationmany times, facilitating growth in householdreal income and creating a predictable envi-ronment for production and investment. Con-ditions appeared for an end to decline and thebeginning of economic growth in Russia. A risein investment activity could be achieved inparticular by bringing foreign investment to the
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Russian economy. Thus the emphasis wasmade on increase of inflow of portfolio in-vestments that on the other hand howeverraised vulnerability of economy to possiblechanges in the foreign capital movement.
In the first quarter of 1996 nonresidentshad no legal investments in the GKO-OFZmarket, but after they received access to the gov-ernment securities market, the market value oftheir GKO-OFZ portfolio in the second quar-ter was estimated at 6.3 billion rubles and in thefourth quarter it rose to 11.7 billion rubles. In1997 the foreign investors’ share in the govern-ment securities market had reached 30 percent.In the second half of the year, however, the sit-uation in the Russian financial market began todeteriorate under the impact of extremely adverseexternal factors. A series of crises broke out in theAsia-Pacific region, financial markets becamedestabilized all over the world, and capital startedto flee from unsafe countries and regions. In-vestors distrusted Russia because it failed to re-solve its budget deficit and government debtproblems while its current account surplus con-tracted. In the fourth quarter of 1997 the non-resident share in the government securities marketdecreased and the first quarter of 1998 saw themarket value of the nonresident GKO-OFZportfolio decline in absolute terms. Faced withthe difficulty of refinancing its debt obligations,the government had to agree to shorter bor-rowing terms. A fall in the demand for govern-ment securities and a sharp rise in the demandfor foreign exchange in 1998 provoked a pro-found financial crisis in Russia, which devaluedthe ruble many times over, caused a precipitousdecline in production and household income.
In 2000 and 2001 external factors for themost part had a favorable effect on the Russ-ian economy as Asian countries were quicklyrecovering from the crisis, international tradeboomed, and energy prices soared. However,as prospects for the future of the foreign-tradesector of the Russian economy, especially thedynamics of prices of major Russian exports,remained unclear during this period, there wasalways a possibility of deviation of a numberof key parameters from the macroeconomicforecasts laid at the basis of the country’s eco-nomic policy.
LIBERALIZATION AND INSTITUTIONAL
DEVELOPMENT
Unlike other G-20 countries, Russia had onlythe last decade to engage in institutional de-velopment in accordance with the principles ofmarket economy. Throughout the period of eco-nomic reforms Russia worked towards creatinga legal and institutional environment for mar-ket economy, legalizing multiple forms of prop-erty ownership, building a market-based pricingand wage systems, revising the principles ofconducting foreign trade, affirming the inde-pendent status of the central bank, institutingbankruptcy procedures and anti-trust regulation,encouraging competition, regulating the nat-ural monopolies and securities market, up-grading accounting standards, and taking othermeasures. However, the application of the lawsdesigned to regulate market-based economic re-lations was in many cases inadequate to ensurethe achievement of the goals set, and this wasone of the factors that imparted negative char-acteristics to the investment and business cli-mate in Russia. The steps that are being takennow and will be taken in the future to ensurethe effective operation of the institutions ofexecutive power and reform the Russian judi-cial system aim at changing the unfavorable sit-uation in this sphere.
Russia has been making big efforts to en-sure transparency of the activities of eco-nomic agents and regulatory agencies, whichit regards as a condition of the successfulfunctioning of a market economy. To bringits practices in this area closer to interna-tional standards, Russia was one of the firstcountries to agree to an IMF evaluation of theRussian practices in the field of transparencyand disclosure of information. In 2000–01Russia held consultations with the IMF toagree on the country’s compliance with thecode of good practices in the field of trans-parency of monetary and financial policy andinternational standards of dissemination of in-formation. In 2000 Russia agreed for the firsttime to the publication of the IMF report onconsultations held with Russia in 2000 withinthe framework of Article IV of the IMF Ar-ticles of Agreement.
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The Bank of Russia also has worked con-sistently within the limits of its competence to-wards improving the practice of disclosinginformation about its monetary policy, bank-ing supervision, and payment systems.
In 2000–01 the Russian authorities draftedthe Concept of Banking Sector Developmentin the Russian Federation and organized itscomprehensive discussion, on which basis thedocument of the government of Russian Fed-eration and the Bank of Russia “Joint Strategyof Development of Banking Sector of the Russ-ian Federation” was prepared, designed for thecoming five-year period. Amendments weremade to the Federal Law on the Central Bankof the Russian Federation (Bank of Russia),Federal Law on Banks and Banking Activities,and Federal Law on Insolvency (Bankruptcy)of Credit Institutions, which required credit in-stitutions to increase transparency (special em-phasis was made on the frequency and contentsof reported data) and to compile and publishreports on a consolidated basis, that is, in-cluding banks and nonbanking organizations.
In 2001 the Russian government and Cen-tral Bank are to work out organizational andlegal measures necessary for the complete con-version of banks to international accountingand financial reporting standards and drawup a timetable for lifting the remaining re-strictions in order to ensure the conversionfrom January 1, 2004. The State Duma, thelower house of Russian parliament, is cur-rently considering amendments to the Fed-eral Law on Banks and Banking Activities,granting the Bank of Russia the right to passto foreign supervisors, on a confidential basis,information it received in supervising banks (ex-cluding statements on customers’ operationsand accounts) without asking for prior per-mission from credit institutions concernedand ensuring safety of information received bythe Bank of Russia from foreign supervisors ona confidential basis.
The Bank of Russia cooperated with theworking group of the Bank for International Set-tlements Committee on Payment and SettlementSystems (CPSS) on central bank principles,practices, and tasks related to payment systemsin drafting the report on the key principles of
systemically important payment systems. Astudy was conducted to evaluate compliancewith the key principles by the Bank of Russiapayment system and private payment systems.The Bank of Russia wrote and sent to the Bankfor International Settlements the first version ofthe Red Book “Russian Payment Systems”,which was compiled in accordance with CPSSrecommendations and methodologies. To fa-cilitate data analysis and in connection withthe release of the Red Book, the Bank of Rus-sia elaborated and introduced a number of ad-ditional reporting forms for credit institutionsand its regional branches and announced itsguidelines for the reform of the Russian paymentsystem. The Bank of Russia is to build its newpayment system in accordance with interna-tional standards.
To ensure fuller compliance with the re-quirements of the Code of Transparency, theBank of Russia took steps to improve the prac-tice of disseminating information directly re-lated to its own activities. Since 1999 itexpanded considerably the contents of thefinancial statements included in the Bank ofRussia’s Annual Report, providing additionalinformation on the practice of managing for-eign exchange reserves, the state of the Russ-ian payment system, and the improvement ofthe Bank of Russia efficiency. The Bank ofRussia introduced the practice of disclosing itsaccounting policy, data on capital and assetsmovement, and detailed comments on indi-vidual balance sheet items.
In the Bank of Russia Newsletter, its officialpublication, the Bank of Russia carried the en-tire set of prudential banking supervision reg-ulations and began to publish materials relatingto the functioning of the payment systems.
The Bank of Russia disseminates infor-mation on the established set of indicators infull compliance with the first edition of theSpecial Data Dissemination Standard(SDDS). Russia’s joining the SDDS has beentemporarily delayed as the IMF had put for-ward additional data dissemination require-ments (such as data on the country’sinternational reserves and foreign debt). TheBank of Russia has now begun to release in-formation on foreign debt with a breakdown
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into government debt and the debt owed bythe Bank of Russia (on the IMF loan), thebanking sector (including the Bank of Rus-sia and Vneshekonombank), and nonfinan-cial institutions and the types of financialinstruments within each sector. In addition,the Bank of Russia has started to release dataon the international investment position,which include information on credit institu-tions, the Central Bank, and Vneshekonom-bank (previously data were released on creditinstitutions only). The Bank of Russia web-site, which contains data compiled in accor-dance with the SDDS and is accessible tooutside users, has been complemented witha description of metadata in Russian andEnglish.
BENEFITS AND CHALLENGES OF
GLOBALIZATION
Russia as a sovereign state with a market econ-omy became integrated with the internationaleconomic and financial systems much laterthan other G-20 countries. By that time manyother nations had already passed such stages asgrowth in international trade in raw materialsand the expansion of the exchange of manu-facturing industry products and services andwere at the stage of creating a global financialmarket. This circumstance is largely responsi-ble for Russia’s current role in internationaltrade and shape of the Russian financial mar-kets’ development. Both positive and nega-tive economic developments in Russia in thelast decade were attributable to the change ofits economic system and this makes the analy-sis of the consequences of globalization moredifficult.
BENEFITS
The liberalization of external economic activ-ity ended the isolation of Russia’s producers ofexport commodities and consumers of im-ported goods from the world market. The sup-ply of imported products increased in thedomestic market, satiating consumer demandand compelling Russian producers to increasethe competitiveness of their goods.
The participation in global economicprocesses helped Russia build up-to-date in-stitutional foundations of a market-based eco-nomic system, such as regulating foreign tradeby tariffs, implementing a transparent and re-sponsible monetary policy by the indepen-dent central bank, and organizing bankingsupervision and the payment system in accor-dance with international standards. Advancedmethods of doing business gained ground inthe private sector. Among the sources of for-mation of personal incomes the share of in-comes acquired from business activity and theproperty ownership has increased.
The participation in the system of inter-national exchange brought the key moderntechnologies to Russia. The use of computersin business and households expanded signifi-cantly. The number of individual and corpo-rate Internet users also increased, although inthis area Russia is lagging far beyond the in-dustrialized nations: It is estimated that nomore than 5 percent of the Russian populationuse the Internet on a regular basis and 10 per-cent use it occasionally. The number of mobiletelephone users in Russia has risen considerably,and although they still account for 2.5 per-cent of the population, the mobile phone is be-coming increasingly accessible and affordableto different population groups in Russia.
CHALLENGES
The liberalization of external economic activ-ity failed to help Russia overcome its export de-pendence on raw materials or stimulate thedevelopment of the production of high-techproducts for export. Competitive imports be-came one of the causes of production declinein the manufacturing sector of the Russianeconomy and a rise in open and latent unem-ployment. Since Russia had no effective andwell-financed social security system, that led toa sharp fall in the standard of living of themajority of the country’s population.
Structural changes in the economy and achronic shortage of funds led to a profound cri-sis of fundamental and applied sciences andprovoked a considerable outflow of intellectualresources from Russia.
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Direct foreign investment in Russia was toosmall to have any significant effect on therates of economic growth or the structure ofthe Russian economy. A steep rise in foreignportfolio investment in 1996–98 when non-residents received access to the Russian gov-ernment securities market was followed by asharp fall caused by the monetary and finan-cial crisis of 1998.
Russia may overcome these difficulties orat least prevent old problems arising again ifit continues to implement institutional and
structural reforms, reduces the risk involved inthe redistribution of export incomes betweensectors, upgrades corporate governance, com-pletes the restructuring of the banking sys-tem, improves its social policy, and joins theWTO. It is very important for Russia to con-vert its system of custom tariffs and custom ad-ministration to WTO standards. It is alsoimportant for Russia’s effective integrationwith the world economy that its debt problemshould be resolved through constructive dia-logue with the creditors.
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The South African economy has opened up sig-nificantly since the first democratic electionsof 1994. Greater integration has taken placethrough capital account and trade liberaliza-tion, underpinned by a range of domesticpolicies intended to guide the economy towardstructural shifts required to competeinternationally—and to minimize the costs ofthis transition. Greater integration has clearlyplayed a role in turning around the SouthAfrican economy—average GDP growth from1994–2000 was 2.7 percent (3.1 percent in2000), compared with 1 percent in the pre-ceding decade.
This case study outlines South Africa’sliberalization process. It describes how the cap-ital account has been liberalized and the man-agement of the macroeconomic effects ofcapital flows. It deals with trade liberalizationand the effects of increased openness on thelabor market (a key determinant of poverty).And it describes the coordination of liberal-ization policies with domestic policies, theeconomic and social challenges of greater globalintegration, and South Africa’s policy responsesto these challenges.
LIBERALIZATION OF THE CAPITAL ACCOUNT
South Africa broadly followed the standardapproach that current account liberalizationshould precede that of the capital account—and the prescription that a gradual rather thana “big bang” liberalization may be preferable.At the same time, and somewhat more con-tentious internationally, this has been accom-panied by the early liberalization of controls onnonresidents’ capital transactions.
Starting in March 1995 capital account lib-eralization changed dramatically the scale of
international capital flows into and out of SouthAfrica. After almost 10 years of capital out-flows, South Africa experienced inward invest-ment averaging around 6.7 percent of GDP ayear. These inflows were triggered by a combi-nation of factors: re-entry into the internationalarena after decades of political isolation, theearly abolition of exchange controls on non-residents, and the strong public commitment tosound fiscal and monetary policy. At the sametime, the gradual liberalization of capital con-trols on residents enabled a substantial diversi-fication of portfolio assets. Outward investmentby residents has averaged around 4 percent ofGDP a year since 1994.
These general trends were accompanied bymarked changes in the characteristics of thecomponents of inflows and outflows, partic-ularly the sources of volatility in the capital ac-count. Prior to political and financialliberalization, short-term lending and cur-rency and deposits were more important in dri-ving the volatility of the financial account (asmeasured by the standard deviation). From1995 to 1999, by contrast, portfolio flowsbecame the most significant source of volatil-ity, primarily from the scale of these inflows,not inherent instability1. Large-scale, andsometimes speculative, activity by nonresi-dents in the domestic bond market became themost important source of shocks to the fi-nancial account. Investment by nonresidentsin South African equities also increased dra-matically after 1995 (with a correspondingincrease in the impact of equity market volatil-ity on the financial account). But it has beenone of the most stable forms of inflow in rel-ative terms: quarterly investment has beenconsistently positive since 1995. This is insharp contrast to the more erratic behavior of
South Africa
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equity investment in the pre-election period,largely explained by South Africa’s subsequentinclusion—and large weighting—in emergingmarket equity indices.
Access to international capital flows in-creased the pool of resources available for do-mestic investment, of particular benefit to theeconomy, given South Africa’s extremely lowsavings rate of around 15 percent of GDP. Italso eased the current account constraint thattraditionally limited South African growth.But while inflows have reached levels similarto those experienced in other emerging mar-kets, a number of features distinguish SouthAfrica’s experience from that of comparablecountries, offsetting the kinds of benefits thatfaster growing emerging markets have achieved.In some cases this reduced certain risks.
South Africa’s capital inflows are signifi-cantly skewed toward (unstable) portfolio in-vestment, especially bond flows, and arecharacterized by disappointing FDI perfor-mance. The inward portfolio investment inSouth Africa in the late 1990s dwarfed that ofthe other emerging economies, largely a func-tion of the liquidity, depth, and sophistica-tion of South Africa’s domestic bond and equitymarkets. After 1994 there was an exponentialincrease in foreign participation in the bondmarket, with purchases and sales of bonds in-creasing from a monthly average of 15 billionrands a month in 1996 to a peak of 160 bil-lion in July 1998. Investment in the equity mar-ket also rose rapidly, with the JohannesburgStock Exchange experiencing positive flows inevery month from the abolition of exchangecontrols on nonresidents in 1995 to March2000. While South Africa’s capital marketshave clearly attracted large flows of portfolioinvestment, they have not so far proved ad-vantageous in attracting direct investment (asmight be expected through their facilitation oftakeovers, mergers, and joint ventures).
Direct investment—which tends to belonger term, more stable, and with a greater po-tential to create jobs and reduce poverty—hasbeen disappointing. Levels increased from 0.1percent of GDP in 1991–94, to just over 1 per-cent in 1995–99. Most major FDI flows wereprivatization related. South Africa’s persistently
low rates of economic growth clearly provideone important obstacle to FDI. (This would inturn derive from a range of factors—some ofthem structural factors contributing to adversemacroeconomic conditions, others operating di-rectly on investor sentiment.)
It may be that sound policies require moretime to reap benefits. South Africa’s experienceto some extent mirrors that of Brazil and Mex-ico in the early 1990s, with large portfolio in-flows and little direct investment. (In the latterhalf of the 1990s, these countries have experi-enced a shift towards direct investment in thecomposition of inflows, particularly Brazil.)
South Africa’s poor FDI performance may,perversely, be a function of the depth and so-phistication of the domestic debt and equitymarkets. Given the low transaction and in-formation costs entailed in investing in capi-tal markets, investors may have beendiscouraged from direct investment, with itscomparatively higher costs. A developed cor-porate sector, coupled with a large and relativelyliquid equity market, may mean that SouthAfrica is more likely to attract portfolio investorsthan direct investors, who may find it difficultto break into South Africa’s established eco-nomic sectors.
Finally, outward investment by SouthAfrican residents, driven by a desire to diver-sify globally after years of isolation, has meantthat net capital flows in South Africa havegenerally been lower than in other emergingeconomies.
MANAGEMENT OF CAPITAL FLOWS
On the whole, South Africa has participatedin international capital markets, while avoid-ing the downside of instability and crisis, evenas the currency has come under pressure in re-cent years. In part, the authorities took ad-vantage of a number of the structural featuresof the South African economy. At the same timeSouth African performance was helped by anumber of careful policy decisions. This isdiscussed in more detail below.
First, capital account liberalization was grad-ual. Exchange controls were abolished for non-residents in 1995. Removal of exchange controls
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on South African residents was phased. Thesereforms focused on institutional investors, thecorporate sector, and private individuals. Thisapproach allowed South Africa to restrict the vol-ume of funds and enabled the government toadapt the pace and strategy of liberalization inresponse to changing circumstances.
Gradualism has not been without its ownchallenges, particularly managing private sectorexpectations. From time to time expectations ofthe announcement of further reforms intro-duced uncertainties into the foreign exchangemarket. But, while there was internal and ex-ternal criticism about the pace of reform, thegradual approach allowed South Africa to avoidpolicy reversals in the face of currency crises.
Second, South Africa’s liberalization processwas backed up by supportive and credible fis-cal and monetary policy, reducing the scope fordomestically generated instability. In particu-lar, reducing the fiscal deficit (and the publicsector borrowing requirement) has been a gov-ernment priority since 1994. The deficit camedown from approximately 5 percent in1994/95 to 1.9 percent in 2000/01; the pub-lic sector borrowing requirement has comedown from 5.7 percent of GDP to 1.3 percent.With the government’s macroeconomic frame-work in 1996, the Growth Employment andRedistribution Strategy, South Africa bothcommitted to a tougher program of deficit re-duction and introduced a medium-term ex-penditure framework, anchored by furthercommitment to fiscally sustainable policy. Inaddition, macro reforms were sequenced withfurther liberalization. From 1994, for instance,the fiscal position was tightened, while ac-counting and reporting of contingent liabili-ties were formalized in 1997.
Third, South Africa reduced a number ofimportant risks through a cautious foreignborrowing strategy, and was largely successfulin managing short-term liabilities in the con-text of low reserves for many years. SouthAfrica’s external debt is extremely low by com-parison with most emerging markets (March2001 estimates put external debt at 3.6 percentof GDP, or 8.0 percent of total debt). Its totalgross loan debt stands at 44.6 percent of GDPaccording to March 2001 estimates. South
Africa embarked on a process of putting in placea risk management framework to manage riskarising from foreign debt. This entails quali-fying risks from exogenous factors and devel-oping a benchmark for optimizing the structureof South Africa’s loan portfolio.
Fourth, after experience of the Asian andLatin American crises, South Africa abandonedan implicit real exchange rate target. SouthAfrica had, until then, used the net open for-ward position as a reasonably effective tool formanaging the demand for foreign currency.But, this had costs. To the extent that the randdepreciated at a rate faster than implied bythe forward contracts, this intervention led tosizable and unpredictable potential costs tothe fiscus. At the same time, the net open for-ward position was poorly understood by in-ternational investors. Perceptions that the entireforward book represented a short-term for-eign liability2 probably put an additional riskpremium on South African foreign borrowing.Furthermore, support of exchange rate targetswas generally associated with currency specu-lation, the risks of which government deemedit prudent to avoid.
Fifth, liberalization was accompanied bysignificant reforms to an already strong finan-cial market infrastructure. Despite repeatedepisodes of exchange rate pressure and sharp de-preciation, South Africa has been protected bya regulatory system that is more establishedand sophisticated than other emerging markets.The first corporate governance rules were pub-lished by the King Commission in 1994. Risk-based capital requirements, in line with theEuropean Union (EU) directives, were intro-duced for banks in 1991 and for securitiesfirms in 1995. Banks were required to reportin terms of the generally accepted accountingrules in 1996. Consolidated accounting rulesfor financial conglomerates were made manda-tory for banking groups in 2000. In rapid suc-cession, minimum international standards wereintroduced, for capital adequacy, accounting andaudit, and disclosure. South Africa is largely orfully compliant with all 12 key financial stabilitycodes and standards, in particular the BasleAccord and the International Organization ofSecurities Commissions standards.
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Sixth, for the banking sector, SouthAfrica’s strong regulation, and the structureof the sector, shielded the economy from thetransformation of currency crises into bank-ing crises. Many of the vulnerabilities asso-ciated with short-term bank flows in otheremerging markets have been a product oftheir impact in poorly regulated and under-developed financial sectors, where creditanalysis and risk management are weak andbad loans can easily spin out of control inboom periods.
Seventh, while capital outflows by SouthAfrican residents hurt domestic investment,outflows by South African residents helpedthe authorities manage the impact of capital in-flows. South Africa has not experienced the assetbooms that have often occurred in other emerg-ing markets during periods of large net in-flows. This has also helped South Africa tolessen the risk of financial crisis due to ex-change rate misalignment, as experienced byother emerging economies as a result of sharpexchange rate appreciations.
Eighth, and related to the fiscal policiesmentioned above, important tax administra-tion and policy reforms have been coordi-nated with liberalization policies. Therelaxation of exchange controls was accom-panied by key income tax reforms to protectthe tax base and minimize tax biases thatcould encourage the export of capital. This fo-cused on the design and implementation ofrules to ensure the appropriate taxation ofoutward investment. Before 1997 the SouthAfrican income tax was source-based: incometax was levied only on income arising from aSouth African source. In 1997 “deeming”rules were introduced to bring non-SouthAfrican sourced passive income (rent, interest,royalties, annuities) accruing to South Africanresidents within the tax base. From January2001, a full residence-based income tax sys-tem was introduced, providing greater secu-rity for the income tax base, as South Africabecomes increasingly integrated with the worldeconomy. Transfer pricing and thin capital-ization rules are also in place to protect the cor-porate tax base against profit-shifting by firmsinvesting into or from South Africa.
MANAGING THE MACROECONOMIC IMPACT
OF CAPITAL FLOWS
While South Africa has proved less vulnerableto swings in emerging market sentiment thanother emerging economies, the authorities en-countered challenges in managing the macro-economic impact of full participation in theinternational capital markets. Global capitalmarket volatility occasionally had dramatic ef-fects on interest rates and the exchange rate, re-quiring difficult policy choices in the contextof low growth and pressing social problems.
One of the most important challenges wasthe vulnerability to financial crisis arising prin-cipally from the volatility of portfolioinvestment—something not readily apparentin annual data3. In South Africa’s case, port-folio investment is clearly a potential conduitfor financial market contagion. Portfolio flowsare subject to herding behavior and to sharpreversals that can lead to macroeconomic im-balances, which frequently require painful ad-justments. The best defense against this iscontinued prudent macroeconomic policy.
Second, capital account liberalization, incombination with the constraints in whichSouth Africa set monetary policy in the past,probably hurt South Africa’s ability to addressstructurally high real interest rates4. Liberal-ization, in the presence of an implicit real ex-change rate target (to contain inflation and easethe current account constraint that has tradi-tionally dogged South African growth), trig-gered a shift to high real interest rates of above10 percent for virtually the entire period frommid-1995 to mid-1999. Financial liberalizationhas also been an important factor contribut-ing to the decline in personal savings in SouthAfrica since 1980s, as financial sector reformsand innovations during the period made iteasier to borrow money to finance consump-tion, in turn contributing to lower domesticsavings and higher real interest rates. These highreal interest rates prevented South Africa frommoving to a higher growth path and had theeffect of attracting large-scale and speculativeforeign investment into the domestic bondmarket. At the same time, periods of signifi-cant outflows limited the ability of the Reserve
SOUTH AFRICA 145
Bank to reduce interest rates. Inflation target-ing is one of South Africa’s key approaches tobring down these high real interest rates.
Third, capital account liberalization haspotentially severe implications for exchangerate volatility—and the impact on inflation anddomestic money market liquidity. So SouthAfrica undertook significant reforms to themonetary policy framework. The changes in-cluded a shift in stages from money supply tar-gets to a broad range of intermediate targets,and eventually to a single inflation target. Mostimportant, South Africa abandoned interven-tion in the forward currency markets, workingdown a net open forward position of morethan $25 billion in 1998 to $4.8 billion in July2001. Other reforms included a new system forimplementing policy, based on daily (soon tobecome weekly) tenders via repurchase trans-actions, replacing the previous discount win-dow. Money market liquidity has beenmanaged through this repo market and throughcapital requirements for banks.
Fourth, fiscal policy also had a role. By re-ducing the fiscal deficit, the authorities reducegovernment’s contribution to the expansion ofdomestic liquidity, in offsetting the potentiallyinflationary increases in liquidity caused byinflows. Fiscal measures were also important inreversing outflows. So fiscal adjustment (orcontinued sound fiscal policies) was central inrestoring macroeconomic balance and signal-ing the credibility of the government’s com-mitment to doing so.
TRADE LIBERALIZATION
While liberalization of the current accountbegan slowly in the late 1980s, the significantopening of the South African economy beganonly with accession to the WTO in 1994.South Africa’s new tariff program officially tookeffect in January 1995, and its early adoptionby the new government signaled its strongcommitment to trade reform. Between 1990and 2000 the average economywide tariff fellfrom 28 percent to 6.5 percent, while the av-erage manufacturing tariff was reduced from 30percent to 6.7 percent. The maximum tariff ratewas cut to 61 percent (40 percent excluding
“sensitive” countries). The number of tarifflines was cut by a third, and the number of sep-arate tariff “bands” or rates was cut from 200to 49.
While effective protection has fallen in theaggregate, it has not fallen as fast as the nom-inal tariff, and has even risen in some sectors.Approximately half of the manufacturing sec-tor exhibits effective protection rates equal topre-liberalization levels, limiting the effect oftariff liberalization on the anti-export bias.
Although South Africa’s trade ratio is stillmarginally lower than that of other nonoilmiddle-income countries, the South Africaneconomy is relatively open in internationalterms. The total trade (merchandise exportsplus imports) to GDP ratio in 1996 was 40 per-cent, compared with 46 percent for nonoilmiddle-income countries. In 2001 it stood at44 percent, almost doubling over the 1990s.
South African exports, and the net impactof trade on growth, have responded well to op-portunities posed by favorable internationalconditions. Historically, South African exportshave shown a high sensitivity to real exchangerates, world demand, and trade policy. Since lib-eralizing, South Africa’s exports of manufac-tures have risen both in absolute terms and asa share of gross output since the early 1990s, withgrowth more than doubling from an average an-nual real rate of 2.6 percent during 1990–94 pe-riod to 6.8 percent during 1994–98. To someextent this growth reflects the post-sanctions ef-fect of the return from international isolation.
Although import penetration is high forSouth Africa (accounting, for instance, for anegative 52 percent of the rise in total outputfor 1994–98), output growth due to exportshas kept pace with the losses due to import pen-etration. Net trade has accounted for 10 per-cent of the rise in total gross output between1993–97. In South Africa’s case there is noevidence of dramatic across-the-board declinesin domestic market share and no clear patternbetween the extent of tariff reduction (or ini-tial tariff level) and the subsequent change ineither output or employment. Liberalization hasnot been de-industrializing.
It would also appear that the net effects oftrade on overall employment levels has been
146 SOUTH AFRICA
marginally positive, with jobs created throughexports just outstripping job losses throughimport penetration.
Complementing trade liberalization, SouthAfrica has pursued the expansion of market ac-cess through preferential trade arrangementswith industrial countries and the pursuit of re-gional economic integration. The most im-portant of these are the Trade Development andCooperation Agreement with the EU, and therecent Southern African Development Com-munity (SADC) free trade agreement.
The SA–EU Agreement on Trade, Devel-opment, and Cooperation should improve mar-ket access for South African exporters to the EUand increase interregional trade and investmentflows. Import tariffs will also decline, reducingthe cost of imported inputs and consumer prices.Tariffs on 86 percent of South Africa’s industrialexports to the EU are to be fully liberalized onimplementation of the agreement. By year six,only 1 percent will be subject to customs duties.The EU’s offer on agricultural products is lessgenerous, and only 62 percent of South Africa’sagricultural exports are scheduled to enter theEU duty free by 2010. In turn, 89 percent ofindustrial imports from the EU will be liberalizedover a 12-year phase-in period, with 62 percentof the tariff lines reduced to zero on imple-mentation. Tariffs on 81 percent of agriculturalimports will be fully liberalized by 2012.
A trade protocol between 11 of the 14 mem-bers of the SADC came into force in January2000. The trade protocol will see 85 percent oftrade freed up over eight years and provides foran asymmetrical arrangement for South Africato open its markets more quickly than othercountries. At the same time, supply-side mea-sures were negotiated and implemented to en-sure that economic integration goes furtherthan the mere dismantling of tariff barriers—and to integrate productive structures with a viewto make them more competitive.
GLOBALIZATION AND POLICY COORDINATION
Trade reform holds the promise of significantadvantages. But it requires effective managementof structural adjustment, and must besufficiently coordinated with other policies. In
a narrow sense these policies include supply-sidemeasures to improve export performance. Morebroadly, trade liberalization—and greater open-ness to the processes of globalization require thecoordination of a range of growth-inducingeconomy wide policies, from promoting com-petition, including privatization, to having apackage of sound fiscal and monetary policies.
Effective management of structural ad-justment requires labor market flexibility, andthe appropriate skilling of workers to partici-pate in economic growth. And especially inSouth Africa, which faces a chronic unem-ployment problem, provision must be made toensure broad access for the poor to productiveresources—that is, capital and land, usuallythrough small and medium-sized enterprise(SME) development and land reform. Spend-ing on social services—including health and ed-ucation, and the provision of safety nets for themost vulnerable—underpins long-term humandevelopment.
To coordinate the government’s Growth,Employment, and Redistribution (GEAR)macroeconomic framework entails a package ofsupply-side measures to improve export per-formance. The most important are accelerateddepreciation allowances for new manufactur-ing investment and tax holidays for new ap-proved projects. The government’s MotorIndustry Development Program, an example ofsuccessful supply-side support, has been in-strumental in the strong rise in automotive ex-ports, which grew at an annual average rate of40.6 percent between 1996 and 1999.
In the more general sense, greater opennesshas been pursued as part of a broad package ofpolicies, set out in the GEAR strategy. In ad-dition to measures related to fiscal policy, pub-lic expenditure management, and monetaryand exchange rate policy, openness-inducingreforms have been accompanied by programsto restructure state-owned assets, supportedby improved competition policy. An expan-sionary infrastructure program has providedelectricity, water, telephones, and houses on alarge scale to the poor and previously disad-vantaged. There have also been skills devel-opment policies and considerable expenditureon health and education.
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Even so, the management of structural re-forms posed significant challenges to govern-ment. Although growth has improved, theeconomy has shed formal sector unskilled jobs,even as it created jobs in the informal sectorand through business services out-sourcing.In addition, demand for high-skilled labor hasaccelerated dramatically over the past sevenyears. Overall, therefore, while the compositionof total employment has changed, the level ofemployment has been relatively stable.
To the extent that trade liberalization re-sults in structural adjustment, short-term joblosses are inevitable. Ideally, trade liberalizationshould facilitate rapid structural adjustment sothat workers who lose jobs obtain new ones inrapidly expanding industries. Although a num-ber of sectors that experienced sharp reductionsin tariffs have also seen increased investmentand strong export growth, they do not tend tobe the same sectors that use less-skilled laborintensively. Furthermore, they remain smalland are unlikely to provide major contributionsto employment in the near future.
Evidence suggests that greater openness totrade has induced shifts in production to high-skill, capital-intensive sectors. Absolutely, andcompared with other emerging markets, SouthAfrica has a low share of exports that use un-skilled labor, and a relatively high share of ex-ports using more skilled labor. All the Asianeconomies (including a much wealthier Korea)have a higher proportion of unskilled labor-intensive exports. The largest export expansionhas occurred in relatively (human and physi-cal) capital-intensive subsectors.
Clearly, part of the challenge of SouthAfrican labor policy is to increase firm-level pro-ductivity, through policies that promote greaterskills development. South Africa’s policy re-sponse has included urgent attention to im-proving the skills base. The Skills DevelopmentLevy is the government’s flagship program toenhance productivity through skills develop-ment. This is a levy grant scheme for financ-ing education and training, paid by privatesector employers through a 1 percent (initially0.5 percent) levy on private sector remunera-tion. Employees are in turn entitled to draw onfunds of sectoral training authorities to re-
cover approved education and training ex-penses. The levy raised 1.3 billion rands in2000/01 and is expected to raise 2.8 billion in2001/02. Eighty percent of receipts go to thesectoral training authorities, and 20 percent goto a national skills fund to support specialtraining needs and training for the unem-ployed. The government is also required tospend 1 percent of its payroll on training. In-clusive of all other skills development pro-grames, it expects to allocate 15.5 billion randsto skills development between 2000/01 and2003/04. Such policies, however, can be ex-pected to operate at a lag.
A further factor contributing to decreasinglevels of unskilled employment is likely to bethe price of low-skilled labor relative to the costof capital, the latter having declined over the1990s due to tax reductions, greater depreci-ation allowances, and—most recently—lowerinterest rates. The worsening relative cost fac-ing labor has encouraged firms to substituteskilled labor and capital for unskilled labor.Higher labor productivity has resulted in unitlabor costs trending down with inflation.
The challenge facing South Africa is topromote productivity growth in ways that donot undermine the growth of lower wage,lower productivity jobs for unskilled, unem-ployed people, while at the same time ensur-ing that the growth of higher-skilled jobscontinues apace. In this respect, the governmentcontinues with consultations aimed at re-forming the labor market, investigating thefeasibility of reducing the cost of labor with-out reducing workers’ wages. Trade-supportingprograms (such as export processing zones,and duty drawback and rebate schemes) alsohave the potential to encourage more labor-intensive activities.
Policies to help the poor to gain access toproductive resources—capital and land—havean important role in providing incomes to themost vulnerable in the economy. South Africahas programs in place in SME development andland reform.
Support to SME development is providedthrough supply-side measures targeting enter-prise constraints. The mechanisms used forsmall business support involve institutional and
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regulatory reforms. Enterprise promotion agen-cies and wholesale financing companies havebeen established to act as intermediaries to ad-dress SME constraints, such as access to financeand information. Government itself administersprograms aimed at increasing SME manufac-turers’ competitiveness, such as co-financingthe acquisition of new technology. Regulatoryreforms include, the recent procurement re-form with an affirmative small, medium, andmicro enterprise participation programs.
SME development has not created jobson the scale envisaged by the government inits GEAR policy (approximately a third ofnew jobs by 2000). Studies suggest that onlythe few, more dynamic SMEs show potentialto contribute to rapid employment creation,while survivalist activities (as a result of “en-forced self-employment”) typify the vast ma-jority of South African SMEs. In partsupply-side measures are not sufficient on theirown to unleash the employment-creation po-tential of the SME sector. Research findingsconsistently show that SME development de-pends decisively on macroeconomic condi-tions, industrial and organizational structures,the adaptability of firms, and above all, the ca-pabilities and aspirations of entrepreneurs.The South African SME sector, far from ho-mogenous, would require a fine-tuned set ofinterventions rather than the generic assis-tance currently provided.
Some evidence suggests that South Africamay face inherent limitations to the growth ofthe SME sector. SMEs are likely to show a bet-ter performance under more favorable macro-economic conditions, and with effectivelydelivered supply-side measures. But research in-dicates that only a small segment of the entireSME economy has or will develop the capac-ity to create employment at socially desirablelevels. These are generally run by highly edu-cated and experienced entrepreneurs with skilledlabor. Given the country’s history of dualism anddiscrimination, strong SMEs and highly skilledlabor are unlikely to emerge in substantial num-bers from formerly disadvantaged segments ofthe population, in the near future.
South Africa has also embarked on an am-bitious constitutionally driven Land Reform
Program, consisting of Redistribution, Resti-tution, and Tenure Reform Programs. In thefive years that the program has been in oper-ation, almost 29,000 households have received745,000 hectares of land in both redistributionand restitution programs. Many millions morehave benefited from protection that affordsthem tenure security.
The redistribution program helps poorand marginalized communities and individu-als get access to land to live on and to farm. Thegovernment provides a grant of 16,000 randsper family for the purchase of land and services.Grants are also provided to help communitiesplan how they are going to use the land andto buy the resources they need to ensure viableand sustainable income-generation enterpriseson the land they have bought. The RestitutionProgram is aimed at restoring land rights andfinancial compensation to people who wereforcibly removed, after 1913, through apartheidand other racially based legislation. So far,however, only 241 of more than 63,000 claimshave been settled, these 241 claims involvedmore than 83,000 beneficiaries. The Tenure Re-form Program, to provide land ownership tothose (mostly black) people with informalrights on the land on which they live, is beingrolled out through a number of consultativeprocesses and legislation.
South Africa’s health, education, and welfarepolicies underpin the economy’s prospects forpoverty eradication and long-term growth. Thesocial grant system has been the major, andmost direct, component of government instru-ments to ameliorate poverty. South Africa hasnine social security grants, with a total uptakeof 4.3 million people a month (more than 10percent of the population). These include an oldage grant (a maximum of 570 rands a month,with an uptake of 1.8 million people in July2001), a child support grant (a maximum of 110rands a month; with an uptake of 1.5 millionpeople), and a disability grant (a maximum of570 rands a month, with an uptake of 634,000people). Total expenditure on these grants in2000/01 stood at about 19 billion rands. Esti-mates suggest that South Africa’s social securitygrants have a significant impact, reducing theaverage poverty gap by approximately 23 percent.
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South Africa also has an unemployment in-surance fund that provides a payment of 45 per-cent of wages for up to six months for workersunemployed from the formal sector, as well ascompensation funds and road accident funds.The expenditure of these funds stood at justunder 8 billion rands in 2000/01. Most re-cently, the government has introduced freebasic services for the poorest South Africanhouseholds, including free electricity and water.South Africa also has a public health system,with nominal charges, and a public educationsystem that does not require the payment ofschool fees from the poorest families. TheSouth African government spent more than 32percent of its consolidated budget (or 80 bil-lion rands) on health and education servicesalone in 2000/01. Analysis of the fiscal inci-dence of social expenditure clearly shows thatsince 1994 there has been a large and signifi-cant shift in social spending away from themore affluent to the formerly disadvantagedmembers of the population. And most socialspending is fairly well targeted to reach thosemost in need of it.
* * *The overriding objective of South African eco-nomic and social policy is to address povertyand inequality—through a series of integratedpolicies but primarily through economicgrowth. Like many small emerging countries,South Africa has made a strong commitmentto achieving its goals through greater integra-tion with the global economy. In the shortterm, however, greater integration into the in-ternational economy does not remove thestructural challenges and constraints that SouthAfrican economic policymakers have to ad-dress in meeting these goals—low savings,high real interest rates, a legacy of inward-looking industrial policies, a low skills and ed-ucation base, labor market dynamics in partdetermined by the need to lessen the apartheid-wage gap, and extremely severe, racially definedincome inequality.
To some extent, however, greater integra-tion changes the context for addressing theseimpediments to growth. In some cases it of-fers important opportunities. For a country
with low savings, access to capital markets of-fers the promise of growth driven by interna-tional savings. Greater integration also easesthe current account constraint on growth.Greater openness (supported by appropriatepolicies) can be expected, in the medium tolong term, to remove the legacy of inward-looking industrial policies. South Africa’s tradeperformance has been strong, with exportsresponding particularly well to positive inter-national conditions.
Exposure to the international economyalso tends to exacerbate the effects of structuralweaknesses, especially those that cannot beaddressed in the short term. South Africa’s ex-perience with high real interest rates, for in-stance, and the shedding of unskilled laborexemplify this downside. Both have had neg-ative impacts on growth and poverty. But itwould not be correct to attribute these out-comes to “globalization”. Ultimately, it is notglobalization that determines whether a coun-try achieves its economic goals. It is the evo-lution of that economy—given its advantagesand weaknesses—in the context of greateropenness.
NOTES
1. Comparisons of relative stability (asmeasured by the coefficient of variation) revealthat portfolio flows have actually been lessvolatile than loans or trade credit. The scale ofportfolio inflows during this period, however,has averaged more than 10 times that of loansand trade credit (peaking at 10 percent ofGDP in 1999).
2. When the value of the contingent lia-bility in fact derives from the divergence be-tween actual and contracted future rates.
3. For example, in the first four months of1998, investment in the bond marketamounted to 2.3 percent of annual GDP; inthe following four months, a net outflow of 2.6percent took place. An even sharper reversal oc-curred in October 1997, when the crash of theHong Kong stock market led to an outflow rep-resenting 0.7 percent of annual GDP in thatmonth. On the positive side, the London list-ing of Old Mutual in July 1999 led to net
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nonresident investment in equities amountingto a 1.2 percent of GDP in that month aloneequivalent to an annualized rate of 14.4 per-cent of GDP.
4. These were well in excess of those of fastgrowing emerging economies, such as Chile,Malaysia, and the Republic of Korea.
TURKEY 151
This study provides a detailed overview of theeconomic reforms in Turkey since 1980 and anaccount of whether the reforms attained theirobjectives. As for most developing countries inthe late 1970s, Turkey also realized the weak-nesses of an import-substitution strategy andmoved to a more outward-oriented economicdevelopment strategy. Especially in the 1980s,there was an accelerated reform and adjustmentprocess in almost all sectors of the economicsystem. It started with the liberalization of theforeign trade regime and the financial sector.And it culminated with the liberalization ofcapital accounts in late 1989, radically chang-ing the policymaking environment.
TRADE LIBERALIZATION
As for many developing economies in the1960s and 1970s, Turkey’s main economicdevelopment strategy was centered on import-substitution policies. It was a period charac-terized by immense public investmentprograms, aimed at expanding the domesticproduction capacity in heavy manufacturingand capital goods. Foreign trade was underheavy protection, with quantitative restric-tions and a fixed exchange rate regime that, onaverage, was overvalued, given purchasingpower parity.
The strategy involved heavy dependence onimported raw materials, and Turkey’s termsof trade deteriorated after the first oil shock in1973–74. This deterioration put a huge bur-den on the balance of payments, compensatedby short-term borrowing. From 1977 onwards,with shortfalls in imports and problems in thelabor market, difficulties emerged on the sup-ply side. With an expansionary fiscal policymaintained on the demand side, imbalances in
aggregate supply and demand accelerated thealready increasing inflation. Measures to over-come the crisis were inadequate, and second oilshock in 1979 deepened the crisis. Turkey’strade liberalization was initiated to resolve the1977–79 balance of payments crisis in an en-vironment of low domestic savings and slug-gish investment.
On January 24, 1980 decisions were an-nounced to curb inflation, fill the foreign fi-nancing gap, and attain a more outward-orientedand market-based economic system. Withinthe framework of these decisions, export subsi-dies were granted, and exchange rates were al-lowed to depreciate in real terms to make Turkishexports more competitive—and promote export-led growth.
The new economic program included ex-port subsidies, a large devaluation, and priceincreases for goods and services produced bystate economic enterprises. The “big push” inthe exchange rate, interest rates, and adminis-trated public product prices was coupled withheterodox export incentive schemes, quicklyimplemented. These moves helped regain theconfidence of international creditors. TheWorld Bank adjustment and InternationalMonetary Fund (IMF) Stand-by loans werearranged rapidly, disbursed in conjunctionwith additional debt relief operations.
Three characteristics of the policy envi-ronment facilitated the trade reform. First,net foreign lending allowed the resumption ofintermediate good imports and eased pres-sure on public finance. Because of the lowrates of capacity utilization (around 45–50percent), industrial firms showed a strong ex-port response to the rapidly altered incentivestructure. Second, the exchange rate depreci-ation was high but sustainable. Third, domestic
Turkey
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absorption was significantly lowered in thefirst half of the 1980s to provide room for theinitial push in export expansion. In this period,real wages and agricultural incomes were de-creased substantially.
EXPANSION OF EXPORT INCENTIVES AND
SUBSIDIES
In the 1970s export incentive schemes—suchas tax rebates, concessional credits, and forexallocations—were already in operation. Butwithout a realistic exchange rate and support-ive macroeconomic policies, their impact waslimited. The composition of exports shifted infavor of manufacturing, while agriculture main-tained its dominance, with an average share ofmore than 60 percent.
The 1980 adjustment policy package ex-panded and consolidated the export incentiveschemes, improved administrative efficiency,and promoted foreign trade companies. Thepost-1980 export incentive schemes can begrouped in five categories:• Exchange rate kept on a depreciating path.
The government’s policy to support ex-porters was a real depreciation, whichamounted to a PPP-plus rule until 1988.After 1988 the Central Bank slowed therate of depreciation (Rodrik 1991).
• Direct payments to exporters. The initial costsof exporters were covered by the govern-ment’s budget and extra-budgetary funds,with direct payments through tax rebatesand cash premia. During 1980–84 tax re-bates dominated direct payments, with sub-sidies reaching 17 percent of the value ofmanufactured exports in 1984. But pressureon the government budget caused a shift inemphasis from export subsidies to a moreactive exchange rate policy. Also after 1984,cash premia from extra-budgetary fundsbecame significant due to the approval ofGATT code and the phasing out of tax re-bates. Import liberalization would also stim-ulate exports. So direct subsidies for exportswere gradually cut, falling to 4.4 percent in1990 and abolished thereafter.
• Preferential and subsidized export credits.The Export Promotion Fund, the Central
Bank, the Turkish Development Bank,and the Turkey Eximbank provided sub-sidized export credits. Rediscount rates forexporters were kept below the commer-cial interest rates. At the beginning of the1980s, Central Bank resources were usedeffectively to promote exports, but after1984 its credits fell to very low levels. Inline with this development, the share of thecommercial bank loans in export credits in-creased, and commercial banks becamethe dominant lender in the export creditmarket.
• Tax exemptions for imported inputs. Im-ported goods, used as input in the pro-duction of export goods, were exempt fromimport taxes. So, tax exemptions increasedgradually, with the export sector growing.
• Corporate tax allowances. Although there isno precise figure for corporate tax al-lowances, it is estimated that tax allowancesincreased as export volume increased.As a result, export subsidies increased as a
percentage of the value of total manufacturedexports between 1980 and 1984 and then de-creased gradually as the export sector becamemore self-sufficient1. The tax rebates werehighest for skill-intensive investment goods, andbelow average for labor- and resource-intensiveconsumer goods in manufacturing. But, theshare of consumer goods was the highest in di-rect payments, because that product group(including textile and food processing) madeup the largest part of manufactured exports.
IMPORT LIBERALIZATION AND STRUCTURE OF
PROTECTION
By the end of the 1970s import commoditieswere classified in three lists: Quota List (importssubject to quantitative limits), Liberalized List1 (including all goods that could be freely im-ported), and Liberalized List 2 (including allitems whose importation required a license).Imports of goods that did not appear in any ofthe three lists were prohibited. According tothe pre-1980 import regime, importers wererequired to place an advance deposit guaranteewith the Central Bank for import activities. In1979 the deposit requirement rates were set at
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20 percent on the value of imports for indus-trial uses and 40 percent for commercial pur-poses. Moreover, tariffs and nontariff charges—municipal tax, stamp duty, wharf charge,and production tax—were also imposed on im-ports (Tiktik 1997).
In the 1970s the composition of importschanged because of the import-substitutionstrategy. With the domestic production of in-vestment goods, their share in the import billcame down from 47 percent in 1970 to 20 per-cent in 1980. But the two oil shocks in the1970s contributed to the increase in the shareof intermediate goods in total imports, from48 percent to 78 percent.
In 1980 the stamp duty on imports was re-duced from 25 percent to 1 percent, and im-port regulations were simplified. In 1981 theQuota List was abolished, and many itemswere transferred from Liberalized List 2 to theless restrictive Liberalized List 1.
The January 1984 reform of the importregime was a major break with the past. Twoprincipal lists were abolished, and three newlists introduced: Prohibited List, List of Im-ports Subject to License, and Fund List (cov-ering luxury goods.) Under the new regime,all commodities not explicitly prohibitedcould be imported. The reductions in quan-titative restrictions were accompanied by cuts in the rates of customs duties. The goodson the Fund List were subject to a dollar-denominated surcharge, in addition to thetrade taxes. The levy proceeds were chan-neled to extra-budgetary funds, to serve twopurposes: financing social projects, such asmass housing, and providing temporary pro-tection to domestic industries.
In 1985 the Prohibited List was phased out,with banned commodities reduced from 500items to 3—weapons, ammunition, and nar-cotics. In 1988, 33 different items were sub-ject to import licenses. In July 1989 thegovernment introduced an “anti-dumping law”to protect domestic production from unfaircompetition. In 1989 import liberalizationgained further momentum. The number ofgoods subject to licenses was reduced from 33to 16, with tariffs and levies on imports reducedsubstantially.
The import regime changed again in 1990.Import guarantee deposits and licensing werephased out entirely. The List of InvestmentGoods was created. And custom duties andMass Housing Fund (MHF) levies were con-solidated in a single list. After the minor tar-iff adjustments in 1991 and 1992, a new setof measures was introduced in January 1993.All tariffs and tariff-equivalent charges otherthan customs duty and MHF charges wereeliminated in line with commitments to the Eu-ropean Union (EU), and the remaining re-ductions in tariffs and MHF were completedby the beginning of 19962.
So Turkey managed in the 1980s both toremove quantity rationing and to reduce im-port tariff levels. The World Bank classified itas an intensive adjuster in 1991.
CUSTOMS UNION WITH THE EU
Turkey established a Customs Union with theEU in January 1, 1996. It agreed to eliminateall the duties and MHF charges imposed onEU and European Free Trade Agreement(EFTA) products, eliminate all the quantita-tive restrictions, and impose common cus-toms duties for the third countries. Theweighted protection rate on EU and EFTAproducts fell from 5.9 percent to zero. And theimport protection rate imposed on third coun-tries’ products came down from 10.8 percentto 6 percent. But import duties on some goods(cars, trucks, leather, shoes, ceramics) were de-ceased gradually. Turkey lowered import du-ties on these goods by 10 percent in 1997, by10 percent in 1998 by 15 percent in 1999and 2000 and by 50 percent in 2001. On Jan-uary 1, 2001, import duties on goods fromthird countries fell to the common customsduty level imposed by the EU.
FINANCIAL TRADE LIBERALIZATION
Since the 1980s individual domestic marketshave taken steps to strengthen connectionswith each other and integrate with the inter-national financial system. All major industri-alized countries liberalized their domesticfinancial markets. Most developing countries
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followed, Turkey among them. It launched aseries of economic, legal and institutional re-forms at the beginning of 1980s.
TRANSFORMATION OF THE EXCHANGE RATE
REGIME
The first step to more market-oriented policieswas the change of the exchange rate regime. Be-fore the 1980s the exchange rate was fixedwith the value of the Turkish lira determinedand adjusted according to the changing eco-nomic conditions. But lags in adjustment oc-casionally resulted in significant overvaluations.So a more realistic and flexible exchange ratepolicy was initiated with the stabilization pro-gram in January 1980. The Turkish lira waslargely devalued against other currencies, anda uniform rate was established (also eliminat-ing the black market). From May 1981 onward,the Central Bank adjusted exchange rates daily.
At the end of 1982, commercial bankswere permitted to hold foreign exchange po-sitions—mainly to facilitate foreign exchangetransfers from abroad and from parallel mar-kets (and to prevent capital flight). The rateregime was broadly liberalized on July 7, 1984with Decree 30: • Restrictions on importing Turkish lira
banknotes, coins, and other means of pay-ments were removed, though exportingTurkish lira items was subject to the gov-ernment’s permission.
• Residents were permitted to hold foreigncurrency and foreign exchange deposits,and to make payments via foreign exchange.
• The Central Bank was authorized to im-port and export gold bullion. Banks werealso authorized to sell gold bullion in thedomestic market.
• Banks were allowed to accept foreign cur-rency deposits from residents, to keep for-eign currency abroad, and to engage inforeign exchange transactions.
• Importing and exporting all kinds of se-curities were allowed. The sale of securitiesto nonresidents, denominated in foreigncurrency and issued in Turkey, was allowed.
• Nonresidents were allowed to purchasereal estate and real rights in Turkey, by
converting foreign exchange and transfer-ring all proceeds through a bank.
• Nonresidents were allowed to invest, engagein commercial activities, purchase shares,engage in partnerships, and open branchoffices, representative offices, and agenciesby bringing the required capital in foreignexchange.
• Banks gained freedom to fix their own ex-change rates within a narrow band aroundthe exchange rate declared by the CentralBank.
• So banks were allowed to freely fix their ex-change rates for commercial, noncommer-cial, and interbank transactions by June 29,1985.
DEREGULATION OF INTEREST RATES
Throughout the 1970s the government con-trolled deposit and lending interest rates. Butreal interest rates became negative due to rapidincrease in inflation toward the end of thedecade. In January 1980 ceilings on deposit andlending interest rates were abolished, since fi-nancial funds were rapidly withdrawn from thebanking system and channeled into parallel fi-nancial markets and foreign exchange. Theinterest rate deregulation aimed to attract sav-ings into the financial system and encouragecompetition among financial institutions inorder to deepen the financial sector. But majorcommercial banks set interest rates collectivelythrough “gentlemen’s agreements” to preventfurther increases in interest rates.
Self-imposed ceilings on deposit interestrates gradually increased due to the excessivedemand for credits as well as competitive pres-sures from the brokerage houses and smallbanks. Many brokerage houses and small banksthat could not make their committed pay-ments failed in the middle of 1982.
Their failure led the government to makenew regulations by taking into account the fu-ture trend of interest rates. It authorized the ninelargest banks to set interest rates and allowedthe smaller banks to pay a premium. But largebanks were also willing to raise deposit inter-est rates. In December 1983 the Central Bankwas reauthorized to determine deposit interest
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rates and review them regularly. In June 1987banks were given freedom to determine theirdeposit interest rates to some extent with acommuniqué from the Central Bank. In Oc-tober 1988 all kinds of deposit interest rates werefreed.
CAPITAL MARKETS LAW AND THE ESTABLISHMENT
OF THE CAPITAL MARKETS BOARD
The Capital Markets Law, enacted in 1981, wasan important step in promoting the securitiesmarkets. It mainly aimed to regulate, promote,and supervise the capital markets and to pro-tect the rights and benefits of investors throughthe secure, transparent, and stable functioningof the capital markets.
In 1982 the Capital Markets Board, sub-ject to the provisions of the Capital MarketsLaw, was founded as a regulatory and super-visory authority for the conditions and func-tioning of capital markets. Since then thebanks and other financial institutions havebeen subject to the law’s provisions and to theboard’s supervision for their capital market in-termediary activities.
GOVERNMENT SECURITIES AUCTIONS IN 1985
Before the 1980s, fiscal deficits were frequentlyfinanced by direct monetization through theCentral Bank Until 1985 governments pre-ferred not to issue securities to finance fiscaldeficits, and the Treasury tended to use theshort-term advance facility granted by theCentral Bank. Monetary policy was thus mostlydependent on fiscal policy. In May 1985 thegovernment began to issue treasury bills andbonds to finance the budget deficit. The neg-ative impact of fiscal deficits on the CentralBank balance sheet was reduced to some extentby treasury auctions.
The government securities auctions pro-vided the pre-conditions for open market op-erations at the Central Bank and for asecondary bills and bonds market at the Is-tanbul Stock Exchange. The government se-curities auctions provided an attractivealternative investment area for financial andnonfinancial institutions since interest rates of
these instruments were determined undermarket conditions and had zero-credit risk.Moreover, yields of these auctions has been ac-cepted as major rates for the economy sincethey were determined by competitive biddingand the volume of auctions was high.
After the financial crisis in 1994, the short-term advance facility of the Central Bank to theTreasury was limited by 12 percent of the ex-cess of the current year’s total general budget ap-propriations over the previous fiscal year’s totalgeneral budget appropriations. This ratio wasgradually lowered to 10 percent in 1996, 6percent in 1997, and 3 percent for subsequentyears. With the new Central Bank Law of 2001the short-term advance facility was forbidden.
MARKET OPENING REFORMS AT THE
CENTRAL BANK
At the beginning of 1986 the Istanbul StockExchange began to operate as a secondary mar-ket platform for government securities. In thesame year, the implementation of monetarypolicy was modified. Under the new monetarypolicy regime, the Central Bank mainly aimedto control money supply by controlling totalreserves of the banking system. With the re-discount facility limited to medium-term cred-its, the reserve needs of the deposit moneybanks could be met only to the extent suppliedby the Central Bank. The limitations imposedby the Central Bank on automatic acquisitionof reserves by individual banks through the re-discount facility required a market-orienteddistribution system to mobilize the excess liq-uidity in the banking system.
The interbank money market. On April 2,1986, banks were required to keep collateralat the Central Bank to be able to do transac-tions in Interbank Money Market. The Inter-bank Money Market has provided efficientfunctioning of the banking sector and devel-oped an understanding of cash management.
Open market operations. In February 1987,the Central Bank commenced open market op-erations as a main tool for implementing mon-etary policy. The operations aimed to adjust theliquidity of the banking system and thus con-trol the money supply.
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Foreign exchange and banknotes markets. InAugust 1988, foreign exchange and banknotesmarkets were established at the Central Bank,with daily fixing sessions. The markets are ac-cepted as another monetary policy instrumentfor using foreign exchange reserves more ef-fectively. The Central Bank announced onJanuary 2, 2002, that it would end its inter-mediary functions in Interbank Money Mar-ket and Foreign Exchange and BanknotesMarkets by December 2, 2002.
CAPITAL ACCOUNT LIBERALIZATION
Capital account liberalization was initiatedwith the economic and financial reforms thatstarted in 1980 and were fully completed in1989. Before 1980 capital flows were con-trolled through foreign exchange controls.After 1980 capital account liberalization wasstarted with the Decrees No. 28 and 30, putin force in December 1983 and July 1984.These decrees partly liberalized the capitalaccounts, and full capital account liberaliza-tion was accomplished in 1989. Decree No.32 was issued in the Official Gazette on Au-gust 11, 1989. With this decree and amend-ments to it, capital movements were fullyliberalized, and the major steps for convert-ibility were taken. The main points of DecreeNo. 32: • Residents can buy foreign exchange with-
out any limitation from the banks or spe-cial finance institutions, and they are notsubject to any restrictions for keeping for-eign exchange.
• Foreign exchange can be brought into thecountry for all services rendered by residentsfor nonresidents.
• Nonresidents can buy and sell all the se-curities listed on the Stock Exchange andthe securities issued by permission of theCapital Markets Board.
• Nonresidents can buy and sell, throughbanks and special finance institutions, thesecurities quoted on the foreign stock ex-change and treasury and government bondsdenominated in the currencies bought andsold by the Central Bank—and transfertheir purchase value abroad.
• Residents are free to issue, introduce, andsell securities abroad—to bring securitiesto Turkey and take them out.
• The proceeds of sales and liquidation of for-eign capital may be transferred freely outof the country by the banks and special fi-nance institutions.
• Obtaining foreign credits is liberalized.• Nonresidents are allowed to open Turkish
lira accounts and to transfer principal andinterests accruing to these accounts inTurkish lira or foreign exchange.
• Blockages on real estate were removed, andthe transfer of income and sales value wasliberalized.
• Nonresidents are allowed to buy and trans-fer foreign exchange and send Turkish liraabroad without limit.
• The banks and private financial institu-tions are obliged to give information aboutthe transfers exceeding $500,000 or itsequivalent of foreign exchange, except im-port, export, and invisible transfers.
• Turkish residents are free to establish liai-son offices and representations abroad.
REFORMS AND REGULATIONS CONCERNING
THE BANKING SECTOR
The banking has traditionally played a promi-nent role in the financial system. As a reflec-tion of the liberalization policy of 1980s, aseries of institutional and legal reforms tookplace for the banking sector. The main purposewas to strengthen the soundness and effec-tiveness of the financial system—by encour-aging competition among banks.
Although competition and insurance are ac-cepted as opposite concepts, the Savings De-posit Insurance Fund was necessarily institutedat the Central Bank by means of an amendmentto the Banks Act in 1983. The main aim be-hind the fund was to re-establish public con-fidence, which deteriorated because of therepeated failures in the banking system, and toprotect depositors against the negative effectsof the banking crisis. Initially, a nominal upperlimit was approved in order to implement foreach savings account. Banks were required toparticipate in the fund.
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Since the 1980s two Bank Acts have beenratified and implemented. The first one was theBanks Act enacted on May 2, 1985, consistingmostly of subjects related to the structural prob-lems of the banking system. It aimed to pro-vide a legal basis for prudential regulation andsupervision. Within the framework of that act,banks were required to have a standard ac-counting system, and the Sworn Bank Auditorwas authorized to monitor legal performanceand financial structure of the banks. Bankswere also required to be audited by independentexternal auditors every year in accord with theglobally accepted principals of accounting. Thegovernment was authorized to change the man-agement of risky banks, and giving credit to asingle customer was restricted.
The Council of Ministers was authorizedto specify the main rules in provisioning fornonperforming loans with an amendment ofthe previous Banks Act in 1983. Then, a de-cree issued on December 11, 1985, requiredbanks to keep specific loan loss provisions fortheir unpaid loans as well as general provi-sions for their whole portfolios.
In January 1987 banks were required topresent to the Central Bank their financial re-ports, which were also audited by the inde-pendent external auditors.
In October 1989 banks were required toadopt capital adequacy ratios in line with theBank for International Settlements guidelinesto ensure that they keep enough capital for therisk of their assets. The application of the cap-ital adequacy ratio has facilitated comparisonswith banks abroad.
After the stabilization program of April 5,1994, the already established Savings DepositsInsurance Fund (SDIF) was reorganized to pre-vent turbulence in the banking sector. The gov-ernment announced a full guarantee to all savingsdeposits. The Central Bank law was amended,and the short-term advance facility to the Trea-sury was limited to increase public confidence.
The second Banks Act, enacted on June 18,1999, broadened measures to strengthen thefinancial structures of banks and the supervi-sion mechanism. Accordingly, weak banks thatcould not be rehabilitated were required to betransferred to the SDIF. The act also aimed to
ensure accordance with international stan-dards and the EU implementations in super-vision mechanisms. The Banking Regulationand Supervision Agency (BRSA) was estab-lished as an organizationally and financially au-tonomous body to enhance the efficiency,competitiveness, and soundness of the bank-ing sector; to maintain public confidence; andto minimize the potential risks to the economycoming from the banking sector. The Banks Actof 1999 made the conditions for establishingand operating banks more demanding. Bankswere also required to establish internal controland risk management systems.
Problems stemming from the fragility of thebanking sector continue. One of the main rea-sons is the weakness of the financial structureof the public banks. Although only 7 of 80banks were owned by the state, their share inbanking assets was 34 percent in 2000. Andtheir financial structures have deterioratedsince they finance public expenditures. Due tothe accumulated “duty-losses” of these banks,their short-term liquidity requirement hasrisen. The sharp increases in interest rates dur-ing financial crisis have also contributed tothis. Since the state-owned banks have usuallyoffered higher interest rates to minimize thecosts of huge losses, the competition in thebanking sector has been distorted.
RECENT MACROECONOMIC DEVELOPMENTS
AND REFORMS
Turkish authorities launched a comprehen-sive disinflation program in 1998, known as theStaff Monitored Program, with the aim of re-ducing inflation and improving the fiscal per-formance of the country. But politicaluncertainties and the earthquakes in Augustand November 1999 impeded the program, asdid the Asian and the Russian crises.
The government announced a new com-prehensive program with the guidance of theIMF at the end of 1999. The program aimedto decrease inflation to single digits by the endof 2002, to reduce the real interest rates, andthus to provide a stable macroeconomic envi-ronment that would improve the long-termgrowth potential. It was basically an exchange
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rate based stabilization program, which an-nounced the value of the exchange rate basketfor the first one and a half years. Afterwards theexchange rate was to fluctuate within a grad-ually widening band. The program also setlimits on some fiscal and monetary aggregates,and introduced important structural measuresin agriculture, social security, fiscal manage-ment, and privatization to help to achieve thefiscal targets. This went hand-in-hand withan appropriate incomes policy.
With the program, interest rates camedown sharply, a result of the removal of ex-change rate uncertainty and the decline in therisk premium. Good progress was then at-tained in curbing inflation, which broughtdown interest expenditure gave relief in thebudget3. But, the inertia in inflation led to areal appreciation of the foreign exchange rate.That real appreciation—together with the re-covery of domestic demand, the increase in in-ternational oil prices, and the weakening of theeuro—hurt the current account with a deficitgreatly exceeding the levels projected at the be-ginning of the program.
The worsening of the current accountdeficit—coupled with the delays in privatiza-tion efforts and structural reforms during thesecond half of the year—blunted capital flowsand led to higher short-term interest rates inAugust 2000. Although the regulatory frame-work existed in principle with the newly formedBRSA, the key supervision and restructuringmeasures were delayed due to delays in ap-pointments to the BRSA board and otherstaffing problems. Besides, the reluctance of thegovernment to take additional measures in theface of a worsening current account deficit ledthe IMF to postpone the release of the thirdtranche of the loan in October.
The expectations of international investorsquickly turned negative. The rise in interestrates hurt the financial structures of banks thathad a high share of government securities intheir portfolios and that financed those secu-rities with rather short maturity resources. Thedeterioration in banks’ balance sheets shat-tered confidence in the financial markets aboutthe sustainability of the program in Novem-ber. And foreign investors began to reduce
their portfolios4. The rapid exit of capital cre-ated serious liquidity problems for banks,highly dependent on foreign funds.
The outflow, estimated at more than $5.2billion, sapped the Central Bank’s foreign ex-change reserves. So interest rates were hiked,hurting the banks that had large governmentpaper portfolios and funded them from theovernight markets. With the hike in short-term interest rates, the prices of both public se-curities and stock prices went down. TheCentral Bank provided liquidity to the marketsby breaching net domestic asset corridors lim-its on November 22. An enhanced policy pack-age put into effect in December 2000 and theIMF’s support in a Supplementary ReserveFacility helped restore the confidence in the pro-gram. So the fluctuations in the markets werepartially removed. Interest rates declined sig-nificantly, but were still higher than before thecrisis. Imports slowed down, and inflationcontinued to decline, if still higher than the rateof depreciation.
Although capital inflows revived, the No-vember crisis increased the vulnerability of thebanking system. The maturity of both do-mestic and foreign funds shortened after theNovember crisis and interest rates, still high,fueled suspicions about the sustainability of theforeign exchange regime. Since there still ap-peared to be serious problems in the funda-mentals of the economy, the stability did notlast long.
A political dispute in the coalition gov-ernment eroded market confidence totally,causing an immense attack on foreign ex-change on February 19, amounting to $7.6billion. The Central Bank tried to defendthe foreign exchange rate with a squeeze in liq-uidity, followed by another hike in short-term interest rates. That hike did not hinderthe capital outflows5. But the liquidity needsof public banks locked up the whole pay-ments system. The unsustainability of theforeign exchange regime became rapidly ap-parent, and the crawling peg regime, the basicpillar of the 1999 disinflation program, wasabandoned on February 22. The dollar ratemoved from 680,000 Turkish liras to 960,000the next day.
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In the aftermath of the financial crisis, anew agreement was made with the IMF inMay 2001. And a new program, “Turkey’sProgram for Transition to a Strong Economy”was announced, more decisive about the struc-tural reforms, the program’s overall strategycan be summarized in three steps: reduce un-certainty in the financial markets, stabilize themoney and the foreign exchange markets, andestablish macroeconomic balances.
One aim of the program was to ensure thelong-term sustainability of fiscal adjustment andto improve the efficiency of the public sectorgovernance. In this regard, the regulations tostrengthen budget discipline and to enhancethe revenue resources have been put in place.To combat tax evasion and distribute the taxburden evenly, the tax regulations extend theuse of tax identification numbers. Precautionswere taken to expand the coverage of the bud-get and improve fiscal control. And the bud-getary, extra-budgetary and revolving fundswere closed. A new Law on Public Financeand the Debt Management was submitted toparliament.
Income policy in line with targeted infla-tion rates was one of the basics of the program.The dialogue with business circles and em-ployee representatives was enhanced to attainmoderate wage and price increases. The Eco-nomic and Social Council Law, which bringstogether employers and employees of the pub-lic and private sectors and other civil societyorganizations, had already been enacted in2000. It aims to develop consensus and col-laboration among social groups in formulatingeconomic and social policies.
Although some important measures weretaken for the banking sector, such as theBRSA, its fragility deepened during the No-vember 2000 and February 2001 crises. Thatis why the new program gave top priority tobanking reform. The overnight positions ofthe state and SDIF banks were reduced to easetheir pressure on the interest rates. The gov-ernance structure of the state-owned bankswas reformed to minimize the political in-fluence on the banking sector. The “dutylosses” of state banks were eliminated. A planto resolve the banks taken over by SDIF was
implemented, and amendments to BankingLaw were approved by the Parliament.
SOME IMPORTANT REGULATORY AND
INSTITUTIONAL REFORMS
The early reforms of 1980s were importantsteps to develop a market economy in Turkey.But they have not prevented macroeconomicinstability and chronic inflation. As time passed,it became more evident that the reform ef-forts should be much more comprehensive. Therecent crises revealed that the current situationwould only worsen without more stringentreforms, especially in the public sector andthe banking sector. The EU accession process,which helps to shape reform agenda and pro-vides a benchmark, also plays an important rolefor Turkey’s reform efforts.
FINANCIAL SECTOR REFORMS
Banking Regulation and Supervision Agency.Although important steps were taken in theliberalization of the financial system in the af-termath of 1980s, some severe problems stillexisted in the banking sector. To contribute tothe efficiency, competitiveness and soundnessof the banking sector, the BRSA was estab-lished with the Banks Act of 1999. The maingoals were: to safeguard the rights and bene-fits of depositors and create the proper envi-ronment, thus contributing directly to theachievement of long-run economic growth ofthe country; to enhance banking sector effi-ciency and competitiveness; to maintain con-fidence in the banking sector; to minimize thepotential risks to the economy from the bank-ing sector; and to enhance the soundness ofthe banking sector.
Transition to an independent central bank.The changes under the new law enacted inApril 2001 emphasized that the primary ob-jective of the Central Bank was to achieve andmaintain price stability. It was prohibitedfrom granting advancing and extending creditto the Treasury and public institutions. Itwas also prohibited from purchasing debt in-struments issued by the Treasury and publicinstitutions in the primary market. The duty
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periods of vice governors were extended fromthree years to five. According to the CentralBank Law of 1970, governors could not be ex-cused from office before the end of their dutyperiods. With the new law, this statementwas extended to vice governors, in accordwith 14 in European Central Banks SystemStatus. Transparency and accountability werealso enhanced.
PUBLIC SECTOR REFORMS
The main aim of the public sector reformswas to ensure transparency and accountabilityin resource allocation in the public sector.
Transparency. In Turkey, the 1980s and1990s witnessed the violation of the principleof the budget unity through extra-budgetaryfunds and duty losses. The flexibility of thebudget was lost, and the preparation and theapplication of the budget became inefficient.With the break in resources and expenditures,the budget system has become inadequate inproviding information to decisionmakers. Inthe 1990s urgent precautions were required toincrease the transparency in public accountsand to increase the efficiency of the budgetprocess. So fiscal adjustment measures beganto be implemented in 2000. With the new pro-gram, important progress has been made ineliminating obstacles and delays in the man-agement of public expenditures—and provid-ing budgetary discipline.
Strengthening public finance and adminis-tration. Turkish authorities were aware of theurgency of the effective regulatory manage-ment system and took important steps in orderto reform the public administration. Theattempts have aimed to build an effective, ac-countable, and merit-based public adminis-tration. The first requirement for this was tobuild a system with the recruitment of civil ser-vants based on the merit of the worker. Thisrequired changes to recruitment. The old sys-tem was dependent on exams, held by the re-cruiting agency and based on flexible criteria.Open to abuse, this sometimes lead to fa-voritism. To prevent this a new examinationsystem was adopted. And a scheme was intro-duced to fight corruption in the public sector.
Structural measures included rationaliz-ing public expenditures and revenues. Reformsinclude strengthening public finances and im-proving operational performance.
Reforms in agriculture. The share of popu-lation in agriculture is still extensive, and in-come inequality is high. So supporting thesector is inevitable.
Earlier support schemes distorted marketsignals, benefiting rich farmers more than poorones. Reform programs instituted in 2000aimed at phasing out support policies and re-placing them with a direct income supportsystem targeting poor farmers directly. In ac-cord with the new program, Direct IncomeSupport to the Farmers was introduced.
Social security. Turkey’s pension schemehas had serious problems, and it has becomea major source of fiscal burden. A reform pro-posal was enacted in September 1999.
The reform introduced a minimum re-tirement age of 58 (female) and 60 (male) forcontributors entering the system; current con-tributors are allowed a gradual transition pe-riod. The reform changed the benefit formulafor new entrants, and provided for gradual ex-pansion of the reference wage period of the fullcontribution career, to improve the link be-tween contributions and benefits. With thereform, discretionary pension indexation, gen-erally based on civil service wage increases,was replaced with pensions being indexed tothe consumer price index, and the ceiling oncontributions was raised. Another importantdevelopment: unemployment insurance. Tra-ditionally, the severance payments programhas been the primary form of protection againstinvoluntary employment in Turkey. With thenew scheme, put into effect in June 2000, nopayments were to be made before February2002.
The second phase of the reform consistedof institutional improvements. To unify normsand standards, to establish and share a commonand reliable database for the three differentinstitutions, and to monitor actuarial and fi-nancial developments, a Social Security Insti-tution was established under the Ministry ofLabor and Social Security. Health insurance andpension insurance departments within Social
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Insurance Corporation and social security wereseparated. The Turkish Employment Institu-tion was established to monitor the needs andprovide the requirements of the active labormarkets and to be responsible for the man-agement of the newly founded unemploymentinsurance system. Another important area ofthe reform process was the establishment ofvoluntary-funded private pension schemes,with a view to support public insurance.
CONCLUSION
Much has been done over the last two decadesin integrating Turkey into the world economy.But as some of the main macroeconomic in-dicators exhibit, the Turkish economy could notadequately benefit from this integration. Themain underlying factor for this failure is theshort-term orientation of economic policies—by frequently changing coalition governmentsand postponing structural reforms, mainly inbanking, public finance, and public manage-ment. High public sector deficits created chronicand high-inflationary environment, impedingthe medium-term planning of economic agents.Another factor is the international economy.After the worldwide spread of capital accountliberalization measures in the 1990s, the vul-nerability of the developing economies to ex-ternal shocks increased considerably. In thatsense, Turkey was no exception. It also suf-fered from the adverse effects of the economiccrisis elsewhere, such as the Gulf War in1990–91 and the Russian Crisis in 1998. Theseshocks led to sudden and huge reversals inshort-term capital flows throughout the 1990s.
To sum up the overall effect of this inte-gration, the balance of payments problems of theTurkish economy seem to have improved slightlyin the last two decades. But this improvementhas been coupled with the declining long-termgrowth rates and with high and persistent in-flation. Especially after the liberalization of thecapital account at the end of 1989, the growthrate became more volatile and the uncertaintyin the economy has increased. The reform hasalso resulted in more foreign indebtedness. Al-though per capita income improved, the in-come distribution has gotten worse.
In an overall assessment of recent decades,one benchmark should be the growth rate.Turkey reached high growth rates of 6 percenta year in the 1960s and 1970s, yet these ratesslowed down significantly and became morevolatile in the 1980s and 1990s. Even so, thegrowth rates of the 1980s and the first half ofthe 1990s seem successful (at around 4.5 per-cent a year) when compared with the poorgrowth of other middle-income developingcountries in the same period.
Turkey’s sluggish performance can be at-tributed to the fall in gross fixed capital for-mation as a percentage of GNP in the early1980s. Scarce public resources led to a declinein public investment. While there was an ex-pansion in the private sector investment, themain driving force of private investment wasthe rapid increase in construction spendingfor housing. If housing is excluded from pri-vate investment, the ratio of private invest-ment to GNP did not move upward—insteadstaying at 10–12 percent of GNP.
With the export-led growth strategy inthis period, substantial subsidies were pro-vided to exporters. But booming exports didnot raise private manufacturing industry’s grossfixed capital formation. Private manufacturingindustry’s gross fixed capital formation wasless than 4 percent of GNP in the 1980s, andit increased only slightly in the 1990s. Why?Because unsustainably high public sector bor-rowing led to high inflation and interest rates,crowding out private investment (Celasun1994). Indeed, the average growth of 3.9 per-cent for 1980–99 can be decomposed as 1.6percent for capital productivity, 1.7 percent forlabor productivity, and 0.6 percent for total fac-tor productivity. These figures are low for ahigh-potential developing economy.
A study by the World Bank (2000) pointsout that the main sources of productivitygrowth in Turkey between 1975 and 1990were changes in the sectoral composition,that is the flow of labor from agriculture toother sectors. That analysis can be extendedto developments in labor market and job cre-ation capacity of the economy. Turkey facesa labor absorption problem, evident in un-employment rates. During 1981–97 total
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employment grew only by 1.5 percent a yearwhile the working-age population (the poolof all potential workers) grew by more than3 percent (World Bank 2000b).
Either the economy is not growing enoughto generate employment for rising population,or it is growing but this growth is not labor-intensive enough. No clear-cut answers areavailable. Basic trade theory suggests that spe-cialization will follow and labor abundanteconomies will produce more labor-intensivegoods, creating more employment after un-dertaking substantial efforts to liberalize tradeand integrate with the world economy. But,employment creation did follow trade liberal-ization in Turkey. Nor did the trade reformsimprove the economy’s general productivity.
NOTES
1. In addition to export incentives andsubsidies, the Free Trade Zones Law was issuedin 1985 with the objective of increasing exportoriented investment and production. Mersinand Antalya free zones became operational in1988; the Aegean and Istanbul Atatürk Airportfree zones in 1990, the Trabzon free zone in1992 and commercial activities have been con-ducted in the Mardin and East Anatolian freezones since October 1995. Turkey has been amember of World Export Processing Zones As-sociation since 1991.
2. Turkey has been a member of the GATTsince 1950. It signed the Uruguay RoundTreaties in 1994. It has accepted GATT regu-lations on textiles, services, and agriculturaltrade—as well as trade related intellectual prop-erty rights. As a result, the Turkish Patent In-stitute was established in 1994. Turkey also hasbeen a member of the WTO since 1995.
3. Even if the realized inflation figureswere above the program targets, they were wellbelow the last 14 year’s averages.
4. The main reasons behind the rapid exitof capital in November can be summarized asfollows: disappointing inflation results for Oc-tober, unexpectedly high monthly trade deficits,political difficulties encountered in privatization,worsening relations with the EU, the economicsituation in Argentina, and disclosure of irreg-ularities in the banking system and a criminalinvestigation into several banks taken over bythe SDIF (Akyuz and Boratav, 2002).
5. Overnight rates reached 5,000 percent.
REFERENCES
Celasun, Merih. 1994. “Trade and Indus-trialization in Turkey: Initial Conditions, Pol-icy and Performance in 1980s.” In G.K.Hellenier, ed., Trade Policy and Industrializa-tion in Turbulent Times. London: Routledge.
Rodrik, Dani. 1991. “Premature Liberal-ization, Incomplete Stabilization: The OzalDecade in Turkey.” In M. Bruno and others,eds., Lessons of Economic Stabilization and ItsAftermath. Cambridge: MIT Press.
Tiktik, Ahmet. 1997. “Trade Liberalizationunder Imperfect Competition: A CGE Analy-sis on Turkey.” Publication 97, Capital Mar-kets Board. Ankara.
World Bank. 2000a. Turkey Country Eco-nomic Memorandum Structural Reforms for Sus-tainable Growth Volume I: Main Report. Report20657. Washington, D.C.
———. 2000b. “Turkey: Economic Re-form, Living Standards and Social WelfareStudy.” Europe and Central Asia Region,Poverty Reduction and Economic Manage-ment Unit, Washington, D.C.
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Globalization has the potential to deliver sub-stantial economic benefits. But it also bringsrisks, which policymakers need to address. Ingeneral, the global response to these risks hasbeen inadequate.
Liberalization and openness are notenough. To benefit from more openness, anew commitment to good policymaking, re-sponsive to globalization’s challenges, is re-quired at the country level. Each country musttackle these challenges in a way appropriate toits domestic setting, but some general princi-ples may be more widely applicable.
The UK experience suggests several suchprinciples:• Macroeconomic policymaking in a global
environment needs to pay particular at-tention to ensuring credibility and consis-tency. This can be achieved through a focuson medium-term stability, openness andtransparency in the conduct of policy, andappropriate institutional structures.
• Capital market openness strengthens theneed for a strong and effective regulatoryframework.
• To compete effectively in global markets,countries need structural policies to facil-itate a dynamic business sector. Labor mar-ket flexibility must be accompanied byinvestment in education and skills, and acompetitive domestic business environ-ment must be encouraged through toughand effective competition policy.
• By itself, a more open and competitive en-vironment cannot guarantee equitable accessto resources by all members of society. Poli-cies that address income disparities are neededto ensure equality of opportunity for all.
• Global solutions are needed for global prob-lems, but a commitment to take domestic
action in support of internationally agreedinitiatives is also necessary, if internationalpolicy coordination is to succeed.
POLICIES TO GET MORE FROM GLOBALIZATION
Global markets provide access to more capital,better technology, greater choice of goods, andthe benefits of larger markets and economiesof scale. Free flows of goods and capital leadto a more efficient allocation of resources andhigher growth and incomes, and increasedcompetition and exposure to world best prac-tice lead to more efficient, responsive, and in-novative domestic economies.
But policymakers need to address risks as-sociated with globalization. For example:• Macroeconomic and financial stability may
be more difficult to achieve with open cap-ital markets and volatile asset prices.
• Integration of financial markets creates op-portunities for their abuse (through op-portunities to launder money, evade taxes,and finance terrorism).
• New technologies and greater competi-tion can adversely affect particular sectors,regions, or types of workers, leading to di-vergences in incomes and opportunities.
• With greater economic integration, prob-lems previously dealt with domesticallycan become international issues, requir-ing an international response.Global integration creates change—which
labor markets, tax and social security systems,regulatory and institutional arrangements, andfiscal and monetary policy frameworks haveoften failed to respond to adequately. Above all,globalization is failing to deliver benefits forthose who need help most—the millions ofpoor people whose standards of living fall
United Kingdom
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below the standards set out in the MillenniumDevelopment Goals.
Because of these problems, a new globalmovement for change has developed. But theright response is to enhance global economiccooperation, not to prevent it. Through con-tinuing cooperation, we need to ensure thatglobalization works for the benefit of all, in-cluding the poorest countries:• We must remove barriers that have pre-
vented countries from sharing in the ben-efits of integration. The potential benefitsof a new trade round to the poorest coun-tries are substantial—and greater than theimpact of development assistance.
• We need to invest in citizens, to ensure thateveryone can take advantage of the bene-fits of greater globalization. In particular,there is a need for a step increase in invest-ment in health and education for the poor-est countries.
• We need to improve the effectiveness of de-velopment assistance: by untying aid, im-proving donor coordination, andharmonizing procedures; and by budgetsupport coupled with better public man-agement and more targeted assistance to-wards the poorest countries.
• There needs to be more dialogue between in-ternational investors and recipient countrygovernments, to ensure that everyone is able
to benefit from the increased opportunitiesoffered by foreign direct investment.But there is a need to localize as well as
globalize—to seek local solutions within aglobal framework. Good policymaking at thecountry level includes:• Macroeconomic reform, to achieve a sta-
ble and predictable fiscal and monetaryframework.
• Capital market reform, to create a dynamicfinancial sector while building an effectiveand comprehensive regulatory framework.
• Structural reform, to create a more dy-namic, efficient, and innovative economy.
• Labor market reform, to promote flexibil-ity and equality of opportunity.
• A commitment to undertake domesticpolicies necessary to support the interna-tional response to global problems.
TRENDS IN THE UK
The post-war period saw a steady decline intrade barriers in the UK, driven by successiverounds of GATT negotiations, along with entryinto the European Community in 1973. Aver-age effective tariffs for the UK fell from 8.7percent in 1972 to 4.7 percent in 1979 (Ennewand Reed 1990). Since then, the subsequent ef-fects of the Tokyo Round and Uruguay Roundcuts have lowered tariffs for most manufacturedgoods to negligible levels. But the agriculturaland textile sectors remain protected however.With exports and imports together now equalto just over half of national income, the UKranks as a relatively open economy (figure 1).
Not surprisingly, trade with the EuropeanUnion (EU) plays a significant role in overallUK trade. The share of intra-EU trade of totalUK trade has risen from 42 percent in 1975 to57 percent in 1999. The UK is one of the mostadvanced economies in implementing the Sin-gle Market initiative, aimed at breaking downfurther barriers to trade and investment withinthe EU. There is still room for progress in re-ducing barriers to trade, both within the EU andbetween the EU and the rest of the world.
Liberalization of capital markets in theUK has been extensive. Exchange controlswere abolished in the UK in 1979, and direct
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UNITED KINGDOM 165
controls on capital markets gradually disman-tled, including the removal of indirect controlson bank lending, the abolition of reserve re-quirements, and the deregulation of the secu-rities market and building society interest rates.
The UK is now one of the most opencountries in the world in terms of capitalflows. Average daily turnover in the Londonforeign exchange market makes up over 30 per-cent of total turnover—the highest in theworld. FDI flows increased significantly dur-ing the 1990s (figure 2). The UK now rankssecond in the world in both inward and out-ward direct investment stocks.
CREATING A STABLE MACROECONOMY
A more integrated global economy poses newchallenges for macroeconomic policy. Credi-bility has become more important, and morequickly rewarded by international capitalmarkets, whereas any losses of credibility aremore quickly and severely punished. Aseconomies become more integrated, the sourcesof economic shocks are likely to widen—andbe transmitted more quickly. Macroframe-works and the credibility of policies are thuslikely to be more severely tested.
In the 1980s and early 1990s, the lack ofa credible macroeconomic framework in theUK led to substantial volatility in output, in-flation, and interest rates. But, from 1997 on-wards, changes to the monetary and fiscalpolicy frameworks have improved macroeco-nomic performance, with low and stable in-flation and balanced fiscal outcomes (figure 3).
MONETARY POLICY
A broad consensus now exists that price stabilityis an essential precondition for achieving highand stable levels of growth and employment.But for much of the past two decades, theUK’s inflation performance was very poor, de-spite attempts to tackle the problem througha variety of different policy measures (figure 4).
In the early 1980s the UK governmentundertook to control inflation through mon-etary targeting, setting targets for the M3 mea-sure of the money supply for several years in
advance, in tandem with projections for the fis-cal deficit. But repeated overshooting of the tar-get led to an upward revision, along with theintroduction of various other monetary targets.At the same time, the exchange rate began togain more weight in the assessment of thestance of monetary policy and, later, as an in-termediate target.
By 1987 monetary policy had shifted to apolicy of pegging the pound informally to theDeutsche mark (“shadowing” it). The stanceof monetary policy remained relatively easy
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until mid-1988, when it became clear thateconomic activity was considerably more ro-bust than previously thought. This forced asharp correction in monetary policy: interestrates were raised dramatically in 1989. But bythe end of 1990 the UK was in recession andthe interest rate was falling again.
The UK entered the Exchange Rate Mech-anism in October 1990, but by 1992 tensionsstarted developing. Although the Bundesbankhad increased interest rates in 1991 and 1992,a similar move was judged inappropriate for theUK at a time of cyclical weakness. This placedincreasing pressure on the exchange rate, withsterling moving to the lower end of its band.Sterling was eventually withdrawn from Ex-change Rate Mechanism in the wake of con-siderable exchange market turbulence.
The UK subsequently adopted a newmonetary policy framework, which centeredon direct targeting of inflation. Moves werealso made to improve the transparency andaccountability of policy. But monetary pol-icy remained firmly in the hands of theChancellor until 1997, when the new Labourgovernment moved to place the operationalresponsibility for monetary policy in thehands of a new, independent Monetary Pol-icy Committee.
Up to this point, monetary policy had re-peatedly failed to maintain price stability:• The objectives of monetary policy were
not specified properly.
• Monetary policy was not sufficientlyforward-looking.
• Roles and responsibilities were not clear andconsistent.
• Monetary policy decisions were made bypoliticians, not experts.
• Monetary policy was not transparent oraccountable.These inadequacies of the monetary pol-
icy framework meant that even when an ap-parently firm and irrevocable monetary targetwas chosen (such as entry into the ExchangeRate Mechanism), the government lacked thecredibility to persuade the public of its com-mitment to the objective. As the government’scredibility diminished, the costs of maintain-ing the exchange rate peg rose, and the prob-ability of exit increased. If targets are to bedurable, they must be backed by the appro-priate institutional framework to ensure theyare also credible.
The new monetary policy framework in-troduced in 1997 is based on a set of keyprinciples:• Clear and sound long term policy objectives.
The inflation target is set by the govern-ment to achieve price stability.
• Pre-commitment, through strong institu-tional arrangements and procedural rules.The Monetary Policy Committee is givenautonomy to achieve the inflation target.
• Maximum openness and transparency, andclear accountability. The Bank of EnglandAct lays down guidelines for the publica-tion of minutes, regular reporting, andclear accountability procedures.These arrangements provide a clear focus
on price stability as the monetary policy goal,along with the flexibility to cope with eco-nomic shocks.
FISCAL POLICY
Monetary policy on its own cannot guaranteestability. Fiscal policy must also be set with theoverall goal of macrostability in mind. Duringthe 1980s and early 1990s, fiscal policy oftenadded to volatility and instability. Temporary,cyclical improvements in the fiscal positionwere misinterpreted as permanent, structural
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improvements, and the resulting over-opti-mistic forecasts led to a loosening of fiscal pol-icy in 1988, when the economy was alreadygrowing significantly above trend.
As the economy returned to trend, the fis-cal position rapidly deteriorated, and the sur-plus fell faster than forecast in successivebudgets. During the ensuing downturn, tax in-creases and spending restraint were required toreturn the public finances to a sustainablepath. These decisions undermined the effec-tive operation of the automatic stabilizers, am-plifying the economic instability. The restraintin public spending also damaged the ability ofdepartments to plan for the medium term,particularly damaging to public investment.
Partly in response to these events, a newfiscal framework has been established, based onfive principles of fiscal management—transparency, stability, responsibility, fairness,and efficiency. These are given effect throughtwo firm fiscal rules:• The golden rule states that, over the eco-
nomic cycle, the government will borrowto invest and not to fund current spend-ing.
• The sustainable investment rule states thatpublic sector net debt, as a proportion ofGDP, will be held over the economic cycleat a stable and prudent level (other thingsequal, taken to be 40 percent).Moreover, an explicitly cautious approach
is taken to forecasting, including a cautious as-sumption for trend growth (2.25 percent forthe 2001 budget), which is audited by the Na-tional Audit Office. The fiscal framework con-strains discretion while allowing flexibility intwo key respects:• Both rules are set over the economic cycle,
allowing fiscal policy to support monetarypolicy in smoothing the economic cycle byallowing the automatic stabilizers to oper-ate freely.
• The rules clearly distinguish between cur-rent and capital spending, allowing thegovernment to borrow for capital spending,which provides benefits to both currentand future generations, making it appro-priate that the cost be spread over time inthe form of interest and debt repayments.
To protect public investment and ensure therules are met, capital and current spendingare now planned and managed separately.
CAPITAL MARKET REFORM
A stable financial environment helps businessand consumers invest for the long term. Alongwith economic stability, it is a necessary pre-cursor to sustainable economic growth. At thesame time, the financial system must be suffi-ciently flexible and innovative to respond to thechanging global economic environment andtake advantage of the opportunities createdby greater economic integration. The benefitsof globalization fundamentally depend on theability of capital to flow freely to the highestreturning investment opportunities, regard-less of national borders.
Openness to capital flows is necessary tobring the benefits of globalization. But with itcomes responsibility for proper risk manage-ment to avoid excessive adverse effects from thevolatility often associated with these flows.Capital from the rest of the world provides anessential input for many economies. But therapid withdrawal of mobile capital cancontribute to crisis, as in 1997–98. Good fi-nancial regulation is essential for the manage-ment and mitigation of this risk.
The adoption of codes and standards forregulation of the banking, insurance, and se-curities sectors will help prevent the building-up of imbalances that can lead to financialcrisis. Sound liquidity management by the fi-nancial sector is fundamental to avoiding cur-rency and maturity mismatches. Sufficientown capital will help firms survive unexpectedlosses, reducing the risk of their failure. Pru-dential regulation should require and supportthese beneficial practices.
Capital market liberalization in the UKhas been accompanied by a series of measuresto upgrade prudential and other elements ofsupervision of financial firms and markets.One of the key themes of reform has been themove towards greater clarity and consistencyof objectives. Previously, regulatory responsi-bility for different areas of financial services wasdivided between the Bank of England and a
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number of other regulatory bodies. That re-sponsibility is now held by a single integratedfinancial services regulator, the Financial Ser-vices Authority (FSA).
This was deemed necessary, not only to en-sure consistency, but because the distinctionsbetween the banking, securities, and insur-ance sectors have become increasingly blurred.A single regulator, with a single set of objec-tives, also provides greater accountability, andconstitutes a more efficient use of scarce reg-ulatory resources.
The FSA has statutory objectives to main-tain confidence in the financial markets; pro-vide appropriate consumer protection, increasepublic awareness of financial issues, and fightfinancial crime. It must ensure that the costsof regulation are outweighed by the benefits.In fulfilling its objectives, the FSA must haveregard for the need of the UK to have a com-petitive, dynamic, and innovative financialsector.
The Bank of England retains responsibil-ity for the overall stability of the financial sys-tem. That involves work to strengthen marketinfrastructure, monitor developments in fi-nancial markets worldwide, and in exceptionalcircumstances undertake liquidity or capitalsupport operations to prevent or limit the im-pact of financial crisis on the financial system.
The changes that have been introducedhave contributed to one of the most compet-itive and open financial markets in the world.The continued strength of the city of Londoncan be attributed in part to the highly com-petitive and diversified nature of the UK fi-nancial market. At the same time, the UKfinancial market has become more “interna-tionalized” with rapid growth in cross-bordertransactions and the international diversifica-tion of investors’ portfolios.
CREATING A DYNAMIC BUSINESS SECTOR
To compete effectively in global markets, theright conditions must be in place to facilitatea dynamic business sector. Structural policiesare needed which:• Improve the education and skills of the
labor force.
• Encourage strong competition.• Promote enterprise and innovation.• Improve the climate for investment.
Two of these areas are discussed here: im-proving skills and competition policy.
SKILLS FOR ENTERPRISE AND GROWTH
The competitive pressure generated by growingworld trade increases the importance of invest-ing in skills. The importation of unskilled,labor-intensive goods from less developed coun-tries has reduced the wages of unskilled work-ers in more developed importing countries,generating greater relative rewards for skill.When global production patterns change to re-flect comparative advantage, structural changewithin the domestic economy is inevitable.
In the UK there has been a shift in em-ployment from manufacturing to services overthe last 20 years, and this has given rise tosome transitional problems. Due to high in-terest rates, contractionary fiscal policy, and re-sulting slow growth, manufacturingemployment fell by around a quarter in theearly 1980s, and the International Labour Or-ganization unemployment rate more than dou-bled. This led to an explosion of long-termunemployment. While unemployment camedown in the boom of the late 1980s, the re-cession of the early 1990s saw unemploymentincrease to very high levels again.
Part of long-term unemployment is due topoor skill levels. The UK lags behind many ofits competitors in basic and intermediate skills,despite some progress in recent years. This re-duces productivity, making it harder for firmsto grow and expand into new fields, and for em-ployees to adapt and build on new technologies.Policies aimed at raising skills and improving theperformance of the education system are there-fore a key component of the government’s poli-cies to promote a dynamic business sector.
Tackling poor basic skills is both an eco-nomic and social imperative. People with poorliteracy and numeracy skills tend to be in low-paid jobs or suffer lengthy periods of unem-ployment. A National Strategy for Basic Skillshas been introduced in the UK to provide basicnumeracy and literacy skills training for adults.
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The New Deal is another policy initiativeintroduced to tackle long-term unemploy-ment. The aim is to provide help and supportin finding employment. It provides for regu-lar contact with a personal adviser, access to jobsearch support, support for self-employment,and opportunities for training and work ex-perience. It has surpassed its targets in gettingpeople back to work.
Policies have also been implemented to es-tablish a culture of lifelong learning. TheLearning and Skills Council has been estab-lished to coordinate, promote, and plan post-16 education and training outside highereducation, focusing particularly on employers’needs. Three flagship initiatives have also beenintroduced to ensure that education and train-ing are accessible to all:• Individual Learning Accounts, which pro-
vide all adults over the age of 19 with theopportunity to organize their own learn-ing. To help break down the financial bar-riers to learning, the account holders areeligible for discounts on certain courses.
• Learndirect, which has been establishedto offer flexible, Internet-based adult learn-ing through its website and through a net-work of over 900 Learndirect centers.
• Information and communications tech-nology learning centers, established acrossthe country, giving everybody the oppor-tunity to raise their information technol-ogy skills.Skilled graduates and postgraduates are
vital for a productive economy able to take ad-vantage of the opportunities offered by rapidlydeveloping technologies and scientific advances.To ensure the UK has a world class supply ofhighly skilled graduates and postgraduates, anambitious target has been set: by the end of thedecade, and for the first time, 50 percent of theUK’s young people can expect to go into highereducation. As participation increases, moreyoung people from currently under-representedgroups are expected to enter higher education.
These policies will increase the opportu-nities for young people and help the UK de-velop the human capital it needs for higherproductivity growth and coping with the forcesof change in globalization.
ENCOURAGING COMPETITION
Providing the right conditions for a competi-tive domestic business environment is impor-tant to ensure that consumer welfare ismaximized (with low prices and wide choice)and that domestic firms can compete in in-ternational markets. This makes it very im-portant to have strong competition policy, anda tough, proactive competition authority to pre-vent competition-damaging mergers and anti-competitive practices.
Over the last few years the UK has strength-ened its competition framework in a numberof ways:• By introducing the Competition Act 1998,
giving competition authorities muchstronger powers to address anti-competitivebehavior, and bringing the UK system moreclosely into line with the main provisionsof European Commission competition law.
• By increasing the budget of the Office ofFair Trading, and appointing a new Di-rector General, John Vickers, a leadingeconomist with strong expertise in com-petition.
• By introducing the Financial Services andMarkets Act 2000, which gives the UK’scompetition authorities new powers toscrutinize the competition effects of fi-nancial services regulations.A radical package of new reforms has now
been proposed, designed to bring about a step-increase in competitive pressures in the UKeconomy. These reforms include:• Giving the UK’s competition authorities
greater independence and power, so thatthey will be able to take decisions in theoverwhelming majority of competitioncases, free from political interference.
• Giving the competition authorities a stronglegal basis for promoting competition acrossthe economy.
• Modernizing the mergers regime, withcompetition authorities judging casesagainst a new competition-based test.
• Making a series of improvements to theUK’s complex monopoly regime, whichallows competition authorities to looks atthe workings of whole markets.
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• Providing new procedures to encourageprivate actions, so that those who areharmed by anti-competitive behavior canget real redress.However, growing international trade and
investment presents new problems for com-petition authorities, as the companies involvedare now frequently multinationals, and as mar-kets for many goods and services can no longerbe defined in purely national terms. Interna-tional coordination of competition cases isthus becoming more necessary.
The UK has been working closely withthe EU and other countries to improve inter-national competition policy coordination. Inparticular, much closer links have been culti-vated with the U.S. competition authorities—working towards a shared understanding ofanalysis and procedures. In recent years, linksbetween UK, European, and North Ameri-can competition authorities have been strength-ened, both formally and informally. Thedevelopment of the EU–U.S. Mergers Work-ing Group in 1999 has improved under-standing of respective approaches to settingremedies in competition cases, compliancemonitoring, and dealing with oligopolisticmarket structures.
Action is also being taken to improve the ex-change of information between competitionauthorities. The Office of Fair Trading hostedan international cartel workshop in the UK lastyear, since when an informal cartel information-sharing network has developed. The UK is alsocommitted to bringing forward new legislationto allow UK authorities to share informationwith foreign authorities to assist them with in-vestigations into breaches of competition law.These changes will greatly enhance the abilityof competition authorities in all nations to ef-fectively combat anti-competitive practices.
ENSURING EQUITABLE OUTCOMES IN A
CHANGING LABOR MARKET
If the domestic economy is to adapt success-fully to the new environment of global com-petition and take the opportunities for growthin new areas that globalization provides, andif this structural change is to be achieved with
the minimum of transitional costs, labor mar-ket flexibility is crucial. But some regions andsome groups of the workforce may suffer dis-proportionately—and for a longer period—from the transitional costs from greateropenness. Unemployment and wage inequal-ity must therefore be addressed if the gains fromglobalization are to be enjoyed throughout theeconomy.
In the UK labor market reforms in the1980s focused on deregulation and increasinglabor market flexibility. Union rights weregradually eroded, wage-fixing arrangementsabolished, and employment protection legis-lation weakened. At the same time, the valueof unemployment benefits was allowed to fallrelative to wages, and criteria for entitlementtightened.
These measures increased the flexibility ofthe UK labor market. But the experiencedemonstrates that such measures are notenough to ensure that everybody benefits fromthe structural transformation towards highergrowth sectors, particularly those at the bot-tom end of the labor market.
Throughout the Organisation for Eco-nomic Co-operation and Development, therehas been a deterioration in the prospects for lowskilled and poorly educated workers. In the UKthis has been reflected by not only a markedincrease in wage inequality, but also a rise inunemployment among the unskilled. Betweenthe early 1980s and the mid-1990s, the per-centage of working-age households with no onein work roughly doubled. The persistence ofworklessness among those at the bottom endof the labor market has widened the incomegap. Between 1977 and 1996–97 income in-equality in the UK rose by a third.
The UK’s experience suggests that unem-ployment and low pay can have long-term ef-fects that damage people’s chances of gettingwork and moving up the income scale. A num-ber of policy reforms have been introduced totackle low pay and poverty directly:• Making work pay, through reform of the
tax and benefit system, underpinned by anational minimum wage. The new Work-ing Families Tax Credit now benefits morethan 1.25 million families.
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• Easing the transition into work by remov-ing barriers to working such as childcarecosts. The childcare tax credit provides di-rect help with childcare costs for the firsttime.
• Supporting families and reducing childpoverty through benefit reform, targetedfunding and (from 2003) a new integratedtax credit for children and an employmenttax credit (to replace the Working FamiliesTax Credit).
• Tackling pensioner poverty through taxand benefit reforms to improve the welfareof all pensioners, including not only thepoorest pensioners but also those on lowand modest incomes.
DOMESTIC POLICIES TO SUPPORT THE
INTERNATIONAL RESPONSE TO GLOBAL PROBLEMS
Globalization and the increased internationalpolicy coordination that goes with it is en-abling policymakers to find solutions to globalproblems that would be beyond individualstates or regional blocs. Environmentalproblems are one example. Greater interna-tional cooperation has helped raise environ-mental standards and find solutions to manyenvironmental problems already, through co-ordinated action to limit the use of ozone-de-pleting substances, put controls on theinternational trade in endangered species, orcombat climate change, for example. But ap-propriate action must be taken on nationalbasis to ensure that the international responsesucceeds.
Climate change is perhaps the most seri-ous global environmental problem. The UK’sRoyal Commission on Environmental Pollu-tion has recommended that the UK should re-duce emissions of greenhouse gases by 60percent of 2000 levels by 2050, and that sim-ilar reductions will be required by other de-veloped countries if atmospheric concentrationsare to be stabilized. Greenhouse gas emissionsaffect climatic conditions across the world,but the impact is likely to be most severe in
developing countries. Without the interna-tional structures established under the aus-pices of the United Nations, there would be noprospect of addressing this problem.
Under the Kyoto protocol, agreed to in1997 under the United Nations FrameworkConvention on Climate Change, developedcountries agreed to targets that will reducetheir overall emissions of a basket of six green-house gases by 5.2 percent below 1990 levelsover 2008–12. Because the EU and its mem-ber states are able under the protocol, to meettheir commitments jointly (so that the EU’s tar-get can be redistributed between member statesin line with their national circumstances), theUK has agreed to reduce its emissions by 12.5percent, its legally binding target under theKyoto Protocol.
Since Kyoto, the UK has been pressingahead and introducing innovative policies thatwill have a significant impact. One of these isthe climate change levy, a tax on industrialenergy use. The levy package also includes ex-emptions for renewable energy, incentives forindustry to agree to energy efficiency targets,enhanced capital allowances for investment inenergy efficiency measures, and extra resourcesfor the promotion of energy efficiency. The levypackage and agreements with energy-intensivesectors are expected to reduce UK emissions by5 million tons of carbon per year by 2010, com-pared with “business as usual”.
Arrangements are also being put in placein the UK for a voluntary emissions tradingscheme, expected to save an additional 0.8million tons of carbon per year by 2010. In-ternational emissions trading would offer scopefor countries to work together to reduce theiremissions at the lowest possible cost.
REFERENCE
Ennew, Christine, David Greenaway, andGeoffrey Reed. “Further Evidence on EffectiveTariffs and Effective Protection in the UK.” Ox-ford Bulletin of Economics and Statistics, 52(1):69–78.
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There is little doubt that global trade and in-vestment have made vital contributions toU.S. economic performance. Especially evidentin the 1990s, this continues to be so in this newdecade as well. It is noteworthy that the in-teraction of the United States with the globaleconomy achieved new high levels as the “new”U.S. economy flourished during that period.
U.S. involvement with the global econ-omy, as reflected in standard measures of open-ness to trade, has been increasing steadily inrecent years. For example, the ratio of trade ingoods and services (exports plus imports) toGDP has been rising for several decades andnow stands at more than 25 percent. Othermeasures—such as import penetration rates, ex-posure to foreign competition, and trade-weighted tariffs—underscore the openness ofthe U.S. economy.
But one should be careful not to overstatethe extent of U.S. openness. The U.S. trade-to-GDP ratio now is not far above levelsreached in the early 1900s and to some extent,the liberalization of U.S. trade in recent decadeshas been a process of unwinding protection im-posed during the middle of the 20th century(as has been the case for many other industrialcountries). Alternative measures (such as cross-border price dispersion) also suggest that theUnited States still has room to move towardeven fuller integration with the global economy.
GAINS FROM TRADE
There is no doubt that, as the United Stateshas become more involved in the global econ-omy, it has benefited enormously from whatare often referred to as the standard gains fromtrade. More open trade has allowed U.S. pro-ducers to concentrate activity where they have
the best knowledge, skills, and resources. Tradehas given them access to a wider range ofcheaper inputs. More and better products havebeen made available at lower cost to U.S. con-sumers, raising living standards.
Economists often debate whether the re-sult from any particular trade-opening step orchange in economic fundamentals that gen-erates additional trade is merely a one-time gain,in which the economy shifts to a new higherlevel of performance, or whether such a stepsupports sustained higher growth. The expe-rience of the 1990s—not just in the UnitedStates, but in the broader global economytoo—strongly suggests that trade and techno-logical change reinforce one another, and thatthe resulting synergies lead to higher real eco-nomic growth over a prolonged period. Butsuch synergies are not a given or automatic, andthey depend on certain key conditions.
The trade-technology-growth interrela-tionship is complex, but more open U.S. tradeclearly has heightened competition, spurringinnovation and rapid adoption of new tech-nologies. The expansion of global marketshas encouraged U.S. firms to take advantageof economies of scale, economies of scope,and network effects. Dynamic interactions ofthis sort have been especially apparent in in-dustries where fixed investment costs are high,where substantial research and developmentexpenditure is required, and where learningcurve effects are important. The computersoftware, semiconductor, airframe, entertain-ment, and pharmaceutical industries provideexamples. A key feature of the 1990s was aclustering of important technological changesin communications and information tech-nology that helped lower costs directly. Theseadvances also facilitated reorganizations of a
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wide range of economic activities, generatingefficiencies at the firm level, globally, and atlevels of aggregation in between. The conse-quences have been evident in the high sus-tained rates of productivity growth duringthe recent long period of U.S. expansion andprosperity.
Further evidence of these forces is seen inchanging patterns of U.S. trade. Capital goodstrade (which includes sectors with a significanthigh-tech component, such as computers, ma-chinery, and telecommunications) has exhib-ited especially rapid growth. Capital goodsnow make up more than 30 percent of U.S.merchandise imports, twice the share of 20years ago. Capital goods exports have recordeda similar expansion. In the past 10 years, U.S.exports of computers, semiconductors, andtelecommunications equipment increased al-most two and a half times. Many of the sameforces have been at work behind a similar dra-matic expansion of U.S. service exports. Theannual growth rate of service exports inknowledge-based areas—such as intellectualproperty, education, insurance, financial ser-vices, and other professional services—has av-eraged close to 9 percent during the past decade.
Increased foreign competition (and po-tential competition) has exerted a beneficial dis-ciplining effect on U.S. producers, who havehad to keep quality up and prices down to com-pete effectively in global markets and at home.Faced with foreign competition, U.S. makersin many instances have identified more viablemarket segments and successfully retooled.(The reaction of U.S. computer chip makersto the challenge posed by lower defect rates onJapanese chips and the response of U.S. automakers to foreign competition are often-citedexamples.) The availability of less-expensive,imported goods has kept U.S. domestic pricesdown across a wide range of products—fromhigh-tech components, to clothing andfootwear, to toys—and, together with a strongdollar, contributed importantly to the low-in-flation environment achieved during the past10 years. It has been argued that greater open-ness also has helped lower the nonacceleratinginflation rate of unemployment through itspositive effects on real wages and productivity.
FOREIGN INVESTMENT AND MULTINATIONAL
CORPORATIONS
New technology and a more open global trad-ing system have allowed U.S. multinational cor-porations (MNCs) to establish global supplychains within which stages of production can beplaced where labor and materials are cheapest—thereby letting U.S. firms concentrate in corecompetencies through a variety of multinationalfirm structures. In some cases intermediate in-puts are obtained by outsourcing; in others, keystages of production are relocated, but still re-tained within an MNC’s overall structure. Oftenfabrication and assembly operations have beenmoved abroad, while research and developmentactivities, new product design, marketing, andsome capital-intensive stages of production havebeen retained in the United States.
Outsourcing and transfers of operationswithin U.S.-headquartered MNCs have beena noteworthy feature of economic relations es-pecially with our North American trading part-ners. Two-way trade between the United Statesand both Canada and Mexico has helped U.S.automakers, for example, respond to changingeconomic conditions and still deliver high-quality products at competitive prices. Some ob-servers argue that shifting operations abroad hasgreatly reduced domestic value added in U.S.MNCs. In fact, the domestic content of pro-duction by U.S.-based parent companies hasremained high (at about 90 percent).
In cases where MNC production is aimedprimarily at foreign sales, local affiliates can alsoplay a key role in providing essential infor-mation about local demand conditions andother input for effective marketing. The im-portance and success of these arrangementscan be gauged by the fact that roughly two-thirds of U.S. export sales now are conductedthrough U.S. MNCs. In many instances, largeU.S. companies in industries that one mightsuppose to be essentially domestic in theirfocus (restaurant chains, beverage producers,filmmakers) earn the majority of their rev-enues from overseas sales.
Direct investment flows associated withMNCs have been significant in both direc-tions. In recent years, inward direct foreign
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investment (and the resulting presence of for-eign MNCs in the U.S. economy) has ex-panded very rapidly, faster than correspondingoutward investment. Although inward flowshave tended to be associated more often withmergers and acquisitions than with new in-vestment, to some extent certain operations offoreign MNCs and related jobs—quite often,high-wage jobs—have been shifted into theUnited States in the process. When direct in-vestment inflows became prominent in thelate 1980s, concerns were expressed about po-tential dominance of U.S. markets by foreign-owned MNCs. For the most part, suchdeleterious effects have not materialized, andforeign MNCs are regarded as having made awelcome contribution to the U.S. economy.U.S. authorities continue to monitor directinvestment inflows to ensure that their effectson market structure and competition are con-sistent with U.S. anti-trust standards, just asthey monitor domestic investment flows.
The global activities of MNCs have raisedissues about international taxation and the repa-triation of profits and capital. In general, his-torical experience confirms that restrictions onrepatriation, capital controls, and similar limi-tations can have a very potent damping effecton capital flows and distort investment decisions.In certain circumstances they risk promptingsudden, widespread capital flight, with broadernegative consequences for both investors andtheir foreign hosts. Accordingly, U.S. authori-ties have promoted actively the free interna-tional movement of direct investment flows,unencumbered by such restrictions, and have de-fended the right of U.S. firms to repatriate prof-its and capital. U.S. authorities in recent yearsalso have worked successfully to reduce doubletaxation on cross-border capital flows throughbilateral tax treaties (and an international modelon which such treaties are based) that generallylimit the taxing rights of host countries.
TRADE-OPENING POLICY AND SUPPORTING
INFRASTRUCTURE
Although the increased openness of the U.S.economy is to some extent the result of forcesexperienced widely and for some time in the
global economy, U.S. openness has been fos-tered by specific policy steps to break down im-pediments to the free flow of products andfactors of production. For many years, theU.S. has been in the forefront of the global ef-fort to lower trade barriers, and our levels ofprotection are among the lowest in the world.(In part because foreign barriers subject toagreed-upon reductions have tended to behigher that those in the United States, thisprocess on balance has most likely resulted inan improved U.S. terms of trade.)
Prominent among agreements on tradeand investment that have been successfullynegotiated and implemented in recent years are:completion of the GATT Uruguay Round,the establishment of the North America FreeTrade Agreement (NAFTA), and the extensionof normal trade relations to China. The UnitedStates is now moving toward the final stage offree trade negotiations with Singapore and theFree Trade Area of the Americas and has justconcluded a free trade agreement with Chile.The Trade Promotion Authority bill, signed inAugust 2002, should facilitate additional trade-liberalizing agreements.
As tariff barriers have come down, atten-tion in the public debate on trade policy hasshifted to nontariff barriers, for which thescale, extent, and economic impacts are moredifficult to measure. The United States hasmade progress in lowering these as well, butthere is room for further progress. The phase-out of existing quotas on textiles and apparelwill not be completed until January 2005,tariff-rate quotas remain on a number of agri-cultural products, and domestic trade remediescontinue to be used.
The trade-opening event with the mostprominent impact in recent years is NAFTA.Starting in about 1994, the first year ofNAFTA, U.S. trade data exhibit a well-definedstructural break. Closer economic integrationwithin North America clearly accounts formuch of the steeper rates of increase recordedsince then for exports and (with somewhat lesscertainty) for imports as well. Since 1994 U.S.import and export shares with NAFTA part-ners have risen roughly four percentage points,of which an important part is attributable to
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cross-border North American trade facilitatedby U.S. MNCs, as noted earlier.
To a great extent, U.S. success in generat-ing and applying new technologies in the moreglobal marketplace has depended on certain es-sential attributes of the U.S. economy and itssupporting infrastructure. A key element inadapting to change and achieving the best al-location of resources has been the flexibility ofthe U.S. labor market. U.S. firms have been lessburdened than those in many other countriesby restrictions on hiring and separations orby other job rules. The high-quality U.S. workforce—augmented to a considerable extent inrecent years by new foreign workers—has metthe need for specialized skills demanded by aneconomic environment where technical changeis occurring at a rapid pace. Turnover and jobmobility have constituted an important chan-nel through which knowledge-based skills andhuman capital have been spread more widely—including the spillover effects from the so-called “new” economy into the “old” one.
The efficiency and depth of U.S. capitalmarkets—particularly, the widespread avail-ability of venture finance (through venture-capital providers and direct equity financing)for start-up operations—have been key ele-ments supporting innovation, growth, andtrade. Such outside financing has proved espe-cially critical for small and medium-sized U.S.firms, where a disproportionate share of newjobs have tended to originate in recent years. De-spite the speculative excesses highlighted bythe recent correction in U.S. high-tech stockprices, evidence is strong that the wider rangeof financing options available in U.S. markets(when compared with the heavily bank-based,inside financing pattern prevalent in manyother industrial countries) provides a moresupportive framework for innovation, diffu-sion of new technology, and capital deepening.
Other institutional aspects of the U.S.economy that also deserve to be highlighted forcontributing to success in meeting the chal-lenges of globalization are: well-established,clear legal standards (including standards forprotection of intellectual property) that arebacked by reliable enforcement; accepted ac-counting practices that (even in the light of
recent failures at some prominent firms) sup-port a high level of transparency; an effectiveregulatory-supervisory structure, with clearrules that strike a balance between limitinganti-competitive behaviors and fostering en-terprise and innovation; and policies that de-liver a stable macroeconomic environment.
COSTS AND CHALLENGES OF GLOBALIZATION
Despite its many benefits, the globalizationprocess has not come without strains. If pre-sent trends continue, globalization may presentimportant future challenges, some of whichhave been raised in recent public debate. TheU.S. economy has experienced, for example,many of the usual dislocations that are un-avoidable side-effects of rapid growth andchange—including changing job mix; re-structuring, relocation, and closing of firms; joblosses in some sectors; and reductions in earn-ings. But this process and its impacts havebeen eased by a number of targeted programs,including Trade Adjustment Assistance,NAFTA Transitional Adjustment Assistance,and the Dislocated Worker Program (whichprovides assistance with job search, placement,and training). Additional programs are aimedat smoothing economic adjustment at thecommunity level.
It has been argued that the gains fromtrade have not been spread evenly across theU.S. economy. It is well documented that forseveral decades, at least up to the mid-1990s,there was a steady widening of wage inequal-ity across skill groups in the U.S. workforce.Observed in other industrial countries as well,this was considerably more pronounced in theUnited States. (At the same time, U.S. within-group wage inequality also increased markedly.)In part because these changes coincided witha period of accelerating globalization, foreigntrade was identified as a possible cause.
It appears from research so far, however, thatonly a small share of the observed shift to-ward greater U.S. wage inequality can be tracedto foreign trade. Other factors such as skill-biased technological change, shifts in laborsupply, and structural changes in U.S. labormarkets mattered more. Similarly, it has been
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hard to confirm any important lasting effect onthe U.S. wage distribution from the opera-tions of MNCs—either U.S. MNCs operat-ing abroad or foreign MNCs in the U.S.economy. But given the complex linkagesamong trade, investment, technological change,and other relevant factors, it is difficult to iso-late the separate contribution of any one fac-tor to changes in wage inequality. These are stillopen questions.
The public debate that often accompaniesprominent measures to open trade typicallyhas concentrated on associated job losses orgains. In the case of NAFTA, for example, therange of estimates of such impacts is wide, buton balance the evidence suggests that themedium-term effects of NAFTA-related tradeon U.S. employment are likely to have beenfairly small. In any event, widespread concernsexpressed in the early 1990s about potentiallymassive U.S. job losses arising from NAFTAhave not been realized. (Likewise, the sometimescontentious public debate on job-loss associatedwith activities of MNCs has come to no firmconclusions—with both positive and negativeestimates in play.) It is worth noting, however,that like many other recent U.S. trade-openingagreements, the employment effects of NAFTAhave been cushioned by arrangements for afairly extended phase-in, with side-agreementsto mitigate the immediate impact on labor.
Whatever may have been the directionand scale of these impacts, several points areclear. The U.S. labor market was better ableto absorb these changes during a period ofrapid expansion with record low rates of un-employment. To a great extent, the necessaryadjustments occurred largely through the op-eration of market forces and were not heavilymanaged or resisted with government inter-vention. Moreover, the common short-runfocus on job impacts may be misplaced. TheU.S. experience suggests that, after account-ing for cyclical effects, a smoothly function-ing economy should ensure that the longer-runeffects on total employment are negligible.Indeed, it is difficult to find credible evidencethat trade or direct investment has affected thelevel of total employment in this country overthe long run.
U.S. financial markets have been essen-tially open to free flow of international capi-tal for quite some time. But the combinationof restructuring and technical change in fi-nancial institutions seen in recent years, aswell reductions of some foreign barriers toflows, has expanded greatly the scale of finan-cial flows both into and out of U.S. marketslately. This has resulted in greater diversifica-tion in patterns of fundraising and investmentin both U.S. and foreign portfolios. (For ex-ample, about 15 percent of fundraising throughissuance of new securities by U.S. corpora-tions now is from foreign sources.)
It would seem unlikely that the diversifi-cation process is complete, however, as thereappears to be considerable scope for recenttrends to continue. The aggregate U.S. private-sector investment portfolio still exhibits a highdegree of “home bias”, meaning that the shareof foreign assets is relatively low and far fromtheir corresponding share in total global cap-italization. Among equities, for example, totalforeign equities held in the aggregate U.S.portfolio (including direct investment holdings)make up only about 20 percent of total equityholdings—compared with the roughly 50 per-cent share that foreign equities make up intotal global capitalization.
A corollary of the openness of U.S. finan-cial markets is that there is no short-term ne-cessity for domestic saving to equal domesticinvestment. During the 1990s domestic sav-ing and investment diverged, and the U.S.current account deficit expanded significantlyto the point now where the annual deficit ismore than $500 billion, approaching 5 percentof GDP. In some other settings, such numberswould set off alarms—and the current imbal-ance indeed presents some potential risks. Butto a great extent the expanding financial inflowsthat are the counterpart of the widening U.S.current account deficit reflect investors’ posi-tive assessment of the strength and stability ofthe U.S. economy and their resulting desire tocontinue to invest in U.S. assets.
It is worth adding that the deficits of the1990s—in contrast to those of the 1980s—occurred in a context of strong U.S. investmentgrowth. Open, smoothly functioning U.S.
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capital markets directed these financial inflowsinto productive uses that supported U.S. cap-ital formation, boosting productivity and po-tential output growth. A key development thatfacilitated this process was the increase in ag-gregate government saving associated with themovement into surplus of the U.S. federalbudget. But even though the budget lately hasmoved back into deficit and even after the re-cent correction in U.S. stock markets, the fa-vorable fundamentals exhibited by the U.S.economy evidently continue to attract foreign(and domestic) investors to U.S. dollar-denominated assets. Indeed, foreigners’ pur-chases of U.S. corporate securities (equitiesand bonds) and agency debt alone generallyhave been more than sufficient to finance thecurrent account deficit.
POLICY IN THE OPEN ECONOMY
Recent experiences have demonstrated thatsound policies are critical to reaping the full ben-efits of integration. The broader risks associatedwith volatility and the importance of such poli-cies were made dramatically apparent in theglobal financial crises of the late 1990s. Inmany respects U.S. financial markets, the U.S.banking system, and the real economy avoidedthe worst potential impacts, but they were notentirely spared. In late 1998, for example, whendefault of a major U.S. hedge fund (LTCM)with potentially widespread systemic conse-quences appeared to be imminent, U.S. au-thorities facilitated an emergency private-sectorrecapitalization, with an arrangement to re-duce LTCM’s positions in an orderly fashion.This step, along with the Federal Reserve’smonetary easing in mid-October 1998, seemedto calm markets eventually, but not withoutsome residual effects persisting for quite a while.
The global financial crises of that time,and especially the events surrounding the near-default of LTCM, revealed a number of weak-nesses of U.S. (and other) financial institutionsactive in global markets. Among them: inad-equate counterparty credit assessment, lack ofinformation on aggregate exposures, inade-quate risk management, concentration of ac-tivity in a few large institutions, and hazards
associated with convergence of trading strate-gies. Since then, steps have been taken to ad-dress some of these problems—many as partof the broad international effort to improve theglobal financial architecture. This includes ini-tiatives to promote improved approaches to riskmanagement, increased transparency, more ef-fective monitoring of markets with potentialvulnerability, and an expansion of resourcesavailable for financial supervision—in all ofwhich the United States continues to be an ac-tive supporter and participant. Efforts in sev-eral of these areas were accelerated—with somesubstantial resulting progress—in response tothe recent round of corporate scandals.
Over the past decade, some of the largestU.S. banks and other financial institutions haveincreased their overseas activities substantially—often as the result of mergers and acquisitions—creating new challenges for U.S. and foreignfinancial supervisors. While expanded opera-tions and new financial instruments have en-abled institutions to shift risk more easily (andhence to manage risk more effectively), both thefinancial institutions themselves and the trans-actions they perform have become more com-plex, and the speed with which an institution’spositions and risks can change has increased. Inresponse, U.S. and other bank supervisors haveplaced more emphasis on evaluating banks’risk management systems, rather than on theirtransactions. In addition, supervisors have rec-ognized the need to rely more on market dis-cipline, prompting in turn an increasedemphasis on improved disclosure by banks andother financial institutions.
Globalization also has affected impor-tantly the context for conducting U.S. macro-economic policy. Obviously, a more open,globally integrated economy means that theUnited States is more exposed to economicand financial shocks arising in the external sec-tor. There has been no shortage of such shocksin recent years. The transmission channels ofU.S. policy to the domestic economy alsohave been altered by globalization. Because ex-ternal trade acts as an automatic stabilizer, ef-fects on the U.S. economy of domestic shocks,including some policy shocks, tend to bemore muted as openness increases. But other
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external channels may work in the oppositedirection. Accordingly, there is a need to cal-ibrate policy carefully to account for the struc-tural changes associated with the process ofglobalization. U.S. monetary policy mustnow take account of spillovers to the globaleconomy—including potential systemic ef-fects in global financial markets, that mayfeed back to the United States in a non-negligible way. But it remains focused on itsmandated objectives of price stability andfull employment.
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