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Student Publications
Author: Felix Mmboyi
Title:
Economic Development Policy
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ABBREVIATIONS
FDI
Foreign Direct Investment
GDP
Gross Domestic Product
IMF
International Monetary Fund
MDGs
Millennium Development Goals
OECD
Organization of Economic Cooperation and Development
PRSP
Poverty Reduction Strategy Paper
UN
United Nations
US
United States
VAT
Value Added Tax
WTO
World Trade Organization
3
PURSUING GROWTH POLICIES: CAN KENYA LEARN
FROM PAST BEST
PRACTISES?
1.0 Introduction
Since the 1990s, many developing countries including Kenya have had
remarkable
success in reducing inflation, as well as improving fiscal and
current account deficits.
According to Levine, Ross et al (1992), countries have not been as
successful at achieving
stability of macroeconomic output and sustainable growth. This is in
large part because
stabilization policies have focused on price stability � even though
real stability, not price
stability, is what's ultimately important for attracting investment
and achieving
sustainable development.
This policy paper lays out a framework for designing macroeconomic
policy geared
toward real macroeconomic stability with growth. This
framework is based on the view
that there need to be broader goals, additional instruments beyond
fiscal and monetary
policies (including capital account management, regulations, and
other microeconomic
tools), and a balanced role for government and the private sector.
In addition,
policymakers need to coordinate fiscal, monetary, exchange rate
policies and design
programs based on flexibility and the individual needs of each
country.
This policy paper is divided into three sections. The first
discusses macroeconomic
objectives, and the need for a broader set of policy goals. The
second examines the
conventional tools of macroeconomic policymaking: fiscal and
monetary, and exchange
rate policies. The third and final section of this note looks at
alternative tools for
macroeconomic management, with an emphasis on interventions in
capital markets.
Some of the issues discussed, such as public sector revenue
mobilization, are relevant to
current policy choices in both low income and middle income
countries. I hope the
discussion will give all policymakers ideas of creative measures
that can be used to
overcome market failures in countries like Kenya.
2.0 Macroeconomic Objectives
I begin the discussion by focusing on the objectives of
macro-economic policymaking. At
the most general level, the goal of economic policy is to maximize
long-run societal well-
being in an equitable and sustainable manner. Much of the recent
discussion of economic
policy has focused on intermediate variables, such as price
stability or the balance of
payments. Intermediate variables, however, are not important in
their own right. Their
importance derives largely from their role as possible indicators of
economic
performance in terms of truly significant variables, such as growth,
development and
equity. Buiter, Willem (2003) for example, states that
price stability should be seen as a tool
for achieving important long-run objectives, such as greater
efficiency and long-term
growth. The centre of attention of macroeconomic policymaking should
be on `real
macroeconomics' and the use of productive capacity--the employment
of capital and
labour at their highest potential level--and improvements in that
productivity.
4
3.0 Stabilization and Growth
Birdsall, Nancy et al (2001) argues that what people truly care
about is the stability and
growth of their real incomes. It should be obvious why growth is
important: even small
changes in the rate of growth, say, from 2.5 per cent to 3 per cent,
add up significantly
over time because of the effect of compounding. With a growth rate
of 2.5 per cent,
incomes double every 28 years; with a growth rate of 3 per cent,
they double every 23
years.
It's the overall stability of output and the real economy, and not
just price stability, that
concerns firms when they make investment decisions. Levine, Ross et
al (1992), states that
high instability generates an `unfriendly' domestic
macro-environment that appears to be
a crucial factor in explaining low rates of capital formation: firms
have less incentive to
invest, and growth will be lower. Similarly, economic policies that
lead to fuller
utilization of resources today may also lead to higher incomes in
the future. This implies
that there may be less of a trade-off between growth and stability
than orthodox
economics suggests.
Barro, Robert (1997) indicates that issues of stabilization and
growth cannot be separated. In
general, the conduct of short-run stabilization policy has long-term
effects. If the
economy's output is lowered 10 per cent today, the best estimate is
that the output path
will be 10 per cent lower than it otherwise would have been ten
years from now. That
means that downturns have long lasting effects. Even Korea and
Malaysia, countries that
economists regard as having recovered well from the Asian crisis,
are moving in a path
some 10 points below the trend they set in the pre-crisis decades.
4.0 Inflation
Bank of Japan (2003) observes that although mainstream economics has
focused on price
stability as one of its primary policy objectives, there is
considerable confusion as to its
role. High inflation is said to signal that the government (fiscal
and monetary authorities)
is not doing its job well. Inflation is thus a variable that is of
concern not in its own right,
but as an indicator of economic mal-performance. There are,
however, two problems
with this analysis. First, many people have started to view the
indicator as the policy
objective itself. Second, the links between inflation and real
variables may be weaker
than usually assumed.
Bruno, Michael (1995) indicates that all economic policies involve
trade-offs, the question
here is whether the benefits of further reducing inflation outweigh
its costs. Since 1991
most developed and developing countries have experienced low or
moderate inflation,
with many countries experiencing relatively low inflation. When
inflation is low or
moderate, efforts to reduce it further may have smaller benefits and
increasing costs,
especially when traditional contractionary monetary policy is the
only instrument used to
fight it. As i will discuss below, this may dampen employment in the
short-term and
growth in the longer-term.
5
Much of the importance placed on fighting
inflation in developing countries like Kenya
today stems from the history of hyperinflation in several
Latin American countries in the
1980s. There were also episodes of very high inflation in some
transition economies of
central and Eastern Europe in the early 1990s. But countries in Asia
have rarely
experienced hyperinflation, and the African experiences have been
quite different from
the Latin American experiences.
According to Bruno, Michael (1995), there is general agreement that
hyperinflation has large
economic costs, and that defeating it should be a top priority.
Hyperinflation, and even
high and uncertain inflation, creates huge uncertainty about changes
in relative prices,
which can be devastating for the information quality of prices and
for the efficiency with
which resources are used. Behaviour gets distorted as firms and
individuals work to
spend money quickly, before it diminishes in value. In some
countries, huge amounts
have been spent on institutional arrangements to protect individuals
from the effects of
inflation. Under more moderate inflation levels (let's say 15 to 20
per cent), these costs
will be much lower.
4.1 The Impact of Inflation on Growth
There is little evidence that moderate inflation has a significantly
adverse impact on
growth. Real growth rates in periods of fairly high inflation have
sometimes been
impressive--and far better than growth rates in seemingly similar
countries that have
brought inflation down. Very high inflation and hyperinflation have
been generally
associated with low growth or open economic recession, although
there are exceptions to
the rule, as in Israel in 1979-1985.
Bruno, Michael (1995) indicates that moderate rates of
inflation have been accompanied by
rapid economic growth quite often, as in Argentina in 1965-1974,
Brazil in 1965-1980,
Chile in 1986-1996, and Poland in 1992-1998. The view that low
inflation facilitates
economic growth is not valid as a general proposition. For
several of these countries, the
periods of low inflation have been among those with the slowest
rates of economic
growth, such as Argentina in 1994-2001, Brazil in 1996-2003, and
Israel in recent years.
Ben-David, Dan et al (1998) observes that unexpected or volatile
inflation has been more
problematic. The high variability in interest rates associated with
volatile inflation can
pose a serious problem in economies where firms have borrowed
extensively, as was
apparent during the Asian crisis. The rise in interest rates led to
widespread bankruptcies
because firms were carrying large levels of short-term debt that had
to be refinanced at
extremely high rates. Of course, had there been a history of high
volatility of interest
rates prior to the crisis, firms probably would not have held so
much short term leverage
in the first place, and the volatility in inflation would have had
far less impact. If firms
come to believe that there will be periodic episodes of high
interest rates, they will limit
their borrowing. But, as explained below, this too can have a
significant adverse effect on
growth.
6
Policymakers should, of course, undertake
policies that mitigate the effects and facilitate
a broad adjustment to `shocks'. When governments respond to
inflation by tightening
macroeconomic policy, while doing little to facilitate the broader
adjustment, the country
is likely to be worse off, especially when the `shock' has already
led to an economic
slowdown.
Overall, it seems clear that the inflation threshold differs from
country to country; but in
general, i can say that the threshold is significantly higher than
the extremely low levels
advocated in most inflation targeting regimes of the late 1990s and
early 2000s. Moderate
inflation does not seem particularly bad for growth, and too low
inflation (aiming at price
stability) may actually be bad for growth.
4.2 The Costs of Fighting Inflation
The benefits of maintaining low inflation have to be offset against
the costs. The costs of
inflation depend, of course, on how inflation is fought. But
whatever the specific tools
employed, the fight against inflation usually leads to higher
unemployment, at least in the
short run, and the risk of lower growth in the medium term.
One of the arguments against excessive inflation as stated by
Alesina, Alberto et al (1993).
is that it impairs the efficiency of the economy, but using tight
monetary policy to fight
inflation can be equally damaging. In Russia, excessively tight
money from 1993 to
1998--defended on the grounds that it was needed to combat
inflation--had extremely
adverse effects on efficiency to the point that between 60 and 80
per cent of all
transactions were conducted by barter. High interest rates used to
fight inflation can also
cause widespread bankruptcies, especially when an economy is
characterized by a
significant amount of leverage, as was the case in East Asia.
A heavy reliance on monetary policy to stabilize the economy may
also lead to interest
rates being highly variable. Both high and excessively variable
interest rates make funds
more expensive. In developing countries like Kenya, equity markets
work poorly, and
most outside financing is in the form of debt. If firms are
reluctant to take on debt they
will have to rely on self-finance, and will find it difficult to
meet their working capital
needs. Thus high and variable interest rates impair the efficiency
of capital markets,
further lowering growth rates.
Akerlof, George et al (1993) indicates that sometimes
governments address one problem,
such as inflation, while exacerbating others. One way to check
inflation is to allow the
currency to appreciate. This reduces aggregate demand and domestic
price pressures at
the same time that imported prices in local currencies fall. Even
when governments do
not deliberately focus on the currency, the exchange rate typically
strengthens when the
government fights inflation by raising interest rates. While this
may reduce inflation, it
can have other costs. The strong currency can hurt exports, the
sectors that compete with
imports, and employment generation. The resulting trade deficit may
lead to an external
balance problem for the future even worse than the problems that
might otherwise have
resulted from inflation.
7
5.0 External Balance
Levine, Ross et al (1992) observes that, like inflation, external
balance is an intermediate
variable, less important in its own right, and more important for
its impact on variables
that are of greater concern, such as stability and growth. It is not
always easy to evaluate
the links between external balance and the more fundamental
objectives (just as it's
difficult to evaluate the links between inflation and the
fundamental objectives).
Countries generally try to maintain rough external balance--but what
this means is not
always clear. Some countries, like the United States, have
maintained large trade deficits
for a long time, without a serious problem. Others seem to face a
problem after only a
short period of a relatively moderate trade deficit.
Frenkel, Roberto (2004) observes that. in the world of fixed
exchange rates that prevailed
before the early 1970s, a country that was buying more from abroad
than it was selling
had to pay for the gap, either by borrowing abroad or selling
international reserves.
Eventually, a country's reserves would run out, and its creditors
would no longer be
willing to lend, leading to a crisis. With flexible exchange rates,
the sequence is slightly
different, but the outcome is not dissimilar. If the country seems
to be borrowing
excessively, lenders and other investors may suddenly lose
confidence in the country and
want their money back. The exchange rate plunges as investors try to
take money out of
the country, making it even more difficult for those in the country
to repay dollar-
denominated short-term debt.
Borrowing from abroad has both short-term and long-term
consequences, but the nature
of those consequences depends on what gives rise to the borrowing.
If countries borrow
to finance productive investments that will generate returns in
excess of the interest rate
charged, then growth will be enhanced. Investors will recognize the
economy's increased
strength and should have more confidence in it. But, by borrowing
abroad, the country is
taking on foreign currency risk, so that a devaluation of the local
currency will raise the
amount of external debt relative to domestic GDP.
Dodd, Randall et al (2005) states that frequently, however, capital
inflows (especially short-
term inflows) go to finance increased consumption. Then foreign
investors might be
justifiably worried about the country's ability to repay its debts.
A lack of external
balance might then be heralding a crisis that will have enormous
costs to society.
Argentina, for example, experienced zero inflation and a strong
consumption-led
recovery in 1996-1997 fuelled by capital inflows. GDP growth
averaged over 6.7 per cent
per year. But the current account deficit as a per cent of GDP
nearly doubled, and
unemployment remained high. The recovery was then followed by a
four-year recession
(1999-2002), during which GDP fell 18 per cent and unemployment
rose.
6.0 Unemployment and Poverty
Frenkel, Roberto (2004) notes that one central objective of
macroeconomic policy should be
to maintain the economy as close to full employment, or full
utilization of the labour
8
force, as possible. Economists consider some
unemployment necessary since it takes time
for workers to move from one job to another, buts significant
underutilization of a
country's capacity obviously represents a great waste of resources.
One problem policy
makers face is at what level they should start to be concerned with
unemployment. As we
discuss later, there is generally a trade-off between unemployment
and inflation. The
question that economists usually ask is how low the unemployment
rate can go without
setting off inflationary pressures. (A similar question could
probably be asked in relation
to underemployment in developing countries like Kenya, but this has
not been subject to
systematic research).
Jorgenson, Dale et al (2001) observes that unemployment and
underemployment are two of
the most important sources of poverty and inequality; without a job,
individuals in most
developing countries are condemned to a life of poverty and
exclusion. Unemployment
also weakens workers' bargaining position, thereby lowering wages
and further
increasing inequity. There are, of course, also huge social costs of
unemployment. But
there are further reasons why unemployment may have a particularly
strong impact on
poverty and inequality.
First, high unemployment typically hurts the least skilled people
the most. There is a `job
ladder', with the most skilled taking jobs from the less skilled in
times of a job shortage.
That is why the unskilled are most likely to experience bouts of
unemployment. Second,
high unemployment pushes down wages, and this increases inequality
even more. Third,
in many countries, especially developing countries, unemployment
insurance is non-
existent or woefully inadequate, and most workers have only a small
buffer of savings.
Hence, after an extended period of unemployment, savings are
consumed, and individuals
generally lose any assets that have been collateralized.
It is clear that two key objectives--maintaining low unemployment
and
underemployment and reducing poverty--typically complement one
another. By the
same token, some policies that promote growth also help to reduce
poverty. But other
policies might promote growth without reducing poverty or promote
stability without
stimulating growth. There are important trade-offs, especially when
policymakers focus
on intermediate variables. In the next section, we look at the main
macroeconomic policy
tools, the trade-offs associated with them, and their use in
achieving long-term and short-
term economic objectives.
7.0 Fiscal and Monetary Policies
Gaspar, Vitor et al (2002) states that the three standard
macroeconomic policy instruments
that governments use to stabilize the macro-economy are fiscal,
monetary, and exchange
rate policies. Yet there are debates on the efficacy of each of
these instruments. For
example, some economists argue that fiscal and monetary policies are
ineffective in all
countries. Others argue that they are important policy tools, though
their effectiveness
depends on conditions in the economy. In addition how policies are
pursued is important:
different instruments have different implications for effectiveness,
equity, development,
and growth.
9
Discussions of policy instruments are often further confused because
governments have
limited ability to pursue one policy independently of the others.
For example, under a
fixed exchange rate system, the exchange rate chosen by the
government might not be
sustainable, given the chosen fiscal and monetary policies. This is
especially true with
open capital markets, since monetary or fiscal policy choices can
cause capital to leave or
enter the country, putting pressure on the fixed exchange rate. I
also discuss the
importance of policy coordination and how this affects basic policy
choices, including the
institutional framework for policymaking.
7.1 Fiscal Policy
Marf�n, Manuel (2005) observes that much of the fiscal policy debate
has come to focus on
the need for developing countries to maintain tight fiscal policy.
One widespread view is
that fiscal deficits should be avoided because they `crowd out'
private investment, can
lead to a loss of investor confidence, and are inflationary.
Standard Keynesian
economics, on the other hand, emphasizes that fiscal policy is an
effective tool for
stimulating an economy facing an economic slowdown.
Yet, even those who believe in the efficacy of fiscal policy in
developed countries
recognize that developing countries face significant impediments to
relying on fiscal
policy during economic downturns (which is when they should engage
in deficit
spending). Many governments like those in Kenya and Tanzania find it
difficult or
expensive to borrow the funds necessary to finance government
spending, while countries
that are able to borrow risk running up excessive debt burdens that
could be difficult to
repay in the future � especially when the funds are not well
invested.
7.1.1 Sources of Fiscal Revenues and Policy Constraints
Borrowing Constraints
Fern�ndez de Lis et al (2001) notes that one of the main reasons the
IMF was founded in
1944 was to help countries in depressed conditions finance deficits
for economic
expansion. The founders recognized the interdependence of nations,
which means that a
downturn in one country can have adverse effects on others. They
also recognized that
capital markets are imperfect, and some countries, especially those
that are heavily
indebted and need funds the most, are sometimes unable to borrow at
all. The modern
theory of capital markets, with asymmetric information and costly
enforcement, explains
why such credit rationing can occur. When it does, countries are
forced to engage in
procyclical fiscal policy: they are forced to cut their deficits
during economic slowdowns,
exacerbating the recession.
Aid Delivery and Absorption
Since the Millennium Development Goals (MDGs) were agreed by the UN
General
Assembly in 2000 and the Monterrey consensus on Financing for
Development in 2002,
10
efforts have been underway to muster support to
increase development assistance to 0.7
per cent of developed country national income. In addition, the
change in aid modalities
has moved towards more direct budget support. The new environment
poses challenges
for both aid donors and recipients. Most people would naturally
expect that an increase in
aid would lead to an increase in spending. What few realize is that
this is only one half of
the equation--aid really only benefits the recipient economy when it
is absorbed. In the
best of times, coordination is needed between officials in the
Ministry of Finance and the
Central Bank. With budgetary support, this cooperation is of
paramount importance.
Aid financing is like other foreign inflows: it impacts exchange
rates, interest rates, and
domestic prices, as we discuss later in this note. The injections of
liquidity, through the
conversion of donor flows into domestic currency, can cause
gyrations in interest and
exchange rates, especially when flows are volatile. Donor flows may
produce exchange-
rate appreciation and, if sustained over a length of time, could
lead to the kind of
overvaluation phenomenon known as `Dutch disease', which we discuss
later, following
the section on exchange rate policies.
Ocampo, J.A. (2002) states that predictability of aid flows over
time is a precondition for
their effective use. But aid flows, like other capital flows, tend
to rise and fall with
economic cycles in donor countries and policy assessments of the
recipient countries, as
well as shifts in donor policies. This volatility is exacerbated by
the gap between
commitments and disbursements. Empirical work suggests that the
volatility of aid flows
exceeds that f other macroeconomic variables, such as GDP or fiscal
revenue. Moreover,
donors end to move in and out together, causing herding behaviour.
The PRSP function
like a rating signal for donors, and they react in a similar fashion
to signals by Bretton
Wood institutions � in many ways, similar to the reactions of
private creditors. When aid
falls; it leads to costly fiscal adjustments in the form of
increased taxation and spending
cuts that reinforce the cyclical impact of declining aid flows.
Similar to other capital
flows, the volatility of aid flows also affects the balance sheets
of the banking system and
credit availability.
Policymakers need to look at the longer term as well, and answer
some hard questions as
they make decisions. If one expands public sector investment now,
using aid, will the
government be able to maintain that level of spending in the future,
when the aid flows
begin to slow? If not, is the initial spending wasted? Countries
like Kenya and other
developing nations need to design policies to reduce aid dependency
by maintaining and
increasing domestic revenues in a sustainable fashion.
Public Resource Mobilization
Tanzi, Vito et al (2001) notes that the most effective way to fund
government spending and
reduce aid dependency is to mobilize domestic resources. The low
levels of tax collection
in many poor countries limits important government expenditures and
forces countries to
borrow or depend on aid flows to finance basic development needs.
Given the volatility
of external financing and the important role that public sector
investment can play in
long-term development, it is critical for governments to be able to
raise domestic
11
revenues. Only with increased tax revenues will
countries be able to sustain long-term
domestic investments and fiscal policy flexibility.
Martner, Ricardo et al (2003) observes that poor countries, on
average, collect only around
about two-thirds of the tax revenues as a percentage of GDP
collected by richer countries.
Even some of the wealthier emerging market countries, such as India,
still have relatively
low tax revenue to GDP. In most developing countries direct taxes,
such as income taxes,
contribute only a small percentage of total tax revenues. For
example, tax collection on
income, profits, and capital gains in Latin America and Asia is
one-third to one-half of
collection levels in OECD countries.
Auerbach, Alan (1991) notes that most developing countries rely on
indirect taxes for
revenue. Many of the reforms of the 1990s and 2000s, which pushed an
agenda of
liberalization, shifted taxation to VAT from other indirect taxes,
such as tariffs and other
trade taxes. VAT is a tax on consumption, rather than investment,
and many orthodox
economists supported the shift to VAT because they believed it would
distort incentives
to invest less than other types of taxes. Yet VAT is also a tax on
the formal sector. It is
therefore not as effective in countries with large informal sectors.
In these countries VAT
operates like a tax on sales rather than a tax on value added. In
fact, VAT can encourage
firms to stay in the informal sector to avoid taxation, hindering
the development of the
formal sector.VAT is also a regressive tax, meaning that the poor
pay more as a share of
income than the wealthy.
Although the WTO has limited the ability to use trade taxes, there
is still some scope
within the WTO for some use of trade taxes as well. For example,
taxes can target luxury
items that are imported; or a system of variable tariffs on
agricultural and industrial goods
can operate in a band within the WTO tariff bindings. (These and
other trade-related
taxes are discussed in the Trade Policy Note in more detail.)
Countries can also impose
export duties to capture some of the gains from devaluation.
Argentina, for example,
imposed export duties that generated revenues of almost 2.5 per cent
of GDP following
the devaluation of the peso in 2001.
Martner, Ricardo et al (2003) states that to reduce evasion,
countries can also try to design
more `corruption-resistant tax structures' that rely on
non-discretionary and readily
observable tax instruments. One such measure is a tax on financial
transaction. Countries
such as Argentina, Brazil, India, and Korea imposed this type of a
tax on bank debits. In
Brazil, for example, the financial transaction tax collects around
1.5 per cent of GDP.
These taxes have the added benefit of providing information about
firm transactions that
can help authorities increase collection and find evading firms.
Korea has also
implemented a similar program to reduce the attractiveness of cash
by offering a subsidy
for credit cards. The goal is to shift transactions from cash to a
medium that is traceable.
These types of taxes generally carry the risk that they might
encourage firms to operate
outside the formal banking sector, but in countries where banking
services are relatively
well developed, these taxes have proved to be effective.
Furthermore, they play a
countercyclical role by slowing financial transactions during
financial booms and
bubbles.
12
7.1.2 The Effectiveness of Fiscal Policy
I now turn the focus to the effectiveness of fiscal policy. Assuming
countries can borrow:
is fiscal policy generally effective � or should it be avoided
because it adds to inflationary
pressures and crowds out private investment? Later in this note I
will discuss low-cost
stimuli and other fiscal measures that countries with limited
ability to borrow can use to
stimulate the economy.
Mahadeva, Lavan et al (2000) observes that in Keynesian analysis,
government expenditures
(or tax cuts) lead to an increase in GDP that's a multiple of
the original expenditure. Most
of the money paid by the government is re-spent, and the more that's
re-spent, the greater
the multiplier. If savings rates are low, as they often are in very
poor countries, then the
proportion of funds going into consumption will be high, the
multiplier will be very large,
and public expenditures will be particularly effective. By contrast,
in East Asia, where
savings rates have been very high, multipliers have been somewhat
smaller.
When households and firms are credit and cash constrained (as there
often are in
developing countries), the multiplier can be even stronger: if those
households and firms
had more money they would spend it. For example, if the government
provides better
unemployment benefits, it's likely that the unemployed will spend
all or almost all of the
benefit. When they spend the money, some of it will go to
individuals (landlords,
storeowners, etc.) who will not spend all of it, but the important
point is that in
developing countries the multiplier can be quite high.
McKinley, Terry (2005) notes that it's important to differentiate
between the effects of
deficits when the economy is in recession and when the economy is at
full employment;
the latter case is when deficits are more likely to have an adverse
effect. Crowding-out
(and inflationary) arguments are then persuasive because the size of
the `pie' is fixed.
When the economy is operating at capacity, increased government
expenditures must
come at the expense of reduced consumption or reduced investment
somewhere else in
the economy. But crowding out is not inevitable when the
economy is below full
employment. The size of the pie can increase so that government
expenditures can rise
without private investment decreasing. Or, in the case of tax cuts,
consumption can
increase, without investment decreasing.
Finally, private sector responses may actually have the opposite
effect � and enhance the
effects of fiscal policy. There may be `crowding in'. For instance,
higher government
expenditures might stimulate the economy and improve the economic
situation so much
that there's room for more investment. Similarly, an increase in
government investments
that complements private investment (for example, spending on
infrastructure) can
increase returns in the private sector and stimulate private
investment and the economy as
a whole.
FitzGerald, Valpy (2006) argues that the success of China's
expenditures during the East
Asian crisis provides a case in point. Part of the reason for
China's success was that
13
current expenditures drew upon a set of
strategic investment plans that focused on
improving infrastructure. The improved infrastructure increased the
returns to private
investments. This, in turn, encouraged productive investments that
stimulated China's
long-term growth. India's experience with stabilization and
adjustment, following its
external debt crisis during the early 1990s, was somewhat different.
Yet, it also provides
clear evidence of complementarities between public investment and
private investment,
which suggests crowding-in rather than crowding-out.
7.1.3 Alternative Fiscal Policy Measures
Fiscal Policy Accounting: Structural and Primary Deficits
Svensson, Lars (2000) observes that a primary aim of economic policy
in developing
countries like Kenya should be to avoid the procyclical bias in
fiscal policy. This can be
consistent with the establishment of rules that guarantee long-term
sustainability of the
fiscal account, such as targets for the public sector deficit and/or
maximum debt-to-GDP
ratios. (The definition of such rules is not an easy task, however,
as demonstrated by the
recent debates over the European Stability and Growth Pact.)
Schneider, Benu (2006) observes that in particular, a focus on the
current fiscal deficit
(measured during the recession) is clearly inappropriate. Rather,
it's essential to estimate
`the structural deficit', which evaluates what the budget
would be without cyclical
fluctuations in a `normal' (full employment) situation. For example,
when tax revenues
fall during a recession, the current fiscal deficit will worsen, but
the structural full
employment deficit will not be affected, and the government will not
be forced to tighten
fiscal policy further to meet its deficit target. If necessary, the
institutions could play a
role in financing any current fiscal deficit that arises. To
the extent that cyclical swings
reduce the efficiency of public sector spending, it may make sense
to determine structural
targets on the basis of an essentially long-term criterion: the
balanced supply of public
and private goods.
Management of Public-private Partnerships
Zahler, Roberto (2003) notes that deficit targets should be
complemented by adequate
mechanisms to manage public-sector guarantees. Deficit targets
create a strong incentive
for governments to promote private (rather than public) sector
investment in
infrastructure to circumvent the targets, even when there is no
economic reason to do so.
A major problem in relation to these guarantees is that they
generate significant
distortions in public sector accounting. The contingency costs of
such projects for the
state are not usually accounted for, and do not show up in current
expenditures. Such
guarantees imply that the government acts as an insurer of risks
that the private investor
might incur. The `insurance premium equivalent' of such guarantees
should be regularly
estimated and budgeted, with the corresponding resources transferred
to special funds
created to serve as a backup in the event that the corresponding
contingencies become
effective. The estimated contingent liabilities should also be added
to the public sector
debt.
14
Automatic Stabilizers: Fiscal Stabilization Funds
Due to the inevitable time lags in the decision making process,
automatic stabilizers may
sometimes be preferable to discretionary changes. Progressive
taxation, which reduces
the impact of taxation on the poor during a recession, is one such
stabilizer. (The shift
toward V.A.T., has moved countries away from progressive taxation,
which may lead to
the tax system being a less effective automatic stabilizer.)
Well-designed social safety
nets that protect vulnerable groups during crises, preferably as
part of permanent social
protection systems, and fiscal stabilization funds are other
important instruments in this
regard.
Fiscal stabilization funds, which sterilize temporary public-sector
revenues, should be a
central tool for countercyclical policy. The experience gained from
the management of
stabilization funds for commodities that have a significant fiscal
impact (the National
Coffee Fund of Colombia, the copper and petroleum funds in Chile and
the oil funds in
several countries) can be extended to develop broader fiscal
stabilization funds. A similar
example is foreign exchange reserves, which provide `self-insurance'
against sudden
interruptions in external financing (as well as reduced currency
appreciation).
7.2 Monetary Policy
Orthodox economists, for the most part, believe that monetary policy
is relatively
ineffective. In this school of thought, the economy normally
operates close to full
employment (a condition clearly not applicable to most developing
countries), so that any
increase in aggregate demand cannot increase output; it can only
push up prices. On the
other hand, Keynesians believe monetary policy is an important tool
in macroeconomic
management.
7.2.1 The Effectiveness of Monetary Policy
Zahler, Roberto (2003) notes that recent experiences confirm both
the strengths and
limitations of monetary policy. In general, economists view monetary
policy as more
effective in restraining an overheated economy than in expanding an
economy in deep
recession. Monetary policy, for example, has not been effective in
stimulating growth in
countries experiencing deflation (such as Japan). In the United
States, lowering interest
rates from 2001 to 2003 did little to stimulate investment, but did
induce households to
refinance their mortgages. The reduced mortgage payments and the
improved financial
position of households enabled consumers to sustain their spending
even as their stock
market wealth diminished enormously.
Shapiro, Carl et al (1984) observes that the impact of monetary
policy in developing
countries is likely to differ from the impact in the United States
and other advanced
industrial countries. Monetary policy has its most direct impact
through the banking
system. In countries with more developed banking sectors the effects
of monetary policy
can be more significant in developing countries than in developed
countries since firms
15
have less access to nonblank sources of finance
and tend to rely more on bank lending. In
many least developed countries, though, the banking sector is
extremely undeveloped,
and most firms rely on self-finance. In these circumstances, the
impact of monetary
policy on the economy is limited. The narrower the impact of
monetary policy, the
greater the costs associated with using it, since a few sectors are
forced to bear the brunt
of adjustment. Those sectors may face greater volatility, as
interest rates rise and fall in
an attempt to stabilize the economy.
Under conventional closed economy analysis, lowering interest rates
leads to increased
investment and higher growth. Recent research points to additional
channels through
which changes in interest rates either reinforce or counteract the
conventional effects.
First, there are several channels through which lowering interest
rates may stimulate
consumption further than the conventional analysis implies. Changes
in the interest rate
represent a redistribution of income between creditors to debtors.
Distribution matters:
debtors may have a higher marginal propensity to consume than
creditors. If firms and
households are credit constrained, lowering interest rates may mean
that firms will have
more money for investment and households will have more money for
consumption. In
addition, there may be wealth, or balance sheet effects. The value
of assets such as stocks
and real estate increases with lower interest rates; and the
increased wealth may induce
households to consume more.
On the other hand, recent research also suggests additional reasons
why monetary policy
might be ineffective. In particular, Greenwald and Stiglitz
(2000) emphasize that credit,
and not the money supply, matters for the level of economic
activity. The banking system
is central in determining the supply of credit. Even if the interest
rate on treasury bills
falls, banks may be reluctant to lend more when they believe their
balance sheets are
weak, or when they perceive the risk of lending to be very high (and
therefore, can
achieve high, safer returns by lending to the government). This is
further complicated in
an open economy by the impact of capital flows. Standard Keynesian
analysis does not
explicitly deal with capital inflows. To the extent that it does, it
assumes that their effects
can be fully sterilized through monetary policy. But this analysis
overlooks the impact of
capital flows on the supply of credit. Capital flows affect the
resources available to
households and firms, and even affect the lending activity of banks.
One reason why it is difficult to disentangle the effects of
monetary policy on an open
economy, particularly one with flexible exchange rates, is that the
impact on capital flows
is hard to predict. The general view is that, other things being
equal, an increase in a
country's real income generated by expansionary macroeconomic
policies is likely to
induce capital inflows. So too, other things being equal, an
increase in the interest rate �
associated with, say, a contractionary monetary policy � will induce
capital inflows and
lead to an exchange rate appreciation (and, alternatively, a lower
interest rate will result
in capital outflows, and a weaker exchange rate). But other things
are never equal,
particularly due to the complex interaction between interest rates
and capital flows.
Reinhart, Carmen et al (2004) notes that in an open economy, lower
interest rates can lead to
capital outflows and a weaker exchange rate. This, combined with the
weakened balance
16
sheets that often result from exchange rate
devaluations, may limit credit availability, and
could attenuate, or even reverse, the normal impact of lower
interest rates on aggregate
demand. Any attempt by policymakers to counteract the drop in demand
by lowering
interest rates further will be partially self-defeating, as the
lower interest rates will induce
even more capital outflows. In other words, open capital markets
limit the effectiveness
of monetary policy.
Kaminsky, Graciela et al (2004) states that .higher interest rates
may attract capital inflows,
increasing the credit supply and leading to higher investment,
limiting or reversing the
usual effect. In addition, there are two medium-term effects of
raising rates. First, when
the central bank raises rates, it usually raises short term rates,
attracting short term
speculative capital. These flows often go into consumption or real
estate, rather than into
long-term productive investment. The implication is that the
short-term boom is
exacerbated, without a long-term positive impact on growth. Second,
the increased
inflows also lead to currency appreciation. This can slow the
economy in the medium to
long term as export and import-substitution industries become less
competitive. The
capital inflows can lead to changes in the structure of production
that stymie medium to
long term growth, while the higher rates do little to limit the
short-term bubble.
Indirect Monetary Policy Instruments
Standard indirect interventions include open-market operations,
changes in reserve
requirements, and central bank lending facilities. Most developed
countries use open
market operations as their main monetary policy tool. Open
market operations are most
effective when countries have relatively developed and liquid
capital markets.
Ffrench-Davis, Ricardo et al (2003) observes that some countries
have gotten around this by
issuing Treasury Bills in the primary market through auctions. The
quantity of new bills
issued, net of the amount of maturing bills, has the effect of
increasing or decreasing the
money supply, similar to open market operations. Nonetheless, when
markets are
underdeveloped or illiquid, the price signal is generally not
efficient, and this method is
usually supplemented by additional mechanisms.
A second monetary tool is the discount rate. The discount
rate is the interest rate the
central bank charges commercial banks for loans, which are usually
short-term in nature.
Some central banks use the discount rate as a signal; for others,
especially those with less
developed markets in which open market operations are not very
effective, it is the main
instrument of monetary policy. The central bank can also use the
discount window to act
as a lender of last resort during liquidity shortages. A third
method for managing the
money supply is through reserve requirements. Reserve
requirement stipulates that banks
hold a percentage of their total reserves with the central bank.
Reserve requirements are
generally not used significantly as monetary policy tools in most
industrialized countries.
However, reserve requirements can be a useful instrument, especially
when targeted to
specific sectors, as discussed below under `direct mechanisms'.
Direct Mechanisms and Other Microeconomic Measures
17
Goodfriend, Marvin et al (2001) notes that monetary policy is
a blunt tool: raising interest
rates affects all sectors of the economy, those experiencing
bubbles, as well as those
experiencing fragile recoveries or still in recession. Rather than
relying on interest rates,
authorities can use other measures to target specific sectors of the
economy. In this
regard, there are three issues that are particularly important for
developing countries: how
to target bubbles; ways to encourage credit when constraints are
specific to certain
sectors of the economy; and ways to encourage bank lending when
credit constraints are
more general.
Direct measures can be extremely useful in developing countries like
Kenya that want to
maintain economic growth, but worry about excessive investment in a
particular sector.
When bubbles exist, central banks can raise reserve requirements on
loans to the sectors
affected, such as real estate or equity markets. This mechanism
could have been effective
at limiting some of the build-up in bubbles prior to the Asian
crisis.
Gordon, Roger et al (2005) observes that when the banking system is
inefficient, these
measures can be particularly useful. Whereas indirect instruments
generally require a
well-developed money market, direct measures are relatively easy to
implement. Many
developing countries are in a position where administrative controls
still work fairly
well--far more effectively than traditional channels of monetary
policy. The
administrative measures China employed in 2004 and 2005, for
example, seem to have
been relatively effective in curtailing the real estate boom. Had
the government relied on
interest rate increases, it would have squelched investments in
factories and other job
creation at the same time (or even before) it had tamed the
speculative boom.
When credit rationing exists, as it does in most developing
countries, what is relevant is
not loan demand, but loan supply; authorities need to implement
policies to induce banks
to increase lending. For example, changing regulatory policies, such
as capital adequacy
requirements and other banking regulations, can impact credit
availability. When
inflation is due to supply shortages in sectors of the economy
experiencing credit
constraints, authorities can look to innovative ways to ensure that
credit reaches these
sectors, rather than raising interest rates and slowing the economy
as a whole.
Development banks are one tool that can help direct credit to areas
in need. Recent
research has focused on isolating market failures and constraints on
growth and on using
market mechanisms, rather than discretion, to determine those
sectors in need.44
7.2.2 The Macroeconomic Dimensions of Prudential Regulations
Gordon, Roger et al (2005) observes that changes in banking
regulations have more
macroeconomic implications than is usually accepted (their effects
tend to be ignored in
most macroeconomic analysis). Banks use microeconomic risk
management to reduce the
risks associated with the individual characteristics of borrowers,
and prudential
regulations have been designed to encourage banks to manage these
risks. But it is more
difficult to reduce risks associated with the common factors that
all market agents face,
such as the effects of macroeconomic policies and the business
cycle. In recent years,
18
increasing attention has been placed on risks
that have a clear macroeconomic origin, and
ways to use prudential regulations as a tool for macroeconomic
policy. Traditional
regulatory tools, including both Basle I and Basle II standards,
have a procyclical bias. In
these systems, banks have to provision capital against loan
delinquency or short-term
expectations of future loan losses. Since expectations of losses are
low during economic
expansions, these systems are not effective in hampering excessive
risk-taking during
booms.
The Spanish system of forward-looking provisions, introduced in
December 1999, is a
major policy innovation in addressing the pro-cyclical elements of
prudential regulation.
According to this system, provisions are made when loans are
disbursed based on
expected (or `latent') losses. Such `latent' risks are
estimated on the basis of a full
business cycle, and are not based on the current economic
environment. This system
implies that provisioning follows the criteria that are
traditionally used by the insurance
industry (where provisions are made when the insurance policy is
issued) rather than by
the banking industry (where they are made when loan payments come
due).
8.0 Microeconomic Measures
In addition to direct management of the exchange rate, microeconomic
interventions can
be used to impact relative prices. For example, microeconomic
policies can be used to
change the composition of demand towards non-tradables and away from
imports. Tax
policies that encourage more spending on domestically produced goods
and less on goods
produced abroad will help to stimulate the economy, and at the same
time, strengthen the
currency. In many developing countries, most luxury consumption
goods are imported. A
high sales tax on such goods discourages these imports. Government
expenditures can
also be weighted towards domestically produced goods.
9.0 Monetary and Exchange Rate Policy Rules and Institutional
Design
Lance Taylor (2006) notes that the choice of exchange rate regime is
closely related to the
broader question of what monetary policy rules the central bank
should follow, and the
institutional design of the central bank itself. There are three
distinct but related
questions: whether the central bank should follow monetary policy
rules, such as fixing
the currency or inflation targeting, or whether it should follow
discretionary policies;
whether the mandate of the central bank should focus on inflation or
whether it should
include other policy variables, such as growth and employment; and
whether the central
bank should be independent.
9.1 Rules vs. Discretion and Inflation Targeting vs. Foreign
Exchange Targeting
In the 1980s, the most favoured rule prescribed expanding the money
supply at a constant
rate. Then, it became clear that the demand function for money was
unstable and hard to
predict, especially in developing countries, and the money supply
rule lost favour. Many
developing countries chose to target the exchange rate since it was
viewed as a simple
and transparent indicator. But the exchange rate crises in the mid
to late 1990s led to a
19
shift to flexible exchange rate regimes, and
today, inflation targeting61 is the preferred
monetary rule.
On the other hand, Keynesian economists generally believe that
central bankers should be
allowed to use more discretion than allowed by strict rules. Because
strict inflation
targeting rules do not distinguish between inflation fuelled by
expectations and inflation
fuelled by VAT increases or external shocks (such as oil price rises
or exchange rate
devaluations) it can lead to procyclical policies. For example,
inflation targeting can lead
to exchange rate targeting or contractionary monetary policies
during periods of
devaluations, counteracting the exchange rate effect on
competitiveness. Inflation
targeting often incorporates two widely used procyclical policies:
anchoring the price
level to a fixed exchange rate during periods of foreign exchange
inflows and
counterbalancing the inflationary effects of devaluation with
contractionary monetary
policies during periods of outflows. Strict inflation targeting can
therefore generate more
output volatility than monetary policy goals that take into account
other objectives such
as reducing the output gap.
J.A. Ocampo et al (2006) notes that a second issue to consider in
choosing monetary regimes
is the efficiency or stability of the inflation-targeting rule. This
is more complicated than
can be addressed in this note, but we will discuss it briefly. It
concerns, for instance, the
extent to which (and the circumstances under which) conventionally
measured changes in
inflation provide a good indicator of whether employment is above or
below the full
employment level. There is, in addition, a more fundamental question
surrounding
inflation targeting: whether a policy structure � in which monetary
authorities focus on
inflation and fiscal authorities focus, for instance, on external
balance � is a good way of
achieving the ultimate objective of full employment with external
balance.
Under inflation targeting, the government or monetary authority
announces a target for
the inflation rate, and the monetary authorities commit to achieve
this target. Inflation
targeting divides responsibilities between government and a monetary
authority, so that
each policymaker focuses on a single objective. The problem is that
dividing
responsibilities reduces coordination.
9.2 Central Bank Mandate
Budnevich, Carlos et al (1997) notes that many countries have
narrowed the mandate of the
central bank to fighting inflation. In the United States, however,
the Federal's Reserve
mandate is not only to ensure price stability, but also to promote
growth and full
employment. A Bank of England Survey of 94 Central Banks found that
only 26 per cent
had monetary stability as their only objective; 70 per cent had
monetary stability
combined with other goals; 3 per cent had no statutory goals; 1 per
cent had only non-
monetary stability as its goal.
There is some evidence that independent central banks with an
inflation target do achieve
lower levels of inflation--it would be striking if they didn't. But
inflation is only an
intermediate variable. The significant question is whether economies
with this
20
institutional structure achieve better
performance in real terms: growth, unemployment,
poverty, equality. There is little evidence that independent central
banks focusing
exclusively on price stability do better in these crucial respects.
Central banks make decisions that affect every aspect of society,
including rates of
economic growth and unemployment. Because there are tradeoffs, these
decisions can
only be made as part of a political process, as discussed in the
next section.
9.3 An Independent Central Bank
An independent central bank has become accepted as the most
appropriate institutional
arrangement to separate macroeconomic policymaking from the
political process. There
are, however, two main criticisms of this approach. The first
criticism is that the
arrangement can undermine democratic governance. Citizens consider
few issues more
important than the quality of macroeconomic management. By
delegating authority over
the economy to an independent central bank, the government is being
held accountable
for something over which it does not have authority. Moreover, we
have seen that
macroeconomic management entails trade-offs, with different
decisions affecting the
well-being of different groups. Such decisions are necessarily
political. Delegating them
to technocrats who are `independent' from the government undermines
democratic
accountability.
While economists and politicians have long discussed the
desirability of independent
central banks, they have spent much less time considering the
importance of
representativeness (or lack thereof) of these banks. The two
concepts are distinct. The
problem in many countries is that the governing body of the central
bank is typically not
representative of society and its broader interests.
Cobham, Alex (2005) notes that governments more sensitive to
democratic processes argue
that they, and not the central bank, should set targets, such as an
inflation target, because
the decision involves trade-offs, such as the trade-off between
unemployment and
inflation. But even a government specified inflation target does not
depoliticize the
conduct of monetary policy. The central bank is responsible for
reaching the target, and
missing it still can have costs that not everyone in society bears
equally.
10.0 Capital Market Interventions and Other Policy Options for
Open Economies
So far, in this note, i have focused on fiscal, monetary and
exchange rate policies. I have
also presented several heterodox measures as alternatives or
enhancements to these. One
of the most important set of economic tools available to
policymakers is capital account
controls and regulations. In this section, i will consider some
additional microeconomic
tools for macroeconomic management, focusing on capital market
interventions.
21
11.0 Interventions in Capital Markets
In the face of market failures in financial markets, pro-cyclical
capital flows and limited
room to manoeuvre for macroeconomic policy, capital market
interventions can be used
to serve multiple purposes. First, they can stabilize short-term
volatile capital flows.
Second, they can give policymakers additional instruments that allow
them more
effective and less costly macroeconomic stabilization measures.
Third, effective capital
account regulations can promote growth by reducing the volatility of
financing and the
volatility of real macroeconomic performance. Finally, they can also
discourage long-
term capital outflows. Of all the objectives of intervention listed,
discouraging long-term
capital outflows is perhaps the most difficult. Yet interventions
can be effective, even if
controls are partially circumvented. The most critical issue today
is not whether market
interventions are desirable in theory, but whether, in practice,
policymakers can design
interventions whose benefit to an economy outweigh the ancillary
costs.
11.1 Price and Quantity Based Controls on Inflows and Outflows
There are different types of capital account regulations. Capital
controls include quantity
and price-based regulations, both of which can be administered on
either inflows or
outflows. In addition, some countries use indirect regulations, such
as prudential
regulations on financial institutions or regulations on investments
of pension funds,
which have implications for capital flows. Thus, a broader concept
of capital account
restrictions is useful to understand the complementary use of, and
overlap among,
different forms of regulation.
Davis, Jeffrey et al (2003) observes that traditional quantity-based
capital restrictions
(administrative restrictions and controls) continue to be widely
used by developing
countries, including key countries such as China and India, despite
the gradual
liberalization of their capital accounts. These regulations are used
to target either inflows
or outflows on domestic or foreign residents. Regulations that
affect domestic residents
include restrictions on currency mismatches (only companies with
foreign exchange
revenues can borrow abroad), end-use limitations (borrowing abroad
is allowed only for
investment and foreign trade), minimum maturities for borrowing
abroad, limitations on
the type of agents that can raise funds abroad through ADRs and
similar instruments,
prohibition on borrowing in foreign currencies by non-corporate
residents and, in some
countries, overall quantitative ceilings. Limitations on
non-residents include restrictions
or a prohibition on their capacity to borrow in the domestic
markets, direct regulations of
portfolio flows (including explicit approval and limitations on the
assets in which they
can invest), sectoral restrictions on FDI, and minimum stay periods.
Easterly, William et al (2003) observes that economists have a
strong proclivity for price-
based as opposed to quantity-based interventions. Price-based
interventions are flexible,
non-discretionary and thus less susceptible to bureaucratic
manipulation, and in line with
market incentives. But the case for price-based interventions is far
from clear. Theoretical
work in economics has shown that sometimes quantity-based
restrictions can reduce risk
more effectively than price interventions.
22
Most economists also prefer regulating inflows to outflows. There
are several reasons for
this. First, regulating inflows helps prevents crises, which should
be the ultimate goal of
policymaking. Second, regulating inflows involves less uncertainty
and more
transparency: creditors know the cost of regulations before they
invest. But, again, the
arguments against regulating outflows are not clear-cut. For
example, restrictions on
outflows may be the only way to solve a collective action problem or
coordination market
failure. When markets exhibit herding behaviour (and creditors and
investors pull their
funds out of a country during a crisis because they are afraid that
others will pull their
funds out first), restrictions on outflows may be the only
instrument available to avoid a
downward recessionary spiral. Markets generally overshoot in these
circumstances, so the
restrictions are welfare enhancing.
The empirical evidence shows that all types of instruments can have
positive effects,
depending on the circumstances under which each mechanism is
applied. Policymakers in
China, India and Malaysia were able to use quantitative capital
account regulations to
achieve critical macroeconomic objectives, including prevention of
maturity mismatches,
attraction of favoured forms of foreign investment, reduction in
overall financial fragility,
and insulation from speculative pressures and contagion effects of
financial crises �
leading to greater economic policy autonomy.
11.2 Soft Controls: Encouraging Market Segmentation
Emran, Shahe et al (2005) notes that soft controls can require
domestic funds, such as social
security or pension funds, to invest their assets in domestic
markets and can prohibit or
limit investment abroad. These restrictions reduce the funds'
potential to generate pro-
cyclical disturbances. Soft controls have an additional positive
effect of creating a local
demand for domestic securities and helping to develop the local
capital markets, and
build a domestic capital base.
This kind of control might become particularly relevant in the
future because of the
growth of privately managed pension funds in many developing
countries, especially in
Latin America. In Chile (the pioneer in this area), such funds are
equivalent to 70 per cent
of annual GDP. Most countries place limits on the extent to which
domestic funds can
invest abroad, and have experienced new sustained growth in domestic
markets, in large
part because of the increased demand for local securities from
domestic pension funds.
Once again, the Chilean experience demonstrates the stimulating role
of pension funds on
the development of domestic capital markets. But it also
demonstrates how pension funds
can generate macro-instability when the markets are not segmented
and funds are allowed
to invest abroad.
12.0 Public-Sector Liability Management in Developing Countries
If domestic debt markets are thin, governments might be tempted to
finance expansionary
fiscal policies through borrowing abroad. But this exposes them to
greater future risk as a
result of exchange rate changes, and undermines the role of exchange
rate changes as part
23
of the adjustment process. One of the reasons
that the countries of East Asia did so well
for so long is that their high savings rate enabled governments to
invest at a high rate
without borrowing from abroad.
The Economist (2003) states that if foreign capital markets
were well functioning,
developing countries would be able to borrow abroad in their own
currency (or in a
market basket of currencies highly correlated with their own
currency). Well functioning
markets would enable the transfer of exchange rate risks to
developing country lenders
who can bear the risk more easily.78 There have been a few instances
in which this
happened, but by and large developing countries have to bear the
brunt of the risk of
exchange rate and interest rate fluctuations. What matters is not so
much the source of the
funds, but the risk associated with the debt, and given that foreign
borrowing entails the
imposition of these high risks, countries should limit their
exposure.
Baunsgaard, Thomas et al (2005) notes that although the fact that
government revenues are
largely related to domestic prices suggests that governments should
borrow in their
domestic currency, there are two reasons why this rule should not be
strictly followed.
The first has to do with macroeconomic management. The government
should manage its
external public sector debt to compensate for the highly procyclical
pattern of external
private capital flows. For example, during phases of reduced private
capital flows, the
public sector can be one of the best net suppliers of foreign
exchange, thanks to its
preferential access to external credit, including credit from
multilateral financial
institutions.
The second reason relates to the depth of domestic bond markets,
which determines the
ability to issue longer-term domestic debt securities. Well
functioning markets require the
existence of secondary markets and market makers that provide
liquidity for these
securities. In the absence of these pre-conditions, the government
faces a trade-off
between maturity and currency mismatches. It may make sense to have
a debt mix that
includes an important component of external liabilities, despite the
associated currency
mismatch. In the long run, the objective of the authorities should
be to deepen the
domestic capital markets. Due to the lower risk levels and the
greater homogeneity of the
securities it issues, the central government has a vital function to
perform in the
development of longer-term primary and secondary markets for
domestic securities,
including the creation of benchmarks for private-sector debt
instruments. The existence
of a government bond enables the market to separate out sovereign
risk from firm risk
more easily, and some assert that this facilitates corporate
borrowing.
13.0 Conclusion: Microeconomic Interventions and Other Heterodox
Measures
Bhattacharya, Amar et al (2000) observes that the claim is sometimes
made that such micro-
economic interventions should be avoided because they lead to
distortions; however,
there are several responses to this objection. First, in developing
countries especially,
there are limits to the effectiveness of the standard instruments;
the losses from
`Harberger triangles' (losses in efficiency, from, say, tax
interventions) pale in
comparison with those arising from the underutilization of a
country's resources.
24
Moreover, developing countries are rife with
market inefficiencies; even in developed
countries, capital markets are characterized by imperfections, many
associated with
inherent limitations caused by imperfect information. Those who
argue against these
micro-economic interventions assume the economy is well described by
a perfectly
competitive model with perfect information and no distortions-- an
assumption
inappropriate for even developed countries, but particularly
irrelevant for the developing
world. Well-designed microeconomic interventions can increase the
efficiency of the
economy at the same time that they contribute to economic stability.
25
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